Bond Insurer Death Watch: FGIC Loses AAA from Fitch; Ackman Estimates Losses for MBIA and Ambac Each at $11.6 Billion (Updated)

Bloomberg reports that hedge fund Pershing Square's chief Bill Ackman has increased pressure on bond insurers and regulators by circulating a new analysis of potential losses to MBIA and Ambac, the two biggest bond insurers, that concludes the damage to each could reach $11.6 billion.

This calculation is arguably more accurate than Ackman's previous estiimates, since it uses a model provided by an investment bank (they typically get the assistance of the firms the report on in developing their models) and list of CDOs and other securities guaranteed by MBIA and Ambac. Ackman posted the list on the Internet so others can make their own computation; this is the first time the list has been made available (some but not all of the instruments were known to be guaranteed).

Note that the publication of this information likely complicates the insurer rescue effort by instilling some nasty reality. Note that Ackman's figures are merely the estimated losses; the bond insurers need to raise more than that to maintain their AAAs, which is the real purpose of this exercise. A downgrade to AA or even A is consistent with the insurers still being likely to be able to pay all their claims, yet would inflict considerable losses on the Street.

As we've reported in the last couple of days, some of the banks considering participating had been bandying about lower financial requirements than the $15 billion sought by Eric Dinallo; the bottom of the range was a reported $3 billion. They are now going to have to consider bigger numbers than some of them might have been prepared to accept.

Further pressure comes from the fact that Fitch announced that it has downgraded FGIC, the number four bond insurer, to AA, a reduction of two ratings grades. If I were a benevolent dictator, I'd have Fed worrying about the bond insurers and the adequacy of capital in the banking industry, rather than relying on and indirect and inefficient (and prone to side effects) remedy of monetary stimulus).

Update 1/30, 6:50 PM: My wording above may have been a bit oblique. The purpose of the bailout exercise is to preserve MBIA and Ambac's AAA ratings from Moody's and S&P (the other insurers, while included in the rescue efforts, are not where the main risk to the financial system lied). An AAA rating implies unquestionable financial capacity. Thus, any fundraising would not merely have to cover losses, but provide a large financial cushion beyond that. Egan Jones has put the total funding need at three times estimated losses, which some have argued is to high. But even if you assume only two times projected losses and you accept Ackman's $23.2 billion loss estimate, that means Dinallo's rescue effort is not seeking remotely enough capital.

Update 1/30, 10:00 PM: A reader sent me a copy of Ackman's letter. I have only looked at it quickly, but a couple of things are noteworthy. First, the model considers only losses on RMBS and ABS CODs. Ackman's earlier analysis also anticipated that there would be losses on MBIA's commercial real estate and below investment grade guarantees, so this model may underestimate the downside for MBIA. Second, the Bloomberg story did not mention that Ackman provided two loss estimates for MBIA, the $11.63 billion publicized, and $12.6 billion "of one reincorporated certain 2007 CDOs of ABS that have been reinusred." I haven't read the full document yet, but I presume this relates to the possibility of non-performance of MBIA's captive reinsurer, Channel Re.

First from the Bloomberg story on Ackman's moves; later an excerpt on the Fitch downgrade:

MBIA Inc. and Ambac Financial Group Inc., the two largest bond insurers, may each lose $11.6 billion on guarantees of residential mortgage securities and some collateralized debt obligations, according to hedge fund manager William Ackman.

Ackman calculated the losses using a model supplied by an unnamed investment bank and sent the findings in a letter to the Securities and Exchange Commission and New York Insurance Superintendent Eric Dinallo. Ackman is a managing partner of Pershing Square Capital Management LP, which is trying to profit from declines in the stocks and bonds of MBIA and Ambac.

Ackman, 41, stepped up his attack by posting on the Internet a list of asset-backed CDOs and other securities guaranteed by Armonk, New York-based MBIA and New York-based Ambac that allows others to craft their own loss predictions. Ackman didn't say how he got details on the securities, many of which haven't been disclosed by the companies.

``Up until this point in time, the market and the regulators have had to rely on the bond insurers and the rating agencies to calculate their own losses in what we deem a self-graded exam,'' Ackman said in a statement preceding release of the letter. ``Now the market will have the opportunity to do its own analysis.''

MBIA fell $3.12, or 20 percent, to $12.86 at 3:42 p.m. in New York Stock Exchange composite trading. Ambac dropped $2.13, or 16 percent, to $10.80. Both companies have lost more than 80 percent of their market value in the past year....

Ambac said Jan. 22 it expects to pay claims on CDOs of $1.1 billion. MBIA said Jan. 9 it will likely report a $737 million expense for the fourth quarter to cover losses related to deteriorating subprime-mortgage securities it guarantees. MBIA is scheduled today to report its fourth-quarter results after the close of regular U.S. equity trading....

In a Jan. 18 letter addressed to the top executives of each ratings company, Ackman said they are underestimating potential losses at MBIA and Ambac by relying on after-tax results, failing to update ratings on reinsurers of bond insurance and ignoring the slide in the commercial mortgage-backed securities market.

In addition to MBIA, Ambac and Security Capital, the other AAA bond insurers are those owned or operated by Assured Guaranty Ltd., CIFG Assurance North America, FGIC Corp. and Financial Security Assurance Inc.

From the Bloomberg story on the FGIC downgrade:

Financial Guaranty Insurance Co., the world's fourth-largest bond insurer, lost its AAA credit rating at Fitch Ratings after missing a deadline to raise capital.

Financial Guaranty, a unit of New York-based FGIC Corp., was cut two levels to AA, New York-based Fitch said today in a statement. The company had been AAA since at least 1991. Moody's Investors Service and Standard & Poor's are also reevaluating their ratings.

The loss of the AAA stamp jeopardizes ratings on bonds Financial Guaranty insured and limits the company's ability to generate new business......

``This announcement is based on FGIC's not yet raising new capital, or having executed other risk mitigation measures, to meet Fitch's AAA capital guidelines within a timeframe consistent with Fitch's expectations,'' the ratings company said today.

FGIC is controlled by Walnut Creek, California-based PMI Group Inc., Blackstone Group LP, and Cypress Group. PMI dropped 27 cents, or 2.9 percent, to $9.16 in New York Stock Exchange composite trading. Blackstone fell 43 cents to $18.56...

About 71 percent of FGIC's guarantees are on municipal bonds, 23 percent are structured finance and 6 percent are international transactions, according to the company's Web site. FGIC guaranteed $21 billion of home-equity securities, $8.8 billion of subprime mortgage debt, and $10.3 billion of CDOs backed by subprime mortgages and other loans, the Web site shows....

Blackstone, based in New York, bought Financial Guaranty with PMI Group and Cypress Group from General Electric Co. for $1.9 billion in 2003.

S&P Drops $534 Billion Bombshell

The bad numbers get bigger all the time. This eyepopping $534 billion figure for the amount of debt that Standard and Poor's plans to either downgrade or put on negative watch was released a couple of hours ago after the exchanges were closed (sorry, I saw it but was unable to post till now). The markets already gave up their quick spell of cheer from the Fed's 50 basis point cut due to further bad news on the bond insurer front. The continuing drumbeat of grim developments on the credit front is a reminder that the underlying problem is one of solvency, and in the vast majority of cases, lower interest rates will not turn bad debts into good ones.

S&P was also so kind as to estimate that these moves could increase bank losses, now at roughly $130 billion, to $265 billion. That may test the patience and/or confidence of our friendly junkies, um, sovereign wealth fund rescuers.

Needless to say, expect a rough ride in the markets tomorrow. The Fed is running out of firepower.

From Bloomberg:

Standard & Poor's said it cut or may reduce ratings on $534 billion of subprime-mortgage securities and collateralized debt obligations, the most sweeping action in response to rising since home-loan defaults.

The downgrades may extend bank losses to more than $265 billion and have a ``ripple impact'' on the broader financial markets, S&P said in a statement today. The securities represent $270.1 billion, or 47 percent, of subprime mortgage bonds rated between January 2006 and June 2007. The New York-based ratings company also said it may cut 572 CDOs valued at $263.9 billion.

The reductions may increase losses at European, Asian and U.S. regional banks, credit unions and government-sponsored enterprises such as Fannie Mae, Freddie Mac and the 12 Federal Home Loan Banks, S&P said. Many of those institutions haven't written down their subprime holdings to reflect a drop in market values and these downgrades may force them to recognize losses, S&P said.

``It is difficult to predict the magnitude of any such effect, but we believe it will have implications for trading revenues, general business activity, and liquidity for the banks,'' S&P said. The ratings company will start reviewing its rankings for some banks, especially those that ``are thinly capitalized,'' it said.

S&P downgraded $50.1 billion of subprime-mortgage securities, none rated higher than A+. More than 69 percent of the AAA rated subprime securities from 2006 and 46 percent from the first half of 2007 were placed on review.

``This one, I didn't see coming,'' said Mark Adelson a consultant at Adelson & Jacob Consulting LLC in New York, and a former asset-backed bond analyst at Nomura Securities.

Some of the largest global banks have already taken ``significant'' losses and they aren't likely to have more writedowns, S&P said. CDOs repackage assets into new securities with varying degrees of risk, from AAA grade to unrated classes. Subprime loans are made to people with poor credit.

Under accounting rules, many smaller banks haven't been required to write down their holdings until the credit ratings fell, enabling them to avoid the losses at bigger competitors including Citigroup Inc., Merrill Lynch & Co. and UBS AG. The world's largest banks have reported losses exceeding $133 billion related to mortgages, CDOs and high-yield, high-risk loans, according to data compiled by Bloomberg.

``If you're holding a AAA piece and it's now downgraded to AA, you might have to write it down, even if you're holding it for an investment,'' Gary Gordon, a bank stock analyst at Portales Partners LLC in New York, said. ``The longer it goes on and the higher the credit rating of the instrument downgraded, the wider the pain.''

Central Bankers: Securitization is Dead, Long Live Banking

John Dizard, in "Prepare for return of a direct lending world," argues that central bankers believe that securitization is not coming back in any meaningful way in the foreseeable future, and banks will therefore have to roll up their sleeves and do old-fashioned lending in much greater volumes than before.

That may seem like a very bland statement, but it is tantamount to saying that a comet has wiped out most of the mammals and the dinosaurs will rise again.

The dinosaurs may indeed have been written off prematurely, but a reversal of the financial services industry pattern of the last 30 years away from balance sheets towards market intermediation will have profound implications. Due to space limitations, Dizard only alludes to them; I'll tease them out.

The first is a shrinkage and radical reformation of Wall Street. The industry's revenue model has shifted from a mix that varied from firm to firm of investment banking (underwriting and M&A), equities, fixed income, and asset management, toward one heavily skewed towards fixed income, with some leavening from prime brokerage (the big profit item here is lending to hedge funds) and asset management at certain firms.

Cyclically, employment on Wall Street peak to trough usually falls about 20%. But a lasting repudiation of the securitization model could lead to even deeper, permanent cuts, although the investment banks may be in denial over its change in fortune. For example, investment trusts, the speculative vehicles that led to the stock market bubble that culminated in the 1929 Crash led to a distaste for pooled vehicles of all kinds, even though some of the trust had been honestly and conservatively managed. It wasn't until the 1950s that memories had faded enough for mutual funds to become a growth industry. It might take that long for bad memories of the damage inflicted by securitization to fade.

Banks have been losing market share in financial intermediation to investment banks since 1980. If banks have to keep more assets on their balance sheets due to a lasting reduction in securitization, it will require a massive increase in bank equity. And where will that come from? The Anglo-Saxon nations that have historically dominated finance have been profligate borrowers and have had low savings rates for many years. The only places that can fill the void are the high-savings nations: China, Japan, the Gulf States, Taiwan. There has already been tooth-gnashing and worries about foreign influence due the investments made by sovereign wealth funds in faltering investment banks.

If the central bankers' forecast is accurate, the shift in financial gravity will be more rapid and complete than observers and industry members anticipate. Even if London and New York nominally remain leading financial centers, the natives will no longer call the shots.

From the Financial Times:

At the beginning of the year I floated a deliberately heretical thought: that it would be impossible to recapitalise adequately the US banking system with new investments of actual cash. Instead, I suggested, it would be necessary to return to a discarded 1980s concept. Not padded shoulders for power suits, though that might help as well, but "supervisory goodwill". That was an accounting tool used by US regulators to allow weak and reorganising depository institutions to meet their capital requirements by using a sort of pretend equity. By the end of the decade, supervisory goodwill, at least under that name, was prohibited by an act of Congress.

I was hoping for a blast of angry mail from readers, particularly those at regulatory agencies and central banks. It never appeared, since it turned out that there was a lot of re-thinking about bank capital adequacy being done by the official and semi-official world. Heresy and irresponsible suggestions were, at least for a moment, allowed.

In the space of just three weeks, though, forced writedowns of asset values, surprising disclosures and the consequent market reactions are forcing a new consensus within the central banking world. There isn't a lot of time to play with what-if's. The "ifs" happened.

Wall Street and the City have been waiting for a series of magical events that will allow the securitisation machine to re-start. Recapitalising the monoline insurers, one-time injections of new equity for banks from sovereign wealth funds, a revival of stock market confidence; all those were, collectively, supposed to revive off-balance-sheet lending.

That's not what the central banking world is thinking. The official world, and those close to it, are anticipating that we're going back to an on-balance-sheet financial industry. That is, the extension of credit will be done, to a much greater degree, through direct lending by depository institutions rather than through the securitisation of structured products. The frenetic expansion of securitised and, it was supposed wisely distributed, risk turned out to be not quite so wise after all.

The problem with putting credit on bank balance sheets is that those balance sheets aren't big enough to cover the losses from past practices and to continue to expand credit at an adequate pace. Shareholders' equity and reserves aren't there, at least in the necessary size.

Very true, the central bankers will say. So we'll just have to get some new shareholders. The "real money investors" are there, and not just the sovereign wealth funds. What about the present shareholders, I ask, my face turning white? As Colbert memorably said: "A banker is a soldier in the service of the state." So perhaps the rally in bank shares might be a little premature. The central banking world is expecting a serious shake-out of individual and perhaps institutional participants.

New money will come in to recapitalise US banks, and perhaps eventually the European banks, but it will demand seniority to existing shareholders. And it will get it. The central banks do care about the capital adequacy of the institutions they oversee and to whom they grant cheap funding. But if mistakes were made under an old regime, then the people who bet their money on that regime are just out of luck.

It won't be enough, of course, to simply assign existing bank shareholders to the role of cannon fodder. The new shareholders have to be given some assurance that there will be sufficient operating cash flow to take care of them, and to finance any further write-offs for, say, losses on leveraged buy-outs or credit cards.

What follows, I believe, will be steep yield curves for some time. Net interest margin, not deal fees, is in the end what the banking business is all about. The central bankers are less comfortable talking about this implication, but it would seem inescapable. The steepness of the yield curve has to come more from low rates at the short end than high rates at the long end, or those McMansions will be underwater for a lot longer than the political system can bear.

During the transition to a new set of shareholders, who will profit from the on-balance-sheet world, the central banks will probably be willing to have case-by-case exceptions to the rules on capital adequacy. They are opposed to black-letter, across the board, permanent changes in capital adequacy rules. Write-offs can be stretched out a bit, or ratios allowed to run a bit thin, but there is not the intent to adopt the let's-pretend style adopted by the Japanese banking system in the early 1990s.

As for the rating agencies . . . there will be a quiet demotion, rather than a purge. Central bankers believe the agencies will not have the same significance in an on-balance-sheet world. During securitisation's heyday, they enabled the other participants in the obscuring of risks. Structured finance isn't over, but the lack of transparency effectively allowed by the abuse of the ratings system has been noted. We're not going back to the pre-structured finance world, but it will be much simpler, and subject to much better disclosure.

Bond Insurers Still Twisting in the Wind

While there was not much in the way of new developments on the bond insurer front on Tuesday, the media chatter features some interesting cross currents.

On the one hand, the Financial Times, which had some relatively upbeat coverage the day before, had an article on the impressively large level of short interest in the two big monolines, MBIA and Ambac, While the markets aren't perfect at forecasting, this is a vote of little confidence in the rescue efforts underway:

According to Data Explorers, which tracks short selling, the percentage of shares on loan relative to the market capitalisation of Ambac stood at 40 per cent last Thursday. For MBIA, the proportion was 39 per cent.....

Current short levels are below the highest proportion of borrowed shares reached at the beginning of January for the bond insurers. However, they still represent a very high level of borrowing.

Even in other cases where shares have been shorted, such as those of UK bank Northern Rock last year, the proportion of shares on loan to market capitalisation rarely reaches the levels on Ambac and MBIA. Data Explorers said that Northern Rock's borrowed shares peaked at about 22 per cent of market capitalisation in September of last year.

Note that the level of short interest isn't just a function of how much investors hate the company; it also reflects how easy it is to borrow the stock. Nevertheless, the betting against Ambac and MBIA is, shall we say, noteworthy.

The Wall Street Journal has two stories today. The first is on how insurance regulators are considering closing the gate now that the horse has left the barn. While it's probably a good idea to keep insurers away from risky instruments they have demonstrated they don't understand, the remedy, closing a loophole dating from 1998, is a bit late in coming. The article focuses on how this bond insurers muscled their way into a business that it proving to be their undoing. Nevertheless, the regulators sound surprisingly timid, fearful of inhibiting innovation. Someone might point out that lobotomies and zeppelins were also innovations.

From the Journal:

Their problems have led New York state Insurance Superintendent Eric Dinallo in recent days to attempt a rescue plan to save bond insurers that could involve financial help from Wall Street firms....

It also is forcing insurance regulators, including Mr. Dinallo's office, to reconsider the 1998 legal loophole that allowed bond insurers to issue credit-default swaps through shell companies called "transformers."

Their activity in derivatives has exploded in recent years. With a credit-default swap, one party, for a fee, assumes the risk that a bond or loan will go bad. The bond insurers wrote such swaps on around $100 billion in complex mortgage securities during the past few years, according to ratings-company estimates...

In a letter to the New York insurance department in 1998, an insurer, Financial Security Assurance Inc., argued that such swaps deals were similar to FSA's existing business of providing guarantees on other types of bonds, albeit through insurance contracts.

"From bond insurers' vantage point, this was identical to their core business," although it involved a different type of contract, said Bruce Stern, FSA's general counsel, who wrote the 1998 letter. "A demand was emerging for guarantees of bond portfolios and it seemed natural for bond insurers to want to do that," he said. FSA has avoided big losses that have hit other bond insurers because it didn't enter the riskiest parts of the business, he said. FSA is a unit of Dexia SA of Brussels.

An insurance examiner working for Paul M. De Robertis, a supervisor in the department's property-casualty bureau, responded in April 1999 that the insurance regulator concurred "with your interpretation of the insurance law."

"Other insurers saw this FSA letter and that is how the 'transformer' business got a boost," said Joseph Buonanno, whose law firm, Hunton & Williams LLP, represented a number of bond insurers in recent years that set up such entities. After New York insurance regulators gave bond insurers their blessing, other state insurance regulators followed suit and the business of writing credit-default swaps on packages of mortgage securities took off.

Following the regulatory green light, bond insurers set up shell companies under Delaware state law. They were known in the industry as transformers because they transformed a traditional bond-insurance contract into a credit-default swap...

The transformers, which in many cases were private companies incorporated in Delaware, issued credit-default swaps to banks and Wall Street firms on corporate and mortgage securities, including many pools of debt known as collateralized debt obligations.

The bond insurers, in turn, guaranteed the transformers' obligations, which required them to pay the interest and principal on the bonds if the securities defaulted. The liabilities of the transformers were consolidated with the financial statements of the bond insurers.

From the perspective of the bond insurers, their obligations under the credit-default swaps business were similar to traditional municipal bond insurance. In both cases, the insurer had to make interest and principal payouts to customers if a bond defaulted.....

For Wall Street firms, the bond insurers' willingness to sell credit-default swaps was a potential bonanza. The swings in the market values of the swaps these transformers sold to Wall Street helped the banks offset fluctuations in the value of the bonds underlying their own transactions. The swaps also benefited the banks by freeing capital, because it allowed the banks to move commitments off their balance sheets. In many cases, the deals enabled the banks to book sizable profits upfront.

The last story is a progress report of sorts on the rescue mission, and it reads very much like a PR plant. Everyone is playing well in the sandbox, even though there is no consensus on how big the rescue effort should be. The numbers bandied about are $3 billion to $15 billion, which is such a wide range as to be a bad sign, particularly since insurance superintendent Eric Dinallo wants $15 billion, a number in light of the continuing deterioration of real estate is likely to be too low; Egan Jones puts the number needed merely to cover losses at $80 billion, and maintenance of an AAA requires a cushion well beyond that While that may be high, the fact that it is so much larger than the numbers under consideration suggest the deal is being envisioned in terms of what the firms might conceivably stump up, as opposed to what level is really needed.

The other amusing bit is the discussion of the options under consideration:

Among the possible solutions being formulated are capital infusions from outside investors or the banks themselves. The Wall Street firms could also arrange to provide a massive line of credit to the bond insurers, giving those firms a cushion of cash.

Another possibility is that the banks could fund a newly created firm that would assume some of the risks or liabilities on bond insurers' books -- an arrangement known as reinsurance. This could free up capital to the insurers but is unattractive to some Wall Street firms wary of taking on unpredictable liability.

Capital infusions are structurally the easiest solution once you figure out how to divide the amount committed among the firms that need the dough (which would not be trivial). But no one expects any outside investors to come to the table, despite the rumors that Wilbur Ross is having a look. He has never done a deal in financial services or in a heavily regulated industry. The theories for his interest are cynical (he is using due diligence as a cheap way to do research on whether a de novo entry would be viable; he is currying favorable press to counter his bad guy, asset stripper image).

A credit line would be easy and appealing for Wall Street, but it isn't clear that that will be sufficient for the insurers to keep their AAA ratings, which is the purpose of this exercise. Both of the two big rating agencies had called on MBIA and Ambac to raise more equity.

The reinsurance idea might be workable if you were dealing with only one firm, but it has the potential to break down in the structuring phase with so many firms involved. And it is vastly more labor intensive than the other options, since they will have to create a new firm, which argues against it. What are the decision rules for what assets go in and go out? How much capital does the reinsurer need? Who runs it? What are its investment policies?

Despite the upbeat talk, the lack of agreement on the funding target and structure says, no matter how many hours have been put in, no serious issues have been resolved. This airplane is idling on the runway.

UBS Posts Loss After $14 Billion Writedown

$14 billion? I thought I'd be inured to big negative numbers coming from investment banks by now, but I caught my breath when I read the headline of the Bloomberg story reporting that UBS is taking a further $14 billion in writedowns, resulting in a $11.4 billion loss for the fourth quarter.

Remember, when UBS and Deutschebank had taken third third quarter markdowns, they were seen as aggressive. The stock market even staged a rally believing that the financial institutions were putting their problems behind them. My, don't those ideas seem quaint now?

Indeed, when UBS announced its 3Q writedown of $4.7 billion, it forecast a profit for the fourth quarter. On December 10,
the bank announced that it planned to write off $10 billion for fourth quarter. It also intended to shore up its balance sheet by selling $11.5 billion (SFr 13 billion) of convertible bonds to the Government of Singapore Investment Corporation and an unnamed Middle Eastern investor, along with some other measures to boost equity.

Note that UBS was not a top player in structured credit origination. This turn of events does not bode well for earnings season among investment banks.

As Bloomberg reports:

UBS AG, Europe's largest bank by assets, reported a record loss after about $14 billion of writedowns on assets infected by subprime mortgages in the U.S.

The fourth-quarter net loss of 12.5 billion Swiss francs ($11.4 billion) will result in a full-year loss of about 4.4 billion francs, the Zurich-based bank said today in an e-mailed statement. The fourth-quarter loss was almost double what analysts surveyed by Bloomberg were estimating. UBS plans to publish its official financial results on Feb. 14.

UBS posted its first annual loss since the company was created through a merger a decade ago, and the fourth-quarter loss was bigger than the record declines reported earlier this month by Citigroup Inc. and Merrill Lynch & Co. The collapse of the U.S. subprime mortgage market has led to more than $130 billion of losses and markdowns at securities firms and banks since June.

UBS reported about $12 billion of losses directly linked to the subprime market and an additional $2 billion for positions related to the U.S. residential market. The company said its so- called Tier 1 capital ratio, a measure of financial strength, was 8.8 percent as of Dec. 31.

Links 1/30/08

Judge accuses RIAA of ‘gamesmanship’ P2Pnet

FBI Probes 14 Companies Over Home Loans Huffington Post. They aren't saying who is targeted, but the FBI is looking into fraud in the securitization process, and insider trading.

FDA flawed on food, medical device safety: GAO MarketWatch

It’s 2002, All Over Again: Homeownership Registers Record Drop in 2007 Housing Wire

OldVet: Jingle Mail Revisited Angry Bear. You reap what you sow....

Yet More Cheery Housing Charts

Sometimes a picture is worth a thousand words....does that mean two are worth two thousand?

From the Businomiics Blog; the underlying data comes from the Census Bureau.





While local markets don't always conform with national patterns, this is another confirmation that a housing recovery is not just around the corner.

Non-Borrowed Bank Reserves Now Negative (Updated)

Reader Carl about ten days ago had sent me a link to a Federal Reserve data series "Aggregate Reserves of Depositary Institutions Adjusted for Reserve Requirements." The series goes back to 1975.

What caught Carl's attention was that the ""non-borrowed reserves" column, under the "not seasonally adjusted" heading, to the right, shows negative values for the last two weeks in January. While the seasonally adjusted non borrowed reserves figures posted are positive, they are so weakly positive as to also be troubling.

This table is cumbersome to read because it contains over 30 years of data and the headings are only at the very top, so I am providing the headers and the most recent data (as of Jan. 24) for December and January to date. Click on them to enlarge. However, you might find it easier to view them at the source.






I would have made noise about it at the time, but I don't normally look at this series, and although the lack of apparent reserves looks quite alarming, it appears to be the result of the operation of the Term Action Facility, which allows banks to post collateral with the Fed and borrow funds for a month (the rate is determined via auction, hence the name). Although some readers quibble with my characterization, I view it as a discount window without the stigma (the participants remain anonymous).

There might have been some technical reason for the numbers looking as bad as they did (and still do) so I was (contrary to usual form) reluctant to stick my neck out. However, if you take the data at face value. the implication is that banks are leaning heavily on the Fed, and if this isn't opportunistic, this would appear to be a very bad sign.

For a frame of reference, just go to the data series and quickly scroll back. There is nothing like this result anywhere in history, not during the Volcker credit crunch, the 1987 crash, the emerging markets and later LTCM crisis, or 9/11. The negative reserves have no historical parallel, nor do the adjusted reserves dropping so close to zero.

Note also there was a very big ratchet down the two weeks before the big fall in the last two weeks. The seasonally adjusted reserves fell to less than a quarter of their former level, and again, the absolute value being that low in unprecedented.

Michael Shedlock (hat tip reader Owen) jumped on this today, via a chart from the St. Louis Fed:



The problem is I am not certain how much of this is due to real stress as opposed to banks taking advantage of a free lunch, since the TAF is giving out one-month loans at 3.123%. at the Jan. 29 auction. That's less than interbank rates, and you get to post terrible collateral too. Everyone with an operating brain cell should be taking as much of this dough as they can, and they clearly are.

But having now created dependence on unduly cheap money, and getting an unprecedented and (at least to me, Shedlock, and concerned readers) scary chart, how is the Fed going to wean the banks off the TAF? And if we have another credit seize up despite the TAF, one can only expect the Fed will crank up the level of funding on offer.

The non-borrowed reserves dropping in the last two weeks seems inconsistent with the pace of the credit crisis. Recall that the the TED spread, the gap between short-term bank borrowing rates and Treasuries rose sharply and by November had hit levels that were troubling, indicative of banks' reluctance to lend to each other. An initial joint operation by central bankers did not break the logjam; a big liquidity operation by the ECB, plus the TAF, did.

The factor making the tightness in bank funding markets worse was that liquidity routinely goes way down at year end (banks cut down on trading to tidy up their books). That pattern was kicking in even earlier than usual in an already-tight credit market. So you would have expected to see the negative reserves pattern (if ever) prior to year end, when the funding needs would be acute and the TAF would be a particularly important source of funding. Why are we seeing this change now, in later January?

For those who want to ponder this matter further, Shedlock was also good enough to provide a backgrounder on borrowed reserves from the book Investing Public Funds by Girard Miller:

Another useful indicator of the Federal Reserve's relative monetary policies can be found weekly in the Federal Reserve data. A key statistic is the net free reserves or net borrowed reserves line item. This statistic measures the degree to which depository institutions have found it necessary to obtain funds in the Fed Funds market and through the Fed discount window in order to obtain required reserves.

During periods of central bank credit-tightening operations, the depository sector might find it necessary to borrow funds to meet reserve requirements. This practice results in net borrowed reserves, which shows as a negative number. Conversely, if ample funds are available through the banking system to meet reserve requirements, banks can become net lenders of reserves through the Fed Funds markets.

Rational agents respond to incentives, and the incentive is to take all the TAF dough you can. But the fact that total reserves also dropped during this period also lends credence to the idea that this dramatic drop in non-borrowed reserves is decidely Not a Good Thing.

Analysts: Bond Insurer Bailout Likely to Come Too Late

Readers know that we've expressed doubts that a rescue plan for the struggling bond insurers will even come into being, so the idea that it would be too late is safer bet. Although it is possible the rating agencies will be pressured into holding off further on their long-overdue downgrades, they've been under that sort of pressure for a very long time. And unlike banks, they don't have a powerful regulator who might make life miserable for them.

Note the lack on convergence among analyst estimates as to the level of losses continues, but the tendency towards dire forecasts seems to be rising. JP Morgan estimates the guarantors will suffer $41 billion in losses, which is more than twice the industry's total equity. That level of impairment also means the rescue plan would be a complete loss to the backers, since even an additional $15 billion would be insufficient to cover the expected losses, let alone preserve an AAA, which requires a much greater equity cushion. Another analyst forecast losses of $65 billion, which according to their estimates, impliesa required capital infusion of $130 billion.

From Bloomberg:

Bond insurers led by MBIA Inc. and Ambac Financial Group Inc. may lose their top AAA ratings before they benefit from any rescue plan.

The bond insurance industry stands to lose $41 billion on securities linked to subprime and other mortgages, according to JPMorgan Chase & Co. analysts. Efforts by New York Insurance Superintendent Eric Dinallo, 44, for a $15 billion fund to bolster insurers' capital are likely to be overtaken by events, independent research firm CreditSights Inc. said today.

``Given the number of competing interests and levels of commitment of participants involved, we think it is unlikely that an agreement sponsored by Dinallo could be hammered out within the appropriate timeframe,'' CreditSights analysts Rob Haines, Craig Guttenplan and Joe Di Carlo in New York wrote in a report. ``In the offchance that any deal could be solidified, the rating agencies are likely to have already taken action.''

The industry guarantees about $2.4 trillion of securities issued by U.S. cities and states and bonds backed by mortgages, credit cards and other assets....

Losses at MBIA may reach $8 billion and those at Ambac may climb to $11.4 billion, according to JPMorgan analysts Chris Flanagan and Kedran Garrison Panageas in New York. Such a scenario would consume 80 percent of claims-paying resources at Ambac and about 50 percent at MBIA, they wrote in a Jan. 25 research note.

Bond insurers' total losses may be as high as $65 billion, according to Independent Strategy, a London-based financial consultancy set up in 1994 by David Roche, a former head of research at Morgan Stanley. The estimate assumes a loss rate of 18 to 22 percent on $250 billion of credit derivatives linked to U.S. property, plus $90 billion of insurance on foreign real estate.

The insurers will need about $130 billion to cover the losses and to recapitalize, and the cash will have to come from taxpayers, Independent Strategy said in a statement today.

Ratings Cut

Fitch Ratings cut the AAA ranking on the financial guarantee units of Ambac in New York and Bermuda-based Security Capital Assurance Ltd. earlier this month. The ratings company is due to rule on whether Financial Guaranty Insurance Co., the fourth- largest bond insurer, has raised enough capital to preserve its AAA rating.

``We are expecting to see a downgrade of FGIC any day now,'' said CreditSights, which has about 700 clients including Wall Street's biggest banks and brokers.

FGIC in Stamford, Connecticut may have its ratings cut by as many as four levels to A+, Michael Cox, an analyst at Royal Bank of Scotland Group Plc in London, wrote in a report published today. The insurer's rankings may be reduced today, he wrote.

The bond insurers, which began by guaranteeing the notes sold by U.S. municipalities to fund roads and schools, are incurring losses after expanding into structured finance such as collateralized debt obligations. CDOs repackage pools of bonds, loans and credit-default swaps and slice them into separate pieces of varying risk and return.

Writedowns Triggered

Lower ratings for the insurers may cause a new round of writedowns on debt holdings at the world's financial companies, potentially forcing banks to raise another $143 billion to bolster capital, analysts at Barclays Capital said last week.

Merrill Lynch & Co. wrote down $1.9 billion of securities and Canadian Imperial Bank of Commerce had to sell more than C$2.75 billion ($2.7 billion) in stock to cover losses after the credit rating of ACA Capital Holdings Inc.'s financial guaranty business was cut 12 levels to CCC by S&P.

Ratings cuts for other bond insurers will be ``much, much smaller than those for ACA, given their stronger starting capital position,'' Bank of America Corp. analysts led by Jeffrey Rosenberg wrote in a report yesterday.

Saving the bond insurers ``will ultimately require a broader multi-faceted regulatory response,'' CreditSights said. In the meantime, the most likely sources of cash infusions are ``white knight investors'' such as billionaire Wilbur Ross, who has expressed interest in buying Ambac, according to the analysts.

Bond Insurer Update: Surprisingly Positive Noises from the FT; Egan Jones Conference Call

Despite the seeming absence of news on the bond insurer rescue front (the only development reported was the selection of the boutique M&A advisory firm Perella Weinberg to assist the State of New York in its efforts to put a deal together), the Financial Times has four articles on it today, from the neutral to upbeat in tone, including the lead article, "US bond insurer rescue takes shape."

One robin does not make a spring, and although the FT is generally more sober than the Wall Street Journal, there were a couple of occasions during the failed SIV bailout effort when the pink paper slipped into an uncharacteristic cheerleading role. (Note I am focusing on the FT because the only other news sighting was a report on the Perella Weinberg engagement in the Journal).

The positive reading from the FT comes from three developments: the Perella Weinberg appointment, the Fed encouraging a deal from behind the scenes, and the claim by some analysts that the amount required is less than the $5 billion pretty pronto/$15 billion in total that insurance superintendent Eric Diallo is seeking. Let's deal with each separately, and also discuss the economics of a deal from an investment bank's perspective.

Perella Weinberg involvement. We had commented that Dinallo and his team almost certainly lacked dealmaking skills, and they were essential for an undertaking like this, particularly since Dinallo is regarded with some antipathy on Wall Street.

While Perella Weiberg has a very senior and seasoned team of merger and acquisition pros, they would not have been my first choice. While the all star team has highly regarded individuals, its knowledge of trading and risk management looks thin (they have one partner, William Kourakos, led Morgan Stanley's capital markets operations at various points through 2004. However, his experience appears to be in high yield bonds and emerging credits, in other words, "story paper" that is more equity than bond like. Similarly, looking at the partners' bios, I saw no evidence of deals experience in financial services. The reason that is a negative is that regulatory issues create another level of complexity, particularly when you have at least two (insurance and investment banking) and possibly three (commercial banking) sets of regulations that might impinge. (Mind you, counsel typically works through the nitty gritty regulatory issues, but if the principals negotiate a deal that somehow runs afoul of a regulatory constraint, it will be very difficult for an agreement with many players and moving parts to be rejiggered).

Similarly, while the partners of the firm are highly regarded, I am not certain how much their stellar reputations and networks buy them with the leaders of the trading operations who will play a key role in any deal.

Had I been Dinallo, I would have tried to get someone with the deal equivalent of star power who also had experience with government or regulatory issues, with Paul Volcker and Felix Rohatyn as first choices (although Rohatyn's senior advisor role at Lehman might be perceived as a conflict of interest). I'm not current on who the best picks might be, but top M&A lawyers also have ample deal making-cat herding skills, and the right law firm in combination with an eminence grise would have been a more powerful combination (in fairness, Dinallo might have tried this route and not been able to get the parties on board).

Fed involvement. The FT article on the Fed's support itself is oddly ambiguous. The title, "Fed quiet on bond insurers rescue," suggests the central bank is doing comparatively little, while the text suggest more may in fact be happening:

In public, at least, it would seem not. In recent days, it has been Eric Dinallo, New York Superintendent of Insurance, who has spearheaded efforts to cut a deal...

By contrast, the New York Fed, and its president, Tim Geithner, have been notably silent, avoiding comment on the issue altogether. This stance is partly because official responsibility for overseeing the bond insurers rests with the state insurance regulators, not the Fed. Thus the insurance regulator from Wisconsin, which regulates Ambac, one of the two biggest bond insurers, also took part in the meeting with banks.

Bankers believe the Fed also wants to avoid derailing private sector efforts to resolve the crisis, either by stepping in too early or forcefully. “LTCM means everyone is now looking to the Fed but the Fed does not want to give the impression that it will just sort things out,” says one former US official, who points out that the “impetus must come from the private sector”.

But there is little doubt that many Wall Street bankers fervently hope the Fed will become involved. Mr Geithner commands considerable credibility on Wall Street. Mr Dinallo, by contrast, invokes more mixed emotions among some bankers because of his previous involvement in enforcement actions.

“This . . . should be organised at a Federal level, not by state regulators,” a senior official at one Wall Street bank claimed in Davos last week.

Bankers involved in the monoline discussions say that, while the Fed initially hung back, it is now an active player in the discussions, albeit discretely. “The Fed is absolutely involved now,” says one policymaker.

In my mind, the issue of the Fed's involvement is an open question, It actually did very little in the LTCM crisis beyond call the heads of 25 firms to its office and tell them there was a big problem looming that they had better sort out. However, the head of the New York Fed's trading desk, Peter Fisher, had been invited by LTCM to look at its books, which added credibility to the Fed's hard nudge to get a deal done. By contrast, here the Fed not only has not examined the financial condition of the bond insurers, but it also lacks the expertise to do so.

Suggestions that bailout costs may be lower than Dinallo target. Dinallo is seeking an eventual $15 billion. The FT says that some firms beg to differ:

Some analysts and bankers believe that figure is too high. Compared with Merrill Lynch’s $3.1bn write-offs linked to monoline hedges, $15bn from all banks may look fairly small, but Merrill’s contracts were mostly with ACA Capital, the bond insurer closest to insolvency.

Writedowns from ratings downgrades to other monolines would not be half as painful, bankers insist. Geraud Charpin, analyst at UBS, believes an industry-wide downgrade from AAA to AA would lead to $10bn in total writedowns at the most for banks on monoline-guaranteed structured bonds such as mortgage-backed debt.

Standard & Poor’s said this month it expected total after-tax losses for the monoline industry from mortgage-backed bonds and the more complex collateralised debt obligations to be $13.6bn.

S&P’s assessment could worsen, particularly since its estimates of losses had grown by 20 per cent, or almost $2.5bn, since its previous examination in mid-December.

S&P said this growth was not significant in terms of individual companies’ capital strengthening plans. A number of monolines have talked about raising $1bn-$2bn of new capital, which across the eight or nine most important groups leads to the proposed $10bn-$15bn.

Some see this figure as inadequate. Independent Strategy, a London-based research house, believes closer to $140bn is needed. But this includes higher loss estimates of $73bn and an increase in the ratio of claims paying resources to total insured liabilities from about 2 per cent to 5 per cent.

The average ratio of monoline equity to total net exposure is a shade under 1 per cent, so a new vehicle operating on a similar basis would need more than $21bn to take on the full $2,400bn in existing industry liabilities.

Banks could ask how much might be needed to set up a vehicle to take out the most toxic exposures. UBS estimates those to amount to about $130.7bn for the six biggest companies, suggesting a starting point for equity of only about $1.3bn.

Perhaps these numbers are being bandied about for negotiating purposes, but if anyone believes them, they need their head examined. ACA has only $60 billion in guarantees, rounding error compared to what is at issue with Ambac and MBIA. And the idea that 1% in equity would be adequate with a portfolio of assets chosen for their dodgyness is ludicrous. The average loan loss reserve for commercial banks for 2006 when the economy looked good and in retrospect, banks were under-reserving, was 1.2%. Although I think rating agency Egan Jones' estimates tend towards the pessimistic, they believe that the bond insurers will take losses of 10% to 35% on the subprimes, CDOs and other structured credits.

Another issue mentioned in the Egan Jones conference call yesterday which we have not delved into in detail is where any investment will sit in the capital structure. The two courses of action that Perella Weinberg is examining is a backup credit facility and an equity investment.

But while a backup facility normally sits high in the capital structure, for insurers, policyholders are first in line in any payout. And the problem here is that any money put up by Wall Street is not for their benefit, but for all the policyholders.

So let's say the firms are worried about their CDO exposures. Let's say they decide to fund $15 billion in a credit line. Let's say $5 billion in deals go a cropper. But the firms that put up the credit line own only 15% of the deal in aggregate. So most of the payout goes to unaffiliated parties.

So the benefit of this operation is not to assure payouts, but to prevent a downgrade because that leads to forced sales by investors who can only hold paper than falls in certain ratings buckets, and in turn forces the Street to price similar holdings lower. But the level of capital required to maintain an AAA is far larger than that required to merely assure that claims are paid for the next year or two

And the estimates of what a downgrade scenario might cost in aggregate vary considerably, which means that different firms are likely to reach very different conclusions, based not merely on their exposures but on their assumptions of loss percentages on those exposures. And lack of agreement on the nature and magnitude of a problem again makes it harder to reach a resolution.

As I've said before, a deal isn't impossible, but it certainly doesn't look likely.

Fed Approaches Negative Real Interest Rate Territory

While the question of whether the Fed will lower interest rates again after its emergency cut last week is still up in the air, it is pretty clear that further cuts in the Fed's target rates are in the offing. And the markets believe the Fed will continue to cut quickly, putting the odds of a 50 basis point cut tomorrow at 88%

At a Fed funds rate of 3.5%, some would say the Fed has already created negative interest rates:



This view, that published real inflation rates understate the real level of price increases, is due at least in part to the work of the Boskin Commission, whose work led to changes in the computation of the consumer price index in the mid 1990s. Some believe that these moves lowered reported CPI by 0.5%, others argue for 1%, while others, per the chart above, believe the dispartiy is even greater.

Why should we believe that the old CPI metric is better than the one we have now? Consider the criticisms the Boskin Commission made of the "old" CPI, which then led to changed to address those issues. From Wikipedia:

The report highlighted four sources of possible bias:

Substitution bias occurs because a fixed market basket fails to reflect the fact that consumers substitute relatively less for more expensive goods when relative prices change.

Outlet substitution bias occurs when shifts to lower price outlets are not properly handled.

Quality change bias occurs when improvements in the quality of products, such as greater energy efficiency or less need for repair, are measured inaccurately or not at all.

New product bias occurs when new products are not introduced in the market basket, or included only with a long lag.

Of the list of four supposed problems, all but the second, outlet substitution, are completely at odds with the concept of what an index is supposed to do, which is to track the price of the same grouping of items over time. For instance, the first one says that if the initial CPI included steak once a month and steak prices rise sharply, then the index should substitute hamburger.

But even if you trust the current inflation figures, a cut to 3% reaches the danger zone. And remember that borrowers that can deduct their interest payments from taxable income enjoy an even lower effective rate.

From Bloomberg:

The Federal Reserve may push interest rates below the pace of inflation this year to avert the first simultaneous decline in U.S. household wealth and income since 1974.

The threat of cascading stock and home values and a weakening labor market will spur the Fed to cut its benchmark rate by half a percentage point tomorrow, traders and economists forecast. That would bring the rate to 3 percent, approaching one measure of price increases monitored by the Fed.

``The Fed is going to have to keep slashing rates, probably below inflation,'' said Robert Shiller, the Yale University economist who co-founded an index of house prices. ``We are starting to see a change in consumer psychology.''

So-called negative real interest rates represent an emergency strategy by Chairman Ben S. Bernanke and are fraught with risks. The central bank would be skewing incentives toward spending, away from saving, typically leading to asset booms and busts that have to be dealt with later.

Negative real rates are ``a substantial danger zone to be in,'' said Marvin Goodfriend, a former senior policy adviser at the Richmond Fed bank. ``The Fed's mistakes have been erring too much on the side of ease, creating circumstances where you had either excessive inflation, or a situation where there is an excessive boom that goes on too long.''....

The central bank will probably lower the rate to at least 2.25 percent in the first half, according to futures prices quoted on the Chicago Board of Trade. The chance of a half-point cut tomorrow is 88 percent, with 12 percent odds on a quarter- point.

Inflation, as measured by the personal consumption expenditures price index minus food and energy, was a 2.5 percent annual rate in the fourth quarter, economists estimate. The Commerce Department releases the figures tomorrow.

The last time the Fed pushed real rates so low was in 2005, in the middle of the three-year housing bubble, when consumers took on $2.9 trillion in new home-loan debt, the biggest increase of any three-year period on record.

Aggressive rate cuts are justified if there's ``conclusive evidence'' that household income prospects are in danger, said Goodfriend, now a professor at the Tepper School of Business at Carnegie Mellon University in Pittsburgh.

Credit Crunch Collateral Damage: Deal for Credit Card Processor on the Rocks

Blackstone's pending $6.4 billion acquisition of Alliance Data Systems, a major credit card processor, may become an unexpected victim of the credit crunch. The deal is foundering not for the usual reasons, such as difficulty in raising debt financing or a change in business conditions leading the buyer to try to renegotiate the deal.

In this case, the Office of the Comptroller of the Currency, put unanticipated, tough conditions on the sale. While the problems the parties are facing are unique to this deal, it has sent a chill through the buyout industry. What other sorts of weird impediments might suddenly emerge?

Note it may be possible to salvage the transaction, for example, by excluding the Alliance's World Finance bank subsidiary from the sale.

From the New York Times:

The turbulence on Wall Street threatened to claim another victim on Monday as the Alliance Data Systems Corporation, the big credit card processor, warned that its proposed $6.4 billion buyout might unravel.

The Blackstone Group, which agreed to buy Alliance Data last May, told the company on Friday that bank regulators had placed “unprecedented and unacceptable requirements” on the acquisition, Alliance Data said...

Blackstone said in a statement on Monday that the Office of the Comptroller of the Currency, a federal banking regulator, had placed onerous requirements on the deal but that the firm would continue to work with Alliance Data to win the approval of the comptroller. But Blackstone reiterated that it regarded the regulator’s requirements as a deal-breaker....

Monday’s announcement may set up a bitter legal fight, like those that arose after the collapsed buyouts of Sallie Mae and United Rentals. In its statement Alliance Data strongly denied Blackstone’s assertion that the deal could not be completed and said its board was “evaluating the company’s possible courses of action.”...

The situation has added complications because Blackstone has not blamed Alliance Data for breaching the deal agreement, which remains in effect. Neither side has acknowledged any problems related to the deal’s financing or the company’s financial health, an argument that has led to the crumbling of other buyouts.

But the agreement specifies that both parties must use their “reasonable best efforts” to win regulatory approval. Both sides saw the chance of a rejection by the comptroller’s offce as so remote that no specific clause was written into the deal agreement, people briefed on the matter said.

Since June, bankers and lawyers for Alliance Data and Blackstone have huddled with regulators in Washington to win approval of the deal. The blessing of the comptroller was required because of its authority over the World Financial Network National Bank, the institution that handles Alliance Data’s credit card services.

But those negotiations began disintegrating around November, as the subprime mortgage crisis escalated, according to these people. With major banks announcing steep drops in their capital levels, the regulator had become nervous about heading off future problems.

On Wednesday, the comptroller’s office made clear its requirements for approval. They included a demand that Blackstone guarantee an unspecified amount of capital and liquidity to the Alliance Data bank. The big factor, according to people with knowledge of the matter, was that the requirement would apparently last indefinitely, even if Blackstone sold the company or took it public again.

Several options may still remain, including potentially shedding the World Financial bank to satisfy the comptroller’s concerns.

Links 12/29/08

Phones tapped at the rate of 1,000 a day Telegraph

A helpful suggestion for the Fed Willem Buiter

Japan's Long-Awaited Inflation Saps Spending, Growth Bloomberg. Be careful what you wish for.

Further revelations dent SocGen’s reputation Financial Times. Eurex, a derivatives exchange, warned the bank about Kerviel last year.

Dunno about you, but I could use something soothing. Cute otter video (hat tip RFK Action Front):

Regulatory Implications of the Failure of Quantitative Risk Management Approaches

A Bloomberg story today points out that the snowballing credit market crisis is an indictment of the use of quantitative measures of risk, particularly one of the longer established and still widely used approaches, value at risk. VAR uses historical trading patterns to determine the probability of loss to a certain percentage of certainty. Firms will set certain risk thresholds for certain types of risk, say 95% or 99% certainty of no loss over a certain time frame.

While VAR is popular, no firm relies solely on VAR. But a big problem is that it is the measure of risk that regulators understand best and thus tends to dominate conversations between regulators and their charges. Some have even claimed that securities firms look to VAR more than they would otherwise due to the role it plays in industry oversight.

What is wrong with VAR? There are three big shortcomings. First is that it relies on historical norms. When you have new instruments with limited trading history like mezzanine CDOs that have never been tested in either a down market or a weak economy, the past is often not a reliable guide to future performance. Second is that even instruments that appear to be the same over time, such as subprime loans, may not in fact be the same instrument in terms of economic performance and therefore trading risk. Subprime mortgages nominally have a ten-year history, but the product in its early years was issued in small volumes and consisted primarily of manufactured housing. And as we now know all too well, vintage 2004 subprimes were vastly better credit risks than the 2007 edition.

The third problem with VAR is that the underlying pricing models assume that securities prices have a normal (as in bell curve) distribution. But that just isn't true. Securities prices exhibit fat tails (extreme moves are more probable than the models assume) and are not symmetrically distributed (stock prices, for example, exhibit negative skewness, meaning the negative portion of the distribution extends further from the mean than the positive end). This says that VAR needs to be used with a handful of salt in those extreme 95% to 99% measures, since that is where the model is most likely to break down (the way of compensating presumably would be to set your risk parameters considerably higher than you would otherwise). But from what I can tell at my remote range, most (all?) players have tended to assume that a very high degree of certainty is good enough.

Now from a practical perspective, since VAR is not the only risk metric in use, firms may compensate for the shortcomings listed above by other means (although recent results would say whatever tools they used were also flawed). But the most serious implication is that this failing is that it shows the regulators were emperors with no clothes. And it appears that none of them plans to hire a tailor.

From Bloomberg:

The risk-taking model that emboldened Wall Street to trade with impunity is broken and everyone from Merrill Lynch & Co. Chief Executive Officer John Thain to Morgan Stanley Chief Financial Officer Colm Kelleher is coming to the realization that no algorithm or triple-A rating can substitute for old-fashioned due diligence.

Value at risk, the measure banks use to calculate the maximum their trades can lose each day, failed to detect the scope of the U.S. subprime mortgage market's collapse as it triggered more than $130 billion of losses since June for the biggest securities firms led by Citigroup Inc., Merrill, Morgan Stanley and UBS AG.

The past six months have exposed the flaws of a financial measure based on historical prices that securities firms use idiosyncratically and that doesn't anticipate every potential disaster, such as the mistaken credit ratings on defaulted subprime debt...

Executives at Merrill, Morgan Stanley and UBS took steps in the past six weeks to overhaul their risk-management groups after internal models failed to foresee the first annual decline in house prices since the Great Depression that eroded five years of trading gains.

Goldman Sachs Group Inc., the firm with the highest nominal VaR, was the sole investment bank to report record earnings in the fourth quarter, while New York-based Merrill, which had the second-lowest nominal VaR of the five biggest U.S. securities firms, posted a $9.8 billion loss for the last three months of 2007, the biggest in its 94-year history...

Hiring risk managers and giving them more power won't alter the mistake that led to last year's slump and that was Wall Street's dependence on statistics to quantify risks, [Nassim] Taleb {a research professor at London Business School and former options trader} said.

``We have had dismal failures in quantitative finance in measuring these risks, yet people hire quants and hire risk managers simply to back up their desire to take these risks,'' he said. ``There are some probabilities that you cannot compute.''...

All the New York-based firms base their calculations at a confidence level of 95 percent, meaning they don't expect one- day drops to exceed the reported amount more than 5 percent of the time.

The amounts differ in part because every firm uses their own methodology and data. For instance, Lehman uses four years of historical data to calculate VaR, with a higher weighting given to more recent time periods, while Morgan Stanley provides VaR calculations using both four years and one year of market data.

``If you compare what peoples' values at risk are versus what their losses were in the third quarter or fourth quarter, the numbers are astounding,'' said David Einhorn, president and co-founder of hedge fund Greenlight Capital LLC in New York. ``There are a lot of things that probably the value-at-risk model said would have trivial losses 95 percent of the time or 99 percent of the time but are now having a huge loss.''....

All of the risk-measurement tools failed to prepare Merrill for the unforeseen declines on triple-A rated securities backed by subprime mortgages, according to the company's third-quarter filing with the U.S. Securities and Exchange Commission. The firm's writedowns related to the highest-rated portions of CDOs backed by pools of home loans, which plunged in value as defaults on the underlying mortgages soared.

``VaR, stress tests and other risk measures significantly underestimated the magnitude of actual loss from the unprecedented credit market environment,'' Merrill's filing said. ``In the past, these AAA ABS CDO securities had never experienced a significant loss in value.''

Securities firms developed statistical models during the early 1990s to better quantify risks as the trading of bonds, stocks, currencies and derivatives increased. J.P. Morgan & Co., now part of JPMorgan Chase & Co., helped popularize the use of value at risk as the primary measurement tool in 1994 when it published its so-called RiskMetrics system.

Four years later, two events helped demonstrate the drawbacks in using statistical analysis based on historical market movements to measure risk. Russia's bond default sent fixed-income markets into a tailspin and Long-Term Capital Management LP, the Greenwich, Connecticut-based hedge fund run by former Salomon Brothers trader John W. Meriwether, had to be bailed out after $4 billion of trading declines.

Russia's default risk was underestimated because value-at- risk computations used by investment banks depended on market events of the preceding two to three years, when nothing similar had occurred, according to Wilson Ervin, who's now chief risk officer at Zurich-based Credit Suisse Group, Switzerland's second-biggest bank after UBS.

Long-Term Capital Management, which amplified its risk by relying on borrowed money for most of its trading bets, blew up in part because it didn't anticipate that investor panic after the Russian default would cut the value of any risky debt, whether it was issued by a country, sold by a company, or backed by mortgages.

The riskiest Russian and Brazilian bonds owned by the fund plunged far more than the safer Russian and Brazilian bonds that it had bet against as a hedge, according to ``When Genius Failed,'' the book written by Roger Lowenstein.

``In a market stress event, some individual sectors that previously appeared unrelated do move together, and as a result, the organization could take losses on both of them or even on positions that were previously deemed to be a hedge,'' said Ed Hida, the partner who runs the risk strategy and analytics services group at Deloitte & Touche LLP in New York.

The other risk tool commonly used by securities firms, known as stress testing or scenario analysis, also failed to prepare the industry for the plummeting value of AAA-rated securities that had previously been deemed the most creditworthy, he said.

``Stress tests are only as good or as predictive as the scenarios used and in many cases the scenarios that played out were much more severe than people anticipated,'' Hida said. ``One lesson learned is that these stress tests should be broader, should consider more scenarios.''

Kelleher, who became Morgan Stanley's CFO in October, explained the flaw in the firm's stress testing in a Dec. 19 interview, the day the company reported its first unprofitable quarter.

``Our assumptions included what at the time was deemed to be a worst-case scenario,'' he said. ``History has proven that the worst-case scenario was not the worst case.''

At Credit Suisse, one of the firms that have so far skirted the worst subprime declines, Ervin said value at risk played no role in helping him navigate the market turmoil.

``Once you go into a crisis like this, I think risk is much more about sitting down with traders, and talking about very specific issues and scenarios,'' he said. ``VaR we know will kind of lag going into a crisis so we don't really watch that as a crisis indicator.''

Still, Ervin said VaR provides a service if used every day because it can pick up fluctuations in the risk that the firm is taking in some distant region or an arcane product that might not otherwise be noticed.

Investment banks will continue to take unsafe risks as long as traders are rewarded for making profits, leaving shareholders, bondholders and sometimes taxpayers to shoulder the consequences, Taleb said.

Wall Street traders ``make an annual bonus and get an annual review based on risks that don't show up on an annual basis,'' Taleb said. ``You have all the incentive in the world to take these risks.''

IMF, Larry Summers: The Wile E. Coyote Moment Has Arrived

There has been a fair bit of discussion of the so-called Minsky Moment, when an economy that has build a house of cards of speculation and over-leveraged "Ponzi units" (creditor that could never make good on their commitments, and are viable only by finding new suckers to give them new debt to pay old lenders) starts to collapse.

But the idea of a Wile E. Coyote moment is less widely discussed. Wile E. Coyote was the famous Warner Brothers character ever in pursuit of Road Runner. One regular bit of shtick was having him run off cliffs and proceed quite a way in thin air, falling only when he looked down and saw the gulf below him.

A couple of policy makers, like the cartoon coyote, appear to have looked down and suddenly realized that there is not much in the way of support on the way to the bottom.

The Financial Times reports both these stories; they may not get the traction they warrant in the US. The first is the managing director of the IMF hitting the panic button:

The intensifying credit crunch is so severe that lower interest rates alone will not be enough “to get out of the turmoil we are in”, Dominique Strauss-Kahn, the managing director of the International Monetary Fund, warned at the weekend.

In a dramatic volte face for an international body that as recently as the autumn called for “continued fiscal consolidation” in the US, Dominique Strauss-Kahn, the new IMF head, gave a green light for the proposed US fiscal stimulus package and called for other countries to follow suit. “I don’t think we would get rid of the crisis with just monetary tools,” he said, adding “a new fiscal policy is probably today an accurate way to answer the crisis”.

Mr Strauss-Kahn’s words rip apart a long-standing global consensus that fiscal retrenchment in the US and Japan is needed to help reduce huge trade imbalances.....

But amid a sudden enthusiasm for fiscal stimulus packages, some voiced caution. Professor Ken Rogoff of Harvard University and a former chief economist of the IMF said aggressive fiscal easing generates “more harm than good in most cases”, leading to unsustainable budgetary position that require painful correction in the longer term.

Then we have former Treasury secretary Larry Summers calling for a series of measures beyond fiscal stimulus to restore confidence in the markets. While he is directionally correct that more needs to be done, his prescription shows either a lack of understanding or awfully wishful thinking:

There is enormous uncertainty around economic or financial forecasts. It is possible that pessimism will recede as declining interest rates and dollar exchange rates increase demand. It is more likely, though, that the situation will deteriorate further as perceptions of declining growth increase credit spreads and risk premiums in financial markets, leading to reduced lending, borrowing and spending exacerbating the pessimism about growth.

Perhaps inevitably given the complexity of the problems, policy measures have seemed ad hoc and reactive: measures to increase bank liquidity one week; to help homeowners avoid foreclosure another; to work towards fiscal stimulus another; to lower interest rates most recently. Confidence would be well served by a comprehensive programme of measures that offers the prospect of accelerating growth and insures against a prolonged downturn. Until that happens, it will be difficult for confidence to return.

Substantial monetary and fiscal stimulus is now in train. This will reduce the severity of any recession and provide some insurance against a protracted downturn. Along with macro-economic stimulus in the US, there is the need for further policy development in three other areas – repair of the financial system, containing the damage caused by the housing sector and assuring the global co-ordination of policy. This column addresses the first of these imperatives; I will address the remainder in the near future.

Although we can quibble about the efficacy of the measures put in place, so far this is conventional wisdom and most would nod their heads sagely. But then Summers starts to go off the rails:

Financial institutions are holding all sorts of credit instruments that are impaired but are difficult to value, creating uncertainty and freezing new lending. Without more visibility, the economy and financial system risk freezing up as Japan’s did in the 1990s.

It is therefore tempting to suggest that paper be aggressively marketed so that prices can be “discovered” and uncertainty resolved. More of this needs to happen. But in the current environment few are looking to increase risk and even fewer are willing to finance increased risk-taking. As a consequence, the prices discovered are likely to be very low and to reflect market conditions more than underlying credit quality. This could trigger cascading liquidations leading to panic.

Proper policy regarding valuing assets and forcing their sale depends on distinguishing between prices that reflect fundamentals and prices that reflect current illiquidity. Good policy is art as much as science, depending as it does on market psychology as well as the underlying realities.

This is an optimistic and probably inaccurate assessment. It regards the main problem as liquidity, that no one wants to make markets right now because conditions are bad (true), price discovery would lead to distressed prices and could generate panic (also true). But he fails to consider that prices might not be all that much higher if the players had adequate balance sheet capacity and good transparency. In other words, the lack of liquidity and transparency issues, while part of the problem, really may not be the big problem. I suspect the real problem will be lack of solvency. There is simply too much debt relative to GDP, and a lot of it will have to be written off.

Assuming that this is a liquidity/ crisis of confidence problem means there might be a tidy way out. But people have been pussyfooting around the notion that this might be a solvency problem. The only case in which it has been addressed is in a very tentative and cosmetic fashion with the New Hope Alliance teaser rate freeze program. Many observers consider it to be a deeply cynical program targeting very few in number, and those who will still pay continue to pay fairly high intro rates (7% ish) on homes with no or negative equity.

If this crisis proves to be mainly a solvency problem, we then face the nasty question of how much do we socialize losses? That gets into questions of both equity (is it fair to the non-deadbeats?) and efficiency (even if it isn't fair, the alternatives might be worse). No one yet seems willing to engage this line of thinking seriously, Instead, we have badly designed fiscal stimulus programs which are almost certain to reduce our degrees of freedom down the road while failing to ameliorate the situation now.

Back to Summers:

The essential element, if there is to be more transparency in the financial system without a major credit crunch, is increased levels of capital. More capital permits more recognition of impairments and makes asset transfers easier by increasing the number of potential purchasers. It is preferable for the economy that banks bolster their capital positions by diluting current owners than by shrinking their lending activities. A critical element of regulatory policy should be insisting on increased capital in existing financial institutions. From this perspective the recent efforts by a number of major financial institutions to raise capital from sovereign wealth funds are constructive. But more will be necessary.

Efforts to infuse capital into existing institutions should be matched by a greater effort to ensure transparent and fair valuations. A capital market where the same loan is valued at one price in a bank, another in a different bank, another in a conduit and yet another as a hedge fund asset to be margined cannot be the basis for sound economic performance.

It is critical that sufficient capital is infused into the bond insurance industry as soon as possible. Their failure or loss of a AAA rating is a potential source of systemic risk. Probably it will be necessary to turn in part to those companies that have a stake in guarantees remaining credible because they have large holdings of guaranteed paper. It appears unlikely that repair will take place without some encouragement and involvement by financial authorities. Though there are many differences and the current problem is more complex, the Long-Term Capital Management work-out is an example of successful public sector involvement.

While attention to date has focused on capital infusions into existing institutions, it would be desirable for capital to be injected into new institutions that do not have the legacy problems of existing ones and can meet the demand for new lending. Warren Buffett’s recent entry into bond insurance is an example. There are grounds for concern about the adequacy of the flow of lending for student loans, automobiles, consumer credit and non-conforming mortgages. In each of these areas, there may be a need for collective private action or for government measures.

This, friankly, is hopelessly confused. More capital is desirable. At this point, that's a motherhood and apple pie statement. But where is it to come from? This country is already dependent on the kindness of foreign creditors to feed our current account deficit which among other things helps us buy oil. They have been very good about buying stakes in our shaky financial firms, but as we tank the dollar thanks to further rate cuts, which will put those investments underwater independent of how the credit market fare, and as the credit markets get worse (a given as the housing market continues to weaken), their funding is going to come at a higher and higher cost, both in political and financial terms. There is no nice way around this problem but Summers puts far too happy a face on it.

Summers' "a loan should be priced the same no matter where it lives" is also pretty hopeless. The pricing differences primarily reflect differences in the structures in which the loan resides.

The bond insurer discussion is also, ahem, wishful. Yes, the companies that would benefit from the firms not being downgraded are the logical places to hit up for funding. But those are the same places that two paragraphs above you told to get more capital. You are now telling them to send it out the front door to the bond insurers. The needs of the bond guarantors are urgent, while capital raising takes time, Doing so with a balance sheet you've just decided to make worse (particularly if you just told the market you already took all the writedowns you possibly needed to take) is far from a position of strength. How will the sovereign wealth fund who are paying for this in the end react to this?

And then Summers wants capital to go to new institutions to compete with the ones with "legacy problems." New players will have an insurmountable competitive advantage over incumbents saddled with messes. Most people, yours truly included, regard Buffett's entry into the bond insurance business as one of the worst things that could have possibly have happened to the current players. Buffett can not only cream off the best business but even charge a premiium because the market knows his AAA is the real deal, but worse, the left-behinds will compete for riskier business, and doubtless compress margins below economically viable levels out of desperation.

If this is an example of good policy thinking, we are serious trouble indeed.

What Happened to the Promised S&P and Moody's Review of MBIA and Ambac?

Why have the rating agencies failed to deliver on actions they promised to take? Remember the announcements that helped feed into the overseas market rout last Monday? This story ran January 16 on Bloomberg:

Standard & Poor's will start a new examination of bond insurers, one month after affirming the companies' AAA ratings, because losses on subprime mortgages will be worse than the firm anticipated.

The ratings company will examine whether insurers including MBIA Inc. and Ambac Financial Group Inc. have enough capital to withstand reductions in the ratings of the mortgage-backed securities they guarantee. The credit test will be completed within a week, said Mimi Barker, a spokeswoman in New York.

Standard & Poor's must define a week differently than I do. If you are generous and assumed S&P started its review January 17, a week later is Thursday January 24. Even if you allow another day to draft a press release, we should have heard something by the end of last week.

You may recall that Moody's also put MBIA on review for a downgrade on January 16, although they did not say when they expected to complete their process. From the Wall Street Journal:

Moody's said late Wednesday that it had placed its ratings on Ambac on review for a downgrade, after the country's second-largest bond insurer significantly stepped up its expected losses from insuring complicated securities backed in some cases by subprime mortgages. Moody's also said it will be evaluating "in the near term" the extent to which its ratings of other firms in the industry will be affected by the sector-wide pressures that produced the losses at Ambac.

Now it goes without saying that the rating agencies don't dare downgrade the insurers while New York State insurance superintendent Eric Dinallo's effort to cobble together a rescue package is underway. They'd be walking into a buzzsaw of criticism for Destroying the Financial World as We Know It and Not Letting the Private Sector Devise a Solution.

So the failure to act is understandable. But what has my paranoid juices going is the failure to make a statement that the ratings reviews were being held in abeyance. Of course, that would put the onus on the agencies to declare Dinallo's effort failed if it became evident no deal would happen but the regulator was still failing around.

But what does this behavior point to instead? An angle that should have occurred to me sooner.

Last week, I gave an initial and then a more thought-out assessment , both concluding Dinallo's initiative was highly likely to come to naught. But I was looking at this from the "can they raise enough dough" standpoint.

That is a mistaken perspective. It assumes the agencies are the immovable object in this equation, when they are in fact the most malleable.

Remember, the markets have already given a huge vote of no confidence in the debt of Ambac and MBIA. Their credit default swaps are trading at distressed level. Distressed means "serious risk of bankruptcy." Now even if you think the market reaction is a tad histrionic, given the rating agencies' track record with structured credits, I would place my faith in the markets' perception of risk. And even if you are merely democratic and split the difference, say, between an AAA and a CCC (and even CCC may be a tad generous), you get a BBB. A downgrade of that magnitude, even while still leaving the bond guarantors with an investment grade rating, makes their guarantees effectively worthless and will create chaos. Barclays estimated that a downgrade of MBIA and Ambac to a mere single A would produce $143 billion of losses to banks and brokerage firms.

Consider further that the amount Dinallo is seeking is likely to prove insufficient. His target of $5 billion now and an additional $10 billion down the road sounds very much in keeping with hedge fund Pershing Square's estimates. But those were made based on end of third quarter data. A current requirement is certain to be lower. And other experts have come up with mind numbing requirements. Rating agency Egan Jones said the bond insurers as an industry need $200 billion to keep their AAA ratings. Even if that is high by, say, 400%, it is still a vastly bigger total than Dinallo is seeking.

But the name of the game is getting the rating agencies not to downgrade the big bond insurers. There already is evidence of a tacit understanding that there will be no downgrades while the negotiations are in play, particularly since Moody's and S&P are participating.

And the very fact that the agencies are part of the process means that they will be subject to both subtle and explicit pressure to knuckle under and accept any package, no matter how inadequate.

Social psychologist Robert Cialdini, in his classic book, Influence: The Psychology of Persuasion, wrote about the power of social assent. One well documented finding from studies of cult members and victims of brainwashing is if you take a person and put him with a group of people who believe in something strongly that is opposed to what he believes and they keep working on him, it is almost certain he will eventually capitulate.

Now the rating agencies could easily protect themselves from that dynamic by sending a mere note-take to the sessions. Conversely, it would be a very bad sign if they senior people who could make commitments participated.

But aside from the dynamics in the room, there is every reason to expect the rating agencies to knuckle under if Dinallo can raise a modest amount of dough, even as little as, say, $2 billion. The agencies through their mistakes have now created the situation where they could be the ones to Destroy the Financial World as We Know It. They will take any route offered to keep from pushing the button, in the hopes that either the economy will miraculously recover or other events will lead to credit repricing, so that the eventual downgrade of the insurers has far less impact than one now.

I still don't think a bailout is likely to succeed, despite the considerable costs of a bond guarantor downgrade. But the fact that the rating agencies will probably go along with any remotely plausible scheme means that a smoke and mirrors version might be put into place.

Trust Me, You Will Enjoy This Piece (Multitasking Edition)

A simply great piece, "The Autumn of the Multitaskers" by Walter Kirn in the Atlantic. As someone who nearly died while multitasking, Kirm is particularly well positioned to discuss the considerable downside and dubious benefits of our modern way of attempting to process inputs. It's an informative and often funny read.

A few representative paragraphs:

But on to the next inevitable contraction that everybody knows is coming, believes should have come a couple of years ago, and suspects can be postponed only if we pay no attention to the matter and stay very, very busy. I mean the end of the decade we may call the Roaring Zeros—these years of overleveraged, overextended, technology-driven, and finally unsustainable investment of our limited human energies in the dream of infinite connectivity. The overdoses, freak-outs, and collapses that converged in the late ’60s to wipe out the gains of the wide-eyed optimists who set out to “Be Here Now” but ended up making posters that read “Speed Kills” are finally coming for the wired utopians who strove to “Be Everywhere at Once” but lost a measure of innocence, or should have, when their manic credo convinced us we could fight two wars at the same time.

The Multitasking Crash.

The Attention-Deficit Recession.....

Human freedom, as classically defined (to think and act and choose with minimal interference by outside powers), was not a product that firms like Microsoft could offer, but they recast it as something they could provide. A product for which they could raise the demand by refining its features, upping its speed, restyling its appearance, and linking it up with all the other products that promised freedom, too, but had replaced it with three inferior substitutes that they could market in its name:

Efficiency, convenience, and mobility.

For proof that these bundled minor virtues don’t amount to freedom but are, instead, a formula for a period of mounting frenzy climaxing with a lapse into fatigue, consider that “Where do you want to go today?” was really manipulative advice, not an open question. “Go somewhere now,” it strongly recommended, then go somewhere else tomorrow, but always go, go, go—and with our help. But did any rebel reply, “Nowhere. I like it fine right here”? Did anyone boldly ask, “What business is it of yours?” Was anyone brave enough to say, “Frankly, I want to go back to bed”?

Maybe a few of us. Not enough of us. Everyone else was going places, it seemed, and either we started going places, too—especially to those places that weren’t places (another word they’d redefined) but were just pictures or documents or videos or boxes on screens where strangers conversed by typing—or else we’d be nowhere (a location once known as “here”) doing nothing (an activity formerly labeled “living”). What a waste this would be. What a waste of our new freedom.

Continue here.

Credit Default Swaps Increase Odds of Bankruptcy

We've discussed before how credit default swaps, which is in essence insurance against the default of particular issuer or index, poses risks to the financial system via counterparty failure. The notional amount of CDS is $45 trillion, but much of that is believed to be fully or nearly fully hedged via offsetting positions. The problem is if some of those hedges turn out not to be effective due to a counterparty, such as an investment bank or hedge fund, taking a financial hit, you could see cascading losses as suddenly-exposed players try to exit or adjust positions.

But there is a more mundane, more likely way that CDS can cause mischief. A study by two University of Texas professors concludes that CDS contracts give creditors incentives to push wobbly companies into bankruptcy. From the Financial Times:

A boom in the use of derivatives is giving creditors strong incentives to push troubled companies into bankruptcy rather than help rescue them, according to new research and industry experts.

A study by academics Henry Hu and Bernard Black concludes that, thanks to explosive growth in credit derivatives, debt-holders such as banks and hedge funds have often more to gain if companies fail than if they survive. The study suggests this development could endanger the stability of the financial system.

The findings highlight a crucial problem in corporate restructuring when more and more companies are facing financial difficulties as a result of the credit crunch and US economic slowdown. According to the research and industry practitioners, creditors have a strong interest in voting against a restructuring plan if they have bought credit or loan default swaps, which trigger payments when a company fails.

“Investors now accumulate positions in a company by targeting layers of debt or multiple layers of debt,” said Michael Reilly of the financing restructuring practice at Bingham McCutchen.

“Where their interests lie are less predictable, especially if they also hold credit default swaps. Their financial interests may be best served by forcing a default if they are on the right side of a CDS position.” The problem is compounded by creditors not having to disclose derivatives positions, making it very difficult for companies and regulators to find out their real intentions.

The study by the two University of Texas academics warns that the breakdown in the relationship between creditors and debtors, which traditionally worked together to keep solvent companies out of bankruptcy, lowers the system’s ability to deal with a credit crunch.

“Spread across the economy, the ‘freezing’ of debtor-creditor relationships can increase systemic financial risk,” says the paper, which has been sent to the Securities and Exchange Commission. “[It] can also increase the economy’s exposure to liquidity shocks”.

Marcia Goldstein, chair of the Business, Finance & Restructuring department at Weil, Gotshal & Manges, one of the biggest corporate restructuring law firms, said anecdotal evidence suggested this was a growing problem regulators should address. She added that the current bankruptcy code and securities disclosure rules were inadequate to address the explosion in exotic securities that make it possible for sophisticated investors to cloak their true economic interest.

The Real Failure of Controls at Societe Generale

Disclosure (or apparent disclousues, who knows if we will ever learn the true story) of how equity derivatives trader Jerome Kerviel caused the biggest trading loss in banking history continues to dribble out.

Today, Bloomberg in "Societe Generale Says Trader Built Up Positions of EU50 Billion," gives more detail on how the trader caused so much damage:

Societe Generale SA said trader Jerome Kerviel built up positions in European stock index futures of 50 billion euros ($73 billion) before the French bank discovered the trades and unwound them last week.

Kerviel, 31, who is being questioned by France's financial police for a third day, took advantage of the bank's practice of checking only net trading positions rather than gross bets to conceal his subterfuge with phony hedges, Paris-based Societe Generale said yesterday. The trading loss of 4.9 billion euros was the biggest in banking history.

The failure to look at gross as well as net exposures is a basic shortcoming and the press and competitors will make a great deal of noise about that.

While further comments will no doubt leak out about the specific failings in SocGen's risk control system, one glaring lapse leaped out:

He took only four days off last August and postponed a vacation at the end of the year, Societe Generale said.

Huh? It is Trading 101 to make staff take a minimum of a full week off at least once a year, better twice, precisely because it is well nigh impossible for sole actors to keep frauds going from afar. For example, the $1.8 billion in losses at Sumitomo Corporation were generated by a copper trader who hadn't taken a vacation in over two years.

This factoid alone says that SocGen's systems (and by that I mean not just computerized risk controls, but broader management practices) were woefully deficient. Managing traders isn't just about designing computer systems to find anomalous patterns; it also involves a certain amount of judgment about overall risk, staff capabilities, procedures, and organization design. The discussion of how Kerviel did what he did appears to be focusing unduly on computer and system failures, and missing the point that they might have reflected or even reinforced larger organizational design failures.

Note I don't dismiss the possibility that the charges against Kerviel are either trumped up or considerably exaggerated. If they fail to hire an outside firm like Eugene Ludwig's Promontory Capital, which is full of former regulators and has conducted a number of high profile rogue trader investigations, to prepare a report and recommend improvements, that suggests there may be more to this story than SocGen is revealing.

"Paying the Price for the Fed’s Success"

I try to avoid being too dependent on a single news outlet on any particular day, but it is Sunday, and the New York Times happens to have a higher hit rate than usual on relevant pieces. Reader Independent Accountant chided me for not pointing to the artilce below by the reliable and thoughtful James Grant, the editor of Grant's Interest Rate Observer.

This piece is a fairly conventional, although well-done, retelling of the story of how benign economic conditions fuel speculation and the use of excessive leverage. However, Grant staked out this theme long before it became popular.

Grant, who has studied the history of banking and finance more deeply than just about anyone, warned of the dangers of excessive leverage so early that it was easy to dismiss him. HIs 1996 book, "The Trouble with Prosperity," talks about the downside of the loss of fear, and even mentions the views of Austrian economists who had foretold that unduly low interest rates would lead to a credit boom and eventual bust. Grant is also fearless enough to offer observations that make him seem a borderline crank in the eyes of modern economists. He points out the virtues of the gold standard in preventing monetary excesses, and notes that the yield curve was generally negative in London from 1880 to 1914, which precluded the prevalent strategy today of borrowing short and lending long.

From the New York Times:

High finance, like some unreliable common stock, goes lower and lower. How did so many experts misjudge so badly? How could the supposedly “contained” subprime mortgage problem metastasize into a global financial panic (some days to the down side, other days to the up side)? And after this drama, what?

Ben S. Bernanke, the chairman of the Federal Reserve, inadvertently warned of the coming troubles four years ago. Speaking to fellow economists in Washington, he described the peace and quiet that, for 20 years, had been gradually settling over the American economy. Compared to the 1970s, recessions were mild and scarce, he noted. Inflation, that bane of yesteryear, was dormant. Economic growth was no longer spasmodic but smooth and almost predictable. The name he gave to these manifold blessings was the Great Moderation, and he thanked the Fed, in which he then served as a governor under Alan Greenspan, for helping to bring them about.

But it was actually the Great Complacency that Mr. Bernanke had put his finger on. In finance, to borrow from the economist Hyman Minsky, nothing is so destabilizing as stability. The paradox is easily explained. Profit-seeking people will take more financial risk when they believe the coast is clear. By taking bigger chances, however, they unwittingly make the world unsafe all over again.

Anxious people don’t ordinarily get in over their heads; it’s the confident ones who do. And nothing builds confidence like the belief that a greater power has conquered the business cycle and laid inflation low. In such happy circumstances, a calculating human will take out a bigger mortgage, build a bigger hedge fund or attempt a gaudier corporate buyout. That is, he or she will borrow more money, or, as they say on Wall Street, lay on more leverage.

So Americans proceeded to borrow. Over the past decade, household indebtedness, expressed as a percentage of the value of household assets, has shot up into record territory. Watching house prices levitate, people did what they could have been expected to do. They borrowed heavily against the accretion in value they had already seen as well as the gains they hopefully anticipated.

There was a rub, however, and this, too, our seers and experts failed to predict. The truth was that house prices were soaring beyond the reach of the average home buyer. Bridging this widening gap brought out the worst in just about everyone who had anything to do with money from 2003 to 2007.

Striving so mightily to make one and one add up to three or four or five, Wall Street, Main Street and Washington collectively brought us to the impasse of 2008, in which a debt crisis is superimposed on a downturn in the economy, which is overlaid on a bear market in real estate, which is conjoined with a persistent and worrying weakness in the overseas value of the dollar. As for the crackup in complex mortgage-backed securities, now at the center of the debt predicament, the global bank UBS has justly called it “the biggest failure of ratings and risk management ever.”

We should not forget Main Street in this 360-degree indictment of American financial practices. Fitch Ratings, shocked by the frequency of early defaults in supposedly safe mortgage structures, belatedly delved into the details of 45 individual loans it considered representative. “The result of the analysis was disconcerting at best,” the ratings agency admitted in a study released at the end of November, “as there was the appearance of fraud or misrepresentation in almost every file.”

It would be asking a lot of an ordinary mortal to hew to the literal truth in a mortgage application when, to the applicant, it seemed as if the money was being offered free. And for 12 full months, from mid-2003 to mid-2004, the Fed set its interest rate, the so-called overnight federal funds rate, at just 1 percent. It took this extraordinary step to ward off the risk of falling prices, or deflation, it said. It would not tolerate too little inflation, it explained, but wanted just enough. At the time, the cost of living was rising by 2 percent a year.

Last week, as the Fed delivered its emergency cut of three-quarters of 1 percent, dropping the funds rate to 3.5 percent, the cost of living was rising on the order of 4 percent a year. Yet inflation was almost an afterthought in the press release in which the Federal Open Market Committee, the central bank’s policy-making arm, explained its surprise intervention: “The committee expects inflation to moderate in coming quarters, but it will be necessary to continue to monitor inflation developments carefully.”

If stability leads to instability, it follows that instability will eventually restore tranquillity. But first must come the tallying up of the errors, misjudgments and outright criminality that blossomed during the Great Moderation. Mr. Bernanke, in an attempt to limit the damage and hasten the healing, is likely to keep the Fed’s rate low — lower, even, than the measured inflation rate.

As for mortgages, the experts had agreed that house prices couldn’t fall as stock prices sometimes do, and they structured their loans without a thought to any such coast-to-coast distress. If house prices do continue to fall, there will be many more defaults, and a correspondingly urgent cry for low and lower mortgage rates.

Nor will the credit crisis bypass corporate America. Complacent as the mortgage lenders, investment bankers designed balance sheets as if steep and prolonged recession was not just unlikely but impossible.

To lubricate the machinery of lending and borrowing, Mr. Bernanke is likely to make dollars increasingly plentiful. The trouble is that, while the Fed is America’s central bank, the dollar is the world’s currency. It lines the vaults of central banks of America’s creditors, especially the up-and-coming states of Asia and the oil-soaked principalities of the Middle East.

Such institutions hold dollars by choice, and not a few of them chafe at the greenback’s steady loss of purchasing power. For some, Tuesday’s hasty rate cut might be the last straw.

As just about nobody predicted the present troubles, humility is what becomes today’s forecaster the most. So I will offer up a humble forecast. Inflation will, at length, make its way up from the bottom of the Fed’s worry list to the very top. Not for years has it seemed to matter that the dollar is only a piece of paper. But, before very long, that homely fact will push itself back to the fore.

Ben Stein Tells Us It's All the Traders' Fault

Here we go again. We have another Ben Stein column, "Can Their Wish Be the Market’s Command?" which says, I kid you not, that we have a bear because a whole bunch of traders got together and made it so.

Since undue contemplation of Ben Stein logic is bad for anyone's mental health, I will limit myself to the main outlines of his argument. The first half of the piece describes how Ben learned in law school that court decisions are completely arbitrary. Judges decide based upon personal prejudice and can always find precedent somewhere to justify their verdict. He then tells that a UK trader buddy described how his firm once ran IBM stock down even though it had just announced great results (note that this apparently occurred during UK trading hours, and some years ago since said trader is now dead, which means there was far less depth in the stock than there in the US, a not trivial detail).

Stein then goes on to say:

As I see it, this is what traders do all day long — and especially what they’ve been doing since the subprime mess burst upon the scene. They have seized upon a fairly bad situation: a stunning number of defaults and foreclosures in the subprime arena, although just a small part of the total financial picture of the United States. They have then tried — with the collaboration of their advance guards in the press — to make it seem like a total catastrophe so they could make money on their short sales. They sense an opportunity to trick other traders and poor retail slobs like you and me, and they generate data and rumor to support their positions, and to make money.

More than that, they trade to support the way they want the market to go. If they are huge traders like some of the major hedge funds, they can sell massively and move the market downward, then suck in other traders who go short, and create a vacuum of fear that sucks down whatever they are selling.

If the current market action is the manifestation of some sort of evil trader genius, they have executed it pretty poorly. Every major firm should have been net short, not just Goldman. The investment banks, with their sales forces and research arms, are in a much more powerful position to push rumors. If the market fall was by design, pray tell me how it benefited the Street? They have taken over $100 billion in writeoffs, and the fourth quarter results are still coming in.

Similarly, the charge that hedge funds are rolling in dough as a result of these gyrations is also badly misguided. It has been widely publicized how the quants have been whipsawed and taken big losses because the action in August were so out of line with historical patterns. November and December have been poor months for them also. Most other portions of the industry, for different reasons, are also not going to benefit from a bear market. As a post from Roger Ehrenberg pointed out:

The real question is, how will a persistent down market impact the returns of the hedge fund and private equity industries? My handicapping: most participants will suffer and suffer badly. Why? In summary:

The net long exposure of most hedge funds will weigh on returns. Historically it has been difficult for most hedge funds to add significant alpha on the short side, the side which may well be the key driver of returns for quite some time....

Bridgewater Associates had a very interesting report yesterday that addressed this very issue. Here are some of their thoughts as it relates to the hedge fund industry:

For the most part, hedge funds have gotten through the credit crunch relatively unscathed. For example, the average hedge fund generated a return of 12.5% last year and 2.5% in the fourth quarter. And private equity funds generated an average return of 11%. The main reason that these two groups held up as well as they did is because the equity market has not fallen nearly as much as the bond markets (i.e., spreads), and the majority of the risk allocation of these funds is in the equity market. And because their performance held up, they have not been forced into much asset liquidation to speak of. But stock market action is beginning to pressure the hedge funds and private equity players.

Hedge funds used to be a lot more hedged than they are today....hedge funds are now heavily long the equity market. Based on fund by fund holdings data we estimate that hedge funds are net long about $150 to $200 billion in U.S. equities (foreign equities are not included in this figure).

So who are these mysterious evil traders killing our collective prosperity? Stein isn't able to provide the name of a single perp.

The most successful, John Paulson, who was massively short the subprime market, was remarkably low profile until his trade reaped huge profits. He certainly wasn't trying to talk the market down; the fundamentals did it just fine on their own.

Yet we get stuff like this:

I know this because I know traders. They’ve told me that they love to sell into fear because fear is bottomless — you can make money selling all day, while buying eventually slows because enthusiasm has limits. The amount of money available to large professional traders is so large that they can overwhelm the market, at least for a while, anytime they want. And they like to do it when the market least expects it.

It is one thing to move the prices of single securities, quite another to move entire markets, particularly ones as big as the global equity markets and the US credit markets. We must have a simply staggering number of traders all conspiring together.

And then we get as close as Stein gets to analysis:

The losses in the stock market since the highs of October 2007 are about 14 percent. This predicts — very roughly — a fall in corporate profits of roughly 14 percent. Yet there has never been a decline of quite that size for even one year in the postwar United States, and never more than two years of declining profits before they regained their previous peak.

Aside from the questionable assumption, that the 14% fall is a predictor of a calendar year decline, Stein reveals complete ignorance of bear market patterns. Stock market falls are due to both declines in earnings expectations AND multiple compression. Seeking Alpha has a very nice table showing the change in the S&P during bull and bear markets since World War II. The average bear market was 393 days with an average decline of 30.6%. So we aren't even to the halfway point by historic standards. And the most recent bear market, in 2002, was less than a year but steeper, a 33.75% fall in the S&P.

Finally, I am not sure the correct comparison for our current situation is past US economic cycles . We are in the process of unwinding a large scale debt-fueled asset bubble, and the closest comparable is Japan in the early 1990s. Indeed, many of the policy remedies are going down the Japanese path of shoring up asset prices and socializing losses rather than letting the markets find a new, lower clearing price. The Nikkei has failed to since reach even 50% of its all time high of 38,957. I don't expect our trajectory to be as bad as Japan's, but the point is that US history may be the wrong place to look for precedents for our current credit woes.

Stein's certainty that there are faceless, powerful enemies in our midst called traders reminds me of Joe McCarthy's' conviction that there were commies in every nook and cranny plotting America's demise. That comparison quickly breaks down since McCarthy was formidable for at least a while and Stein isn't. But then again, Marx said that history repeats itself, the first time as tragedy, the second time as farce.

Robert Shiller Calls for More Encompassing Solutions to Credit Market Woes

In today's New York Times, Yale economist and author of Irrational Exuberance Robert Shiller says, in effect, that the problems in the financial system are large enough to call for large scale, possibly even radical remedies. Shiller admits to not having a notion of what those measures should be. He does call for some changes he deems obvious, helpful, but only partial solutions, such as raising the amount of bank deposits subject to FDIC insurance and the brokerage firm balances covered by SIPC.

What is interesting is that the list of problems that Shiller lists as most pressing all go back to the breakdown of the securitization model. In fact, the simpler form of securitization, such as mortgage pass-throughs, have not, to my knowledge, led to any serious problems; it's the more complex variants, particularly structured finance, which is what has gone awry. Yet one of the points of structured finance was to create higher-rated tranches that had more predictable payment characteristics than simple pass-throughs did. Thus, if structured credits are sufficiently tarnished that the market shrinks, say to 20% of its former volume, that would have serious implications for many lending markets. Would investors be willing to consume more of the same underlying credits in less packaged form, or will banks wind up keeping a higher proportion of the loans they originate on their balance sheets?

That is a long-winded way of saying that reformers need to look long and hard at the structured credit mess, because that is the epicenter of this earthquake.

From the New York Times:

The key to maintaining economic stability is well-placed confidence in the markets. Bubbles, by contrast, result from misplaced confidence.

We are living in a post-bubble world, following the stock market bubble of the 1990s and the real estate bubble of the 2000s. That is the backdrop for the current crisis. We need to restore confidence in the markets’ basic ability to function, not in their presumed tendency to make us all rich by always going up.

Some short-term remedies are under way. President Bush has said that fiscal policy is urgently needed to address the current situation and has reached tentative agreement with Congress on a temporary tax cut of $150 billion. This might increase the official federal deficit from about 1 percent of gross domestic product to something like 2 percent, about where it was a couple of years ago. And on Tuesday, the Federal Reserve under its chairman, Ben S. Bernanke, made an emergency between-meetings cut of three-quarters of a percentage point in the federal funds rate. The move brought that benchmark rate down to its level midway into the 2001 recession, and the Fed has signaled that it stands ready to make further cuts.

While a temporary tax cut and interest rate cuts are good ideas, they don’t address the underlying crisis of confidence. If these measures succeed merely in making people consume more, running to the malls and making the already-negative personal saving rate even more negative, they won’t restore faith in the financial markets.

One main response to the Depression that helped prevent another from occurring was a set of tools that improved confidence by truly improving market security. One of these was the Federal Deposit Insurance Corporation, in 1933, but there were also a large number of others, especially the Securities and Exchange Commission the next year.

These were not obvious innovations and, in fact, were highly controversial at the time. Indeed, it is never obvious how the government should foster well-functioning markets. The fundamental role of governments in promoting markets is clear, but the design of their instruments must make creative use of a great deal of information about financial theory, human psychology and existing institutions and practices. The successful markets we have are a result of considerable inventive effort.

The F.D.I.C. was controversial because it was established amid the ruins of various state-level deposit insurance plans that had just gone bankrupt. Critics at the time also argued that federal deposit insurance would encourage unsound banking. But it turns out that the F.D.I.C. was a very good idea. It restored confidence in the banking system during the Depression, and with hardly any cost.

The S.E.C. was similarly controversial. Critics said it would hamstring or straitjacket the markets. But it is now the model for securities regulation around the world.

We need such inventive effort today. It won’t be easy, but the first step would be to set up a national study commission and to pay for serious creative research on how to adapt important ideas, like deposit insurance and securities regulation, to a modern financial world.

Mr. Bernanke certainly knows the importance of well-functioning markets. In his 2000 book, “Essays on the Great Depression,” he wrote persuasively that runs on the banks and extensive defaults on loans reduced the efficiency of the financial sector, prevented it from doing its normal job in allocating resources, and contributed to the Depression’s severity.

The Depression-era problems he studied are mirrored by similar issues today, and they need urgent attention. The very fact that many people feel they can no longer rely on some of our financial institutions may bring a self-fulfilling prophecy, which could then fundamentally harm economic activity.

The mortgage market is suffering. People are having a hard time getting mortgages, and mortgage originators are finding it harder to sell their mortgages to those who would repackage them in mortgage securities.

The commercial paper market is suffering, too. The amount of outstanding asset-backed commercial paper, which has become a main element of an unregulated, uninsured, shadow banking system, has fallen 30 percent since August.

Other credit markets are also having problems. For example, some municipal borrowers have already had the credit ratings of their debt lowered because of the downgrading of Ambac, a municipal bond insurer, by Fitch Ratings. Problems in the bond market are likely to multiply if there are further downgradings of Ambac, or downgradings of other insurers like MBIA.

CONFIDENCE in our brokerage firms is suffering. With every announcement of major losses, some people start to wonder whether they can rely on these companies.

The Bank of England’s bailout of the mortgage lender Northern Rock in September was truly urgent. The bank was experiencing a run, the first in Britain since 1866. The newspaper photographs of long lines of people waiting on the street to withdraw their money probably rekindled dormant fears. People tend to remember such dramatic stories because they remember when their own confidence has been shaken.

The Northern Rock bailout was needed because ordinary depositors had begun to worry about their saving accounts. It was necessary to show them that they didn’t have to be worried. Improvements in the deposit insurance system in Britain began immediately after this crisis.

In the United States, the very least we can do is to raise the F.D.I.C.’s limits on insured deposits. The limit of $5,000 in 1934 was 12 years’ worth of per capita personal income at the time. The limit was last raised in 1980, to $100,000, which was then 10 years’ income. But because of inflation and economic growth, that limit is less than three years’ income today.

The Federal Deposit Insurance Reform Act of 2005 did not raise that ceiling, though it will start indexing the limit to inflation in 2010. We have allowed deposit insurance to go three-quarters of the way to extinction.

The insurance limits of the Securities Investor Protection Corporation, which protects customers when brokerage firms fail, were also last raised in 1980 — to $100,000 in cash accounts and $500,000 in securities — and thus have suffered an equally drastic erosion in real value. Such erosion could suddenly matter if the crisis, or even just the psychology of the crisis, were to worsen.

But far beyond this, at a time when so many problems have arisen outside the limits of existing federal insurance programs, we need to do more than update the programs for inflation. We need to consider the fundamental principles on which they were based, stress-test them for today’s environment and consider extending them in creative ways.

Qatar Pursuing $3 Billion Investment in Credit Suisse

Another day, another sovereign investment fund check to an investment bank. How the mighty are fallen.

The story in the Telegraph makes clear the proposed Qatar Investment Authority acquisition of 5% of Credit Suisse, worth roughly $3 billiion, is not a done deal but seems likely to go through. And the article goes to some pains to stress that unlike previous recipients of foreign largesse, Credit Suisse has a solid balance sheet and no pressing need for capital. The article indicates that the Qataris are buying a secondary market position.

While this may be a clever move, given that Credit Suisse, despite its unimpaired status, is doubtless taking a stock price haircut due to industry woes, who knows what lies ahead. SocGen looked like a great institution a mere week ago.

From the Telegraph:

Powerful funds backed by the Qatari government are considering assembling a significant stake in Credit Suisse, one of Europe's largest banks, The Sunday Telegraph has learned.

Investment entities believed to be affiliated to the Qatar Investment Authority, which is closely linked to the emirate's royal family and has tabled unsuccessful bids for J Sainsbury and Thames Water, are understood to be considering building a 5 per cent stake in the Zurich-based bank.....

Sovereign wealth funds from Abu Dhabi, China, Dubai and Singapore have snapped up large stakes in banks such as Citigroup, Merrill Lynch, Morgan Stanley and UBS as they wilted under the weight of huge losses related to the implosion of the American sub-prime mortgage industry.

Any investment in Credit Suisse by the QIA or another sovereign investor would, however, be seen differently. Other than a $1.9bn writedown related to the sub-prime crisis announced in November, the bank has so far emerged comparatively unscathed from the credit crunch and has avoided the need to seek recourse to cash-rich foreign governments in order to recapitalise its balance sheet.

Credit Suisse boasts a strong capital position, with tier 1 capital of about 12 per cent, according to the latest figures, and any move by Qatar to invest in the Swiss group would not dilute its existing capital structure.

The acquisition of 5 per cent of Credit Suisse would represent an outlay of just over $3bn at Friday's closing share price of 59.95 Swiss francs.

People close to the situation said last night that the Qataris might already have been buying shares in the open market but that it was unclear whether they planned to become long-term investors.

The Swiss stock exchange requires shareholdings of more than 3 per cent to be disclosed, implying that the Qataris had not yet crossed that threshold.

One person cautioned this weekend that the Qataris' plans had not been finalised and that they could end up taking a stake larger or smaller than 5 per cent, or pursuing the investment through an alternative vehicle.

It was unclear last night whether the prospective Qatari investors had held discussions about any investment with Credit Suisse's management, which is led by Brady Dougan, its chief executive.

"This is not about shoring up an ailing balance sheet," one source said. "This would not dilute Credit Suisse's capital structure or signal anything like the message that other banks' huge writedowns and their need to attract large foreign investments have sent out."

Credit Suisse's existing major shareholders include Olyan Group, a Saudi investment firm, and Axa, the French insurer.

The growing influence wielded by sovereign wealth funds was one of the talking points at last week's World Economic Forum in Davos.

Larry Summers, the former US treasury secretary, called for a code of conduct for such investors and questioned their ability to remain passive shareholders in the event of a bank's collapse.

Summers said: "Is there any country in the world that can assert confidently that, when there are billions of dollars on the line, their head of state and their foreign minister are not going to become involved in the negotiation of that transaction?"

Links 1/27/08

No Longer Civil Bank Lawyer's Blog. Criminal prosecutions of mortgage fraudsters have begun. Too bad it's always the small fry that take the fall.

BIS warns against fragmented regulation Financial Times. Not a new observation (see Financial Armageddon as an example), but this story gives a concise recap.

Microchips Everywhere: a Future Vision Associated Press. Big Brother is coming to a store near you.

"Welfare for Wall Street, Federal Reserve-Style"

Thomas Palley posts only occasionally, but just about everything he writes is first rate, and today's offering is no exception.

Palley argues one of our favorite views, that the Federal Reserve interest rate cuts have had more to do with trying to prop up asset values than with stimulating growth. He points out that this approach has not achieved its aim (asset prices are still falling) and may produce unintended and undesirable consequences. The nature of the crisis on Wall Street demonstrates the need for a systemic as well as firm-specific view of risk, which in turn means there must be an overarching regulator. Yet the Fed remains hostile to this view.

From Palley:

The Federal Reserve’s recent surprise decision to lower its short-term interest rate target by three-quarters of a point has received much attention. Most commentary has focused on the idea that the Fed is trying to stimulate spending in the hope of preventing a recession. Over-looked, and equally important, is the fact that lower interest rates raise asset prices, which is something Wall Street desperately needs to prevent a systemic meltdown.

The Federal Reserve is right to play the interest rate card aggressively since the economy-wide costs of a financial meltdown are so large. But let’s not fool ourselves about Wall Street and free markets. The Fed is using its government granted power of fixing interest rates to bailout Wall Street. That is welfare, Federal Reserve-style.

Normally, economists focus on the effect of interest rates on business investment and consumer spending. The thinking is that lower rates cause increased spending, albeit with long and variable lags and the net impact is also highly uncertain and contingent on the state of confidence.

However, another feature of lower interest rates is that they increase the price of fixed income assets. Thus, when interest rates go down, bond prices go up, and that is critical for understanding recent Federal Reserve policy moves.

The U.S. financial system is currently deeply stressed. Growing perceptions of heightened default risk on mortgages and consumer debts have caused large price declines for securities backed by these assets. That in turn has caused massive losses at banks and insurance companies, eroding their capital. This erosion has placed many firms in danger of regulatory insolvency, unable to meet capital requirements. Some are in deeper danger of bankruptcy with the value of liabilities exceeding assets.

The problem is acutely visible among bond insurers, where rising default rates have reduced asset values while simultaneously increasing potential payouts on insured securities. If the bond insurers are downgraded, this could trigger a cascade of losses that could fracture the system. This is because insured bonds would fall in value, thereby wiping out further capital.

This possibility means maintaining asset prices, and preventing further mark-to-market losses is critical. The Fed’s problem is that as quickly as it has been lowering the federal funds rate, default rates on mortgage and consumer debts have been rising. Consequently, rising credit risk has offset the effect of a lower federal funds rate, so that asset prices have remained weak.

Moreover, there are pitfalls in the low interest rate policy. On one hand lower rates increase bond prices and also reduce defaults on adjustable rate mortgages. On the other hand, lower interest rates could trigger a wave of mortgage re-financing by those good risks still capable of re-financing. That would cause pre-payment losses to holders of existing mortgage backed securities, while also concentrating the proportion of remaining bad risks. The net effect is prices of mortgage-backed securities could fall further.

The fact that Wall Street needs this helping hand has important public policy implications. The existing system of regulation by capital requirements helps discipline risk-taking, but it has proven inadequate. The problem is individual firms do not take account of the impact of their risk-taking on others, so that the system takes on too much risk. This problem can only be solved by a system-wide regulator who monitors and limits total risk-taking. Yet, that is exactly what the Federal Reserve has rejected during the last twenty-five years of de-regulation.

Remedying this failing calls for deep regulatory reform that is nothing less than paradigm change. This is something the Fed will resist and Congress will have to push. But until deep regulatory reform is enacted, the “welfare for Wall Street” problem will persist.

US Commercial Real Estate Sales Tank

The Financial Times reports that commercial real estate sales in the US have fallen dramatically, due to uncertainty about financing, vacancy, and defaults. It isn't yet clear what the price impact will be once sales pick up again, although experts believe that the decline will be less than that of the housing market.

From the Financial Times:

US office property sales fell by the largest amount since the September 11 2001 terror attacks in the final three months of last year, raising fears that commercial real estate is heading for a meltdown.

Commercial property in general, and offices in particular, are coming off a boom period, when prices and rents set records last year.

However, far fewer deals have been closed since August, when the credit squeeze essentially shut down the market for commercial mortgage-backed securities and made borrowing more expensive.

The volume of office space sold in the final quarter of 2007 fell 42 per cent to $26.5bn, compared with the same period in 2006, according to data released on Friday by Real Capital Analytics, a real estate data company. Sales of property portfolios fell to $5bn, after logging $105bn in the first three quarters.

“What’s happening now is a capital markets event,” said Dan Fasulo, managing director at RCA.

Spreads on CMBX, an index that tracks commercial mortgage backed securities, have recently suggested that default rates are expected to reach three times historical levels. But analysts say commercial property is not expected to suffer the same slump as housing because it has not experienced such high levels of overbuilding.

However, if the US economy experiences a deep recession, commercial property is considered to be at risk. Demand for space is largely driven by the health of the business environment.

“The wildcard is whether or not the US falls into a recession. What’s causing the market to hold up is the high level of occupancy and high level of rent,” said Mr Fasulo. “Unless [there is a recession] you are not going to see a [major] deterioration.”

The collapse in property transactions was not limited to office real estate. In retail property, volumes of sales fell by 30.1 per cent to $10.1bn and industrial real estate saw a 22 per cent drop in sales to $26.5bn.

Excluding the $22bn acquisition of Archstone-Smith - the second largest US apartment owner - by Tishman Speyer and Lehman Brothers, sales of retail property were down 60 per cent.

Lower sales were spurred by tighter credit conditions meaning that buyers could raise less cash to pay for property and expected lower prices.

“There was a disconnect between buyers and sellers and that drove sales lower,” said Dan Fasulo, managing director at RCA.

The drop in office property sales in the last quarter did not stop the full year 2007 seeing a 55 per cent jump in sales volumes to a record $211bn.

Office property prices in central business areas of cities are 10 per cent lower in the last quarter from their peak levels in the first quarter. RCA expects prices for all types of property to fall another 5 to 10 per cent this year.

Does Violating International Law Make Us Safer?

This Administration is not merely incapable of learning, but seems insistent on doing the wrong thing with a vehemence. The invasion of Iraq was a violation of international law (the fig leaf of UN Resolution 1441 in the run up to the invasion has not impressed the experts), an attack on a country that posed no threat to the US and had taken no aggressive actions. Even if Saddam had possessed WMD, he had no ability to deliver them to the US.

Henry Kissinger spoke about a year ago at a synagogue to which he owed a big favor. It had sponsored his family's escape from Germany, and as he tells the story, they got out at the last possible moment. It was an informal presentation, and Kissinger could not contain his contempt for the Administration, stating repeatedly not merely that they had made mistakes, but that every decision they made was the wrong one. My friend who was in attendance said it was the most unequivocal condemnation she had ever heard.

It appears to have enlisted a bit of support in their active, reckless incompetence. In the Guardian, James Galbraith dissects the manifesto of five former Nato generals, led by former chairman of the Joint Chiefs of Staff John Shalikashvili in arguing for pre-emptive nuclear attacks to prevent the spread of nuclear arms and WMD (hat tip Mark Thoma).

There are no checks on this process. We got it woefully wrong with Iraq, insisting they had WMD when a team of UN weapons had found none and was barred from completing its work. And it's OK for India and Israel to not sign the international nuclear accords and become nuclear powers, but not for Iran. The US arrogance is breathtaking. We are a rapidly fading military power, yet we try to play the role of Collussus bestride the world. And because Iraq has visibly overstrained our capabilities, we are now having to threaten the use of nukes.

And even if you believe this is mere saber rattling intended to serve merely as a deterrent, there is no evidence that it is effective. Jonathan Glover's book Humanity, which looks into why the horrors of the 20th century came about, also dissects how the Russian missile crisis was averted. He attributes it to two factors: the recent publication of Barbara Tuchman's The Guns of August, which made clear how World War I was the result of failed communications and rigid assumptions, and a half-day briefing the new President and his key lieutenants received on the horrors of nuclear war. In fact, a gripping passage reveals how Dean Rusk had to go to some lengths to rein in the Navy, which was overly eager to engage the Soviets.

But perhaps the most articulate defense of the reason to stay within the confines of international law comes from Roger Bolt's screenplay about Thomas More, A Man for All Seasons:

More: Yes. What would you do? Cut a great road through the law to get at the Devil?

Roper: I`d cut down every law in England to do that.

More: Oh! (advances on Roper) And when the last law was down, and the Devil turned round on you --where would you hide, Roper, the laws all being flat? (He leaves him) This country’s planted thick with laws --man's laws, not God's --and if you cut them down --and you’re just the man to do it --d`you really think you could stand upright in the winds that would blow then? (Quietly) Yes, I`d give the Devil benefit of law, for my own safety`s sake.

Talking up pre-emptive strikes serves to legitimate unwarranted aggression, which per More's speech, can just as easily be used to justify attacks on us.

From the Guardian:

Five former Nato generals, including the former chairman of the US Joint Chiefs of Staff, John Shalikashvili, have written a "radical manifesto" which states that "the West must be ready to resort to a pre-emptive nuclear attack to try to halt the 'imminent' spread of nuclear and other weapons of mass destruction."

In other words, the generals argue that "the west" - meaning the nuclear powers including the United States, France and Britain - should prepare to use nuclear weapons, not to deter a nuclear attack, not to retaliate following such an attack, and not even to pre-empt an imminent nuclear attack. Rather, they should use them to prevent the acquisition of nuclear weapons by a non-nuclear state. And not only that, they should use them to prevent the acquisition of biological or chemical weapons by such a state.

Under this doctrine, the US could have used nuclear weapons in the invasion of Iraq in 2003, to destroy that country's presumed stockpiles of chemical and biological weapons - stockpiles that did not in fact exist. Under it, the US could have used nuclear weapons against North Korea in 2006. The doctrine would also have justified a nuclear attack on Pakistan at any time prior to that country's nuclear tests in 1998. Or on India, at any time prior to 1974.

The Nuremberg principles are the bedrock of international law on war crimes. Principle VI criminalises the "planning, preparation, initiation or waging of a war of aggression ..." and states that the following are war crimes:

"Violations of the laws or customs of war which include, but are not limited to, murder, ill-treatment or deportation of slave labor or for any other purpose of the civilian population of or in occupied territory; murder or ill-treatment of prisoners of war or persons on the seas, killing of hostages, plunder of public or private property, wanton destruction of cities, towns, or villages, or devastation not justified by military necessity."

To state the obvious: the use of a nuclear weapon on the military production facilities of a non-nuclear state will mean dropping big bombs on populated areas. Nuclear test sites are kept remote for obvious reasons; research labs, reactors and enrichment facilities need not be. Nuclear bombs inflict total devastation on the "cities, towns or villages" that they hit. They are the ultimate in "wanton destruction". Their use against a state with whom we are not actually at war cannot, by definition, be "justified by military necessity".

"The west" has lived from 1946 to the present day with a nuclear-armed Russia; no necessity of using nuclear weapons against that country ever arose. Similarly with China, since 1964. To attack some new nuclear pretender now would certainly constitute the "waging of a war of aggression ..." That's a crime. And the planning and preparation for such a war is no less a crime than the war itself.

Next, consider what it means to determine that a country is about to acquire nuclear weapons. How does one know? The facilities that Iran possesses to enrich uranium are legal under the non-proliferation treaty. Yes, they might be used, at some point, to provide fuel for bombs. But maybe they won't be. How could we tell? And suppose we were wrong? Ambiguity is the nature of this situation, and of the world in which we live. During the cold war, ambiguity helped keep both sides safe: it was a stabilising force. We would not use nuclear weapons, under the systems then devised, unless ambiguity disappeared. But the generals' doctrine has no tolerance for ambiguity; it would make ambiguity itself a cause for war. Thus, causes for war could be made to arise, wherever anyone in power wanted them to.

The generals' doctrine would not only violate international law, it repudiates the principle of international law. For a law to be a law, it must apply equally to all. But the doctrine holds that "the west" is fundamentally a different entity from all other countries. As the former Reagan official Paul Craig Roberts has pointed out, it holds that our use of weapons of mass destruction to prevent the acquisition of weapons of mass destruction is not, itself, an illegal use of weapons of mass destruction. Thus "the west" can stand as judge, jury and executioner over all other countries. By what right? No law works that way. And no country claiming such a right can also claim to respect the law, or ask any other country to respect it.

Conversely, suppose we stated the generals' doctrine as a principle: that any nuclear state which suspects another state of being about to acquire nuclear weapons has the right to attack that state - and with nuclear weapons if it has them. Now suppose North Korea suspects South Korea of that intention. Does North Korea acquire a right to strike the South? Under any principle of law, the generals' answer must be, that it does. Thus their doctrine does not protect against nuclear war. It leads, rather, directly to nuclear war.

Is this proposed doctrine unprecedented? No, in fact it is not. For as Heather Purcell and I documented in 1994, US nuclear war-fighting plans in 1961 called for an unprovoked attack on the Soviet Union, as soon as sufficient nuclear forces were expected to be ready, in late 1963. President Kennedy quashed the plan. As JFK's adviser Ted Sorensen put it in a letter to the New York Times on July 1, 2002:

"A pre-emptive strike is usually sold to the president as a 'surgical' air strike; there is no such thing. So many bombings are required that widespread devastation, chaos and war unavoidably follow ... Yes, Kennedy 'thought about' a pre-emptive strike; but he forcefully rejected it, as would any thoughtful American president or citizen."

It's not just citizens and presidents who are obliged to think carefully about what General Shalikashvili and his British, French, German and Dutch colleagues now suggest. Military officers - as they know well - also have that obligation. Nuremberg Principle IV states:

"The fact that a person acted pursuant to order of his government or of a superior does not relieve him from responsibility under international law, provided a moral choice was in fact possible to him."

Any officer in the nuclear chain of command of the United States, Britain or France, faced with an order to use nuclear weapons against a non-nuclear state would be obliged, as a matter of law, to ponder those words with care. For ultimately, as Nuremberg showed, it is not force that prevails. In the final analysis, it is law.

Links 1/26/08

Memorial for bear that served in WWII BBC

Economic stimulus package: criticism grows ataxingmatter

The $600 Mortgage Multiplier Marginal Utility. Ken Houghton has found the most ridiculous CEO pronouncement I have seen in a long time.

Which Private Equity Firms Create the Weakest Companies? Deal Journal, Wall Street Journal

The great fiscal stimulus package ... of 1929 MarketWatch. Cheery, aren't we?

US pawnbrokers benefit from tough times Financial Times

The unintentional humor of ‘A Charge to Keep’ The Carpetbagger Report (hat tip Angry Bear). Don't ask questions, just go read it.

Massachusetts Subpoenas MBIA and Ambac Over Disclosure

A reader pointed us to the fact that the State of Massachusetts has issued subpoenas to MBIA and Ambac regarding bond issued by Massachusetts cities and town that they guaranteed from January 1, 2006 onward. According to CNN, the state is investigating whether the insurers made adequate disclosure of their involvement in mortgage-related instruments. Put more simply, could a reasonably inquisitive mind have figured out the bond insurers might be a wee bit overextended?

It is pretty much certain that the bond insurers did not tell the municipalities about their rapidly growing book of securitization risks. I am no expert, but the issue of liability will probably revolve around whether the insurers had an obligation to reveal more than was presented in their public financials and insurance filings, or similarly, whether any of the municipalities attempted to do due diligence and were given less than complete answers.

Needless to say, if the Massachusetts investigation looks like it will lead to a lawsuit, it represents another set of claims against already weak balance sheets, and will make any rescue operation even more difficult.

From CNN:

Massachusetts' top securities regulator on Wednesday said he issued subpoenas to a pair of municipal bond insurers, seeking information on how much the firms disclosed to cities and towns about their exposure to mortgage-related investments that have recently plunged in value.

Secretary of State William Galvin sent the subpoenas last week to New York-based Ambac Financial Group Inc. (NYSE:AKT) (NYSE:AKF) (NYSE:AFK) (NYSE:ABK) and Armonk, N.Y.-based MBIA Inc. (NYSE:MBE) (NYSE:MBI) He is seeking lists of public bonds in Massachusetts that the firms agreed to back by insuring repayment, and related documents. He gave the firms until Feb. 1 to turn over the documents....

'This office wants to know when and if MBIA and Ambac disclosed to bond issuers -- the cities, towns, districts and other public authorities -- that their financial condition as an insurer was being severely impacted as a result of their involvement with these highly risky securities,' Galvin said.

Galvin questioned whether Massachusetts cities and towns would have relied on Ambac and MBIA for financial guarantees to ensure bond investors are repaid, had the governments known about the firms' guarantees of CDOs.

If cities and towns are unable to repay bond investors, insurers repay the principal and interest -- a guarantee that comes at a premium price to municipalities if the insurer boasts a strong rating from outside agencies that assess' financial strength.

'Cities and towns rely on these companies in order to quickly and cost-effectively raise money for such needs as public safety, buildings and schools,' Galvin said. 'The market relies on the insurance provided by these companies to price the bonds and to insure that investors get paid in the event of a default.

'If the credit quality of these companies comes into question, the impact on cities and towns is enormous, raising costs to municipalities and increasing investors' risk,' he said.

Goldman Sued on Countrywide Underwriting

Don't get too excited, this move by New York City and State to sue lead manager Goldman, 25 other underwriters and accounting firms over a Countrwide stock offering is routine securities fraud, in this case making misrepresentations about the company's prospects. No one has yet to develop a legal theory to go after Goldman for the move that has many offended, being net short subprime related debt while continuing to sell them to investors. And the latter is unlikely to go anywhere (saver perhaps serving as fodder for Congressional investigations) because that action didn't violate any securities laws.

However, the Countrywide deal raises an interesting question. Banks like Bank of America are going to the market and will of course put the best possible spin on the outlook for their business. Wonder if this will be the breeding ground for further litigation.

From Bloomberg:

Goldman Sachs Group Inc. and 25 other underwriters of Countrywide Financial Corp., the biggest U.S. mortgage lender, were named as defendants in a suit by New York state and city officials for allegedly making misleading statements about the company's prospects.

New York City Comptroller William Thompson Jr. and state Comptroller Thomas DiNapoli added the 26 securities firms, two accounting companies and additional Countrywide officers and directors as plaintiffs in the investor securities-fraud lawsuit filed last year in federal court, according to a statement issued today by Thompson's office.

The state and city pension funds' combined losses due to Countrywide's declining stock price were as much as $100 million, Thompson said on Nov. 30.

Willem Buiter Heaps Scorn on Fed's 75 Basis Point Rate Cut

Willem Buiter's immediate reaction to the Fed's emergency rate cut earlier this week was sharply negative, and upon reflection, his view has become even more critical. Buiter sees the reason for the cut as a "knee jerk" response to the prospect of a sharp fall in equity prices. He looks at the proximate causes of the fall – heightened worry about monoline downgrades, and the hasty unwinding of suddenly discovered trades at SocGen – and finds neither points to the sort of fundamental new information about the economy that might justify Fed action.

Note that the SocGen sales aren't the first occasion in recent weeks that sales by a big player has helped fuel a market decline. Cassandra in Tokyo pointed to a sharp down day in Tokyo last week in which the pattern of trading suggested forced sales out of a major portfolio, and similarly, efforts to reduce quant pain played a role in market volatility in August. The Fed should have considered the possibility of exceptional, one-off factors before pulling the trigger.

By happenstance, Cassandra today has learned of the existence of the Bernanke Rule, which is a new and improved version of the Taylor Rule:

The Bernanke Rule, by contrast, stipulates how much the Central Bank should change the nominal interest in response to nominal divergences of the stock market indices from levels that cause those that own lots of stocks - whether leveraged or unleveraged - to hoot, howl, cry-foul, (and this is most important distinction) irrespective of what these changes in interest rates will do to the actual rates of inflation, inflationary expectations, in comparison to any reasonable target rates of inflation.

She and Buiter should compare notes.

Half the reason for reading the post is Buiter's colorful phrase-making. For instance, he swiftly dispatches both the monoline business model and the adequacy (in dollar terms) of the rescue effort. He sees it as patently obvious that they are carrying far more risk than they can credibly handle. He is also, as we are, suspicious of the "rogue trader" explanation of the SocGen mess.

From Buiter:

Even with a few days worth of hindsight, the Fed’s out-of-sequence, out-of-hours 75 basis points cut in the target for the Federal Funds rate continues to look extraordinary and deeply misguided. Indeed, it looks less and less like a decisive pre-emptive move in response to unexpected bad news designed to meet the Fed’s triple mandate of maximum employment, stable prices and moderate long-term interest rates, than a knee-jerk panic reaction to a global stock market collapse.

Did the sharp global decline in stock values at the beginning of this week reflect a rational re-assessment of fundamentals? The only two candidate explanations I have heard are (a) that the collapse was probably triggered by concerns about the financial viability of the monolines and (b) that it was intensified by the unwinding by SocGen of the long equity positions taken by its employee of the year (not!). I find neither explanation convincing. If the collapse was a spurious, non-fundamental event, there is no reason for the Fed to react to it. The ability of the Fed to meet its fundamental objectives is seriously undermined if it is perceived as the poodle of the equity markets.

Monolines

Fear about the credit ratings or even the financial viability of some of the monolines is not a plausible driver of a fundamentals-based stock market retreat. The monolines insure default risk. They don’t diminish it, but only spread it. They therefore fulfil the same economic function as credit default swaps (CDS).

When a monoline insures credit risk, this has a number of consequences. First, if no default has occurred as yet, the debt instrument (a bond, say) that is insured now carries a lower risk premium, provided the probability of default of the monoline is lower than that of the original issuer of the bond and provided the default risk of the original issuer and of the monoline are not perfectly correlated. This is one reason why monolines without a AAA rating cannot get new business. Second, the original issuer (or the party offering the credit-risk-insurance-enhanced instrument) pays an insurance premium to the monoline. If markets are reasonably efficient, there should be no free lunch here: the cost of the default insurance should equal the reduction in borrowing costs permitted because of the insurance.

Third, when a default occurs, it redistributes the financial cost of the default from the holder of the debt instrument to the monoline.

Finally, if monolines are better able to bear the default risk than the issuers of the securities they insure, and if other credit risk insurance mechanisms (e.g. CDS) are not perfect substitutes, there will be an increase in economy-wide efficiency. This could, but need not, be reflected in an increase in aggregate stock market values (adding together the equity of the issuers of the debt and that of the monolines).

Monolines are few in number and small. They don’t have a lot of capital. It seems unlikely that, in an even vaguely rational world, their existence would make a huge different to the performance of the credit markets and, indirectly, the equity markets. It is clear that, while they may well offer credible protection against idiosyncratic default risk of individual borrowers, they will offer no protection against a significant economy-wide increase in defaults, such as may be associated with a recession. Monolines are unbelievably leveraged: last year the value of their outstanding guarantees was 150 times capital, with the notional value of the insured assets at around $ 3.3 trillion and capital of between $20 billion and $25 bn.

It does not take a wildly implausible increase in the level of the average default rate to wipe out this capital. I don’t understand a business model for default risk insurance which implies that your capital will be wiped out if less than 0.7 percent of your insured assets go belly-up. The efforts by New York state's Insurance Superintendent to get a posse of banks to put up between $ 5.0 bn and $15.0 billion to shore up the capital of the monolines, after one of the largest two (AMBAC) lost its AAA rating, seem modest compared to reasonable estimates of the expected losses of the monoline industry. Perhaps the decimal point should be moved one place to the right?

In addition, the monolines share a feature with one of the other villains of the securitisation crisis: the rating agencies. The rating agencies started out rating sovereign debt and large corporates – an activity that does not require more than an abacus and a modal IQ. They then expanded into the rating of complex structured products (ABS, CDOs etc.). They were revealed to be out of their depth in this business.

The monolines started life in the 1970s as insurers of American municipal bonds. In recent years, they have expanded on a large scale into the insurance of complex structured products, such as ABS and CDOs. While there appears to have been little exposure of the monolines to thesubprime market, it would seem to this outsider that they either grossly underestimated the default risk on the bonds they insured, or grossly underpriced it. (They were of course not alone in this during the years of global underestimation/underpricing of credit risk and all other forms of risk from 2003 till 2007). With the reassessment and repricing of risk now under way, it is inevitable that the monolines would take a massive hit and that new underwriting business would be on much more stringent terms. The entry of new, and one hopes better capitalized, firms, such as the venture created by Berkshire Hathaway, into the monoline industry is therefore very welcome.

But the magnitude of the stock market declines stands in no proportion to the fundamental importance of the monolines, even in aggregate. With their ludicrously high leverage, they were never able to provide any kind of cushion against even a small increase in aggregate as opposed to idiosyncratic, default risk.

Société Générale

The fraud at Société Générale, resulting in a € 5bn loss will provide bloggers and columnists everywhere with material for weeks to come. It raises serious issues for regulators and supervisors of banks and other financial institutions. But it is not a macroeconomically significant event. Like all theft, the fraud itself merely redistributed wealth, without any obvious effects on aggregate demand. To make a loss of €5bn, there probably was an exposure of between €50 and €70bn. Société Générale closed all these positions in a hurry starting Monday. This may have contributed to the stock market decline in Europe, but the rout was already under way in Europe (and earlier in Asia), before Société Générale did its bit for the bears. I assume the Fed must have been informed of the Société Générale debacle by the French regulator (the Banque de France) before it decided on its rate cut (Monday evening US time).

The stock market sometimes loses its nerve. Left to its own devices, it will recover it. There is no monetary policy mandate to protect those who lose their nerve against those who don’t. So it looks as though the Fed, like the stock market, simply lost its nerve.

As an aside, I am usually a believer in the screw-up theory of history rather than the conspiracy theory of history, but in the case of Société Générale I am not so sure. How could one man, a junior trader, even if he is a wizz at Solitaire, carry a € 50 billion to € 70 billion position day after day without anyone else noticing? He is supposed to have been long equity. That cannot have been a long outright position, because this would have been noticed in the cash markets. It cannot have been in the equity futures markets either, because that requires margin payments whenever stocks fall. The perp would have been caught a long time ago. So how did he do it? Did he sell equity puts? Could he have done this on his own? Unlikely, I would say. He has also, conveniently, disappeared. If he is found hanging from a bridge somewhere, my suspicions that there is more to this than has thus far met the eye will have been confirmed.

Conclusion

The stock market giveth - the stock market taketh away; and then the stock market giveth again etc. Most of the high frequency movement in stock prices is fluff – noise that policy makers ought to ignore.

Many commentators talk as if a recession in the US is a done deal, with a recession in the UK not far behind and significant weakening in Euroland coming up fast in the outside lane. I am not so sure.

A recession in the US is possible, but not in my view the most likely outcome. Employment appears to be holding up better than would be consistent with the economy already being in recession or about to enter it. Clearly, the housing sector and the financial sector in the US have over-expanded in the latest credit boom and will have to contract painfully. Profits, capital and employment in these two sectors will all fall. But outside these two sectors there has not been any significant degree of excessive capital formation in the US economy. The same holds for the UK. In Euroland the situation is even better, because there the housing sector has only expanded excessively in a few cases (Spain and Ireland), while the financial sector appears to have expanded excessively only in the Netherlands, Germany, Spain and Ireland.

The contraction of the financial sector will have repercussions for the non-financial economy, especially for the household sector, which is more highly leveraged than the non-financial corporate sector. But as yet there is no sign of a major across-the-board decline in activity even in the US, let alone in the UK and in Euroland.

Both the housing sector and the financial sector are among the most vocal sectors in the economy. The amount of attention paid to these sectors by politicians, policy makers and the media is quite disproportionate, when compared to their fundamental economic significance. When regulatory capture extends to the central bank, the quality of monetary policy making is bound to suffer. We have seen this in the US since Greenspan took over from Volcker as Chairman of the Fed. And it continues today.

We will see a slowdown in global growth, with the most severe slowdown likely in the US and the UK. But even there I don’t understand how those yielding the R-word can be as confident as they pretend to be.

Further Bank Writedowns: Barclays Says $143 Billion for Bond Insurance; Oliver Wyman Says $300 Billion in General

Bad credit-related news continues, and if the Dow is any measure, the stock market response is subdued.

Barclays estimates that the losses that banks would take due to bond insurer credit rating downgrades and the impact on the instruments they insured would be $143 billion if they are downgraded to single A (I find that remarkably precise). A downgrade to AA has a mere $22 billion impact.

Given that Egan Jones has downgraded MBIA to B= and the bond and credit default swaps markets price the bond insurers at distressed credit levels, this estimate may prove to be light.

Needless to say, findings like this increase the pressure on regulators and banks themselves to orchestrate a rescue.

From Bloomberg:

Banks that raised $72 billion to shore up capital depleted by subprime-related losses may require another $143 billion should credit rating firms downgrade bond insurers, according to analysts at Barclays Capital.

Banks will need at least $22 billion if bonds covered by insurers led by MBIA Inc. and Ambac Assurance Corp. are cut one level from AAA, and six times more for downgrades by four steps to A, Paul Fenner-Leitao wrote in a report published today. Barclays' estimates are based on banks holding as much as 75 percent of the $820 billion of structured securities guaranteed by bond insurers.

``This is a huge amount, but the assumptions we use are also very aggressive,'' Fenner-Leitao in London said in a telephone interview. The estimate shows how bank capital could be diminished in the event of significant downgrades, he said....

Fitch is likely to cut the rankings of other bond insurers in the ``very near term,'' with Financial Guaranty Insurance Co. at greatest risk, Fenner-Leitao wrote in the report. New York- based FGIC insures $315 billion of bonds.

Standard & Poor's cut New York-based ACA Capital Holdings Inc.'s rating by 12 levels to CCC last month, causing Merrill Lynch & Co. to write down $1.9 billion of securities and Canadian Imperial Bank of Commerce to sell more than C$2.75 billion ($2.7 billion) in stock to cover writedowns.

Consulting firm Oliver Wyman, which specializes in financial services, issued a press release on a report, "State of the Financial Services Industry" which foresees another $300 billion in subprime-related losses to the banking industry (hat tip Boom2Bust). Note that this computation does not appear to consider the impact of bond insurer downgrades; ie, it looks at subprime-related losses and carries them through to bank balance sheets. From the Telegraph:

"While governments, central banks and regulators scramble to address the aftermath of the sub-prime fallout, several other crises are mounting."

Tumbling property prices - especially in the UK and Spain - a weakening dollar, a possible collapse in commodity prices, and a fall in Chinese and Indian stocks will "disrupt" the global economy, the report claimed.

Banks are already coming off one of the worst trading periods in memory, with shares across the industry plummeting 40pc in the past six months.

Oliver Wyman has estimated that financial services companies have already taken a $300bn hit on their sub-prime exposure.

It estimates that $1,300bn worth of sub-prime mortgages were written in total.

US banks will feel the pinch in particular, Oliver Wyman predicts. "North American financial services firms will have a tough year," it said. "Market uncertainty, combined with further write-downs and expected home-price and loan-volume declines, implies more squeezes on earnings. Banks most likely will have to increase loan-loss reserves."

So Far, Hype Exceeds Progress on Bond Insurer Rescue Front

Despite New York insurance superintendent Eric Dinallo's desire to move a rescue of bond insurers along with all possible speed, and the very real pressure of an imminent downgrade (note that Security Capital Insurance was downgraded five levels by Fitch yesterday from AAA to A), there was perilous little in the way of progress. Indeed, the very limited reports from the sessions themselves were not encouraging.

The view from afar, as from Davos, about the prospect of a rescue is positive, perhaps desperately so. As the Financial Times' Gillian Tett tells us:

As news of a possible bail-out of the monoline industry trickled out on Wednesday night, one senior investment banker in Davos sent an urgent message to his junior staff: crunch the numbers to work out whether this makes financial sense for the banks – or not.

The answer? “We are still running the metrics,” he told me yesterday. “But we think that injecting capital would be cheaper for the banks than making write-offs [against a monoline downgrade]. We would seriously consider taking part.”

Similar debates are now undoubtedly occurring all over the financial world. For though the workings of the monoline industry used to be a topic which only excited geeks – or FT market reporters – almost all the financiers I have met so far in Davos believe it will be difficult (nay, impossible) to restore confidence in the financial world without a “solution” for the monoline problem.

When I read "solution," I think, "Final Solution."

I don't buy one bit of Tett's reasoning:

However, the proposed monoline bail-out idea does seem to have more merit. After all, the monoline initiative is not necessarily about propping up market prices per se – but more about dealing with counterparty risk. Moreover, there is a case to be made that the investor reaction to the troubles at the monolines has recently become a trifle extreme – partly, as I noted above, due to widespread ignorance about how the monolines actually work.

Those who have read the Pershing Square analyses, or summaries thereof, don't find the reactions extreme. But to the premise: pray tell how is a rescue not a propping up of prices? No one would care about the monolines' fate if the value of most of instruments they insured did not depend on the ratings. And the credit default swaps market and the secondary market price of MBIA's bond issue say that the debts are at high risk of bankruptcy, therefore the guarantees are also at high risk of being worthless. So this most assuredly is about propping up the underlying value of these securities in order to keep prices from collapsing. To pretend otherwise is wrongheaded.

Back to the events du jour. Closer to home, things do not look so pretty on the rescue beat. The Journal gives a surprisingly blunt take, "Bond-Insurer Rescue Effort Faces Wall Street Skepticism":

Mr. Dinallo said he wants to solve the problems "as soon as possible." However, he said, "these are complicated issues involving a number of parties, and any effective plan will take some time to finalize."

The shares of MBIA and Ambac, which had risen sharply on news of the plan, gave up much of their earlier gains. However, the story that Wilbur Ross was looking at investing in Ambac pushed the shares up in after-hours trading.

The Journal discussed exposures of key players, Merrill with $3.45 billion of "super senior" CDOs, Citi with $3.8 billion:

But it isn't clear whether those firms would have the money, or the inclination, to use it to aid bond insurers. One consideration might be whether they think the cost of participating in a bailout might be greater than any loss of value in their holdings.

Note also they will get tax deductions on losses, which they can carry forward, while an equity investment offers no tax bennies.

And we get to the real fly in the ointment: even if Dinallo can reach a deal with a funding group, will the bond insurers accept it? I am not an expert on insurance regulations, but it seems to me there is a case to be made that the financial statements the insurers have been filings are misleading. Dinallo needs to be willing to use whatever tools he has to threaten a regulatory takeover (in effect, putting the insurance subs in runoff mode) to cudgel the board at the parent company level into submission.

The coverage from CNBC was even more downbeat. From "Bankers Downplay Reports of Bond Insurer Rescue":

Bankers who met with New York insurance regulators to discuss a reported bailout of troubled bond insurers downplayed the meeting's significance Thursday, with one calling it a "non-event."

Bankers told CNBC that there was no consensus formed at the meeting and no movement on creating substantial plans for a rescue. Moreover, reports of the meeting may have made a bad situation for the industry worse, bankers said, as a subsequent jump in bond insurer stock prices scared off private equity firms that may otherwise have injected capital into the companies.

And the last complicating factor: the Street neither likes nor trusts Dinallo. From the Journal:

By exploring a bailout of the nation's bond insurers, New York State Insurance Superintendent Eric Dinallo is tackling a problem that threatens Wall Street and ordinary investors alike..... At the same time, he has another potential obstacle. In a previous job, he rubbed many influential Wall Street figures the wrong way -- including some he is now turning to for help.....

Mr. Dinallo has a colorful history with some of the firms and executives he is now leaning on to come up with a rescue plan. The 44-year-old lawyer made his name on Wall Street while working as the top investigator from 1999 to 2003 for Eliot Spitzer, who was then New York's state attorney general....

Messrs. Spitzer and Dinallo led a very public campaign against Wall Street that in 2003 resulted in 10 big Wall Street firms paying $1.4 billion to settle allegations they issued tainted stock research in a bid to win more lucrative investment-banking business. Some executives on Wall Street felt that Mr. Dinallo was part of a team that was prone to making sometimes inflammatory public statements....

Today, some executives currently dealing with Mr. Dinallo on this latest issue said they now proceed with caution on dealing with him because of their previous dealings.

And it also appears the regulator has not been taking sufficient care to improve his image. From the Financial Times:

Meanwhile, there is justifiable unease among some bankers about how this bail-out has been organised. “The state regulators have put a gun to our heads and we just don’t like that,” complained senior one banker to me. “This smacks of something cobbled together by people without the experience. This is not how it should be done.”

While it may seem silly to let egos get in the way when there is so much to be gained or lost, the fact is that dealmaking requires highly developed interpersonal skills, particularly negotiating skills. And in a deal with multiple parties with differing economic interests (no one wants to tip their hand, no one wants to be taken), the dynamics are particularly fraught. It requires time and attention to the dynamics of the room as well as the issues on the table. Too many people focus on content and unwittingly let tensions build that lead to ruptures later.

Unfortunately, experience as a litigator is likely to have given Dinallo the wrong reflexes. And he may lack the sense to delegate the vital negotiation/facilitation role to someone who can pull it off.

China's Tough Choices

Brad Setser has an excellent post, "The PBoC's dilemmas," which he later admits is really China's dilemmas. He focuses on two issues. First is that due to the loosening of the yuan peg against the dollar, the central bank is losing $4 billion a month, mainly on its Treasury holdings (note this is due to the fall in the value of the bonds; the spread over the cost of funding is still positive).

The second is that a slowdown in the US isn't hurting China; indeed, short-term, the Chinese benefit. Why? We cut rates, that leads to a dollar decline. Even though the yuan is now being allowed to appreciate at a moderate rate against the dollar, when the dollar falls, as it has and is almost certain to continue to do, Chinese competitiveness improves versus the rest of the world. Note that Michael Pettis reads the tea leaves somewhat differently; he thinks the latest data releases point to a badly overheating economy and mismanaged monetary policy. A US slowdown and more yuan appreciation would be salutary in his view.

I hate to differ with Setser, but I take issue on his first point, that the $4 billion a month (and certain to rise) losses that China is suffering on depreciating foreign assets poses a problem. I doubt that it does.

In dealing with the Chinese, we tend not to want to see their hegemonic aims. Frankly, China believes its time is almost here. The US is now spending $20 billion a month on Iraq, and the only beneficiary is Halliburton. That exercise has strained our armed forces, damaged our finances, and hurt our global reputation. And there is no end in sight to the costs.

The question isn't whether China can afford the FX losses (it can) but whether they derive value from them. We have long believed that China would never use the trump card that it holds by being our biggest funding source, because using it would hurt their economy as well as ours. We tend to forget that the Chinese have had a proud history of subordinating the welfare of their people to their governments' objectives.

Japan has had this hold over us too, but not to the same degree (our current account deficit is worse now) but never would have used it because Japan is as close to a socialist society as you will see, so the idea of voluntarily inflicting economic pain on its citizenry is a no go (inflicting it out of ineptitude, however, is a different matter). It is also a military protectorate of the US and therefore in no position to push its luck.

Now the Chinese have yet to have reason to cross wills with us, and the change in government in Taiwan to one keen on closer relations with the mainland has probably removed the biggest potential source of contention (but again, closer alliance with Taiwan puts us further in Chinese thrall, since Taiwan is our biggest single source of chips). But if it were to happen, consider the example of the Saudis. The Saudis wanted concessions from Israel in the wake of the 1967 war, specifically, return of land and access to sites that were important to Muslims. The Israelis said no and we backed them. The Saudis threatened an oil embargo. We laughed and said they'd never dare, it would hurt them too.

You know how that movie turned out.

To Setser's post:

Whatever troubles the Fed faces, at least it is still profitable. The same cannot be said for China's central bank. And while the Fed just has to worry about economic conditions in the US, the People's Bank of China has to worry about economic conditions in both the US and China....

Dilemma 1. China's central bank is now losing money. At least it would be if it measured its performance like a normal financial institution.

Goldman Sachs' Hong Liang calculates that -- taking into account currency losses -- the PBoC is now losing about $4b a month....$4b a month is very plausible.

Consider a bit of (very) ballpark math. Suppose the PBoC is paying an average of 1.5% on its liabilities -- the low rate reflects the fact that a lot of the PBoC's liabilities are "RMB cash" (which pays no interest). Further suppose that the PBoC gets an average of 4.5% (a fairly generous coupon given how Treasuries are trading these days) on its foreign assets. And suppose that the RMB appreciates by 7% this year against the basket of China's reserves (The RMB appreciated by 7% against the dollar last year). The PBoC's total return on its foreign assets, in RMB terms, would be -2.5%. Taking into account the PBoC's funding costs, it would lose roughly $60b on its $1500b in current assets.

Even in this scenario, the PBoC's cash flow is still positive. It would be paying about $22.5b in interest (a bit more actually, as the RMB would appreciate, increasing the dollar value of RMB payments),and it would be getting about $67.5b in interest.

But $45b in interest income is too small to offset the $105b (unrealized) currency loss on its foreign assets. As the renminbi appreciates, the PBoC's dollars and euros will fall in value relative to the PBoC's renminbi liabilities.

My very rough numbers are meant only to give an idea of scale.* They do though highlight the financial problem the PBoC faces as t raises domestic rates (to cool China's economy) while US rates are falling. Raising rates increases the PBoC's costs even as falling US rates cut into the PBoC's interest income.

Dilemma 2. Is a US slump contractionary or expansionary?

It isn't clear -- at least not to me -- whether a US slump helps or hurts China. Remember, China's growth accelerated over the past two years even as the US slowed a bit.

Look at the graph that accompanies Andrew Batson's article in the Wall Street Journal.

Note that domestic demand contributed less to China's growth in 2005, 2006 and 2007 than it did in 2003 and 2004. Consumption actually contributed less to China's growth recently than in the late 1990s. The graphs clearly show that China's record growth over the past couple of years stems in large part from the record contribution of net exports to China's growth.

And that contribution came even as the US slowed. See Daniel Gros over at the RGE Europe Economonitor.

A US slump obviously tends to reduce China's exports to the US -- or at least slow the pace of increase. That is obviously contractionary, both directly and indirectly. China's trade surplus tends to lead to more rapid reserve growth, and that tends to feed into faster money and credit growth. See Mr. Pettis.

But a US slowdown also tends to weaken the dollar and also the RMB, at least so long as the RMB tracks the dollar. As Goldman's Hong Liang notes, the RMB has depreciated against Europe and most of Asia over the past two years. That has supported China's exports (at least if you think exchange rates matter) and China's growth.

There is another link as well: so long as China's currency tracks the dollar, China has difficulty pursuing a dramatically different monetary policy from the US. Yes, capital controls provide it with a measure of monetary policy autonomy. But the bigger the gap between US and Chinese rates, the stronger the incentive to move money into China -- and the more money comes in, the more difficulties the PBoC faces with sterilization. Don't listen to me; listen to Yu Yongding.

Right now, China is importing a weak currency and loose monetary policy from the US. Over the past two years, the net effect of the US slowdown has been positive -- arguably too positive, as China's economy and markets seem to have overheated.

But there is no guarantee the positive will continue to outweigh the negative, particularly is the US slowdown turns into a recession and Europe also slows.

Chine consequently has to weigh whether to continue to tighten policy -- and risk slowing domestic demand growth just when net exports stop contributing as strong to Chinese growth -- or whether to in effect follow the US and adopt a more stimulative policy stance and risk adding to already strong inflationary pressures in China.

That is a real dilemma.

China has been holding domestic demand growth back -- whether by limiting lending or running a fairly tight fiscal policy. But policy makers can only take their foot off the brakes if they conclude that inflation is no longer a risk. And that is a hard call when inflation is still well above China's comfort level.

Then again, it isn't really a dilemma for the PBoC. In China, the PBoC doesn't call the monetary policy shots. But it is a dilemma for China's government.

Egan Jones: Bond Insurers Need $200 Billion to Retain AAA

Bill Ackman of hedge fund Pershing Square has gotten a considerable amount of flack for his outspoken, negative views of the bond insurers, particularly MBIA and Ambac, which his firm has shorted. Ackman has been circulating a detailed analysis that estimates that the additional equity needed to maintain an AAA rating at the two biggest firms is roughly $15 billion.

This calculation is sharply contested by new rating agency Egan Jones (which also downgraded MBIA to a B+, a junk rating) which says the industry needs more than an order of magnitude more capital, namely $200 billion.

What is a bit scary is that Ackman gave his findings to New York insurance superintendent Eric Dinallo an unstated amount of time before the presentation of the report at an investor conference in late November. Dinallo contacted Warren Buffett in November about getting into the muni bond business because he recognized the monolines might have trouble writing that business. One has to wonder whether the timing had anything to do with the Pershing Square briefing.

Similarly, Dinallo is trying to raise $5 billion immediately, $15 billion longer term to shore up the bond insurers. The $5 billion seems driven by the rating agencies' immediate demands; the $15 billion is, shall we say, preternaturally similar to Pershing Square's estimates.

Now we have a rating agency, which no doubt enjoyed far greater cooperation and access (and presumably insurance industry expertise, which Pershing Square lacks) coming up with a vastly higher estimate. Why is that so troubling? Because it appears the regulators themselves either have no estimates of their own, or lack confidence in them and were therefore influenced significantly by the Pershing Square analysis. In other words, the regulators may be completely clueless.

From the Times:

America's biggest mortgage bond insurers collectively need a $200 billion (£101 billion) capital injection if they are to maintain their key AAA credit ratings, a figure that dwarfs a plan by New York regulators to put together a capital infusion of up to $15 billion, a leading ratings expert said yesterday.

The failure to maintain their AAA ratings will lead to a further round of multibillion-dollar writedowns among the Wall Street banks and other large owners of the bonds, Sean Egan of Egan Jones Ratings Company, said. It would also push some of them into receivership, Mr Egan added.

Links and Quick Takes 1/25/08

Stimulus Gone Bad Paul Krugman, New York Times. Krugman's ability to present economic ideas simply without compromising accuracy is a rare skill indeed.

The iPhone Meets the Fourth Amendment Adam Gershowitz. Absrtact:

Imagine that police arrest an individual for a simple traffic infraction, such as running a stop sign. Under the search incident to arrest doctrine, officers are entitled to search the body of the person they are arresting to ensure that he does not have any weapons or will not destroy any evidence. The search incident to an arrest is automatic and allows officers to open containers on the person, even if there is no probable cause to believe there is anything illegal inside of those containers. What happens, however, when the arrestee is carrying an iPhone in his pocket? May the police search the iPhone's call history, cell phone contacts, emails, pictures, movies, calendar entries and, perhaps most significantly, the browsing history from recent internet use? Under longstanding Supreme Court precedent decided well before handheld technology was even contemplated, the answer appears to be yes

Housing drags economy down the sink Merrill Lynch. This is the report that called for a further 20% to 30% fall in housing prices. It gives an overall US forecast and some grist for thought.

The Two Faces of Bill Gates Econospeak. Contrasts Gates' call for kinder capitalism (which is a scary echo of "compassionate conservatism") with Microsoft's efforts to develop tools to monitor employees that would make Big Brother green with envy.

Some People Never Learn The Future of Things.

Rogue trader? I'm shocked, shocked Rather indirect, Aaron Brown from Wilmott via jck, but choice:

This is mixing market losses with frauds and intermediate types of miscalculations.

So far, this appears to be an intermediate case, although SocGen is presenting it as a fraud. An authorized trader exceeded limits and lost more than he was supposed to be able to lose. SocGen claims the trader fraudulently concealed the losses, but this is a common claim after large losses, and one that is rarely substantiated later. Even in the relatively clear-cut case of Nick Leeson, some people believe that knowledge of the trades went beyond Nick himself.

BCCI was a clear fraud, about 50% bigger than this one (and that was in 1990 money). If you aggregate all the fraud in the US Savings and Loan industry in the mid-80’s, you get something two orders of magnitude larger. But there has never been a concealed trading problem this big, or at least, there has never been one that became unconcealed. It’s wise to remember that we have never seen a story of outsized concealed trading gains. Since you figure half the rogue traders guess right about the market, and far more than half should make money given that they can costlessly double-up after losses, you should remember that you are looking at censored data.

Mortgage Servicing Kickbacks?

Mortgage servicing, a business about which most people were once blissfully ignorant, is increasingly getting less-than-good press. The latest sighting comes from Katie Porter at Credit Slips, who tells of pending litigation against Fidelity National, a big, behind-the-scenes player in the servicing game.

Effectively, Fidelity was taking extra compensation that was unseen by bankruptcy judges because they were called "attorney's fees" or suchlike, when in fact a big chunk of those charges went not to the attorney-subcontractors as reported, but to Fidelity. Porter doesn't explain why the subterfuge made sense for Fidelity; presumably, they though the judges might nix the charges, but the amounts are so small that (at least to a layperson like me) it's surprising that they might be contested. In other words, being caught cutting corners wouldn't seem to be worth the payofff, but Fidelity clearly though it was. And the day of reckoning is upon them.

From Credit Slips:

Last week, a class action lawsuit (Harris v. Fidelity National) was filed against Fidelity National Information Services, a huge player in the billion dollar world of mortgage servicing. "What? I've never heard of them," you say. Fidelity is the company that provides default servicing to most of the large residential mortgage servicers. Their role is a shadowy one; unless you've delved deeply into how consumer mortgages are serviced, you probably weren't aware of their existence--much less how they may be driving up costs for consumers. Foreclosure petitions, proofs of claims, and bankruptcy court motions never bear Fidelity's name (instead they are signed by the regular servicers or by local counsel retained by the servicers.) But despite its invisibility, Fidelity is almost always part of the action in foreclosures or bankruptcy cases.

The lawsuit alleges that Fidelity receives illegal kickbacks from attorneys who work under contract with them. The exhibits to the class action are clear. Fidelity bills its clients--the servicers--for certain fees-- for example, $100 to review a bankruptcy plan. The servicer includes those fees as due and owing on bankruptcy proofs of claims, many of which appear only as "attorneys fees" or "postpetition charges." However, Fidelity requires attorneys to let it "retain" $50 of that $100. Fidelty characterizes these as "admin fees" paid by the attorney to Fidelity. The big problem with this practice is that bankruptcy law requires full disclosure of where the debtor's money is going. If the service is getting the debtor to pay these fees, the bankruptcy court should be approving those charges and who is going to receive the debtor's money. At least, that's how the class action has framed the legal issues in the case.

More Wall Street Bloodletting

The knives are out on Wall Street,, the cyclical ritual has begun. First the story is that the firms are excising businesses and people who were there only by dint of being in the right place during the frenzied upswing, but truth be told, really aren't up to the firm's standards, or so goes the party line.

Then in the succeeding waves, the next target is the mid level people, who are comparatively costly but deemed to be replaceable. Then the firm starts cutting people it knows are valuable, but has decided that the overall headcount has to reach a talismanic number, no matter what it takes to reach it. Subsequent firings depend on politics and caprice. Did the boss see you at your desk early? That might win your points for dedication, might lose them because it is seen a sign of desperation, or might merely have the unfortunate effect of reminding him you exist when he needs to draw up a new hit list.

As in the past retrenchments, the point comes where being fired, while still a huge ego blow, is no longer a scarlet letter of career dishonor. Too many known-to-be-good colleagues have also been dumped. And even though the firms freely admit they cut too deeply the last time around and resolve not to do so again, they are unable to contain themselves.

This Bloomberg story reports that Morgan Stanley, Credit Suisse, and Lehman are eliminating a total of 1,640 jobs. Small beer so far, unless you are one of the ones tagged to go. But we are still early in this process. Peak to trough, employment in the securities industry typically falls 20%.

Interestingly, the cuts at Morgan Stanley include asset management, which is not an area obviously affected by the credit contraction.

The story also give a tally of job losses at big financial players, which is useful, but that lumps in people like mortgage brokers at Wachovia with Masters of the Universe. I'd be very curious to see a breakout of cut from institutional versus retail businesses. From Bloomberg:

Morgan Stanley, Lehman Brothers Holdings Inc. and Credit Suisse Group are eliminating about 1,640 jobs as the worst U.S. housing market in 26 years slows economic growth and their profit outlook.

Morgan Stanley's cuts will affect asset management, retail brokerage and support areas such as technology and administration, said a person familiar with the firm's plans. The positions at Lehman are concentrated in structured finance, commercial real estate, securitization, trading of mortgages and collateralized debt obligations, a second person said....

Credit Suisse, the second-biggest Swiss bank, said today it's cutting 500 investment banking jobs, mostly in equities and fixed-income units. The cuts are ``due to market conditions and projected staffing levels required to meet client needs,'' according to the statement e-mailed today by Bruce Corwin, a spokesman in New York.

Lehman, the largest underwriter of mortgage-backed bonds, has already cut 3,750 jobs at subsidiaries that make home loans and shut down one of them last year...

The new cuts at Morgan Stanley, which will take place over coming weeks, equate to about 2 percent of the 48,256 people that the firm employed at the end of November....Lehman's cuts represent about 4 percent of the headcount in the fixed-income division...The Credit Suisse reductions will trim 2.5 percent of jobs from its investment banking division, which had 20,300 employees at the end of September, according to the company's Web site....

The following is a table of jobs eliminated by the biggest banks and securities firms due to the collapse of the subprime mortgage market.



Firm Number of Jobs Cut

Citigroup 4,200

Lehman Brothers 3,890

Bank of America 3,650

Washington Mutual 2,600

Morgan Stanley 1,900

HSBC 1,650

Bear Stearns 1,550

UBS 1,500

Merrill Lynch 1,000

National City 900

RBC 500

Wells Fargo 500

Wachovia 443

Deutsche Bank 370

Credit Suisse 820

JPMorgan Chase 100
_____
Total 25,573

Wilbur Ross Considering Ambac Investment + Sanity Check

Ooh, either Wilbur Ross, a savvy investor in distressed assets, has completely lost his judgment with his advancing years, or he has been leaned on by the powers that be to look at this deal in the hopes that it might bring others to the table.

But remember, Marty Whitman, another storied distressed investor, owns 10% of MBIA and and then doubled up on his underwater bet by buying a big chunk of its 14% notes, which immediately traded down sharply. He seems to feel there is a resturcturing play, but any restructuring is in the hands of regulators. This is not the sort of game he is used to.

Let's consider this fact: Eric Dinallo, the New York insurance superintendent, called Warren Buffet, who is in the insurance business. He didn't step forward to rescue anyone and he clearly has the firepower and expertise. Now Dinallo is going to interested parties to try to raise capital, financial institutions who are directly exposed and would take writedowns if the bond insurers go south. What is a purely economic investor doing looking at them when firms that have a genuine interest in their welfare (and understand the risks of the instruments involved) are having to be invited to the table?

I don't see this going anywhere (and neither does Calculated Risk), but perhaps I am giving Ross too much credit. Even good investors can do stupid things.

This deal chatter may serve to buy some breathing space with the rating agencies, which may give New York state insurance superintendent Eric Dinallo time to at least try a Hail Mary pass. As we discussed earlier, there is no way for his low probability effort to get done in time under the current ratings review schedule with the ratings agencies.

First we have the story from the UK Evening Standard, and then, for sanity check, an excerpt from a letter that Pershing Square's Bill Ackman, who is heavily short Ambac and MBIA (both their stocks and their debt via credit default swapw) sent to the rating agencies.

From the Standard:

Billionaire vulture fund operator Wilbur Ross is in takeover talks with Ambac, the troubled bond insurer whose recent financial crisis was a major factor in this week's dramatic US interest rate cut.....

Insiders said the negotiations are serious and progressing well. News of the talks came after last night's dramatic intervention by US regulators to rescue the stricken bond insurance market.

Ross declined to comment on specific potential deals but said he was keen to buy a bond insurer to take advantage of a coming wave of consolidation....

"The monoline insurance industry's success depends on the reversal of some very unfortunate errors," Ross said. "It took what was a very safe industry and, through quite terrible misapplication of risk management, caused the troubles we see today."

He added that any deal would depend on whether "you really have your arms around the degree of insolvency" in the sector.

Coming wave of consolidation? Huh? We saw a similar sort of consolidation among subprime brokers. It's called collapse, athough, in fairness, the insurers have longer tailed liabilities so this sector won't implode as quickly.

Now from Ackman, courtesy Goode Value Investing:

Below we highlight a number of factors that you have failed to consider in your prior
assessments of the bond insurers’ capital adequacy:

1) Impact of Losses Should be Measured on a Pre-tax Basis

We believe that each of you overstates the bond insurers capital cushion due to tax benefits you include in calculating the impact of RMBS and CDO losses. For instance, in S&P’s recent press release update published yesterday, MBIA’s losses on RMBS and CDOs are expressed as “after-tax” losses. In order, therefore, to determine the actual cash losses implied by S&P’s after-tax estimate, one must gross up the reported $3.18 billion of after-tax losses. Assuming a tax rate of 38%, it appears that S&P is estimating MBIA’s actual cash losses at $5.13 billion, nearly $2 billion more than the losses adjusted for tax benefits.

Insurance claims must be paid in cash. A bond insurer is only able to obtain tax benefits if the insurer is a going concern and is able to generate sufficient taxable income in the current or future years to offset the losses from paid insurance claims. Your analysis makes the aggressive assumption that the bond insurers will remain going concerns and
will therefore be able to continue to write new premiums and generate income in the future.

Based on recent industry developments – including Berkshire Hathaway’s entrance into the business – it appears unlikely that MBIA, Ambac and many of the other bond insurers will be able to continue as going concerns. In a runoff scenario, we do not believe that the bond insurers will generate sufficient taxable income to offset the net operating losses generated by paid losses. While U.S. corporations can receive tax refunds by carrying back tax losses up to two calendar years, the amounts that could be refunded from carrying back losses are de minimis relative to claims payable. Even in the event the bond insurers generate taxable income in future years, it may be many years before these tax benefits can be realized, if ever, particularly in the event of corporate ownership changes caused by capital raising or stockholder turnover.

Net operating loss carryforwards are not cash and are not available to pay claims and should therefore not be deducted from losses in calculating bond insurer capital adequacy. By using after-tax loss estimates rather than pre-tax losses – the amount that will need to be paid in cash – you are understating the actual losses payable by more than 60%.

Your updated rating assessments should be adjusted to exclude tax benefits in your calculation of capital adequacy

2) Covenant Violations and Loss of Access to Liquidity Facilities

As a result of recent losses, both MBIA and Ambac have triggered covenant violations on their liquidity facilities. As a result, Ambac has lost access to $400 million of funding and MBIA to $500 million of capital. The impact of the loss of these facilities is material to the liquidity profile of the holding companies and their insurance subsidiaries and must be considered in your credit assessment.

3) Loss Estimates Must Incorporate Reinsured Exposures

Your ratings of the bond insurers are based on the bond insurers’ net credit exposures. That is, you reduce their credit exposure by those exposures that have been reinsured. This is best understood by example.

As of September 30, 2007, MBIA has re-insured approximately $80 billion of par value of its exposures. More than $42 billion of this reinsurance was purchased from Channel Re, a Bermuda- based reinsurer whose only customer is MBIA. The two most senior officers of Channel Re are former executives of MBIA. MBIA owns 17% of the company and has two representatives on Channel Re’s board of directors.

On recent conference calls, Moody’s and S&P have stated that they have not yet updated their ratings of the monoline reinsurers including Channel Re. Earlier this week, on January 16th, Partner Re and Renaissance Re, the majority equity owners of Channel Re, wrote off the entire value of their investments in Channel Re due to losses it has recently incurred that substantially exceed Channel Re’s capital, an impairment that Channel Re’s two majority owners have concluded is “other than temporary.”

Despite the fact that Channel Re has negative book equity and $42 billion of MBIA’s credit exposure – $21.5 billion of which is CDOs of ABS or CLO/CBOs – Moody’s and S&P continue to rate the company Triple A with a stable outlook. Fitch does not rate
Channel Re and apparently relies on S&P’s and Moody’s stale Triple A ratings in its analysis of MBIA’s capital adequacy.

Captive reinsurers whose ratings are not regularly updated offer the potential for abuse. We believe that MBIA reinsured on a quota share basis 25% of its 2007 CDO transactions with Channel Re. As a result of Moody’s and S&P not updating its ratings
of Channel Re, these exposures do not appear on MBIA’s list of exposures and have not been included in your calculation of MBIA’s capital adequacy.

MBIA’s second largest reinsurer is Ram Re which has reinsured $11 billion of par as of September 30, 2007. While the rating agencies have not updated their credit ratings of Ram Re, the market appears to have already done so. The publicly traded stock of Ram Holdings Ltd., the parent company of Ram Re, has declined 92% in the last year. The company currently trades as a penny stock with a market value of $32 million.

We believe that Ram Re is substantially undercapitalized and therefore, like Channel Re, is unlikely to be able to meet its obligations to MBIA.

We also note that MBIA reinsures Ambac, and Ambac reinsures MBIA. You must also consider the iterative impact of downgrades of one on the other with respect to both reinsurance and their respective guarantees of each other’s investment portfolio assets which we discuss further below.

In your updated assessment, it is critical that you update your ratings of the bond insurers’ reinsurers and reconsolidate and calculate the losses on these exposures that have been reinsured with reinsurers that are inadequately capitalized.

4) Investment Portfolios are Riskier Than They Appear

As you are well aware, the investment portfolios of the bond insurers include a substantial amount, often a majority, of bonds that are guaranteed by either the bond insurer itself or by other bond insurers. The bond insurers include these guarantees in
calculating the weighted average ratings of their investment portfolios. We note that a minimum average Double A rating is a key rating agency criterion for the insurers’ Triple A rating.

A guaranty to oneself is of course worthless and therefore you should exclude the bond insurers’ guaranty of its own investment obligations and use the underlying ratings of these instruments in determining the portfolios’ credit quality.

You should also carefully calculate the impact of a downgrade of the bonds held by one bond insurer that are guaranteed by other insurers in your calculation of capital adequacy. In light of the general distress in the industry, we believe that the rating agencies should evaluate the bond insurers’ investment portfolios as considered on an underlying rating basis.

5) Commercial Mortgage Backed Securities (CMBS)

To date, you have limited your analysis to RMBS securities and other structured finance securities with exposure to RMBS (CDOs). This limited review of exposures ignores the fact that the same lending practices and flawed incentive schemes that fueled the subprime lending bubble have been very much at work in CMBS and corporate finance.

On January 17, 2008, Fitch commented that it believed that CMBS delinquencies are “likely to double, and perhaps even triple, by the end of 2008.” As of September 30, 2007, MBIA had insured $43 billion net par of CMBS securities, the vast majority of
which was underwritten in the past two years. Failing to consider the potential for losses in this portfolio in your calculation of capital adequacy is simply negligent.

6) Claims-Paying Resources Definition Overstates Capital Available to Pay Claims

The rating agencies have adopted the bond insurance industry’s definition of capital in the form of “Claims Paying Resources” or “CPR.” We believe there are significant flaws with the calculation of CPR used by the industry and the rating agencies.

First, bond insurers include the present value of future premiums discounted at extremely low discount rates ~5% in their calculation of claims paying resources. Substantially all of these premiums are from structured finance guarantees. We believe that the bond insurers and the rating agencies do not adequately consider the facts that: (1) when structured finance obligations default, accelerate, or otherwise prepay ahead of schedule these premiums disappear, (2) purchasers of secondary market guarantees are likely to terminate their periodic premium payments because of the deteriorating credit quality of
the bond insurers, (3) the reserves for losses on these exposures (for example 12% of premium for MBIA) have proven to be inadequate and therefore overstate the net premium income, and (4) there is no provision for overhead, remediation, legal or other costs required for the bond insurers to run their business going forward. There is also no mechanism whereby the bond insurers can borrow against these potential future premiums to be used to pay claims in the present day.

There is no other financial institution in the world which takes the present value of interest spread income on loans in its portfolio and adds it to its capital. For all of the above reasons, we believe that the present value of future premiums should not be included in CPR.

CPR includes the bond insurers’ so-called depression lines of credit. As you well know, depression lines of credit can only be drawn to pay claims on municipal obligations and only after a substantial deductible. In that the losses are occurring primarily on structured finance obligations, these lines of credit should not be included in CPR

The Capital Base included in CPR is also likely to be overstated because the investment assets of the bond insurers consist primarily of bond insurer guaranteed obligations that are valued inclusive of the guarantee, when they should be valued on an unwrapped basis. The high degree of balance sheet leverage for certain bond insurers means that small changes in the values of these portfolios have a large impact on the bond insurers’ capital base.

You should adjust your estimate of CPR for each insurer to reflect the above factors in order to accurately establish the capital available to pay claims.

7) MBIA’s $1 Billion Surplus Note Issuance

Last Friday, MBIA priced an offering of surplus notes at par with a 14% yield. Within one week the notes traded down to the mid-70s and have a yield to call of more than 20%. Previous to their pricing, the notes were rated by Moody’s and S&P at Double A.

The MBIA surplus note issuance is perhaps the clearest example of the failure of the rating agencies to accurately assess the creditworthiness of a bond insurer. MBIA is still rated Triple A by all three raters. The notes received a Double A rating because of their subordination to the other obligations of MBIA Insurance Corporation. That said, how can a billion dollars of Double A rated obligations sell in a cash transaction between sophisticated parties at a 14% yield, and then trade to yield of 20% or more — a rate consistent with a Triple C or near-to-default obligation?

Bank of America 5 ¾% bonds due 2017, obligations of a financial institution that is also rated Double A, closed today at 5.55% yield, a more than 15 percentage point lower rate than the MBIA surplus notes. This is prima facie evidence that your ratings of MBIA are overstated.

Billions of MBIA’s CDO Exposure Require Payment on Default

You have stated that bond insurers have no accelerating CDO guarantees and that all of their contracts are structured as “pay-as-you-go.” I quote S&P from a paragraph entitled, “Time is On Their Side,” in their December 19, 2007 report: “Detailed Results of Subprime Stress Test of Financial Guarantors.”

“As for swap exposure, except for ACA there are no collateral posting requirements and swaps are written in pay-as-you-go format.”

On January 9, 2008, MBIA filed a copy of a powerpoint presentation which was used in the Surplus Notes offering road show. On page 8, MBIA states that $8.1 billion of its Multi-sector CDOs require payment with “Credit events as they occur.”

The liquidity demands of accelerating CDO exposure create extreme liquidity risk and must be considered in the context of the bond insurer ratings. We encourage you to examine all of the bond insurers CDS/CDO exposure to determine the amount of
exposure that is not pay-as-you-go, but rather accelerates, and consider the liquiditydemands of such exposures in your rating assessments.

9) Holding Company Liquidity Risk

In light of recent events, we believe it is likely that most bond insurers will be prevented from upstreaming dividends to their holding companies as a result of regulatory intervention, as regulators work to preserve capital for policyholders.

Most bond insurer holding companies have limited cash, have lost or will lose access to liquidity facilities, and have substantial cash needs for interest payments, operating expenses, and dividends (for so long as they continue to be paid). In addition, bond insurers with substantial investment management or swap operations have additional liquidity needs in the event of a downgrade.

We believe that both MBIA and Ambac have substantial collateral posting obligations in the event of a holding company downgrade. For example, MBIA has $45 billion of derivative obligations at the holding company that relate to currency, interest-rate, and credit default swaps that the holding company has entered into. The combination of volatility in each of these markets and the increased collateral demands required in holding company downgrade scenarios will put a severe strain on holding company liquidity.

The bond insurers’ muni-GIC business is also a large potential liquidity strain as municipalities withdraw funds from these GIC programs, assets must be liquidated, and/or collateral must be posted. Various MTM programs also create liquidity risk as
assets may have to be sold to meet redeeming bondholders. The liquidity risks of these programs and the underlying assets should be carefully examined.

ACA’s immolation is but one example of what happens to a once-investment grade bond insurer which, if downgraded, is required to post collateral.

In addition, as a result of shareholder, bondholder, and/or surplus noteholder litigation, we expect holding company legal expenses and eventual litigation claims to rise substantially. Because the holding companies typically provide indemnities for
employees and directors, we would expect that directors would be loathe to allow liquidity to leave the holding company estate, depriving directors and employees of the resources to protect themselves from claims. In these circumstances, we would expect companies to seek bankruptcy as a means to protect the allocation of value among various stakeholders.

10) MBIA - Warburg Pincus Transaction

You have assumed in your analysis that the Warburg Pincus deal and follow-on rights offering are certainties even though neither transaction has closed. While Warburg has made affirmative statements about the transaction, both publicly as well as privately, to surplus note buyers and the media, we believe there continues to be transaction closure risk for both the initial stock purchase and future rights offering, with the rights offering having greater uncertainty.

You have also assumed that 100% of the $1 billion Warburg deal will be downstreamed to the insurance subsidiaries and this, too, is not a certainty. You should receive assurances from MBIA and require it to contribute the full billion dollars to its insurance subsidiaries before you include the funds in calculating insurance company capital.

With the collapse in MBIA’s stock price and today’s downgrade of Ambac, we believe it will be difficult for MBIA to execute the rights offering, particularly before the March 31st, 2008 drop dead date. With the stock at $8.55 per share and the market aware that the $500 million in rights offering proceeds is insufficient to adequately capitalize the company, it will be difficult to set a market-clearing price. Assuming for a moment the price is set at $5.00 per share, the company would have to issue 100 million shares and may sell control to Warburg at a discount in the event shareholders elect not to participate. We believe a shareholder vote and approved registration statement will likely be required in such a circumstance, delaying the ability to consummate the transaction beyond the March 31st Warburg backstop drop dead date.

11) Future Business Prospects and Franchise Value Have Been Irreparably
Destroyed

Following the dramatic decline in share prices, widening of credit protection spreads, dismal performance of the high yield surplus note issuance, and recognition of multibillion dollar losses in a supposed “no-loss” business, the ability of bond insurers to market their “AAA” seal of approval has been permanently undermined. As uncertainty has grown, municipalities have raised capital without insurance and found that they can borrow at attractive rates as compared to historical insured bond issuances.

The entrance of Berkshire Hathaway is a devastating competitive reality that will capture the lion’s share of an already shrinking market for municipal bond insurance. While some commentators have suggested that this might create a pricing umbrella that will benefit the existing bond insurers, this is demonstrably false. Because Berkshire Hathaway already possesses a real Triple A rating, the bonds that are wrapped with its guarantee will trade with a tighter spread when compared to a bond insured by a traditional bond insurer, even one without legacy structured finance exposure.

Consequently, Berkshire will be able to charge higher premiums than the other monolines by taking a higher percentage of the spread (perhaps as much as 80% or more) that is saved through the use of insurance, and still provide the issuer with an overall lower cost of borrowing that if they bought insurance from a traditional monoline. As such, we believe that Berkshire Hathaway will likely quickly reach an 80%-90% market share of municipal bond insurance.

12) Going Concern Opinion

In light of all of the above and other current developments, we believe it will be difficult for MBIA, Ambac, and certain other bond insurers to obtain going concern opinions from their auditors. You should consider the likelihood of the insurers’ obtaining clean opinions and the implications if they do not in your rating assessments.

Lastly I encourage you to ask yourself the following question while looking at your image in the mirror:

Does a company deserve your highest Triple A rating whose stock price has declined 90%, has cut its dividend, is scrambling to raise capital, completed a partial financing at 14% interest (now trading at a 20% yield one week later), has incurred losses massively in excess of its promised zero-loss expectations wiping out more than half of book value, with Berkshire Hathaway as a new competitor, having lost access to its only liquidity facility, and having concealed material information from the marketplace?

Can this possibly make sense?

Worrisome Signs for the Bond Insurer Bailout

I hate to be a nay-sayer, and I want to make it clear that it really would be for the best if New York State insurance superintendent Eric Dinallo could pull off a rescue of the troubled bond insurers. But as we pointed out, this is an uphill battle under the best of circumstances, and the initial tidbits dribbling out in the media from the discussions are not encouraging.

Before we get to the news items, let's go through a list of what makes this difficult:

1. Lack of a template. The closest parallel was the wind-down of Long Term Capital Management, in which 24 firms stumped up cash which served to shore up the firm. In LTCM's case, the exposures were known, the damage could be estimated with reasonable certainty, and the liquidation horizon wasn't that long. By contrast, here there are more institutions, both the insurers and the parties potentially at risk, more uncertainty as to total liability and how it might play out over time, and a longer time frame for liquidation, assuming the insurers are put in run-off mode.

2. Likely lack of involvement of top decision makers. The Fed called the heads of the 24 biggest firms (25 if you count Bear, which absented itself, much to the fury of everyone else) and was able to get their largely undivided attention for the days it took to hammer out a deal.

3. Lack of useful urgency. Time pressure is invaluable in getting a deal closed. While LTCM was at risk of a very immediate collapse, which helped focus the collective financial mind, here the immediate risk is of ratings downgrades. That would start a process of cascading selling by investors who are restricted to holding investments that meet certain rating thresholds that is widely expected to have nasty repercussions.

S&P and Moody's said they would review the two big insurers, MBIA and Ambac, within a week following Fitch's downgrade of Ambac after trading hours last Friday. There is no way a package can be in place by then, not even meaningful expressions of interest. Dinallo may be able to get the rating agencies to hold off another week, but even that addition of a still unrealistic amount of time to conclude a deal may be demotivating rather than energizing.

And if downgrade avoidance is not the reason to do a deal now, then there is no obvious deadline to force closure. The underlying exposures will bleed over time (although Pershing Square, the hedge fund that has done a great deal of analysis of the insurers and is heavily short, argues convincingly that MBIA will become insolvent at the holding company level by at the latest the end of 2008. However, even that does not impair the insurance contracts, which is what investors are worried about).

4. Complexity due to differing situations at each insurer. Related to, but separate from point 1. is that each insurer has a different mix of business. That means that even if Dinallo comes up with a template for one firm, it may have to be modified considerably to work elsewhere, In addition, MBIA has further complicating issues due to its dependence on its stuffee, um, reinsurer, ChannelRe.

5. Insufficient managerial bandwidth and competing management priorities. One of the scenarios I worried about last year was that several largish hedge funds going south at the same time. The fact that the LTCM rescue tied up the top brass on Wall Street, as well as some of the top lawyers, said that it would be logistically impossible to orchestrate multiple rescues on a compressed timeframe. Too many decisions and calls for action would fall on a very few key people. That would be true even in somewhat normal times. Now we have managements that are stressed with adverse business conditions and the need to make headcount cuts and other tough decisions.

6. Lack of clout. While Dinallo is as talented a guy as you can probably find both in the insurance industry and among regulators, he doesn't come close to commanding the authority of the Fed, or even the OCC. And while Timothy Geithner, the head of the New York Fed, and Henry Paulson are making supportive noises, there is not yet any sign that they are throwing their weight behind this effort.

7. Limited understanding of the banks and securities firms of the insurance industry. One factor that helped considerably in the LTCM rescue is that everyone was buzzword compatible. Running a big Wall Street firm and running a massive trading book like LTCM had are very very similar. No one in the rescue group had to get up to speed and everyone could communicate efficiently.

Insurance accounting is arcane and is not the same as GAAP. Indeed, most people who invest the time to learn the insurance business tend to specialize in it. That factor will make it harder for any investor to get his arms around the bond insurers' exposures and the natures of their risk. This communication/comprehension issue will also have the effect of creating delay.

8. Last but not least, this demand for more dough is coming precisely at a time when the industry (save Goldman) is hemmoraging capital.

Now to get to the less-than-encouraging sightings du jour. First from the New York Times:

Eric R. Dinallo, the New York insurance superintendent who regulates MBIA, called Wall Street executives on Tuesday to set up the meeting at his office in Lower Manhattan. He led the session on Wednesday and suggested that the group move in as little as 48 hours to get a deal done ahead of any downgrading of the bond guarantors by credit ratings firms.

According to two people, Mr. Dinallo said he would talk with the bankers one on one and reconvene the group — which included executives from Citigroup, Goldman Sachs and Merrill Lynch — on Thursday or Friday. Neither federal officials nor executives of the two insurers attended the meeting....

Mr. Dinallo could face resistance from banks that do not have significant exposure to the guarantors and thus have less incentive to put up money. It is also unclear how executives and shareholders of the companies would react to the plan and the prospect of ceding control.

Sean Dilweg, the commissioner of insurance in Wisconsin, which regulates Ambac, sat in on the meeting but said he would be working with Ambac directly. Mr. Dilweg said he met separately on Tuesday with executives at Ambac, which is based in New York but chartered in Wisconsin.

“Eric is looking at the overall issue, but I am pretty confident that we will work through Ambac’s specific issues,” Mr. Dilweg said in a telephone interview. “They are a stable and well-capitalized company but they have some choices to make.”

Other options open to the banks include providing lines of credit and other backup financing to the guarantors. A chief goal of any rescue would be to help the companies regain or keep triple-A credit ratings, which are seen as vital to their business.

There is one positive item, and if it would work this is a no-brainer. If a mere $15 billion in backup lines of credit would make this go away, the problem is trivial. But the agencies have to date said they want equity, not credit.

However the other signs are not encouraging. As much as Dinallo is trying to move things along as quickly as possible, it doesn't appear that he even has a group of funding sources that has agreed at least to explore this in a concerted fashion. A two hour meeting and further individual discussions, with a group meeting in the works but not yet firm, is the sign this program is in the organizational/selling/shape of the table stage. Until you get a committed, or close to committed group in a room and lock the doors, you haven't gotten things seriously underway, Even deals where everyone knows the playbook, like M&A, take days of full day sessions to hash out details. The fact that Dinallo wants to meet in 48 hours and "get a deal done" says that he may have perilous little appreciation of what it takes to get arrangements of this sort nailed down. Let's hope not.

It is also troubling that Dinallo is not in control. He is empowered to deal only regarding MBIA (not certain if any of the smaller bond insurers are under his purview), and has no authority regarding Ambac. And the moron of a regulator from Wisconsin is not only not on the same page, but is dumb enough to undermine Dinallo by saying to the press that all is well in the land of cheeseheads. The odds of Ambac pulling through look even more remote.

The Wall Street Journal was more downbeat than one might expect, comparing this effort to the failed SIV rescue plan. The Journal was unwittingly turned into a cheerleader on that one, so this may be a case of once burned, twice shy. Nevertheless:

A banker who attended the bailout discussions, between investment banks and New York Insurance Superintendent Eric Dinallo, said they were "very preliminary."

That is consistent with the Times' reporting, and not encouraging.

When Sensible People Advocate Continued Credit Dependence (George Magnus/Fed Edition)

George Magnus, the UBS economist who popularized the concept of a Minsky Moment and has been prescient in his bearish calls on the credit markets, veered today and, in a Financial Times comment, "More is needed to unblock credit arteries," gave unqualified support for aggressive monetary easing.

Put it another way, when mere New York Times reporters, in today's piece, "A Fear That the Cure Could Be Poison," sound a reasonable cautionary note absent from Magnus' piece, namely that too much stimulus could create a new financial mess down the road (their culprit was inflation), something is wrong. And the ECB is still plenty worried about inflation, even if Magnus dismisses it.

Of course, it may simply be that Magnus is better at forecasting than policy. And it is also fair to say that there is no good playbook for the mess we are in.

As an aside, I believe that, as the Times suggests, attempts to forestall the inevitable may well make things worse. Our economy has become completely dependent on credit form overseas. Today's Bloomberg shows that China still reports robust growth despite the falloff in the US. That on the one hand suggests problems in the US may slow but not tank global growth, but also may suggest that China is not as deeply hostage to our continued growth as many would like to believe.

Put it more bluntly: too much easing will tank the dollar. Brad Setser has said that while the current account surplus has fallen. so too have foreign private inflows. We are living on the largesse of foreign central banks. Remember, the oil embargo of the 1970s started because we made the mistake of calling Saudi Arabia's bluff when they told us to get Israel to withdraw from the lands occupied in the 1967 war, and give access to some sites important to Muslims. What if they decide again to push us over Israel? The states with the liquidity are not democracies, they are not accountable to voters and are willing to take losses (say on Treasury holdings) if they perceive there to be long-term gain. This set of circumstances will give not-necessarily friendly economic partners even greater sway over us.

Here is the part of Magnus' piece where he manages to hoist himself on his own petard:

The Federal Reserve’s surprise emergency cut in interest rates on January 22 may be followed quickly by another reduction at the formal meeting on January 30 and almost certainly presages easing by European central banks. We should banish all talk about whether these initiatives are inflationary or not. It is not for nothing that we call a banking crisis a “deflationary credit event”. What the Fed is trying to do is to head off the worst aspects of a banking crisis in which the arteries of credit that drive economic activity are becoming blocked.

The feast-to-famine turnround in the willingness to lend and the terms of lending, while rare, is not unprecedented. It happened after the US savings and loan crisis in the 1980s, in the commercial property fall-out and Scandinavian and Japanese banking crises in the early 1990s, and after the dotcom bust in 2001. The most recent feast can be appreciated by looking at the credit intensity of gross domestic product, or the amount of credit generated per $1 of GDP growth. This remained at about $1.50 for decades after 1950, eventually rising in the 1980s and peaking at $3 during the 1990s. The credit machine went into top gear again and by 2007, nearly $4.50 of credit was being generated per $1 of GDP growth.

While there is no methodology for determining the optimal debt to GDP ratio, the increase from the 1980s and particularly in the current decade is alarming and all the signals are that it is not sustainable. Mortgage defaults, rising credit card delinquencies, and the expected rise in commercial real estate and corporate bad debt, in combination with our non-existent saving rate, all confirm that the economy is carrying far more borrowings than it can support. Yet Magnus thinks the answer is to "unblock the credit arteries" and give more of the same! It's tantamount to prescribing a quadruple bypass, then sending the patient home with no post-op lifestyle changes, not even a supply of Lipitor.

Like it or not, America is going to have to consume less and save more. That means a slowdown, likely a recession. Any other remedy piles on more debt and risks even greater credit losses and institutional carnage down the road, as well as the greater possibility of disruptive changes in our lifeline of credit from abroad.

Links 1/24/08

Turmoil puts big takeovers on hold Financial Times

No virgins for you News.com.au (hat tip Transterrestrial Musings)

Charts for the Big Bounce The Financial Ninja. Note I am an agnostic as regards technical trading. However, (I know one trader who is enormously successful using it, but he also waits until the signals are overwhelming. Regardless, the charts certainly have the right oracular look.

Bloomberg Dismisses Stimulus Package The Huffington Post.

Hedge Fund and Private Equity Managers to Take it on the Chin

Roger Ehrenberg's latest post, "Alternative Asset Managers and Down Market Cycles: What to Expect," isn't quite as blunt as my headline above, but it comes pretty close. He at least says that suffering, while common, will not be universal.

Cheap funding was important to the success of hedge and LBO funds and its evaporation will lead to a reversal of fortune. Moreover, while many hedge funds relied on leverage to produce their outsized returns, even some who didn't are confounded by the divergent-from-historical-patterns trading markets we are facing now.

Let me digress with a wee story. In the stone ages, when I was young, I was sent to work on a Treasury study. The firm I worked for had never advised a Treasury business; this was one of the very biggest operations in London that had gone from making money to losing lots of it. The only reason I was sent was that, unlike everyone else on this project, I had at least been in a dealing room.

We really had no idea what we were doing, and even worse, the partner wanted to find a way to beat the foreign exchange markets with four months of end of day trading data (meaning the closing price) in four currencies. It was a thoroughly miserable experience, particularly since the main reason for the client's troubles was one we could not readily solve, absent a massive change in personnel.

This was 1984, a strong dollar environment. The FX traders had all learned the business when the dollar was weak, so their reflexes were all wrong.

I think we will see a lot of this sort of problem.

While the tough times for hedge funds are not surprising, private equity funds maintain that they add fundamental value by improving operation, not by mere financial engineering. Yet it isn't hard to imagine that this claim is exaggerated. Why? Look at how hard public companies have been working to wring out costs any way they can. Any low hanging fruit is long gone. Indeed, the main benefit of being private these days is to get out of the glare of the spotlight and be able to pursue long term strategies. But it isn't clear to me how much private equity talk along those lines is really sincere.

Ehrenberg says that LBO firms will either put their money into lower return deals or into PIPEs. Personally, PiPEs are the worst of both worlds. You have a big enough stake to be visible and thus have difficulty exiting, but by virtue of have a holding in a public entity, you as an investor cannot get inside information. One of the big advantages of being private is you can know everything about your investment if you have the time and energy.

Ehrenberg fails to consider a third possibility: that investors will demand a reduction in commitments. In the dot-com bust, it was evident that venture capitalist were not going to be able to put all the money they had raised to work. Investors were unwilling to pay 2% (the annual commitment fee) on funds that would never be put to work, and successfully demanded reductions, often as much as 50%.

From Ehrenberg:

The real question is, how will a persistent down market impact the returns of the hedge fund and private equity industries? My handicapping: most participants will suffer and suffer badly. Why? In summary:

The net long exposure of most hedge funds will weigh on returns. Historically it has been difficult for most hedge funds to add significant alpha on the short side, the side which may well be the key driver of returns for quite some time.
The excess capital across the private equity industry and sharply wider financing spreads will hurt new deal returns. An unfriendly equity market will make for a limited IPO calendar, eliminating an exit that has proved so fruitful for many of the largest PE firms and their investors over the past three years.

Bridgewater Associates had a very interesting report yesterday that addressed this very issue. Here are some of their thoughts as it relates to the hedge fund industry:

For the most part, hedge funds have gotten through the credit crunch relatively unscathed. For example, the average hedge fund generated a return of 12.5% last year and 2.5% in the fourth quarter. And private equity funds generated an average return of 11%. The main reason that these two groups held up as well as they did is because the equity market has not fallen nearly as much as the bond markets (i.e., spreads), and the majority of the risk allocation of these funds is in the equity market. And because their performance held up, they have not been forced into much asset liquidation to speak of. But stock market action is beginning to pressure the hedge funds and private equity players.

Hedge funds used to be a lot more hedged than they are today....hedge funds are now heavily long the equity market. Based on fund by fund holdings data we estimate that hedge funds are net long about $150 to $200 billion in U.S. equities (foreign equities are not included in this figure).

********************
Hedge funds are also highly leveraged. Losses raise a fund’s leverage ratio, which requires asset liquidations to bring the leverage ratio back to normal.

Let's see, big net long equity exposure + high leverage + down markets = not good. Clearly we are both taking an industry-wide view of things, but I think it is important to have a grip on the thematic issues in order to gauge possible broad-based effects. Earlier this week I wrote a post that identified industry-specific knowledge, liquidity and value-orientation as being key components for success in volatile markets. Let me add a long time horizon to that list. One of the big issues plaguing many hedge funds is a focus on managing to monthly and quarterly numbers. In real life, this is no way to run a business. Some of the greatest investments of all-time have looked really crappy at the beginning and the thesis has played out over time. If you've got the time, which means either long lock-ups, stable and mature investors, eye-popping long-term performance or both.....

Bridgewater also had some cautionary words for the private equity industry:

Private equity also looks vulnerable... One element that we showed was the recent deterioration in the yield on private equity deals, driven by too much money chasing too few good deals. This contrasts with the fat yields that existed a few years ago. Those fat yields contributed to the recent high returns on private equity (2007 private equity returns were 11% according to Cambridge Associates and the average return over the past three years was 20% per year). The recent skinny yields, combined with public equity market weakness, are a bad sign for future private equity returns.

I heartily agree. This is an area I've written about quite a bit, both about the glut of capital saturating the high end of the industry and new types of structures (like KKR's investment in Sun Microsystems) that might become the vehicles for deploying capital. Until credit market capitulation is complete, bank balance sheets have been rebuilt (through a combination of external fund-raising via SWFs and other deep-pocketed investors and internal fund-raising through a Fed-induced steepening of the yield curve) and investors have coughed up and marked-to-market all that seemingly low-risk paper trading at 20 in their books, it will be hard to see how debt capital formation will support the scale of private equity transactions we've witnessed in the 2005-07 period. So where does all that private equity go? Either to far less levered deals generating far lower IRRs than in recent years, or into PIPEs and other types of minority stakes that offer downside protection but with modest upside and 10-12% IRRs instead of the 25%+ IRRs we've become accustomed to. In short, it is hard to see the halcyon days for the private equity industry in the near term.

So in the final analysis I think we all need to dial down our expectations. Structural issues will continue to depress hedge fund and private equity returns until the credit cycle and its impact on global equity markets plays itself out. It won't be pretty but we'll all get through it. And some will thrive. Those who have the breadth of skills, the capital and the long-term orientation to take advantage of others less fortunate.

Robert Reich Grasps the Enormity of the Problem

Although Robert Reich is a smart fellow (and I mean that sincerely), like a lot of Beltway types, he isn't as well versed in the ways of the world of finance as he is in the workings of public policy and opinion.

Thus I found his recent post, "The Politics of an Economic Nightmare," intriguing due to its shift in posture. Heretofore, Reich has been calling for stimulus to save the working man. It's been well argued, but nevertheless pretty standard "here's' what you do in a slowdown" fare. But it is now clear that Reich has engaged the problem more deeply, and realizes that a stimulus package is not only more likely as a sop to the voting public in an election year, but is almost guaranteed to be badly focused, overly large, and ineffective. If Reich now understands most of the elements of our problem that is a positive sign from a policy standpoint, i.e, that influential people who are not finance types are wising up.

He also acknowledges the ugly fact that our salvation lies in the hands of rich foreigners, but misses the fact that trashing our currency via aggressive rate cuts and an even larger fiscal deficit won't exactly endear us to them. But there is only so much you can say in a single post, particularly since Reich's preference is for brevity.

From Reich:

A possible economic meltdown is worrisome enough, but a possible meltdown in an election year is downright frightening. For months now, Republicans have been pushing the White House to take some action that looked and sounded big enough to give them some cover if and when things got worse. President Bush has now responded with a stimulus package more than twice as large as the one Bill Clinton briefly entertained at the start of 1993 but couldn't get passed.

Not to be outdone, Democrats want to appear at least as bold, which means they'll suspend pay-go rules and throw fiscal responsibility out the window. In other words, hold your noses, because the "bipartisan" stimulus package that's about to be introduced could be a real stinker, including tax cuts for everyone and everything under the sun -- except, perhaps, for the key group of lower-income Americans. These are the people who don't earn enough to pay much if any income taxes, but who are the most likely to spend whatever extra money they get and therefore are most likely to stimulate the economy. The real behind-the-scenes battle will be over whose constituencies get what tax cuts, and for how long. Don't be surprised if the only thing Congress really stimulates is campaign contributions.

Meanwhile, Fed chairman Ben Bernanke and Co. have surprised everyone with a rate cut larger and sooner than expected. The three-quarters of a percentage point ("75 basis points" in biz-speak) cut announced Tuesday morning may not sound like much, but it's bigger than any rate cut in decades. The politics here are more subtle because Bernanke and his Federal Reserve governors are supposed to be independent of politics. But as witnessed under the reign of previous chairman Alan "it's prudent to reduce the surplus with a tax cut" Greenspan, Fed chairs can have political agendas. Bernanke has been under a lot of pressure lately to cut rates big-time -- and the pressure has come not only from Washington Republicans but from panicked Wall Street Democrats, including, apparently, my old colleague Robert Rubin, formerly President Clinton's treasury secretary. (By the way, what could Rubin have been thinking when he allowed Citicorp to sell all those fancy securitized debt instruments, while agreeing to buy them back if they couldn't be resold?) Expect lots and lots more Washington activity -- enough seemingly bold strokes to convince voters that our nation's capital is doing whatever is necessary to stop whatever seems to be going wrong with the economy.

The problem is, people have different views about what's going wrong. Wall Street sees it as a credit crisis -- a mess that seems never to reach bottom because nobody on Wall Street has any idea how many bad loans are out there. Therefore, nobody knows how big the losses are likely to be when the bottom is finally reached. And precisely because nobody knows, nobody wants to lend any more money. A rate cut won't change this. It's like offering a 10-pound lobster to someone so constipated he can't take in another mouthful.

Main Street sees it as a housing crisis. As I've noted, homes are the biggest assets Americans own -- their golden geese for retirement and their piggy banks for home equity loans and refinancing. But home prices have been dropping quickly. It's the first time this has happened in many decades -- beyond the memories of most Americans, which is why they never expected it to happen, why they bought houses so readily when credit was so easily available, and why so many people bought two or more of them, speculating and fixing up and then flipping. But now several million Americans may lose their homes, and tens of millions more have only their credit cards to live on and are reaching the outer limits of what they can spend. As consumer spending shrinks, companies will reduce production and cut payrolls. That has already begun to happen. It's called recession.

How much worse can it get? As I said before, the housing bubble drove home prices up 20 to 40 percent above historic averages relative to earnings and rents. So now that the bubble is bursting, you can expect prices to drop by roughly the same amount, and new home construction to contract. The latter plunged last month to its lowest point in more than 16 years. A managing partner of a large Wall Street financial house told me a few days ago the scenario could get much worse. He gave a 20 percent chance of a depression.

Even if a stimulus package were precisely targeted to consumers most likely to spend any money they received, the housing slump could overwhelm it. According to a recent estimate by Merrill-Lynch, the slump will hit consumer spending to the tune of $360 billion this year and next. That's more than double the size of the stimulus package President Bush or any leading Democrat is now talking about. And the Merrill-Lynch estimate is conservative.

In reality, the crisis is both a credit crunch and the bursting of the housing bubble. Wall Street is in terrible shape and Main Street is about to be in terrible shape. And there's not a whole lot that can be done about either of these problems -- because they are the results of years of lax credit standards, get-rich-quick schemes, wild speculation on Wall Street and in the housing market, and gross irresponsibility by the Fed, the Treasury and the Comptroller of the Currency.

As a practical matter, our only real hope for avoiding a deep recession or worse depends on loans and investments from abroad -- some major U.S. financial firms have already gotten key cash infusions from foreign governments buying stakes in them -- combined with export earnings as the dollar continues to weaken. But this is something no politician wants to admit, especially in an election year. So we're going to go through weeks of posturing about stimulus packages of one sort or another, and then see enacted the big fat bonanza of a temporary tax break that will likely have little effect. That, perhaps along with a few more rate cuts by the Fed. The presidential candidates will be asked what should be done about the worsening economy, and they'll give vague answers. None will likely admit the truth: We're going to need the rest of the world to bail us out.

Fed Taken to the Woodshed at Davos

A panel of blue chip authorities, including former Treasury Secretary Larry Summers, legendary investor George Soros, and well respected economists such as Stephen Roach and Nouriel Roubini were sharply critical of the stewardship of central banks in recent years, particularly the Fed.

We've noted before that not all central bankers were asleep at the switch. Australia's retired Reserve Bank Governor Ian Macfarlane used a combination of private scolding, public statements, and a wee interest rate tightening to let some air out of the lucky country's housing bubble, which by every measure was worse than our own. Macfarlane has also spoken and written about the problems that asset bubbles present to monetary authorities (big issue: they are popular while in progress and central banks lack a clear mandate to tackle them). But why has Macfalane been virtually alone among the officialdom in talking about this problem, and why hasn't his message gotten greater play?

From Bloomberg:

The U.S. Federal Reserve and other central banks are partly to blame for the financial-market slump that's now threatening to derail the global economy, said investors and former policy makers at the World Economic Forum.

``It's hard to give central banks a very high grade over the last couple of years on recognition of bubbles and actions taken to address them in the policy or regulatory spheres,'' said former U.S. Treasury Secretary Lawrence Summers in a panel in Davos, Switzerland. Billionaire investor George Soros said central banks have ``lost control'' of financial markets.

The Fed, which yesterday announced its first emergency rate cut since 2001 as U.S. recession fears rose, has been criticized for paying too much attention to economic growth and not enough to so-called asset price bubbles. By cutting rates to protect growth when bubbles burst, the Fed only encourages investors to take bigger risks in the future, said Morgan Stanley's Stephen Roach.

``It's a dangerous, reckless and irresponsible way to run the world's largest economy,'' said Roach, chairman of Morgan Stanley in Asia, who was also in Davos.....

``Central banks lost control of the situation when they allowed financial institutions to develop new financial instruments which they themselves didn't understand,'' said Soros.

Greenspan and Bernanke counter that it's too difficult for central banks to spot bubbles before they emerge and raising rates to curb higher housing or stock prices would risk derailing the rest of the economy.

Nor was the Fed alone in slashing rates at the start of the decade. The ECB cut its benchmark to 2 percent in 2003, the lowest since the aftermath of World War II, and the Bank of England reduced its key rate to a 48-year low.

While house prices surged in the U.K., Spain and Ireland, those booms have now withered as contagion from the subprime collapse spreads.

Some Davos attendees came to the Fed's defense, saying it's difficult to identify bubbles and more attention should be paid to better regulation.

``We could pierce bubbles but we'd pierce a lot of non- bubbles and take a lot out of gross domestic product,'' said John Snow, also a former Treasury Secretary and now chairman of Cerberus Capital Management LP. ``We need to reform regulation.''

The ECB nevertheless argues that it may be possible for central banks to ``lean against the wind'' by raising rates in the early stage of a bubble to head off future gains.

``It's good for a central bank to ease when the risks are of a crash in the global economy, but that means you have to have a more systematic approach to asset bubbles,'' said Nouriel Roubini, founder of New York-based Roubini Global Economics LLC, in Davos. ``If we have a `Greenspan put' or a `Bernanke put,' then we will create over and over again a distortion of excessive debt and leverage.''