Thomas Palley: The Implications of Debt-Fueled Business Cycles

A very good Project Syndicate article by Thomas Palley highlights the way a shift in US policy priorities circa the early 1980s has lead to a lasting change in the foundation of economic growth in the US. Prior to that, the emphasis was on increasing incomes of workers and being wary of trade deficits. As worker incomes rose, businesses had a natural incentive to find ways to use less of it, generally via greater investment in equipment, technology, or improved business methods, which fostered business investment and led to productivity gains that were shared between corporations and workers. Rising incomes also supported rising domestic consumption. All in all, a virtuous circle.

That paradigm changed, and while Palley does not name names here (he does in another post, which we intend to highlight tomorrow), the culprit is the Chicago school of economics, whose free market ideology drove Reagan-era policies and has become deeply rooted in the business and increasingly the public psyche. Palley argues persuasively that this is a bankrupt model and ties it directly to our current economic woes: asset bubbles, stagnant wages, high and rising levels of debt. Needless to say, he is also critical of monetary easing and fiscal stimulus, seeing them as continued reliance on unsound and unsustainable practices.

From Palley:

A second big American interest-rate cut in a fortnight, alongside an economic stimulus plan that united Republicans and Democrats, demonstrates that US policymakers are keen to head off a recession that looks like the consequence of rising mortgage defaults and falling home prices. But there is a deeper problem that has been overlooked: the US economy relies upon asset price inflation and rising indebtedness to fuel growth.

Therein lies a profound contradiction. On one hand, policy must fuel asset bubbles to keep the economy growing. On the other hand, such bubbles inevitably create financial crises when they eventually implode.

This is a contradiction with global implications. Many countries have relied for growth on US consumer spending and investments in outsourcing to supply those consumers. If America's bubble economy is now tapped out, global growth will slow sharply. It is not clear that other countries have the will or capacity to develop alternative engines of growth.

America's economic contradictions are part of a new business cycle that has emerged since 1980. The business cycles of presidents Ronald Reagan, George Bush Sr, Bill Clinton, and George Bush share strong similarities and are different from pre-1980 cycles. The similarities are large trade deficits, manufacturing job loss, asset price inflation, rising debt-to-income ratios, and detachment of wages from productivity growth.

The new cycle rests on financial booms and cheap imports. Financial booms provide collateral that supports debt-financed spending. Borrowing is also supported by an easing of credit standards and new financial products that increase leverage and widen the range of assets that can be borrowed against. Cheap imports ameliorate the effects of wage stagnation.

This structure contrasts with the pre-1980 business cycle, which rested on wage growth tied to productivity growth and full employment. Wage growth, rather than borrowing and financial booms, fuelled demand growth. That encouraged investment spending, which in turn drove productivity gains and output growth.

The differences between the new and old cycle are starkly revealed in attitudes toward the trade deficit. Previously, trade deficits were viewed as a serious problem, being a leakage of demand that undermined employment and output. Since 1980, trade deficits have been dismissed as the outcome of free-market choices. Moreover, the Federal Reserve has viewed trade deficits as a helpful brake on inflation, while politicians now view them as a way to buy off consumers afflicted by wage stagnation.

The new business cycle also embeds a monetary policy that replaces concern with real wages with a focus on asset prices. Whereas pre-1980 monetary policy tacitly aimed at putting a floor under labour markets to preserve employment and wages, it now tacitly puts a floor under asset prices. This is not a matter of the Fed bailing out investors. Rather, the economy has become so vulnerable to declines in asset prices that the Fed is obliged to intervene to prevent them from inflicting broad damage.

All these features have been present in the current economic expansion. Wages have stagnated despite strong productivity growth, while the trade deficit has set new records. Manufacturing has lost 1.8m jobs. Prior to 1980, manufacturing employment increased during every expansion and always exceeded the previous peak level. Between 1980 and 2000, manufacturing employment continued to grow in expansions, but each time it failed to recover the previous peak. This time, manufacturing employment has actually fallen during the expansion, something unprecedented in American history.

The essential role of asset inflation has been especially visible as a result of the housing bubble, which also highlights the role of monetary policy. Despite the massive tax cuts of 2001 and the increase in military and security spending, the US experienced a prolonged jobless recovery. That compelled the Fed to keep interest rates at historic lows for an extended period, and rates were raised only gradually because of fears about the recovery's fragility.

Low interest rates eventually jump-started the expansion through a house price bubble that supported a debt-financed consumer-spending binge and triggered a construction boom. Meanwhile, prolonged low interest rates contributed to a "chase for yield" in the financial sector that resulted in disregard of credit risk.

In this way, the Fed contributed to creating the sub-prime crisis. However, in the Fed's defence, low interest rates were needed to maintain the expansion. In effect, the new cycle locks the Fed into an unstable stance whereby it must prevent asset price declines to avert recession, yet must also promote asset bubbles to sustain expansions.

So, even if the Fed and US treasury now manage to stave off recession, what will fuel future growth? With debt burdens elevated and housing prices significantly above levels warranted by their historical relation to income, the business cycle of the last two decades appears exhausted.

It is not enough to deal only with the crisis of the day. Policy must also chart a stable long-term course, which implies the need to reconsider the paradigm of the past 25 years. That means ending trade deficits that drain spending and jobs, and restoring the link between wages and productivity. That way, wage income, not debt and asset price inflation, can again provide the engine of demand growth.

SEC Proposes Cosmetic Regulations for Rating Agencies

The Wall Street Journal and Bloomberg report that the SEC is mulling regulations for rating agencies. Note that rating agencies have benefited from being a protected class, since the SEC determines who can be a Nationally Recognized Statistical Ratings Organization, yet heretofore has imposed no obligations on them.

In the 1970s, the SEC set regulatory capital requirements on various types of financial institutions; these in turn rested on credit ratings set by NRSROs. The three large incumbents, Moody's Standard & Poor's and Fitch were given the designation.

Only a very few firms have been able to join the club since then; the SEC has not only failed to set standards for new applicants, but is also has never acknowledged receipt of applications. Thus NRSROs have the unique advantage of enjoying a high regulatory barrier to entry with no accompanying responsibilities.

And the new SEC proposals are a continuation of this proud, hands-off, no obligations tradition. Its great reform proposal? To require the rating agencies to publish how well their past ratings have done and disclose performance differences among ratings for different product categories.

The latter requirement flies in the face of the myth that the rating agencies have promulgated, namely, that their ratings mean the same thing, in terms of default risk, across products. That practice started slipping in the early 1990s, yet the agencies continued to maintain that their ratings standards were the consistent across products.

Note also that this proposal fails to acknowledge the fundamental conflict of interest that created this mess, that the ratings agencies are paid by issuers, when their ratings are for the use of investors. Taking that one on is too hard for an SEC ideologically opposed to meaningful intervention, no matter how patent the need for it is.

Contrast this attitude with the tough words from an EU regulator, as quoted in Reuters:

European Union Internal Market Commissioner, Charlie McCreevy, warned on Wednesday that if credit ratings agencies did not correct the lack of distinctive ratings for structured finance products, he would take action.

"If the proposals are not forthcoming in coming months, I would not hesitate to move forward to have it addressed with regulatory action," McCreevy told the Society of Business Economists in London....

"I am not going to be prescriptive today but I will say this: strong independent professional oversight of the credit professionals within the rating agencies...and of the operation of the ratings function is absolutely essential if market and regulator confidence is to be restored with respect to the effective management of the conflict of interest inherent in the rating agencies' business models," McCreevy told the audience in London.

Now consider the harebrained statements from the SEC, via Bloomberg:

The U.S. Securities and Exchange Commission may propose new rules for credit-rating companies to help evaluate securities following investor losses related to subprime mortgages, the agency's chairman said.

The rules would increase disclosure about ``past ratings'' to help determine whether rankings successfully predicted the risk of default, SEC Chairman Christopher Cox said at a securities conference in Washington today. The regulations may also address the differences between ratings on structured debt and rankings for corporate and municipal bonds.

Investors could then use the enhanced disclosure to ``punish chronically poor and unreliable ratings,'' Cox told reporters after his speech. ``The rules that we may consider would provide information to the markets in a way that facilitates'' comparisons, he said.

Punish chronically poor and unreliable ratings? What in God's name is that supposed to mean? The market already disagrees plenty with published ratings. Has Cox ever looked at the AAA ABX index? And all of this patently obvious repudiation by the market of rating agency grades has had zero effect on their behavior. Even the specter of monoline credit default swaps of MBIA and Ambac priced at distressed levels still has not embarrassed them into making downgrades. Why? They are paid by the issuers! What investors and the market thinks has zero effect on their bottom line. If months of horrific press won't induce them to clean up their act (the reforms proposed by S&P are similarly cosmetic), a mere tabulation of past performance certainly won't.

In case you think I am being unfair, consider this excerpt from the Wall Street Journal story:

SEC Chairman Christopher Cox said the potential rules "would require credit-rating agencies to make disclosures surrounding past ratings in a format that would improve the comparability of track records and promote competitive assessments of the accuracy of past ratings."

He added that the SEC "may propose rules aimed at enhancing investor understanding" about the differences between how ratings are treated for standard municipal and corporate debt, as compared with innovative financial instruments crafted by Wall Street banks.

Translation: the problem isn't that the ratings are bogus, it's the investors' fault that they don't understand that the ratings are bogus. So we'll try harder to educate those dumb investors.

Just as the EU is having to do the heavy lifting on antitrust with Microsoft, so too will they with rating agency reform. The US seems unwilling to take steps that will reduce a company's God-given right to its profits, no matter how much their actions cost the greater economy.

Links 2/9/08

Hundreds of lawyers 'bugged on prison visits' Telegraph

Stimulus Package Will Hasten Collapse of Fannie and Freddie Dean Baker

French paradox redux? U.S. vs. French on being full PhysOrg

How Non-Borrowed Reserves Became a Sexy Subject Caroline Baum, Bloomberg (hat tip Felix Salmon). Baum explains that the negative non-borrowed reserves sightings are no cause for worry (we have some comments in an update here)

Behind the Great Firewall Guardian

UBS Raises Concern About Negative Non-Borrowed Bank Reserves

In an earlier post, we had taken a worried look at the fact that banks' net non-borrowed reserves went negative in January. We were only somewhat concerned because this unprecedented pattern was clearly the result of the Fed's implementation of its TAF, the Term Auction Facility, which gives banks funding if they post collateral (and it can be plenty crappy collateral) at better rates than they can get in the interbank market. In other words, banks would be nuts not to use it. As we said last week:

[In this] Federal Reserve data series "Aggregate Reservesof Depositary Institutions Adjusted for Reserve Requirements" .... 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 weaklypositive as to also be troubling.

This table is cumbersome to read because it contains over 30 years of data and theheadings 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.




... 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.

A reader passed along a research note from Simon Penn, a London-based strategist at UBS, who takes the grim view that the Fed is indeed propping up the banking system:

What if the Fed's rate cuts aren't motivated by the desire to stave off
recession, rather they're to prevent a major banking crisis. Not one of
escalating subprime losses or monoline downgrades, but actually a sheer lack of cash. The Fed's not telling anyone what it's up to because it doesn't want to cause panic, but the evidence is actually there in its own data...

Ok, so things might not be quite as bad as that, but the situation isn't far off. That's because of the TAF. ....a savvy bank can put down lesser quality paper that it can't generally do very much with (and certainly no one else really wants it), raise funds through the TAF, then use those funds to put down as reserves, and then conveniently gets paid a modest rate of interest against those reserves (which acts as a partial offset against the TAF). While there's a small net cost to the banks, the real loser here is the Fed, what it gets stuck with is an ever growing pile of collateral.

Now consider this - that collateral is actually what's backing the entire US banking system by way of its conversion to dollars and then the flow of those same dollars back to the Fed....

All this changes the complex of the US banking system somewhat. From the gold standard to the subprime standard perhaps?

Update 2/9/02, 2:00 AM: Caroline Baum at Bloomberg says that the worries are for naught (hat tip Felix Salmon):

The writer of the e-mail directs his readers to the most recent H.3 report, which shows total reserves ($41.6 billion) less TAF credit ($50 billion) less discount window borrowings ($390 million) equals non-borrowed reserves (minus $8.8 billion). The negative number is really an accounting quirk: If banks borrow more than they need, non-borrowed reserves are a negative number.

This gentleman is overlooking the fact that the Fed is ``a monopoly provider of reserves,'' said Jim Glassman, senior U.S. economist at JPMorgan Chase & Co. ``This is a non-starter. There is no such thing as a banking system short of reserves. The Fed has absolute control over the supply.''

There may be times, such as late last year, when banks are reluctant to lend to one another for a period longer than overnight. ``And any one bank can have a problem'' funding itself, Glassman said. But in a world where ``the Fed can print money, there is no shortage,'' he said. ``The banks get the reserves they want.''

Those hyperventilating over TAF borrowing may want to consider an alternate scenario.

``Suppose the Fed cut the discount rate so that it stood below the funds rate,'' Kasriel said. (He said this yesterday, not two decades ago.) ``Would these folks be upset if banks went to the discount window for funds? What's the difference? It's a difference without a distinction.''

I am still not entirely sure I agree with this. I think the reality lies somewhere between the two extremes. Heavy borrowing at the discount window would be a sign of alarm; it means a bank can't otherwise raise funding in the interbank markets. A lot of discount window usage would mean a lot of banks were under stress.

Individual banks are accordingly unwilling to use the discount window because it says loud and clear they are in trouble. That was one of the reasons for creating the TAF, so that banks could get discount-window type funding, but longer-term (the discount window is overnight, while the TAF is 28 or 35 days, depending on the auction) on a non-disclosed basis. However, as we said at the outset, the Fed has made TAF funding so attractive that banks should be trying to access it whether they need it or not.

Thus we cannot tell whether the TAF borrowing is a substitute for going to the discount window, which is a sign of trouble, or merely opportunistic. And the TAF usage is the cause of the negative non-borrowed reserves.

But perhaps the point to make is that the fundamental question is the continued existence of the TAF (the non-borrowed reserves issue is a red herring). It was implemented to address extreme risk aversion in the interbank markets, which was made worse by the customary fall in liquidity at year end (banks wind down their activities in December to make accounting cleaner). The TAF was initially supposed to be a temporary facility, but (as far as I can tell) there is no plan to wean banks off it.

To reiterate: the negative non-borrowed reserves are not the real issue; the question is whether banks have become reliant on the TAF. In this bad credit market, when the Fed is on a program to ease aggressively, the Fed is not going to tinker with the TAF whether or not there is still a real need for it. Thus we mere mortals outside the regulatory regime will remain largely in the dark as to whether it is a prop or a mere expedient.

Bear Stearns Short Subprime to Tune of $1 Billion

Bloomberg reports that Bear Stearns increased its short subprime position from $600 million in November to $1 billion. The story suggests that this hedge is to offset trading positions; there is no indication that the firm is "net short" as Goldman is.

For those who might think there is something wrong with this strategy, consider: the firm was one of the biggest issuers and managers of subprime paper. One of the expectations of a manager is that it makes a market in the offerings it sold. That obligation necessitates that a firms hold trading positions; what Bear seems to be doing is to use hedges to reduce its inventory exposure. Bear also said it had reduced subprime and CDO long positions.

From Bloomberg:

Bear Stearns Cos., the U.S. securities firm that posted its first-ever loss last quarter on mortgage writedowns, has more than $1 billion of trades that profit if subprime home loans and bonds continue to deteriorate.

The ``short'' positions on subprime mortgage securities increased from $600 million at the end of November, Chief Financial Officer Sam Molinaro said today at an investor conference in Naples, Florida. The company also reduced its holdings of so-called collateralized debt obligations and underlying bonds, Molinaro said.

The sinking value of assets tied to mortgages led to Bear Stearns's fourth-quarter loss of $854 million, and Molinaro said today that one of the firm's biggest mistakes was ``not being conservative enough and bearish enough on the subprime market.'' The firm has reversed ``long'' subprime trades that stood at $1 billion at the end of August, Molinaro said.

``There's definitely a lot of short plays out there,'' said Mark Adelson, a founding member of Adelson & Jacob Consulting in Long Island City, New York. Some subprime bonds ``could easily be bad enough that they don't pay off a penny,'' said Adelson, a former Nomura Holdings Inc. mortgage analyst.

In an interview after Molinaro's remarks, Bear Stearns spokesman Russell Sherman said the New York-based firm's subprime trades are a ``hedge'' against potential losses on investments in higher-rated mortgages, he said.

``We are using short positions to offset other long positions in our mortgage inventory,'' he said. He didn't provide details on specific trades.

Sovereign Wealth Funds Cool on Further Bailouts of Western Banks

There is an old saying, "Fool me once, shame on thee, fool me twice, shame on me."

We've said it was a mistake to assume that sovereign wealth funds would continue to write checks uncomplainingly to salvage our troubled financial institutions. They've already been through one round of fundraising and things are getting worse, not better. Coming to the well again is a sign of weakness. First, it confirms that conditions have deteriorated, and thus any earlier investment is under water. Second, it says that the heads of the firms didn't raise enough money the first time around. That means they either estimated losses poorly, which says they don't have a good handle on their business, or they knew how bad things were but decided to put on an optimistic face and raise a smaller initial amount on more favorable terms, on the assumption that would lead to less total dilution. The latter possibility says the CEOs were, ahem, less than candid.

The funds are not going to be made into fools. An article by Gillian Tett in today's Financial Times says that the SWF are becoming resistant to appeals for cash from financial firms. Resource and industrial investments are higher economic priorities for them. And though the article doesn't mention it, I am sure they are also wondering why domestic investors like the big private equity firms aren't doing their part.

That doesn't mean they won't stump up the cash in the end. But it will be on much tougher terms, which means more dilution of existing investors. If the government investors wind up with very large economic interests, say 20% or more, it is fantasy to think that they don't have sway over the business.

It has been remarkable that American policy makers have blithely assumed that the rest of the world will continue to make up for our lack of domestic savings out of a misguided faith that no one would dare crimp US consumption.

In the past, central banks have been content to buy Treasuries, which has been an easy and painless way for us to get our debt fix. Many have depicted the growth of sovereign wealth funds as a plus, since it means that the foreign governments will be buying more asset classes. No one seems to have considered that they expect higher returns on these investments and will do more due diligence. In other words, the shift of investing to sovereign wealth funds means the cost of our heretofore cheap funding will rise. Our foreign money sources don't have to cut off funding to discipline our behavior; all they have to do is increase its cost.

From the Financial Times:

Earlier this week, I chatted with a jet-lagged senior US financier. Like many of his ilk, he is flitting around the Middle East and Asia trying to extract finance from sovereign wealth funds and other investment groups.

His latest travels have delivered a surprise: some funds are quietly getting cold feet about the idea of putting more capital directly into western banks, he says.

“There is a backlash building,” he muttered into a crackling cell phone.

This is striking stuff. In recent months, many equity investors have taken comfort from the idea that sovereign wealth funds could ride to the rescue of Wall Street, if not the City of London too.

For as the subprime scourge has spread, US policymakers have leant on the largest US banks to raise capital, almost at any cost. Consequently, they have passed the begging bowl around the sovereign wealth funds, with considerable success. Thus far some $40bn to 60bn worth of injections have been promised to groups such as Merrill Lynch and Citi, depending on how you measure the promises.

But having stepped into the breach so visibly late last year, some funds are now getting jitters. In China, for example, there are rising complaints that funds are foolish to shovel cash directly into risk-laden US banks when they could be using it in better ways, such as purchasing western commodity or manufacturing groups.

“The Chinese are worried they are turning into [the source of] dumb money,” says one well-placed Asian financier, who partly blames the trend on the Blackstone saga, which produced significant paper losses for the Chinese investors.

Meanwhile, in the Middle East, the latest round of Federal Reserve interest rate cuts has created unease. For sure, some powerful Gulf investors have been heartened to see that the US authorities are acting in a resolute way. They are doubly relieved that the dollar has held up so well so far. But the dramatic scale of Fed cuts has prompted concern that Wall Street is still sitting on a putrid mess – contrary to what the US banks told the sovereign wealth funds late last year.

Unsurprisingly, this leaves Gulf investors cynical about promises from Wall Street banks. It also has some Asian and Gulf funds concluding that if they are going to invest to take advantage of the subprime mess, they are foolish to do so directly or alone. Hence some are now turning to private equity funds such as JC Flowers which are at least trained to analyse the subprime mess.

Now, it would be nice to think this sentiment shift does not matter too much for the US banks. After all, the recent infusion of funds means the largest Wall Street groups are looking pretty well capitalised on paper. It also means they should be able to absorb subprime losses, which banks such as Goldman Sachs think could reach $200bn for the banks soon.

However, the problem is that subprime is just one of several potential looming shocks. Defaults on other forms of consumer debt and commercial property could rise this year. So could defaults on corporate leveraged loans from 2009 on.

Meanwhile, the monolines insurers are threatening to blast another hole in banks’ balance sheets. Indeed, if you tot up all the hits that could emerge in the next couple of years, it is easy to reach a sum of $500bn, or far more. This is sizeable, given that Goldman Sachs calculates that the banks’ capital is around $1,600bn.

I would bet that in the coming weeks large western banks will once again start passing the begging bowl around the Middle East and Asia. But I would also bet that these banks will find the going increasingly tough.

Yes, US political pressure might produce a bit more money for banks. The Gulf and Asia remain flush with cash. But if the sovereign wealth fund money is now flowing to private equity funds instead of western banks, this gives this tale a whole new twist.

Stand by to see a new chapter unfold in this financial crunch.

Increasing Inflation and Recession Pressures Weigh on the Fed

While the markets anticipate more aggressive cuts in target Fed funds rates soon, the central bank's task is complicated considerably by rising inflationary pressures. A Wall Street Journal story says that remarks Fed officials show worry that monetary policy may become too expansive:

Federal Reserve officials are acknowledging increasing weakness in the economy, signaling a willingness to cut rates again at their next meeting. But inflation concerns are rising among some officials, indicating the magnitude of their next move may be a matter of contention....

Some officials.... expect growth to rebound in the second half, and they are wary of cutting rates so low now that they would spur higher inflation as the economy recovers. Monetary policy works with a lag, so interest-rate cuts tend to boost the economy six months to a year after they are implemented.

Oddly, there is no mention of the possibility of stagflation.

Another oversight is the omission of the most concrete sign of inflation concerns: the lousy results at the latest Treasury bond auction. The 30 year bond sale Thursday did badly. Investors are crowding to the short end of the yield curve at the expense of current income, rather than risk principal losses at the long end. As the blog Across the Curve said,

Prices of Treasury coupon securities plummeted in a tumultuos trading session which was reminiscent of trading in the 1980s. The outstanding 30 year bond traded early in the day with a 111 handle and trades now late in the day with a 107 handle. That’s the way stocks trade! As I wrote earlier the Treasury conducted a 30 year bond auction and the results were less than festive. Trading since that time has been volatile and the issue continues in a downward (price) spiral.....

On the day yields have backed up rather dramatcally and the yield curve continues to steepen. The fickle benchmark 2 year note ended its sub 2.00 percent flirtation and is back at 2.03 percent as its yield increased by 11 basis points today. The 5 year yield increased by 16 basis points as did the yield on the 10 year note. The issues yield 2.81 percent and 3.76 percent, respectively. The bete noir for the day, the 30 year bond, suffered ignominy and misfortune as its yield soared by 18 basis points to 4.53 percent.

The yield curve as measured by the 2 year/10 year spread hit another record wide for the cycle at 173 basis points. That is 33 basis points wider than where it was before the Fed ease a little over a week ago.

Yet as inflation indicators are flashing red, so too are recession warnings. In "Credit Card Spree May Be Ending," the Journal reported another sign of economic weakness, a sharp fall in consumer credit in December, in tandem with rising credit card defaults:

Credit-card delinquencies are rising across the nation, a sign that some Americans are at the end of their rope financially. And these mounting delinquencies, in turn, have prompted banks to tighten lending standards, keeping people who have maxed out their cards from finding new sources of credit....

Such a pullback may already be taking shape. Yesterday, the Federal Reserve reported an abrupt slowdown in consumers' credit-card borrowings. In December, Americans had $944 billion in total revolving debt, most of it on credit cards, a seasonally adjusted annualized increase of 2.7%....

Evidence is mounting that the plastic-fueled spending spree won't last. In December, an average of 7.6% of credit-card loans were either at least 60 days delinquent or had gone into default, up from 6.4% a year earlier, according to research firm RiskMetrics Group.....

Yesterday, card issuer Discover Financial Services said 49% of consumers it surveyed in January plan to reduce their discretionary spending this month. That was an increase of five percentage points from its December survey and a 10-point jump since September.

It goes without saying that consumer retrenchment is a negative for growth. Further confirmation comes from another Journal story on poor retail sales in January:

A dismal January at the mall offered the latest sign that the U.S. economy is in or near a recession -- and is already sending ripples that reach well beyond the retailers to commercial-property landlords, construction companies and container ports.

Retailers turned in their worst monthly sales results in nearly five years, and big chains appeared to be girding themselves for a prolonged slowdown in consumer spending by announcing plans to close hundreds of stores and cut thousands of jobs.

Even gift-card redemptions, which were expected to give January sales figures a bigger lift, instead offered a glimpse at just how strapped consumers are. Wal-Mart Stores Inc. yesterday noted that redemptions were below its expections, and said consumers were holding onto the cards longer -- or using them to buy groceries rather than treats like electronics.

As a result, a Bloomberg reports that the consensus view among economists is that the odds of a US recession have risen to 50%.
The Fed Funds market shows uncertainty as to what the central bank's next move might be, although there is no doubt that more cuts are in order. Note that traders see a 100 basis point cut as a reasonable possibility, which would presumably come about as the result of another intermediate cut. Once you give the markets what they want, they only ask for more.

From the Cleveland Fed:

Warning: Anger at Financiers Rising

While one data point does not constitute a trend, a first page article in today's New York Times, "Creators of Credit Crisis Revel in Las Vegas," may signal a shift in popular sentiment. Normally, "how the mighty are fallen" stories are exercises in shadenfreude. But this one, on the annual convention of the American Securitization Forum, the industry group that helped bring us subprimes and collateralized debt obligations, is openly outraged, at least compared to the usual anodyne tone of New York Times reporting.

At a plush industry convention in Las Vegas, AFS members are sighted licking their wounds and plotting to find ways to profit from the crisis they helped bring about. While the article also mentions some of the losses that participants have taken, no one seems to be in dire straits. And there seems to be little in the way of remorse or self-recrimination.

Criminal investigations into Wall Street's securitization practices corroborates the public's increasingly dim view of the industry. Deep down, many subscribe to Balzac's view that great fortunes are built on great crimes.

Today's Wall Street Journal gives an update on the probes:

The Justice Department's U.S. attorney's office in Manhattan, based near Wall Street, has notified the Securities and Exchange Commission that it wants to see information the agency is gathering in its investigation of Merrill Lynch & Co., according to people familiar with the matter. The SEC is examining, among other things, whether the securities firm booked inflated prices of mortgage bonds it held despite knowledge that the valuations had dropped, the people say.

The move by the U.S. attorney's office comes as the SEC has upgraded its Merrill probe to a formal investigation...

The interest by the federal prosecutors is preliminary; it is unclear whether the SEC has turned over information. But the U.S. attorney's office request could be a precursor to a criminal investigation, these people say.

In the last month or so, I have noticed a marked increase in hostility towards the financial services industry, both in the number of cynical, critical comments on this blog and the intensity of their venom. These are a few from the last week:

The wealth creation over the past decade plus has been on the back of a system that has grown more corrupt by the year. It is a parasytic system that is rotten to the core and feeding off the real economy, empowered by the bankrupt foreign economic policy that has essentially given away our competitive advantages and gutted out industrial base. Who said American's aren't generous? ......

Global collusion and financial engineering gurus fused together packages of localized loan pools into globalized loan pools in hopes that the default rates would be insignificant and thus any impairment or dilution would be diluted to zero risk.

The result of what these gurus engineered is a global systemic financial failure resulting in denial on their part, no accountability on their part and defaults on a global scale never before seen. These gurus will return to Davos with new derivatives and be held in high regard, versus being placed into global prison cells! .....

Wall Street has become a conduit unto itself and a zero sum wealth "creator" for the financial economy at the expense of the real economy. We are heading for a complete disaster and the more you read this moronic commentary [from a Wall Street strategist] the more you realize that never has there been a better time to sell. Rotten to the core.

And my personal favorite, in response to a post "Martin Wolf: Can We Corral the Financiers?"

The model has already been put forward by the enragés:

On 2 June, Paris sections — encouraged by the enragés ("enraged ones") Jacques Roux and Jacques Hébert — took over the Convention, calling for administrative and political purges, a low fixed price for bread, and a limitation of the electoral franchise to sans-culottes alone. With the backing of the National Guard, they convinced the Convention to arrest 31 Girondin leaders, including Jacques Pierre Brissot. Following these arrests, the Jacobins gained control of the Committee of Public Safety on 10 June, installing the revolutionary dictatorship. On 13 July the assassination of Jean-Paul Marat — a Jacobin leader and journalist known for his bloodthirsty rhetoric — by Charlotte Corday, a Girondin, resulted in further increase of Jacobin political influence.[9] Georges Danton, the leader of the August 1792 uprising against the King, was removed from the Committee. On 27 July Robespierre, self-styled as "the Incorruptible", made his entrance, quickly becoming the most influential member of the Committee as it moved to take radical measures against the Revolution's domestic and foreign enemies.[10]

For those who don't know the history of the French Revolution, Danton was guillotined, as was Robespierre. In other words, let the mob exact bloody justice.

Americans, unlike the French, don't have a tradition of taking to the barricades when they are unhappy with their government. We are therefore unlikely to see the specter of heads of former Masters of the Universe being carried around on pikes.

But we are in the early stages of a credit crisis. The American consumer is only beginning to retrench. Unemployment is on the rise and many households are already in perilous financial shape, in no position to take any shocks. As conditions worsen, the anger against the financial elite which profited so handsomely during the boom years and is relatively unaffected by the downturn can only become more acute.

If a full-blown financial crisis develops, say along the lines envisioned by Nouriel Roubini, do not underestimate the potential for something we haven't seen in the US for 40 years: demonstrations and other forms of collective action. Anger is a corrosive, destabilizing force. If conditions get bad enough, it can and will reach a boiling point.

Mind you, this is a downside scenario, but it is important to understand its full ramifications.

From the New York Times:

It was Monday night on the Strip, and John Devaney was giving a party for himself and fellow connoisseurs of risk who have seen their hot hands go cold.

In a gilded ballroom at the Venetian, the revelers sipped cabernet, dined on surf and turf and crowed as the Blue Man Group put on a private show.

The partygoers had traveled to Sin City this week — Mr. Devaney by chartered jet — for an event that before the current credit squeeze might have been called the Predators’ Ball of this era.

This time, with mortgage securities replacing the junk bonds of the 1980s, the gathering felt more like group therapy.

The occasion was, officially, the 5th annual conference of the American Securitization Forum, a celebration of the financial wizardry that supposedly turns risky mortgages and other loans into gilt-edged securities but, as Mr. Devaney belatedly discovered, does not always make them safe. Mr. Devaney, a 37-year-old money manager, lost big on bond investments last year. This week, in Las Vegas fashion, he said he was doubling down.

The four-day event at the Venetian drew more than 6,500 financial professionals from across the country. Many came in search of ways to ride out — or better yet, to profit from — the mortgage mess their industry helped to create.

Wall Street banks played a crucial role in the mortgage crisis by buying home loans and bundling them into securities. Regulators are examining whether investment banks and mortgage lenders hid the risks of subprime debt from investors.

While the mood was more somber than in years past, when home prices were soaring and mortgage lending boomed, there was plenty of fun and games. Countrywide Financial, the troubled lender that has come to symbolize some of the excesses of the mortgage business, was the host of a party on Sunday night where people cheered while watching the Super Bowl on big-screen televisions. On Monday came the gala dinner sponsored by Mr. Devaney. On Tuesday the conference organized an outing on a golf course near the California border.

Between such revels, attendees spent their time in meeting rooms with golden trim, listening to panel discussions with titles like “Transparency, Valuation and Rebuilding Investor Confidence” and “Legislation, Regulation and Market Oversight — A Global Review.”

At the conference last year, Mr. Devaney grabbed headlines — and was proved prophetic — when he said he hated subprime mortgage securities and was “hoping the whole thing explodes.” In March, before he incurred his big losses, he told The New York Times he was hoping to expand and diversify his trading business.

This year, Mr. Devaney, a brash bond trader, said he had grown cocky during the mortgage boom and paid the price. A hedge fund run by his company, United Capital Markets, plummeted last year, and he lost $100 million. The rout prompted him to sell a mansion on Key Biscayne, near Miami, his private jet and his yacht, Positive Carry, named after a financial maneuver in which the cost of financing an investment is less than the return obtained from it.

Mr. Devaney has, however, profited from turbulent markets in the past, and made his name earlier this decade trading troubled bonds backed by trailer home loans and business-franchise loans.

“In a funny way I want to thank the market for dealing me a direct hit,” Mr. Devaney said during one panel discussion, drawing laughter from the crowd. “As a trader, if you make money for too many years you lose sight of risk unless you get sucker- punched.”

Mr. Devaney said he was now buying beaten-down bonds for pennies on the dollar, betting their prices would revive.

But his financial troubles are small compared with losses in the housing market and broader economy. Many people are struggling to pay their mortgages and hold on to their homes. Nearly a quarter of home loans made to people with blemished, or subprime, credit are delinquent or in foreclosure, and defaults now are rising even on loans made to people with good credit. Some of the people who attended the Las Vegas gathering had recently lost their jobs and came hoping to find new ones.

At times, the unease here was palpable. During one panel discussion, a money manager stood up and denounced credit ratings agencies, which many investors have criticized for underestimating the risks posed by securities backed by subprime loans. In the last 12 months, the ratings firms have downgraded many securities they had awarded high marks to only a year or two earlier.

“In my 38 years this has been the worst capital destruction and the worst rating decline in history,” Robert L. Rodriguez, the chief executive of First Pacific Advisors, a mutual fund company based in Los Angeles, said to a panel of four executives from ratings firms. “All of you should be ashamed of yourself.”

The lashing elicited scattered applause. The panelists listened, their lips pursed. Some then admitted making some mistakes but said most investors in top-rated triple-A securities would get their money back.

“We all have heard a lot of criticism over the last several months, and some of that criticism is certainly justified,” said Glenn Costello, co-head of the residential mortgage-backed securities group at Fitch Ratings. But he added that a frequent criticism of ratings firms — that they are beholden to the investment banks and mortgage companies whose securities they rate — reflected “a real lack of understanding of how we as ratings agencies go about doing what we do.”

During another discussion, managers of much-maligned collateralized debt obligations — packages of bonds that are packages of other debt — criticized the media for what they said was negative coverage of the securities. Most of the speakers on that panel asked that reporters be allowed in the session only if they did not directly quote their remarks or did so with their permission.

But other managers and bankers said investors and journalists were right to question why so much wealth was destroyed so quickly. As for the view that some securities are trading at far lower prices than they deserved to be, Len Blum, a managing director at Westwood Capital, a boutique investment bank based in New York, said investors always overreacted to bad news, just as they overreacted to good news.

“The market always paints with a broad brush,” he said.

Another banker, Joseph M. Donovan, said the hand-wringing was overdone. He said what ailed the market was clear, but added that solutions would take time.

In his estimation, defaults are highest in cases where lenders take too many risks because neither they nor borrowers have much to lose. Mortgage companies sold the loans to Wall Street banks, and homeowners did not put any money down. Mr. Donovan, a retired Credit Suisse executive, said the packagers of the securities and investors took false comfort from the diversity of loans backing their securities.

“We need to step back and take a breather,” he said. “I don’t think there is anything fundamentally wrong.” Mr. Devaney, the bond trader, generally agrees with Mr. Donovan, whom he regards as a mentor.

Standing near a conference booth for Standard & Poor’s, the ratings firm, Mr. Devaney said to a fellow trader that he should buy bonds backed by second mortgages trading at deep discounts.

“I am buying things at 10 to 15 cents” on the dollar, Mr. Devaney boasted. The other trader, who did not consent to being identified, said he was worried that the bond prices might fall more.

Later, Mr. Devaney himself seemed to have second thoughts.

“I’m worried I won’t be able to call the bottom,” he said. But he quickly regained his old confidence. “Most of the stuff I have has limited downside,” he said.

Bill Gross: Let the Monolines Sink

Bill Gross, founder of bond investing giant Pimco, has almost no kind words for the bond insurance industry in a comment in the Financial Times, "Rescuing monolines is not a long-term solution." He views a salvage operation for the industry as at best a stopgap to prevent a crisis in the so-called shadow banking system. He implies that there are now so many potential triggers for a meltdown that any can attempt to hold the powers that be up for a bailout, and in aggregate, they cannot all be saved.

Gross does not mince words: the monoline business was "dubious" even when it was only insuring relatively low risk municipal securities. It is untenable in its present form.

From the Financial Times:

What is good for Ambac, the bond insurer, is good for the country. Well, perhaps in the short run if it prevents a run on the shadow banking system – our over-leveraged system of financial conduits that have provided the spending power to keep the US economy going in recent years. But not in the long run.

The Ambac business model is as faulty now as was chairman Charles Wilson’s forecast for General Motors more than a half century ago. Wilson’s response to a US Senate inquiry in 1955 implied that GM’s near monopolistic control was beneficial to the country. It was, until the domestic motor industry fell asleep at the wheel of innovation and became more concerned with placating its labour unions with outsized pay packages and long-term pension and healthcare benefits. Creative destruction and the incessant march of globalisation changed a GM chairman’s smile to a frown, and the US economy turned from industrialisation to financialisation in order to stay at the top of the global pecking order.

Those who put their faith in the ability of a finance-based economy to remain healthy are being similarly challenged today. A critic can find numerous examples of incredible, bubble-popping asset structures – from subprime mortgages to structured investment vehicles to collateralised debt obligations squared – that are threatening to reverse the expansion of the shadow banks and break our finance-based economy’s back. The most recent one, however, centres around the monoline insurers with Ambac as the most important link in the chain that presumably cannot be allowed to break.

Monoline insurers are so named because they originally covered just one line of business – municipal bonds. Today, however, because they do not insure lives, or automobiles or medical expenses, the name has stuck despite their additional reach into insuring financial assets of all varieties. In a real sense, the monolines have taken on their shoulders a supersized portion of the guaranteed solvency of modern asset structures. In combination with overly generous triple-A ratings on not only these assets but the monoline companies themselves, they have fostered a bubble of immeasurable but clearly significant proportions.

That the monolines could shoulder this modern-day burden like a classical Greek Atlas was dubious from the start. How could Ambac, through the magic of its triple-A rating, with equity capital of less than $5bn, insure the debt of the state of California, the world’s sixth-largest economy? How could an investor in California’s municipal bonds be comforted by a company that during a potential liquidity crisis might find the capital markets closed to it, versus the nation’s largest state with its obvious ongoing taxing authority? Apply the same logic to the gargantuan size of the asset-backed market it has insured in recent years – subprimes and CDOs in the trillions of dollars – and you must come to the same logical conclusion: this is absurd. It is as if Barney Fife, television’s Sheriff of Mayberry in The Andy Griffith Show, promised to bring law and order to the entire country.

As long as the illusion lasted, however, it is clear that monoline guarantees fostered an expansion of our modern shadow banking system and therefore an extension of US and even global economic prosperity. Because US consumers were able to borrow at “guaranteed” triple-A rates with an additional servicing/underwriting spread, their spending power was artificially elevated. In order to maintain those levels and avoid a nasty recession, authorities through both official and backdoor channels now endorse a rescue effort. What is good for Ambac, they reason, is good for the country – and by extension the world.

As stock markets rise on optimistic workout developments, it is clear that it is – in the short run. But like General Motors a half century back, the sense of stability imparted to an oligopolistic industry with visible flaws is not likely to last, nor may the hope for a return to economic growth of recent years. The modern US financed-based economy has a striking resemblance to Barney Fife, guaranteeing global prosperity without the productive industrial-based firepower to back it up. Neither ultra-low interest rates or tax rebates, nor investor-led and authority-based monoline bailouts are likely to change that significantly during the next few years.

Chinese Think Globalization Happening Too Quickly

The Chinese aren't alone in their dim view of globalization. In fact, a BBC poll (hat tip Dani Rodrik) found that a higher proportion of Chinese are unhappy about the pace of globalization than Americans. One of the nations least pleased with the speed of integration is Australia, another big beneficiary via a commodities boom.

Links 12/8/08

Australia releases whaling photos BBC. Australia has caused a diplomatic row with Japan by releasing photos that show that its claims that its whale killing is for "scientific research" is a "charade." Good for them.

Sentiment Signs Says US$ Will Rally Mish's Global Economic Trend Analysis

To Catch a Country CFO.com What happens if a sovereign wealth fund engages in insider trading?

Loss Mitigation Lacking for Seriously Delinquent Borrowers: State Bank Supervisors Housing Wire

Economists Who Missed the Housing Bubble Give Low Marks to Bernanke Dean Baker

Pending Home Sales Plummet 24.2% The Big Picture

Don't count on daily comic relief, but Boom2Bust came upon this offering:

Deutsche Bank CEO: Bond Insurer Downgrade Will Create Debt " Tsunami"

Deutsche Bank's CEO Josef Ackermann issued a stark warning today: bond insurer downgrades would have catastrophic consequences, on par with the subprime crisis.

Note tha this view is in contrast with teh comparatively sanguine readings that have been coming from some US analysts and the US media, which now appears to regard teh increasing possibility of bond insurer downgrades are No Big Deal. The stock market is staging a wee rally despite a downbeat reading on the odds of success for the bailout talks led by New York insurance superintendent Eric Dinallo.

Ackermann's warning is consistent with a rumor we heard earlier this week from a well-placed source, who said that Trichet, the ECB's chief, had made a strong plea for the Treasury to bail out the bond guarantors. And by that we don't mean mean merely "get involved in Dinallo's talks"; we mean stump up cash. (Note this same source predicted Trichet's about face on interest rate cuts, and said they would be triggered by worries about the banking system, so his quote at the end of the Bloomberg story may be obligatory posturing).

The reason is that European banks were big buyers of later vintage CDOs (2006-2007) and RMBS, which will not only take a hit when any credit enhancement provided by the bond guarantors is removed but independent of any price impact, downgrades will also reduce their statutory capital. Why? Banks (which bought primarily AAA tranches) can treat AAA paper as a risk free asset; the reserve requirements are minimal. A downgrade to AA increases the reserve requirements markedly, and CDOs are generally downgraded more than a mere grade or two when they fall (I wish I could be more crisp here, but Basel II makes matters more complicated). Thus a loss of the bond guarantor AAA has a quick and nasty impact on bank capital adequacy.

From Bloomberg:

Deutsche Bank AG Chief Executive Officer Josef Ackermann said rating downgrades for bond insurers pose risks that could match the U.S. subprime market collapse.

``It could be a tsunami-like event comparable to subprime,'' Ackermann said in a Bloomberg Television interview in Frankfurt today. Deutsche Bank, Germany's biggest bank, is ``well positioned'' on its risk from bond insurers, he said.....

Banks and securities firms have already reported credit losses and writedowns of $146 billion. Downgrades of the bond insurers may force financial firms to write down a further $70 billion, Oppenheimer & Co. analyst Meredith Whitney said last month....

``It is bad practice to rely on the judgment of those whose misjudgments have caused the current crisis,'' Ackman wrote in the letter dated Feb. 5.

European Central Bank President Jean-Claude Trichet rejected Ackermann's characterization of the potential fallout from bond insurer downgrades.

``I certainly would not mention anything like waves of tsunami or any other mention of that sort,'' Trichet said at a press conference in Frankfurt. ``The fact that this correction continues along various markets is not something which should surprise us, its an ongoing process.''

On Blogging Economics and Aesthetics

Readers may have noticed that this site has gotten what one can most politely call visually busy. I'm not happy with the awkward adolescent ad-cluttered look. That in turn leads to a broader discussion of aesthetics, not just in terms of appearance but also positioning.

The visual issue is pretty obvious: I'd like this to be a reasonably serious, thoughtful blog, but at this stage, most of the ads are the sort where payment depends on the number of clicks. And (unfortunately) visual clutter leads to more clicks. Higher traffic sites can do well with more attractive banner ads, but even at a reasonably good level of traffic (over 10,000 page views/day) we don't yet have the volume to attract advertisements more in keeping with the image I'd like to project.

But there is an open question as to what the payoff to blogging really is. Most bloggers are not motivated solely by monetary results (they'd need their heads examined if they were). The returns to blogging resemble those in fields like sports, acting, and writing that have many people dabbling in it for non-financial or indirectly-financial motives. The payoff curve looks hyperbolic: most make nothing or very little, and there is a steep vertical ascent to the small number who do make a decent return on the time invested.

One reason for the steep payoff curve is that very high traffic blogs enjoy network effects. Readers come to chat among themselves, which takes some of the load of the blogger. And they often point to breaking news and interesting stories, reducing the research burden.

But even then, a top blogger makes a teeny fraction of what J.K. Rowling or Tom Cruise earns. The oft-repeated example of a successful blog is monghabay.com, which reportedly earns $15,000-$18,000 a month, which is a nice level of income for a stay-at-home job that one could pursue out of a low-cost location. But if that is as good as it gets, it is hardly an exciting number.

But many bloggers, the measure of results may not be ad revenue or number of hits, but raising one's profile with a target audience. But in my case, the spillover benefits aren't as great as say, for a money manager or lawyer who might get new clients. There are few blogs by management consultants, in part because (truth be told) there are hardly any new ideas in that field, and partly because the news doesn't provide much grist for commentary (companies are skilled at not showing their dirty laundry in public). Ditto corporate finance deal advisors.

Other bloggers seek to monetize their traffic in a more direct way: The Big Picture and RGE Monitor both have paid premium services; Calculated Risk has recently launched a paid newsletter.

Another complicating factor in the finance/economic space, is any blogger is effectively competing with many incumbents and standards are very high. And a significant proportion of the top-notch participants are blogging solely for non-financial reasons. Take the large number of academics who have sizable followings: Paul Krugman, Tyler Cowen, Mark Thoma, Brad DeLong, and Greg Mankiw. Some who post less frequently maintain high visibility due to the quality of their output, witness Dani Rodrik, Menzie Chinn, Brad Setser, James Hamilton, and Willem Buiter.

And then we have the MSM bloggers, the flotilla of blogs launched by the Wall Street Journal, FT Alphaville, Felix Salmon (a bit of a hybrid, since he had an independent reputation before joining Portfolio), Andrew Leonard at Salon, Justin Fox at Time, Colin Barr at Fortune, to name just a few.

It's enough to make one decide to stay in bed.

Back to the economic issues. One of the blog gurus, Yaro Starak, says that there is a period when blog ad revenues double every month, and we are in that phase now. A few months of that and hey, the blog would pay a nice base level of income. And 27 more months like that and we'll be bigger than the US GDP. (Note I also get some syndication revenue which is growing also, but not as dramatically).

But even in this seemingly narrow space, there are tensions between commercial considerations and image, less stark but fundamentally no different than when an actor decided between doing an art-house movie with a great, demanding part versus a big budget flick with a role that is lucrative and typecast.

Others may have different dilemmas, but in my case, somewhat sensational stories (usually malfeasance in banks) not only bring more traffic, but those readers seem more inclined to poke around the ads. By contrast, I will also get high traffic when I blog repeatedly on a topic of interest (the tsuris in the bond insurers being the latest example) but even though that too produces more traffic, ad revenues decline. And this is with readers e-mailing to tell me how much they appreciate these posts. It seems that doing a good job for the sophisticated readers I'd like to cultivate is not a winning proposition, revenue-wise. They're too focused to look at, much the less click on, those busy ads.

Now some of the stories spilling out of Money:Tech suggest there may be other revenue sources for bloggers. One is that Gerson Lehrman is trying to get hedge funds that buy their channel checking service to also hire bloggers that the hedge fund has taken note of through them. Why anyone with an operating brain cell would go through Gerson Lehrman is beyond me. Aside from paying an unnecessary markup, Gerson Lehrman is the in the business of collecting information, and they would almost certainly own any IP the blogger produced for them. If you want proprietary information, contract directly, and if you want to keep you identity secret, have your attorney be the go-between. Hedge funds are perfectly happy to pay well for useful information; its value is diluted rather than enhanced by going via a middle man who does better by trying to sell it multiple times.

I wouldn't work for Gerson Lehrman in any event, because I question the business practices of a company that in a fair number of cases gets employees to trade on expertise and information gained through their employer.

A pet idea of mine is whether ad agencies could be persuaded to include packages of bloggers in their Internet ad strategies. The analogy takes place in the print world: some companies will place advertisements in multiple small-circulation magazines that reach a specific and otherwise hard-to-access audience (think the Harpers/Atlantic/New Yorker/New Republic crowd). While a single blog is unlikely to command enough traffic to interest a big-budget advertiser, a well selected package of blogs might.

S&P Announces Changes to Forestall Criticism and Regulation

Standard & Poor's is to announce some measures today in an effort to bolster its damaged reputation. These moves seem a bit late in coming, given the firestorm of well-deserved criticism aimed at rating agencies. Indeed, the timing is a bit sus, as they would say in Australia, coming only as international regulators are considering how to improve rating agency conduct. The decision to issue the press release now could be viewed as an effort to take the wind out the sails of the International Organization of Securities Commissions plans to implement a code of conduct.

Unfortunately, S&P's changes focus mainly on the possibility of individuals being co-opted by their clients, either by working with them for too long or seeking to curry favor in the hopes of getting a job with them. And even those measures look ineffective. Five years seems too long a period to have an analyst stay with the same company if the concern is loss of objectivity (although it admittedly takes time to get to know a company well).

There are also plans to improve statistical measures, but as we saw with subprime asset backed securities, many important metrics were added late in the game and earlier issues were not re-rated using the new screens. It isn't clear whether practices like that will remain in place. And even if you run all the right ratios, if you have unrepresentative data, like 2006 & 2007 mortgages that are vastly worse than earlier vintages, all better computations give you is even greater false confidence in a "garbage in, garbage out" exercise.

The real problem that the agencies are paid by the very organizations they rate, and as long as this conflict remains, all other measures are mere window-dressing. The creation of an ombudsman role is an inadequate, unrealistic remedy for a problematic payment structure.

Yet the ratings agency appears to believe this approach will work. In the Wall Street Journal, Deven Sharma, S&P's president said, "By increasing transparency, we can increase the confidence in the credit market."

If S&P really believes a few organizational tweaks will save their reputation and along with it, the debt markets, their judgment is badly impaired. This statement is simultaneously woefully misguided and grandiose.

From the Wall Street Journal:

Standard & Poor's Ratings Services plans to announce 27 separate actions it will take in hopes of bolstering confidence in credit markets and the bond-rating firm's analytical integrity, including tougher oversight of analysts to spot potential conflicts of interest.

Some of the changes by the McGraw-Hill Cos. unit are organizational and cultural moves aimed at countering criticism that rating firms have grown too close to underwriters and other entities....

Among the changes set to be announced today, S&P will rotate lead rating analysts after five years of following the same company, government bond issuer, or structured-finance arranger. The new practice, which will be phased in, should prevent professional or personal relationships from affecting ratings, company officials said.

Analysts who leave S&P to work at a bond issuer will have some deals they previously rated reviewed to make sure their objectivity wasn't compromised by the prospect of the new job.

Meanwhile, ratings analysts will be required to undergo more training, surveillance tools will be added to track structured-finance performance and S&P will establish an ombudsman to address concerns about potential conflicts of interest in the rating process. An auditing or governance expert also will be brought in to publicly review S&P's processes.

Some additional tidbits from Bloomberg:

Standard & Poor's plans to hire an ombudsman, demand disclosure of collateral that backs structured finance securities and change the way it measures risk in response to losses in mortgage-backed securities....

The changes come a day after the International Organization of Securities Commissions in Madrid said S&P and rival Moody's Investors Service may face a code of conduct prohibiting ``advice on the design of structured products which an agency also rates.'' IOSCO, the forum of securities regulators, also urged financial institutions to disclose their risk of losses from structured finance....

Potential conflicts of interest between rating companies and the banks that pay their fees were flagged last year by European Central Bank President Jean-Claude Trichet and U.S. Senate Banking Committee Chairman Christopher Dodd. The Securities and Exchange Commission said in August that it was examining the way the companies assign ratings...

S&P also plans to hire an outside firm to periodically review procedures, create an independent risk assessment oversight committee, build an analyst certification program and add more information to ratings including liquidity and correlation assessments.

Ambac, FGIC May Be Put in Runoff Mode

The Wall Street Journal today says that even if the efforts to raise new funding for the troubled bond insurers are successful, they are unlikely to stave off a ratings downgrade. This story, based in part on reports coming from the rescue discussions led by New York state insurance superintendent Eric Dinallo, indicates that the reality of how bad the bond guarantors' situation is is finally sinking in.

One proposal that is underway for FGIC and under consideration for Ambac is to put the companies in runoff mode. That means they stop writing new business and continue operations only to see through existing guarantees. That also means they try to find a way to unwind their credit default swaps on collateralized debt obligations.

I must admit I am at a loss to understand how this process would work. The CDS were written to credit enhance collateralized debt obligations. Unless the CDOs are owned in their entirety by the parties involved in the negotiation (almost certainly not), the group will be taking actions which will affect the value of the CDOs. The unwinding of the CDS will also hit some tranches, presumably the lower rated ones, worse than other (those who have worked on CDO structuring and pricing are very much encouraged to speak up).

The article implies that the CDOs in question are on "portfolios of CDOs" raising the possibility that the CDOs in question are only ones that the banks entered into with the monolines, perhaps to hedge trading inventory and unsold underwritings . If so, that wouldn't involve third parties and wouldn't be problematic legally. But the article then refers to what appears to be total CDO exposures of FGIC and Ambac, so Journal's reporting isn't at all clear.

But independent of possible ramifications to investors, CDOs are heterogeneous. While CDS on corporate reference entities and indices have ready markets to provide pricing, CDS written on CDO tranches are likely to be one-off events. Any credit default swaps written on them would presumably be difficult to evaluate, given both changes in the underlying credit and deterioration in creditworthiness of the guarantors. How different banks with different and legitimately hard to analyze risks reach agreement on a pricing methodology (necessary for determining how to take them out of their CDS exposures) may well be a very complicated task. I hope the banks can reach agreement for this could prove to be a large stumbling block (or perhaps there is a simple way to cut the Gordian knot that, as an outsider, I fail to see).

Note that the Journal story quotes a UBS analyst who has far and away the rosiest view of the industry.

Separately, the Financial Times reports on yet another largely unrecognized hole in the bond insurers' balance sheets. Wall Street was apparently fond of a so-called negative basis trades. If they bought a bond, hedged it with credit default swaps, then hedged the risk of the guarantor defaulting (generally a monoline) with a different guarantor (generally a different monoline), they could accelerate the expected profits over the life of the deal into the current period. The result is that the bond insurers have an unknown (to the outside world) but potentially significant number of guarantees written on each other. Yikes. The FT report suggests that losses on these CDS are not factored into most estimates.

From the Wall Street Journal:

Rescue plans are starting to take shape for struggling bond insurers, but they aren't likely to prevent further ratings downgrades for many of the companies.....

Still, some banks and investors working toward salvaging the bond insurers, which guarantee the interest and principal in the event of default, are realizing that even the best plans could require them to settle for less -- less risk, less reward and bond insurers with less-than-triple-A ratings in the future, according to several people familiar with the rescue talks.

A group of banks -- betting that the insurers still have some value -- are working with the management and investors of New York-based Financial Guaranty Insurance Co. on a potential plan for FGIC. They have held a series of meetings and conference calls in recent days. The group, which is led by Calyon, a unit of French bank Credit Agricole SA, includes UBS AG, Société Générale SA, Citigroup Inc., and Barclays PLC. A Calyon spokeswoman declined to comment.

The banks are trying to figure out how to commute, or unwind, their credit-default swaps, which are contracts they entered into with FGIC and other bond insurers to guarantee their portfolios of complex debt securities known as collateralized-debt obligations, or CDOs, according to people familiar with the talks.

A consortium of banks working toward a rescue plan for bond-insurer Ambac Financial Group Inc. also is discussing a similar option, according to people familiar with the matter

The banks, then, would share in the proceeds that the bond insurers would make as they collect premiums and wait for their existing portfolio of policies to expire, or "run off." In this scenario, the most the banks are hoping for is that the bond insurers' credit ratings don't fall below double-A, but they aren't getting their hopes up for a return to triple-A glory, according to two of the people.

"There's run-off value as you get rid of the toxic elements of these companies through commutations," says David Havens, an analyst at UBS Securities, who isn't involved in any of the bailout talks. "Only about 5% of the business is problematic, and 95% is fine."

Ambac, FGIC and rivals MBIA, Security Capital Assurance Ltd. and CIFG Holding Ltd. are exposed to about $100 billion in CDOs that were backed by rapidly deteriorating subprime mortgage collateral, according to Fitch Ratings.

Some analysts estimate that sharp downgrades of these bond insurers, or their insolvency, could cause banks to write down as much as $70 billion. In late December, for example, Calyon said €1.2 billion ($1.75 billion) in its write-downs was tied to bond insurers, mainly ACA Financial Guaranty Corp., which was downgraded to triple-C from single-A.

By unwinding the credit-default swaps, the banks would enable the bond insurers to free up capital, which they could use to help preserve their ratings or help prevent further downgrades.

Of about $315 billion in debt that FGIC had insured through to Sept. 30, 2007, about $31 billion was backed by mortgage collateral and $8 billion was backed by subprime mortgages, according to an FGIC presentation. Ambac has about $67 billion in CDO exposure....

Fitch, for example, says it is possible that the majority of bond insurers won't continue to have triple-A ratings in the future.

"It's just an indeterminable amount of losses on these assets and the final number could be far more significant that we had been envisioning," Thomas Abruzzo, managing director at Fitch, says. Last month, Fitch and Standard & Poor's downgraded FGIC to double-A from triple-A. Fitch also downgraded Ambac to double-A.

A key hurdle for the banks and the bond insurers is determining how much the banks should get in exchange for tearing up their credit-default swaps, and whether owning stakes in companies that could get further downgraded is fair compensation, says one person familiar with the discussions.

Another option being bandied about by analysts and others is to form a new company, funded by the banks, which could take responsibility for meeting the obligations of some of the insurance policies -- mainly the credit-default contracts -- weighing on the bond insurers.

This model would have the added benefit of enabling banks to unwind some of their credit-default swaps with the other beleaguered bond insurers, and guarantee their debt with the new, triple-A-rated bond insurer.

But there are potential downsides, too. Banks might be choosy about which risks they would be willing to let the new insurer take on, and that could mean bond insurers might be left with the high-risk business, Steve Stelmach, an analyst at Friedman, Billings, Ramsey & Co. noted in a recent research note.

From the Financial Times, "New danger appears on the monoline horizon":

As the bond insurers, or monolines, have seen their seemingly rock-solid AAA ratings begin to buckle, worries have grown about what downgrades for these companies might mean for banks.

Now, one particular type of trade done between banks and monolines is being seen as an extra hidden danger.

These so-called negative basis trades were done in large volumes in recent years. They allowed both banks and monolines to book apparently “free money” and saw monolines writing guarantees on each other. If they have to be unwound, it will be a costly business for all involved.

The real problem is that almost no one has any idea how significant the profits taken on these trades might be. These trades were profitable because a bond could pay out more in interest than it cost to buy the insurance available in the derivatives market to protect the holder against default. In the world of structured finance, a bank would buy a bond, get it guaranteed, or wrapped, by a monoline to support the bond’s AAA rating, but then also pay another monoline to write a default swap on the first monoline, to guard against it defaulting on its guarantee.

The difference between what the bank paid for the insurance and what it received in yield from the bond could be pocketed as “risk-free” profit – and in many cases banks took the entire value of that income over the life of the bond upfront.

One senior industry insider admits that billions of dollars worth of these trades were done, but insists they were mostly restricted to the arena of utility and infrastructure debt. These were attractive both because they were of long maturities and because they were often linked to inflation, which would increase the returns.

“On a £100m deal over 25 years a bank could conservatively book £5m up front – even more if it was index linked,” says the senior industry executive.

For the monolines, the trades were also seen as near risk-free profit when taking the position of writing protection on peers.

The same executive insists that monoline activity in CDOs was restricted to the hedging of senior tranches that banks had retained on their books after structuring deals and had nothing to do with negative basis trades.

However, others are less sure. Monoline analysts at some of the banks believe a large amount of negative basis trades in the US were done on super senior CDO tranches, but admit they have no idea what proportion of total CDO business for the monolines that was.

Bob McKee, an analyst at Independent Strategy, a London research house, believes that up to $150bn worth of CDO business done by the monolines could be negative basis trades.

Standard & Poor’s, in a note on the potential impact of monolines on banks this week, said it believed some of the CDOs hedged by bond insurers were part of a strategy of “negative basis trades”.

The problem is that if monolines are downgraded and their protection becomes ineffective, profits booked up-front need to be reversed. Restating earnings is a very tricky area for investment banks – not least because the traders involved will have long ago pocketed their bonuses.

Rogoff: "America needs foreign advice on its ailing economy"

Once in a while, separate thinkers reach strikingly similar conclusion. It gets even more interesting when their observations come to light in a compressed timeframe.

Yesterday, Willem Buiter pointed out a major difference in perspective between US and foreign economists. Americans are wedded to the idea of doing whatever it takes to forestall a recession, no matter how costly it proves in the long term; many foreign economists think the US needs to wean itself off its debt habit, which will inevitably lead to a period of painful readjustment.

Harvard economist Kenneth Rogoff sings from the same hymnal today in a Project Syndicate article (hat tip Mark Thoma), but manages to avoid directly criticizing his professional colleagues. He instead points out that Americans need to listen to experts in developing countries that have survived the very sort of crises that the US is now facing.

No matter how astute and fact based Rogoff's observations are (he earlier released a persuasive and troubling analysis with his colleague Carmen Reinhart), no policy maker in America will accept the idea either that our economy has anything in common with that of the developing world or that it is in danger of banana-republic type troubles. There is therefore no chance his eminently sensible proposal will be taken seriously.

The political and economic leadership of this country has difficulty even learning lessons from other advanced economies. Exceptionalism is a deeply-rooted notion in the American psyche, and that plus prideful inability to recognize how rapidly our standing is slipping will almost certainly prevent us from learning invaluable lessons from those who have been down the painful path we are on.

From Rogoff:

As the United States' epic financial crisis continues to unfold, one can only wish that US policymakers were half as good at listening to advice from developing countries as they are at giving it. Americans don't seem to realize that their subprime mortgage meltdown has much in common with many previous post-1945 banking crises throughout the world.

The silver lining is that there are many highly distinguished current and former policymakers out there, particularly from emerging market countries, who have seen this movie before. If US policymakers would only listen, they might get an idea or two about how to deal with financial crises from experts who have come out safely on the other side.

Unfortunately, the parallel between today's US crisis and previous financial crises is not mere hyperbole. The qualitative parallels are obvious: banks using off-balance loans to finance highly risky ventures, exotic new financial instruments, and excessive exuberance over the promise of new markets.

But there are strong quantitative parallels as well. Professor Carmen Reinhart of the University of Maryland and I systematically compared the run-up to the US subprime crisis with the run-up to the 19 worst financial crises in the industrialized world over the past 60 years. These include epic crises in the Scandinavian countries, Spain, and Japan, along with lesser events such as the US savings and loan crises of the 1980s.

Across virtually all the major indicators - including equity and housing price runs-ups, trade balance deficits, surges in government and household indebtedness, and pre-crisis growth trajectories - red lights are blinking for the US. Simply put, surging capital flows into the US artificially held down interest rates and inflated asset prices, leading to laxity in banking and regulatory standards and, ultimately, to a meltdown.

When Asia and Latin America had their financial meltdowns in the 1990s and early 2000s, they took advice not only from the International Monetary Fund, but also from a number of small panels composed of eminent people representing diverse backgrounds and experiences. The US should do the same. The head of the IMF, Frenchman Dominique Strauss-Kahn, could easily select a superb panel from any range of former crisis countries, including Mexico, Brazil, Korea, Turkey, Japan, and Sweden, not to mention Argentina, Russia, Chile, and many others.

Admittedly, the IMF's panel would have to look past America's current hypocrisy. The US Treasury strongly encouraged Asia to tighten fiscal policy during its 1990s crisis. But today the US Congress and president are tripping over themselves to adopt an ill-advised giant fiscal stimulus package, whose main effects will be to tie the hands of the next president in simplifying the US tax code and closing the budget deficit.

Americans firmly told Japan that the only way to clean up its economy was to purge insolvent banks and regenerate the financial system through Schumpeterian "creative destruction." Today, US authorities appear willing to contemplate any measure, no matter how inflationary, to insure that none of its major banks and investment houses fails.

For years, foreign governments complained about American hedge funds, arguing that their non-transparent behavior posed unacceptable risks to stability. Now, many US politicians are complaining about the transparency of sovereign wealth funds (big government investors mainly from Asia and the Middle East), which are taking shares in trophy American assets such as Citibank and Merrill Lynch.

In fact, having countries like Russia and China more vested in the well-being of the US economy would not be a bad thing. Yes, the IMF ought to develop a voluntary code of conduct for sovereign wealth funds, but it should not be used as a weapon to enforce financial protectionism.

For years, I, along with many others, have complained that emerging markets need greater representation in global financial governance. Today, the issue goes far beyond symbolism. The US economy is in trouble, and the problems it spins off are unlikely to stop at the US border. Experts from emerging markets and elsewhere have much to say about dealing with financial crises. America should start to listen before it is too late.

Links 2/7/08

Credit Crisis: Where Was the SEC? Forbes (hat tip Michael Panzner)

PE-backed bankruptcies The Deal

Wealthy stressed by rocky economy Investment News

New Century, Lawyers Face Claims They Lied in 5-Year-Old Suit Bloomberg

ISM Nonmanufacturing index James Hamilton, Econbrowser

This is off topic, but in times like these, we need all the humor we can get:

Buffett Bearish on Dollar, Blames Banks for Credit Mess

Bloomberg and the Telegraph report on a speech made by Warren Buffett in Toronto. He sees the dollar falling over the next decade unless policies change, has harsh words for the financial services industry, and says there is plenty of credit available. The last bit sounds troublingly at odds with facts, until you realize he is speaking from his own viewpoint. If you are one of the few true AAAs still standing, money is pretty cheap.

From Bloomberg:

The only currency Berkshire directly owns now is the Brazilian real, Buffett said. He blamed the declining dollar on the current account deficit, with the U.S. trade imbalance playing the largest role.

``If something is unsustainable, it's going to have consequences; so far the consequences have been a general decline in the dollar against major currencies,'' Buffett said. ``If we continue the same policies, we're going to get the same results in the next five or 10 years.''

From the Telegraph:

Mr Buffett, known as the "Sage of Omaha" for his investment record, suggested that the banking fraternity has only itself to blame for its recent problems which have seen banks write off more than $130bn (£66.3bn) so far.

"It's sort of a little poetic justice, in that the people that brewed this toxic Kool-Aid found themselves drinking a lot of it in the end," Mr Buffett said, making reference to the American soft drink.....

"I wouldn't quite call it a credit crunch," he said. "Money is available, and it's really quite cheap because of the lowering of rates that has taken place."

However, he said what had taken place was "a re-pricing of risk," leading to an "unavailability of what I might call 'dumb money', of which there was plenty around a year ago."

The problem is that important sectors of the economy, in particular the housing market, became dependent on dumb money.

MBIA to Sell $750 Million in New Shares, Increase Loss Reserves

While this move by MBIA to increase equity and reserves is hardly adequate to preserve an AAA based on what that rating is supposed to mean, the rating agencies, despite their posturing otherwise, are desperate to avoid downgrading MBIA and Ambac,. This fig leaf may be deemed to be adequate, at least for the next six to nine months. However, Fitch, which has taken a tougher stance than Moody's and Standard & Poors, is more likely to issue a downgrade, irrespective of this development.

In a sign of the doubts surrounding MBIA, Warburg Pincus is having to backstop the planned sale of preferred stock. This is reminiscent of a trader doubling down, a strategy far more likely to blow up than succeed.

Note that the value of preferred stock presupposed that the preferred dividends will actually be paid. But MBIA is a holding company; the insurance subsidiaries are regulated entities and can upstream cash to the parent only to the extent they are profitable (and then only a percentage of profits is eligible to be dividended up to the parent) or if approved by the regulator.

Eric Dinallo, who is trying to orchestrate the bailout of the bond insurers, regulates MBIA. His priority is protecting the policyholders of the regulated subsidiaries, not the equity investors. Bill Ackman of Pershing Square has repeatedly forecast that MBIA's holding company will become insolvent as early as June-July, and under a best case scenario, by the end of 2008.

I anticipate Warburg Pincus will wind up owning a lot of this paper.

From MarketWatch:

MBIA Inc. said late Wednesday that it plans to raise $750 million selling new shares to prop up its struggling bond insurance business.

Private-equity firm Warburg Pincus, which has already invested in MBIA , will backstop the sale of 50.3 million new shares by agreeing to buy up to $750 million of preferred stock that may be converted into common stock later, subject to some conditions.

MBIA also said it added $100 million to reserves to cover probable losses on securities backed by prime, second-lien mortgages....

Several bond insurers have begun to lose AAA ratings, imperiling their business models. But some have been trying to keep their top ratings by raising new capital. MBIA has already borrowed $1 billion and a $500 million investment from Warburg closed in late January....

"This is good progress," New York State Insurance Superintendent Dinallo said in a statement on Wednesday after MBIA's announcement. "It's the kind of transaction we've been discussing and encouraging."...

Still, MBIA may still find it tough to maintain its AAA ratings, according to one leading agency.

Fitch said on Wednesday that it may cut MBIA's AAA rating within four to six weeks because losses will increase materially from the bond insurer's large exposure to structured finance CDOs, which topped $30 billion at the end of September.

Such losses could threaten MBIA's AAA rating, regardless of how much capital the bond insurer raises, Fitch warned.

Hot Ladies Talking With Bald Dudes

Funny and too true. Hat tip The Big Picture via reader Doug.

Self-Employment Takes Biggest Hit in 15 Years

Forbes and Bloomberg discuss Labor Department statistics that show that the hours worked by the self-employed fell at a 15.5% annualized rate in the third quarter of 207, the steepest drop in 15 years. The subprime crisis may be the big culprit, since construction workers and mortgage brokers are often in the ranks of the self-employed.

Note that the findings of the BLS Household Survey conflict with the oft-commented-upon monthly employment report, which in 2007 kept showing rising employment among small businesses via its "birth-death model", which is basically a statistical plug. Many including yours truly have been highly skeptical, given that it was pretty obvious that the construction sector was shedding workers at a rapid clip.

From Bloomberg:

The increase in U.S. unemployment that's jeopardizing economic growth is being driven by a drop in the number of people working for themselves, government figures indicate....

The figures may be another indication of how the deepest real-estate slump in a quarter century is filtering through the economic statistics. The Labor Department said today that worker productivity grew more than forecast last quarter as hours for all employees, including those who work for themselves, fell at a 1.5 percent pace, the most in five years.

The number of people running their own businesses dropped by 365,000 last quarter, compared with the same period in 2006, according to separate Labor Department numbers.

The decline in the number of hours worked by the self- employed last quarter reflected a 9 percent annualized drop in employment combined with a 7 percent decrease in average weekly hours for those still with work, the department said.

The issue may also help resolve some discrepancies among various labor statistics, economists said.

The unemployment rate, calculated from the household survey that covers the self-employed, jumped 0.3 percentage point in December. The increase prompted some economists to predict the U.S. was already, or would soon be, in a recession.

Even as the jobless rate rose, revised figures from the survey of businesses, which doesn't track single-employee companies, showed hiring accelerated on average from the third quarter to the last three months of the year. Payrolls dropped in January for the first time in more than four years.

``Self-employment, as only calculated by the household survey, is probably reflecting the slump in the subprime mortgage market,'' said Michael Englund, chief economist at Action Economics LLC, a forecasting firm in Boulder, Colorado.

Many mortgage brokers involved in the subprime industry work for themselves, Englund said, citing anecdotal evidence and conversations with clients.

Self-employment may also help explain why first-time applications for jobless benefits have yet to reach levels normally associated with a weakening labor market. A four-week moving average of claims has ranged from 306,000 to 345,000 since July. Most economists believe it takes readings in excess of 350,000 to indicate an increase in firings.

Self-employed Americans, although they may file claims, are not eligible for benefits under the unemployment insurance system, according to the Labor Department.

``This could really help explain a lot of the conflicting signals in the data,'' said Englund.

Rating Agencies May Face Restrictions in Structured Finance

Although it's merely talk at this point, international regulators are considering how to reform rating agencies' role in structured finance, which in hindsight contributed to many parties buying paper that was considerably riskier than they realized,

One notion is to limit their their role in advising issuers on the design of structured finance products, which is where the biggest conflict of interest lay for the raging agencies. The problem, as this Bloomberg article notes, is that this approach may still leave a great deal of room for mischief.

An aside: while this article does not purport to present all the ideas under consideration, it seems odd that there is no discussion of the fundamental problem with the rating agencies' posture, namely, that (save new agency Egan Jones) they are paid by issuers, when their ratings are meant to serve investors. But perhaps no one believes that the investors in aggregate will pay as much for the service as the issuers did (and the idea of depriving the agencies of revenues, no matter how badly they screwed up, seems verboten. Why are parties thriving under a regulatory umbrella being treated with kid gloves, particularly when no one questions that their failings have caused considerable harm?)

Note that the rating agencies are hiding behind the canard that they don't advise on deal structure when even industry textbooks confirm that that is precisely what they do. And also note that they have had the temerity to tell that lie in Congressional hearings.

But a bigger question looms: so many investors are holding paper that has fallen sharply in value that the future of the structured finance market itself is in question, and that poses a very fundamental challenge for the entire financial system. A recent article in the Financial Times indicated that while market participants (ie, the people who've been selling and trading this stuff) expect the market to come back soon, central bankers are pessimistic, and anticipate that we will see a return to much more bank intermediation (that is, banks holding much of the loans they lend).

History suggests the pessimistic view may be accurate. After the crash of 1929, investment trusts, the speculative vehicles culpable in the stock market bubble, were deeply suspect. So many people had been burned that even with the new securities law regime of 1933-1934, investment trusts (rebranded as mutual funds) did not become popular again until the 1950s, which was roughly when the stock market had made up its losses.

From Bloomberg:

Moody's Investors Service and Standard & Poor's may be restricted from advising banks on structured debt securities after criticism the firms failed to downgrade subprime-related notes as investor losses mounted.

Ratings firms may face a code of conduct prohibiting ``advice on the design of structured products which an agency also rates,'' the International Organization of Securities Commissions in Madrid said today. IOSCO, the forum of securities regulators, also called on financial institutions to disclose their risk of losses from structured finance.

Regulators including Michel Prada, France's chief securities official and chairman of IOSCO's Technical Committee, have rebuked ratings companies for being involved in creating the securities responsible for at least $146 billion of losses in the wake of the subprime slump.

``This doesn't address the core issue, which is ratings being paid for by issuers,'' said Christian Stracke, a strategist at CreditSights Inc. in London. ``It's a good first step but it leaves a lot of wiggle room.''

Borrowers pay for credit ratings rather than investors. Potential conflicts of interest between rating companies and the banks that pay their fees were flagged last year by European Central Bank President Jean-Claude Trichet and U.S. Senate Banking Committee Chairman Christopher Dodd. The Securities and Exchange Commission said in August it was examining the way the companies assign ratings.

Prada, France's securities regulator since 2003, focused on possible conflicts between ratings companies and investment banks that create collateralized debt obligations. ``The first depends more and more on the second in their business development,'' he said in September.

``S&P's ratings business doesn't provide consulting services and our analysts do not provide consulting services,'' said Martin Winn, a spokesman at the company in London. ``Together with the other rating agencies, we are proposing changes to the code that would explicitly prohibit ratings firms from carrying out these activities.''

Moody's earned $884 million in 2006, or 43 percent of total revenue, from rating so-called structured notes, securities that package asset- and mortgage-backed debt, according to Neil Godsey, an equity analyst at Friedman, Billings, Ramsey Group Inc. in Arlington, Virginia. That's more than triple the $274 million generated in 2001.

CDOs are created by packaging assets including bonds, loans or credit-default swaps and using their income to pay investors. The securities are divided into different portions of varying risk, offering a range of returns.

Willem Buiter: "Why the US may well need a recession, 2"

Willem Buiter continues his quixotic campaign to extirpate lousy economic logic in the US. In a colorfully written post, he ridicules the refusal of any US economist (as far as he can tell) to consider that an American recession is necessary. He points to the obvious fact (commented on repeatedly in this blog) that the current level of US consumption in relation to GDP is unsustainable. A drop in consumption and a rise in savings to the degree needed to restore a semblance of macroeconomic balance is certain to trigger a slowdown, more likely a period of negative growth. Yet the current efforts to prop up aggregate demand and keep the distortions going will only make the inevitable correction worse.

Buiter interestingly points to what he considers to be the source of US myopia: an American tendency to see itself as a largely closed system, with at most a simple input-output function (we pay for imports by selling Treasuries) and not recognizing that the US is a participant in a system that is ultimately bigger than it is and might start putting limits on this behavior.

I saw a demonstration of this insularity at a conference on sovereign wealth funds last evening. The participants were all remarkably sanguine about the growing role these entities are coming to play, noting rather blandly that they were being very helpful in shoring up our creaking financial system. And the idea which also held sway that evening, that the investors had no influence because they held minority stakes, is absurd. As veteran deal maker Felix Rohatyn pointed out, “You don’t need to appoint two directors to a board to have influence when you own 10 percent of the company.”

With the continuing leaks in our financial system, we will soon pass 10% in concentrated holdings in foreign hands at quite a few financial players. Standard & Poor's anticipates that it coming reviews and downgrades of subprime debt will increase writedowns of financial firms from their current $130 billion to $265 billion. And as conditions worsen, future investments will be on less favorable terms, so struggling firms will have to give up more equity to get the needed infusion.

But what perhaps was the most remarkable subtext of the conference, in confirmation of Buiter's views, was that this situation is sustainable, that the US can indefinitely run a large current account deficit (the consequence of an inadequate savings rate) and continue to import money from abroad. That program guarantees a deteriorating dollar, may precipitate a dollar crisis, and risks the dollar's standing as reserve currency. If the US has to start funding its current account deficit in foreign currencies, as it did briefly during the Carter Administration, that will put us on a very short leash.

It reminded me of Japan, circa 1986, when very intelligent people were telling me that the even-then-obviously-overvalued Nikkei could never go down because the capital flows were so great. Essentially, it was a weight of money argument. And it still looked correct for three more years.

When otherwise smart people start believing things that are not sensible, it's a warning sign of serious trouble. And unlike 1986, the volcano has started to emit smoke.

From Buiter:

A while ago I argued in this blog that the US might benefit from a recession, because it was highly unlikely that the fundamental adjustment required in the US economy – a substantial increase in the national saving rate – is achievable without a period of growth below potential. Others have made similar points, and not just the usual European suspects, with post-colonial chips on their shoulders and an excess of Schadenfreude whenever the US trips over a banana peel. In recent contributions to the FT, Chrystia Freeland (Canadian, I believe)and Ricardo Hausmann (Venezuelan, when last I met him) have also made the point that the US needs, or would benefit from, an early serious slowdown in economic activity/recession. As the proud owner of both a US and a UK passport (and the former owner of a Dutch passport), my motives are, of course, beyond suspicion.

No US economist working in the US whose views I have read or heard supports the idea that a recession might be what the US needs right now. I think part of the difference in perspective comes from the fact that Europeans and other non-Americans view the US as an open economy that for decades has been saving too little and has been living beyond its means by borrowing abroad. They believe that the external constraint on the US addiction to current consumption is likely to become binding soon and certain to become binding in due course. Americans still tend to do much of their thinking about the US economy as if it were either the entire world economy, or at any rate a closed economy with just a couple of large holes in it: one through which oil imports pour in and another through which US Treasury bills and bonds disappear, never to be seen again.

In fact the US is well on its way to becoming a semi-small open economy on the trade side (with some influence over its terms of trade) and a small open economy on the financial side. The US now accounts for about thirty percent of world GDP at market exchange rates (less at PPP exchange rates).

In the financial field, the speed with which the euro is bridging the gap with the US dollar, once considered unassailable as an international reserve currency, has surprised even the greatest euro optimists. With the US now the world's largest external debtor nation, monetary policy in the US is increasingly constrained by international financial markets. The (to my mind) reckless interest rate cuts by the Fed risk spooking domestic and international holders of US dollar-denominated securities who have many alternative investment opportunities, both low risk sovereign debt instruments and higher-risk/higher-return investments in non-US equities, including those issued by emerging markets. The risk of a sharp sell-off of US dollar -denominated securities and an associated increase in long-term US dollar interest rates could easily turn the US slowdown into a recession, even a prolonged one. A US recession that would be mild with 10-year US Treasury bonds yielding 3.6 percent could become deep with 10-year US Treasury bonds at 6.6 percent.

But even if the US were a closed economy, I would still believe that the kind of sustained increase in the national saving rate - by at least six percent of GDP to give US citizens hope of a dignified retirement (rather more than the three percent of GDP increase in the national saving rate required to restore external sustainability for the US) - cannot in practice be achieved without passing through a material slowdown, and possibly a recession.

Higher saving means lower consumption or higher income without a commensurate increase in consumption. I am sufficiently Keynesian to believe that a planned reduction in consumption will cause a temporary slowdown in activity. The kind of supply-side miracle that would produce an increase in income without a matching increase in private and public consumption is hard to visualise for the US. China has managed just that during the past decade, but the US is hardly China.

For the past couple of decades, the US consumer has been saved from the consequences of his under-saving by wallet-expanding painless capital gains. Unfortunately these capital gains were to a significant extent bubble-born and these bubbles have imploded one after the other. After the tech bubble and bust and the housing boom and bust, I cannot see another asset bubble coming along in time to rescue the improvident US consumer.

Therefore, to restore a sustainable external balance and to accumulate the financial assets that will support a greying US population in the style it would like to and hopes and expects to be accustomed to, the US private and public sectors must save more. To get to a higher saving and wealth trajectory, the US economy will first have to pass through the valley of the shadow of deficient effective demand, rising excess capacity and growing unemployment. Postponing the necessary adjustment will just make the pain of the eventual unavoidable correction that much greater.

There are two ways to achieve a traverse to a higher saving and financial wealth trajectory without passing through a slump. The first would be for US investment demand to rise by the same amount as consumption demand falls. This, however, would mean that the external imbalance would not be corrected. An increase in domestic capital formation that matches the increase in planned national saving is therefore not part of a sustainable adjustment programme. In addition, it is not easy to see what would motivate such an increase in investment.

A significant increase in private fixed investment is unlikely, because there are now, at the margin, many more attractive investment opportunities in other parts of the world. The US economy labours increasingly under an inadequate and ageing stock of infrastructure capital. The education and skill levels of its labour force are no longer the best in the world. Even in the higher education sector, where the US still has virtually all of the world’s leading institutions, the overall picture is one of islands of excellence in a sea of mediocrity. Secondary education is typically and on average poor, as are numeracy skills and literacy standards. Immigration has helped keep up US skill levels and underpinned it meritocratic traditions. Post-9/11 immigration paranoia threatens that vital contribution to US economic dynamism. Meritocracy is mutating into plutocracy.

A major boost to infrastructure investment would be more than welcome to boost the supply-side of the economy. For external balance reasons it would, however, have to be financed by a further increase in public saving. Any US politician running on a programme of higher taxes or lower current spending to pay for better infrastructure would in all likelihood not get elected.

The second way for the US economy to achieve a lasting increase in the saving rate without a temporary slump, would be for net exports to rise by the same amount as planned saving. That’s possible but not likely. The decline in the nominal external value of the US dollar is certainly helping, but the shift of domestic resources from the non-traded sectors (including construction) to the traded sectors (both exporting and import-competing) is unlikely to be accomplished solely through relative price signals. Painful quantity adjustment, including idle labour and capital in the over-expanded non-traded sectors is likely to be necessary.

So I don’t understand why both Larry Summers and Martin Feldstein, who have for many years preached the need for America to save more, do a 180-degree turn whenever there are signs that a higher saving rate may actually be in the making, and recommend expansionary fiscal and monetary measures to prevent at all cost a decline in the level or even the growth rate of consumption. The American economy is broke. To fix it a slowdown is well-nigh inevitable and a recession is likely to be necessary.

But the ostriches in the Fed, the White House and the Capitol are unmoved by such concepts as unsustainability. The prevailing ethos is myopic at best: let’s just put out this immediate fire, because it threatens today’s comfort level. Postponing adjustment raises the expected cost of the eventual adjustment, but that is then and this is now. Also, something may turn up. Santa Claus could exist after all. We may learn to harness as a source of renewable energy the hot air put out by the Congress.

It is hard to have a rational discussion with those who embody and express the views of a nation that is in denial. The US establishment and political class, and quite possibly much of its electorate, are indeed in denial, and not just about the need for an early traverse to a higher national saving rate. The economic, social and political model of the US has developed serious albeit remediable flaws and needs major surgery. Unfortunately none of those running for office today are likely to be willing or able to wield the scalpel as required.

Martin Wolf: Can We Corral the Financiers?

Readers may note we have a fair number of posts from the Financial Times today. The pink paper is having a good day, and conversely, in the US, Super Tuesday has taken pride of place in the news.

Martin Wolf in today's Financial Times argues that more aggressive reform of the financial sector is needed, yet looks at most of the notions under consideration by the powers that be and finds they reveal a lack of regulatory will. Wolf makes the case for more tough-mindedness while at the same time warning of considerable resistance to intervention.

One statistic in the article is particularly noteworthy. The profits of financial firms grew from under 5% of after tax profits in 1982 to nearly 41% in 2007 while their share of corporate value added grew from 8% to 16%. Translation: financiers have managed to suck fees out of the economy well in excess of their utility. And Wolf does not mention some of the unhealthy side effects of the finance cart leading the economy horse, namely, the short-term earnings fixation that has badly distorted corporate behavior, encouraging underinvestment and excessive cost-cutting.

Ultimately, Wolf is not optimistic that the needed changes will occur. Unfortunately, that means we may have to have a Depression-type disaster, or close to it, to shake the stubborn faith in a badly flawed status quo.

From Wolf:

When will the next financial crisis come? We do not know. Yet of one thing we can be sure: unless we learn from this crisis, another one will put the world economy back on to the rocks in the not too distant future.

Every week, 50 of the world’s most influential economists discuss Martin Wolf’s articles on FT.com
The FT has published a number of contributions on the lessons: Charles Goodhart of the London School of Economics and Avinash Persaud of Intelligence Capital offered “a proposal for how to avoid the next crash” (January 31); Francisco González of BBVA discussed “What banks can learn from this credit crisis” (February 4); and Daniel Heller of the Swiss National Bank argued for three ways to reform bank bonuses (February 4). The substance of Mr Heller’s argument was similar to a contribution of my own (“Regulators should intervene in bankers’ pay”, January 15), but without the regulatory coercion.

The big question, indeed, is whether lessons must be embedded in regulation. Optimistic opponents of regulation argue that the banks have learnt their lesson and will behave more responsibly in future. Pessimistic opponents fear that legislators might create a Sarbanes- Oxley squared. The Act passed by the US Congress in 2002, after Enron and other scandals, was bad enough, they say. The banks might now suffer something worse.

“Dream on” is my reply to the optimists. To the pessimists, I respond: yes, the danger of over-regulation is real, but so is that of doing nothing at all.

Two points shine out about the financial system over the past three decades: its ability to generate crises, and the mismatch between public risk and private reward.

It is true, on the first point, that none of the financial crises of this period has gravely damaged the world economy, although some have devastated individual economies. But it is probably just a matter of time. What would be happening now if US inflation were out of control or foreign official support for the US dollar were withdrawn? A deep and prolonged US recession would be probable, with devastating economic and political consequences.

It also true, on the second point, that the banking sector is the recipient of massive explicit and implicit public subsidies: it is largely guaranteed against liquidity risk; many of its liabilities seem to be contingent claims on the state; and central banks create an upward- sloping yield curve whenever banks are decapitalised, thereby offering a direct transfer to any institution able to borrow at the low rate and lend at the higher one.

In addition, banking institutions suffer from massive agency problems – between clients and institutions, shareholders and management and management and other staff. All this is also exacerbated by the difficulty of monitoring the quality of transactions until long after the event.

Consider, for example, the process that brought subprime loans to investors in special investment vehicles (SIVs). In between the ultimate borrowers and the risk-takers were loan-originators, designers and packagers of securitised assets, ratings agencies, sales staff, managers of banks and SIVs and managers of pension – and other – funds. Given the number of agents and the wealth of information asymmetries, it is astounding how little went wrong.

Yet big risks have indeed been run. The US itself looks almost like a giant hedge fund. The profits of financial companies jumped from below 5 per cent of total corporate profits, after tax, in 1982 to 41 per cent in 2007, even though their share of corporate value added only rose from 8 to 16 per cent. Banking profit margins have been strong, until recently. Now, at long last, earnings per share and valuations have collapsed.

Yet can anything effective be done to contain the risk-taking this implies? To answer this, we must distinguish “micro-prudential” controls over institutions from “macro-prudential controls” over the entire system.

On the former, the consensus of regulators seems to be that we need tweaks to the existing system. This could include: greater attention to liquidity management, alongside the focus on capital requirements in Basel II; more stress-testing of “value at risk” models; greater transparency throughout the businesses; and greater independence of ratings agencies from issuers.

I would argue, however, that none of this will make a sufficient difference. Regulators must also pay attention to the incentives – particularly the structure of pay – within the businesses. I would argue, in addition, that regulators would have to take a tougher approach than most did in the past cycle.

The bigger point still, however, concerns macro-prudential regulation. As William White of the Bank for International Settlement has noted, banks almost always get into trouble together.* The most recent cycle of mad lending, followed by panic and revulsion, is a paradigmatic example.

One response would be to raise capital requirements counter-cyclically, in response to the growth of credit, as Profs Goodhart and Persaud suggested. They also suggest a variable maximum loan-to-value ratio for mortgages. Mr White adds the need for tighter monetary policy.

These are all reasonable ideas. Yet, as Mr White also notes, the strength of the pressures against taking “away the punchbowl just as the party gets going”, in former Fed governor William McChesney’s famous phrase, is formidable. In addition to bureaucratic inertia, such action is subject both to unavoidable uncertainty about the dangers of current trends and to resistance from private interests. Furthermore, regulators are in constant danger of losing sight of the systemic wood for the institutional trees. I would add to all this the simple fact that freedom of US monetary policy is constrained by the monetary and exchange-rate policies of others, notably of China.

In the end, we are left with a dilemma. On the one hand, we have a banking sector that has a demonstrated capacity to generate huge crises because of the incentives to take on under-appreciated risks. On the other hand, we lack the will and even the capacity to regulate it.

Yet we have no obvious alternative but to try to do so. A financial sector that generates vast rewards for insiders and repeated crises for hundreds of millions of innocent bystanders is, I would argue, politically unacceptable in the long run. Those who want market-led globalisation to prosper will recognise that this is its Achilles heel. Effective action must be taken now, before a still bigger global crisis arrives.

Warning: Credit Default Swaps May Not Work As Advertised

A very good, accessible article, "CDS market may create added risks," by Satayjit Das appears in today's Financial Times.

We've sometimes discussed the fact that credit default swaps, which effectively are insurance policies against defaults, suffer from considerable counterparty risk. A policy is only as good as the entity that wrote it, and many of the players in the CDS game hedge or partially hedge the insurance they have written with contracts from others. Thus, a failure to pay could easily lead to cascading problems.

Das gives further insight into the potential trouble spots in the CDS market, noting that even when everyone pays up properly, CDS hedges have failed to provide the insurance against risk that they were supposed to. He also discusses how practice has deviated from theory when parties failed to post adequate collateral as well as operational risks.

From the Financial Times:

In May 2006, Alan Greenspan, the former Federal Reserve chairman, noted: “The credit default swap is probably the most important instrument in finance. … What CDS did is lay-off all the risk of highly leveraged institutions – and that’s what banks are, highly leveraged – on stable American and international institutions.”

The reality may prove different.

The CDS is economically similar to credit insurance. The buyer of protection (typically a bank) transfers the risk of default of a borrower (the reference entity) to a protection seller who for a fee indemnifies the protection buyer against credit losses. Current debate has focused on the size of the market. But the key problem is that a combination of documentation and counterparty risks means that the market may not function as participants and regulators hope if actual defaults occur.

CDS documentation, which is highly standardised, generally does not exactly match the terms of the underlying risk being hedged. CDS contracts are also technically complex in relation to the identity of the entity being hedged, the events that are covered and how the CDS contract is to be settled. This means that the hedge may not provide the protection sought.

In case of default, the protection buyer in CDS must deliver a defaulted bond or loan – the deliverable obligation – to the protection seller in return for receiving the face value of the delivered item (known as physical settlement). When Delphi defaulted, for example, the volume of CDS outstanding was $28bn against $5.2bn of bonds and loans. On actively traded names CDS volumes are substantially greater than outstanding debt making it difficult to settle contracts.

Shortage of deliverable items and practical restrictions on settling CDS contracts have forced the use of “protocols” – where any two counterparties, by mutual consent, substitute cash settlement (based on the market price of defaulted bonds) for physical delivery. In Delphi, the protocol resulted in a settlement price of 63.38 per cent (the market estimate of recovery by the lender). The protection buyer received 36.62 per cent (100 per cent - 63.38 per cent) or $3.662m per $10m CDS contract. Fitch Ratings assigned a recovery rating to Delphi’s senior unsecured obligation equating to a 0-10 per cent recovery band - far below the price established through the protocol. The buyer of protection may have potentially received a payment on its hedge below its actual losses – effectively it would not have been fully hedged.

CDS contracts substitute the risk of the protection seller for the risk of the loan or bond being hedged. Some 60-70 per cent of ultimate CDS protection sellers are financial guarantors (monoline insurers) and hedge funds. Concerns about the credit standing of monolines are well documented. Recently, Merrill Lynch took a charge of $3.1bn against counterparty risk on hedges with financial guarantors.

In the case of hedge funds, the CDS is marked to market daily. Any gain or loss is covered by collateral (cash or high quality securities) to minimise performance risk. If there is a failure to meet a margin call then the position must be closed out and the collateral applied against the loss. As the case of ACA highlighted, banks may not be willing or able to close out positions where collateral isn’t posted. Collateral models also use historical volatility and correlation that may underestimate the risk.

Then there are operational risks – mark to market of the CDS and control of collateral.

If the CDS contracts fail then “hedged” banks are exposed to losses on the underlying credit risk. The CDS market entails complex chains of risk – similar to the re-insurance chains that proved so problematic in the case of Lloyd’s of London. A default may quickly cause the financial system to become gridlocked as uncertainty about counterparty risks restricts trading.

As the credit crisis deepens, the risk of actual defaults becomes real. The CDS market will be tested and may be found wanting.

CDS contracts may not actually improve the overall stability and security of the financial system but actually create additional risks.

Evidence Wachovia Knew of and Profited from Theft

This story is so heinous that I couldn't let it go by. Court filings indicate Wachovia not only permitted telemarketers to steal from individuals, but they were aware of the practice and turned a blind eye because it was profitable to them. And the targets of the fraud were typically elderly.

The suit was filed last spring; Wachovia implemented some anti-fraud measures last summer, after the case was written up in the New York Times, with the usual blandishments about ": “Earning the trust of our customers is at the heart of what we do every day." Actually, that bit of corporate pablum is true even if the fraud allegations are proven true (likely). The Wachovia customers were stealing from accounts at other banks, yet Wachovia refused to shut them down, despite warnings from other institutions and red-flag levels of bad checks.

Note also that the victims of the fraud had to turn to civll suits because banks accused of participation in this type of fraud have never been prosecuted or publicly fined.

From the New York Times:

Last spring, Wachovia bank was accused in a lawsuit of allowing fraudulent telemarketers to use the bank’s accounts to steal millions of dollars from unsuspecting victims. When asked about the suit, bank executives said they had been unaware of the thefts.

But newly released documents from that lawsuit now show that Wachovia had long known about allegations of fraud and that the bank, in fact, solicited business from companies it knew had been accused of telemarketing crimes.

Internal Wachovia e-mail, for example, show that high-ranking employees at the nation’s fourth-largest bank frequently warned colleagues about telemarketing frauds routed through its accounts.

Documents also show that Wachovia was alerted by other banks and federal agencies about ongoing deceptions, but that it continued to provide banking services to multiple companies that helped steal as much as $400 million from unsuspecting victims.

“YIKES!!!!” wrote one Wachovia executive in 2005, warning colleagues that an account used by telemarketers had drawn 4,500 complaints in just two months. “DOUBLE YIKES!!!!” she added. “There is more, but nothing more that I want to put into a note.”

However, Wachovia continued processing fraudulent transactions for that account and others, partly because the bank charged fraud artists a large fee every time a victim spotted a bogus transaction and demanded their money back. One company alone paid Wachovia about $1.5 million over 11 months, according to investigators.

“We are making a ton of money from them,” wrote Linda Pera, a Wachovia executive, in 2005 about a company that was later accused by federal prosecutors of helping steal up to $142 million.

Ms. Pera left Wachovia in 2006, and could not be located.

Lawyers pursuing the lawsuit against Wachovia, which was filed in a Pennsylvania federal court on behalf of a woman named Mary Faloney and other apparent victims, have asked a judge to declare the case a class action, which could expand it to as many as 500,000 plaintiffs.

The lawsuit alleges that Wachovia accepted fraudulent, unsigned checks that withdrew funds from the accounts of victims, often elderly. Wachovia forwarded those checks to other banks that were unaware of the frauds, which in turn sent money to the swindlers.

A judge is expected to rule on the class action request by this summer. Wachovia, in court filings, has denied the suit’s allegations. The company declined to comment on the pending litigation.

However, Wachovia’s senior vice president for risk management, Alan Chudoba, said that the bank introduced reforms aimed at telemarketing frauds last summer. Those changes, which came about after an article in The New York Times last May reported that thieves had used Wachovia accounts, include greater scrutiny of accounts used by telemarketers and stronger fraud protections...

The Pennsylvania suit against Wachovia alleges that the bank’s involvement with telemarketing thefts dates to October 2003, when Wachovia was warned by another bank that a Wachovia client named AmeriNet had tried to process more than $100,000 in improper withdrawals.

AmeriNet was a “payment processor,” a company that creates unsigned checks on behalf of telemarketers to withdraw funds automatically from customer accounts. Such checks, once widely used by businesses collecting monthly fees, are legal if customers approve the transactions.

However, a Wachovia executive wrote to colleagues, evidence suggested AmeriNet was creating unapproved checks.

“Keep in mind historically, telemarketing is an easy way to money launder and commit fraud. To knowingly bank a customer who is perpetrating fraud places the bank at great exposure,” wrote that executive, Tim Brady, according to documents that are part of the lawsuit.

Mr. Brady, who did not return phone calls, recommended closing the AmeriNet account in 2003, according to that e-mail message. But Wachovia continued working with the company until 2005, when AmeriNet paid $50,000 to settle complaints filed by the attorneys general of five states. Wachovia was not named in those complaints.

In late 2003, a Wachovia executive announced to colleagues via e-mail that her unit, because of AmeriNet, had seen “an increase in our annual revenue projection.”

Wachovia declined to comment on those e-mail messages, citing pending litigation.

Wachovia also worked with other payment processors, according to court documents. In 2004, Wachovia held a lunch for the owner of a payment processor that the bank knew had drawn thousands of previous complaints.

“It is important that our relationship is firm and in good standing” with the owner of that company, Your Money Access, wrote the Wachovia executive, Ms. Pera, to colleagues. Your Money Access was sued last year by the Federal Trade Commission and seven states on suspicion of helping to steal up to $69 million.

There were other internal warnings, as well.

In 2005, a Wachovia fraud investigator wrote to colleagues that 79 percent of the checks submitted by one Wachovia client, Suntasia, had been returned in August because of unauthorized withdrawals and other problems. Regulators say return rates in excess of 2.5 percent is evidence of potential fraud.

“I have good reason to believe that all of the deposited items are unauthorized drafts,” wrote the fraud investigator, Bill McCann in a 2005 e-mail message.

But Wachovia continued doing business with Suntasia until last year, when the company was shut down by a court order, according to the lawsuit.

Wachovia declined to comment on Mr. McCann’s e-mail. Mr. McCann declined to return calls.

Moreover, executives at other banks, including Bank of America, Wells Fargo, Citizens Bank, the Social Security Administration and the Justice Department Federal Credit Union also warned Wachovia multiple times that its accounts were being used for fraud, according to the lawsuit against the bank.

In 2006, an executive at Citizens Bank wrote via e-mail that thieves were routing unauthorized checks through Wachovia that stole from Citizens account holders.

“We have spoken to many of our customers who have been victimized by this scam,” wrote the Citizens executive, according to court documents. “We would appreciate it if you would shut down accounts of any customers of yours that may be engaging in improper activity.”

But Wachovia kept that account open until it was frozen by a federal court a few weeks later, as part of a government lawsuit against the client.

A Wachovia spokeswoman said that in every case where a bank complained, an investigation was opened and that some accounts were closed.

But court records show that many of those accounts stayed open for years after the complaints were received.

Last June, after Wachovia’s involvement with telemarketing thefts was reported by The Times, Congressional lawmakers, including Representative Edward J. Markey, Democrat of Massachusetts and senior member of the House Energy and Commerce Committee, asked five regulatory agencies to answer questions regarding the unsigned checking system that fraud artists used. Senator Tom Harkin, Democrat of Iowa, also asked the Senate Banking Committee to investigate the issue.

Many of those agencies responded by saying they lacked jurisdiction. “Clearly, more needs to be done to prevent fraud in this area,” Mr. Markey said in a statement. A spokeswoman for Mr. Harkin said lawmakers were considering hearings.

Other regulators say the banks are to blame.

“These types of crimes only are possible because banks tolerate them,” said the United States attorney in Philadelphia, Patrick L. Meehan, who prosecuted a payment processor accused of using Wachovia accounts to steal more than $100 million.

“Who knows how many other crimes like this are occurring every day without anyone realizing it?” Mr. Meehan said.

Links 2/6/08

The Limits To Scenario Planning The Oil Drum. Much more interesting post than the anodyne title would lead you to believe. One of its threads in how people misread "The Limits to Growth."

Bankruptcy: No Obstacle to Private-Equity Profits Felix Salmon

The Huge Hole in Unemployment Insurance Robert Reich

Howard's Economic Record John Quiggin. Not all that it was cracked up to be, despite having the strong tailwind of a commodities boom.

Billionaire Schwarzman: ‘I’m Not Wealthy’ Wealth Journal, Wall Street Journal. The only time I ever spoke to Scharzman in a small setting was when meeting with him and Pete Peterson to discuss a possible M&A assignment in 1986, one that was sufficiently juicy that in the end Felix Rohatyn worked on it personally.

Despite having a potentially profitable and high profile transaction in front of the then young Blackstone, which was an investment banking boutique in the process of raising its first fund, the two could not restrain themselves from talking, in front of prospective clients, how jealous they were of how much money Henry Kravis was making. And at some length, to boot.

It appear Schwarzman hasn't changed in the intervening 20+ years.

Happiness: Enough Already Newsweek (hat tip Dani Rodrik). The piece argues that happiness is overvalued and normal sadness is pathologized (a point of view useful to the makers of Prozac). Cynically, however, I note that this sort of research is suddenly getting a hearing as the country is certain to go into a collective bad mood due to deteriorating economic fundamentals.

Predicting recession James Hamilton, Econbrowser. This is an excellent post and I hate relegating it to a mere link, but there is way too much good material on offer this evening and this post may be a hair geeky for the average reader. Hamilton turns the post over to the work of Michael Dueker, a senior portfolio strategist at Russell Investments, who has developed a model for forecasting recessions. Dueker's assessment: "Current recession forecasts indicate that it would be unprecedented not to have a recession in 2008."

Sharp CMBX Move Signals Heightened Worry

As many reader likely know, the Markit CMBX indices are commercial real estate mortgage-backed securities default indexes, However, unlike the more familiar subprime indexes, the ABX, which is based on bond prices (so down is bad), the CMBX is based on spreads. When spreads go up, bond prices go down, so for the CMBX, up is bad (assuming you are long real estate or bonds).

Since the CMBX is a proxy for the market, many argue that it is used so much for punting that it isn't a reliable guide to fundamentals. What is interesting is that the CMBX AAA index has reached a sudden nasty new height; the indexes for lower-rated bonds have merely returned to or are approaching their worst historical levels of early January. But even if you view it as a mere sentiment indicator, investor mood seems to have taken a sharp turn for the worse.

From MarkIt:







Update: I had seen this chart earlier today, courtesy Mark Thoma, from MIT News, and initially neglected to include it in the post. The accompanying report is also informative, Key paragraph:

"This is evidence that the commercial property market continued to fall, and at an accelerated rate, through the last quarter of 2007, no doubt due to the effects of the credit crunch," said MIT Center for Real Estate Director David Geltner.

Nouriel Roubini's Doomsday Scenario

In today's post, "The Rising Risk of a Systemic Financial Meltdown: The Twelve Steps to Financial Disaster," the bearish and prescient professor Nouriel Roubini sets forth how a systemic financial crisis could play out.

The most troubling thing about this piece is that it is quite plausible.

Of Roubini's twelve steps, the first eight are economic and financial market conditions that are putting severe stress on the financial system; the last four describe the resulting crisis. Since the piece is long, I've edited down the sections that cover issues that are likely to be most familiar to readers.

From RGE Monitor:

Why did the Fed ease the Fed Funds rate by a whopping 125bps in eight days this past January?.... the flow of bad macro news in mid-January did not justify, by itself, such a radical inter-meeting emergency Fed action followed by another cut at the formal FOMC meeting.

To understand the Fed actions one has to realize that there is now a rising probability of a “catastrophic” financial and economic outcome, i.e. a vicious circle where a deep recession makes the financial losses more severe and where, in turn, large and growing financial losses and a financial meltdown make the recession even more severe...

That is the reason the Fed had thrown all caution to the wind – after a year in which it was behind the curve and underplaying the economic and financial risks – and has taken a very aggressive approach to risk management....

To understand the risks that the financial system is facing today I present the “nightmare” or “catastrophic” scenario that the Fed and financial officials around the world are now worried about. Such a scenario – however extreme – has a rising and significant probability of occurring. Thus, it does not describe a very low probability event but rather an outcome that is quite possible.

Start first with the recession that is now enveloping the US economy. Let us assume – as likely - that this recession – that already started in December 2007 - will be worse than the mild ones – that lasted 8 months – that occurred in 1990-91 and 2001. The recession of 2008 will be more severe for several reasons: first, we have the biggest housing bust in US history with home prices likely to eventually fall 20 to 30%; second, because of a credit bubble that went beyond mortgages and because of reckless financial innovation and securitization the ongoing credit bust will lead to a severe credit crunch; third, US households – whose consumption is over 70% of GDP - have spent well beyond their means for years now piling up a massive amount of debt, both mortgage and otherwise; now that home prices are falling and a severe credit crunch is emerging the retrenchment of private consumption will be serious and protracted. So let us suppose that the recession of 2008 will last at least four quarters and, possibly, up to six quarters. What will be the consequences of it?

Here are the twelve steps or stages of a scenario of systemic financial meltdown associated with this severe economic recession…

First, this is the worst housing recession in US history and there is no sign it will bottom out any time soon. At this point it is clear that US home prices will fall between 20% and 30% from their bubbly peak; that would wipe out between $4 trillion and $6 trillion of household wealth..... a 30% fall in home values would imply that over 10 million households would have negative equity in their homes and would have a big incentive to use “jingle mail” (i.e. default, put the home keys in an envelope and send it to their mortgage bank)....

Second, losses for the financial system from the subprime disaster are now estimated to be as high as $250 to $300 billion. But the financial losses will not be only in subprime mortgages and the related RMBS and CDOs. They are now spreading to near prime and prime mortgages as the same reckless lending practices in subprime (no down-payment, no verification of income, jobs and assets (i.e. NINJA or LIAR loans), interest rate only, negative amortization, teaser rates, etc.) were occurring across the entire spectrum of mortgages; about 60% of all mortgage origination since 2005 through 2007 had these reckless and toxic features. So this is a generalized mortgage crisis and meltdown, not just a subprime one. And losses among all sorts of mortgages will sharply increase as home prices fall sharply and the economy spins into a serious recession. Goldman Sachs now estimates total mortgage credit losses of about $400 billion; but the eventual figures could be much larger if home prices fall more than 20%. Also, the RMBS and CDO markets for securitization of mortgages – already dead for subprime and frozen for other mortgages - remain in a severe credit crunch, thus reducing further the ability of banks to originate mortgages. The mortgage credit crunch will become even more severe.

Also add to the woes and losses of the financial institutions the meltdown of hundreds of billions of off balance SIVs and conduits; this meltdown and the roll-off of the ABCP market has forced banks to bring back on balance sheet these toxic off balance sheet vehicles.... And because of securitization the securitized toxic waste has been spread from banks to capital markets and their investors in the US and abroad, thus increasing – rather than reducing systemic risk – and making the credit crunch global.

Third, the recession will lead – as it is already doing – to a sharp increase in defaults on other forms of unsecured consumer debt: credit cards, auto loans, student loans..... As the Fed loan officers survey suggest the credit crunch is spreading throughout the mortgage market and from mortgages to consumer credit, and from large banks to smaller banks.

Fourth, while there is serious uncertainty about the losses that monolines will undertake on their insurance of RMBS, CDO and other toxic ABS products, it is now clear that such losses are much higher than the $10-15 billion rescue package that regulators are trying to patch up..... The monolines should be downgraded as no private rescue package – short of an unlikely public bailout – is realistic or feasible given the deep losses of the monolines on their insurance of toxic ABS products.

Next, the downgrade of the monolines will lead to another $150 of writedowns on ABS portfolios for financial institutions that have already massive losses. It will also lead to additional losses on their portfolio of muni bonds. The downgrade of the monolines will also lead to large losses – and potential runs – on the money market funds that invested in some of these toxic products. The money market funds that are backed by banks or that bought liquidity protection from banks against the risk of a fall in the NAV may avoid a run but such a rescue will exacerbate the capital and liquidity problems of their underwriters. The monolines’ downgrade will then also lead to another sharp drop in US equity markets that are already shaken by the risk of a severe recession and large losses in the financial system.

Fifth, the commercial real estate loan market will soon enter into a meltdown similar to the subprime one....

Sixth, it is possible that some large regional or even national bank that is very exposed to mortgages, residential and commercial, will go bankrupt. Thus some big banks may join the 200 plus subprime lenders that have gone bankrupt. This, like in the case of Northern Rock, will lead to depositors’ panic and concerns about deposit insurance. The Fed will have to reaffirm the implicit doctrine that some banks are too big to be allowed to fail. But these bank bankruptcies will lead to severe fiscal losses of bank bailout and effective nationalization of the affected institutions. Already Countrywide – an institution that was more likely insolvent than illiquid – has been bailed out with public money via a $55 billion loan from the FHLB system, a semi-public system of funding of mortgage lenders. Banks’ bankruptcies will add to an already severe credit crunch.

Seventh, the banks losses on their portfolio of leveraged loans are already large and growing. The ability of financial institutions to syndicate and securitize their leveraged loans – a good chunk of which were issued to finance very risky and reckless LBOs – is now at serious risk. And hundreds of billions of dollars of leveraged loans are now stuck on the balance sheet of financial institutions at values well below par (currently about 90 cents on the dollar but soon much lower)..... And add to this problem the fact that some actual large LBOs will end up into bankruptcy as some of these corporations taken private are effectively bankrupt in a recession and given the repricing of risk; convenant-lite and PIK toggles may only postpone – not avoid – such bankruptcies and make them uglier when they do eventually occur....

Eighth, once a severe recession is underway a massive wave of corporate defaults will take place. In a typical year US corporate default rates are about 3.8% (average for 1971-2007); in 2006 and 2007 this figure was a puny 0.6%. And in a typical US recession such default rates surge above 10%. Also during such distressed periods the RGD – or recovery given default – rates are much lower, thus adding to the total losses from a default. Default rates were very low in the last two years because of a slosh of liquidity, easy credit conditions and very low spreads (with junk bond yields being only 260bps above Treasuries until mid June 2007). But now the repricing of risk has been massive: junk bond spreads close to 700bps, iTraxx and CDX indices pricing massive corporate default rates and the junk bond yield issuance market is now semi-frozen. While on average the US and European corporations are in better shape – in terms of profitability and debt burden – than in 2001 there is a large fat tail of corporations with very low profitability and that have piled up a mass of junk bond debt that will soon come to refinancing at much higher spreads. Corporate default rates will surge during the 2008 recession and peak well above 10% based on recent studies. And once defaults are higher and credit spreads higher massive losses will occur among the credit default swaps (CDS) that provided protection against corporate defaults. Estimates of the losses on a notional value of $50 trillion CDS against a bond base of $5 trillion are varied (from $20 billion to $250 billion with a number closer to the latter figure more likely). Losses on CDS do not represent only a transfer of wealth from those who sold protection to those who bought it. If losses are large some of the counterparties who sold protection – possibly large institutions such as monolines, some hedge funds or a large broker dealer – may go bankrupt leading to even greater systemic risk as those who bought protection may face counterparties who cannot pay.

Ninth, the “shadow banking system” (as defined by the PIMCO folks) or more precisely the “shadow financial system” (as it is composed by non-bank financial institutions) will soon get into serious trouble. This shadow financial system is composed of financial institutions that – like banks – borrow short and in liquid forms and lend or invest long in more illiquid assets. This system includes: SIVs, conduits, money market funds, monolines, investment banks, hedge funds and other non-bank financial institutions. All these institutions are subject to market risk, credit risk (given their risky investments) and especially liquidity/rollover risk as their short term liquid liabilities can be rolled off easily while their assets are more long term and illiquid. Unlike banks these non-bank financial institutions don’t have direct or indirect access to the central bank’s lender of last resort support as they are not depository institutions. Thus, in the case of financial distress and/or illiquidity they may go bankrupt because of both insolvency and/or lack of liquidity and inability to roll over or refinance their short term liabilities. Deepening problems in the economy and in the financial markets and poor risk managements will lead some of these institutions to go belly up: a few large hedge funds, a few money market funds, the entire SIV system and, possibly, one or two large and systemically important broker dealers. Dealing with the distress of this shadow financial system will be very problematic as this system – stressed by credit and liquidity problems - cannot be directly rescued by the central banks in the way that banks can.

Tenth, stock markets in the US and abroad will start pricing a severe US recession – rather than a mild recession – and a sharp global economic slowdown. The fall in stock markets – after the late January 2008 rally fizzles out – will resume as investors will soon realize that the economic downturn is more severe, that the monolines will not be rescued, that financial losses will mount, and that earnings will sharply drop in a recession not just among financial firms but also non financial ones. A few long equity hedge funds will go belly up in 2008 after the massive losses of many hedge funds in August, November and, again, January 2008. Large margin calls will be triggered for long equity investors and another round of massive equity shorting will take place. Long covering and margin calls will lead to a cascading fall in equity markets in the US and a transmission to global equity markets. US and global equity markets will enter into a persistent bear market as in a typical US recession the S&P500 falls by about 28%.

Eleventh, the worsening credit crunch that is affecting most credit markets and credit derivative markets will lead to a dry-up of liquidity in a variety of financial markets, including otherwise very liquid derivatives markets. Another round of credit crunch in interbank markets will ensue triggered by counterparty risk, lack of trust, liquidity premia and credit risk. A variety of interbank rates – TED spreads, BOR-OIS spreads, BOT – Tbill spreads, interbank-policy rate spreads, swap spreads, VIX and other gauges of investors’ risk aversion – will massively widen again. Even the easing of the liquidity crunch after massive central banks’ actions in December and January will reverse as credit concerns keep interbank spread wide in spite of further injections of liquidity by central banks.

Twelfth, a vicious circle of losses, capital reduction, credit contraction, forced liquidation and fire sales of assets at below fundamental prices will ensue leading to a cascading and mounting cycle of losses and further credit contraction. In illiquid market actual market prices are now even lower than the lower fundamental value that they now have given the credit problems in the economy. Market prices include a large illiquidity discount on top of the discount due to the credit and fundamental problems of the underlying assets that are backing the distressed financial assets. Capital losses will lead to margin calls and further reduction of risk taking by a variety of financial institutions that are now forced to mark to market their positions. Such a forced fire sale of assets in illiquid markets will lead to further losses that will further contract credit and trigger further margin calls and disintermediation of credit. The triggering event for the next round of this cascade is the downgrade of the monolines and the ensuing sharp drop in equity markets; both will trigger margin calls and further credit disintermediation.

Based on estimates by Goldman Sachs $200 billion of losses in the financial system lead to a contraction of credit of $2 trillion given that institutions hold about $10 of assets per dollar of capital. The recapitalization of banks sovereign wealth funds – about $80 billion so far – will be unable to stop this credit disintermediation – (the move from off balance sheet to on balance sheet and moves of assets and liabilities from the shadow banking system to the formal banking system) and the ensuing contraction in credit as the mounting losses will dominate by a large margin any bank recapitalization from SWFs. A contagious and cascading spiral of credit disintermediation, credit contraction, sharp fall in asset prices and sharp widening in credit spreads will then be transmitted to most parts of the financial system. This massive credit crunch will make the economic contraction more severe and lead to further financial losses. Total losses in the financial system will add up to more than $1 trillion and the economic recession will become deeper, more protracted and severe.

A near global economic recession will ensue as the financial and credit losses and the credit crunch spread around the world. Panic, fire sales, cascading fall in asset prices will exacerbate the financial and real economic distress as a number of large and systemically important financial institutions go bankrupt. A 1987 style stock market crash could occur leading to further panic and severe financial and economic distress. Monetary and fiscal easing will not be able to prevent a systemic financial meltdown as credit and insolvency problems trump illiquidity problems. The lack of trust in counterparties – driven by the opacity and lack of transparency in financial markets, and uncertainty about the size of the losses and who is holding the toxic waste securities – will add to the impotence of monetary policy and lead to massive hoarding of liquidity that will exacerbates the liquidity and credit crunch.

In this meltdown scenario US and global financial markets will experience their most severe crisis in the last quarter of a century.

Can the Fed and other financial officials avoid this nightmare scenario that keeps them awake at night? The answer to this question – to be detailed in a follow-up article – is twofold: first, it is not easy to manage and control such a contagious financial crisis that is more severe and dangerous than any faced by the US in a quarter of a century; second, the extent and severity of this financial crisis will depend on whether the policy response – monetary, fiscal, regulatory, financial and otherwise – is coherent, timely and credible. I will argue – in my next article - that one should be pessimistic about the ability of policy and financial authorities to manage and contain a crisis of this magnitude; thus, one should be prepared for the worst, i.e. a systemic financial crisis.

Another Scary Chart from Krugman (ISM Non-manufacturing/Employment Edition)

Stocks were down today, largely in reaction to the release of the so-called ISM non-manufacturing report, which monitors activity in the service sector (primarily assesses banks, retailers and construction companies). The results showed the sharpest contraction since 2001.

Paul Krugman, who is not the bearish type, said the report indicates a recession is underway:

The ISM non-manufacturing report came in today.... the fact that it has fallen off a cliff should worry us.

But how bad is it? The latest report has an employment diffusion index of 43.9 (50 means no change, anything less than 50 means job contraction). Here’s the historical relationship between the index (horizontal axis) and the actual monthly change in employment, in thousands (vertical axis), data since July 1997. If this report is at all right, we’re in serious recession territory.


Add: As explained above, the horizontal axis is the ISM employment index, the vertical axis is the change in nonfarm employment over the following month. Fwiw, the best-fit relationship says that this month’s report portends a loss of 137,000 jobs next month. You don’t want to take that too seriously, but it’s appropriate to cry “eek”.

Monoline Updates: S&P Says Downgrade Will Hurt Banks; Fitch Downgrade of MBIA More Likely; XL Capital Takes Hit

Standard & Poor's issued a research report today that stresses that bond insurer downgrades would hurt banks and in some cases could lead to reductions of their debt ratings. This report is in contrast to the comparatively cheery view of Morgan Stanley yesterday, that bond guarantor downgrades (presumably to AA; note further downgrades are possible) would lead to bank writedowns of $5 to $7 billion, hardly worth lot of fuss in an industry that has written off over $130 billion so far.

The report points to an issue apparently not considered in earlier analyses: hedges to CDO exposures provided by the bond insurers. S&P estimates that these hedges total $125 billion and while it isn't clear who bought the protection, the rating agency says some it likely to be on the books on investment banks. And what they don't say is the second most likely candidate is hedge funds. If hedges on CDOs turned out to be less valuable that previously assumed, investment banks may be holding insufficient collateral on margin loans to hedge funds. That too could lead to writedowns.

Interestingly, this S&P report follows an earlier slap at MBIA over its CEO Dunton's claim that the insurer had enough capital. The rating agency shot back the next day to disabuse Danton of that notion. While today's report does not appear to be in response to the Morgan Stanley conference call, its relatively short length (1477 words) doesn't eliminate that a a possibility. More likely is that the release was triggered by news stories that some participants in the industry rescue talks lead by New York state insurance superintendent Eric Dinallo.

Regardless, S&P is making it abundantly clear that both the threat of downgrades and the implications are serious.

From Research Recap:

Downgrades of monoline bond insurers could lead to downgrades in the credit ratings of banks, Standard & Poor’s says in a new report, Downgrades Of Bond Insurers Can Add To Subprime Woes For Banks.

Downgrades of bond insurers (Financial Guaranty Insurance Co. was downgraded to ‘AA’; ACA Financial Guaranty Corp. to ‘CCC’; and ‘AAA’ rated MBIA Inc., Ambac Assurance Corp., and Security Capital Assurance Ltd. are on CreditWatch Negative) prompt questions about the effect on both commercial and investment banks, S&P says. “Of course, successful capital-raising efforts would eliminate the need to focus on the potential effect of downgrades on financial institutions. In the absence of additional capital, however, it is useful to think about the possible ramifications of downgrades, which could affect the $2.5 trillion of obligations guaranteed by the bond insurers.”

Bond insurers are suffering as a result of their roles as guarantors of mortgage-related securities, and downgrading them could affect all markets in which they are active, including the municipal bond, commercial mortgage-backed securities (CMBS), and other structured finance areas. In turn, dislocation in those markets could affect banks, S & P says.

Standard & Poor’s Ratings Services believes that the specific, identifiable effect on banks may be significant and, in a few cases, could lead to downgrades.

The area that represents the potential for the highest losses is the hedges that the bond insurers provide for the so-called “super-senior” CDO tranches. To date, losses that banks have reported on their CDO exposures have predominantly been on unhedged exposures. However, $125 billion of subprime-related CDOs hedged by bond insurers remains concentrated in the hands of a relatively small number of banks. Few banks have disclosed how much that exposure is.

Citigroup Inc. reported that it had bought protection on $10 billion of super-senior tranches of high-grade CDOs (not necessarily all from bond insurers), Merrill Lynch & Co. Inc. reported $19.9 billion of hedges with bond insurers, and Canadian Imperial Bank of Commerce (CIBC) $9.9 billion. The value of those hedges has increased as the values of the underlying CDOs have fallen and now can be presumed to be 40%-60% of the notional amounts. In some cases, banks have taken reserves against the increased counterparty risk represented by their own assessment of the credit deterioration in bond insurers. Citigroup added $900 million to reserves, Merrill Lynch added $3.1 billion, and CIBC announced $2 billion, with the majority of that related to ACA’s severe downgrade to ‘CCC’ from ‘A’.

More reserving may be necessary to reflect the increase in counterparty risk, if the ratings on guarantors are lowered.

Separately, Bloomberg reports that Fitch has put MBIA on review for a downgrade as a result of updating its assumptions on subprime losses. The rating agency rather bluntly said that current capital levels may be insufficient to warrant an AAA rating:

MBIA Inc.'s AAA bond insurance ranking was placed back under review for a downgrade by Fitch Ratings less than a month after being affirmed with a stable outlook.

Fitch, which also put CIFG Financial Guaranty back under review, is updating its assumptions for higher losses on U.S. subprime-mortgage securities, the New York-based ratings company said today in a statement. If loss projections rise materially, the AAA ratings on bond insurers may no longer be appropriate regardless of how much capital they hold, the company said.

Fitch will likely raise the amount of capital it requires, a move that would put ``further downward pressure on the ratings'' of Ambac Assurance Corp., CIFG, Financial Guaranty Insurance Co., MBIA and Security Capital Assurance Ltd., according to the statement. Ratings on $2.4 trillion of debt the industry guarantees would be thrown into doubt if the downgrades expand.

``Right now the AAA ratings for MBIA, Ambac and FGIC simply aren't justified,'' said Janet Tavakoli, president of Chicago- based Tavakoli Structured Finance, said in an interview with Bloomberg Television. ``They simply don't have the capital.''

Fitch has already cut the AAA insurer ratings of New York- based Ambac Financial Group Inc., FGIC Corp., and Security Capital, and they remain under review for further downgrades.

``A sharp increase in expected losses would be especially problematic for the ratings of financial guarantors -- even more problematic than the previously discussed increases in AAA capital guidelines, which has been the primary focus of recent analysis of the industry,'' Fitch said.

Bloomberg also tells us that Bermuda-based insurer XL Capital took a $1.1 billion loss due to its writedown on its 46% stake in bond insurer Security Capital, which lost its AAA rating from Fitch:

XL Capital Ltd., the Bermuda-based business insurer, said it lost $1.06 billion in the fourth quarter as it wrote down the value of investments including a stake in bond insurer Security Capital Assurance Ltd.

XL lost $6.01 a share, compared with net profit of $481.1 million, or $2.62 a year earlier, the company said today in a statement. Excluding investment losses, XL earned 66 cents a share, lagging the $1.45 average estimate of 14 analysts surveyed by Bloomberg. The results wiped out the two prior quarters of earnings and exceeded the $1.04 billion loss XL posted in the third quarter of 2005, after Hurricane Katrina.

Chairman Michael Esposito resigned from XL's board in December to focus on his duties as chairman of Security Capital, which is 46 percent owned by XL. Security Capital declined more than 80 percent in the past year and lost its AAA bond insurer grade at Fitch Ratings after saying Jan. 23 it wouldn't raise new capital because of market conditions. The same day XL said it could lose as much as $1.2 billion in the fourth quarter.

CDO Trading in Deep Freeze

Bloomberg reports that CDO trading has ground to a virtual halt, which isn't surprising given the number of pending downgrades and the propensity for CDOs to be downgraded by multiple notchhes.

From Bloomberg:

Buying and selling of collateralized debt obligations based on mortgage bonds, high-yield loans or preferred shares has ground to a near-halt, traders said at the securitization industry's largest conference.

``We're definitely in a period of very low liquidity at the moment, which has actually been dropping precipitously in the last few weeks,'' Ross Heller, an executive director at JPMorgan Securities Inc., said yesterday during a panel discussion at the American Securitization Forum's annual conference in Las Vegas. ``It's a challenging time.''

The slowdown of the more than $2 trillion CDO market follows record downgrades in mortgage-linked securities last year. Some AAA rated debt lost all its value. CDOs, which have fueled unprecedented bank writedowns since mid-2007, repackage assets into new securities with varying risks.

Lighter trading volumes for asset-backed bonds and larger- than-typical differences between the prices at which they can be bought and sold have made valuing holdings difficult and dissuaded investors from purchasing the debt, said Sanjeev Handa, head of global public markets at TIAA-CREF....

Investors with experience with residential-mortgage assets have been buyers, paying in the ``mid-teens to low 30'' cents on the dollar for the senior-most, or super-senior, classes of CDOs comprised of low-rated asset-backed bonds, he [Brian Carosielli, Merrill managing director] said...

``I've traded one bond that's worthless eight times this year,'' [Richard] Rizzo [a director at Deutshce Bank] said. ``So it's like, `How many times can I trade the same bond that's worthless for five cents?' It is kind of funny.''

Fitch Plans to Downgrade up to $220 Billion of CDOs

Th announcement by Fitch of tis intent to downgrade as much as $220 billion of CDOs is in keeping with an announcement by Standard & Poor's of its plans to downgrade or put on review up to $534 billion of CDOs. Both are the result of new, more negative default assumptions in the underlying assets.

From Bloomberg:

Fitch Ratings may downgrade $220 billion of collateralized debt obligations as mortgage-related losses increase.

The New York-based company may lower the securities by as much as five levels after failing to accurately assess the risk of debt that packages other assets. CDOs with AAA grades that are based on credit-default swaps and aren't actively managed may face the steepest reductions, according to guidelines proposed by Fitch today.

Ratings firms are responding to criticism that they failed to react quickly enough as rising defaults on subprime mortgages in the U.S. caused a plunge in the value of CDOs. Fitch, a unit of Fimalac SA in Paris, lowered $67 billion of mortgage-linked CDOs in November, slashing some AAA debt to speculative grade, or junk.

``Fitch is acknowledging that it was overly optimistic in its default rate and other assumptions in its original CDO methodology,'' said Christian Stracke, an analyst at bond research firm CreditSights Inc. in London.

Moody's Investors Service last year downgraded $76 billion of CDOs and began this year with $185 billion of deals under review. The New York-based company said yesterday that it may overhaul its system for evaluating structured-finance securities, proposing options including a numerical scale and a designation of ``.sf'' to differentiate a structured-finance ranking from a corporate credit grade.

Reuters gives some additional detail:

Fitch said the change in methodology would probably hit synthetic CDOs the hardest, leading to an average downgrade of five notches for the $75 billion worth it rates. Synthetic CDOs are created from portfolios of credit derivatives, typically on investment-grade corporate borrowers....Synthetic CDOs are based on portfolios of credit default swaps, which are bets on whether a company will default.

And we have a new feedback loop:

Many investment-grade CDOs have large concentrations, 25 to 30 percent, of credits in the banking and finance industry, which included some of the most liquid names in the derivatives market, he said.

"We are taking a harsher view of that industry concentration in our new approach," he [Ken Gill, managing director for structured credit] said.

New Bond Insurer Storyline: Downgrade Likely, But Not So Terrible

The bond insurer front was quiet, with the only major news item the release of a report by Morgan Stanley's credit analyst that argues that bank losses from a bond insurer downgrade would be only $5 to $7 billion, and it therefore isn't worth their while to stump up for a rescue.

At this point, the estimates for losses, both for the bond insurer and financial institutions, are disparate, and despite the problem coming into greater focus, the figures from different sources do not yet show any sign of converging. That alone is troubling and says a great deal about the opacity and general uselessness of insurance industry accounting.

Note that this contradicts a rumor I heard yesterday, that European banks (note that the banks in the rescue discussions are primarily foreign) believe they are very exposed in the event of a downgrade, to the point where there have been concerned calls from the ECB to try to get the Treasury Department involved in a bailout. That is certain to be a non-starter.

One reason that a rescue may not make sense to US banks is the ones with the biggest CDO exposures may have taken writedowns that are sufficiently large that they believe the hit they would suffer from a bond insurer downgrade is limited.

Note that the Reuters story on the Morgan Stanley conference call was not explicit, but it presumably contemplated a downgrade only to AA, not a deeper cut that some believe is more appropriate. The story also refers briefly to a Citigroup research note that also views a bailout is unlikely.

From Reuters:

Financial institutions are likely to take only around $5 billion to $7 billion in losses from their exposure to bond insurers, far below recent estimates of as much as $70 billion, Morgan Stanley said on Monday.

Morgan Stanley also said a bailout of the bond insurance industry is not in the economic interest of banks, though analysts at CreditSights said late on Sunday they now view a bailout as more likely.

Monoline bond insurers are under review by credit ratings agencies and may lose the "AAA" ratings vital to their business.

Rating agencies do not view the bond insurers' capital as adequate due to expected losses from insuring securities linked to the subprime mortgage market where defaults have risen.

Some analysts have said they believe U.S. financial institutions exposed to the bond insurers are facing as much as $50 billion to $70 billion in losses, but Greg Peters, Morgan Stanley's lead credit analyst, said he views exposures as significantly lower.

"That (number) seems too high to us to begin with, and that is a gross number," he said on Monday on a conference call.

Morgan Stanley evaluated mortgage exposure in collateralized debt obligations (CDOs) insured by the bond insurance arms of Ambac Financial Group Inc (ABK.N: Quote, Profile, Research), FGIC, Security Capital Assurance (SCA.N: Quote, Profile, Research), and MBIA Inc (MBI.N: Quote, Profile, Research), and determined that exposures by U.S. banks is likely in the $20 billion to $25 billion range.

Once the capacity of the bond insurers to pay out claims is taken into account, and assuming that a bankruptcy does not force the insurance arms of the companies out of business, likely losses by banks are in the $5 billion to $7 billion range, Peters said....

In this scenario, the counterparty exposure of banks to the insurers is negligible, he added.

Peters views a rating downgrade of MBIA or Ambac as likely and argues that supporting ailing insurers is not in the economic interests of banks.

"We just don't think the incentives exist, banks are clearly capital constrained, the exposure to the monolines is far from uniform, so one dealer might not want to help out their competitor when they have a very limited exposure," Peters said...

"A LTCM-style kind of bailout is pretty remote," Peters said on the call.

Unlike LTCM, which was hurt by a temporary liquidity phenomenon, "you're actually asking banks and dealers to pony up cash to help plug a loss that's far from temporary."

Citigroup analysts agreed a bailout is unlikely. "The scale of their losses on CDOs of ABS both explains why a bailout has been so slow in coming, and makes one unlikely in future," Citi analysts said in a note sent on Monday.

"While political intervention is always hard to judge, we therefore think downgrades probably will take place, albeit of uncertain magnitude," they added.

CreditSights analyst Rob Haines, however, argued that comments made by U.S. regulators, including Treasury Secretary Henry Paulson, who said last week he was monitoring the situation, make a bailout increasingly likely.

"Based on numerous comments from various regulators, we believe that the economic argument for a bailout is likely to build momentum," Haines said in a report published late on Sunday.

As new entrants enter the bond insurance business and some existing insurers hold onto their top ratings, the markets may not need insurers such as Ambac, Morgan Stanley's Peters said.

Financial Security Assurance (FSA), Assured Guaranty Corp (AGO), whose "AAA" ratings are not under review, and the new market entrant created by Warren Buffett's Berkshire Hathaway Inc (BRKa.N: Quote, Profile, Research) (BRKb.N: Quote, Profile, Research) will likely be sufficient to satisfy market needs for bond insurance, Peters added.

"We're not convinced that you need to have existing monolines still up and running as you have other ways that you could actually wrap that risk."

Should We Be Worried About China's Growth?

A comment by Kenneth Rogoff in the Financial Times argues that rapidly growing emerging markets exhibit periods of crisis, and China has a long list of possible causes. Yet policymakers, focused on slowing US growth and financial institution stress in the US and Europe, have overlooked the problem that a sudden slowdown in China could pose.

From the Financial Times:

Given the highly vulnerable state of the US and European economies, what would happen to global growth if the Chinese juggernaut also started sputtering? Few investors or policymakers seem to be seriously contemplating this scenario.

China’s remarkable resilience to both the 2001 global recession and the 1997-98 Asian financial crisis has convinced almost everyone that another year of double-digit growth is all but inevitable. In fact, the odds of a significant growth recession in China – at least one year of sub-6 per cent growth – during the next couple of years are 50:50. With Chinese inflation spiking, notable backpedalling on market reforms and falling export demand, 2008 could be particularly challenging.

True, reality has consistently flattened China forecasters who are anything less than ebullient. With 11.4 per cent growth in 2007 and the Olympics coming up this summer, why should 2008 be different? With all due respect to the extraordinary recent performance of China’s managers, the country faces economic, financial, social and political landmines just like any other emerging market, with epic environmental problems to boot. And, throughout history, no emerging market has escaped bouts of crisis indefinitely.

Inflation of more than 6 per cent is the immediate problem. Those who think inflation is caused by too little pork rather than too much money are wrong. China’s relatively pegged exchange rate system has led the authorities to flood the economy with renminbi. Rampant money supply growth is the flipside of the country’s $1,400bn accumulation of foreign currency reserves. The real surprise is that inflation did not sprout earlier.

The authorities must stuff the inflation genie back in the bottle. It is not going to be easy in an economy where highly controlled financial markets render normal instruments of monetary control relatively ineffective.

Until now, China has avoided this problem, as millions of idle farm workers moved to the cities, keeping wages in check. But as many of the most able workers have already migrated, the challenge of filling China’s burgeoning factories is intensifying.

Protectionism is another growing risk. With income and wealth inequality rising throughout the developed world, politicians may start lashing out at China with trade sanctions on automobile parts, steel, paper products and, of course, textiles. China’s explosive export growth has made it far more vulnerable to a fall in exports than it was during the 2001 global recession.

Perhaps the greatest threat to China’s expansion, however, comes from pressures created by its own exploding inequality levels. According to World Bank statistics, income inequality in China has leapfrogged that of the US and Russia, which is no small feat. Rising inequality is placing enormous strains on the political system, as is evident from a recent sequence of ill-considered policies that have been aimed at mitigating the problem. The government’s recent attempt to fight food inflation by using price controls is a highly conspicuous example.

But so, too, is the dubious new labour law which, at least on paper, prevents companies from firing workers with 10 years or more experience. It is as if China hopes to transform itself into France. Indeed, the greatest danger to China’s economy is that, after years of market-oriented reform, the country’s leadership seems to be losing faith in markets and adopting policies such as rationing that turn back the clock to old-style communist days. With rising inflation, bloated investment and a soft global economy, now is hardly the time for China to make its system more inflexible. Historically, emerging markets get into trouble when policy reform is moving backwards at the same time as an economic or financial crisis is starting to unfold. Rather than try to deal with inequality by labour market fiat, the government would do better to improve the social safety net through provision of more and better healthcare and pensions.

Rather than deal with inflation through price caps, China should accelerate exchange-rate appreciation, thereby reining in money growth. If China were to slow dramatically, while growth in Europe and the US was still weak, recent low global interest rates, high commodity prices and strong global growth would be history. Global policymakers and investors who are losing sleep over US growth ought to pay more attention to rising risks coming from the other side of the globe.

New York Times Calls a Sea Change in Consumer Attitudes Towards Debt

While the New York Times gives plenty of caveats, its story,"Economy Fitful, Americans Start to Pay as They Go," says the American love affair with debt has gone sour:

But now the freewheeling days of credit and risk may have run their course — at least for a while and perhaps much longer — as a period of involuntary thrift unfolds in many households. With the number of jobs shrinking, housing prices falling and debt levels swelling, the same nation that pioneered the no-money-down mortgage suddenly confronts an unfamiliar imperative: more Americans must live within their means....

The shift under way feels to some analysts like a cultural inflection point, one with huge implications for an economy driven overwhelmingly by consumer spending.

While some experts question whether most Americans, particularly baby boomers, will ever give up their buy-now/pay-later way of life, the unraveling of the real estate market appears to have left millions of families with little choice, yanking fresh credit from their grasp.

“The long collapse in the United States savings rate is over,” said Ethan S. Harris, chief United States economist for Lehman Brothers. “People are going to start saving the old-fashioned way, rather than letting the stock market and rising home values do it for them.”

In 1984, Americans were still saving more than one-tenth of their income, according to the government. A decade later, the rate was down by half. Now, the savings rate is slightly negative, suggesting that on average Americans spend more than their disposable income.

A telling anecdote: a couple that earns $55,000 a year got into debt keeping up appearances and has had to cut back considerably. They now looks at a Cadillac-owning (likely leasing) neighbor with pity rather than envy, imagining that he too is over his head.

If conspicuous consumption (at least in the middle classes) is no longer a barometer of success, that will create fundamental challenges not just for marketers but also for manufacturers. One implication: consumers will be less willing to trade up to new products, and will expect new purchases to last longer. That may lead to a willingness to pay somewhat more for something with the notion that it is an investment rather than something they will keep for a year or two. Put more simply, buyers will increasingly think of goods as durables rather than disposables.

Links 2/5/08

Constitutional law and Padilla rdan, Angry Bear

Wal-Mart Ignores Widow's Letter Asking Why It Took Employees 9 Hours To Find Her Husband's Body In A Bathroom Stall Huffington Post

Great firewall of China faces online rebels International Herald Tribune

How risky are uninsured bank deposits? MarketWatch. A sign of the times.

Bubble Economy Endgame Mish's Global Economic Trend Analysis

Mein Feuhrer! I can walk! Cassandra Does Tokyo

Does happiness last? VoxEU

Scary Credit Tightening Chart

Fitch was warning of lax lending practices in commercial real estate in the US starting in April of last year. The typical pattern, of going from unduly generous terms to stringent ones, with nary a stop in between, is occurring now, and with a vengeance.

By happenstance, I had dinner with a colleague whose family manages a large number of commercial buildings in one of the biggest US cities. He says the number of defaults in rentals that they are seeing, including tenants disappearing in the night, is markedly worse than during the real estate downturn of the early 1990s. And we aren't even in a full blown economic downturn yet. This deterioration in cash flow will make banks even more leery of lending.

From Paul Krugman:

Meanwhile, out in the nonpolitical world (although everything is political these days), the new Federal Reserve senior loan officer survey shows an incredible credit crunch in progress — worse than the crunches following the S&L crisis, worse than the brief crunch when LTCM blew up, worse than the dotcom bust. This is pretty grim.

The Wall Street Journal discusses the loan officer survey, which covery more loan types than commercial real estate:

The January survey offers the hardest evidence yet that the credit crunch is spreading. Although banks also reported some tightening of lending requirements on credit cards and other consumer loans, commercial and industrial loans have been the most severely affected.

One-third of the U.S. banks and about two-thirds of the foreign banks responding told the Fed they had tightened lending standards on commercial and industrial loans during the three months ended Jan. 31. About half the banks said they have widened the spread between their cost of funds and what they are charging borrowers....

About a third of the banks participating in the survey reported weaker demand for commercial and industrial loans, while about one in 10 reported strong demand. Among those that saw a reduced appetite for loans, "a decrease in customers' needs to finance inventories and investment in plant and equipment" was cited frequently. Additionally, 70% of the respondents cited a drop in businesses' needs for merger-and-acquisition financing as a reason for lower demand....

"The easy credit has gone away," Mr. Knowles said. "Everything is scrutinized to a higher degree now."

The survey also found that 80% of U.S. banks tightened terms on commercial real-estate loans during the period, the highest percentage since the survey question was introduced in 1990; almost half of banks also reported weaker demand for those loans.

Sudden Shifts in Climate Likely

This story, reporting on work by an international group published in the Proceedings of the National Academy of Sciences, warned that human induced change could push the climate to certain tipping point as early as the current century.

This research is getting little coverage in the US. According to a search in Google News, it has appeared so far only on Fox News.

From BBC:

Many of Earth's climate systems will undergo a series of sudden shifts this century as a result of human-induced climate change, a study suggests.

A number of these shifts could occur this century, say the report's authors.

They argue that society should not be lulled into a false sense of security by the idea that climate change will be a gradual process.

The work by an international team appears in the Proceedings of the National Academy of Sciences journal.

"Our findings suggest that a variety of tipping elements could reach their critical point within this century under human-induced climate change," he said.

"The greatest threats are tipping of the Arctic sea-ice and the Greenland ice sheet, and at least five other elements could surprise us by exhibiting a nearby tipping point."

The bulk of climate scientists now believe that human induced global warming has begun to affect some aspects of our climate.

But that change is the start of a series of more dramatic changes if global warming continues, according to a group of more than 50 scientists.

In a formal survey the researchers said that a number of systems that influence the Earth's weather patterns could begin to collapse suddenly if there's even a slight increase in global temperatures.

At greatest risk is arctic sea ice, the Greenland ice sheet and the west Antarctic ice sheet.

The researchers have listed and ranked nine ecological systems that they say could be lost this century as a result of global warming. The nine tipping elements and the time it will take them to undergo a major transition are:

* Melting of Arctic sea-ice (about 10 years)
* Decay of the Greenland ice sheet (about 300 years)
* Collapse of the West Antarctic ice sheet (about 300 years)
* Collapse of the Atlantic thermohaline circulation (about 100 years)
* Increase in the El Nino Southern Oscillation (about 100 years)
* Collapse of the Indian summer monsoon (about 1 year)
* Greening of the Sahara/Sahel and disruption of the West African monsoon (about 10 years)
* Dieback of the Amazon rainforest (about 50 years)
* Dieback of the Boreal Forest (about 50 years)

The paper also demonstrates how, in principle, early warning systems could be established using real-time monitoring and modelling to detect the proximity of certain tipping points.

Private Equity Firms Snub Monoline Rescue

The refusal of private equity firms to join in the salvage of bond insurers being orchestrated by New York state insurance superintendent Eric Dinallo comes as no surprise. In fact, it is shocking that this idea was ever regarded as a serious possibility. Nevertheless, the headline in the Financial Times reads, "Setback for monoline rescue." I suppose that makes for better copy than, "Highly unlikely avenue for monoline rescue funding predictably fails to pan out."

From the Financial Times:

Leading private equity firms are unlikely to participate in any recapitalisation of Ambac and MBIA, increasing the pressure on banks to come up with a rescue package for the bond insurers.

A number of firms, including Bain Capital, Carlyle Group, Kohlberg Kravis Roberts and TPG, have looked at investing in the cash-strapped groups, which guarantee the value of everything from municipal bonds to the most complicated mortgage securities.

These investors have all concluded that the risks are far too great, according to people familiar with their thinking.

The decision puts more pressure on the banks to provide rescue financing for Ambac and MBIA. Some large banks and securities firms could face large writedowns on mortgage securities as well as derivatives if the US bond insurers lose their Triple-A credit ratings.

A group of eight banks is already considering a plan to inject capital into Ambac, which needs at least $1bn. Several banks are also believed to be talking to MBIA, which needs at least $500m. It is likely that any solutions, which are also a top priority for regulators, will be crafted for each bond insurer rather than as a general bail-out.

“People who have a logical interest – a logical commercial relationship – are engaged, and that’s a good sign,” a US Treasury official said.

The reluctance of big private equity firms to become involved comes after all have looked closely at the two big monolines. They have also studied the experience of Warburg Pincus, which committed $1bn to MBIA in early December at what seemed an attractive price only to see MBIA’s share go into freefall.

Additionally, they have noted that Blackstone, which has a minority stake in FGIC, has so far declined to put more money into that troubled bond insurer.

“If we worry that we can get shot from the shadows by something we can’t see coming, it is not for us,” says the managing director in charge of financial service investments for one of the leading private equity funds. “The financial guarantors pass neither the shadow test nor the ability to understand test.”

The next two to four weeks will be vital for the bond insurers because the biggest ratings agencies have made it clear they are very close to cutting their ratings. Fitch, a smaller ratings agency, has already cut the Triple-A ratings of Ambac and FGIC.

Have Ethics Come to Wall Street? Firms Impose Standards on Coal Projects

Perhaps my memory is failing me, but the insistence by three major Wall Street firms, that utilities prove that their new coal-fired plants are economically viable, is at a minimum highly unusual (I'd say unprecedented).

Normal Wall Street practice is simply "disclose and sell." Under securities laws, if the issuer presents its financial situation and risks accurately, he ought to be free and clear, even if the deal goes sour. And the lead manager and underwriters (that is, the investment banks selling the paper) have extremely limited liability. The prospectus is written by the issuer (in this case, the utilities), the only language that the managers provide is related to pricing and the mechanics of the underwriting (CDOs and other structured finance products are a completely different kettle of fish, since the Wall Street firms in many cases created the legal entities that sold the paper).

So it is very out of character for investment banks to place conditions on issuers. That's usually left to the market. One might surmise that the three firms, Citigroup, JP Morgan, and Morgan Stanley, anticipate that investors will come to recognize these risks and they are trying to do the industry a favor by being pro-active.

But a Wall Street Journal article points to surprising motive. The firms claim they don't want to be associated with debt that comes a cropper. Is this a rare sighting of risk aversion, um, ethics? Even more surprising, these standards come out of protracted negotiations with the industry and environmental groups.

Given the limited financial liability under securities laws, this stance is inexplicable. Perhaps the firms are worried about reputational risk (better late than never) or regulatory backlash of some sort.

But why does the cynic in me think these strictures might have something to do with these firms' ambitions in the carbon trading business or in funding alternative energy?

Even if the motives are not be what they appear to be, this is still a welcome development.

From the Wall Street Journal:

Three of Wall Street's biggest investment banks are set to announce today that they are imposing new environmental standards that will make it harder for companies to get financing to build coal-fired power plants in the U.S.

Citigroup Inc., J.P. Morgan Chase & Co. and Morgan Stanley say they have concluded that the U.S. government will cap greenhouse-gas emissions from power plants sometime in the next few years. The banks will require utilities seeking financing for plants before then to prove the plants will be economically viable even under potentially stringent federal caps on carbon dioxide, the main man-made greenhouse gas.

The move shows Wall Street is the latest U.S. business sector that sees some kind of government emissions-capping as inevitable. But it shows disagreement about what to do.

It also marks the latest obstacle to coal, which provides about half of U.S. electricity but emits large amounts of CO2. Citing costs, the U.S. government last week pulled support for a project called FutureGen that many utilities saw as a step toward burning coal cleanly.

The standards, which would apply to all but the smallest plants, result from nine months of negotiations among the three banks and some of the biggest U.S. utilities and environmental groups. The standards could hurt coal-dependent utilities that haven't begun factoring a future price of CO2 emissions into their planning. But they could help utilities that have.

The banks say they don't want to be involved with debt that goes bad as a result of government emissions caps that require the power plants they finance to buy large numbers of extra pollution allowances. Under a cap-and-trade system to limit greenhouse-gas emissions, the government would distribute a certain number of emission allowances each year. Companies whose emissions exceeded their allowances would have to buy more from companies that had more than needed. Congress is considering several cap-and-trade proposals.

"We have to wake up some people who are asleep," says Jeffrey Holzschuh, vice chairman of institutional securities at Morgan Stanley.

The banks are likely to continue to finance certain coal-fired power plants: those designed to capture greenhouse-gas emissions and shoot them underground if that technology became practical. But they make it less likely the banks will finance other coal-fired plants. Several dozen are on the drawing board in the U.S., many not yet financed...

The banks are under pressure from environmental groups but say their bigger motive is financial. Most major presidential candidates favor legislation to limit emissions. "What is earth-shakingly different between now and two years ago is the focus on CO2," says Eric Fornell, vice chairman of J.P. Morgan's natural-resources banking division. Several states have begun requiring utilities to account for the potential cost of emissions in new-plant plans.

The banks say they will encourage energy-efficiency and renewable-energy pushes before backing new coal plants. And they say they will help utilities push for new government policies that make efficiency programs and renewable energy more practical.

When utilities apply for financing for coal-fired plants, the banks will use "somewhat conservative" assumptions about future caps, says Hal Clark, co-chairman of Citi's power-sector investment-banking division. The banks say they will consider the possibility that utilities will have to pay for their allowances -- an idea utilities are fighting.

Two environmental groups -- Environmental Defense and the Natural Resources Defense Council -- worked with the banks to develop the standards. Mark Brownstein, an Environmental Defense official, says if utilities have to pay for emission allowances, "the days of conventional coal really are over."

But several utilities that helped draft the standards say they shouldn't have to pay for most of their allowances. Michael Morris, chief executive of American Electric Power Co., says his company believes it should get 90% to 95% free. Most big coal-fired utilities paying for their allowances would drive up their costs and consumers' electric bills.

Some conventional coal-fired plants could pass muster if the utility showed it could raise its rates to cover the higher cost of polluting. "It's still conceivable that conventional coal plants might make the most sense in a specific location in a specific community," J.P. Morgan's Mr. Fornell says.

AEP's Mr. Morris says the new standards clearly make it "more difficult" to build a conventional coal plant. AEP is designing new plants to capture and store CO2 if that technology becomes viable. The Wall Street seal of approval, he says, might help surmount local opposition. "A regulator may find this another reason to go forward" in approving a new coal-fired plant, Mr. Morris says. A spokesman for Southern Co., another big utility that helped draft the standards, says it believes they will stimulate more discussion.

Leveragd Loan "Disarray" = More Losses for Wall Street

The Financial Times reports that selling group discipline broke down on a $14 billion loan syndication for the acquisition of Harrah's by Apollo Group and Texas Pacific Group. Buyers are unresponsive, a big problem for Wall Street, which is sitting on $150 billion of inventory that is already considerably underwater.

Ironically, the interest rate cut that the market virtually demanded made this particular problem worse, since these deals are floating rate and the new lower levels make them even less appealing.

In the late 1980s, bridge financing, as it was then called, brought investment banks a heap of trouble. But there is no institutional memory. All anyone cares about is the current bonus cycle.

From the Financial Times:

The leveraged loan market begins the week in “disarray” following the collapse of efforts to syndicate $14bn of the debt used to finance the $30bn buy-out of Harrah’s Entertainment, bankers say.

The group of banks backing buyers Apollo Management and Texas Pacific Group are having trouble selling on the leveraged buy-out debt to third parties. With the bulk of the debt remaining on their books, the banks are sitting on a sizeable loss.

The freeze in the debt market means they now face larger potential losses on other big buy-outs, such as BCE and Clear Channel Communications, and will be more desperate to get out of the financing commitments on those deals.

Banks are already saddled with more than $150bn of unsyndicated debt, most of it LBO-related, according to S&P data.

Virtually every loan-backed buy-out deal done in the past few months is trading well below 90 cents on the dollar. With most investors concluding that the bottom is not yet in sight, there is little sense that the current level is a bargain. The prospect of massive losses took its toll on the group of banks arranging the Harrah’s financing.

Credit Suisse, under pressure to get its lending exposures down, sold about $1bn of its share of the debt ahead of the agreed schedule, infuriating the other banks. Credit Suisse informed fellow members of the syndicate of its intention in early January, according to one person familiar with the matter.

“There is no contractual obligation,” this person added. “We cannot concede control over our own capital.”

That may be the pattern in future deals. “The Harrah’s precedent frees other underwriters to deal with situations as they see fit,” noted Standard & Poor’s Weekly Wrap.

“The market is in total disarray,” said the head of debt capital markets at one major Wall Street firm. Another senior banker involved in the deal added: “The last 10 days have been the worst ever. There is a complete buyers’ strike.”

Kingman Penniman, president of KDP Investment Advisors, said: “It’s very hard to see an environment where that overhang of debt is going to be cleared any time soon. But it does look like some of the bigger deals might not get done.”

Ironically, the Federal Reserve’s dramatic 1.25 percentage point cut in interest rates in January contributed to Harrah’s problem, because loans are floating rate and with benchmarks such as Libor dropping, returns to investors fall proportionately.

The Fed rate reduction also meant lower returns on earlier deals to finance the mega buy-outs of the last few months, including the loans on deals such as First Data and Alltel...

The head of debt at one private equity firm said: “Technical factors haven’t been fixed and the bad macro outlook has kicked in.

“Even if you are comfortable with the individual credit, why bid when the market is going lower?”

Links 2/4/08

The Minsky Moment John Cassidy, The New Yorker (hat tip reader Doug)

Did Life Evolve in Ice? Discovery Magazine

The US subprime mortgage crisis: A credit boom gone bad? VoxEU. Three IMF economists have analyzed the data, and our suspicioun are officially borne out.

Huckabee Asks Jesus to Stimulate Economy Andy Borowitz, Huffington Post

Peculiar Washington Post Article on Japan

Sunday's Washington Post has a long article on Japan, "For Japan, a Long, Slow Slide," that is truly odd. Mind you, on the surface, there is nothing wrong with it. It makes the usual observations: Japan's population is aging, productivity is falling, the country is losing its economic standing. It give the impression that Japan is sliding into a genteel, self-imposed poverty due to insularity, lack of drive and innovation, and a resignation to its fallen standing.

What is striking is what the article fails to say. Despite the continuing squeeze on Japanese workers (income fell last year by 1.9% despite positive inflation), Japan is an export powerhouse and has the largest foreign exchange reserves in the world. While all is admittedly not well in Japan, one can make the case that worker incomes have been reduced to preserve national competitiveness. The image that Japan is a basket case is useful, since otherwise, its trading partners would insist on a stronger yen.

And the most notable lapse is the failure to mention the role of the collapse of the joint stock market and real estate bubbles in the early 1990s that led to financial crisis, socialization of losses, deflation, and low to no growth. While some have speculated that we may be going down the Japan path, that idea is absent from this article. Indeed, whether intentionally or not, it stresses the conditions in Japan not found in the US: low birthrate and tough immigration restrictions; sapping of competitive spirit; limited income disparity. Yet those very features, which are described as negative, also supported social cohesion, which may well have prevented chaos during the worst years of its banking crisis. How well would America muddle through if its financial system falls off a cliff?

From the Washington Post:

As the United States frets noisily about a recession, Japan is quietly enduring a far more fundamental economic slide, one that seems irreversible.

This country, which got rich quick in a postwar miracle of manufacturing and alarmed Americans by buying up baubles such as Rockefeller Center, is steadily slipping backward as a major economic force.

Fifteen years ago, Japan ranked fourth among the world's countries in gross domestic product per capita. It now ranks 20th. In 1994, its share of the world's economy peaked at 18 percent; in 2006, the number was below 10 percent.

The government acknowledged last month what has long been obvious to economists and foreign investors, if not to the Japanese public and many politicians. The minister of economic and fiscal policy, Hiroko Ota, told parliament that Japan could no longer be described as a "first-class" economy.

"I have a sense of crisis because Japan has not nurtured industries that will grow in the future," said Ota, who offered no specific remedies for the crisis.

Japan is still the world's second-largest economy, as measured by gross size, although the island nation has been surpassed by China in purchasing power. In coming decades, the economies of China and India will dwarf Japan's, according to many projections. By 2050, Japan's economy will be about the size of Indonesia's or Brazil's, according to a study by PricewaterhouseCoopers.

Japan's slide relative to other major economies is not a tabloid tale of suddenly squandered riches. It is rather an insidious petering out of growth, productivity and innovation -- and of political will to stop the slippage.

The slide has dovetailed with another quietly insidious crisis -- the petering out of the population. Japan has the world's highest proportion of elderly people and the lowest proportion of children.

By 2050, population decline will have reduced economic growth to zero, according to the Japan Center for Economic Research. Seventy percent of the country's labor force will have disappeared.

The undertow is already being felt here. Supermarket and department store sales have declined for 11 consecutive years. Toyota now is arguably the world's largest carmaker, but sales of new cars of all brands in Japan peaked 18 years ago and have been falling steadily since then.

Still, with the exception of increasing poverty among the elderly in shrinking rural towns, this remains a remarkably comfortable middle-class country, with good health care and infrastructure and a low crime rate.

Unemployment is at a 10-year low of 3.9 percent, although wages are stagnant or declining. Thanks to six consecutive years of (relatively slow) growth, the panic and deflation that accompanied the bursting of Japan's real estate bubble in the 1990s are gone.

"People here are rich, happy, safe and clean," said Oki Matsumoto, chief executive of Monex Inc., an Internet investment company. They also have more savings in the bank than residents of any other major wealthy country.

And that is precisely the problem, according to Matsumoto and many others who worry about Japan's future.

"Although the situation is not good, because it is not so bad, people from top to bottom remain indifferent," said Minoru Morita, a political analyst in Tokyo. "The leaders in this country don't expect too much and they are very good at adapting to a new environment, even if that means a downward spiral."

Economists here say that although Japan's economy is growing, it is not growing nearly fast enough to keep pace with other countries, especially booming China and much of the rest of Asia.

Japan, in many ways, continues to keep out foreign capital and foreign management. It ranks last in foreign direct investment among the 30 members of the Organization for Economic Cooperation and Development, and second to last in venture capital investment...

In the classes he teaches at Tokyo's Keio University, Shumpei Takemori compares Japan's passive acceptance of economic slippage to that of a frog swimming in a dish of slowly warming water. "Our problem is that the frog is already boiled," said Takemori, a professor of economics. "It doesn't have enough energy to jump."

A jump toward restructuring did occur here after the bursting of the bubble in the 1990s.

Junichiro Koizumi, prime minister from 2001 to 2006, moved more aggressively than any postwar Japanese leader to overhaul the banking system, deregulate big business and open up the economy. His government convinced many investors that "Japan is back," and the stock market rebounded.

But under his successors -- Shinzo Abe and now Yasuo Fukuda -- the momentum for change has stalled. In recent months, there has been re-regulation.

New building codes hobbled the home-building industry, sending housing starts last fall to a 40-year low. New lending regulations created a credit squeeze for small businesses. For the first time since 1990, Japanese companies are increasingly buying each other's shares to stave off acquisition by foreign companies, according to research done by Nomura Securities.

Japan's foreign minister, Masahiko Komura, said last month that the government might consider requiring long-term foreign residents to prove proficiency in speaking Japanese, a suggestion that spooked foreign businessmen here.

Regardless of government policy, some downward drift of Japan from its lofty economic perch is natural and inevitable, according to economists and business leaders.

Japan's spectacular flush of manufacturing wealth after World War II was, in many ways, "lucky," said Matsumoto, the investment company executive, who is a student of Japanese economic history.

"The government took a huge bet on a few strategic industries -- like steel and automobiles -- and it worked," he said. "It took our economy up to second place in the world. It is totally abnormal for a country with 127 million people."

Citing the rise of China and India, Matsumoto says global capitalism is shifting patterns of wealth creation in a way that more closely links a country's gross domestic product with the size of its population.

What concerns political and economic analysts is that many Japanese politicians -- and the voters they represent -- do not understand how wealth is being created in the 21st century.

"The current leadership of Japan came of age during the incredible success after World War II," said Matsumoto. "They think that what worked then will work forever."

"Bernanke Makes Bulls From Dollar Bears"

Long term, the dollar is not a good bet unless the US increases its savings rate and reduces its current account deficit considerably. Monetary easing and fiscal stimulus only exacerbate the problem.

But never forget the Wall Street saying, "Don't fight the tape."

From Bloomberg:

Ben S. Bernanke's decision to lower interest rates 1.25 percentage points last month will end the dollar's two-year slide, according to the world's biggest currency traders.

For the first time since 2003, investors are focused on relative growth prospects rather than absolute borrowing costs, according to Geoffrey Yu, a London-based strategist with UBS AG, the No. 2 trader. The steepest cuts by a Federal Reserve chairman in seven years will support economic growth in the U.S. as Europe slows, said BNP Paribas SA, the most accurate currency forecaster Bloomberg tracks. The dollar will gain at least 9 percent against the euro this year, UBS and BNP predict.

``We're not chasing dollar weakness any lower,'' said Robert Robis, a fixed-income manager in New York at OppenheimerFunds Inc., which oversees $260 billion. ``The Fed's actions have avoided a long recession and we may start to see a recovery later this year.''...

Futures traders cut the value of contracts benefiting from a drop in the dollar to $13.9 billion as of Jan. 29, according to Charlotte, North Carolina-based Bank of America Corp., the second-largest U.S. bank by assets. That's down from a record $32.3 billion in November....

While two Fed cuts slashed the target rate for overnight loans between banks to 3 percent in nine days, the European Central Bank kept its benchmark rate unchanged at a seven-year high of 4 percent in an attempt to curb inflation. The ECB will keep rates unchanged at its Feb. 7 meeting, according to all 55 economists surveyed by Bloomberg News.

``If aggressive cuts by the Fed can stimulate the economy, then the U.S. will definitely lead the way in terms of economic recovery,'' [UBS strategist Geoffrey] Yu said. ``The ECB is behind the curve, so it's time to move back'' into the dollar, he said.

Stiglitz: On the Fallen Standing of the US High Finance

This article from Project Syndicate (hat tip Mark Thoma) is a report from Davos by Nobel Prize winner Joesph Stiglitz on the considerable skepticism abroad toward US financial and business practice, particularly our faith in deregulation. It is a telling indicator of how rapidly the world is changing, yet many in the US are still in denial.

From Stiglitz:

Not surprisingly, the atmosphere at this year’s World Economic Forum was grim. Those who think that globalisation, technology, and the market economy will solve the world’s problems seemed subdued. Most chastened of all were the bankers.
Against the backdrop of the sub-prime crisis, the disasters at many financial institutions, and the weakening of the stock market, these “masters of the universe” seemed less omniscient than they did a short while ago.

And it was not just the bankers who were in the Davos doghouse this year, but also their regulators – the central bankers.

Anyone who goes to international conferences is used to hearing Americans lecture everyone else about transparency. There was still some of that at Davos. I heard the usual suspects – including a former treasury secretary who had been particularly vociferous in such admonishments during the East Asia crisis -– bang on about the need for transparency at sovereign wealth funds (though not at American or European hedge funds).

But this time, developing countries could not resist commenting on the hypocrisy of it all. There was even a touch of schadenfreude in the air about the problems the United States is having right now –- though it was moderated, of course, by worries about the downturn’s impact on their own economies.

Had America really told others to bring in American banks to teach them about how to run their business? Had America really boasted about its superior risk management systems, going so far as to develop a new regulatory system (called Basle II)? Basle II is dead –- at least until memories of the current disaster fade.

Bankers – and the rating agencies – believed in financial alchemy. They thought that financial innovations could somehow turn bad mortgages into good securities, meriting AAA ratings. But one lesson of modern finance theory is that, in well functioning financial markets, repackaging risks should not make much difference.

If we know the price of cream and the price of skim milk, we can figure out the price of milk with 1% cream, 2% cream, or 4% cream. There might be some money in repackaging, but not the billions that banks made by slicing and dicing sub-prime mortgages into packages whose value was much greater than their contents.

It seemed too good to be true -– and it was.

Worse, banks failed to understand the first principle of risk management: diversification only works when risks are not correlated, and macro-shocks (such as those that affect housing prices or borrowers’ ability to repay) affect the probability of default for all mortgages.

I argued at Davos that central bankers also got it wrong by misjudging the threat of a downturn and failing to provide sufficient regulation. They waited too long to take action. Because it normally takes a year or more for the full effects of monetary policy to be felt, central banks need to act preemptively, not reactively.

Worse, the US Federal Reserve and its previous chairman, Alan Greenspan, may have helped create the problem, encouraging households to take on risky variable-rate mortgages by reassuring those who worried about a housing bubble that there was at most a little “froth” in the market.

Normally, a Davos audience would rally to the support of the central bankers. This time, a vote at the end of the session supported my view by a margin of three to one.
Even the plea of one of central banker that “no one could have predicted the problems” moved few in the audience -– perhaps because several people sitting there had, like me, explicitly warned about the impending problem in previous years.

The only thing we got wrong was how bad banks’ lending practices were, how non-transparent banks really were, and how inadequate their risk management systems were.

It was interesting to see the different cultural attitudes to the crisis on display. In Japan, the CEO of a major bank would have apologised to his employees and his country, and would have refused his pension and bonus so that those who suffered as a result of corporate failures could share the money. He would have resigned.

In America, the only questions are whether a board will force a CEO to leave and, if so, how big his severance package will be. When I asked one CEO whether there was any discussion of returning their bonuses, the response was not just no, but an aggressive defence of the bonus system.

This is the third US crisis in the past 20 years, after the Savings & Loan crisis of 1989 and the Enron/WorldCom crisis in 2002.

Deregulation has not worked. Unfettered markets may produce big bonuses for CEOs, but they do not lead, as if by an invisible hand, to societal well-being. Until we achieve a better balance between markets and government, the world will continue to pay a high price.

Monoline Update: Are the Rating Agencies Moving the Goalposts?

We have been skeptical about the possibility of a private-sector rescue of the troubled bond insurers. Nevertheless, both the Wall Street Journal and the Financial Times reported progress on discussions to shore up Ambac, the number two insurer, and that efforts were underway to assist the smaller fry. From the Financial Times:

US and European banks are joining forces to try to solve the crisis among US bond insurers that could exacerbate the impact of the credit squeeze.

One group, including Citigroup and Barclays, is examining options for supporting Ambac Financial, the bond insurer. Separate teams are working with other bond insurers, according to people close to the process.

Note that the worst outcome for Wall Street isn't that the insurers are downgraded; it's that they spend money trying to salvage them up and they nevertheless lose their AAAs later. What we find surprising is that Wall Street is willing to stump up cash, worse, at least some equity funding, at a time when money is tight and more writeoffs are likely. And this is also taking place despite the fact that the majority of Wall Street analysts who have taken a look at the bond insurers are putting out even bigger loss estimates than Bill Ackman, the head of Pershing Square who has been saying that the monoline business model is unworkable since 2002.

What gives? Two things: the investment banks' assumptions and the rating agencies actions.

A mere patching of the leaks at the bond guarantors is not a sensible move unless you have a very optimistic set of assumptions. If you believe that the economic downturn is only a two-quarter event and that a rising economy will take pressure off the insurers, investing would be attractive.

The problem, of course, is that the bond insurer troubles are driven primarily by the housing market. The last housing recession, which started in 1989, lasted 15 quarters and had less unsold home inventory (as a percentage of outstanding) than we have now. Even if you date the start of this housing slump at end of second quarter 2007, we have a long way to go. Thus the idea that this charade can be kept gong beyond two or three quarters is highly questionable.

Or is it? The mistake is believing, as we perhaps have too much, that the rating agency saber rattling means they have the will to downgrade. They don't. The very last thing they want to do is be accused of causing The End of the Financial World as We Know It.

Even thought anyone who has looked at these companies in a serious way knows the AAA ratings for MBIA and Ambac are a sham, they are coming to resemble guys on death row that it takes 20 years to execute. The rating agencies, while threatening that downgrades are imminent, keep allowing the timetable for fundraising to be extended. According to the Wall Street Journal:

Moody's prepared investors for bond-insurer downgrades in a research note Thursday and subsequent investor call Friday.

Some firms "may be unable to restore financial strength to levels consistent with a Aaa rating," the firm wrote. Moody's is likely to make decisions on downgrades this month, it said, possibly sooner in the month for insurers having trouble raising capital.

While this sounds like the heat is on, the reality is more nuanced. If the rating agencies believe serious negotiations are underway for specific firms, the decisions on downgrades "this month' probably means that they have until at least the end of February.

The focus on Ambac makes sense too. Its troubled exposures are primarily CDOs, which will come a cropper sooner than other instruments might, and will also inflict damage on Wall Street firms. MBIA's guarantees, by contrast, are spread across more types of instruments. The cost of an MBIA downgrade is likely to be shared more broadly, making it harder to round up interested parties to write checks.

Also note that despite the continuing deterioration in the credit markets, the rating agencies have not increased the required fundraising for the bond insurers. That seems highly inconsistent with recent developments, most notably S&P saying that it will either downgrade or put on review $534 billion of debt, and estimated that this move could increase bank and investment bank losses from $130 billion to $265 billion.

Pray tell me how this has no impact on MBIA and Ambac? This confirms that Moody's and S&P will take advantage of any route open to them to avoid downgrading the insurers. If they raise remotely adequate amounts of money (or can use some reinsurance hocus-pocus), the game will go on until events, or a big disparity between the top two agencies and Fitch, make the charade untenable.

A jaded and informed view comes from reader Scott, an institutional investor who has been on this beat for some time (and is holding his short position):

I have two problems with the concept. One, the size of the help involved, particularly given the rumored rescuers. Certainly Citi and UBS, and to a lesser extent WB, who in any event doesn't to my understanding have tons of exposure on their own books, just don't have the wherewithal to do more than pay lip service to a real bailout, so it will be almost totally cosmetic if they're the real players--just enough to allow Moodys and S&P maintain the charade that ABK's a triple A credit.

And perhaps more importantly from an investor's viewpoint, Dinallo's only interest here is in making sure insured claims get paid, and mostly muni ones at that, I suspect, so that from an investor's viewpoint the money will remain at the insurance subsidiary, and will not get upstreamed to the public holding company. Maybe that will allow these guys to stay open, but in terms of competing for future business, they'll clearly be left with the worst stuff available--anybody in their right minds, assuming anybody in their right minds will be buying this insurance going forward in the first place, will place their business with Buffett, so they'll be competing for business he doesn't want--adverse selection of the worst sort.

I'm sure that somebody like 3rd Avenue believes that they'll be able to negotiate some sort of anti-dilution deal alongside of Warburg, and it strikes me as possible that they're sitting at table with the rescue party, and will be able to. But anybody later to the game, or less savvy than Marty Whitman in this kind of investing, will get killed by the dilution involved even in a cosmetic rescue, I'd think. And even a reinsurance deal will make them less profitable going forward, although I'm not sure what would get reinsured--reinsurance on the structured finance-mortgage related stuff would simply be buying claims, as far as I can tell, unless the entity putting up the money was the counterparty on the claims, in which case it would essentially be exactly the same as taking the assets back on balance sheet, so I don't see the incentive for them to do that. Reinsurance on "good" municipal bonds would simply make no-loss assets on which claims almost certainly will not be paid less profitable.

I guess the long and short of it is that I can't get my little mind around a rescue that is more than a cosmetic stop-gap, or one that doesn't dilute current holders into oblivion.

Links 2/3/08

The Financial Times Says Bankers are Too Dumb to Breathe Dean Baker

BLS Censors Birth/Death Employment Disclaimer Bernanke Panky News

Cramer: "Ethanol is a fuel that doesn't work" The Big Picture. Cramer is so often nuts that I wanted to highlight one of those rare occasions when he says something sensible. 

Inflation expectations are rising Greg Mankiw

The Naked Economics Professor's Office Culture of Life News. Warning: the author of this blog has an overwrought writing style which can undermine her considerable research. Nevertheless, the latter part of this item discusses an article in the Washington Post on Japan's economy. Her observations are astute.