Barclays: Counterparty Risk in Credit Default Swaps Only $36 to $47 Billion

This post comes in significant degree from jck at Alea, who has access to the report, "Counterparty risk in credit markets," from Barclays Capital and was kind enough to post the summary of key points. Despite the link, I seem unable to download it, but the summary is sufficiently detailed that I don't think I am missing much.

The bottom line is that the authors estimate the impact of a $2 trillion in notional amount failure (yes, that's a big failure) at producing a maximum of $36 to $47 billion in losses. That is a comparatively low number when you consider that the size of the potential financial train wrecks these days for the most part have larger price tags attached. And while the Barclay's report also said this number would be reduced by netting, it also pointed out that a large default could roil other OTC derivatives markets and that collateralization may be less than ideal.

My big concern with any analysis is that the knock-on effects are hard to anticipate. Two month agos, no one would have dreamed of massive failures in the auction rate securities markets. The reaction seems vastly disproportionate to the risk at hand, yet we are where we are.

Consider the panic with SIVs last year. Money market investors were fleeing them due to the perceived potential for losses. However, it was the investors in the subordinated slice, the capital notes, who were taking the hits (this is generally medium term, not money market paper); the commercial paper, which was the paper held by money market investors, was senior to that and thus at much less risk of losses.

I have never seen loss figures published across the SIV sector, but my impression is that the total damage across the $400 billion SIV market were 3% ish (that's why the industry in the end decided to take the funds on balance sheet for the most part. The losses were painful but not catastrophic).

Money market funds are loss intolerant, ditto enhanced cash funds, but nevertheless, one would think a $12 billion-in-losses event wouldn't have systemic consequences, particularly when they were second in line to take a bullet. Yet it led to the shutdown of the asset-backed commercial paper market, which it turn led a lot of borrowers to tap lines of credit unexpectedly and all at once, which led to unanticipated balance sheet demands on the part of banks (utilized credit lines have capital charges attached) which lead to banks being reluctant to lend to each other, which led to a big rise in interbank rates relative to risk free rates, which led to panic and extraordinary measures among central banker.

For the want of a nail a shoe was lost....

That is a long winded way of saying that my bet would be a big counterparty failure (or smaller related failures that add up to a biggish number) might well lead to not-so terrible direct losses, but the impact on psychology and the fear of who might have suffered losses and who might default next could lead to collateral damage out of proportion to the triggering losses.

From Alea:
Report: Key points

Counterparty risk is highly skewed towards the buyer of CDS protection

While the maximum potential loss to the seller of protection is the contract spread for the rest of the contract duration, the buyer of protection could arguably lose the full notional of the contract (in case of simultaneous defaults by counterparty and the reference credit and zero recovery). Thus, counterparty risk is evidently more of a concern for buyers of protection.

All ISDA contract holders are ranked pari passu to senior debt, in terms of claims on a defaulting counterparty

Hedge funds might be asked by dealer/brokers to post margin to cover closing-out risk going forward

Given their higher risk profile, margining for hedge funds tends to be somewhat more stringent. They typically post collateral at 100% of their current exposure, and furthermore might also be asked to post collateral to cover close-out risk on their contracts for a certain number of days going forward. The estimation of forward exposure is done through forecasting future scenarios.

Netting agreements are typically applicable across all derivatives that are traded on ISDA contracts

Netting agreements come into action in the case of actual counterparty default. Without such agreements, a surviving counterparty would legally have to fully meet its obligations to the defaulting counterparty, while only being left with a claim on its dues from the same. However, the provision for netting allows a bank to calculate its dues to a defaulter by netting out-of-the-money and in-the-money contracts and to arrive at a single figure for dues. In fact netting agreements are typically applicable across all derivatives that are traded on ISDA contracts, effectively building in a natural hedge to counterparty default risk on a firm-wide level.

Scenarios in case of an actual counterparty default

Even in the absence of reference entity default, a failure of a major counterparty could lead to losses across the financial system. Upon the default of the counterparty, OTC derivatives would be immediately and significantly re-priced, with credit spreads likely widening dramatically. This means that CDS contracts would be terminated at a spread significantly higher than the spread at which collateral was last posted, leading to the crystallisation of significant losses.

Illustrating potential gap risk losses on CDS positions

The total notional amount outstanding of OTC credit derivatives for broker/dealers is $42.5trn. There are approximately 55 broker/dealers who buy or sell protection. We analyse a scenario where a relatively large counterparty defaults. We assume that this counterparty sold $1trn of protection and bought $1trn of protection. We further assume that the proportion of IG protection sold by the counterparty is 65% and the average life of contract affected is five years. We continue to assume that the recovery rate on the counterparty is 40%.

We believe that a default of a major counterparty would cause a significant re-pricing in credit. Although consequences of such an unprecedented event are difficult to quantify, we estimate losses for a variety of scenarios. In our analysis, we allow the IG credit spreads to jump between 10bp and 60bp upon a counterparty default. We view the IG spread jumps of 30-40bp as the most likely in case of a default of a counterparty with $2trn of outstanding CDS. Assuming a beta of 4x between the Crossover and the Main, we imply that HY spreads could jump between 40bp and 240bp, with 120-160bp being most likely.

Our analysis shows that the failure of a major counterparty which had $2trn outstanding in OTC credit derivatives, could result in losses of $36-47bn in the financial system solely due to the immediate re-pricing of credit risk due to a counterparty default. We stress that these losses are crystallised by investors who had exposure to the defaulting counterparty. Additional to these, there would also be large, potentially concentrated, MTM losses for investors without exposure to the defaulting counterparty. These losses would result from a re-pricing of risk, which we do not account for here.However, we would add the caveat that netting could significantly reduce our estimated losses. The figures above are un-netted, as data on netted exposures is very hard to obtain.

There are two factors which could cause the realised losses to be larger than our estimates. The first is the fact that, while we assumed full collateralisation, in reality, collateralisation is imperfect. This would mean that at the point of last posting of collateral, there would be some MTM positions which are not backed by collateral and any losses on these positions would increase the loss from gap risk. The second is forward margining. Any collateral posted by hedge funds with the defaulting counterparty as part of forward margining would be subject to a loss. This loss would amount to the value of collateral less recovery.

Our analysis we have concentrated solely on credit derivatives. However, in terms of amounts outstanding, credit derivatives constitute only 8% of all the OTC derivatives, with interest rate derivatives constituting the largest proportion of 67% (Figure 17). We believe that a default of a major counterparty would cause a significant re-pricing in all OTC derivatives. This implies that these contracts would also be vulnerable to large gap risk. Given the enormous amounts outstanding of these derivatives, netted exposures could be large and therefore gap risk losses on other OTC derivatives could be significant.

Will Ambac Have a Deal Next Week?

We aren't in a position to answer the question posed in the headline, but following a leak that lead to a 250 point rally in the Dow, the noises coming from the team trying to rescue the troubled number two bond insurer have suddenly taken an optimistic tone. While the initial reports were vague, the Wall Street Journal, the Financial Times and the New York Times carry broadly similar reports.

Ambac and the rating agencies received a proposal from eight banks (Citigroup, UBS, Royal Bank of Scotland, Wachovia, Barclays. Societe Generale, BNP Paribas, and Dresdner) on Friday afternoon. As the Times reports, the proposal involves both providing an equity infusion and splitting the company:

Under Ambac’s plan, one part of the company would guarantee relatively safe municipal bonds, while the other would insure more complex securities backed by mortgages and other debt. In all, Ambac guarantees about $556.2 billion of securities.

The company also hopes to raise $2.5 billion through a rights offering to its existing shareholders; the sale will be backed by banks. Ambac also plans to raise roughly $500 million in new debt, according to the person who has seen the plan, who was not authorized to talk about it.

The banks, which include Citigroup and UBS, delivered a draft of the plan to Ambac and credit ratings agencies on Friday, and the company is expected to give its formal consent soon. Officials involved in drafting the plan hope the two new subsidiaries will both receive triple-A ratings, though the firm backing mortgage-related bonds could be rated slightly lower.

Note the artful phrasing: this is Ambac's plan, but the document came from the eight banks, as stated in the Wall Street Journal, "committing to the equity and debt participation."

Note: the banks aren't making an equity infusion. As I read this, they are merely backstopping a public offering by Ambac. This is the most lukewarm form of support they could provide.

Why haven't the banks stepped forth more wholeheartedly? Analyst James Bianco of Bianco Research, in an e-mail this evening, goes through the history and is mystified as to why a deal hasn't been wrapped up long ago:

The Monoline bailout hysteria started January 23.
The New York Times - (January 24) Next on the Worry List: Shaky Insurers of Bonds

Regulators fear a possible chain of events in which the troubled bond insurers, MBIA and Ambac, might be unable to keep their promise to pay investors if borrowers default on their debt.....the talks focused on raising as much as $15 billion for the companies … Eric R. Dinallo, the New York insurance superintendent who regulates MBIA..... suggested that the group move in as little as 48 hours to get a deal done ahead of any downgrading of the bond guarantors by credit ratings firms.

So the bailout was suppose to be done by Janaury 26 and total $15 billion. We have been told that a monoline downgrade is critical to the entire financial system. UBS estimates it will cost the banking system $203 billion in additional writedowns. Barclays estimates it will cost $143 billion in writedowns. Oppenheimer estimates that it will cost Merrill, Citi and UBS $40 to $70 billion alone.

Today we learn that a bailout is again very close.

The Financial Times - (February 22) Banks to aid Ambac with up to $3bn
A group of banks is preparing to inject $2bn to $3bn into the troubled bond insurer Ambac.... The money from banks would be part of a plan to split Ambac’s operations, people involved in the discussions said. Ambac is also considering raising equity from shareholders and it is not yet clear how much capital it will need, or what credit ratings the split businesses will have.

Let me get this straight.

If the monolines get downgraded, the banking system is at risk for $143 billion to $203 billion of losses. This is why they were 48 hours from a $15 billion deal on January 23. Now on February 22, they are again 48 hours away from a $3 billion deal for just Ambac spread among eight banks. So the longer they talked the smaller the number got.....

My questions - If the fate of the financial system only needs $3 billion to get “fixed,” why did it take eight banks a month to negotiate coughing up $300 million each? Don’t they pay Robert Rubin more each year? B of A took less much less time to bailout Countrywide with a $4 billion deal all by itself.

Something just doesn’t make sense here. If they are staring at hundred of hundreds of billion in losses, and $300 million each stops all this, why was their even a negotiation? Just write the check and move on to the next issue.

What am I missing?

I think Citi paid Rubin only $15.2 million, but point well taken.

Personally, I am surprised too that he banks are stepping up now as opposed to a month ago, since as we discussed earlier, the idea of a split makes it vastly less attractive for the banks to provide support. Any break-up plan is likely to be biased in favor of shoring up the muni operations. Dinallo's head would be on a pike if after all these machinations, a newly established muni operation didn't get a triple A rating. If the banks faced a free rider problem a month ago (which was presumably one reason not to stump up cash) when it was merely the structured finance businesses that appeared to be in trouble, that issue got magnified by now that the muni business is looking like the higher priority.

And FT Alphaville pointed out, as we have, that multiple businesses will require more equity than a single one:

So MBIA is paying lip service to the idea that they can’t favour one class of claimant over the other. But how they’ll do that remains unclear. For a start, as its chief executive hinted at above, two (or three or four) separate businesses will require greater capital underpinning than in one combined entity. And what has always been rather unclear in the bond insurer split plan is where the reserves go.

So reason 1. for not doing a deal may have been a free rider problem. To continue the list:

2. Writing a check may not make the problem go away. Remember, the worst outcome for the banks is not that the monolines are downgraded; it's that they throw scarce cash at the problem and the downgrade threat resurfaces in six months to a year. That means they have wasted money and will still face the damage inflicted by a downgrade, or face an ongoing sinkhole of having to put funds in every time the monolines look shaky.

3. Not all the banks may be that badly exposed. One thing that is nasty about these deals is that everyone at the table is assumed to stump up the same amount. Some may not regard their exposure as that bad. They have their numbers; the analysts don't. Remember, even though Citi and Merrll have large CDO positions, they also have taken large writeoffs. They may not think they have further downside. And one big name not participating, or demanding a lesser role, could poison the negotiating dynamic.

4. They may have believed the monolines' prior statements. Ambac and MBIA have both been maintaining that Bill Ackman is all wet, that his mark to market analysis is wrong. Apparently the CDS contracts the insurers wrote do not have to be paid out until the CDOs liquidate, and for some contracts, apparently, a liquidation does not trigger a payout on the principal portion of the deal; they aren't required to pay until the underling assets reach final maturity, which can take as long as 30 to 45 years. That means the payouts are spread out over a longer time period than Ackman assumed.

Note I'm not entirely sure I buy this argument, simply because the insurers have never been very forthcoming when pressed. If the bulk of their agreements worked this way, the downgrade worries should have gone away. The fact that they didn't suggests matters aren't quite that simple. Yet the S&P and Moody's downgrade threats would seem to make this moot. It doesn't matter who is right; what matters is what it takes to placate the ratings agencies.

5. The banks are in vastly worse shape than they dare admit. Maybe contributing $300 million is a big deal for them, and they have been pressing behind the scenes for a government bailout or (more likely) that official pressure be applied quietly to get the rating agencies to back down. Remember, as we said before, the rating agencies are the part of the equation that is the most malleable. Maybe the banks took a month to play that strategy out.

So I may very well be proven wrong and Ambac will be rescued and split up, which seemed a particularly implausible outcome. If the press has this right, the banks and Ambac are largely on the same page. The wild card in theory is the rating agencies, but in fact, they are desperate not to downgrade the monolines. They've moved back their deadline any time an excuse cropped up. So I'd expect them to fall in line unless there is something deficient in the plan, such as inadequate detail as to how the split will be put into effect. But that may lead to further negotiation rather than a flat-out rejection.

Is the Heyday of Hedge Funds Over?

Pity the poor hedge fund manager. The markets have gotten so treacherous of late that most are not likely to see as much in years past from their 20% of the upside fees, but 2% on a big fund isn't too shabby either.

However, the bigger pressure comes from the fact that plain-vanilla, low cost strategies have been doing much better of late. If this sort of pattern continues, the seemingly endless flow of cash into the sector may not simply slow, but could actually reverse. Just as real estate Sam Zell's sale of his Equity Office Trust in February 2007 to Blackstone at a record low capitalization rate (low cap rate = high valuation) represented a market peak, so to may have the IPO of hedge fund Fortress, which went public the same month. Its price has fallen 50% since then.

This article in the Wall Street Journal describes how hedge funds with simpler strategies are performing better and attracting more funds. But it fails to mention that these strategies may also be simpler to replicate with automated tools at vastly lower costs.

Experts maintain that hedge funds will never cut their fees, that they offer a high skill service and will always be able to dictate price. I recall the days when commercial banks insisted that credit card businesses would never have to cut their charges (remember, once upon a time all cards carried an annual fee). Similarly, investment bankers argued with complete conviction that M&A fees would never be reduced. Both have come to pass. This shift to less complex strategies may set the stage for pushback on hedge fund fees.

From the Wall Street Journal:

The past decade has been the era of the hedge fund, as investors snapped them up for their track record of beating the market with often highly complex trades.

But now, as the credit crunch upends financial markets, that very complexity is coming back to bite some of them...

A pair of $2 billion funds run by AQR Capital Management Inc. are down about 15% this year. And yesterday Citigroup announced a bailout of an in-house hedge-fund group clobbered in part by bad bets on highly complex mortgage-related securities.

Last month alone, so-called "quantitative" hedge funds (which make investments based on sophisticated mathematical formulas) fell 6% as a group, according to data-tracker Hedge Fund Research Inc.

Other funds have hit the scrap heap. D.B. Zwirn & Co. and Sailfish LLC have both seen investors rush for the exits, forcing each firm to close big funds....

Total assets under management world-wide in funds like these now add up to $1.9 trillion, up from $490 billion in 2000.

The most-successful fund managers enjoy celebrity-billionaire status, even as regular investors struggle to figure out what they are up to.

This opacity, though, is now hurting hedge funds. Investors are pulling back, worried as they watch assorted financial institutions suffer from bad trading bets.

The recent exodus from the most sophisticated hedge-fund variants represents a flight to simplicity as investors snap up easier-to-understand assets instead. As a result, gold, silver, oil and other commodities are soaring. Even agricultural commodities, once the most boring part of the market, are on a tear. Soybeans and wheat are up more than 75% in the past year....

Not all hedge funds are taking it on the chin. A subset of funds that simply buy a portfolio of stocks while simultaneously betting on other stocks to fall -- known as "long-short" funds -- are currently in vogue.

Funds like these gained 10.5% last year and are down just 1.7% in 2008, soundly beating the market in both periods, according to fund-tracker Hedge Fund Research.

One of the hottest variants is one of the simplest: so-called 130/30 funds. These generally invest $130 in stocks they think will rise in price, then bet against $30 of stocks the fund considers overpriced. In a rough market, this strategy can be appealing because if the market does fall, the fund still stands to make at least some money on the bearish bets.

Investment funds using this style, including mutual funds, could manage as much as $1 trillion in three years, according to Merrill Lynch, up from almost nothing just two years ago and $75 billion today.

"Investors are shifting to simple strategies, where there is much greater pricing certainty," says Henry Bregstein, an attorney at Katten Muchin Rosenman LLP, who is working with a client who is shuttering all of its funds that focus on hard-to-price strategies. "There's also growing scrutiny of how all hedge funds value their positions."

A big part of the problem facing the struggling hedge funds is that many count on investing heavy doses of borrowed money, or "leverage," to amplify returns. Now, however, banks are either cutting their lending to hedge funds or making it more expensive to borrow. As borrowing gets tougher, the returns of heavily leveraged funds likely will be hurt.

Also hurting funds like these is the fact that investors are increasingly fretting about how they value their holdings. The risk is that funds may be overstating returns, or that they simply don't know with certainty what their holdings may be worth, given the difficulties in the credit markets.

Lara Price, head of research for Octane, a firm that invests in hedge funds, says her firm has become more worried about whether the results of some debt-focused hedge funds reflect their true value, as more of their investments become difficult to trade.

This kind of nervousness has led investors to sell debt-related investments in recent weeks, representing a new blow for the markets. Because many areas of the credit markets remain virtually frozen, much of the selling is taking place in areas where investors can exit more easily -- causing those areas of the debt markets to take particularly big hits.

No More Home-Grown Bacon in the UK?

The pig farming industry in England is in crisis. From the Telegraph:

Farming leaders believe that a viable domestic pig sector could be wiped out within months unless urgent action is taken by the government and retailers. The national pig herd has already halved over the past 12 years.

Desperate UK pig farmers have doubled the usual number of breeding sows they are sending to slaughter to 7,000 a week because they can no longer afford to feed them following a doubling of wheat prices since last summer.

The high number of animals being culled lays bare a crisis that is devastating the pig industry. Wheat is the main constituent of pig feed, and, on average, farmers are losing £27 per pig due to the massive increase in overheads.

Peter Kendall, the president of the National Farmers Union, said that the pig industry is "on a knife-edge" and that there could be a "massive fall-out" by the summer unless action is taken.

According to the National Pig Association (NPA), the number of breeding sows being slaughtered each week is currently 7,000. This is double the usual figure of 3,500 sows, which are culled because they have reached the end of their productive life...

Given that sows produce an average of 21 piglets per year - whose meat ends up on supermarket shelves - the increase in slaughters will take at least 73,500 pigs out of the food chain within a year.

The crisis is affecting both commercial farmers who supply supermarkets, and pedigree farmers, who tend to sell through farm shops.

Jimmy Doherty, owner of the Essex Pig Company and star of the Jimmy's Farm TV series, has had to slaughter 50 of his 95 rare-breed sows as the cost of feeding them has risen so steeply.

"I am busy killing my sows as I can't afford to feed them. It is very, very difficult at the moment," said Mr Doherty.

Pig-feed costs at his Pannington Hall Farm have risen from £130 a tonne in January to £225 today. "I've slashed my herd to bits. I will go down to a core of around 30 pedigree sows. It is a crisis. It is a very sad thing as people don't see what is happening and don't understand," he said....

"We really should look at the price we pay for food. If beer prices go up, people will still spend £4 on a pint. But if bacon goes up, people say 'I'm not paying that'," he said.

"The supermarkets need to pay farmers more. Because they have such a stranglehold, they can say 'If you don't like it, shove off'," he said.

The NFU's Mr Kendall said that the UK market has been flooded with cheap pork imports from abroad. He said that 70pc of this pork would fail to meet domestic safety standards.

Supermarkets said they are doing what they can to help the industry. A spokeswoman for DEFRA said that the increase in feed costs is a "global phenomenon". She said that a £12.5m package was made to the livestock sector last October. James Hall experiences the harsh realities of pig farming in Britain today

Some Banks Can't Foreclose, Unable to Find Loan Documents

Readers may have heard of cases, starting in Ohio, where judges have dismissed foreclosures because the bank (usually the mortgage servicer on behalf of a securitized entity) was unable to provide the right paperwork showing that it in fact owned the mortgage. That often results from mortgages passing though several hands before being securitized and the documentation required to execute the transfer not being performed properly at all steps along the chain.

Although the article doesn't say so clearly, one point of failure is that quite a few mortgage companies are out of business. If one of them failed to sign the documentation over correctly to a purchaser, it's impossible to go back and have them make corrections. But it also suggests that the lack of meticulousness has been around for some time, but means than foreclosing banks used to attempt to prove ownership before are now being rejected by the courts.

These cases have been dismissed without prejudice, meaning the bank can come back and foreclose again once it finds the right paperwork or goes back to the previous holders and gets the needed approvals.

Some banks in the end are not able to locate the needed documents, giving the defaulting borrower a free house.

Tanta has often gone on at considerable length about how the push for efficiency in mortgage processing has undermined good practice. This goes one step further: banks have gotten so keen to cut costs that they have simply gotten sloppy. Large transactions used to have procedures in place with a certain amount of double checking to make sure everything, including the forms, were in order. That appears to have gone by the wayside at some firms.

I have little sympathy with some of the sources quoted in the article, that the judges are wasting the time of the banks. I am bothered by the claims that the judges are favoring homeowners because they live in the same community as the borrower. Judges spend all day enforcing the code of law. They get offended when parties to a suit are cavalier about the law or rules of procedure. In the vast majority of cases, I have no doubt that the judges are angered by the conduct of the bank in trying to enforce an agreement without being able to prove that they have legitimate standing, rather than them having a bias in favor of the local guy.

From Bloomberg:

-- Joe Lents hasn't made a payment on his $1.5 million mortgage since 2002.

That's when Washington Mutual Inc. first tried to foreclose on his home in Boca Raton, Florida. The Seattle-based lender failed to prove that it owned Lents's mortgage note and dropped attempts to take his house. Subsequent efforts to foreclose have stalled because no one has produced the paperwork.

``If you're going to take my house away from me, you better own the note,'' said Lents, 63, the former chief executive officer of a now-defunct voice recognition software company.

Judges in at least five states have stopped foreclosure proceedings because the banks that pool mortgages into securities and the companies that collect monthly payments haven't been able to prove they own the mortgages. The confusion is another headache for U.S. Treasury Secretary Henry Paulson as he revises rules for packaging mortgages into securities.

``I think it's going to become pretty hairy,'' said Josh Rosner, managing director at the New York-based investment research firm Graham Fisher & Co. ``Regulators appear to have ignored this, given the size and scope of the problem.''

More than $2.1 trillion, or 19 percent, of outstanding mortgages have been bundled into securities by private banks, according to Inside Mortgage Finance, a Bethesda, Maryland-based industry newsletter. Those loans may be sold several times before they land in a security. Mortgage servicers, who collect monthly payments and distribute them to securities investors, can buy and sell the home loans many times.

Each time the mortgages change hands, the sellers are required to sign over the mortgage notes to the buyers. In the rush to originate more loans during the U.S. mortgage boom, from 2003 to 2006, that assignment of ownership wasn't always properly completed, said Alan White, assistant professor at Valparaiso University School of Law in Valparaiso, Indiana.

``Loans were mass produced and short cuts were taken,'' White said. ``A lot of the paperwork is done in the name of the original lender and a lot of the original lenders aren't around anymore.''

More than 100 mortgage companies stopped making loans, closed or were sold last year, according to Bloomberg data.

The foreclosure rate, at 1.69 percent of all U.S. homeowners, is the highest since the Mortgage Bankers Association began tracking it in 1993. The foreclosure rate for subprime borrowers, who have bad or incomplete credit and whose mortgages typically are securitized by private banks rather than government-sponsored entities Fannie Mae and Freddie Mac, is at a four-year high, according to the mortgage bankers.

More than 1.5 million homeowners will enter the foreclosure process this year, said Rick Sharga, executive vice president for marketing at RealtyTrac Inc., the Irvine, California-based seller of foreclosure information. About half of them, 750,000, will have their homes repossessed, Sharga said.

Borrower advocates, including Ohio Attorney General Marc Dann, have seized upon the issue of missing mortgage notes as a way to stem foreclosures.

``The best thing to do is to keep people in their homes and for everybody to take steps necessary to make that happen,'' said Chris Geidner, an attorney in Dann's office. ``These trusts are purchasing these notes, and before they even get the paperwork, they foreclose on people. They become foreclosure machines.''

When the mortgage servicers and securitizing banks that act as trustees of the securities fail to present proof that they own a mortgage, they sometimes file what's called a lost-note affidavit, said April Charney, a lawyer at Jacksonville Area Legal Aid in Florida.

Nobody knows how widespread the use of lost-note affidavits are, Charney said. She's had foreclosure proceedings for 300 clients dismissed or postponed in the past year, with about 80 percent of them involving lost-note affidavits, she said.

``They raise the issue of whether the trusts own the loans at all,'' Charney said. ``Lost-note affidavits are pattern and practice in the industry. They are not exceptions. They are the rule.''

State laws generally make it difficult to foreclose because they favor the homeowner, said Stuart Saft, a real estate lawyer and partner at the New York firm Dewey & LeBoeuf LLP.

``All these loan documents are being sent to the inside of a mountain in the middle of America and not being checked very carefully,'' Saft said. ``The lenders can't find the paper. We're dealing with a lot of paper produced in a mortgage closing.''

Requiring banks to produce the paperwork at a foreclosure hearing is a nuisance, said Jeffrey Naimon, a partner in the Washington office of Buckley Kolar LLP.

``It's a gigantic waste of time,'' Naimon said. ``The mortgage may have transferred five, six, eight times. It's possible that you don't have all the pieces of paper, but it was enough to convince the next guy in the chain. There's no true controversy over whether the owner owns the loan.''

Judges are becoming increasingly impatient with plaintiffs who produce no more proof of ownership than a lost-note affidavit or a copy of the note, said Michael Doan, an attorney at Doan Law Firm LLP in Carlsbad, California.

``Things are heating up,'' Doan said.

In Ohio, where RealtyTrac reported an 88 percent jump in foreclosures last year, Dann, the attorney general, is now arguing 40 foreclosure cases that challenge ownership of mortgage notes, according to his office.

U.S. District Judge David D. Dowd Jr. in Ohio's northern district chastised Deutsche Bank National Trust Co. and Argent Mortgage Securities Inc. in October for what he called their ``cavalier approach'' and ``take my word for it'' attitude toward proving ownership of the mortgage note in a foreclosure case.

John Gallagher, a spokesman for Frankfurt-based Deutsche Bank AG, said the bank had no comment.

Federal District Judge Christopher Boyko dismissed 14 foreclosure cases in Cleveland in November due to the inability of the trustee and the servicer to prove ownership of the mortgages.

Similar cases were dismissed during the past year by judges in California, Massachusetts, Kansas and New York.

``Judges are human beings,'' said Kenneth M. Lapine, a partner at the Cleveland law firm Roetzel & Andress LPA. ``They no doubt feel the little guy needs all the help he can get against the impersonal, out of town, mega-investment banking company.''

U.S. Bankruptcy Judge Samuel L. Bufford in Los Angeles issued a notice last month warning plaintiffs in foreclosure cases to bring the mortgage notes to court and not submit copies.

``This requirement will apply because developments in the secondary market for mortgages and other security interests cause the court to lack confidence that presenting a copy of a promissory note is sufficient to show that movant has a right to enforce the note or that it qualifies as a real party in interest,'' the notice said.

Quick foreclosures benefit communities because properties in default lose value and homeowners in financial distress don't maintain their houses or pay real estate taxes, said Saft of Dewey & Leboeuf.

``When banks originally made the loans they used people's money from pension funds and savings accounts and they should be allowed to foreclose the loan as quickly as possible before the property depreciates in value any more,'' Saft said. ``The mortgage industry has been painted as the enemy when all they did was make loans to enable people to buy homes. Now there's less money available for new borrowers to buy homes and that's what's causing the value of homes to go down.''

Lents is former CEO of Investco Inc., a Boca Raton, Florida-based developer of voice recognition software. In 2002, the U.S. Securities and Exchange Commission sanctioned Lents and others for stock manipulation, according to the SEC Web site. He lost his job, was fined and his assets were frozen. That's the reason he couldn't pay his mortgage, he said.

``If the homeowner doesn't object to the lost-note affidavit, the judge rubber-stamps it,'' Lents said. ``Is it oversight, or are they trying to get around the law?''

Washington Mutual spokeswoman Geri Ann Baptista said the bank had no comment.

``I can't believe the handling of notes is worse than it was five years ago,'' said Guy Cecala, publisher of Inside Mortgage Finance. ``What we didn't have back then were armies of attorneys out there looking for loopholes. People are challenging foreclosures and courts are paying a lot more attention to foreclosures than they ever did before.''

American Home Mortgage Investment Corp., the Melville, New York-based lender that filed for bankruptcy last August, said it was paying $45,000 a month to store loan paperwork and petitioned U.S. Bankruptcy Judge Christopher Sontchi in Wilmington, Delaware, for the right to toss it all. Sontchi ruled last week that American Home Mortgage could charge banks from $3 to $13 a file to retrieve documents.

The home-loan industry has had a central electronic database since 1997 to track mortgages as they are bought and sold. It's run by Mortgage Electronic Registration System, or MERS, a subsidiary of Vienna, Virginia-based MERSCORP Inc., which is owned by mortgage companies.

MERS has 3,246 member companies and about half of outstanding mortgages are registered with the company, including loans purchased by government-sponsored entities Fannie Mae, Freddie Mac and Ginnie Mae, said R.K. Arnold, the company's CEO.

For about half of U.S. mortgages, there is no tracking mechanism.

MERS rules don't allow members to submit lost-note affidavits in place of mortgage notes, Arnold said.

``A lot of companies say the note is lost when it's highly unlikely the note is lost,'' Arnold said. ``Saying a note is lost when it's not really lost is wrong.''

Lents's attorney, Jane Raskin of Raskin & Raskin in Miami, said she has no idea who owns Lents's mortgage note.

``Something is wrong if you start from what I think is the reasonable assumption that these banks are not losing all of these notes,'' Raskin said. ``As an officer of the court, I find it troubling that they've been going in and saying we lost the note, and because nobody is challenging it, the foreclosures are pushed through the system.''

The End of the Current Model of Financial Capitalism?

A comment in today's Financial Times, "The fall of a financial model," by Jean-Louis Beffa, chairman of Saint Gobain and Xavier Ragot of the Paris School of Economics argues that the approach to financial capitalism in operation for the last decade is coming to an end. They define the model as giving a primary to profit as the measure of corporate efficiency and having minimal government regulation of the financial sector (for the most part, it is self-regulated).

The piece does not pose a crisp solution to the stresses it cites and argues that governments are likely to experiment with new approaches which may not be compatible with each other.

From the Financial Times:

Recent changes in the world economy and financial markets mark the end of the present standard model of financial capitalism, built up over the last decade or so. In this model, financial stability is mainly based on the self-regulation of the financial sector, which alone assesses the risks produced by its financial innovations.

Moreover, the link between finance and the real economy hinges on an adequate return on investment for shareholders, who punish poor management by making share prices fall, leaving the company open to takeover. The only role assigned to governments is to guarantee free circulation of capital between companies and between countries. As alternative economic models collapsed over the past two decades, public opinion came to accept this model of financial capitalism. Today, governments and labour unions accept profit as the most relevant criterion for assessing a company’s efficiency. This model is experiencing three crises, all of which refer to changes in the relationship between governments and markets.

The first concerns the significant, yet silent, return of governments to the economic playing field. Three of the five richest nations by total gross domestic product have become de facto neo-mercantilist, setting their sights on trade surpluses. China is keeping its currency artificially low in order to increase its trade surplus and lower its costs of production vis-a-vis competitor countries. Japan is pursuing government-oriented policies to bolster its position in high-technology markets. Finally, and to a lesser degree, Germany has been carrying out reforms to restore industrial competitiveness. In addition, countries that have access to natural resources, notably oil and gas, have revenues that serve as both an instrument and aim of their international policy. Trade surpluses have resulted, demonstrating the capacity of governments to acquire massive amounts of foreign assets through sovereign wealth funds. The problems that arise are not economic, but political. Governments may use technology transfer or control of strategic national assets as a means to increase bargaining power in international affairs.

The second change involves company ownership. Three transformations should be noted. The first relates to the emergence of active shareholders, who build up significant stakes with the aim of exerting strong influence on management. The second relates to activist shareholders and their demand for short-term returns, resulting in decisions that are not in the company’s long-term interests. The third involves leveraged buy-outs, closely linking the interests of managers and shareholders and taking advantage of easy credit.

These shifts in the distribution of power raise questions: what is the relationship between shareholder meetings and boards? To what extent should companies be allowed to protect themselves from hostile bids or creeping takeovers? In what form and how frequently should accounting information be provided to shareholders?

Company ownership has not yet found a new balance, as shown in Europe by the absence of agreement on the takeover directive and on one share/one vote rather than multiple voting rights. Regulators’ desire to increase supervision of creeping takeovers is telling. The trends are risky: a shareholder can pursue speculative or self-interested aims to the detriment of other shareholders and against the company’s best interest by breaking up the business or by avoiding taking risk.

The third crisis is the one rocking financial markets. Unlike the internet bubble, this is not a crisis based on irrational behaviour but one of sophistication and disintermediation. The new risks produced by financial innovation were left to a sector that alone was considered able to understand its instruments. The crisis demonstrates the costs to the real economy and lack of an efficient self-regulating system.

All these risks call for a new relationship between the workings of financial markets and regulatory actions of governments. Democratic governments will have to deal for a long time with less democratic economies that use financial market mechanisms for political ends. Each sovereign investor must clarify its intentions and define its code of conduct. Governments must also define with greater precision the sectors they consider strategic.

The changes in company ownership also call for greater transparency in order to prevent actions that offend business ethics, such as creeping takeovers and speculative strategies that undermine companies’ long-term interests. The board’s role of defining solutions that satisfy shareholders’ divergent interests will have to be strengthened. It should allow for corporate governance that encourages long-term strategies while satisfying shareholder interests. Finally, regulators should supervise the whole of financial markets to assess systemic risk, eliminate off-balance-sheet ambiguities and bring within the scope of supervision actors that have eluded market authorities.

How governments deal with these crises will depend on their national interests. These issues will be difficult to deal with in Europe where country responses will diverge. One can expect to see the co-existence of various models, varying by level of government intervention in financial markets. There is a great distance, however, between co-existence and compatibility.

"When Bankers Fear to Act"

Floyd Norris in the New York Times has an interesting article that laments the fact that, unlike past financial crises, no one has stepped forward to encourage the sort of risk-taking needed to restore order to the markets.

Even though I enjoyed the piece, ultimately, the effort to look for a single agent to rally the industry misses the peculiar and deeply-rooted nature of our current mess. After all, Hank Paulson has repeatedly waded in to try to find solutions to pressing problems with very little success. Admittedly, the Treasury is a comparatively disadvantaged position, but nevertheless Paulson have endeavored to play the very role that Norris calls for.

So what is different now? The is one element Norris alludes to but does not tease out sufficiently: the financial markets have grown so large and complicated that the number of financial firms involved and the number of big problems they face are too large to be tackled. Just look at the monoline mess. You have several insurers, each with its own set of financial players that will be hurt in the case of a loss. Moreover, you have a large free rider problem. It's impractical to involve all the exposed parties in a bailout effort; the number is easily in the thousands. But limiting the salvage operation to the ones who will be hurt the most means that they are aiding the rest too.

Now in the past examples that Norris cites, bankers stepped forward even though they no doubt faced similar free rider issues. He makes the mistake of attributing action back then to leadership. I would argue the failure of firms to step forward now is due to a shift in values.

The generational change in orientation towards markets and self-interest as primary guides for behavior has has a very destructive effect on action in support of the collective good. It's difficult to imagine many children from upper middle class families today doing what young people did in the 1960s, demonstrating against the war (and risking going to jail), going to the South to register blacks to vote (risking their lives). Too many of the people I know who give time and money to charities are motivated to a significant degree by the networking opportunities.

In the old days, most people in the markets felt they had duties, and those might entail taking losses for the sake of the industry and one's reputation. As we have discovered, individuals and firms are now willing to chuck reputation if the costs get too high and duty is a four letter word. It's for fogies and fools.

But there is a bigger problem than the shift in values. Due to the complexity of the markets and the instruments and the number of flashpoints, there is insufficient capacity to analyze the problem and negotiate solutions.

We commented upon this last year with a vastly simpler crisis scenario (this is a small section of a considerably longer discussion):

So what could happen now? Let's say we have another day like Feb 27, but Bernanke isn't able to reassure markets. We see further ratcheting down and panic spreading to other markets.

....the lack of an LTCM in a that kind of meltdown is vastly worse. You can't get people into a room, knock heads together, and force a solution. The problem is too big and spread out for that to work....

Now imagine that it isn't a single institution, but even a handful of medium sized ones that add up to the market presence of a big one. Or a large institution plus a few middling ones. You get the picture. The diversification of the current system in most cases will reduce the risk of systemic failure. But with derivatives, with the right (meaning wrong) conditions, like another 1998, I am not at all confident that we are better off now.

In the scenario above, we argued that the simultaneous failure of multiple large-ish hedge funds would be too managerially demanding for Wall Street to manage. There wouldn't be enough top executive and legal bandwidth to handle multiple crisis negotiations in parallel.

Now consider: what we were worried about was a mere hedge fund rescue. That is actually not a hugely complicated operation (the big issue is the fighting among the creditors and the need to reach agreement pretty quickly, because these firms can go down fast). That is far less complicated than figuring out what to do with problems that involve not just the financial dealers, but end investors and (ultimately) flawed structures and bad incentives.

In parallel, we have a subprime/housing crisis (which one might call a securitization crisis) which has led to wide-scale problems in affiliated markets, such as SIVs, asset backed commercial paper, and potentially the credit default swaps market if the monoline problems are not resolved. And if the securitization machine remains broken (likely) banks will be forced to carry more loans on their balance sheets, which will lead to a systemic reduction in leverage on an ongoing basis. We also have an auction rate securities crisis. Leveraged loans and commercial real estate aren't quite at the crisis level, but they will lead to further balance sheet damage.

There are too many problems on too many fronts for the regulators or the industry to analyze and come up with solutions. Each is fiendishly complex. So instead we are getting patchwork, symptom-oriented approaches.

And the worst is even if the industry knew what to do, there isn't enough capital in the large institutions to execute a rescue, even in one crisis area. They've been forced to go begging to the sovereign wealth funds, who are already signaling that they are not keen to extend themselves any further. And they are far from done with taking writedowns.

So that's a very long winded way of saying Norris' piece misses the depth and complexity of our current situation.

From the New York Times:

Where is the next J. P. Morgan?

In times of market crisis, the safest course for any one market participant may be the riskiest course for the entire market. If everyone wants to sell, prices can go in only one direction.

In past financial crises, it has fallen to someone — regulators, investment banks or even a single banker — to organize collective action and avert disaster.

Such moves involved persuading people to take steps that seemed to go against their own private interests. Buy stocks when everyone wants to sell? Lend money to a bank in danger of failing, when your own bank might need the money tomorrow? Join with others to buy securities from a desperate seller, rather than try to maximize your own profits from his precarious position? It goes against the basic principle of markets, that your job is to look out for yourself.

But all those things have happened in the past. Unfortunately, nothing like them is happening in the current crisis.

In 1907, Morgan demanded that presidents of New York trust companies — then a type of second-class bank — act together to save one of their own, the Trust Company of America, from a bank run.

The presidents, wrote Robert F. Bruner and Sean D. Carr in their book, “The Panic of 1907,” were “convinced that it was their primary responsibility to conserve their assets in order to survive the financial storm that was swirling around them.” Morgan said that would simply assure that all would fail, one by one.

Morgan, then the dominant figure in American finance, called the presidents to a Saturday meeting in his library — and locked the door. Not until dawn Sunday did he let them out, after they had committed the needed cash.

In 1987, on Tuesday, Oct. 20, it appeared that the crash of the previous day was going to get worse. Market makers had little capital and less appetite to risk it, and one by one trading in the shares of major companies was halted because there were no buyers. In Chicago, the futures market was talking about halting trading in stock index futures because there were not enough stocks trading to know what the futures were worth.

That changed when two major brokerage firms — Goldman Sachs and Salomon Brothers — sent word to the New York Stock Exchange floor that they would buy any stock in the Standard & Poor’s 500 if their orders were needed to keep the shares trading. Just after that word was sent, the market turned around.

In 1998, when a possible hedge fund failure seemed to threaten the financial system, it was the Federal Reserve Bank of New York that called in all the major financial institutions and organized a bailout.

But efforts to organize concerted action this time have been limited. Treasury Secretary Henry M. Paulson Jr. has sought to get agreements in two areas — renegotiating mortgages and putting together a fund to deal with one of the early manifestations of the problem, the threatened collapse of odd financial instruments called structured investment vehicles — but there has been no visible effort to deal with the underlying problem.

In part, that may reflect the slow realization of what is at stake. For many months, we called it the subprime mortgage crisis, because that was where the problem first became apparent. But that label is far too narrow, and serves to obscure what is at stake.

“Rather ominously, borrowing costs for even the most creditworthy of firms have started to rise,” said Paul Ashworth, an economist with Capital Economics in London. Homeowners who can still get mortgages have seen rates rise in recent weeks, and banks say they are tightening their standards for both credit cards and commercial real estate loans.

“The principal cause for concern today is the paralysis of the credit markets,” Martin Feldstein, a Harvard economist and an adviser to President Ronald Reagan, wrote in The Wall Street Journal this week. “The collapse of confidence in credit markets is now preventing that necessary extension of credit. The decline of credit creation includes not only the banks but also the bond markets, hedge funds, insurance companies and mutual funds. Securitization, leveraged buyouts and credit insurance have also atrophied.”

The latest area of crisis is one that Morgan would have recognized in 1907. The major Wall Street houses — from Morgan Stanley and Goldman Sachs to Citigroup and Merrill Lynch — have refused to commit capital to the auction-rate market, a market that was supposed to allow investors to sell each week, via an auction that set interest rates.

Now many auctions are failing. That has left customers unable to sell securities that were supposed to have virtually guaranteed liquidity, and it has left the issuers — who paid fees to the banks to conduct the auctions — paying ridiculously high interest rates. It’s not easy to get both borrowers and lenders feeling angry and abandoned, but Wall Street has managed the feat.

When the crisis storms gathered in late 2007, much of the problem was with complicated securities — collateralized debt obligations, for example — that were extremely difficult to analyze. The failure of buyers to step up may have been rational. But that is not true with some of the auction-rate securities. They represent loans to borrowers that by any standard should be deemed good credits.

But the big banks were unable or unwilling to either buy the securities or find customers to buy them. That lack of action has damaged the reputation of each of the houses, in ways that would have been unthinkable a few months ago. But the bosses are scared. They no longer are sure just how adequate their capital is, and they are afraid to commit it while the financial crisis swirls around them. Some got their jobs because their predecessors were too willing to take risks.

It is not clear what the Fed or the Treasury could, or should, do now. The players can no longer be gathered into a single room, and they are regulated in different countries around the world, if they are regulated at all. Things are far more difficult because many of these markets are unregulated, making it difficult to gauge who is at risk and for how much.

But it is hard to see this ending until something is done to, in Mr. Feldstein’s words, assure “that necessary extension of credit.” Lowering interest rates will not, by itself, do that so long as the banks and investors are too scared to lend money at any rate.

In their book on the Panic of 1907, published last year before the crisis began, Mr. Bruner and Mr. Carr hailed Morgan’s actions, as well as the Fed’s 1998 move to salvage the hedge fund. But they warned, presciently as it turned out, that the current environment might hamper similar efforts in a new crisis.

“In a globally complex financial system, will such collective action be possible if the crisis is triggered beyond the reach of any of today’s regulators?” they asked.

So far, it appears the answer is no.

The Treasury Doth Speak With Forked Tongue (Housing Bailout Edition)

Man, not only does the Administration tell whoppers, but it is completely shameless about them. The latest sighting comes from Reuters:

Treasury Undersecretary Robert Steel told the Reuters Housing Summit it is proper for homeownership to hold a special status....

"If I default on my credit card debt, no one here knows and it has no affect on your credit card debt. If I am your next-door neighbor and I get foreclosed and thrown out, and the grass goes to heck and the home is boarded up ... that affects you," he said at the Reuters Summit in New York and Washington.

With that in mind, Steel said, the Treasury Department is working to develop programs that aid borrowers who are facing foreclosure, but a government bailout of the housing sector is not now needed.

Let's deal with the minor misrepresentation before dealing with the larger one. Do the people in the Treasury live in the real world? Rising defaults on credit cards ARE affecting other credit card borrowers. The issuers are cutting back on credit lines and raising their interest charges and fees even higher. The effect of abandoned houses on a neighborhood is obvious, but Steel is disingenuous to pretend that rising credit card defaults don't impose costs on other borrowers. The industry is pulling out all stops to both contain risks and increase revenues.

And while losing your access to credit cards isn't as awful or visible as losing your home, it isn't as invisible as Steel suggests. I certainly notice when people pay only in cash. I figure they either have credit issues or are trying not to leave a paper trail (in New York, one reason might be that they are claiming residence in a lower-tax state).

Now to the bigger issue. A Treasury representative has the gall to get up and say the Treasury doesn't do bailouts when the idea floated by the Office of Thrift Supervision has all the earmarks of being one. As reported in the New York Times (which repeated the canard that the Administration "oppose[s] any taxpayer bailout"):

A more modest plan is being developed by John M. Reich, director of the Office of Thrift Supervision, the agency that regulates savings and loan companies. His plan, still in rough form, would create a voluntary system under which mortgage lenders would reduce debt and monthly payments to reflect the diminished sales value of a home.

It would take the remainder of the mortgage as a “negative amortization certificate,” a lien that the investor could recoup if the house were later sold for its original mortgage value or higher.

In an interview, Mr. Reich said he hoped that most of the old mortgages would be replaced by cheaper mortgages insured through the F.H.A.

Let's parse this. The plan is to take mortgages now in the hands of private investors (remember a lot of this paper is in securitized vehicles; there will need to be a substitution of assets; that alone is problematic, but let's assume the Fed will sprinkle fairy dust so this can happen) and substitute is with a new fixed rate mortgage probably from the FHA plus a "negative amortization certificate". (Note that the Washington Post story on this plan was more definitive, that the FHA would provide the mortgage).

Intuitively, I don't see how this will fly if the FHA doesn't also guarantee the certificate too, and that was Tanta's first reaction (I'm sure well see her usual robust analysis soon enough):

Apparently, only the FHA mortgage would be a lien against the property, with the certificate being an obligation of FHA? It certainly surprises me that the OTS feels confident it can work out the legal kinks with that quickly enough to make a difference.

Now I may be making the mistake of assuming this plan is earnest. It may be a deeply cynical effort to muddy the waters, with the real intent of simply stymieing the proposal to allow judges to modify mortgages in bankruptcy (as we discussed in an earlier post, the idea isn't as heinous as its critics make it sound). Given the difficulties with asset substitution in securitized deals, this could take a long time to see the light of day (if ever), which may be the whole point.

But if the powers that be seriously intend to move ahead with it, the presentation treats the public as too dumb to understand that the government is indeed stepping in and assuming considerable financial risk, which will lead to hard costs. The "this is not a bailout" really means "we don't don't have to ask Congress to authorize a disbursement." The idea that increasing FHA mortgages to weak borrowers isn't a liability that will result in losses down the road is absurd. The FHA didn't qualify these borrowers initially (remember, the reason the FHA lost share to subprime is that they have good procedures as far as borrower screening is concerned). For this program to have any impact, the FHA almost certainly will have to relax its lending criteria considerably. And even if a fixed rate obligation reduces the homeowner's payment stress, the presence of the negative equity certificate will lower his incentive to keep the home. The market will have to appreciate considerably for him to show any gain.

There are good odds that homeowners may go through the hassle of getting the new financing and conclude in a year or two if their housing market doesn't improve, that they are better off giving up on the house (remember, research is now concluding that falling housing prices play a far bigger role in defaults than previously recognized).

So we'll see a transfer of losses. Instead of investors taking foreclosure-related losses now, we'll see the FHA taking foreclosure-related losses later. But that isn't a bailout because the Bush Administration is sticking its successors with it.

As Joseph Goebbels said,

The most brilliant propagandist technique will yield no success unless one fundamental principle is borne in mind constantly - it must confine itself to a few points and repeat them over and over.

So expect to see every homeowner rescue program assigned the preferred tag line "private sector solution" no matter how much in the end winds up coming from the public purse.

The Fed's Self-Delusion (Inflation Edition)

Individuals and institutions are capable of considerable self-deception when faced with difficult choices. The Fed's latest signals about what it intends to do about inflation are a classic example.

Both Bloomberg and the Financial Times tell us that the central bank stands ready to raise rates quickly to ward off inflation. From Bloomberg:

Federal Reserve officials signaled they are prepared to quickly reverse last month's interest-rate cuts after concluding that borrowing costs need to be kept low for now.

Policy makers cut their 2008 growth forecasts and said that rates should be held down ``for a time,'' minutes of their Jan. 29-30 meeting showed yesterday. They also called inflation ``disappointing,'' and some foresaw raising rates, possibly at a ``rapid'' pace once the economy recovers.

This little scenario is very convenient and very unlikely to happen. First, we are already seeing signs of inflation in the real economy, as anyone who goes to a grocery store will attest. I don't know about other readers, but I find myself starting to exhibit classic inflation behavior, stocking up on goods that are rising rapidly in price (if I could hoard milk, I would).

Second, conventional market-based measures of inflation expectations may be distorted by the flight to quality induced by the credit market crisis (why the Fed looks only at fixed income markets and not commodity prices is beyond me). Many experts place great stock in the fact that the spread between ten-year TIPS and ten-year Treasuries has hardly budged in the last two year.

But again, I wonder. TIPS aren't a great inflation hedge; their yields are adjusted based on CPI, and as we all know, CPI by design is lower than broader measures of inflation. I wonder if they are becoming a dumb money product, and savvier investors worried about inflation are using other investments to hedge inflation exposures. Remember, ten years ago, only the bravest (as well as the most naive) retail investors would trade commodity futures. Now any retail player can get commodity exposures easily through a variety of ETFs and ETNs.

And most traditional benchmarks are show higher expectation of price increases. Indeed, the Cleveland Fed takes issue with the simple reading of TIPS spreads. From the Financial Times:

Crude comparisons of the difference in yield between ordinary Treasury bonds and Treasury inflation-protected securities show little change.

But these measures do not take into account the jump in the liquidity risk premium since the start of the credit crisis, which increased the attractiveness of more liquid ordinary bonds.

Adjusting for this, the Cleveland Fed calculates that the inflation rate the market expects to prevail over the next 10 years has risen sharply, from 2.3 per cent at the end of July last year to 3.2 per cent today.

Using a different approach, Macroeconomic Advisers estimates that the inflation rate expected to prevail over a five-year period starting five years from now has gone up from roughly 2.5 per cent last spring to 2.96 per cent today.

Some survey-based measures of inflation expectations have also edged up, although they remain much more stable than market-based measures.

Jim Hamilton at Econbrowser has a longer-form discussion of the inflation data and Fed statements.

But the Fed tells itself not to worry:

The Fed minutes argue that the market-based measures may exaggerate the move-up in expected inflation. Changes in recent months “probably reflected at least in part increased uncertainty – inflation risk – rather than greater inflation expectations”.

One has to wonder if this is rationalization, since the Fed is unwilling to contemplate a rate increase now, or even a halt in cuts, given the shakiness of the financial system.

We've had stagflation before. We are now experiencing asset price deflation and commodity price inflation, and the powers that be are fighting the deflation. For a time, manufacturers may suffer some margin compression to avoid increasing consumer prices too much, but higher commodity prices in the end will lead to consumer prices (unless we have a severe recession that leads energy and metals prices to fall. But that won't give much relief to agricultural prices). Indeed, some analysts argues that the increase in retail sales in January was strictly inflation-induced.

Moreover, even if the Fed is right and inflation isn't rising all that quickly (yet), I doubt its ability to change its policy on a dime. It was slow to recognize the depth of the subprime/credit mess, and has tried to play catch up with rapid and fairly large rate reductions. It now seems complacent about inflation, when inflation expectations are slow to build but difficult to reverse. And the Fed is very afraid of crossing Wall Street, and interest rate increases lead to lower securities prices, at least when they translate into higher prevailing interest rates. Note that the 17 rate increases the Fed implemented prior to the real estate reversal had just about no impact on the price and availability of credit. Now that lenders and investors are more cautious and the securitization machine is down for repairs, Fed rate increases might have more impact than they did the last go-round.

Links 2/23/08

Promises, Promises from Microsoft. Again Groklaw

Wall Street Bank Run David Ignatius, Washington Post. Frankly, this isn't a very good piece, but I include it because it suggests how far behind the public at large may be in understanding our financial woes.

What do the US, Saudi Arabia and China have in common? Brad Setser

British Columbia "the clear leader in North American climate policy" WorldChanging. BC implements a carbon tax.

FDA Clears Avastin for Breast Cancer Huffington Post. This gives a clearer explanation than the Wall Street Journal as to why this call represented a lowering of the FDA's standards.

A ‘Moral Hazard’ for a Housing Bailout: Sorting the Victims From Those Who Volunteered Edmund Andrews, New York Times. This is worrisome. The Bank of America "have the government buy our bad mortgages" plan is treated with some seriousness. They were dumb enough to buy Countrywide, they should live with the consequences.

Links 2/22/08

Identical Twins Not As Identical As Believed Science News

FBI Will Not Go After Borrowers Who Lied on Mortgage Applications homeguide123.com

Goldman Sachs likely to cut about 1,500 jobs MarketWatch. A leading indicator that the firm is going to take some earnings hits.

Boomers and the Medical System OldVet, Angry Bear

It's too late to protect your ARS Michael Shedlock

Economicindicators.gov to Stay Open The Big Picture. Hooray! Once in a while, calling your Congressman pays off.

The real cost of the Iraq war Justin Fox, Time

Desperate Measures: Treasury May Support Housing Via "Negative Equity Certificates"

Any doubts that we are going down the Japan path of trying to shore up inflated asset value rather than letting the market find the right level, should now be over. Bloomberg tells us that the Office of Thrift Supervision is looking into a plan that will enable homeowners to refinance houses that have negative equity.

Before we get into the fact that this might be very difficult to put into effect (as Tanta alludes), this move is all about propping up the portion of the housing market where the lenders/investors have the most to lose, and correspondingly, where it is most rational for the homeowner to walk away. Consider, as Credit Slips did, that the Hope Now Alliance program was also targeted at borrowers who had very low (less than 3%) to negative equity) and as Credit Slips discussed, 75% of the interventions resulted repayment plans. These do not change the terms of the mortgage.

A different post at Credit Slips discussed the concept of "hostage value" in these loans:

A side note for the Not-Commercial-Law-Jocks: "Hostage value" in secured lending refers to the ability of a secured lender to extract a payment in excess of the value of the collateral from a borrower by threatening to repossess the collateral. The classic example was the old practice of taking a security interest in all of a family's household goods, which might add up to a resale value of $2000, then demanding that every penny (plus interest) of a $10,000 loan be repaid before the security interest would be released. This version of the practice involving household goods is now banned by the FTC. In bankruptcy law, undersecured claims would be bifurcated into its secured ($2000) and unsecured ($8000) portions.

Rescue programs [operated by the states] limit their payouts to 100% of the value of the property, which makes sense b