China Tries to Goose Flagging Stock Market

I am late to this story, which ran Thursday in the Financial Times, but is sufficiently important as to merit comment (and my quick search of the usual suspect blogs showed it went unreported there too). The Chinese temporarily suspended tax collection on mutual funds to bolster share prices.

China's stock market, which has been white hot until recently, now posed a major problem for the authorities, Until recently, they had wanted to cool off its meteoric trajectory, but now having gotten what they wanted (the market is off 40%, bringing it merely to the level of last October), they are concerned about further deterioration.

The reason this is of such concern is that Chinese banks pay less than 1% interest to retail customers when inflation is over 7%. That pretty much guarantees that cash will seek out better havens, and the stock market has proven to be a popular destination. Thus, too much of a fall would wipe out savings (as opposed to mere paper gains) and has the potential to create social dislocation.

So much for the idea that China is ready for a market economy.

From the Financial Times:

Beijing has temporarily suspended the collection of corporate taxes from Chinese mutual funds in an attempt to boost the country's slumping stock prices.

China's finance ministry and State Administration of Taxation announced the exemption in a brief statement carried by state media last night but did not say how long the measure would last.

The exemption applies to all income from investment funds from securities markets - including stock and bond trading, and interest or dividends from stock or bond investments - according to state news agency Xinhua.

The exemption also applies to investors who receive income from such funds, the notice said.

The move is aimed at shoring up a market that has dropped almost 40 per cent since the historic peak it reached in October and contrasts with the situation a year ago, when officials were casting around for a way to slow a raging bull market.

The government raised the stamp duty on all stock trading in May in an attempt to damp its meteoric rise.

The market fell more than 15 per cent in the days following the announcement but soon rebounded and ended the year up nearly 100 per cent.

Mutual funds make up the most significant group of institutional investors in China, with more than 350 funds controlling more than $450bn in assets.....

The corporate tax rate in China can be as high as 33 per cent although there are exemptions and the government has recently lowered the rate for most domestic companies.

Overlevered Brits Facing Their Day of Reckoning

If you read between the lines of the Financial Times story that served as a point of departure for a post earlier this evening ("Desperate Central Bankers to Bail Out MBS Market?") it was clear that the Bank of England was the most keen to shore up the wobbly mortgage securities market.

This New York Times article, "Debt-Gorged British Start to Worry That the Party Is Ending," explains why. The British are on the same downward path we are on, with perhaps a one-year delay, and an even higher level of gearing.

From the New York Times:

At one point, Alexis Hall had more than 50 pairs of designer shoes and handbags. It never occurred to the 39-year-old media relations executive from Glasgow that her £31,500 in debt ($63,000) would be a problem.

“It was so easy to get the loans and the credit that you almost think the goods are a gift from the shop,” she said....

As the United States economy weakens, many Americans are being overwhelmed by personal debt, but Britons are even more profligate. For most of the last decade, consumers here went on a debt-financed spending spree that made them the most indebted rich nation in the world, racking up a record £1.4 trillion in debt ($2.8 trillion) — more than the country’s gross domestic product.

By comparison, personal debt in the United States is $13.8 trillion, including mortgage debt, slightly less than the country’s $14 trillion G.D.P.

And while the Federal Reserve in Washington has cut interest rates, in an effort to loosen lenders’ grip on credit, the Bank of England’s interest rate increases last year are trickling through to mortgages at the very time home values are dropping and banks are becoming more reluctant to lend.

Until now, debt has mostly been a good thing for Britain. In the hands of free-spending consumers, it fueled economic growth. The government borrowed heavily in recent years to invest in infrastructure, health and education, creating a virtuous cycle: government spending led to job creation, which led to greater consumer confidence and more spending, which, in turn, stimulated growth.

Economists say Britain’s relationship to debt is complex, but at its core is a phenomenon more akin to recent American history than European trends. As in the United States, a decade-long housing boom and strong economic growth bolstered consumer confidence, creating a perception of wealth almost unknown in countries like Germany and Italy.

“Culturally, maybe also because of the defeat in the war, Germans remain reluctant to borrow and banks are often state-owned, pushing less for profits from lending,” said Alistair Milne, a professor at Cass Business School in London.

Since many younger Britons have never lived through a period of slow growth, few now see the need to hold back on borrowing, not to mention saving....

To her parent’s generation, Ms. Hall said, owing money beyond a mortgage was “shameful,” an admission of living beyond one’s means. Debt was also more difficult to get.

That changed in the late 1990s when American lenders, including Citigroup and CapitalOne, pushed into the British market with a panoply of new lending products. Fierce competition among banks meant potential borrowers were suddenly bombarded with advertising and offers for low- or no-interest loans and credit cards.

While Britain’s financial regulators watched the explosion of retail lending from the sidelines, their counterparts in Germany and France were more restrictive. As a result, the British market became the largest and most sophisticated in Europe.

The growth was also fueled by soaring demand for debt on the back of rising real estate prices and relatively low interest rates in the late 1990s and early 2000s. Those who did not own a house rushed to join the homeowners watching their property triple in value.

The trend on the Continent was the opposite. Home prices in most European countries barely moved, mainly because markets were more regulated, there was more housing stock and renting was more popular...

As the perception of wealth grew, the social stigma around debt disappeared. Borrowing became such an accepted part of life that today one in five teenagers does not consider being in debt to be a bad thing, a survey by Nationwide Building Society showed.

Debt levels increased further as it became easier to get loans, and retailers, like computer chain PC World, offered both goods and the loans to buy them. Consumers happily accepted, thinking that as long as they were deemed creditworthy, they were not in danger of defaulting....

The ease of the bankruptcy process, the availability of debt, the property boom and strong economic growth, lulled consumers into a “false sense of security that is now coming to haunt us,” said James Falla, a debt adviser at London-based Thomas Charles....

And things are changing. Growth has already started to slow this year, and the government lowered its 2008 forecast to 1.75 percent to 2.25 percent, after 3.1 percent growth last year.

Home prices are falling.... Last year, housing foreclosures reached the highest level since 1999 and are expected to rise still further this year.

And more than one million homeowners have adjustable-rate mortgages that are expected to reset in the next 12 months — to significantly higher rates...

According to a survey for the Office of National Statistics, less than half the population saves regularly, and more than 39 percent said they would rather enjoy a good standard of living today than save for retirement. Ms. Hall said she was among that 39 percent. She recently took out new loans, planning to repay her existing debt. But she ended up spending the money on more luxury goods instead.

This year, she published a book about her experiences. She said she did not expect the book’s proceeds to repay her debts, but it may help the growing number of people in similar positions cope with theirs.

Links 3/22/08

Leaping stingray kills US woman BBC

Steve Forbes on Ending the Panic Cactus, Angry Bear

The Bear Meltdown Rattles B-Students Business Week. I am no doubt going to anger a lot of fellow MBAs, but in my view, fewer people getting that degree would be a plus. I was in a position to get far more out of it than most (liberal arts major, no work experience) and I felt what I was taught in two years could have been boiled down to six months. They are mainly finishing schools and employment agencies. And they often have the effect of encouraging kids to go into whatever is hot at the time (the top recruiters at B-schools are almost inevitably industries due for a correction) whether or not it really is a fit with their talents and temperament.

Continuation Point Michael Panzner

Another 75 James Hamilton, Econbrowser. I had wanted to feature this post, but it somehow got overlooked. Worth reading still, in part because it is as close as the even-tempered Hamilton ever gets to a rant.

Fannie, Freddie Face “Severe” Capital Pressures, Say Analysts Housing Wire

Antidote du jour. This video has made the rounds, but I though it still made for a good bunny feature for Easter:

Desperate Central Bankers to Bail Out MBS Market? (Not Yet, Perhaps....)

I quoted Lucy Kellaway, who once said (apropos management fads), "No idea is too ridiculous to be put into practice," and warned that the credit crisis would soon get that sort of treatment.

A story in the Financial Times indicated we are getting closer to that stage:

Central banks on both sides of the Atlantic are actively engaged in discussions about the feasibility of mass purchases of mortgage-backed securities as a possible solution to the credit crisis.

Such a move would involve the use of public funds to shore up the market in a key financial instrument and restore confidence by ending the current vicious circle of forced sales, falling prices and weakening balance sheets.

The Fed apparently called Greg Ip at the Wall Street Journal to quash this leak, um, rumor (hat tip Calculated Risk) but don't be surprised if it rears its ugly head in a few months.

Nevertheless, this is a curious and appallingly naive characterization of the problem. Yes, we are seeing credit contraction, and it isn't pretty. But the deleveraging isn't the result of a feedback loop operating in a vacuum; it's that a lot of mortgage borrowers cannot make their payments, and their number will increase over the next few years to to ARM resets. And because prices in most markets had risen to levels that were way out of line with incomes, there are simply not even remotely enough people who could afford to buy the houses undergoing defaults at the prices at which they had been financed.

There seems to be a collective fantasy at work, that somehow the powers that be can wave magic wands and turn bad assets into good ones. While you can do that on a small scale, we have a roughly $20 trillion residential housing market that is being repriced for good reason. We've gone on about this ad nauseum; a fresh statement of the underlying problem comes from Bill Fleckenstein in "Catering to the Balioiut Nation" (hat tip Nattering Naybob):

Where will all this stop? Can those who behaved prudently afford to bail out those who behaved imprudently? Why should they have to? And is that what we really want? After all, this country's median income of roughly $49,000 can hardly be expected to service the debt of the median home price of $234,000, up from approximately $160,000 in 2000.

Let's do a little math. Forty-nine thousand dollars in yearly income leaves approximately $35,000 in after-tax dollars. Call it $3,000 a month. A 30-year, fixed-rate mortgage would cost approximately $1,500 per month. That leaves only $1,500 a month for a family to pay for everything else! (Of course, in many communities the math is even less tenable.) This is the crux of the problem, and the government cannot fix it.

Housing prices, thanks to the bubble and inflation, have risen well past the point where the median (or typical middle-class) family can afford them. Either income must rise -- which seems unlikely on an inflated-adjusted basis -- or home prices must come down.

And if that didn't convince you, have a look at this (click to enlarge):


Even coordinated government action cannot prop up asset prices when the underlying cash flow isn't there. Japan tried that, and they had the advantage of having very high domestic savings. The Home Owners Loan Corporation of the Great Depression's results are not comparable to our current situation. First, it was not implemented till 1933, so the weakest borrowers had already lost their homes. Second, mortgages were structured differently then than now: much shorter terms (15 year was the usual limit) and vastly loan to value ratios (50% was the max, and of course, paydowns would reduce that amount). HOLC refinanced these into 30 year mortgages. Thus even with large housing price declines, the HOLC in the vast majority of cases was issuing loans against homes that still had equity.

Conversely, the damage of letting housing fall to a market clearing level appears to be overstated, and the lack of empirical investigation into the results of housing busts in other advanced economies is a major lapse. This comes from a post last August:

Let's look at what has happened in other countries that had large declines in real estate prices.

The housing recession of the early 1990s was far worse overseas.....

In the late 1980s and early 1990s, the United Kingdom, Finland, Norway, and Sweden experienced peak to trough falls in prices of greater than 25 per cent. Sharper falls have been observed in some South and East Asian economies over the 1990s, particularly in Hong Kong and Japan.

....yet despite Gross invoking the specter of the Depression, these economies suffered only short, nasty recessions. UK GDP fell 2.5% in 1991 and 0.5% in 1992.. According to NATO, Finland had a steeper fall because its contraction was caused by economic overheating, depressed foreign markets, and the dismantling of the barter system between Finland and the former Soviet Union under which Soviet oil and gas had been exchanged for Finnish manufactured goods. Thus its fall in housing prices was more a consequence than a cause of its recession. Sweden similarly suffered from disruption of its trade relationship with the former USSR. Hong Kong has enjoyed high growth and volatile real estate prices, but the only year it had negative GDP growth was 1998, the year after its reunification with the mainland, when it suffered a major capital flight.

So while these economies all have different structures than the US, their experience nevertheless suggests that even severe housing recessions do not inflict long-term damage. I'd very much like to hear the views of those who have studied the international record more deeply, but this quick survey suggests the price of a housing recession is a sharp but short-lived real economy contraction.

Another problem with the "let's just go buy the mortgages" line of thinking is a propensity to rely on models rather than empiricism. With all due respect to Paul Krugman, who came to the right conclusion in his post, his analysis seems to have encouraged some other economists (witness this post from Brad De Long, whose analysis is mainly sound) who are trying to restore the bubble equilibrium (point H on Krugman's chart):

But in the current situation, a lot of securities are held by market players who have leveraged themselves up. When prices fall beyond a certain point, they get calls from Mr. Margin, and have to sell off some of their holdings to meet those calls. The result can be a stretch of the demand curve that’s sloped the “wrong way”: falling prices actually reduce demand. So the market could look like this:

Krugman has the right insight: H exists only by virtue of leverage. He continued:

Implicitly, Fed policy seems to be based on the view that if only they can restore confidence — with extra liquidity to the banks, Fed fund rate cuts, whatever — they can get us out of L and back to H. That’s the LTCM model: Rubin and Greenspan met a crisis with a rate cut and a show of confidence, and the whole thing went away.

But at this point a series of rate cuts and other stuff just hasn’t done the trick — which suggests that maybe there isn’t a high-price equilibrium out there at all. Maybe the underlying losses in housing and elsewhere are sufficiently large that the situation really looks like this:


And in that case, the Fed can’t rescue the financial markets. All it — and the feds in general — can do is to try to limit the effects of financial crisis on the rest of the economy.

Let's consider another complicating factor: that just about every effort to ameliorate the credit crisis has merely produced problems elsewhere. The "let's just buy the mortgages" advocates forget that the sharp rise in Freddie and Fannie spreads that kicked off the latest round of deleveraging didn't come out of a clear sky, It was a negative market reaction to the increase in the mortgage ceilings on the GSEs in combination of making them the refinancer of crappy mortgages. That would be enough to spook any investor. In a post earlier this week, we went thougt a list of unintended consequences (a more accurate term would have been backfires) of the Fed's efforts to date. Reader Lune ventured what might happen next:

Now we have 3) Fed opens TSLF to broker-dealers. Given the track record of our esteemed Fed so far, I shudder to think what the unintended consequences of this one will be, and I'm disturbed that it's very likely that no one has thought about that while running around in a panic shooting from the hip at any shadow that comes up. Anyway, here's my speculation...

The Fed is already close to tapping its full balance sheet. The trigger for the collapse of the past few weeks has been the rise of agency spreads, which is the cause not the effect of all the implosions we've seen so far. So to stop the panic, the Fed would have to intervene in the agency market. But it's remaining reserves of ~$400bil is tiny compared to the amount of debt out there. Furthermore, even a full faith govt. guarantee is unlikely to stop the rise in premiums (witness Ginnie Mae debt, where spreads are increasing even with a govt. guarantee). This is partially because of panic, and partially because agency debt will have fundamentally different behavior when it includes all the extra debt Congress is talking about stuffing it with. So with that uncertainty and unpredictability, it's no wonder spreads are increasing.

As the spreads continue to claim more casualties, more firms will line up for funding (when do hedge funds get to drink directly from the punch bowl? At this rate, probably in a week or two), and the Fed, unable to say no, will have to start issuing treasuries to expand its balance sheet. Within a matter of a month or two, the Fed will find itself with a trillion or so dollars of impaired debt in a "repo" that can't ever be recalled (some because the counterparty's balance sheet is still too weak, others because the counterparty has gone BK). The ultimate casualty? The Fed itself, unable to lower interest rates below 0%, facing default on collateral on its hands, and counterparties (central banks) unwilling to trust the Fed to manage the dollar any longer.

Oh yeah, and mortgage markets will still be frozen.

We are unlikely to see a bottom to the housing market for quite a while (historical precedents suggest early 2011) and that solvency problems have to work there way through the system. If we must have rescue operations, I would much prefer something along the lines suggested by Robert Reich:

The next question is how to cushion the blow for middle and lower-income people who might lose their homes or their jobs, cars, medical insurance, and large chunks of their pensions. This may require federally-subsidized insurance -- mortgage insurance so homeowners can meet payments, along with expanded unemployment insurance, health insurance, maybe even pension insurance. All hard to accomplish, but ultimately more important than bailing out the big banks.

I will admit to not having thought this idea through, but the intent of policy should be to limit damage to individuals rather than intervene in asset market in ways that are destined to fail anyhow. After all, isn't all this hooplah to prevent a recession? And I thought recessions were bad because they increased unemployment (oh yes, and lower corporate profits too). Maybe it's time to recognize that a recession is unavoidable, and that the efforts to contain it are producing serious side effects that are at least as bad as the problem they are intended to solve. And that's just looking at the immediate impact; this becomes a net negative effort when the Fed's credibility is irreparably damaged (and we are just about there).

The one bit of good news: the FT article made clear that any rescue program was not going to come into being any time soon, and that was before the Fed's denial.

Why Didn't Bear Use its Credit Lines?

I am mystified at the efforts by soon-to-be-ex chairman of Bear Stearns and still-barely-a-billionaire Joe Lewis, who took a large stake in the securities firm, to try to find another buyer for Bear.

My pet theory is that Lewis et all are bluffing, knowing they have a very bad hand, to scare bondholders and CDS owners to buy up the shares and are selling into their bid.

But as strange as that is, a stunning revelation came from a very senior Japanese executive, who sent these notes from a meeting with a top Japanese financial official:

The depth of the problems at Bear Stearns which led up to the buyout are not clear. Mr. X wondered why they did not try to use committed credit lines before agreeing to the JPM Chase deal. These lines were significant and included large amounts committed by Japanese banks, who are now relieved that they did not have to extend the credit.

Maybe Bear assumed at the rate of its cash depletion that it would burn through those credit lines quickly and being more leveraged might make other solutions more difficult, but the tone of the Japanese notes is that the credit lines were large enough in aggregate to have made a difference.

And even odder: those credit lines are still in place (although the downgrades by the rating agencies on Friday might have changed the pricing or reduced the size of facilities). Why did the Fed stump up a whole $30 billion? This seems a tremendous oversight on its behalf. Yes, those lines no doubt terminate upon a change in control, but if Bear draws them down, they become an obligation of JPM when the deal closes.

The Fed probably could have leaned on the banks to keep them in force. After all, they would be lending against a better balance sheet with JPM, although adding the Bear lines to whatever credit facilities they now have with JPM might put them over their limits for exposure to any one bank. But the Fed could have offered to backstop the excess, which would be a smaller commitment than the one it made.

After all, the whole logic of the Fed going to the lengths was to save the rest of the banking and securities industry, not Bear per se. The fear was that a bankruptcy filing would have lead to colossal disruption, possibly failures of other firms, and writedowns at other firms due to forced sales of securities. The Fed thus had considerable leverage to persuade other firms to go along, particularly since they were already obligated to lend to Bear. Syndicating the risk, particularly when the parties were already exposed, would have been a logical move.

Stranger and stranger....

Links Good Friday

Partying Like Its 1929 Paul Krugman

AP president: US arrests journalist in Iraq to 'control' information Raw Story

Wall Street Taps Fed's New Loan Program Wall Street Journal

You Weren't Meant to Have a Boss Paul Graham. This essay looks at the workplace from an unexpected angle.

Alan Greenspan Loses His Mind Paul Kedrosky

Paul Krugman Wonders Whether He Is Dumb. I Say: "NO!!" Brad De Long. A very good answer to a question Krugman posed about the Fed's ability to achieve its target rate.

James Cayne risks lawsuit as he seeks counter-offer for Bear Stearns Times (hat tip Felix Salmon). Whatever these guys are smoking, I want some. It must be incredibly strong.

Antidote du jour. Some bunnies for Easter:

IMF: Commodity Prices "Part Speculative"

I'm late to this item, which appeared in the Financial Times on Thursday, but according to Google News, was not reported elsewhere, so I thought it was still worth featuring.

The IMF warned that commodities prices include a speculative element as investors are treating it as a new asset class and a safe haven in a time of declining dollar.

One could cynically argue that the IMF is talking its book, since the rapid rise in commodities prices in the last two months is destabilizing. However, the sharp, across the board basic materials price declines in the wake of the Fed delivering a mere 75 basis point cut lends creedence to the IMF's warning.

From the Financial Times:

The strength of commodities prices, such as crude oil, this year is explained in a large part by speculative factors such as investors piling into the new asset class and the weakness of the US dollar, the International Monetary Fund said on Thursday.

The warning came as commodities prices fell across the board, with oil prices dropping below the $100 a barrel level, gold prices tumbling 10 per cent from their recent record above $1,000 a troy ounce and sharp falls in base metals and grains.....

The IMF said that the constellation of dollar depreciation and falling short-term real interest rates “has pushed up commodity prices through a number of channels, including by enhancing the attractiveness of commodities as an alternative asset.”

“Overall, these financial factors seem to explain a large part of the increase in crude oil prices so far in 2008, as well as the rising prices of other commodities,” it said.

It added that as global economic growth is widely expected to decline this year and in 2009, “prices of most commodities should eventually start easing.” However, it added that “unless there is a substantial global downturn, however, the extent of easing may be small, given the current tight balances in some commodity markets.”

The IMF said that in all recent global downturns, commodity prices declined sharply, “suggesting a disconnect between commodity prices and the ongoing slowdown.”

However, it added that much of the apparent disconnect reflected the fact that developing countries, which have been responsible for the bulk of recent commodity demand growth, have so far been less affected by the slowing growth.

We have noted before that commodities prices are very much influenced by GDP growth in emerging markets. We expect they will slow down in the third or fourth quarter of this year, as the US slowdown take hold and starts to affect demand for imports.

Extreme Measures V and VI; Drop Mark-to-Market; Beg Oil Producers to Rescue Banks

A sign of the times: we haven't sighted an Extreme Measure since October, and here we have two in one day (note that day was Thursday; we started on this last night but there were so many news-driven items that we are getting to this only now).

By way of background, an Extreme Measure is a recommendation to take a radical and, upon examination, unworkable approach to a pressing problem. Not surprisingly, the Extreme Measures have attempted to address the US housing crisis or the credit contraction.

The first was from Bill Gross at Pimco, who suggested that the US government "rescue" the 2 millionish homeowners who stood to lose their homes. A second came from Gillian Tett, the capital markets editor at the Financial Times, who argued that investment bankers should decompose CDOs and other structured credits into their constituent parts. Third was an article by Cambiz Alikhani of Arundel Iveagh Investment Management in the Financial Times, "Banks should form a bail-out vehicle to ease the credit crisis." The last (till today's outcropping) came from Sheila Bair, chairman of the FDIC, who proposed that mortgage servicers freeze all adjustable rate mortgages facing resets at their current rates.

We got a little cautious after the Bair sighting, because, as ridiculous as it was, it was actually implemented in a sufficiently watered-down form as to be cosmetic via the New Hope Alliance program announced with much fanfare last December. And we must also note that while the particular proposal by Gross has not gotten any traction, the idea of somehow bailing out beleaguered homeowners is very much alive and well. That signaled that we may be entering a phase in which as Financial Times columnist Lucy Kellaway said regarding management fads, "No idea is too ridiculous not to be put into practice."

The normally sensible Paul De Grauwe called for a suspension of mark-to-market. This first part of his article argues that solvency and liquidity issues can't be easily picked apart:

This interconnection between liquidity and solvency problems is em bedded in the activities of banks and financial institutions that fund long-term investments with short-term loans. Withdrawals trigger solvency problems, which in turn become signals for further withdrawals, creating liquidity problem

While this statement is true, when most commentators argue that the current credit crisis is a solvency, not a liquidity crisis, they are not referring to financial institutions, but the underlying borrowers, in particular overstretched homeowners who cannot make their mortgage and consumer loan payments. Thus to shift the focus to solvency versus liquidity at an institutional level is because they hold bought assets that are now overpriced due to the deterioration in creditworthiness.

The failure to acknowledge the problem with the underlying holdings is where his argument runs afoul:

Today the accounting rule of marking to market is driving us at high speed into the abyss. A speed limit must be imposed. It can be achieved only by temporarily allowing financial institutions not to mark to market. This will make it possible to keep the assets on their books for a while at their previous values (or historic costs). If this is done, the spiral will be slowed down. Prices of many financial assets will recover because they are fundamentally sound. Their value is artificially pulled down by the liquidity-solvency spiral.

Slowing the spiral will prevent more innocent bystanders from being caught by the whirlwind. It will, of course, not solve all financial problems. Confidence in the financial system must be restored so that the market can start co-ordinating again towards a good equilibrium.

As nice as this sounds in theory (and De Grauwe isn't alone in advocating this idea), it won't provide the desired benefits. Yes, it will put brakes on troubling "financial accelerator" by which writedowns lead to balance sheet shrinkage which leads to further deleveraging (witness tougher margin requirements imposed on hedge funds, which leads them to deleverage, or sell assets, and some of the selling may depress prices of assets held on balance sheets elsewhere to lead to further margin calls and/or writedowns).

But there is no obvious way out of this box, for the cure is as bad as the disease. The first and second acute phases of the credit crunch (August-September and November-December) occurred because banks were hoarding liquidity and were reluctant to lend to each other. In crude terms that was because they perceived risks to be high (hhm, wonder why, probably the state of their own finances) and couldn't tell who was sound and who wasn't, therefore no one could be trusted very much.

Less transparency will only make that worry even worse. It might alleviate the pressure in certain sectors of the market where lending is collateralized (ie, among brokers and hedge funds) but will exacerbate the interbank worries. And it will send a bag signal to the greater world, that things are so bad that the rules have to be suspended. This will deter outside investors from recapitalizing troubled firms, since they won't trust their books.

We also have the recent and painful experience of Enron and other accounting fraud at corporations, something that simply never took place before on such a large scale basis (at least after the securities regulatory framework was established in 1933 and 1934). While mark to market is far from ideal, the alternatives are worse.

John Dizard suggested "regulatory forbearance" which is a fancy way of saying let firms operate with less capital than the regs normally allow. That's a simpler and more easily reversed finesse. And he also indicated that the powers that be are working on a more nuanced version of creating some slack in mark to market rules:

I have made enquiries in the relevant official circles about the state of thinking on the enforcement of mark-to-market rules. While the central banks are not inclined to suspend the rules, they are having meaningful discussions with the accountants about their application, if you get my drift. Basically, for straight corporate credits, including the merger and acquisition loans, mark-to-market of the tradeable securities will stay in place. However, for structured credits, such as CDOs, where valuations are being done on the basis of illiquid and arguably oversold indices, the accountants would be encouraged to find ways to value the securities that don't result in a cycle of mark-to-illiquid-market followed by liquidation, followed by more marks, and so on.

The other Extreme Measure comes from Anil Kashyap and Hyun Song Shin, "Ask the oil producers to rescue Wall Street." While the US will probably eventually be bailed out in whole or in part by foreign investors, the timing is seriously off. Too many high profile players were badly burned in last fall's round of equity infusions; prices will have to at least look like they have bottomed before anyone is likely to step forward again. China's Citic having barely avoided putting $1 billion in Bear Stearns no doubt has instilled much more caution. Remember, these players are governmental entities, so avoiding losses is far more important than maximizing gains.

In fairness, the article does provide a good analysis of why other routes to recapitalize banks don't look so hot. But its ideas regarding Middle Eastern investors can only be regarded as fuzzy-headed:

But since the January meeting of the Fed’s open market committee, when the central bank made it abundantly clear that it will try everything possible to stave off collapse, oil prices have risen from roughly $92 a barrel to $109 (as of March 18). Other commodity prices have also risen over this period. Given the deteriorating prospects for the global economy over this time, a plausible interpretation is that some of the financing that might have gone to the financial institutions has instead been directed towards buying commodities such as oil. This portfolio reallocation represents a pure windfall for the oil producers.

Middle Eastern oil countries produce roughly 25m barrels of oil a day. If they could be persuaded to recycle $4 a barrel of the $17 price run up since the January Federal open market committee meeting, this would represent $4bn of capital that could be deployed; Bear Stearns was sold for $250m. Admittedly, this is a conversation for Condoleezza Rice, secretary of state, and not Hank Paulson, Treasury secretary, to have.

$4 billion? What are they smoking? Banks have taken over $150 billion of writedowns so far, with more to come. $4 billion is a rounding error. And par for the course, the authors conveniently neglected the Fed's $30 billion first loss position in the Bear deal. That $4 billion is an order of magnitude too little.

Plus the idea that special pleadings by a lame duck administration will succeed is also quite a stretch. Bush and Cheney can't get the Saudis to pump more oil, so why should Condi be able to persuade them to write checks? I doubt any foreigners will stump up much cash until they see who the new occupant of the Oval Office will be and have a sense of his or her posture towards housing and the financial services industry.

Treasury Hoarding Leads to Dramatic Increase in Repo Fails

Today's Bloomberg provides yet another example of how the credit crisis is producing behavior well outside historical norms. We had noted, courtesy Alea, that fails in the repo market had reached "massive" levels.

The explanation? A lot of Treasuries are now held by investors who aren't willing to lend them (this is often due to simple lack of experience, plus retail buyers having failed to authorize the account to lend securities). I wonder if this has the potential to complicate the operation of the Fed's new facilities designed to unfreeze the mortgage market. The Fed may be running into constraints beyond the size of its balance sheet (note technically it can make its balance sheet larger, but those operations would be "unsterilized" or inflationary).

The scarcity of Treasuries for repos means that buying for repoing will also lead Treasury prices to rise and yields to plummet, which is one reason why three month bills traded at an 50 year low of 0.56% yesterday and a stunning 0.39% today, a rate last seen in 1954.

Since bill prices are used as the input into other pricing models (most notably the Black-Scholes option pricing model), the distortions in the Treasure market have the potential to feed into other markets (we've already seen problems with new issue bond pricing due to sharp increases in spreads and blow-ups of correlation models in the credit default swaps market).

From Bloomberg:

Surging demand for U.S. Treasuries is causing failures to deliver or receive government debt in the $6.3 trillion a day market for borrowing and lending to climb to the highest level in almost four years.

Failures, an indication of scarcity, surged to $1.795 trillion in the week ended March 5, the highest since May 2004, and up from $374 billion the prior week. They have averaged $493.4 billion a week this year, compared with $359.6 billion over the last five years and $168.8 billion back through July 1990, according to Federal Reserve Bank of New York data.

Investors seeking the safety of government debt amid the loss of confidence in credit markets pushed rates on three-month bills today to 0.387 percent, the lowest level since 1954....

``It shows you the kind of anxieties that are going on and the keen demand for Treasuries,'' said Tony Crescenzi, chief bond market strategist at Miller Tabak & Co. in New York. ``The rise in fails tells us about the inability of dealers to obtain Treasury collateral.''

In a repurchase agreement, or repo, a customer provides cash to a dealer in exchange for a bill, note or bond. The exchange is reversed the next day, with the customer receiving interest on the overnight loan. A Treasury security is termed on ``special'' when it is in such demand that owners can borrow cash against it at interest rates lower than the general collateral rate.

The Treasury Department cautioned dealers in January to guard against failing to settle in the Treasury repo market as interest rates fall. It cited periods of such failures to receive or deliver securities, known as `fails' in the repo market, earlier in the decade when rates dropped.

The difference between the rate for borrowing and lending non-specific Treasury securities, or the general collateral rate, has averaged 63 basis points below the central bank's target rate for overnight loans this year. The spread has averaged about 8 basis points the past 10 years.

Overnight general collateral repo rates have traded lower than the Fed's target rate for overnight lending every day this year. The rate on general collateral repo closed today at 0.9 percent, according to data from GovPX Inc., a unit of ICAP Plc, the world's largest inter-dealer broker, compared with 1.25 percent yesterday. Today's rate is 1325 basis points below the Fed's target rate for overnight lending of 2.25 percent.

Investors' unwillingness to hold privately issued mortgage- backed bonds amid record home foreclosures sent premiums on even Fannie Mae and Freddie Mac guaranteed assets to the highest in 22 years earlier this month. The two government-chartered companies are the biggest sources of U.S. housing finance.

The current rise in Treasury fails is similar to increases that occurred in August 2003, said George Goncalves, chief Treasury and agency strategist at Morgan Stanley in New York.

``At that time, short positions in U.S. Treasuries were building but interest rates were declining, and that led to a pick up in fails as a result,'' Goncalves said. ``It seems like we have a repeat in the making. This also explains why the repo markets are in flux.''

Treasury fails rose to a record $3.244 trillion in the week ended Aug. 20, 2003, the highest to date through July 1990, or as far back as the New York Fed tracks the data on its Web site. For the month of August 2003, the weekly average was $2.751 trillion.

Dead Cat Bounce?

The markets are making wildly different interpretations of the news and economic prospects. Record low T-bill prices and a sudden fall in commodities suggests that a serious slowdown and deleveraging pose major risks, yet equities had a strong showing, with the Dow up over 260 points. What gives?

We've had repeated head-fake rallies in this bear market, and with prospects for housing poor for more than the usual anticipatory horizon for stocks (six months), the foundation for optimism seems questionable. More specifics come from John Authers at the Financial Times and Roger Ehrenberg.

First from Authers:

Can the stock market now indulge in a brief bear market rally?

Yesterday's Merrill Lynch survey of fund managers made clear that the preconditions are in place.

More global fund managers are overweight in cash, compared to their benchmarks, than at any time since the survey started in 1998. Fund managers also believe that equities are undervalued by the biggest margin since the bear market bottomed in 2003, and that bonds are overvalued.

So, there is a lot of cash on the sidelines, in the hands of managers who believe stocks are cheap, and the end of the quarter is close. Many may want to use that cash to buy stocks before the quarter is up.

There is another reason to expect a rally: the bounce from Monday's panic levels, as traders realised that Wall Street's banks were not about to collapse one after another, has led to a rash of predictions that the bottom has been hit.

There are also hopes that the authorities have at last found a "silver bullet" to end the crisis. False hopes have been invested in several other putative silver bullets, but the news that Fannie Mae and Freddie Mac, the powerful US mortgage agencies, will be allowed to buy more mortgage-backed securities is as good a candidate as any.

History's biggest bear markets have all had several big rallies when investors thought the worst was overDoes a bear market rally need a catalyst? Not necessarily. Tuesday's surge was triggered by terrible results from two investment banks. Given how negative sentiment had become, the mere fact that they were not epochally disastrous was enough to trigger a rally.

In the short term, the mere absence of bad news (which is not a given) might allow the markets to enjoy a bounce.

Now Ehrenberg:

What we saw today is yet another example of the "dead cat bounce." And I believe this baby is going to be bouncing for a little while, after which in all likelihood the rally will cease, fear will return and the market will continue its march downward in the face of massive de-leveraging. There is no choice; it is the case of the irresistible force (investors hoping and wishing for the bad times to be over, courtesy of the Fed) meeting the immovable object (the disastrous fiscal and financial market realities facing the U.S.). The Fed can lower rates to 0% - but that in and of itself doesn't create jobs, make banks more willing to lend and stimulate economic activity. What it will do, of course, is cause a massive capital flight out of the U.S. and its debased currency, fueling a downward spiral of economic activity in tandem with upward pressure on prices that will hit with devastating effect. Not a scenario I am looking forward to.

The rally in the dollar would seem to argue against Ehrenbergs' point about debasing the currency, but that looks to be triggered by the Fed merely debasing it more slowly than anticipated. Hardly a cause for long-term optimism.

Commodities Plunge Continues

We had observed that commodities prices looked overbought, historically fell during recessions, and in recent years had been strongly influenced by emerging market demand, which looked vulnerable to a US slowdown. These observations have proven out much sooner than we anticipated. Commodities continued their fall today.

From Bloomberg;

Gold headed for its biggest weekly drop in 25 years, leading a drop in commodity prices, after the dollar rallied and concern mounted a U.S.-led slowdown in the global economy will reduce consumption of raw materials.

Oil fell below $100 a barrel for the first time since March 5, soybeans erased this year's gains and cocoa headed for its steepest decline since at least 1986. The UBS Bloomberg Constant Maturity Commodity Index, down 3.2 percent as of 9:30 a.m. in New York, is having its worst week since at least 1997, led by declines in silver, cocoa and sugar.

``Global recession fears are causing selling pressure in all commodities,'' said James Mound, head analyst for MoundReport.com, a commodities newsletter, in Palm Coast, Florida. ``The markets are focusing on want-based items instead of need-based items.''

Gold in London has plunged 11 percent from its record $1,032.70 an ounce on March 17 after the Federal Reserve cut its overnight-lending rate less than expected by 75 basis points to 2.25 percent. The dollar has recovered 3 percent from an all-time low against the euro and rallied almost 4 percent from a 12-year low against the yen.

Commodities have advanced in each of the past six years, driven by demand from China seeking to feed its population and power its expanding economy. The dollar's slide has boosted demand for raw materials, which become cheaper for buyers holding other currencies, while some investors are seeking higher returns following a slump in equities.

The money flowing into commodities is ``absolutely enormous,'' James Proudlock, commodity product head for Europe, Middle East and Asia at JPMorgan Securities Ltd., said at a sugar conference yesterday in Geneva.

There are 361 commodity funds that had $98 billion in assets as of Feb. 28, compared with 345 funds with $80 billion at the end of 2007, he said.

The rally, according to Paul Touradji of the $3.5 billion hedge fund Touradji Capital Management LP, was a ``buying orgy'' that had inflated prices and increased the risks of a collapse.

Commodities ``have all gone parabolically higher on frenzied money flow,'' New York-based Touradji wrote to clients March 10. ``Unless that money flow continues ad infinitum, in which case prices would go to infinity, then the fundamentals had better be improving as quickly as prices have been, otherwise there is nothing else to keep the markets at these levels.''....

``A protracted slowdown is ultimately not good for commodities as people won't have enough money to buy anything,'' said Hong Kong-based Dick Poon, manager of the precious metals trading desk at Heraeus Ltd., a unit of processor Heraeus Holding GmbH in Germany.

Gold for immediate delivery dropped as much as 4.1 percent to $905.41 an ounce, the lowest since Feb. 19, and traded at $917.20 as of 1:30 p.m. in London. The metal's 8.3 percent drop this week would be the biggest since March 1983. The U.K. and U.S. are on holiday tomorrow.

Gold may slump to $840 by April, said Michael Lewis, Deutsche Bank AG's head of commodities research in London.

Gold futures for April delivery fell $28, or 3 percent, to $917.30 an ounce on the Comex division of the New York Mercantile Exchange.

Oil soared to a record this year even as analysts forecast that consumption would increase less than in 2007. Crude oil for May delivery fell as much as $3.62, or 3.5 percent, to $98.92 a barrel on the New York Mercantile Exchange, and traded at $99.70.

U.S. prices are likely to fall toward $90 a barrel this spring as the country's slowing economy encourages traders to exit commodity markets, Goldman Sachs Group Inc. analysts including Jeffrey Currie wrote in a report today. Deutsche Bank's Lewis said prices will be $90 by next month.

``The oil price slump along with all the other commodities resulted from the dollar staging a rally, so the large funds flowed out of the commodities complex,'' said Victor Shum, senior principal at consultants Purvin & Gertz Inc. in Singapore. ``Investors have found a trigger to focus more on fundamentals.''

Copper declined to its lowest in a month on the London Metal Exchange on concern the reduction in borrowing costs won't stop the U.S. from slipping into a recession. Corn and soybean futures in Chicago extended losses as the dollar's rally reduced the appeal of commodities as an alternative investment.

Cocoa futures for May delivery dropped as much as $274, or 11 percent, to $2,259 a metric ton on ICE Futures U.S., the former New York Board of Trade.

Credit Suisse Bombshell: Surprise Warning of 1Q Loss

The market had taken some comfort from Lehman's and Goldman's first quarter better-than-expected results; these will likely be undone by the surprise warning by Credit Suisse, which heretofore had looked comparatively unscathed, by virtue of remaining profitable. That was undone today when the Swiss bank announced it expected to lose money this quarter.

What is particularly troubling is that the bank's' loss at least in part stemmed from inadequate controls. The bank found intentional mispricings by a small number of traders who have since been sacked. The Bloomberg story notes:

The Swiss bank hasn't disclosed the names of the traders responsible for the incorrect pricing of residential mortgage- backed bonds and collateralized debt obligations. Credit Suisse said it reassigned trading responsibility for the CDO business and took measures to improve controls to prevent and detect misconduct, which were ``not effective'' previously.

On the scale of recent Wall Street woes, however, the damage is small in absolute terms. The bank is taking writedowns of $2.65 billion, which it will spread over its fourth quarter 2007 and first quarter 2008. It expects to report the first loss in five years for the current quarter.

From the Financial Times:

Credit Suisse on Thursday issued a surprise profits warning, a move that will shatter the fragile confidence restored among leading investment banks after better than expected results from some top Wall Street houses this week.

The Swiss bank, which is particularly active in leveraged loans and commercial mortgage backed securities, said based on its latest estimates, it was “unlikely to be profitable in the first quarter.”....

“With regard to 2008, including valuation reductions, Credit Suisse was profitable through the end of February. In the light of difficult market conditions in March, at this time, Credit Suisse believes it is unlikely to be profitable in the first quarter”, it said....

In a brighter piece of news, Credit Suisse lowered the size of the surprise writedown it announced last month, shortly after reporting its 2007 results, but that is likely to be wholly overshadowed by the profits announcement.

Rather than $2.85bn, spread between late 2007 and early 2008, the bank revised the figure down to $2.65bn. Translated into Swiss francs, the group’s reporting currency, that means a SFr1.68bn pre-tax hit in the first quarter. Previous to today’s profit warning, the bank had expected to be profitable in the period.

Deflation Watch: US Short Term Rates Fall Below Japan's

Investors are so nervous that they are willing to take almost nothing in nominal terms, which is tantamount to a meaningful negative real return, to sit in the safety of three-month T-bills, which are now a mere 0.56%.

One explanation is the large number of fails in the repo market, which as Alea reports, is "massive":

What “Fails” mean:

If primary dealer A does not deliver a security to primary dealer B as scheduled, then dealer A reports a fail to deliver and dealer B reports a fail to receive. In contrast, if primary dealer A does not deliver a security to customer C, then dealer A reports a fail to deliver and the fail to receive is not reported. A settlement fail goes unreported if neither the buyer nor the seller is a primary dealer.

This is recent data to march 5th on settlement fails between primary dealers. Settlement fails are reported on a cumulative basis for each week, including nontrading days.

U.S. Treasury Securities (In Millions of Dollars)
Fails to Receive: 891,825
Change from Previous Week: 696,427
Fails to Deliver: 903,242
Change from Previous Week: 724,368

Not only is this the lowest level the rate has achieved since 1958, but as reader James Bianco of Bianco Research tells us, it puts US short rates below Japan's for the first time since 1993 (click to enlarge):



An article in the Wall Street Journal today with the rather misleading title, "Fed Fix Works For Now," says that the Fed is achieving some success in lowering mortgage bond yields. But the plunge in short rates and the rise in TED spreads says that much of the rest of the market is running for cover.

Bloomberg gave further commentary on the markets' frazzled nerves:

Bonds gained on concern the investment firm run by ex-Long- Term Capital Management LP chief John Meriwether is facing losses and Thornburg Mortgage Inc. may go bankrupt. This week the Federal Reserve has cut interest rates, opened the so-called discount window to investment banks and arranged the sale of Bear Stearns Cos. to relieve market turmoil.

``There's a whole flight-to-quality trade,'' said Joe Tully, managing director of the money-market desk in Newark, New Jersey, at Prudential Investment Management, who's betting $1 against a colleague that bill rates won't fall below zero. ``The markets are totally skittish. They just want to be in bills.''....

``It's a capital preservation trade,'' said Michael Cloherty, an interest-rate strategist at Banc of America Securities LLC in New York. ``The rationale is, `I'll buy a bill, I know that when the thing matures I'll get 100 cents on the dollar.'''

The three-month London interbank offered rate, or Libor, for dollars rose for the first time in three weeks, indicating the Fed is struggling to instill confidence in money markets. The difference between what the government and companies pay for three-months loans, known as the TED spread, increased 32 basis points to 1.98 percentage points, the biggest gain since Jan. 22, when the Fed made an emergency cut in borrowing costs.

A high TED spread says banks are reluctant to lend to each other, which is not good. An earlier Fed measure, the Term Auction Facility, was designed to address high TED spreads. That appears no longer to be working.

Link 3/20/08

How Apple Got Everything Right By Doing Everything Wrong Wired

How Leander Kahney Got Everything Wrong by Being an Irredeemable Jackass John Gruber. A shellacking of the Apple article above.

Doesn't Everyone Know that It's Not a Subprime Problem? Dean Baker

The Difference Between Investment Banks, Hedge Funds, Credit Card Borrowers and Microcredit: "The Poor Always Pay Back" Vivian Norris de Montaigu, Huffington Post

Lewis Fights The Bear (and Gets Mauled) Cassandra Does Tokyo

The World's Scariest Chart Business Week (hat tip Felix Salmon)

Fed Bypasses Emergency-Loan Policy on Rate for Securities Firms Bloomberg

Bear Stearns' shareholders should take the $2 and run MarketWatch

Antidote du jour:

Primary Dealers Get Flattering Marks on Collateral for Fed Loans

A professional investor alerted me to a not-widely-noted element of the Fed's new discount window clone for primary dealers, the so-called Primary Dealers' Credit Facility (I am going to lose track of the acronyms given the speed with which the Fed is coming up with new ways to socialize losses).

This overview is from the Fed's press release:

The PDCF will provide overnight funding to primary dealers in exchange for a specified range of collateral, including all collateral eligible for tri-party repurchase agreements arranged by the Federal Reserve Bank of New York, as well as all investment-grade corporate securities, municipal securities, mortgage-backed securities and asset-backed securities for which a price is available.

The PDCF will remain in operation for a minimum period of six months and may be extended as conditions warrant to foster the functioning of financial markets.

Ah, but how will the Fed assign values to the collateral? From the Fed's FAQ:

What collateral is eligible for pledging?

Eligible collateral will include all collateral eligible for tri-party repurchase agreements arranged by the Federal Reserve Open Market Trading Desk, as well as all investment-grade corporate securities, municipal securities, mortgage-backed securities, and asset-backed securities for which a price is available.

How will collateral be valued?

The collateral will be valued by the clearing banks based on a range of pricing services.

That sounds objective and innocuous, right? Guess again. As the investor commented:

Note also that the Fed’s accepting the clearing banks’ valuations on the assets that the brokers present as collateral. That is so very understanding of them. Given that the clearing banks hold similar assets themselves, they are probably grading on a curve here, so as not to mark down their own assets simultaneously, I’m guessing. We’ll give the best student here an A—make that a triple A!—and hey, look, we’re all triple A on this bus. Yikes.

Update 11:30 AM: We had missed these comments from Willem Buiter on the same issue, which reader Jay pointed out:

“…the pledged collateral will be valued by the clearing banks used by the primary dealers to access the new facility, based on a range of pricing services.” This suggests that the Fed will accept whatever valuations the clearing banks may come up with. The only qualification is that collateral that is not priced by the clearing banks will not be eligible for pledge under the PDCF.

Collateral eligible for pledge under the PDCF includes all collateral eligible for pledge in open market operations, plus investment grade corporate securities, municipal securities, mortgage-backed securities, and asset-backed securities.

This arrangement is an invitation to the primary dealers and their clearers to collude to rip off the Fed by overvaluing the collateral, including using false markets and/or arbitrary internal pricing models as part of their ‘..range of pricing services’ (what are pricing services anyway?). They can then split the difference. If the Fed wants to be mugged, why not let the primary dealers themselves price the collateral they offer the Fed?

For all collateral that is not priced in verifiable, liquid markets, the Fed should arrange its own auctions to discover the reservation prices of those offering the collateral. Leaving it to the clearers is a written invitation to be offered dross at gold valuations. The tax payer will be the loser. A bad and incomprehensible miss. This can be gamed by a bunch of reasonably smart high school kids.

The problem is I'm not sure Buiter's idea of an auction works either, since sales in small lots do not represent the prices that would apply to larger transaction sizes....but at least it's an idea. It would at least be better if the Fed checked prices (including those that can be