Uwe Reinhardt: "Bankers and Patriots"

Uwe Reinhardt is a professor at Princeton whose son (the Marine mentioned below) served in Iraq. This piece first appeared in the Princetonian in April; I thank Willem Buiter for reproducing it on his blog.

As the Fed and the Treasury once again staff the shovel brigade behind one of Wall Street’s periodic asset-bubble parades - lest the foul economic odor in its wake seep too deeply into the rest of the economy - my mind wanders back to spring 2002, when the previous asset bubble had burst. At the end of the financial accounting course I then taught, I projected onto the screen the picture of a Princeton graduate who had just joined the Marines. “Take a good look at your classmate,” I told the 300 or so students in the class. “He is likely to be ordered abroad soon, there to lead a platoon of enlisted Marines into possibly lethal combat, for the sake of you and me, he is told. When he and his men come home - if they do come home - what will you have made of their country? Will you have used the accounting tools I taught you to make the country better and stronger, or will you have used them to engage in the shenanigans that drove our recent asset bubble and begot the current recession - just to make money, country be damned?”

America is a nation at war. Our sailors, soldiers and Marines fight with great honor at high risk to life and limb, and at very low pay, for what they believe to be our nation’s best interest. They often take added personal risks to avoid visiting collateral damage on innocent bystanders of a foreign land. Against that backdrop and the financial crisis and consequent recession now besetting our country, it is pertinent to ask: Do the leaders of our financial markets ever stop to think what their reckless recent conduct has done to the country these brave warriors fight to protect?

At their best, our financial markets play a pivotal role in enhancing human welfare. They then channel the savings of households, business firms and governments anywhere in the world efficiently to their most productive uses anywhere else in the world and allocate financial risk from those unable or unwilling to bear it to those who can tolerate it. Many of the recent innovations in these markets such as structured securities, currency- and interest-rate swaps, credit default swaps, and so on, have made these important functions ever more efficient.

But when investment banks seek profits by recklessly concocting hundreds of billions of mortgage-backed securities that are anchored in shaky mortgages whose quality no one has bothered to check, sell these dodgy derivatives to others, and even risk their own institution’s equity cushions by borrowing billions of dollars to invest in junk securities themselves, they are not making their country stronger. Instead, they act like reckless laboratory scientists who concoct toxic substances that can infect not only them, but also millions of innocent bystanders.

When investment banks sell multiple credit default swaps to buyers who do not own the underlying bond, but merely want to bet on its default, the banks stray into pure Las Vegas-style gambling. Productive risk taking is the central driver of efficient capitalism, but how does helping person A gamble on the default of a bond held by person B strengthen the American economy? Why not sell bets on the weather as well? No one seems to have a clear idea of the net financial exposure our banks have to the $45 trillion or so of notional credit-default swaps currently reported to be outstanding. In an era of widespread credit defaults, such multiple credit-insurance contracts on given bonds could confront some banks with huge claims that their equity cushions might not be able to absorb, forcing the Fed and the Treasury yet again to mobilize their shovel brigade, at taxpayers’ expense.

Finally, when, for handsome fees, smooth-talking investment bankers persuade unsophisticated treasurers of local school districts or small endowments to enter into highly risky and opaque interest-rate swaps, or into investing their limited funds in the so-called “toxic waste” tranches of complex structured securities, they are not making America stronger. They risk driving important local institutions to the brink of bankruptcy. An innate professional ethic deters the overwhelming fraction of our physicians from exploiting their patients’ clinical ignorance as no set of explicit regulations ever could. Does an analogous ethical anchor - a financial Primum Non Nocere - constrain Wall Street as well?

This is not an idle question. American leaders of finance now promise to practice self-discipline guided merely by regulatory principles rather than by explicit rules. That would be a sensible approach, but only in markets whose agents are ethically principled and, yes, patriotic - like, say, 18-year old sailors, soldiers and Marines.

Buiter added:

Uwe E. Reinhardt is the James Madison Professor of Political Economy and a professor in the Woodrow Wilson School of Princeton University. He can be reached at reinhard@princeton.edu.

Monoline Downgrade Fallout: Muni Prices, MBIA Collateral

In the anxious January/February period, when New York Insurance Superintendent Eric Dinallo made Herculean efforts to come up with $15 billion for MBIA and Ambac, it was a high-stakes drama, since it was assumed that the loss of the AAA ratings would End the World of Finance As We Know It.

Now that the once-unthinkable has come to pass and the two big bond guarantors are no longer AAA rated, the reaction is more muted. Hey, when you've got the Fed backstopping the financial system, why worry? But the monolines have been on the ropes for months; the rating agencies have given plenty of warning of the likelihood of downgrades (although Moody's cutting MBIA from Aaa to A2 on its insurance sub was a big surprise), so investors have had time to arrange their affairs accordingly. While we'll no doubt see knock-on effects for some time, perhaps we'll escape worst-case scenario of cascading forced sales.

But don't kid yourself that there won't be dislocations, particularly since they've already started. Indeed, the generally positive Wall Street Journal is chastened:

The long-anticipated credit-rating downgrades of the nation's big bond insurers are pressuring financial markets, perhaps worse than expected.

The Journal describes another shoe that is dropping:

Financial firms like Bank of America Corp., J.P. Morgan Chase & Co., Depfa Bank of Dublin, Citigroup and several other European banks are involved in the business of backstopping municipal-bond issuers, whose debt often is also insured by bond insurers. If Wall Street can't sell the bonds, called variable-rate demand notes, in weekly or daily scheduled sales, they or the investors can exercise their right to sell it to banks that have agreed to be buyers of last resort.

Those obligations are coming home to roost as money-market-fund managers sell out their positions on bonds insured by Ambac or MBIA. In some cases, the bonds must be sold by the funds to these backstop banks if the ratings of the insurance company reach a certain threshold.

Of the approximately $420 billion market for variable-rate demand notes, about $70 billion is insured by Ambac or MBIA, according to industry estimates. Of that $70 billion, bankers said as much as $35 billion is likely to be sold back to these banks, further straining their balance sheets.

When these banks do step in, the interest rate on the bonds typically rises, hurting issuers. Issuers are also forced to repay the full principal on their debt sooner than their original 30- or 10-year maturity.

Bloomberg reports that the muni bond market was hard hit, since it already had a fairly heavy calendar of new issues:

U.S. municipal bonds dropped, driving benchmark 30-year yields to the highest since July 2004...

The municipal market sagged for two weeks amid above- average issuance, selling related to bond-insurer downgrades and property-and-casualty companies liquidating to meet flood- related claims in the Midwest, according to David Thompson, president of Chicago-based bond dealer Griffin, Kubik, Stephens & Thompson Inc.

``A `perfect storm' of supply'' has been driving declines, Thompson said in market commentary today...

Most benchmark yields rose this week to levels last seen after the collapse of the auction-rate securities market and liquidations by some municipal-bond hedge funds in late February...

``There's virtually no bid out there right now,'' said Michael McKenna, a trader with Livingston, New Jersey-based GMS Group LLC. ``There's such a huge liquidity issue in municipals again. We're getting hit.''

The Financial Times tells us that banks and investment banks have $125 billion of guarantees from Ambac and MBIA, which support various structured credits and other assets. The only recent estimate we've seen of possible losses from them is $10 billion for Citi, Merrill, and UBS, the firms with the greatest exposure.

We had commented yesterday on MBIA's need to provide extra collateral on its guaranteed investment contracts as a result of the downgrade (and corrected an erroneous surmise of its impact on claims paying resources). MBIA announced that will have to post $4.5 billion in collateral on its GICs and may also face $2.9 billion in termination expenses on GICs. The insurer said it has $15.2 billion available to satisfy these needs. This is consistent with the estimates in their latest 10-Q.

The Financial Times provided further detail:

The ratings cuts are not expected to have a significant impact on the need for the bond insurers to post collateral on derivatives and other contracts. According to analysts, only further downgrades to the triple B category would likely trigger demands from banks for collateral payments.

Now, to continuing debates about the endgame, which (let us stress) is not imminent. However, the monolines having nada in the way of a viable long-term business strategy (limited credit enhancement opportunities to begin with due to absence of AAA; bona fide risk assumption now required due to changes in muni bond rating practices thanks to Congressional pressure, something they've never done intentionally; and generally bad outlook for municipal creditworthiness). So while they may find the occasional bit of viable business, they are effectively moving towards a run-off, whether they have admitted it to themselves yet or not.

Felix Salmon had a interesting conversation with Josh Rosner, who (like Felix) has been talking to the NYSID. Rosner said that the regulator would block the credit default swaps holders right to accelerate (demand immediate payment) in the event of insolvency or custodianship (which we indicated was unlikely). Felix quoted Rosner:

I expect that the NYSID would ultimately attempt to abrogate any attempts by counterparties to use the acceleration clause. That is not to say I agree that it is right to violate contracts that the NYSID knew existed nor is it to say that I believe they could do so without it leading to protracted court challenges, rather it is to say that is my expectation of what they would likely do to protect claims paying resources for muni policyholders.

Felix also asked if Rosner thought the monolines would make good on their commitments:

If policies were all to pay over time, assuming no further degradation in the macro economy and thus deterioration of CMBS and other commercial asset classes they should be close to being able to meet their obligations at maturity. I do, however, expect further deterioration so, at this point, I am comfortable saying that no one can honestly tell you whether they will ultimately have enough $.

Finally, the GIC misque led me to dig deeper into MBIA's statement that it has $16 billion in "claims paying resources". It appears that MBIA defines the term in a way that departs from that used by the industry association, the Association of Financial Guarantee Insurers. Since this figure, although mentioned in SEC filings, is published and computed in an operating supplement that is subject to neither GAAP nor SAAP, this deviation no doubt is permissible.

I'd be curious to get reader input. I'm disturbed by MBIA's propensity to stretch the truth to near the breaking point, and the differences to me look significant. One item, flagged in the discussion below lifted from the revised version of the post, seems particularly aggressive. There are other disparities, but it isn't clear whether other financial guarantors take similar liberties.

However, the reader input on the GIC question led me to look deeper into the definition of claims paying resources, and I am troubled by what I see. MBIA's statutory surplus, as shown for its combined insurance companies at the end of 2007, was $3.7 billion (versus $4.1 billion the prior year end). That is a lot less than the so-called claims paying resources. This concept is used by bond insurers (my impression is not by the insurance industry generally; "claims paying ability" which is usually a rating, is a different concept).

CPR is equal to capital (which in insurance lingo is surplus) PLUS the unearned premiums (this definition comes from the financial guarantors' industry association, the AFGI). Yet in MBIA's case (per its statutory filings) the unearned premiums (year end 2007) show $3.5 billion of unearned premiums (see the liablity side of the balance sheet) while the asset side shows $7.3 billion of uncollected premiums. Query how you get to $16 billion if the definition of claims paying resources is surplus + unearned premiums.

Aha, but it's in the operating supplement, page 7, which as our former general counsel points out, is prepared in accordance neither with GAAP nor SAAP and "should be treated with due caution". Using the year end figures to make it comparable to the statutory report, they add a $2.7 billion contingency reserve to the surplus and $2.6 billion of present value of installment premiums (I have serious problems with that concept; if you are a bank, you don't get to discount your future interest spread and count its as some sort of capital). They also show $900 million in "Loss and LAE reserves" and "soft capital" of $850 million.

What raises my eyebrows (aside from the notion of the present value of installment premiums) is that the operating supplement shows that their claims paying resources increased by $1.5 billion by the end of the first quarter versus year end The change is largely explained by the change in "Loss and LAE reserves" which increased by $1.2 billion since year end (note that "Loss and LAE reserve" corresponds to the total shown for "Loss" on the year end statutory balance sheet).

Any readers who know this area are encouraged to comment.

IMF: US Economy Stagnant, Recommends Hold on Rates

The cold water Yankee crowd is not going to like the latest word from the IMF, which sees the US economy at close to a stall level on growth for the next six months. It believes that diminished demand will alleviate inflationary pressures and endorsed the idea of standing pat on interest rates for now.

I'd be inclined to support the IMF's view, with one caveat: the Fed is working overtime to impede the deleveraging process, which ultimately is inevitable. Having a recession, even a deeper or more protracted one than usual, is better than the alternatives (trying to validate asset prices and providing undue monetary stimulus, which will only lead to either a worse downturn or a Japan-like lost decade). Serious credit contraction is deflationary (that's what high interest rates are intended to achieve in inflation-fighting: make credit so costly that its use falls sharply).

From the Financial Times:

The International Monetary Fund yesterday warned that the US economy was likely to stagnate in the second half of this year, pouring cold water on hopes that recovery could soon be under way.

It said that continued economic weakness would result in inflation risk going down, not up, in the coming months, and urged the Federal Reserve to keep interest rates on hold for the time being. The statement challenges market expectations that rate increases will soon be required.

The IMF also suggested that the dollar had declined to a level at which it was close to its medium-term equilibrium value on a broad trade-weighted basis, if not all the way there.

John Lipsky, the number two IMF official, said: "We anticipate the economy will slow to virtual stagnation in the second half of the year." The IMF is forecasting no growth at all in the US this year, measured from the final quarter of 2007 to the final quarter of 2008.

The IMF growth forecast is far below the average of private sector and US authorities' forecasts. The mainstream view at the Federal Reserve - set out in projections in April - is for growth of between 0.3 per cent and 1.2 per cent this year.

However, the IMF was equally far from consensus when it forecast serious US weakness earlier this year, since when the Fed and private forecasters lowered their projections.

Mr Lipsky said rising energy prices were weighing on household real incomes. A slowdown in jobs and income growth would reduce purchasing power, while strains in the financial system were restricting the flow of credit to US households.

He said the IMF did expect that growth would start to pick up in 2009 but said that recovery would be "gradual rather than aggressive".

The IMF first deputy managing director added "our expectation is that the sluggishness in growth we foresee in the coming quarters will create greater economic slack and reduce inflation fears".

In its official review of the US economy released yesterday, the IMF said that US interest rates - currently at 2 per cent - should be kept "on hold".

At the same time Mr Lipsky said the Fed would have to be "attentive" to the possibility of a deterioration in inflation expectations.

The US central bank may have to take rates back up quite quickly when the economy starts to recover, he added.

The IMF reiterated its controversial suggestion that the US authorities might need to provide "increased direct support" for the housing sector to stop house prices falling below fair value. This view is popular among congressional Democrats but opposed by the White House and US Treasury.

It also said additional public support for the financial sector might be necessary.

Note that the concept of "fair value" is not defined. Housing prices need to fall further to come into thier historical relationship with incomes.

If the IMF means that the US authorities should intervene to prevent housing from overshooting on the downside, that is not an awful idea in the abstract. However, given the already-considerable support the housing market already has (Fannie, Freddie, FHA, Federal Home Loan Banks), I'm leery of administering more of the medicine that helped get us in this mess (in fact, one argument against further intervention is the substantial government role in housing limited profits there for banks, which led them to pursue the areas where the government played a lesser role, namely higher risk credits).

Links 6/21/08

Global war deaths have been substantially underestimated PhysOrg

Soros, the Man Who Cries Wolf, Now Is Warning of a 'Superbubble' Greg Ip, Wall Street Journal. Maybe Soros simply underestimated the tenacity and resourcefulness of the power that be in keeping the charade going well past its sell-by date.

How to save money on gas Jim Hamilton, Econbrowser. A real sign of the times.

British Airways raises fuel charges for high-flyers Times Online. Ditto.

The witch's hat Macro Man. If you believe in technical indicators, some reasons to be worried.

Good Inflation? Doug Noland, Prudent Bear. For those not familiar with his weekly offering, scroll past the news compilation to find his essay.

Four bits of information to help understand China a little better … Brad Setser

Antidote du jour:

MBIA Downgrade Increases Collateral Requirements; Clarification on CDS Acceleration in Insolvency/Custodianship (Corrected and Updated)

Warning: the post below is a bit geeky. Readers might start with our other current MBIA post and then return here for further details.

Please also note that due to a reader catching an error I have looked further into the concept of claims paying resources and made considerable modifications to the paragraphs relating to claims paying resources below, and also added another sentence flagged as "Update".

Did MBIA's downgrade impair as much as 25% of its claims-paying resources? Consider these statements, the first from a letter from MBIA yesterday on the Moody's downgrade of its insurance sub from Aaa to A2 (hat tip to Jason for a useful question):

This ratings action will give certain holders of guaranteed investment contracts the right to terminate the contracts or to require that additional collateral be posted. Again, we have more than sufficient liquid assets to meet any additional requirements arising from any terminations or collateral posting requirements.

The same letter notes that MBIA has $16 billion in claims-paying resources (we'll return to that concept later). Update: a reader has advised me that teh GICs are not in the same entity as the insurers and hence any changes there would not affect claims paying resources.

Now track back to the most recent 10-Q to see what the effect of a downgrade to A would be. It increases the cost of funding on $400 million of instruments (rounding error). Here is the part related to the GICs:

Investment agreements issued by our asset/liability products segment generally provide for collateral posting or termination in the event of a downgrade of MBIA Corp.’s credit ratings. The maximum collateral posting would occur at a single-A financial strength rating by Moody’s or S&P, and the maximum terminations would occur at a triple-B financial strength rating by Moody’s or S&P. Based on the asset portfolio as of March 31, 2008, the maximum collateral posting requirement at a single-A financial strength rating would be $12.7 billion and free collateral at a triple-B financial strength rating would be $9.2 billion. As of March 31, 2008, the Company’s collateral posting requirement totaled $8.25 billion and free collateral totaled $16.8 billion based on MBIA Corp.’s current financial strength ratings. We believe that the liquidity position of the asset/liability products segment is adequate to meet these requirements related to investment agreements under stress scenarios.

Per the update above, although this nearly $4.5 billion reduction seems significant, it apparently has no impact on claims-paying resources.

I am shortly going to turn the mike over to a former general counsel of a bond insurer, who provides a great deal of informative detail on the issue that the New York Times raised in its recent article on MBIA, namely, what happens to the credit-default swaps contracts in the event of insolvency or regulatory takeover. He very clearly states:

Given the billions of surplus to policyholders reported by MBIA and the mechanics of statutory accounting (which is very different from GAAP), regulatory insolvency seems extremely unlikely in any future I can foresee.

However, the reader input on the GIC question led me to look deeper into the definition of claims paying resources, and I am troubled by what I see. MBIA's statutory surplus, as shown for its combined insurance companies at the end of 2007, was $3.7 billion (versus $4.1 billion the prior year end). That is a lot less than the so-called claims paying resources. This concept is used by bond insurers (my impression is not by the insurance industry generally; "claims paying ability" which is usually a rating, is a different concept).

CPR is equal to capital (which in insurance lingo is surplus) PLUS the unearned premiums (this definition comes from the financial guarantors' industry association, the AFGI). . Yet in MBIA's case (per its statutory filings) the unearned premiums (year end 2007) show $3.5 billion of unearned premiums (see the liablity side of the balance sheet) while the asset side shows $7.3 billion of uncollected premiums. Query how you get to $16 billion if the definition of claims paying resources is surplus + unearned premiums.

Aha, but it's in the operating supplement, page 7, which as our former general counsel points out, is prepared in accordance neither with GAAP nor SAAP and "should be treated with due caution". Using the year end figures to make it comparable to the statutory report, they add a $2.7 billion contingency reserve to the surplus and $2.6 billion of present value of installment premiums (I have serious problems with that concept; if you are a bank, you don't get to discount your future interest spread and count its as some sort of capital). They also show $900 million in "Loss and LAE reserves" and "soft capital" of $850 million.

What raises my eyebrows (aside from the notion of the present value of installment premiums) is that the operating supplement shows that their claims paying resources increased by $1.5 billion by the end of the first quarter versus year end The change is largely explained by the change in "Loss and LAE reserves" which increased by $1.2 billion since year end (note that "Loss and LAE reserve" corresponds to the total shown for "Loss" on the year end statutory balance sheet).

Any readers who know this area are encouraged to comment.

Although there have been a number of red flags waved about MBIA, the biggest is its reinsurance. This discussion came from a letter Ackman sent to MBIA in January:

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

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

Despite the fact that Channel Re has negative book equity and $42 billion of MBIA’s credit exposure – $21.5 billion of which is CDOs of ABS or CLO/CBOs – Moody’s and S&P continue to rate the company Triple A with a stable outlook....

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

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

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

Moody's downgraded Channel Re to Aa3 in February. The point is that serious impairment of either reinsurer has the potential to substantially lower MBIA's surplus (the cost of replacing the reinsurance would be substantial, and likely uneconomic).

Let me emphasize that none of the above points to solvency issues in the near term. But they do raise worries about long-term viability, particularly as the credit crunch rolls on and municipalities start showing signs of distress.

Now to the information on how CDS would play out in the arguably not-so-likely event that MBIA were to get in serious trouble. I was wrong in some of the things I said earlier. While the CDS holders do have the right to accelerate (demand immediate payment), it is far more useful to them as a bargaining chip, since forcing an insurer into insolvency is a "nuclear option". However, the reasons it plays out that way are complex.

From the former bond insurer general counsel:

I agree entirely with your position on MBIA's obligation to downstream $900 mm to the insurer.

As to the CDS, it rapidly becomes very complicated. I don't have copies of any of MBIA's CDS, but accept the accuracy of their statement that "Typically in MBIA's policies insuring CDS contracts, there are no provisions that allow a counterparty to terminate the insured CDS contract and make a claim under the policy, absent MBIA's bankruptcy or insolvency or an MBIA payment default on the policy insuring the CDS contract. Each insured CDS contract that MBIA Corp. enters into is governed by an International Swaps and Derivatives Association, Inc. (ISDA) Master Agreement and Confirmation. MBIA's CDS contracts typically conform to the Monoline Supplement Agreement, where a bankruptcy of the credit support provider, including the initiation of a receivership proceeding by the NYSID, would give the counterparty the option to terminate the swap and receive a termination payment; it would not be an automatic termination event." The CDS I negotiated for my former employer adhered to that standard (except for the Monoline Supplement Agreement, which according to my recollection covered CDS written on monolines rather than CDS written by monolines, but it's been a while and I could be wrong or the form could have changed).

Having said that, our next stop is indeed parsing the language. I'm sure you've already noted the weasel-word "typically"; no need to discuss the implications and resulting questions.

Let's think about bankruptcy and insolvency. First, MBIA the insurance company is not subject to the Bankruptcy Code and cannot voluntarily file for bankruptcy, but they could be involuntarily filed into bankruptcy by their creditors. Such a bankruptcy filing would almost certainly be dismissed by the bankruptcy court. But it would take time. The standard ISDA bankruptcy event is triggered if the filing isn't dismissed within 15 days, which just isn't possible (absent massive intervention with the bankruptcy court); it would probably require 45-90 days, by which time the termination event would have occurred. Second, insolvency, which again is a matter of definition; probably MBIA, like other monolines, limited the definition to entering rehabilitation, conservatorship or other similar regulatory proceedings and excluded a balance-sheet test or other, broader, tests of insolvency in the normal ISDA definition. Given the billions of surplus to policyholders reported by MBIA and the mechanics of statutory accounting (which is very different from GAAP), regulatory insolvency seems extremely unlikely in any future I can foresee.

The other termination event is a default by MBIA on the actual policy insuring the CDS, which requires both an initial default on the underlying security and by MBIA on that policy - they probably didn't permit cross-default clauses in their CDS. So that again is extremely unlikely, and in any event would be limited to that single CDS.

But let's assume a bankruptcy termination event occurs. Then the question is whether the counterparties will terminate the swaps (and how long it has to make its decision, which depends in part on whether the termination event merely has to occur or, more likely, occur and be continuing). Termination of all the CDS could require MBIA to pay its counterparties the cost of replacing the CDS with an equivalent protection seller (another interesting question) - if, as is probable, MBIA agreed to make 6(e) mark-to-market payments upon termination, which again depends on the CDS documentation. It's also probable that being required to pay such an amount would render MBIA insolvent under statutory accounting, which presumably would result in their entering rehabilitation proceedings. At that point, Mr. Dinallo could refuse to pay the mark-to-market payments, which arguably are not the sort of losses intended to be covered by financial guaranty insurance - and MBIA would become solvent again, able to pay claims on defaulting securities as they became due.

My own view is that termination is a "nuclear option" that operates to the detriment of both parties, and that (like any other lender) the CDS counterparties don't want to force MBIA into insolvency. They want negotiating leverage, and presumably would get it in much the same way ACA did: a forbearance agreement would be negotiated, under which the CDS counterparties would agree not to terminate the swaps - but the counterparties would probably extract something in exchange for forbearing. Of course, all the counterparties would have to agree, because termination by any one counterparty would force the others to terminate as well, so the negotiations would be long and wearing, and probably conducted under the auspices of the NYSID. I don't think anyone really wants to go there, and in that sense agree with Felix Salmon.

The operating supplement is a filing that's conventionally made by insurers, but required neither by the SEC nor the insurance regulators and not prepared under either GAAP or stat. It's available on MBIA's website and should be read with appropriate caution, although the op supp contains much useful information not available in any other format. MBIA's statutory financials are also available on its website.

Update 6:20 AM: FT Alphaville raises an issue which complicates the analysis above:

In the case of MBIA and Ambac, we’re not talking about bankruptcy or margin calls. Indeed in many cases, the value of the insurance written is already worthless - in the case of MBIA, many wrapped bonds have an underlying rating now higher than the wrapper. Policyholders, in other words, have everything to gain from terminating the insurance contracts.

So the fact that the policyholders have no downside (except legal costs) may embolden them. If nothing else, since the insurance is worth less than the underlying bonds, it would be worth pursuing courses of action to terminate the CDS so as to end payments on useless guarantees.

It's going to be an interesting next few months....
Second Update 6/21, 12:05 AM: This paragraph comes from today's Wall Street Journal story on the downgrades of bond insurers FGIc and Security Capital Assurance:

For both companies, Moody's noted that a breach of the minimum regulatory capital requirement heightens the risk of regulatory intervention, which could trigger a market value termination of their credit default swap contracts.

"Exploding Commodity Prices Signal Future Inflation"

In a VoxEU post, Guillermo Calvo argues forcefully that rising commodity prices are the result of excess liquidity rather than supply and demand.

From VoxEU:

Here, one of the world’s leading macroeconomists argues that the explosion of commodity prices is the result of a very real global financial storm associated with excess liquidity in several non-G7 countries and nourished by low G7 central banks’ interest rates. The commodity price explosion is a harbinger of future inflation.

Oil, metals, and now food prices are heading to the sky with a virulence that is hard to rationalise on the basis of world output growth – not even on the basis of China’s and India’s fast growth, let alone the expected global slowdown. This phenomenon has been accompanied by much higher transaction volumes in forward markets. Thus, analysts and policymakers have been quick in pointing an accusing finger at the proverbial speculator, who has even been declared persona non grata in some countries, like India, where commodity futures have been banned.

The thrust of this column is that we are not going through another self-fulfilling bubble. Today’s explosion of commodity prices is the result of a very real global financial storm associated with large excess liquidity in several non-G7 countries and nourished by low G7 central banks’ interest rates. This price explosion could be a leading indicator of future inflation driven by fundamentals.

Commodity stockpiles

Absence of a substantial increase in physical commodity inventories has been mentioned as evidence of absence of speculative activity (by Martin Wolf and, more guardedly, Paul Krugman).1 But that is not valid. Suppose, for the sake of the argument, that the demand for commodities for current consumption or production is completely inelastic (food and oil are good examples in the short run). If speculators attempt to stockpile commodities, commodity prices will go up. And they will go up as much as necessary to discourage the speculators from adding to their stocks, that’s all. To keep matters simple, I will zero in on that special case and explain what drives speculators to stockpile so aggressively as to provoke a price explosion.

Incentives to stockpile commodities stem from the combination of low central bank interest rates (especially in the US) and the growth in sovereign wealth funds. The latter, in my view, is the crucial factor. Sovereign wealth funds have been created partly with the intent of switching the composition of government wealth from highly liquid but low-return assets to more risky but much more profitable investment projects. Thus, their attempt to get rid of excess liquidity resembles the econ 101 exercise in which the student is asked to trace the effects of a portfolio switch away from money and into capital. The answer is – of course – higher prices. I will return to that in a moment after I explain why central bank interest rates are also important.

Interest rates and prices

Take the Fed rate (i.e., the Federal Funds rate). Recently, the Fed rate has been sharply lowered and the market does not expect that it will be raised with equal impetus in at least one year hence. This must certainly add to sovereign wealth funds’ determination to switch away from US Treasury Bills, which, incidentally, helps to explain the suddenness of the price rise. However, Treasury Bills do not exactly fit the characteristics of the econ 101 money. If the demand for Treasury Bills goes down, their price will fall until Treasury Bills’ holders find the yield attractive enough to drop their other investment projects. In this case there would be no upward pressure on the general price level, but the effective Fed rate will likely rise. This, in turn, will induce the Fed to pump in more liquidity through open market operations, creating econ 101 money (actually, high-powered money) through the purchase of Treasury Bills. Therefore, low and momentarily pegged central bank interest rates imply that the fall in the demand for Treasury Bills results in an expansion of the money supply. Now we can confidently employ the econ 101 result to argue that the portfolio switch implies higher prices. Notice that this argument does not rely on the more standard concern that the Fed is pumping in liquidity to rescue the financial system. This may be a problem in the future but, to the extent that the Fed is simply substituting safe assets for risky assets in banks’ portfolios, the policy need not result in a sharp increase in monetary aggregates and prices.

Not all prices show the same degree of flexibility. Commodity prices are at the high end of the flexibility spectrum, while wages are likely to be on the other. Thus, the price rise phenomenon will bring about a change in relative prices in favour of commodities. Interestingly, however, eventually, as the slow-moving prices catch up, these sharp differences across prices will disappear and a much more uniform price rise phenomenon will materialise. Thus, when analysed from the perspective of some future time, this whole episode will look very much like a bubble in the commodity market, a market mirage, even though what is behind it is a fundamental factor: lower demand for liquid assets by sovereigns like China, Chile or Dubai. Overshooting of commodity prices could be large because even though sovereign wealth funds are not large in terms of wealth, they are quite large with respect to monetary aggregates. For example, several reports estimate that sovereign wealth funds’ assets under management exceed US$3.5 trillion and are growing fast,2 while US M1 and M2 are, respectively, US$1.4 and US$7.8 trillion as of April 2008.

Inflation to come

However, US monetary aggregates do not yet show an increase as sharp as that of commodity prices.3 Should we conclude that the above argument has feet of clay? There are at least two different answers to this potential objection. One answer is that under well-developed financial markets the expectation that a portfolio switch with the above characteristics will take place could trigger anticipatory price increases. The second answer hinges on the observation that Treasury Bills are possibly closer to money than to pure bonds (especially under high counter-party risk). The relevant money concept could be an aggregate involving M2 and Treasury Bills, for example.4 Thus, the portfolio shift, unaccompanied by a change in the Fed rate, would be tantamount to an increase in money velocity of circulation – another econ 101 experiment with similar inflationary implications. In this case, M2 need not change!5

In short, my conjecture is that commodity prices are the result of portfolio shift against liquid assets by sovereign investors, sovereign wealth funds, partly triggered by lax monetary policy, especially in the US.6 Is this a harbinger of higher CPI inflation? If interest rates continue to be low, my answer would be a resounding yes. But there is probably room for an effective anti-inflationary battle. This will likely call for a sharp rise in interest rates and will enhance the risk of deepening recession, particularly if financial vulnerabilities have not been resolved. Thus, policymakers should seriously start worrying about inflation and stop chasing imaginary destabilising speculators.

Footnotes may be found here.

Link 6/20/08

Insecticide 'killing Kenya lions' BBC

Saving the planet will be difficult, but do not despair Philip Stephens, Financial Times. Key quote:

Denial is a still a big problem, as demonstrated by the latest survey of global attitudes from the Pew Research Centre. The good news is that majorities in 14 of the 24 countries covered by this annual poll see global warming as a very serious problem. The bad news is that those countries with the smallest concerned majorities are the ones that are also contributing most to the stock of carbon dioxide in the atmosphere.

Less than half – 42 per cent – of people in the US think the rising temperature of the planet is a serious problem. In China, the figure is a mere 24 per cent. That compares with figures of 70 per cent and above in Japan, France, Tanzania and Turkey and 92 per cent in Brazil. That for Germany, surprisingly, is only 61 per cent and for Britain, less surprisingly, 56 per cent.

Oil vs. the Environment: What is the Tradeoff? Dean Baker. Provides some back-of-the-envelope estimates

Do Oil Futures Impact the Cash Price? YES!!! Econompic Data

Conventional wisdom wrong about Arab journalists' anti-Americanism PhysOrg

Barclays May Get $927 Million From Sumitomo Mitsui, Nikkei Says Bloomberg

It’s Not Nice to Short Bank Stocks Floyd Norris, New York Times

Market power, asset allocation, and oil prices Steve Waldman

Walter Bagehot Was Wrong James Grant, New York Sun (hat tip Barry Ritholtz). Required reading.

Antidote du jour:

Fools and Their Money (Bear Stearns Hedge Funds Edition)

My favorite section of the indictment against Ralph Cioffi and Miatthew Tannin (which is good reading):

As described to investors by the defendants and others, the High Grade Fund's objective was to provide a modest, safe and steady source of returns to its investors. CIOFFI, TANNIN and others told investors that they could expect annual returns of approximately 10 to 12%, and that the High Grade Fund was not designed to hit "home runs." The defendants and others led investors to believe that the High Grade was only slightly riskier than a money market fund.

For a considerable period, the High Grade Fund's performance was generally consistent with these representations. By 2006, however, the fund's performance had begun to decline. In part as a response to this performance decline, and as a consequence of threatened investor withdrawals of money ("redemptions") from the High Grade Fund, CIOFFI, TANNIN and others opened the Enhanced Fund in August 2006.

The Enhanced Fund invested primarily in CDOs. It employed substantially more leverage than the High Grade Fund. CIOFFI, TANNIN and others told investors that the Enhanced Fund would generate greater profits than the High Grade Fund, but that
the Enhanced Fund would carry only limited additional risk, in part because it would invest in an even higher proportion of the
least risky securities. The increased profits would result from increased leverage.

Anything that promises money market risk and 8-10% real returns is not an investment. It's a scam.

On the MBIA, Ambac Downgrades; Regulatory Comments on MBIA

As readers probably know by now, Moody's, the last holdout on the AAA rating for the two big monolines MBIA and Ambac, downgraded both companies earlier today, and more harshly than Standard & Poor's. And even with this downgrade, it underscored that more cuts are likely to be in the offing

Per Bloomberg:

MBIA's MBIA Insurance Corp. unit was reduced five levels to A2 from Aaa, New York-based Moody's said today in a statement. Ambac Assurance Corp. was lowered three steps to Aa3, Moody's said in a separate release. The outlook on both is negative.

Standard & Poor's now has both at AA, which is equivalent to a Moody's Aa2 (Aa3 is lower than Aa2). Note that the ratings on the insurance subs are the ones of most concern to investors. Note further that Moody's takes a dimmer view of MBIA than Ambac.

The rating agency underscored that questionable new business prospects are a major concern:

MBIA's downgrade reflects its ``limited financial flexibility and impaired franchise,'' Moody's analyst Jack Dorer said today in a statement. Ambac has ``significantly constrained new business prospects'' and likely will incur more losses, Dorer said.

This is a fairly blunt statement, and confirms the widespread view that the monoline business model has gone the way of the dodo bird. The free lunch of guaranteeing muni bonds that, were they rated on the corporate scale, in many cases wouldn't need credit enhancement, is over. Municipal guaranteed will involve real risk assumption, a skill the monolines have not mastered.

With Warren Buffett offering a true AAA, most of the business worth doing will gravitate to him. And with doubts about ratings strength in play, what government body would sign up for a guarantee, designed to boost their rating, if a future downgrade may render it moot? ACA, which had only a singe A was able to write only $7 billion of muni guarantees out of a $70 billion portfolio.

Another part of the statement from Moody's called the truthfulness of MBIA into question:

MBIA is $2.6 billion short of its target capital level for an Aaa company, Moody's said. The rating company also said MBIA's decision to retain $1.1 billion at its holding company was ``indicative of a more aggressive capital management strategy'' and contributed to the extent of the downgrade...

Ambac is $225 million below the Aaa target level, Moody's said.

Sp the depth of MBIA's downgrade is a self-inflicted wound. Had the monoline acted in accordance with its earlier promises, it would have gotten a higher mark.

But note specifically that the rating agency felt compelled to state the amount of capital MBIA needed to secure an AAA. Contrast this with the statement from MBIA on its website:

The rating agencies are now indicating that the ratings of the Insurance Company are dependent on other factors besides the amount of capital or claims-paying resources it has.

This has been the big excuse for MBIA not downstreaming the $900 million at issue to the insurance sub. They have asserted that no matter what they did, the ratings agencies will not give them an AAA. Moody's has decided to correct the record. Again, another falsehood from MBIA, and a whopper at that. Felix Salmon, in a fresh post, tells of a conversation with a Hampton Finar of the New York State Insurance Department, and the NYSID falls largely in line with the MBIA story:

MBIA "needed a capital infusion to help them ride this out at triple-A," said Finer: "they weren't hitting the rating agency ratios". This is almost exactly the same as the Jay Brown talking points. The capital-raising was done for the sake of the ratings agencies, and once the ratings agencies said that it wouldn't do any good, there was no obvious point in doing so any more.

This is debatable; MBIA could conceivably have raised enough capital, although it would have been massively dilutive. But that still isn't the same as saying it was unattainable, which is what Finer implies (in fairness, it would probably be seen as highly aggressive for a regulator to call the rating agency to verify the accuracy of the statements that MBIA made to NYSID, so it's understandable that NYSID would share MBIA's view. We hope they've wised up now).

The NYSID also seems more than a tad in denial about the viability of the bond insurer's business prospects. Again from Salmon:

Was NYSID upset that MBIA didn't send the money downstream? Not particularly. If it had really wanted MBIA to do that, it could have forced the issue, but it didn't. "We have a lot of authority over how that money gets used," said Finer. "We'd like to see what else can be done with it." If that involves sending it to a different subsidiary, that might be fine; the only thing he seemed keen not to see was the money getting sent directly back to shareholders.....

Finer was also keen to see MBIA back in the business of writing insurance again. "We don't really want companies in indefinite run-off, they're kind of poisonous," he said, since such companies have much less incentive to pay out than one which stands to lose a lot of business if it starts denying claims. "Companies should be downgraded, frankly, in indefinite runoff."

What about a corporate structure where the old insurance subsidiary was in de facto runoff while a new subsidiary was writing new policies? That could be made to work, said Finer, so long as the reputation of the new subsidiary rested to some degree on the alacrity with which the old subsidiary paid its claims.

This conversation appears to have taken place before the Moody's downgrades, and the severity of the cut on MBIA may put a different complexion on things. The NYSID may be regretting its decision to indulge MIBIA on keeping the $900 million at the parent level.

I must admit I have trouble with the logic here: things are OK at the MBIA insurance sub; we'd rather have them pursue new business. As we have discussed at length elsewhere, there does not appear for there to be any strategically viable route for them to take. Whether the insurers recognize it or not, the best economic scenario (as in maximum NPV) is for them to be in runoff mode.

Any attractive new business opportunities will be highly limited given their deteriorating outlook. The rating agencies are no doubt worried about other shoes dropping. While subprime writedowns have largely run their course, Alt-A and Option ARMs have only begun to hit in a serious way (although the monolines may not be seriously exposed here) and the housing-related deterioration in muni credits has just started. So as the Moody's negative outlook indicates, things can only get worse. Yet to keep the company from shrinking, the pressure will be high to write more business than is attractive on a risk/return basis given the external environment and their competitive disadvantages.

And if they do go ahead and somehow write new business? Well, it allows management to preserve its holding company empire, and the nature of insurance is that you collect premiums and pay losses later. So they might be able to kick the can down the road for a few years more beyond what the endgame horizon would otherwise have been. But when the gig is finally up, it will be a larger book, and therefore a larger mess, that will need to be resolved.

Yet per Salmon, the regulator reaffirmed his confidence in the solvency of MIBA:

We think there's enough money to pay all the claims based on what the current expected losses are. Things have deteriorated a little bit, but whatever gauge you want to use, the current claims-paying resources in the industry for MBIA and Ambac are going to be sufficient to pay all the losses on the policies they wrote.

The key variable in the statement above is "current".

More on the MBIA/NYT Slugfest

Felix Salmon and I see the contretemps between MBIA and the New York Times quite differently, as our posts (and e-mail exchanges) illustrate. I like Salmon, but ironically, the way we got to know each other was when he savaged a Gretchen Morgenson piece, and I took issue with some of his arguments, so this latest discussion has an oddly familiar feel (I give Felix credit for being a good sport).

By way of update, Felix has weighed in twice on the MBIA/NYT contretemps (here and here) both times on the MBIA side. The second post addressed some of my and Sam Jones of FT Alphavillle's issues with the MBIA retort to the New York Times article.

Felix seems to have missed the point of my post, which is clearly flagged in the headline, "MBIA Lies in Attack on New York Times," namely, that MBIA's attempts to rebut the NYT article were simply untrue as far as the main points at issue were concerned. And note that Salmon in his initial post said that he'd take the veracity of MBIA over the NYT ("According to MBIA, and frankly I trust them more than I trust the NYT on this...").

Felix's second post, instead of acknowledging where MBIA dissembled, plays up other arguments the company has made ("gee, things have changed, so we have better uses for the dough."). That fails to address the lack of candor of the company, which is one of the reason it's in the shape is in. It is no longer trusted in many quarters. As the case of Bear Stearns and Lehman make all too clear, trust in management is even more important in financial services than in other industries. Their financial statements have substantial opaque elements, as our buddy Charles Gaspario has noted, so investors are put in the position of having to take a lot on faith.

And if things have changed, and putting $900 million into its current sub makes no sense, why not dividend the money back to shareholders? That's unconventional to be sure, but not completely unheard of (but we all know that no management will admit that they just went though a difficult, highly dilutive fundraising for naught). But if the executives were really out to maximize shareholder value, which is widely asserted to be their primary duty, that's precisely what they'd do..

Most observers believe the monoline business model is dead, between the changes in muni bond rating procedures that are being forced on the rating agencies (ie, no more free lunches by insuring credits that were better than the rating agency marks suggested they weret) and the entry of Warren Buffet, who has an uncontested AAA, vastly more capital, and unlike the monolines, has very successful insurance operations that take real risks. Buffett will cherry pick the best risks (that's Ajit Jain's the head of his insurance op's MO); good luck to anyone who'd go up against them (and that's even assuming a new MBIA sub could get an AAA, particularly if required to reinsure the existing exposures on the current muni book, which Dinallo indicated was something the wanted).

And we have the additional complication that thanks to the fall in housing prices, which are the basis for real estate taxes on which many local authorities depend, this isnt' exactly the greatest time to be seeking new business in the muni bond guarantee business. Historical models will prove singularly unrelaible. I find it difficult to believe that any new insurance operation under MBIA has a realistic chance of commercial success.

Felix also accepts the company line that MBIA is solvent. That is obviously currently true, but the idea that they will continue to be solvent is far more contested than he admits. He contends that (aside from the "strong" AA rating) critic Ackman and Dinallo have never disputed the solvency of the insurance ops. That is only narrowly accurate. Ackman called for both bond insurers to be put in runoff mode before the end of 2008 to keep the holding company expenses from draining funds needed to pay insurance obligations. Since that hasn't happened, it isn't clear what Ackman's views would be now (he has closed his position and moved on). Dinallo is in an awkward position, having basically admitted the accuracy of Ackman's analysis via his January-February efforts to have MBIA and Ambac raise $15 billion (the amount Ackman had indicated that the insurers would need to maintain their AAAs). It does not behoove Dinallo (or any financial regulator) to raise red flags about solvency unless a regulatory seizure is imminent. Given that he is in negotiations with MBIA, the NYT article may have been singularly unhelpful from his standpoint, since it paints a picture that the company has the upper hand.

The markets see the situation differently. As a recent Bloomberg article noted,

Moody's Investors Service has created a new unit that surprises even its own director.

The team from Moody's Analytics, which operates separately from Moody's ratings division, uses credit-default swap prices as an alternative system of grading debt. These so-called implied ratings often differ significantly from Moody's official grades.

The implied ratings frequently show that swap traders think debt is in more danger of defaulting than Moody's credit ratings signify. And here's the kicker: The swaps traders are usually right.....

Using CDS market prices, Munves's unit assigns implied ratings of Caa1 to both MBIA and Ambac. That's seven notches below junk and 15 below the official Moody's rating.

This is the definition of a CCC/Caa rating:

Bonds of poor quality. Issuers may be in default or are at risk of being in default.

Similarly, Salmon eventually acknowledges the point made in the earlier post, that the NYT was correct in its contention that the investors would have the right to accelerate (demand immediate payment of) the credit default swaps in the event of a regulatory takeover, a point that MBIA attempted to dispute. Again, my main bone of contention with the company is the persistent dishonesty of MBIA management; I wouldn't trust them to run a dog pound.

Felix argued that investors might chose not to exercise that option, citing the example of ACA, which was downgraded and has received a number of waivers from swaps holders. Again, correct, but he misses some key elements. For instance, he asserts the waivers are being used to permit the run-off to continue. Not exactly true. From the press release of the third waiver notice:

The extended forbearance period will permit the Company and its counterparties to continue their productive discussions to develop a lasting solution for the Company's capital and liquidity issues. During this period, the Company plans to work with its financial advisor, The Blackstone Group, to further build upon the significant progress achieved since early December 2007. The Company seeks to finalize the terms of a solution by the end of this extended forbearance period and to proceed to closing as soon as practicable thereafter.

This basically says a liquidation or settlement of some sort is being negotiated.

More important, ACA is not a precedent for MBIA for a key reason: it's muni operations are small relative to its total book. From FT Alphaville:

ACA was always a breed somewhat apart from the largest bond insurers, MBIA and Ambac. For a start since it started out with just a single-A rating - before being slashed to CCC - it had collateral posting written into its positions, hence its current difficulties. But that meant it was a less attractive prospect for the municipal issuers seeking a top notch rating in any case.

So the public finance portion of ACA’s (already much smaller) business is less significant - according to its website, last September, ACA had $7bn of gross par exposure in its public finance business against $69.1bn of notional exposure in its structured credit lines. So ACA is more bad bank, than good bank. Other monolines’ municipals operations are much larger overall than their lately forays into the world of structured credit.

MBIA or Ambac going asunder represents a very messy legal problem. For ACA, there is only so much in the way of assets for the policyholders to divide; the muni policyholders may or may not be treated fairly, but they are rounding error. The vast majority of claimants are in the same boat.

Per the discussion in Felix's and our earlier post, MBIA's CDS holders do have the right to jump to the head of the queue and take priority in payout of the insurer's assets. The CDS holders interests are opposed to those of the municipalities who got guarantees. And to secure those rights, I think it likely that the CDS holders would threaten, or more likely, go as far as filing suit to secure their rights. Dinallo is more concerned politically about protecting the muni holders, but it isn't clear that he can skew any settlement to (conceptually) a pro-ration among CDS and muni policy holders when the CDS policy holders clearly have a priority claim. It's likely, though not guaranteed, that Dinallo would try to mete out an "equitable" settlement (being perceived to have screwed local communities is the kiss of death for anyone with political aspirations) and the CDS holders will be forced to pull the trigger by asserting their right to accelerate. That way, Dinallo could make clear that his options in working out a resolution were limited.

The only thing that might prevent CDS holders from asserting their rights is political considerations (for instance, pension funds who hold structured credits with CDS wraps would not want to look like bad guys with municipalities who are possible clients, ditto investment banks and banks). But these instruments got placed in a lot of hands, and it only take a few claimants to throw sand in the gears.; the others are effectively free riders.

Citigroup Sees Substantial 2Q Writedowns, Rising Credit Costs

Citigroup's latest discussion of its business prospects belies the idea that the credit markets are on the mend. From MarketWatch:

Citigroup Inc. Chief Financial Officer Gary Crittenden said Thursday that the bank faces continuing credit problems in the second quarter, with credit costs rising, provisions for bad consumer loans growing and "substantial" write-downs for subprime assets likely.

"If current trends prevail, it is fair to conclude we will continue to have substantial additional marks on our subprime exposure this quarter," Crittenden said during a conference call sponsored by Deutsche Bank.
Crittenden added that it's reasonable to expect that credit costs will continue to rise through 2008, and that provisions for losses in its consumer business will also grow.

Crittenden said that Citi expects revenue growth of 9% "two to three years out" and sees long-term expense reduction of $15 billion.

China to Increase Fuel Prices; Oil Falls

China had said it would increase fuel prices, which are heavily subsidized, in a statement last month, but had not given any timetable for its actions. Most observers had assumed any change would take place after the Olympics.

In a surprise move, perhaps impelled by inflation concerns, the Chinese announced a price hike effective tomorrow. From Bloomberg:

Crude oil fell more than $1 a barrel on speculation demand will decline, after state-run Chinese television said the country will raise fuel prices.

China, the second-biggest fuel consumer after the U.S., will increase gasoline and diesel prices by 1,000 yuan ($145.50) a ton starting tomorrow, China Central Television said. Jet fuel and power prices will also increase. Oil has almost doubled in the past year partly because of rising Chinese demand.

``The announcement of the Chinese fuel price increase sent the market sharply lower,'' said Michael Fitzpatrick, vice president for energy risk management at MF Global Ltd. in New York. ``This should have a big impact on demand.''

Crude oil for July delivery fell $1.58, or 1.2 percent, to $135.10 a barrel at 10:34 a.m. on the New York Mercantile Exchange. Futures climbed to a record $139.89 on June 16. Prices are 94 percent higher than a year ago.

``The developing countries, in particular China, have been driving demand growth,'' said Eric Wittenauer, an analyst at Wachovia Securities in St. Louis. ``Subsidies and price caps insulate consumers from the full impact of higher prices. By rolling them back, some of the insulation is reduced and we can expect to see a demand response.''

Brent crude oil for August settlement declined $1.80, or 1.3 percent, to $134.64 a barrel on London's ICE Futures Europe exchange. Prices climbed to a record $139.32 on June 16.

MBIA Lies in Attack on New York Times

Let's start with some admissions: Gretchen Morgenson, one of two authors (the other is Vikas Bajaj) of a takedown piece on MBIA yesterday, has some detractors in the blogsphere because, frankly, her understanding of credit instruments leaves something to be desired. Her critics overlook her solid work on executive comp and corporate malfeasance. When she has access to court documents and SEC filings. she is specific and accurate.

Based on watching months of the slugfest between MBIA and Bill Ackman, where MBIA would make vitriolic charges against Ackman which (aside from the obvious fact that he was short) often deliberately misconsrued what he had written (written, mind you, so it was possible to track things back), I'd take Morgenson over MBIA in general, and in particularly, since the first two items (the most important ones by far) in its salvo against the piece are a bald-faced lie followed by an attempt at obfuscation that actually confirms the NYT's position.

The MBIA retort is on its website, with the high-minded title "MBIA Clarifications and Corrections of Media Misperceptions and Errors," but it devolves quickly from there.

If you read the story, it made two charges:

1. MBIA had reneged on a promise to remit $900 million of its recent $1.1 billion capital raise to its insurance subsidiaries

2. New York insurance superintendent Eric Dinallo can't use the threat of putting the insurer into runoff mode to force it to downstream the $900 million because terms of MBIA's credit default contracts, which would reportedly accelerate upon a regulatory seizure and thus give them priority over muni bond guarantees

What is completely amazing is the start of the attack. If you begin with a brazen lie, why should anyone trust anything that follows? This is the first substantive paragraph:

#1 The story leads with the speculative question of “whether regulators will let MBIA…renege on a promise to shore up a crucial unit with $900 million in capital.” That phrasing is erroneous, primarily because no such “promise” has ever been made. The $900 million referenced is part of the net proceeds from the $1.1 billion equity offering that closed in February, which was issued as part of MBIA’s overall capital strengthening plan. The prospectus for the offering stated in the Use of Proceeds section: “We estimate that the net proceeds from this offering and the backstop commitment will be approximately $959 million, after deducting estimated expenses relating to this offering and the backstop commitment. The net proceeds of this offering and the backstop commitment shall be used to support our business plan and operations.” No promise was made to put the capital in MBIA Insurance Corporation.

First, the idea that the parent company has a plan separate from the subs is specious. The parent exists to serve the subs, not vice versa. This is from the former general counsel of a bond insurer:

As for the comment about MBIA's business plan being that of the holding company rather than the insurer, the business plan of the holding company is to hold the insurer. If any evidence is needed, the "Summary" section of the February pro supp should suffice (http://sec.gov/Archives/edgar/data/814585/000119312508025162/d424b5.htm).

Second, MBIA in fact made public statements that it would remit $900 million to the subs, then recanted. Amusingly, the MBIA site references some press releases and statements and argues why it now doesn't make sense to remit cash to the sub. That does not refute the point that it promised earlier to do so, which is flat out denies in the paragraph above (or are we going to get into Clinton-esque parsings of what "promise" means?)

This appeared in a May 12 Bloomberg story:

MBIA Inc., the ailing bond insurer, rose in New York Stock Exchange trading after saying it will pump $900 million into its insurance unit and reporting a first-quarter loss that was narrower than some analysts' estimates.

This piece ran June 11 (note the section below is from the original version of the article, but the substance is unchanged):

MBIA Inc., downgraded from AAA by Standard & Poor's last week, hasn't given $900 million to its insurance unit as planned and said it is now re-evaluating its business strategy and capital deployment plans.

``Our landscape has changed,'' MBIA Chief Financial Officer C. Edward Chaplin said today in a statement distributed by Business Wire.

FT Alphaville, in its post on this contretemps, notes there had been a reversal, and that the change elicited a hailstorm of criticism and selective support.

Let's move to the second main bone of contention. the issue of whether a regulatory takeover would give the CDS holders the right to accelerate (demand payment immediately). Again from MBIA:

#2 In the second paragraph the story asserts that, “Most of these [credit default] contracts stipulate that if MBIA…is taken over by state regulators…buyers can demand payment immediately” and references “the threat that similar swaps pose to MBIA." This analysis is misleading. Typically in MBIA’s policies insuring CDS contracts, there are no provisions that allow a counterparty to terminate the insured CDS contract and make a claim under the policy, absent MBIA’s bankruptcy or insolvency or an MBIA payment default on the policy insuring the CDS contract. Each insured CDS contract that MBIA Corp. enters into is governed by an International Swaps and Derivatives Association, Inc. (ISDA) Master Agreement and Confirmation. MBIA’s CDS contracts typically conform to the Monoline Supplement Agreement, where a bankruptcy of the credit support provider, including the initiation of a receivership proceeding by the NYSID, would give the counterparty the option to terminate the swap and receive a termination payment; it would not be an automatic termination event. As MBIA’s financial condition and statutory capital are very strong and its claim paying resources are in excess of $16 billion, even mention of such a bankruptcy or insolvency proceeding is highly theoretical and extremely remote.

This is obfuscation (and I have e-mailed the former monoline general counsel for further comment, so you may want to check this post later for updates). If the NYSID initiates receivership proceedings (initiates, mind you, it doesn't even have to have taken control), the counterparty can terminate the swap. Pray tell, which counterparty that had an operating brain cell wouldn't avail itself of that opportunity? You'd want to be at the head of the payment queue in a wind-down scenario. The only question is whether there are any limitations on the NYSID's ability to initiate receivership proceedings (i.e. perhaps it cannot do so in the absence of default of a bankruptcy filing, but one would assume that would have been stated, if true, since it would represent a powerful argument in MBIA's defense).

So despite all the huffing and puffing from MBIA, as the its paragraph above stands, MBIA is arguing that the NYT is wrong because they said "demand immediately" and the ISDA standard form agreements (which they conform with) say the swap counterparty has the option to terminate? I fail to understand how MBIA can pretend there is any substantive difference here.

Now MBIA does catch some bona fide errors, such as saying the swaps are against companies as opposed to structured credits. They also disputed the NYT claim that MBIA had $230 billion of "mortgages and related securities". MBIA says it has only $69 billion of "mortgage and residential real estate-related exposure." MBIA referenced an operating supplement issued in conjunction with its 10-Q. I searched under "operating supplement" and looked for releases around the time of its 10-Q (and also looked at the 10-Q itself). I can't verify MBIA's statement and am left wondering if a definitional difference could make both statements accurate (the Times no doubt included commercial real estate expsosures and may have folded in MBIA's captive reinsurer, Channel Re, but without further detail, the gap does look awfully large)/

Finally, MBIA also gets into a "he said, she said" regarding Dinallo, starting with "While it is inappropriate for us to speak on behalf of the NYSID.." and then arguing "our highly creditworthy balance sheet and liquidity with over $16 billion in claims-paying resources make talk of a regulatory takeover misleading and irrelevant. " Um, we'll turn to the NYT:

Mr. Dinallo confirmed last week that the swaps written by MBIA and other financial guarantors were a big factor in his dealings with the weakened bond insurers.

“It is a concern that possibly if one of the companies filed for rehabilitation or if we move to rehabilitate, the holders of the credit default swaps could move to get preferential treatment,” he said.

Mr. Dinallo said he could refuse to honor acceleration demands if he took over a bond insurance firm, but such a move would almost certainly prompt investors who hold the credit default swaps to press their cases in court.

Let's get real here. Dinallo was worried enough about the future of the bond insurers to try to organize a rescue in the amount of $15 billion total for MBIA and Ambac, and their subsequent fundraisings fell vastly short of that number. The fact that he has looked into the swaps issue in this level of detail says he still sees risks. If MBIA has not been able to persuade either its regulator or its rating agencies, who presumably see more detail than the monoline presents in its public filings, that all is well, why should the greater public believe their assertions?

Links 6/19/08

Arctic sea ice melt 'even faster' BBC

Probe shows kiddie porn rap was bogus Boston Herald. Scary, since a guy lost his job and his reputation thanks to malware.

Mixed US messages to Iran Kaveh L Afrasiabi Asia Times. Repeated episodes of "bad faith diplomacy" by the US.

Fed's Bear Stearns Books Look Prime for Cooking Jonathan Weil, Bloomberg

WSJ Reports that Obama Uses Paperclip: Common Older-Style Big-Government Device Dean Baker

FDIC’s Bair: ‘Playbook’ Needed for Failure of Investment Banks Housing Wire. Shiela Bair is having to say this NOW....help me. But maybe the big dogs don't want to go there since to plan for failure is to admit there could be one.

FSA rejects 'American imperialism' in City oil market Times Online. Funny how no regulator every has speculators in his purview. Sort of like gambling in Casablanca.

China and India lose their appeal for investors on inflation fears Telegraph

Antidote du jour:

Paulson Pushing Harder for Fed As Financial Stability Regulator

I really wish the Bush administration was over, now. Here we have the Treasury secretary calling for the nation's central bank, which already has internal tensions in its charter (preserving the soundness of the banking system, keeping inflation low and stable, and maintaining full employment) to also be in charge of financial stability:

Mr. Paulson appears to agree with the broad principle. "We should quickly consider how to most appropriately give the Fed the authority to access necessary information from highly complex financial institutions and the responsibility to intervene in order to protect the system, so they can carry out the role our nation has come to expect -- stabilizing the overall system when it is threatened," Mr. Paulson will say.

Since when does "the nation" expect the Fed to ride in to the rescue? That's Wall Street's fond wish, but in Bush Administration logic, the desires of the financial services industry are identical with the national interest.

The article notes that this speech by Paulson (to be made tomorrow) reaffirms his vision of consolidation of banking and securities regulation under the Fed's aegis. and also promotes the idea of the central bank as a financial stability regulator. That was a grand (one might say overreaching) idea from a Treasury secretary with less than a year remaining in office. But rather than act like an adult and recognize that this program will fall to his successors, who will decide which if any elements to adopt, Paulson has decided to try to push it forward, with emphasis on expanding the Fed's purview.

It hasn't done very well on any of its current responsibilities. Absent some seasonal adjustments that BreakingViews($) deemed "dubious" the last three months inflation would have reached an annualized rate of 8.3%. Similarly, many analysts have started looking past headline unemployment, and find the trends in broader measures even worse. U-6, the broadest measure of unemployment, stands at 9.7%, up from 8.3% a year ago (while U-3, the official unemployment rate, was 5.5% this May versus 4.5% the May prior). And we don't need to discuss the health, or rather, the flagging-even-while-on-life-support status of the banking system.

But no, the latest Bush proposal is to expand the mandate of the very body that had a large role in creating the mess we are in, via overly lax monetary policies and a distaste for its supervisory responsibilities, and officially put it in charge of stability.

And what does financial stability extend to, exactly? The stock market? The commodities market? Why don't we simply officially declare the end of capitalism and make the government the underwriter of all risk. We might as well be honest about what's afoot.

In fact, one can argue that our financial distress is the result of the central bank's mission creep. As one former Fed economist friend observed, Greenspan's big problem was that he needed to be liked. Another former Fed economist, Richard Alford, described at some length how the Fed compromised its independence by throwing its weight behind various Administration policy initiatives, when true independence would dictate remaining silent. Greenspan backed the Clinton deficit reduction, the Bush ownership society (by talking up ARMs) and its Social Security reform program.

And Greenspan took an undue, unprecedented interest in the stock market. A May 2000 Wall Street Journal front page story reveled the then-called Maestro not only pouring over market-related data himself, but putting Fed economist on the task as well. Similarly, the Fed's orchestration of the rescue of LTCM was controversial at the time. It isn't clear that an LTCM collapse would have been a systemic event, and the central bank leaned on firms over which it had no formal jurisdiction. In retrospect, had LTCM failed, even if it produced considerable dislocation, it would have led to new-found caution and respect for risk, particularly counterparty exposures.

In fact, a financial stability role conflicts with tough oversight. Shuttering weak firms creates worries; sweeping problems under the rug and hoping they go away keeps confidence high. And markets are all about confidence.

Think that is an exaggeration? Consider another Wall Street Journal story today with the misleading headline, "Banks Find New Ways To Ease Pain of Bad Loans." A more accurate title would be "Banks Play Accounting Tricks To Disguise How Bad Things Really Are":

In January, Astoria Financial Corp. told investors that its pile of nonperforming loans had grown to about $106 million as of the end of last year. Three months later, the thrift holding company said the number was just $68 million.

How did Astoria do it? By changing its internal policy on when mortgages are classified on its books as troubled. The Lake Success, N.Y., company now counts home loans as nonperforming when the borrower misses at least three payments, instead of two....

From lengthening the time it takes to write off troubled mortgages, to parking lousy loans in subsidiaries that don't count toward regulatory capital levels, the creative maneuvers are perfectly legal....

"Spending all the time gaming the system rather than addressing the problems doesn't reflect well on the institutions," said David Fanger, chief credit officer in the financial-institutions group at Moody's Investors Service, a unit of Moody's Corp. "What this really is about is buying yourself time. ... At the end of the day, the losses are likely to not be that different."....

At Wells Fargo & Co., the fourth-largest U.S. bank by stock-market value, investors and analysts are jittery about its $83.6 billion portfolio of home-equity loans, which is showing signs of stress as real-estate values tumble throughout much of the country.

Until recently, the San Francisco bank had written off home-equity loans -- essentially taking a charge to earnings in anticipation of borrowers' defaulting -- once borrowers fell 120 days behind on payments. But on April 1, the bank started waiting for up to 180 days.....

BankAtlantic Bancorp Inc., which is based in Fort Lauderdale, Fla., earlier this year transferred about $100 million of troubled commercial-real-estate loans into a new subsidiary.

That essentially erased the loans from BankAtlantic's retail-banking unit. Since that unit is federally regulated, BankAtlantic eventually might have faced regulatory action if it didn't substantially beef up the unit's capital and reserve levels to cover the bad loans.

Now one can argue that the Fed isn't the only banking regulator (true) and that regulators can't do much if banks exploit loopholes (particularly if they drop their federal charters become state-chartered banks and are no longer under the purview of the Fed or the OCC). Nevertheless, there is plenty a regulator can do to discourage behavior that it technically permitted but it dislikes (beyond changing the regs). A simple tactic is to make clear that banks that engage in skirting-at-the-margin practices will be subject to far more aggressive supervision and audit. It's possible to make audits punitive (one ploy of the Japanese Ministry of Finance). But as the subprime mess attests, the OCC used its authority to put some limits on subprime lending, while the Fed cast a blind eye.

Having said that, if we must have a stability regulator, it most certainly should not be the Fed. England has some division of roles, with the FSA having supervisory responsibilities, and the Bank of England tasked with monetary policy and financial markets stability. Yet Sir John Gieve, the Deputy Governor of the Bank of England who was responsible for stability, suddenly resigned, presumably over the handling of the Northern Rock meltdown. Yet the Bank of England is more of an old-fashioned central bank, concerned with probity and moral hazard, so Gieve's departure may serve as proof of the difficulty of having the two roles sit under the same roof.

One of the most successful elements of the American political system is its system of checks and balances (which sadly is eroding as imperial presidents chip away at the other two branches). Having one body responsible for both monetary policy and market stability is too much power, and with conflicting objectives. Despite the example of the Greenspan and Bernanke Fed, a central bank should have a bias towards tight credit and a sound currency, while a stability-minded regulator will want to break glass and increase liquidity at the first sign of trouble. Much better to split the roles and let independent bodies duke it out.

Bloomberg: Lehman Sold $5 Billion of Assets to Investee Hedge Fund

A Bloomberg article shed some light on a story passed to us, namely that some of the Lehman asset sales had been achieved via transfers to 2 funds in which Lehman retained an economic interest. While we indicated that our information fell in the category of a rumor, since it came from a single source and the information was not of the sort that could be readily corroborated, the Bloomberg article confirms many of the elements he presented.

Lehman did indeed sell $5 billion of assets to a fund in which the investment bank has an economic interest, R3 Capital Partners, and its founder was indeed the former head of Lehman's principal investing group. The disparity with our report was that the amount alleged to have been sold was much greater, $55 billion versus the $5 billion in the Bloomberg story. However, this $5 billion is material relative to the $70 billion of net asset sales Lehman reported for the last quarter and begs the question of whether it should have been disclosed in the supplemental information provided at the same time as the earnings press release. We hope that the 10-Q filing, which will contain the balance sheet and footnores, will be more forthcoming.

The second fund mentioned in the earlier post, One William Street, is also run by a former Lehman staffer, as our source had indicated. However, the Bloomberg piece is silent on whether Lehman in an investor in this fund or not. The Bloomberg story says the assets sold by Lehman to that fund were a mere $5 million.

Note that while this information is very helpful, it still leaves unanswered the question of how Lehman achieved these sales, particularly since they were spread across a wide range of instrument types and credit qualities. The markets are still difficult; it is normally much easier to sell better rated paper at decent prices than lesser rated instruments. Even if Lehman's marks were reasonable assuming small transaction sizes, larger sales generally have a negative market impact and thus could lead to losses upon disposition (and have the unfortunate side effect of forcing Lehman to mark down remaining positions similar in type). Other banks have financed sales of leveraged loans and some Alt-A portfolios. It isn't out of the question that some of the other assets sold by Lehman were financed or placed with entities in which the firm has an economic interest.

From Bloomberg:

Lehman Brothers Holdings Inc. invested in former trader Rick Rieder's new hedge fund and sold it about $5 billion of assets, positioning the investment bank to profit from the stakes while shrinking its own balance sheet.

Lehman, the fourth-biggest U.S. securities firm, is a minority investor in the fund, called R3 Capital Partners,...

``These are assets we feel very comfortable with,'' Rieder, 46, said in an interview today. ``They have terrific potential for great returns. Just like other shareholders, Lehman will benefit from the returns we'll make going forward.''

The 21-year Lehman veteran most recently ran the global principal strategies group, investing in credit arbitrage, aviation finance and private equity, and left the firm last month to start R3 in New York. Lehman, which reported a $2.8 billion second-quarter loss earlier this week, sold $147 billion of assets in the three months ended May 30 as it hunkered down to weather the credit crisis.

Rieder said 75 percent of the assets his fund bought from Lehman were corporate bonds and loans. There were also some distressed debt and aviation stakes in the mix, two other areas he focused on while at Lehman. The fund will continue to acquire similar holdings in the marketplace, Rieder said....

Among the assets sold during the past quarter were $26 billion of mortgage bonds and leveraged loans, which have plummeted in value during a credit-market contraction that has saddled banks and brokerages worldwide with about $396 billion of losses.

R3 bought about $100 million of Lehman's so-called Level 3 assets, which are the hardest to value because market prices are scarce, according to people familiar with the matter. Most of the firm's mortgage-related holdings are categorized as Level 3, along with other distressed debt.

Lehman sold $3.5 billion of Level 3 assets during the quarter, the firm's finance chief, Ian Lowitt, told analysts in a June 16 conference call.

David Sherr, another former Lehman executive who set up his own hedge fund, bought less than $5 million of assets from Lehman, according to people with knowledge of the transaction. His New York-based fund, One William Street Capital Management, has about $500 million under management.

Sherr, who headed Lehman's securitization division until he left the firm in December, didn't reply to a phone call seeking comment.

Ambac Tells Nasty Fitch to Go Away As Shorts Vindicated

Well, Ambac seems to be resorting to a strategy popular among those in denial:rather than admit you need to lose weight to stave off a heart attack, throw away the scale instead.

Ambac has decided to fire Fitch as one of its rating agencies. And why is that? Well, Fitch had the bad taste to bite the hand that feeds it (remember, fees are paid by the companies) by issuing ratings that are somewhat more candid than Standard & Poor's and Moody's. Fitch was the first to downgrade Ambac to AA (although the newly-established Moody's indicative rating scale, which shows the rating implicit in credit default swap spreads, shows both MBIA and Ambac to be junk credits).

Appallingly, the Wall Street Journal, rather than flagging that this action calls the integrity of the ratings process into question, instead takes the tack that companies will start fighting newly emboldened (more accurately, no longer asleep at the switch) ratings agencies:

The move raises new questions about whether companies, particularly financial firms, will become more aggressive in criticizing how the credit raters do their job and the validity some give those grades and how they are handed out.

Hopefully, Fitch will get more out of this in profile than it loses in fees. It had indicated that it will continue to rate MBIA as long as it feels it can do so accurately. No announcement has yet been made relative to Ambac, but one assumes Fitch will take the same stance.

Illustrating how greater world views the monolines, Bloomberg says the struggle is over, despite the bond guarantors trying to fight a rearguard action in "Bill Ackman Was Right: MBIA, Ambac on `Ratings Cliff'":

Bill Ackman was right: the world's largest bond insurers aren't worthy of a AAA credit rating and may be headed for the bottom of the scale....

That once-unthinkable scenario would trigger clauses in $400 billion of derivative contracts written to insure collateralized debt obligations and other securities, allowing policyholders to demand immediate payment for market losses, which have reached $20 billion, according to company filings. Downgrades of the insurers would cause a drop in rankings for the $2 trillion of debt that the companies guarantee, wiping out the value of the CDO insurance held by Wall Street firms, analysts at Oppenheimer & Co. said.

``Given the volume of credit-default swap contracts the industry has written, there is a real element of a ratings cliff across the bond insurance sector,'' said Fitch managing director Thomas Abruzzo, the first analyst to strip MBIA and Ambac of their top ratings....

Ackman said CIFG ``provides a road map for what happens to a bond insurer when its capital is depleted.'' ...

CIFG, XL Capital Assurance, and FGIC's insurance unit may all fall short of regulatory capital requirements by June 30, according to Robert Haines, an analyst with CreditSights Inc. in New York.

Downgrades may cause Citigroup Inc., Merrill Lynch & Co. and UBS AG to write down the value of insured-debt holdings by at least $10 billion, according to Meredith Whitney, an analyst at Oppenheimer in New York. Banks and insurance companies would also be required by regulators to hold more capital to protect against losses on lower-rated debt, according to analysts at Charlotte, North Carolina-based Wachovia Corp.

CIFG is working on a plan to bolster capital, spokesman Michael Ballinger said. Because MBIA has a surplus of $3.9 billion, insolvency is ``both highly theoretical and extremely unlikely,'' Kevin Brown, a spokesman for MBIA said in an e-mailed statement...

Instead of writing standard insurance policies for the CDOs, the companies provided guarantees in the form of credit-default swap contracts, financial instruments that allow one party to assume the risk of a security defaulting in exchange for a fee from another....

Unlike insurance, the swaps include so-called termination clauses that can be triggered if a company becomes insolvent, Mackin said. The feature requires insurers to compensate CDO holders for any drop in value, or mark-to-market loss, on the securities....

The credit ratings of some CDOs have tumbled so far that the insurers have recorded combined unrealized losses of at least $20 billion.

Some companies' termination payments would eat up all their claims-paying resources, according to filings and rating company reports....

In a June 8 report, CreditSights' Haines wrote that ``statutory surplus levels at some of the monoline financial guarantors are extremely alarming.''...

Even in an insolvency, regulators may step in to halt the payments or banks may decide not to demand compensation, Abruzzo said. ACA Financial Guaranty Corp. has reached five agreements with banks since December, allowing it to avoid posting collateral on CDOs it guaranteed using swaps. ACA has been cut to CCC by S&P.....

MBIA and Ambac may need to raise capital to avoid becoming insolvent if loss reserves continue at the recent pace, Haines said. The companies were both cut to AA from AAA by Fitch and S&P. Moody's said on June 4 that it probably will also reduce its ratings...

In the past two quarters, MBIA's insurance unit set aside reserves of $2 billion to cover losses on $51 billion of guarantees on home-equity securities and CDOs backed by subprime mortgages.

Ambac booked about $2 billion of loss reserves, leaving it with a statutory surplus of $3.6 billion. It guaranteed around $47 billion of CDOs and home-equity debt.

While both companies are above the regulatory capital requirements, S&P said in a February report that in a ``stress case scenario,'' MBIA may be forced to pay a total $7.9 billion in claims on a present-value basis and Ambac may be forced to pay $6.2 billion.

``That's what puts these companies into the nightmare scenario,'' CreditSights' Haines said.

Paulson & Co. Founder Says Credit Losses May Exceed $1.3 Trillion

John Paulson, of the eponymous hedge fund Paulson & Co., contends that the credit contraction has run only about 1/3 of its course as far as writedowns are concerned. He anticipates that the total credit losses will reach $1.3 trillion, which exceeds the IMF's forecast of $845 billion.

Paulson, who made a spectacularly successful bet against subprime last year and secured the services of Greenspan as an advisor, is far from an orthodox source, but the flip side is he has no conventional institutional or political constraints to blunt his predictions.

From Bloomberg:

``We're only about a third of the way through the writedowns,'' [John] Paulson, 52, told the GAIM International hedge fund conference in Monaco today. ``There are a lot of problems out there and it will continue to be felt through the year. We don't see any signs of stabilizing.''

Paulson, whose New York-based company manages about $33 billion, made bets last year that subprime-mortgage debt would fall after he noticed ``bubble like'' prices. His Paulson Partners fund rose 18 percent a year since it started in 1994, and his main subprime-debt fund rose 591 percent last year. Banks and securities firm worldwide posted more than $395 billion in losses and writedowns since the subprime crisis started last year.

The U.S. is heading into a recession as falling home prices weigh on consumer spending, Paulson said. The second half of this year will be worse than the first as the economic slowdown spills into 2009. Signs of stress are ``accelerating'' in the housing market, and he's betting on falling securities prices, he said.

``I don't consider myself a bull or a bear,'' he told the audience at Monaco's Grimaldi Forum. ``I'm a realist.''....

Ambac Financial Group Inc., the second-biggest bond insurer, is ``the most leveraged, troubled company out there,'' Paulson said. It's at risk of being downgraded to non-investment grade, he said. Ambac spokeswoman Vandana Sharma declined to comment....

Paulson's outlook is consistent with the view of hedge funds meeting in Monaco this week. More than 80 percent of the 1,300 fund managers, investors and service providers gathered in Monaco for the annual conference said they expect the credit crisis will continue, according to a GAIM survey. About 23 percent said the situation ``will deteriorate significantly.''

Bill Browder, founder and head of Hermitage Capital Management, said securities firms have a ``vested interest'' in claiming an early end to the crunch. ``If we're in the seventh or eighth inning, this is a 100-inning game,'' he said....

Paulson said he's preparing to buy distressed securities such as bank loans, call them a ``potentially $10 trillion opportunity.'' While it is still ``premature'' to invest in many of them, he sees ``opportunities this year'' to buy mortgage backed debt, he said.

He hired employees this year to research securities firms such as Citigroup Inc. for long-term investment positions. ``We're trying to see the right entrance point,'' he said. ``If you invest too early, you lose money.''

Has the Fed Compromised Its Independence? (And Otherwise Messed Up?)

Today in the Financial Times, John Plender has an apple pie and motherhood column on the importance of central bank independence, It's a tad ironic, since he fails to recognize that it's an illusion in the US. But Plender isn't to be faulted. An entire generation has grown up in the Greenspan/Bernanke era, and thus has no idea of what an independent central bank in the US would look like. As the article demonstrates, Plender's view is widely shared:

There are few things on which economists are in total agreement. But practitioners of the dismal science come pretty close on the issue of independent central banking. Most see the move to hand operational control of monetary policy to central banking technocrats as having provided vital underpinning for the recent long period of low inflation and stable growth. Yet the independence of the world's leading central banks is increasingly under threat...

As yet, the US Federal Reserve's position looks less vulnerable. But Paul McCulley of Pimco, the bond fund manager, believes that the game has changed since the Bear Stearns rescue. This, he argues, was a fiscal policy action little different from the role of Congress in bailing out Chrysler. Having watched the Fed conduct a multibillion-dollar bail-out of an investment bank that it did not supervise, the politicians may now apply pressure for the central bank to firefight elsewhere.

That is not to say the Fed's operational independence in setting interest rates will be impaired. Mr McCulley's point is rather that the Fed will be less independent in regulatory matters, as well in as the size and composition of its balance sheet.

The biggest threat to independence, though, could simply come from a failure to keep the lid on inflation. There are signs on both sides of the Atlantic that monetary policymakers have been slow to recognise the extent of the current inflationary threat.

Former Federal Reserve economist Richard Alford takes issue with that view. Alford has criticized the Fed's recent policies (see here for an interview that was very popular with readers) and has gone digging deeper to find its roots.

Alford was so kind as to share with me an article he is developing. It's a bit too long to post in full, so let me give the broad strokes followed by the concluding section.

Few have any memory of America's central bank having a openly contentious relationship with the Treasury and Congress. Even though Paul Volcker had to withstand considerable pressure, some of his predecessors fought open turf wars. Yet from the end of World War II to the (sadly) supine Arthur Burns era, there were not infrequent pitched battles with the Fed with incidents that would seem unthinkable now. For example, Truman summoned the FOMC to pressure them into a more accommodative policy during the Korean War, then issued a White House press release claiming the Fed had made a commitment that it had not agreed to. The Fed played hardball, leaking its version of the meeting, which contradicted the press release. That led Congress to join the fray, trying to bring the Fed to heel via sharply critical hearings.

While Volker did endure widespread criticism and harangues from Congress, even for those who lived through that era. the memories of the ritual roughings up are dim. In addition, there was at least initial support for his harsh measures. Moreover, (unbeknownst to me) Volcker was masterful at defanging Congress long enough for his remedies to take hold. Had someone less adept been at the helm, a firefight might well have ensued.

I do hope Alford's thesis reaches a broader audience. From Alford:

This most recent period is the trickiest to come to grips with. There has been no sustained acceleration in the rate of inflation. The FOMC wasn’t called to the White House. No Chairman was denied reappointment. The semi-annual Congressional kerfuffle over monetary policy became a tea party.

However, there are reasons to look beneath the tranquil surface. Inflation in the latter part of the period was by one estimate 50-100 basis points lower than it would have been had it not been for globalization and imported disinflation. Furthermore, while measured inflation remained low and relatively stable, there were two significant asset bubbles, the trade deficit reached 6% of GDP, and the personal saving rate fell to 0.0%. Hence the question remains -- did the Fed promote short-term gains and high employment with low inflation, at the expense of long-term problems engendering unsustainable financial and external imbalances?

With respect to the housing bubble, the Fed asserts its innocence. It says that monetary policy was appropriate. It also takes the position that while, ex post, it is clear that supervision and regulation was too lax, no one saw the housing and credit bubble forming. Consequently, they cannot be blamed. There are problems with these defenses.

The assertion that the stance of monetary policy was appropriate given the measured inflation rate just assumes away the problem. If policy contributed to the bubble, then it was inappropriate regardless of the inflation rate. Contrary to the Fed position, people did see the housing and credit bubbles forming, although they were in the minority. Most importantly, the Fed as the central bank and the principle banking regulator alone had the responsibility of forestalling systemic risks. Even if no one else saw the bubble forming, the Fed should have. Saying no one else saw the crisis brewing is no defense.

Since the first Latin American debt crisis, we have had a Fed that has been eager to lean against financial headwinds, but completely unwilling to take in sail when dealing with strong financial tail winds. The Fed did not the lean against either the NASDAQ or housing bubbles. Greenspan acknowledged that the NASDAQ might be a bubble, but decided it was appropriate to wait until the bubble popped and then mop up. Post 2000, the Fed denied the existence of a housing bubble. It ignored the declining credit standards, increased leverage, declining quality spreads and a Fed funds target below that implied by the Taylor Rule. The Fed then chose to characterize the bubble as localized froth even after it started to deflate. It then asserted that it was a contained sub-prime problem.

We have a Fed that is willing to incur short-term costs if it reduces inflation, but will not incur short-term costs to achieve financial stability or external balance. This would be less of a problem if another agency or agencies had the willingness and ability to insure financial and external balance, but it is clear that we do not. The Fed was granted independence and insulated from political pressure in order to accept short-term costs in order to enhance the prospects for long term growth. However, the current Fed, like the Fed of the 1970s, failed to use the freedom it was granted.

Assuming for the moment that the Fed either made an error of commission (spiking the punch bowl) or omission (failure to exercise its regulatory and supervisory powers), is there any reason to believe it was the result of an erosion of the independence of the Fed? Unfortunately, the public record suggests that Fed independence has been compromised. There is reason to believe that Greenspan entered into deals with two of the three administrations during his tenure as Chairman. Some commentators believe that he entered into deals with all three. However, the number is unimportant. What is important is that the Fed’s independence was compromised and a very public precedent was set. Never again will an FOMC Chairman be able to say “The Fed does not make deals” to a President or a Secretary of the Treasury or a member of Congress.

Compare the behavior of the Chairmen of the 1950s and Volcker to that of Greenspan. Chairman Eccles and McCabe both lost their Chairmanships because they wouldn’t compromise Fed independence. They stood their ground even after being summoned to the White House. Martin, appointed by Truman, was in later life referred to by Truman as “the traitor” presumably for taking the punch bowl away. The public image of Volcker is that of a man who twice a year endured public Congressional assaults, resisted political pressure, and enabled the Fed to stay the course.

Greenspan, on the other hand, jumped at the chance to meet Clinton, traveling to Little Rock before the inauguration. Bob Woodward in his book “Maestro” quotes Clinton telling Gore after the pre-inauguration meeting: “We can do business.” Woodward also quotes Secretary of the Treasury Bentsen telling Clinton that they had effectively reached a “gentleman’s agreement” with Greenspan. The agreement evidently involved Greenspan’s support for budget deficit reduction financed in part by tax increases. It is not clear what Greenspan received.

Even if the deal with Clinton contributed to a good policy mix, Greenspan should never have entered into that agreement/deal/understanding or another agreement/deal/understanding. The very act of negotiating and injecting the Fed into a discussion of budget decisions compromised Fed independence. Why shouldn’t Bush have expected the same? Why shouldn’t every succeeding President expect the Fed Chairman to be a “business” partner? Refusal to deal on the part of the Fed can no longer be attributed to principle and precedent. Refusal “ to do business” will now be viewed as a rejection, partisan or otherwise. The Fed is no longer able to stand apart from political battles. Greenspan severely compromised the Fed standing as an agency insulated from the short-sighted and partisan politics of Washington DC.

Greenspan risked the NASDAQ bubble during the Clinton years (part of the quo for the quid?) and more recently implicitly accepted the risk of a housing bubble as he touted ARMs as the Bush Administration and Congress promoted the ownership society. Financial innovation was lauded while it produced short-term gains. The Fed failed to adequately pursue its regulatory responsibilities as it kept rates low, despite the relatively high levels of leverage, derivatives markets that dwarfed the underlying cash markets, breakdowns in lending standards and credit spreads that even it didn’t think compensated for the risks. Like Greenspan, the current Fed implicitly decided to risk long term stability rather than incur short-term costs. With globalization holding down measured inflation, it seems that no risk was not worth taking.

After failing to use the independence granted to it by statute, the Fed is now pushing the bounds of its legal authority. It is making decisions that might better be reserved for elected officials. It argues that these steps are necessary, but the Fed is being drawn into the micro management of credit allocation and income re-distribution -- a far cry from “inflation targeting”. The Fed is willingly injecting itself into areas that are the provenance of the Congress. Congress has not objected yet, but it will when it is to Congress’s advantage. Will it have costs? How does monetary policy designed by the people responsible for the tax code, fiscal deficit and Federal debt sound?

Greenspan had very considerable political skills, but he did not use them to maintain Fed independence or insulate the Fed as it took policy steps that imposed short-term costs. He curried political favor and opined on issues other than monetary policy. There is no evidence that Bernanke made a deal. Bernanke also made it clear that unlike Greenspan he would refrain from commenting on issues other than monetary policy, but there is evidence that it was too late and that the Fed is “in play”. Recent behavior, first by the Administration and now by the Senate, indicates that positions on the Board of Governors are to be treated as patronage jobs doled out to party loyalists. The qualifications of a recent appointment look to be entirely political. Dodd’s refusal to consider confirming any appointments until after the next election is just as egregious, especially when one considers the depleted Board, soon to be down to three (2 if one assumes that Bernanke will retire when he isn’t reappointed Chairman.), and the challenges facing the Fed.

I am reminded of a Thomas Nast political cartoon from the 1870s. It features a banner across the Capitol building that reads:
“To the victors belong the spoils. We must spoil everything.”

How Dangerous Are OTC Markets?

This week's Institutional Risk Analytics has an alarming title: "Is Risk Management Even Possible in an OTC Marketplace?" By all indications, the article points to a strong "no".

As much as I am a harsh critic of so-called financial innovation, the headline goes further than the case the article makes. OTC markets covers a large territory. The Treasury, corporate, and agency bond markets are OTC. Because those instruments are offered publicly (ie, the size and terms of each issue are known) and the valuation process for these securities is pretty straightforward, the potential for trading in them to cause a large scale problem is no greater than in other simple products (remember, it's possible to create disasters via simple operator error, such as believing as Walter Wriston did, that countries don't go bankrupt).

Even in derivatives-land, some products are sufficiently straightforward, such as simple ("plain vanilla") interest rate and currency swaps, as to not pose undue risks if properly managed. But the problem is that financial firms have come to have high return requirements, and these simple products aren't very lucrative (indeed, some are marginally profitable but the dealers stay in the market because most large players prefer institutions that make markets in the full range of financial products).

A general pattern in the last 15+ years is that large financial firms have take on more and more risk in order to keep their returns high and their profits growing. Some of that is via leverage, some of that is via launching or expanding the market for new products (think CDS and CDOs), some of it is by taking risks they shunned before (think of leveraged loans).

I've only excerpted some bits of this article, but in case you decide to read it in its entirety (which I do recommend), I wanted to address some quotes that give a misleading impression. One is at the start of the article:

OTC derivatives had been legally permitted for the first time in 1993 by a regulatory exemption that Wendy Gramm had adopted as virtually her last act as CFTC chair.

That's not correct. OTC equity options and FX options had been around well before 1990. Swiss Bank formed a joint venture, which was a precursor to a full buyout, of O'Connor & Associates, a Chicago-based derivatives trading firm. The reason for the deal was O'Connor's leadership in OTC equity and FX options. Um, those are derivatives, and regulated by the CBOE, which is a self-regulatory organization under the supervision of the SEC. Bankers Trust was another big player in those markets back then. I hate to sound pedantic, but it makes me crazy when people make definitive statements that are just plain wrong.

Putting this quibble aside, the article has a very good section on how the FDIC is gearing up for a big increase in bank failures. The rest of the article focuses on the problems posed by OTC markets. Some excerpts:

One veteran federal regulator, who provided comments on our upcoming article for the Journal of Structured Finance, put to rest some of our fears that Washington is clueless about the nature of the OTC problem....:

Regulator: You suggest in your article that the issues raised by OTC markets have not been discussed within the regulatory community, but in fact it has and is being discussed intensively. Whether or not the OTC market needs to be officially "regulated" seems debatable, especially since regulators do not have the legal authority to enforce such a change.

The IRA: So the US and other nations must simply accept the fact that OTC markets are here to stay and that these inefficient markets will periodically destroy a large financial institution? That seems like a recipe for disaster, financially and politically.

Regulator: Part of the problem is cultural. Today we think that all markets are at a minimum weak form efficient. The Efficient Market Hypothesis is taught as gospel. The underlying assumptions of modern economic thought -- ready prices, informational symmetry, and rational expectations -- are all suspect and have been for a long time. We tend to view economics and modeling as a science governed by laws similar to the laws of nature. We believe that markets can be confined to probability spaces we understand and can reasonably estimate. This is not true.

The IRA: So you agree with our view that risk management of OTC markets is essentially impossible? Or does your statement apply to all financial markets?

Regulator: The reality is that economics is a social science and the attempts to make it "hard" are always going to run aground on the reality that human actions don't follow the "simple" laws of nature; they learn, adapt, herd, swarm, fall prey to trends, forget, remember, forget again - and in a semi-rational and sometimes irrational manner. The probability spaces are impacted by things traditional theory freely jettisons in order to make the model tractable. Therefore, risk models, upon which so much of the OTC market rests, are simply a way to communicate and express views of value -- usually rather naive and simplistic views -- and miss huge chunks of the real underlying "human action" risks.

The IRA: Ludwig von Mises, the author of Human Action, would be pleased to hear your comments. So, again, you agree with our view that most alleged "risk management" systems deployed on Wall Street are really just tools used to do deals and have no real capacity to measure let alone limit risk?

Regulator: The risk and pricing models are often created in order to convince traders and end-user investors that all these financial transactions -- behind which are human behaviors and cash flows -- are "manageable" and can be properly understood with the right analytics, data and "secret sauce." This witchcraft and sorcery can turn a toad into a prince, a rotten apple into a juicy melon. But it's all spurious precision. It's all vaporware. The models are used to create liquidity, which spurs volume, which garners big commissions and large EPS for dealers. The senior managers know that the models and assumptions upon which the higher spread product is based for things like OTC complex instruments are garbage, but you need a "basis" upon which to talk and compare so you can drive business. This charade works 90% of the time when things are calm, but as Hynman Minsky wrote in 1980 "stability is ultimately destabilizing." When risk regimes change, those who don't "know" these truisms find themselves naked.

We then spoke to Bob Feinberg, our favorite observer of financial services policy on Capitol Hill, about the state of the banking industry and congressional efforts to address the subprime financial meltdown....

Feinberg: At the last CMRE event that Elizabeth Currier allowed you and I to attend, which was in 2004, Larry Kudlow called for monetary reflation in order to make the economy look healthy so George W. Bush could be re-elected. It's happening again this year on behalf of all incumbents. The late Bob Weintraub called this the presidential cycle. It doesn't always work. In 1992, Greenspan didn't accommodate "41" (aka George H.W. Bush), and for a time there was doubt as to Greenspan's reappointment because 41 blamed Greenspan for his defeat. Fighting deflation becomes the Fed's excuse for pre-election monetary expansion, even if there is no deflation in sight. The way Greenspan put it in 2004 was that deflation was a low-probability, high-value event that must be staved off, just to be safe.

The IRA: But is it even possible to reflate the US economy when the financial industry is in such a terrible state?

Feinberg: I stand by my previous view about the model being broken, but I don't think people realize that this can't be fixed, that industries have life cycles, and the banking industry is about a half century past its best-if-used-by date. Greenspan once said to the Senate Banking Committee that some people would say that the only thing banks do is live off the yield curve. Whenever that model isn't available, they have to resort to extremely risky gambits to try to earn the returns Wall Street demands. It's a 19th century business model that got an extension thanks to the ability to arbitrage securities, but once they actually try to create new products, these instruments must be risky and opaque. So they've ended up as GSEs, CDOs and CDEs (Capital-Destroying Entities). Another acronym is the Disaster-Prone Organization (DPO), an expression coined by Prof. Anthony F.C. Sutton in his book, St. Clair, in which he laid out the reasons for the failure of the coal industry, which was just as powerful in its day as the banks are now.

The IRA: So you see the US banking industry going the way of king coal? Obviously the neither the Fed nor the Congress is willing to admit that a big constituency like the banking industry is moribund.

Feinberg: The bottom line is that the system is broken and can't be fixed. The reason the banks keep coming up with opaque products is that they're trying to de-commoditize a business that is mature and adds little or no value to the economy. In fact, over time and on net, the banking system destroys value. I wonder what song and dance the geniuses at Treasury are going to come up with next to justify buying worthless CDOs in the name of "reliquefying the market." I'm fascinated by the application of Gresham's Law to this situation; that bad collateral is manifestly driving out the good. I even read that banks are making bad loans in order to create some bad collateral, because the Fed will buy it.

The IRA: I take it that you do not expect the Congress to propose significant reforms of market structure?

Feinberg: After LTCM, the President's Working Group did a report and found that the financial system was just fine. After Amaranth, I think, some congressional committee(s), certainly Senate Banking, asked the PWG to go back and take a look at what they said in 1998, and PWG came back and said it had nothing to add. They asserted that the opaque market for derivatives could best be monitored by the banking regulators. I think this assertion needs to be rethought given what's happened with Bear and LEH..

Links 6/18/08

'Oldest' computer music unveiled BBC

Apple’s Engineers: an Unexpected Profit Center Oren Hurvitz

Regulators, Genetic Testing Companies Begin Face Off Wired

U.S. Tells China Subprime Woes Are No Reason to Keep Markets Closed New York Times. Only Hank Paulson could say that with a straight face.

The Confidence Man New York Magazine. On David Einhorn.

The "Enron Loophole" Mark Thoma

Japan’s Great Insight Long or Short Capital (hat tip Felix Salmon)

WSJ's Greg Ip Going to The Economist Barry Ritholtz. Aha, this explains why Sudeep Reddy wrote page one WSJ story on the Fed's change in sentiment yesterday....

Central banks — not sovereign funds — are doing the heavy lifting these days; they financed much of the US deficit in the first quarter Brad Setser

Antidote du jour:

MBIA Refuses to Downstream Cash, Uses CDS Fears to Defy Regulators

Let me tell you, if we have a revolution in the next decade, one of the triggers will have been the flagrant disregard shown by big players like MBIA for regulations, legal commitments, and fair dealing. I'm not surprised to see financially oriented sites calling for mass protests (but not yet against bond guarantors).

The latest bit of MBIA chicanery manages to sink far beneath the already low standards set by the bond insurer. Readers may recall that MBIA had refused to downstream $900 million raised in highly dilutive equity offerings to its insurance subsidiaries (note it had raised $1.1 billion, all of which was initially slotted to go to the subs, then when it was revealed that the money was still in the holding company, said in early May that they would remit $900 million to the insurance ops, then in early June basically said that they had changed their mind). As we noted last week:

The whole purpose of the fundraising was for the parent to then downstream the proceeds to the insurance subsidiaries. That's where the insurance is written, that's where the capital shortfall is.

So why is MBIA hoarding cash at the parent level? Well, executives (along with other corporate charges) are paid out of the parent company's books. The subsidiaries can dividend cash up only if the are profitable OR get permission from their regulator.....

So what does the holding of so much cash at the parent level mean? Aside from being a shameless case of duplicity, it says one of two things, neither pretty. First, they expect losses for the foreseeable future, and expect the regulators to prohibit dividend payments too. But withholding the entire $1.1 billion is an admission of how bad they expect things to get. Or second, they expect the regulators to put MBIA into runoff mode, and are keeping their cash to support the parent level empire that would otherwise be starved out of existence. But if so, the representations made by management about the soundness of the company are false.

So why hasn't Eric Dinallo, who is unusually pro-active for an insurance regulator, taken MBIA management out and shot them by putting the company in runoff mode? (Note he is almost certain not go that far, but he has that as the big gun in his arsenal.) MBIA has booby trapped itself. As the New York Times reports:

MBIA has written $137 billion in swaps, which are privately traded insurance contracts that let people bet on companies’ financial health. Most of these contracts stipulate that if MBIA’s bond insurance unit becomes insolvent or is taken over by state regulators, buyers can demand payment immediately.

But if that were to happen, MBIA would have far less money to pay policyholders and owners of municipal bonds backed by the company. So the swaps give MBIA significant leverage over Eric R. Dinallo, the commissioner of the New York State insurance department, who wanted the company to bolster its insurance unit with the $900 million in cash.

In the case of Bear Stearns, the Federal Reserve feared that credit default swaps might unleash a chain reaction of losses if the bank were allowed to collapse. Given the threat that similar swaps may pose to MBIA, Mr. Dinallo is unlikely to push for a regulatory takeover of the subsidiary even if Joseph W. Brown, MBIA’s chief executive, refuses to recapitalize the unit.....

Mr. Dinallo said he could refuse to honor acceleration demands if he took over a bond insurance firm, but such a move would almost certainly prompt investors who hold the credit default swaps to press their cases in court. The acceleration clause is a standard feature in credit default swaps written by many bond guarantors, including Ambac and the Financial Guaranty Insurance Company.

How could people this dishonorable ever gotten themselves in charge of anything more consequential than a used car dealership? The excuse is that MBIA now plans to start a new subsidiary, but given that that the incumbents mismanaged MBIA so as to lose its AAA ratings (Moody's has not officially lowered the boom, but its downgrade is widely expected), reversed themselves on actions that their regulator required and they agreed to, and are now in open defiance of their regulator, do you really think they are going to get approval to start a new subsidiary? This is clearly a stalling action to keep as much cash as possible at the parent level to maintain the employment of and benefits to the executives.

Dinallo nevertheless appears to be giving the outrageous, self-serving MBIA proposal some consideration, provided the new sub resinsures the muni bond guarantees of the existing insurance operations, However, it's one thing for him to keep talking, another thing to take action. I wish there were a way for him to force the removal of the current management without putting the subs into runof. Industry old hands see through this malarkey:

John Miller, chief investment officer at Nuveen Asset Management, a big municipal bond fund manager in Chicago, voiced skepticism about MBIA’s plans to start a new insurance subsidiary that could reinsure its existing portfolio.

“It would be surprising to me if it would be successful,” Mr. Miller said. “It will still be an MBIA-insured bond and then reinsured also by MBIA, but MBIA as a new company.”

Some believe this tactic is self-defeating:

Joshua Rosner, an analyst at Graham-Fisher in New York, said, “It seems to me that if Jay Brown insists on putting the money anywhere other than at the insurance subsidiary or through a new subsidiary directly under it, he is making a very clear statement that he no longer believes in the viability of the insurance company to meet its obligations.”

Unfortunately, no matter what the outcome, this sorry saga has a few chapters to go.

RBS Publishes Global Stock and Bond Crash Alert

Ah, just when you thought it might be safe to venture into the markets again, RBS sends out a red alert, warning private clients to prepare themselves for a full fledged rout in equities and bond markets in the next three months, with the S&P losing 300 points, or nearly a quarter of its value, by September.

That's a bold and pretty specific call. The technically-minded believe that if the S&P 500 were to breach 1270 (closing, not intraday), the next support level is hundreds of points lower. In addition, the impact of inflation has not been factored into asset prices. The chart below (click to enlarge) illustrates how devastating inflation is to stock valuations. The S&P 500 multiple fell from over 17 to below 8 during the early 1970s, and pretty quickly too. However, then the impetus was the oil embargo, but note that as inflation became embedded, a bear market rally fizzled and the market hit even lower earnings multiples.



Now the flip side is forecasts like this have a way of not playing out according to script. Like the Heisenberg uncertainty principle, the very act of making such a projection influences the outcome. It may be that a mere reversal of the denial about the combination of the inability to treat fragile financial markets and inflation simultaneously will provoke a selloff (but it could be a grinding loss of confidence over 6-9 months rather than a speedy affair). Or as with the 1970s, there may be a now-unforeseen shock (one shudders to think, but at attack on Iran would send already high oil prices to ghastly levels, almost certainly precipitating a global recession).

From the Telegraph:

The Royal Bank of Scotland has advised clients to brace for a full-fledged crash in global stock and credit markets over the next three months as inflation paralyses the major central banks.

"A very nasty period is soon to be upon us - be prepared," said Bob Janjuah, the bank's credit strategist...

RBS said the iTraxx index of high-grade corporate bonds could soar to 130/150 while the "Crossover" index of lower grade corporate bonds could reach 650/700 in a renewed bout of panic on the debt markets.

"I do not think I can be much blunter. If you have to be in credit, focus on quality, short durations, non-cyclical defensive names.

"Cash is the key safe haven. This is about not losing your money, and not losing your job," said Mr Janjuah, who became a City star after his grim warnings last year about the credit crisis proved all too accurate.

RBS expects Wall Street to rally a little further into early July before short-lived momentum from America's fiscal boost begins to fizzle out, and the delayed effects of the oil spike inflict their damage.

"Globalisation was always going to risk putting G7 bankers into a dangerous corner at some point. We have got to that point," he said....

The authorities cannot respond with easy money because oil and food costs continue to push headline inflation to levels that are unsettling the markets. "The ugly spoiler is that we may need to see much lower global growth in order to get lower inflation," he said.

"The Fed is in panic mode. The massive credibility chasms down which the Fed and maybe even the ECB will plummet when they fail to hike rates in the face of higher inflation will combine to give us a big sell-off in risky assets," he said.

Kit Jukes, RBS's head of debt markets, said Europe would not be immune. "Economic weakness is spreading and the latest data on consumer demand and confidence are dire. The ECB is hell-bent on raising rates...

Ultimately, the bank expects the oil price spike to subside as the more powerful force of debt deflation takes hold next year.

Mohamed El-Erian's Odd Piece on Global Imbalances

Full disclosure: I'm normally a fan of Mohamed El-Erian, former head of Harvard Management, now co-president of bond giant Pimco. But his current comment in the Financial Times, "How best to manage global imbalances," struck me as more than a tad disingenuous.

Let's go through the article:

Whatever happened to the debate on global payments imbalances?...At its roots, the policy solution called for simultaneous implementation of three sets of measures. First, a reduction in US domestic aggregate demand to contain imports and encourage a shift to exports. Second, an increase in consumption in Asia and the Middle East, including having China adopt a higher and flexible exchange rate. Third, structural reforms in western Europe to enhance the growth potential of the global economy.

Most observers agreed on the elegance and theoretical potency of this policy combination, which reduces imbalances in the context of high global growth, contained inflation and relatively stable financial markets. Indeed, the question was never about design. It was about implementation.

I may be about to put foot in mouth and chew, but I follow the economic press pretty closely and saw no evidence of a discussion along the lines El-Erian indicates. Perhaps there was an article in Foreign Affairs that I missed, but the discussions I've read among top level economists seems still to be in the "is the culprit the savings glut in developing countries or is it overconsumptoin in America?" stage.

Now El-Erian does travel in elevated circles, so this idea may have been kicked around, but for it to have gotten anywhere, it would have had to either come out as an official recommendation of an august body or been otherwise pre-sold, via speeches and op-ed pieces. I have seen no trial balloons ANYWHERE in the US by anyone prominent arguing that a recession would be a good thing (um, that's what "reduction in domestic aggregate demand" means). You'd need to do a pretty hard sales campaign, and I find no evidence of one.

And how could the Fed go along, given its mandate of full employment and price stability? That too would take a bit of artwork.

The only reference I have ever seen to something along El-Erian's line of thinking was from El-Erian himself and Michael Spence in a Wall Street Journal op-ed more than a year ago, Except then they presented it as a scenario of how global imbalances could work themselves out on their own, not a policy recommendation. From the Journal:

Now to the future. Over time, emerging markets will inevitably divert more of their assets to more sophisticated investments abroad. That shift will have many effects, some of which depend on the decisions taken by emerging economies while others depend on the evolution of the global context....

While the shift is inevitable, it would be unlikely that the emerging economies as a group would deliberately take actions that directly undermine global economic markets. There will also be domestic pressure on policy makers in emerging countries to gradually shift their emphasis away from the producer and towards the consumer...

Under this state of the world, domestic consumption in the rest of the world picks up over time, facilitating the needed adjustment in the U.S. The result is a gradual journey to a more normal relationship between assets and income returns, with savings moving to a more normal long-run pattern.

But this process is not automatic.... it is particularly sensitive to "policy mistakes."

Among these policy mistakes, protectionism measures in the U.S. would derail the global adjustment So, too, would the inability of emerging economies to navigate their complex policy challenges.

Geopolitical shocks would also be a problem,....Finally, significant "market accidents" that, in the past, have been associated with excessive leverage and triggered sudden and large portfolio changes and credit rationing, would add to the policy complexity.

So where does all this leave us? The current configuration of global imbalances, while highly unusual is not a real puzzle. It is the result of a series of individual decisions in both advanced and emerging economies that were largely rational when considered at the micro level.

These decisions reflected individual self interest, and happened to coincide. The aggregation of these decisions at the national and international levels raises considerable challenges, as does the ability to maintain an orderly global reconciliation process over time. The fundamental question, therefore, is whether these global considerations will be sufficient to minimize the risk of "policy mistakes" in a world that is subject to geo-political risk and bouts of excessive leverage.

If this represented some sort of policy program agreed on in high circles, it was so coded that it went by me completely.

Back to the current offering from the FT:

The policy solution stalled because of a basic co-ordination problem, or what is known in game theory as the “prisoners’ dilemma”. While all parties had an interest in the outcome, any individual party that moved first risked being worse off if others did not follow. With multilateral co-ordination mechanisms such as the Group of Seven industrial countries and the International Monetary Fund lacking representation and legitimacy, there was no way to provide parties with sufficient assurances that their actions would be accompanied by others. As a result, no one took sufficiently meaningful action.

Again, El-Erian says pretty directly that this idea got at least to the talking stages. But who in the US has the authority to push the economy into a recession? The last guy who did that, Volcker, had Carter's blessing and even broader support (at least initially) because there was a general recognition that inflation had gotten to a level that was painful. We aren't even close to that sort of consensus on our trade deficit or lack of savings as a problem.

The Europeans agreeing to "structural solutions" I assume is code for more more flexible labor markets. But Europe is not a major actor in the global imbalances story, so it isn't clear why they should go along and impose unpopular measures to solve a problem not of their making. And the Chinese building a consumer economy is a much longer time horizon process than cutting domestic demand might be in the US. How do you sync the two programs?

Back to El-Erian:

With the policy solution stuck, the process is now being driven by the reality that components of the imbalances have reached their natural point of exhaustion. The risk is that while the imbalances will be corrected over time, it will be at a high cost for the global economy. Relative prices are now leading the adjustment process through the impact of a substantial terms-of-trade shock led by the surge in oil and food prices. Second-round effects, via the prices of other goods and wages in some emerging economies, will also be in play.

The price shock will serve to undermine real incomes in the US and lower imports. On the policy front, it will accentuate the tug of war that the Federal Reserve faces on account of its now conflicting inflation and employment objectives. Emerging economies face greater inflation in the context of their buoyant liquidity conditions. Several will see their real effective exchange rates appreciate, by means including measures to allow the nominal exchange rate to appreciate markedly against the dollar. In Europe, growing demands for wage increases may force companies to step up structural reforms and will cause the European Central Bank to increase its hawkish rhetoric.

Under this scenario, the question for markets is no longer whether the global imbalances adjust. They will. Instead, the focus should be on the collateral damage of the adjustment process – damage that is region-specific given differences in policy flexibility and initial economic and financial conditions. In the US, look for renewed pressure for further fiscal stimulus and a monetary policy that, while appropriate for the US, is too inflationary for the rest of the world. In Asia and the Middle East, the spike in inflationary pressures may inadvertently slow the move towards more efficient tools of indirect economic management. In Europe, expect attempts to bypass fiscal responsibility guidelines in order to mute political protest.

As this bumpy and disorderly process plays out, it is important not to lose sight of important lessons. Indeed, the fact that the system has ended up eschewing the superior policy solution speaks to the urgency of learning from them. An increasingly interconnected world cannot maintain high growth and low inflation without a bold modernisation of the mechanisms for international policy co-ordination, starting with the G7. Governments must continue to refine their policy instruments and pay greater attention to the secondary and tertiary consequences of their actions. The private sector must assume greater responsibility for forward-looking risk management. In the absence of these changes, the inevitable adjustment of the global imbalances will continue to entail a serious cost in global welfare.

To be honest, I do not believe there is any pretty way out of the situation we are in.

However, I question El-Erian's assumption at the beginning of the final paragraph, that we can have a highly interconnected world with high growth, low inflation, and some measure of stability. El-Erian believes that more powerful international institutions will do the trick, but there are limits to how much sovereignity nations are willing to sacrifice. I can't see the US, China, or Russia ceding too much control.

And as we have noted before. some evidence suggests that free capital flows in and of themselves produce instability and crises. A recent paper by Kenneth Rogoff and Carmen Reinhart found that

Periods of high international capital mobility have repeatedly produced international banking crises, not only famously as they did in the 1990s, but historically.

Thus part of the solution may not lie in stronger international organizations, but more robust, and somewhat more self-contained domestic markets. The notion of China and India being less export and more domestic consumption oriented fits that pattern. And that in turn means a somewhat lower level of international trade and capital flows.

So How Did Lehman Delever? A Not-Very-Pretty Possibility

The markets responded positively today to Lehman's announcement of its second quarter results, its provision of a financial supplement that gave more detail on its balance sheet exposures and how they had changed over time, and its investor conference call, The stock was up over 5% of the day, although its closing price of $27.20 is still below the offering price last week of $28.00.

One of the problems with the conference call format is that the balance sheet is not available until the 10-Q is filed. For most companies, the balance sheet is not where the action is, but financial firms are an exception, particularly in trying times. So the analysts miss the opportunity to grill management on the really meaty stuff. Admittedly, there was a page in the Lehman press release that contained leverage computations, and the supplement did provide a good deal of detail on certain types of exposures. But as Michael Mayo of Deutshce Bank pointed out during the Q&A, it's hard to know what to make of those figures without having the carrying values (as in average markdown). And even with the detail, several analysts asked for more breakdowns which Lehman said it would provide to them.

First, we'll deal with a few anomalies, then we'll get to what is admittedly a rumor, but one if true with pretty serious implications.

The preliminary announcement indicated that Lehman's reduction in gross assets was $130 billion and net was $70 billion; today, the gross figure was $147 billion. Figures can move around while statements are being finalized, and the gross number is probably less important than the net.

The marks on the now-somewhat-notorious SunCal deal (largely raw land) is 70 cents on the dollar. Land, which in a negative carry item (you have to keep paying taxes) is very much a "beauty is in the eye of the beholder" asset unless you have developed properties nearby to give a benchmark. I'm not clear what stage this project is in (the plan was to subdivide, develop, and sell lots, so the "development" consists of getting roads and utilities in). However, the Wall Street Journal indicated that land values in the area have fallen by as much as 60%. Lehman's exposure is senior debt, and a mark in the mid-70s seems a tad aggressive (um, where is the cashflow to service debt? Mid-70s seems high for an asset that by its demographics is probably non-performing). This is not a large exposure ($1.6 billion gross), but it is one David Einhorn discussed, and taking what appears to be a generous valuation on a high-profile position raises unnecessary questions.

Another oddity is compensation expenses. They rose $418 million ($130 of that was severance) when headcount fell by 1,900.

A further question mark is Level Three assets. They fell on a gross level from $40 billion to $38 billion, but when you decompose that, Lehman sold $3 billion of assets in the Level 3 bucket, wrote down $2 billion, and then added another $3.5 billion. That might not seem so bad were it not for this statement from Dick Fuld in the conference call:

We had the benefit of much greater price visibility due to the number of assets that were sold especially in the commercial and residential mortgage area that were the result of our deleveraging and the strong trading volumes in the cash, and then certain derivative markets that gave us important additional valuation information.

If they had a much better sense of market values, particularly in the sometimes thorny derivatives arena, one would have expected some assets to be moved out of Level 3 via having market reference points, as opposed to by offloading them or reducing their values. But that appeared not to have happened.

The last, looming mystery is how Lehman delevered in a crappy credit market. Their quarter ended in May, and March, thanks to the Bear meltdown and the worries about Lehman, would not have been a good time to sell assets. Similarly, one would have expected sales to be concentrated in certain sectors of the market where pricing was more favorable. Lehman went to great pains to show that the sales were spread across product and said they were not concentrated in the highest credit qualty assets either. They also said sales were spread over the quarter (given March, I find that to be quite a statement).

This seems to be too good to be true, and begs the question I raised when Lehman first began talking up its delevering via CNBC: were these really arm's length sales, or, as has happened with a lot of leveraged loans and some Alt-A portfolios, were they financed? Note no analyst raised this issue in the conference call.

I received an e-mail from a former Lehman MD yesterday. I am not able to independently verify it, so be warned that this falls in the category of a rumor. Nevertheless, it is sufficiently specific that it sounds credible to me, and it explains the mystery of how Lehman was able to distribute its sales so well across its various types of holdings and not take any apparent big hits to tidy up its balance sheet (even if you have marked an asset at a defensible price, the offer for, say, $5 million in assets is gong to be higher than if you are trying to unload $500 million, and thus you could take a loss on a supposedly conservative mark if you get serious about reducing exposures in a wobbly market).

The message:

Curious whether, to your knowledge, they've given much detail around the reduction in gross & net leverage they achieved in the May qtr. My understanding is that the vast majority of the reduction came from spinning out two large businesses into independent entities: the mortgage trading business (now called "One William St Capital") and the principal investing business (now called "R3 Capital"). R3 Capital is starting life with assets of around $55 billion.

From friends both inside & outside LEH, I understand that LEH is keeping a 45% stake in each business. They are continuing to vest stock for former LEH employees who join the new ventures (so LEH is effectively paying much of their compensation...this may be why LEH's compensation expense spiked in the May qtr). LEH's continued economic interest in the two entities has been described to be as "complex" (ie, it's not as simple as 45% carried interest in profits or losses). The main driver, unsurprisingly, was to allow LEH to maintain as much econ interest as possible, consistent with meeting accounting standards to get the biz's off LEH's balance sheet.

I haven't spoken to anyone who has had much to say either way about whether (& to what extent) LEH would face contingent liabilities in the event the new entities were counterparties to losses...but it's not that hard to imagine a situation where either of these two entities faced losses from derivatives contracts that exceeded (by a wide margin) the capitalization of the newco's. Will the counterparties, in those cases, look to LEH as a backstop? How could they not?

Anyway, perhaps LEH has given adequate disclosure on this today, and if so my concerns are moot.

I read the conference call transcript and the filings today and saw no reference of asset sales to new entities.

Now if this is indeed accurate, and comes out at some future point, I'd be pretty unhappy if I were an analyst. Given the recent history with Bear Stearn's failed hedge funds and SIVs, financial firms have had a pretty hard time not supporting off-balance sheet businesses and sponsored entities when they run aground. And if Lehman managed to maintain a 45% economic interest while getting an off balance sheet treatment (their accountant must be some sort of evil genius), it would be even harder for them not to step up in the event of mishap.

If true, and I stress if true, this stinks to high heaven. But given that Lehman played fast and loose with SEC Rule FD, this would be another instance of questionable business practices.

Anyone who can corroborate or deny is very much encouraged to speak up.

Links 6/17/08

Homosexual brain resembles that of opposite sex: study PhysOrg

Blogger arrests hit record high BBC. I am not certain that this is as meaningful as it seems, since the number of bloggers is also at a record high.

Exposing Bush Administration Corruption Stephen Lendman. I was plenty upset about Clinton corruption too (please, the commodity trading, the sale of the Lincoln bedroom, the list goes on) but they now look like amateurs (hat tip Michael Panzner). The source is a former member of the CIA who was also given a two star general rank as an advisor to the Joint Chiefs of Staff. Some indirect confirmation: Army Overseer Tells of Ouster Over KBR Stir New York Times

Morgan Stanley warns of 'catastrophic event' as ECB fights Federal Reserve Ambrose Evans-Pritchard. Telegraph

The April TIC data lends itself to a host of different headlines … Brad Setser

Booming, China Faults U.S. Policy on the Economy New York Times. Good, albeit sobering, piece (although Dean Baker thinks the reporters should have been a bit more tough-minded). Representative quote:

Last month, Liu Mingkang, the chairman of the China Banking Regulatory Commission, delivered a lecture at the British Museum in London in which he blamed the American government for the subprime mortgage crisis that came close to freezing Western debt markets and required extensive intervention by the Federal Reserve. The turmoil, he said, was “counteracting the course of global civilization.”

“Does moneymaking or doing business justify the regulators in ignoring their duty for prudential supervision and their job of preventing misbehavior?” he said.

Re-thinking That ‘70’s Inflation Show Thomas Palley. Key section:

In effect, fighting a price - wage spiral with high interest rates is a form of class based policy that breaks the spiral by undercutting the bargaining power of workers.

Note: Mark Thoma doesn't necessarily buy it.

Antidote du jour. I don't normally go for videos, but I liked the sound effects here:

Fed Rate Increase Looking Less Likely

How little resolve our central bank has. We said we thought Fed was unlikely to raise rates, or if it did, it would be at most 25 basis points between now and year end., which falls in the category of being cosmetic. The central bank has been particularly, one might say unduly, attentive to the health of banks. Despite a good deal of cheery chat that the credit crisis is on the mend, the housing market has not bottomed, and corporate and consumer defaults are on the rise.

However, as some alert readers noted, the markets chose to read Bernanke's statement as more hawkish than it was. While it did acknowledge concerns about the dollar, it also mentioned risks to growth. Thus the Journal story, "Fed Mood Tilts Away From Rate Increase" may overstate the degree of change in Fed posture.

From the Journal:

The Federal Reserve is almost certain to leave interest rates unchanged when it meets next week, and it currently doesn't appear to see a compelling case for raising rates before the fall...An August rate hike can't be ruled out...

But for now, Fed officials want to both demonstrate their vigilance against inflation risks, particularly from soaring energy prices and the weak dollar, while also giving the economy time to recover from the trouble in the housing, labor and financial markets.

As a result, the Fed's policy statement following its meeting next Tuesday and Wednesday is likely to use stronger language about the risks from inflation than in May, but is unlikely to go so far as to ratify market expectations of a rate hike as soon as August....

In recent days, markets have seized on comments made last week by Fed Chairman Ben Bernanke that suggested a greater focus on inflation concerns, and particularly on the public's expectations of a rise in inflation. "The latest round of increases in energy prices has added to the upside risks to inflation and inflation expectations," he said in a speech on June 9. He said that the Fed "will strongly resist" allowing inflation expectations to get out of hand.....

But Mr. Bernanke also said in his speech that the housing contraction and energy-price surges "suggest that growth risks remain to the downside," even though the risk that the economy "has entered a substantial downturn" had fallen.

There is so far little evidence that either underlying inflation or the public's long-term inflation expectations have reached a danger point. Mr. Bernanke and most other officials believe inflation expectations remain under control. The pace of inflation, excluding volatile energy and food prices, has remained near the top of the Fed's preferred range of 1.5% to 2%, based on its preferred price index. And with the economy weak, workers are unable to win wage gains in a way that would send inflation spiraling higher. The latest data show wage gains actually slowing -- the opposite of what has occurred in Europe, where rising wages are triggering tough anti-inflation rhetoric from the European Central Bank.

What's more, Mr. Bernanke and other Fed officials believe financial markets remain especially fragile. Raising rates soon could worsen those troubles, hitting the mortgage sector and lengthening the housing downturn.

"The outlook for the financial crisis would worsen," said Tom Gallagher, an analyst at brokerage ISI Group. The Fed usually doesn't stop easing rates until the unemployment rate peaks, Mr. Gallagher notes, and a peak in jobless figures hasn't necessarily happened yet. If rate hikes were to start soon, "the Fed would be tightening well in advance of the traditional indicators."...

Several presidents of regional Fed banks have expressed strong concerns in recent months about the inflation outlook. That could lead to more dissent at the upcoming meeting, continuing a string of minority opposition since last fall.

Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, said in a speech Monday that the Fed should be prepared to raise rates as the risks of weaker growth diminish. But Mr. Lacker, who is generally hawkish on inflation, also suggested a willingness to hold rates steady for now, by noting that inflation expectations haven't gone "adrift."

"We seem to have dodged this risk so far," Mr. Lacker said. "Inflation expectations are higher than I would like, but are relatively stable."

Note that other observers are coming to the same view, including Bill Fleckenstein at MSN and Ed McKelvey at Goldman. But I particularly like how John Dizard makes his case:

Dr Egon Spengler: "There's something very important I forgot to tell you."

Dr Peter Venkman: "What?"

Dr Spengler: "Don't cross the streams."

Dr Venkman: "Why?"

Dr Spengler: "It would be bad."

Dr Venkman: "I'm fuzzy on the whole good/bad thing. What do you mean, 'bad'?"

Dr Spengler: "Try to imagine all life as you know it stopping instantaneously and every molecule in your body exploding at the speed of light."

Dr Ray Stantz: "Total protonic reversal."

Dr Venkman: "Right. That's bad. Okay. All right. Important safety tip. Thanks, Egon."

( Ghostbusters , 1984)

Ben Bernanke and Jean-Claude Trichet have nearly crossed some "streams" of their own in the past couple of weeks, much like Bill Murray's disreputable "scientist", Dr Venkman. This has had results for, among others, Lehman Brothers' shareholders and management, close to "total protonic reversal".

The central bankers' streams are two mutually exclusive policies: the containment of inflation and the avoidance of systemic risk to the financial system. The official pretence, now hard to maintain, is that, thanks to clever management, there is no contradiction between the two; that careful balancing of priorities can ensure stable currencies and the continued support of a highly leveraged financial system.

Not.

Just as capital is being withdrawn from speculative trades, there are more possibilities emerging for speculation all the time, thanks to the internal contradictions of central banking. The time for principled stands by Federal Reserve governors against official support for over-leveraging came and went years ago, starting in 1998. It's really too late for that now. Time was bought, for politicians, policy people and the investment world. Now it will be paid for.

The question is whether it will be paid for with devalued currency or with cans of preserved food and AK-47 ammunition. The answer is devalued currency. No, Lehman - or the next name - will not be allowed to collapse. To avoid that, though, policy will need to remain accommodative, as they say.

So, contrary to what is now being priced in, I do not think the Federal Reserve will raise the policy rates just before the presidential election. The European Central Bank may have more nerve, but its board may run into political roadblocks to tightening, whatever the governing treaty says.

AIG's Connolly: "Crisis of Capitalism is Upon Us"

It's one thing to read an apocalyptic alarm from, say, a blogger or a newsletter writer. It's quite another to see it coming from an analyst at a large institution, in this case AIG.

Bernard Connolly is deeply critical of central banks, not just of their recent actions but also of their very existence, and thinks they have gone from bad to worse with their devotion to inflation targeting. Connolly believes the monetary authorities have gotten themselves in a fix where they lack good options, but he sees raising rates now as the worst move they could make.

An interesting aspect of this piece, particularly for US readers, is Connolly's observations about the politics of ECB chief Trichet's moves. He argues that Trichet has gone beyond his mandate, perhaps to force action from the G8.

While I am not certain I agree fully with Connolly's analysis, I do think the Fed has cut too deeply, too fast. As much as it would be better for rates to be higher, I'm not certain if we can get from A to B right now. The financial system is a mess. For instance, banks for some time have been well behind on foreclosures; it appears this is by design, so as not to alarm the public and shareholders. Similarly, the Bank of England says banks are hoarding cash, another sign of fragility. The Fed somehow hoped that banks would recapitalize in this window of improved market conditions, but they haven't to even remotely the degree necessary, and the losses in the pipeline are probably worse than the Fed has been willing to admit to itself.

As much as I don't like coddling banks, my sense is things are far more precarious than they appear. I'd rather see the Fed sit tight for three or four months and see if demand destruction due to high oil prices and a cut in subsidies in developing countries (particularly China, which has said it will lower supports and may take action after the Olympics) puts some downward pressure on oil prices.

Regardless of whether you agree with Connolly's views, I recommend him for his fresh perspective and trenchant writing style.

From Connolly:

We have lost count of how many notes we have, in the past few years, written with some reference to a crisis of capitalism. Tragically, that crisis is now upon us, and the pace of unravelling seems to be accelerating. The next highly foreseeable development is that there will be a worldwide crimping of central bank independence as the political process increasingly sees -- rightly or wrongly, but in our view largely rightly -- central banks as having fouled up.

The yob culture of Britain’s streets seems to have spread to several of the central banks. Those banks are behaving like gangs of brutish, feral fifteen-year-olds who egg each other on, claiming “respect”, by knocking down elderly passers-by and kicking the life out of them. So far, governments have reacted...by saying that we have to let these young people express themselves. But the tide may be turning...

The ultimate fons et origo of the present mess is, arguably, the very existence of central banks, for that existence is a token of a decision taken by society, in virtually all countries, that financial risk must be at least to some extent socialised and that central banks are necessary to prevent or alleviate financial crises. Moral hazard is thus inherent in all, or virtually all, our societies. But the proximate reason for the mess, ironically enough, is that central banks have reinterpreted their mission, largely perversely, and have fallen prey to the totemism of inflation targeting. That totemism is essentially imposing on the world a version of Bundesbank philosophy that is proving highly malignant in the moral-hazard-ridden but innovative and, in most circumstances, beneficial financial system we actually have...

One implication worth stressing from the very outset is that while Trichet told us all last week that he will, if he is allowed to get away with it, impose 1930s-like conditions in the euro-area cads, the Fed has, in its recent pronouncements, come close to saying that it is prepared to impose some aspects of 1930s conditions -- and not least a stock market crash -- on the US. And while Trichet can argue that he is only doing what the politicians have, through the treaty, told him to do, however stupid or destructive that may be, the Fed will have only itself to blame.... In our note of a month ago, "The Fed: Damned If It Does and Damned If It Doesn't?", we argued that while the vicious circle posited by Fisher might well exist, another, and more dangerous, vicious circle would be created if the Fed were to give the impression of being constrained by the dollar...

But who has won the argument in and about the ECB? Our understanding is that Trichet sprang his announcement on surprised ECB Council members at the real Council meeting -- the dinner on the Wednesday evening preceding the formal meeting2. We further understand that even those who welcomed Trichet's announcement -- such as Weber -- were taken aback by it (though not as taken aback as banks' exotic rate structures desks, which were ripped up and torn into shreds by the sudden reversal of the shape of the euro curve; one presumes that Trichet did not anticipate the wild movements in the curve, for those movements were very unwelcome from the point view of a global financial system which in some ways looks even more vulnerable than before the Bear Stearns rescue). Many others were appalled by it. Significantly, it seems the Irish said (as we suggested last Friday) they could accept Trichet's decision, but not this month -- in other words, not until after today's referendum.

Implicitly, what Trichet did at his press conference was something along the lines of, "Forget anything you thought you knew about the euro: it is from now on going to be a hard, Germanic currency. The ECB is the Bundesbank and the euro is the DEM. The value of the euro and the level of interest rates will be no more affected by the fact that countries such a Spain, Portugal, Greece, Ireland and Italy are members of the euro zone than were the dollar and US rates affected by the fact that at various
times countries such as Nicaragua were dollarised." If Trichet were allowed to get away with that, the status of the euro would be radically transformed. Even more important, Trichet was in effect announcing a coup d’état in EMU. The question of whether the euro would be hard or soft, and whether the ECB would respond to conditions in the area as a whole, to conditions in weak countries or to conditions only in Germany – at bottom, the question of whether France or Germany would
predominate in EMU – was the subject of many years of detailed – and, it has to be said, inconclusive – political discussion and negotiation, though admittedly not politically accountable discussion and negotiation. Now Trichet, a jumped-up civil servant, though admittedly the high priest of the caste of civil servants, or at least of énarques, appears to be saying, “I don’t care about all that: This question is not being decided by my personal diktat, and my decision is in favour of Germany.”

Will Trichet be allowed to get away with it? Does he want to get away with it (recall our suggestion made last Friday that Trichet, who is known to have been worrying about divergence within the euro area for the past couple of years, may in effect have decided to force the politicians to make the decisions about the future of EMU before an uncontrollable economic and financial crisis develops, knowing as he must that the ECB cannot resolve the problems and contradictions now so clearly exposed within it). The stakes are now very high indeed. Lagarde's implication that the G8 would force Trichet to change his mind represents a very considerable upping of the ante. If the ECB goes ahead and hikes, Lagarde (and Sarkozy) will look foolish. If that were to happen, the rumours that have been swirling for some months, to the effect that Sarkozy might threaten Merkel that France could withdraw from monetary union, might begin to have some substance. But if Trichet backs
down, he will have made a political -- though entirely unaccountable -- forum, the G8, the arbiter of ECB policy. ECB independence will be gone. Thus the G8 is shaping up to be potentially as climactic as the famous Bath Ecofin meeting of September 1992. Then, the pressures on Schlesinger, and his reaction to them, precipitated the ERM crisis.

What might the line-up at the G8 be? The belief in the market that the US government and the Fed were disconcerted and discommoded by Trichet's announcement seems credible. For what that announcement did, coming immediately after Bernanke's comments on the dollar (to which we shall return in Part 2 of this note), was potentially to re-create the conditions of the summer and early autumn of 1987. Then, the market perception that the Fed would be obliged by the Louvre Agreement to support the dollar, by following Bundesbank rate moves, was very definitely a factor ccontributing to
the Wall Street Crash of October of that year (true, the US stock market had gone parabolic in the months preceding the 1987 crash and was thus very vulnerable; but the factors of vulnerability now, though different from those of 1987, are very considerable; more obviously, the parabolic variable recently has been the oil price -- a sharp fall in that price would reduce equity vulnerability, but, as noted earlier, we defer substantive discussion of the oil/inflation/dollar/rates/stocks nexus to Part 2).

We suspect that the US, or at least the US government side, will want to make it clear to Trichet (or perhaps in reality to Weber) that it will not look kindly on any attempt by the ECB,.... to push up not just euro rates but dollar rates. Equally clearly, the Italians will side with the French. So, too, will the British government, which has troubles of its own with the turbulent monetary priest of Threadneedle Street. The Canadian government, too, will not wish to endorse an ECB role as global rate-setter. The Japanese -- including, we suspect, the BoJ – will have been aghast at what one can consider the collective loutishness of some of the other major central banks. So Trichet and the Germans may well be isolated.

That said, we cannot predict the G8 outcome with any confidence whatsoever. But Lagarde has ensured that its outcome -- whichever way it goes – could be dramatic. The politicians will strike back against the central banks, whether at Osaka or later. The central banks (again with the exception of the BoJ, for reasons we hope to develop in a subsequent note) have, in putting the entire global economic and financial system at risk in pursuit of “respect”, over-reached themselves.

Note that this was published prior to the G8 meeting this weekend. The public pronouncements seemed very tame, so it does not appear that the backlash that Connolly hoped for took place.

Quelle Surprise! Wall Street Journal Downplays EU Calls for Tougher Rating Agency Regulation

I've had less cause of late to criticize the Wall Street Journal as the paper has made strides in its coverage of the credit markets. However, today's paper has a story in which ideology appears to have compromised its reporting.

Today Charlie McCreevy, EU internal markets commissioner, is to outline proposals for closer, tougher oversight of rating agencies. His speech contains some withering attacks on the US regime, not merely its structure, but also the failure of regulators to exercise the powers they had. From the Financial Times:

Mr McCreevy is to make clear that nothing short of supervision will do. "I am now convinced that limited but mandatory, well-targeted and robust internal governance reforms are going to be imperative to complement stronger external oversight of rating agencies," he will say. "I have concluded that a regulatory solution at European level is now necessary to deal with some of the core issues."

The announcement comes just weeks after the International Organisation of Securities Commissions proposed changes to the industry code of conduct, a code Mr McCreevy will make clear falls far short of what is needed.

In withering language, Mr McCreevy will describe the code as "a toothless wonder" and point out that "no supervisor appears to have got as much as a sniff of the rot at the heart of the structured finance rating process before it all blew up".

He will say that he is "deeply sceptical" about its usefulness. "Many of the recent IOSCO task force recommendations do not appear enforceable in a meaningful way," he will suggest.

He will also call for "robust firewalls" to protect those responsible for the integrity of the process from executives whose priority is "to drive forward" earnings.

So McCreevy thinks both the current regime and the IOSC proposals are grossly inadequate. And how does the Journal present his views?

Europe's top markets official is set to unveil a plan to regulate bond-rating companies, a move that adds heft to similar efforts by U.S. officials to address causes of the yearlong global credit crunch.

Charlie McCreevy, the European Union commissioner for internal markets and services, plans to say in a speech Monday that he will propose legislation designed to address what he sees as conflicts of interest at credit-ratings companies. In a draft of his speech, he called current voluntary codes of conduct a "toothless wonder."...

Among other measures, Mr. McCreevy wants to enforce so-called fire walls between operations of the ratings companies that raise fees from clients issuing bonds and operations that rate the bonds. He wants ratings companies to register in a way similar to that in the U.S.

Policy makers have criticized ratings companies because their ratings of structured products failed to reflect their true risks, particularly under stress. Critics say there is an inherent conflict of interest in the business: an issuer of debt pays the agencies to rate its product and sometimes, in the case of structured credit, to help design the product, too.

The U.S. Securities and Exchange Commission recently recommended that credit-rating firms make more information about ratings publicly available.

Mr. McCreevy's plans would ban some practices and require firms to distinguish between corporate or government debt and complex structured products.

So the Journal intimates that McCreevy is pretty much on the same page as US regulators, and makes no mention of his unusually harsh criticism or specifically, that supervision was woefully inadequate and is badly needed.

Misconstruing where McCreevy stands relative to his US counterparts seems a deliberate attempt to play down calls for more stringent regulation.

Managers of Failed Bear Hedge Funds May Face Criminal Indictments (And Why Not Bear?)

The Wall Street Journal reports that criminal charges against the managers of the failed Bear Stearns hedge funds, Ralph Cioffi and Matthew Tannin, are imminent. The Journal also indicates there are no charges pending against Bear Stearns or any other Bear executives.

Pray tell, why not?

The funds were clearly under the supervision of Bear Stearns; the Journal story reports that Cioffi had to get approval from Bear's compliance department to move $2 of the $6 million he had invested in the riskier of the two funds he managed into an internal Bear fund. The funds were located in the Bear headquarters building and used Bear's risk management systems.

Early on in the meltdown of the funds, Bear had tried to take the position that they were independent entities and therefore could sink or swim on their own. Bear was forced to relent, and my view at the time was that it was due to the rest of Wall Street having considerable leverage (literally, the other firms could cut repo lines or take other punitive action) rather that out of a consideration of legal niceties (exactly how responsible should Bear be as sponsor of the funds?).

Had I not read about Cioffi's little chat with compliance, I could have accepted the view that the funds were independent enough in legal structure and operation as to get Bear off the hook. But that interaction says that Cioffi thought that Bear had oversight of the fund (and if Bear didn't, the compliance officer should have dismissed the inquiry rather than giving approval). Similarly, the story also indicates the funds were NOT independent, but part of Bear's asset management operation. These all say the firm had a duty to supervise. Unless it is established that Cioffi and Tannin willfully misled the firm, it ought to be Bear, not these individuals, that is in the dock.

From the Journal:

The former Bear Stearns managers, Ralph Cioffi and Matthew Tannin, managed two high-profile bond portfolios for the securities firm's asset-management unit. They could be charged with securities fraud within the next week, says one of the people familiar with the matter, though evidence could emerge that would change that.

At issue is whether the managers intentionally misled investors by presenting a rosy picture of the funds at a time when they were privately communicating with colleagues about their worries over how the investment vehicles would ride out weakness in the mortgage market....

But in February 2007, the feverish activity in the subprime-mortgage market began to slow, and securities tied to the mortgages swooned. Still, Mr. Cioffi and a number of his colleagues remained upbeat...

On Feb. 27, 2007, a warning signal came from a closely watched slice of the ABX, an index that tracks subprime-mortgage securities. The indicator slid to a low of 63 from well north of 90 at the beginning of the year...

In March, the ABX recovered some ground. That's when Mr. Cioffi, who had worked at Bear Stearns for 22 years, sought and received permission from the firm's compliance officials to move $2 million of the $6 million he personally had invested in the riskier hedge fund into a separate internal fund called Structured Risk Partners...

It is unclear what Mr. Cioffi's expectations for the mortgage market were at the time. During the investigation, he has said that a shift of that size would have had no material impact on his substantial net worth at the time. He told colleagues that it was an effort to use money gained from his investment in the High-Grade fund to give a boost to a neighboring hedge fund at the firm. To bring charges, prosecutors would have to allege that Messrs. Cioffi and Tannin deliberately misled investors.

In April 2007, Mr. Cioffi exchanged emails with colleagues in which he expressed concerns about the credit markets, and wondered how a downturn might affect his investors, according to people familiar with the matter. In an April 25 call with fund investors, however, he sounded an upbeat note, telling participants he was "cautiously optimistic" about his and Mr. Tannin's ability to hedge their portfolio.

"The market will stabilize," Mr. Cioffi said, adding: "We have a plan in place that will get the funds back on track to generate positive returns," according to a review of the transcript of the call. The two funds had solid financing from lenders, he said, and "significant" cash on hand. It is unclear how much money the funds actually had at the time. Mr. Tannin echoed Mr. Cioffi's reassurances, counseling investors not to be alarmed by "articles daily about how the world is coming to an end." He added, "We're quite comfortable with where we sit."

The swoon wasn't reported to investors until early June, partly because of the standard delays in calculating monthly returns. But in May, the fund managers began selling billions of dollars in bonds to raise cash for the struggling funds. As the bad news leaked out, some investor rushed for the exits, demanding that Messrs. Cioffi and Tannin return their money.

But the fund managers didn't have enough cash handy to repay investors and meet "margin calls" -- demands from lenders for additional cash or collateral -- so they refused the redemption requests. This created further investor anxiety.

By late June, the riskier fund, which faced unmet margin calls and notices of default, essentially was left to die. To salvage the less-risky High-Grade fund, Bear Stearns officials agreed to lend it as much as $3.2 billion to meet its immediate needs. (Bear Stearns ultimately lent just half that; the loan was never fully repaid.) On July 31, the funds filed for bankruptcy protection in a New York federal court.

Now I may be giving Cioffi far too much credit; it's quite possible that prosecutors have a damning e-mail or witness recollection of a phone conversation to back their charges.

However, it isn't just common for traders to hold on to an outdated view when markets undergo a sea change. I first saw this in 1984. I was part of a team tasked to figure out why the biggest Treasury operation in London had gone from money-spinning to loss-making.

The root cause was actually pretty simple, although the remedies were not as obvious. The senior managers, and in particular, the highly regarded, highly connected FX trading desk, had grown up in a weak dollar environment. The dollar had, as a result of Volcker's tough monetary policies, suddenly become a strong currency. The traders' reflexes were dead wrong.

Never attribute to malice that which can be explained by incompetence. Although the details may prove otherwise, I find it plausible that Cioffi and Tannin were slow to recognize that subprime was terminal, and Bear did an incompetent job of supervising them. And if that's the case, it's Bear, and not the two managers, who should be the focus of the investigation.

Links 6/16/08

PAPUA NEW GUINEA: The world's first climate change "refugees" Irin Asia

Ebb and flow of the sea drives world's big extinction events PhysOrg

Why We Can't See America's Ziggurats in Iraq Tom Englehardt. On US mega-bases in Iraq, which are well covered in the military press but hardly mentioned in the popular media.

Bush pledges on Iraq bases a ruse Asia Times

Insolvency creeps towards dot-com crash level Times Online

Deflation rather than inflation could soon be our big worry Roger Bootle, Telegraph

WP Tries To Tell Housing Bubble Story Culture of Life News. The writing tends towards the overwrought, but points our errors in the WaPo article on housing and has some great cartoons.

Unreported Loan Delinquencies The Nattering Naybob

Minimum Wage and the Supply Curve Spencer, Angry Bear

Europe’s plan B for the Lisbon treaty Wolfgang Munchau, Financial Times. Munchau argues that the EU will let Ireland exit, if it comes to that, and suffer the consequences. Willem Buiter disagrees.

Antidote du jour:

Wall Street Losses Reach Half of Post 2004 Profits (And the Fat Lady Has Yet to Sing)

Today's New York Times provides an interesting bit of context for investment banks woes: losses from July 2007 to present roughly equal the profits earned from the beginning of 2004 through that date.

The story merely alludes to the question of whether the rich bonuses of the boom years were warranted, but broaches another topic that the former Masters of the Universe may not want to consider: the industry is going to experience secular as well as cyclical changes. Drastic falls in employment are normal in the securities industry (peak to trough declines are typically 20%) and bonuses fall even more dramatically (producers who one earned in the $1 to $3 million range in the dotcom era had to make do with a mere $300,000 to $400,000 in the last downturn).

But at a minimum, investment banks are just about certain to be required to keep higher equity levels, and that alone will reduce profits. If credit default swaps do indeed move to exchanges, that eliminates another lucrative revenue source. Additional reforms are may well reduce the attractiveness of other activities.

From the New York Times:

The numbers are staggering. Between early 2004 and mid-2007, a period of unprecedented wealth on Wall Street, seven of the nation’s largest financial companies earned a combined $254 billion in profits.

But since last July, those same banks — Bank of America, Citigroup, JPMorgan Chase, Lehman Brothers, Merrill Lynch, Goldman Sachs and Morgan Stanley — have written down the value of the assets they hold by $107.2 billion, gutting their earnings and share prices. Worldwide, the reckoning totals $380 billion, much of which reflects a plunge in the value of tricky mortgage investments.....

But the finish line just seems to keep moving further away. Even when the losses end, bank executives are looking toward a new era of lower returns, thinner profits and fewer jobs....

“They are going to have to build a new business model,” Richard X. Bove, a financial services analyst at Punk Ziegel, said of investment banks. “I do not believe those businesses have the ability to generate the kind of profit they did in recent years without all the leverage.”...

The latest round of results is likely to draw special scrutiny because Wall Street firms are disclosing capital levels under new international banking standards known as Basel II. And Merrill Lynch, Citigroup and UBS are also expected to suffer from the ratings downgrades recently issued for MBIA and Ambac, two bond reinsurers....

“It’s a fairly unique situation, that you would give so much back,” said Alec Young, global equity strategist for Standard & Poor’s Equity Research. “The industry did enjoy real salad days over that period, but now the write-downs and losses have been so huge. It’s a significant percentage of the money generated.”

Even the winners in this cycle — JPMorgan Chase and Goldman Sachs — have had to pull out giant erasers to work through their loan books. JPMorgan, which had the financial heft to buy Bear Stearns, wiped out 15 percent of recent profits by lowering the values of its loan and mortgage assets. At Goldman, the cost of such write-downs is so far 12 percent of recent profits.

The banks are supposed to be especially good at valuing all the lumps of loans and assets they own. That is why many a Wall Street bonus is based on estimates of hard-to-value dealings in arcane assets. The very mortgage bonds that are now being written down, in fact, led to hefty bonuses for bank employees before the good times ended.

Some analysts predict that independent brokerage houses will merge with commercial banks, if the government begins regulating them. That uncertainty leaves executives at these companies unsure of how to plan for the future, said David Trone, an analyst at Fox-Pitt Kelton Cochran Caronia Waller, who is predicting bank consolidation.

“We’re in a weird limbo now,” Mr. Trone said.

Inflation Expectations in Japan at 7%, Spurs Consumption

The Fed has tended to dismiss the inflationary impact of rising energy and food prices, arguing that they aren't significant until they lead to inflationary expectations and higher wage demands.

Yet in Japan, where zero inflation to deflation has been the norm, and workers, like their American peers, lack bargaining power, not only have inflation expectations risen sharply, but consumers are engaging in classic inflationary economy behavior" anticipatory spending.

While this Bloomberg story indicates that the money so far is coming from money held in low to no yield bank accounts or as cash, one has to wonder whether this change in mindset might affect Japan's army of predominantly female retail currency traders, the main drivers of the carry trade.

From Bloomberg:

A scourge that is threatening growth from Europe to China, inflation might be exactly what Japan needs. The prospect of higher prices may lift the economy by drawing out some of the 1,500 trillion yen ($14 trillion) Japanese households have squirreled away. Half sits in savings accounts paying almost no interest. Some is even stuffed under mattresses...

A 12 percent increase in the cost of gasoline this year has raised consumer expectations for inflation overall, after prices were flat except for fresh foods in 2007. A Bank of Japan survey found that households anticipate prices will go up by more than 7 percent in the next 12 months. That outlook helps explain why their spending climbed last quarter twice as fast as in the previous three months.....

According to the Paris-based Organization for Economic Cooperation and Development, consumers will spend enough this year to help Japan avoid a recession. Early evidence: The first quarter's 0.8 percent increase in household expenditures accounted for half of the economy's expansion after inflation, the government reported last week...

For the last two years, ``domestic demand has been the big drag, the big disappointment,'' Koll says. ``2008 is a good year to be optimistic.''

Not everyone shares that optimism. Stanford University economist John Taylor says inflation is no good, no matter what. ``You could go back to a real spiral, and things could get worse for Japan,'' Taylor says. ``It's hard to believe at this point, but you could get too much inflation.''

A study published last month by Tokyo-based Nippon Research Institute showed that about 44 percent of households plan to cut back on spending this year because of higher food and energy prices....

Jessop argues that just because consumer confidence is weak doesn't mean people will definitely be spending less. ``You need to look at what people do, not what they say,'' he says. Indeed, last quarter's spending surge came in the face of the worst consumer sentiment since Japan's last recession ended in 2002.

The explanation may lie with Japan's hoard of household savings. ``The amount of money involved is almost unimaginably large,'' says Richard Jerram, chief Japan economist at Macquarie Group Ltd. in Tokyo. The Bank of Japan's 1,500 trillion-yen estimate of household wealth -- including bank deposits, cash and investments -- represents roughly three times the country's annual gross domestic product.

AIG's CEO Sullivan Resigns; Willmustad Named CEO

In a board meeting where it was believed that Martin Sullivan, AIG CEO, would resign, the expected took place. Robert Willmustad has been designated CEO of the insurer. From the Wall Street Journal:

Robert Willumstad, a former Citigroup Inc. executive and chairman of the board of American International Group Inc., has been appointed chief executive of AIG, effective immediately....

Stephen Bollenbach, a director of AIG who is well-liked by some dissident AIG shareholders, including billionaire Eli Broad, will be named lead director....

The decision to put Mr. Willumstad in charge and make Mr. Bollenbach lead director appeared to be designed to placate big shareholders who were frustrated with the board's performance and had wanted fresh blood to lead the company. Some had wanted the board to conduct a search for an outside successor to Mr. Sullivan.....

Mr. Willumstad's background makes him uniquely qualified for that role. As the former president of Citigroup and a longtime lieutenant to its onetime chief executive, Sanford I. Weill, Mr. Willumstad brought to AIG extensive experience with sprawling financial empires built by strong-willed leaders...

Investors in the other companies have called for breakups, but it's not clear how AIG could be easily broken up. Another issue facing a new leader would be dealing with AIG's entrenched culture, where many employees have been for their entire careers.

Since when is Citi under Sandy Weill a model of good management? Weill was very good at doing deals and integrating them successfully, but that it is a different skill set than running an operation on an ongoing basis.

What the Journal's report fails to stress is that the multi-billion losses posted the last two quarters, which undid Sullivan's credibility, were the the result of writedowns on credit default swaps on subprime deals. AIG has taken issue with the mark-to-market treatment, saying, for instance, in the case of the insurer's 4Q writedown, that the economic losses were only $900 million, less than 10% of the $11.1 billion writedown. However, auditors also cited faulty accounting.

A friend who had the misfortune to join AIG in a senior role right before Maurice Greenberg's departure said his exit made insurer like a car where the axles had been removed: it was still rolling on but the wheels were about to come off. All decisions, even trivial ones, had to be approved by Greenberg, and the lack of normal decision making processes was paralyzing the company. I do not know how far Sullivan got in delegating authority, but it would be very difficult for someone who did not know AIG from the inside to step into the CEO slot if Sullivan has not made much progress on that issue.

From an earlier report in the Wall Street Journal:

It's not clear what a new chief executive, interim or permanent, can do to solve those problems [writedowns and depressed stock price] amid ongoing upheaval in the mortgage and credit markets. No new CEO can cure what ails American real estate...

And a new leader who isn't closely tied to the Greenberg era could also have room to maneuver. Even as Mr. Sullivan tried to steer AIG past the accounting scandal, he had to contend with the fact that Mr. Greenberg – his onetime mentor – leads another firm, Starr International Co., that is AIG's largest shareholder.

AIG and Mr. Greenberg are also engaged in a number of ongoing and contentious legal battles. Someone without that shared history and who hasn't been fighting those battles for the past three years might have an easier time negotiating an end to the tensions...

Mr. Sullivan spent his first year or so on the job merely trying to steady the ship. That's a monumental undertaking, given that AIG has operations in over 100 countries and a diverse range of businesses that runs from car insurance to consumer loans to aircraft leasing.

A successor who came from outside the company would have to tackle that stabilizing job again, most likely without Mr. Sullivan's long-standing relationships with the leaders of many of those varied businesses, or detailed knowledge of their operations.

ECB: "Litterbin of the Last Resort"

We've read from time to time that European banks have been launching deals, and not particularly good ones at that, solely for the purpose of using those securities as collateral for loans from the ECB. However, we hadn't seen a longer-form treatment of that phenomenon. The Economist has decided to step into the breach. The subhead says it all: "The assets being dumped on the ECB do not look very recyclable."

From the Economist:

The European Central Bank (ECB), widely praised for providing banks with ample liquidity during the credit crunch, now has a problem: how to encourage banks to place freshly created asset-backed securities (ABS) with investors, rather than dumping them, like so much radioactive waste, in its vaults.

The ECB accepts a wide range of assets, including those such as ABS for which there is temporarily very little trading, as collateral in its refinancing operations. Provided the tranche of securities is the most senior, and rated A- or above, the ECB will take it. No surprise then that since August a large number of banks have designed ABS tranches, backed mostly by mortgages, purely for ECB consumption. Of €208 billion ($320 billion) of eligible securities created, only about €5.8 billion have been placed with investors, according to calculations by JPMorgan....

On the face of it there is no immediate problem. Only around 16% of the ECB's collateral so far is ABS. Banks are drinking from the liquidity fountain and keeping the cost of high-street mortgages contained at the same time, which they might not be able to do otherwise.

But it is not helping the revival of a publicly traded ABS market, and may be fostering the creation of even murkier securities. Many of today's ABS are even less transparent than those sold before the crisis—the ECB requires a rating by only one agency, not the usual two, and pre-sale reports are often sloppily prepared. That, at least, is the concern of some rival central bankers, although the ECB itself is not panicking, yet...

All the main central banks have learnt a lot from this crisis. America's Federal Reserve and the Bank of England found that they had too few tools to cope with the liquidity drought. The Fed threw open its emergency lending facilities to investment banks, as well as accepting a much broader range of collateral in its open-market operations. The Bank of England, several months too late, widened the range of collateral it accepts as well. Only the ECB, rather smugly, can say that it has stuck to its pre-crisis rules. But there are still gaping differences that can be “gamed”, or arbitraged, between the three systems.

The Fed accepts complex credit derivatives in its liquidity operations, which the others do not; the Bank of England, with its Special Liquidity Scheme dating from April, accepts AAA securities of all types, but only those held on a bank's balance sheet before the end of last year. The British bank also applies more stringent “haircuts”—ie, it is tougher on valuations—than the ECB, according to market participants. The result, unless the ECB changes its tune, is that it could well end up as the repository of last resort. If banks start to default, the ECB—and ultimately the euro-zone taxpayer—could be left holding a lot of toxic assets. Almost as bad—for those with a mind for justice—is the thought that the same supposed rocket scientists, using the same benighted techniques that caused the mess, may be taking everyone for a ride again.

Central bank liquidity policy needs refining and harmonising, as the Financial Stability Forum, a group of banking-industry regulators, made clear in a report in April. This week Mervyn King, the Bank of England's governor, hinted at plans for an integrated framework “making clear the terms on which liquidity will be provided in times of stress”.

Market participants say the trouble is that spelling out those terms beforehand can create moral hazard and encourage recklessness. One argument doing the rounds is that the ECB's broad acceptance of collateral before the crisis may actually have added fuel to the fire.

Guest Post: Does Connectivity in the Financial System Produce Instability?

With the financial system on the exam table, it has been more than a bit troubling, that certain questions are neglected in serious academic/policy debates.

The discussion of possible remedies focuses on regulatory solutions, everything from requiring mortgage brokers to be licensed to increasing financial institution capital requirements and having much greater harmonisation, as the Brtis like to put it, of banking and brokerage firm oversight.

While these measures individually and collectively could be salutary, no one seems to be willing to consider the fundamental question: did the push to facilitate the free flow of capital, both domestically and across borders, play a role in this crisis? For the last 15+ years, the push in policy has been towards increased efficiency, which means lower transaction costs, less supervision, little interest in considering whether so-called innovations benefit anyone beyond their purveyors (Martin Mayer observed that, "A lot of what is called innovative is simply a way to find new technology to do what has been forbidden with the old technology.").

It's important to examine this question, because many in this society have come to believe that regulation is bad and ever to be avoided. Yet markets like the equities markets, where participants trade an ambiguous promise anonymously, depend on regulation. Thus, the question should be, "What level of regulation is optimal?" rather than "How much regulation can we eliminate?" The problem with the latter approach is that it can take years for problems to develop, and when they do show up, since the tools to stop them have been thrown away, a full blow crisis has to develop for corrective measures to be implemented.

Some evidence suggests that free capital flows in and of themselves produce instability and crises. A recent paper by Kenneth Rogoff and Carmen Reinhart found that

Periods of high international capital mobility have repeatedly produced international banking crises, not only famously as they did in the 1990s, but historically.

Yet the focus of policy has been to increase the cross border flow of funds. Indeed, when the post mortems of this era are in, I suspect the carry trade will be found to have been a major culprit.

Another indicator: as the financial services industry has become increasingly deregulated and boundaries between businesses become blurred or meaningless (fund managers versus brokerage accounts, hedge funds versus proprietary trading desks, investment bank versus commercial bank) bank profitability has fallen and the industry has pushed into higher risk activities to try to compensate. Indeed, not only have overall risk measures risen, but the top banks also appear to be following common strategies. Both behaviors increase systemic risk.

Reader Richard Kline has been pondering this issue in a series of posts (see here, here and here) from a complex systems perspective rather than the traditional finance/markets vantage point. The discussion below summarizes his argument; a fuller treatment can be found here.

As always, your comments very much appreciated.

From Richard Kline:

Is high connectivity in the financial system desirable from the standpoint of stability? Conventional wisdom would largely say, yes; highly connected capital and exchange markets should ‘reduce inefficiencies,’ bring liquid capital to where ‘it is needed,’ and ‘level the playing field.’ Theoretical simulations of high connectivity systems together with related experience from systems design suggest the reverse: raising connectivity or undampening propagation in a system beyond modest levels in either case leads to high systemic asymmetry at best and pervasive systemic instability at worst. Those wishing an extended discussion of the underlying concepts will find it here. The basic concerns follow below.

CONNECTIVITY

Self-modulation occurs in systems with throughput, nodes, and connectivity between those nodes. If considered in idealized form, the financial system in general, and market behaviors in particular can be evaluated in these terms. Capital, debt contracts, futures, and the like could function as throughput, with both velocity V and volume L. Participants can function as nodes; highly dissimilar if large organizations negotiating specific contracts and deals; highly similar if bidders on regulated exchanges. Nodes vary thus both in size S and in the degree to which they behave differently D from each other. Connectivity K is simply the number of links any given node has to other nodes engaged in similar behavior. Both connectivity and differentiation impede throughput flows, but in opposite ways. The more nodes are connected, the more easily capital or information or loss exposure can flow; this is how connectivity is generally conceived in capital
markets, and the reasoning behind open exchanges. The more that nodes, i.e. participants, are similar in form or behavior, that is the less differentiated they are, the more throughput flows. Again, this is the reasoning behind common regulatory regimes, accounting rules, a common currency, etc.

Correlation across a system tends to involve shifts in differentiation D and connectivity K. That is, correlation largely concerns overall similarity of behavior amongst nodes; institutions move the same products, firms compete on price, market participants act in different directions at somewhat different times---or the same direction all at once, and so on. By contrast, modulation across a system tends to involve shifts in throughput, both in velocity V and volume L, but also regarding self-correlation of throughput. That is, modulation largely concerns similarity of form or movement of throughput; bonds are offered at regular intervals near known prices, varying product risks are ‘factored out’ by insurance or hedges, futures contracts channel price movements, and so on. From this perspective, several generalizations follow:

Organization in a system will self-generalize: order ‘flows’ across the nodes in a system inherently as differentiation D per node and connectivity K per node shift. Even if these changes are linear at the level of individual nodes, they are typically nonlinear at the level of the system, and may involve complete state changes with very short thresholds of transformation. Simulations show that even at very low levels of connectivity, K=2 [yes, two connections per highly similar node], systems will constantly if mostly gradually change their overall alignment. At high levels of connectivity, though, systems are prone to frequent, global transformations. Highly connected systems have inherently transient stability, unless otherwise buffered or dampened.

Connectivity K between nodes allows both order and throughput to circulate widely in a system. However, K is often agnostic as to the influences it allows to propagate, so that if changes in K may yield outcomes as intended they can yield and often do yield ones pervasive and unintended.

Differences between parts of a system impede flows across a system, whether flows of order, of throughput, or both. Differences create ‘inefficiencies,’ but they also buffer propagation in a system. Specifically, differentiation D---the extent to which nodes in a system vary in size, composition, and function---buffers node to node flow. Thus, increasing the similarity of participant behavior in markets (lowering differentiation) has the effect of lowering impedance for the same level of connectivity and/or ‘liquidity’ of throughput. If, for example, everyone carries a large balance on plastic and a low balance on passbook, more throughput moves through one part of the financial system, faster, and more easily.

Lowering nodal differentiation D in a system increases ‘efficiency’ in that it lowers buffering of throughput and allows connectivity to propagate order changes in a system. However, this may be at the expense of system stability as the effect may be the same as increasing connectivity K to the degree where system organization becomes chaotic. Residential property owners, developers, property assessors, mortgage originators, the capital markets, and the bond raters once had diverse profit strategies, but gradually they converged toward the fee-for-service, flip the product model of the capital markets. Connectivity increased, and throughput soared. Um, yes . . . .

Background correlation---the mapping of a system to its supporting context---often also serves as a buffer to propagation in a system since the background order is independent of and often resistant to modification by the order of a coordinated system. If the background order is itself highly correlated, though, it may function as a catalyst rather than as a buffer. Program trading in the late 80s where selling out of many portfolios was correlated to a few common background indices is an example. This is an endemic issue in financial markets, where despite being ostensibly buffered by high participant differentiation of behavior they nonetheless become correlated globally to a few background variables.

Systems with pervasive connectivity K amongst nodes have the advantage of being significantly adaptive to external changes. Raising connectivity for a system increases its overall adaptivity. This has been a purpose of just in time ordering, for example. However, such adaptivity is achieved at the expense of stable internal organization since high-K systems are very prone to system-wide changes: they are globally rather than locally adaptive. The auction rate market for municipal bonds was highly adaptive to very small changes in rates and extremely flexible for participants; it adapted globally to the shift in a single parameter, re-sale probability: look at it now.

‘Liquidity’ in a system is a composite behavior (a multi-variate derived state). Not only does throughput vary in velocity V as well as in the ‘headline number’ of volume L, it may modify itself through self-correlation as will be mentioned below. Additionally as per the above description, changes in both differentiation D and connectivity K in a system greatly change how throughput behaves. Where D and K remain generally the same, ‘liquidity’ can be influenced by varying volume or modulating velocity. As we see with the failure of ‘liquidity’ in US capital markets 08, volume and velocity alone are insufficient: the banks have low D---most are functionally insolvent---with decreased K---they little lend to each other. Studies of connectivity imply that in such conditions many minor local optimae develop with low overall systemic flow; just so. Despite large volume capital injection, the financial system remains ‘illiquid.’

MODULATION

Capital of similar form or moving in similar ways across a system of nodes-participants needn’t be reshaped drastically transaction by transaction; rather, it can be disproportionately influenced by small changes to the system which raise or lower impedance to its movement. This is what is meant by modulation. Central bank interest rate setting is substantially a modulation effect. A central bank ‘signal’ is small in relation to overall capital throughput, but even in the absence of legal compulsion that signal forms a value range around which transaction throughput is abundant and moves freely, while defining outlier value ranges where throughput moves poorly and accordingly is scarce.

Independent of connectivity, nodes within a system are not necessarily correlated amongst themselves, or at least not highly correlated. Despite this, throughput in a system---capital principally in the context of the financial system---can become more or less self-correlated. For example, if many different forms or terms of throughput move across nodes, any form which has lower resistance will move over more nodes. If its volume can scale, a larger share of throughput over a larger share of nodes is of the same form. Other forms or terms of throughput most nearly similar may see their velocity, volume, and distribution increase as well. In particular, if and as nodal differentiation decreases, the action of throughput is increasingly similar regardless of where it passes through a system: the throughput in effect self-correlates even if nodes and local connectivities retain significant diversity. Auto-correlative changes do not require overt
external intervention, although in financial markets such throughput convergences are highly profitable if spotted or maximized so external intervention in throughput flows is high and probable. If throughput flows and node differentiation and connectivity influence each other progressively, the process becomes self-modulating.

It is possible that as throughput across such a system becomes increasingly modulated, it can yield a field effect. Field phenomena have low overall resistance to point-source propagation; that is, they can globally reference their order state on a continuous basis. Marginal pricing in markets with good transparency strongly suggest a field order. Individual nodes may wish to diverge from a price point, but resistance from the rest of the market will be high; over any near duration, the field order will reduce the price discontinuity to the field order. Field effects can be modeled by tensors, but their ‘statistical logic’ to use a broad term is distinct from that which follows from the kinds of statistical tools typically used for economic activity. In principle, throughput in a system is likely a tensor field, while the system it is mapped to if nodal may well itself be a scalar field. The concept of capital flows as field phenomena is one
that I cannot prove but which should be studied more closely.

Finally, fields induce flow. Set a price or a volume gradient for capital, and said capital will flow across a system, typically towards high capital density regions. A gradient may thus ‘induce’ illiquid or capital-like assets to shift toward liquid forms, or otherwise to shift their state. Moreover, if throughput is sufficiently high in volume, velocity, or both, it can override, even mask, differences in nodes in the system. In part for this reason, system performance with high throughput will consistently give a misleading view of system stability. Correlation of throughput can by field induction carry flow behavior beyond the structural capacity of existing nodes. Again, large-large reasoning does not hold, especially for field phenomena: small value signals can reference larger flows of throughput which furthermore they do not necessarily transact directly. From this perspective, several generalizations follow:

Self-modulation of throughput in a system in effect simulates increasing connectivity K or decreasing differentiation D because throughput increasingly ‘acts the same’ regardless of its velocity or volume. Viewed from the perspective of connectivity above, systems with self-modulating throughput are less stable than their D and K values would suggest, and can become self-destabilizing: they overshoot.

While self-correlation of throughput is not necessarily bad or good, it can mask relevant distinctions. Consider MBSs, inherently of different quality and risk. However, this throughput had to act the same way to pass down-channel readily, so increasingly it had to ‘look the same.’ Hedges were bundled in, tranches were selectively sliced, and even ratings models themselves progressively tweaked to yield uniform AAA ratings. Self-correlation improved flow, even ‘induced liquidity,’ but this was no virtue from the standpoints of risk assessment or risk concentration. Moreover, MBSs of correlated appearance easily correlated their price declines, regardless of underlying differences in performance.

Dense concentrations of capital may drive other nodes to act increasingly the same way as high connectivity allows their ‘order to flow’ across a system. To the extent that they also modulate capital flows, the impact is not only increased but may be self-enhancing by field functions; in effect, such concentrations inherently propagate their own organizational order. Such order flows are not necessarily either complete, linear, or stable; however, their net effect may be to drive differentiation D down, and increasingly to correlate it. Again, in view of the summary above, this not only creates system asymmetry---i.e. the rich get richer---but lowers system stability: dense concentrations of capital are likely inherently destabilizing. For example, it has recently been identified that globally most central bank rates are negative or very low in real terms regardless of their nominal levels. One interpretation for the driver behind this result maybe that the ‘gravity well’ of US and Japanese real rates---which have both been low or negative since the early 90s for the most part---optimized rates first in closely integrated countries, than in others because smaller currencies with higher rates were more expensive to borrow and re-loan. From that perspective, financial preference steadily shifted to low-rate, high liquidity currencies, the opposite of what monetary policies anticipate: rates could either be higher than local conditions warranted or lower, but the ‘gravity’ of very low US and Japanese rates wouldn’t tolerate a middle position.

Statistical reasoning appropriate for field functions is seldom used in assessing throughput organization in the financial system, leading to misunderstanding of systemic conditions by observers. Stability and instability are not Cartesian plots but matrix distributions. The invisible hand is the beck and grasp of a tensor field; current analysis sees the fingernails on the hand, at most.

Stuart Kaufman. 1993. The Origins of Order.
Christopher Chase-Dunn and Andrew Hall. 1995. Rise and Demise.

[Kaufman’s text is dense but seminal in discussions of systemic connectivity, in this case amongst genes. Chase-Dunn and Hall consider core-periphery relations, a concept from political economy which has different implications from the perspective of systemic connectivity.]

Martin Mayer on Past and Current Misdeeds in Finance

Institutional Risk Analytics has an informative, engaging interview with Martin Mayer, who is a professional polymath (he is the author of 34 books, former banking columnist, art critic, film critic, and currently a guest scholar at Brookings). I very much recommend reading the entire piece and provide some tidbits below.

From Institutional Risk Analytics:

Mayer: What is happening on this LIBOR business? That is a very strange story that the five big banks are cooking their books on reporting LIBOR.

The IRA: Well, with many banks now struggling to fund themselves, the larger banks don't want to be seen as aggressively bidding in the funds markets for fear of starting a reputational issue a la Bear, Stearns (NYSE:BSC) or Lehman Brothers (NYSE:LEH). LIBOR is a manifestation that global investors don't want to lend to US or even EU banks.....

The IRA: Agreed. But despite the obvious logic of institutions like DTCC [Depository Trust & Clearing Corporation], we've still allowed our OTC markets to fragments and thereby become a source of systemic instability. How did this happen?

Mayer: One of the problems I have with the OTC markets and the arguments that we mustn't cramp innovation is that a lot of what is called innovative is simply a way to find new technology to do what has been forbidden with the old technology.

The IRA: Yes, techno-regulatory arbitrage. What a lovely thought; using new technology as a means for committing financial fraud. It's kind of like the affordable housing and innovative financing games.

Mayer: Yes. Innovation allows you to go back to some scam that was prohibited under the old regime. How can you oppose innovation? The fact that the whole purpose of the innovation is to get around the existing regulation never seems to occur to regulators or members of Congress.....

The IRA: Going back to your point about market structure, how do you explain to people outside the world of finance how we go it so badly wrong? You have a very wide circle of friends outside the markets. What do you tell them? How did Americans forget the lessons of the 1920s and 1930s to arrive at this sad circumstance?

Mayer: In part, it is theory, namely the strange conjunction of Susan Phillips, Wendy Graham and Alan Greenspan over a decade ago. Bill Seidman too, for that matter, when he was at FDIC. In an odd way, we became technologically backward regarding market structure because the people in charge of supervising financial institutions namely the Fed -- did not know anything about it. Look at the Fed's employment roster. There were people who were obsessed by monetary theory. And there were people whose chief responsibility was performing tasks like handling checks, namely operations. There were various models of equilibrium in circulation at the time which provided overall comfort. And Alan Greenspan really believed with religious fervor that markets cure their own ills. Remember Barry Bosworth's warning that diversification devalues knowledge. So the notion that the technology made it possible to drive risk beyond any reasonable limit wasn't in anybody's head. As I said before, there are a certain number of tested Wall Street scams that have been forbidden by regulation. If you can find a way to use technology to revive one of these scams, then you are an innovator and you get paid extremely well for the five years these techniques work, and then you go away.

The IRA: How can other nations around the world take the US seriously when we show such a capacity for collective self-delusion?

Mayer: Yup. In addition to using technical innovation to evade regulatory limits, there was also a confusion of purpose at the Fed. The Fed really never wanted to exam banks. And it really didn't want to be in a admonitory position vis-a-vis the banks. The commercial banks are the mechanism by which monetary policy is conveyed to the world. And the Fed needed them very badly. But beyond just monetary policy, what got forgotten was the reason why we separated commercial banking and investment banking in the 1930s. Obviously it got more and more difficult to enforce that separation as the technology changed. But that didn't mean that there were not good reasons for the continued separation. The way I like to put it is that the commercial banker wants to know how am I going to be repaid, the investment banker asks how am I going to sell the paper. These two attitudes really do not coexist well together.

The IRA: Banks globally have been miserable failures when it comes to combining investment and commercial banking.

Mayer: Correct. It is a very different mindset. And historically, in terms of public policy, we have relied upon the commercial banks to keep the markets and the economy on an even keel. Greenspan's observation was that, after all, the banks are going to protect us because they are lending their own money

The IRA: Yes, but in a market dominated by investment bankers, no such discipline prevails. The investment bankers rarely create value and, judging by their recent behavior, care nothing about the long-term health of the global markets or the economy.

Mayer: Well, of course that was inaccurate because commercial bankers lend other peoples money. But beyond that, the notion that people who gamble with their own money are more responsible gamblers than those who gamble with their Uncle Joe's money was always very strange to me. People who are gamblers are gamblers and they will run through anybody's money. The difference between their own money and other people's money usually does not mean much to a gambler....

Mayer: [Ed} Kane is a very amusing guy and very sound. His coinage of the term "zombie thrifts" was one of the great features of the 1990s. But to go back to the thought, where all of this business with the Fed supporting Wall Street starts really with Continental Illinois. What happened was that in order to keep Continental Illinois going, the FDIC had to buy the billion dollars of notes the holding company had sold in Aruba. The FDIC was not willing to put up the money, so the Federal Reserve Bank of Chicago loaned money to the FDIC to carry Continental Illinois until they could sell it off. The Board of Governors of the Fed, remember, has no money. Silas Keehn threatened to call the loan. There was a congressional hearing which I quoted in my book The Fed where Seidman said in a jocular way that if the Fed wanted its money back they could close down the FDIC because he could not pay them! So you developed a situation where the lender of last resort to the banking holding companies was the FDIC. And the lender of last resort to the FDIC was the Federal Reserve. The Fed began to get into very non-standard situations after that, as in the case of the Bank of New England failure where the FDIC was again using the Feds money.

The IRA: Well, again, they did not have the liquidity. But the odd thing about both of these situations was that the FDIC did not first go to the Treasury via the Federal Financing Bank. By statute the FDIC has a credit line directly with Treasury, yet instead they went to the Fed.

Mayer: Correct. The FDIC had the reserves in both cases, but they did not want to use them. The FDIC insurance would not be as meaningful if the agency itself were seen to be in difficult financial straits.

The IRA: So these types of innovative financing techniques by and between the regulators are essentially the precursors of what we see today, albeit with the Fed now lending directly to the insolvent non-depository institutions like BSC and perhaps LEH.

Mayer: Yes, that is where I see this situation we have today with the Fed holding billions of dollars in junk paper starting, with Continental Illinois and the like. You see, one the problems that the FDIC had in Continental Illinois was that the bank had a billion dollars in offshore deposits. The FDIC had no legal authority to bail out these depositors. Another example was the National Bank of Washington....

Mayer: In the second edition of The Bankers, about two thirds of the way through, I promulgated three laws of financial derivatives. The first law is that when the whole is priced to sell for less than the sum of the parts, some of the parts are overpriced. Second law is that when you segment value you segment liquidity.

The IRA: So much for innovation.

Mayer: And the third law is that risk shifting instruments will tend over time to shift risk unto those less able to bear it because them what's got want to keep and hedge, and them that ain't got want to bet and speculate. Three laws from the 1990s and all three still true. This business about appetite for risk or ability to shift risk is all crap. The banks and funds own some of this junk, but not so much. They don't seem to be howling nearly so much as the guy who packaged these assets and stupidly kept inventory.

Links 6/15/08

Dead dolphins: Navy admits use of anti-submarine sonar off Cornish coast Telegraph

Companies get OK to annoy polar bears PhysOrg

Water-fuel car unveiled in Japan Reuters. After this, no one should be permitted to criticize bloggers for their reporting standards. This piece even has a little video.

Cheney's false comment on oil drilling attacked AP. It never ends....

AP Files 7 DMCA Takedowns Against Drudge Retort Workbench

Libertarians and global warming John Quiggin

At the Fed, Precedent Takes a Holiday James Picerno, Seeking Alpha

New homes slump worst since 1945 Guardian

OPEC reels in world use estimate on less U.S. demand MarketWatch

The counterparty's over Economist

NAR: 4% Quarterly Gain is (Oops) Actually a 30% Loss The Big Picture

Hotline Suicide Calls Jump Michael Shedlock

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