Tuesday, September 30, 2008

Risk Of A Total Systemic Meltdown

The Risk Of A Total Systemic Meltdown Is Now As High As Ever.
The Us And Global Financial Crisis Is Becoming Much More Severe In Spite Of The Treasury Rescue Plan.

By Nouriel Roubini | 29 September 2008

It is obvious that the current financial crisis is becoming more severe in spite of the Treasury rescue plan (or maybe because of it, as this plan it totally flawed). The severe strains in financial markets (money markets, credit markets, stock markets, CDS and derivative markets) are becoming more severe rather than less severe in spite of the nuclear option (after the Fannie and Freddie $200 billion bazooka bailout failed to restore confidence) of a $700 billion package. Interbank spreads are widening (TED spread, swap spreads, Libo-OIS spread) and are at levels never seen before; credit spreads (such as junk bond yield spreads relative to Treasuries) are widening to new peaks; short-term Treasury yields are going back to near zero levels as the flight to safety mushrooms; CDS spreads for financial institutions are rising to extreme levels (Morgan Stanley was at 1200 last week) as the ban on shorting of financial stock has moved the pressures on financial firms to the CDS market; and stock markets around the world have reacted very negatively to this rescue package. (US market are down about 3% this morning at their opening.)

Let me explain now in more detail why we are now back to the risk of a total systemic financial meltdown.

It is no surprise as financial institutions in the US and around advanced economies are going bust: in the US the latest victims were WaMu (the largest US S&L) and today Wachovia (the sixth largest US bank); in the UK after Northern Rock and the acquisition of HBOS by Lloyds TSB you now have the bust and rescue of B&B; in Belgium you had Fortis going bust and being rescued over the weekend; in Germany HRE, a major financial institution is also near bust and in need of a government rescue. So this is not just a US financial crisis; it is a global financial crisis hitting institutions in the US, UK, Eurozone and other advanced economies (Iceland, Australia, New Zealand, Canada etc.).

And the strains in financial markets— especially short term interbank markets— are becoming more severe in spite of the Fed and other central banks having literally injected about $300 billion of liquidity in the financial system last week alone including massive liquidity lending to Morgan and Goldman. In a solvency crisis and credit crisis that goes well beyond illiquidity no one is lending to counterparties as no one trusts any counterparty (even the safest ones) and everyone is hoarding the liquidity that is injected by central banks. And since this liquidity goes only to banks and major broker dealers the rest of the shadow banking system has no access to this liquidity as the normal credit transmission mechanisms are blocked.

After the bust of Bear and Lehman and the merger of Merrill with BofA I suggested that Morgan Stanley and Goldman Sachs should also merge with a large financial institution that has a large base of insured deposits so as to avoid a run on their overnite liabilities. Instead Morgan and Goldman went for the cosmetic approach of converting into bank holding companies as a way to get further liquidity support— and regulation as banks— of the Fed and as a way to acquire safe deposits. But neither institution can create in a short time a franchise of branches and neither one has the time and resources to acquire smaller banks. And the injection of $8bn of Japanese capital into Morgan and $5bn of capital from Buffett into Goldman are but drops in the ocean as both institutions need much more capital.

Thus, the gambit of converting into a 'bank', while not being a bank has not worked and the runs against them has accelerated in the last week. Morgan’s CDS spread went through the roof on Friday to over 1200 and the firm has already lost over a third of its hedge funds clients together with their highly profitable prime brokering business (this is really a kiss of death for Morgan); and the coming roll-off of the interbank lines to Morgan would seal its collapse. Even Goldman Sachs is under severe stress losing business, losing money, experiencing a severe widening of its CDS spreads and at risk of losing most of its value, as most of its lines of business (including trading) are now losing money.

Both institutions are highly recommended to stop dithering and playing for time as delay will be destructive. They should merge now with a large foreign financial institution as no US institution is sound enough and large enough to be a sound merger partner. If Mack and Blankfein don’t want to end up like Fuld they should do today a Thain and merge as fast as they can with some other large commercial bank. Maybe Mitsubishi and a bunch of Japanese life insurers can take over Morgan; in Europe Barclays has its share of capital trouble and has just swallowed part of Lehman; while most other UK banks are too weak to take over Goldman.

The only institution sound enough to swallow Goldman may be HSBC. Or maybe Nomura in Japan should make a bid for Goldman. Either way Mack and Blankfein should sell their firm at a major discount to the current 'price' before they end up like Bear and be offered in a few weeks a couple of bucks a share for their faltering operation. And the Fed and Treasury should tell them to hurry up as they are both much bigger than Bear or Lehman and their collapse would have severe systemic effects.

When investors don’t trust even venerable institutions such as Morgan Stanley and Goldman Sachs any more you know that the financial crisis is as severe as ever and the fear of collapse of counterparties does not spare anyone. When a nuclear option of a monster $700 billion rescue plan is not even able to rally stock markets (as they are all in free fall today) you know this is a global crisis of confidence in the financial system. We were literally a hair's breadth from total meltdown of the system on Wednesday (and Thursday morning) two weeks ago when the $85bn bailout of AIG led to a 5% fall in US stock markets (instead of a rally).

Then the US authorities went for the nuclear option of the $700 billion plan, together with bans on short sales, a guarantee of money market funds and an injection of over $300 billion in the financial system, as a way to stave off the meltdown. Now the prospect of this plan passing (although there is some lingering deal risk as the votes in the House are not certain)— as well as the other massive policy actions taken, e.g., to stop short selling "speculation" and support interbank markets and money market funds— is not sufficient to make the markets rally, as there is a generalized loss of confidence in financial markets and in financial institutions that no policy action seems able to stem.

The next step of this panic could become the mother of all bank runs, i.e., a run on the trillion dollar plus of the cross border short-term interbank liabilities of the US banking and financial system as foreign banks are starting to worry about the safety of their liquid exposures to US financial institutions. A 'silent' cross border bank run has already begun, as foreign banks have become increasingly worried about the solvency of US banks and have started to reduce their exposure. And if this run accelerates— as it may— a total meltdown of the US financial system could occur.

We are thus now in a generalized panic mode and back to the risk of a systemic meltdown of the entire international financial system. And both US and foreign policy authorities seem to be clueless about what needs to be done next. Maybe they should start with a coordinated 100 bps reduction in policy rates in all of the major economies in the world to show that they are starting seriously to recognize and address this rapidly worsening financial crisis. [[That last would be worse than useless; the problem is not the cost of money, but the probability of the return of money. And no one doubts that the CBs are fully engaged with trying to forestall this looming catastrophe.: normxxx]]


The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Australia Faces Worse Crisis

Australia Faces Worse Crisis Than America

By Ambrose Evans-Pritchard, Telegraph, UK | 30 September 2008

The world's financial storm has swept through Australia and New Zealand this week amid mounting signs of contagion across the Pacific region. Financial shares were pummelled in Sydney on Tuesday after investor flight forced National Australia Bank (NAB) to slash a £400m bond sale by two thirds. The retreat comes days after the Melbourne lender shocked the markets by announcing a 90% write-down on its £550m holdings of US mortgage debt, an admission that its AAA-rated securities are virtually worthless.

In New Zealand, Guardian Trust said it was suspending withdrawals from its mortgage fund owing to "liquidity difficulties in the market". Hanover Finance— the country' third biggest operator— last week froze repayments to investors. The company said its "industry model has collapsed" as the housing market goes into a nose dive. Some 23 finance companies have gone bankrupt in New Zealand over the last year.

It is now clear that the Antipodes are tipping into a serious downturn. Australia's NAB business confidence index fell to its lowest level in seventeen years in June. New Zealand's central bank began to cut interest rates last week on fears that the economy may have contracted in the second quarter, and is now entering recession. Housing starts slumped 20% in June to the lowest since 1986.

Gabriel Stein, from Lombard Street Research, said Australia could prove vulnerable once the global commodity cycle turns down. It has racked up a current account deficit of 6.2% of GDP despite enjoying a coal, wheat, and metals boom, effectively spending its resources bonanza in advance. Household debt has reached 177% of GDP, almost a world record.

"It is amazing that in the midst of the biggest commodity boom ever seen they have still been unable to get a current account surplus. They have been living beyond their means for 10 years. What worries me is that productivity growth has been very low: they have coasting after their reforms in the 1990s," he said. Australia's Reserve Bank has had to grapple with vast inflows of Asian capital, especially Japanese money fleeing near zero rates at home. Short of imposing currency controls, it would have been almost impossible to stop the inflows.

"The easy money went straight into real estate," said Hans Redeker, currency chief at BNP Paribas. "Australia will now have to generate 4% of GDP to meet payments to foreign holders of its assets," he said. This is twice as high as the burden faced by the US. Both the Australian and New Zealand dollars have fallen hard in recent days and now appear to be breaking down through key technical support against major currencies, including the US dollar. "The Aussie is going down, big time," said Mr Redeker.

The picture is darkening across the Pacific Rim. The Bank of Japan's deputy governor, Kiyohiko Nishimura, said its economy may now be falling into a "technical recession". Household income dropped 2.1% in June compared to a year earlier and manufacturers are the gloomiest since the deflation crunch in 2003. The decision by National Australia Bank to make drastic provisions on its US mortgage debt could have ramifications in the US itself. It opted for a 100% write-off on a clutch of "senior strips" of collateralized debt obligations (CDO) worth £450m— even though they were all rated AAA. No US bank has admitted to such fearsome loss rates.


The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Banking Crash Hits Europe

Banking Crash Hits Europe As ECB Loses Traction

By Ambrose Evans-Pritchard | 30 September 2008

The global credit crisis has slammed into Europe with stunning violence over the last two days, triggering five major bank rescues and a near total shut-down of the region's credit markets. The Dutch-Belgian bank Fortis, Britain's Bradford and Bingley, and Iceland's Glitnir, were all partially or fully nationalized after failing to roll-over debts in the short-term money markets, while the French state pledged support for the Franco-Belgian lender Dexia after the share price collapsed on reports of a capital shortage. "The European financial sector is on trial: we have to support our banks." said French President Nicolas Sarkozy. He has reportedly ordered the state investment arm Caisse Des Depots to shore up Dexia, even though the bank is based in Belgium.

Germany's Hypo Real Estate, a commercial property lender, was rescued with a €35bn lifeline from a consortium of local banks. The lender has $560bn in liabilities, almost as much as Lehman Brothers. Hypo Real's share price crashed 74pc, setting off a masse exodus from financial stocks in Frankfurt. Commerzbank fell 23% and Aareal Bank was off 43%. Anglo Irish Bank was down 44% in Dublin on wholesale funding fears.

Europe's credit markets have come close to seizing up as three-month Euribor jumped to a record 5.22% and OIS spreads rocketed to 113 basis points. "The interbank market has collapsed," said Hans Redeker, currency chief at BNP Paribas. "We're now seeing a domino effect as the credit multiplier goes into reverse and forces banks to cut back lending to clients," he said. Mr Redeker said the latest alarming twist is a move by banks to deposit €28bn in funds at the European Central Bank in a panic flight to safety. This has jammed the mechanism used by the authorities to shore up the financial system in a crisis.

"The ECB is no longer able to inject liquidity because the money is just coming back to them again. This is extremely serious. If monetary policy is no longer working, there is a risk that the whole system will blow up in days," he said. The euro plunged on Monday as the wave of bank failures hit the newswires, dropping 2% to $1.43 against the dollar. It recovered slightly as the US Federal Reserve flooded the markets with $630bn of dollar funding with fellow central banks in the biggest liquidity blitz in history.

Analysts say German finance minister Peer Steinbrueck may have spoken too soon when he crowed last week that the US would lose its status as a superpower as a result of this crisis. He told Der Spiegel yesterday that we are "all staring into the abyss". Germany— over-leveraged to Asian demand for machine tools, and Mid-East and Russian demand for luxury cars— is perhaps in equally deep trouble, though of a different kind. The combined crises at both Fortis and Dexia have sent tremors through Belgium, which is already traumatized by political civil war between the Flemings and Walloons. Fortis is Belgium's biggest private employer.

It is unclear whether the country has the resources to bail out two banks with liabilities that dwarf the economy if the crisis deepens, although a joint intervention by The Netherlands and Luxembourg to rescue Fortis has helped Belgium share the risk. Together the three states put €11.2bn to buy Fortis stock. This tripartite model is unlikely to work so well in others parts of Europe, since Benelux already operates as a closely linked team. The EU lacks a single treasury to take charge in a fast-moving crisis, leaving a patchwork of regulators and conflicting agendas.

Carsten Brzenski, chief economist at ING in Brussels, said the global crisis was now engulfing Europe with devastating speed. "We are at imminent risk of a credit crunch. Key markets are not functioning properly. The Europeans thought the sub-prime crisis was just American rubbish that the US should clean up itself, but now they are finding out that it is their rubbish too," he said.

Data from the IMF shows that European banks hold 75% as much exposure to toxic US housing debt as US banks themselves. Moreover they have mounting bad debts from the British, Spanish, French, Dutch, Scandinavian, and East European housing markets, where property bubbles reached even more extreme levels than in the US. The interest spread between Italian 10-year bonds and German Bunds have ballooned to 92 basis points, the highest since the launch of the euro. Bond traders warn that the spreads are starting to reflect a serious risk of EMU break-up and could spiral out of control in a self-feeding effect.

As the eurozone slides into recession, the ECB is coming under intense criticism for keeping monetary policy too tight. The decision to raise rates into the teeth of the crisis in July has been slammed as overkill by the political leaders in France, Spain, and Italy. Mr Sarkozy has called an emergency meeting of the EU's big five powers next week to fashion a response to the crisis. Half of the ECB's shadow council have called for a rate cut this week, insisting that the German-led bloc of ECB governors have overstated the inflation risk caused by the oil spike earlier this year.

Jacques Cailloux, Europe economist at RBS, said the hawks had won a Pyrrhic victory by imposing their hardline monetary edicts on Europe. "They have won a battle but lost the war. The July decision will hardly go down in history books as a great policy decision," he said.

Financial Crisis: Ireland’s Banks Are Rescued
Ireland Has Launched A Full-Scale Rescue Of Its Financial System, Issuing A State Guarantee Worth €400bn (£316bn) To Cover The Key Liabilities Of Its Biggest Banks And Mortgage Lenders.

By Ambrose Evans-Pritchard | 30 September 2008

Irish package for banks may prove one Guinness too many for the EU Commission. It is the most dramatic and comprehensive bank bail-out in Europe since the Scandinavian rescues of the early 1990s and may serve as a model for Britain and other countries that so far have been muddling through from one mishap to another with a mish-mash of ad hoc policies. The state guarantee exceeds 200% of Irish GDP, marking a new phase in the escalation of the crisis.

The move came as Standard & Poor's cut Iceland's sovereign credit rating from AA— to A+ following its nationalisation of Glitnir Bank. It is a warning that the cascade of bank bail-outs on both sides of the Atlantic could start to undermine the credit-worthiness of Western states. S&P warned that the tiny Nordic island is now saddled with liabilities that dwarf its economy.

The euro suffered the sharpest drop since the launch of the currency, dropping almost 3% at one stage to $1.40 against the dollar in a day of high drama across Europe. Belgium, France, and Luxembourg stepped in to rescue Dexia, the world's biggest lender to local authorities. The trio agreed to inject €6.4bn in fresh capital after the share priced crashed on Monday. Dexia's top management stepped down.

"We must have total confidence in the safety of the French banking system: there is absolutely no reason to panic," said Christian Noyer, head of the Banque de France. "The credit crisis is working its way up the food chain," said Chris Whalen, head of Institutional Risk Analytics. "Now states that sponsored the idiocy of the credit bubble are being challenged themselves. Unfortunately this could lead to global debt deflation. We are seeing a shrinkage of bank capital and this will cause a depression unless we stop it," he said.

The Irish measures amounts to a state rescue of Allied Irish Bank, Bank of Ireland, Anglo Irish Bank, Irish Life and Permanent, and Irish Nationwide, which all suffered a frightening share slide on Monday. "We can't bail out a particular bank: that wouldn't be right," said Brian Lenihan, the Irish finance minister. "What we have decided to do is give a general guarantee that the banks can lend in security and safety", he said. RBC Capital Markets said it was unclear whether wholesale support for Irish banks is legal under EU state aid rules.

"This may be one Guinness too many for the EU Commission. The action may affect trade between EU member states and raise the ire of other governments," it said. The EU Competition watchdog said it was in "urgent" consultations with Dublin. The Irish banks have been bleeding money as the property bust sets off a chain of defaults. House prices have fallen for eighteen months, and are now down 13% from their peak. Construction reached 21% of gross domestic product at the height of the bubble.

Under EMU membership the Irish authorities have been unable to cut interest rates to cushion the hard-landing. The European Central Bank raised rates in July to 4.25%. With Euribor now at record levels, the borrowing cost for Irish homeowners on floating rates (55% of the total) has risen by 1.5 percentage points since the credit crunch began. Ireland is now the first eurozone state in official recession. Unemployment has risen from 5% to 6.1% since January.

Moritz Kraemer, head of European sovereign ratings at S&P, said there is no immediate threat to Ireland's AAA rating. The country has tiny national debt (25% of GDP) and may not have to commit state funds for the rescue plan to restore confidence. "If it all goes terrible wrong in the property market, there could be significant losses for the treasury given the size of the Irish banking system. This could hit the sovereign rating," he said. It is another matter for Iceland where the three biggest banks have ammassed liabilities equal to 800% of the country's GDP in a breackneck expansion across Europe.

S&P said the Glitnir nationalisation had alone cost 5.9% of GDP, but the taxpayer burden could reach well beyond that figure. "The Icelandic banks are super-sized compared to the Icelandic budget. If there is a systemic crisis it could be very hard for the authorities to stop it. Moreover, the banks have used aggressive leverage, so their funding base is volatile," he said.

The euro suffered the sharpest drop since the launch of the currency, dropping almost 3% at one stage to $1.40 against the dollar in a day of high drama across Europe. Mr Whalen who advises the Icelandic authorities, said the country would muddle through. "Iceland has an open economy, so it has been easy for the hedge funds to come in and rape the currency. But the country is really like a giant private equity fund. Its banks buy real things so its liabilities are matched by assets. I am not really worried," he said.


The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

A Brief Guide To Fixing Finance

A Brief Guide To Fixing Finance:
Know What Went Wrong Before Beginning To Fix Anything

Click here for a link to complete article:

By Martin Neil Baily and Robert E. Litan, The Brookings Institution | 27 September 2008

There has been a "domino-like" character to the financial crisis that is now readily apparent to all:
  1. the bubble in home prices, fueled by the ready availability of credit, resulted in an underestimate of the risks of residential real estate;

  2. the peaking of residential home prices in 2006, combined with lax lending standards were followed by a very high rate of delinquencies on subprime mortgages in 2007 and a rising rate of delinquencies on prime mortgages;

  3. losses thereafter on the complex "Collateralized Debt Obligations" (CDOs) that were backed by these mortgages;

  4. increased liabilities by the many financial institutions (banks, investment banks, insurance companies, and hedge funds) that issued "credit default swaps" contracts (CDS) that insured the CDOs;

  5. losses suffered by financial institutions that held CDOs and/or that issued CDS’s;

  6. cutbacks in credit extended by highly leveraged lenders that suffered these losses.

These events, individually and in combination, have led to the bear stock market, whose downward slide accelerated Monday, September 15 through mid day Thursday the 18, after Lehman Brothers filed for bankruptcy and the Federal Reserve lent AIG $85 billion to keep it afloat— although the market quickly recovered at the end of the week after the Administration’s massive mortgage securities rescue initiative was announced.

So far, the financial turmoil on Wall Street has had a surprisingly modest impact on Main Street. Despite the crisis and the surge in commodity prices, the non-financial sector of the economy has continued to grow, spurred in significant part by a large growth in exports (fueled, in turn, by a steep decline in the dollar). Whether this pattern will continue— and specifically whether consumer spending will hold up in the face of the recent nerve-racking financial events and the steady climb in the unemployment rate (now over 6 percent)— is one of the large uncertainties confronting us all.

Likewise, in retrospect it is now relatively easy to see that much of this financial carnage, and thus any subsequent economic damage, could have been avoided:
  • Had policy makers reined in the increasingly irresponsible subprime mortgage lending practices that were apparent earlier this decade— the proliferation of "no-doc" loans, often taken out with little or no equity from subprime borrowers, and frequently on adjustable terms with seductively attractive initial "teaser" interest rates, all on the widely held assumption that home prices would continue to rise— it is likely that this crisis would been largely, if not entirely, avoided. When there is a significant probability that an asset market is in a speculative bubble, it is time to tighten lending standards, not loosen them.

  • Had Federal policymakers in both the Congress and the Administration not pressed so hard on "affordable housing goals" that encouraged lenders to extend and borrowers to take out loans that could not be reasonably serviced unless home prices continued to rise, and which Fannie and Freddie began to buy in large volumes in the last several years, Fannie and Freddie may have escaped the fate that has befallen them.

  • Had the credit rating agencies whose stamps of approval were key to the sale of CDOs and other complex securities that later suffered losses been more transparent in how their ratings were provided and in the limited nature of the data on which they were made, it is likely that these securities would have been much more difficult to sell, and thus in turn, that subprime mortgages would not have been so easily originated.

  • Had regulators done a better job monitoring the risk exposures of commercial banks, especially through their creation of off-balance entities known as "Structured Investment Vehicles" (SIVs), the market for CDOs would not have been so deep (the same is true for the state insurance regulators who oversaw the "monoline" insurers that insured CDOs and AIG, the nation’s largest insurer, that issued them).

  • Had policy makers not permitted investment banks to vastly increase their leverage so that they were far more exposed to failure when they suffered losses from their various investments, the previously independent investment banks may have been able to avoid their forced alliances with commercial banks (or, in the case, of Lehman, failure).

  • And had financial institutions followed their own internal risk management guidelines, then it is possible that the current crisis would not be so deep and that the face of both of the commercial and investment banking industries would now not be so radically changed.

Recognizing what went wrong is important in assessing what needs to be changed in the future. We do not plan to get into the blame game, nor is it productive for policy makers to do so (though we expect a certain amount of this during an election campaign). Instead, it is vital that those charged with fixing this mess draw on what is now widely known and agreed upon so as to develop appropriate reforms that would dramatically lower the risks and consequences of future such financial crises, without chilling the financial innovation for which America’s highly entrepreneurial financial sector has long been known. That is the approach we will follow in this project, and in the broad suggestions outlined next.

  M O R E. . .


The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Hussman Votes No!

Hussman Votes No! You Can't Rescue The Financial System If You Can't Read A Balance Sheet.
Click here for a link to complete article:

By John P. Hussman, Ph.D. | 30 September 2008

This is a bad idea.

However the final legislation is written, the Troubled Assets Relief Program (TARP) being rushed through Congress will evidently be built around its single worst provision, which is that the Treasury will have authority to purchase distressed mortgage securities from U.S. financials. As I noted last week in An Open Letter To Congress Regarding the Current Financial Crisis, the sequence of bankruptcies that we've observed among U.S. financials has been almost exactly in order of their gross leverage (the ratio of total assets to shareholder equity). The reason for that is:

1) as the assets of a financial company lose value, the losses reduce the asset side of the balance sheet, but also reduce shareholder equity on the liability side;

2) as the cushion of shareholder equity becomes thinner, customers begin to make withdrawals;

3) in order to satisfy customer withdrawals, the financial company is forced to liquidate assets at distressed prices, prompting a further reduction in shareholder equity;

4) go back to 1) and continue the vicious cycle until shareholder equity goes negative and the company becomes insolvent.

Let's return to the basic balance sheet of a typical financial company before the writedowns:

Good Assets: $95
Questionable Assets: $5

Liabilities To Customers: $80
Debt to Bondholders: $17
Shareholder Equity: $3

Now let's write down the questionable assets— not all the way to zero, but to $2:

Good Assets: $95
Questionable Assets: $2

Liabilities To Customers: $80
Debt to Bondholders: $17
Shareholder Equity: $0

This shortfall of protection on the liability side of the balance sheet is what causes a run on the institution, because once shareholder equity is gone, the only way to get at the debt to bondholders is for the company to declare bankruptcy. The concern has been that continuing bankruptcies would throw the whole financial system into disarray, especially for investment banks having lots of counterparty relationships with other institutions. But the reality is that for nearly all of these institutions, the cushion of debt to bondholders has always been more than sufficient to protect customers from losses even in the event of bankruptcy.

What the financial system has needed most has been for Congress to streamline the bankruptcy process for investment banks, so that in the event of failure, the "good bank" (assets and liabilities, ex the debt to bondholders) could be cut away quickly and liquidated to an acquirer, leaving the proceeds as a residual for the bondholders. Indeed, that's exactly how it works for regulated banks. What investors overlooked in last week's panic was that we actually saw the largest bank failure in history— Washington Mutual— with absolutely no losses to customers or the U.S. government, precisely because the good bank was seamlessly cut away and sold to J.P. Morgan, wiping out shareholder equity, preferred equity, and subordinated debt, with partial repayment to the bondholders.

Snap— just like that! Now, let's go back to the previous balance sheet. The Treasury plan seeks to buy up those questionable assets and thereby protect the institution against failure. Problem is, suppose the Treasury buys those questionable assets at their going value of $2. Here's the result:

Good Assets: $95
Cash Proceeds from Sale of Questionable Assets to Treasury: $2

Liabilities To Customers: $80
Debt to Bondholders: $17
Shareholder Equity: $0

Does this transaction protect the institution against failure? No! If you buy the bad assets off the balance sheet at their market value, nothing changes on the liability side! You may have improved the "quality" of the balance sheet, but you've provided no additional capital. At best, you've allowed the bank to liquidate its assets more easily to meet continuing customer withdrawals in the vicious cycle described above.

The only way that buying the questionable assets will increase capital on the liability side of the balance sheet is if the Treasury overpays for them.

A better approach would be for the government to provide capital directly, in the form of a "super-bond," in an amount no greater than the debt to bondholders. The "super-bond" would be subordinate to customer liabilities, so it could be counted as capital for the purpose of capital requirements, and would be seen by customers as a legitimate cushion of protection. However, in the event of bankruptcy, it would have a senior claim in front of both stockholders and even senior bondholders. Do that, and you've actually got a mechanism to protect the financial system while at the same time protecting customers and taxpayers. Ideally, the super-bond accrues a relatively high rate of interest so that financials have an incentive to shift to private financing as soon as possible, but you would also defer the interest until the bank meets a minimal level of profitability to make sure that the financing doesn't strain the institution's liquidity.

But then, Congress didn't do this because nobody thinks in terms of balance sheets. So after a nice pop to maybe 1300 or even 1400 on the S&P 500, we can expect all hell to break loose again.

As a side note, a lot has been made of Warren Buffett's investment in the senior preferred stock of Goldman Sachs. But it's notable that Buffett invested in Goldman only upon the conversion of Goldman to a bank holding company, which puts it under a different regulatory structure that gives it access to the Fed window. Goldman's balance sheet has $40 billion of shareholder equity that would have to be drilled through before getting at the preferred. [[Moreover, WB's preferred is 'senior' to all of GS's other preferred: normxxx]]. Evidently, Buffett believes that Goldman's asset mix is diversified enough, and light enough in mortgage assets, that Goldman won't take a major haircut on its entire (largely hedged) portfolio of assets.

Buffett's investment may reflect confidence in Goldman, particularly with a government backstop on whatever questionable assets it does own, but if anything, it suggests that the government should have gone the same route— namely, provide capital in return for a financially viable security that is senior to common shareholder equity, have it accrue a relatively high rate of interest, and allow it to be repaid early (Buffett's preferred is callable by Goldman) as soon as the financial institution can secure cheaper financing.

Instead, the government is taking on financially non-viable securities and warrants on common equity, while failing to improve the capital position of these financial companies at all (unless it overpays). Taxpayers will not make money here.

As Congressman Scott Garrett noted to taxpayers on Sunday, "This morning we should be very much alarmed. Obviously, Washington is not listening to your wishes. Those who used to work for Goldman Sachs will support this deal. Those who have blocked reform in the past will support this deal. I will not support this deal." I [John Hussman] couldn't agree more. This is not a good deal, because it will waste taxpayer money without addressing the fundamental solvency problems.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable market action. At present, however, there's not a lot to stand in the way of a violent short squeeze, particularly in financials, on the prospect of hundreds of billions in helicopter money for Wall Street. The Fund remains well hedged against substantial downside risk, but we did establish a modest "anti-hedge" on market weakness last week: an out-of-the-money index call option position amounting to about 1% of assets, not to create a significant positive exposure, but to soften our hedge in the event of a hyperactive relief rally.

This is not a long position for us, and certainly not a "buy signal." It's just risk-management to provide for the contingency that investors could shift to a risk-taking preference for a while. If broad improvement in market action confirms that sort of shift, we'll allow that call exposure to go "in-the-money," which would provide the Strategic Growth Fund with a modest positive exposure to market fluctuations. Poor internal market action on any relief rally would encourage us to clip off that call option exposure or raise our strike prices to capture any intrinsic value that accrues.

In bonds, the Market Climate last week was characterized by relatively neutral yield levels and modestly unfavorable yield pressures. If the legislation is passed, as appears likely, Treasury prices may be pressured lower on expectations of expanded supply, combined with potential aversion of foreign investors to hold a currency that is increasingly backed by junk. If you take a U.S. dollar out of your wallet, you'll see "Federal Reserve Note" written prominently along the top. Witness how the U.S. currency is now backed. The Treasury plan will make the situation no better.

For our part, the Strategic Total Return Fund is primarily invested in short-dated Treasury securities with little sensitivity to interest rate fluctuations. The Fund also holds about 30% of assets in a mix of foreign currencies, precious metals shares, and utility stocks.

  M O R E. . .


The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Monday, September 29, 2008

Who's Next After Lehman Brothers?

Who's Next After Lehman Brothers Is Fed To The Wolves?
One Can Date The Onset Of The Great Depression From December 1930 With The Collapse Of The New York Bank Of The United States, A Mid-Size Lender To The Jewish Community In New York.

By Ambrose Evans-Pritchard, Telegraph, UK | 16 September 2008

It is often alleged that the '[WASP] Anglo' elites let The New York Bank Of The United States fail from motives of anti-semitic malice. True or not, the consequences were dire for almost everybody. The failure set off a worldwide run on US gold deposits (ie, the dollar), and forced the Federal Reserve to raise interest rates into the slump. Some 4,000 lenders were ultimately driven to the wall.

We will find out soon enough whether the decision to throw Lehman Brothers to the wolves a [couple of weeks ago] was any wiser. Princeton economist Paul Krugman has accused the US Treasury and the Fed of playing "Russian Roulette" with the financial system, warning that the 'shadow' banking system could disintegrate within days. The hunting packs switched instantly to AIG, driving down its shares by 90%. The world's biggest insurer [was] suddenly on the brink of collapse as well. The killer virus is striking deep into a whole new sector of the financial system.

"This is a potentially very dangerous situation," said Professor Tim Congdon from the London School of Economics. "Banking system capital is being wiped out. The risk is that this could lead to a contraction of credit and set off a self-reinforcing downward spiral, leading to the sort of debt-deflation we saw in the 1930s. It is already clear that money growth has ground to a halt over the past three months. We must prevent it from actually contracting. If the Fed and European Central Bank don't cut interest rates soon, it is going to be a problem," he said.

When creditors cut off funding to Bear Stearns in March, the Fed reacted with dramatic speed. It invoked nuclear powers under Article 13 (3) of its charter, allowing it— in "unusual and exigent circumstances"— to take credit liabilities on to its own books for the first time since the Roosevelt era. It was fiercely criticised for rescuing Wall Street from its own folly, but the risk was a meltdown in the vast, untested market for derivatives. Bear Stearns alone had over $13 trillion in contracts, with heavy exposure to the turbo-charged CDS credit swaps that so [belatedly] terrify the New York Fed.

Nobody was ready for a derivatives shock at that time. This time, hopefully, they [would be[[— needless to say, they weren't!: normxxx]]] The Bear Stearns bail-out gave the banks an extra six months to clean up their positions and lower exposure. Hence the orderly unwinding of trades at an emergency session of the International Swaps and Derivatives Association on Sunday afternoon.

With the tail risk of a derivatives Chernobyl out of the way, the Fed and the Treasury at last feel safe enough to strike a blow against moral hazard. The line has to be drawn somewhere. Unlike mortgage giants Fannie Mae and Freddie Mac, broker dealers are not crucial pillars of the US housing market. Lehman is an optimal candidate for ritual sacrifice. While the appearances of free market discipline have been upheld, the reality of the weekend events is a further lurch towards socialism, or state capitalism if you prefer.

The Fed's lending window has been widened, allowing all forms of investment grade paper [[aka, "crap": normxxx]] to be used as collateral in exchange for taxpayer credit. Even equities are now admitted, though under a disguised formula. "With investment banks falling like ninepins, the Fed may have decided that it would be prudent to provide some official underpinning for equity market values and hope to avoid a stockmarket collapse," said Stephen Lewis, chief economist at Insinger de Beaufort. Yet the dangers remain acute, even after the move to shield Merrill Lynch from contagion by orchestrating a shotgun wedding with Bank of America.

The credit crunch is about to bite deeper. The interest rate on Tier 1 debt for typical banks has jumped by 125 basis points since Friday. "This is a violent effect," said Willem Sels, credit strategist at Dresdner Kleinwort. The closely-watched Libor/OIS spread on three-month money in the US has risen to 105 basis points, pointing to a lending crunch over the winter. Europe's iTraxx Crossover index measuring default risk on junk debt has surged to over 600.

"There is a flight to quality. People are hoarding liquidity and this is going to prove very damaging. What concerns me is that the banks refused to take on Lehman's bad assets even at a low valuation, and that tells you they still don't know where the clearing level is for this mortgage debt," he said. As this newspaper has long feared, the world is now faced with both a tightening credit squeeze and a synchronised hard-landing across most of the world economy. The Eurozone and Japan are almost certainly in recession already. Britain will follow soon.

America is plummeting into a second downward leg as the fiscal stimulus package fades and the exports mini-boom stalls. China cut interest rates yesterday following a sharp fall in property prices over the summer. Superficially, one can blame Lehman and its ilk for the excesses that led to this crisis. However, the root cause lies in the actions of governments across the Western world. They held interest rates too low for much of the past two decades, and encouraged the debt burden to explode to unprecedented levels.

This reckless experiment has left our societies acutely vulnerable to a sudden reversal of debt issuance, or "deleveraging" as it is known. The ferocious purge now under way will come at a high human cost. Millions in Britain, Europe, the US, and the rest of the world will lose their jobs over the next two years, through no fault of their own.

Having caused this crisis, it would now be remiss for governments to pursue a policy of strict debt liquidation in the name of capitalist purity. As the bankruptcies mount, the state will have an obligation to step in to preserve social stability. If that means the temporary nationalisation of large chunks of the Western economy, so be it. This is too grave a crisis for ideological preening and free market infantilism. May those calling for debt liquidation "a l'outrance" [["to the utmost" or "to the death": normxxx]] be the first in line to lose their jobs.



The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Sunday, September 28, 2008

Lehman's Demise Triggered Cash Crunch Around Globe

Lehman's Demise Triggered Cash Crunch Around Globe
Decision To Let Firm Fail Marked A Turning Point In Crisis

By Carrick Mollenkamp and Mark Whitehouse, UK; Jon Hilsenrath And Ianthe Jeanne Dugan, UK | 29 September 2008

Two weeks ago, Wall Street titans and the government's most powerful economic stewards made a fateful choice: Rather than propping up another failing financial institution, they let 158-year-old Lehman Brothers Holdings Inc. collapse. Now, the consequences of that decision look more dire than almost anyone imagined.

AFP/Getty Images. A policeman tries to calm and direct customers crowding the entrance of a branch of Hong Kong's Bank of East Asia after rumors spread about BEA's exposure to assets linked to failed investment bank Lehman Brothers.

Lehman's bankruptcy filing in the early hours of Monday, Sept. 15, sparked a chain reaction that sent credit markets into disarray. It accelerated the downward spiral of giant U.S. insurer American International Group Inc. and precipitated losses for everyone from Norwegian pensioners to investors in the Reserve Primary Fund, a U.S. money-market mutual fund that was supposed to be as safe as cash. Within days, the chaos enveloped even Wall Street pillars Goldman Sachs Group Inc. and Morgan Stanley. Alarmed U.S. officials rushed to unveil a more systemic solution to the crisis, leading to Sunday's agreement with congressional leaders on a $700 billion financial-markets bailout plan.

The genesis and aftermath of Lehman's downfall illustrate the difficult position policy makers are in as they grapple with a deepening financial crisis. They don't want to be seen as too willing to step in and save financial institutions that got into trouble by taking big risks. But in an age where markets, banks and investors are linked through a web of complex and opaque financial relationships, the pain of letting a large institution go has proved almost overwhelming.

In hindsight, some critics say the systemic crisis that has emerged since the Lehman collapse could have been avoided if the government had stepped in. Before Lehman, federal officials had dealt with a series of financial brushfires in a way designed to keep troubled institutions such as Fannie Mae, Freddie Mac and Bear Stearns Cos. in business. Judging them as too big to fail, officials committed billions of taxpayer dollars to prop them up. Not so Lehman.

"I don't understand why they didn't understand that the markets would be completely spooked by this failure," says Richard Portes, professor of economics at London Business School and president of the Centre for Economic Policy Research. Rather than showing the government's resolve, he says, letting Lehman fail only exacerbated the central problem that has afflicted markets since the financial crisis began more than a year ago: Nobody knows which financial firms will be able to make good on their debts.

To be sure, Lehman's downfall was largely of its own making. The firm bet heavily on investments in overheated real-estate markets, used large amounts of borrowed money to supercharge its returns, then was slower than others to recognize its losses and raise capital when its bets went wrong. The depth of the firm's woes made finding a willing buyer a difficult task, leaving officials with few viable options. Given the limited time and information available, many experts believe government officials made the best choices possible.

Struggle For Capital

As they watched Lehman struggle to raise capital, policy makers— including Treasury Secretary Henry Paulson, Federal Reserve Chairman Ben Bernanke and New York Fed President Timothy Geithner— mulled the question of whether they could let Lehman fail. On the one hand, they didn't want to come to the rescue because they were concerned about moral hazard, the idea that bailouts encourage irresponsible risk-taking, according to people familiar with the planning. They doubted Lehman had viable buyers and they thought the market and the Fed had had time to prepare to handle the fallout if a big institution collapsed.

Still, some Fed officials were leery of sending signals that the Fed was done working with Wall Street to stop the spreading crisis. Mr. Geithner, for one, had been telling others that the markets were still in for serious trouble. "If you don't do something, the outcome is going to be bad," Mr. Geithner told executives as they gathered to bargain over Lehman's fate at the New York Fed's downtown headquarters on Friday night, Sept. 12, according to a person in the meeting. At one point, officials raised with Wall Street bankers the possibility of a private-sector rescue fund, but the bankers either balked at the idea of bailing out a competitor or didn't have the extra funds needed, people familiar with the situation said.

Prepare The Markets

Over the weekend, as possible buyouts by Bank of America Corp. and U.K. bank Barclays PLC fell through, Fed officials focused on what needed to be done to prepare markets for what would be the largest bankruptcy in U.S. history. Lehman's total assets of more than $630 billion dwarf WorldCom's assets when the telecom company filed for bankruptcy in 2002 with assets of $104 billion. Officials were particularly concerned with two areas: the credit-default-swap market, where players buy and sell insurance against defaults on corporate and other bonds; and the so-called repo market, where Wall Street banks fund their investments by putting up securities as collateral for short-term loans.

The Fed had been pushing Wall Street firms for months to set up a new clearinghouse for credit-default swaps. The idea was to provide a more orderly settlement of trades in this opaque, diffuse market with a staggering $55 trillion in notional value, and, among other things, make the market less vulnerable if a major dealer failed. But that hadn't gotten off the ground. As a result, nobody knew exactly which firms had made trades with Lehman and for what amounts.

On Monday, those trades would be stuck in limbo. In a last-ditch effort to ease the problem, New York Fed staff worked with Lehman officials and the firm's major trading partners to figure out which firms were on opposite sides of trades with Lehman and cancel them out. If, for example, two of Lehman's trading partners had made opposite bets on the debt of General Motors Corp., they could cancel their trades with Lehman and face each other directly instead.

The Fed had also seen with the collapse of Bear Stearns how the repo market was prone to severe disruptions when lenders got skittish, a problem that threatened to cut off crucial funding to Wall Street banks. Because repo loans are made for periods of as little as a day, the funding can disappear suddenly— one reason the Fed set up an emergency facility to lend to securities firms in the wake of Bear Stearns's collapse. Fed officials worked furiously through Sunday to expand that facility, allowing banks to put up as collateral for loans a wider range of securities, including stocks.

On Sunday, after the Barclays deal fell through, the group began to "spray foam on the runway"— the term Mr. Geithner used to describe measures to cushion the blow. By that night, Fed officials recognized that their preparations might not cover all contingencies. Still, they expected the turbulence to settle down after a time, with the help of the expanded lending facilities they hurried Sunday to put in place. They also felt that financial institutions and markets had been given enough time to prepare for the shock of a large failure since the crisis consumed Bear Stearns in March.

But Lehman's bankruptcy, filed early Monday morning in federal bankruptcy court— case No. 08-13555— proved far more destabilizing, and spread much further, than many had expected. The bankruptcy immediately wiped out huge investments for Lehman shareholders and bondholders. Among the biggest was Norway's government pension fund, which invests the country's surplus oil revenue. As of the end of 2007, the most recent data available, the fund owned more than $800 million worth of Lehman bonds and stock. Lehman's demise has become a lightning rod for critics who have long questioned the way the government was investing the oil resources. A spokesman said the fund's management is "very concerned and monitoring the situation closely."

The government's decision to let Lehman go marked a turning point in the way investors assess risk. When the Fed stepped in to engineer the takeover of Bear Stearns by J.P. Morgan Chase & Co. in March, Bear's shareholders lost most of their investments, but bondholders came out well. In the financial hierarchy of risk, this wasn't surprising, since bondholders have more contractual rights to get their money back than equity holders. But it created a false impression among investors that the government would step in to rescue bondholders when the next bank ran into trouble. By letting Lehman fail, the government had suddenly disabused the market of that notion.

The reaction was most evident in the massive credit-default-swap market, where the cost of insurance against bond defaults shot up Monday in its largest one-day rise ever. In the U.S., the average cost of five-year insurance on $10 million in debt rose to $194,000 from $152,000 Friday, according to the Markit CDX index. When the cost of default insurance rises, that generates losses for sellers of insurance, such as banks, hedge funds and insurance companies. At the same time, those sellers must put up extra cash as collateral to guarantee they will be able to make good on their obligations. On Monday alone, sellers of insurance had to find some $140 billion to make such margin calls, estimates asset-management firm Bridgewater Associates.

As investors scrambled to get the cash, they were forced to sell whatever they could— a liquidation that hit financial markets around the world.

Cash Calls

The cash calls added to the problems of AIG, which was already teetering toward collapse as it sought to meet more than $14 billion in added collateral payments triggered by a downgrade in its credit rating. AIG was one of the biggest sellers in the default insurance market, with contracts outstanding on more than $400 billion in bonds. To make matters worse, actual trading in the CDS market declined to a trickle as players tried to assess how much of their money was tied up in Lehman. The bankruptcy meant that many hedge funds and banks that were on the profitable side of a trade with Lehman were now out of luck because they couldn't collect their money. Also, clients of Lehman's prime brokerage, which provides lending and trading services to hedge funds, would have to try to retrieve their money or their securities through the courts.

Autonomy Capital Research, a London-based hedge fund that was started in 2003 by former Lehman trader Robert Charles Gibbins, was among the Lehman clients who got caught. When Lehman filed for bankruptcy protection, it froze about $60 million of Autonomy's funds, according to a person close to the situation. That is about 2% of the $2.5 billion Autonomy manages. An official at Autonomy declined to comment.

Spooked that other securities firms could fail, hedge funds rushed to buy default insurance on the firms with which they did business. But sellers were hesitant, prompting something akin to what happens if every homeowner in a neighborhood tries to buy homeowners insurance at exactly the same time. The moves dramatically drove up the cost of insurance on Morgan Stanley and Goldman Sachs debt in what became a dangerous spiral of fear about those firms.

At the same time, hedge funds began pulling their money out of the two firms. Over the next few days, for example, Morgan Stanley would lose about 10% of the assets in its prime-brokerage business. "It was just mayhem," says Thomas Priore, the CEO of New York-based hedge fund Institutional Credit Partners LLC. People were paralyzed by fear of what could erupt.

Amid the uncertainty about how Lehman's bankruptcy would affect other financial institutions, rumors and confusion sparked wild swings in stock prices. On Tuesday, for example, a London-based analyst issued a report saying that Swiss banking giant UBS AG, already hurt by tens of billions of dollars in write-downs, might lose another $4 billion because of its exposure to Lehman. Shares in UBS fell 17% on the day. UBS subsequently said its exposure was no more than $300 million.

Rising concerns about the health of financial institutions quickly spread to the markets on which banks depend to borrow money. At around 7 a.m. Tuesday in New York, the market got its first jolt of how bad the day was going to be: In London, the British Bankers' Association reported a huge rise in the London interbank offered rate, a benchmark that is supposed to reflect banks' borrowing costs. In its sharpest spike ever, overnight dollar Libor had risen to 6.44% from 3.11%. But even at those rates, banks were balking at lending to one another.

Within a few hours, the markets had shifted their focus to the fate of Goldman Sachs and Morgan Stanley, which found themselves fighting to restore investors' flagging confidence. During an earnings presentation in which he answered one after another question about the firm's ability to borrow money, Goldman chief financial officer David Viniar made an admission: "We certainly did not anticipate exactly what happened to Lehman," he said.

Morgan Stanley's stock, meanwhile, plunged 28% in early trading as investors bet that it would be the next after Lehman to fall. At around 4 p.m., the firm decided to report its third-quarter earnings a day early, in the hope that the decent results would halt the stock decline. "I care that it could be contagion," Morgan Stanley chief financial officer Colm Kelleher said in a conference call with analysts. "You've got fear in the market."

Even as Morgan Stanley's call was taking place, the Lehman fallout cropped up in a different corner of finance: so-called money-market funds, widely seen as a safe alternative to bank deposits. Many of the funds had bought IOUs, known as commercial paper, which Lehman issued to borrow money for short periods. Now, though, the paper was worth only 20 cents on the dollar.

At around 5 p.m. New York time, a well-known money-market fund manager called The Reserve said that its main fund, the Reserve Primary Fund, owned Lehman debt with a face value of $785 million. The result, said The Reserve, a strongly conservative fund which had criticized its rivals for taking on too much risk in the commercial-paper market, was that its net asset value had fallen below $1 a share— the first time a money-market fund had "broken the buck" in 14 years. [[And the first time ever for retail clients!: normxxx]]

The trouble in the commercial-paper market presented a particularly serious threat to the broader economy. Companies all over the world depend on commercial paper for short-term borrowings, which they use for everything from paying salaries to buying raw materials. But as jittery money-market funds pulled out, the market all but froze.

On Wednesday, the freeze in lending markets triggered a dramatic turn of events in the U.K. Amid growing concerns about its heavy dependence on markets to fund its business, HBOS PLC, the UK's biggest mortgage lender, saw it share price plummet by 19%. The situation was a red flag for government officials, who suffered embarrassment earlier this year when they were forced to nationalize troubled mortgage lender Northern Rock PLC, which had become the target of the country's first bank run in more than a century.

Moving quickly, the government brokered an emergency sale of HBOS to UK bank Lloyds TSB Group PLC. In a sign of their desperation to make the deal happen, officials went so far as to amend the UK's antitrust rules, which could have prevented the merger. Together, HBOS and Lloyds control nearly a third of the UK mortgage market.

Back in New York, the situation at Morgan Stanley and Goldman Sachs was worsening rapidly. In the middle of the trading day, at about 2 p.m., Morgan Stanley CEO John Mack dispatched an email to employees: "What's happening out here? It's very clear to me— we're in the midst of a market controlled by fear and rumors." By the end of Wednesday, employees at Morgan Stanley and Goldman were shell-shocked. Morgan Stanley's shares had fallen 24% to $21.75 while Goldman, the largest investment bank by market value, fell 14% to $114.50.

By Thursday, Messrs. Paulson and Bernanke decided that the fallout presented too great a threat to the financial system and the economy. In the biggest government intervention in financial markets since the 1930s, they extended federal insurance to some $3.4 trillion in money-market funds and proposed a $700 billion plan to take bad assets off the balance sheets of banks. Three days later, Goldman Sachs and Morgan Stanley applied to the Fed to become commercial banks— a historic move that ended the tradition of lightly regulated Wall Street securities firms that take big risks in the pursuit of equally big returns.

To some, the government's decision to resort to a bailout represents a tacit admission: For all officials' desire to allow markets to punish the risk-taking that engendered the crisis, banks have the upper hand. "Lehman demonstrated that it's much harder than we thought to deal effectively with banks' misbehavior," says Charles Wyplosz, an economics professor at the Graduate Institute in Geneva. You have to look the devil in the eyes and the eyes are pretty frightening.



The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Saturday, September 27, 2008

Buffett's CDS "Time Bomb" Goes Off

Buffett's CDS "Time Bomb" Goes Off On Wall Street

By James B. Kelleher | 27 September 2008

CHICAGO (Reuters)— On Main Street, insurance protects people from the effects of catastrophes. But on Wall Street, specialized insurance known as a credit default swaps are turning a bad situation into a catastrophe. When historians write about the current crisis, much of the blame will go to the slump in the housing and mortgage markets, which triggered the losses, layoffs and liquidations sweeping the financial industry. But credit default swaps— complex derivatives originally designed to protect banks from deadbeat borrowers— are adding to the turmoil.

"This was supposedly a way to hedge risk," says Ellen Brown, the author of the book Web of Debt: The Shocking Truth About Our Money System and How We Can Break Free (Revised and Updated Paperback, 2008). "I'm sure their predictive models were right as far as the risk of the things they were insuring against. But what they didn't factor in was the risk that the sellers of this protection wouldn't pay ... That's what we're seeing now." Brown is hardly alone in her criticism of the derivatives. Five years ago, billionaire investor Warren Buffett called them a "time bomb" and "financial weapons of mass destruction" and directed the insurance arm of his Berkshire Hathaway Inc (BRKa.N) to exit the business.

Recent events suggest Buffett was right. The collapse of Bear Stearns. The fire sale of Merrill Lynch & Co Inc (MER.N). The meltdown at American International Group Inc (AIG.N). In each case, credit default swaps played a role in the fall of these financial giants. The latest victim is insurer AIG, which received an emergency $85 billion loan from the U.S. Federal Reserve late on Tuesday to stave off a bankruptcy.

Over the last three quarters, AIG suffered $18 billion of losses tied to guarantees it wrote on mortgage-linked derivatives. Its struggles intensified in recent weeks as losses in its own investments led to cuts in its credit ratings. Those cuts triggered clauses in the policies AIG had written that forced it to put up billions of dollars in extra collateral— billions it did not have and could not raise.

Easy Money

When the credit default market began back in the mid-1990s, the transactions were simpler, more transparent affairs. Not all the sellers were insurance companies like AIG— most were not. But the protection buyer usually knew the protection seller. As it grew— according to the industry's trade group, the credit default market grew to $46 trillion by the first half of 2007 from $631 billion in 2000— all that changed.

The 'over-the-counter' market grew up and some of the most active players became asset managers, including hedge fund managers, [[mostly unknown to the insured: normxxx]] who bought and sold the policies like any other investment. And in those deals, they sold protection as often as they bought it. But rarely set aside the reserves they would need if the obligation ever had to be paid.

In one notorious case, a small hedge fund agreed to insure UBS AG (UBSN.VX), the Swiss banking giant, from losses related to defaults on $1.3 billion of subprime mortgages for an annual premium of about $2 million. The trouble was, the hedge fund set up a subsidiary to stand behind the guarantee— and capitalized it with just $4.6 million. As long as the loans performed, the fund made a killing, raking in an annualized return of nearly 44 percent.

But in the summer of 2007, as home owners began to default, things got ugly. UBS demanded the hedge fund put up additional collateral. The fund balked. UBS sued. The dispute is hardly unique. Both Wachovia Corp (WB.N) and Citigroup Inc (C.N) are involved in similar litigation with firms that promised to step up and act like insurers— but were not actually insurers. "Insurance companies have armies of actuaries and deep pools of policyholders and the financial wherewithal to pay claims," says Mike Barry, a spokesman at the Insurance Information Institute.


Another problem: As hedge funds and others bought and sold these protection policies, they did not always get prior written consent from the people they were supposed to be insuring. Patrick Parkinson, the deputy director of the Fed's research and statistic arm, calls the practice "sloppy." As a result, some protection buyers had trouble figuring out who was standing behind the insurance they bought. And it put investors into webs of relationships they did not understand.

"This is the derivative nightmare that everyone has been warning about," says Peter Schiff, the president of Euro Pacific Capital at the author of Crash Proof: How to Profit From the Coming Economic Collapse. "They booked all these derivatives assuming bad things would never happen. It was like writing fire insurance, assuming no one is ever going to have a fire, only now they're turning around and watching as the whole town burns down."



The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Credit Default Swaps Explained

Credit Default Swaps Explained

By Dirk Van Dijk, CFA | 27 September 2008

At this point, it makes sense to explain just what a credit default swap, or CDS, is. They were the key reason for the demise of AIG (AIG), and for the fear that if they were not bailed out that the whole ball of wax would come unglued. Essentially it is an insurance policy, but an unregulated one (the State of N.Y. just recently said that it would (belatedly) start to regulate part of the market— can you say closing the barn door?).

If you buy a bond from, say, General Motors (GM), you are lending them money for a set interest rate for a specified length of time. You face two sets of risks in doing so. The first is that they go bankrupt and don't pay you back. The second is that interest rates rise and the bond falls in value (think of bond prices and interest rates as being on opposite sides of a see-saw).

With a CDS, you could go out and find someone who will insure against the default risk. For a given premium, the seller of the CDS will pay off on the GM bond if GM goes belly up. Now, if it was from a real insurance company, the insurance company would be regulated and would have to hold enough money in reserve to pay you off in case GM actually did go belly up. This is just like a Life Insurance company has to have enough cash on had to pay off on your policy in case you die.

However, since this is an unregulated market, someone can sell you a CDS and blow the money in Las Vegas. In that case, if GM did go belly up, you would just plain be out of luck. In the case of life insurance, there are strict limits on who can take out a policy on you. You can take out a policy on your own life, and on close family members.

In some circumstances you can take out a policy on your business partner, but beyond that there are not many people you can take out a policy on. You have to have what is called an insurable interest; you can't just wander the halls of the hospital looking for people who are unlikely to make it and take out life insurance policies on them. This is not true for the CDS market.

You are perfectly free to take out a "life insurance policy" on GM, GE, or any other firm that issues a bond, and you do not have to be holding the bond. You could even take out a "life insurance policy" on the 'toxic' garbage that Wall Street has been pumping out. This ability to buy insurance on things that you have no insurable interest in transformed this market into a huge casino. It is totally unregulated, and even the new steps by the New York State Insurance Commissioner, Eric Dinnallo, only covers the least egregious part of the market, where people actually have an insurable interest (i.e. hold the underlying bond).

Regulation of this market was specifically prohibited under the Commodity Futures Modernization Act of 2001. That provision was slipped into the bill in the dead of night by our old friend Senator Phil Gramm of Texas— now Vice Chairman of UBS (UBS). People use this market to bet on the credit worthiness of companies, and often hedge funds will hold both long and short positions on the same underlying credit. (NOTE: figures are made up here, not a reflection of the actual creditworthiness of any real company.) For example, the hedge fund might make a bet that it is worthwhile to get $200,000 up front and be on the hook for $10 million if GXX defaults sometime in the next five years.

Then after a few months, GXX raises a bunch of capital which significantly strengthens its balance sheet and lowers the risk of default, so it can make a bet with someone else who would now be willing to take just $100,000 to bet that GXX will not go belly up within then next five years. The hedge fund could have a perfectly matched book, so in theory they were totally indifferent if GXX survives or not. However, suppose that the person who they made the bet with goes bankrupt themselves and can't pay up. That hedge fund might then have a hard time paying its counter party. This is where the fear of "cascading cross defaults" comes in.

All this is to say that the CDS market has seen more growth than practically any market in the history of mankind. It is currently at over $62 TRILLION, up from under $1 Trillion a decade ago. It would not take a very big percentage of that market to fail to leave a very big mark on the world financial system. When the dust settles from all the current mess, bringing this market under control has to be high on the agenda.

I would suggest that the contracts be standardized and that they be traded on an exchange, where the exchange itself acts as the counter-party for each trade (this is how the commodity exchanges work). It might also make sense to require that any party buying a CDS have an insurable interest in the underlying bond (i.e. that they are using it to hedge, not speculate).

This however, is work for the next Congress and Administration. First, we have to put out the fire with a well crafted and responsible bailout bill to prevent these cascading cross defaults from occurring. The original Paulson proposal was not well crafted, yet Congress doesn't appear likely to make significant improvements to the bill.



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Japanese Go Bargain-Hunting

Japanese Go Bargain-Hunting On Wall Street

By Blaine Harden | 24 September 2008

TOKYO, Sept. 24— Major Japanese banks and investment houses, fat with cash and apparently largely free of toxic investments, are spotting opportunity in the global financial mess and snapping up substantial holdings on Wall Street. With U.S. financial institutions still desperate for capital, analysts here say more major purchases are likely in coming days and weeks as the financial crisis churns on. Nomura Holdings, Japan's largest brokerage house, announced Tuesday it would buy for an undisclosed sum the 2,500-person European and Middle Eastern operation of the failed Lehman Brothers investment bank— one day after it had picked up Lehman's Asia-Pacific franchise, employer of about 3,000 people, for $190 million. Lehman filed for bankruptcy protection last week.

This is a once-in-a-generation opportunity, Kenichi Watanabe, chief executive of Nomura, said in a statement. He added that "our ability to capitalize on this opportunity in spite of such volatile markets reflects our financial strength." Although Nomura has lost money in the past two quarters, it had assets of about $263 billion as of March 31, making the purchases relatively small.

Japan's largest bank, Mitsubishi UFJ spent about $10 billion in August to buy the remaining shares of California's second-largest bank, UnionBanCal. Meanwhile, Sumitomo Mitsui Financial Group, Japan's third-largest bank, is planning a possible investment in Goldman Sachs, the Kyodo news agency reported Wednesday, citing unnamed sources. Japan's chance to buy up investment talent that its banks and brokerage firms have long coveted is, in part, a function of turmoil on Wall Street, where investment firms are desperate to cover bad wagers on subprime mortgages and other failed speculation.

It is also the culmination of the slow, stolid recovery of banks and other financial institutions from Japan's market meltdown in the 1990s. "We didn't take part in the good growth of the worldwide economy in the 1990s and now we are not getting hit by the downward trend," said Oki Matsumoto, chief executive officer of Monex Group, one of Japan's largest online brokers. "Japan has huge reserves of capital. We are much safer than any other country."

Banks and brokerage houses here spent nearly two decades rebuilding, selling off bad debt and devouring each other in mergers. These mergers, as several weaker banks were digested by stronger rivals, account for the alphabet-soup names of banks like Mitsubishi UFJ. Banks here have also changed their credit culture. Before they lent money on the basis of assets, much as U.S. lenders still do. Now, many banks here analyze the cash flow of their clients before they extend large amounts of credit.

"They spent the last 18 years going to hell and then coming back," said Ken Courtis, former vice chairman of Goldman Sachs in East Asia. "It is now the U.S. banks and investment firms that are on the hellish road toward the bottom." As Japanese banks recovered over the past five years, their cash reserves grew at an astonishing rate, owing to the peculiarities of this country's investing culture and its continuing economic problems.

There are about $15 trillion in personal financial assets in Japan, about $8 trillion of which are on deposit in banks. Banks are stuffed with money from an aging population whose consumer spending has been declining for years. Supermarket and department store sales have declined for 11 consecutive years, while sales of new cars of all brands peaked 18 years ago and have been falling ever since.

In the past two years, millions of elderly Japanese have grown alarmed about the security of their government pensions. The government announced early last year that more than 50 million pension records had been misfiled. The problem has not yet been sorted out, and it has led to people stuffing even more savings into banks.

As important to the capacity of banks here to accumulate capital: The cost of keeping someone's money in Japan is close to zero. Most depositors receive less than 1 percent interest on their savings. The central bank in Japan keeps interest rates extraordinarily low (0.5 percent for overnight loans to banks).

In large measure, low interest rates are a function of the country's huge public debt burden. At 182 percent of the Japan's gross domestic product, it is the most onerous in the world. The government acquired much of this debt in the 1990s, when it bailed out troubled banks. If interest rates were allowed to rise substantially, Japan's ability to service this debt could be threatened.

Finally, cash-flush banks in Japan have few local opportunities for profit. The economy is contracting and a recession is likely. Export-dependent companies such as Toyota report flat or declining worldwide sales, and foreign direct investment in Japan is by far the lowest among the world's major economies.

As Watanabe, the president of Nomura, made clear Monday: Opportunities are mostly elsewhere. "It will significantly extend our reach in Asia," he said, referring to the purchase of Lehman's regional operation. We see immediate strategic benefits, delivering the scale and scope to realize our vision to be a world-class investment bank.



The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.