A fashion model posing in Victoria Station.
Ilargi: Last night’s Daily Show, the ever more brilliant comedy fake-news show that "gives you the news before it is even true", featured a conversation between Jon Stewart and his roving reporter John Oliver which, in comedic terms, painted a bleak picture of America’s future. Talking about the legacy of Shrub, Oliver noted that finding yet another area in which the administration could screw up was not easy: "like finding a vein in a failing junkie".
When Stewart asked if it was the intention of the US government to make American children eat roadkill, Oliver replied that that was not enough: "They want them to fight over roadkill". Stewart inquired if this is what will be left for the next president, and the roving reporter corrected him: "The Last President".
I have pondered before what the legitimacy is of a government that has lost control over its economy. That is a serious question, it’s not just theory. And there can no longer be any doubt that the government, comprised of the administration as well as Congress, Senate, and all regulatory agencies in the financial sector, if they haven’t already lost control, are on the verge of doing so.
It’s hard to see how they would regain that control within the present, democratic, system. There is a contested $700 billion+ plan that still doesn’t even begin to address the true problems in the US economy. Far more money will be needed to keep the present financial structure standing, and the only source for that money is, once again, the taxpayer. For no matter how deep in debt the taxpayer already is, the banks are in much deeper.
The global shadow banking system, the source of perhaps $800 trillion in outstanding derivatives, with $62 trillion in credit default swaps alone, is shaking on its foundations, and it will inevitably tumble, as Nouriel Roubini, one more time, stated this week.
The US administration’s answer to the trouble is predictable: it seeks dictatorial powers. The Paulson plan is very clear in this, it wants democratic institutions such as the legislative and the judicial branches of government to get out of the way, insisting they are hindrances and nuisances in the urgent process of "saving the system". Makes you think of twirling movements in the Founding Fathers’ graves, doesn’t it? And then we still ignore the issue of how pre-meditated the plan is.
If the plan is accepted in anything close to its present form, the US can no longer be called a functioning democracy (assuming it could still be before). Well, you can call it anything you want of course, and many will insist it still is democratic, but that doesn’t make it true.
We should look beyond the -interesting- discussion about legal repercussions of what happens in New York and Washington, I think we are all focused so much on what goes on in the US that we need a bit of a wake-up call. This is not a problem in the American banking and financial system, it's global, it will hit everywhere throughout the world.
Yesterday saw a real-life bank run in Hong Kong, we had French bank Société Générale sending a directive to its clients advising them to sell all their Chinese -and other Far East- bank holdings: "The great unwind has only just begun". Britain’s home sales are now at 1959 levels, and there are predictions of riots, and soon too, in Spain. If SocGen’s report is accurate, and the Chinese banks are teetering that badly, this may well turn into a "God help us all" issue.
The legality questions, concerning a government in the face of its failing economy, will play all over the globe, and there's no telling which country goes first. What’s certain is that we live in historic times, since it's equally certain that the global economic system can’t be "saved". Still, all over that same globe, I see people participating in business as usual, preparing to purchase homes and iPods and "green" cars, preparing to sent their kids to university, preparing for well-endowed retirements. And the band played on.
Buffett to Goldman Sachs: "I Got $5 Billion, but Its Gonna Cost Ya"
Tonight's Goldman Sachs/Warren Buffett deal is a classic example of our post 2001 news: Looks good as a headline, is godawful underneath. Of course, futures popped on the announcement. The WSJ subhead read "Move by Famed Investor Amid Crisis Seen as Vote of Confidence in Banking System." Puh-leeze.
Vote of confidence? Hardly. Doubtful. It is merely an opportunistic deal, and probably a damn good one, for Berkshire Hathaway (BRK). On the other hand, for Goldman Sachs, it is a very expensive deal. If you delve beneath the headlines, you see that Warren is not so much making a vote of confidence as he is extracting pound of flesh (and then some). Verily, let's look at the details to figure out just how much GS is paying for this capital:
- Goldman Sachs pays a fat dividend to Berkshire Hathaway of 10% on $5 Billion dollars -- that's $500 million per year. And, since this is a preferred, it gets paid out of net income in after tax dollars dollars. Ouch.
- Goldman gets the right to call the preferred at any time at a 10 percent premium. Ouch again.
- Buffett gets $5 billion worth of warrants with a strike price of $115, or about 43.47 million shares. The warrants are good for only 5 years.
If Buffett were to go to the Street earlier today to buy 44 million calls with a $115 strike price (circa 2010), they would have cost him about $1.5 billion dollars. With GS now trading at $135, Buffett’s $5 billion investment is more like $3.5B, in terms of net cost to him. Hence, the 10% interest is more like 14%.
Doug Kass thinks its an even better deal for Berkshire -- goes further than I do, putting an intrinsic value on the warrants of about $2 billion. That makes Buffet's net cost $3B -- so the effective yield is closer to 17%. (Ouch) A friend points out that Goldie bought back 1.5 million shares in the quarter ending 8/31, at an average price of $180 a share. (Nice trade). I’m thinking the buyback program may be on hold for a while here.
Bottom line: This is a terribly expensive deal, but probably a necessary one. The smart boys at 85 Broad Street did not want to wait until they were too desperate to get even a mediocre deal. They sure as hell did not want to "pull a Fuld."
This also looks like a steady stream of income for Berkshire Hathaway. And what do you want to bet me that Warren asked for -- and got -- a very serious promise from Bernanke & Paulson that Goldman would under no circumstances be allowed to tank like Lehman? This might even be a riskless deal for Buffett. Vote of Confidence my ass . .
Warren Buffett to invest $10 billion in Goldman
Warren Buffett, one of the richest men in the world, is to invest up to $10bn (£5.4bn) in Goldman Sachs as the investment bank attempts to bolster its financial position amid continued fallout on Wall Street as a result of the sustained credit crisis. Mr Buffett, known as the "Sage of Omaha" for his legendary investment skills, will buy an initial $5bn holding through his Berkshire Hathaway investment vehicle, and will receive warrants to buy up to another $5bn at a later date.
Goldman is also raising a further $2.5bn through a public offering of its shares, which soared by 8.4pc to $135.56 in extended after-hours trading. The investment is a major vote of confidence in the bank, which has largely avoided the worst of the sub-prime crisis, but also highlights just how precarious the market has become that an institution such as Goldman feels the need to raise money in the first place.
The news – perhaps unthinkable just a fortnight ago – should act as a fillip for the wider stock market, given that Mr Buffett is perceived by many as a shrewd investor to whom timing is crucial. Dow Jones index futures were last night trading 160 points higher, following a 161 point fall in normal trading hours yesterday.
It is the first time Mr Buffett has bought a stake in an investment bank since purchasing a holding in Salomon Brothers in 1987. His investment comes just a day after Goldman changed its legal status to allow it to become a federal holding bank. "Buffett did this after Goldman converted to a bank holding company," said Pat Dorsey, director of equity research at Morningstar, meaning that the US Federal Reserve is now Goldman's regulator.
"Buffett is saying that, with less leverage and more stable sources of funding, this is an institution worth investing in. From Buffett's perspective you have a world-class firm in a less-competitive landscape, with a hopefully less-risky business model." As a result of its initial investment, Berkshire will own the equivalent of a 10pc stake in Goldman, based on last night's closing market capitalisation, in return for buying $5bn of perpetual preferred shares which will pay a 10pc dividend and which the bank can buy back at any time for a 10pc premium.
Berkshire will also receive warrants to purchase $5bn of ordinary shares at a strike price of $115 a share at any point over the next five years. Mr Buffett said last night "Goldman Sachs is an exceptional institution" with "the intellectual and financial capital to continue its track record of out-performance". Although the fact that it is Mr Buffett who has chosen to invest in the company will come as a surprise to many, the market has been awash with rumours for days that Goldman was on the verge of some form of fundraising.
Just last week, UBS analyst Glenn Schorr, following a meeting with Goldman chief financial officer David Viniar, wrote that he was "pretty confident" that the bank's management was "lining up all viable options". Japanese bank Sumitomo Mitsui Finanacial Group is also reported to be considering investing $2.5bn in Goldman.
Hong Kong bank BEA reassures panicked customers
Panicked customers queued to withdraw their savings from branches of the Bank of East Asia in Hong Kong as rumours circulated that the bank was facing financial problems, agencies reported.
Panicked customers queued to withdraw their savings from branches of the Bank of East Asia in Hong Kong as rumours circulated that the bank was facing financial problems, agencies report. The rumours were categorically denied by the bank's management, which nevertheless had to extend business hours by 30 minutes to cope with the queues of anxious customers.
The Bank of East Asia (BEA), owned by one of Hong Kong's wealthiest families, blamed "malicious rumours" that it said had been circulating in the market since Monday and questioned the bank's financial stability. The bank, Hong Kong's third-largest lender, said it had asked police to investigate. The shares fell 11pc.
"The management of BEA hereby states in the strongest possible terms that such rumours have no basis in fact," BEA said in an e-mailed statement. "The bank's financial position is sound and stable." Hong Kong's central bank said it would provide liquidity to Bank of East Asia if necessary and reiterated that the bank and the city's banking system were sound.
"I can confirm categorically that these rumours are unfounded," Joseph Yam, Chief Executive of the Hong Kong Monetary Authority, told reporters, referring to rumours about Bank of East Asia's financial stability. "The banking system of Hong Kong is very robust," he added.
The BEA's statement said the bank had assets of more than $50bn (£27bn) in June and its capital adequacy ratio was 14.6pc – a level it described as "well above the international required level". It said the bank's total exposure to the collapsed US investment bank Lehman Brothers and American International Group, the world's largest insurer that was bailed out last week, was HK$422.8m (£29m) and HK49.9m, respectively.
The assurance did little to calm the bank's customers, however, who feared the bank might be another casualty of the global credit crunch and flocked to its 130 city branches to withdraw money. "We're a little bit concerned," said Sonny Hsu, a Hong Kong-based analyst at Fitch Ratings, told Bloomberg. "We'll keep an eye on what's going on. If you just look at the numbers, I think the bank is financially still sound."
$5 Trillion Cash Pool Needed to Stop Rout
Treasury Secretary Henry Paulson's $700 billion plan to buy devalued assets from financial companies is "a joke" because it doesn't go far enough to calm markets, said Kenichi Ohmae, president of Business Breakthrough Inc.
Ohmae, nicknamed "Mr. Strategy" during his 23 years as a McKinsey & Co. partner, called for a $5 trillion "international facility" to be made available to financial institutions. The system could be modeled on one used by Sweden during its banking crisis in the early 1990s, he said. "This is a liquidity crisis," Ohmae said at an investor forum hosted by CLSA Asia-Pacific Markets, the regional broking arm of Credit Agricole SA, in Hong Kong yesterday. "The liquidity has to be so big that people won't get panicky."
Paulson's proposal to remove hard-to-sell assets clogging the financial system marks the broadest intervention since at least the Great Depression. Asian stocks fell today, following U.S. shares lower as investors questioned whether the effort is enough to prevent a recession.
The plan came after the collapse of 158-year-old Lehman Brothers Holdings Inc. and the government takeover of insurer American International Group Inc. caused financial markets to seize up last week. The calamity was the culmination of a year during which the U.S. housing market slump left banks and securities firms with more than $520 billion of asset writedowns and credit losses. Yesterday, Paulson and lawmakers narrowed their differences on the plan and agreed that the U.S. should get equity in participating companies.
Ohmae, 65, is the author of management books including "The Mind of The Strategist," "The Borderless World" and "The End of the Nation State." Business Breakthrough, founded in 1998, provides online management training. One way of funding the $5 trillion facility would be through contributions from foreign exchange reserves in China, Japan, Taiwan, the Gulf states, the European Union and Russia, Ohmae said.
An international relief effort on that scale might be difficult to coordinate, said Robert Howe, founder of Hong Kong- based hedge fund manager Geomatrix (HK) Ltd., which oversees $32 million. "I doubt the practicality of getting international cooperation on something like this," he said.
Ohmae compared the current financial crisis with Japan's 15- year economic decline that began in 1989. Both started with a property bubble, which wiped out companies' equity when it burst, and like in Japan, the current one could lead to escalating bankruptcies as banks worried about their own survival rein in lending, he said.
The financial-market upheaval may lead to slower growth in China and the reversal of the commodity boom as ship orders are canceled and steel supply dumped, said Ohmae. What Ohmae called Japan's "Viagra" economy and Australia's "dig and deliver" boom may also fizzle as China weakens, he said.
Against the backdrop of a potential global market panic, Paulson's plan is insufficient, said Ohmae. Paulson is a former chief executive of Goldman Sachs Group Inc., the world's biggest securities firm. "He wants to fix problems one by one as if he were still the chief executive officer of Goldman Sachs," he said. "He has to take his CEO hat completely off and come up with a systemic solution as opposed to a one-by-one solution."
UK property sales drop to lowest level since 1959
The number of houses sold in Britain last month fell to its lowest since 1959 as the government's delayed announcement on changes to stamp duty deterred first-time buyers. HM Revenue & Customs said 62,000 houses were sold in August, less than half the figure for a year ago.
The news came as the British Banker's Association revealed mortgage approvals dived 64% in the year to August.
David Dooks, BBA statistics director, said: "The low number of mortgage approvals in previous months predicted lower gross lending in August and, together with remortgaging, a much weaker net lending figure than of late resulted.
"Falling property prices, economic pressures on households, tighter lending criteria and anticipation of the government's announcement on stamp duty all suppressed or delayed demand in August and will continue having an impact." Mortgage approvals for house purchases tumbled to 21,086 - the lowest since the series started in 1997 and down from 58,564 in August 2007, when mortgage lending had started to slow.
The number of people remortgaging fell to 47,765, against a six-month average of 66,626. Simon Rubinsohn, chief economist at the Royal Institution of Chartered Surveyors, said: "Data released by the BBA show a further drop in the number of mortgage approvals in August. This is not altogether surprising given that speculation was rife during the month about a possible announcement on stamp duty.
"The subsequent decision by the government to widen the zero band on stamp duty, albeit only temporarily, alongside the introduction of more competitive mortgage products by lenders should have helped bolster interest in the housing market this month, but these developments are likely to have been overshadowed by concerns stemming from the turmoil in financial markets. In addition, the renewed focus on risk has lifted the cost of wholesale money, which may well feed back into higher mortgage rates."
The chancellor, Alistair Darling, this month raised the level at which stamp duty becomes payable on house purchases from £125,000 to £175,000, for a year. Opposition parties used the mortgage figures to attack the government. Shadow chief secretary to the Treasury, Philip Hammond, said: "In the week that Gordon Brown attempts to save his job, these figures are a timely reminder of his damaging dithering over stamp duty. With mortgage approvals now at record lows, the effects of his economic incompetence are now clear for all to see - with would-be homeowners left to pick up the pieces."
Meanwhile, Moneyfacts.co.uk said yesterday borrowers with a deposit of 10% or less have seen the number of mortgages available to them more than halve in a year. Darren Cook, mortgage specialist at Moneyfacts.co.uk, said: "This time last year, 74.2% of mortgages were available for borrowers with a deposit of 10% or less; that has dropped to 29.2%
SocGen issues China alert as fears mount on banks
Société Générale has advised clients to dump shares of banks exposed to the Far East. "The collapse of emerging market economies will shake investors to the core. The great unwind has only just begun," said Albert Edwards, the bank's global strategist.
"The big surprise in store is what could happen in China. The potential for a deep recession in the US is already on the radar screen, but people will be stunned if China's economy contracts, as I believe it will. Investors could be massively caught out," he said.
"The consensus has a touching belief that emerging markets will prove resilient despite a deep downturn in developed economies. My view is that an outright contraction in global GDP is entirely possible next year." "The emerging market boom is totally tied up with a decade of ballooning current account deficits in the US. Put that into reverse and you'll be surprised what pops out of the woodwork."
Mr Edwards said the vast accumulation of foreign exchange reserves – led by China with $1.8 trillion – had provided the "rocket fuel" of liquidity for frontier markets. This virtuous circle has now turned vicious as America tightens its belt. Countries in Asia and Latin America are intervening to prop up their currencies, causing reserves to fall.
"We could see monthly trade surpluses in the US within a year. The emerging market liquidity squeeze will intensify ferociously, and assets linked to the region will become toxic waste. That includes previously resilient banks such as HSBC, Standard Chartered and Banco Santander," he said. The gloomy forecast comes as Fitch Ratings warns of mounting distress for banks in China, where debt has been shunted off books to circumvent state limits on credit growth.
The pattern looks eerily like the use of "conduits" by Western banks at the height of the credit bubble. The agency's China team, Charlene Chu and Chunling Wen, said banks had used an "underground market" on a large scale to stoke up lending. "These types of credit and/or institutions fall outside the traditional structures of financial supervision, exposing banks to a growing amount of risk that is for the most part hidden.
By getting a portion of their credit off books, Chinese banks are able to comply with official loan quotas while in practice exceeding them," he said. Under the mechanism, the loans are packaged into wealth products and sold to investors searching for bumper yields. The parallel with the US sub-prime debacle is striking, although Fitch avoids an explicit parallel.
Moreover, the banks issue "entrusted loans" in which they act as piggy-in-the-middle between two sets of clients, keeping the credits of the portfolio sheet. These loans have reached 1.5 trillion yuan ($220bn). Even without such off-books liabilities, the banks are facing a crunch as the economy slows hard and the property market stalls. Shenzen house prices are already down 30pc.
"The Chinese banking system is nearing the point at which it can no longer sustain additional large net withdrawals of liquidity without generating further strains on banks' ability to lend," it said. Morgan Stanley said this month that China's housing market was heading for a "melt-down". Data is patchy and rarely reliable, but it is clear that home sales in Beijing, Shanghai and other Eastern cities have fallen drastically over the summer.
Libor Jumps as Banks Seek Cash to Shore Up Finances
Money-market interest rates increased as banks sought to bolster balance sheets amid deepening concern a bailout of financial institutions won't happen quickly enough to ease short-term funding constraints.
The one-month London interbank offered rate, or Libor, for dollars jumped 22 basis points to 3.43 percent, the highest level since January, the British Bankers' Association said today. The corresponding rates in euros and pounds also rose, while yields on Treasury bills tumbled as investors fled all but the shortest- maturity government debt.
Efforts by the Federal Reserve, the European Central Bank and Bank of Japan to revive money markets with emergency cash auctions haven't worked. Banks are hoarding cash and balking at lending to each other on concern more institutions will fail following the collapse of Lehman Brothers Holdings Inc. and the U.S. government takeover of American International Group Inc. A $700 billion bank rescue plan from Treasury Secretary Henry Paulson has met resistance from Congressional Democrats and Republicans.
"There's no real term funding markets except for central banks," said Meyrick Chapman, a fixed-income strategist in London at UBS AG. "The Libor is meaningless. It's for unsecured lending and there is no unsecured lending as far as I can see."
Banks typically hold onto cash to bolster their balance sheets before closing their books at quarter-end. One-month dollar Libor soared 40 basis points at the end of November as banks refused to lend funds for year-end. The one-month Libor rate for euros rose 7 basis points today to 4.91 percent, and the pound rate also advanced 7 basis points, to 5.91 percent. The overnight rate for dollars doubled to 6.44 percent on Sept. 16 after the Lehman bankruptcy and AIG rescue.
The Treasury and Fed last week unveiled the proposal to move troubled assets from the balance sheets of U.S. financial companies and put them in a new institution. Congressional leaders are weighing new strategies, including the possibility of approving only a $150 billion initial installment for the government to purchase troubled assets from financial firms.
The difference between the Libor for three-month dollar loans and the overnight indexed swap rate, the Libor-OIS spread that measures the availability of funds in the market, widened 31 basis points to 166 basis points today, the highest level since at least December 2001. That compares with an average of 8 basis points in the 12 months to July 31, 2007, before the credit squeeze started.
Demand for euros at today's European Central Bank auction of three-month loans was the strongest on record, while banks paid a record premium for dollar loans at yesterday's Fed sale. The ECB allotted 50 billion euros ($73.3 billion) at a marginal rate of 4.98 percent. That's the highest since 2000. Banks bid for 155 billion euros. Banks paid 3.75 percent at yesterday's 28-day Fed term auction facility, or TAF. That's 57 basis points more than yesterday's one-month rate, the widest spread since the TAF program began in December.
Libor loans aren't secured and typically command rates above those of secured loans of similar maturities. "We've seen quite a bit of upward pressure in the past couple of weeks and the fact that the TAF came in at over 50 basis points above yesterday's one-month Libor will no doubt add to that," said Barry Moran, a Dublin-based money-market trader at Bank of Ireland, the country's second-biggest bank.
Treasuries rose, led by three-month bills, on concern about the pace of the bailout. Rates on three-month Treasury bills plunged 31 basis points, or 0.31 percentage point, to 0.41 percent. Rates dropped to 0.02 percent on Sept. 17, the lowest since World War II. European and U.K government bonds climbed amid speculation the region is slipping into a recession.
To help ease the gridlock in dollar funding, the Fed arranged $30 billion in swap lines today with central banks in Norway, Sweden, Denmark and Australia.
The Fed, the ECB and the Bank of Japan joined with counterparts in Switzerland, the U.K. and Canada last week to pump hundreds of billions of dollars into the financial system. The world's biggest financial companies posted $522 billion in subprime-related losses and writedowns since the start of last year. That's more than last year's gross domestic product of Ireland and Finland combined, according to data compiled by Bloomberg.
US Treasuries: Will foreign investors remain buyers?
Could this be the turn in the bond market? The relief rally following the promised $700bn ($538bn) clean-up of Wall Street’s toxic waste lasted barely more than a trading day. Foreign investors may finally be cottoning on that they are bailing out Uncle Sam. With bonds and shares falling – and oil shooting up – this could get nasty.
For most of this month, Treasury bond prices rose on the theory that, in the midst of a crisis, they were a safe haven. But, as Hank Paulson and Ben Bernanke have approved a bewildering array of ever more far-rearching bailouts, investors started adding up the numbers. Depending how you account for the quasi-nationalisations of Fannie Mae and Freddie Mac, the total cost is now well over $1 trillion – and possible several trillion dollars.
If Uncle Sam was rich, this might not matter too much. But the government’s deficit is already yawning as the result of a slowing economy. On conservative estimates, it will reach $450bn next year. It doesn't take a dire assumption to think it could top $1tr by 2010. What’s more, the country as a whole is still relying on funds from abroad to finance its trade gap. The current account deficit is running at $60bn a month, a cool $720bn annually
From an international investor’s perspective, this is beginning to look worrying. Last week they were receiving a yield of only 3.4pc for holding US government paper for 10 years. Even if inflation comes back under control and hovers around 3pc, that doesn’t look like much compensation. Something more like 5pc-6pc would be reasonable. If inflation starts to take off – and Monday’s astonishing 12pc spike in oil prices is not a comforting omen – a reasonable bond yield would be still higher.
In the past week, the dollar has fallen by 3pc on a trade-weighted index while the price of 10-year Treasuries have dropped 4pc. Put these together and foreign buyers of have suffered a 7pc loss. The real worry is that there could be a stampede for the exits as they try to cash out before suffering even bigger losses. The Federal Reserve might then be forced into the unpleasant task of pushing up interest rates in the midst of a crisis.
Does the US face a full-scale run on its currency?
This just arrived in my e-mail from Alex Patelis, global strategist at Merrill Lynch.
AS THE US PRINTING PRESS STARTS: Taking Stock
* Treasury buying mortgage-related assets: $700bn
* Potential supplementary stimulus package favoured by Democrats: $100bn
* Insuring money market funds: $50bn
* Treasury fortifying the Fed's balance sheet: $100bn
* Expansion of temporary swap lines with central banks: $180bn
* Loan to AIG: $85bn
* Fed purchase of agency discount notes & ABCP: amount not specified
* Fed loans through the Primary Dealer Credit Facility: $20bn through sept 17
* Fed's discount window: $33bn balance
* Treasury purchase of GSE MBS this month: $10bn
* Potential cost of Fannie/Freddie bailout: $200-$300bn
* Financing the current account deficit: priceless
Investment Implications: SELL THE US DOLLAR
"The fiscal cost to the United States is likely to be enormous. Speculation will intensify on a possible US government paper downgrade. US policy-making and credibility has been put into question. The safety of US assets has been put into question. We remain concerned with the repercussions that this crisis will have on the financial flows into the United States against the context of a still large current account deficit." Ouch!
Mr Patelis has come within a whisker of warning that the US now faces a full-scale run on its currency and debt markets. There is certainly a risk that this could happen. By my tally, the serial bail-outs add $1.6 trillion to total US debt, or 12pc of GDP, (at least on paper). This is worse than the Swedish banking collapse in the early 1990s.
An entire generation of American policy-makers - Clinton, Bush, Rubin, Greenspan, and the Congressional leadership of both parties - has come perilously close to ruining a great nation. The creation of the credit bubble was one of the most disgraceful episodes of economic government in western history.
Nothing can justify it. There is no parallel to the Spain of Phillip II, who ruined his empire to pursue the religious cause of Counter-Reformation, or to the bankruptcy of the British Empire combating fascism. It occurred because America abandoned all restraint and gave licence to consumer hedonism. Having said that, I still believe that the US has the cultural vitality to pull itself out of this debacle.
While I endorse Mr Patelis's indictment, I do not entirely share his conclusions. The debt added is backed by collateral, mostly housing, and is therefore nothing like normal government debt. Even if it were, the US general government debt (owed to the public, under IMF measures) would rise from 48pc to 60pc of GDP. Yes, I know the US "national debt" is higher, but that is not the relevant benchmark for worldwide comparisons.
This extra debt is a tax on the future. It is unconscionable, but it is not a catastrophe. It would still leave US debt at French or German levels, and well below those of Japan and Italy - assuming you believe the official figures. I do not think it will come to this. The RTC made a profit in the early 1990s as the Savings and Loan crisis slowly abated. Paulson's `TARP' may do likewise. The ABX index used to price subprime debt almost certainly overstates the likely default rate.
Stephen Jen, currency chief at Morgan Stanley, says bank crises are bloody for currencies, but nationalizations of the banking system (which is what we have here, in disguised form) typically mark the bottom. I do not share the widespread view that the dollar will collapse. This has prompted a volley of hostile comment, as if I was somehow turning traitor to the cause of bears, or had become an optimist overnight.
The reason why it will not collapse - at least for now - is that the euro is facing an even deeper and more intractable crisis, Britain is mangled, Sweden frozen, most of Eastern Europe is facing a swing from property boom to bust, Brazil is about to slow dramatically, Japan is in full-recession, and China's banking systems is buckling, as Fitch warned today.
What I envisage as this credit crisis goes turns into a full-fledged global economic slump is that half the world resorts to currency devaluation in a beggar-thy-neighbour scramble to stave off recession and cling to market share. This will be very good for gold, though only once the EMU smash-up becomes more evident, perhaps with the onset of street protests in Spain. You won't have to wait very long.
To those GATA loyalists asking me why I never report on their claim that the gold price is manipulated by central banks, I can only say that it would be a full-time job to attempt to verify such assertions. I cannot judge whether China, Japan, Russia, emerging Asia, or the Mid-East petro-powers are colluding in such practices, or ascertain why they would do so. And unless they collude, any unilateral efforts by the US to suppress gold would prove futile -- would it not?
Paulson Plan May Push U.S. Debt to Post-WWII Levels
Treasury Secretary Henry Paulson's $700 billion proposal to stabilize the banking system may push the national debt to the highest level since 1954, threatening an erosion of foreign appetite for U.S. bonds.
The plan, which asks Congress for funds to buy devalued securities from financial institutions, would drive the debt above 70 percent of gross domestic product and the annual budget gap to an all-time high, possibly exceeding $1 trillion next year, economists estimated.
"This is sobering, absolutely sobering, even to someone who doesn't drink," said Stan Collender, a former analyst for the House and Senate budget committees, now at Qorvis Communications in Washington. At risk for the world's largest economy: a jump in interest rates prompted by the glut of additional Treasuries needed to finance the plan, and a diminished desire among international investors to add to their holdings. The dollar yesterday slid the most against the euro since the European currency's 1999 introduction.
During a five-hour hearing of the Senate Banking Committee today, Paulson said it is "difficult to determine" what the ultimate cost of the plan would be, though he said the objective is to minimize the cost to taxpayers. He's asking lawmakers to lift the legal ceiling on the federal debt to a record $11.3 trillion from the current $10.6 trillion.
Treasuries fell in the past two trading days after Paulson signaled Sept. 18 a sweeping rescue was needed, with the 10-year note yield rising 29 basis points to 3.84 percent. The two-year note climbed 47 basis points on Sept. 19, the most in 23 years. A basis point is 0.01 percentage point.
"The market is very, very negative because of the consequences of raising the debt ceiling and the increase in debt in general," Manfred Wolf, head of currency sales in New York for HVB America Inc., a unit of Germany's second-largest bank. "Foreigners may not be that attracted anymore to U.S. assets." Gross U.S. debt, which includes debt held by the public and by government agencies, this year reached about $9.6 trillion, or about 68 percent of gross domestic product.
The Treasury is already borrowing to fund Federal Reserve efforts to inject liquidity into credit markets. Last week it announced sales of $200 billion in short-term debt. "We've all used the phrase `uncharted waters' so often, yet we keep finding new uncharted waters," said Louis Crandall, chief economist of Wrightson ICAP, a research firm Jersey City, New Jersey. "The fact that the Treasury's borrowing operations are now being affected on such an unprecedented scale adds new uncertainties" to bond markets.
The Treasury's potential use of all $700 billion to purchase impaired assets would raise the country's debt to more than 70 percent of GDP. The last time American taxpayers owed as much was in 1954, when the nation was still paying down costs incurred during World War II.
"It's an alarming level of debt given that we're not fighting something like World War II," said Robert Bixby, executive director of the Concord Coalition, a non-partisan budget watchdog group. The government reaching the requested debt limit would entail every man, woman and child in the U.S. owing more than $37,000 each. The median U.S. income last year was $50,233. "We're putting a lot of debt on the books and people are going to be spending a lot of money paying that off for a long time," Bixby said.
If Treasury spends the entire amount next year, as some economists expect, it would drive next year's budget deficit, now projected to be around $500 billion, to $1 trillion or more. That would increase the annual shortfall to about 7 percent of GDP, a record level. The deficit rose to 6 percent of the economy in 1983, when then-President Ronald Reagan was ramping up Cold War- era defense spending and cutting taxes.
Michael Feroli, an economist at JPMorgan Chase & Co. in New York, says the combination of the Paulson plan, additional government expenditures, and a slower economy, could swell the deficit to $1.5 trillion -- 10 percent of GDP. To be sure, several developed nations have debt levels far higher than that of the U.S., including Japan at 196 percent of GDP and Italy at 104 percent of GDP, according to the International Monetary Fund.
The money for the Paulson plan will go to buy assets at prices that many market analysts say are depressed. Though it's still far from clear what price the Treasury would pay for them, it's possible those assets could increase in value as the crisis recedes and, as was the case with the government's 1979 bailout of Chrysler Corp., taxpayers could ultimately profit.
"This is not an outright expenditure," said William Cline, senior fellow at the Peterson Institute for International Economics in Washington and a former Treasury official. "It is essentially the U.S. becoming a market investor, and the full expectation is to make money on this stuff."
The man who has bet $1.5 billion against British banks
The billionaire John Paulson was revealed yesterday as one of the hedge fund bosses who has been short-selling UK bank shares - placing a near £1bn bet that their share prices would fall dramatically.
His New York-based Paulson & Co was last year's most successful hedge fund after it bet against the sub-prime mortgages that later turned toxic in the credit crunch. Paulson & Co has placed bets on four high street banks, including HBOS, which was forced to agree a rescue takeover by Lloyds TSB last week after a precipitous collapse in its shares.
Emergency rules rushed in by the Financial Services Authority to ban short selling in bank shares after the woes of HBOS yesterday unmasked Paulson & Co as one of the funds betting on shares falling. Short sellers bet that share prices will fall by selling shares they do not own in the hope of buying them back more cheaply - hence making a profit.
After last week's tumultuous stock market movements, the FSA ordered speculators to close down all short positions in bank shares within 24 hours or have their names made public. The FSA's surprise clampdown fuelled London's record-breaking stock market rise on Friday. But the three-month ban failed to arrest the decline in bank shares yesterday, with HBOS the biggest faller in the FTSE 100, losing 14% of its value.
Paulson & Co admitted to four short positions:
· 0.87% of Royal Bank of Scotland worth £294m
· 1.76% of Lloyds TSB worth £260m
· 0.95% of HBOS worth £93m
· 1.18% of Barclays worth £258m
The hedge fund was one of a handful which braved the new FSA regime and retained their short positions past Friday's deadline - leading to yesterday's disclosures of their bets to the stock market. Among the other dozen or so disclosures, Barclays Global Investors - owned by Barclays Bank - admitted taking a short position in St James's Place, a fund management group which is 59% owned by HBOS.
Odey Asset management - run by Crispin Odey, who married into one of the families that founded Barclays - also admitted it was short in banking group Investec. The first fund to show its hand was Forteulus, based in London, which was short in London Scottish Bank.
The disclosures of the short positions came amid further volatile trading on the market; bank shares were particularly hard hit by anxieties that the US authorities's $700bn plan to bail banks out of their toxic mortgage assets would be blocked by Congress.
Bank shares were also knocked by figures from the British Bankers' Association showing the lowest level of mortgage approvals since records began in 1997 - 21,086 home loans were approved in August. The lenders blamed Alistair Darling for adding to the woes by causing uncertainty about whether stamp duty on homes was to be abolished.
These pressures weighed particularly on the share price of HBOS - as did concerns that its takeover could fall apart.
The value of the deal alters with the share price of Lloyds TSB and last night valued each HBOS share at 218p. In normal circumstances, HBOS shares would be near that level. But last night they closed at 188p. The unusually wide gap caused confusion in the City and led to suggestions market traders think the takeover has a lot of hurdles to cross and could yet fail.
Leigh Goodwin, banks analyst at the stockbroker Fox Pitt Kelton, said: "It's an unusual movement and it could be over concerns that there will be some block on the deal." Bradford & Bingley was also sharply lower, falling another 12% amid continued speculation that it would need to find a buyer to provide a long-term solution to its business model. The hedge fund Steadfast admitted it was shorting the lender.
Amid speculation that the FSA has been dusting down contingency plans in the event of further sharp falls in its share price, two ratings agencies downgraded their view on the bank. B&B reiterated that its capital position was the strongest of the banks. After the stock market closed, it revealed it had taken action to stem losses caused by mortgages it bought from a financial services company owned by General Motors.
Standard & Poor's credit analyst, Nick Hill, said: "The downgrade reflects our view that constraints on B&B have increased materially in recent weeks, although liquidity is currently strong. At the heart of these problems is the likelihood that asset quality in B&B's key products of self-certified and buy-to-let mortgages continues to weaken rapidly."
Good ideas and lies
Daniel Davies, in one of the great blog posts of this era, laid down a key principle: Good ideas do not need lots of lies told about them in order to gain public acceptance. He was talking about the selling of the Iraq war, but it applies more generally. So, this morning Hank Paulson told a whopper:We gave you a simple, three-page legislative outline and I thought it would have been presumptuous for us on that outline to come up with an oversight mechanism. That’s the role of Congress, that’s something we’re going to work on together. So if any of you felt that I didn’t believe that we needed oversight: I believe we need oversight. We need oversight.
What the proposal actually did, of course, was explicitly rule out any oversight, plus grant immunity from future review:Sec. 8. Review.
Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.
I’m not playing gotcha here. This is telling: if Paulson can’t be honest about what he himself sent to Congress — if he not only made an incredible power grab, but is now engaged in black-is-white claims that he didn’t — there is no reason to trust him on anything related to his bailout plan.
Mortgage Defaults Already at $50 Billion Per Month…$700 Billion Won’t Go Too Far!
As we exit the Summer season and housing demand falls, defaults should pick back up again as values fall. Early signs indicate a severe fall going into Winter. Subprime defaults will continue for much longer given the number of new defaults we are seeing and the 50% recidivism rate amongst modified subprime loans. This is mostly due to negative equity and borrowers simply finding it cheaper to rent.
But the new waive of housing defaults will come from the Alt-A (includes Pay Options), Jumbo Prime and the Second Mortgage universes. This is also due to values being down so much in the bubble states and the negative equity effect. CA prices are off 30-60% depending in the region in the past 16-months.
Compared to the size of the Alt-A, Pay Option ARM, Second Mortgage and Jumbo Prime universes, Subprime is miniscule. With prices down so much in such a short period of time, most that bought, refinanced with cash out, or put a second mortgage on their property since 2002-03 in these ‘higher’ paper grades suddenly find themselves stuck in their homes without the ability to refinance or sell.
When home owners are stuck where do the buyers come from? Move-up buyers have always been the dominant force in the market. However, now that most homeowners who purchased between 2003-2007 are stuck or can’t afford to re-buy the home in which they currently live given new lending guidelines and the lack of exotic loan programs, move-up buyers are all but non-existent. That leaves investors, first time home owners and renters to carry the real estate market going forward and they have always been the weakest market participants.
As with Subprimes, much of the Alt-A (especially Pay Option ARMs) and Jumbo Prime universes have severe recasts or resets typically after the first 5-10 years. With respect to these loan types, we have simply not got here yet. Most subprime loans reset after two to three years. We are seeing the exact same thing happening to these higher grade exotics as what happened to subprime when resets begin in earnest.
It may not happen at such a large percentage of total loans but the universes are so much larger than Subprime it won’t have to and the effects will still be far worse. Also remember, when the larger loans reset the borrowers are in a much deeper negative equity position than most of the Subprimes ever were.
I have been told recently by Green Credit Solutions, the nation’s leading mortgage modification firm with which I work closely, that ‘being upside down in the property is the single worst thing on the home owner…they tell us either to get the principal balance brought down through the modification to a level where there is equity or they will walk’. This has changed in the past 4-5 months from ‘better rates’ being what was asked for the most.
If defaults remain at roughly $20 billion per month in CA and $50 billion nationally and this new $700 billion bailout is suppose to clean up banks past troubles, what is left for the potential $1 trillion in current defaults coming over the next two years? This plan is being debated today in Washington as if mortgage and housing crisis was over and they are trying to clean up the aftermath. I am sure many there really think this is about the real estate market.
Perhaps this program will grease the wheels, everyone will begin lending again and home values will soar making it so home owners can freely sell or refinance. But given the data I see daily, I am betting against that. The problem is, anything short of physical real estate being a liquid asset once again or an across the board principal balance reduction and new terms on every loan in America, and the housing crisis remain front pages indefinitely as the negative equity feedback loop continues and more borrowers are forced into loan default each month
When the gamblers bail out the casino: Where is America's Vladimir Putin?
Why should American taxpayers give US Treasury Secretary "Hank" Paulson a blank check to bail out the shareholders of busted banks? Why should the Treasury turn itself into a toxic waste dump for their bad loans? Why not let other banks join the unlamented Brothers Lehman in bankruptcy court, and start a new bank with taxpayers' money?
Or have the Treasury pay interest on delinquent mortgages, and make them whole? Even better, why not let the Chinese, or the Saudis or other foreign investors take control of failed American banks? They've got the money, and they gladly would pay a premium for an inside seat at the American table.
None of the above will occur. America will give between US$700-$800 billion to the Treasury to buy any bank assets it wants, on any terms, with no possible legal recourse. It is an invitation to abuse of power unparalleled in American history, in which ill-paid civil servants will set prices on the portfolios of the banking system with no oversight and no threat of legal penalty.
Why are the voices raised in protest so shrill and few? Why will Americans fall on their fountain-pens for their bankers? If America is to adopt socialism, why not have socialism for the poor, rather than for the rich? Why should American households that earn $50,000 a year subsidize Goldman Sachs partners who earn $5 million a year?
Believe it or not, there is a rational explanation, and quite in keeping with America's national motto, E pluribus hokum. Part of the problem is that Wall Street, like the ethnic godfather in the old joke, has made America an offer it can't understand. The collapsing the mortgage-backed securities market embodies a degree of complexity that mystifies the average policy wonk. But that is a lesser, superficial side of the story.
Paulson's dreadful scheme will become law, because Americans love their bankers. The bankers enable their collective gambling habit. Think of America as a town with one casino, in which the only economic activity is gambling. Most people lose, but the casino keeps lending them more money to play. Eventually, of course, the casino must go bankrupt. At this point, the townspeople people vote to tax themselves in order to bail out the casino. Collectively, the gamblers cannot help but lose; individually they nonetheless hope to win their way out of the hole.
Americans are so deep in the hole that they might as well keep putting borrowed quarters into the one-armed bandit. They have hardly saved anything for the past 10 years. Instead, they counted on capital gains to replace the retirement savings they never put aside, first in tech stocks, then in houses. That hasn't worked out. The S&P 500 Index of American equities today is worth what it was in 1997, after adjusting for inflation (and a pensioner who sells stock purchased in 1997 will pay a 20% capital gains tax on an illusory inflationary gain of 40%). Home prices doubled between 1997 and 2007 before falling by more than 20%, with no floor in sight.
As it is, many of the baby boomers now on the verge of retirement will spend their declining years working at Wal-Mart or McDonalds rather than cruising the Caribbean. Some of them still have time to tighten their belts and save 10% of their income (by consuming 10% less), plus a good deal more to compensate for the missing savings of the 1990s.
Altogether, they'd rather gamble, and if that requires a bailout of the house, they gladly will chip in to pay for it. After all, today's baby boomers won't pay for the bailout. The next generation of taxpayers will pay for Paulson's $700-$800 billion. If that enables the present generation to keep borrowing rather than saving, it is no skin off their back. If home prices continue to collapse, the baby boomers will die in debt anyway, working at low-paying jobs until the day before their funerals.
The homeowners of America hope against hope that somehow, sometime, the price of their one only asset will bounce back. The character of Mortimer Duke in the 1983 film Trading Places comes to mind. After losing his fortune in the frozen orange juice futures market, Duke screams, "I want trading reopened right now. Get those brokers back in here! Turn those machines back on! Turn those machines back on!" If a reverse takeover of the US government by Goldman Sachs is what it takes to turn the machines back on, the American public will support it. Sadly, there is no reason to expect the bailout of bank shareholders to have any effect at all on American home prices, which will continue to sink into the sand.
Contrary to what the Bush administration says, it is not the case that banks' troubled mortgage assets cannot be sold in the private market. Those are the so-called "Level III" assets that banks say they cannot value. But that is only a dodge that the banks use to postpone taking losses. There is a ready bid for these assets from hedge funds, in multi-hundred-billion-dollar size.
The trouble is that the market bid is 25% to 30% below the prices that banks carry these assets on their books. Traders at Wall Street boutiques who specialize in distressed securities say that US regional banks regularly make discreet offers to sell private mortgage-backed securities (not guaranteed by a federal agency) at prices, for example, of 75 to 80 cents on the dollar. Hedge funds bid, for example, 55 to 60 cents in return.
On rare occasions, the bank seller and the hedge fund buyer will meet in the middle, although very few transactions occur. Although many banks are desperate to sell, they cannot accept the offered price without taking losses over the threshold of mortality, for write-downs of this magnitude would destroy their shareholders' capital. Investment banks typically hold about $30 of securities for every $1 of capital, so a 3% write-down would leave them insolvent.
Lehman Brothers classified 14% of its assets as Level III at the end of the first quarter; Goldman Sachs was at 13%. Why is Lehman bankrupt, and Goldman Sachs still in business? If Secretary Paulson, the former head of Goldman Sachs, had not proposed a general bailout last week, we might already have had the answer to that question.
For the Paulson bailout to be helpful to the banks, it must buy their securities at much higher prices than the private market is willing to pay. Otherwise it makes no sense at all, for the banks could sell at any moment to the hedge funds. But that is a subsidy to private banks, administered at the whim of the Treasury Secretary, without oversight and without the possibility of legal recourse.
Some Democrats in Congress are asking for some form of oversight, but it is hard to imagine how they might use it, for a Treasury with $800 billion to spend would constitute the whole market bid for low-quality mortgage assets, and would set whatever prices it wished. Professionals with years of experience set prices on these securities with great uncertainty. How would an overseer determine if it had set the correct price? And if the Treasury decided to bail out one bank (say, Goldman Sachs) rather than another, how would the overseer judge whether that decision was judicious, politically motivated, venal, or arbitrary?
Opposition to the Treasury plan is disturbingly thing. Bloomberg News on June 21 quoted the Democratic chairman of the Senate Banking Committee, Christopher Dodd, saying, "I know of nobody who is arguing over the amount of money or even about that the secretary ought to have the authority to purchase these toxic instruments, these bad debts."
Why the taxpayers of America would allow their pockets to be picked in this fashion requires a different sort of explanation than one finds in economics textbooks. My analogy of gamblers taxing themselves to bail out the casino is inspired, in part, by a remarkable new book by the Canadian economists Reuven and Gabrielle Brenner (with Aaron Brown), A World of Chance. In effect, the Brenners re-interpret economic theory in terms of gambling, showing how profoundly gambling figures into human behavior, especially in such matters as so-called life-cycle investing. The 50-ish householder who has not made enough to retire may take outsized chances, considering that as matters stand, he will work until he drops dead in any case. The Brenners write:If people reach the age of fifty or fifty-five and have not "made it," what are their financial options to still live the good life? Except for allocating a few bucks to buy lottery tickets, it is hard to think of any other option. If people find themselves down on their luck and see no immediate opportunities to get rich, what can they do to sustain their hopes and dreams?
Allocating a fraction of their portfolios with a chance to win a large prize is among the options. And when people are leapfrogged - that is, when some "Joneses" who were "below" them jump ahead - how can they catch up? They will tend to challenge their luck for a while, taking risks that they might have contemplated before in business, financial markets, and other areas but did not follow up with action.
A World of Chance undermines our usual view of "economic man" and substitutes the angst-ridden, uncertain denizen of a world that offers no certainties and requires risk-taking as a matter of survival. I hope to offer a proper review of the work in the near future. As my marker, though, permit me to leave the thought that for providing a theoretical foundation for the counter-intuitive behavior of American taxpayers, the Brenners deserve the Nobel Prize in economics.
Alas for the gamblers of America: they will tax themselves to keep the casino in operation, but it will not profit them. Where, oh where, is America's Vladimir Putin, who will drive out the oligarchs who have stolen the country's treasure and debased its currency?
Experts offer alternatives to bailout
To hear Henry M. Paulson Jr. and Ben S. Bernanke tell it, there is only one plan to save the economy -- use $700 billion in taxpayer money to take the worst of Wall Street's assets off its books.
But leading economists and financial thinkers argue that there are a host of alternatives that would reduce taxpayers' liabilities and perhaps more effectively address the urgent crisis in financial markets. Although these experts concede that the clock is ticking, they say different approaches have been dismissed too quickly.
While the government's plan is built around buying troubled assets, other options offer sharply different visions. One approach seeks to reduce taxpayers' liability by offering collateral-backed loans to troubled banks, leaving them to work out their own solutions. Another idea is to have the government set up a profit-driven investment fund with the aim of infusing the financial system with cash without taking on bad debt.
Still others suggest radically different tactics of directly helping homeowners by reducing mortgage principal or bolstering banks by suspending capital gains taxes. The administration has said it is willing to negotiate key parts of its plan -- including a possible concession allowing the government to take equity stakes in financial firms in exchange for bailing them out -- but senior officials stand by the fundamental approach they have adopted to solve the crisis.
"They presented this as a comprehensive, decisive solution, but it's clearly not comprehensive and probably not decisive," said Simon Johnson, a former chief economist at the International Monetary Fund and a professor at Massachusetts Institute of Technology.
The cost of a mistake could be huge. It could result in a catastrophic collapse of the U.S. financial system that could ripple across the world or in a staggering clean-up bill for taxpayers. At the core of the debate is whether Paulson, the former chief executive of Goldman Sachs now charged with rescuing Wall Street as Treasury secretary, and Bernanke, the Federal Reserve chairman and one of the leading academics on financial crises, are serving up the best possible recipe for purging the U.S. financial system of billions of dollars worth of distressed mortgage-related debt.
Under the administration's rescue plan, the Treasury secretary would have broad discretion to buy up to $700 billion worth of troubled mortgage-backed assets and other securities that Wall Street firms have been struggling to sell. Administration officials hope that once those assets are cleansed, money will flow freely through the financial system once again and that the government can hold onto the securities until they recover some of their value.
In testimony on Capitol Hill yesterday, Bernanke and Paulson explained that they formulated their plan after considering past crises, from the U.S. savings-and-loan bailouts of the 1980s to the bursting of Japan's economic bubble a few years later. But they ultimately decided that the response to the current crisis needed to be a fast and massive fix.
"The situation we have now is unique and new," Bernanke said. He later continued, "The firms we're dealing with now are not necessarily failing, but they are contracting. They are de-leveraging. They're pulling back. And they will be unwilling to make credit available as long as these market conditions are in the condition they are." Many of the alternatives fall under four basic approaches:
Government as lender Critics of the administration's plan argue that an alternative could be crafted to minimize the exposure of the government -- and taxpayers -- to risk. Johnson, the MIT professor, suggested that the government, instead of taking on the bad debt, could offer loans to troubled banks, allowing them to put up their sickened portfolios of mortgage-backed debt as collateral.
This would give the banks access to badly needed cash at attractive interest rates set by the government. But it would not completely let them off the hook for making those bad investments in the first place. Because government money would come in the form of loans, rather an outright purchase of the risky investments, taxpayers would be offered greater protection. Ultimately, the banks would have to pay off the loans and take back the securities, though at a time when the market for them may have improved. If the value of the securities is still depressed, that would be the banks' problem, not the taxpayers'.
"The risk to the government/taxpayer is that the bank goes out of business and so isn't around to settle up," Johnson said. "But the government is also the regulator, and they can do a more forceful job of making sure the banks have enough capital, so the incentives are pretty well aligned."
Interest rates would be set at a level attractive to banks, the relatively low rate at which the Treasury borrows plus a small premium. Only if the banks were nearing default would the government take a more active role in propping them up, perhaps even taking them over outright.
Government as hedge fund Some market analysts and fund managers worry that the Paulson plan would allow Wall Street to dump the worst kind of mortgage securities on the federal government. One solution could be the establishment of a fund that limits its purchases to profitable mortgage securities and other assets.
The creation of a $700 billion investment fund could help reinvigorate the business of trading mortgage securities, greasing the wheels of the credit markets by bringing in a new, cash-rich investor: the federal government. While this solution runs the risk of not cleaning up enough of the bad debt on firms' books, taxpayers could be more confident of getting their money back because the government would be selective about which securities it bought.
Mortgage breaks Liberal thinkers say the government could intervene in the financial system by addressing the ailing mortgages at the heart of the crisis. Under this approach, the government could reduce the amount of principal that struggling homeowners owe.
"It's about foreclosures, stupid," said John Taylor, chief executive of the liberal National Community Reinvestment Coalition.
One idea is for the government to take control of some mortgage-backed securities -- most likely by buying them from financial firms -- and then work to restructure the underlying loans into something homeowners could afford. The value of the securities, both those bought by the government and those in private hands, could improve as foreclosures and late payments drop. If so, financial firms holding mortgage-backed securities could see a recovery in their balance sheets.
To make it fair for homeowners who keep up with their payments, borrowers who receive federal help would be required to give the government some of their gains if they eventually sell their homes for a profit. But advocates of the idea acknowledge that it may take time to address the problems of millions of struggling homeowners. In the meantime, critics of this approach say the financial system could fall into chaos.
Tax breaks for Wall Street Conservative analysts take a different tack, though their criticism of the Paulson plan has been no less sharp. They say that because the proposal forgives Wall Street for its past sins, it creates an incentive for investors to behave irresponsibly in the future.
Some of these thinkers complain that the government's rescue punishes taxpayers too severely for Wall Street's mistakes. They propose a cheaper alternative that calls for the repeal of the capital gains tax for two years, which would provide Wall Street a stimulus to reinvigorate the financial system.
Accounting rules that require banks to estimate the market value of their troubled mortgage securities would also be suspended for five years, giving financial firms the ability to value these assets at prices more reflective of the market before the panic gripped Wall Street.
Rep. Jeb Hensarling (R-Tex.) said this plan, which he announced on Capitol Hill yesterday, was still being finalized. Hensarling said the precise cost of the capital gains tax repeal, for instance, was still being determined. "We agreed that inaction is not an option, but that doesn't mean that we've concluded that the Paulson plan is the only option," said Hensarling. "There are alternatives to consider, and we think we have a worthy one."
All of these alternatives try to get at the root of the turmoil facing the financial markets and the economy but in different ways. According to Lawrence Summers, former Treasury secretary, the government might have to try multiple approaches.
"If you have hypertension, you're way overweight and you're in the process of having a heart attack, what's your most fundamental problem? It's really not that useful to distinguish between them," Summers said at a Brookings Institute forum.
"They're all components of the situation, and you're not going to get to a very satisfactory place unless you address all of them. That's how I think of our financial reality right now."
Now is the Time to Resist Wall Street's Shock Doctrine
I wrote The Shock Doctrine in the hopes that it would make us all better prepared for the next big shock. Well, that shock has certainly arrived, along with gloves-off attempts to use it to push through radical pro-corporate policies (which of course will further enrich the very players who created the market crisis in the first place...).
The best summary of how the right plans to use the economic crisis to push through their policy wish list comes from Former Republican House Speaker Newt Gingrich. On Sunday, Gingrich laid out 18 policy prescriptions for Congress to take in order to "return to a Reagan-Thatcher policy of economic growth through fundamental reforms." In the midst of this economic crisis, he is actually demanding the repeal of the Sarbanes-Oxley Act, which would lead to further deregulation of the financial industry. Gingrich is also calling for reforming the education system to allow "competition" (a.k.a. vouchers), strengthening border enforcement, cutting corporate taxes and his signature move: allowing offshore drilling.
It would be a grave mistake to underestimate the right's ability to use this crisis -- created by deregulation and privatization -- to demand more of the same. Don't forget that Newt Gingrich's 527 organization, American Solutions for Winning the Future, is still riding the wave of success from its offshore drilling campaign, "Drill Here, Drill Now!" Just four months ago, offshore drilling was not even on the political radar and now the U.S. House of Representatives has passed supportive legislation. Gingrich is holding an event this Saturday, September 27 that will be broadcast on satellite television to shore up public support for these controversial policies.
What Gingrich's wish list tells us is that the dumping of private debt into the public coffers is only stage one of the current shock. The second comes when the debt crisis currently being created by this bailout becomes the excuse to privatize social security, lower corporate taxes and cut spending on the poor. A President McCain would embrace these policies willingly. A President Obama would come under huge pressure from the think tanks and the corporate media to abandon his campaign promises and embrace austerity and "free-market stimulus."
We have seen this many times before, in this country and around the world. But here's the thing: these opportunistic tactics can only work if we let them. They work when we respond to crisis by regressing, wanting to believe in "strong leaders" - even if they are the same strong leaders who used the September 11 attacks to push through the Patriot Act and launch the illegal war in Iraq.
So let's be absolutely clear: there are no saviors who are going to look out for us in this crisis. Certainly not Henry Paulson, former CEO of Goldman Sachs, one of the companies that will benefit most from his proposed bailout (which is actually a stick up). The only hope of preventing another dose of shock politics is loud, organized grassroots pressure on all political parties: they have to know right now that after seven years of Bush, Americans are becoming shock resistant.
Request For Urgent Business Relationship
Subject: Request For Urgent Business Relationship
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Paulson’s plan was not a true solution to the crisis
Desperate times call for desperate measures. But remember, no less, that decisions taken in haste may shape the financial system for a generation. Speed is essential. But it is no less essential to get any new regime right. No doubt, the crisis has long passed the stage when governments could leave the private sector to save itself, with just a little help from central banks. For the US, the rescue of Bear Stearns was the moment when that option evaporated.
But the events of the past two and a half weeks – the rescues of Fannie Mae and Freddie Mac, the failure of Lehman Brothers, the sale of Merrill Lynch, the rescue of AIG, the flight to safety in the markets and the decisions by Morgan Stanley and Goldman Sachs to become regulated bank holding companies – have made a comprehensive solution inevitable. The US public expects action. The question is whether it will get the right action. To answer it, we must agree on the challenge the US financial system faces and the criteria for judging how it should be met.
What then is the challenge? The answer given by Hank Paulson, the all-action US Treasury secretary, last Friday, in announcing his “troubled asset relief programme”, is that “the underlying weakness in our financial system today is the illiquid mortgage assets that have lost value as the housing correction has proceeded. These illiquid assets are choking off the flow of credit that is so vitally important to our economy.” The core challenge, then, is viewed as illiquidity, not insolvency. By creating a market for the toxic assets, Mr Paulson hopes to halt the spiral of falling prices and bankruptcies.
I suggest we should take a broader view of events. The aggregate stock of US debt rose from a mere 163 per cent of gross domestic product in 1980 to 346 per cent in 2007. Just two sectors of the economy were responsible for this massive rise in leverage: households, whose indebtedness jumped from 50 per cent of GDP in 1980 to 71 per cent in 2000 and 100 per cent in 2007; and the financial sector, whose indebtedness jumped from just 21 per cent of GDP in 1980 to 83 per cent in 2000 and 116 per cent in 2007 (see charts). The balance sheets of the financial sector exploded, as did the sector’s notional profitability. But leverage, alas, works both ways.
Since US net international debt was 39 per cent of GDP at the end of 2007, virtually all of this debt is an asset of another domestic entity and would net out to zero. But when the gross debt stock is huge and economic conditions difficult, the chances that many entities are bankrupt is high. When people fear mass insolvency, lenders stop lending and the indebted stop spending. The result can be the “debt deflation”, described by the American economist, Irving Fisher, in 1933 and experienced by Japan in the 1990s.
Given the recent explosion in leverage, the challenge is unlikely to be one of mispricing of the toxic mortgage-backed securities alone. Many people and institutions made leveraged bets that have since gone sour. Their debt cannot be repaid. Creditors are responding accordingly.
Now turn to the criteria to be used in judging the intervention. First, it would deal with the systemic threat. Second, it would minimise damage to incentives. Third, it would come at minimum cost and risk to the taxpayer. Not least, it would be consistent with ideas of social justice.
The fundamental problem with the Paulson scheme, as proposed, is then that it is neither a necessary nor an efficient solution. It is not necessary, because the Federal Reserve is able to manage illiquidity through its many lender-of-last resort operations. It is not efficient, because it can only deal with insolvency by buying bad assets at far above their true value, thereby guaranteeing big losses for taxpayers and providing an open-ended bail-out to the most irresponsible investors.
Furthermore, these assets are illiquid precisely because they are so hard to value. The government risks finding its coffers stuffed with huge amounts of overpriced junk even if it tries not to do so. Also objectionable, though more in design than in the fundamentals, were the unchecked powers for the Treasury. Such a fund should be operated professionally, under independent oversight. Finally, if the US government is to bail out incompetent investors it should surely also provide more help to the poor and often ill-informed borrowers.
Yet, above all, a scheme for dealing with the crisis must be able to remedy the looming decapitalisation of the financial system in as targeted a manner as possible. A fascinating debate on how to do this is under way in the economists’ forum on FT.com. To the contributions, including Tuesday’s Comment page article by Dominique Strauss-Kahn, managing director of the International Monetary Fund, I would add one by Luigi Zingales of Chicago University’s graduate school of business.*
The simplest way to recapitalise institutions is by forcing them to raise equity and halt dividends. If that did not work, there could be forced conversions of debt into equity. The attraction of debt-equity swaps is that they would create losses for creditors, which are essential for the long-run health of any financial system.
The advantage of these schemes is that they would require not a penny of public money. Their drawback is that they would be disruptive and highly unpopular: banking institutions would have to be valued, whereupon undercapitalised entities would have to adopt one of the ways to improve their capital positions.
If, as seems plausible, a scheme that imposes such pain on the financial sector would be rejected out of hand, the next best alternative would be injection of preference shares by the government into decapitalised institutions, on the lines proposed by Charles Calomiris of Columbia University. This would be a bail-out, but one that constrained the behaviour of beneficiaries, not least on payment of dividends. That would make it far better than dropping benefits on the unworthy, via mass purchases of overpriced toxic paper.
What then do I conclude? Yes, there may well be a place for intervention in the market for toxic securities. But this is a costly and ineffective way of meeting today’s deepest challenge. What is needed, still more, is a clear and effective way of deleveraging and recapitalising the financial sector, ideally without using taxpayer funds. If such funds are to be used, they must also be injected in as carefully targeted and controlled a way as possible. Comprehensive action is essential, as Mr Paulson has decided. But let the US take the time to make that comprehensive action righ
What is to be Done?
"The creatures outside looked from pig to man, and from man to pig, and from pig to man again; but already it was impossible to say which was which."
George Orwell Animal Farm
Watching and listening to the Big Media comment yesterday on the press release by the Fed's Board of Governors regarding Morgan Stanley (NYSE:MS) and Goldman Sachs (NYSE:GS) becoming bank holding companies, it struck us that very few people outside the risk community really understand the corporate structure of financial firms.
Even Dick Bove, the dean of the sell side bank analyst community, got it wrong, in our view, when he said on CNBC yesterday morning that the decision by MS and GS to submit to federal bank regulation would result in "no change" to the business models of these monoline dealers. To give you a hint about why we say this, let us remind you of comment we published last December ("Outlook 2008: Valuation, Attestation, and Litigation" ):
"Last summer, around the time that Countrywide Financial CEO Angelo Mozillo was on CNBC telling the Money Honey about going back 'in the bank,' the music stopped in the game of musical chairs that was the market for complex structured assets. Bids evaporated and, now six months later, value is likewise disappearing from balance sheets public and private."
The reason that investors were fleeing firms like Bear, Stearns, Lehman, MS and GS, is not because they don't already own banks - each, in fact, either owned small FDIC-insured industrial loan companies or private trust companies. But rather the Street was turning away from these firms because they were unwilling to take risk on the entire organization.
When Mozillo proclaimed his intention last summer to go back "in the bank," what he was really saying to Maria Bartiromo is that nobody wanted to do business with his publicly traded parent holding company, the firm now known as Countrywide Financial that is a direct subsidiary of Bank of America. Countrywide Financial, in turn, is the parent of Countrywide Bank FSB.
Unlike commercial banks such as BAC, JPMorgan Chase and Citigroup broker dealers and even insurance companies such as AIG tended to book principal trades and other risk positions in the publicly traded parent and/ or other non-bank units. Since the subsidiary banks of GS and MS are very small and the broker-dealer units were, until recently, much more highly leveraged than banks, when the Street began to back away from both firms last week, the only alternative was to get "in the bank" or die a la Bear and Lehman.
Last week, when neither GS nor MS could cut a merger deal with a commercial bank, the only choice was mutation. Thus the expedited application to the Fed's board for conversion of the publicly traded parent holding companies to regulated BHCs. But it is the transformation of the industrial loan companies of MS and GS into national banks that holds the key to understand why such a change was necessary.
In the institutional money markets, counterparties of BHCs always insist on doing business with the lead bank rather than the publicly-listed parent company. The reason for this is very simple as demonstrated by the bankruptcy of Lehman Brothers. Publicly listed shell holding companies can and do die, but the operating units generally are either acquired or resolved via a government receivership. Thus counterparties always prefer - indeed insist - on dealing with the regulated bank, not the thinly capitalized shell holding company, and by so doing are effectively senior to all of the debt holders of the parent company!
If you are trading say interest rate swaps, when you do a deal with C or JPM, the contract specifies the subsidiary bank as counterparty, Citibank NA and JPMorgan Chase Bank NA. By becoming BHCs and, more important, converting their existing non-bank subs into full fledged national bank charters, MS and GS finally have achieved equal footing with the large universal banks - almost a decade after the passage of the Gramm-Leach-Bliley legislation repealing most of the Depression-era Glass Steagall legislation.
As the press reports indicate, GS intends to move several hundred billion dollars worth of business activities and assets into its Goldman Sachs Bank USA bank unit, effectively creating a business model configuration comparable to a money center bank. It is not merely that the age of the independent investment bank is at an end, but further than the banksters are being forced to hide what remains of their principal trading business behind a regulated national bank regulated not by the Fed, but by the Comptroller of the Currency.
Today, GS actually owns three FDIC-insured banks:
CERT 57485-Goldman Sachs Bank USA SALT LAKE CITY, UT CERT 33124-GOLDMAN SACHS TRUST CO NEW YORK CITY, NY CERT 57337-GOLDMAN SACHS TRUST CO NA NEW YORK, NY
The shadow banking system is unravelling
Last week saw the demise of the shadow banking system that has been created over the past 20 years. Because of a greater regulation of banks, most financial intermediation in the past two decades has grown within this shadow system whose members are broker-dealers, hedge funds, private equity groups, structured investment vehicles and conduits, money market funds and non-bank mortgage lenders.
Like banks, most members of this system borrow very short-term and in liquid ways, are more highly leveraged than banks (the exception being money market funds) and lend and invest into more illiquid and long-term instruments. Like banks, they carry the risk that an otherwise solvent but liquid institution may be subject to a self-fulfilling and destructive run on its liquid liabilities.
But unlike banks, which are sheltered from the risk of a run – via deposit insurance and central banks’ lender-of-last-resort liquidity – most members of the shadow system did not have access to these firewalls that prevent runs. A generalised run on these shadow banks started when the deleveraging after the asset bubble bust led to uncertainty about which institutions were solvent. The first stage was the collapse of the entire SIVs/conduits system once investors realised the toxicity of its investments and its very short-term funding seized up.
The next step was the run on the big US broker-dealers: first Bear Stearns lost its liquidity in days. The Federal Reserve then extended its lender-of-last-resort support to systemically important broker-dealers. But even this did not prevent a run on the other broker-dealers given concerns about solvency: it was the turn of Lehman Brothers to collapse. Merrill Lynch would have faced the same fate had it not been sold.
The pressure moved to Morgan Stanley and Goldman Sachs: both would be well advised to merge – like Merrill – with a large bank that has a stable base of insured deposits.
The third stage was the collapse of other leveraged institutions that were both illiquid and most likely insolvent given their reckless lending: Fannie Mae and Freddie Mac, AIG and more than 300 mortgage lenders.
The fourth stage was panic in the money markets. Funds were competing aggressively for assets and, in order to provide higher returns to attract investors, some of them invested in illiquid instruments. Once these investments went bust, panic ensued among investors, leading to a massive run on such funds. This would have been disastrous; so, in another radical departure, the US extended deposit insurance to the funds.
The next stage will be a run on thousands of highly leveraged hedge funds. After a brief lock-up period, investors in such funds can redeem their investments on a quarterly basis; thus a bank-like run on hedge funds is highly possible. Hundreds of smaller, younger funds that have taken excessive risks with high leverage and are poorly managed may collapse. A massive shake-out of the bloated hedge fund industry is likely in the next two years.
Even private equity firms and their reckless, highly leveraged buy-outs will not be spared. The private equity bubble led to more than $1,000bn of LBOs that should never have occurred. The run on these LBOs is slowed by the existence of “convenant-lite” clauses, which do not include traditional default triggers, and “payment-in-kind toggles”, which allow borrowers to defer cash interest payments and accrue more debt, but these only delay the eventual refinancing crisis and will make uglier the bankruptcy that will follow. Even the largest LBOs, such as GMAC and Chrysler, are now at risk.
We are observing an accelerated run on the shadow banking system that is leading to its unravelling. If lender-of-last-resort support and deposit insurance are extended to more of its members, these institutions will have to be regulated like banks, to avoid moral hazard. Of course this severe financial crisis is also taking its toll on traditional banks: hundreds are insolvent and will have to close.
The real economic side of this financial crisis will be a severe US recession. Financial contagion, the strong euro, falling US imports, the bursting of European housing bubbles, high oil prices and a hawkish European Central Bank will lead to a recession in the eurozone, the UK and most advanced economies.
European financial institutions are at risk of sharp losses because of the toxic US securitised products sold to them; the massive increase in leverage following aggressive risk-taking and domestic securitisation; a severe liquidity crunch exacerbated by a dollar shortage and a credit crunch; the bursting of domestic housing bubbles; household and corporate defaults in the recession; losses hidden by regulatory forbearance; the exposure of Swedish, Austrian and Italian banks to the Baltic states, Iceland and southern Europe where housing and credit bubbles financed in foreign currency are leading to hard landings.
Thus the financial crisis of the century will also envelop European financial institutions