Update 9.15 PM EDT Ilargi: I don’t like late updates, but this is big, make that stunning. The FDIC stealthily shut down WaMu earlier today, and that’s the biggest shut-down they’ve ever done, by a mile and a half and a mule. if anyone still thinks this thing is over, or nearing its end, think again.
JPMorgan buys WaMu
JPMorgan Chase acquired the troubled thrift Washington Mutual Inc., the Federal Deposit Insurance Corporation announced late Thursday, marking yet the latest stunning development in the ongoing credit crisis.
Under the deal, which was arranged by federal banking regulators, JPMorgan Chase will acquire all the banking operations of the Seattle-based WaMu, as well as its assets and financial contracts. JPMorgan Chase will also make a payment of $1.9 billion.
The Office of Thrift Supervision shut down the bank on Thursday and named the FDIC as receiver. "For bank customers, it will be a seamless transition," said FDIC Chairman Sheila Bair. "There will be no interruption in services and bank customers should expect business as usual come Friday morning,"
Shares of WaMu, which finished the day down 25%, plunged an additional 73% in after hours trading on the news.
WaMu and a subsidiary, Washington Mutual FSB, have combined assets of $307 billion and total deposits of $188 billion.
WaMu, the nation's largest savings and loan, has been one of the most hard-hit banks during the financial crisis. Many of its assets are tied up in mortgages, many of which have gone sour as housing prices fell. The company's stock freefall, combined with several ratings agency downgrades, has led many analysts to speculate that the endgame for the embattled savings and loan was imminent.
The Seattle-based thrift, which oversees about 2,300 locations nationwide, had reportedly put itself up for sale last week, hiring Several other large institutions including Wells Fargo, Citigroup and HSBC reportedly had pored over the company's books but failed have all been mentioned as possible suitors.
Earlier Thursday, reports surfaced that WaMu had approached private equity firms about a potential takeover of the firm, and that federal regulators are also rushing to broker a deal as financial pressures mount on the firm. WaMu has been hit by a series of credit downgrades in the past month, which has increased the urgency on the company to find a buyer. Credit agency Standard & Poor's downgraded WaMu on Wednesday, lowering the firm from junk status to an even lower junk status.
Rating agency DBRS also downgraded WaMu on Wednesday, lowering the holding company's credit rating to junk bond status but keeping the firm's banking business at investment grade status. The fall of Washington Mutual is the latest turn in a dizzying two weeks that has seen the bankruptcy of Lehman Brothers, the acquisition of Merrill Lynch by Bank of America and the near collapse of insurance giant AIG.
The widening credit crisis has prompted President Bush to seek from Congress extraordinary authority to spend as much a $700 billion to bail out the nation's financial system by purchasing toxic assets from banks. President Bush, in a televised address on Wednesday night, said the nation is in the middle of a "serious financial crisis" that threatens the economy. "The market is not functioning properly," Bush said. There is a widespread loss of confidence. America could slip into a financial panic."
This year, 12 banks have been forced to close their doors. In July IndyMac was closed down marking the largest collapse of an FDIC-insured institution since 1984. The Pasadena, Calif.-based bank failed because it backed risky home loans.
Federal regulators were quick to point out Thursday evening that the WaMu-JPMorgan Chase deal would not have any impact to its insurance fund which covers customer deposits when banks fail. "WaMu's balance sheet and the payment paid by JPMorgan Chase allowed a transaction in which neither the uninsured depositors nor the insurance fund absorbed any losses," Bair said.
When IndyMac was shut down, it had assets of $32 billion and deposits of $19 billion. The FDIC protected most of IndyMac customer's assets. The FDIC insures the assets held by the 8,451 institutions with a total of $13.4 trillion.
Ilargi: Today, I look out over what will soon be an entire continent of ruins, and I got to tell you, I get physically sick watching in my mind’s eye what I see unfold. I’ll open today with a clip from Dave Letterman’s show last night. Yeah, that’s right, on the heels of Daily Show’s John Oliver quipping that the out-of-hand superfast-growing-spreading Shrubs-on-steroids who’ve killed all other vegetation in this land don’t just want American children to eat roadkill, they want them to fight over it, I get back to comedy once more.
It’s sick and sad that the only real information I get from the media is through comedy shows. Why do you think Jon Stewart is the man these days? "Serious" newsmakers are not allowed to vent their anger at what goes on, no matter how justified. So we turn to humor to understand what happens. We also do so because we need to laugh in the face of impending disaster. I don’t think even one in a million has a conscious clue how grave it will be, but I do think many have nagging neurons whose activity gets ever harder to deny. Yet, denial is what we do best.
And that’s why we need to laugh. But don’t for a moment think it will be you who has the last laugh.
I don’t think Letterman understands the economy; neither do I think it’s easy to get him angry. But last night he was. And then he’s at his best. It’s a pity that he wasn’t over the past decade, that it took people like him and Jon Stewart all the way till September 2008 to get to the point. It’s not fair, I know, to put the conscience of a continent in the hands of a handful of guys whose only wish is to be funny, but at the same time, that’s where it is, whether they like it or not.
Paul Krugman, professor and New York Times columnist, is not an angry man either. And while he has critical views, nobody in their right mind would label him a doomer. But Krugman is as angry as Letterman. It’s a shame that he feels the need to veil his anger behind polite words. Krugman knows what’s going on, but he still can’t bring himself to say it. Instead, he says:
But there’s another possible explanation, which I find terrifyingly plausible: the plan came first, and all this stuff about price discovery is an after-the-fact rationalization, invented when people started asking questions.
But I will say it. It’s clear by now that the Paulson plan, the $700 billion one that will cost $7 trillion, was not hastily put together. It had been on the shelf for a long time, waiting for the right time to hit the stage lights, much like a lurking killer influenza virus. The right time is the one, today, when the economy is at its weakest, when people are filled with fear about something they do not understand. They're not trying to save the economy, they're trying to liquidate it, and take it over.
This is the time the US political system has chosen to unleash the tried tactic of Shock and Awe upon its own people. This is what Naomi Klein calls disaster capitalism. Pick up a copy of her Shock Doctrine. The same thing has been played out by the US, the IMF, the World Bank and all their accomplices throughout the planet, for decades. It’s not the Shrub cabal that’s behind it, this has been going on under Democratic rule just as much. And now it will be tested at home.
Word this morning is that the plan is about to be signed. Word is also that the FDIC needs hundreds of billions of dollars. Which are not included in the plan. Hence, once the plan is signed and sealed, and Paulson is appointed by his peers as the crisis dictator of the world economy, he will come back to Congress with the next trillion dollar emergency that must be solved within a timeframe that leaves no space for due diligence.
The underlying message for the public eye is that the housing market must be stabilized. But that is impossible at present price levels. At these levels, not nearly enough homes can be sold. Not now, and not ten years from now. Yet, if prices come down to affordable levels, perhaps as much as 50 million American home owners will own as much as 5 times more on their mortgages than their homes are worth. That means debt servitude, which means poverty and misery and mass foreclosures as well as mass unemployment. And that in turn will turn America into a land of hoovervilles and tent cities, into Shantyland.
Because of the Paulson plan, and the upcoming FDIC bail-out, and whatever comes next, all they had left will be gone too.
Note: On September 30, a walloping amount of US corporate debt needs to be refinanced. The Friends of Hank will start robbing the corpses of their jewelry and golden teeth October 1st.
Note 2: To assess the health of US banks, this might be useful: Bill Gross at Pimco, the no 1 US bondtrader, says he was offered: "We were offered a sizeable piece of a six month Morgan Stanley obligation at a yield of 25 percent."
Got that? A 25% return on one of the sole two remaining Wall Street banks. How comfortable are you feeling right now?
China banks told to halt lending to US banks
Chinese regulators have told domestic banks to stop interbank lending to U.S. financial institutions to prevent possible losses during the financial crisis, the South China Morning Post reported on Thursday.
The Hong Kong newspaper cited unidentified industry sources as saying the instruction from the China Banking Regulatory Commission (CBRC) applied to interbank lending of all currencies to U.S. banks but not to banks from other countries.
"The decree appears to be Beijing's first attempt to erect defences against the deepening U.S. financial meltdown after the mainland's major lenders reported billions of U.S. dollars in exposure to the credit crisis," the SCMP said.
John McCain Cancels Letterman: 'This doesn't smell right'
"In the middle of the taping Dave got word that McCain was, in fact just down the street being interviewed by Katie Couric. Dave even cut over to the live video of the interview, and said, "Hey Senator, can I give you a ride home?"
Earlier in the show, Dave kept saying, "You don't suspend your campaign. This doesn't smell right. This isn't the way a tested hero behaves." And he joked: "I think someone's putting something in his metamucil."
"He can't run the campaign because the economy is cratering? Fine, put in your second string quarterback, Sarah Palin. Where is she?"
"What are you going to do if you're elected and things get tough? Suspend being president? We've got a guy like that now!"
Bail-out Plan: "The Hard Issues Are Resolved"
Senate Banking Committee Chairman Christopher Dodd said that lawmakers have "work to do" to reach an agreement on a $700 billion financial rescue plan. Dodd made his comment this morning before a meeting with Republicans to negotiate an accord.
President George W. Bush in a televised address last night urged swift action to help avert "a long and painful" recession. The $700 billion proposal would allow the Treasury to buy troubled assets to restore financial stability, Fed Chairman Ben S. Bernanke said yesterday. Representative Spencer Bachus, the top Republican on the Financial Services Committee, said lawmakers were not close to a deal, as he entered a meeting to negotiate an accord.
House Financial Services Committee Chairman Barney Frank told reporters last night that House and Senate Democrats had reached a deal among themselves on the legislation. Democrats on Frank's panel and the Senate Banking Committee are meeting today with committee Republicans to try to reach an accord.
Michael Steel, a spokesman for House Republican leader John Boehner, said there "will not be a final deal as a result" of the meeting this morning. "We have made some progress but are not nearly at that point," Steel said in an e-mail message last night.
"The package is basically done," Representative Paul Kanjorski, a Pennsylvania Democrat, told CNBC today. "The hard issues are resolved. They have to shake hands. They have to smile and they have to have the photo set." Bush invited presidential candidates John McCain and Barack Obama, along with congressional leaders, to a meeting at the White House this afternoon to accelerate the talks.
Report: Deal coming soon
House Speaker Nancy Pelosi voiced hope Thursday that a White House accommodation with congressional leaders on protections for taxpayers will help speed agreement on a bill to stabilize distressed financial markets.
Pelosi spoke to reporters as Democratic and Republican negotiators worked in a closed-door meeting on Capitol Hill to nail down the outline of an agreement by the end of the day. The pace of developments was quickening in advance of a highly-anticipated meeting that President Bush will hold with leading lawmakers and presidential nominees John McCain and Barack Obama later in the day.
Bush told the nation in a televised address Wednesday night that passage of the $700 billion bailout package his administration has proposed is urgently needed to calm the markets and restore confidence in the reeling financial system. And his top spokeswoman, Dana Perino, said Thursday she thought "significant progress" was being made.
Financial markets were mixed in early trading; the Dow Jones industrial average rose more than 200 points on optimism about the deal but a credit market squeeze remained as doubts about the proposed plan's effectiveness drove demand for short-term, safe-haven assets.
Pelosi, D-Calif., said that Bush's agreement with Democrats on limiting pay for executives of bailed out financial institutions and giving taxpayers an equity stake in the companies is evidence of progress. She also said that McCain, R-Ariz., had called her and that she'd told him that talks were headed in the right direction. At the White House, Perino told reporters that lawmakers can "hopefully close on a framework where we can get this legislation passed."
Senior lawmakers and the administration were still wrangling over major elements of the relief bill, including how to phase in the eye-popping cost _ a measure demanded by Democrats and some Republicans who want stronger congressional control over the bailout _ without spooking markets. A plan to let the government take an ownership stake in troubled companies as part of the rescue, rather than just buying bad debt, also was under intense negotiation.
The core of the plan envisions the government buying up sour assets of shaky financial firms in a bid to keep them from going under and to stave off a potentially severe recession. Even as political figures haggled over the shape and price of the bailout, new economic indicators showed that orders for big-ticket manufactured goods plunged in August by the largest amount in seven months and that new applications for unemployment benefits were at their highest level in seven years.
And new home sales tumbled in August to the slowest pace in 17 years, while the average sales price fell by the largest amount on record. It served to further dramatize the problem that Washington is trying to solve. Bush acknowledged Wednesday night that the bailout would be a "tough vote" for lawmakers. But he said failing to approve it would risk dire consequences for the economy and most Americans.
"Without immediate action by Congress, America could slip into a financial panic, and a distressing scenario would unfold," Bush said as he worked to resurrect the unpopular bailout package. "Our entire economy is in danger." Bush's warning came soon after he invited Obama and McCain, one of whom will inherit the economic mess in four months, as well as key congressional leaders to a White House meeting Thursday to work on a compromise.
With the administration's original proposal considered dead in Congress, House leaders said they were making progress toward revised legislation that could be approved. Rep. Barney Frank, D-Mass., who has led negotiations with Treasury Secretary Henry Paulson on the package, said that given the progress of the talks, the White House meeting was a distraction.
"We're going to have to interrupt a negotiating session tomorrow between the Democrats and Republicans on a bill where I think we are getting pretty close, and troop down to the White House for their photo op," said Frank, the House Financial Services Committee chairman. "I wish they'd checked with us."
Paulson and Federal Reserve Chairman Ben Bernanke have been crisscrossing Capitol Hill in recent days, shuttling between public hearings on the proposal and private meetings with lawmakers, to sell the proposal. Obama and McCain are calling for a bipartisan effort to deal with the crisis, little more than five weeks before national elections in which the economy has emerged as the dominant theme.
"The plan that has been submitted to Congress by the Bush administration is flawed, but the effort to protect the American economy must not fail," they said in a joint statement Wednesday night. "This is a time to rise above politics for the good of the country. We cannot risk an economic catastrophe."
Presidential politics intruded, nonetheless, when McCain said earlier Wednesday he intended to return to Washington and was asking Obama to agree to delay their first debate, scheduled for Friday, to deal with the meltdown. Obama said the debate should go ahead.
Lawmakers in both parties have objected strenuously to the rescue plan over the past two days, Republicans complaining about federal intervention in private business and Democrats pressing to tack on more conditions and help for beleaguered homeowners. But many in both parties said they were open to legislation, although on different terms than the White House has proposed.
Proposed $700 Billion Bailout Is Too Little, Too Late to End Debt Crisis
We believe Congress may be on the verge of making what could become one of the greatest policy mistakes of modern times, passing bailout legislation that could aggravate, rather than alleviate, the nation's massive debt crisis.
With this in mind, we are submitting our white paper on this urgent topic to members of Congress and banking regulators, and I wanted to make sure you have a copy right now. Earlier this week, I gave you a preview in the form of a partial first draft. Below is our press release with a link to the final report.
Proposed $700 Billion Bailout
Is Too Little, Too Late to End Debt Crisis; Too Much, Too Soon for U.S. Bond Markets
Weiss Research Submits Policy
Recommendations to Congress Today
JUPITER, FL, September 24, 2008 — The proposal before Congress for a $700 billion financial industry bailout will not only fail to end the massive U.S. debt crisis but could actually aggravate the crisis by driving up interest rates, according to a white paper submitted to Congress and banking regulators today by Weiss Research, Inc. Therefore, Weiss recommends limiting and reducing the bailout as much as possible, while bolstering existing safety nets for consumers.
Based on recently released FDIC and Federal Reserve data, Weiss Research finds that:
1. 1,479 U.S. banks and 158 U.S. thrifts are at risk of failure, with total assets of $3.6 trillion, or 36 times the assets of banks on the FDIC's list of troubled institutions.
2. Among those with $5 billion or more in assets, 61 banks and 25 thrifts are heavily exposed to nonperforming mortgages.
3. The bailouts announced and proposed to date, although expected to cost over $1 trillion, are too small to rescue most institutions at risk, let alone address multiple problems with U.S. interest-bearing debts outstanding of $51 trillion and derivatives held by U.S. banks of $180 trillion.
Martin D. Weiss, president of Weiss Research, comments: "There should be no illusion that the $700 billion estimate proposed by the Administration will be enough to end the crisis. Nor should there be any false hopes that the market for U.S. government securities can absorb the additional burden of a $700 billion bailout without putting major upward pressure on U.S. interest rates, aggravating the very debt crisis that the government is seeking to alleviate." Among its policy recommendations, Weiss urges Congress to:
1. Severely limit the government's authority to buy bad private-sector debts by requiring it to pay strictly fair market value, including a substantial discount that reflects their poor liquidity.
2. Disclose to the public that there are significant risks in the financial system that the government is not able to address.
3. Focus more resources on strengthening existing safety nets, including FDIC insurance of bank deposits, SIPC coverage of brokerage accounts and state guarantee associations that cover insurance policies.
"Rather than focusing on the protection of imprudent institutions and speculators," concludes Weiss, "Congress should do more to protect prudent individuals and savers."
Regardless of what Congress decides, Weiss recommends that individuals continue to invest and save prudently, seeking the safest havens for their money, such as safe banks and U.S. Treasury bills or equivalent.
The Weiss Research white paper, "Proposed $700 Billion Bailout Is Too Little, Too Late to End the Debt Crisis; Too Much, Too Soon for the U.S. Bond Market," is available at http://www.moneyandmarkets.com/files/documents/Final-Bailout-White-Paper.pdf. In addition, as a public service for consumers seeking advice on how and where to find safer institutions, Weiss Research provides a free 1-hour informational video on the Internet, entitled "The X List," at www.MoneyandMarkets.com.
Democrats claim Wall Street bailout breakthrough
Democratic Rep. Barney Frank said on Wednesday Democrats had reached an agreement to stem one of the worst U.S. financial disasters in decades, and that there would be enough votes to pass the measure and send it to President George W. Bush to sign into law.
"We now have between House and Senate Democrats an agreement on what we think should be in the bill, and we have a meeting scheduled at 10 a.m. tomorrow to meet with the Republicans," said Frank, chairman of the House of Representatives Financial Services Committee. Proponents of a rescue plan have expressed hope that a bill could be delivered to Bush within days.
While the Bush administration had asked Congress for $700 billion for an unprecedented Wall Street bailout, Frank said that amount might not be delivered all at once. "One tranche doesn't work," he said, adding that "safeguards" were needed. Frank said there would be tough congressional oversight of as well as limits on compensation packages for executives of companies that receive federal relief.
The Massachusetts senator said a limited number of details still had to be resolved, but thought it could be done quickly. These matters involved bankruptcy protections for families on the verge of losing their homes and giving the government a return on its money if the company being helped prospers.
Frank took a dig at Republican presidential nominee John McCain, who interrupted his campaign to return to Washington on Thursday to help work on a Wall Street bailout. "All of sudden, now that we are on the verge of making a deal, John McCain here drops himself in to help us make a deal, Frank said.
He expressed fear that McCain, a U.S. senator from Arizona who has spent much of the year away from the Capitol campaigning, could end up slowing down work on the bill. The Massachusetts Democrat noted that a meeting on Capitol Hill on Thursday will be interrupted for a "photo op" at the White House with congressional Democrats and Republicans as well as Bush. "We're trying to rescue the economy, not the McCain campaign," Frank said.
"Earlier today it became clear to me we would get the votes to pass this bill," Frank told CNBC in an earlier interview. He said it could take a few days to craft final legislation. Frank spoke shortly after Bush delivered a nationally televised address in which he warned that the United States was in the midst of a financial crisis that could push the economy into a long-term recession if the government did not act.
Frank said he was pleased that the president spoke after calls by Democrats in Congress that he explain to the nation what was at stake. Democrats blamed the crisis largely on the failure of Bush to adequately regulate the financial industry. Frank said that lawmakers writing the legislation have kept the Bush administration informed of what they intend to do.
"We know very well what Treasury and the Federal Reserve think would make this unworkable. I do not think we will have anything in here that they think would make it unworkable," Frank said. The issue of government controls on compensation for executives of corporations that participate in the bailout had ignited a firestorm, with Americans complaining to their representatives in Congress that these corporate chiefs shouldn't be rewarded for failure.
"On the executive compensation thing, it went to the core of their (the Bush administration's) being," said Frank. "It was like asking the chief rabbi of Jerusalem to eat bacon on Yom Kippur. It was the most unthinkable thing they could think of."
Gross: PIMCO Wouldn't Touch Morgan Stanley Bonds With a Ten Foot Pole
An interesting aside at the end of the NYT's piece on PIMCO's Bill Gross this afternoon:“We were offered this morning a six-month sizable piece of Morgan Stanley,” he said Tuesday. “Here’s the surviving investment bank that just last night got equitized or bailed out by a Japanese bank. We were offered a sizeable piece of a six month Morgan Stanley obligation at a yield of 25 percent, O.K.?”
Pimco didn’t buy the bonds, however, “because we thought we could get it even cheaper,” Mr. Gross explained. “That’s where the fear builds in and makes for totally illiquid markets. Where no one trusts anybody; no one trusts any price. There’s a total lack of trust and confidence in the markets. And that’s what a market depends on.”
Got that? This is a guy who, like Warren Buffett, feasts on opportunity. Morgan Stanley comes along and says "Hey, we've survived, we just raised a ton of new capital from Mitsubishi, and we got the US government to make us a bank--so can we sell you a bond?" And even at an almost incomprehensible yield of 25 percent, Gross said, "No way."
No wonder Morgan Stanley's stock cratered at the end of the day.
A sneaking suspicion
So now the whole rationale for the plan is “price discovery”: we’re going to throw lots of taxpayer funds into the pot because that will let us find the true values of troubled assets, which are higher than the fire sale prices out there, and so balance sheet will improve, confidence will return, etc, etc..
So I just did a Nexis search trying to find out when Paulson and Bernanke started talking about price discovery, which we’re now told are at the core of the plan’s logic. And the answer is …
I can’t find any use of the term, or even a hint of the argument, until yesterday’s Senate hearings. One possible explanation: It wasn’t until yesterday that they realized that it would actually be necessary to explain themselves.
But there’s another possible explanation, which I find terrifyingly plausible: the plan came first, and all this stuff about price discovery is an after-the-fact rationalization, invented when people started asking questions.
It has seemed very strange to me that such a supposedly crucial economic program would be based on such an exotic argument. My sneaking suspicion is that they started with a determination to throw money at the financial industry, and everything else is just an excuse.
FDIC May Need $150 Billion Bailout as Local Bank Failures Mount
Americans have gotten used to the idea that bank failures were as rare as a category five hurricane. No banks went bust in 2005 or 2006. Seven collapsed in 2007 as the credit crisis began to exact a toll. So far in 2008, 12 more, with total assets of $42 billion, have fallen -- that's the worst wave of bank failures since 1992.
IndyMac, which had $32 billion in assets when it went into receivership, is the most expensive bank failure the FDIC has ever covered. And that record may not stand for long. By the end of 2009, about 100 U.S. banks with collective assets of more than $800 billion will fail, predicts Christopher Whalen, managing director of Institutional Risk Analytics, a Torrance, California-based firm that sells its analysis of FDIC data to investors.
"It's not going to be Armageddon," says Mark Vaughan, an economist and assistant vice president for banking supervision and regulation at the Federal Reserve Bank of Richmond, Virginia. "But it's going to be bad."
The FDIC knows which banks are at risk; it has a watch list with 117 institutions. The agency won't disclose their names because doing so could cause depositors to panic and pull out all of their funds. It won't take many more failures before the FDIC itself runs out of money. The agency had $45.2 billion in its coffers as of June 30, far short of the $200 billion Whalen says it will need to pay claims by the end of next year. The U.S. Treasury will almost certainly come to the rescue.
Regardless of who wins control of the White House and Congress in November, no politician is likely to vote in favor of leaving federally insured depositors out in the cold. A taxpayer bailout of the FDIC would come on the heels of intervention by the U.S. Treasury Department and Federal Reserve to save investment bank Bear Stearns Cos., mortgage giants Fannie Mae and Freddie Mac and the world's largest insurer, American International Group Inc.
Emergency federal funding of the FDIC could swell the cost of government rescues of failed financial institutions to more than $400 billion -- not including the $700 billion general Wall Street bailout now under discussion in Congress. That number would be even higher if the government were on the hook for uninsured deposits -- which amount to $2.6 trillion, 37 percent of the total of $7 trillion held in the U.S. branches of all FDIC member banks.
The subprime crisis -- which started in the suburbs of California and Florida and migrated through the alchemy of securitization to Wall Street investment banks -- has come almost full circle, spreading its toxins to the very lenders who first extended those teaser-rate, no-document mortgages to homeowners.
In 2006, IndyMac was the largest provider of mortgages that didn't require borrowers to provide proof of their incomes. And as of mid-September, investors were worried that Washington Mutual Inc., the biggest thrift in the U.S., would be the next bank to go belly up. A federal takeover of Washington Mutual, which has assets of $310 billion, could cost taxpayers $24 billion more, according to Richard Bove, an analyst at Miami-based Ladenburg Thalmann & Co.
The reckoning that has run through Wall Street, claiming investment banks Lehman Brothers Holdings Inc. and Bear Stearns among its victims, has been slower to hit Main Street. In mid- 2007, Wall Street firms began disclosing losses on their packages of securitized home loans.
From August 2007 to September 2008, banks worldwide wrote down more than $500 billion. Regional banks, by contrast, have waited to write off their bad mortgages, hoping the housing market would improve and defaults would level off. Instead, they've risen. FDIC-insured banks charged off $26.4 billion of bad loans in the second quarter of 2008, the most since 1991.
U.S. lenders, in their embrace of subprime lending, committed the same analytical fallacy as their Wall Street counterparts. When it came to assessing risk, they relied on the recent past to predict the near future. They were blinded by years of rising home prices and low mortgage default rates.
The FDIC fell into the same trap. As recently as March, an internal FDIC memo estimated the cost to cover bank collapses in 2008 would be just $1 billion, dropping to $450 million in 2009. It wasn't even close. The IndyMac failure alone, which happened four months after that memo was circulated, will cost the FDIC $8.9 billion -- and the bill for all 12 collapses will be about $11 billion, the FDIC says.
FDIC Chairman Sheila Bair says the agency's forecast was based on models using data from the past 20 years, which included long periods with few bank failures. "Given the change in economic conditions, we need to weight the more recent data more heavily," Bair says. "You also need a good dose of common sense."
Bair says depositors shouldn't fret about their banks. "We do have a handful with some significant challenges," she says. "Overall, banks are quite safe and sound." Bair is duty bound to say that, says Joseph Mason, an economist who worked for the Treasury from 1995 to 1998. Part of the FDIC's job is to reassure the public and prevent runs on banks. Mason says Bair's rhetoric masks the agency's inability to grasp the scope of the coming crisis.
"The FDIC and the banking regulators are ignoring the problems, hoping they'll go away," he says. "They won't."
The quake that shook markets in September may make the FDIC's task more complicated and expensive. With investment banks in eclipse, deposit-taking institutions will now play a larger role in financing the economy. Earlier this month, Bank of America Corp. agreed to buy Merrill Lynch & Co. for $50 billion, and Wachovia Corp. and Morgan Stanley were in talks about a potential merger.
From 2002 to 2007, U.S. lenders made a total of $2.5 trillion in subprime mortgages, according to the newsletter Inside Mortgage Finance. "Given the magnitude of the bad loans still on bank balance sheets, it would be miraculous for the FDIC to squeak by with losses of less than $200 billion," Whalen says. On Sept. 18, in yet another stunning turn of events, Paulson proposed a plan that would cost the government, if not necessarily the FDIC, hundreds of billions of dollars more.
The Treasury secretary says the government will purchase toxic mortgage debt from banks in an effort to cleanse the financial system. In an unprecedented move, the Treasury also pledged $50 billion to insure nonbank money market funds.
Bair says Paulson's plan won't reduce the number of banks on the FDIC's watch list.
One reason the rolling financial crisis is hitting regional banks later than it walloped Wall Street is because the very system that is meant to protect depositors -- federal insurance -- has also served to prop up weak lenders. So has the ready supply of credit extended to banks by another government- chartered group, the Federal Home Loan Banks.
Because all deposits up to $100,000 are insured, most savers can be agnostic about where they put their money. They don't have to know -- or care -- whether a bank is making sound or foolish loans. Unlike buyers of stocks or bonds, people who put their money in banks rarely do research about the soundness of the institution. That makes it easy for banks -- both prudent and reckless ones -- to raise cash.
Banks have taken the FDIC's protection and run with it, thanks to the phenomenon of brokered deposits -- and a giant loophole in federal regulations. As of June 30, Whalen says banks held $644 billion from brokers who offer customers a way to gain FDIC insurance for multiple accounts.
Promontory Interfinancial Network LLC, an Arlington, Virginia-based company founded in 2002 by former federal officials --including some from the FDIC itself -- has figured out how to help wealthy clients insure as much as $50 million each by putting their money into separate accounts at 500 different banks. While the law does limit insurance to $100,000 per account, it places no ceiling on the number of different banks where an individual can hold accounts -- a loophole Congress failed to close even after the savings and loan debacle of 1984- 1992.
Bair says brokered deposits can provide quick cash but also create potential danger. "It is quite easy to get brokered deposits, and there's not a lot of market discipline with the brokered deposits," she says. "When there's excessive reliance on them, particularly to fuel rapid growth on the balance sheet, that's definitely a high-risk factor."
The other big source of money for banks is the FHLB, an under-the-radar network of 12 regional banks created by Congress in 1932 to help lenders finance mortgages. Lenders had borrowed a total of $840.6 billion from the FHLB system as of June 30, up 38 percent from $608 billion in the same period a year earlier. Treasury Secretary Henry Paulson, in a little-noticed action on Sept. 7, the day after he announced the bailout of Fannie and Freddie, extended a secured credit line to the FHLB to provide an emergency source of funding if needed.
Vaughan says credit from the FHLB is keeping some sick banks afloat and postponing the inevitable. "What's going to happen," he says, "is that weak banks will use FHLB advances to avoid discipline from funding markets. In some cases, that will keep their doors open longer than they otherwise would, all-the-while offloading more and more potential losses onto the FDIC and taxpayers."
EU refuses bail-out package despite crisis fears
The European Union has no plans “yet” for a rescue package along the lines of the Paulson plan despite severe stress in the region’s banking system and further evidence that the bloc is sliding into a deep and protracted recession.
“The situation we face here in Europe is less acute and member states do not at this point consider that a US style plan is needed,” said Joaquin Almunia, the EU’s economics commissioner, in a tense session at the European Parliament. “We didn’t have subprime mortgages. We do not have investment banks. In any case, it’s not up to the EU; it’s up to every one of the member states to decide whether they need to launch this kind of fiscal initiative.”
The comments fell far short of reassuring doubters that the EU system has the machinery to tackle a major financial crisis.
Daniel Gross, director of the Centre for European Policy Studies in Brussels, said euro-zone lenders are heavily exposed to the fall-out from the US credit crisis, describing the Paulson plan as a de facto rescue for the Euopean banking system.
It has emerged that French finance minster Christine Lagarde was one of those pleading with US Treasury Secretary Hank Paulson last week to bail out AIG, which had insured over $300bn of credit derivatives to European firms. Mr Gross said Deutsche Bank deploys fifty times leverage and has liabilites of $2,000bn, equivalent to 80pc of Germany’s GDP. Fortis Bank has liabilities of 300pc of Belgian GDP.
These dwarf the burden of any US bank on the US government balance sheet. He said EU states do not have the means to bail out these banks. Any rescue would have to come from the European Central Bank, yet it is not allowed to carry out bail-outs under the Maastricht Treaty law.
The picture is clearly going from bad worse across the eurozone and the Nordic region. Germany’s IFO index of business expectations fell to 86.5 in September, the lowest level in fifteen years. “The time has come to cut interest rates,” said Gernot Nerb, the IFO’s chief economist. “A full-blown recession is looming in the 2009 for the euro area,” said Jacques Cailloux, Europe economist at the Royal Bank of Scotland.
“We think Germany’s economy will contract next year. Foreign manufacturing orders have been falling for eight months in row, which is the longest continuous drop on record. German house prices have fallen 4pc this year, which is surprising for a country that has seen no increase for ten years,” he said.
“The country has a `high-beta’ to the global cycle because of its industrial exports. Given this macro-outlook, we think the ECB should cut rates,” he said. Spain’s finance minister Pedro Solbes said on Wednesday that his country’s economy may faces outright contraction in the second half of the year, warning that debt arrears had become “very disturbing”.
Even oil-rich Norway is facing strains in its credit system as the mayhem goes global. The Norges Bank joined with the central banks of Sweden, Denmark and Australia in an emergency scheme to draw $30bn of US dollar funds in a swap accord with the Federal Reserve. “There is now an unusually high degree of uncertainty linked to the turbulence in financial markets. The crisis in financial markets has deepened. In Norway there are also clear signs that economic growth is slowing,” it said.
The wild ructions in the Oslo, Stockholm, and Copenhagen credit markets are a fresh reminder that there is almost nowhere left to hide in world economy as the fall-out from the collapse of Lehman Brothers continues to wreak havoc. Under the swap deal, the Fed is providing $5bn each to Norway and Denmark, and $10bn each to Sweden and Australia. It aims to assuage the frantic scramble for dollars by banks with exposure to US toxic debt.
Denmark is in full-fledged recession and has already suffered two embarrasing bank failures this summer as the bubble burst in commercial real estate. The central bank seized Roskilde Bank in August in a $8bn bail-out after a deposit run by client in a Nordic version of the Northern Rock debacle, warning that the total collapse of the lender would pose a “significant threat to the financial stability of Denmark”.
It stepped in again this week to rescue EBH Bank with a state guarantee, and has pushed shotgun marriages for two other distressed lenders, Lokalbanken and Forstaedernes. Stein Bocian, chief economist at Danske Bank, said the banks had lent heavily to developers in high-risk projects, relying on short-term funding in the capital markets. The game ended when the credit window jammed shut. “Short-term funding has become extremely expensive and now they can’t roll over their loans,” he said.
Denmark has enjoyed a blistering credit boom over recent years, fuelled by membership of Europe’s Exchange Rate Mechanism which fixed the Dranish krona to the euro. The policy caused the country to import the monetary policy of the ECB at a time when it was far too loose for Danish needs. Intrest rates were just 2pc until the end of 2005. The result was to push household debt to 260pc of GDP, the highest level in the world. This compares to 135pc in America.
Denmark’s housing bubble is now popping with the same destructive effect as bubbles in the US, Britain, Ireland, Spain, and indeed China. Danish prices have dropped 4pc so far nationwide on official data, but estate agents say properties are now off at least 20pc in parts of Copenhagen. Across the Oresund in Sweden, the economy has ground to a halt and Volvo sales in Russia, Europe, and the US have plummeted. The flagship car company laying off 8pc of its 25,000-strong work force and cancelling a production shift.
Adding to the gloom, the pan-Nordic airline SAS is now battling for its life, the latest casualty of the global aviation crunch. The carrier has denied persistent reports that it will soon be taken over Lufthansa. Stefan Ingves, governor of Sweden’s Riksbank, said on Wednesday his country had been battered by the “renewed wave of international financial unrest” but insisted that the banking system remained fully solvent. He described the swap agreement with the Fed as a precautionary measure.
The Swedish treasury suspended bond sales last week because the market had ceased to function properly. There have been concerns that Swedish banks could face a squeeze over coming months as the property boom deflates and the losses mount on heavy investments in the Baltic region, where Estonia and Latvia are sliding into deep recession.
The International Monetary Fund has warned that the Baltic slump could “cause a credit crunch in Sweden itself” if the Swedish banks prove unable to roll over their loans in the wholesale capital markets. It said that Swedbank and SEB are highly exposed to the region. Svedbank is the dominant lender in Estonia and Latvia, earning 30pc of its porfits in the region. The share prices of the two banks have fallen by two thirds since mid-2007 and are understood to have been the target of aggressive “shorting” by hedge funds.
European banking on borrowed time
The US financial system is being nationalised. The piecemeal approach followed so far had clearly not been working. Hence the US political system is working overtime to reach a bipartisan agreement on a systemic solution. The centrepiece is already known: the US government is going to buy $700bn (€480bn, £380bn) of the so-called “toxic” assets.
More measures are certain to follow as the banks will require recapitalisation to the extent that they make losses. As a result, the US government will soon own a large share of the US banking system. If the details are generous enough, this should be sufficient finally to restore orderly market conditions. Can Europe be far behind? The synchronised movements in global markets over the last few weeks have shown that contagion works on the way down and on the way up.
But the case of AIG, the US insurer, also shows the importance of another, hidden, link across financial markets, namely massive evasion of regulatory requirements. AIG’s last annual report reveals that it had written coverage for more than $300bn of credit insurance for European banks. The comment by AIG itself on these positions was that they were “for the purpose of providing them with regulatory capital relief rather than risk mitigation in exchange for a minimum guaranteed fee”.
Thus, a formal default by AIG would have exposed European banks to large increases in regulatory capital requirements, with possibly devastating effects on their ratings and market confidence. Thus, the US Treasury has saved, inter alia, the European banking system.
The extent of regulatory arbitrage can also be seen in the very large gap between overall leverage ratios and the official regulatory ratios. The dozen largest European banks have now, on average, an overall leverage ratio (shareholders’ equity to total assets) of 35, which has actually increased so far this year, compared with less than 20 for the largest US banks. But at the same time most large European banks also report regulatory leverage ratios of close to 10.
This is partly due to the fact that the massive in-house investment banking operations of European banks are subject only to limited regulatory capital requirements. Another part of the explanation must be regulatory arbitrage, for example, through the credit insurance offered by AIG.
Europe’s banks will benefit greatly from the effective nationalisation of the US financial system now being planned, because the larger ones, which all have significant US operations will also benefit from the $700bn bail-out fund. But it remains unclear how many of these assets they still hold in their balance sheets and how volatile their liability base will prove if confidence does not return quickly.
The crucial problem on this side of the Atlantic is that the largest European banks have become not only too big to fail, but also too big to be saved. For example, the total liabilities of Deutsche Bank (leverage ratio over 50!) amount to about €2,000bn (more than Fannie Mae) or more than 80 per cent of the gross domestic product of Germany.
This is simply too much for the Bundesbank or even the German state, given that the German budget is bound by the rules of the European Union’s stability pact and the German government cannot order (unlike the US Treasury) its central bank to issue more currency. Similarly, the total liabilities of Barclays of around £1,300bn (leverage ratio 60!) are roughly equivalent to the GDP of the UK. Fortis bank has a leverage ratio of “only” 33, but its liabilities are three times the GDP of its home country of Belgium.
With banks that have outgrown their home turf, national treasuries and regulators in Europe are living on borrowed time: they cannot simply develop “road maps” (the only result of various Ecofin discussions of regulatory reform by finance ministers), but must contemplate a worst-case scenario.
Given that solutions for the largest institutions can no longer be found at the national level it is apparent that the European Central Bank will need to be put in charge as it is the only institution that can issue unlimited amounts of a global reserve currency. The authorities in the UK and Switzerland – which cannot rely on the ECB – can only pray that no accident happens to the giants they have in their own garden.
Checking Under the Consumer’s Hood
The evidence is clear that the consumer has already been retrenching throughout all of 2008, not just of late. New data out on the household debt service ratio indicates that as of April, Joe Ultra Light Six (JULS) was looking a little less Ultra-like having reduced his debt service burden from 14.35% to 13.85%. Tudo bem, that’s good work considering that the tax rebates had not even hit. This can be reduced by a combination of government transfers to JULS, new debt pay down habits or conditions, forgiveness and bankruptcy.
Now I will be the first to admit that this chart is a ways from popping the economic Happy Days bubbly bottle just yet. I’d like to see about 12% (about two trillion in debt reduction) to declare JULS reasonably healthy again, but at this pace and considering nearly two more quarters have gone by, one should at least pay heed. Plus we do have some hard evidence elsewhere that Joe may have continued his new habit beyond April, and towards dropping the Ultra moniker and picking up a new one, just Joe Six Pack. His demand deposits on hand have upticked from several years of pernicious decline. $320 billion here might impress this Doctor’s diagnosis. Unfortunately fuel costs have only dropped marginally, and inflation is still the major threat to drag this process out.
Joe right now is almost forced into this new savings and debt reduction mode because his debt enablers are simply put, withdrawing credit. Word is that unless you have a 700 FICO score or more, you can’t even get an auto loan nowadays. The debt enablers have also really backed away from home mortgages as well, which makes stopping the downturn in housing prices problematic. Could house prices seriously overshoot normal valuations?
At minimum these high homeowner vacancy rates need to come off, and new data on that front is a month off.
A $700 billion slap in the face
The initial Treasury stance on the bailout was one of sheer demand for authority: give us total discretion and a blank check, and we’ll fix things. There was no explanation of the theory of the case — of why we should believe the proposed intervention would work.
So many of us turned to our own analyses, and concluded that it probably wouldn’t work — unless it amounted to a huge giveaway to the financial industry. Now, under duress, Ben Bernanke (not Paulson!) has offered an explanation of sorts about the missing theory. And it is, in effect, a metastasized version of the “slap-in-the-face” theory that has failed to resolve the crisis so far.
Before I explain the apparent logic here, let’s talk about how governments normally respond to financial crisis: namely, they rescue the failing financial institutions, taking temporary ownership while keeping them running. If they don’t want to keep the institutions public, they eventually dispose of bad assets and pay off enough debt to make the institutions viable again, then sell them back to the private sector. But the first step is rescue with ownership.
That’s what we did in the S&L crisis; that’s what Sweden did in the early 90s; that’s what was just done with Fannie and Freddie; it’s even what was done just last week with AIG. It’s more or less what would happen with the Dodd plan, which would buy bad debt but get equity warrants that depend on the later losses on that debt.
But now Paulson and Bernanke are proposing, very nearly, to do the opposite: they want to buy bad paper from everyone, not just institutions in trouble, while taking no ownership. In fact, they’ve said that they don’t want equity warrants precisely because they would lead financial institutions that aren’t in trouble to stay away. So we’re talking about a bailout specifically designed to funnel money to those who don’t need it.
It took four days before P&B offered any explanation whatsoever of their logic. But as of now, it seems that the argument runs like this: mortgage-related assets are currently being sold at “fire-sale” prices, which don’t reflect their true, “hold to maturity” value; we’re going to pay true value — and that will make everyone’s balance sheet look better and restore confidence to the markets.
As I said, this is really a giant version of the slap-in-the-face theory: markets are getting hysterical, and the feds can calm them down by buying when everyone else is selling. So, three points:
- They’re still offering something for nothing. In major financial crises, the beginning of the end comes when the government accepts that it will have to pay some cost to recapitalize the banks. But in this case they’re still insisting that it’s basically a confidence problem, and it we can wave our magic wand — a $700 billion magic wand, but that’s just to impress people — the whole thing will go away.
- They’re asserting that Treasury and the Fed know true values better than the market. Just to be fair, it’s possible, maybe even probable, that mortgage-related paper is being sold too cheaply. But how sure are we of that? There are plenty of cash-rich private investors out there; how many of them are buying MBS? And isn’t it bizarre to have officials who miscalled so much — “All the signs I look at,” declared Paulson in April 2007, show “the housing market is at or near a bottom” — confidently declaring that they know better than the market what a broad class of securities is worth?
- Even if it works, the system will remain badly undercapitalized. Realistic estimates say that there will be $800 billion or more of real, medium-term — not fire-sale — losses on home mortgages. Only around $480 billion have been acknowledged by financial institutions so far. So even if the fire-sale discount is removed, we’ll still have a crippled system. And Paulson is offering nothing to fix that — unless he ends up paying much more than the paper is worth, by any standard.
Meanwhile, Paulson and Bernanke seem to be digging in their heels against equity warrants or anything else that would make this a more standard financial rescue. I say no deal on those terms — and if the lack of a deal puts the financial world under strain, blame Paulson and Bernanke, who have wasted most of a week demanding authority without explanation.
Asia Needs Deal to Prevent Panic Selling of U.S. Debt, Yu Says
Japan, China and other holders of U.S. government debt must quickly reach an agreement to prevent panic sales leading to a global financial collapse, said Yu Yongding, a former adviser to the Chinese central bank. ``We are in the same boat, we must cooperate,'' Yu said in an interview in Beijing on Sept. 23. ``If there's no selling in a panicked way, then China willingly can continue to provide our financial support by continuing to hold U.S. assets.''
An agreement is needed so that no nation rushes to sell, ``causing a collapse,'' Yu said. Japan is the biggest owner of U.S. Treasury bills, holding $593 billion, and China is second with $519 billion. Asian countries together hold half of the $2.67 trillion total held by foreign nations.
China, Japan, South Korea and others should meet soon to seal a deal, said Yu, a former academic member of the central bank's monetary policy committee. The talks should involve finance ministers, central bank governors and even national leaders, he said.
``Whether some kind of agreement between them to continue to hold Treasury bills is viable, I'm not sure,'' said James McCormack, head of sovereign ratings at Fitch Ratings Ltd in Hong Kong. ``It would be unusual. If it became apparent that sovereigns in Asia were selling Treasuries the market would take that quite badly, it's something to be avoided.''
The global credit crisis, triggered by a housing slump in the U.S., has saddled financial companies with more than $520 billion in writedowns and losses, collapsing Bear Stearns Cos. and Lehman Brothers Holdings Inc. in the process. Insurer American International Group Inc. and mortgage giants Fannie Mae and Freddie Mac also were rescued by the government.
U.S. Treasury Secretary Henry Paulson is urging Congress to pass a $700 billion plan to remove devalued assets from the banking system. Federal Reserve Chairman Ben S. Bernanke said Sept. 24 that the U.S. is facing ``grave threats'' to its financial stability.
China's huge holdings of U.S. debt means it must bear a large proportion of the ``burden of sorting things out'' in the U.S., Yu said. China is not in a hurry to dump its U.S. holdings and communication between the two nations every ``couple of days'' is keeping Chinese leaders informed and helping to avoid a potential panic, he added. ``China is very worried about the safety of its assets,'' he said. ``If you want China to keep calm, you must ensure China that its assets are safe.''
Yu said China is helping the U.S. ``in a very big way'' and added that it should get something in return. The U.S. should avoid labeling it an unfair trader and a currency manipulator and not politicize other issues, he said. ``It is not fair that we are doing this in good faith and are prepared to bear serious consequences and you are still labeling China this and that, accusing China of this and that,'' he said. ``China knows what to do. We don't need your intervention.''
The U.S. financial crisis had taught China a lesson and that was: ``Why are we piling up these IOUs if they may default?'' China's economic expansion strategy, which emphasizes export growth that has led to trade surpluses and the accumulation of $1.81 trillion in foreign-exchange reserves, is the main problem, said Yu. ``Our export-growth strategy has run its natural course,'' he said. ``We should change course.''
China should stop intervening in the foreign currency markets and thus allow rapid appreciation of the yuan, he said. While this would cause pain for exporters, China could ease the transition by using its strong fiscal position to aid those who lose their jobs. It also should stimulate domestic demand to offset lower income from overseas sales.
Without yuan appreciation, China will continue to accumulate foreign reserves, which means further accumulating ``IOUs from the U.S.,'' said Yu. ``This is paper and it may default and it will not increase China's national welfare.'' If China doesn't allow the yuan to appreciate and continues to promote export-led growth it will lead to confrontation with the U.S. and Europe, Yu said.
Moody's, S&P Knowingly Engineered 'Race To The Bottom'
In August 2004, Moody's Corp. unveiled a new credit-rating model that Wall Street banks used to sow the seeds of their own demise. The formula allowed securities firms to sell more top-rated, subprime mortgage-backed bonds than ever before.
A week later, Standard & Poor's moved to revise its own methods. An S&P executive urged colleagues to adjust rating requirements for securities backed by commercial properties because of the "threat of losing deals." The world's two largest bond-analysis providers repeatedly eased their standards as they pursued profits from structured investment pools sold by their clients, according to company documents, e-mails and interviews with more than 50 Wall Street professionals. It amounted to a "market-share war where criteria were relaxed," says former S&P Managing Director Richard Gugliada.
"I knew it was wrong at the time," says Gugliada, 46, who retired from the McGraw-Hill Cos. subsidiary in 2006 and was interviewed in May near his home in Staten Island, New York. "It was either that or skip the business. That wasn't my mandate. My mandate was to find a way. Find the way."
Wall Street underwrote $3.2 trillion of loans to homebuyers with bad credit and undocumented incomes from 2002 to 2007. Investment banks packaged much of that debt into investment pools that won AAA ratings, the gold standard, from New York-based Moody's and S&P. Flawed grades on securities that later turned to junk now lie at the root of the worst financial crisis since the Great Depression, says economist Joseph Stiglitz.
"Without these AAA ratings, that would have stopped the flow of money," says Stiglitz, 65, a professor at Columbia University in New York who won the Nobel Prize in 2001 for his analysis of markets with asymmetric information. S&P and Moody's "were trying to please clients," he said. "You not only grade a company but tell it how to get the grade it wants."
Presidential candidates John McCain and Barack Obama lay responsibility for the carnage with Wall Street itself. The Securities and Exchange Commission in July identified S&P and Moody's as accessories, finding they violated internal procedures and improperly managed the conflicts of interest inherent in providing credit ratings to the banks that paid them.
S&P and Moody's earned as much as three times more for grading the most complex of these products, such as the unregulated investment pools known as collateralized debt obligations, as they did from corporate bonds. As homeowners defaulted, the raters have downgraded more than three-quarters of the AAA-rated CDOs bonds issued in the last two years.
Facing the threat of lawsuits and tighter regulation, Moody's and S&P now say they are adopting tougher requirements to more accurately evaluate and monitor debt. "We have made significant progress in achieving these goals," Chris Atkins, S&P's vice president of communications, wrote last week in a statement to Bloomberg. "Working with policy makers and market participants around the world, we will continue to take steps to meet and exceed the high standards for quality we have put in place." He wouldn't respond to specific questions for this story.
"The rating agencies' models were too flawed and cut too many corners, and the raters got pressured by the bankers," says Tonko Gast, the chief investment officer of the $5.1 billion New York hedge fund Dynamic Credit Partners LLC. He reverse-engineers the raters' models as part of his investing strategy. "That's how the race to the bottom was kind of invisible for a lot of people," he says.
Starting in 1996, Moody's used a framework known as the binomial expansion technique for rating CDOs, structured funds consisting of aircraft leases, franchise loans, high-yield bonds, hotel mortgages and mutual-fund fees. On the theory that diversification reduced risk, the BET formula rewarded balanced portfolios and punished concentrations of assets, using a proprietary measurement Moody's called the diversity score.
On Aug. 10, 2004, Moody's Managing Director Gary Witt introduced a new CDO rating method that dispensed with the diversity test and made other adjustments to the evaluation of structured-finance products. "People were just starting to do deals that were all residential," says Witt, 49. He retired from Moody's this year and is now an assistant professor of statistics at Temple University's Fox School of Business in Philadelphia. The BET model "is not as well suited for the highly correlated portfolios that were becoming common in 2004," he says.
The emphasis on diversity turned into an obstacle after the 2001 recession, when some assets plummeted in value. Home mortgages, auto loans and credit-card receivables offered higher returns for CDO managers. As mortgage rates fell and the market boomed, investment firms argued the risks in housing were small.
"I know people lobbied Moody's to accommodate more concentrated residential mortgage risk in CDOs, and Moody's obliged," says Douglas Lucas, 52, the head of CDO research at UBS Securities LLC in New York. The former Moody's analyst says he invented the diversity score in the late 1980s.
A statistical tabulation appearing in the appendix of Witt's paper represented the new formula as more rigorous in calculating risks than the BET. A side-by-side comparison showed that the new model projected losses that were 24 to 165 percent higher than forecast by the old, on a hypothetical investment pool. Bankers "could put together a deal with greater concentrations in one area or another," says Jeremy Gluck, 52, a former Moody's managing director, who worked with Witt at the time.
In September 2005, Witt and colleagues published a follow-up analysis. Compared with the BET, the new model now projected that the likelihood of collateral defaults affecting CDO bonds rated at least Aa could be 73 percent lower at the extreme, in a range of possibilities. The new comparison was based on a hypothetical investment pool in which 75 percent of the assets were residential mortgage- backed securities, including 30 percent that were subprime.
Moody's could produce a lower default rate by incorporating a decade of ratings stability for structured finance into its assumptions. The average five-year loss rate on U.S. structured finance products between 1993 and 2003 was 1.9 percent, compared with 6.3 percent for corporate bonds, the company had said in September 2004. A drawback was that raters didn't have data going back to the 1920s, as they did on corporate bonds. In a press release on the report, Moody's said "structured- finance ratings are broadly comparable in quality to the ratings of corporate bonds."
Philippe Jorion, 53, a finance professor at the University of California, Irvine, criticizes the Moody's decision to factor ratings stability into its evaluations. "This uses the output of their model as input into their models," Jorion says. "This type of model is totally out of touch with the underlying economic reality."
U.S. New-Home Sales Fell 11.5% in August to 17-Year Low
Sales of new homes in the U.S. fell in August to a 17-year low, signaling the housing market suffered another setback even before the latest turmoil in financial markets. Sales dropped 11.5 percent, more than forecast, to an annual rate of 460,000, the fewest since January 1991, the Commerce Department said today in Washington. The median sales price dropped to a four-year low.
A financial meltdown that prompted the government this week to ask Congress for $700 billion in emergency funding to buy up troubled bank assets may continue to clog the flow of credit to homebuyers and businesses. Shrinking credit availability threatens to extend the three-year housing slump and deepen the economic downturn.
"The market is looking particularly depressing," said Guy Lebas, chief economist at Janney Montgomery Scott LLC in Philadelphia, whose sales forecast was the closest. "Construction activity has to fall further than it has, as do prices," to reduce a glut of unsold homes.
Economists had forecast new-home sales would drop to a 510,000 annual pace, according to the median estimate in a Bloomberg survey of 75 economists. Forecasts ranged from 493,000 to 555,000. July sales were revised up to a 520,000 pace from a previously estimated 515,000. Stocks rose on speculation that Congress will reach agreement on the bailout package and help avert a long recession.
Other reports today showed orders for durable goods in August dropped 4.5 percent and first-time claims for unemployment benefits surged last week to the highest level in seven years as hurricanes Ike and Gustav threw thousands out of work in Texas and Louisiana. The median price of a new home dropped 6.2 percent from a year earlier to $221,900, the lowest level since September 2004. Sales of new homes were down 35 percent from August 2007, the Commerce report showed.
While builders cut back, they weren't able to keep pace with the slump in sales. The number of homes for sale fell to a four-year low of 408,000, down 4.4 percent from the prior month. The decline was the biggest since 1963. Still, the supply of homes at the current sales rate rose to 10.9 months' worth from 10.3 months.
While accounting for only about 10 percent of the housing market, new-home purchases are considered a timelier indicator because they are based on contract signings. Sales of previously owned homes, which make up the remainder, are compiled from closings and reflect contracts signed weeks or months earlier.
Resales decreased 2.2 percent in August to an annual pace of 4.91 million units and median prices fell 9.5 percent from a year earlier, a record decline, the National Association of Realtors said yesterday. Inventories of new properties have been falling since July 2006 as builders have scaled back in the last two years. Ground was broken on the fewest new houses in 17 years in August, and permits, a sign of future construction, also fell, Commerce Department figures showed last week.
Orders for U.S. Durable Goods Drop Twice as Much as Forecast
Orders for U.S. durable goods fell more than twice as much as forecast in August, a sign that slower sales and tighter credit conditions prompted companies to cut spending.
The 4.5 percent drop in bookings of goods meant to last several years followed a revised 0.8 percent gain in July that was smaller than previously reported. Excluding transportation equipment, orders decreased 3 percent, the biggest drop since January 2007.
The credit crisis that brought down Lehman Brothers Holdings Inc. and American International Group Inc. this month is making it harder for companies to invest in new equipment. Less U.S. demand and shrinking economies overseas increase the risk that manufacturing will falter.
"This is finally some sort of reaction to a tightness in credit," said Rudy Narvas, a senior economist at 4Cast Inc. in New York, whose forecast for the drop in non-transportation orders was closest. "Plans to invest by companies are being restrained."
Another government report today showed the number of Americans filing first-time claims for unemployment benefits rose last week to the highest since September 2001 as hurricanes threw thousands out of work in Texas and Louisiana. Initial jobless claims increased by 32,000 to 493,000 in the week that ended Sept. 20, from a revised 461,000 the prior week, the Labor Department said.
Economists had projected durable goods orders would fall 1.9 percent after a previously reported 1.3 percent increase in July, according to the median of 74 forecast in a Bloomberg News survey. Estimates ranged from a drop of 5.9 percent to a gain of 0.3 percent. Excluding transportation equipment, orders were projected to fall 0.5 percent, according to the Bloomberg survey. Estimates ranged from a decline of 2.5 percent to an increase of 0.9 percent.
Bookings for non-defense capital goods excluding aircraft, a measure of future business investment, dropped 2 percent after a 0.4 percent increase in July that was smaller than previously estimated. The decline last month was the biggest since January 2007. Shipments of those items, used in calculating gross domestic product, fell 1.7 percent.
Bookings for transportation equipment dropped 8.9 percent, today's report showed. Orders for commercial aircraft decreased 38 percent and those for automobiles fell 8.1 percent, the most since January 2007. Boeing Co., the world's second-largest commercial planemaker, may have to provide more financing for its customers and may see more cancellations because of the spreading financial turmoil, Chief Executive Officer Jim McNerney said yesterday.
Previous economic slumps saw 5 percent to 10 percent of Boeing's orders canceled, McNerney told reporters after a speech in Boston. This time around, "it could be a little worse, could be better than that. We'll have to monitor the situation," he said. The company has a record $275 billion in order backlogs for commercial planes.
Chicago-based Boeing received orders for 38 aircraft in August, down from 70 a month earlier. About 27,000 Boeing machinists went on strike on Sept. 6. Orders for machinery dropped 6.2 percent and demand for metals fell 9.3 percent, the biggest decline since April 1993. The drop in metals may partly reflect the fall in commodity costs in recent months since the figures aren't adjusted for prices.
American manufacturers have offset weakening domestic demand in recent months by filling overseas orders, with support from a lower dollar that's made U.S. goods more competitive. Still, further export expansion is in question as economies overseas falter.
Europe's economy contracted in the second quarter for the first time since the introduction of the euro almost a decade ago. Japan's economy shrank in the same period as consumers spent less and exports fell, the Japanese government said last month.
A $25 Billion Lifeline for GM, Ford, and Chrysler
In Washington these days, an 11-figure expenditure barely attracts notice.
With Congress preoccupied with the massive, $700 billion bailout plan for the financial industry, General Motors, Ford, and Chrysler have finally secured Part One of their own federal rescue plan. A bill set to be passed by Congress and signed by President Bush as early as this weekend—separate from the controversial Wall Street bailout plan—includes $25 billion in loans for the beleaguered Detroit automakers and several of their suppliers.
"It seemed like a lot when we first started pushing this," says Democratic Sen. Debbie Stabenow of Michigan, one of the bill's sponsors. "Suddenly, it seems so small." But please don't call it a "bailout"—Detroit is too proud for that. Exact details will come later, but the loans would probably amount to at least $5 billion for each of the Detroit 3, plus smaller amounts for suppliers.
That would allow them to borrow money at interest rates as low as 4 percent—a steep discount compared with the double-digit rates they're paying now. Over several years, the automakers could save hundreds of millions in financing costs. Plus, they'll have five years before they have to start repaying the loans.
It might seem like a stealth rescue, but the plan has been in the works for at least 18 months. Approval for the loans was first included in last year's Energy Independence Act. Earlier this year, the automakers sought a first installment of loans totaling about $6 billion. But the nationwide credit crunch severely crimped their ability to borrow, and besides, next to bailouts like $200 billion for Fannie Mae and Freddie Mac, a mere $6 billion started to seem unduly modest. So Detroit raised the ante to $25 billion, the most allowed under current law.
Some details of the program:
It's much bigger than the Chrysler bailout of 1980. Back then, the government gave Chrysler a $1.5 billion loan guarantee to stave off a bankruptcy filing. That's equivalent to about $4 billion today—less than the amount each of the Detroit 3 is likely to get this time around.
There are few strings attached. The 1980 plan also included a long list of rules Chrysler had to abide by in order to get the money (including, get this, "an energy savings plan focusing on the national need to lessen U.S. dependence on petroleum"). The current legislation requires only that the money be used to retool old assembly lines and develop advanced, fuel-efficient technology. Since the automakers are already spending billions to do that, they could easily shift money around and use the low-interest funds to effectively support almost any project.
It props up a private company. In 1980, Chrysler was a public company, just as GM and Ford are today. But last year a private equity firm, Cerberus Capital Management, bought Chrysler, taking the firm private. And there's little or no precedent for the government aiding a private company that has no stockholders among the public. "I'd draw a line between public and private," says Kathryn Rudie Harrigan, a strategy professor at Columbia Business School. "I understand there are a lot of jobs at stake, but the taxpayer can only carry so much."
Detroit desperately needs the help. Many analysts expect all three domestic car companies to face a life-threatening crisis if the U.S. car market, down about 20 percent so far this year, stays in the doldrums. GM and Ford could start to run out of cash by the second half of 2009, a precursor to declaring bankruptcy. Chrysler's finances are now private, but its sales are down even more than at Ford and GM, and it may be starting to bleed its corporate parent, Cerberus.
The idea behind the loans is to buy time while the Detroit 3 revamp their lineups, develop new hybrids and other fuel-sippers, and convert old SUV plants into factories turning out hot cars able to compete with those from Toyota and Honda. "I think they're on the verge of really turning the page," says Stabenow. But Detroit has fallen mightily. Consumers reeling from $4 gas have fled the big trucks and SUVs that the manufacturers milked for two decades, and Detroit's smaller cars tend to rate poorly compared with competitors.
The domestics' U.S. market share is now about 48 percent, a staggering fall of nearly 20 points since the start of the decade. Fitch Ratings expects GM and Ford to produce about 1.3 million fewer cars this year than in 2007. Even cheap loans will do little to help erase years of red ink. "Even if they had positive cash flow," says Mark Oline of Fitch, "it's going to take some time to make a dent in their debt load."
There's more aid coming. This year's $25 billion is just a down payment. The automakers now plan to ask the government for another $25 billion in loans next year. It's just spare change, after all.
Dollar tumbles as bailout hangs in the balance
The greenback was down more than a cent against sterling at $1.8608 in early trading in London and also weaker against the euro. The dollar, which in August staged a recovery against a range of currencies as investors turned their attention to the potential fallout in emerging markets, is also being hit by fears that US Treasury Secretary Hank Paulson's planned $700bn bail-out of Wall Street banks will swell the deficit.
In a televised address to the nation last night, Mr Bush implored Congress to vote in favour of Mr Paulson's rescue package, or risk "a financial panic and a distressing scenario". The unprecedented events of the last two weeks, including the collapse of Wall Street investment bank Lehman Brothers, have shaken the world's financial markets.
Thursday's dollar selling came amid new signs that banks are still unwilling to lend cheaply to each other. In Hong Kong, the three-month interbank rate jumped to 3.8pc - the highest this year. In Singapore, the three-month dollar loan rate raced almost a third of a percentage point to 3.68pc, the second-biggest rise this year. Adarsh Sinha, currency strategist at Barclays, said that the weakness of the dollar was "justified".
"Our view is that what really matters is that all this will lead to a deterioration in the fiscal position of the US, and there is so much uncertainty about whether this plan will work," he said. Steven Barrow, analyst at Standard bank said that in the short-term, uncertainty over the US economy was likely to see the dollar weakening further, to about $1.90 against the pound.
"The dollar has been hit by the developments of the last week or so, and when the bailout plan goes through the market can't be sure that it's the end of the matter, there is a degree of scepticism," he said. However, Mr Barrow warned that the dollar was unlikely to rise above $2 again, and said that over the course of the next year or so it was likely to strengthen against the pound to the $1.65-$1.70 mark.
Auto lenders push to add car loan debts to bailout
The auto lending industry jumped into the debate Tuesday over a $700-billion bailout for the U.S. financial market, warning that car loans could be choked off should lawmakers fail to restore the flow of money through Wall Street.
Lawmakers from both parties vented their anger over the problem Tuesday, while Bush administration officials warned that unless Congress acts, the U.S. credit markets could tumble into chaos and speed an economic recession.
Stock markets fell Tuesday after prospects for the original plan dimmed, but lawmakers said they understood the need to pass something, vowing that any bill will include more oversight, tougher rules for financial firms and help for people facing foreclosure or eviction.
"While Wall Street gets to sell their bad investments to the treasury, homeowners will still be saddled with mortgages they can't afford," said Sen. Richard Shelby, R-Ala. "Wall Street bet that the government would rescue them if they got into trouble. That may be the bet that pays off."
Democrats and some Republicans also were pressing for more extensive changes, including limits on executive pay and requiring financial firms to sell the government stock that could recoup any profits from a revival following the bailout. "The custom on Wall Street is when you assume the risk, you get paid for that," said Sen. Jack Reed, D-R.I.
President George W. Bush told reporters Tuesday in New York that he had talked with world leaders about Treasury Secretary Henry Paulson's plan. "And now they're wondering about our Congress," Bush said. "And I've assured them as well, having spoken to the leaders of Congress of both political parties, that there is the desire to get something done quickly."
Democrats warned that Republican support would be essential to passing any bill. House Majority Leader Steny Hoyer of Maryland called on Bush to address the nation in a prime-time speech, saying he needed to explain the need for the bailout to the American people.
Under the plan Paulson pitched to Congress last week, the treasury would buy $700 billion worth of bonds and other securities based on mortgages that banks currently can't or won't sell. By boosting the market for such debt, Paulson said he hopes to reset the financial system, taking out the bad loans and getting banks to begin lending again.
The alternatives drafted by Sen. Christopher Dodd, D-Conn., and Rep. Barney Frank, D-Mass., would allow the treasury to accept reasonable requests to modify the terms of mortgages it buys. They also would allow renters to stay in foreclosed properties as long as their payments were up-to-date. The latest versions of the bailout plan broaden the kinds of investments the treasury could buy to include troubled assets, such as actual mortgage loans.
But auto lending firms are lobbying to have car loan-backed debt covered by the bailout as well. Sen. Charles Schumer, D-N.Y., said during Tuesday's Senate hearing that the auto lending market essentially had been closed to buyers with credit scores of less than 720 -- generally considered an excellent grade. Over a year, Schumer said, such limits would shave 6 million vehicles, roughly a 35% drop, from typical annual sales of 17 million.
"Even though the workers in Buffalo and Detroit and St. Louis are blameless, they will suffer," Schumer said. The American Financial Services Association, a trade group of lenders, said in a statement Tuesday that the plan should be expanded to cover auto finance companies and car loans.
"As a result of the ripple effect of the credit crunch in the mortgage sector, the ability of finance companies to secure credit lines from investors has been brought to a virtual standstill," said AFSA President and Chief Executive Officer Chris Stinebert. "Absent intervention by Congress, the ability of domestic manufacturers to finance new motor vehicle sales may come to a halt."
Linda Becker, a spokeswoman for Chrysler LLC, said the company was looking at the proposal. GMAC spokeswoman Gina Proia declined to comment on the request, saying GMAC supported any move that would stabilize markets. Ford Credit spokeswoman Brenda Hines said the company was not involved in any talks on the Paulson bailout plan.
Paulson said the treasury eventually would make some of the $700 billion back when it sold the assets it plans to buy, and that unfreezing credit markets would provide the most relief to all homeowners. "The American taxpayer is already on the hook," Paulson told a hearing of the Senate Banking, Housing and Urban Affairs Committee. "The best protection for the taxpayer and the first protection for the taxpayer is to have this work."
Merrill Lynch's Wolf Sees Meltdown for Canadian Housing Market
The Canadian housing market is headed for a meltdown because households finances are in even worse shape than in the U.S. or the U.K., said David Wolf, chief strategist Merrill Lynch & Co. Canada.
Wolf said in a report published today that Canadian families in 2007 carried an average net debt load that was 6.3 percent of their disposable income, more than in the U.K. and "not far off" from the 2005 peak in the U.S.
"We fear that it may simply be a matter of time" before home prices start plunging, Wolf said. "We're just now starting to see house prices fall in Canada, and sharp rises in unsold home inventories increasingly imply that this will not be a transitory phenomenon."
The average resale price for existing homes in Canada's major markets fell to C$316,052 ($305,600) in August, 5.1 percent lower than a year earlier, the Canadian Real Estate Association said on Sept. 15. The Bank of Canada said in July that housing would cut 0.1 percentage point off economic growth this year, after adding 0.2 percentage point last year.
"I do not accept this conclusion, not at all," Prime Minister Stephen Harper told reporters in Vancouver today when asked about Wolf's report. "We will not see the same situation as in the United States," he said, citing stronger consumer demand and the absence of subprime mortgages in Canada.
SEC plans action against Royal Bank
U.S. federal enforcement officials are turning their sights to the Royal Bank of Canada as they crack down on financial institutions amid mounting public anger over a plan to bail out banks exposed to the credit crisis at the expense of taxpayers, according to officials.
Canada's largest bank is at the top of the list for enforcement agents at the Securities Exchange Commission who are pursuing financial institutions implicated in the collapse of the $330-billion auction-rate securities market, according to two federal officials. The collapse of the market in the spring left many Americans unable to access funds they believed would be there for them to pay for short-term needs like college tuition and medical expenses, according to the S.E.C.
The disclosure is the first time officials at the agency have acknowledged they are preparing a federal enforcement action against RBC, and follows a parallel probe being pursued by state authorities. The pending enforcement action would make RBC one of the first Canadian banks to be called to account for its role in the credit crisis.
The regulator is actively pursuing a case against RBC after previous investigations found firms dealing in auction-rate securities misled customers into believing the financial products were safe and highly liquid investments comparable to cash deposits, according to an enforcement officer.
A U.S. federal official said there had been a brief hiatus in enforcement actions amid the recent market panic that swept Wall Street, but authorities were redoubling their efforts after a bailout plan was proposed that leaves taxpayers on the hook for losses on complex securities that have gone bad.
An RBC executive said Wednesday the bank was working with regulators, and indicated management at the bank's capital markets operations expected to reach a comprehensive settlement with U.S. authorities. The bank faces an estimated payout of $1-billion based on precedent-setting agreements negotiated with other U.S. and international institutions by state and federal authorities to buy back securities held by individual customers, charities and small businesses, and to reimburse those clients for damages.
RBC is also the target of a class-action law suit from customers of the bank alleging there was mis-selling of the securities pursuant to "top down management directives", according to a filing submitted to in a U.S. district court by law-firm Girard Gibbs. The filing and the wider probe by federal authorities is also investigating the extent to which dealers continued to market auction rate securities as liquid investments even after it became clear the system for maintaining cash flows could collapse.
The focus of the investigation into RBC's activities is its treatment of individuals and families rather than institutional investors, reflecting a significant shift by U.S. authorities that have focused largely on bigger shareholder losses in recent financial crisis.
Auction-rate securities became a favoured form of financing used by dealers amid the credit boom, but when the market froze many customers were unable to access their money and some were left holding securities that will not mature for decades.
The focus of regulators has been on getting these customers their money back, though the SEC is now expected to zero in on the conduct of bankers after a fresh agency directive that investigations encompass the conduct of individuals as a deterrent to others.
RBC has already begun writing down its estimated $4.9-billion exposure to the auction-rate securities market and has been setting aside money for losses on U.S. credit markets.
But over the past decade the bank's American and capital markets operations have been a big contributor to earnings. Wednesday RBC underlined its continued commitment to its U.S. operations by dividing its capital markets empire between Toronto and New York, appointing co-heads in each city.
Gordon Brown warns short-selling ban may become permanent
Speaking at the Labour Party conference, Gordon Brown signalled that at least some elements of the crack-down on short-selling imposed by the Financial Services Authority last week would continue.
Meanwhile, the FSA said it might name and shame and even fine – hedge funds which do not disclose short positions in banks. The move came after Eton Park, a hedge fund set up by former Goldman Sachs bankers, yesterday announced to the stock exchange its short position in HSBC was 0.28pc. The hedge fund also disclosed the position on Tuesday.
The FSA attempted to stop the battering of banks' shares on Thursday by banning new short selling in financial stocks and forcing investors to disclose existing positions by Tuesday. Mr Brown defended the ban, saying "when a group of people are exploiting a difficult economic situation, it is right to stop it."
The FSA said the ban would be in place until January when permanent new rules on shorting would be formulated. Mr Brown said: "I think you'll find new rules come in for the future...We have very unusual and volatile financial markets . It would be wrong for good companies to be brought down by speculators."
Darren Fox, a lawyer at Simmons & Simmons who represents some of London's biggest hedge funds, said his clients were "really quite shell shocked and juggling about 15 balls in the air". However, the FSA has still made limited amendments to last week's ban. Yesterday the regulator said the restrictions would be measured on a fund by fund basis, not at a manager level.
This means that even if a fund manager has an overall long position due to balancing between long and short positions, he or she still has to disclose the holding in each fund. Clive Cunningham, a partner at law firm Taylor Wessing, said the FSA would probably have to put any future rules on shorting on firmer footing than they are on currently. "Last week's action was taken under the Code of Market Conduct, which are guidelines not a legal rule," Mr Cunningham said.
Man Group, the London-listed hedge fund, has lobbied the FSA to be added to the list of protected shares which cannot be shorted. Despite being a hedge fund, Man has argued its shares have been hit as investors have been forced to stop selling mainstream banks and insurers.