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2008 October 01 Wednesday
Credit Crunch Spreading

Car sales are tanking as many potential buyers can't get auto loans. Even Toyota sales are down 32.3%, almost as bad as Chrysler.

Nearly every automaker posted double-digit declines. Sales were down 34.5 percent at the Ford Motor Company, 32.8 percent at Chrysler, 32.3 percent at Toyota and 24 percent at Honda.

Fewer car loans are getting approval.

Loan refusals are at their highest levels since 1984, when the data started to be tracked. CNW Marketing Research, Bandon, Ore., reported that just 63% of auto loans have been approved this year, vs. 83% last year.

Credit gets used to buy many things. This decrease in credit availability for cars is getting repeated in other industries for buying other types of goods and services.

Warren Buffett says he's never seen economic fear this bad. He's 78 years old btw.

Billionaire Warren Buffett, the world's preeminent stock picker, said the U.S. economy is ``flat on the floor'', in a television interview with Charlie Rose that was to air late yesterday on PBS.

Economic Fear

``In my adult lifetime I don't think I've ever seen people as fearful, economically, as they are now,'' said Buffett, chairman of Omaha, Nebraska-based Berkshire Hathaway Inc.

AT&T has a hard time selling commercial paper and it is a profitable company.

AT&T Inc. Chairman and CEO Randall Stephenson said Tuesday that his company was unable to sell any commercial paper last week for terms longer than overnight. Commercial paper, which helps lubricate the flow of business operations, is a short-term IOU available to corporations that banks usually know are good for the money.

New securities issues are tanking.

Total securities underwriting fell to $803 billion in the third quarter, down 55% from the second quarter and 43% below the third quarter of last year, according to Thomson Reuters, which tracks new securities issues. Imputed fees fell 41% from the third quarter of 2007, to $4.9 billion, a six-year low.

With commercial-paper markets and interbank lending both sputtering, and an entire week without a single investment-grade bond deal after Lehman Brothers Holdings Inc. filed for bankruptcy protection, some bankers said the credit markets were nearing the kind of "systemic failure" that has long been suggested could be a doomsday scenario for the markets.

Cattle farmers are finding it hard to borrow.

The credit crisis has made it tough for ranchers and farmers to place their "feeder" cattle at feedlots to be fattened on corn and other feed before slaughter, with deposit requirements doubling in some cases to 40 percent of the cost.

New York research firm Innovest Strategic Value Advisors says credit card bad debts will cost about $100 billion in the US in 2009.

“If history is any indicator, there should be an equivalent surge in credit-card charge-offs very soon,” he said. “We forecast first quarter credit-card charge-offs will be $18.6-billion (U.S.) and that the total 2009 charge-off bill will add up to $96-billion.”

Laura Nishikawa, Innovest's consumer finance analyst, said the credit card issuers that will be hurt least in the coming crunch will be those who had the “foresight” to improve their risk management performance during the bull market, even if they sacrificed some growth in the process.

We've been living beyond our means. That's going to stop.

The banking crisis is going global.

In the last two days, governments from London to Berlin have seized or bailed out five faltering banks. In Ireland, where rumors of panicked withdrawals from banks spooked the stock market, the government has offered a two-year blanket guarantee on all deposits and bank debt.

Asia has been less buffeted by the turmoil, though a brief run on a bank in Hong Kong last week brought back dark memories of June 1997, when speculation against the Thai currency sparked a financial crisis that fanned rapidly across Asia, and later to Brazil and Russia.

Several European financial institutions have needed rescue recently.

As Fortis was being rescued, the British government took control of Bradford & Bingley, a medium-sized mortgage lender. The government is nationalizing the £42-billion ($76-billion U.S.) mortgage book, whose default rate was climbing as the British property market soured. Santander, the Spanish banking giant, agreed to buy Bradford & Bingley's £21-billion deposit book and 197 branches for about £600-million.

Two other European banks, Germany's Hypo Real Estate, a property-financing bank, and Iceland's Glitnir Bank, were also offered lifelines as the financial crisis spread like wildfire. Hypo was offered a credit line from a group of local financial institutions. It did not reveal the size of the loan, though media reports put it at about €35-billion. Still, investors abandoned Hypo shares, sending them down 74 per cent to €3.52.

In the US mortgage applications dropped sharply.

In yet another sign of the economic crisis, the Mortgage Bankers Association said Wednesday that mortgage applications plunged 23% last week.

How much further to the bottom?

By Randall Parker    2008 October 01 10:30 PM Entry Permalink | Comments (12)
2008 September 20 Saturday
Prevent Banks From Being Too Big To Fail?

Steve Sailer proposes size limits on financial institutions so that they don't become too big to fail.

There is a lot of talk about how we need more governmental regulation of today's enormously complex financial markets, but the obvious problem with that is that barely anybody understands how today's enormously complex financial markets work, and those that do generally have better things to do than get paid at civil servants' salary levels.

So, what we need are a few new but simple regulations. But those are hard to come up with. Let me toss one idea out there: We shouldn't permit financial institutions to get too big to fail.

But I do not think size by itself is the problem. First off, Hank Paulson decided that Lehman Brothers could fail but AIG couldn't. Why? AIG was an insurer for lots of securities that lots of banks and other financial institutions held. If AIG failed then all that insurance would have become worthless and all those securities would have been downgraded. Then the banks would have sold those securities and took huge losses. The point here: AIG was too intertwined with other financial institutions.

So I would argue that bigger financial institutions should get saddled with more restrictions in order to limit their ability to take other institutions with them when they crash. Limit counterparty risk.

AIG's losses came in security instruments that started out with AAA ratings. Are ratings agencies the biggest causes of the financial crisis?

It now appears that a large proportion of AIG’s $41bn in writedowns stem from its exposure to so-called supersenior instruments, or the most senior chunks of pools of debt backed by mortgage and corporate bonds.

Until last summer, these instruments were considered so utterly safe and dull that they carried a triple A rating and rarely moved in price. That was because these instruments sat so high in the capital structure that they only suffer losses if a tsunami of defaults occur – and in the halcyon days before the credit crunch most investors, and rating agencies, found it impossible to imagine such a shock. However, this once-unthinkable scenario is now starting to materialise in relation to some bundles of mortgage-linked debt, causing the price of supersenior debt to fall 30 and 60 per cent, according to different measures. That has created vast mark-to-market losses at the entities holding this stuff, such as Merrill Lynch and UBS. It has also hit AIG, both in terms of securities it holds and those it has insured.

Update: A better idea: Prevent banks from buying securities that are AAA rated only as a result of being insured. Security insurance sets up the conditions of a massive failure. If the insurance agency fails then massive numbers of securities get downgraded and dumped all at once.

By Randall Parker    2008 September 20 11:00 PM Entry Permalink | Comments (2)
2008 September 18 Thursday
Treasury 3 Month Rate Almost 0%

The US 3 month Treasury Bill rate has fallen to almost 0%.

Investors pushed down the rate to 0.0203 percent on concern that credit market losses will widen after the bankruptcy of Lehman Brothers Holdings Inc. and the federal takeover of American International Group Inc. In a sign of banks' reluctance to lend, the rates charged for short-term loans relative to U.S. bill rates rose to the highest on record.

That rate has never been so low since before World War II. Yes, you have to go back to the late Great Depression years for a T-bill rate that low.

The Treasury-EuroDollar (TED) Spread, a measure of flight from risk, has soared.

The Wall Street Journal reported in Wednesday’s newspaper that overnight LIBOR, a key interbank lending rate, had surged to more than 6%. That rate declined to 5.03125% overnight. However, the key three-month lending rate rose to 3.0625% from 2.87625%. Despite news of the Federal Reserve’s bailout of American International Group, worries about liquidity spiked on news that U.K. bank HBOS may be facing short-term funding problems.

The TED spread hasn't been this big since 1987 or perhaps earlier.

Goldman Sachs might be able to stay independent. But the other still independent US investment bank, Morgan Stanley, is looking for a merger partner.

Seeking to avoid the kind of fate that led Lehman and Bear Stearns to collapse, John J. Mack, Morgan Stanley’s chief executive, made an unsuccessful effort on Tuesday evening to persuade Citigroup’s chief executive, Vikram S. Pandit, to enter into a combination, according to people briefed on the talks.

“We need a merger partner or we’re not going to make it,” Mr. Mack told Mr. Pandit, according to two people briefed on the talks.

Washington Mutual has put itself up for sale and Citibank might buy it instead.

Will a few mergers stop the financial panic? Or will it spread?

By Randall Parker    2008 September 18 12:06 AM Entry Permalink | Comments (1)
2008 September 17 Wednesday
Financial Reform Debate Intensifies

Peter J. Wallison, formerly general counsel of the Treasury Department in the Reagan administration, argues that US Treasury Secretary Hank Paulson took over Freddie Mac and Fannie Mac in a way that guarantees further Congressional mischief.

Mr. Paulson has correctly noted that Fannie and Freddie operate on flawed business models -- as government-sponsored enterprises they have conflicting missions, and force the taxpayers to subsidize the risk-taking of for-profit managements. But he argued that, after they have been re-established as operating companies, Congress can decide their future.

This is stunningly naive. Recent statements by Barney Frank (D., Mass.), the chairman of the House Financial Services Committee, and Chuck Schumer (D., N.Y.), a powerful member of the Senate Banking Committee, make clear that Congress will never let them be privatized, broken up, slimmed down, nationalized or any of the other options hopeful reformers are putting forth today. Fannie and Freddie in their current form are just what Congress wants: an inexhaustible source of campaign contributions and funds for favored groups.

But was there a way for Paulson to reduce the future mischief potential of Fannie and Freddie? Wallison says yes.

What should have been done? A receiver, not a conservator, should have been put in charge of Fannie and Freddie. A receiver could have wiped out the common and preferred shares, repudiated unfavorable contracts, created a good bank/bad bank structure for isolating the bad assets, and otherwise taken steps to reduce the losses to taxpayers.

A web site called which tracks campaign donations has a chart that shows Senator Barack Obama was the second largest recipient of campaign donations from Fannie Mae and Freddie Mac from 1989-2008. Senator Christopher Dodd, chairman of the Senate Banking Committee, was the biggest recipient of Fannie/Freddie money. Though in 2008 alone the New York Times finds McCain got more from Fannie and Freddie than Obama did. Neither Dodd nor Obama want to abolish or privatize Fannie and Freddie. Not sure where McCain stands on this question.

Fannie and Freddie have been a way for former high officials in government to hop into the public-private hybrid sector and make a lot of money.

Fannie and Freddie have also been places for big Washington Democrats to go to work in the semi-private sector and pocket millions. The Clinton administration's White House Budget Director Franklin Raines ran Fannie and collected $50 million. Jamie Gorelick — Clinton Justice Department official — worked for Fannie and took home $26 million. Big Democrat Jim Johnson, recently on Obama's VP search committee, has hauled in millions from his Fannie Mae CEO job.

Tyler Cowen says we had incorrect regulation of the financial industry.

In short, there was plenty of regulation — yet much of it made the problem worse. These laws and institutions should have reined in bank risk while encouraging financial transparency, but did not. This deficiency — not a conscientious laissez-faire policy — is where the Bush administration went wrong.

It would be unfair, however, to blame the Republicans alone for these regulatory failures. The Democrats have a long history of uncritically favoring expansion of homeownership, which contributed to the excesses at Fannie Mae and Freddie Mac, the humbled mortgage giants.

Even with the crisis well advanced Democrats in Congress wanted Fannie and Freddie to dig their holes even deeper.

The privatization of Fannie Mae dates back to the Johnson administration, which wanted to get the agency’s debt off its books. But now, of course, the government is on the hook for the agency’s debt. As late as this spring, Congressional Democrats were pushing for weaker capital requirements for the mortgage agencies.

This reminds me of the savings and loan crisis that reached a climax while Ronald Reagan was President. The genesis of the crisis was in the 1970s when inflation drove up interest rates that the S&Ls had to pay and made them insolvent. Well, rather than shut down all those S&Ls Congress, and chiefly though not solely Democrats in Congress, decided to raise the limits on what the savings and loans could do in hopes that by raising their insured deposit limits and letting them into new lines of business that they'd be able to earn their way out of insolvency. Instead these financial institutions dug holes even deeper leading to the Keating Five scandal where John McCain found his character questioned and he became a tireless crusader against private donations to election campaigns.

I think that banks shouldn't be able to buy bond insurance policies. Bank health shouldn't be wrapped up with insurance industry health.

By Randall Parker    2008 September 17 11:50 PM Entry Permalink | Comments (2)
2008 September 16 Tuesday
US Federal Reserve Rescues Insurer AIG

$1.1 trillion insurer American International Group (AIG) avoids collapse by a Fed takeover. Since AIG isn't a bank the Federal Deposition Insurance Corporation couldn't step in. So the Fed did the deed.

The Federal Reserve Board on Tuesday, with the full support of the Treasury Department, authorized the Federal Reserve Bank of New York to lend up to $85 billion to the American International Group (AIG) under section 13(3) of the Federal Reserve Act. The secured loan has terms and conditions designed to protect the interests of the U.S. government and taxpayers.

The Board determined that, in current circumstances, a disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth, and materially weaker economic performance.  

The purpose of this liquidity facility is to assist AIG in meeting its obligations as they come due. This loan will facilitate a process under which AIG will sell certain of its businesses in an orderly manner, with the least possible disruption to the overall economy. 

The AIG facility has a 24-month term. Interest will accrue on the outstanding balance at a rate of three-month Libor plus 850 basis points. AIG will be permitted to draw up to $85 billion under the facility.

The interests of taxpayers are protected by key terms of the loan. The loan is collateralized by all the assets of AIG, and of its primary non-regulated subsidiaries.  These assets include the stock of substantially all of the regulated subsidiaries.  The loan is expected to be repaid from the proceeds of the sale of the firm’s assets. The U.S. government will receive a 79.9 percent equity interest in AIG and has the right to veto the payment of dividends to common and preferred shareholders.

If the counterparty risk of an AIG collapse is as massive as some people say it is then the most surprising thing about the AIG crash is just how little the stock market went down as this crisis intensified. My interpretation: the big players on Wall Street knew that Ben Bernanke and Hank Paulson would find a way to prevent the house of credit default swap (CDS) cards from falling down. The threat was so massive that the disaster wouldn't be allowed to happen.

But how could the Fed intervene without legal authority from Congress to take over an insurance company? Before this deal was announced some commentators were opining that the Fed does not have the legal authority to lend tens of billions of dollars to an insurance company and become a big stock holder in it. Well, the law is what government entities decide is the law. Megan McArdle opines (correctly in my view) no major player is going to try to stop the Fed because noone wants responsibility for the problem.

It's probable that they don't actually have the legal right to do anything like this. Their authority is this: who's going to stop them? No one wants to take on responsibility for this mess themselves.

Megan has many thoughtful observations about which regulatory changes might reduce the risk of another massive financial failure.

Given AIG's role as a very large scale insurer of debt securities its collapse could have caused a massive disastrous chain reaction. I know some of you do not believe this. But seems likely to me.

What frightened Fed and Treasury officials was not simply the prospect of another giant corporate bankruptcy, but A.I.G.’s its role as an enormous provider of financial insurance, which effectively requires it cover losses suffered by other institutions in the instance of defaults of securities that they have purchased. That means A.I.G. is potentially on the hook for securities that were once considered safe.

If A.I.G. had collapsed — and been unable to pay all of its insurance claims — institutional investors around the world would have been instantly forced to reappraise the value of billions of dollars in debt securities, which in turn would have reduced their own capital and the value of their own debt.

“It would have been a chain reaction,” said Uwe Reinhardt, a professor of economics at Princeton University. “The spillover effects could have been incredible.”

What financial regulatory changes are needed to make the financial world less like a house of cards?

The Fed claims it won't lose money on the deal. Supposedly AIG is faced with a liquidity crisis, not an insolvency crisis.

According to the Fed’s statement on the deal, it has a two-year term, and will pay an interest rate of three-month Libor plus 850 basis points. Taxpayers are protected, the bank said, by the fact that the loan is collateralized by all of the assets of AIG and its subsidiaries. As of its most recent SEC filing, AIG was reporting assets of $ 1 trillion.

David Leonhardt of the New York Times wonders whether bailouts make things worse in the long run.

Barry Ritholtz — who runs an equity research firm in New York and writes The Big Picture, one of the best-read economics blogs — is going to publish a book soon making the case that the bailout actually helped cause the decline. The book is called, “Bailout Nation.” In it, Mr. Ritholtz sketches out an intriguing alternative history of Chrysler and Detroit.

If Chrysler had collapsed, he argues, vulture investors might have swooped in and reconstituted the company as a smaller automaker less tied to the failed strategies of Detroit’s Big Three and their unions. “If Chrysler goes belly up,” he says, “it also might have forced some deep introspection at Ford and G.M. and might have changed their attitude toward fuel efficiency and manufacturing quality.” Some of the bailout’s opponents — from free-market conservatives to Senator Gary Hart, then a rising Democrat — were making similar arguments three decades ago.

Well, I do not want to see most of the banks collapse like a bunch of dominoes just so some investors will learn some lessons. Sure, the Great Depression taught a whole generation to be wary about investments and debt. But do you want to live through that kind of educational experience? I don't.

As far as Detroit in the early 80s is concerned: the US Congress has kept the automakers in a slow death bear hug with the UAW. That's not the fault of the people who run the car companies. Also, a continuing focus on fuel efficiency would not have worked as gasoline prices fell and the car buyers decided they wanted big cars once again.

By Randall Parker    2008 September 16 10:19 PM Entry Permalink | Comments (29)
2008 September 14 Sunday
Liquidity Crisis Unfolds Over Weekend

In case you have missed the scope of what is unfolding here's a list of the major Wall Street and Federal Reserve events of this weekend. The big banks are afraid of a liquidity crisis and stronger banks are banding together.

Second, to establish a collateralized borrowing facility, which ten banks (Bank of America, Barclays, Citibank, Credit Suisse, Deutsche Bank, Goldman Sachs, JP Morgan, Merrill Lynch, Morgan Stanley, and UBS) have committed to fund for $7 billion each ($70 billion in total). The facility will be available to these participating institutions for liquidity up to a maximum of one third of the facility for any one bank. It is anticipated that the size of the facility may increase as other banks are permitted to join the facility.

Nouriel Roubini said on CNBC that the investment banks can not survive as independent units. So Morgan Stanley will need to tie up with a conventional bank if it is to survive. The effects of the Glass-Steagall Act (which separated investment banks from retail banks) have been almost totally reversed.

Lehman Brothers might be headed into chapter 11 bankruptcy. At the time of this writing they are trying to sell themselves to one last potential suitor.

As potential suitors walked away from a deal to rescue Lehman Brothers Holdings Inc on Sunday, it became increasingly likely that the only place the troubled investment bank has to turn is a bankruptcy court.

The biggest insurer in the United States, AIG, is fighting for its survival.

American International Group, the nation's largest insurer, plans to unveil a restructuring plan as soon as Monday morning that will include selling off part of its business to raise cash and boost investors' confidence, according to a published report.

Other big investment banks are afraid they too will find it impossible to raise capital at affordable rates. Merrill Lynch decided to cut a deal before they went up against the wall. Bank of America is to buy Merrill Lynch for $29 per share.

Bank of America has struck a $44 billion deal to buy Merrill Lynch, according to two people familiar with the negotiations, a merger that will unite the nation's largest consumer bank with one of its most celebrated investment banking firms.

Many months after Warren Buffett said we were going to have a long deep recession due to financial reasons former Fed chief Alan Greenspan is now saying we are going thru a once-in-a-century financial crisis. Er, wouldn't that make it worse than the Great Depression?

The United States is mired in a "once-in-a century" financial crisis which is now more than likely to spark a recession, former Federal Reserve chief Alan Greenspan said Sunday.

The talismanic ex-central banker said that the crisis was the worst he had seen in his career, still had a long way to go and would continue to effect home prices in the United States.

"First of all, let's recognize that this is a once-in-a-half-century, probably once-in-a-century type of event," Greenspan said on ABC's "This Week."

The Federal Reserve has just announced a broadening in the types of collateral it will accept from major banks. This is a move to allow the Fed to give more banks more very large sums of money.

The collateral eligible to be pledged at the Primary Dealer Credit Facility (PDCF) has been broadened to closely match the types of collateral that can be pledged in the tri-party repo systems of the two major clearing banks. Previously, PDCF collateral had been limited to investment-grade debt securities.

The collateral for the Term Securities Lending Facility (TSLF) also has been expanded; eligible collateral for Schedule 2 auctions will now include all investment-grade debt securities. Previously, only Treasury securities, agency securities, and AAA-rated mortgage-backed and asset-backed securities could be pledged.

These changes represent a significant broadening in the collateral accepted under both programs and should enhance the effectiveness of these facilities in supporting the liquidity of primary dealers and financial markets more generally.

The recession is going to deepen, housing prices will continue to fall, and default rates will rise on more types of credit aside from mortgages. Major financial institutions have fallen just from the mortgage crisis. So what happens to the rest of them as the bad credits start piling up in other areas?

Update: The cost of insuring against company defaults soared even for seemingly stronger firms such as Morgan Stanley and Goldman Sachs. This illustrates how deeply the market distrusts all the investment banks at this point.

Among some market participants, the wait on Sunday was excruciating. There was trading in credit default swaps — contracts that allow traders to buy or sell protection against a company defaulting on its debts, and there were few willing to sell such protection.

Instead, traders said, the cost of buying protection against defaults soared, even for financial firms that are considered to be in good shape, like such as Morgan Stanley and Goldman Sachs.

If the markets do not trust the investment banks then the other market participants will be reluctant to take the opposite side of trades with them or to let large amounts of money flow through the investment banks.

Will stock prices go through a huge decline on Monday or some other day soon?

Some even recalled the stock market crash in 1987, the biggest fall ever seen by the current generation of Wall Streeters. “This is an earth-shattering event, this is like a tectonic plate shifting event,” said Thomas Priore, chief executive of Institutional Credit Partners, a hedge fund active in credit markets. “This is welcome back to Black Monday.”

Update: What caused this debacle? Something this big requires multiple causes that all come together. First off, the East Asians bid up the dollar and drove down interest rates so that we could live beyond our means without causing consumer price inflation. This fed into the real estate bubble. Second, Democrats in Congress (with support from George W. Bush and Bill Clinton before him) pressured financial institutions to lend lots of money in sub-prime mortgages to poor blacks and Hispanics (see more here). This helped lower the quality of mortgage debt. Third, the price of oil skyrocketed and drained disposable income. This comes courtesy of Peak Oil. The problem is going to get worse.

By Randall Parker    2008 September 14 07:44 PM Entry Permalink | Comments (21)
2008 September 10 Wednesday
Tyler Cowen Sees Treasury Had No Choice Over Mortgage Agencies

The US government had to bail out Freddie Mac and Fannie Mae because the only other alternative was another Great Depression.

But let's say that the Treasury did not support the debt of the mortgage agencies. The Chinese bought over $300 billion of that stuff and they were told that it is essentially riskless. The flow of capital from them and from other central banks, sovereign wealth funds, and plain old ordinary investors would shut down very quickly. The dollar would fall say 30-40 percent in a week, there would be payments system gridlock, margin calls at the clearinghouses would go unmet, and only a trading shutdown would stop the Dow from shedding half its value. Most of the U.S. banking system would be insolvent. Emergency Fed/Treasury action would recapitalize the FDIC but we would lose an independent central bank and setting the money supply would be a crapshoot. The rate of unemployment would climb into double digits and stay there. Many Americans would not have access to their savings. The future supply of foreign investment would be noticeably lower. The Federal government would lose its AAA rating and we would pay much more in borrowing costs. The deficit would skyrocket.

Oh come on Tyler, don't hold back. Tell us what you really think.

David, I don't think of those as extreme predictions! Maybe the dollar would fall only by 20 percent. If nothing else, just imagine what happens when the banks holding all that agency paper are formally belly-up, all at the same time, not to mention the effects from agency equity, which we will be seeing as it stands. Or think about how highly leveraged and thinly capitalized so many parts of American finance are. Look at what kind of assets money market funds are holding and what would happen if there was a general run on such funds. Under these scenarios the U.S. financial system shuts down for a while and that doesn't require any radical assumptions. It's another Great Depression. Abroad, the Chinese and others would be *very* surprised to take losses on agency debt. Blame it on a collective nudge-nudge, wink-wink if you want, but that is their market expectation, very much encouraged by the U.S. government, and they would view anything else as equivalent to expropriation.

Tyler's argument is that while Freddie and Fannie as semi-private government corporations are really bad ideas it is too late to basically disown those corps and let them collapse. Too much US government financial credibility was invested in their lack of risk. If we let their creditors lose their money a lot more other US government obligations would come to be seen as lacking credible backing.

Tyler says US banks have too much in Freddie and Fannie debt issues and would collapse if their debt became worth little.

1. The current operation of the money market requires ongoing faith in a variety of assets and commitments.  Just try tracing through the consequences of a general "run" on money market funds, which "promise" a redemption ratio of $1 a share but on the other hand really don't make such a promise.  How quickly would Merrill Lynch cry Uncle, how quickly would the Fed's balance sheet be exhausted, and how many commitments would they have made in the meantime and how many people would have to sell stocks to find cash and make margin calls?  Or think about what would happen if FASB ruled that Frannie debt securities did not qualify as "ready cash" for accounting purposes.  (As a general tendency I find that economists vastly underrate the importance of accounting as an economic force.  I might add that many market advocates are unaware of how quickly liquidity can vanish in these markets; just look at auction-rate securities.)  And those aren't even the biggest potential problems arising from a default.

Tyler thinks the US government made promises that left it with no other choices than to bail out Freddie and Fannie.

How many phone calls do you think Hank Paulson has received from the Chinese central bank since August 2007?

"Are you *sure* that paper is safe enough for us to keep on buying?"

We'll never know exactly what kind of verbal dance Paulson concocted in response, but just look at the resulting flow of purchases and the relatively slight mark-up over Treasuries over that period of time. The Chinese (among others) thought we were standing behind the securities, at least in any world-state short of federal government quasi-bankruptcy. (In fact Paulson is in a total bind once that phone call comes in. He doesn't have much incentive to just say "tough luck" and precipitate a crisis when otherwise no crisis is on the horizon.)

Note that the financial crisis is so large at this point that bad decisions by the US Treasury Secretary could precipitate a global financial meltdown and Great Depression. The stakes in this game are very high.

On the bright side, if the Chinese stopped buying our debt we would stop running a trade deficit with them as the dollar plunged in value. But that'd be a hollow victory for us as the US economy would enormously contract if the world lost faith in our debt.

By Randall Parker    2008 September 10 11:15 PM Entry Permalink | Comments (12)
2008 August 24 Sunday
US Federal Reserve Holds Interest Rates Low To Help Banks

The central bank of the United States basically is transferring money from everyone else to bail out banks.

Ben S. Bernanke, the chairman of the Federal Reserve, rejects that thinking, as do a majority of the Fed’s policy makers. They argue — and several of them repeated their arguments in interviews here that were mostly off the record — that they had no choice but to cut the key lending rate that the Fed controls to 2 percent from 5.25 percent in just eight months. Otherwise, they said, the housing and credit crises would have resulted in much more damage to the economy.

The Fed is basically using low interest rates to subsidize banks. The low interest rates boost inflation and therefore take money away from everyone else. The money gets transferred ot banks. The Fed exists to protect bank shareholders. You pay bank shareholders via inflation and via lower interest rates you get paid on bank accounts and bonds.

Now, they argue, the so-called federal funds rate must be kept at 2 percent — for no one knows how long — so that banks and other lenders can borrow at low rates and lend at higher ones, using their fattened earnings from this process to rebuild the capital they need. The banks’ capital eroded as numerous loans made during the bubble years went bad and were written off, reducing their ability and willingness to lend to the public.

“Lenders have been hit by a shock so severe that they are contracting and withdrawing from private sector lending,” Janet L. Yellen, president of the Federal Reserve Bank of San Francisco, said in an interview.

Lower interest rates mean that if you are a saver and put your money into certificates of deposit (CDs) at banks then you get paid less. Basically, part of the money to help banks recover is getting taken from you and the interest rate you get paid isn't enough to keep ahead of inflation. You aren't compensated for this. You aren't getting shares in these banks in exchange for helping to build up their capital reserves.

Do the rest of us derive a big enough benefit to make subsidizing banks in this fashion justified for the common good?

By Randall Parker    2008 August 24 08:05 PM Entry Permalink | Comments (4)
2007 December 15 Saturday
Frozen Credit Markets Compel Central Banks To Operate In Unison

A group of central banks made up of the US Federal Reserve, the Bank of Canada, the European Central Bank, the Bank of England, and the Swiss National Bank tried to work in unison to inject cash into credit markets to try to unfreeze them.

The Bank of Canada joined the U.S. Federal Reserve and other central banks yesterday in an audacious attempt to ease choked credit markets without resorting to inflation-stoking interest-rate cuts.

Analysts said the moves, billed as the biggest act of coordinated economic co-operation since 9/11, could be a novel way to get borrowing rolling again or a costly mistake if markets fail to respond and the freeze in borrowing drags on.

Not much happening here kids. Just most of the big central banks trying to act in unison to reverse a worsening global financial crisis. What, me worry?

This action is apparently unprecedented in scope.

If there is a precedent for yesterday's joint operation to inject liquidity into the international finance system by the western world's five leading central banks, we have yet to find it.

There was some co-ordination of activity after 9/11 but this operation is of a wholly different magnitude. The new multi-billion dollar facility is the starkest illustration yet of the alarming scale of the collapse of credit - and a welcome sign that central banks are treating it with the seriousness it deserves.

We have this size of crisis and world oil production hasn't even started to decline rapidly. Wait till that happens and this crisis will seem like small potatoes in comparison.

They certainly gave it the good old college try. But oops, darn it, the attempt looks like a dud.

The biggest concerted effort by central banks in six years to restore confidence in global money markets is showing little sign of success.

The rates banks charge each other for three-month loans held at seven-year highs for a second day after policy makers in the U.S., U.K., Canada, Switzerland and the euro region agreed to ease the logjam in short-term credit markets. The cost of borrowing in euros stayed at 4.95 percent, the British Bankers' Association said today, up from last month's low of 4.57 percent and 3.68 percent a year ago.

Noone knows how to value huge quantities of SIVs and other obscure debt instruments. Any institution that holds lots of them has a balance sheet that can't be deciphered. What is Citibank worth? That's an extremely speculative question. Is Morgan Stanley or Chase solvent? Hard to tell. A lot of investors thought our markets are very transparent and now they discover they can't trust debt ratings issued by Fitch, Moody's or Standards & Poors.

The ratings agencies are paid by the very organizations that want their bonds to get high ratings.

Rating agencies face a similar conflict to that of independent experts – that is, they are paid by the very people upon whom they are assessing. Ratings agencies are paid hefty sums by bond issuers to assess the creditworthiness of the asset. Moody’s is a stand-alone publicly listed company on the NYSE, while S&P is part of publisher McGraw Hill – both have to earn a return for shareholders.

Regular (non central) banks are afraid to lend each other money.

While yesterday's joint move was sketched at the G20 a month ago, and fine-tuned in encrypted telephoned calls over the past month, the final trigger seems to have been the spike in the crucial three-month money rates that lubricate finance. Dollar and sterling Libor spreads have vaulted in recent days. Euribor spreads reached an all-time high of 99 yesterday morning.

"A co-ordinated move like this has the 'wow factor'," said Paul Mackel, currency strategist at HSBC. "But there's a lot of scepticism over whether this will be enough medicine to end the credit crisis. Is it already too late?"

It is unusual for so many banks to engender fear all at the same time.

Central banks in Europe and North America unleashed a powerful and rare arsenal of liquidity measures Wednesday meant to stave off the threat of a steep deterioration in credit conditions over Christmas.

But analysts fear the measures will only delay the inevitable balance sheet pain and market turmoil that is necessary to purge shaky debt securities from global markets. And Bank of Canada Governor David Dodge conceded he was unsure the measures would have a lasting effect.

“It's very unusual. But it's also very unusual to see all the world's banks at such risk,” said Sherry Cooper, chief economist at BMO Nesbitt Burns Inc.

“They wouldn't be doing this if they didn't know this situation is very serious.”

Dr. Irwin Kellner sees parallels with the 1930s liquidity trap.

Today there are some similarities to the liquidity trap of the 1930s. The credit crunch is clearly one of them. No matter what the Fed does on Tuesday, it will not be able to thaw out the frosty financial markets.

This is because the markets lack confidence. As I wrote two weeks ago, "fear, and not a lack of liquidity, is what's freezing up the credit markets ... and ... it's going to take a lot more than infusions of liquidity to thaw them." See Nov. 26 column

You know that fear is stronger than greed these days when banks refuse to lend to each other - never mind to businesses or to consumers.

A good indication of this is the three-month LIBOR spread against comparable maturity Treasuries. It's over 200 basis points (2 percentage points) today versus an average of about 25 bps between 2003 and this past spring.

The banking industry is experiencing a crisis in trust.

What scares the central bankers now is the evaporation of trust from the system. Banks don't believe each other's numbers; since nobody knows the real value of some of the mortgage-backed securities everyone is holding, they assume the worst. They start hoarding cash as a buffer against their own losses and because they're nervous about lending to anyone else.

I hope the central banks can prevent a much larger crisis and just limit the fall-out to a moderate recession.

By Randall Parker    2007 December 15 02:25 PM Entry Permalink | Comments (1)
2007 October 14 Sunday
Big Bank Fund To Prevent Mortgage Securities Collapse

Geez, this suggests there's a problem in the securities market that could snowball.

Several of the world’s biggest banks are in talks to put up about $75 billion in a backup fund that could be used to buy risky mortgage securities and other assets, a move designed to ease pressure on a crucial part of the credit markets that threatens the broader economy.

Citigroup, Bank of America and JPMorgan Chase, along with several other financial institutions, have been meeting to come up with a plan to create a fund that could prevent a sharp sell-off in securities owned by bank-affiliated investment vehicles. The meetings, which began three weeks ago, have been orchestrated by senior officials at the Treasury Department, and the discussions have intensified in the last few days.

If only we had access to a bunch of parallel universes we could find out if funds like this one are needed in order to prevent market meltdowns and global depressions.

Should we react to this news by thinking that wise big money knows how to prevent calamity and big money is motivated enough to prevent a depression? Or should we react by thinking that our financial system isn't all that stable and economic panics are still quite possible?

By Randall Parker    2007 October 14 01:51 PM Entry Permalink | Comments (0)
New York City No Longer Center Of Finance?

Daniel Gross, writing for the New York Times Magazine, reports signs that New York City is rapidly ceasing to be the preeminent financial capital of the world.

Some of the trends highlighted in these reports are troubling for the United States financial-services industry and for New York, its spiritual and historical home. The Committee on Capital Markets Regulation noted that the U.S. share of global initial public offerings — those outside the company’s home country — fell from 50 percent in 2000 to 5 percent in 2005. Until recently, the directors of China Construction Bank would have seen no alternative to a New York offering. Only New York had the experienced underwriters, the highly transparent, trustworthy markets and the deep pool of capital to handle such a deal. That’s no longer the case. In 2001, New York’s stock exchanges accounted for half of the world’s stock-market capitalization. Today, the total is more like 37 percent. In 2005, 9 of the 10 largest I.P.O.’s took place outside the United States. The world’s largest-ever I.P.O., the $19.1 billion offering of Industrial and Commercial Bank of China, was staged in Hong Kong in 2006. In the lucrative field of investment banking, sales and trading revenues, the McKinsey report concluded that “European revenues are now nearly equal to those in the U.S.”

Part of this is driven by technology. Trading floors are getting replaced by totally automated computerized trading. The buyers and sellers still exist scattered over many cities and countries as they always were. But there is less need for traders at the center making a market in securities. Automation is reducing labor needs. But also communications and computing technologies are reducing the need for concentrations of workers to enable them to come into close physical proximity with each other.

New York City has a great deal to lose from outsourcing.

What does all this diffusion mean for New York’s economy? Potentially, a great deal. Steve Malanga, senior fellow at the Manhattan Institute, estimates that there are 175,000 securities-industry jobs in New York, which pay an average wage of $350,000. The Committee on Capital Markets Regulation notes that the securities industry accounts for 4.7 percent of the jobs in New York City but 20.7 percent of the wages. But the impact is even larger, since the spending of Wall Street hotshots supports a huge number of other jobs. Between 1995 and 2005, the sector grew at an average annual rate of 6.6 percent in New York and provided more than a third of business income-tax revenues, according to McKinsey.

Will the high income jobs leave New York City? Will financial work diffuse across many more countries and cities?

The high cost of doing business in New York combines with technologies that eliminate the need for close physical proximity. The result is that new companies can start up in lower cost locations and rapidly grab big chunks of market share away from NYC-based companies.

Because of the high costs of living and doing business in New York, the city is likely to continue to lose market share. Take the case of BATS, an alternative trading platform based in Kansas City, Mo., that has come out of nowhere to gain a 9 percent share in the market for trading United States stocks. “Our location is one of the principal factors that enabled us to go from start-up to the third-largest equities exchange in the U.S. in a matter of 18 months,” says Joe Ratterman, its president and chief executive officer. The company’s computers reside in a New Jersey data center, and it has two sales representatives in New York. But the rest of its 33 employees work out of a 10,000-square-foot office complex with views of downtown Kansas City.

Think about that. 18 months from start-up to 9 percent market share. New York City's financial worker employment could suffer shrinkage far more rapid than what happened to the smoke stack manufacturing industries back in the 1970s and 1980s.

Gross speculates that New York City can still survive by becoming a services economy which caters to the needs of the super wealthy. The city still has the lawyers, accountants, investment bankers, and other skilled workers that allow complex deals to get put together in face-to-face meetings. But anything automated strikes me as better done in lower cost locales.

By Randall Parker    2007 October 14 11:47 AM Entry Permalink | Comments (1)
2007 September 25 Tuesday
Foreign Investment In US Declines With Dollar Decline

The rise in oil prices, accumulating debt burdens, the bursting of the housing bubble, and the large US trade deficit have pushed down the US dollar. The long expected adjustment of currencies is taking place. Also, foreign buying of US securities has declined as the dollar has weakened.

Even before the recent market turmoil began, foreign buying of U.S. financial assets had slowed. A Treasury Department report showed foreign holdings of long-term securities such as equities, notes and bonds increased by a net $19.2 billion in July, the slowest pace in seven months and well below the $97.3 billion tallied in June.

Worries about foreigners wanting to diversify out of dollars rose last week after Saudi Arabia decided for the first time not to cut interest rates in lock step with the U.S. Fed, leading to some speculation that it would soon end its currency's peg to the dollar.

A decline in the dollar combined with a decline in foreign investments creates inflationary pressures in a few ways. First off, imports cost more. Second, the drop in the dollar also increases foreign demand for US goods and therefore enables US manufacturers to raise prices. Third, the decline in foreign purchases of bonds raises interest rates. All these forces are inflationary. If strong inflation shows up then the US Federal Reserve will have to raise interest rates and push the US economy into a recession.

The Middle Eastern nations no longer use their oil revenue to buy goods from the United States.

What happened? Oil nations are more willing to diversify out of the dollar than they used to be, said Mansoor Mohi-uddin, the head of foreign exchange strategy at UBS, in Zurich.

Stephen Jen, the global head of current research for Morgan Stanley in London, agreed. "Oil exporters' propensity to import from the U.S. has declined in recent years, while their tendency to import from Europe and Asia has risen steadily," he said, adding that OPEC nations currently buy more than three times as much from the European Union as from the United States.

The recent decision of the Saudi central bank to not follow the US Federal Reserve in lowering interest rates indicates the Saudis may be headed toward breaking their dollar peg. The Saudis import most of their goods from the European Union and the rise of the Euro against the dollar has caused a high rate of inflation in Saudi Arabia. By letting their currency rise against the dollar they will reduce their cost of imported goods from Europe and lower internal prices.

Foreign cash flows into US securities has even reversed.

The tally for all of the third quarter isn't yet in, but last week we learned what happened to some of these investment flows in July. Net foreign purchases of U.S. stocks dropped to $21 billion, from $29 billion in June. Net foreign purchases of U.S. corporate bonds slumped to $4 billion from $26 billion the prior month as the incipient credit crunch throttled global demand for junk. All that spare cash flowed into short-term debt, which saw an inflow of $67 billion after an outflow of $28 billion in June. Meanwhile, counting stock swaps and the repaid principal on bonds, foreigners actually took $3 billion more out of long-term U.S. securities than they put in.

Americans have been living beyond their means, importing more goods than they exported. American living standards may stagnate or fall during the readjustment that will bring imports and exports back into balance. That readjustment will be a contributing cause of the next recession.

Even East Asian bondholders are becoming reluctant to buy US financial paper.

The dollar's slump to a 15-year low against six of its most actively traded peers is turning the gains into losses for international bondholders, prompting China, Japan and Taiwan to sell. Overseas investors own more than half of the $4.4 trillion in marketable U.S. government debt outstanding, up from a third in 2001, according to data compiled by the Treasury Department.

``The support that Asia has shown in buying U.S. Treasuries has been a major supporter of keeping long-term interest rates lower than where they probably would be,'' said Gary Pollack, who oversees $12 billion as head of fixed-income trading in New York at the private wealth management unit of Deutsche Bank AG, Germany's biggest bank. ``This could put some upward pressure on yields in the United States.''

Higher long term interest rates will raise mortgage payments and further dampen demand for housing and therefore cause more of a housing price decline. This produces winners and losers. It is good news for people who want to buy a house a few years from now.

Early on China's big effect was as lower priced maker of goods but now China's demand for raw materials is exerting a larger influence on financial markets and prices.

China's emergence in the early 1990s as the low-cost workshop of the world furnished global markets with an endless supply of cheap goods, creating stiff competition that kept down prices everywhere. For a time, that effect more than offset costs for raw materials, notably oil, which also began to rise as China, India and other emerging economies began to develop.

Now, however, these populations can increasingly afford to live a little better, driving a new spiral of demand for building materials to accommodate expanding infrastructure; foodstuffs to feed cattle as more meat is put on the table; and oil to fuel new cars and more manufacturing.

Over the past five years alone, oil prices have risen 158 percent, to around $80, while the price of wheat has soared 126 percent. Costs for nickel, used to build Alno's sinks, have shot up 415 percent.

The price of food has been rising like the price of oil and for similar reasons.

"Food is going to be like oil," a product that gets more expensive as China and India get richer, said Chris Williamson, chief economist at NTC Economics in London.

Alan Greenspan fears higher long term inflation is coming.

The former chairman of the U.S. Federal Reserve, Alan Greenspan, is doubtful. In his new memoir, he writes that inflation could hit 4 percent to 5 percent in a decade, enough to halve the purchasing power of a dollar in about 15 years.

As salaries continue to rise in China and as Chinese demand pushes up costs of raw materials the Chinese manufacturers are beginning to raise prices and economists expect they will continue to do so. China will shift from being a deflationary force on prices to being an inflationary force.

The burst of the housing bubble has caused the Federal Reserve's to use lower interests rates to try to avoid a recession. But inflationary pressures might force the Fed to eventually shift gear on interest rates.

If the Fed gets it just right, the economy will slip through this crisis and keep expanding with only modest inflation, making investors happy. If the Fed's rate cuts are too little, too late, recession fears will return, sending another cold wind through credit markets and the stock market. If the Fed cuts rates too much, inflation could loom.

What was troubling some investors after the Fed rate cut last week, a reduction in short-term rates by half a percentage point, to 4.75%, was the latter risk -- the risk of inflation.

If rising inflation forces a rise in interest rates then the US economy could go into recession.

Some money managers already are warning that inflation may force the Fed to raise rates early next year, taking back last week's gift. Higher rates would hurt stocks because they stifle the economy and make it harder for investors to borrow.

Something similar happened in 1999, when the Fed had to raise rates after cutting them during the 1998 financial crisis. The economy ended up in recession in 2001.

The recession will be uneven. Some exporters will experience sales growth made possible by a weakening dollar.

By Randall Parker    2007 September 25 08:58 PM Entry Permalink | Comments (4)
2007 August 10 Friday
Central Banks Try To Stem Credit Crisis

In the United States, the Fed stepped in with big cash injections into financial markets in response to a credit crunch.

The Federal Reserve injected $38billion into the banking system in three operations Friday, attempting to avert a credit crunch that could threaten the economy.

The central bank pledged to provide cash as needed "to facilitate the orderly functioning of financial markets."

It was the Fed's biggest one-day injection since it added $81.25 billion shortly after 9-11. The Fed added $24 billion on Thursday.

Since the subprime mortgage crisis is of American origin you might expect the biggest central bank intervention would happen in the U.S. of A. Nope. The European Central Bank made far larger cash injections into European banks.

PARIS -- As European stocks continued a steep fall today, the European Central Bank announced a new injection of $83.9 billion into the banking system to try to calm markets agitated by a crisis in U.S. mortgage loans.

The move followed the Frankfurt-based bank's previous infusion of $130.7 billion into the system Thursday. The outlay is in response to a sudden leap in lending rates after a French bank, BNP Paribas, froze three funds dependent partly on American sub-prime loans.

All of the central banks have injected over $300 billion so far.

In all, central banks in Europe, Asia and North America have pumped out more than $300 billion over 48 hours in an effort to keep money flowing through the arteries of the global financial system, hoping to prevent a credit market seizure that could imperil economies.

The Bank of Japan and Federal Reserve Bank of Australia also intervened to inject money into their banking systems.

The Federal Reserve added $38 billion to markets, the Bank of Japan $8.5 billion and the Reserve Bank of Australia $4.2 billion, signaling broad concern among central bankers.

European financial institutions are taking big losses in American mortgage bonds.

The European sell-off began Thursday with an announcement by BNP Paribas, France's largest bank, that it was halting withdrawals from three hedge funds with a total value of about $2.2 billion that had exposure to U.S. subprime loans. The bank's shares were down 4.4 percent Friday.

Bear Stearns started the pattern where major financial institutions report big losses in the mortgage market.

Bear Stearns triggered a decline in the credit markets in June after two of its hedge funds faltered as default rates on home loans to people with poor credit rose. For subprime mortgages turned into securities, defaults hit a 10-year high.

The company pledged $1.3 billion to help stem losses in the funds. They filed for bankruptcy protection on July 31, two weeks after Bear Stearns told investors they would get little, if any, money back. The firm then blocked investors from pulling money from a third fund as losses in the credit markets expanded beyond subprime-mortgage securities.

More financial institutions keep popping up with big subprime mortgage losses.

Another European fund valued at 750m was frozen too, and a Dutch bank pulled its planned new listing after suffering subprime losses. Back across the pond, the Wall Street Journal reported that a second Goldman Sachs Group hedge fund is also suffering losses and selling positions due to subprime worries.

Smaller European banks are getting hit by losses in the US mortgage market too.

The same day, NIBC, a midsize Dutch bank, said the subprime snafu had contributed to a $189 million loss in one of its U.S. investment books in the first half of this year. And dodgy real estate loans have made a big dent in forecasted earnings this year at German lender IKB.

Equity markets are getting in part hit because the credit crunch is reducing the capital available to do leveraged buyouts that drive up stock prices.

The problem is that if sub-prime is doing badly then there is a risk that no one wants to buy structured products of any type. And that's one of the main reasons why the equity markets are falling.

There has been a lot of leveraged buyouts in the US helping push up the value of equities, financed by debt and underwritten by American and European banks.

In recent years financial market commentators argued over whether we were in a housing bubble. Well, the current bubble popping sound we are hearing in the financial markets indicates that, yes, we really were in a big real estate bubble.

What's becoming clearer by the day is that we're watching the unraveling of a global real estate financing bubble. The U.S. subprime market is the heart of the problem, but financial innovation has spread the risk around the world in a way that wasn't possible a generation ago. Long-term assets -- real estate -- have been financed by hedge funds with short-term debt instruments, and the amount of the debt now exceeds the value of the collateral in these subprime investments. Somebody is going to have to swallow the difference, and the challenge for regulators in both the U.S. and Europe is to assist this debt workout while protecting an otherwise healthy global economy.

How much will financial institutions and their stock holders be made to suffer for their folly? On the one hand we do not want a credit crunch so severe that it causes a global depression. On the other hand, financial institutions need to be severely punished by markets when they make mistakes. Unfortunately, it was the central banks who let the real estate bubble happen in the first place. I'm not expecting the central banks to accurately calibrate their response to this crisis.

By Randall Parker    2007 August 10 11:16 PM Entry Permalink | Comments (5)
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