Tuesday, December 30, 2008

Morgan's currency call

By Karen Remo-Listana
Wednesday, December 31, 2008

The dollar is set to head higher in the first half of next year, before giving back some of its gains in the second half, assuming the global economy bottoms next summer, a report from Morgan Stanley said.

"As the world cycles through summer, fall, winter and spring, investors can anticipate various cyclical currency trades. US dollar strengthens as the world slows, but will weaken as the world recovers," said the report, sent to Emirates Business. And since the world is likely to enter deeper into the "winter" season, the dollar should strengthen further. But when "spring' comes, the dollar is likely to give back some of its gains.

"In 2009, assuming that the global economy does find a trough by summer, we see the dollar rallying further into the trough, but underperforming most other currencies as the world recovers in the second half," it said.

Through its "Four Seasons'" currency concept, the New York-based investment bank said real global economic growth and equity buoyancy demarcate four distinct scenarios for the world, further noting that different currencies tend to perform best in these four quadrants.

The US Treasuries will likely remain well supported while a flare-up in inflation is not a probable risk, the report added.

There are two main risks however to Morgan Stanley's dollar view – inflation and an unsustainable federal debt profile.

The Fed's QE operations, it said, need an exit strategy. The latest talk of the Fed issuing its own debt may be one way the Fed could unwind its balance sheet in time to stabilise inflation expectations.(Bennie Bucks to the rescue? - AM) In addition, the dollar's performance will be driven by inflation expectations.

Similarly, the super-sized US fiscal deficits will be a risk for the dollar, though it views the US Treasuries are more likely to be a preferred safe haven asset in a global recession, marginalizing other sovereign debt.

On the other hand, Morgan Stanley says emerging market (EM) currencies are 'summer' currencies that do not perform well in 'winter' while euro – historically a "winter" currency – will suffer because of possible fractures in Eastern Europe.

"EM currency 'moment' is not over, in our view," it said. "In fact, the process is roughly halfway complete. We see weaker Latam currencies in the first half. Pressures on AXJ currencies will likely persist, as these countries' exports collapse and their central banks cut interest rates. We believe that even the Chinese yuan will be allowed to weaken against the dollar in the coming months."

It said Eastern European currencies may come under intense balance of payments pressures while the situation in Russia especially deserves investors' full attention, as "the familiar structural fragilities of Eastern Europe will expose the broad region to possible discrete changes in the rouble" it said.

It remains bearish on the euro in the first half. "Though the euro is no longer over-valued, it is still over-rated and over-owned," it said.

"We would not be surprised if the world's reserve holdings of British pound and Swiss franc start to decline from here, with the euro being a beneficiary of this prospective new trend," Morgan Stanley said.

Capitalism matches mankind

(Another favorite of mine from Winnie: The inherent vice of capitalism is the unequal sharing of blessings; the inherent virtue of socialism is the equal sharing of miseries. - AM)

Commentary by Caroline Baum
Dec. 30 (Bloomberg)

The year 2008 will be remembered as one that exposed the fatal flaws in free-market capitalism, sending it to an untimely death.

Or will it?

That capitalism’s obituary is already being written suggests the enemies of the free market were waiting to pounce.

Last week, Arianna Huffington, co-founder of the Huffington Post, wrote that laissez-faire capitalism, “a monumental failure in practice,” should be “as dead as Soviet Communism” as an ideology.

On National Public Radio, Daniel Schorr pronounced “the death of a doctrine” in his year-end review.

All I could think of was Winston Churchill’s assertion about democracy. Capitalism is surely the worst economic system, except for all the others that have been tried.

With its ideology under fire and its practice falsely maligned, it is to the defense of free markets that I devote my final column of the year.

Before you can declare free markets a failure, you have to establish that they exist, says Paul Kasriel, chief economist at the Northern Trust Co. in Chicago.

We do not have free markets in credit in the U.S. or anywhere else that I know of,” he says. “The price of short- term credit is fixed by central banks. It would only be by accident that a central bank would fix the price of short-term credit” at the precise level that a free market would.

Fixing the price of any other commodity, including labor, has proven to be a failure, an affront to the inviolable invisible hand. Yet when it comes to setting the interest rate that will keep the economy on an even keel, we put our faith in a chosen few to get it right.

All sorts of unintended consequences flow forth from central bankers’ fixing of a short-term rate. Hold the rate too low, and it leads to a misallocation of capital into, say, housing or dot- com stocks. That’s what happened in the late 1990s and again in the early part of this decade.

“We are now experiencing the economic and financial market fallout from (Alan) Greenspan’s interference with the free market,” Kasriel says.

In a true free market, risk-takers are punished for bad bets. Not so in the current crisis, where financial institutions -- with the exception of Lehman Brothers -- are deemed too big to fail and rescued, merged or recapitalized.

One supposed nail in capitalism’s coffin is the assertion that deregulation created the problems. This is curious, given that banks, which are at the root of the credit crunch, are among the most highly regulated institutions.

“There is a small army of people overseeing the banking industry,” says Paul DeRosa, a partner at Mt. Lucas Management Corp. in New York. And yet “we’ve had a banking crisis every 15 years since 1837. The number of people devoted to regulation doesn’t seem to matter.”

Regulators from the Federal Reserve, Securities and Exchange Commission, Office of the Controller of the Currency and New York State Banking Commission are “on the premises 365 days a year,” he says.

The regulatory structure may have been antiquated and overlapping. That’s no excuse for the regulators to be caught napping.

Censuring the free market is a way of deflecting blame from the true source, according to Dan Mitchell, senior fellow at the libertarian Cato Institute in Washington.

“The genesis of the problem is bad government policy,” Mitchell says, pointing to everything from easy money to “affordable lending schemes” to the “corrupt system of subsidies from Fannie Mae and Freddie Mac” to the tax code’s favorable treatment of debt (the interest is deductible) versus equity.

Fannie’s and Freddie’s generous campaign contributions (anywhere else, these would be called bribes) encouraged Congress to look the other way as the two housing finance agencies used their implicit government guarantee to increase their leverage and buy riskier mortgages.

Those clamoring for more regulation as a solution to the current crisis are forgetting that Congress has oversight responsibility for the regulator of those agencies.

“I have no confidence regulation will solve the problem,” says Allan Meltzer, professor of economics at Carnegie Mellon University in Pittsburgh. “Lawyers and bureaucrats make regulations. Markets figure out how to circumvent the costly ones.”

As a case in point, Meltzer pointed to the Basel Accords, which “required banks that hold more risky assets to hold more reserves. So they held them off their balance sheet, where they went from being poorly monitored to not monitored at all.”

Capitalism has spread across the globe, lifting millions out of poverty as “a direct consequence of government stepping out of the way,” DeRosa says.

Yet critics of free-market capitalism are implicitly arguing for a bigger role for government.

Alas, government isn’t some benevolent matriarch acting in the public interest, even if it knew what that was. It is a conglomeration of politicians acting in their own self-interest, guided by payoffs from special-interest groups. That’s a poor substitute for the market’s price signals, not to mention a guarantee of inefficiency and waste.

“Capitalism is the only system that produces both growth and freedom,” Meltzer says. Unlike socialism and communism, “it doesn’t depend on someone’s ideas of perfection.”

Yes, markets are guilty of excess, greed, even corruption.

“We’re not perfect people,” Meltzer says. “Capitalism matches mankind."

This thing of ours

Federal Reserve Press Release

Release Date: December 30, 2008
For immediate release

The Federal Reserve on Tuesday announced that it expects to begin operations in early January under the previously announced program to purchase mortgage-backed securities (MBS) (half a trillion worth - AM) and that it has selected private investment managers to act as its agents in implementing the program.

Because of the size and complexity of the agency MBS program, a competitive request for proposal (RFP) process was employed to select four investment managers and a custodian. The investment managers are BlackRock Inc., Goldman Sachs Asset Management, PIMCO and Wellington Management Company, LLP.

(Wasn't sure why Wellington was named ... but now I do, they are the 3rd largest institutional holder of GS stock. Welcome to the 'waste management business'. -AM)


Holder / Shares / % Out / Value / Reported

Barclays Global Investors UK Holdings Ltd 17,355,918 4.39 $2,221,557,504 30-Sep-08
STATE STREET CORPORATION 16,769,356 4.24 $2,146,477,568 30-Sep-08
WELLINGTON MANAGEMENT COMPANY, LLP 15,840,670 4.01 $2,027,605,760 30-Sep-08

SEC digs deep

(That all you got Cox? - AM)

By David Scheer
Dec. 30 (Bloomberg

The U.S. Securities and Exchange Commission, under congressional scrutiny for failing to detect Bernard Madoff’s alleged $50 billion Ponzi scheme, said it halted an unrelated $23 million scam targeting Haitian-Americans.

A federal judge in Miami agreed to freeze assets and appoint a receiver after the SEC sued George Theodule and two companies he helped control, claiming he lured investors by promising to double their money within 90 days, the agency said in a statement today. Theodule lost at least $18 million on securities trades in the past year, while early investors got funds raised from later participants, the SEC said.

Theodule, 48, encouraged people to form investment clubs that funneled funds to the firms, raising more than $23 million since November 2007, the SEC said. Participants were told some profits would fund ventures benefiting the Haitian community in the U.S., Haiti and Sierra Leone, it said.

“This alleged Ponzi scheme preyed upon unsuspecting members of a close-knit community, attempting to take advantage of the trust they had in each other,” Linda Thomsen, the SEC’s enforcement director, said in the agency’s statement.

Holy C.R.A.P. Pimpco!

Wall Street Journal
December 30, 2008

WASHINGTON -- The federal government Monday deepened its involvement in the U.S. automotive industry by committing $6 billion to stabilize GMAC LLC, a financing company vital to the future of struggling car maker General Motors Corp.

In a sign the government's role in the industry could become open-ended, the Treasury Department said Monday it had set up a separate program within the Troubled Asset Relief Program (Can I be the first? Car Rescue Asset Program, C.R.A.P.- AM), a fund originally designed to help banks, to make investments directed at the auto industry. A Treasury official said the new program didn't have a specific dollar limit.(Wherever our imagination takes us?-AM)

The Treasury purchased $5 billion in senior preferred equity in GMAC and offered a new $1 billion loan to GM so the auto maker could participate in a rights offering at GMAC. (Oh this is the priceless part. PIMPCO not only doesn't take a loss, not only gets the juice from GMAC debt ramping cause your taxpayer money is subordinate but gets the Government to pony up 1 billion so that GMAC can hit the 75% limit. Will Paul McCulley's next blogging adventure with Bun Bun,his Netherlands Dwarf pet bunny,-hand to God check out their web site - be entitled, 'Yo, we punk'd the taxpayer?' -AM) That loan comes in addition to the recent $17.4 billion emergency plan to rescue GM and Chrysler LLC.

The move by Treasury is the second part of a two-step rescue by the government of GMAC.(Part 2 of 2? Isn't that optimistic? -AM) Last week, the Federal Reserve approved the finance company's application to become a bank-holding company, a move sought by other companies, too, to take advantage of new government programs aimed at stabilizing banks.

The Fed's approval was conditional on GMAC raising new capital, which the company tried to do through a debt-equity swap that expired Friday. The company's goal was to raise $30 billion by converting 75% of its issued debt into preferred-stock holdings. Last week, less than 60% of bondholders had signed on and the offering had been extended four times. At the same time as the Treasury announcement Monday, GMAC said it had raised enough capital to satisfy the Fed's conditions. It wasn't clear whether the government's intervention prompted or followed GMAC's meeting the capital requirement.(Read your full article, I guess when it's written by committee -4 folks cited - they don't check each other's notes - AM)
—Neal Boudette and Sharon Terlep contributed to this article.

Monday, December 29, 2008

Yuan Watch : 2012 Unification?

By Ko Shu-ling
Tuesday, Dec 30, 2008
Taipei Times

Beijing is likely to expedite the process of unification with Taiwan and possibly try to achieve the goal by 2012, an expert attending a cross-strait forum said yesterday.

Lai I-chung, an executive member of the pro-localization Taiwan Thinktank and former director of the Democratic Progressive Party’s (DPP) International Affairs Department, said that 2012 is a year important to Taiwan’s survival.

As Chinese President Hu Jintao and Premier Wen Jiabao are scheduled to step down, they are likely to do something to leave a historic legacy and set the course for their successors, Lai said.

Also, President Ma Ying-jeou’s four-year term will expire and Beijing is likely to make an effort to help Ma win the election. If Ma loses, Beijing would speed up its unification efforts, Lai said.

Washington is preoccupied with financial and other domestic problems, Japan is suffering from political instability and India has switched its concerns to internal problems, so the US is likely to pay little attention to the Taiwan Strait as long as it obtains Beijing’s assurance that its interests in the region were not under threat, Lai added.

If Beijing’s economy continues to deteriorate, its leaders are likely to adopt drastic measures to divert public attention, Lai said. Possible scenarios include creating conflict or even launching a military assault under the pretext of a crackdown on an uprising in the wake of Ma’s election defeat.

Lai made the remarks during a forum organized by the Institute for National Development in Taipei yesterday morning. The forum was held to analyze the just concluded economic forum between the Chinese Nationalist Party (KMT) and the Chinese Communist Party (CCP).

Lai said Taiwan was facing an “immediate and present danger,” the prelude of a historic tragedy, such as the 1938 annexation of Austria into Greater Germany by the Nazis.

The impact of such a possibility in 2012 far outweighs the repercussion of the KMT-CCP forum, Lai said.

Soochow University political science professor Lo Chih-cheng said that Ma’s China policy had pushed the nation toward unprecedented peril and that Beijing’s Taiwan strategy was to lay the groundwork for de jure unification with Taiwan.

Among the problems Taiwan faces, Lo said, was Beijing and Taipei’s teaming up to “internalize” cross-strait relations. Second, the KMT-CCP economic forums are moving toward setting the agenda for cross-strait negotiations.

Taipei is cooperating with Beijing to exclude international invention in the Taiwan Strait and make the Taiwan question China’s internal affair, Lo said. As the Ma administration thinks the shortcut to the international community is through Beijing, it has pinned all the nation’s hopes of participation in international organizations on Beijing’s goodwill.

“Taiwan must learn a lesson from Hong Kong,” Lo said. “If no one in Taiwan or the international community can rein in the Ma administration’s determination to unify with China, Taiwan will be doomed because we are entering a danger zone.”

Yuan Watch : Fraud prevention

(I know that you know what I'm thinkin' - AM)

December 29, 2008

BEIJING - An executive at a major Chinese state-owned mining company was sentenced to death for taking bribes and embezzling more than US$10 million (S$14.4 million), state media reported on Monday.

Yu Weiping, deputy manager of Yunnan Copper Group, took bribes of more than 4 million dollars, and embezzled over 41 million yuan (S$8.6 million), the official Xinhua news agency reported.

Yu also misappropriated 27 million yuan and lent the money to others, Xinhua quoted the Intermediate People's Court in Kunming, capital of the southwestern province of Yunnan, as saying.

Crazy is as crazy forecasts

By Tony Jackson
December 29th, 2008
Financial Times

Absolute Strategy Research (ASR) calculates that for Europe, the ratio of buys to hold/sell recommendations hit about 63 per cent at the start of 2008, just after the market's all-time peak. The trough of 38 per cent came back in 2003, just as the market was poised for an explosive four-year rally. The ratio is now a little over 50 per cent, suggesting the market has further to fall. (One need not be sociopathic to be a stock 'analyst' but obviously neither is it detrimental to the cause - AM)

Back in the real world, my guess is that equities will not be the real story next year, any more than they were in this. That is not to say equity markets will be calm. Rather, they will be an expression of what is happening elsewhere, mainly in credit.

Begin with the fact that corporate defaults are still eerily low. According to Standard & Poor's, the latest 12-month trailing figure for global defaults was 2.7 per cent. This compares with the average for 1981-2007 - that is, excluding the period of almost zero defaults at the peak of the bubble - of 4.4 per cent.

Even leveraged loans - mainly a legacy of the private equity bubble - were on a default rate of only 3.8 per cent, compared with a peak in 2002 of almost 6 per cent.

But the distress rate - the proportion of loans trading below 80 cents on the dollar - is off the scale at 76 per cent, compared with a 2002 peak of just 10 per cent. If that figure is half-way right, watch out.

Ditto with the behaviour of banks' loan officers. According to the US Federal Reserve, 84 per cent of US banks are now restricting lending to large corporates. That compares with about 60 per cent in the past two recessions.

Mr. Steel meets hottest fire

(An accompanying graph to this article shows that steel industry output closely tracks global GDP output -watching steel prices can be a good indication of larger trends. Steel is also a good proxy for China which is the world's biggest steel producing and consuming nation. China has contributed more to global growth than any other country in this recent expansion. The steel ETF, SLX, has been absolutely crushed in the last 6 months falling 73%. Despite its' climb from November lows, it has fallen ~15% again in the last 10 days - AM)

By Peter Marsh
Published: December 29 2008 02:00
Financial Times

Global steel production could easily plunge by 10 per cent or more next year, with China leading the slump in output.

But although the industry is in its worst state since steel prices hit rock bottom towards the end of 2001, some industry observers believe there are a few bright spots on the horizon.

"The speed and decisiveness of the cutbacks in production [by big steelmakers] have been unprecedented, which means profitability in this downturn for the steel industry is likely to hold up better than in other comparable periods," says John Lichtenstein, head of the metals industry group at Accenture.

By controlling supply better than in previous downturns, steel companies should be in a better position to keep prices at fairly high levels - and so guard against too steep a fall in earnings, he believes.

Backing up this argument is research from Meps, a UK-based steel consultancy, which expects average prices of all steel grades sold worldwide to climb marginally over the next few months, rather than continue the steep falls that started in July.

According to Meps, average steel prices should rise to $750 a tonne by next July, from a low point of $676 a tonne seen earlier this month.

Even though the price has fallen precipitously from $1,160 a tonne in July 2008, today's steel price is still considerably above the low point of $275 a tonne seen in November 2001, which was the last time the sector was in a state of slump.

Rod Beddows, chief executive of Hatch Corporate Finance, a financial group specialising in the metals industry, reckons the steel business should be bracing itself for a "sharp" downturn "with a period of four years between the sector returning to the level of output and demand it experienced in the first half of 2008".

Matthias Hellstern, who monitors the European steel industry on behalf of Moody's, says that any upturn that comes later in 2009, perhaps around the second or third quarters, will be "extremely mild".

Mr Hellstern reckons there is a chance that global steel production will fail to return to the levels of the first half of 2008 until 2013.

On the assumption that steel production in 2008 will be slightly lower than the 1.34bn tonnes recorded in 2007, it could, according to Mr Hellstern's calculations, be more than five years before annual output sector climbs again to this level.

According to data from the London-based Iron and Steel Statistics Bureau, an industry research body, there have been only four occasions since 1900, apart from periods of world wars, when the global steel sector has taken four years or longer to climb out of a downturn by attaining the previous high point in production.

However, not all analysts are quite as downbeat as Mr Hellstern.

Peter Marcus, managing partner at World Steel Dynamics, a US consultancy, believes that output could rebound by 12.9 per cent in 2010, following a fall of 13.9 per cent in 2009, which would mean annual output returning to the level of 2007 in 2011.

Sunday, December 28, 2008

Yuan Watch : Lock-up Expiration

By Winny Wang | 2008-12-29

Share investors are advised to be cautious in the last three days of trading for this year as concerns persist over possible selling of non-tradable equities in the Shanghai stock market, analysts said.

The lock-up periods of 13.2 billion non-tradable shares, accounting for 2.6 percent of the circulation in the A-share market, expire over the last 10 days of this month.

"A total of 650 million non-tradable shares have been sold so far this month, equivalent to 4.81 billion yuan and a rise of 73.85 percent from a month earlier, which greatly dampened the market's performance," said Zhou Yu, an analyst at Pacific Securities Co.

"Concerns over declining corporate earnings and a resumption of new share sales will be under the spotlight in the early part of next year," said Teng Yin, an analyst of Everbright Securities Co.

Liu Xinhua, assistant chairman of the China Securities Regulatory Commission, last week said the regulator will encourage pension funds, insurers and mutual funds to invest more in the domestic stock markets.

A taste without excessive vig

By Samantha Zee
Dec. 28 (Bloomberg)

IndyMac Bank is close to being sold to a group of private equity and hedge fund firms in a transaction that may be announced as early as tomorrow, the New York Times reported, citing unidentified people briefed on the matter.

The buyers include private equity firms J.C. Flowers & Co.(led by ex-Goldie J. Christopher Flowers) and Dune Capital Management (founded by ex-Goldie Daniel Niedich and Steven Mnuchin) and the hedge fund firm Paulson & Co. (mortgage vulture extraordinaire), the people told the newspaper. The proposed sale is unusual in that it’s one of the first transactions involving unregulated private equity firms acquiring a bank-holding company, the Times said in its Dealbook section.

The investor group would buy the whole California-based mortgage lender that was seized by U.S. regulators five months ago. The purchase would include IndyMac’s 33 branches, reverse- mortgage unit and its $176 billion loan-servicing portfolio, the newspaper said.

(Oh and by the way below is the plan Bair proposed right around the time Timmy G let it be leaked he wanted her out because she was more concerned about the FDIC then the financial system as a whole. Hmmm... sure will be interesting what the Three Amigos propose as an alternative won't it? - AM)

'Under the plan, people who took out fixed-rate mortgages from IndyMac Federal would be able to seek lower priced loans if they were in, or near, default. The FDIC authorized IndyMac to modify loans that were 60 days or more delinquent, allowing monthly payments to be reduced to a level no greater than 38% of monthly household income.'- CEP News December 4, 2008

Yuan Watch : Petitioning the Big Red Dragon

December 27th, 2008
Wall Street Journal

SHANGHAI -- A group of foreign banks in China has asked the Chinese government to delay a recently imposed tax on interest paid on money borrowed from overseas, arguing that the tax would exacerbate the impact of the global financial crisis.

The request concerns a new withholding tax on interest payments on all loans to banks in China from overseas lenders. The tax, which is retroactive to Jan. 1, is expected to disproportionately affect the Chinese operations of foreign banks, which are more likely to borrow from overseas sources, such as their parent companies. Chinese banks typically have large deposit bases, so are less reliant on borrowing from overseas.

A petition signed by 36 foreign banks, seen Friday by Dow Jones Newswires, describes the tax as an excessive burden on foreign lenders operating in China. The petition was signed Dec. 23 and addressed to China's State Council, its banking regulator, its central bank and the Ministry of Finance.

The new tax is technically directed at the offshore lenders, saying they must pay tax on the interest they earn on loans made to banks in China.

However, the China-based entity is responsible for paying the tax on the lender's behalf, the statement said.

Under China's corporate income-tax regulations, a 10% withholding tax will be broadly charged, but a lower rate of 7% will be placed on lenders from places with which China has a tax treaty, such as Hong Kong.

A cover letter for the petition from accounting firm Ernst & Young said the measure, together with recent changes to the banks' business tax, could roughly add an additional 1 billion yuan ($146.2 million) to the banking sector's tax bill this year.

"As far as an independent bank is concerned, this could be the difference between surviving the financial crisis or not," the accounting firm said in the letter addressed to the tax bureau.

Auld Lang Syne 2009, Hooray 2010!

( A great prognostication, although I doubt Hilary will put on a veil. - AM)

Chronicle of a decline foretold
By Niall Ferguson
Published: December 27 2008 02:00 | Last updated: December 27 2008 02:00
Financial Times

It was the year when people finally gave up trying to predict the year ahead. It was the year when every forecast had to be revised - usually downwards - at least three times.

The Great Repression began in August 2007 and reached its nadir in 2009. It was clearly not a Great Depression on the scale of the 1930s, when output in the US declined by as much as a third and unemployment reached 25 per cent. Nor was it merely a Big Recession. As output in the developed world continued to decline throughout 2009 - despite the best efforts of central banks and finance ministries - the tag "Great Repression" seemed more and more apt: though this was the worst economic crisis in 70 years, many people remained in deep denial about it.

"We assumed that we economists had learnt how to combat this kind of crisis," admitted one of President Barack Obama's "dream team" of economic advisers, shortly after his return to academic life in September 2009. "We thought that if the Fed injected enough liquidity into the financial system, we could avoid deflation. We thought if the government ran a big enough deficit, we could end a recession. It turned out we were wrong."

The root of the problem remained the US's property bubble, which continued to deflate. Many people had assumed that by the end of 2008 the worst must be over. It was not. House prices continued to slide in the US. As they did, more and more families found themselves in negative equity, with debts exceeding the value of their homes. In turn, rising foreclosures translated into bigger losses on mortgage-backed securities and yet more red ink on banks' balance sheets.

With total debt above 350 per cent of US gross domestic product, the excesses of the age of leverage proved difficult to purge. Households reined in their consumption. Banks sought to restrict new lending. The recession deepened. Unemployment rose towards 10 per cent, and then higher. The economic downward spiral seemed unstoppable. No matter how hard they saved, Americans simply could not stabilise the ratio of their debts to their disposable incomes. The paradox of thrift meant that rising savings translated into falling consumer demand, which led to rising unemployment, falling incomes and so on, ever downwards.

"Necessity will be the mother of invention," Obama declared in his inaugural address on January 20. "By investing in innovation, we can restore our faith in American creativity. We need to build new schools, not new shopping malls. We need to produce clean energy, not dirty derivatives." The rhetoric flew high. But the markets sank lower. The contagion spread inexorably from subprime to prime mortgages, to commercial real estate, to corporate bonds and back to the financial sector. By the end of June, Standard & Poor's 500 Index had sunk to 624, its lowest monthly close since January 1996.

The crux of the problem was the fundamental insolvency of the big banks, another reality that policymakers sought to repress. In 2008, the Bank of England had estimated total losses on toxic assets at about $2.8 trillion. Yet total bank writedowns by the end of 2008 were little more than $583bn, while total capital raised was just $435bn. Losses, in other words, were either being massively understated, or they had been incurred outside the banking system. Either way, the system of credit creation had broken down. The banks could not contract their balance sheets because of a host of pre-arranged credit lines, which their clients were now desperately drawing on, while their only source of new capital was the US Treasury, which had to contend with an increasingly sceptical Congress.

There was uproar when Timothy Geithner, US Treasury secretary, requested an additional $300bn to provide further equity injections for Citigroup, Bank of America and the seven other big banks, just a week after imposing an agonising "mega-merger" on the automobile industry. In Detroit, the Big Three had become just a Big One. The banks, by contrast, seemed to enjoy an infinite claim on public funds. Yet no amount of money seemed enough to persuade them to make new loans at lower rates. As one indignant Michigan lawmaker put it: "Nobody wants to face the fact that these institutions [the banks] are bust. Not only have they lost all of their capital. If we genuinely marked their assets to market, they would have lost it twice over. The Big Three were never so badly managed as these bankrupt banks."

In the first quarter, the Fed continued to do everything in its power to avert the slide into deflation. The effective federal funds rate had already hit zero by the end of 2008. In all but name, quantitative easing had begun in November 2008, with large-scale purchases of the debt and mortgage-backed securities of government-sponsored agencies (the renationalised mortgage giants Fannie Mae and Freddie Mac) and the promise of future purchases of government bonds. Yet the expansion of the monetary base was negated by the contraction of broader monetary measures such as M2 (the measurement of money and its "close substitutes", such as savings deposits, that is a key indicator of inflation). The ailing banks were eating liquidity almost as fast as the Fed could create it. The Fed increasingly resembled a government-owned hedge fund, leveraged at more than 75 to 1, its balance sheet composed of assets everyone else wanted to be rid of.

The position of the US federal government was scarcely better. By the end of 2008, the total value of loans, investments and guarantees given by the Fed and the Treasury since the start of the crisis had already reached $7.8 trillion. In the year to November 30 2008, the total federal debt had increased by more than $1.5 trillion. Morgan Stanley estimated that the total federal deficit for the fiscal year 2009 could equal 12.5 per cent of GDP. The figure would have been even higher had Obama not been persuaded by his chief economic adviser, Lawrence Summers, to postpone his planned healthcare reform and promised spending increases in education, research and foreign aid.

Despite the fears of the still-influential former Treasury secretary Robert Rubin, investors around the world were more than happy to buy new issues of US Treasuries, no matter how voluminous. Contrary to conventional wisdom, the quadrupling of the deficit did not lead to falling bond prices and rising yields. Instead, the flight to quality and the deflationary pressures unleashed by the crisis around the world drove long-term yields downwards. They remained at close to 3 per cent all year.

Nor was there a dollar rout, as many had feared. The foreign appetite for the US currency withstood the Fed's money-printing antics, and the trade weighted exchange rate actually appreciated during 2009.

Here was the irony at the heart of the crisis. In all kinds of ways, the Great Repression had "Made in America" stamped all over it. Yet its effects were more severe in the rest of the world than in the US. And, as a consequence, the US managed to retain its "safe haven" status. The worse things got elsewhere, the more readily investors bought Treasuries and held dollars.

For the rest of the world, 2009 proved to be an annus horribilis . Japan was plunged back into the deflationary nightmare of the 1990s by yen appreciation and a collapse of consumer confidence. Things were little better in Europe. By the first quarter of 2009, it became apparent that the problems of the European banks were just as serious as those of their American counterparts. Moreover, in the absence of a European-wide finance ministry, all talk of a European stimulus package was just that - mere talk. In practice, fiscal policy became a matter of sauve qui peut , with each European country improvising its own bailout and its own stimulus package. The result was a mess.

Political instability struck China, where riots by newly redundant workers in Shenzhen and other export centres provoked a heavy-handed clampdown by the government, but also a renewed effort by the People's Bank of China to prevent the appreciation of the yuan by buying up yet more hundreds of billions of dollars of US Treasuries. "Chimerica" - the symbiotic relationship between China and America - not only survived the crisis but gained from it. Although Obama's decision to attend the first G2 summit in Beijing in April dismayed some liberals, most recognised that trade trumped Tibet at such a time of economic crisis.

This asymmetric character of the global crisis - the fact that the shocks were even bigger on the periphery than at the epicentre - had its disadvantages for the US, to be sure. Any hope that America could depreciate its way out from under its external debt burden faded as 10-year yields and the dollar held firm. Nor did American manufacturers get a second wind from reviving exports, as they would have done had the dollar sagged. The Fed's achievement was to keep inflation in positive territory - just. Those who had feared galloping inflation and the end of the dollar as a reserve currency were confounded.

On the other hand, the troubles of the rest of the world meant that in relative terms the US gained, politically as well as economically. Many commentators had warned in 2008 that the financial crisis would be the final nail in the coffin of America's credibility around the world. First, neoconservatism had been discredited in Iraq. Now the "Washington consensus" on free markets had collapsed. Yet this was to overlook two things. The first was that most other economic systems fared even worse than America's when the crisis struck: the country's fiercest critics - Russia, Venezuela - fell flattest. The second was the enormous boost to America's international reputation that followed Obama's inauguration.

If proof were needed that the US constitution still worked, here it was. If proof were needed that America had expunged its original sin of racial discrimination, here it was. And if proof were needed that Americans were pragmatists, not ideologues, here it was. It was not that Obama's New New Deal produced an economic miracle. It was more that the federal takeover of the big banks and the conversion of all private mortgage debt into new 50-year Obamabonds signalled an impressive boldness on the part of the new president.

The same was true of Obama's decision to fly to Tehran in June - a decision that did more than anything else to sour relations with Hillary Clinton, whose supporters never quite recovered from the sight of the former presidential candidate shrouded in a veil. Like Richard Nixon's visit to China in 1972, it symbolised a readiness on Obama's part to rethink the very fundamentals of American grand strategy. And the downfall of the Iranian president Mahmoud Ahmadinejad - followed soon after by the abandonment of the country's nuclear weapons programme - was a significant prize in its own right. With their economy prostrate, the pragmatists in Tehran were finally ready to make their peace with "the Great Satan" in return for desperately needed investment.

Meanwhile, al-Qaeda's bungled attempt to assassinate Obama only served to discredit radical Islamism and to reinforce Obama's public image as "The One".

By year end, it was possible for the first time to detect - rather than just to hope for - the beginning of the end of the Great Repression. The downward spiral in America's real estate market and the banking system had finally been halted by radical steps that the administration had initially hesitated to take. At the same time, the far larger economic problems in the rest of the world had given Obama a unique opportunity to reassert American leadership.

The "unipolar moment" was over, no question. But power is a relative concept, as the president pointed out in his last press conference of the year: "They warned us that America was doomed to decline. And we certainly all got poorer this year. But they forgot that if everyone else declined even further, then America would still be out in front. After all, in the land of the blind, the one-eyed man is king."

And, with a wink, President Barack Obama wished the world a happy new year.

Deflationary shock

First a personal disclaimer: It is not that I was so smart to get out of the market, just that I was too stupid to get in. Couldn't figure out why the McMansions offered 'captivating value', why stocks were just going to keep going up, why oil would go to $200 ... so I opted out. Took a Chauncey Gardener approach and learned a lot by watching. My belief is that Chauncey will be wearing toothpicks under his eyelids in 2009.
'The mendacity of hope and the urgency of not', should be the investors' mantra in this new Year of our Lord but unfortunately the lure of easy money doesn't fade easily - it literally has to be beaten out of a fella. Folks need to appreciate that fortunes weren't lost in 1929, they were lost by buying all the way down. Stocks bottom when no one cares.
Much has been made of looking at history to predict today's woes. B.S. Bernakke, a student of history, seems determined to make his own mistakes. The best he can do, in this humble blogger's opinion is to concentrate the timeline by truncating the misery.
Since we are too timid to drop the banks in the acid bath of price discovery as Sweden did, our alternative is too accelerate the Japanese process by flooding the insolvent banks with liquidity, removing all incentives to being risk-adverse by threatening to monetize cows, and ultimately bridging the output gap by stimulating anything that moves.
Try as we might though, the creative destruction of Mr. Market will continue, albeit in a much more temporally compressed form then the historical slideshow of our eastern friends.
As I sit on a Scrooge McDuck pile of powder, certainly I would like to be an investing smartypants too. Armed with the knowledge that the moment to deploy funds is when every emotional neuron is screaming 'oh hell no!' here is what I am looking for - with the admonition that if I am wrong I lose only opportunity.
Simply put, I am waiting for gold to crash.
What I am looking for is a deflationary shock marked by gold dropping 30-40% from current levels. If gold crouches all else will be in a fetal position save the dollar and treasuries (and maybe just maybe the UK pound). I'm putting my mental chips down on Rosenberg's 1.5% prediction for the 10 year.
What to do then? Why that which I've waited for. Become a long-term investor.
First in the 'hards' and select bonds - then in the 'softs', then equities. then housing.
Someday I will short the long bond into dust. But today is not that day.

Does this mean I'll get the rocket car I was promised?

By Richard Gray, Science Correspondent
Last Updated: 4:50PM GMT 27 Dec 2008

While it has seemed an impossible goal for nearly 100 years, scientists now believe that they are on brink of cracking one of the biggest problems in physics by harnessing the power of nuclear fusion, the reaction that burns at the heart of the sun.

In the spring, a team will begin attempts to ignite a tiny man-made star inside a laboratory and trigger a thermonuclear reaction.

Its goal is to generate temperatures of more than 100 million degrees Celsius and pressures billions of times higher than those found anywhere else on earth, from a speck of fuel little bigger than a pinhead. If successful, the experiment will mark the first step towards building a practical nuclear fusion power station and a source of almost limitless energy.

At a time when fossil fuel supplies are dwindling and fears about global warming are forcing governments to seek clean energy sources, fusion could provide the answer. Hydrogen, the fuel needed for fusion reactions, is among the most abundant in the universe. Building work on the £1.2 billion nuclear fusion experiment is due to be completed in spring.

Scientists at the National Ignition Facility (NIF) in Livermore, nestled among the wine-producing vineyards of central California, will use a laser that concentrates 1,000 times the electric generating power of the United States into a billionth of a second.

The result should be an explosion in the 32ft-wide reaction chamber which will produce at least 10 times the amount of energy used to create it.

"We are creating the conditions that exist inside the sun," said Ed Moses, director of the facility. "It is like tapping into the real solar energy as fusion is the source of all energy in the world. It is really exciting physics, but beyond that there are huge social, economic and global problems that it can help to solve."

Inside a structure covering an area the size of three football pitches, a single infrared laser will be sent through almost a mile of lenses, mirrors and amplifiers to create a beam more than 10 billion times more powerful than a household light bulb.

Housed within a hanger-sized room that has to be pumped clear of dust to prevent impurities getting into the beam, the laser will then be split into 192 separate beams, converted into ultraviolet light and focused into a capsule at the centre of an aluminium and concrete-coated target chamber.

When the laser beams hit the inside of the capsule, they should generate high-energy X-rays that, within a few billionths of a second, compress the fuel pellet inside until its outer shell blows off.

This explosion of the fuel pellet shell produces an equal and opposite reaction that compresses the fuel itself together until nuclear fusion begins, releasing vast amounts of energy.

Scientists have been attempting to harness nuclear fusion since Albert Einstein’s equation E=mc², which he derived in 1905, raised the possibility that fusing atoms together could release tremendous amounts of energy.

Under Einstein’s theory, the amount of energy locked up in one gram of matter is enough to power 28,500 100-watt lightbulbs for a year.

Until now, such fusion has only been possible inside nuclear weapons and highly unstable plasmas created in incredibly strong magnetic fields. The work at Livermore could change all this

Saturday, December 27, 2008

Now is not the time to eat alone

(PIMPCO must have said NYET. Quite a game of chicken they are playing. GMAC debt is senior to the TARP funds that GMAC hopes to get by becoming a BHC. The catch is that GMAC needs for PIMPCO to tender its' bonds (and take a loss) to hit the required 75% tender threshold (to become a BHC). PIMPCO must be betting that the Federales will not take away the BHC status they granted on Christmas Eve. PIMPCO gets to have their cake (not take a loss by tendering the bonds)- and eat it to (have the GMAC debt rally since it is senior to TARP funds). Pretty sneaky eh? Bet the ~60% who did tender and did take a loss will be a bit ticked off. Tough luck folks, in 'this thing of ours' it's members only. - AM)

5 hours ago

Even after a crucial deadline came and went, the financing arm of General Motors Corp. remained silent Saturday on whether it cleared a final hurdle to become a bank holding company and gain access to billions in federal bailout money.
Analysts have speculated that if GMAC Financial Services LLC doesn't obtain financial help it would have to file for bankruptcy protection or shut down, which would be a serious blow to parent GM's own chances for survival.
GMAC had received the Federal Reserve's approval to become a bank holding company earlier in the week, but the approval was contingent on the ailing auto and home loan provider completing a complicated debt-for-equity exchange by 11:59 p.m. EST Friday.
In an e-mail early Saturday, GMAC spokeswoman Gina Proia did not provide any specifics.
"The offer did expire yesterday at 11:59 p.m. as planned. We have not yet issued final results but intend to in the near term. I have no further comment on the exchange until then," she wrote.
Becoming a bank holding company would both qualify GMAC to access the government's bank rescue funds and support GMAC loans to car buyers and GM dealerships. GM owns 49 percent of GMAC.
The Federal Reserve apparently needed to see that bondholders were willing to inject more capital into GMAC. The bondholders needed reassurance that the Fed would approve GMAC's application to qualify for federal aid.
If the auto lender failed to meet the exchange deadline, the repercussions for General Motors could be dire, according to Erich Merkle, an auto industry analyst with Crowe Horwath LLP.
General Motors' ownership of GMAC has kept the finance arm lending to dealers and car buyers, even as credit from banks has dried up. If GMAC goes under, other institutions aren't likely to step in to replace the credit lost by GM's dealers and customers.
"It would make a difficult selling environment for GM that much more difficult," Merkle said in an interview Saturday.
The Fed's action Wednesday came as GMAC was struggling to get bondholders to convert 75 percent of their debt into equity of the company.

Friday, December 26, 2008

Doublemint Bailout

Wall Street Journal
December 26, 2008

A fund (that would be you - AM) has bought an additional $16 billion in collateralized debt obligations from AIG that was insured through credit-default swap contracts.

The CDO purchases allow AIG to cancel an equivalent amount of CDS contracts its finance subsidiary had written on those securities, relieving some of the financial pressure that led the government to step in to help the troubled insurance giant in September.

The Maiden Lane III fund paid $6.7 billion to buy the latest batch of CDOs, while CDS counterparties kept $9.2 billion of collateral. (What is not mentioned is that the 9.2 billion is effectively a bailout of the counterparty. This article is written in such a way that one might assume that the Federales are paying 6.7B for 16B face. Hence they paid 40%. Au contraire - Federales are paying 16B for 16B face and only the Good Lord knows what it is worth. My guess, maybe a nickel. This was 2 bailouts in 1!-AM)

So far, Maiden Lane III has bought $62.1 billion of such CDOs at a cost of about $24.3 billion (well not exactly like the example above we gave away the collateral - AM) AIG said, adding that it is looking for ways to eliminate the remaining $12.3 billion. (The other 12.3 Billion? - a collaterized garbage truck - $2.6 billion of remaining physically-settled CDS and approximately $9.7 billion of "cash-settled" or "pay-as-you-go" CDS in respect of protected baskets of reference credits (which may also include single name CDS in addition to securities and loans) - AM).

Maiden Lane III was formed by AIG and the New York Fed last month to try to resolve the insurance firm's bad bets on CDS contracts.( A taxpayer redistribution for speculative bets made by rich folks - AM) AIG invested $5 billion in equity and the Fed has agreed to lend as much as $30 billion.

The entity will collect cash flows from the CDOs to first pay off the Fed's loan and then repay AIG's equity investment. After that, if there are any profits, they would be split 67% to the Fed and 33% to AIG. (I look forward to that reporting, I'm sure the results will be transparent, don't you? - AM)

Wednesday, December 24, 2008

Yuan Watch : Using Usury

Dec. 24 (Bloomberg)
By Zhao Yidi, Zhang Dingmin and Irene Shen

After months of rejection from Beijing banks, Wang Fei got the money to start a dried-fruit business by pledging his apartment to a pawnbroker.

The 25-year-old law-school graduate is following a path taken by a growing number of Chinese entrepreneurs and small businesses. Within days of offering his 90 square meter (969 square feet) flat as security, Wang got 400,000 yuan ($58,421) from Baoruitong Pawnshop Co., the nation’s biggest pawnbroker.

“We were desperate,” said Wang in an interview in Beijing’s Viva shopping mall, where his stall is. “The banks said they need at least a month to give us the loan, but our business will vanish if it takes that long.”

Pawn shops, banned during more than three decades of Communist rule from 1956 to 1987, are making a comeback as China’s government tries to ease the credit crunch that is strangling small businesses. Baoruitong’s loans have risen by more than 70 percent per year since 1997, said Xu Yunpeng, manager of the firm’s real-estate department.

In 1997, Beijing only had four pawn shops. This year, Beijing and Shanghai authorized a record 94 new outlets for 2009 in an effort to channel funds to the entrepreneurs who drove the nation’s biggest economic boom, according to the Beijing Pawn Trade Association and Shanghai Pawn Trade Association.

In Beijing, home to 336,684 private companies, lending by pawn shops increased by 71 percent to 9 billion yuan in the first nine months from a year earlier, according to the Beijing association. The Ministry of Commerce in Beijing issued 46 new pawn-shop licenses for 2009, adding to 115 existing outlets.

Filling a Gap

“Pawn shops are filling in the financing gap by lending to small and medium-sized companies and there is still room to expand that function,” said Yi Xianrong, a researcher with the Institute of Finance and Banking under the Chinese Academy of Social Sciences in Beijing.

“Bank loans extended to small and medium enterprises in the first three quarters this year have dropped from the same period a year earlier,” said Jia Kang, head of Institute of Fiscal Science at the Ministry of Finance. He declined to give figures.

“Speed and simple procedure is our lifeblood,” said Xu in an interview at the company’s two-floor Beijing headquarters. “Our industry serves people in need. Clients can get cash in minutes if they bring in diamonds, jade, and watches.” For autos and real estate, “we aim to hand clients their cash within 12 hours.”

Baoruitong charges as much as 3.2 percent per month for loans backed by real estate and 4.7 percent those with movable assets such as cars as collateral. The rates are approved by the Ministry of Commerce. Chinese banks offer loans to small start- ups at around 0.75 percent per month.

“The pawn shops have the ability to work with the government during this global financial crisis and domestic economic slowdown,” said Duan Wei, deputy director of the local Ministry of Commerce bureau. “Together we’ll help small and medium companies pass this financial winter.”

Pawnbrokers have become so important for entrepreneurs that Bank of Communications Ltd., China’s fifth-largest bank by assets, has teamed up with Beijing Huaxia Pawnshop Co. to target small and medium-sized businesses. Under their joint project, “Bank- Pawn-Expressway,” a borrower can get a quick loan from Huaxia to meet urgent funding needs and then repay the pawn shop once it gets a cheaper bank loan, which the pawn shop guarantees.

“We work 24 hours a day and we can burn the midnight oil to do due diligence, which banks won’t,” said Huaxia Chairman Yang Yong, in a Dec. 8 interview. “And we can deliver to your home.”

Still, even pawnbrokers are feeling the effects of China’s slowing growth. Yang said loan defaults, rare in normal years, are on the rise. A recent attempt to recover a loan by selling the pledged year-old Mercedes S350 returned only 900,000 yuan, or 90 percent of the loan, he said.

“We thought there won’t be a problem selling a car like that for 1.1 million,” he said. A new S350 costs as much as 1.45 million yuan.

For entrepreneur Wang and business partner Dong Huan, the pawn-shop loan allowed them to buy their first batch of dried jujubes and raisins from Xinjiang province and pay rent on their 20 square-meter booth.

“The interest rate they charge is high, but they are so fast and easy,” said Wang, who paid the debt in four months. “If I ever need cash again, I will go to the pawn shops.”

Yuan Watch : Settlement Trials

Dow Jones
December 24, 2008

China's State Council decided Wednesday to begin yuan settlement trials with some regional countries, a move that analysts say will boost regional trade and further liberalize the local currency.

The Cabinet said it will also raise the export-tax rebates on some goods yet again, and expand a government-run fund to support exporters.

The plans, decided at the Cabinet's Standing Committee meeting chaired by Premier Wen Jiabao Wednesday, come after China's exports have been badly hurt by weaker external demand.

One trial will be for trade between two regions in the mainland -- Guangdong province and the Yangtze River Delta -- and Hong Kong and Macau outside the mainland.

The government will also start another trial to allow the yuan to be used as a settlement currency for trade between Yunnan province and Guangxi autonomous region on the one hand, and the Association of Southeast Asian Nations on the other.

The Cabinet said it will also mandate policy banks to expand export buyers' credit, which is a form of credit facility given to the importer. It didn't elaborate.

Wang Qing, an economist with Morgan Stanley, said the yuan settlement trial is "potentially very important," because that will boost regional trade. The global crisis and dollar shortage have caused difficulties for some of China's trade partners to import goods from China, he said.

The yuan settlement trial for neighboring countries is an important first step for China to internationalize the yuan, he said. To carry out the trial, China would need to keep a stable exchange rate between the yuan and the U.S. dollar, Mr. Wang said.

In another move to liberalize China's capital account, China will allow eligible companies in Hong Kong to use the yuan as a settlement currency for trade transactions, Hong Kong Chief Executive Donald Tsang said earlier this month.

Additionally, the Cabinet said it plans to raise export-tax rebates further on some highly value-added machinery and electrical products, but didn't provide a timeframe, list the specific items, or specify the magnitude of the planned increase.

The previous increase in export-tax rebates took effect Dec. 1, when rebates were increased to between 9% and 14% on a range of labor-intensive goods as well as mechanical and electrical products.

The Cabinet also decided Wednesday to "appropriately increase" the size of the country's foreign-trade development fund. It didn't elaborate. In 1996, China set up the fund using part of the revenue from export-quota bidding to help exporters.

According to rules set by the Ministry of Finance, a certain proportion of the fund is used to support exports of machinery and electrical goods. The ministry doesn't regularly disclose the size of the fund it manages.

In the eleven months ended Nov 30, China's exports of machinery and electrical goods totaled $761.3 billion and accounted for 57.8% of the country's total trade during the period.

Barn door meets horse

Wall Street Journal
December 24, 2008

The Securities and Exchange Commission on Tuesday granted a key exemption allowing New York Stock Exchange parent NYSE Euronext to clear credit-default swaps in the U.S., though has yet to approve two rival offerings.

The approval is a first step toward providing greater oversight to the $54 trillion market, which has operated unregulated while its growth has exploded over the past decade. Congress is expected to take up the issue next year as it sorts out a broader review of financial-market oversight.

Approving new platforms to process CDSs is part of an effort to reduce risk in a market blamed for exacerbating the financial crisis.

NYSE Euronext, in partnership with large U.K.-based trade-clearing house LCH.Clearnet Group Ltd., is one of at least three rivals seeking to process CDS trades in the U.S.

Chicago Mercantile Exchange parent CME Group Inc. and IntercontinentalExchange Inc. are awaiting SEC exemptions to launch their own CDS platforms. ICE also requires approval from the New York Federal Reserve.

The three regulators involved in the process have maintained that all approvals would be coordinated to avoid any party securing a competitive advantage.

NYSE Euronext launched a European CDS clearing operation this week, and the SEC decision extends access to U.S. market participants.

The CME cleared one hurdle Tuesday when the Commodity Futures Trading Commission and the New York Fed said that they had no objections.

The CFTC said the proposed Credit Market Derivatives Exchange controlled by CME and Citadel Investment Group, the hedge-fund manager, complied with federal laws for derivatives clearing organizations. The partners are establishing a $7 billion fund to guarantee CDS trades.

Credit-default swaps are privately traded contracts that require one party to pay another if a third party defaults.

In October, LCH.Clearnet agreed to be acquired by U.S. Depository Trust & Clearing Corp., the large U.S. stocks and bond clearinghouse.

Until now, buyers and sellers of credit-default swaps made their deals privately with little scrutiny from regulators. When big players in the market started having problems, it sent ripples through financial markets and fear spread.

CDO 101 is now in session

H/t Felix

by Noah Millman
December 23, 2008

As readers of this blog may recall, I’ve spent the last several years working in an industry now credibly blamed for bringing on what is almost certainly the worst economic crisis since the Great Depression. Not only have I been working on Wall Street, but I work in structured finance. While I wasn’t at the epicenter of the crisis – I didn’t put together mortgage securitizations, and I don’t work for one of the big firms – I was certainly using some of the same financial technology, and trading the same products, as the businesses that were at the epicenter.

Given my eye-of-the-storm view of the matter, I thought it would be of interest to relate two stories from my long career in structured finance, one that may help explain why, if you asked me in 2004 or 2005, I would have staunchly defended structured finance technology as having real social benefit and why, by a couple of years later, it was clear to anyone looking honestly at the business that something had gone very wrong. I’ve chosen two stories that, as it happens, do not relate to mortgage securitization, for two reasons: first, because my world was primarily centered on corporate structured finance, so that’s what I know best, but, second, because I want to make it clear that both the promise and the peril of this financial technology extend well beyond the best-reported area of mortgage finance.

First, the promise.

Most of what I’ve worked on over the years is structuring and issuing synthetic corporate CDOs, and actively adjusting the composition of those asset pools over time. Our firm closed its first synthetic CDO in late 2001. To refresh everyone’s memory, late 2001 saw the terrorist attacks on New York and Washington, the collapse of Enron, and, following shortly thereafter in early 2002, the collapse of Worldcom. Enron and Worldcom were, at the time, the two biggest corporate frauds in history, and their collapse had far-reaching consequences.

Enron and Worldcom had invested huge amounts of mostly borrowed money in, respectively, a variety of commodity trading operations and broadband telecommunications infrastructure. Both firms appeared to be profitable, and numerous other firms – energy-generation utilities in the first case, telecom providers in the second – borrowed lots of money to invest in competing platforms, so as not to be left behind. When it became clear that both firms were frauds at heart, and that these activities were not profitable, it didn’t take long for people to figure out that there were a whole lot of other firms out there that were now in trouble. The market had already priced in a slowdown in telecom, for example, but it thought this slowdown was from a base of real profitability. If there had been no profit when times were good, then things were going to be much worse than originally anticipated now that times were bad.

Everyone knows what happened to the stock market in 2002. The corporate debt market situation was not as well-reported because it was of less interest to individual investors. But it was of enormous importance to the future of these companies, and to the world economy. Many of these companies had huge debt loads and substantial near-term refinancing needs. And it wasn’t clear they were going to get that refinancing, as investors were not eager to buy bonds from companies that might be the next Enron or Worldcom, and banks were not eager to lend more when they were increasing their provisions against their existing holdings. There was a real danger of a credit crunch, and a catastrophic series of bankruptcies that would cripple the banking sector for years.

Everyone also knows what the Fed did to respond to this threat: it dropped interest rates to what were once considered extremely low levels (the same thing the Fed did after the S&L debacle). Since banks borrow short via deposits and lend long, dropping the front end of the curve straightforwardly increases banks’ profitability which should (if banks are well-capitalized) make them more willing to risk capital by lending. And lend they did: most of the companies in question got new financing and, over the next two years, corporate America dramatically improved its balance sheets, paying down and/or extending out its debt, setting itself up for several years of extraordinary profit growth.

But, once again, what’s less reported is the role that structured finance played in facilitating bank lending. And it played a very important role. One reason banks were willing to lend again was that the credit derivatives marketplace made it possible for them to price and hedge their credit risk. Prior to the development of credit derivatives, it was extremely difficult for banks to get a clear picture of the price of credit. There was no market for corporate loans, and the corporate bond market is a clubby place where transparent pricing is available only for the most liquid issuers. But by 2002, the credit derivatives marketplace had matured to the point that banks could use it as one input into their decisionmaking process about when to lend.

And they could hedge their risk as well. Let’s say you were a utility that needed to roll over $1 billion in debt coming due in six months. The syndicate that lent you the money initially is ten banks, so that’s $100 million per bank on average. None of the banks want to take that much risk. At their previous level of security, they’d want to cut back to $25 million each; if they can get additional security, they’d consider going to $50 million each. How do you increase lending capacity? Well, if a bank can buy a credit default swap on $50 million, then it can lend $100 million, and hedge itself back to $50 million. And who would write that default swap? Maybe a hedge fund making a bet that credit would outperform equity (so-called “capital structure arbitrage”) and was therefore writing credit-default-swaps and shorting stock as a hedge. Maybe an insurance company taking advantage of wide spreads to take additional corporate credit exposure in its investment portfolio. Maybe a foreign bank that isn’t part of the lending syndicate for the utility looking to diversify geographically.

Or maybe the protection seller was a structured finance vehicle. This could be a vehicle set up by the bank itself – a balance-sheet CDO. This was an increasingly popular technology early in the decade, and it enabled banks to reduce concentrations to a wide variety of corporate credit risks all in one shot. Basically, the bank would take its portfolio of loans, and transfer a portion of these loans to a special-purpose vehicle via a credit default swap. Then the vehicle would issue various classes of debt, backed by government bonds and by the cashflow from this default swap, rated based on their relative level of seniority. The ratings agency process for rating this debt was based, as always with the agencies, on their historical data on corporate defaults and recoveries on defaulted assets in workout, and, given that corporate default data goes back to the 1920s, they’ve got a pretty decent data set to work off – moreover, this is the same data set that corporate bond investors such as insurance companies have long used in their own investment process, so market confidence in the ratings methodology was pretty high. If a bank set up such a vehicle, it could significantly expands its capacity to lend – it was effectively creating a synthetic syndicate for every loan it needed to hedge, a syndicate consisting not of other banks but of a much wider array of other investors, each investing at its preferred level of risk.

And apart from bank balance sheet CDOs, there were also “arbitrage” CDOs – investment vehicles structured around CDO technology. Equity investors in such vehicles were basically borrowing for term from the various classes of debt investor to purchase a portfolio of corporate risk, and could change the composition of that portfolio (subject to a variety of ratings agency restrictions) to capitalize on market moves of various kinds. By 2002, this CDO market had already become synthetic, which meant that a variety of investment banks could create such structures on the fly designed around the precise risks investors wished to access (in terms of the underlying portfolio and the degree of leverage in the structure). Again, because of the robustness and familiarity of the data set used by the agencies, market confidence in the ratings process was fairly high. Arbitrage vehicles of this sort made a material contribution to the liquidity of the corporate credit default swap market in the early 2000s, and thereby made it possible for banks to hedge their credit exposures to corporations to whom they extended credit, which in turn made it possible for them to expand their lending activities at precisely the moment when they were most nervous about doing so, and when the economy most needed them to do so.

Coming out of the experience of 2002, I can fairly say that I was a believer in the social value of credit derivatives and structured finance as part of the great machine of capitalism. I had seen this market and this technology play an important part in speeding the recovery from a fairly serious corporate borrowing binge that started with the internet bubble and ended with the collapse of Enron and Worldcom. Not the leading part – the Fed’s rate cuts were clearly much more important – but an important part nonetheless. Credit derivatives and structured finance were supposed to increase market transparency and liquidity, facilitate the more efficient pricing and distribution of credit risk, and hence smooth out the credit cycle. And that’s exactly what they appeared to have done.

Then, the peril.

Fast-forward to 2006. I could easily spend 10,000 words explaining all the ways in which the credit-derivatives and structured-products markets had grown, and changed. By this time, structured finance technology had facilitated a truly insane inflation of the housing market, and the extension of credit on absurd terms to borrowers who nobody could rationally expect to be able to pay. And credit derivatives made it possible for companies like AIG to leverage their AAA credit ratings to acquire enormous nominal amounts of purportedly loss-remote credit risk and leverage this risk hundreds of times without any regulatory body being aware of their activities, much less able to intervene to control them. Much of this has been well-reported in a variety of venues. I want to tell one anecdote from the corporate structured finance market (the market I know best) as a means of debunking what I think is a rather self-justifying explanations for how things went so wrong in the mortgage market.

It has been argued that, in a nutshell, the reason things went so wrong in the structured finance market is that “nobody” thought that the national housing market could suffer a meaningful year-on-year price decline. Local markets could decline, yes, and that national market could stagnate for a bit, as it had in past recessions. But a significant national decline in housing prices was inconceivable, and hence was not factored in to the ratings-agency models for mortgage securitizations. Rather, the agencies assumed historic default correlations between different geographies were predictive of future correlations, as well as that historic default rates were predictive of future default rates.

The argument against this is that the agencies should have known that the structured finance market they created by rating all this paper was, itself, changing the complexion of the underlying mortgages, and that this could change both default rates and default correlations (as, indeed, occurred). They should have factored this “reflexivity” (to use George Soros’ term) into their models, and made their ratings tougher. And there’s a great deal of truth to this, but I think this objection gives the agencies too much credit. After all, if all they got wrong was not paying attention to the tails of the distribution – the “black swan” problem – then they made the kind of error that happens all the time in finance; indeed, the kind of error that routinely creates bubbles. The thing about black swans is that you have no idea how likely they are, which makes it extremely difficult to build them into your models. There are always Cassandras out there saying the sky is about to fall, and eventually they will be right, but if you listen to them all the time you’ll never get out of bed.

The agencies got so much more wrong than that (for example, they didn’t rate the quality of servicers or originators of loans, which you would think would be important in assessing the credit quality of the mortgages in a securitization). But the thing they got most wrong was ignoring the quality of their own data set. The sub-prime mortgage market was still young when the agencies began rating securitizations dominated by such mortgages. And the structured finance market was in its infancy when the agencies began rating CDOs backed by asset-backed securities backed in turn by sub-prime mortgages. There is simply no way that the agencies had an adequate data set to justify rating these deals at all. And I can best illustrate the agencies’ disregard for the quality of their data sets by reference to a product unrelated to mortgages: the constant-proportion debt obligation, or CPDO.

This obscure little product was launched in late 2006 to great fanfare. And it was, indeed, an ingenious little fraud of a product. Here’s how it worked.

Some clever structurer noticed that, historically, investment-grade companies don’t default very often. Rather, they deteriorate for a while first, get downgraded to junk status, and eventually they default. That’s why the short-term ratings for relatively low-rated investment-grade companies may be reasonably high: even BBB companies are generally good for the next 90 days; if they weren’t, they wouldn’t be rated BBB. And this suggested the possibility of a trading strategy.

What if you bought a portfolio of investment-grade corporate debt and, every six months, purged it of the bonds that were downgraded to junk, replacing these with new investment-grade bonds. Obviously, you’d expect the downgraded bonds to underperform the remainder of the pool, so you’d have losses you need to make up, so assume you also sell out of a handful of bonds that have done well, and replace these with higher-yielding bonds that are still investment-grade, thus keeping your yield relatively constant. You’d still expect some losses if you wanted to keep your average rating relatively constant, though. So you need some excess yield to make up for these losses.

You find that yield by leveraging the portfolio. After all, it’s an investment-grade portfolio, very unlikely to default in the short term. You can borrow very cheaply short-term, invest in longer-term bonds, and earn the spread differential. If the bonds go against you, that’s OK, because you’re going to hold them to maturity and you’ll always be able to roll your short-term borrowing. And, if you can get a high enough degree of leverage, the excess in current yield from the differential between where you borrow and the yield on your portfolio should more than pay for the cost of rolling out of your losers every six months. And if you do that successfully, you’ve got a trading strategy that never loses principal, but has a surprisingly high expected yield. Sound good?

Well, it sounded great to the ratings agencies, who blessed this strategy by giving it a AAA rating.

How did they justify that AAA rating? By looking at the historic cost of rolling credit derivatives on indices of investment-grade corporate issuers, which generally have a high-BBB rating. These had been around for about three years when the first CPDOs were rated, and the roll had never cost more than 3 basis points. Factoring in that cost, at a leverage of 15-to-1, and using historic 6-month default rates for the portfolio (since the index would be rolled every six months), the proposed trading strategy would never lose money. Hence a AAA rating.

Let me reiterate that, just to drive the point home. The ratings agencies said: you can take a BBB-rated index, leverage it 15-to-1, and follow an entirely automatic trading strategy (no trader discretion, no forecasting of defaults or anything, just a formula-driven adjustment to the leverage ratio and an automatic roll of the index), and the result is rated AAA.

Needless to say, this worked out really well for all concerned. But that’s not really the point. The point is: the notion that you could grant a AAA based on a trading strategy for which there was at best three-years of data (three years that encompassed not a single recession, I’ll note) is mind-boggling. And, worse than that, nobody at the agencies apparently stood up and said, “wait a second: how can you turn a BBB into a AAA by leveraging it 15-to-1? That’s impossible!” Which, of course, it is.

I want to be very clear about something: we’re not talking about a CDO where the AAA investor is providing leverage, and there are subordinate investors below who bear the first risks of loss. This was a trading strategy; the investor in the AAA CPDO had first-loss risk with respect to a BBB portfolio. The trading strategy was just supposed to generate enough returns to create “virtual” subordination to justify the AAA.

When I first heard about this product, I thought: whichever agencies rated this thing have lost their minds. When people asked me whether it made sense as an investment, I said: it’s an outright fraud. You’re practically guaranteed to lose money. I never bought or sold one of these things myself, and neither did anyone else in our group. But the existence of such a ridiculous product should have been a wake-up call about just how divorced from reality the agencies were. And if they were out to lunch on something as straightforwardly absurd as the CPDO, how out to lunch were they on other products, ones that were far more significant to the markets and the economy, where the absurdity of their assumptions was less-obvious?

How did a market that, I thought, had really helped capitalism work in 2002 become the great destroyer of capitalism of the last two years? There were a lot of contributors to the catastrophe, but one indispensable one is that the ratings agencies monetized their sterling reputations in an extraordinary fashion, and nobody in regulatory apparatus of government saw that this was happening, and what it might portend. The success of 2002 depended on market confidence in the ratings agency process: that’s what made investors willing to buy the notes issued by structured finance vehicles that issued the credit protection that made it possible for banks to hedge. Without that confidence, the market would never have developed. And by 2006, the agencies understood just how much that confidence was worth.

The ratings agencies have an enormous amount of power: pension funds and insurance companies invest according to their rules; under Basel II, bank capital ratios are substantially determined by how the agencies rate their portfolios of loans; and, of course, the entire “shadow banking system” created by providers of super-senior credit protection (monoline insurers, bank-sponsored asset-backed conduits, AIG Financial Products, etc) was only possible because of the ratings agencies. By 2006, the entire financial system was extraordinarily leveraged to the opinions of these government-blessed non-governmental independent agencies, and these agencies were monetizing their market position by trashing their process.

Now, of course, the agencies have radically reversed course. They have completely changed their models, of course. But they’ve also begun to “follow the market”, incorporating credit derivatives swap and equity market pricing into their ratings for companies. If in 2006 the market had, to an alarming degree, delegated its risk-management to the ratings agencies, now the ratings agencies have delegated a great deal of their ratings process to the market. And so the market has lost any reason for confidence in the agencies in both directions: they cannot be trusted when the market is strong to assess the downside risks the market is ignoring, and they cannot be trusted when the market is weak to assess a company’s financial condition independently of the market panic.

This collapse of confidence is having a material impact on the ability of the credit markets to find their footing. I don’t want to minimize the impact of other factors – rates held too low for too long, Wall Street greed, an Administration with an ideological aversion to regulation – but I want to emphasize this one because of its unique contribution to this particular bubble and because I don’t see an obvious solution to it. The old model is permanently broken, and we have not yet come up with an alternative. Right now, we’re in the low-trust environment that is the reality when the libertarian fantasy of eliminating the market-distorting regulators actually comes to pass. The market is inevitably focused on a short time horizon, fickle and volatile by its very nature. We want major financial institutions – banks, insurers, etc. – to look beyond the market to longer term risk metrics. Without the agencies as an independent arbiter of what these might be, the market is all we have left. Trust is a very hard thing to rebuild, and structural changes – having the agencies be government-sponsored, or paid by investors rather than issuers – are insufficient solutions (government-sponsored entities are also capable of seeking to monetize their position – look at Fannie Mae – and investor-sponsored agencies would be subject to the same pressures to facilitate the business that investors want to do).

We are still in a dark wood wandering, the right road lost.

Bankster Swagpile

(Add currency risk to the Full Faith and Credit guaranteed bankster swagpile. - AM)

By Patricia Kuo
Dec. 24 (Bloomberg)

U.S. banks including Citigroup Inc., Goldman Sachs Group Inc. and Morgan Stanley may sell government- guaranteed bonds in Asia next year, tapping growing demand for the region's local-currency debt to bolster their balance sheets.

U.S. financial institutions sold more than $100 billion of government-backed notes in dollars, euros and British pounds since Oct. 14, when the Federal Deposit Insurance Corp. agreed to guarantee their bonds to help them cope with $678 billion of losses and writedowns amid the global credit crunch.

``Banks like Morgan Stanley and Goldman will have to tap Asian currencies because the potential supply is too big for dollars, euros and pounds to take on,'' said Arthur Lau, a fund manager at JF Asset Management Ltd. in Hong Kong, which oversees $128 billion. ``It's a perfect product for insurance companies in Asia. The bonds offer good yield pick-up, high credit ratings, good liquidity and no currency mismatch.''

U.S. banks may be forced to follow European and Australian banks, which lured fund managers to $6.6 billion of government- backed securities in Asia-Pacific since September with yields of as much as double those on sovereign debt, data compiled by Bloomberg show. Sales of FDIC-backed notes maturing in more than a year may reach $450 billion by the end of June, Barclays Capital analysts said on Dec. 9.

Citigroup's $3.75 billion of 2.875 percent FDIC-guaranteed bonds maturing in 2011 traded at 168 basis points above U.S. Treasuries today, Bank of America Corp. prices show. The notes were priced to yield 188.4 basis points more than government debt when sold on Dec. 2, according to Bloomberg data.

``The traditional G3 market is stretched and would likely remain difficult for some time, while funds in the Asian domestic markets still have a lot of money that needs to be put to work,'' said Clifford Lee, head of fixed income at DBS Group Holdings Ltd. in Singapore. ``The setting is perfect for the Asian local- currency market to grow.''

One month doth a year make

December 22, 2008
Wall Street Journal

One of the hallmarks of the long market downturns in the 1930s and the 1970s has returned: Rank-and-file investors are losing faith in stocks.

Today's investors are surveying a stock-market collapse and a wave of Wall Street failures and scandals. Many have headed for the exits: Investors pulled a record $72 billion from stock funds overall in October alone, according to the Investment Company Institute, a mutual-fund trade group

Investors' discomfort with stocks has been growing for years, since just after the 2000 selloff of dotcom shares. From 2002 through 2005, investors put an average of $62 billion a year into U.S. stock mutual funds, less than half the annual level of the previous decade. Since 2006, investors have been pulling money out of U.S. stock funds at a rate of about $40 billion a year.

The sustained troubles of the 1930s exposed scandals in speculative instruments. So-called investment trusts used investor money and borrowed funds to buy high-flying securities, sometimes buying stock in one another. Of the 1,183 investment trusts and other funds that existed from 1927 through 1936, more than half had failed by 1937, a government study showed.

The Dow didn't return to its 1929 high until 1954. New York University financial historian Richard Sylla recalls that even in the 1950s, some people were so spooked by the Depression that they were storing money in jars in the basement.

The stock recovery of the 1940s and 1950s became a speculative boom in the 1960s, marked by the so-called Nifty Fifty stocks that brokers said would rise for years. They didn't.

In 1966, the Dow flirted with the 1000 level, then shed 25%. That bull-and-bear pattern would repeat for 16 years amid inflation and soaring oil prices. Investor confidence was hammered again.

That confidence has been shaken by two bad bear markets in less than a decade. Between 2000 and 2002, the Dow fell 38% and the Nasdaq Composite Index shed 78%. This year's market collapse knocked 47% off the Dow in just over 12 months, returning stocks to 1997 levels. As of Friday, the Dow still was 39% off its 2007 record.

In 2001, people's hopes for stocks were extremely high. Only 5% of those surveyed expected average annual stock returns in the coming decade to be 5% or less, according to University of Oregon Prof. Paul Slovic, whose company, Decision Research, conducts the surveys. Today, nearly one-third of those surveyed expect such stock weakness, reflecting the decline in investor optimism.

But there is a surprising amount of optimism left. More than half of the small investors surveyed still expect annual gains of 10% or more over the next decade -- at, or above, historical averages.

Tuesday, December 23, 2008

Roseanne Roseannadanna issues 2009 predictions

Mrs. Richard Feder from Fort Lee, New Jersey writes in and says:

'Dear Roseanne Roseannadanna,

Mr. Feder has lost half of our money due to Bernie Madoff and I need to hide what is left. Should I buy gold or a CD. If I buy gold and the markets crash will gold go up or down? If a CD, and the dollar crashes will a higher interest rate offset the lower dollar?'

Mrs. Feder I didn't think it was possible but you are just as stupid as your husband, but I know exactly what you are thinking cause I Roseanne Roseannadanna lost money with Bernie too.

Imagine if you will a teeny,tiny, teenage Roseanne Roseannadanna, cute as a little doll, going to prom with a boy named Scott Sosnik. 20 years later I'm in Fort Lee, New Jersey at a Starbucks hoping I don't run into either you or Mr. Feder and seeing Scott ordering a triple something. Well we got to talking and well he was honest, and I love honest ... honest talk, honest books, honest people, and most of all honest investments. I hate it when people do these tricks and make themselves look like real great investors, with fancy cars and suits and offices and little kerchiefs and shiny shoes and stuff.

So anyway I'm like at Scott's office and I don't know why but quess who walks in but Bernie Madoff. Kind of a smurfy looking guy and he's carrying like a bunch of books.
Anyway after I Roseanne Roseannadanna finished investing most of my money with Scott and went back to my car guess what, when that cutey Bernie left his car which was, not to fancy either, parked next to mine he dropped one of them books! It was long black and perfect and I thought I was gonna die. And just between you and me Roseanne Roaseannadanna I saw your name in it.

It just goes to show you it's always something, if it's not one thing, it's another, if you don't know who you are investing with or in then you need to do it yourself.

Gold over a CD? No then yes, yes then no then yes.
Gold and markets crash? Up or down? Yes, but down before up.
CD.. dollar crashes will a higher rate offset the lower dollar? No then yes.

Have a pleasant tomorrow.

Analyst Alchemy

(2 observations here. First, back in 2007 I recall reading that insurance companies had the same amount of 'toxic' mortgage assets on their books as the investment banks save that they were,in aggregate,of lower rating. The second is that the proposition that lower-rated mortgage backed securities are worth anything is in and of itself a fantasy.

On October 6, 2006 Citizen Grant produced a chart from Paul Singer, general partner of Elliott Associates, that was originally presented at a Grant's conference showing a home price depreciation of 7% or more would wipe out all MBS classes below AA- i.e., A and lower). We're not talking haircut, we're talking decapitation. The dead parrot sketch would most certainly apply.

These aren't money good, they are money gone.

Translation of article below : auditors are allowing insurance companies to state imaginary regulatory capital by turning nothing into something
. -AM)

Wall Street Journal
December 23,2008

Accounting watchdogs are fast-tracking an effort to provide a small dose of "mark-to-market" relief for financial firms, as banks and life insurers continue grappling with deteriorating investment holdings.

The Financial Accounting Standards Board last week began steps to loosen a rule regarding when financial firms must book losses on a narrowly defined subset of lower-rated mortgage-backed securities, commercial-backed securities and certain other structured securities.

Late Friday, FASB asked for public comment on the proposal, a sign that it is under serious consideration.

For those financial firms that hold the relatively small group of securities at issue, managements and their auditors would have more leeway to put off a potential write-down that would clip net income. That could help bolster their regulatory capital.

Mark-to-market issues have taken center stage lately as life insurers designate swelling numbers of securities as "temporary impairments." They quarantine these "unrealized" losses in a special bucket within shareholder's equity called "other comprehensive income." Gains and losses in that bucket often aren't included in how regulators in the financial sector measure capital.

Eventually, though, if the losses don't reverse, a firm has to recognize them as "other than temporary." In that case, the loss runs through net income, a move that grabs investor attention and can affect measures of regulatory capital.

The numbers have gotten so huge -- $27 billion at giant insurer MetLife Inc. in late November -- that many investors are worried insurers are failing to recognize reality. And a battle could erupt at year end as auditors potentially demand write-downs of at least some of the securities.

The possible rule revision falls far short of what banking and insurance executives were seeking because they wanted relief that would give them greater leeway in valuing a wider range of securities. But it illustrates how aggressive they have become in trying to stave off paper losses. Analysts are still trying to figure out which companies might own the particular securities at issue.

FASB staff's proposed easing pertains to certain structured securities that were rated lower than double-A at the time of origination.
Most pieces of a securitization are more highly rated when created, many at triple-A.

The rub is that there isn't a clear rule on when losses have to be recognized on any type of debt security. Many banks and insurers continue to maintain, even after some securities have shown market losses for more than a year, that they will eventually be money good. The insurers add that they match investments with policy obligations, and they have cash hoards to ensure they won't be forced sellers.

At MetLife, the nation's biggest life insurer by assets, unrealized losses more than doubled between Sept. 30 and late November, the company told analysts Dec. 8. The company says the "temporarily impaired" securities all are performing well and are overwhelmingly highly rated. It attributed many securities' declines to "supply/demand imbalances" as "deleveraging" continues in much of the financial world. The company expects $200 million to $300 million in realized losses for the fourth quarter.

The FASB staff said the goal is to make the rule more consistent with a broader impairment standard that permits "the use of reasonable management judgment" of the probability of collecting all amounts due. Its change isn't assured; some board members at last Monday's meeting expressed serious reservations about the move. Year-end conversations between auditors and insurance executives likely "will be substantial and somewhat heated," says Andrew Edelsberg, an analyst with ratings firm A.M. Best Co.

"At the end of the day, you have to have a methodology that makes sense and that will be ratified by your audit committee and your outside auditors," adds Rosemarie Mirabella, another analyst at Best.

Synthetic CDO casualties

(There are approximately 600 billion in synthetic CDOs -best guess I've seen- outstanding and the triggering event in each individual contract is known only to the counterparties -AM)

Wall Street Journal
December 23, 2008

...a vast superstructure of credit derivatives such as synthetic CDOs, built up over the past decade, has spread the risk of lending to U.S. companies -- and how far the pain is likely to reach. They're called derivatives in part because they don't entail any direct investment into companies. Instead, they're more like side bets on the companies' fortunes.

Global investors have already lost billions of dollars on derivative investments tied to U.S. subprime mortgages, but many more -- including towns, charities, school districts, pension funds, insurance companies and regional banks -- put money into synthetic CDOs that insure the equivalent of trillions of dollars in mostly U.S. corporate debt.

Synthetic CDOs are vulnerable at this stage in the financial crisis, because of the way they work. They generate income by selling insurance against bond defaults, typically on a pool of 100 or more companies. One way they do so is by entering into contracts known as "credit-default swaps." Investors, receive regular payments from credit-default-swap buyers, which are usually banks or hedge funds.

In return for the income, investors agreed to make huge payments in what was seen as a highly unlikely event: a wave of corporate defaults greater than any experienced in the previous two decades. Now, though, as financial firms implode and a slump in consumer spending hits retailers and manufacturers, that event is starting to happen.

As a result, synthetic-CDO deals are poised to trigger a massive transfer of wealth from investors to hedge funds and the trading units of big U.S. investment banks. By various estimates, the amount of money set to change hands could be anywhere from tens of billions to hundreds of billions of dollars.

"A lot of people shouldn't have been buying these investments in the first place," says Greg Medcraft, former global head of securitization at French bank Société Générale. Earlier this year, Mr. Medcraft became chairman of finance at the town council of Woollahra, a Sydney suburb that had invested heavily in synthetic CDOs before he arrived. "We've got to learn some lessons from what's happening," he says.

Investors are now scrambling to get out of synthetic CDOs by buying default insurance, causing prices to rise. As of Dec. 19, the average annual cost of five-year insurance on $10 million in North American investment-grade companies had reached $215,000, up from $143,000 in early September, according to data provider Markit. That, in turn, helps drive up the cost of borrowing for all kinds of companies, which must consider the cost of default insurance when gauging how much interest they will pay on newly issued bonds.

As synthetic CDOs run into trouble, investors are popping up in unexpected places. In Singapore, hundreds of individuals, including retirees, who bought these notes were recently told they were unlikely to get any of their money back. In Wisconsin, five school districts that put a combined $200 million into synthetic CDOs in 2006 now face budget shortfalls due to write-downs on those investments. Belgian bank KBC recently took a €1.6 billion ($2.23 billion) write-down on synthetic-CDO investments. Australian town councils invested nearly A$600 million in synthetic CDOs, according to a government report.

Meanwhile, the price of default insurance on companies widely used in synthetic CDOs suggests cumulative losses to defaults could rise to more than 10% over the next five years.

Nearly a quarter of the synthetic-CDO securities that started with investment-grade credit ratings from S&P have already been cut to junk, according to data from the rating firm.

"This isn't what investors, and the professionals that created these products, envisioned or wanted to happen," says Mark Adelson, chief credit officer at Standard & Poor's.