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W.I.L. Finance Digest for Week of August 18, 2008

This Week’s Entries : This week’s W.I.L. Offshore News Digest is here.

August 18, 2008

Global financial and economic systems will not begin to “normalize” until the massive global pool of speculative finance deflates.

Doug Noland continues his look at he calls the "global leveraged speculating community" from last week. The community grew by the bubble and now is in the painful process of shrinking with the bubble. They have been the marginal price setters for many/most financial and real asset markets for who knows how long, causing major disfunctions in the real economy along the way. Now this "dysfunctional relationship" is being unwound, and the real and financial economies are and will be forced to adjust together.

The divergence between underlying fundamental developments and market trading dynamics became only more striking this week. July consumer prices were reported up 5.6% from a year earlier, the largest y-o-y increase since January 1991. July import prices were up a record 21.6% y-o-y (data going back to 1982). Despite much worse-than-expected inflation readings, the bond market rallied Thursday. Understandably, the market is rather confident the Fed will ignore inflationary pressures as long as employment trends remain weak. And weak they were. Thursday's report had continuing claims for unemployment jumping another 114,000 last week to 3.417 million -- the highest level since November 2003. Continuing claims were up a notable 320,000 in three weeks, increasing the y-t-d gain to 727,000.

The Treasury market is similarly content to disregard what will now be massive ongoing supply of new government debt issues. The federal deficit surged to a record $102.8 billion during July. [$100 billion is a month!] Spending for the month was up 27.2% y-o-y, pushing fiscal y-t-d spending growth to a positive 8.5%. Receipts were down 5.8% from last July, with fiscal y-t-d Receipts now running 1.0% below a year ago. With two months to go, the fiscal y-t-d deficit has surged to $371 billion, up sharply from last year's comparable $157 billion.

And despite troubling developments in the Caucasus and heightened geopolitical tensions, the energy and commodities rout ran unabated. Sure, the global economy is slowing. Yet the dramatic price moves being witnessed are indicative of panic liquidations. It is now clear that many within the leveraged speculating community have suffered huge losses over the past few weeks. For a "community" that was already suffering a difficult year, blowups in the popular energy, commodities and short dollar trades were a decisive backbreaker. Huge rallies in heavily shorted stocks and sectors have added further pain. One can now expect major redemptions at quarter and year-ends, a dynamic that likely ensures recent near-chaotic market conditions become the norm for awhile.

I could go on and on with a discussion on deteriorating fundamentals. The economy is rapidly sinking into what will prove a deep and protracted downturn. Mortgage problems are broadening and worsening, ushering in another leg of financial system and housing market tumult. Financial sector spreads widened meaningfully again this week, and it is worth noting that American Express issued 5-year debt this afternoon at an eye-opening 425 basis points above Treasuries. Fannie and Freddie debt spreads also widened significantly this week, as did benchmark agency MBS spreads. A severe credit crunch is now tightening its noose around much of the real economy.

But, for now, fundamentals are not driving market prices. As I wrote last week, markets are about greed and fear -- and right now fear dominates. Those that crowded into the crowded energy and commodities trade are having their heads handed to them. It is also my sense that the scores of long/short funds are likely struggling as well, as many popular longs are performing poorly and popular shorts are in many cases rising spectacularly. The proliferation of "market neutral" and "quant" strategies created too many players all working cleverly to play the same game. Those ranks will be thinned over the coming months.

Today's [Friday, 8/15] Wall Street Journal chronicled the pain suffered by one particular hedge fund. Launched in September 2006 by a hot UBS trader, the fund immediately raised $3.0 billion. Performance has not met expectations. The fund dropped 34% in 2007 and was down 77% y-t-d through July. Worse yet, investors had agreed to up to a 5-year lockup. So, even the small amount of their remaining investment [apx. 15% of invested capital] is inaccessible.

A lot has been written about all the crazy mortgage and derivative products that were peddled during the bubble. The incredible mania that engulfed the hedge fund community has not yet received it due. It is simply hard to believe the days of new fund managers raising billions with extended lockups is not coming to an abrupt end. And this is an industry that has for the past few years luxuriated in enormous investment inflows.

While I still read articles noting increased hedge fund investments ... I cannot believe the more sophisticated money is not running or at least considering heading for the exits. At the minimum, the industry appears to have passed a major inflection point, and one should contemplate that acute Ponzi dynamics could easily materialize. As long as the industry was posting strong returns, inflows remained predictably huge. And robust flows ensured that favored positions could be increased and additional leverage employed -- self-reinforcing bull market dynamics. These inflows worked to mark up the value of previous investments, as global securities and commodities markets soared. Investors were completely enamored, while "genius" fund managers raked in billions.

This bubble will not function well in reverse. And I know the argument that most hedge funds are still outperforming the major equities indices. This just does not matter much. I expect the entire dynamic of this industry to change now that the majority of funds face "high water marks" (losses that have to be recovered before incentive fees can again be collected). After suffering losses, many managers will be tempted to role the dice with investors' money: "Heads I win and get my head above the high water mark; tails investors lose and I close the fund and enjoy time at the beach." More responsible managers will operate under intense pressure for performance, forced to place bets but with little room for error. This is a particularly grueling endeavor, and you can rest assured that markets will not cooperate.

Such significantly altered trading dynamics -- not to mention all the burst global speculative bubbles -- create a backdrop where it becomes extremely difficult for speculators to perform. And resulting wild market volatility significantly compounds the pressure and angst. At the same time, many managers had expected to implement various strategies to play the markets' downside -- including shorting, buying put options, writing calls, and certainly playing CDS (credit default swaps) and various other derivatives. Yet because the global leveraged speculating community ballooned to unimaginable dimensions, these various systemic "hedges" and bearish speculations all became one big crowded trade. Things are just not going work as expected, a huge problem for investors with grossly inflated expectations.

Wall Street and global speculator community travails are today at the heart of acute monetary disorder. Global pricing mechanisms have turned dysfunctional. Crude oil, the most important commodity in the world, now sees its price fluctuate 30% over a few short weeks -- to the upside and then to the downside. Currency values have become similarly unhinged. At the same time, liquidity conditions throughout the global debt markets have turned quite spotty at best. All these factors are working corrosively on the global economy.

The consensus view holds that the Fed should maintain today's (grossly inequitable) negative real interest rates indefinitely. This, as the thinking goes, is how the financial sector will repair itself. Everything will then return to normal -- eventually. Besides, inflation will not be much of an issue. I contend that global financial and economic systems will not begin to "normalize" until this massive global pool of speculative finance deflates. Speculators have for some time been the marginal price setters for global securities, energy, commodities and many other asset markets. This is a precarious dynamic, especially considering that large numbers of speculators are impaired and will now be fighting to save their businesses. Things both financial and economic have become hopelessly unstable. And this dysfunctional pricing backdrop has become the major impediment to unavoidable U.S. and global economic adjustment.

August 18, 2008

Doug Noland's "global leveraged speculating community" (see above) is the tip of the overly bloated financial industry iceberg. Since the 1990s it has ballooned to a historically high percentage of U.S. and global GDP, spurred on by a proliferation of products whose risk has been disguised. Now an initial report from a committee led by former Fed vice chairman Gerald Corrigan makes a first timid suggestion that maybe all this nonsense ought to be reigned in. However timid the recommendations, Martin Hutchinson notes: "[I]t does represent the first institutional step towards a goal that all non-financiers should welcome: the downsizing of finance in the U.S. and global economy."

A committee led by Gerald Corrigan, former vice chairman of the Federal Reserve Bank of New York, produced a report this week that promises to revolutionize finance. It proposes to place severe limits on derivatives, bringing them under the ambit of regulators and protecting retail investors from their more egregious products. His report met with a favorable reception from the major international banks; not surprising as it shuts the stable door after horses have bolted to the extent of about $500 billion of losses and counting. For investor and market protection, it does not go far enough. However it does represent the first institutional step towards a goal that all non-financiers should welcome: the downsizing of finance in the U.S. and global economy.

The effect of the report, and of the changes currently under way in finance, can be seen from its treatment of the Auction-Rate Securities market, a $330 billion behemoth that melted down in February. In these transactions, investors buy long term bonds or preferred stock, the interest rate payable on which is determined by an auction process every 30 days or so. Thus investors who no longer wish to hold the securities can in theory sell them to other investors who are prepared to hold them, but only with a higher yield. In practice, in a credit crunch, they did not work. The report proposes a prohibition on selling Auction-Rate Securities to retail investors. In addition, during the last week banks have agreed to repurchase a total of $41 billion in ARS from retail investors -- $18.6 billion by UBS (on top of a previous $3.5 billion) and $20 billion by Citigroup and Merrill Lynch. At least part of the UBS repurchases will be at par, and all repurchases will be at prices close to par.

The Auction-Rate Securities disaster is symptomatic of what went wrong in the investment banking industry following the invention of derivatives in the late 1970s, and the move towards dominance of the major Wall Street houses by traders rather than traditional corporate financiers. Traditional investor protections, devised by seasoned corporate financiers who understood the business cycle and wished to preserve the firm's good name in a downturn, were replaced by the manic bonus-hunting short term-ism of the typical trader.

ARSs have mostly come in two varieties: auction rate preferred stock, issued by corporations and particularly financial institutions, and auction-rate municipal bonds, issued by municipalities. There have been relatively few issues of auction rate conventional corporate debt, perhaps because a deep market already existed for corporate commercial paper at the time ARS were first issued (ARS are unlikely to be truly competitive with commercial paper backed by a bank backstop line, which for the issuer has the same characteristics of a variable interest rate and guaranteed availability over the medium or long term.)

The first auction rate preferred stock was sold by Citicorp (now Citigroup) in 1984. Within three years, the market had grown to $12 billion in outstandings, at which point disaster occurred. An issue of ARP for MCorp, a Texas bank suffering bad debt problems in real estate, suffered a liquidity crisis when there were no longer sufficient bidders for MCorp's short term paper within the price parameters set down for the issue (typically, at that stage, ARP issues prescribed a maximum as well as a minimum rate at which rates would be set.)

This was not surprising. Even the first Citigroup issue had been sold to investors as "just like short term paper" when it was no such thing. Corporate financiers with experience of the difficulties suffered by the international Floating Rate Note market in the credit crisis of 1979-82, then only a few years back, were well aware that while interest rates on floating rate paper would more or less keep up with market levels, in a period of illiquidity prices could fall arbitrarily far, as investors' liquidity preference became so strong that they were no longer ready to bid on new issues of the paper at any yield.

The ARS market thus rested fundamentally on a lie. It is extraordinary that the market lasted 24 years before blowing up, reaching total outstandings of $300 billion and spreading from the preferred stock market to municipal bonds. Retail and institutional investors were fed the market's Big Lie by salesmen, and so believed that ARS were high quality, perfectly liquid paper. The blow-up of February 2008 thus came as a great shock to the market, and it is not surprising that the banks have felt it necessary to buy back retail ARS, lest their costs of doing so be dwarfed by settlements on class action suits from lawyers representing investors – which suits would be justified, for once.

An even more dangerous derivatives-related product, also based fundamentally on a Big Lie, is the credit default swap. Here the Big Lie is that these represent hedging transactions, and hence a net reduction of risk, passing credit risk from the overstretched banks to institutions better able to bear it. Corrigan treats CDS lightly, recommending simply that all these transactions pass through a central clearing house, a recommendation that has been generally accepted, and that was made more urgent by the Bear Stearns collapse.

However a moment's thought, and examination of the principal amounts involved, will tell you that CDS are far more than a hedging instrument. The total amount of corporate debt outstanding in the United States is about $5 trillion, to which can be added $12 trillion of home mortgages to get an idea of the universe of U.S. risks that can be transferred. With bits and pieces, say $20 trillion in total. Yet the principal amount of CDS outstanding exceeds $60 trillion, and is increasing rapidly.

In reality the CDS market moved beyond simple hedging and risk transfer many years ago, and became a sophisticated casino in which Wall Street participants could gamble, look for suckers, transfer income to more convenient years (when their bonus percentages were higher), hide mistakes and play games with the accounting. Given the spurious nature of the motivations behind CDS trading, there can be no doubt that multiple billions of losses have been accrued already in this market, only part of which losses have so far been recognized in financial statements.

When the CDS market is examined closely, it becomes clear that like ARS, it rests on a lie and has very little value to the global economy. Like much of Wall Street's activity over the past two decades, it represents pure rent seeking. Forcing trades to pass through a central clearing house reduces counterparty risk, but does not alter the fact that the CDS market creates many times as much risk as it hedges or transfers. Selling a credit risk more than once, or selling a risk that is not in one's portfolio is not hedging, it is pure speculation, increasing the overall risk in the financial system. The last year has surely demonstrated that excessive credit risks remain the principal threat to a financial system's stability; hence it is truly crazy to encourage a product that multiplies them many-fold. Given the size of the liabilities involved, CDS represent a huge and largely hidden iceberg, which could strike the shoddily designed financial system Titanic at any time.

One should give CDS the benefit of the doubt and assume that at the margin they serve a useful function in risk transfer and balancing of obligations between institutions. However, there can be no reasonable risk-management justification in selling a credit risk one does not possess, or "going short" in the credit of a third party, so that one benefits from that third party's collapse. Far more than mere short selling of stocks, short selling of credit needs to be prohibited, in order that the total volume of CDS outstanding remains a fraction of the credit risks involved and not a multiple of them, and the global financial system is protected from destabilizing games.

A third derivatives-related disaster whose full cost is not yet apparent is the collapse of Fannie Mae and Freddie Mac. Again, those institutions were based on a lie, that they were really private sector companies that could be relied upon to pursue profit in a rational fashion, without endangering the national solvency by their default. In practice, they leveraged more than would have been possible without the government's quasi-guarantee, lobbied like to crazy to ensure they were not properly regulated and collapsed thankfully into the arms of the taxpayer as soon as ill winds began to blow. The cost of the collapse will certainly be far more than the $25 billion estimated by the Congressional Budget Office, since their lending and guarantee practices were so unsound. Indeed, by their presence they turned the soundest product in financial markets, the home mortgage, into an obscene speculative casino, causing collateral damage of many times their own losses.

Finally we have the biggest lie of all, a U.S. monetary policy pursued since 1995 that pretends the free market system works just fine when government agencies are playing games with the value of the monetary unit, inflating its outstanding volume by about 10% per annum, far more than would be justified by economic growth. That lie will cause the largest losses of all -- but I have written about it many times.

Corrigan is a feeble first step in the right direction. Its prohibition on the sale of auction rate securities to retail investors demonstrates as does nothing else that much of the financial services innovation of the last generation was spurious and unsound, and needs to be done away with. Rents achieved by the financial services industry will thereby become much diminished, and millions of more or less honest if overpaid toilers will be thrown out of jobs. Needless to say, stock and bond prices will suffer a meltdown when this becomes fully apparent to the trading fraternity.

For the rest of the global economy, this denouement cannot come quickly enough.

August 18, 2008

The Financial Times dissects the the year past, commencing with the approximate start of the current credit crisis, in an extensive series of articles. That a crisis in the credit markets would hit sometime has been inevitable for a long time. There was just too much debt outstanding relative to the underlying "real" economic activity, and it ran on confidence alone. It was the classic bubble in search of a pin. The only question was when, and how much additional damage would be done with the measures designed to delay it.

Now the conventional talking heads, like those who write for the FT, have declared that a true crisis is here, so that makes it official. The blow-by-blow is worth reading ... and asking, again, why did so few see what we now are experiencing coming? It is not as if what is happening is unprecedented. Just the scope is.

In the end one is left with the impression that no truly original and hard questions are being asked by those closest to the policy levers. No one is looking at the Austrian economic theory that fiat money systems and central banks are plain incompatible with stability and efficiency, and that today's crisis was an inevitable consequence of trying to pretend otherwise. The day that fundamental element of the system is challenged is the day we will think that establishment cluelessness is not endemic.

Just over a year ago, Hiroshi Nakaso, a senior official at the Bank of Japan, started to fear that the global financial system was heading for a jolt. Back then, most American policymakers assumed that the western banking system was extraordinarily strong. Thus while U.S. mortgage defaults were rising, western officials were convinced that such losses would be easily "contained".

But as Mr. Nakaso watched western markets in July 2007, he had a sense of déjà vu. "I see striking similarities in what I see today with the early stages of our own financial crisis [in Japan] more than a decade ago," he privately warned international contacts shortly after IKB, a German lender, imploded as a result of subprime losses. "Probably we will have to be prepared for more events to come ... the crisis management skills of central banks and financial authorities will be truly tested."

His fears proved well-founded. On August 9, 2007, the European Central Bank sent shock waves around world financial capitals when it injected €95 billion ($150 billion) worth of funds into the money markets to prevent borrowing costs from spiralling sharply. The U.S. Federal Reserve soon followed suit. But while the central banks had billed these moves as "pre-emptive" actions to quell incipient market tensions, they did not bring the panic to an end.

On the contrary, as markets that were crucial for raising funds started to dry up last August, a network of financial vehicles slid into crisis, causing the price of many debt securities to collapse. That started a chain reaction that created liquidity and solvency crises at U.S. and European banks -- on a scale last seen in Japan almost exactly a decade ago.

A year later, there is still no sign of an end to these problems. Instead, the sense of pressure on western banks has risen so high that by some measures this is now the worst financial crisis seen in the west for 70 years.

What has made this upheaval so shocking is not simply its scale and duration but the fact that almost all western policymakers and bankers were caught unawares. "If you had said a year ago that America could suffer a banking crisis on the scale of Japan, people would have laughed," one former senior U.S. regulator admits.

And yet plenty of people did see it coming. Just not the kind that policy nitwits pay any attention to.

Or as the Bank for International Settlements, which groups central banks, observes in its latest annual report: "The duration of the turmoil, its scope and the growing evidence of effects on the real economy have come as a great surprise to most commentators, private as well as public." Adding that it "is essential we understand what is going on", the BIS points out that the crucial question is: "How could problems with subprime mortgages, being such a small sector of global financial markets, provoke such dislocation?"

The answer to this seeming mystery lies in the slippery concept of financial "faith". Over the past decade, western banking has experienced an extraordinary burst of innovation, as financiers have discovered ways to slice and dice their loans -- such as the now controversial subprime mortgages -- and then turn these into securities that can be sold to investors all over the world.

Tracking the scale of this activity with any precision has always been hard, since much of it occurs in private deals. However, industry data suggest that between 2000 and 2006, nominal global issuance of credit instruments rose 12-fold, to $3 trillion a year from $250 billion. This activity appears to have become particularly intense from 2004, partly because investors were searching for ways to boost returns after a long period in which central banks had kept interest rates low.

To be sure, ahead of last summer's crisis some policymakers and investors were uneasy about the scale of this explosion. In particular, there was growing concern that "slicing and dicing" was fueling a credit bubble, leading to artificially low borrowing costs, spiraling leverage and a collapse in lending standards. When world leaders gathered in Davos for the annual economic forum in January 2007, Jean-Claude Trichet, governor of the ECB, complained about the opacity of some financial innovation and warned that there could soon be some "repricing of credit risk."

From 2005 onwards, Timothy Geithner, president of the New York Federal Reserve, called on banks to prepare for so-called "fat tails" -- a statistical term for extremely negative events which occur more commonly than usual banking models suggest. Behind the scenes, a few bankers and investors also prepared for a crash. Deutsche Bank, for example, started betting on subprime defaults as early as 2006, while JPMorgan Chase placed trades to protect itself from a crash in spring 2007 and asset managers such as Pimco and BlackRock stopped purchasing many debt instruments in early 2007. Yet most investors, bankers and even regulators did not change their behavior to any significant degree, owing to a widespread adherence to three big assumptions -- or articles of faith -- that have steathily underpinned 21st century finance in recent years.

The first of these was a belief that modern capital markets had become so much more advanced than their predecessors that banks would always be able to trade debt securities. This encouraged banks to keep lowering lending standards, since they assumed they could sell the risk on. "Abundant market liquidity led some firms to overestimate the market's capacity to absorb risk," says the Institute of International Finance, a Washington-based lobby group, in a recent report. "The same buoyant environment resulted in market pressure for high returns ... and high levels of competition among financial firms."

Second, many investors assumed that the credit rating agencies offered an easy and cost-effective compass with which to navigate this ever more complex world. Thus many continued to purchase complex securities throughout the first half of 2007 -- even though most investors barely understood these products.

But third, and perhaps most crucially, there was a widespread assumption that the process of "slicing and dicing" debt had made the financial system more stable. Policymakers thought that because the pain of any potential credit defaults was spread among millions of investors, rather than concentrated in particular banks, it would be much easier for the system to absorb shocks than in the past. "People had looked at what had happened to the Japanese banks and said, 'this simply cannot happen here', because the banks were no longer holding all the credit risk," one senior European policymaker recalls.

In private, some central bank officials harbored doubts about this new creed. From 2003, senior officials at the BIS in Basel, for example, repeatedly warned that risk dispersion might not always be benign. However, such warnings were largely kept out of public view, partly because the U.S. Federal Reserve was convinced that financial innovation had changed the system in a fundamentally beneficial way.

Consequently, no attempt was made to force banks to boost their capital reserves to offset exploding debt issuance. Instead, regulatory rules permitted banks to cut their capital levels sharply, which they duly did. "People really believed that the world was different," recalls Larry Fink, head of BlackRock investment group. "There was this huge trust in the intellectual capital of Wall Street -- and that appeared to be supported by the fact that banks were making so much money."

As a result, when high rates of subprime default emerged in late 2006, there was initially a widespread assumption that the system would absorb the pain relatively smoothly. After all, the system had easily weathered shocks earlier in the decade, such as the attacks of September 11 2001 or the collapse of the Amaranth hedge fund in 2006. Moreover, the U.S. government initially estimated that subprime losses would be just $50-$100 billion -- a tiny fraction of the total capital of western banks or assets held by global investment funds.

In fact, the subprime losses started to hit the financial system in the early summer of 2007 in unexpected ways, triggering unforeseen events such as the implosion of IKB. And as the surprise spread, the three pillars of faith that had supported the credit boom started to crumble.

First, it became clear to investors that it was dangerous to use the ratings agencies as a guide for complex debt securities. In the summer of 2007, the agencies started downgrading billions of dollars of supposedly "ultra-safe" debt -- causing prices to crumble. Last week, for example, Merrill Lynch sold a portfolio of complex debt at 22% of its face value, even though this had carried the top-notch triple-A rating.

Then, as bewildered investors lost faith in ratings, many stopped buying complex instruments altogether. That created an immediate funding crisis at many investment vehicles, since most had funded themselves by issuing notes in the asset-backed commercial paper market. It also meant that banks were no longer able to turn assets such as mortgages into subprime bonds and sell these on. That in turn meant the second key assumption that had underpinned 21st-century finance -- that the capital markets would always stay liquid -- was overturned.

Worse still, the third pillar of faith -- that banks would be better protected from a crisis because of risk dispersion -- also cracked. As investment vehicles lost their ability to raise finance, they turned to their banks for help. That squeezed the banks' balance sheets at the very moment that they were facing their own losses on debt securities and finding it impossible to sell on loans.

As a result, western banks found themselves running out of capital in a way that no regulator or banker had ever foreseen. Peter Fisher, a managing director of BlackRock and former U.S. Treasury undersecretary, wrote in a recent paper: "It seems clear that risk dispersion did not work as expected. Major financial institutions did not succeed in shedding risks so much as transferring them among their own business lines."

Banks started hoarding cash and stopped lending to each other as financiers lost faith in their ability to judge the health of other institutions -- or even their own. "Firms became reluctant to participate in money markets ... as a result subprime credit problems turned into a systemic liquidity crunch," says the IIF.

Then a vicious deleveraging spiral got under way. As banks scurried to improve their balance sheets, they began selling assets and cutting loans to hedge funds. But that hit asset prices, hurting those balance sheets once again. What made this "feedback loop" doubly intense was that the introduction of mark-to-market accounting earlier this decade forced banks to readjust their books after every panicky price drop -- in contrast to the pattern seen in the 1990s Japanese banking crisis, or the Latin American debt debacle of the 1980s.

At several points over the past year, policymakers have hoped that this vicious cycle might be coming to an end. Last autumn, for example, conditions briefly improved. Early this year brought another respite when central banks pumped more liquidity into the system. Similarly, when the Fed stepped in to prevent the implosion of Bear Stearns in March, sentiment stabilized for a period.

However, in practical terms, the real challenge for financiers and policymakers now -- as in Japan a decade ago -- is how to build a new sense of trust in finance. In the medium term, regulators are preparing reforms that aim to make the system look credible, even in a world where the benefits of risk dispersion are no longer taken as a creed. These would force banks to hold more capital and ensure that the securitization process is more transparent. Separately, groups such as the IIF are trying to introduce measures that could rebuild confidence in complex financial instruments.

More immediately, the banks are trying to rekindle investor trust by replenishing their capital bases. The IIF calculates that in the year to June, banks made $476 billion in credit writedowns, as debt prices plunged in the panic (although tangible credit losses are hitherto just $50 billion). However, they have also raised $354 billion in capital. Financiers are also trying to restart trading in frozen debt markets. Experience from earlier financial crises suggests that this will only occur when investors are convinced that they have seen true "clearing prices". Events such as Merrill Lynch's recent fire sale of its CDO portfolio may be a step in this direction.

But while confidence is returning in some areas, it continues to be undermined in others. A decade ago in Japan, the banking woes started with a property slump but later spread when banks were forced to cut their lending -- which unexpectedly created more bad loans. Thus far, banks have not yet encountered this "second round" effect on a significant scale.

Though defaults are rising on consumer loans, for example, losses on corporate debt remain modest. However, most bankers and policymakers fear that a second wave is simply a matter of time. That makes it hard to predict when the credit crunch will end, how big the total losses may eventually be or even whether the banks are adequately capitalized yet.

"What we learnt in Japan is that banks have a tendency to underestimate how their assets could deteriorate due to the feedback problems," Mr. Nakaso recalls.

A year into the credit crisis, in other words, trust remains a rare commodity in the banking world. It will take years, not months, to restore that crucial ingredient -- particularly given that so many of the assumptions underlying 21st-century finance have turned out to be so dangerously wrong.

The writer, the FT's capital markets editor, is on sabbatical writing a book about the credit crisis. Her first book, on Japan's banking crisis, was published in 2003 as Saving the Sun

Big Freeze Part 2: Investment Banking
August 18, 2008

On Friday August 3, 2007, as U.S. financial markets were approaching the summer doldrums and bankers began to head off for holidays on Long Island or Cape Cod, Bear Stearns held a conference call for investors.

Shares in the investment bank, the 5th largest in the world, had fallen as investors worried about the collapse of two hedge funds that it managed and its exposure to the troubled housing market. But few were prepared for the candor of Sam Molinaro, its chief financial officer. Instead of reassuring them about Bear Stearns' financial condition, he scared them even more: "I have been at this for 22 years. It is about as bad as I have seen it in the fixed income market during that period ... [what] we have been seeing over the last eight weeks has been pretty extreme."

Later that afternoon, Jim Cramer, the former hedge fund manager, whose show, Mad Money, on the CNBC financial cable channel had become a cult among U.S. retail investors, took to the air to sound his own alarm. Mr. Cramer chided Bear Stearns for admitting publicly that it was struggling to cope but then launched into an angry tirade. He lambasted Ben Bernanke, chairman of the Federal Reserve, for not cutting interest rates aggressively, and said bank executives were calling him in distress. "We have Armageddon. In the fixed income markets, we have Armageddon," he shouted, as Erin Burnett, his co-host, tried to calm him down.

If all of this sounded bizarrely alarmist at the time, a year later it reads like a fair assessment of the havoc that was breaking out in financial markets as the liquidity that had washed through the U.S. economy and the rest of the world abruptly froze.

As Americans defaulted on subprime mortgages in increasing numbers, bond markets became chaotic. Most of these mortgages had been securitized by banks and sold to investors in complex collateralized debt obligations, which were rated by credit agencies led by Moody's and Standard & Poor's. Investors knew that the lower-rated tranches would be at risk in any downturn, but few predicted the damage to investment grade securities.

The chaos in the U.S. housing market and structured finance rippled into the wholesale markets in which banks raise short-term finance. Trust evaporated as financial institutions hoarded cash and withdrew credit from others. The London interbank offered rate, the main measure of interbank lending rates, rose sharply.

The effect was devastating. Six weeks later, Northern Rock, the mortgage lender that relied on interbank funding, was rescued by the UK government after other institutions refused to lend to it. Seven months after Mr. Molinaro's warning, Bear Stearns itself succumbed to the market crisis. It was given emergency funding by the Federal Reserve and forced to sell itself to JPMorgan Chase for $2.1 billion, paying the ultimate price for the market's loss of confidence.

Financial institutions are still fighting to restore stability. Banks such as Citigroup, UBS and Merrill Lynch have made billions of dollars worth of asset writedowns, forced out chief executives and repeatedly raised new capital. Lehman Brothers has fought to persuade investors that it is more stable than Bear Stearns.

It is impossible yet to know the full damage from the credit crisis. Bank writedowns are estimated at $476 billion by the International Institute of Finance. This is still less than the $600 billion of U.S. bank failures in the savings and loans crisis of the early 1990s but $1,600 billion has been cut from the global market capitalization of banks.

Many bankers think the eventual bill will top the S&L crisis, although it may cause less financial harm than the Scandinavian and Japanese banking crises of the 1990s. But, whatever the ultimate bill, the impact on investment banking and financial regulation will be profound. "This has been a very deep and unusual crisis that involves the unwinding of a decade of excess. The impact on the financial sector has been seven on the Richter scale [a 'major' earthquake], as dramatic as anything for 25 years," says Bill Winters, co-head of the investment bank at JPMorgan Chase, which has navigated the crisis better than most.

The crisis has called into question the existence of independent investment banks, the institutions that have been among the biggest winners of the past three decades of financial and trade liberalization. Investment banks led by Goldman Sachs have grown rapidly and rewarded their employees lavishly: Wall Street banks paid bonuses of $33 billion last year.

But many analysts think that the crisis has shifted power in the direction of "universal" banks -- those with retail as well as investment banking arms -- and away from broker-dealers such as Goldman and Morgan Stanley. The latter may find it hard to keep on operating with small, highly leveraged balance sheets, relying on wholesale markets for funding. "It is pretty clear that retail deposit-taking institutions are in a stronger position ... I think the business model will change significantly and there will be fewer independent investment banks," says James Wiener, a partner in Oliver Wyman, the financial consultancy.

Not surprisingly, the universal banks that have expanded into investment banking in the past decade -- many by investing heavily in bond operations -- agree with this. They think the crisis will give them an opportunity to grab business from the independents, or acquire them. "Stand-alone investment banks will struggle to operate in anything like the way they were before the crisis," says the head of investment banking at one commercial bank. "They are not going to be able to operate with the same degree of flexibility and leverage."

Investment banks have two challenges. One is to reassure investors that they are financially stable. Bear Stearns collapsed while it was making money and had, theoretically at least, a sound balance sheet. Its former leaders still complain that short-selling hedge funds spread false rumours to bring their institution down.

While they argue this point, however, the four remaining big investment banks have rushed to reduce their leverage and raise their capital reserves. Goldman Sachs, the strongest of them, now holds $90 billion in cash and liquid assets and its balance sheet debt has an average maturity of eight years. This makes them safer but it adds to their second challenge of making enough money to satisfy shareholders and keep their most highly valued employees from joining hedge funds or private equity groups.

Banks enjoyed a run from 1998 onwards (with a brief interruption after the September 11, 2001 attacks) of rising profits and high ratings. They had been valued at one to 1.5 times their book value because of their earnings volatility but their share prices rose as they persuaded investors that they had learnt how to manage risk.

Few people believe that now and banks' share prices have fallen abruptly. Not only are their earnings back to being rated as they were before, but the banks have to find ways to replace the huge revenues from bond financing over the past decade.

The optimists point to the industry's history of migrating from one business to another. The chief executive of one bank says that investment banks often lose 70% of their revenues in financial crises and replace them with new ones. "Investment banks have shown an amazing ability to reinvent themselves," says Mr. Wiener.

Indeed, Scott Sprinzen, an S&P analyst, says investment bank revenues have held up well so far, although results have been hurt by writedowns. Their troubles have even brought them some business -- they have earned fees raising capital for each other.

But their longer-term outlook is clouded. The credit crisis has brought home once again the need for investment banks to have diverse earnings streams so that mishaps in one area can be offset elsewhere. In practice, only Goldman Sachs has had sufficient depth and breadth to ride out this crisis reasonably unscathed.

Before the crisis, others were trying to mimic Goldman's expertise in hedge funds and trading. Bear Stearns was trying to build its fund management arm, Merrill was continuing a long push to transcend its roots as a retail broker and Lehman was expanding outside fixed income. But Bear has gone and others have been set back.

Their capacity to bounce back is constrained by new limits on their balance sheets and freedom of manoeuvre. The market is imposing its own disciplines and regulators are likely to impose others. Bear Stearns' near-collapse prompted the biggest government intervention in the financial system since the splitting of banks and investment banks and the setting up of the Securities and Exchange Commission in the wake of the Great Depression.

The Federal Reserve has long provided a funding back-stop to banks that took retail deposits through its discount window, but investment banks were not given the same explicit backing. That policy changed during Bear's rescue, when the Treasury and the Fed judged that it was too central to the U.S. financial system to be allowed to fail.

The Fed gave investment banks temporary access to the discount window and has since extended the guarantee. Even if it eventually closes off access, the precedent has been clearly established: In times of financial distress, the Fed will give financial backing to investment banks.

In return, the Fed will demand much closer oversight. Reforms to the regulatory system await the next president and Congress but the Fed is very likely to gain some oversight of investment banks as well as large retail banks.

Indeed, officials hope that the Bear rescue, which was carried out on terms that involved the bank's shareholders and executives suffering heavy losses, will serve as a warning. "Investment banks should have a deep interest in making the Fed comfortable. They will not want it to escalate late [launch emergency action in response to a funding crisis]," says one banker.

Fed oversight of investment banks, instead of them being supervised mostly by the SEC, would come at a cost. "A government back-stop would reduce the risks of the business but it could also take away some of the profit potential," says Mr. Sprinzen of S&P.

When there was no implicit government guarantee, investment banks could run highly leveraged balance sheets, carry out a lot of proprietary trading and lend to hedge funds and private equity groups. Now they face scrutiny of, and perhaps curbs on, their most profitable activities.

Some investment bankers remain sanguine, arguing that the past few years was an era of super-profitability that is not likely to return in a hurry. They say that investment banks will be able to adapt after a year or two and resume as normal, albeit with lower revenues and share prices.

But the fear is that investment banks' advantages over their universal bank rivals have been eroded by this crisis. There are not many independents in any case. The disappearance of Bear leaves only Goldman, Morgan Stanley, Merrill Lynch and Lehman Brothers as big broker-dealers.

It may be that merchant banks such as Lazard, private equity groups such as Kohlberg Kravis Roberts, or hedge funds such as Citadel or Fortress will expand to fill the gap left by Bear. Consolidation in financial services has often prompted the rise of new players.

But there is another possibility: that investment banks such as Lehman and Merrill will give up the unequal struggle to match Goldman and be swallowed up into universal banks. Partners at Goldman, who have traditionally worried about being outsmarted by Morgan Stanley and others, now have another concern.

If their rivals cannot bounce back from the credit crisis of 2007, Goldman could end up as an industry of one.
How risk refused to be sliced and diced.

Last week [in late July], after a year of continuous, shocking writedowns of banking balance sheets, Merrill Lynch sold a $30 billion portfolio of structured securities based on U.S. mortgages for 22 cents on the dollar.

The portfolio was made up of collateralized debt obligations, the structured finance vehicles that lay at the heart of the credit crisis that broke out a year ago. It was described by William Tanona, a Goldman Sachs analyst, as a "capitulation trade" that was painful but necessary.

John Thain (below), Merrill's chief executive, clearly wanted to draw a line on the past year and move on. But the irony is that CDOs were designed to relieve banks of the necessity to hold loan risks on their balance sheets at all.

The Merrill trade is a sad epitaph for a period in which banks thought they had transformed themselves from lenders to intermediaries in credit markets, and investment banks believed they could lend money as effectively as commercial banks.

In practice, it did not work out that way. When the credit markets froze in August last year, many banks had not yet passed on the risk to others. Many were holding asset-backed securities in "warehouses" and were working on splicing them up into CDOs, getting them rated by a credit agency such as Moody's or Standard & Poor's.

This version of banking had developed over two decades with the evolution of credit derivatives and structured finance. Instead of a bank making loans and then either holding them on its balance sheet or syndicating them to others, it structured them into new securities.

This opened up the market for credit to all kinds of investors. The cash flow from a portfolio of mortgages could be spliced into a variety of securities with different interest rates, appealing to a wide range of buyers. Hedge funds and insurance companies became the holders of mortgage loans.

The collapse of the CDO market and recriminations among bankers, credit agencies, investors and regulators has called all of this into question. If the CDO market was riddled with such flawed assumptions and lax calculations, what does that say about the theory behind it?

Few believe the CDO debacle will cause a return to old ways. "We are not going back to the days when banks made loans and kept them all on their books. We have seen that movie and we know what happens in the end," says one senior banker.

Indeed, the reason why banks moved first to loan syndication and then to securitisation was that they suffered so badly in past banking crises when the borrowers defaulted. Although CDOs failed to protect them, that was not entirely the fault of structured finance techniques.

For one thing, several banks were caught out not only because it took time to structure the securities but because they deliberately held on to what they regarded as "safe" tranches of loans. UBS was badly damaged by retaining "super-senior" CDO debt.

But banks will be a lot warier about treating structured finance as the cure-all for lending risk in future. They are unlikely to be given much choice: Investors in such securities will demand more transparency and may well require an originating bank to keep some exposure.

The ultimate lesson of the CDO collapse is that technology does not obviate the need to assess a borrower carefully. Neither banks nor credit agencies did this well enough on behalf of investors and it proved a painful experience for everyone.

Big Freeze Part 3: The Economy
August 18, 2008

Imagine you had fallen asleep a year ago and had just woken up, wanting to reacquaint yourself with the world economy. You would get quite a shock. Just as it was last summer, global growth is strong. The IMF expects expansion of 4.1% this year, compared with an average of 3.4% since 1990.

Inflation is the real surprise. Last July the IMF predicted price pressures would remain "generally well-contained despite strong global growth". Today, inflation in advanced economies is at its highest rate since 1992, rising from 2.2% in 2007 to an IMF projection of 3.4% in 2008. For emerging and developing countries inflation is up from 6.4% to 9.1%, the fastest since 1999.

On seeing the data alongside high food and oil prices -- still way above their levels last year, in spite of recent falls -- your immediate historical parallel would not be one that is often drawn, with the early 1930s. It would be the inflation followed by stagnation of the 1970s. The IMF's forecast of a slowing world economy in the second half of 2008 is entirely consistent with high commodity prices.

You would not have expected U.S. interest rates to have been cut from 5.25% to 2%, for real interest rates across Asia to be negative, and for European interest rates to be more or less the same as a year ago.

So, a year into the big freeze in financial markets and the world economy bears all the hallmarks of overheating, not another Great Depression. Yet that global truth is almost entirely lost on policymakers, many of whom talk about rising energy and food prices as if they had nothing to do with them.

Ben Bernanke, the Federal Reserve chairman, told Congress in July that domestic problems had been "compounded by rapid increases in the prices of energy and other commodities". Jean-Claude Trichet, president of the European Central Bank, complains that the "worrying level of inflation rates results largely from sharp increases in energy and food prices at the global level". Mervyn King, the Bank of England governor, meanwhile insists that rising UK inflation is the fault of "developments in the global balance of demand and supply for food and energy".

Such sentiments are shared in the developing world. Speaking after the annual meeting of the Bank for International Settlements, Zhou Xiaochuan, governor of the People's Bank of China, said: "We know the international price of energy and other commodities, they add additional pressure to inflation in China."

Each statement is accurate taken in isolation. Collectively, they are nonsense. The world cannot import inflation. If every country pursues policies to maintain demand and "look through" a temporary rise in commodities, global demand is likely to continue to exceed supply for some time.

As Mr. King, when he was thinking more globally, told British parliamentarians in June: "The biggest challenge for the world economy as a whole is not the oil price as such -- I think there are mechanisms that will lead eventually to an equilibrating between demand and supply -- but it is trying to ensure a monetary policy framework for the world as a whole that does not build into it an excess inflationary impetus." The implication was that the world, but not individual countries, might need the ravages of a credit crisis to slow the rate of global expansion enough to keep inflation under control.

So how did the global economy get into such a mess? There is little doubt that the immediate cause of both the commodities price boom and the credit crisis has been low global interest rates.

Cheap money encouraged rapid growth: Between 2004 and 2007, the world economy expanded at its fastest rate in 30 years. It encouraged investors to search for higher yields and buy into new asset classes. The new money led to easier credit conditions, extending cash to U.S. borrowers with patchy credit histories who previously had been unable to buy property, cars and durable goods.

U.S. expenditure on imports maintained the rapid expansion of production in Asia and in oil exporters, aided by extremely competitive exchange rates and rigid currency ties. Meanwhile, consumption restraint kept capital flowing from poor to rich countries and stopped the world economy overheating.

For a long time, this appeared to be a virtuous circle, dubbed "Bretton Woods II" in reference to the pegged exchange rate system that operated from the end of the second world war until the early 1970s. Most economists thought the 21st century version would prove as unsustainable as its predecessor, relying as it did on ever-greater trade deficits. Concerns grew over "global imbalances" and predictions abounded that they would finally unwind with a collapse in confidence in the U.S. dollar.

None of the forecasts of doom materialized. Instead, the crucial rupture came when rising defaults among U.S. subprime mortgage-holders undermined the rationale for the expansion of credit, forcing the contraction of financial balance sheets that has stalked the financial world ever since.

Over the past year, meanwhile, rapid global economic growth finally hit capacity constraints. Demand for commodities and food continued to exceed supply, forcing prices sharply higher, raising inflation and further undermining spending power in advanced economies.

Most economists were sanguine when the credit crisis broke last August. A crisis in subprime mortgages would not affect the vast bulk of lending to households and companies, they argued, and the stock of subprime debt was too small to affect the health of the financial sector. Central bankers welcomed what they saw as a desirable repricing of risk.

But as August wore on and the crisis deepened, economic views as well as policy began to change. The European Central Bank and the Federal Reserve offered emergency liquidity support for financial institutions. By mid-September, the Fed had cut its policy rates by half a percentage point and the ECB had postponed a rise it had previously pencilled in. Ever since, the U.S. has been easing monetary and fiscal policy.

Each central bank has a delicate balancing act to perform. Let high inflation become normal in an economy and a wage-price spiral can develop, requiring much more brutal policy action in the future. But allow the economy to weaken too far and a vicious circle could develop, with more bank defaults leading to further downward pressure on growth.

The conditions are different in every country. As the Bank for International Settlements, the central bankers' bank, said in its annual report, this should "rule out a 'one size fits all' response."

Gulf, Asian and developing economies are caught between the popular demand for continued rapid growth and the constraint of higher inflation, made all the more damaging by the fact that food and fuel account for a higher proportion of spending in poor countries.

So far, maintaining growth has been the priority. Price rises started in food and energy but have now become widespread, with signs of upward pressure on wages. The Asian Development Bank warned last month of the danger of "repeating the mistakes industrialised nations made prior to the Great Inflation of the 1970s."

Hardest to deal with is the collective action problem: The right policies for individual economies do not necessarily add up to the right policies for the world. This is where the IMF should step forward to break the deadlock. But the IMF's impotence in securing policy changes from countries that have no need of its finance has been laid bare over the past year.

In its recently updated World Economic Outlook, it noted how the U.S., the Eurozone, Japan, China and Saudi Arabia had agreed "mutually consistent" policies in 2006 to squeeze global imbalances and make the global economy a safer place. Last month, John Lipsky, the Fund's #2, insisted he still viewed the policy proposals to be relevant. But he was forced to concede that there has been little progress in implementing them.

China's currency has appreciated against the dollar but not by much on a trade-weighted basis. The U.S. has abandoned budgetary consolidation in favor of stimulus packages. Saudi Arabia's plans to spend more of its oil revenues on its population have come unstuck as energy prices have risen. Europe and Japan are peripheral to the action and have made little impact on imbalances either way.

Mr. Lipsky was forced to conclude: "While the dollar depreciation is helping to reduce the U.S. current account deficit, it has not been sufficient to alleviate imbalances and risks. Rather, new misalignments may be emerging and risks may be shifting."

So what next for the world economy? If consensus forecasts are to be believed, everything will be fine. The world economy will slow just enough to ensure that the inflationary period is temporary, financial markets will gradually recover, and the world economy will continue to grow at about 4.5% a year indefinitely.

This appears much too rosy and probably suggests a faster sustainable rate of world economic expansion than the evidence of the past few years suggests is plausible. As the BIS annual report concluded: "With inflation a clear and present threat, and with real policy rates in most countries very low by historical standards, a global bias towards monetary tightening would seem appropriate."

Many central bankers certainly think the consensus is too optimistic. In private, dark humor abounds. They are sure they will make a mistake but have no idea in which direction it will be. And everyone wants someone else to take the really tough decisions.

The U.S. and Europe want Asia to tighten policy and revalue currencies to snuff out inflation. Asia, however, insists that its exchange rate policies are its own concern and wants to defend its remarkable growth rates and export-led industries, blaming advanced economies for a home-grown financial crisis. Oil producers hope to be able to ride the energy boom without succumbing either to an inflationary spiral or a sudden worldwide recession, sending oil prices crashing.

For all the disagreements, there is little doubt that the world economy is in trouble, poised between the rock of recession and hard place of overheating. It will take a remarkable resumption in global policy co-ordination and a huge dose of luck to avoid one or the other.

A Fed under pressure is forced to push its mandate to the limit.


In a series of speeches, Paul Volcker, the former Fed chairman, expressed concern that too much is being asked of the Fed, which is operating at the limit of its mandate and of what its tools can achieve. This sentiment is shared within the current Fed. Policymakers fear the market exaggerates the Fed's power to shape economic tradeoffs as opposed to choose between them. Many Fed officials feel the current policy mix is wrong -- that the government should do more, allowing them to do less. But they are sceptical of the merits of a second stimulus, and feel if public funds are deployed, they should be targeted at housing and bank capital instead.

Big Freeze Part 4: A U.S. Recovery
August 18, 2008

Macroeconomists, like medical scientists, use case studies to teach their students about the maladies to which the system is susceptible. For supply shocks and stagflation, the example is the 1970s. The financial dislocations that occur when bubbles burst are illustrated by the Great Depression and Japan's problems in the 1990s. The importance of central bank credibility in resisting inflation emerges from discussion of the experience of the late 1960s and the 1970s.

What is most remarkable and troubling about our current difficulties is that all these elements -- supply shocks, financial dislocations and concern about rising underlying inflation -- are present at once. Moreover, the crisis is global in scope. Concerns about recession are spreading from the U.S. to much of the industrialized world. Significant slowdowns appear more likely in a number of emerging markets, with inflation concerns worldwide at their highest level in more than a decade. There is a growing consensus that the west is facing the most serious financial crisis since the second world war.

Perhaps unsurprisingly in the face of so many adverse surprises, the policy debate has become cacophonous. Some emphasise the necessity of the painful adjustments under way, while others urge their mitigation. Some focus on product price inflation, others on asset price deflation as the principal problem. Some focus on assuring that imprudent lending by financial institutions is discouraged, others on assuring that financing for investment by households and businesses remains available. Some focus on slowing market adjustments to prevent panic, others on the need for rapid adjustment of prices to true fundamental levels, even if this is painful in the short run.

Equally unsurprisingly given the chaotic debate, policymaking has become increasingly reactive and erratic, with a growing tendency to repeat traditional errors. While U.S. policymakers have long cited Japan's indecisiveness with respect to troubled financial institutions, its resort to gimmickry and market manipulation, and its lack of transparency in the management of financial crisis in the 1990s as a negative example, they are increasingly repeating Japan's errors.

Within the past month, the Treasury has made explicit the implicit guarantee on the $5,000 billion balance sheet of Fannie Mae and Freddie Mac in order to prevent a run on the government-sponsored enterprises while imposing no penalties on shareholders or forcing any changes on management -- not even the cessation of dividends.

The Securities and Exchange Commission has sought to make short-selling harder, with the stated objective of raising (many would say manipulating) the stock prices of financial institutions, while some in Congress have proposed to prevent certain investors from going long on commodity futures. Without much sign of official resistance, the global banking industry is pushing for less reliance on market prices and more on managerial judgment in valuing the assets where bad credit and investment decisions have led to hundreds of billions of dollars of losses over the past year.

Setting policy in a more proactive and principled way requires reaching a number of judgments regarding where things currently stand and the likely effects of potential actions or failures to act. In an effort to advance the debate, the remainder of this article poses and provides my answer to what seem to me to be the crucial questions for American economic policy.

How long will the economy stay weak on the current policy path?

The best available estimates suggest that the American economy is operating between 2 and 2.5% below its sustainable potential level. This translates into more than $300 billion, or $4,000 for the average family of four, in lost output. Even if, as I think unlikely, recession is avoided, growth is almost certain to be so slow that the gap between actual and potential output comes close to doubling over the next year or so. Given that unemployment peaked nearly two years after the end of the last recession, output and employment are likely to remain below their potential levels for several years in the best of circumstances. ...

Just as the bottom was called early a number of times in Japan in the early 1990s and in the U.S. in the early 1930s, we have seen and no doubt will see moments of sunlight that create hope that the worst is past. Yet it bears emphasis that in the current context there can be no confident reliance on the equilibrating powers of the market.

Alan Greenspan has been fond of explaining that the resilience of the U.S. financial system and economy results from reliance on two pillars: banks and capital markets. When the banks were in trouble, as in 1991, capital markets took up the slack; when the capital markets were in trouble, as in 1998, the banks took up the slack. Unfortunately, today both the banks and the capital markets show signs of crisis.

The point can be put in another way. Four vicious cycles are simultaneously under way: Falling asset prices are forcing levered holders to sell, driving prices further down; losses at financial institutions are reducing their ability to finance investment, which in turn reduces asset values, causing further losses; the weakness of the financial system is reducing growth, which in turn weakens the financial system; and falling output is hitting employment, which in turn leads to reduced demand for output.

Without active efforts to interfere with these mechanisms, there can be no basis for confidence that the American economy will recover even in the medium term.

Are substantial output losses necessary or desirable?

It is often argued that the current economic downturn is an inevitability that cannot be prevented, or that is necessary and desirable. Some observers almost seem to suggest that a recession is a kind of just desert for a country that has lived beyond its means. The more serious concerns are that an economic downturn is a necessary concomitant of increasing U.S. national saving and reducing current account deficits, or of preserving the credibility of the Federal Reserve's commitment to price stability.

Granting that U.S. consumer spending grew more rapidly than GDP over most of the past decade and that ultimately the consumption share of GDP will have to fall back to more normal levels, it is hard to see why necessary increases in saving require a protracted recession. Instead, declines in consumer spending and improvements in the government's fiscal position should be sequenced to coincide with improvements in net exports and investment. Allowing consumer spending to spiral downwards without offsetting policy actions risks reducing investment and incomes in the U.S. and transmitting the U.S. slowdown to the rest of the world. Moreover, even if the argument for supporting consumption at present were rejected, there would still be a strong argument for supporting investment in areas such as infrastructure, where there is no evidence of a glut and considerable evidence of shortfalls. ...

On balance, in the U.S. at least, the risk that output will be too low over the next several years seems considerably greater than the risk that it will be too great and cause the economy to overheat or overborrow.

Can policy stimulate demand without adverse side-effects?

With the Federal funds rate at 2%, the remaining scope for monetary policy to stimulate the U.S. economy is surely very limited. Even here, those who see a case for raising rates should remember that in the current environment the Fed funds rate is a very misleading indicator, as widening credit spreads and increased term premiums have caused borrowing costs to fall much less than the policy interest rate.

There remains considerable scope, however, for fiscal policy to stimulate demand on both the tax and spending sides over the next several years. The limited available evidence suggests that the propensity to consume out of the recent round of rebates was larger than many thought. More important, given the pressures on state and local budgets and the dramatic increase in some inputs (the cost of building highways has risen 70 per cent since 2004), there is now a substantial backlog of infrastructure projects that have been interrupted or put on hold. Allowing these projects to go forward on a significant scale would stimulate the economy and would channel demand towards the construction workers -- mostly men with relatively little education -- who have borne the brunt of the economic downturn and whose medium-term prospects are bleakest.

In thinking about fiscal policy, it is essential to consider both near and long term. For the near term, larger deficits are likely to be potent in stimulating demand, especially in the context of an economy where there are constraints on the ability to lend and borrow. This is especially the case when new spending is directed at addressing the "repressed deficit" associated with the failure to maintain an adequate infrastructure.

Success in using fiscal policy will depend on also taking concrete steps that reduce projected deficits in the medium to long term. The enactment of new permanent measures, such as the extension of the 2001 tax cuts, without means to pay for them would be counterproductive. Conversely, measures that pointed to long-term fiscal savings would reinforce fiscal stimulus.

In the current global context, there is no reason why fiscal stimulus should be confined to the U.S. Measures that increase spending in countries where high saving has led to large current account surpluses are necessary if the global economy is to be rebalanced without a big downturn as U.S. saving eventually increases. China, where household consumption has fallen below 40% of GDP -- a record peacetime low for any big economy -- stands out in this regard.

How serious are the remaining financial problems?

This is unknowable given uncertainties about market fluctuations and the real economy. While there surely will come a time when things hit bottom, it is not yet clear that it is at hand.

Several sources of evidence suggest that house prices will fall for some time to come, perhaps by 10% or more. Big further declines would be necessary to restore their traditional level relative to rents, incomes or the price of other goods. There are growing signs that rates of default and foreclosure will rise considerably even well outside the subprime sector.

Beyond housing, there are also grounds for considerable concern about consumer and automobile credit, particularly if the economy turns down. Big and as yet not reported losses on commercial construction lending lie ahead. While the rate of default on corporate debt has not yet reached high levels, this is likely to change in the near future. For example, the pricing of the debt of the big American automobile companies now suggests a probability well over 90% that one or more of them will go into default in the next five years -- and the probability would no doubt be greater if markets did not recognize the possibility of extraordinary Federal support.

Then there is the problematic situation of the banking system. Where traditional non-mark to market accounting is in use, banks have not yet revised estimates of their capital to reflect likely future losses. In many cases, they have instead assumed that the market's valuation of their assets reflects transient liquidity factors rather than underlying problems, and so are planning with assumptions considerably more optimistic than those embodied in market prices. Perhaps they will prove correct -- but nothing in the experience of the past year gives confidence in the judgment of those who believe that market prices substantially undervalue their assets.

In all likelihood, the financial system will require very substantial capital infusions over the next year or two if it is to remain healthy. It is not clear where the capital will come from. Most of those who have provided financial institutions with capital over the past year have been badly burned. As valuations fall, it becomes increasingly difficult for financial institutions to raise capital necessary for them to retain market confidence, leading to further declines in valuation and yet another vicious cycle.

How can the authorities best support the financial system?

To date the focus of public policy has been on the extension of credit to banks and other financial institutions by the Federal Reserve so as to ensure their liquidity. This strategy is appropriate but may be reaching its limits. Where the problems a financial institution faces are of confidence or liquidity, lending can be highly efficacious. When the problems are of underlying solvency and the constraint on lending is a lack of capital, lending is not an availing strategy. It is necessary, at least on a contingency basis, to plan policy responses to such problems.

First, as the ad hoc nature of the policy response to Bear Stearns and the GSEs illustrates, we do not have a framework in place in which the authorities can do what is necessary to counter systemic risk when a systemically important institution gets in trouble and at the same time protect the interests of taxpayers and the broader financial system.

Second, there is as yet no framework in place for handling the large quantity of bad assets sitting on financial institution balance sheets. During the last U.S. banking crisis in the early 1990s, the Resolution Trust Corporation was established to manage impaired assets of banks and savings and loan institutions that the government had taken over. But it acquired assets only after the government took over banks. Consideration should be given to whether the government should establish a mechanism for purchasing assets from stressed banks in return for warrants or other consideration.

Third, there is the question of whether government will need to find a way to recapitalize institutions through taking some kind of preferred interest, as ultimately proved necessary in the U.S. in the 1930s and Japan in the 1990s. This is obviously a big step that one wants to avoid if possible. But in the absence of any framework for the government infusing capital, there is the danger that liabilities will simply be guaranteed de facto or de jure with no other change made, creating problems down the road. Government involvement in recapitalising financial institutions is like devaluation: a very unattractive last resort. Delay is tempting, but it can be enormously costly.

Today, the end of the current financial crisis looks further away than it did in August 2007. Policy is not yet ahead of the curve. I used to remark in the context of the emerging market crises of the 1990s that I would date the moment of recovery from the first time an official pronouncement proved to be too pessimistic. By this standard, recovery is not at hand.

The best prospects for managing a very difficult situation involve a comprehensive effort to support the real economy through temporary fiscal stimulus and the financial system through a programme of measures directed at capital rather than liquidity problems. These steps offer no assurance of success but reactive drift raises the risks of costly failure.

August 24, 2008

The sharp drop in oil and natural-gas prices has produced an even sharper pullback in energy stocks, creating what may be one of the best buying opportunities in the sector in several years.

Unless you buy into the "energy bubble" thesis, which would view the recent pullback in energy prices as the first stage of a decline from a secular peak, it looks like the shares of enery producers are cheap. (See entry below which argues against the bubble thesis.) They have fallen far further from their peaks than the commodities themselves.

According to one energy analyst, the large North American independents trade at close to half his estimate of their net asset value. The international majors trade at single-digit P/E multiples, as if they were shrinking. And the Canadian tar oil sands plays have slid too, despite their huge reserves which may last another 100 years. Sounds like bargain territory for those with some degree of faith in conventional energy sources' propects.

Energy issues have rarely been so inexpensive, relative to oil and gas prices, estimated asset values and earnings. Barring a collapse in oil and gas, energy could prove to be one of the market's top groups over the next year. Most of the stocks could easily rise 25% or more.

It is hard to find a sizable energy company that is trading for more than 10 times next year's estimated earnings. As the table below shows, the major oils -- ExxonMobil (XOM), Chevron (CVX), BP (BP) and ConocoPhillips (COP) -- now fetch five to seven times next year's projected profits. The majors have rarely had such low price/earnings ratios.

The projected 2009 profit estimates could prove too high, of course, given the 22% drop in oil prices to $115 a barrel from a peak of $147 on July 11. Natural gas has fallen even more sharply, declining 35% to $8.50 per million BTUs from a July high of over $13.

The stocks, however, seem to be discounting a drop in oil to well below $100 a barrel, and a skid in gas to as low as $6 per million BTUs. Energy shares have badly trailed commodity prices. The XLE (XLE) -- the exchange-traded fund for the S&P 500's energy issues -- is up just 6% over the past year, while oil has risen 66%.

Investors have several ways to play energy, inc

"This has been one of the sharpest corrections ever in E&P," says David Kistler, an energy analyst at Houston-based Simmons & Co., which focuses on independent North American energy and production stocks. "Nearly every stock screens with tremendous valuation upside." Simmons estimates that major independents like Anadarko Petroleum (APC), Devon Energy (DVN) and XTO Energy (XTO) now trade at little more than half their net asset values. Kistler views the independents' risk/reward ratio as excellent.

The independents benefit from growing production bases heavily tilted toward North America, shielding them from Venezuelan-style expropriation, Russian strong-arming and the general shift in the balance of power to host countries and state-owned companies. This is one reason that the market has awarded higher P/Es to the independents than to the majors.

Kistler says that investors fear further stock-price declines if there is permanent "demand destruction" in the U.S., in reaction to high fuel costs.

Independents like Anadarko, Devon Energy and XTO have come down hard because they get most or nearly all their revenue from natural gas, which could be more vulnerable than oil, thanks to rising domestic production. There is no way to export sizable amounts of gas, so high production can slam prices. Kistler says the stocks should rally if oil and gas prices hold at current levels.

It is probably cheaper to buy energy reserves on the New York Stock Exchange than to drill for them, given sharply higher finding costs and the risks of dry holes. This could prompt a new wave of takeovers if the independents' share prices do not bounce back.

Anadarko and Devon are viewed as prime targets. Anadarko, which has grown through acquisitions, is considered receptive to a takeover. And Devon, headed by longtime CEO Larry Nichols, 66, finally may be willing to deal. XTO is viewed as an unlikely seller because CEO Bob Simpson, 60, seems intent on creating the largest domestic natural-gas producer.

The majors beckon, given their low P/Es, strong balance sheets and diversified business mixes that involve energy production, refining and chemicals. Exxon has $30 billion in net cash (cash less debt) and is likely to produce almost $50 billion of after-tax profit this year. One potential plus for the majors next year is that refining margins, which have collapsed, could reverse.

A legitimate knock on the U.S. majors is that they are stingy with dividends, paying out just a fraction of their profits and opting instead to earmark much of their earnings for stock buybacks that have done little for their share prices or valuations. Exxon and Conoco yield just 2%; Chevron, 3%. Exxon may buy back $35 billion of stock this year, while paying out $8 billion in dividends. The overly conservative U.S. majors could easily offer 5% dividends and still have ample funds for buybacks. European oil giants like BP and Royal Dutch Shell have payouts in the 4% to 5% range.

What is ailing the major oils? Exxon grabbed headlines with its second-quarter after-tax profits of $11 billion, a record for any company. Its earnings were deemed obscene by those in Washington who want to revive the 1970s-era windfall profits taxes. Exxon's earnings, however, did not play as well on Wall Street. Analysts noted that they trailed the consensus estimate for the second straight quarter and that Exxon's energy production had fallen 8%.

Some one-time factors hurt Exxon, the largest and best-managed major oil, but even a generous assessment of its production showed a 2% drop. Exxon and Chevron are being hurt by so-called production-sharing agreements with the governments of the foreign lands from which they pump oil and gas.

These largely undisclosed accords, involving nations such as Angola, typically limit the Western oil companies' returns and production after their initial investments are recouped. Given high oil prices, these agreements are quickly putting the host countries in the driver's seat. In a recent research note, Oppenheimer analyst Fadel Gheit wrote that "high oil prices are not good for Exxon's business as they increase government take in royalties and taxes, strengthen national oil companies, limit access to resources, but, above all, depress the share price." Gheit may exaggerate the impact. Only about 20% of Exxon's output is subject to production-sharing agreements, and the company did enjoy a sharp rise in second-quarter earnings. In any case, the problems seem well-discounted in Exxon's share price.

Still, the overriding fear in the investment community is that the international oil giants will have a tough time maintaining production levels, given less-favorable international operating conditions. At current valuations, they are being treated like wasting assets.

Paul Cheng, Lehman Brothers' energy analyst, is a fan of Chevron because of its low valuation. It recently was trading at 83, just 6.6 times projected 2008 profits of $12.70 a share. Cheng expects the company to be able to boost output by 4% in 2009 and 2010, according to a recent note. Wall Street seems wary of Chevron because much of its production growth is coming from potential trouble spots overseas, including Nigeria, Kazakhstan and Angola. Conoco, whose shares, at 80, trade at a rock-bottom six times projected 2008 earnings, has less international exposure than Chevron and Exxon, but that has not helped its valuation.

Canadian energy producers also have fallen sharply, including oil-sands operators like Suncor (SU) and Canadian Natural Resources (CNQ). Shares of Suncor, the most prominent oil-sands play, have slid to about 50 from 74 in May, hurt by lower crude prices and disappointing production. But Suncor's daily output should rise sharply in the next year, and its shares now are at a reasonable 8.5 times next year's estimated earnings. In recent years, Suncor has consistently traded at a P/E premium to other major oil companies because it has enormous reserves that may last a century, against the 10 to 20 years for the major international oils. This is a huge advantage.

Among U.S. independents, XTO has been particularly hard hit on Wall Street, with its stock tumbling to the mid-40s from a June peak of 73, as investors fret over declining gas prices and the company's $10 billion acquisition spree this year. But over the past 22 years under Simpson's leadership, XTO has become a leading U.S. natural-gas producer, with excellent drilling results, low finding costs and shrewd acquisitions.

At a recent 45, XTO was valued at 10 times projected 2008 profits and at less than $2.50 per thousand cubic feet of reserves. The company has long traded at a premium to its peers, based on earnings, cash flow and reserves, but that premium has disappeared. Given such valuations, it seems tough to go wrong now with XTO or almost any major energy stock, even if energy prices fall a little further.

August 24, 2008

This is a correction, not a fundamental change in the long-term correlation of things.

Byron King contributes his say on the several-month pullback in energy and precious metals prices. He too thinks we have been witnessing a correction, not a collapse. One of the factors that pops most bubbles, although not all, is that supply of the inflated asset expands and eventually overwealms speculative demand. For example, when the Hunt brothers tried to corner the silver market in 1979-80, suddenly old coin collections and grandmothers' tea sets came out of the woodwork. King points out the the increased oil and gold prices have not resulted in supply increases. To the contrary, supply at best is keeping up. Thus while prices may have risen too far too fast, the bubble case is weak.

What is going on with gold and oil?

Here is what we know. Prices for both gold and oil were moving upward for most of the spring and well into summer. Then prices hit a peak. Gold touched $980 per ounce. Oil topped $146 per barrel. Now prices are falling

Back when oil was in the $140s, I said -- in both print and broadcast interviews -- that oil prices were running up too far, too fast. I predicted that oil prices would decline to $100-110, based on the fundamentals. Well, we have seen the decline and we are almost there.

High oil prices have caused big changes in patterns of consumption. Indeed, the U.S. Department of Energy just announced that U.S. oil demand fell by about 800,000 barrels per day during the first half of 2008, compared with the same period last year. This is the biggest volume decline in 26 years, since the recession of the early 1980s.

Sure, some headlines describe what is going on as something like the "oil bubble" or "commodities bubble" popping. Some people are talking and acting as if we were going back in time to the last era of cheap energy, cheap gold and cheap commodities. But do not believe it. Do not bet on it. And do not play the markets that way.

A Correction Was Due

What is going on? We are in the midst of a short- to medium-term correction in the trends for energy and resources. Keep this in mind: This is a CORRECTION, not a fundamental change in the long-term correlation of things. The long-term trends are still upward, in terms of value and pricing. But for now, the money is leaving energy and resources for pastures that look greener.

What pastures are greener? Well -- speaking of green -- the U.S. dollar is strengthening. It turns out that the euro is not the powerhouse currency that a lot of people believed it was. So the dollar has been strengthening against the euro for the past couple of weeks.

And it turns out that euroland has its own economic problems. In fact, the euro can go down against the dollar, as well as up. That is exactly what has happened. Euro down, dollar up. So in consequence, we are seeing the dollar going up, and oil and gold going down.

There is more to the equation. The economists are describing a recession occurring in parts of the euroland economic space. Germany -- with Europe's largest economy -- has been hard hit, so there has been quite a bit of drag on the euroland economy.

And then there are indications that the long-awaited U.S. recession is finally just around the corner. Really, we are just in the middle innings of the banking meltdown and housing crash in the U.S. The recent stock market turnaround may just be the 7th-inning stretch. I expect to see more large banks and investment houses either fail or get bailed out before the end of 2008.

So with two of the world's largest economies about to enter the doldrums, world markets are seeing demand for energy and commodities slacken. Thus, we have monetary issues with the dollar. And there are demand issues with economic slowdown in two of the world's largest economic blocks. Prices for benchmark items like gold and oil are falling.

But looking in the long-term gold and oil are headed back up, for all the familiar reasons. Really, it is not like anyone is finding new large gold or oil deposits out in exploration land. Indeed, a whole lot of looking is leading to not very much finding in the exploration patch.

The big gold miners are pulling ore out of the ground. But generally, they are not replacing their mined reserves through reserve growth or resource expansion. To the extent that the mining companies are expanding reserves in the short term, it is by digging deeper. And that raises the cost structure for production.

Rising production costs are eating into profitability. So in the medium to long term, the big guys will have to find new reserves by digging on Wall Street, if not on the TSX Venture Exchange. There is already some takeover activity occurring, but it has been hamstrung by the broken world banking system.

It is the same thing with the large Western oil companies. It is a rare oil company that replaces its annual output with new reserves.

August 24, 2008

Gold at $800 looks like a bargain in the new world currency disorder.

Veteran UK analyst/writer Ambrose Evans-Pritchard weighs in on the gold correction. His conclusion: "Gold bugs, you ain't seen nothing yet."

A war breaks out in the Caucasus, pitting Russia against a close ally of the United States. Inflation reaches a new peak in the euro-zone. The CPI reaches the highest in Britain since Bank of England independence. Rampant inflation sweeps the developing world. Yet gold crashes. It has failed to deliver on its core promises as a safe-haven and inflation hedge, at least for now. Why? ...

Gold has fallen from $1030 an ounce in February to $807 today in London trading. It has collapsed through key layers of technical support, triggering automatic stop-loss sales. The Goldman Sachs short-position that I have been observing with some curiosity has paid off.

For gold bugs, the unthinkable has now happened. The metal has fallen through its 50-week moving average, the key support line that has held solid through the 7-year bull market. ... Courtesy of my old colleague Peter Brimelow -- whose columns on gold are a must-read -- note that Australia's Privateer point and figure chart has also broken its upward line for the first time since 2002. This is serious technical damage.

So have we reached the moment when gold bugs must start questioning their deepest assumptions. Have they bought too deeply into the "dollar-collapse/M3 monetary bubble" tale, ignoring all the other moving parts in the complex global system? Nobody wants to be left holding the bag all the way down to the bottom of the slide, long after the hedge funds have sold out.

Well, my own view is that gold bugs should start looking very closely at something else: the implosion of Europe. (Japan is in recession too) ... The slow-burn damage of the over-valued euro is becoming apparent in every corner of the eurozone. ...

As readers know, I do not believe the eurozone is a fully workable currency union over the long run. There was a momentary "convergence" when the currencies were fixed in perpetuity, mostly in 1995. They have diverged ever since. The rift between North and South was not enough to fracture the system in the first post-EMU downturn, the dotcom bust. We have moved a long way since then. The Club Med bloc is now massively dependent on capital inflows from North Europe to plug their current account gaps: Spain (10%), Portugal (10%), Greece (14%). UBS warned that these flows are no longer forthcoming.

The central banks of Asia, the Mid-East, and Russia have been parking a chunk of their $6 trillion reserves in European bonds on the assumption that the euro can serve as a twin pillar of the global monetary system alongside the dollar. But the euro is nothing like the dollar. It has no European government, tax, or social security system to back it up. Each member country is sovereign, each fiercely proud, answering to its own ancient rythms.

It lacks the mechanism of "fiscal transfers" to switch money to depressed regions. The Babel of languages keeps workers pinned down in their own country. The escape valve of labor mobility is half-blocked. We are about to find out whether EMU really has the levels of political solidarity of a nation, the kind that holds America's currency union together through storms.

My guess is that political protest will mark the next phase of this drama. Almost half a million people have lost their jobs in Spain alone over the last year. At some point, the feeling of national impotence in the face of monetary rule from Frankfurt will erupt into popular fury. The ECB will swallow its pride and opt for a weak euro policy, or face its own destruction.

What we are about to see is a race to the bottom by the world's major currencies as each tries to devalue against others in a beggar-thy-neighbour policy to shore up exports, or indeed simply because they have to cut rates frantically to stave off the consequences of debt-deleveraging and the risk of an outright Slump.

When that happens -- if it is not already happening -- it will become clear that the both pillars of the global monetary system are unstable, infested with the dry rot of excess debt.

The Fed has already invoked Article 13 (3) -- the "unusual and exigent circumstances" clause last used in the Great Depression -- to rescue Bear Stearns. The U.S. Treasury has since had to shore up Fannie and Freddie, the world's two biggest financial institutions.

Europe's turn will come next. We will discover that Europe cannot conduct such rescues. There is no lender of last resort in the system. The ECB is prohibited by the Maastricht Treaty from carrying out direct bail-outs. There is no EU treasury. So the answer will be drift and paralysis.

When EU Single Market Commissioner Charlie McCreevy was asked at a dinner what Brussels would have done if the eurozone faced a crisis like Bear Stearns, he rolled his eyes and thanked the Heavens that so such crisis had yet happened. It will.

Gold bugs, you ain't seen nothing yet. Gold at $800 looks like a bargain in the new world currency disorder.