Toxic Banks: Not Just US Problem

I've heard some people remark that the credit crunch has shown the weakness of US banks as compared to the rest of the world (which generally means Europe, when it comes to the financial industry). I found that hard to believe, because it seemed that some of the names hit hardest were European banks. So I was interested to read in the Financial Times Lex column (sorry, no free link) that sub prime credit write downs by banks have totaled $493 billion worldwide. Of that, $250 billion was in the US, but $221 billion was in Europe, with $22 billion elsewhere.

And yet, the European economy has not taken the same hit as that of the US. The housing bubble in the US has been one factor, but there's been a similar bubble in many parts of Europe - Spain, Denmark, the UK, and Ireland. I'm guessing that the relative strength of the euro has been the reason. But it seems that won't be lasting long:

The US and European economies are of similar size, as are their banking industries, which both have market capitalisations of about $1,000bn. Yet European banking stocks have outperformed since the credit crisis began. So far, US banks have suffered most. The worst is yet to come in Europe.

Those in the US looking for economic salvation by investing overseas are likely to find that the safety is only temporary. Ah, well, misery loves company.

Companies Paying Bond-Holders "In Kind"

In the non-profit world, there is a term called "payment-in-kind." That means an individual or company has supported a non-profit not with cash payments, but through donations of goods or services that the non-profit needs if it is going to operate. But when you bring payment-in-kind to the world of investing, you might also bring along the non-profit label - as in, this can be a great way of making nothing. According to the Financial Times, many companies have sold bonds with a PIK feature that allows borrowers to pay bondholders with shares or bonds rather than cash.:

During the buy-out boom, Standard & Poor’s Leveraged Commentary & Data estimates 43 bond deals were done with a PIK feature. Some analysts suspect, however, that the actual number was higher.

And now some of those companies are turning the concept into practice. This should be pretty damn disturbing to people who lend money to corporations. It's a credit crisis of a different kind.

In the past, when times were flush (at least on paper), companies often did not want to dilute ownership and its control and value. But what happens when a company can say, "Oh, that money we owed you? Here's another bond to make up for it." The bonds then effectively become IOUs, and when you expect to get cash, instead there is more paper. Companies may avoid default, but to what end? This turns credit ratings on their head, since, I'd argue, this lets borrowers effectively walk away from obligations in a legal manner. If compaies can, then often they will - and if they do, then the credit ratings that attempted to quantify how safe an investment was become meaningless.

Coming U.S. Bank Failures?

The Financial Times is reporting that the U.S. comptroller of the currency John Dugan, who oversees about 1,700 national banks, said that banks failures will rise back for virtually none to at least historic rates, and could climb above that.

“That is a natural consequence of the economy going from historically exceptionally benign credit conditions to something that is more normal to something you would get in a downturn.”

Mr Dugan’s comments come as US banks report big spikes in reserves for expected losses on consumer and small business loans, reflecting the spread of the credit crisis from Wall Street to the broader economy.

As companies shove more money onto the shelf for reserves against expected losses, they have less money to invest, less money to pay off obligations, and less money to calm down panicked investors who suddenly want their cash back and who create a run on the bank. Can you say Bear Stearns?

Did the Feds Topple Bear?

New Jersey Institute of Technology management professor Michael Ehrlich has an interesting premise. A former government arbitrage trader himself, his research and background suggest to him that by announcing that it would make $200 billion available to finance securities from investment banks, the Fed may have unintentionally set off the panic that claimed Bear Stearns.
"I think it's a bad thing for Bear Stearns shareholders, but a brilliant thing for public policy," Ehrlich says. We've established a precedent that they're prepared to bail out firms to protect the little guys ... but that the people responsible bear the costs."

As he says, that means management and the shareholders. I think some of those shareholders often may be little guys, but, realistically, this is capitalism and they continued were holding stock in a company making ever riskier trades because they liked the returns.

The minute the Federal Reserve made the announcement, everyone in the markets started asking whether the Fed knew something that they didn't, which may well have triggered speculation about Bear Stearns - smallest of the investment banks - that turned into "a classic run on the bank," according to Ehrlich.

I keep asking myself the question of whether the Fed's new willingness to lend to investment banks might be handing more money to the very organizations that have proven themselves so tremendously reckless. Ehrlich thinks I'm looking at it the wrong way, and that the effect is to keep the financial system propped up while the shareholders take the brunt of the heat.

But I still feel unconvinced, because I think businesspeople are likely to take this as a tacit guarantee that no matter how stupidly they act, someone will pull their chestnuts out of the fire. All they need to do is keep diversified enough that their estates don't get clobbered like those of the Bear employees.

In any case, Ehrlich also thinks that this is by no view charity on the part of JP Morgan. As he deemed the Fed's move for public policy, so he called the acquisition a "brilliant" move that will probably give the new owner a profit of several billion dollars. Guess I don't see that as something to dissuade behavior in the future - because all the high-powered type A's will assume that they will be the ones coming out on top. We've seen the same behavior in virtually every man-made financial calamity in history, and there's no reason to think that people will act much differently. The only question is how much time it will take them to get back to the usual business.

Cracks in the Financial Fissure

So JP Morgan Chase & Co. is going to buy Bear Stearns. That may seem like a rescue, but it's not. This is yet another crack in the world's money foundation. First the UK government felt it had to take over North Rock, then the Fed was trying to support Bear Stearns through JP Morgan, but it has instead turned into an outright acquisition at $2 a share. Let's get some perspective on this. If you look at a chart, like this one from the Wall Street Journal, notice that the 52-week stock high was $170.23 and the low was $26.85. This isn't a "fire sale" as some in the media portray. This is bankruptcy and selling off the assets without the intervention of a court. And what is the Fed doing? Here's how the WSJ phrases it:

The Federal Reserve announced one of the broadest expansions of its lending authority since the 1930s in an effort to stem a credit crisis that is engulfing the financial system and threatening a deep recession.

For the first time securities dealers, effective today and for at least the next six months, may borrow from the Fed on much the same terms as banks. The Fed also lowered the rate charged on such borrowings from what's known as its discount window by a quarter of a percentage point, to 3.25%, and extended the maximum term to 90 days from 30.

This is a panicked attempt to keep everyone from taking that final plummet that Bears enjoyed. There isn't money because many people are no longer trusting the systems. But to keep things afloat, the Fed has potentially opened the flood gates. After all, it was large investment houses and banks - and the greedy credulity of investors - that landed everyone here in the first place. So now the country is supposed to trust their judgment with even more money? Maybe it's necessary to keep the whole system from freezing up, like an engine without oil, but only at the risk of having so much money out there that they dollar loses a lot more value.

I know there's the theory that some institutions are too large to fail, because you can't afford to have them out of business. But I'm wondering if what we're facing is more like a case of fiscal gangrene, in which you amputate a limb or the patient itself dies. Those who worship at the altar of capitalism must realize that can't adopt a deity and then insist on only the friendly parts. That's like saying you want to be a fundamentalist Christian but believe in only heaven and not hell. and I'm afraid that we're only just beginning to see the literal hell that we'll all be forced to pay.

Light Dawns on This Marblehead - Lenders, Fear, and Liquidity

The title of this post refers to an old Massachusetts put down of someone who suddenly grasps an idea - light dawns over Marblehead, which is a city on the north short of the state. And that's how I felt this morning, when looking at the latest problems with credit prices going higher.

I find that many financial stories, particularly those about the credit crunch, either assume that one understands the dynamics in advance, or assumes that the dynamics don't exist - that is, "And while I wave my hands, the credit markets seize up like an internal combustion engine running without oil." My flash of understanding was on the simple dynamic of what is happening at banks. The underlying driver is fear, as we keep hearing in the stories. But that fear does two things. One, is that the lenders are now afraid that because they've been making bad decisions for so long, any more reasonably drawn decision will be just as risky. So they price risk higher. For example, I received the following in an email from the Financial Times this morning:

Rising credit spreads meant AAA-rated General Electric paid a higher rate on a recent five year bond issue that it did for a comparable bond last May, according to Bloomberg calculations.

Alright, so it's the FT quoting Bloomberg. But consider the substance: GE is having to pay more for credit. It's not that the conglomerate is a worse credit risk. It's that the lenders have frayed nerves, and figure that since stupid decisions went wrong, then all decisions will go wrong.

Compounding that outlet of fear is another. Lenders have been caught having to restate financials to take into account unexpected losses. So they are taking cash and not only paying off the debts that came about from their ill-considered investments in the credit derivative markets, where essentially they create bonds and pay interest based on what they expect to get from payments on underlying assets like mortgages, but they are putting cash in reserves for future screw-ups. That means they lend a lot less of the money they have than they used to, and supply and demand then drives up the cost of interest.

Paulson Adresses Everything But Real Problem

I was driving about on errands with my daughter and was listening to NPR when I heard US Secretary of the Treasury Henry Paulson speak at the National Press Club talk about how the Bush administration was going to fix the credit crisis:

1. Wag a finger at the regulators for not making mortgage lenders explain in plain English to borrowers just what the hell they were in for.


2. Plead with lenders to keep lending, because, after all, if the public isn't borrowing, it's not spending.


3. Actually toughen licensing standards for all those mortgage lenders who can't make loans anyway because no one will front the money because of the mess the mortgage market is in.


4. Have regulators "catch up with innovation and help restore investor confidence but not go so far as to create new problems, make our markets less efficient or cut off credit to those who need it."


5. Cluck at sloppy lending practices.


6. And, of course, let industry self-regulate.

He managed to miss the major issue: when you've got people who are incredibly greedy and who have forgotten their duties to business, the markets, and the public in general, then they will continue to create complex, crackpot schemes to extract cash from the pockets of others and put it into their own. If the financial industries could regulate themselves, don't you think they might have by now? They don't because they don't want to be limited in what they do. The people in charge of all these stupid Ponzi schemes want to continue their quest for unending and unrestrained profits. That's like saying you want so much water from a well that you pump it dry. Now you're left with no water, and no prospect of getting any.

This is a case where self regulation will do nothing. The longer the federal government waits, the more cash it will have to create out of thin air to grease the market's wheels, and the more value of the dollar it will burn off, probably never to return, at least in our lifetimes.

The Next Big Financial Debacle?

Some experts on a risk management mailing list I'm on are guessing that there's a new finanical bugaboo on the horizon, credit default swaps derivatives, that could make the sub-prime problems look like small change. Two parties enter into an agreement. One pays the other a fixed sum periodically though a coupon bond - which means that the second has purchased the bond from the first. The second doesn't have to pay anything else, and keeps collecting interest over the life of the bond (and, presumably, recaptures the initial investment) unless some pre-determined credit event - such as a debt restructuring, bankruptcy, or a drop in credit rating - occurs. In such a situation, the second party pays a fixed sum to the first and then the entire arrangement is terminated.

The derivates can become a form of credit insurance, with the second party being the insurer. However, they can also allow third parties to speculate on an entity's ability to repay a debt - legalized gambling, I think it should be called. So long as you only have the occasional credit explosion, the system can work. But what happens when you have one comapny after another in trouble? Now you have to wonder whether the insurers actually have the money to cough up - and some of the big players in that market are the very financial institutions that have been pouring money out because of the sub-prime mess.

According to an article in Wikipedia (link above), these are the most widely traded credit derivative product. More so than mortgage-backed bonds. The outstanding swaps currently top $46 trillion - with a t. To add some perspective, the US stock market is only $22 trillion, with mortgate securites hitting a mere $7 trillion. And an article in Bloomberg notes that this is the fastest-growing form of derivative on the market.

This could bear out Warren Buffet's remarks from 2003, in which he called derivatives in general "financial weapons of mass destruction" that could hurt the entire global financial system, and not just the people involved with the specific transactions.

Banks Doing Worse Than Saying

Whatever the banks say publicly about the credit crunch, it appears to be a lot worse. An article in the Financial Times of two days ago mentions how banks have been quietly borrowing a huge amount over the last few weeks - $50 billion - from the Fed under a new mechanism that the U.S. central bank introduced two months ago:

The use of the Fed’s Term Auction Facility, which allows banks to borrow at relatively attractive rates against a wider range of their assets than previously permitted, saw borrowing of nearly $50bn of one-month funds from the Fed by mid-February.

US officials say the trend shows that financial authorities have become far more adept at channelling liquidity into the banking system to alleviate financial stress, after failing to calm money markets last year.

However, the move has sparked unease among some analysts about the stress developing in opaque corners of the US banking system and the banks’ growing reliance on indirect forms of government support.

It's not just in the US that there are signs of problems. The government of the U.K. decided to preemptively nationalize mortgage lender and bank Northern Rock. And now Credit Suisse has "revealed $2.85bn of losses on structured credit positions caused in part by “pricing errors” by some of the Swiss investment bank’s traders." That will mean re-examining 2007's stated financial results. And so central banks print more money - it has to coem from somewhere - while banks face just how badly they have been managed, as that's all you can describe the need to run for funds and the inability to see a multi-billion dollar loss in advance.

The Next Corporate Scandal

When writing a recent article on how regulators and prosecutors were going after people farther down the authority line in corporations, a corporate lawyer and former federal prosecutor said that he expected the subprime mess to eventually turn into investigations, at least. Already there is confirmation that it has. According to an organization called the Asymmetric Threats Contingency Alliance (ATCA) - a group of government officials, business people, academics, "original thinkers," and some 250 members of major media - the FBI "has opened criminal investigations into 14 companies relating to improper subprime mortgage loans," while the SEC has started some three dozen civil investigatons.

If you think that the write-downs were bad enough, just wait, as there will be plenty of lost value when companies spend the time, money, and attention to deal with these investigations. And given that we're talking about the subprime debacle, these won't be small companies. I think we can expect them to be among the largest global financial companies. Bear Stearns, Goldman Sachs and Morgan Stanley have all said that government entities are asking about their subprime activities. Reported SEC targets include Swiss bank UBS AG; US investment banks Morgan Stanley, Merrill Lynch, Bear Stearns; and bond insurer MBIA.

Wachovia Penny Wise and Billions Foolish

Although I don't bank with Wachovia, I walked into a branch the other day to cash a check that came in late from a client, wanting to deposit cash rather than wait for the instrument to clear. "There will be a five dollar charge to do that," said a teller who was remarkably unpleasant for 8:40 in the morning.

"But that's ridiculous," I said. "The bank is obligated to pay me."

"Sorry, but that's the bank's policy because you're not a customer. Do you want to cash the check or not?"

This is the type of pettiness that makes people hate banks. It's called charging people for the dubious privilege of doing business. Bad enough as a non-customer, I've heard of banks considering charging customers to use teller services. Are the branch staffs really so entirely busy without a let-up that additional people walking up will require additional staff? That certainly wasn't the case where I was, and I doubt it's really that much of a problem over all.

But then, many banks have long since decided that customers were an annoyance. We're just the little people who keep insignificant sums of money in the bank, so it can lend. No, the real important lines of business are the speculative ones - you know, the ones like those derivative investment vehicles that cause banks to write down billions upon billions of dollars of institutional value.

Wachovia wrote down $1.7 billion in its last quarter, and saw only 3 cents per share earnings. Thanks, collateralized debt obligations. Oh, and a $24 billion acquisition of Golden West Financial Corp. and its steady supply of mortgage losses.

Instead of sitting on the roller coaster of questionable profit and trying to squeeze every penny out of the public, here's a radical notion: treat customers well, get their business, see them refer others to you, and be more intelligent about taking risk. Give up the $5 here and there while stemming the grossly unnecessary losses, and it can add up to real money.

Wolfgang Münchau on the Current Financial Crisis

The Financial Times has a good column by Wolfgang Münchau, noting that if the current credit crisis were just about sub prime mortgages, it would already be over. The problem is that there is way more money tied up in other ventures that are find so long as defaults and insolvencies stay at reasonably low levels. Combine that with a recession - and it seems pretty clear that economies are slowing - and the results could be really bad.

Less Profitable Time for Large Banks?

The Wall Street Journal is running an article suggesting that "the next few years will be a return to a simpler and possibly less-profitable time" for the big banks. But I wonder whether that is true when you take everything into account.

The basic thrust is that the banks will be holding on to more of the loans they make, rather than turning them into collateralized securities, and that they will do less of the off-balance-sheet lending that they were doing to corporations to put a check on capital costs. And then the article suggests:

The upshot: Bank investors expecting a big rebound in earnings growth after the debacle of 2007 will likely be disappointed. The slowdown is likely to be especially pronounced at some of the biggest banks, such as Citigroup Inc. Bank of America Corp. and J.P. Morgan Chase & Co.

Supposedly this is going to be a "negative" effect on investors. Frankly, I thought that the fallout from all the supposedly insanely profitable activity was negative enough, and that you'd have to be insane to want more of it. Banks writing down tens of billions of dollars in value and needing to find large cash influxes from countries to stem the capital loss in paying off the bad bets? Now that's negative. When everything is tallied, how much of the profit growth still exists? Even that which wasn't written off may have turned, instead, to loss of investor and customer faith, which means a dramatic reduction of good will, reflected in hits on stock price. As the article quoted Gerard Cassidy, an RBC Capital Markets analyst:

The originate-and-sell business model "encouraged reckless lending" that triggered the current mortgage morass, Mr. Cassidy said. Keeping loans on banks' books will help avoid future meltdowns that could torpedo years of profits.

It was also interesting to read about yet another respectable business scam: off-balance-sheet conduits of banks issuing "short-term commercial paper to purchase debt such as corporate receivables, mortgages and auto loans, capturing the difference in rates between the two." Many of the people running these institutions really do seem far too clever for their own good - and for the good of the investors, otherwise known as the people who own the businesses.

Legal Snag in Credit Mess

Gretchen Morgenson has been doing a good job for the New York Times of following some of the more interesting threads in the credit meltdown. She has a story about a legal snag on the mortgage front - a federal judge in Ohio has dismissed 14 foreclosure cases brought by mortgage investors because they didn't prove that they had title to the properties they wanted to seize:

But as foreclosures have surged, the complex structure and disparate ownership of mortgage securities have made it harder for borrowers to work out troubled loans, in part because they cannot identify who holds the mortgage notes, consumer advocates say.

Now, the Ohio ruling indicates that the intricacies of the mortgage pools are starting to create problems for lenders as well. Lawyers for troubled homeowners are expected to seize upon the district judge’s opinion as a way to impede foreclosures across the country or force investors to settle with homeowners. And it may encourage judges in other courts to demand more documentation of ownership from lenders trying to foreclose.

I hadn't realized that the structures put additional squeeze on the borrowers, but if it works against one, then it's going to work against the other. The cases were brought by Deutsche Bank National Trust Company - amusingly enough, Deutsche Bank is one of the firms that is being least affected by the meltdown. When asked for proof of assignment of the mortgages, the bank's lawyers could only dig up letters of intent to transfer, and not the actual documents that would have shown ownership. As the judge wrote (and paper reported):

The institutions seem to adopt the attitude that since they have been doing this for so long, unchallenged, this practice equates with legal compliance. Finally put to the test, their weak legal arguments compel the court to stop them at the gate.

One source said he had heard of cases where a loan was in more than one pool, and there is apparently no repository showing who has what. Here's another snippet from the story:

And a recent study of 1,733 foreclosures by Katherine M. Porter, an associate professor of law at the University of Iowa, found that 40 percent of the creditors foreclosing on borrowers did not show proof of ownership.

No proof of ownership would mean no standing to sue - and although I'm not a lawyer, I think this problem is going to run very deep. It's not just about foreclosures. You have huge pools of securities that are based on owning these loans, only if you can't prove that you own the loans, are you now in the middle of securities fraud?

Some Financial Companies Get It Right

The Wall Street Journal has an article about some financial companies - Goldman Sachs, Lehman Brothers, and Deutsche Bank - that have managed to largely ride out the credit crunch. What was the common theme? They all knew risk when they saw it and didn't let their desire for easy profits undermine intelligent management. Some of the strategies included shorting the mortgage collateralized debt obligations (CDOs), greatly limiting exposure, and choosing carefully from among opportunities. In other words, this is old fashioned prudence governing recklessness. None seem headed for the massive write-offs some of their competitors are facing.

Credit Crunch and Trickle Down Economics

We're starting to see the beginning of credit crunch fall-out. From the tech sector, Cisco Systems mentioned that if large banks are having to write down billions of dollars because of bundling debt into securities and getting rating agencies to give a better credit rating than the individual loans could often get, chances are they won't have money to spend on things like new technology. As a Financial Times story quoted:

“If there is a concerted slowdown in financial services you are going to have a big problem,” Richard Parower, managing director at J&W Seligman, said.

Makes sense, and investors agreed by suddenly knocking the NASDAQ composite down. Stocks recovered, more or less, but in a way that doesn't matter. Banks buy less and are wary of deals, which means that law firms don't get all the money they were used to. As things slow, there will be a drop in spending, and in jobs, probably. Tech and finance will affect virtually everything. Energy costs are hitting everyone and everything and food is getting more expensive, so consumers will have less to spend. Borrowing can't cover it, as the dollar is no longer so attractive a deal for those countries like China that are brining in the cash.

Personally, I'm steering more of my own writing business to publications that serve sectors that have some cushioning against recession, like legal, food, and I'm even considering getting a foot into the health care door. Now's the time to take stock of where things will go and to seek out the relative safety you might find.

Blooming Housing Crisis

All the powers that be in economic circles keep saying that the housing crisis hasn't spilled over yet into the rest of the economy. But this is sounding like so much whistling in the dark - or, perhaps, trying to keep those ever irrational markets from wigging out - and it's not clear that they can keep it up with a straight face. First, the Wall Street Journal Online reports:

In a model of central-banker understatement, Mr. Bernanke noted to the Economic Club of New York that "the past several months have been an eventful period for the U.S. economy." And he recounted the mortgage meltdown, market panic and increase in Fed anxiety about the economy that prompted a reversal of the Fed's risk balance toward growth worries and the resulting half-percentage-point reduction in the cost of borrowed money last month. While members of the Federal Open Market Committee agreed Sept. 18 that "significant spillovers [from housing-market trouble] to household and business spending were not yet evident," the downside risks to both had clearly increased, exacerbated by "somewhat downbeat consumer sentiment, and slower growth in private-sector employment."

The WSJO continues, calling feedback that the Fed is getting from local bankers and executives "a darker description" than that collected and published before the Fed came out with its Beige Book report, a collection of "anecdotal information on current economic conditions" each branch of the Fed gathers from "key business contacts, economists, market experts, and other sources." The Treasury department is trying to build a coalition that will help stabilize the mortgage markets, August housing starts in Japan were down 43 percent from the same period in 2006, and, according to NPR, the US foreclosure rate is the highest it's been since the Great Depression. At this rate, how can conditions not spill into the rest of the economy. It sounds as thought it already has, only no one has wanted to be the first to say it.

Banks Start Fund for Credit Market

Working with the Treasury department, Citigroup, Bank of America, and JPMorgan Chase are creating a fund that will buy between $75 billion and $100 billion in structured investment vehicles (SIVs) - the mortgage-backed securities that have seen such trouble recently. The New York Times has a story that has yet another piece of the puzzle, which can be hard to grasp if you come at this from the outside, like I do:

The effort is intended to help SIVs that need to sell securities do so in an orderly manner. Bank and government officials are concerned that if these vehicles are forced to dump billions of dollars worth of debt in the coming weeks, it could cause a repeat of the crisis that rattled markets in August and sent the cost of mortgages and other loans soaring.

In other words, these SIVs, like many other forms of financing, come with strings. The people running them have to ensure certain conditions or face serious consequences, like being declared in default (or whatever the equivalent for an SIV would be):

[Christian Stracke of the research firm CreditSights]said that by serving as another buyer of the highest-rated securities, the banks are hoping to ease the immediate strain on SIVs, which could be forced to sell billions of dollars worth of assets in a fire sale if they are not able to raise new financing and when their capital falls below certain thresholds. The effort, however, will not resolve the longer-term problem many SIVs face with more risky mortgage bonds, he said.

The SIVs have financial covenants, and they cannot allow their free capital to fall too much. So they need to sell more short-term debt to keep investing in the long-term debt to get the cash flow to pay off the short-term debt and keep afloat. It sounds, to me, like a legalized version of a Ponzi scheme, but then I'm not a high finance person.

Supposedly the fund - called a conduit - will invest only in top rated securities and won't help the sub-prime area that has most of the fundamental trouble. But then, one of the main problems has been that the rating agencies apparently were favorable in their ratings for the sub-prime. Why should anyone believe that a AAA rating actually means anything, either?

“For me, this is more of a P.R. blitz,” he said. The banks are “saying, it’s not just that we are doing this on an ad hoc, individual basis. Rather, we have a plan and consortium in cooperation with Treasury, which gives it a veneer of respectability.”

But the institutions themselves have lost tremendous credibility because of culpability. Maybe people will forget, or maybe the new investments are actually sound. The question is who will bet on that?

Foreclosures Up, Income Increases Uneven

The problem with focusing on only the "big picture" issues of the economy is that you miss the little guys who, collectively, are the real driving force. According to the Financial Times, U.S. home foreclosures doubled last month:

The number of foreclosures jumped to 223,538 in September, 99 per cent higher than the number last year, though down 8 per cent from August, according to RealtyTrac, which compiles housing data. California had the largest number of foreclosures, with 51,259, and Florida was second, with 33,354.
Nevada, which has seen explosive housing growth around Las Vegas, had the highest rate of foreclosures, with one for every 185 households. The overall foreclosure rate was one for every 557 households.

Countrywide Financial, the nation's largest mortgage lender, said "The number of foreclosures jumped to 223,538 in September, 99 per cent higher than the number last year, though down 8 per cent from August, according to RealtyTrac, which compiles housing data. California had the largest number of foreclosures, with 51,259, and Florida was second, with 33,354. Nevada, which has seen explosive housing growth around Las Vegas, had the highest rate of foreclosures, with one for every 185 households. The overall foreclosure rate was one for every 557 households."

RealtyTrac said the foreclosure jump was due in part to sub-prime borrowers being unable to make payments after rates went up. Countrywide Financial, the nation's largest mortgage lender, has seen deliquencies as a percentage of unpaid loans go to 5.85 percent, versus 4.04 percent a year ago. Its issuance of ARMs has dropped by 76 percent. Daily mortgage loan applications are down by 39 percent. This is alarming news.
And now factor in what the New York Times reports:

"New data shows that after adjusting for inflation, 95 percent of Americans reported smaller incomes to the tax man in 2005 than in 2000."

People had a bit more in their pockets due to the tax cuts - from about $20 a month for those in the bottom half of income to $5,400 a month for those in the top 1 percent. And only those in the top 5 percent of income saw higher incomes both before and after taxes. More than three-quarters of all taxpayers make less then $5,400 per month. When the bulk of the little guys are getting hit hard, the entire economy will follow. And I think the signs of this are getting clearer than I'd like. This is one of those times that I sure hope I'm completely wrong.

More Credit Fall-Out

I don't have a lot of time today, but here's some round-up of the ongoing credit crisis - which, I think, it really an economic crisis because while Alan Greenspan might think the worst is over, I suspect he's talking strictly of liquidity issues. The impact on consumers and, therefore, business has got to last for years, unless lenders go back to the same risky behaviors that got us here in the first place, and that would be tragic, simply compounding the impact farther down the line.

• Deutsche Bank's investment bank unit is expecting "a third-quarter pre-tax loss of up to €350m (£242m), after €2.2bn of charges relating to leveraged loans, structured credit products and trading," according to the Financial Times. That's about $493 million in loss and almost $3.1 billion in charges in US dollars, according to the XE.com conversion calculator.


• The same article said that Merrill Lynch's fixed income trading practice will see a loss of $1.5 billion in the third quarter. The company has sacked the heads of fixed-income trading and structured credit products. Sounds like scapegoating to me - the company got greedy, didn't exercise oversight and prudence, and now wants to blame someone.


• Bears Sterns is cutting its workforce by another 310 jobs.


• The European Central Bank is keeping its interest rate at 4 percent, while the Bank of England is staying at 5.75 percent. Although I'm far from an expert in high finance and economics, I'd wonder if this might influence the Fed to not go for another rate drop, the expectation of which, according to analysts, is fueling the renewed optimism (notice I'm not saying strength) in the U.S. stock market. If so, a surprise could spell an unpleasant drop in the the DOW and NASDAQ by November.


• According to another FT story (love that paper), a McKinsey Global Institute study suggests that "[g]lobal financial markets face a permanent shift in power from traditional money managers to opaque groups such as petro-dollar investors, Asian central banks, hedge funds and private equity groups." Their holdings apparently represent 5 percent of the world's financial assets. If current trends continue, that could become three-quarters the size of the global pension markets. That's influence and power among people who are out of the reach of global regulation.

The big story, I think is the last one. There are seismic shifts in business as usual. The entire global financial structure is undergoing a restructuring in reasonable assumptions and perceptions. That is going to affect how every company has to consider its financing options, which means reconsidering its business.

Storms Gather on Housing Front ... Right?

The New York Times reported new homes sales at their slowest pace in more than seven years, with median prices down 7.5 percent from the previous year. Though, interestingly, when you look at the actual Commerce Department Report, the numbers are hardly written in stone:

Sales of new one-family houses in August 2007 were at a seasonally adjusted annual rate of 795,000, according to estimates released jointly today by the U.S. Census Bureau and the Department of Housing and Urban Development. This is 8.3 percent (±12.4%)* below the revised July rate of 867,000 and is 21.2 percent (±9.0%) below the August 2006 estimate of 1,009,000.

Those margins of error at a 90 percent confidence level are pretty big; in comparison with the revised July rate, the potential error is even larger than the estimated difference.

So, the Times is comparing a reasonably uncertain estimate to more accurate past numbers. And then other questions come up, as well. Is the drop in home sales also due to builders expecting a slow-down and scaling back their work levels? Why not look at the median number of months for sales apparently jumping from roughly 4 in 2005 and 2006 to the current 6? This is an example of the problem with reporting on economic data - it takes knowledge and effort to dig in and understand exactly what it is saying.

For those who'd like some perspective on the numbers, Investors Business Daily has a couple of informative graphs that show trends (at the bottom of the page).

Falling Dollar and Credit Crunch

I've mentioned the credit crisis a number of times in this blog, and now we have another consideration: the state of the dollar. According to the New York Times (and other outlets as well, I'm sure), the dollar fell to a new low point against the euro:

Currencies are influenced by many factors, chief among them expectations for interest rates and inflation. If rates were to fall in the United States and remain unchanged in Europe, as many investors are expecting, traders will probably bid up the exchange value of euros.

It makes sense. As interest rates drop in the US, you get less bang for your literal buck, and you want to hold currency that has greater strength, because there's greater demand.

But forget about interest rates going forward, for a moment, and consider what happens to existing debt. As the value of the dollar falls, people and institutions in other countries find that the notes they hold keep dropping in effective value in their home currencies. Instead of paying the equivalent of X euros or Y yen, suddenly you're getting some percentage less. US investors don't see that particular effect as much because they are still paying for things in dollars.

Unfortunately, much of what we consume in this country is imported. As the dollar drops, the imports become more expensive. Consumers need more money to do the same purchasing, and they're not getting it from credit, so they buy less. That slows the economy and, I'm guessing, weakens the dollar even more, because people internationally are less interested in being tied to our currency. That acts as a positive feedback loop, helping to increase the effect.

All in all, I have a funny feeling that the business climate over the next couple of years is going to be much rockier and difficult than I hear most people in business admitting. Maybe I'm wrong, or maybe they don't want to come out and say what is actually happening.

More Debt Madness Upcoming?

I'm on a number of specialty email lists, including one from a major international risk management firm. It ran an opinion piece from a reader who noted something that I hadn't realized: companies have created the same types of security derivatives based on debt for the credit card market as they have for mortgages. This should shake everyone's shoes.

People have been living on credit, at least in the US, as many have noted. Fueling much of their buying has been low mortgage rates. People refinanced, pulled out cash, and made purchases, thinking that higher housing prices would cover their rears. Now that it's ending, and many mortgages are suddenly rising in price, they will start turning to credit cards.

According to this opinion piece, the US has a total of $904 billion in revolving credit debt - mostly credit cards. The UK has $100 billion on plastic. Bank of England data says that British banks have written off $18 billion in bad debt over the last 12 months. Moody's suggests that American credit card companies have seen bad debt jumping by almost a third in one year.

Credit cards are the last refuge of those not making more money who are trying to manage higher costs of living, and that's piling a lot of weight on what appears to be a flimsy structure. If you thought the sub-prime mortgage situation was a fiasco, what do you call what will happen with credit cards? Unmitigated disaster? Or depression?

A Sudden Realization About the Sub-Prime Crisis

I've written a fair amount about this topic, so this will be short. (Having impending deadlines, like other forms of death, concentrates the mind wonderfully.) But when I started thinking about how this debacle came to being, I wrote the following:

By combining pools of mortgages with rising housing prices, lenders were able to wash off the risk because the failure of some percentage of borrowers still left the pool safely covered.

That was the explanation I had read, but something bothered me about it. It didn't quite make sense that some juggling could improve the credit rating that much. After all, to really cover the potential default rates, you'd probably need to add a significant number of "good" mortgages that would be unlikely to default so the return on the investment had a reasonable chance of occurring. But then the default rates shouldn't have had that kind of impact. And yet, it seemed that the derivative securities were largely based on poor credit lending. How did bundling them get better ratings than the individual loans would have?

After paying attention to more reporting on the subject, I think I now understand. The rating agencies abdicated any ethical or moral responsibility to give an honest opinion on the derivatives because they are paid by the very financial institutions that were issuing them. Unfortunately, investors pay significant heed to these ratings and often pass on doing further due diligence. I could understand that from individuals who are intimidated by understanding financial matters. But these derivatives could never have taken off without significant institutional investor participation. What happened here? Don't these large organizations that hire lots of brainy people actually do their own thinking? Actually, many rely on the opinions of others far more than you might thing, certainly in proxy voting issues, as I learned in writing an article for Corporate Secretary.

So many individual investors, putting their money into money markets, pension funds, and other aggregations of cash might be taking a larger risk than they realize, because they don't always know who's really making the decisions. Where has the financial media been through all this? This story has an Enron-like cast, with lots of people writing in awe of the clever financing and no one pointing out that the Emperor ruled in the buff.

Blame the Home Buyers

I've heard a couple of broadcast pieces lately that note how many of the problems with the sub-prime market meltdown started with home buyers lying about their incomes on the mortgage applications. Although I haven't yet heard anyone come out and say, "It's all their fault," there's an undertone in the reporting and in the remarks from experts.

It's total bunk, in my opinion. The responsibilty for prudent lending isn't the customer's. Risk management is clearly the duty of the lender. Why did the people lie? Because they had poor credit and yet desperately wanted to own their own home instead of continuingly putting money into a landlord's pocket. That's not a hard psychology to predict. No one goes into this type of financial obligation consciously thinking that they are going to fail. They tell themselves that it will be tough, but that they'll be able to do it. And then they don't read the fine print of how rates can suddenly jump.

These were people motivated by the desire to get out from under. Why did lenders grant lans? Becasue they figured they could squeeze out that much more profit. It's a classic credit strategy: you get more return for risk that is greater. I can understand that, but you have a problem when the money you want cranks the risk up to a much higher degree. They lenders should have done projections to see how much danger loans were in from potential default at different levels of interest - not from a lack of inherent trustworthiness of the borrowers, but because they changed the economic conditions to make payback virtually impossible.

"But that's why we wanted a high enough income in the first place," they will claim. Oh, please, don't make me laugh. They wanted higher income and yet wouldn't verify? The only reason they did verify - or check enough - is because they wanted to do the business too badly. You'd think that a mortgage company would have all the power in a negotiation, but, ironically, they didn't. This is a perfect example of neediness in a negotiation (see my review of Jim Camp's book, No).

The entire credit industry wanted every penny it thought was out there, and so completely dropped all the barriers of logic, reason, and prudence. Last week, the Financial Times had a story about web sites that would charge people to act as income verification, even though the people had never worked for them. Yup, that would be financial fraud. But to trust the word of a phone call? Not to check what business the company was in? How long does it take to run a standard credit check on a company and how much does it cost? The answers are not long and not much. If the borrowers were literally criminal in their misrepresentations, the lenders were figuratively criminally stupid.

Although it will be painful for the global economy, I do hope that governments don't drop interest rates to effectively bail out the lenders. It's not as if they haven't seen the potential consequences of foolish risk taking in the past. How many lessons does someone need before having to pay for their actions? We expect poor individuals to pay at the first mistake. Perhaps it's time that business leaders do their own hard times.

Business Using Sub-Prime as an Excuse

There have been many news accounts of how the meltdown in the sub-prime credit markets have become like a contagion, affecting a growing amount of all business. The reasoning, as I understand it, goes something like this:

1. Housing prices kept escalating, so people had burgeoning amounts of equity, at least on paper.



2. Sub-prime lenders kept taking on more risk because high demand for homes and rising housing prices made it seem relative safe.



3. Lenders bundled together derivative securities that held the mortgages.



4. By combining pools of mortgages with rising housing prices, lenders were able to wash off the risk because the failure of some percentage of borrowers still left the pool safely covered.



5. Prices topped and dropped, and a growing number of people were defaulting - not just on first mortgages, but on secondary ones, including equity-backed lines of credit.



6. Someone had to start paying out money, which meant credit insurers and mortgage lenders alike had to start pouring out cash, which meant reducing liquidity.



7. Those with lots of cash didn't want to lose it, so they stopped underwriting so much of the business being done.



8. As a result, some groups are losing money on deals because they couldn't get the terms they needed, and some hedge funds started to close because they were effectively undertaking high stakes gambling and finding that the house eventually wins.



9. Private equity firms, which had been indirectly fueling the rise in stock prices (not some quick miracle of economic conditions), are backing away from deals because they can't get the terms and returns that drive their business models. (Friday's Wall Street Journal had an article called "Leveraged Buyout Remorse?" with the following first line: "Having spent years racing to put deals together, some private-equity firms are puzzling over whether they should take them apart.")



10. The stock market is likely to see an increasing pinch as people and institutions aren't rushing to make a killing on the next takeover prospect.

So it's all the fault of the sub-prime markets, we hear. But I don't buy it. Yes, that is a mechanism, but it's not the finger pulling the trigger. That honor belongs to greed unchecked by business sense.

In the face of economic history, expecting that prices relative to other demands of life could rise forever, and even planning on that happening, is idiotic. That has never happened and isn't about to start. What we are seeing is the same as the tulip market mania of the 16th century. It's multi-level marketing on a grand scale. It's a ponzi scheme. At each point, furthering of the business "model" depends on someone having the expectation that no matter what the inflated price, he or she will shortly see the same type of return. If a business or investor wants to take some risk for high returns, that's fine, but it's called risk for a reason. There is a measurable chance, sometimes large, that you will lose part or all of the money you've invested.

To put virtually all of your eggs into this one basket is insane. Yet that's what the markets have done. All manners of companies have been betting on consumer spending to continue. But the spending wasn't itself fueled by increases in wages. No, because that would lead to inflation and corporations having higher labor expenses, and smaller returns. Instead, everyone more or less turned their heads, opened the credit taps, and let the money flow because, well, those increased housing prices would make everything fine in the end. One could always refinance, pay off the one lender at risk by transferring the risk to another, and take a little extra money out at the same time.

It's over. People are increasingly stuck in houses they couldn't afford and that, with dropping prices, they can't afford to sell, because they would remain in debt as the sales price wouldn't cover the mortgage. The markets are experiencing (I'm not sure they realize quite what is actually happening) a cold turkey economic abuse program. Now governments are involved, making cash available to keep enough money in the system to leave it afloat. Although you won't see it called such, this is the world's largest economic bailout masked as maintaining market liquidity. The sums that are going in and will probably continue to pour in will dwarf the savings and load debacle this country experienced. I wouldn't be surprised if it ultimately overtook the real spending during the Great Depression. We are in a pile of doo-doo, and all the finger-pointing and rationalization won't change the fact that it is of our own making.