Tuesday, September 30, 2008

The fallout of credit crisis hurt security lending business

Public pension funds and other big investors have long squeezed out a few extra bucks by lending stock held in their portfolios -- for a fee -- to short-sellers. Now those funds are starting to feel a squeeze of their own.

The collapse of Lehman Brothers Holdings Inc. and Washington Mutual Inc. have set off new troubles in the securities-lending business, and the recent freeze in short-term debt markets has only compounded the problem.

That has left a number of big financial firms -- from the California State Teachers' pension fund to giant mutual funds -- with at least temporary losses. They could become permanent if conditions don't improve soon.

The business of securities lending can seem yet another obscure corner of Wall Street. But it is big business for funds with huge portfolios of stocks. The profits earned from securities lending are one reason why index fund companies like Vanguard can charge clients such small fees. They can also boost overall pension-fund returns.

Under a typical agreement, a pension fund lends out securities and receives cash as collateral, plus another 2%. That cash is then handed over to a broker, who invests the money so that the pension fund can get an additional return on that collateral of as much as 1% per transaction.

The pressure on securities-lending programs comes at a time when pension funds and mutual funds around the world are voluntarily restricting their lending of shares of financial companies to hedge funds. The funds use borrowed shares for short-selling, though most say that this is to prevent speculators from shorting the stocks. In a short sale, a trader borrows a security and hopes it will fall in price before the trader has to buy it back and return it.

The California Public Employees' Retirement System, for instance, earned $118 million in net income for a $38 billion securities-lending program for the year ended in June. Over the past eight years, the program had cumulative net earnings of nearly $1.2 billion.

That has worked reliably for years. But the decline in Lehman and Washington Mutual have set off an unsettling chain of events: first causing the value of their own securities to plummet, then contributing to a freeze in the credit markets that hurt most short-term debt securities.

After that happened, investors were forced to make up the difference when they returned the collateral to the borrower of the securities. Christopher Ailman

"Our earnings in this program will be affected," said Christopher Ailman, chief investment officer for the California State Teachers' Retirement System, the nation's second-largest pension fund that lends securities valued around $29 billion.

Mr. Ailman said the fund "will not get face value" for collateral invested in medium-term notes issued by Lehman Brothers and Washington Mutual. The amount of losses is unclear because the pension fund expects to hold the paper for a long time and wait for a price rebound.

They aren't alone. Northern Trust Corp. on Monday said it is taking a pretax charge of $150 million in the third quarter to pay back investors who lost money on collateral from securities lending that was invested by the Chicago-based investment firm.

Bank of New York Mellon Corp. took similar action last week, saying it will "provide support" to clients impacted by the Lehman bankruptcy filing, including those in a fund used for "reinvestment of cash collateral within the company's securities lending business."

We're going into another Great Depression - WSJ

Willingess and ability of Fed to help the slumping economy will prevent it from falling into depression. It is hard to imagine a depression could get under way when capital is waiting in the swing.... Let's consider some of the arguments that have been surfacing lately. "We're going into another Great Depression." The failure on Monday of the U.S. House of Representatives to pass the bailout plan makes those G-D words seem possible for the first time. But I don't think another depression is likely, for two reasons. First, when you spend time studying the Crash of 1929 and the depression that followed, what stands out the most is the dearth of doomsayers. Even Roger Babson, the economist known to posterity as "the man who called the crash," did no such thing; he forecast only a 15% to 20% drop, not the apocalypse that actually occurred. Depressions start not when lots of people are worried about them, as we have today, but when no one is worried about them, as in 1929. Second, the Great Depression and the Panic of 1873 (which triggered what arguably was the worst depression in U.S. history) both occurred before the Federal Reserve Bank had aggressively grown into its role as "lender of last resort." In the wake of 1873, after a railroad-building boom had swept the nation and then gone bust, companies and consumers alike were left gasping for capital. Nothing but the passage of time could supply it; the Fed would not be established until 1913. After the crash of 1929, when the Fed was still weak, years passed before the federal government could flood the economy with cash. Today, however, the resolve of the Fed is not in question; nor is there any doubt that the Treasury Department is willing to provide the financing it takes to get the economy moving again. Furthermore, U.S. nonfinancial companies have just under $1 trillion in cash on their books. Even though Wall Street is dead, innovation is not: In the months to come, clever new financial go-betweens will spring up and find a way to get that cash flowing again. It's hard to see how a depression could get under way when so much capital is waiting in the wings. "Diversification is dead." There's an old saying that the only things that go up in a down market are correlations -- the tightness of the linkages among various assets like U.S. and foreign markets, stocks and bonds, commodities or real estate. Normally, one asset will tend to zig while another zags. But in bear markets, they converge -- and in really terrible bear markets, they move in complete lockstep. That's what is happening now, but it will not last indefinitely. It never does. While diversification does not work all the time, it does work over the course of time. There's nothing wrong with raising a little cash if that would prevent you from panicking completely. This is particularly true for retirees. Whittle down your stock position gradually, in baby steps -- say, 1% at a time -- not in one fell swoop. And set a limit beyond which you will not go; otherwise, when stocks stage their inevitable recovery, you will miss out.

Fund raising stymied by dwindling reserves of confidence

The billions of dollars of losses by investors – from shareholders to bondholders – from the collapse of banks across the globe has dented confidence to such an extent that fund-raising is expected to be extremely difficult in the next few weeks. The daily announcements of forced bail-outs and bank collapses from the US to Europe is fuelling rather than easing concerns among investors, even those who until just a few weeks ago thought they would be relatively safe. Bondholders are one class of investor who would certainly have thought they were unlikely to lose money, even if a firm ran into trouble. Ashish Shah, analyst at Barclays Capital, says: “Investors’ ideas about which banks are too big to fail have changed dramatically. “Recent bankruptcies have shown that all types of investor can be at risk and this realisation is going to make fundraising challenging for many institutions going forward.” Already, it is proving extremely hard for banks to raise much-needed capital in the equity – or equity-linked markets, where investors’ positions have been decimated by a chain reaction of bank failures and rescue efforts. Barclays analysts say: “The preferred and equity markets are largely closed to financials following the treatment of [Fannie Mae and Freddie Mac], Lehman Brothers and Washington Mutual. Likewise, convertible issuance is down sharply due to the short-selling ban on financials”. The bond markets, which for much of this year continued to provide large amounts of financing for financial institutions, are also now proving difficult ground, even for the most short-dated funds. Just weeks ago, investors were snapping up bonds by financial institutions, arguing that the relatively high yields offered a welcome lift to returns. The bankruptcy of Lehman Brothers two weeks ago – expected to result in losses of $110bn for its senior bondholders alone – dramatically changed perceptions of bondholder risk. Lehman bonds are expected to recover less than 20 cents in the dollar. Creditors to Washington Mutual were also wiped out. Michael Kastner, portfolio manager at SterlingStamos, says: “It will be a long while before corporate bond investors say owning bonds [sold at attractive yields] are a no brainer”. The effects are being felt at short- and long-term maturities. Following the Lehman bankruptcy , about $400bn was taken out of US money market funds, which are heavy buyers of short-term debt issued by financial institutions. The outflows from money market funds appear to have been stemmed by moves by the Federal Reserve to provide money market funds with indirect access to its lending window. However, Alex Roever, analyst at JP Morgan, says about 60 per cent of that money has been moved into money market funds backed by government securities. He says: “It seems unlikely much of the money that fled to the quality of government securities will return soon. On a marginal basis that means there is less money available to fund banks and financials”. With another four significant bank bail-outs in Europe in just two days, holders of financial debt in the region are regarding their exposures with concern. However, the main difference in Europe is that governments have generally acted in a way that protects senior creditors. Belgo-Dutch bank Fortis and Glitnir of Iceland have both received state capital injections to keep them as going concerns, while Germany’s Hypo Real Estate was given €35bn worth of creditor guarantees to stave off a funding crisis at the specialist property lender. In the UK, unsecured senior bondholders have been offered explicit guarantees by the government in the cases of both Bradford & Bingley this weekend and Northern Rock last year. However, holders of subordinated bonds and hybrid debt-capital instruments such as fixed income preference shares have been squeezed and both face uncertain futures. In some ways this is to be expected given that such instruments are meant to be at greater risk of losses. But it is striking because of the growth of such instruments from banks in recent years, and in the first half of this year. Suki Mann, strategist at SGCIB, says: “It would not surprise us if we get very little issuance in bank capital paper for the rest of this year. “It’s not about spread levels, or need to issue (banks are relying more than ever on central bank funding) – there is simply no market. “The demise of WaMu in particular, wiping out senior bondholders – albeit in extremis – will have many senior bondholders of other troubled US banks sitting uncomfortably. There may even be long term funding repercussions for financial institutions.” Another problem for banks especially is that with the demise of structured investment vehicles and conduits, which were a major source of demand for floating rate bonds from financial issuers, a whole source of funding has simply disappeared, perhaps never to return. However, there is a considerable amount of floating-rate debt maturing in the next 12 months, and the collapse of the structured finance market, as well as the reduced appetite for even short-term bank debt from money market investors, is expected to be keenly felt, both in the US and in Europe. Citigroup analysts say: “Despite all the excitement about the Tarp (troubled asset relief programme) to our minds the market’s main focus going forward will be on funding and on deleveraging, Any institution that needs funding in this environment – be they hedge fund, corporate or bank – looks vulnerable.”

Important to curb destructive power of deleveraging - FT

The consequences of the remarkable events and policy developments that have led to the creation of the $700bn banking bail-out plan are by no means over. The far reaching implications of the crisis for the banking industry, capital markets, the role of government in the economy, and confidence in US dollar debt will be with us for a long time. The most urgent issue is how to contain the destructive power of deleveraging. Financial stability must be restored to avoid a harsh economic downturn that would amplify the credit crisis. Moreover, policy must provide for orderly financing flows, especially of debt rollovers, the absence of which has forced up money market and private lending rates in spite of copious liquidity provision. The Emergency Economic Stabilisation Act 2008 (EESA), as the bail-out plan is now called, marks an important precedent for the US. It acknowledges the need for extensive government intervention in dealing with the financial crisis by deploying the government's balance sheet to absorb part of the contraction in private sector credit. The enormous fiscal consequences will have to be managed later. The good news is that the act could relieve some liquidity and capital constraints for participating banks, and it might have some indirect effects in moderating home price deflation and foreclosures. The key issue is the pricing of the assets to be bought. The reverse auction system and the ethics of paying premium prices suggest that prices paid will be on the low, but not firesale, side. In a limited gesture, the government is entitled to receive warrants from participating banks, and the Securities and Exchange Commission will have the authority to suspend mark-to-market accounting, where deemed appropriate. Against this, there is no explicit provision for homeowner debt relief to help manage household deleveraging. The larger objection to the EESA is that, because it sees the financial crisis through a mortgage prism only, it does not go far enough. Mortgages are only one, albeit significant, source of deleveraging. Most systemic banking crises have been resolved via state-backed re-capitalisation in some form, and the EESA will make a modest contribution at best. Mortgages and mortgage-backed securities account for about $23,000bn of the $48,000bn of total debt owed by the financial and non-financial private sectors. The focus only on the mortgage sector misses the point that debt destruction and asset deflation are generic. The shrinkage of balance sheets is occurring equally in banks and in the non-financial sector. Full crisis management must provide, therefore, for the re-capitalisation of the banking system by the state in exchange for equity participation that could be sold back at a later date. This could be bolstered by a more robust change in accounting standards, so that some types of losses could be absorbed over time and reported in the income statement, rather than appear in immediate capital destruction. How much capital do US banks need? Using a loan loss rate of about 5 per cent (roughly 3 per cent historically), a top-down estimate suggests there may be about $2,000 to $2,500bn of mark-to-market losses in the economy. Assuming a 50 per cent recovery rate and allowing for the $300bn or so of capital raised since August 2007, the banking system may now be undercapitalised by about $700bn. It might have been better to use the EESA authority for this purpose, rather than to buy bad assets. Not all of this needs to be provided by the state, because the EESA, dividend suspensions, a steep yield curve, and earnings over the next few years should all help. Re-capitalisation, however, is needed now, and only the government can make it happen. It would help to limit the more destructive aspects of deleveraging, strengthening capital to asset ratios, without intensifying the pace of asset sales. It would contribute to rebuilding confidence in money markets, institutions and instruments. The economic cycle will have to run its course, but the urgent priority is to rebuild financial stability through the containment of deleveraging. The EESA will help but it will not defuse the crisis alone. The writer is senior economic adviser, UBS Investment Bank, and author of The Age of Ageing, (John Wiley & Sons, October 2008)

Monday, September 29, 2008

New World Order in Bank Acquisitions: Asset Stripping De Rigueur

In regulatory intervention, the regulators have the authority and have now the ability and willingness to strip the assets away from bondholders and stockholders, especially leaving them a smaller asset pool for recoveries. These powers were enacted with the FDIC Act of 1991 whereas many of the major bank failures in the last real estate cycle occured prior to the its passage. Therefore history has given little guidance in the way of a template of major bank resolutions under these circumstance.

How is this for an explanation of the financial crisis in 100 words or less?

"As in every preceding crisis, the main cause was far too large a mass of credits -- that is, of debts -- for the amount of cash in which they were redeemable. Trade and speculation had long been so active, and too often recklessly expanded, that this disproportion had become dangerous, and a menace to our safety...a serious reaction, a serious revulsion, was inevitable unless we moderated our pace and mended our ways..I could foresee that this vast and growing disproportion between the volume of credits and cash would finally lead to collapse." That is a description of the Panic of 1907, courtesy of financier Henry Clews, who in 1908 wrote the book "Fifty Years in Wall Street." Mr. Clews also investigated the American stock panics of 1812, 1823, 1825, 1837, 1857, well, you get the idea, all the way through the Panic of 1893. The common denominator: too much debt, too much speculation. Flail as investors and financiers might, Mr. Clews argued that market panics were America's birthright. The country was built on innovation and growth, he said, and growth "requires outlays of capital in advance of obtainable results.... We thus have a ceaseless stream of new issues of stocks, mortgages and commercial paper and have, therefore, at all times outstanding a large amount of obligations which, from the uncertainty of their basis, are liable to wide fluctuations in value." Then there is unchanging human nature. Banks that hold toxic mortgage-backed securities and "hung" bridge loans are reacting in 2008 just as stockholders did in the downturn of 1904, when many railways and industrial companies were forced to liquidate their holdings. That left the country "sprinkled with poor rich men, capitalists with a good deal of property, real and personal, including stocks, but all unsalable in the market except at a ruinous loss. Their policy is naturally to hold on to what they have left till the tide turns," he wrote. The cure? Mr. Clews argued for more lending. "In every panic very much depends upon the prudence and control of the money-lenders...this is tantamount to saying that all depends on the calmness and wisdom of the banks." Now we might define "calmness and wisdom" as restrictions on lending, but "if they lose their heads and indiscriminately refuse to lend, or lend only to the few unquestionably strong borrowers, the worst forms of panic ensue," Mr. Clews warned. In the end, it is the business cycle as fate: "The action of commerce, like a motion of the sea or the atmosphere, follows an undulatory line. First comes an ascending wave of activity and rising prices; next, when prices have risen to a point that [limits] demand, comes a period of hesitation or caution; then, carefulness among lenders and discounters; then comes the descending movement, in which holders simultaneously endeavor to [withdraw their money], thereby accelerating a general fall in prices. Credit then becomes more sensitive and is contracted; transactions are diminished; losses are incurred through the depreciation of property; and finally the ordeal becomes so severe to the debtor class that forcible liquidation has to be adopted, and insolvent firms and institutions must be wound up."

Sunday, September 28, 2008

The doctors' bill - Economist

The chairman of the Federal Reserve and the treasury secretary give Congress a gloomy prognosis for the economy, and propose a drastic remedy.

AMERICAN congressmen are used to hyperbole, but they were left speechless by the dire scenario Ben Bernanke, the chairman of the Federal Reserve, painted for them on the night of September 18th. He “told us that our American economy’s arteries, our financial system, is clogged, and if we don’t act, the patient will surely suffer a heart attack, maybe next week, maybe in six months, but it will happen,” according to Charles Schumer, a Democratic senator from New York. Mr Schumer’s interpretation: failure to act would cause “a depression”. Mr Bernanke and Hank Paulson, the treasury secretary, had met congressional leaders to argue that ad hoc responses to the continuing financial crisis like that week’s bail-out of American International Group (AIG), a huge insurer, were no longer sufficient. By the weekend Mr Paulson had asked for authority to own up to $700 billion in mortgage-related assets. By the time The Economist went to press, Congress and Mr Paulson appeared to have agreed on the broad outlines of what is being called the Troubled Asset Relief Programme, or TARP.

However, passage was not assured as rank-and-file congressmen, in particular Republicans, balked. Uncertainty over the outcome rattled credit markets: three-month interbank rates jumped and Treasury yields fell on September 24th. In a prime-time address that evening to rally support, George Bush warned of bank failures, plummeting house values and millions of lost jobs if Congress did not act.

Both the crisis and the authorities’ response have been called the most sweeping since the Depression. Yet the differences from that era are more notable than the similarities to it. From the stockmarket crash of 1929 to the federally declared bank holiday that marked its bottom, three and a half years elapsed, and unemployment reached 25%. This crisis has been under way for a little over a year and unemployment is just over 6%, lower even than in the wake of the last, mild recession. More than 4% of mortgages are now seriously delinquent (see chart 1), but the figure topped 40% in 1934.

The scale of the American authorities’ response reflects both the violence with which this crisis has spread, and the determination of the American authorities, most importantly Mr Bernanke, to learn from the mistakes that made the Depression so deep and long.

In responding with such speed and vigour, they run several risks. One is that they overdo it, paying far too much for assets, sending the deficit into the stratosphere and triggering a run on the dollar. The risk of underdoing it may be even greater. Politicians, determined not to be seen as doing favours for Wall Street, might blunt the programme’s effect in the name of protecting the taxpayer. Then there’s the logistical nightmare of fixing a market whose very complexity is central to the crisis.

Experience, at home and abroad, is a poor guide. In past episodes authorities have typically not committed public money to their financial systems until bank failures and insolvency have become widespread. The first wave of savings-and-loan failures came in the early 1980s; the Resolution Trust Corporation was not created to dispose of their assets until 1989. Japan’s banks began to fail in 1991, but a mechanism for taking over large, insolvent banks was not set up until 1998. Mr Paulson and Mr Bernanke are attempting to prevent the crisis from reaching that stage. “The firms we’re dealing with now are not necessarily failing, but they are contracting, they are deleveraging,” Mr Bernanke told Congress. They are unable to raise capital and are refusing to lend, and that, he said, is squeezing the economy.

One risk with such a pre-emptive bail-out is that to congressmen the benefits are hypothetical whereas the fiscal and political costs, five weeks before an election, are all too real. In polls voters waver between opposition and support depending on how the question is asked.

In spite of these risks, the odds seem to be in favour of both political passage and success. America has owned up to its mistakes with exceptional speed, and pulled out the stops to correct them.

After the crisis first broke in August last year, the Fed pursued a two-pronged strategy. The first element was to lower interest rates to cushion the economy. The second was to use its balance sheet to help commercial and investment banks finance their holdings of hard-to-value securities and avoid fire-sales of assets. Behind this approach lay the belief that the economy and the financial system were basically solid. Yes, too many houses had been built and prices were too high, but a return to more normal levels would be manageable if stretched over a few years. And banks in aggregate had entered the crisis in good shape, with much more capital this June than in 1990. The Fed saw their problem essentially as illiquidity, not insolvency. The Bush administration broadly shared this diagnosis—and an aversion to using public money to help overextended borrowers.

The intensification of the crisis came not from the banks but the “shadow banking system”: the finance companies, investment banks, off-balance-sheet vehicles, government-sponsored enterprises and hedge funds that fuelled the credit boom, aided by less regulation and more leverage than commercial banks. As home prices fell and loan losses mounted, more of the shadow system became insolvent.

Insolvency cannot be cured with more loans, no matter how easy the terms. It requires more capital, which in deep crises only the government can provide. Mr Bernanke’s groundbreaking paper on the Depression, published in 1983, noted that recovery began in 1933 with large infusions of federal cash into institutions, through the Reconstruction Finance Corporation, and households, through the Home Owners’ Loan Corporation. They were, he wrote, “the only major New Deal programme which successfully promoted economic recovery.”

A month ago Mr Bernanke and his closest aides began to think something similar might now be needed. The Fed and the Treasury had already drawn up contingency plans, thinking it would be months before a need arose. Then the financial hurricane blew up over the weekend of September 13th and 14th. That is when Mr Paulson, Mr Bernanke and Tim Geithner, president of the Federal Reserve Bank of New York, decided not to commit any public money to a bail-out of Lehman Brothers. They reasoned, wrongly, that the financial system was adequately prepared. The company’s failure, coupled with the near-bankruptcy of AIG, threw the safety of all financial institutions into doubt, causing their stocks to plunge and borrowing costs to soar.

Several money-market funds that held Lehman debt reported negative returns, sparking a flight of cash to the safety of Treasury bills that briefly pushed their yields close to zero. On September 18th companies could no longer issue commercial paper. Banks, anticipating huge demands from companies seeking funds, began hoarding cash, sending the federal funds rate as high as 6%. That week, no investment-grade bonds were issued, for the first time (holidays aside) since 1981.

Conceivably, the Fed could have contained the damage by supplying lots of cash. But that would have meant ever greater and more creative use of its balance sheet. By September 17th it had grown to $1 trillion, up by 10% in a fortnight, with most of it tied up in loans to banks, investment banks, foreign central banks, AIG and Bear Stearns (see chart 2). It was becoming the lender of first resort, not last.

Such steps were also courting political risk. After the rescue of AIG, Nancy Pelosi, speaker of the House of Representatives, demanded, “Why does one person have the right to grant $85 billion in a bail-out [to AIG] without the scrutiny and transparency the American people deserve?” Mr Bernanke later acknowledged that the Fed wanted to get out of crisis management, for which it lacked authority and broad support. “We prefer to get back to monetary policy, which is our function, our key mission,” he told Congress this week.

The Fed chairman told Mr Paulson on September 17th that the time had come to call for a big injection of public money. By the next day Mr Paulson was in agreement and the two men, after getting Mr Bush’s approval, approached Capitol Hill.

Mr Paulson’s first proposal left Democrats cold: it would give the Treasury virtually unchecked authority for two years to spend up to $700 billion on mortgage assets or anything else necessary to stabilise the system. It looked like a power-grab. Democrats countered with several conditions: troubled mortgages would be modified where possible to keep homeowners in their homes; an oversight board would watch over the programme; taxpayers would share any gains for participating companies via shares or warrants; and executives’ compensation would be capped. By September 24th, Mr Paulson seemed to be bending to all these conditions.

For its part, the finance industry is ready to yield to all of these conditions in order to get something done. “It was a gargantuan abyss that we faced last week,” says Steve Bartlett, chairman of the Financial Services Roundtable, which represents about 100 big financial firms.

Assuming it comes into existence, there are still numerous risks surrounding the TARP. The first is that it does too much. At $700 billion, the amount allocated to it easily exceeds the Federal Deposit Insurance Corporation’s (FDIC) estimate of roughly $500 billion of residential mortgages seriously delinquent in June, out of a total of $10.6 trillion, though that figure will rise. The Treasury has sought broad authority to buy not just mortgage securities but anything related to them, such as credit derivatives, and if necessary equity in companies weakened by their bad loans.

The arithmetic of crisis

When the loans to AIG and Bear Stearns assets are added in, the gross public backing so far approaches 6% of GDP, well above the 3.7% of the savings-and-loan bail-out in the late 1980s and early 1990s (see chart 3). That would still be much less than the average cost of resolving banking crises around the world in the past three decades, which a study by Luc Laeven and Fabian Valencia, of the IMF, puts at 16%. One reason why bail-outs, especially in emerging markets, have been so costly is inadequate safeguards against abuse, says Gerard Caprio, an economist at Williams College. “There was a lot of outright looting going on.”

The Congressional Budget Office had pegged next year’s federal budget deficit at more than $400 billion, or 3% of GDP. Private estimates top $600 billion. Tack on $700 billion and various other crisis-related outlays and the total could reach 10% of GDP, notes JPMorgan Chase, a level last seen in the second world war. On September 22nd the euro made its largest-ever advance against the dollar on worries that America might one day inflate its way out of those debts. Such fears are compounded by the expansion of the Fed’s balance sheet. Some even think that the burden of repairing a broken financial system could place the dollar’s status as the world’s leading reserve currency in jeopardy.

The consequences will probably not be so far-reaching. The true cost to taxpayers is unlikely to be anywhere near $700 billion, because many of the acquired mortgages will be repaid. The expansion of the Fed’s balance sheet reflects a fear-induced demand for cash, which drove the federal funds rate above the 2% target.

It is more likely that the programme will not go far enough. Conscious of the public’s deep antipathy to anything that smacks of favours for Wall Street, politicians from both parties have insisted that the protection of the taxpayer be paramount. Yet the point of bail-outs is to socialise losses that are clogging the financial system. If taxpayers are completely insulated from losses, the bail-out will probably be ineffective. “The ultimate taxpayer protection will be the market stability provided,” Mr Paulson argues.

This is especially critical in deciding how the government will set the price for the assets it purchases. An impaired mortgage security might yield 65 cents on the dollar if held to maturity. But because the market is so illiquid and suspicion about mortgage values so high, it might fetch just 35 cents in the market today. Recapitalising banks would mean paying as close to 65 cents as possible. Those that valued them at less on their books could mark them up, boosting their capital. On the other hand, minimising taxpayer losses would dictate that the government seek to pay only 35 cents. But this would provide little benefit to the selling banks, and those that carried them at higher values on their books could see their capital further impaired.

To some, that would be fine. “If they choose to fail rather than sell their debt at its real market value and record the loss on the books, they should be free to take that option,” said Michael Enzi, a Republican senator from Wyoming. The failure of smaller regional banks may be tolerable. The FDIC offers a proven system for coping with failed entities (although it too may need a loan from the taxpayer) and other banks are keen to snap up their deposits. But the final result of big-bank failures would be a deeper crisis and a bigger cost in lost economic output.

Similarly, requiring participating banks to give the government warrants or cap their executives’ salaries might make them less willing to take part. Veterans of the emerging-markets crises of the 1990s say their effectiveness would have been crippled had their ability instantly to deploy cash as they saw fit been compromised. “There is far more risk that the authorities will have too little flexibility…than there is risk that they will have too much authority,” says Lawrence Summers, a former treasury secretary.

A more serious criticism is that buying assets is an inefficient way to recapitalise the banking system. Better, many argue, to inject cash directly into weakened banks. A dollar of new equity could support $10 in assets, reducing the pressure to deleverage. Moreover, since the price of banks’ shares are less arbitrary and more homogeneous than those of illiquid mortgage securities, the process would be far more transparent, says Doug Elmendorf of the Brookings Institution. But banks might not volunteer to sell equity to the government before they reach death’s door; and the prospect of share dilution could discourage private investors. In any event, the Treasury plan could be flexible enough to permit such capital injections.

But will it work?

ReutersTime to mend the market

There have been several false dawns since the crisis began in August of last year. This could be another. The TARP may address the root cause, namely house prices and mortgage defaults, but the crisis has long since mutated. “The same underlying phenomenon that we saw in housing we’re seeing in auto loans, in credit-card loans and student loans,” says Eric Mindich, head of Eton Park Capital Management, a hedge fund. The crisis could claim another institution before the TARP’s effect is felt.

The TARP could conceivably slow the resolution of the crisis by stopping property prices and home ownership falling to sustainable levels. Some homeowners who are up-to-date with payments but whose home is worth less than their mortgage may stop paying, betting the federal government will be a more forgiving creditor. The Treasury is considering using the TARP to write down mortgages to levels that squeezed homeowners can afford. But in the meantime, buyers might be reluctant to step in while a big inventory of government-owned property hangs over the market. That’s one reason Japan’s many efforts to bail out its banks failed to revitalise its economy: the institutions that took over the loans were hesitant to dispose of them for fear of pushing insolvent borrowers into bankruptcy, says Takeo Hoshi of the University of California at San Diego.

All the same, the TARP is likely to mark a turning-point. “It promises to break the vicious circle of deleveraging in the mortgage market,” predicts Jan Hatzius, an economist at Goldman Sachs. This does not mean the economy will soon rebound, but it does suggest the worst scenarios will be averted. If the TARP helps banks and investors establish reliable prices for mortgage securities, it could restart lending and help bring the housing crisis to an end.

This will not come without a price. The unprecedented intrusion of the federal government into the capital markets seems certain to be accompanied by a heavier regulatory hand, something on which both Barack Obama and John McCain now agree.

Even without new rules, more of the system will be regulated because so much of it has been absorbed by banks, which are closely overseen. Sheila Bair, chairman of the FDIC, thinks this is a good thing. Banks were relative pillars of stability because of their insured deposits and the regulation that accompanied it. Although some banks have failed, she notes that other banks, not taxpayers, will pay the clean-up costs. Now that institutions like money-market funds are caught by the federal safety net even though that was never intended, they can expect to pay for it.

Yet predictions of a sea change towards more invasive government are premature. The Depression witnessed a pervasive expansion of the federal government into numerous walks of life, from trucking and railways to farming, out of a broadly shared belief that capitalism had failed utterly. If Mr Paulson and Mr Bernanke have prevented a Depression-like collapse in economic output with their actions these past two weeks, then they may also have prevented a Depression-like backlash against the free market.

RRR - Treasury Bailout Plan

It is not Reuse, Reduce, & Recycle. REINVEST, REIMBURSE, REFORM IMPROVING THE FINANCIAL RESCUE LEGISLATION Significant bipartisan work has built consensus around dramatic improvements to the original Bush-Paulson plan to stabilize American financial markets -- including cutting in half the Administration's initial request for $700 billion and requiring Congressional review for any future commitment of taxpayers' funds. If the government loses money, the financial industry will pay back the taxpayers. 3 Phases of a Financial Rescue with Strong Taxpayer Protections Reinvest in the troubled financial markets to stabilize our economy and insulate Main Street from Wall Street Reimburse the taxpayer … through ownership of shares and appreciation in the value of purchased assets Reform business-as-usual on Wall Street strong Congressional oversight and no golden parachutes CRITICAL IMPROVEMENTS TO THE RESCUE PLAN Democrats have insisted from day one on substantial changes to make the Bush-Paulson plan acceptable -- protecting American taxpayers and Main Street -- and these elements will be included in the legislation Protection for taxpayers, ensuring THEY share IN ANY profits Cuts the payment of $700 billion in half and conditions future payments on Congressional review Gives taxpayers an ownership stake and profit-making opportunities with participating companies Puts taxpayers first in line to recover assets if participating company fails Guarantees taxpayers are repaid in full -- if other protections have not actually produced a profit Allows the government to purchase troubled assets from pension plans, local governments, and small banks that serve low- and middle-income families Limits on excessive compensation for CEOs and executives New restrictions on CEO and executive compensation for participating companies: No multi-million dollar golden parachutes Limits CEO compensation that encourages unnecessary risk-taking Recovers bonuses paid based on promised gains that later turn out to be false or inaccurate Strong independent oversight and transparency Four separate independent oversight entities or processes to protect the taxpayer A strong oversight board appointed by bipartisan leaders of Congress A GAO presence at Treasury to oversee the program and conduct audits to ensure strong internal controls, and to prevent waste, fraud, and abuse An independent Inspector General to monitor the Treasury Secretary's decisions Transparency -- requiring posting of transactions online -- to help jumpstart private sector demand Meaningful judicial review of the Treasury Secretary's actions Help to prevent home foreclosures crippling the American economy The government can use its power as the owner of mortgages and mortgage backed securities to facilitate loan modifications (such as, reduced principal or interest rate, lengthened time to pay back the mortgage) to help reduce the 2 million projected foreclosures in the next year Extends provision (passed earlier in this Congress) to stop tax liability on mortgage foreclosures Helps save small businesses that need credit by aiding small community banks hurt by the mortgage crisis—allowing these banks to deduct losses from investments in Fannie Mae and Freddie Mac stocks

Saturday, September 27, 2008

Credit Call for Wachovia

Pick-a-Pay --The issue of Wachovia's centers on pick-a-pay loans, which is is payment option loan (ARM) and similar to Alt-A in terms of FICO (661) and LTV (current 85% vs origin 71%). --The size of the Pick-a-Pay loan is ~120 bil, 14% of asset. worst case scenario analysis --The default of loan is expected to reach 30%, while the highest level in S&L in commercial loan is just 12% and the highest delinquency level of subprime ARM is 22%. --the loss severity for Alt-A is 20%. Let's inflate it to 30%- 40% --the expected loss rate is 9% - 12%, ~10.8 bil - 14.4 bil loss. --The allowance in the second half of 2008 will reach 6.6 bil, so it might cover the potential loss. HEL --The next riskiest loan is HEL loan with a size of 62 bil, 28 bil first lien and 36 bil second lien worst case scenario analysis --first lien loss rate 3% - 5%, 1 bil - 1.4 bil --second lien loss rate 5% - 7%, 2 bil - 2.5 bil --total loss: 3 bil - 4 bil Commercial Real Estate --48.4 bil, loss rate 1% (0.3% historic peak), 0.5 bil Traditional Mortgage --52 bil, loss rate 1% - 2%, 0.5 - 1 bil Commercial Loan --160.6 bil, loss rate 1% - 2%, 1.6 bil - 3.2 bil --remaining exposure to RMBS (8k p36, http://www.blogger.com/post-create.g?blogID=3864161393184469427) ~4 bil --max loss: ~27 bil --allowance ~10 bil --incremental loss: -17 bil --capital equity: 75 bil, mkt 20 bil subor + junior: 34 bil Trading --10y bond 672 bp --5y CDS 1560 bp Credit Call --short 5y senior CDS and short 10 y bond --the risk of shorting CDS or long 10 y bond alone is the uncertainty of being acquired by another company. When JPM acquired WaMu, the loan is not made whole.

FICO cutoff

Agency cutoff - 620 several years ago. but was moved up to 660. Lower cutoff of Alt-A and Jumbo - 600 and 620 Subprime cutoff - 500 Average FICOs in 2004 Jumbo - 735 Alt-A - 710 Subprime - 620

Tensions Between Bush White House and House Republicans

The unexpected opposition from House Republicans on Thursday had thrown into chaos efforts to craft a rescue package for the financial markets. Democratic leaders of the House and Senate, after working with the Bush White House for several days on details, said they felt blindsided by the Republican move.

The face-off reflected years of tension between the Bush White House and House Republicans, and exposed the ideological differences within the Republican Party over the role of government in free markets.

President George W. Bush, who urged lawmakers to "rise to the occasion" Friday, has said his first instinct is to not intervene in the market. But he became convinced of the need after Mr. Paulson and Federal Reserve Chairman Ben Bernanke warned that the financial crisis could spread to Main Street from Wall Street and throw the country into a deep recession.

Many Senate Republicans, including Bob Bennett of Utah and Judd Gregg of New Hampshire, have tried to be supportive of the White House's efforts to find common ground with Democrats. But conservatives who dominate the Republican Party's caucus in the House have been less amenable, particularly those disaffected with the Bush administration's sizable domestic spending and the realities of life as a minority party. Rep. Tom Davis (R., Va.) said Republicans have felt like "bystanders" the past two years and wanted to be brought into the negotiations as full partners. Democrats "have got to come and meet us halfway," he said.

Obama attributed the origin of the crisis to government's excessive deregulation

We also have to recognize that this is a final verdict on eight years of failed economic policies promoted by George Bush, supported by Senator McCain — the theory that basically says that we can shred regulations and consumer protections and give more and more to the most and somehow prosperity will trickle down,” Mr. Obama said. “It hasn’t worked, and I think that the fundamentals of the economy have to be measured by whether or not the middle class is getting a fair shake.”

Friday, September 26, 2008

Short-Sale Ban Wallops Convertible-Bond Market - WSJ

The Securities and Exchange Commission's ban on short selling of financial stocks has effectively shut down much of the convertible-bond market, a crucial area of financing for struggling companies. Convertible securities are essentially bonds that can be exchanged for stock in the future. It's a relatively small market with less than $400 billion in securities outstanding, according to market participants, a fraction of the total for investment-grade bonds. But in times of stress, struggling companies turn to convertibles in order to raise capital when a share price has fallen. Battered financial companies, such as Bank of America Corp. and Citigroup Inc., sold billions of dollars in convertible debt earlier this year. Of the roughly $60 billion in convertible securities issued in the first eight months of this year, 65% was from financials, according to research by analysts now at Barclays Capital. "At the beginning of the year it was the 'convert' guys that provided the liquidity to all these institutions. Now the SEC is literally shutting the market down," says Adam Stern, chief executive at hedge-fund manager AM Investment Partners. A major buyer of convertible securities has long been hedge funds employing a strategy known as convertible arbitrage, which aims to profit from mismatches between the price of a company's convertibles and its stock. At its most basic level, the strategy entails buying the convertible and selling the underlying stock short. In convertible arbitrage, short selling -- the sale of borrowed stock -- is not a bet against a particular company's fortunes, but rather an actively managed hedge. The combination of long and short positions is essentially neutral to moves in the underlying stock but will profit from the stock's volatility. The SEC rule banning short sales of financial stocks makes that arbitrage impossible. While most nonfinancial stocks still can be shorted, the effect of the ban is rippling through the entire convertibles market, according to traders and money managers. The anti-shorting rules are scheduled to expire on Oct. 2, but an extension is widely expected. "At least 75% of investors" in convertible securities hedge their positions, Elliot Bossen, chief investment officer of Chapel Hill, N.C., Silverback Asset Management, wrote in a letter to the SEC and lawmakers Wednesday. "This important source of capital will disappear entirely," if the rules remain in effect, he wrote, adding that the SEC's move "contributed to the seizing up of liquidity in the market for convertible securities." Traders say the impact has been clearly visible in the prices of convertible securities. Typically, when a stock falls, converts fall about one-third as far the common shares. Instead, convertibles on financial names have been suffering big losses compared with the stocks. According to traders, the convertible preferred securities issued by Bank of America as part of a $6.9 billion capital raise in January have fallen about 9% in value since last Friday, while the bank's stock is down about 6%. Citi's convertible preferreds, also issued in January, are down about 10% while the stock is down 3%. Because of the short-sale rules, "you've got people who are being forced to sell," says mutual-fund manager Edward Silverstein, who oversees the MainStay Convertible Fund. Market participants say there are many reasons trading in convertibles has dried up. Not only does the SEC rule hamper hedge funds, Wall Street trading desks also have been handcuffed. At some firms, convertible securities are traded separately from stocks. While an exemption provided by the SEC allows dealers to sell stocks short as part of their function as market makers, that leeway doesn't apply to market-making in convertibles. Participants in the convertible bond market say the SEC should follow the example set by regulators in the U.K., whose short-selling limitations allow for hedging. An SEC spokesman declined to comment specifically on convertibles, but said it may consider additional steps "as necessary."

How does Fed raise fund for its book

How does Fed raise funds: via Treasury who issued debts The Board's H.4.1 statistical release, "Factors Affecting Reserve Balances of Depository Institutions andCondition Statement of Federal Reserve Banks" has been modified in a number of ways. On September 17, theTreasury Department announced the Supplementary Financing Program. Under this program, the Treasuryissues marketable debt and deposits the proceeds in an account at the Federal Reserve that is segregatedfrom the Treasury General Account. This account is shown as "U.S. Treasury, supplementary financingaccount" in table 1, table 4, and table 5. On September 19, the Federal Reserve announced a new lending facility to extend non-recourse loans to U.S.depository institutions and bank holding companies to finance their purchases of high-quality asset-backedcommercial paper from money market mutual funds. Extensions of this credit are reported in table 1 as"Asset-backed commercial paper money market mutual fund liquidity facility" and reflected in "Otherloans" in table 3, table 4, and table 5. On September 21, the Board of Governors authorized the Federal Reserve Bank of New York to extend creditto the U.S. broker-dealer subsidiaries of Goldman Sachs, Morgan Stanley, and Merrill Lynch against alltypes of collateral that may be pledged at the Federal Reserve's primary credit facility for depositoryinstitutions or at the existing Primary Dealer Credit Facility. In addition, the Board authorized theFederal Reserve Bank of New York to extend credit to the London-based broker-dealer subsidiaries ofGoldman Sachs, Morgan Stanley, and Merrill Lynch against the types of collateral that would be eligibleto be pledged at the Primary Dealer Credit Facility. Credit extended under these authorizations will beincluded, along with credit extended under the Primary Dealer Credit Facility, in Table 1 under the entry"Primary dealer and other broker-dealer credit." http://www.federalreserve.gov/releases/h41/Current/

Failure of Washington Mutual

Instead, J.P. Morgan agreed to pay $1.9 billion to the government for WaMu's banking operations and will assume the loan portfolio of the thrift, which has $307 billion in assets. The full cost to J.P. Morgan will be much higher, because it plans to write down about $31 billion of the bad loans and raise $8 billion in new capital. All WaMu depositors will have access to their cash, but holders of more than $30 billion in debt and preferred stock will likely see little if any recovery. The deal will vault J.P. Morgan into first place in nationwide deposits and greatly expand its franchise. The seizure was another watershed event in a frenetic period for the U.S. banking system, and came while members of Congress wrangled over the Bush administration's proposed $700 billion bailout package. The tally of U.S. financial giants that have either been seized by the government or sold themselves off to stronger firms in recent weeks includes mortgage titans Fannie Mae and Freddie Mac, insurer American International Group Inc., and Wall Street firms Lehman Brothers Holdings Inc. and Merrill Lynch & Co. The failure of WaMu eclipsed what had long been America's largest bank bust on record, the 1984 collapse of Continental Illinois, which had $40 billion in assets.

Thursday, September 25, 2008

Financial system learns to adapt to cruel necessity

Governmen is resolving short term issues gripped the market. The long term issues remains: the growth of the economy, the reserve currency status of the dollar, the attractiveness of the financial market as a destination for foreign savings.... Who would have ever thought that the most sophisticated financial system in the world - that of the US - would trigger the most dramatic government rescue operation in history? Some may see this as a sad indication of the sharp and rapid deterioration in the standing of the country. More accurately, it speaks to how quickly the cruel realities of an unanticipated deleveraging process can alter the policy and institutional landscape. As is now widely recognised, left to their own devices, US financial markets simply could not accommodate the large and simultaneous shrinkage of multiple balance sheets without major damage to institutions and, critically, the system. Last week, the damage had migrated to the essential component of any financial system - the smooth functioning of cash, collateral and counterparty risk management. You would think all this would be too arcane for the politicians to take notice until it was too late. Yet they did because disruptions affected money market funds and, as such, became a real and present danger to the average American. In these circumstances, the authorities had no option but to act urgently. They did so by coming up with a bold and targeted multifaceted approach. In the process they made two transitions that are key to successful crisis management: most importantly, move away from piecemeal measures and towards a comprehensive and self-reinforcing policy programme; and see internal measures supported by some action by other countries. The proposed package has three elements that will likely be reinforced in coming weeks. First, injecting liquidity and providing insurance to restore some normalcy to money markets; second, and currently subject to intense Congressional debate, using the government's balance sheet to stabilise free-falling asset values, including those that have clearly overshot and will ultimately make money for taxpayers; and third, a counter-cyclical regulatory response that, controversially, stymies short sellers. If implemented fully and reinforced in a timely basis, this policy package will likely succeed in stabilising markets and help jump-start the process of repair. But it will not assist every institution and investment fund. Expect further casualties to be concentrated among smaller banks and some hedge funds. These shorter-term issues are important, but they should not be allowed to divert attention from some longer-term questions that will fundamentally impact the country's growth potential, the reserve currency status of the dollar and the attractiveness of US financial markets as the destination for large foreign savings. Four items are likely to dominate. First, the steps leading to the package, and the package itself, have fundamentally, but not yet coherently, redefined the financial landscape. Second, the banking system is now converging towards a more heavily regulated "utilities model". It will be slimmer, less risky and less profitable. Society can no longer underwrite the risk of a banking system that is seen to privatise the gains and socialise the losses. In the process, the growth potential of the US economy will be negatively impacted. Third, with the disappearance of investment banks, institutional investors must get used to a world with fewer counterparties. Judging from the experience of other countries, this may favour large institutional investors and encourage consolidation, especially among hedge funds. Finally, risk premiums will be re-aligned throughout markets. Most notable, instruments benefiting from government support (such as mortgages) will outperform Treasuries issued to fund the rescue package, and outperform instruments outside the package. These are complex structural changes that the system will only be able to accommodate over time, and not necessarily in an orderly fashion. They reflect the fact that, in responding to crises, policy actions involve both intended and unintended consequences.

GE Cuts Earnings Forecast

The Fairfield, Conn., conglomerate said it expects third-quarter earnings of 43 cents to 48 cents a share, down from its July forecast of 50 cents to 54 cents a share. It also lowered its forecast for the full year, to $1.95 to $2.10 per share, from an already reduced $2.20 to $2.30. That translates into as much as $2 billion less profit for the year. It marked the first time since 2002 that GE lowered financial projections ahead of its quarterly earnings release. The downturn in GE's financial business appears to have several causes: consumers who are slower to pay their bills, businesses who may have trouble repaying loans and declines in the commercial-real-estate market. Chief Financial Officer Keith Sherin said GE may have trouble completing some real-estate sales in the third quarter. The company plans to reduce its commercial-real-estate holdings to "below $80 billion in 2009," from about $90 billion today. "It's performing well," he said. "But the size is something investors have expressed concerns about." To preserve capital at its financial business, GE said it would reduce the share of profits that the unit hands over to the parent company. GE also said it would curb long-term and short-term borrowing at the finance unit, suspending plans to sell $10 billion in long-term debt in the fourth quarter and reducing sales of short-term commercial paper to less than 15% of the unit's debt.

Wednesday, September 24, 2008

Republican anger at 'financial socialism'

Congressional Republicans yesterday voiced their strongest objections to date about the Bush administration's $700bn financial rescue plans, dealing a blow to White House ambitions for them to be quickly approved. As Hank Paulson, Treasury secretary, and Ben Bernanke, chairman of the Federal Reserve, predicted grim consequences if the plan were rejected, the Republicans' Senate leadership called for new provisions on executive pay, which the administration opposes, while others cast doubt on the whole package. "We are going to advance taxpayers' dollars, and government ends up in effect taking an equity position in businesses," Mitch McConnell, Senate minority leader, said. "I think the taxpayers should expect no less than strict limits on the type of executive compensation that might be possible for those involved in these partially government-controlled enterprises." Growing Republican doubts will make it harder for momentum to build in favour of the proposal. Harry Reid, the Democratic Senate majority leader, yesterday said the Republicans needed to "start producing some votes for us". Although the Democratic leadership supports the need for a rescue package, many rank-and-file members are wary of pushing through what could be an unpopular $700bn (€480bn, £380bn) intervention in an election year. The political unrest surrounding the bail-out plan was on display throughout yesterday's tense hearing before the Senate banking committee - the first since the new authorities were demanded by the administration over the weekend. Richard Shelby, the top Republican on the Senate banking committee, warned "we could very well spend $700bn and not resolve the crisis". He called on the US to exhaust "all reasonable alternatives" before committing itself to the plan. Elizabeth Dole of North Carolina said: "I am very sceptical of this proposal and am extremely frustrated that we find ourselves in this position." Jim Bunning of Kentucky added: "This massive bail-out is not the solution, it is financial socialism, it is un-American." Meanwhile, Democrats pressed the administration to agree that the government should automatically take stakes in the companies it acquires, as well as curbs on executives' pay and bankruptcy reform that would allow judges to modify the terms of mortgage loans. Chuck Schumer, the New York senator and chairman of the joint economic committee, suggested the bail-out could be smaller and its effect evaluated in January. After the hearing Chris Dodd, the Democratic chairman of the banking committee, said the Treasury proposal was "not acceptable". "A lot of reservations have been expressed this morning by Democrats and Republicans on this matter . . . This is not going to work." Mr Paulson had argued during the hearing that the full amount was needed to stabilise markets and that limits on executive pay and mandatory government stakes in participating firms could undermine the plan's effects. "The best protection for the taxpayer, and the first protection for the taxpayer, is to have this work," he said. The administration aims for approval of its bail-out plan this week. Yesterday, Dick Cheney, US vicepresident, sought to win over the conservative Republican Study Committee after 31 of its members signed a letter last week decrying the "the increasing propensity, size and frequency of government interventions". A second hearing on the plan is scheduled for today. Such doubts are all the more significant in the light of the administration's declared goal of securing the approval for the rescue package from both houses of -Congress this week - no small ambition for a measure of such unprecedented size. Amid questions over whether conservative Republicans would stand by the White House proposal, one senior Democrat in the House of Representatives, Steny Hoyer, yesterday called on Mr Bush to make a public case for the need for a rescue plan to the US public. "I don't think there's any member [of Congress] comfortable with this request [for the rescue package]," he said. Indeed, without strong support from Republicans in the legislative branch, and a vigorous campaign by the administration itself, many Democrats are likely to be uneasy about supporting such a momentous and controversial measure. Yesterday, some Democrats called for lawmakers to reject any bail-out of Wall Street at all. However, the biggest threat to the passage of a bail-out ultimately lies in the Senate. While Nancy Pelosi, House speaker, has the authority to push congressional Democrats to back a final deal (enough Democrats to fall in line and support the deal) while allowing them to air their grievances, the Senate's procedural rules give any single lawmaker in the upper house the power to block legislation indefinitely. Democrats led by Mr Dodd could force the administration to make concessions on issues such as executive compensation. But it is Mr Shelby who has assumed the role of sceptic-in-chief - a position he also held in 1979 when he voted against loan guarantees for Chrysler, the US carmaker. His role contrasts with that of Barney Frank, the chairman of the House financial services committee, whom Ms Pelosi has entrusted to take the lead on negotiations.

Congress wrangles over how best to avoid financial Armageddon

IF ONLY, America’s financial authorities must feel, they could gag congressmen as easily as they have muzzled short-sellers. Financial markets around the world were choppy this week as Republicans and Democrats wrangled over the $700 billion rescue plan for Wall Street proposed last week by Hank Paulson, America's treasury secretary. One fear is that Mr Paulson’s troubled asset relief programme (TARP) will be blocked on Capitol Hill. That is possibly overdone: the risk of being blamed for plunging the world’s greatest economy into financial ruin is a good incentive for all sides to reach a compromise. Of more concern is that the plan, if it were approved, would neither shore up the financial system nor save the American economy. On that point there is room for argument, and hence for more uncertainty in the markets. Mr Paulson’s plan is to use public money to buy assets from banks whose value has slumped with every lurch downwards in America’s housing market and which have been shunned by the private sector. With a floor put under the value of those instruments it should be easier for banks to raise capital. Without capital, and amid relentless write-downs on those toxic assets, banks would have to curtail lending, causing a massive credit drought in America. That would not only further batter the housing market. It might also push companies into bankruptcy, too, causing mayhem in the $62 trillion market for credit derivatives. “Despite the efforts of the Federal Reserve, the Treasury and other agencies, global financial markets remain under extraordinary stress,” Ben Bernanke, chairman of the Federal Reserve, said in prepared remarks for a hearing of the Senate Banking Committee on Tuesday September 23rd. “Action by Congress is urgently required to stabilise the situation and avert what otherwise could be very serious consequences for our financial markets and for our economy.” Few dispute the potential threat; the demise of a 75-year-old investment-banking model on Wall Street in just a few days shows the financial system to be vulnerable. But there is plenty for everyone to dislike about aspects of Mr Paulson’s plan. It could safeguard irresponsible bankers’ jobs, while doing little to stop troubled mortgage debtors from being thrown out of their homes. It seeks to invest massive power in a treasury secretary with a lifelong loyalty to Wall Street. The banks with the worst assets (ie, those which have made the worst decisions) could receive the most help. Most disturbing, the taxpayer will be funding an enormous, ill-defined programme, without any stipulation as yet that the banks who orchestrated the mess will pay a penalty. All those points have been raised in Congress by legislators who are understandably fearful of the political consequences of bailing out Wall Street. But there is a legitimate riposte. The more restrictions they put on the bail-out, the more likely it will emerge as a messy fudge, lacking the wallop necessary to put the banks on a more stable footing. Financiers have different concerns. If the TARP seeks to buy assets too cheaply, banks will not take part. If prices are too high, the taxpayer may lose out. Even if the purchase of toxic assets goes ahead, might banks remain undercapitalised? Some have proposed a parallel scheme in which the government would take shares (or warrants) in troubled banks, if necessary, to build up their capital. This might be unnecessary. The TARP could be extended to allow the purchase of bank shares if necessary, or even of mortgages, which might allay some of the fears of homeowners. With enough force, it could prevent financial Armageddon. But it may also prolong the period necessary for asset prices to reach their natural floor, dragging out the crisis. With such high stakes involved, it is no wonder that markets are on their toes. Bank shares led a slump in European and Asian stock markets on Tuesday, though the Dow Jones Industrial Average opened slightly higher after an oil rally on Monday petered out. Three-month interbank spreads in London loosened from the extraordinarily tight levels of last week, but were still “at highly stressed levels,” according to Morgan Stanley. The dollar, meanwhile, was slightly stronger against the euro after four days of decline. How long it can remain as firm as it is, with the Treasury pumping money into all manner of financial assets with possible inflationary consequences, is one question the markets are not keen to address.

Don't assume the euro will displace the dollar

A combination of negative real interest rates and an exploding budget deficit as the US government takes on the "bad" assets of the banking system looks awful for the dollar. If the worst has yet to happen, it is because the crisis-driven homing instinct of Americans has led to substantial repatriation of overseas investments. There is nonetheless a groundswell of comment about the viability of a reserve currency attached to a broken financial system, a persistent current account deficit and a fiscal nightmare. With the euro taking a growing chunk of official reserves, and panic in the air, is dollar hegemony at an end? In the extreme circumstances now prevailing, nothing can be ruled out. But if sterling's history is any guide, it is risky to forecast the instant demise of a reserve currency. For while the US outgrew the UK economy from the 1870s, it took two world wars, a botched return to the gold standard and a subsequent devaluation, before the dollar definitively replaced sterling in 1945. There are good reasons for the protracted lag, not least the incumbency advantage stemming from network effects. Because everyone now uses the dollar it offers a degree of liquidity and acceptability that others cannot match until such time as the US makes so great a hash of policy that these benefits are outweighed by costs. Maybe the latest financial crisis will do the trick, but I doubt it. The first reason, forcefully advanced by Adam Posen, of the Peterson Institute for International Economics, is that the dollar's status is not purely about economics. For many countries security considerations are paramount. It seems inconceivable that Japan, Korea, Taiwan or Saudi Arabia would wish to junk the dollar given their current security relationships with the US. How far China sees its huge dollar reserves as a potential foreign policy weapon is unclear. What is clear is that the economic cost of using the weapon would be high and with reserves piling up at an annual rate of $500bn it is becoming ever higher. Charles Dumas, of Lombard Street Research, estimates that China makes 1-2 per cent on its (largely) dollar reserves. It then loses up to 10 per cent on the exchange rate and suffers a Chinese inflation rate of 6 per cent for a total real return in yuan of about minus 15 per cent. That is a loss of $270bn a year, or a stunning 7-8 per cent of gross domestic product. How long this can continue is moot. Yet interdependence on this scale means that selling dollar reserves would be an economic catastrophe. Diversifying new flows would make more sense and would not finish the dollar. To return to the analogy with sterling, the euro is not the only candidate to displace the dollar. Those who like to extrapolate China's current growth rate could argue that the shift of power to Asia will ultimately turn the yuan into a reserve currency. In the very long term there may be something in this, but I am suspicious of mechanistic extrapolations. And, would an undemocratic developing country command sufficient confidence for its currency to achieve such status? The euro is another matter. Inside and outside Europe it has been a notable success and it has taken a growing share of foreign exchange reserves at the dollar's expense. Yet those who expect the euro to dethrone the dollar before long are taking much about the integrity of monetary union for granted. This is because the pressures of adjustment to internal divergence as the euro soars will be exceptionally difficult to handle. The north-south divide in the eurozone in terms of relative unit labour costs requires a huge effort by the south, and Italy in particular, to address a serious loss of competitiveness. Countries such as Spain are also struggling with cyclical problems arising from the divergence in real interest rates in Europe. Before assuming the euro will topple the dollar, you have to be utterly confident that these problems will be well managed. I am not.

Record oil jump blamed on more than short-term factors - FT

What explains Monday's record one-day $25 jump in the price of the oil? One factor was certainly a technical one - a need by financial investors who had bet on falling oil prices to cover their positions ahead of the expiry of the Nymex October West Texas Intermediate contract. The problem has been been exacerbated by a drop in oil market liquidity in New York, with some market-makers curtailing their operations. This has led to a sharp increase in price volatility, traders and bankers say. But fundamentals also played a role. A shortage of oil for immediate delivery in the US because of hurricane-related disruptions has created tensions in energy markets. Although there is a consensus that Monday's oil price spike does not reflect a dramatic and overnight change in the supply and demand balance, traders say that the recovery of Nymex November prices to above $106 a barrel from last week's low of $90 does signal that fundamentals are tightening. Supplies are lower than expected - not only in the US Gulf of Mexico after the damage of hurricanes Ike and Gustav, but also from Nigeria, Mexico and Saudi Arabia. At the same time, China's oil imports remain strong. The market was yesterday trying to understand why oil prices moved so much at the expiry of the October contract. Some traders pointed to participants unwinding previous bets on falling prices. If their short positions had not been closed, they would have had to deliver physical barrels to their counterparties. Other traders said, however, that physical end-users of oil, such as refineries, were behind the price rise because they were trying to secure physical supplies Howard Gruenspecht, head of the statistical arm of the US Department of Energy, said that Monday's spike was likely to have been the result of a "squeeze where some trader had a short-term position he needed to get out of and started buying a little too late". Buyers yesterday continued to scuttle for spot oil, leading to further price tensions: the difference between the Nymex new front-month contract - November - and the second month - December - widened sharply. The spread jumped above $1.40 a barrel by the New York opening, up from 40 cents in earlier London trading. "The strength of the November-December spread shows there is actual tightness in the US oil market," said Nauman Barakat, vice-president of Macquarie Futures in New York. The Nymex November WTI spot price, however, fell $2.50 to $106.85. Traders said the scarcity was particularly acute at the delivery point for the Nymex contract in Cushing, Oklahoma, after weeks of supply disruption caused by hurricanes Ike and Gustav. Washington estimates that about 995,000 barrels a day in crude oil supplies in the Gulf of Mexico, or 76.6 per cent of the normal production level, remains shut down. Losses to supply are now higher than in 2004 when hurricane Katrina struck the Gulf of Mexico. Rob Laughlin, of MF Global in London, said it was taking much longer to restart Gulf oil production than "anyone had forecast". Washington has eased the shortage by lending oil from its Strategic Petroleum Reserve to refineries, but they are scrambling for more. ConocoPhillips has taken a 1m barrels oil loan from the US Department of Energy to cover for lost supplies. Marathon, another US refiner, has taken 750,000 barrels.

Home Sales Fall 2.2% in Auguest

Sales of existing homes fell 2.2% in August from the previous month to an annual sales pace of 4.91 million units, the National Association of Realtors said Wednesday. The data cover sales of homes, condominiums, and townhouses. The inventory of unsold houses fell to a 10.4-month supply at the current sales pace, compared to July's 10.9-month supply. The current inventory is still large and many analysts say prices must fall even more to attract buyers. The median home price was $203,100 in August, down 9.5% from the year before. Besides tighter loan standards and falling prices, the housing market also has been hurt by a weakening job market. Nonfarm payrolls have declined for eight consecutive months

Priavte equity firms still have a lot of fund

Private-equity firms are sitting on more than $400 billion in uninvested capital, according to London-based data provider Preqin. Several firms have raised dedicated funds for investing in banks and other distressed financial assets, with much of the money coming from pension funds and sovereign wealth funds. TPG has raised more than $7 billion for a financial-sector investment fund and Carlyle Group is targeting about $3 billion for a similar vehicle. Private-equity firms have looked at investing in distressed banks, but often pulled back. This summer, several private-equity firms including MatlinPatterson Global Advisers LLC and Fortress Investment Group looked at investing in BankUnited Financial Corp., based in Coral Gables, Fla., but didn't pull the trigger.

Why Regulators are cautions about letting outside investors take a big role at banks

The new move could be controversial. Regulators have historically been cautious about letting profit-hungry outside investors take a big role at banks. One reason is that the investors might push for loans to risky borrowers to make a quick profit. If the bank fails, that would cost the government because of the federal insurance that covers bank deposits, generally up to $100,000. Another fear: A private-equity firm might try to force a bank in which it invests to lend money on favorable terms to other companies in the private-equity firm's stable.

Fed's role in the economy today still pales in comparison to the 1930s

The federal government's role in the economy today still pales in comparison to the 1930s in the depths of the Great Depression. That era gave birth to agencies like the SEC -- but also mammoth job-creation programs like the Tennessee Valley Authority, which built dams during the Depression years. By the 1980s, however, an era of deregulation had curtailed Washington's hand in business.

Tuesday, September 23, 2008

Why Paulson is Wrong -

Debt-forgiveness and debt-equity swap is one solution to solving the current crisis. Blunt bailout will undermine the fundamental of capitalism: people reap the profit have to bear the risk of loss. But the coordination issue and unwillingness of debt holders could be hurdle to this approach. Why Paulson is Wrong Luigi Zingales Robert C. Mc Cormack Professor of Entrepreneurship and Finance University of Chicago -GSB When a profitable company is hit by a very large liability, as was the case in 1985 when Texaco lost a $12 billion court case against Pennzoil, the solution is not to have the government buy its assets at inflated prices: the solution is Chapter 11. In Chapter 11, companies with a solid underlying business generally swap debt for equity: the old equity holders are wiped out and the old debt claims are transformed into equity claims in the new entity which continues operating with a new capital structure. Alternatively, the debtholders can agree to cut down the face value of debt, in exchange for some warrants. Even before Chapter 11, these procedures were the solutions adopted to deal with the large railroad bankruptcies at the turn of the twentieth century. So why is this well established approach not used to solve the financial sectors current problems? The obvious answer is that we do not have time; Chapter 11 procedures are generally long and complex, and the crisis has reached a point where time is of the essence. If left to the negotiations of the parties involved this process will take months and we do not have this luxury. However, we are in extraordinary times and the government has taken and is prepared to take unprecedented measures. As if rescuing AIG and prohibiting all short-selling of financial stocks was not enough, now Treasury Secretary Paulson proposes a sort of Resolution Trust Corporation (RTC) that will buy out (with taxpayers’ money) the distressed assets of the financial sector. But, at what price? If banks and financial institutions find it difficult to recapitalize (i.e., issue new equity) it is because the private sector is uncertain about the value of the assets they have in their portfolio and does not want to overpay. Would the government be better in valuing those assets? No. In a negotiation between a government official and banker with a bonus at risk, who will have more clout in determining the price? The Paulson RTC will buy toxic assets at inflated prices thereby creating a charitable institution that provides welfare to the rich—at the taxpayers’ expense. If this subsidy is large enough, it will succeed in stopping the crisis. But, again, at what price? The answer: Billions of dollars in taxpayer money and, even worse, the violation of the fundamental capitalist principle that she who reaps the gains also bears the losses. Remember that in the Savings and Loan crisis, the government had to bail out those institutions because the deposits were federally insured. But in this case the government does not have do bail out the debtholders of Bear Sterns, AIG, or any of the other financial institutions that will benefit from the Paulson RTC. Since we do not have time for a Chapter 11 and we do not want to bail out all the creditors, the lesser evil is to do what judges do in contentious and overextended bankruptcy processes: to cram down a restructuring plan on creditors, where part of the debt is forgiven in exchange for some equity or some warrants. And there is a precedent for such a bold move. During the Great Depression, many debt contracts were indexed to gold. So when the dollar convertibility into gold was suspended, the value of that debt soared, threatening the survival of many institutions. The Roosevelt Administration declared the clause invalid, de facto forcing debt forgiveness. Furthermore, the Supreme Court maintained this decision. My colleague and current Fed Governor Randall Koszner studied this episode and showed that not only stock prices, but bond prices as well, soared after the Supreme Court upheld the decision. How is that possible? As corporate finance experts have been saying for the last thirty years, there are real costs from having too much debt and too little equity in the capital structure, and a reduction in the face value of debt can benefit not only the equityholders, but also the debtholders. If debt forgiveness benefits both equity and debtholders, why do debtholders not voluntarily agree to it? First of all, there is a coordination problem. Even if each individual debtholder benefits from a reduction in the face value of debt, she will benefit even more if everybody else cuts the face value of their debt and she does not. Hence, everybody waits for the other to move first, creating obvious delay. Secondly, from a debtholder point of view, a government bail-out is better. Thus, any talk of a government bail-out reduces the debtholders’ incentives to act, making the government bail-out more necessary. As during the Great Depression and in many debt restructurings, it makes sense in the current contingency to mandate a partial debt forgiveness or a debt-for-equity swap in the financial sector. It has the benefit of being a well-tested strategy in the private sector and it leaves the taxpayers out of the picture. But if it is so simple, why no expert has mentioned it? The major players in the financial sector do not like it. It is much more appealing for the financial industry to be bailed out at taxpayers’ expense than to bear their share of pain. Forcing a debt-for-equity swap or a debt forgiveness would be no greater a violation of private property rights than a massive bailout, but it faces much stronger political opposition. The appeal of the Paulson solution is that it taxes the many and benefits the few. Since the many (we, the taxpayers) are dispersed, we cannot put up a good fight in Capitol Hill; while the financial industry is well represented at all the levels. It is enough to say that for 6 of the last 13 years, the Secretary of Treasury was a Goldman Sachs alumnus. But, as financial experts, this silence is also our responsibility. Just as it is difficult to find a doctor willing to testify against another doctor in a malpractice suit, no matter how egregious the case, finance experts in both political parties are too friendly to the industry they study and work in. The decisions that will be made this weekend matter not just to the prospects of the U.S. economy in the year to come; they will shape the type of capitalism we will live in for the next fifty years. Do we want to live in a system where profits are private, but losses are socialized? Where taxpayer money is used to prop up failed firms? Or do we want to live in a system where people are held responsible for their decisions, where imprudent behavior is penalized and prudent behavior rewarded? For somebody like me who believes strongly in the free market system, the most serious risk of the current situation is that the interest of few financiers will undermine the fundamental workings of the capitalist system. The time has come to save capitalism from the capitalists.

Monday, September 22, 2008

How does a central bank dig its way out? - inflation or recapitalisation

If central banks are faced with a massive hit to their balance sheets, it will not necessarily be the end of the world. It has happened before – for example, during the financial crises of the 1990s. But history suggests that fixing a central bank's balance sheet is never pleasant. Faced with credit losses, a central bank can either dig its way out through inflation or await recapitalisation by taxpayers. Both solutions are extremely traumatic. Raging inflation causes all kinds of distortions and inefficiencies. (And don't think central banks have ruled out the inflation tax. In fact, inflation has spiked during the past year, conveniently facilitating a necessary correction in the real price of houses.) Taxpayer bailouts, on the other hand, are seldom smooth and inevitably compromise central bank independence. There is also a fairness issue. The financial sector has produced extraordinary profits, particularly in the Anglophone countries. And, while calculating the size of the financial sector is extremely difficult due to its opaqueness and complexity, official US statistics indicate that financial firms accounted for roughly one-third of American corporate profits in 2006. Multi-million dollar bonuses on Wall Street and in the City of London have become routine, and financial firms have dominated donor lists for all the major political candidates in the 2008 US presidential election. Why, then, should ordinary taxpayers foot the bill to bail out the financial industry? Why not the auto and steel industries, or any of the other industries that have suffered downturns in recent years? This argument is all the more forceful if central banks turn to the "inflation tax", which falls disproportionately on the poor, who have less means to protect themselves from price increases that undermine the value of their savings. So how do central banks dig their way out of this deep hole? The key is to sharpen the distinction between financial firms whose distress is truly panic driven (and therefore temporary), and problems that are more fundamental. After a period of massive expansion during which the financial services sector nearly doubled in size, some retrenchment is natural and normal. The sub-prime mortgage loan problem triggered a drop in some financial institutions' key lines of business, particularly their opaque but extremely profitable derivatives businesses. Some shrinkage of the industry is inevitable. Central banks have to start fostering consolidation, rather than indiscriminately extending credit. In principle, the financial industry can become smaller by having each institution contract proportionately, say, by 15%. But this is not the typical pattern in any industry. If sovereign wealth funds want to enter and keep capital-starved firms afloat in hopes of a big rebound, they should be allowed to do so. But they should realise that large foreign shareholders in financial firms may be far less effective than locals in coaxing central banks to extend massive, no-strings-attached credit lines. It is time to take stock of the crisis and recognise that the financial industry is undergoing fundamental shifts, and is not simply the victim of speculative panic against housing loans. Certainly better regulation is part of the answer over the longer run, but it is no panacea. Today's financial firm equity and bond holders must bear the main cost, or there is little hope they will behave more responsibly in the future.

No More Creampuffs - Kenneth Rogoff

The Government Is Willing to Let Wall Street Firms Fail. That's Good.

News of Lehman Brothers and Merrill Lynch on a ticker in New York. (By Mary Altaffer -- Associated Press)

By Kenneth Rogoff

Tuesday, September 16, 2008; Page A21

This past weekend, the U.S. Treasury and the Federal Reserve finally made it abundantly clear that they won't bail out every significant financial firm in America. Certainly this came as a rude shock to many financiers. In allowing the nation's fourth-largest investment bank, Lehman Brothers, to file for bankruptcy, and by forcefully indicating that they are prepared to see even more bankruptcies, our financial regulators showed Wall Street that they are not such creampuffs after all.

The question now: What's next? Assuming the financial sector continues to melt down over the next couple of months, at what point, if any, should the government get back into the game? It would be a mistake to do so before a great deal more consolidation takes place. During the epic boom of the past 20 years, the financial services sector became badly bloated. At its peak, it accounted for over one-third of corporate profits in the United States, not to mention the staggering billions of dollars in bonuses that Goldman Sachs ($12.1 billion in 2007) and others paid their employees. Now, in the wake of the subprime mortgage debacle, investment banks are seeing some of their most profitable lines of business evaporate. Profits from complex mortgage products are not coming back anytime soon; nor are profits in many other areas that rely on huge borrowing.

Instead, "deleveraging" is the buzzword throughout the financial system, as firms prune their borrowing and their positions. As profits come down to more earthly levels, the U.S. financial system is going to shrink. In all likelihood, at least 15 percent of financial employees -- including at the high end -- are going to lose their jobs. In principle, this shrinkage could take place through all firms and banks trimming their operations proportionately. But that is not how a capitalist economy operates. Whether it is the auto, airline or tech industries, the strong devour the weak. That is why it was inevitable that some banks would either fail or submit to distress mergers, including even some of the largest. That is why it has been quite clear for some months that the trauma to the U.S. financial system was not over.

Letting a big investment bank go, as the Fed and Treasury did this weekend, was a calculated risk in a difficult situation. And the risks are very real. With the immense interconnectivity of the financial system, there really is no telling where the unprecedented failure of a big investment bank might lead. On the other hand, ponying up tens of billions in tax money, as the Federal Reserve did in March when another investment bank, Bear Stearns, collapsed, is no answer, either. With the housing market still weakening, with U.S. exports likely to suffer as the global economy falters and with unemployment rising, it is clear that simply bailing out Lehman Brothers would not stop the rot in the financial system.

In March, the Federal Reserve took on $29 billion in risky Bear Stearns assets. Bailing out Lehman probably would have involved at least as large a commitment. If such a maneuver could have put an end to the crisis, it might have been justified, but that is hardly the case with many other giants teetering. This is not to mention the trillions of dollars in liabilities the Treasury took on 10 days ago in bailing out the mortgage giants Fannie Mae and Freddie Mac. These alone will probably end up costing taxpayers $100 billion to $200 billion, assuming inflation-adjusted housing prices fall another 10 to 12 percent.

Will taxpayers now escape without further damage? Probably not. More likely, the stress will continue for some time, radiating out into corporate debt, hitting big automakers, many debt-strapped cities and others. At some point, the federal government will blink again, and taxpayers will probably end up paying at least another couple hundred billion dollars before this extraordinary mess ends. But by placing some of the burden on the shareholders and bondholders of the big financial institutions, financial regulators have at least forced some discipline onto the system, making bankers and investors think twice before they once again head off to the races. By allowing firms that took excessive risks to fail, regulators also reduce the political pressure to overregulate the system in the aftermath of the crisis. Let's hope they hang tough for at least a little while longer.

Fannie, Freddie Bought Subprime and Alt-A MBS

Sept. 22 (Bloomberg) -- Freddie Mac Chief Executive OfficerRichard Syron stood before investors at New York's Palace Hotelin May last year lauding his company's ``cautious'' avoidance ofthe subprime-mortgage crisis. What Syron, who was ousted last week, didn't say was thatFreddie Mac had been gorging on subprime and Alt-A debt. While itand the larger Fannie Mae bought the safest classes of themortgage-loan pools, Freddie's purchases totaled $158 billion, or13 percent, of all the securities created in 2006 and 2007,according to data from its regulator and Inside MBS & ABS. Fannie Mae of Washington and McLean, Virginia-based FreddieMac held $114 billion of subprime and $71 billion in Alt-A securities as of June 30, according to the companies. Subprimemortgages were given to people with poor credit scores. Alt-Aloans, which rank between subprime and prime, were made toborrowers with better credit who provided no proof of income,bought property for investment or took out so-called optionadjustable-rate mortgages. The biggest suppliers of the securities to Fannie andFreddie included Countrywide Financial Corp. of Calabasas,California, as well as Irvine-California-based New CenturyFinancial Corp. and Ameriquest Mortgage Co., lenders that eitherwent bankrupt or were forced to sell themselves. Fannie andFreddie were the biggest buyers of loans from Countrywide,according to the company. The companies said they were urged to increase purchases ofsubprime debt by the Bush administration. The Department of Housing and Urban Development said in 2005 that Fannie and Freddie should increase financing for low-income areas or moderate-income regions with high minority populations to 37percent of new business from 34 percent in 2001 through 2004. That rose to 39 percent last year. As they acquired subprime debt, Fannie and Freddie fed on mortgage-backed securities, rather than buying or guaranteeing individual loans, according to Judy Kennedy, chief executiveofficer of the National Association of Affordable Housing Lendersin Washington. The companies could have bought ``hundreds of billions ofdollars'' of loans made to low-income people by banks, some ofwhich were granted with terms that were equal to prime, saidKennedy, whose organization represents financial companiesincluding JPMorgan Chase & Co. of New York, Charlotte, NorthCarolina-based Bank of America Corp. and pension funds. Fannieand Freddie failed to buy $50 billion to $90 billion ofapartment-building loans that would also have qualified, shesaid. The bonds Fannie and Freddie bought comprised thousands ofloans to borrowers with poor credit. The securities are split into pieces with varying risk and returns. Fannie and Freddie bought the safest of the top-rated pieces of the securities.Their yields of about 0.1 percentage points above the Londoninterbank offered rate made the debt less appealing to other investors, such as hedge funds or collateralized debt obligations, whose safest pieces were bought by banks. The lowestinvestment-grade classes offered yields of about 1.95 percentpoints over Libor. New Century, now the biggest subprime lender in bankruptcy,produced 24 percent. It created a security for Fannie and Freddiein August 2006. About 75 percent of the loans had interest ratesset to adjust to as high as 20 percent, mostly after two years,from an average of 8.3 percent. Countrywide, which faces investigations for fraudulentlending practices, supplied about 23 percent of Fannie's andFreddie's total loan volume in 2007, according to Credit Suisse. Terry Francisco, a spokesman for Bank of America Corp.,which bought Countrywide for $2.5 billion in stock in July,declined to comment.