Muni-Bond Bargains: Devil's in Details

If your stock portfolio has turned to sewage, maybe you should invest in a waste-treatment plant. Municipal bonds -- the tax-free securities issued by state and local authorities to fund such mundane projects -- are a once-in-a-lifetime bargain. Munis an Attractive Bargain for Investors Burned by the Market 3:26 WSJ's Intelligent Investor columnist Jason Zweig says municipal bonds are an attractive option for skittish investors. He tells colleague Nikki Waller munis are the cheapest they've been in at least 50 years, but that investors should be careful where they shop. For the first time in at least 50 years, munis offer much higher yields than Treasury bonds. That makes no sense, because the interest on municipals (unlike on Treasurys) is generally free of federal, state or local income tax. The tax exemption puts real money in your pocket. For an investor in the 33% federal tax bracket, longer-term munis are yielding almost 8% after tax, and even more if you live in an income-tax hell like California, New York or Oregon. Reid Smith, a portfolio manager at the Vanguard funds, points out that even if interest rates rise -- knocking down muni prices -- tax rates are also likely to go up. That would make the tax exemption on municipals even more valuable. Think about that 8% yield for a second. Since 1926, stocks have averaged a 9.6% annualized return, or only about 7% after tax. From today's yield levels, munis stand a good chance of outperforming stocks, after tax, in the long run. Unfortunately, despite its reputation for safety, the muni market is illiquid, fragmented and fraught with risk for the unwary investor. Last year, long-term national muni funds lost an average of 9.4% as the financial crisis battered the bond insurers that had enabled roughly half of all munis to be rated AAA. Ten funds, according to Morningstar, fell by at least 15% each -- a shocker in an investment category that has had a negative return in only four out of the past 25 years. What went wrong? Look at Eaton Vance National Municipals Fund, which lost 31.6% in 2008. Last March, the fund had $1.3 billion, or 23% of its net assets, in "tender option bonds." Spotting this exposure was no cinch: You had to read the semiannual report with a magnifying glass, circle each bond designated with footnote 1 ("inverse floating rate obligation"), then total all 27 of them. Although the fund was up to its armpits in tender-option bonds, who knew? Tender-option bonds are created when an investment bank takes the income from a muni and splits it into two pools of cash flow. The first is short-term and fixed-rate; the other, the tender-option part, is long-term and often highly variable. Last March, the Eaton Vance fund held a 30-year bond from the Virginia Housing Development Authority that was paying 17.518% and valued at $5.4 million; just six months later, the rate had dropped to 1.043% and the value to $2.6 million, a 52% loss. Robert MacIntosh, co-director of munis at Eaton Vance, says that the fund still holds this security and that tender-option yields have bounced back. "TOBs are part of our overall investment process," he says, "and we factor in the extra volatility associated with them in looking at the total portfolio." He adds, "They've been very positive performers over the years, and they have great tax-free income." But the whole point of municipal bonds is to provide tax-free fixed income. So you should steer clear of funds that rely on tender-option bonds and other yield shenanigans. Here are some red flags. First, download the fund's annual report, prospectus and "statement of additional information" in PDF format. Then use Acrobat's search function to look for keywords that may signal trouble, like "tender," "inverse" and "derivative." In the annual report, make sure the total investments in bonds don't exceed 100% of net assets by more than a percentage point or two. Insist on annual expenses of 0.5% or less, so the manager won't make risky bets to overcome the drag of high costs. Avoid any fund with portfolio turnover greater than 50%, a sign of excessive trading. Finally, Hugh McGuirk, head of the municipal team at T. Rowe Price, warns that bonds with interest rates that aren't multiples of 0.05 are likely to be tender-option bonds. Stick to funds from major firms with a sterling reputation, like T. Rowe Price Tax-Free Income or Vanguard Intermediate-Term Tax Exempt. If your brokerage has a free dividend-reinvestment program, then iShares S&P National Municipal Bond, an exchange-traded fund, is a solid choice. Whatever you do, don't chase the highest yields. To keep your muni money safe, stay out of the sewer. Write to Jason Zweig at intelligentinvestor@wsj.com

Honda Profit Declined 90%; Porsche Sales, Profit Drop

By YOSHIO TAKAHASHI in Tokyo and CHRISTOPH RAUWALD in Stuttgart The deep slump in global automobile sales has caught up with Honda Motor Co. and Porsche Automobil Holding SE, two of the industry's most reliable profit-makers. Honda Motor and Porsche, two of the strongest auto makers, reported their earnings dropped sharply. Honda, which cited weak consumer confidence for a 90% decline in profit, builds the Civic sedan in Greensburg, Ind. Honda reported Friday a 90% drop in net profit for the December quarter, dragged down by the credit crisis, cautious consumer sentiment and the yen's strength, and further slashed its forecast for the full fiscal year. Porsche, meanwhile, said revenue in the first six months of its current fiscal year fell 14% to €3 billion ($3.84 billion) as a result of a 27% decline in vehicle sales in the period from August to January. Porsche did not release precise profit figures. Chief Executive Wendelin Wiedeking said operating earnings fell in line with the sales decline, but pretax earnings at the group level rose thanks to substantial gains on its controlling stake in Volkswagen AG. The industry's crisis "has obviously reached a new, unprecedented magnitude," said Mr. Wiedeking at Porsche shareholder's meeting Friday in Stuttgart, Germany. The difficulties Honda and Porsche are encountering underscore the deep trouble in the auto industry. Both companies typically outpace most of their rivals in profit and for years have posted consistent gains. The downbeat results come a day after Ford Motor Co. reported a $5.9 billion loss in the fourth quarter, and a $14.57 billion loss for 2008, the worst in its 106-year history. The sharp profit drop for Tokyo-based Honda, the first of Japan's top three car makers to report results for the December quarter, bodes ill for its local rivals. Analysts expect Toyota Motor Corp. and Nissan Motor Co. to post losses in the period. Ford Posts Loss of $5.9 BillionAuto Sales Continue to SkidThis fiscal year's operating loss for Toyota, which will release earnings Friday, is likely to balloon from the 150 billion yen ($1.66 billion) the company projected just a month ago, the Nikkei reported Friday. Nissan will release earnings on Feb. 9. Honda, Japan's second-largest car maker by volume after Toyota, posted a net profit of 20.24 billion yen in the three months to Dec. 31, down from a 200 billion yen profit a year earlier. The maker of the Civic and Accord brands, as well as the Acura upscale line of vehicles, logged an operating profit of 102.45 billion yen, tumbling from 276.24 billion yen a year earlier. Sales fell 17% to 2.53 trillion yen in the quarter. Honda, like its competitors, recently stepped up efforts to cut back production for the current fiscal year to bring down inventory levels as demand collapses in the U.S., Europe and Japan. For the current fiscal year through March, the company lowered its net profit outlook to 80 billion yen from 185 billion yen. Sales are now pegged at 10.10 trillion yen, lower than the 10.40 trillion yen previously forecast. Shares of Honda fell 9.2%, or 210 yen, on the Tokyo exchange while Porsche's shares rose 2.4%, to €46, in Frankfurt trading, both on Friday. Write to Yoshio Takahashi at yoshio.takahashi@dowjones.com and Christoph Rauwald at christoph.rauwald@dowjones.com

Debt Markets See Record Issuance

--$100.29 bil of US dollar denominated IG issuance in Jan. But excluding debt backed by FDIC, the issuance was 75.8 bil. Excluding Non US debt, it will shrink to 57.25 bil, below 74.27 bil in Jan 2008 and 77.2 bil in 2007 --4.76 bil HY in Jan 2009 By ANDREW EDWARDS and MARK BROWN The economy may be sliding, but the debt markets have certainly found some traction. Corporate bond issuers tapped the debt capital markets on an unprecedented scale in January, taking advantage of renewed investor appetite for corporate credit. The $100.29 billion of U.S. dollar-denominated investment-grade issuance was the highest on record, according to figures released Friday by Dealogic. That easily trounced the previous record of $81.86 billion in 2001. In the riskier high-yield market, issuance was $4.76 billion, well below the levels of recent years but certainly respectable. The market has opened up even wider in recent days as chief financial officers attempt to capitalize on so-far insatiable demand. However, a closer look at the figures makes for a more disturbing read. Excluding debt that was backed by the U.S. government, January U.S.-dollar-denominated issuance came in at $75.84 billion. Excluding debt from outside the U.S., that shrinks to $57.25 billion, well below the $74.7 billion issued last January and the $77.2 billion issued in January 2007. Cellco Partnership/Verizon Wireless Capital was offering $4 billion in the investment-grade corporate bond market Friday, according to a person familiar with the deal. The $3.5 billion five-year note was launched at a spread, or risk premium, of 3.90 percentage points above Treasurys. The $500 million, three-year note was launched at 4.05 points above Treasurys. These yield premiums are at the tighter end of the expected range, which indicates demand since investors are willing to accept less. European debt markets were equally buoyant. Nonfinancial, investment-grade, euro-denominated bond issuance totaled €48.4 billion ($62.75 billion) this month, according to figures from Société Générale AG. That is easily the highest figure since the creation of the common European currency. The previous highest monthly figure was €24.9 billion, in January 2003, it said.

GDP Q4 2008

--QoQ GDP droped 3.8%, back to back drop but better than expected. --Private Inventories positively contributed 1.32% to GDP, indicating the pile-up of US companies and further cutback in future manfuacturing sector. --Gross private fixed investment dropped 12.3%, where th spending in equipment and software item registered the worst number, 27.8%, in the past 50 years, indicating the futher weakness in technology sector. --Weakness in consumer spending is expected to persist, following a 3.5% drop in the fourth quarter and a 3.8% decline in the previous quarter -- the worst back-to-back drops in more than 50 years, suggesting the further weakness in consumer sector. --contribution to GDP a.personal consumption -2.47% b.prviate investment -1.80% c.net exports 0.09% d.government spending 0.38%

Outlook of Leveraged Finance - from Creditsights

--historic recovery does not apply to the current market environment. Recovery in 1990-1992 and 2000-2002 was 31%, 8% lower than the historic normal. Now more corps use secured debt laden bonds. So recovery will be lower. --The lack of Debt-in-possesion will impaire recovery prospect. eg LyondelBasell --creditsights one year forward default probability forecast stands at 11.7%, next to 1991 since 1970s --the lower debt price will be a reflection of higher cost of capital and the market environment --there will be divergence between loan and bond recovery prospects because the need for refinance will drive sme high yield corporate issuers to defaults. - fundamentals hurt, weak balance sheets maim but liquidity kills. --roughly $175 bil of S&P rated leverage finance debt (loand & debt) will come due for refinancing in 2009. A good portion is unfunded revovling line of credit. --the fact that 20% of loans are considered convenant-lite does not change the relative value seniority of loan asset classes. It still enjoyed the proection of secured creditors as per the bankruptcy code. --as of Jan 2009, Leveraged Loan S&P/LSTA was trading at ~64, 16% (lib 1.12), 3.3 MD while HY index was trading at ~63, 18%, 4 MD. But from risk-reward perspective, investing in leveraged loan is more attractive and loans have been impacted by a large degree by market technicals. --the risk is still market technical - redemptions

solution to Strcuture Finance - from Creditsights

problems of current SF --opaque --misaligned incentive solutions covered bond backed by mortgages assets vs ABS --Assets stay in originators' balance sheet not in SPE (for ABS) so the incentives of originators and issuers are aligned, won't reduce originators' regulatory capital, the loss of bonds can recourse to originators. Also incentives are aligned --no tanching like ABS, no prepayment because prepaid asset/collateral will be replace

Critical time for Fed's CP facility

By Paul J Davies and Michael Mackenzie Published: January 30 2009 02:00 Last updated: January 30 2009 02:00 The next couple of weeks will prove an important test of the health of short-term lending markets in the US and whether companies still need the helping hand of the Federal Reserve to get money through the door. In the three months since the Fed opened up its commercial paper funding facility (CPFF) on October 27, the volume of 90-day borrowing companies have drawn from it has steadily risen, reaching about $351bn by Wednesday January 21, the most recent date for which data is available. The programme and its companion money market investor funding facility (MMIFF) were designed to help companies and financial institutions issue short term debt after US money market funds were hit with a wave of redemptions in the panic following the collapse of Lehman Brothers. The next fortnight will be critical because a huge volume of corporate paper issued into the CPFF in its first days comes due for refinancing. According to analysts at Morgan Stanley, $145bn of paper has been maturing throughout this week and another $98bn will mature next week. The latest Fed data on commercial paper market activity released yesterday showed a net reduction of almost $100bn in CP outstanding by the end of Wednesday across the markets, with the majority of this coming from a contraction in CP from financial institutions. Meanwhile, US non-financial corporates added just a net $3.8bn in CP this week, although because the data only shows activity up until Wednesday, it does not cover 90-day paper that was issued in the last three days of October when the CPFF was up and running. Interested observers will not be able to tell how much of that stayed with the Fed and how much corporates managed to push into the private markets until the central bank releases another balance sheet statement next Thursday. These statements are published a week in arrears. "Anyway you look at it, this will be one of the first true tests of a Fed liquidity programme post fourth-quarter stresses as CPFF might be in the midst of being unwound or at least used less frequently," says George Goncalves, strategist at Morgan Stanley. The big hope among regulators is that the use of the CPFF will shrink, as this would indicate the private sector is functioning once more. There has already been an increase in the proportion of CP issued that has maturities of 81 days and over, versus other maturities. This along with the latest Fed data indicates that companies could be looking to refinance what was put into the CPFF at the same maturity. According to Morgan Stanley analysts, about 25 per cent of paper issued last week was 81 days-plus paper, a very high proportion historically, matched in recent times only by the period around the opening of the CPFF (see chart). However, rates have increased too, according to the Fed data, especially for unsecured financial paper at the longer maturities, where rates jumped back above 200 basis points, from less than 100bp. This rise has come at a time when outstanding volumes of financial CP have dropped by $118bn over the month, which analysts said was partly due to the passing of the year-end period when funding needs were greatest, but also reflected a move towards issuing longer term debt into the bond markets in January. Financial CP has its own Fed facility in the form of the MMIFF, but use of this has remained at zero since it was launched, which is one reason why rates on financial CP remain higher than those on non-financial. Part of the reason is that banks and other financial institutions have been able to issue long-term debt that is backed by the Federal Deposit Insurance Corp. Last year, the FDIC launched the Temporary Liquidity Guarantee Program, which backs debt for up to three years. But the sharp rise in financial CP rates at a time when volumes are falling suggests renewed strains or risk aversion among money market investors - and so could bode ill for private participation in new non-financial corporate paper also. "If little returns to the CPFF in the next few days, it would demonstrate a dramatic improvement in the ability of the CP market to operate without Fed support," says another analyst. "We are not getting our hopes up, though," he added because there remains a very wide spread between rates on AA-rated CP that qualifies for the Fed scheme and A2-rated paper, which does not. "[This] suggests to us that Fed participation is still essential to reasonable pricing in this market." However, non-financial corporate CP rates for -AA-rated paper are quite healthy at about 49bp, according to the Fed data, which some said could be seen as a reason to expect less participation in the CPFF, which involves other expenses in terms of fees. Also, the interbank money market rates that shot higher in the wake of Lehman's collapse have fallen sharply since the CPFF was introduced in October. "With short-term funding spreads considerably improved, issuers will likely shy away from further CPFF participation at its current pricing scheme, which has not changed since the end of October," says Mr Goncalves.

Thaw Is Felt in Market for Commercial Paper

By LIZ RAPPAPORT A significant batch of companies that had turned to the Federal Reserve as a buyer of last resort for their commercial paper have likely moved back to private buyers, showing that the once-frozen market has thawed, but not completely. The amount of three-month debt the Fed holds in its Commercial Paper Funding Facility fell by $102 billion in a week when about $230 billion of commercial paper the Fed owned was set to mature. That suggests some issuers likely returned to the open market. The market for this three-month debt took the heavy new supply load in stride. While the Fed doesn't disclose whose debt it is buying, or delineate which purchases are new and which are refinancings, investors have kept a close eye this week on the commercial-paper market's reaction as a test of the Fed's efforts to restore credit markets to more-normal functioning. "I believe the CP market has been stabilized, but it is not back to full health," says Joseph Abate, money market strategist at Barclays Capital. Still, many issuers did resell their debt back to the Fed for another three months of financing, even though the Fed charges them higher interest rates than others pay in the open market, say traders. Meanwhile, a few have found alternatives to the market and the Fed, by turning to other, cheaper debt venues such as issuing certificates of deposit or Yankee CDs, or other shorter-term debt, say traders. The total outstanding amount of short-term debt in the commercial-paper market fell by $86.8 billion in the week ended Wednesday -- the third straight week of decline, according to Fed data. The debt sold by financial companies fell substantially, by $93.5 billion. The deluge of supply maturing this week didn't alter rates, a mark of strength for the market, say analysts. The Fed is buying commercial paper at rates of 1.2% to 3.2%, while borrowers with access to the open market are borrowing for three months at rates ranging from 0.4% to a little more than 2%, according to Fed data. Money market fund managers, which buy commercial paper, still are wary of foreign bank debt, say traders and analysts, but these borrowers rely heavily on the market to borrow much-needed U.S. dollars. So these banks ended up rolling over their debt with the Fed, says one trading desk head. Goldman Sachs Group, Conoco Sell Bonds Goldman Sachs Group Inc. sold $2 billion in 10-year notes without government backing and nonfinancial firms raised almost $14 billion as investors clamored for investment-grade bonds. Oil producer ConocoPhillips sold $6 billion in bonds, and AT&T Inc., $5.5 billion, among Thursday's largest deals. Goldman Sachs and other financial institutions have sold billions of dollars of short-term bonds at cheap rates through the Federal Deposit Insurance Corp.'s Temporary Liquidity Guarantee Program. "The successful placement of unguaranteed, unsecured financial debt is a critical signpost pointing to further thawing in the credit markets," said Jon Duensing, principal at Smith Breeden Associates.

Option ARMs See Rising Defaults

--28% option ARM was delinquent in Dec vs 6% prime vs. >50% subprime By RUTH SIMON Defaults on a popular form of mortgage that gave home buyers a choice of how much to pay each month are rising and could rival those on subprime loans, potentially causing more trouble for investors and banks. Nearly $750 billion of option adjustable-rate mortgages, or option ARMs, were issued from 2004 to 2007, according to Inside Mortgage Finance, an industry publication. Rising delinquencies are creating fresh challenges for companies such as Bank of America Corp., J.P. Morgan Chase & Co. and Wells Fargo & Co. that acquired troubled option-ARM lenders. Option ARMs typically were made to borrowers with higher credit scores than those getting subprime mortgages. But many of these borrowers were stretched thin even when they were making payments, and are particularly vulnerable to a weakening economy and falling home prices. Borrowers can face payment shock when they must begin making payments of full interest and principal. Often, these loans were taken out without full documentation of borrowers' incomes and assets, and the reported incomes were often overstated, analysts say. Option ARMs are concentrated in areas such as California and Florida that have seen some of the biggest home-price downturns. Option ARMs, which have been largely abandoned, give borrowers multiple payment options, including a minimum payment that often was less than the monthly interest due. Borrowers who made the minimum payment on a regular basis often saw their loan balances grow, also known as "negative amortization." And with home prices falling, more than 55% of borrowers with option ARMs owe more than their homes are valued at, according to J.P. Morgan Securities Inc. As of December, 28% of option ARMs were delinquent or in foreclosure, according to LPS Applied Analytics, a data firm that analyzes mortgage performance. That compares with 23% in September. An additional 7% involve properties that have already been taken back by the lenders. By comparison, 6% of prime loans have problems. Problems with subprime are still the worst. Just over half of subprime loans were delinquent, in foreclosure, or related to bank-owned properties as of December. The nearly $750 billion of option ARMs issued from 2004 to 2007 compares with roughly $1.9 trillion each of subprime and jumbo mortgages in that period. Nearly 61% of option ARMs originated in 2007 will eventually default, according to a recent analysis by Goldman Sachs, which assumed a further 10% decline in home prices. That compares with a 63% default rate for subprime loans originated in 2007. Goldman estimates more than half of all option ARMs outstanding will default. In a recent conference call, Bank of America said it had added $750 million to its impaired portfolio reserves to offset higher-than-expected losses related to its acquisition of Countrywide Financial Corp. The company said the increase "was focused principally in the pay option ARM product." This week, Wells Fargo said $59.8 billion of its "Pick A Payment" option ARM mortgage portfolio was "credit impaired," including $24.3 billion in loans on which the company has taken a credit write-down.

U.S. Eyes Two-Part Bailout for Banks

By DAMIAN PALETTA, JONATHAN WEISMAN and DEBORAH SOLOMON The nation's top economic officials are discussing a new way to stabilize the financial system by buying a portion of banks' bad assets and offering guarantees against future losses on some of the remainder, in an effort to help banks while trying to mitigate the cost to taxpayers. Barack Obama This approach, which merges two competing ideas, was discussed this week at a meeting that included Treasury Secretary Timothy Geithner, Federal Reserve Chairman Ben Bernanke and Federal Deposit Insurance Corp. Chairman Sheila Bair, according to people briefed on the meeting. The emerging plan comes as the administration seeks to jolt the economy with an $819 billion stimulus plan and a series of additional moves designed to stem foreclosures, overhaul financial regulation and get credit flowing again. Amid that flurry of activity, President Barack Obama stepped up his rhetorical attacks Thursday on the same banks his officials are planning to aid. Summoning reporters after a closed meeting with Mr. Geithner, Mr. Obama blasted earlier news that Wall Street had paid out $18.4 billion in bonuses, calling it "the height of irresponsibility" and "shameful." "There will be time for them to make profits, and there will be time for them to get bonuses," he said. "Now is not that time." The tough talk suggested a firmer stand from the administration in its oversight of banks. But it also had a political purpose: eliciting support for an expensive and unpopular bailout program that will likely require more cash from Congress. The latest bank-aid discussions represent one idea of several being contemplated by officials, who stressed that conversations are fluid and much could change. In addition, there have been disagreements among officials as to the best approach. Ms. Bair, for example, wanted the government to buy a larger amount of bad assets, but Treasury officials worried about the expense, according to people briefed on the matter. The Obama administration has been working to craft what it calls a "comprehensive" approach to the financial crisis after months of ad hoc rescues. The decision on banks will be coupled with a broad program aimed to prevent foreclosures, White House aides say. Besides the stimulus bill and an overhaul of the financial regulatory system, officials are working on a plan to stabilize domestic auto makers. Mr. Obama called his stimulus plan "only one leg of the stool," adding that the other elements "will be rolled out systematically in the coming weeks, so that the American people will have a clear sense of a comprehensive strategy designed to put people back to work, reopen businesses and get credit flowing again." Lawrence Summers Mr. Obama met with former Federal Reserve Chairman Paul Volcker Wednesday to begin work on the regulatory overhaul. House Financial Services Committee Chairman Barney Frank (D., Mass.) said Thursday White House aides want a legislative plan ready for the meeting in London on April 2 of the Group of 20 developed and developing nations. The Treasury, under the auspices of former Secretary Henry Paulson, has already committed $335 billion to help financial institutions. Mr. Obama's aid to homeowners could cost between $50 billion and $100 billion, and the so-called bad bank that would buy up assets could ultimately reach a size of $2 trillion, according to people familiar with the matter. The central question facing policy makers: How does the government help banks exorcise their bad bets? For many of these assets, there is no current market price. If the government buys the assets for more than they are ultimately worth, taxpayers will take the hit. If the government pays too little, banks will have to record losses on other similar assets, exacerbating the problem. Under the concept being discussed, the government "bad bank," possibly run by the FDIC, would buy only assets banks have already marked down heavily. This could avoid crushing the value of other assets held by banks. It could also potentially sidestep the pricing dilemma because banks have already recognized the low value of the assets being purchased. Mr. Geithner discussed the latest idea Wednesday afternoon at the meeting with Mr. Bernanke, Ms. Bair and Comptroller of the Currency John Dugan, people familiar with the matter said. Mr. Geithner met with his staff throughout the day Thursday and with Mr. Obama in the afternoon. The remaining troubled assets -- likely a sizable amount -- would be covered by a type of insurance against future losses. This would apply to mortgages, mortgage-backed securities and other loans that banks are holding until they mature. Banks have probably given these assets an overly optimistic value because they plan to hold them. This would be similar to a structure set up recently to protect Citigroup Inc. and Bank of America Corp., in which the government and the bank would share future losses on a set pool of assets. In addition, the Treasury is also likely to make more capital injections into banks. The plans under discussion suggest Washington expects Wall Street to pay a higher price for being bailed out. Mr. Obama's excoriation of Wall Street executives came a day after New York State Comptroller Thomas P. DiNapoli estimated that Wall Street firms paid $18.4 billion in cash bonuses last year to employees living in New York City. That represents a 44% decline from 2007; but that securities firms are issuing bonuses at all has fanned criticism Wall Street is disconnected from political and economic reality. Timothy Geithner Many banks have already said they won't pay 2008 bonuses to top executives. Some financial institutions, such as Citigroup and UBS AG, also are instituting a "clawback" provision that will allow a company to recoup payments under certain circumstances. On Thursday, UBS told managing directors in its U.S. investment-banking unit that they will get no cash bonuses for 2008. In crafting an approach that covers the broad spectrum of the financial crisis, the White House is attempting to navigate a course between economists who say the president is doing too little and those saying he is trying to do too much. The incremental approach has not worked, said Sen. Charles E. Schumer (D., N.Y.) in an interview, but the risks of moving forward all at once are high. "A death of a thousand cuts is a very bad way to go," Mr. Schumer said, "but every one of the comprehensive solution has major problems." Both possible solutions to banks' woes are largely untested during a severe economic downturn. The bad-bank idea is similar to the Resolution Trust Corp., which was created to help clean up the savings-and-loan crisis. But the RTC only dealt with assets accumulated from failed institutions, not struggling ones. And the insurance aid for Citigroup and Bank of America is relatively new, and the ultimate cost to taxpayers is not known. William Seidman, who led the FDIC and RTC during the savings-and-loan crisis, says the government could end up cobbling together too many initiatives that don't fit together. "This is a horse designed by a committee and it looks like a camel," he says. Each leg of the administration's approach depends on one of the others. Consumers may do little with their stimulus cash if they are threatened by foreclosure or can't get a loan from the bank, for example. Administration officials also say a rescue of the financial system won't be complete until they can assure investors that a stronger regulatory system will prevent another financial collapse. Some economists worry the White House will create pieces of the puzzle that will ultimately be too weak. "You have to decide, 'Should I pay Peter? Should I pay Paul?' You do have to make some choices here," says Martin Baily, a former chairman of the White House Council of Economic Advisers under Bill Clinton. Mr. Baily and others have cautioned that tackling a financial regulatory overhaul in this environment, with so many other initiatives under way, will add uncertainty to the financial sector. Kevin Hassett, director of economic policy studies at the conservative American Enterprise Institute, sees the opposite problem. He says the administration should be doing more. As they confront the immediate economic crisis, for example, Obama aides have taken off the table a concurrent effort to solve long-term problems with the tax code and with Social Security and Medicare -- both of which the White House has pledged to tackle eventually. "They're not being ambitious enough," says Mr. Hassett. Write to Damian Paletta at damian.paletta@wsj.com, Jonathan Weisman at

Blight of capital protectionism will give rise to dollar crisis

By David Roche Published: January 30 2009 02:00 Last updated: January 30 2009 02:00 So much taxpayers money is being spent on bailing out the banks that many of them, once significant global players, will be forced to focus on domestic lending to give taxpayers a bang for their buck. Banks that accept state aid are under a lot of political pressure to expand their domestic loan books. Complying with the instructions of their new political masters will mean only one thing: even faster destruction of foreign credit and capital flows. The result will be tantamount to protectionism against the globalisation and free flow of capital. Capital protectionism is the worst form of protectionism. It hits the efficient allocation of investment on a global scale, as well as trade financing and trade in every type of good and service. In contrast to trade protectionism, which normally takes a sniper shot at specific goods, capital protectionism affects every ingredient of globalisation. The outcome is anti-growth from a global perspective because it lowers the productivity of all economies by limiting market forces. But the most immediate impact of capital protectionism is likely to be to magnify the damage being wrought on emerging markets by the credit crisis. Over the last ten years, asset bubbles have been engendered in emerging markets by locals borrowing 'cheap' foreign credit compared to that available locally, and by misplaced confidence in the solidity of local currencies versus the borrowed currency. Ironically, cheap credit borrowed in a weak foreign currency did boost local currencies and then, by setting off asset bubbles, the illusion of fundamentally sound superior economic growth became the common currency in emerging economies. Now the sudden withdrawal of foreign credit makes the rollover of such debts almost impossible. Living standards, growth, currencies and credit ratings will pay the price. The most dangerously affected area by the squeeze on international funding will not be Eastern Europe: though its banks, corporations and consumers will suffer greatly from the aftermath of a foreign currency credit binge. It is China and the other Asian factory economies that will suffer most, because they are about to get hit by the double whammy of plummeting trade and a drought in foreign capital inflows. China boomed on the huge demand for its exports created by the high tide of credit-financed spending and illusory wealth in rich countries. And investment benefited from capital inflows that swelled domestic credit and created China's very own asset bubbles. But now many of these asset bubbles have burst (real estate and the stock market). That is why China's economy began to sink well before exports did - to the chagrin of the 'decoupling' school of illusory economic thought. In 2009, China's exports could fall 20 per cent or so and every 1 per cent fall causes a contraction of 0.6 per cent in domestic GDP because the Chinese economy is structurally way over-exposed to exports and manufacturing and way under- resourced as a consumer and service economy. Investment into China will also fall (who needs new factories today?). Capital inflows will dry up as banks globally shrink their loan books and rich countries' credit allocation turns nationalist. What China is about to suffer is our credit crisis, not theirs, though that might indeed come. All this will have two consequences globally. First, China won't turn outwards towards its international peers to look for common engines of growth that could lift the global economy. Instead, it will turn inwards and focus on using all resources, including its massive stock of international assets, to boost domestic demand. Second, Chinese demand for US Treasuries and financial assets will wither. Part of that will be down to prioritisation of domestic issues and distrust of investing international resources in bailing out the US, whose model Chinese officials feel has failed them. But it will also be down to shrinking external surpluses on both capital and trade accounts. There will be fewer dollars to recycle. The ultimate result of the global credit crisis is a dollar crisis transmitted through the factory economies of Asia. It will begin once the current scramble for dollars to repay corporate debt in emerging markets subsides. The writer is president of Independent Strategy, a global investment consultancy

Asia's suffering

Jan 29th 2009 From The Economist print edition The slump in East Asia was made at home as well as in the West CHINA’s lunar new year sees the world’s largest migration, as tens of millions of workers flock home. Deserting for a few days the factories that make the goods that fill the world’s shops, they surge back to their native villages. This week, however, as they feasted to the deafening rattle of the firecrackers lit to greet the Year of the Ox, their celebrations had an anxious tinge (see article). Many will not have jobs to go back to. China’s breakneck growth has stalled. The rest of East Asia, too, which had hoped that it was somehow “decoupled” from the economic trauma of the West, has found itself hit as hard as anywhere in the world—and in some cases harder. The temptation is to see this as a plague visited on the region from outside, which its governments are powerless to resist or cure. In truth, their policy errors have played their part in the downturn, so the remedies are partly in their hands. The scale and speed of that downturn is breathtaking (see article), and broader in scope than in the financial crisis of 1997-98. China’s GDP, which expanded by 13% in 2007, scarcely grew at all in the last quarter of 2008 on a seasonally adjusted basis. In the same quarter Japan’s GDP is estimated to have fallen at an annualised rate of 10%, Singapore’s at 17% and South Korea’s at 21%. Industrial-production numbers have fallen even more dramatically, plummeting in Taiwan, for example, by 32% in the year to December. Nobody’s buying it The immediate causes are plain enough: destocking on a huge scale and a collapse in exports. Even in China, exports are spluttering, down by 2.8% in December compared with the previous year. That month Japan’s fell by 35% and Singapore’s by 20%. Falls in imports are often even starker: China’s were down by 21% in December; Vietnam’s by 45% in January. Some had suggested that soaring intra-regional trade would protect Asia against a downturn in the West. But that’s not happening, because trade within Asia is part of a globalised supply chain which is ultimately linked to demand in the rich world. Some Asians are blaming the West. The Western consensus in favour of globalisation lured them, they say, into opening their economies and pursuing export-led growth to satisfy the bottomless pit of Western consumer demand. They have been betrayed. Western financial incompetence has trashed the value of their investments and consumer demand has dried up. This explanation, which absolves Asian governments of responsibility for economic suffering, has an obvious appeal across the region. Awkwardly, however, it tells only one part of the story. Most of the slowdown in regional economic growth so far stems not from a fall in net exports but from weaker domestic demand. Even in China, the region’s top exporter, imports are falling faster than exports. Domestic demand has been weak not just because of the gloomy global outlook, but also because of government policies. After the crisis a decade ago, many countries fixed their broken financial systems, but left their economies skewed towards exports. Savings remained high and domestic consumption was suppressed. Partly out of fright at the balance-of-payments pressures faced then, countries have run large trade surpluses and built up huge foreign-exchange reserves. Thus the savings of poor Asian farmers have financed the habits of spendthrift Westerners. That’s not all bad. One consequence is that Asian governments have plenty of scope for boosting domestic demand and thus spurring economic recovery. China, in particular, has the wherewithal to make good on its promises of massive economic stimulus. A big public-works programme is the way to go, because it needs the investment anyway. When Japan spent heavily on infrastructure to boost its economy in the early 1990s, much of the money was wasted, because it was not short of the stuff. China, by contrast, could still do with more and better bridges, roads and railways. Safety in numbers Yet infrastructure spending alone is not a long-term solution. This sort of stimulus will sooner or later become unaffordable, and growth based on it will run out of steam. To get onto a sustainable long-term growth path—and to help pull the rest of the world out of recession—Asia’s economies need to become less dependent on exports in other ways. Asian governments must introduce structural reforms that encourage people to spend and reduce the need for them to save. In China, farmers must be given reliable title to their land so that they can borrow money against it or sell it. In many countries, including China, governments need to establish safety-nets that ease worries about the cost of children’s education and of health care. And across Asia, economies need to shift away from increasingly capital-intensive manufacturing towards labour-intensive services, so that a bigger share of national income goes to households. For Asian governments trying to fix their countries’ problems, the temptation is to reach for familiar tools—mercantilist currency policies to boost exports. But the region’s leaders seem to realise that a round of competitive devaluation will help no one. China has responded to American accusations of currency “manipulation” by denying it has any intention of devaluing the yuan to boost exports. Structural reforms to boost demand would not only help cushion the blow to Asia’s poor and thus help avert an explosion of social unrest that governments such as China’s fear; they would also help counter the relentless rise in protectionist pressure in the West. If emerging Asia needs a warning of the dangers of relying on exports, it need look no further than Japan. Japan’s decade-long stagnation ended in 2002, thanks to a boom in exports, especially to China. Now, largely because of its failure to tackle the root causes of weak domestic demand, it is taking more of an economic hiding than any other rich country. Japan used to see itself as the lead goose in a regional flight formation, showing the way to export-led prosperity. It is time for the other geese to break ranks.

The game changer

By George Soros Published: January 29 2009 02:00 Last updated: January 29 2009 02:00 In the past, whenever the financial system came close to a breakdown, the authorities rode to the rescue and prevented it from going over the brink. That is what I expected in 2008 but that is not what happened. On Monday September 15, Lehman Brothers, the US investment bank, was allowed to go into bankruptcy without proper preparation. It was a game-changing event with catastrophic consequences. For a start, the price of credit default swaps, a form of insurance against companies defaulting on debt, went through the roof as investors took cover. AIG, the insurance giant, was carrying a large short position in CDS and faced imminent default. By the next day Hank Paulson, then US Treasury secretary, had to reverse himself and come to the rescue of AIG. But worse was to come. Lehman was one of the main market-makers in commercial paper and a large issuer of these short-term obligations to boot. Reserve Primary, an independent money market fund, held Lehman paper and, since it had no deep pocket to turn to, it had to "break the buck" - stop redeeming its shares at par. That caused panic among depositors: by Thursday a run on money market funds was in full swing. The panic then spread to the stock market. The financial system suffered cardiac arrest and had to be put on artificial life support. How could Lehman have been left to go under? The responsibility lies squarely with the financial authorities, notably the Treasury and the Federal Reserve. The claim that they lacked the necessary legal powers is a lame excuse. In an emergency they could and should have done whatever was necessary to prevent the system from collapsing. That is what they have done on other occasions. The fact is, they allowed it to happen. On a deeper level, too, credit default swaps played a critical role in Lehman's demise. My explanation is controversial and all three steps of my argument will take the reader to unfamiliar ground. First, there is an asymmetry in the risk/reward ratio between being long or short in the stock market. (Being long means owning a stock, being short means selling a stock one does not own.) Being long has unlimited potential on the upside but limited exposure on the downside. Being short is the reverse. The asymmetry manifests itself in the following way: losing on a long position reduces one's risk exposure while losing on a short position increases it. As a result, one can be more patient being long and wrong than being short and wrong. The asymmetry serves to discourage the short-selling of stocks. The second step is to understand credit default swaps and to recognise that the CDS market offers a convenient way of shorting bonds. In that market the asymmetry in risk/reward works in the opposite way to stocks. Going short on bonds by buying a CDS contract carries limited risk but unlimited profit potential; by contrast, selling credit default swaps offers limited profits but practically unlimited risks. The asymmetry encourages speculating on the short side, which in turn exerts a downward pressure on the underlying bonds. When an adverse development is expected, the negative effect can become overwhelming because CDS tend to be priced as warrants, not as options: people buy them not because they expect an eventual default but because they expect the CDS to appreciate during the lifetime of the contract. No arbitrage can correct the mispricing. That can be clearly seen in US and UK government bonds, whose actual price is much higher than that implied by CDS. These asymmetries are difficult to reconcile with the efficient market hypothesis, the notion that securities prices accurately reflect all known information. The third step is to recognise reflexivity - that is to say, the mispricing of financial instruments can affect the fundamentals that market prices are supposed to reflect. Nowhere is this phenomenon more pronounced than in the case of financial institutions, whose ability to do business is dependent on confidence and trust. That means that "bear raids" to drive down the share prices of these institutions can be self-validating. That is in direct contradiction to the efficient market hypothesis. Putting these three considerations together leads to the conclusion that Lehman, AIG and other financial institutions were destroyed by bear raids in which the shorting of stocks and buying of CDS amplified and reinforced each other. Unlimited shorting was made possible by the 2007 abolition of the uptick rule (which hindered bear raids by allowing short-selling only when prices were rising). The unlimited selling of bonds was facilitated by the CDS market. Together, the two made a lethal combination. That is what AIG, one of the most successful insurance companies in the world, failed to understand. Its business was selling insurance and, when it saw a seriously mispriced risk, it went to town insuring it, in the belief that diversifying risk reduces it. It expected to make a fortune in the long run but it was destroyed in short order. My argument raises some interesting questions. What would have happened if the uptick rule on shorting shares had been kept, in effect, but "naked" short-selling (where the vendor has not borrowed the stock in advance) and speculating in CDS had both been outlawed? The bankruptcy of Lehman might have been avoided but what would have happened to the asset super-bubble? One can only conjecture. My guess is that the bubble would have been deflated more slowly, with less catastrophic results, but that the after-effects would have lingered longer. It would have resembled more the Japanese experience than what is happening now. What is the proper role of shortselling? Undoubtedly it gives markets greater depth and continuity, making them more resilient, but it is not without dangers. As bear raids can be self-validating, they ought to be kept under control. If the efficient market hypothesis were valid, there would be an a priori reason for imposing no constraints. As it is, both the uptick rule and allowing short-selling only when it is covered by borrowed stock are useful pragmatic measures that seem to work well without any clear-cut theoretical justification. What about credit default swaps? Here I take a more radical view than most people. The prevailing view is that they ought to be traded on regulated exchanges. I believe they are toxic and should be used only by prescription. They could be used to insure actual bonds but - in light of their asymmetric character - not to speculate against countries or companies. CDS are not, however, the only synthetic financial instruments that have proved toxic. The same applies to the slicing and dicing of collateralised debt obligations and to the portfolio insurance contracts that caused the stock market crash of 1987, to mention only two that have done a lot of damage. The issuance of stock is closely regulated by authorities such as the Securities and Exchange Commission; why not the issuance of derivatives and other synthetic instruments? The role of reflexivity and the asymmetries identified earlier ought to prompt a rejection of the efficient market hypothesis and a thorough reconsideration of the regulatory regime. Now that the bankruptcy of Lehman has had the same shock effect on the behaviour of consumers and businesses as the bank failures of the 1930s, the problems facing the administration of President Barack Obama are even greater than those that confronted Franklin D. Roosevelt. Total credit outstanding was 160 per cent of gross domestic product in 1929 and rose to 260 per cent in 1932; we entered the crash of 2008 at 365 per cent and the ratio is bound to rise to 500 per cent. This is without taking into account the pervasive use of derivatives, which was absent in the 1930s but immensely complicates the current situation. On the positive side, we have the experience of the 1930s and the prescriptions of John Maynard Keynes to draw on. The bursting of bubbles causes credit contraction, the forced liquidation of assets, deflation and wealth destruction that may reach catastrophic proportions. In a deflationary environment, the weight of accumulated debt can sink the banking system and push the economy into depression. That is what needs to be prevented at all costs. It can be done - by creating money to offset the contraction of credit, recapitalising the banking system and writing off or down the accumulated debt in an orderly manner. They require radical and unorthodox policy measures. For best results, the three processes should be combined. If these measures were successful and credit started to expand, deflationary pressures would be replaced by the spectre of inflation and the authorities would have to drain the excess money supply from the economy almost as fast as they had pumped it in. There is no way to escape from a far-fromequilibrium situation - global deflation and depression - except by first inducing its opposite and then reducing it. To prevent the US economy from sliding into a depression, Mr Obama must implement a radical and comprehensive set of policies. Alongside the welladvanced fiscal stimulus package, these should include a system-wide and compulsory recapitalisation of the banking system and a thorough overhaul of the mortgage system - reducing the cost of mortgages and foreclosures. Energy policy could also play an important role in counteracting both depression and deflation. The American consumer can no longer act as the motor of the global economy. Alternative energy and developments that produce energy savings could serve as a new motor, but only if the price of conventional fuels is kept high enough to justify investing in those activities. That would involve putting a floor under the price of fossil fuels by imposing a price on carbon emissions and import duties on oil to keep the domestic price above, say, $70 per barrel. Finally, the international financial system must be reformed. Far from providing a level playing field, the current system favours the countries in control of the international financial institutions, notably the US, to the detriment of nations at the periphery. The periphery countries have been subject to the market discipline dictated by the Washington consensus but the US was exempt from it. How unfair the system is has been revealed by a crisis that originated in the US yet is doing more damage to the periphery. Assistance is needed to protect the financial systems of periphery countries, including trade finance, something that will require large contingency funds available at little notice for brief periods of time. Periphery governments will also need long-term financing to enable them to engage in counter-cyclical fiscal policies. In addition, banking regulations need to be internationally co-ordinated. Market regulations should be global as well. National governments also need to co-ordinate their macroeconomic policies in order to avoid wide currency swings and other disruption. This is a condensed, almost shorthand account of what needs to be done to turn the global economy around. It should give a sense of how difficult a task it is. The writer is chairman of Soros Fund Management and founder of the Open Society Institute. These are extracts from an e-book update to The New Paradigm for Financial Markets - The credit crisis of 2008 and what it means (Public-Affairs Books, New York) The Soros investment year Positions I took were too big for ever more volatile markets Although I positioned myself reasonably well for what was coming last year, one thing I got wrong cost me dearly: there was no decoupling between markets of the developed and developing worlds. Indian and Chinese stocks were hit even harder than those in the US and Europe. Since we did not reduce our exposure, we lost more money in India than we had made the year before. Our Chinese manager did better by his stock selection; we were also helped by the appreciation of the renminbi. I had to push very hard in my macro-account to offset both these losses and those incurred by our external managers. This had its own drawback: I overtraded. The positions I took were too large for the increasingly volatile markets and, in order to manage my risk, I could not go against the market in a big way. I had to try to catch minor moves. That made it difficult to maintain short positions. Although I am an experienced short-seller, I got caught several times and largely missed the biggest down-draught, in October and November. On the long side, where I stuck to my guns, I lost an enormous amount of money. I was impressed by the potential in the new deep-water oilfield in Brazil and bought a large strategic position in Petrobras, only to see it decline by 75 per cent at one point in time. We also got caught in the developing petrochemical industry in the Gulf. We did get out of our strategic long position in CVRD, the Brazilian iron ore producer, in time for the end of the commodity bubble and shorted the other big iron ore groups. But we missed an opportunity in the commodities themselves - partly because I knew from experience how difficult it is to trade them. I was also slow to recognise the reversal of fortune for the dollar and gave back a large portion of our profits. Under the direction of my new chief investment officer, we did make money in the UK, where we bet that short-term interest rates would decline and shorted sterling against the euro. We also made good money by going long on the credit markets after their collapse. Eventually I understood that the strength of the dollar was due not to people choosing to hold dollars but to their inability to maintain or roll over their dollar obligations. In a very real sense the strength of the dollar, like the fever associated with sickness, was a measure of the disruption of the financial system. This insight helped me to anticipate the downturn of the dollar at the end of 2008. As a result, we ended the year almost meeting my target of 10 per cent minimum return, after spending most of the year in the red.

Big government fights back

--fiscal activism is inavoidable and appropriate --the real worry is that the final price tage might be larger than today's figures suggest --net cost might be much smaller --this need not be a calamitous. Governments can work off huge debt without defaults or inflation Jan 29th 2009 WASHINGTON, DC From The Economist print edition Public debt soars as governments battle financial crisis and recession. Will fiscal firepower work? FEW now doubt that the world economy is in its most parlous state since the 1930s. Demand is slumping across the globe as firms and consumers are battered by a pernicious, self-reinforcing bombardment of dysfunctional financial markets, falling wealth, higher unemployment and rampant fear. The IMF’s latest forecasts, published on Wednesday January 28th, suggest 2009 will bring the deepest global recession in the post-war era. To stem the slump, governments are fighting back with an activism rarely seen outside wartime (see interactive graphic). In some countries, notably China, official estimates overstate the likely fiscal stimulus. But even adjusted for bureaucratic hyperbole the government response is hefty. Weighted by their economies’ size, the plans of 11 big advanced and emerging economies are worth an average of 3.6% of GDP—though spread over several years. The IMF expects tax cuts and spending worth 1.5% of global GDP to kick in this year. In many rich countries the stimulus has been matched—and often dwarfed—by the upfront costs of financial rescues, including the recapitalisation of banks and guarantees for troubled assets. America’s Treasury has so far promised about $1 trillion (7% of GDP) for the finance industry. Add in the tax revenues lost from slumping output and falling asset prices as well as the spending on higher unemployment benefits, and the IMF expects rich countries’ combined fiscal deficit to rise to 7% of GDP in 2009, up from less than 2% in 2007. By the end of this year the developed world’s gross government debt, as a share of GDP, may be 15-20 percentage points higher than it was two years ago. Emerging economies are spilling less red ink, both because their banking industries are in less of a mess and because their stimulus plans, in general, are smaller. But they, too, will shift from a budget surplus in 2007 to a deficit of 3% of GDP. All told, public-sector debt is rising at its fastest pace since the second world war. Most economists agree that the red ink is both unavoidable and appropriate. To prevent a steep recession becoming a depression, governments must step in to forestall financial collapse and counter the slump in private demand. Financial markets seem to agree. Yields on government bonds in most rich countries are extremely low as shell-shocked investors clamour for the safety of public debt. Yet a few signs of skittishness are emerging. Prices of credit-default swaps on sovereign debt have risen sharply, suggesting that investors see growing risks of default. Within the rich world, risk premiums have risen dramatically for already-indebted governments such as those of Greece and Italy. Yields on America’s 30-year bonds saw their biggest jump in two decades in mid-January, as investors fretted about Uncle Sam’s demand for cash. This skittishness partly reflects uncertainty about how the government debt will be financed. But the real worry is that the ultimate public price tag will be much bigger than today’s figures suggest. That seems plausible. Large as they are, the immediate costs of the financial clean-ups seem modest against the scale of the banking mess and costs of previous banking crises. So far America’s government has put less than half as much public money into the financial sector, relative to the size of its economy, as Japan did in the 1990s. More will be necessary if, as is rumoured, Barack Obama’s team creates a bad bank to take on troubled loans and puts more capital into banks. Goldman Sachs recently estimated that the total value of troubled American bank assets was $5.7 trillion; that makes an initial cost of several trillion dollars seem possible. The net cost—and hence the net addition to long-term public debt—will be much smaller. On average, the IMF reckons, rich countries recover half their outlays for financial rescues. Sweden, whose banking rescue is seen as a model, recouped more than 90%. America may eventually manage something close to that, but the initial investment must be big. Relax and spend Unfortunately, the political cost of bailing out bankers and the huge sums involved mean that many politicians in rich countries are loth to spend heavily. History suggests that is a mistake. Failure to mend a broken financial system quickly means a longer recession; it also renders fiscal stimulus much less potent. Contrast Japan, which had numerous fiscal-stimulus packages in the 1990s, but failed to emerge from its slump until its debt problem was finally dealt with, with South Korea in 1997, which spent 13% of GDP on a large, speedy bank-rescue package. The fiscal costs of that error can be enormous. In a recent paper Ken Rogoff of Harvard University and Carmen Reinhart of the University of Maryland estimated that the big banking crises of the post-war period, on average, raised real public debt by more than 80% of GDP. Most of that rise came not from financial rescues but from prolonged recessions and the fiscal expansions designed to combat them. Even this year, half the deterioration of the rich world’s deficits has stemmed from economic weakness. If fiscal stimulus is no substitute for financial clean-ups, it is an important support at a time of slumping demand. But much depends on how well the plans are structured. All the big economies foresee some tax cuts, particularly for individuals. (Only a few, including Canada and Russia, plan to cut corporate taxes.) But the focus of the global fiscal boost is on spending, particularly on infrastructure. Economic theory suggests that makes sense. When firms and consumers are gripped with uncertainty, government spending is a surer way to boost demand. Consumers and firms might save the money. The empirical evidence, however, is less than conclusive. Economists’ estimates for the “multiplier” effect of government spending and tax cuts vary widely, with equally reputable studies showing opposite results. More important, the scale of the global slump means that historical multipliers may not mean very much. That suggests a broad strategy—involving both tax cuts and spending—is prudent. Less sensible, however, is the distribution of stimulus between countries. America’s fiscal package, at $800 billion or more, will be by far the biggest in absolute terms and one of the biggest relative to the size of its economy. Lamentably, rich creditor countries, such as Germany, are doing much less. In the emerging world China’s boldness is laudable, and fat reserve cushions have also given other emerging economies more room. But many will find their ability to borrow constrained by investors’ flight from risk—and the surge in public debt in the rich world. In its latest estimates, the Institute of International Finance, a bankers’ group, expects private-capital flows to emerging economies of only $165 billion this year, down more than 80% from 2007. If politicians dither over bank rescues, if countries that can stimulate safely do not do enough, and if fearful investors shy away from emerging markets, the odds of a lasting recovery of the global economy seem slim. And that, in turn, will mean far bigger rises in public debt. A multi-year downturn could easily send government-debt ratios up by 30% of GDP or more. This need not be calamitous. Governments can work off huge debt burdens without default or high inflation. During the second world war, for instance, Britain’s gross debt burden rose above 200% of GDP; America’s topped 120%. During the 1990s, fast growth and fiscal prudence allowed countries from Ireland to Canada to cut their debt levels sharply. The difference this time is that the rich world already faces the costs of an ageing population, which promise a fiscal burden many times greater than even the darkest scenarios for the financial crisis. Right now fiscal activism is indispensable, but the consequences will be bigger and longer-lasting than many realise.

A great migration into the unknown

Jan 29th 2009 XINJI From The Economist print edition Global recession is hitting China’s workers hard AS THE lunar new year holiday winds down in China, millions of workers are expected to stream back from the countryside to jobs in the cities. But in Xinji, a fur- and leather-processing city in northern China and a big producer of holiday fireworks, there will be little to go back to. The global economic crisis has dealt a hefty blow to this once booming city. China’s leaders are struggling to cope with the biggest upsurge of unemployment the country has faced in years. Migrants from the countryside, the main source of labour for export-oriented industries and construction sites, have been the hardest hit so far. Millions have been thrown out of work. Urban white-collar workers, for years pampered by double-digit growth, speak of shrinking bonuses and frozen wages. Some are losing jobs, too. Students, whom the government always fears upsetting, face the most difficult employment prospects since the upheaval in Tiananmen Square 20 years ago. As the Communist Party prepares to celebrate 60 years in power on October 1st, it worries that citizens will be in a fractious mood. Xinji sits about four hours’ drive south of Beijing, in the dusty plain of Hebei province. It is typical of China’s many fast-emerging cities, driven by the big ambitions of local governments. It is now just as typical of the many Chinese boomtowns that are hitting the buffers. Xinji has suffered badly from falling demand for its clothing exports. By November, most of its factories had closed two months earlier than normal for the spring festival break. Tens of thousands of workers went back to their nearby villages, expecting to return after the holiday. Many won’t do so. This is a huge problem for Xinji’s government, whose aspirations are symbolised by the city’s new town with its broad boulevards, an Eiffel-Tower-like structure at one crossroads and a rocket-shaped protrusion on top of the leather-clothing exhibition centre. It had been planning for an average of 13% growth a year for the rest of the decade. When thousands of Chinese factories began to halt production late last year as export orders dried up, much attention focused on the travails of Guangdong, an export-driven southern province bordering on Hong Kong. Several protests broke out as factories there closed down, leaving employees unpaid. But after making their point, many of the workers departed for their home villages in distant inland provinces. Xinji’s workers are mainly local. It cannot shed its difficulties so easily. Nor can many other towns and cities across China. Figures relating to the country’s migrant labour force are vague. But officials believe that of more than 200m non-agricultural workers from the countryside, more than 80m work close to their villages. The proportion working closer to home has increased in recent years, as more jobs have appeared inland that offer better conditions than factory work in Guangdong and other places on the coast. In Maoying village on the edge of Xinji, next to a leather-processing zone, the Communist Party chief, Li Qiangbao, says 400 villagers would normally be employed in nearby factories. Mr Li says he thinks many of them will still be able to find at least some work after the holiday, but they will be earning less. This may be over-optimistic. Marc Blecher of Oberlin College says Xinji is a good example of “market Leninism” in China. Its government-inspired focus mainly on one line of business helped it prosper, but may be its undoing. In the early 1990s local leaders decided that Xinji’s future lay in leather and fur. They compelled the area’s widely scattered village-run tanneries to consolidate and move to new industrial zones where, supposedly, they could enjoy economies of scale and control pollution better. They established a huge leather and fur-trading centre and encouraged entrepreneurs to look abroad for markets. Most of Xinji’s fur and leather exports ended up in the former Soviet Union, Russia in particular. To get around slow and cumbersome customs procedures, most Xinji exporters hired Russian middlemen with government connections to speed things up. Officials worried about this capricious system and an over-reliance on Russia, but quality was not quite good enough for a big push into Western markets. The city prospered anyway. By its own reckoning, Xinji’s economy grew by 13.4% in 2007 (close to the national rate), with leather and fur products making up about 80% of its exports of more than $200m. Until the global crisis hit, around 80% of these products were sold abroad. “Protect Eight” Chinese officials—Xinji’s included—often proclaim that high growth is crucial for social stability. They say that 8% is the minimum needed to prevent joblessness from triggering serious unrest (more serious, that is, than the tens of thousands of mostly small protests that occur every year in China, even at the best of times). The figure may be arbitrary, but the frequent repetition of the “Protect Eight” mantra sends a clear signal to local authorities that they cannot afford to slacken. Most of them have aimed for, and achieved, much higher targets in this decade. The governments of Xinji and many towns like it must now be worried. Early this month Xinji’s party chief, Zhang Guoliang, told a gathering of senior officials that maintaining high growth remained “an unshirkable task”. But he lowered his sights. In 2009, he said, Xinji would strive for 10% GDP growth along with an 8% increase in farmers’ net incomes and an 11% rise in urban disposable incomes. In a city of idle or semi-idle factories, this still sounds ambitious. In the past Xinji has found it hard to benefit from export-tax rebates, such as those announced by the central government late last year in an effort to revive labour-intensive industries. Because of the dodgy methods used to ship goods to Russia, there are no receipts for claiming the rebates. China’s system of residential registration, a legacy of the Mao era that divides citizens into urban and rural according to their parentage, means that workers from villages around Xinji who work in the city’s leather factories remain, technically, farmers. Their wages are therefore counted in the farmers’ net income category. (Xinji, like all Chinese cities, includes an urban area and a much larger rural hinterland. Its official urban population, including “farmers” who have stayed longer than six months, is around 200,000. More than 400,000 live in the countryside.) This makes Mr Zhang’s income-boosting goal an especially tough one. About a third of the income of Xinji’s “farmers” derives from the leather industry. In Maoying village around two-thirds comes from leather and other non-farming work. Zhang Jianmin, of Minzu University in Beijing, reckons that around 10% of Chinese workers from the countryside who are employed beyond their home areas will be out of a job this year—about 15m people. Officials have little idea what will happen to them. Many, they hope, will scatter across the countryside where, though disaffected, they will at least have food and shelter. Another Maoist legacy is the entitlement of those classified as rural dwellers to the use of a piece of land. It is usually tiny, but big enough to live on. In recent years, however, millions of farmers have lost all their land to relentless urban expansion (local governments have profited massively from selling appropriated rural land to developers). Many of these farmers have been absorbed into the urban workforce, but often not into urban social-security schemes. They face a perilous future. Millions of jobless migrants may well remain in cities, if not protesting then at least pushing up crime rates. The central government is anxious to cushion the blow. It has made it easier for farmers to register new businesses and has encouraged banks to lend them money. Local authorities say they are providing free job training for returning migrants. President Hu Jintao has just announced big increases this year in agricultural subsidies. But there are reasons to be sceptical. Few rural folk may be keen to start new businesses during a slowdown, even if the state-owned banks are willing to lend to them (most farmers have little to use as collateral, since their land-use rights cannot be mortgaged). Local governments in poorer provinces, where most migrant workers come from, may well balk at spending more money on training at a time when their revenues are falling. One Chinese newspaper said boosting grain subsidies would probably be offset by the continuing high cost of fertiliser. In Maoying village a poster announces a plan to boost benefits for participants in a new rural health-care scheme, which has been rolled out across the country over the past few years. Yang Lianyun of the Hebei Academy of Social Sciences says that government subsidies for this scheme have increased by 50% this year in Shijiazhuang prefecture, to which Xinji belongs. But the impact of this may also be less than meets the eye. Even with such increases, rural residents still have to pay a large part of hospitalisation costs out of their own pockets. Some prefer not to go. On top of a 4 trillion yuan ($585 billion) stimulus package announced in November, the government said on January 21st that it would spend 850 billion yuan on extending health insurance to more than 90% of citizens over the next three years. But details of both plans have yet to be announced. Barber-shop discontents The government has some grounds for hoping that it can weather the rural storm. Vague and incomplete government statistics suggest that protests have been rising generally in China in recent years. Most of them have occurred in rural areas, often as a result of land seizures. In a barber shop in Maoying, customers fume about pollution and local corruption (sentiments echoed on local internet forums). But protests have been directed against local governments and have not explicitly challenged the Communist Party’s monopoly of power. There is also little sign of co-ordination among different disaffected groups. With some notable exceptions, the party is getting better at handling unrest. In Hebei province the authorities are keen to maintain social calm, since the province surrounds the capital as well as the port city of Tianjin. Directives on dealing with “sudden incidents”, issued by Xinji last year, repeat the central government’s constant slogan that “stability is paramount”. They stress the need to placate protesters rather than respond with force. Rural China is no stranger to sharp employment fluctuations. In 2003, during an outbreak of SARS, many migrant workers were forced to return to their villages for several weeks. Migrants in and around Beijing also experienced severe disruption before and during the Olympic games in August last year, when the government ordered the temporary closure of many dirty industries and restricted movement to the capital. Neither episode triggered serious unrest, despite the blow to incomes. In the late 1990s, even amid the Asian financial crisis of 1997-98, China resolutely carried out a massive restructuring of its state-owned enterprises (SOEs). Some 40m lost their jobs. As many people lost their jobs each year as the number forecast for migrant labourers this year. It was traumatic for those involved, who (unlike today’s migrant workers) believed that they enjoyed jobs for life. Protests were frequent; some, in the rustbelt of the north-east in 2002, were the largest China had experienced in many years. The unrest was urban, close to seats of party power and embarrassing to a party that prided itself on being the champion of the proletariat. Yet, apart from an adjustment of party rhetoric that year towards a more pro-poor line, the political fallout was minimal. But there are important differences between then and now. For one thing, the SOE restructuring hit blue-collar workers hard even as the middle class—a new pillar of support for the party—was beginning to grow and flourish. At the same time as closing down, selling off and merging SOEs, the government virtually gave away the housing stock attached to them. This ensured that laid-off workers still had somewhere affordable to live (they also got subsistence payments that today’s migrants would envy). And it gave the new middle class an asset base that would soar in value—until, that is, the deflation of China’s property bubble last year and the onset of the current crisis. Restless citizens, dangerous students Now the party faces broader discontent. China’s notoriously contentious unemployment figures, which do not cover migrant workers (no statistics are published for rural joblessness), look rosy beside those of some Western countries. But they suggest a growing problem. On January 20th the government said the urban unemployment rate in 2008 rose to 4.2%, up from 4% the previous year and the first increase in five years. The government’s target for this year is to keep the rate below 4.6%—the highest figure since 1980. In Xinji it is the relatively pampered urban workforce (by official classification) that has been the first to break ranks. For three days, beginning on January 8th, as many as 300 workers from the Xinji Spinning and Weaving Company gathered outside the city government’s headquarters to demand the subsistence wages promised by their employers when the former state-owned factory closed in August. Since the SOE reforms a decade ago, the internet has become a far more widely used and powerful medium for dissent. Protesters in Xinji used it to draw attention to their complaints. Many citizens wrote messages on a local bulletin board expressing their support. One of Xinji’s deputy mayors met the demonstrators and helped to arrange payment of the overdue money, possibly (some say) with government funds. Buying protesters’ silence is a frequent tactic of local officials, who fear that visible unrest may tarnish their careers. Among urban citizens, it is the job prospects of graduates that worry officials most. A rapid increase in the number of university places in recent years has been accompanied by declining numbers of college leavers who regard themselves as suitably employed. A record 5.6m graduated last year, nearly 650,000 more than the year before. Another 6.1m will graduate in 2009. Around 1.5m, however, were jobless at the end of last year. This month China’s prime minister, Wen Jiabao, convened a cabinet meeting to discuss the problem (“If you are worried, I am more worried than you,” he had told students during a campus visit earlier). The government said it would give loans to graduates to help them start businesses as well as to companies that employ them. Discontent among students is particularly alarming to Chinese officials because of the historical role they have played in political upheavals, from the anarchic Cultural Revolution in the late 1960s to the Tiananmen Square protests of 1989. The authorities will be particularly vigilant around May 4th, the 90th anniversary of student-led protests that led to the birth of the communist movement, and on June 4th, the 20th anniversary of the suppression of nationwide student demonstrations calling for more democracy. The students involved in the 1989 unrest were also disheartened by grim job prospects. But there has been little sign of political activism among students in recent years. They have taken to the streets only to make nationalist points, and in support of the government. The authorities worry about the destabilising potential of nationalist ferment too, but far less than it does about calls for democratic reform. Whether or not unemployment brings unrest on the scale seen in 1989, the party will be severely challenged over the next few months. Disagreement is growing within its own ranks, and between different parts of the bureaucracy, over how to spend the money earmarked for stimulus measures and how to prevent it being siphoned off, or pocketed, by local governments. President Hu and Mr Wen will face considerable pressure to do more to help farmers and the urban poor. Just before the lunar new year the government announced unprecedented one-off payments totalling 9.7 billion yuan to 74m people living close to the poverty line. President Hu also sought to burnish his political credentials by visiting Jinggangshan, an area known as the cradle of the Chinese communist revolution. In January 2008 a law was implemented that made it harder to fire employees. Now some complain that it is being widely ignored. Other laws are being stretched, too. In December Xinji’s environmental bureau said that in order to “address the negative impact” of the crisis, it would “simplify” procedures in order to provide swift clearance for those projects that would create “little” or no pollution—a strong hint that it was lowering its guard. Wu Xiaoling, a former vice governor of the central bank and now a senior legislator, is said to have suggested recently that GDP growth should cease to be used to judge officials’ performance. Improving “public welfare” should instead be given top priority, she said. Messrs Hu and Wen want to keep both the pro-growth and the pro-welfare camps happy (more welfare spending, they reckon, could help consumers to save less and spend more). But most of all they want local governments to keep factories and businesses open.

Creditors DIP into pockets again to save companies

--DIP dries up alongside with other credit --DIPS become tougher because more companies have pledged all or nearly all of their assets --More debtors tapp existing creditors so creditors can preserve the original investments. As a result, some existing creditors will have higher seniority than the rest in the same class --DIPS also come in strict terms: shorter term from 12-18ms to 2-6ms; high premium, 900bps insteado 400bps By Nicole Bullock and Anousha Sakoui Published: January 29 2009 02:00 Last updated: January 29 2009 02:00 In the US, companies often need money to go bankrupt. In the early hours of January 8, creditors to one of the world's largest petrochemicals groups scrambled through the halls of the bankruptcy court of the Southern District of New York, fighting to scrape together the cash just to keep the lights on at the plants. The lenders were rushing to raise a special loan vital to the chances of Lyondell Chemical, a subsidiary of LyondellBasell, reorganising in bankruptcy, while jockeying to preserve their investments. Without the loan, Lyondell risked becoming one of the world's biggest liquidations. These special loans, called debtor-in-possession financing, or DIPs, fund operations while bankrupt companies restructure. To attract interest, lenders providing DIP finance typically receive a priority claim over other existing debt. At one time, DIPs were easy to raise. In the last financial downturn at the start of the decade, specialised DIP providers, existing creditors and other investors all lined up to finance the restructurings of bankrupt retailer Kmart and even WorldCom. But this time around, DIP finance lenders has dried up alongside all types of credit, so forcing existing creditors to provide rescue financing in the hope of minimising any eventual losses. "The only way to get DIP financing is what we call the defensive DIP, which is where existing lenders fund it to help preserve their recovery on their original investment. That is effectively what happened in [Lyondell]," says Steven Smith, global head of leveraged finance and restructuring at UBS in New York, which participated in the Lyondell DIP. The scarcity of DIP financing comes as defaults and bankruptcies are set to skyrocket this year. The stakes for lenders are high: banks and hedge funds, some of the creditors to troubled companies, are nursing massive losses from last year's market collapse. Investors also know liquidations tend to result in bigger losses than reorganisations. But funding is scarce on all sides and advisers are having to dream up alternative sources and structures in order to draw in fresh lending. Typically, in a defensive DIP new money and prioritisation is spread equally among existing lenders. The controversial aspects of the Lyondell loan is that some existing lenders were given the chance to put in even more new funds for the DIP and to prioritise more existing debt. This made more of their debt senior to other lenders of the same class - and they received a huge interest rate. The company needed $8bn, one of the largest DIP loans ever and a challenging amount to raise in any market. Some lenders have objected to the Lyondell situation, questioning the criteria used to participate in the attractive "additional money" part of the loan. On Monday, UBS held a conference call with investors to explain the criteria for participation in the DIP. Late last week, a group of Lyondell bondholders also balked, arguing "disparate" treatment in a letter to federal bankruptcy judge, Robert Gerber. "You may see more structures like [Lyondell] to get existing lenders to participate," says Bram Smith, interim executive director of the Loan Syndications and Trading Association (LSTA). Mr Smith says the structure was rare, but not unprecedented. DIPs are also tougher these days because many companies have already pledged all or nearly all of their collateral to existing loans, as the financing market has moved away from unsecured debt in recent years. With so many corporate assets already pledged, restructuring specialists expect to see an increased percentage of DIP loans in which lenders get a lien that supersedes everything else in the capital structure. DIPs also are coming with stricter terms, which give companies less time to reorganise. Diane Vazza of Standard & Poor's says the maturities of DIPs have shortened to 2-6 months from 12-18 months. Also, risk premiums have more than doubled to 900 basis points this year from 429bp in 2001, according to Dealogic. But some situations have still run in a more traditional fashion. Smurfit-Stone, the paperboard company, this week raised $750m in bankruptcy loans at rates below current market averages and with the participation of outside lenders. "It may be too early to say that [the Smurfit DIP] is a signal of a thawing in the market, but the willingness of third-party lenders to participate alongside existing creditors is a positive sign," says Mark Cohen, head of restructuring at Deutsche Bank, which was a coarranger on the loan. However, tight credit is severely limiting DIP volumes in general, while deep-pocketed specialist DIP lenders like General Electric Capital, which has said it is being "more selective" in this area, are retrenching. It is in the interests of investors to come up with financing because losses in liquidation are likely to be greater. Even senior lenders to retail companies, which are at the epicentre of the financial downturn, recover less than 50 per cent of what they would if the company reorganised under Chapter 11, according to S&P. "There is a lot less confidence that issuers are going to make it through," says Steven Miller, managing director at S&P Leveraged Commentary & Data. "Everyone wants to move up in the capital structure."

Chinese Premier Blames Recession on U.S. Actions

By JASON DEAN in Beijing, JAMES T. AREDDY in Shanghai and SERENA NG in New York Chinese Premier Wen Jiabao squarely blamed the U.S.-led financial system for the world's deepening economic slump, in the most public indication yet of discord between the U.S. government and its largest creditor. Leaders in China, the world's third-largest economy, have been surprised and upset over how much the problems of the U.S. financial sector have hurt China's holdings. In response, Beijing is re-examining its U.S. investments, say people familiar with the government's thinking. Mr. Wen, the first Chinese premier to visit the annual global gathering of economic and political leaders in Davos, Switzerland, delivered a strongly worded indictment of the causes of the crisis, clearly aimed largely at the United States though he didn't name it. Mr. Wen blamed an "excessive expansion of financial institutions in blind pursuit of profit," a failure of government supervision of the financial sector, and an "unsustainable model of development, characterized by prolonged low savings and high consumption." Chinese leaders have felt burned by a series of bad experiences with U.S. investments they had believed were safe, say people familiar with their thinking, including holdings in Morgan Stanley, the collapsed Reserve Primary Fund and mortgage giants Fannie Mae and Freddie Mac. As a result, the people say, government leaders decided not to make new investments in a number of U.S. companies that sought China's capital. China's pullback from Fannie and Freddie debt helped push up rates on U.S. mortgages last year just as Washington was seeking to revive the U.S. housing market. To be sure, China's economy now is so closely intertwined with the U.S.'s that major, abrupt changes are unlikely. The U.S.-China economic relationship has become arguably the world's most important. China has been recycling its vast export earnings by financing the U.S. deficit through buying Treasurys, helping to keep U.S. interest rates low and give American consumers more spending power to buy Chinese exports. China now has roughly $2 trillion in foreign exchange reserves, and has continued to buy U.S. government debt -- surpassing Japan in September as the biggest foreign holder of Treasurys, by one official U.S. measure. China must continue to recycle its trade surplus if it doesn't want its currency to appreciate too quickly. Still, the relatively smooth financial ties between the two powers that underpinned the global economic boom of recent years are being tested. As both sides survey the wreckage of the U.S. housing bubble and credit crunch, mutual recriminations are raising doubts about the relationship. The Chinese premier's remarks came a few days after Treasury Secretary Timothy Geithner fanned the flames when he accused China of "manipulating" its currency during his confirmation process. That was widely seen as an escalation of long-standing U.S. complaints that China artificially depresses the value of the yuan to bolster its exports, and prompted strong denials from Beijing. The Obama administration has since played down the statement's significance. More Friction Frictions between the two countries began to worsen long before Mr. Obama took office. The Chinese central bank last year stopped lending its Treasury holdings for fear the borrowers will go bankrupt, according to people familiar with the discussions -- a decision that disrupted the functioning of the Treasury market. Beijing rejected pleas by Washington to resume its lending of Treasurys, the people said. Meanwhile, China -- for years the largest foreign investor in bonds from Fannie Mae and Freddie Mac -- has been sharply trimming its holdings of that debt. After making direct net purchases of $46.0 billion in the first half of 2008, China's government and companies were net sellers of $26.1 billion in the five months through November, according to the latest U.S. data. Weak demand for such debt from China and other foreign investors helped prompt the Federal Reserve to announce in November that it would take the step of buying up to $600 billion in debt from Fannie, Freddie and two other U.S. government-related mortgage businesses. While Chinese officials have generally been circumspect in public, some Chinese commentators have sharpened their rhetoric in recent weeks. Washington "should not expect continuous inflow of more cheap foreign capital to fund its one-after-another massive bailouts," said a December editorial in the government-owned, English-language China Daily. Officials at the newspaper said the commentary wasn't ordered by the government. Cash-rich Chinese financial institutions are under withering criticism at home for investments in the West that have lost money, such as a $5.6 billion stake in Morgan Stanley purchased by China's sovereign wealth fund, China Investment Corp., 13 months ago. The U.S. company's shares have dropped around 60% since then. Chinese institutions have rebuffed entreaties to invest in struggling U.S. companies even as investors from Japan and the Middle East have stepped up. For years, Washington has pushed China to adopt an economic and financial system more like that in the U.S. -- arguing, for example, that China should liberalize capital flows in and out of the country. In many cases, China has moved more slowly than the U.S. desired. Beijing has resisted American pressure to let its currency appreciate in line with market forces, for example, which economists say has helped inflate China's trade surplus. But often, U.S. suggestions had a sympathetic audience among reformers in China's government, and many of China's financial overhauls in recent decades have been inspired by the U.S. model. Now, some of these changes, and their proponents, have lost credibility in China in the wake of the financial meltdown, and recently commentators and officials in China have been increasingly critical about Washington. Amid high-level Sino-U.S. economic talks in Beijing in early December, Chinese officials admonished the U.S. and Europe for their financial governance. Vice Premier Wang Qishan, China's top finance official, called on the U.S. to "take all necessary measures to stabilize its economy and financial markets to ensure the security of China's assets and investments in the U.S." A similar complaint was issued by Lou Jiwei, chairman of CIC, the government fund established in 2007 to seek higher returns on a $200 billion chunk of China's currency holdings. Mr. Lou said in a December speech that he has "lost confidence" because of inconsistent government policies concerning support for Western banks. "We don't know when these institutions will be invested in by their governments," he said. Fate of U.S. Investments CIC officials are especially sensitive about the fate of their U.S. investments because they have been under fire for the poor performance of earlier deals. CIC has sustained large paper losses on the $3 billion it invested in Blackstone Group LP in June 2007, as well as the Morgan Stanley stake. Staffed by officials, some western-educated, who have helped promote financial-market liberalization in China, CIC is also viewed by some Chinese as a symbol of the country's close financial ties to the U.S. -- another reason it has been in the crosshairs. Around October, a lengthy Chinese-language essay began circulating on the Internet excoriating Mr. Lou and other top CIC officials, along with Zhou Xiaochuan, China's central bank governor, for being too close to the U.S. and then Treasury Secretary Henry Paulson. The diatribe quickly gained wide circulation in Chinese financial circles. One passage charged that Mr. Zhou "colluded with Henry Paulson to buy U.S. bonds, forced [Chinese yuan] appreciation, attached China's economy to the U.S. and broke China's economic independence." Chinese and U.S. interests remain deeply enmeshed. Washington's huge stimulus plans will result in even heavier borrowing, and, while rising savings in the U.S. could create more domestic capital to help fund that, Chinese lending will remain important. Japan investors, too, have been selling Fannie and Freddie debt and making other moves to limit their U.S. risk. An official at another Asian central bank in charge of managing hundreds of billions of dollars in foreign exchange reserves noted late last year that trading in some derivative instruments had factored in a slightly higher possibility of default by the U.S. government, though that prospect is still viewed by most investors as extremely low. The alarm for Chinese leaders started ringing loudly in July and August as problems deepened at Fannie and Freddie. Senior Chinese leaders, who hadn't been apprised in detail of how China's reserves were being invested, learned for the first time in published reports that the country's exposure to debt from those two alone totaled nearly $400 billion, say people familiar with the matter. Fearing that the U.S. government might not fully back the companies, China demanded and received regular briefings throughout the peak of the crisis from high-level Treasury Department officials, including Mr. Paulson, on the market for U.S. debt securities -- especially those of the mortgage giants. Mr. Paulson and other Treasury officials spoke regularly with Vice Premier Wang and other senior Chinese officials to soothe their concerns. Hit With Questions Chinese officials often bombarded their U.S. counterparts with questions, according to people who were present at meetings. While Mr. Paulson was in Beijing for the Olympics in August, he dined with Mr. Zhou, the central bank chief, at the Whampoa Club, an upscale restaurant that serves modern Chinese cuisine in a traditional courtyard building near the city's Financial Street. On Sept. 7, Mr. Paulson announced that the U.S. government would seize Fannie and Freddie, but Chinese officials remained concerned. At one briefing for Chinese officials to explain the change, said people present, they questioned and debated the meaning of nearly every line of the new Treasury plan. Then Washington allowed Lehman Brothers Holdings Inc. to collapse, further shaking Beijing's faith. One casualty was CIC's nearly $5.4 billion investment in the Reserve Primary Fund, the money-market fund that "broke the buck" in September as a result of the Lehman collapse. CIC had placed money in the Primary Fund because "money market funds are supposed to be very safe," said a Chinese official in an interview late last year. But on Sept. 16, the Primary Fund's managers announced that they were delaying redemptions. CIC officials emailed Reserve asking to withdraw all of its money from the fund, and promptly received a reply agreeing to the request, says the Chinese official. CIC officials believed the agreement meant that CIC had become a creditor to the troubled fund, and therefore was entitled to all of its money. A Reserve spokeswoman says the company doesn't comment on individual clients. Later in the day on Sept. 16, Reserve announced that the Primary Fund's net asset value had fallen to 97 cents a share, below the standard $1.00 level. Reserve initially said redemption requests received before 3 p.m. that day would be honored in full, but has since said that the net asset value already was down to 99 cents a share by 11 a.m. As Reserve further delayed payments, CIC began to fear that it might not get all of its money. The Reserve issue "is causing a lot of concern with a lot of financial institutions in China," said the Chinese official. Some officials expected that the U.S. and its financial institutions would better protect China from loss. "If the U.S. is treating us this way, eventually that will be enough cause for concern in the stability of the [U.S.] system," the official said. A CIC spokeswoman declined to comment on the current status of the dispute. Write to Jason Dean at jason.dean@wsj.com, James T. Areddy at james.areddy@wsj.com and Serena Ng at serena.ng@wsj.com