Countrywide Financial Mortgage Banking vs Bankings

Our Mortgage Banking Segment produces mortgage loans through a variety of channels on a national scale. The mortgage loans we produce in this segment are generally sold into the secondary mortgage market, primarily in the form of securities, and to a lesser extent in the form of loans. We typically perform the ongoing servicing functions related to the mortgage loans that we produce. We also provide various loan closing services such as escrow, flood determination and appraisal. Historically, mortgage banking loan production has occurred in Countrywide Home Loans ("CHL"). Over the past several years, we have been transitioning this production to our bank subsidiary, Countrywide Bank, FSB ("Countrywide Bank" or the "Bank"). As of December 31, 2007, over 90% of our monthly mortgage loan production occurred in Countrywide Bank. Effective January 1, 2008, our production channels have moved into the Bank, completing the migration of substantially all of our loan production activities from CHL to the Bank. The mortgage loan production, the related balance sheet and the income relating to the holding and sale of these loans is included in our Mortgage Banking Segment regardless of whether the activity occurred in CHL or Countrywide Bank. We group the activities of our Mortgage Banking Segment into three business sectors—Loan Production, Loan Servicing and Loan Closing Services. Banking Operations Our Banking Operations primarily fund and purchase mortgage loans and home equity loans for investment purposes. The majority of these loans are sourced through our production channels. For liquidity and asset-liability management purposes, we also invest in securities such as collateralized mortgage obligations and agency MBS. Banking Operations activities provide the Company with an expanded product menu, lower cost funding sources and opportunities for a stable source of revenue in the form of net interest income. Asset growth is funded by the Bank's liability base. The Bank obtains retail deposits, primarily certificates of deposit, through 194 financial centers (163 of which are located in CHL's retail branch offices) as of December 31, 2007, call centers and the Internet. Countrywide Bank also offers deposit accounts through deposit brokers (generally, well-recognized financial intermediaries). A significant portion of Countrywide Bank's deposit liabilities are comprised of custodial funds that relate to our loan servicing portfolio. Countrywide Bank also offers commercial deposit accounts to title and mortgage insurance companies through a commercial banking unit. The Bank also borrows funds from other sources to supplement its deposit liabilities, including mortgage loan-secured borrowings from the Federal Home Loan Bank ("FHLB") of Atlanta and repurchase agreements secured by loans and securities. Countrywide Bank acts as a mortgage document custodian, primarily for our mortgage banking operations. As a document custodian, we verify, maintain and release collateral for issuers, servicers, sellers and purchasers of debt securitizations. We also provide other services, including safekeeping, collateral review/certification, collateral releases and customer reporting.

Japan's Companies Gird for Attack

After years of opening up to foreign investment and takeovers, the world's No. 2 economy is getting back to fending them off. Many companies are reviving cross-shareholdings, in which business partners or even competitors buy stakes in each other to make takeovers harder. They're dusting off an American antitakeover defense out of the 1980s, the poison pill. Government ministries have joined in, attempting to ring-fence industries they deem strategic. The new bulwark-building marks a major reversal for Japan. The nation has long been one of the most closed among major economies. But in the 1990s, during a decade of economic stagnation, international investors began pouring in. Japan allowed signature corporations to fall into foreign hands, including Nissan Motor Co. and Long-Term Credit Bank of Japan, since renamed Shinsei Bank Ltd. Under former Prime Minister Junichiro Koizumi earlier this decade, the country allowed foreign companies to buy Japanese companies with their own shares. Foreign ownership of shares soared, to 28% in 2006 from 4% in 1988. Now the opening appears to be narrowing again. In a controversial recommendation this month, the Ministry of Economy, Trade and Industry said that The Children's Investment Fund LLP, a United Kingdom-based hedge fund, shouldn't be allowed to increase its stake in Electric Power Development Co., a formerly government-owned utility, beyond its current 9.9%. In a speech shortly afterward, European Union trade chief Peter Mandelson told Japanese officials and businessmen that Japan "remains the most closed investment market in the developed world." Distrust of outside investors is bleeding into popular culture. Last year, public broadcaster NHK ran a drama series called "Vulture," about a Japanese fund manager who acquires indebted companies for a U.S. investment firm. Its tagline: "Is that man the devil or a savior?" Behind Japan's renewed fortress mentality: Many companies here look ripe for takeovers. Though profits are up, shares remain cheap. On average, Japanese stocks are now trading at about 15 times earnings, down from a price-to-earnings ratio of more than 50 just five years ago, according to Nikko Citigroup Ltd. Nearly two-thirds of Japan's listed companies trade at a price-to-book ratio of less than 1, according to consulting firm UWiN Corp. That means their assets could be sold for more than the cost of buying the whole company. That spells opportunity for growing ranks of activist shareholders and private-equity funds here. Over the past five years, foreign firms including TPG and Kohlberg Kravis Roberts & Co. have set up shop in Japan. Between 2002 and 2007, the value of private-equity buyouts has almost tripled to $11.1 billion, according to data tracker Dealogic. The activity is modest compared with the U.S.'s $434 billion in buyouts last year. Hostile takeovers, meanwhile, have been practically nonexistent in Japan. Dealogic says there were five such attempts last year, together worth a modest $477 million. None were successful. Yet the fear is real. In a society that until recently counted on lifetime employment, some managers worry that acquirers will ax jobs. Others suggest that outside investors' pursuit of profits could clash with ideals such as honoring a founder's vision. 'Greedy, Adulterous' In a speech earlier this year, Takao Kitabata, a vice minister of Economy, Trade and Industry, posed the question, "Are corporations the property of stockholders?" Shareholders are "stupid, greedy, adulterous, irresponsible and threatening," he said. "They are the type of people who just sell the stock if they get mad." Japan isn't alone in its protectionist tendencies: Governments including the U.S., Germany and Australia have lately proposed or erected barriers to foreign investors. And Japan's shift isn't universal. Many top officials continue to argue for openness to outside investors. Some companies are lowering their guard: Mail-order company Nissen Holdings Co. and contact-lens retailer Nihon Optical Co. have let their poison-pill protections elapse. "Adopting takeover defenses doesn't give us the right image in the market," says a Nihon Optical spokeswoman. The country's renewed willingness to coddle corporations comes at a time when it arguably needs to shake them up. Japan's per-capita gross domestic product was the lowest in the Group of Seven rich nations last year. In the early 1990s, it was the highest. Making matters worse, more Japanese are retiring each year than are joining the work force. To avoid falling living standards, Japan needs to raise its work force's productivity. It must also generate more wealth with its vast savings -- about $15 trillion, mostly earning near-zero interest in bank accounts. .... http://online.wsj.com/article/SB120951658668054687.html?mod=todays_us_page_one

GDP Q1 08

--Real GDP QoQ is 0.6%, beating estimate and , same level as Q4 07 (GDP 11.7 tril) --Major driver is consumer service, especially Medi care expense (11% of GDP) --net export shrink due to currency devaluation --Business investment decline (-0.7%), but still holding at similar level, implying corporations are expanding moderately and gearing up for recession --Inventory increased 0.81%, reflecting stronger demand compared to last quarter

Subprime Delinquency Rate Growing More Slowly

The subprime-mortgage market still is getting worse each month, but there are some indications that the massive problem of borrowers falling behind on their loans may be moderating. Data provided recently to holders of securities backed by subprime mortgages showed that the number of borrowers who were delinquent on their home loans rose at a slower pace in April than in March. It was the third month in a row in which mortgages went bad at a slower rate. The data come from so-called "remittance reports" that are distributed monthly by trustees of mortgage-backed securities tracked by the widely followed ABX indexes. Among pools of subprime mortgages made in the second half of 2005, the proportion of loans that were more than 60 days delinquent rose by 1.23 percentage points in April to 35.9%. That compared with a 1.61-percentage-point increase in March, a 2.36-point increase in February and a 2.64-point rise in January, according to a report from Wachovia Capital Markets. The report said similar trends were observed in April for loans made in 2006 and the first half of 2007. On average, between 25% and 40% of the subprime loans in these groups are more than 60 days delinquent. While it is hard to predict when the subprime market will hit bottom, some analysts think the recent data indicate that some sort of stabilization is under way. "The trajectory is beginning to flatten out, and this could be a turning point for prices" of mortgage securities, said Glenn Schultz, a senior analyst at Wachovia. As many poorly underwritten subprime loans made between mid-2005 and mid-2007 go bad early in their lives, Mr. Schultz expects the remaining loans to perform more normally. In recent weeks, some portions of the ABX indexes have bounced off their record lows, and traders say some investors are buying subprime bonds again after their market prices dropped to deeply discounted levels. But many market participants remain skeptical or bearish about the outlook for subprime. Richard Parkus, an analyst at Deutsche Bank Securities, says the recent remittance data showed "no clear evidence of any recovery," and his firm continues to expect extraordinarily high levels of losses among subprime loans. Skeptics also say that with home prices falling and unemployment rising, delinquencies will keep climbing. There is also a possibility that the recent delinquency data might have been influenced by seasonal factors, such as individuals using recent tax refunds to become current on their mortgage payments.

Junk Bonds Are on a Roll, But Danger Lies Ahead

The junk-bond market is closing out its best month in years, but many investors and analysts are skeptical about the outlook. The concern in the junk, or "high yield," market isn't just a likely surge in defaults, which is the norm for companies with low credit quality during an economic downturn. This time around, there are worries that when defaults occur, the recovery rates on those bonds and loans will be far more meager than in the past. The main source of those concerns is the hundreds of billions of dollars of noninvestment-grade loans issued in recent years. Before the onset of the credit crunch, such loans went to market with fewer protections for holders in the event that issuers ran into financial trouble. In order to compensate investors for the increased risks of holding that debt, some say yields will need to stay relatively high and that prices may not improve much. Still, investors in the high-yield debt market can smile for now. The Merrill Lynch High-Yield Bond Index is up 0.6% for the year, having been down 4.5% on March 17, the day after the collapse of Bear Stearns Cos. The yield spread over comparable U.S. Treasurys, a barometer of market sentiment, has narrowed sharply to 6.85 percentage points from a high of 8.6 percentage points. Yet, with an average yield of about 10%, high-yield debt offers a healthy income stream. Investment-grade corporate bonds are yielding around 6%. Like other parts of the bond market, sentiment rebounded after the Federal Reserve aided J.P. Morgan Chase & Co.'s pending takeover of Bear Stearns in an attempt to keep the brokerage house's problems from spiraling through the financial system. That, combined with the Fed's decision to let brokerage houses borrow from the central bank, created a greater comfort with taking on risk. Meanwhile, brokerage houses have made progress in clearing the decks of hundreds of billions of dollars of high-yield debt that had been sitting on their books since last summer, particularly loans backing leveraged buyouts. Now the focus is on the economy and credit quality of low-rated issuers. "This is the most dangerous time of the cycle for high yield," says Tom Swaney, a portfolio manager and head of the credit team at OppenheimerFunds. "You know the defaults are going to come, but you don't know exactly when, and you don't know what kind of risk premium you need to earn to ride it out." Thus far, default rates, which have risen, remain low. Still, Moody's Investors Service last month said it expects defaults on U.S. speculative-grade debt to rise to 6.6% by next March from 2.2% last month. If the economy goes into a deep recession, defaults could top 10%, Moody's says. However, Moody's believes that, thanks to healthy corporate balance sheets outside the financial sector, a more likely outcome is that fewer defaults will materialize. While high-yield investors are used to the ups and downs of the default cycle, there is a new wrinkle to contend with. Starting in 2004, many low-quality companies that would have issued conventional, unsecured high-yield debt instead turned to the syndicated-loan market, especially for leveraged buyouts.

Weak Board Salvage Regional Banks' Chiefs' Misbehalf

How can the chiefs of these banks still be at the helm when leaders like Charles Prince, Stanley O'Neal and Marcel Ospel were shoved out of Citi, Merrill and UBS, respectively? Sure, all three companies lost about half their value in the past year. That's bad. But so has RBS. And the losses inflicted by WaMu and National City on their investors are far more horrific. There are probably a few reasons for the discrepancy over which bosses get the ax. The main reason may be the composition of their respective boards. Unlike the big Wall Street banks, regional institutions tend to draw local executives, who may be more forgiving when it comes to a neighbor's shortcomings. After all, it would be quite uncomfortable to bump into somebody you have just sacked on the local golf course. National City may be a case in point. Its board mainly consists not of global financial heavyweights, but of local worthies. There is the president of a hometown community college, the boss of a paint company based down the street and the head of a restaurant group named Eat'n Park. The situation is a bit better at RBS. But for an institution that has global pretensions, its board is stuffed with a lot of Scots. But it isn't just weak boards that have saved the scalps of provincial-bank bosses. It is up to shareholders to hold directors accountable. Because investment banks tend to pay their employees giant bonuses loaded with restricted stock, they often make up the largest block of shareholders. So when the stock buckles, the blade gets sharpened fast.

ETF redemption -- exhchange for underlying wo tax efficient

An exchange-traded fund (or ETF) is an investment vehicle traded on stock exchanges, much like stocks or bonds. An ETF holds assets such as stocks, bonds, or futures. Institutional investors can redeem large blocks of shares of the ETF (known as "creation units") for a "basket" of the underlying assets or, alternately, exchange the underlying assets for creation units. This creation and redemption of shares enables institutions to engage in arbitrage and causes the value of the ETF to approximate the net asset value of the underlying assets. Most ETFs track an index, such as the Dow Jones Industrial Average or the S&P 500. An index mutual funds redemption when fund sell actual shares for investors with tax implications. But ETF usually just exchange shares without tax implications. Hence ETF is more tax efficient.

bottom comparison beteween 1990s and 2008 by buyout firms

Some buyout bigwigs compare the situation with the early 1990s. Then, U.S. credit woes stemmed from a deflating junk-bond bubble, which had fueled a commercial-real-estate boom. The blowup of Drexel Burnham Lambert was an early sign the bottom was approaching. Several regional banks subsequently collapsed. By this analogy, Bear Stearns's meltdown may have marked the beginning of the end of the current credit crunch. The more-cautious buyout firms may, however, doubt the worst is really over until regional banks start failing. The Federal Reserve's moves to stabilize markets and rescue Bear may prevent that from happening. Investments by private-equity firms such as TPG and Corsair could also shore up some banks. So buyout shops waiting for better deals may miss the boat.

Why Banks Raise Hybrids

Hybrid bonds such as preferred shares that havecharacteristics of both debt and equity count toward capitalreserves, allowing banks to replenish their coffers withoutdiluting equity. Hybrids typically allow issuers to defer interest payments without defaulting, and credit-rating companies usually consider the bulk of the money raised as equity, meaning only a portion is counted as debt on an issuer's balance sheet. Merrill Lynch, after writing down the value of $6.5 billionof assets, sold $7 billion of senior unsecured notes in itsbiggest debt offering, attracting investors with spreads as muchas triple what it paid a year ago. Merrill Lynch, the third-biggest U.S. securities firm, also issued $2.55 billion ofperpetual preferred shares that yield 8.625 percent, its largestsale of the securities. The firm split its bond sale between $1.5 billion of 5-year6.15 percent notes that priced to yield 325 basis points morethan Treasuries of similar maturity and $5.5 billion of 10-year6.875 percent notes that paid a spread of 320 basis points,Bloomberg data show. That compares with the 107-basis pointspread Merrill Lynch paid on $1 billion of 10-year notes in April2007. Merrill Lynch may now lose its A1 ranking at Moody'sInvestors Service because the credit rating service won't countthe proceeds of the preferred sale as equity, Sanford C. Bernstein & Co. analyst Brad Hintz said today in a note toclients. Credit-rating companies typically don't allow more than 25 percent of a bank's capital base to be made up of preferred stock, a limit Merrill is ``well over,'' he said.

Juniper (JNPR) Q1 08

Overall --Earning 110 mil, EPS 0.2 up 44% --Revenue 822.9 mil, up 31% Comments: --High profit and high quality

American Express (AXP) Q1 08

Overall --Earning 991 mil, -6% --Revenue 7.2 bil, 11% up --driver: interntional market Segments: Card Services (3.7 bil 50% share) --earning 523 mil, -19%, revenue up 11% to 3.7 bil --provision 881 mil, up 52% Internatonal Card (20%) --earning: 133 mil, up 30%, revenue up 22% to 1.2 bil --provision 229, up 24% Credit quality --provision match writeoff closely, not dramatic change comments: --overall credit quality is fine

Leverage Crushed Austraillian Brokerage

Freewheeling borrowing to buy stocks has led to brokerage collapses in Australia, fueled by broad-ranging margin calls in a rocky market. Two brokerage firms -- Opes Prime Stockbroking Ltd. in Melbourne and Lift Capital Ltd. in Sydney -- have been forced into receivership, the Australian equivalent of bankruptcy, after nervous creditors withdrew their support. A third brokerage, Tricom Equities Ltd., is staggering under similar debt burdens. Traders expect more firms will go under. Victims include the brokerages' customers. The expansion-minded brokers borrowed heavily, using customers' shares as collateral. When the market went south, the lenders liquidated the customers' holdings in an attempt to minimize their own losses. The brokerages' creditors, Australia & New Zealand Banking Group Ltd., the country's fourth-biggest lender by market capitalization, and Merrill Lynch & Co. together dumped more than two billion Australian dollars (US$1.9 billion) in shares they held as collateral. The mess has provoked a series of investigations and threats of lawsuits, and has shaken confidence in Australia's stock market. The root of the problem is a loophole in Australian regulations that allows brokers to put up customers' shares as loan collateral, without notifying the customers. The investors apparently didn't know their shares had been pledged against the loans until it was too late. In the U.S., brokers are forbidden from dipping into a customer's account for their own purposes. Opes, which began operations in 2003, disclosed in documents to investors that it could do this. But many customers now say they had no idea their stock had been so pledged. The brokers used the loans to expand their own margin-lending activities to customers. Margin lending can be quite profitable for brokers, who earn interest from the borrowings. That setup worked fine as long as the Australian market rose. During its five-year run, the A&P/ASX 200, Australia's benchmark index, climbed 130%. But since hitting a high Nov. 1, the index has dropped 18%, joining a global market rout. Suddenly, the brokers were hit by margin calls of their own from ANZ and Merrill. Some Opes and Lift customers have lost millions of dollars in equity as ANZ and Merrill sold off these shares. Two directors of mineral-resources company Paladin Energy Ltd. had their stakes sold without their consent, the company said in a filing with the stock exchange. Those directors are planning to sue, the filing said. Paladin directors didn't respond to calls seeking comment. The tumult isn't confined to Australia. In Singapore, the management-led buyout of an engineering concern called Jade Technologies Holdings Ltd. fell apart after the chief executive, Anthony Soh, had his stake sold out from under him. Mr. Soh's shares had resided in an Opes account. The investigations are mounting. The Australian Securities and Investments Commission and the Australian Securities Exchange have launched probes into possible fraud. Singapore's white-collar-crime unit has started its own inquiry. ANZ faces a public-relations nightmare for its involvement. The bank is conducting an internal inquiry to uncover whether any of the bank's employees breached risk controls or ethical standards. During a briefing Wednesday of the bank's financial results, Chief Executive Mike Smith expressed frustration with the bank's involvement in the collapse of Opes. "This is very irritating. I'm absolutely determined to see whether there have been any breaches in our processes or standards," Mr. Smith said. He said the internal probe includes all the bank's securities-lending activities, not just the loans to Opes, but he added that he wasn't prepared yet to provide any details. Merrill and the regulators declined to comment.

Lehman Mortgage Servicing Rights

Lehman also booked a $364 million pretax gain on changes in the value of mortgage-servicing rights, which are treated as an asset because they represent the future cash flows from fees borrowers pay to the companies that collect mortgage payments. The value of these rights changes depending on expectations of things like the future direction of interest rates, risk associated with mortgages and, most importantly, the likelihood that investors will prepay their loans. When expected prepayments decline, holders of servicing rights see gains. Prepayment rates have been dropping since last year because fewer people can refinance mortgages.

The Changing Business of Banking: Implications for Financial Stability and Lessons from Recent Market Turmoil

The recent market turmoil certainly has underscored how banking and financial intermediation have been changing, and it has taught some important lessons about the implications for financial stability that I don't believe were previously well understood. Commercial banks and other financial market participants need to incorporate those lessons into their risk-management practices. Bank supervisors need to encourage and monitor banks' efforts to strengthen their practices and we need to consider how regulatory and supervisory policies should be modified to reinforce incentives for sound practices. Finally, changes in the ways savings are channeled to borrowers have also affected the role of the nonbank sector. Central banks and other policymakers need to think carefully about the implications of these changes for financial stability and the appropriate prudential regulation of nonbank financial institutions.1 The Changing Business of Banking Even before the recent market turmoil, it was abundantly clear that the business of banking has changed quite significantly over the past several decades. The primary impetus for change has been intensified competitive pressures from the securities markets. Changes in technology (for example, the development and expansion of credit-scoring techniques) have allowed a larger share of credit extensions to households and businesses to be packaged in securities and sold to entities that often can fund the securities more cheaply than banks can fund loans. The effects probably have been greatest for the U.S. household sector. Securitization of residential mortgages began in the 1970s; the share of outstanding mortgages that have been securitized grew fairly steadily throughout the 1980s and 1990s and has fluctuated between 50 and 60 percent since then. Nonmortgage consumer credit (credit card and installment debt) began to be securitized in the late 1980s, and in recent years more than 20 percent of the outstanding stock has been securitized. Until the summer of 2007, there was very strong demand for securitized credit from mutual funds, pension funds, and other institutional investors. Throughout that period, household wealth was rising rapidly, and, directly or indirectly, households were allocating an increasing share of their wealth to vehicles that were managed or advised by professional asset managers. At the same time, advances in the technology of modeling, pricing, and trading of risk over the past several decades gave added impetus to the migration of credit to securities markets. Competition from the securities market has significantly affected all segments of banking, but the most dramatic changes have occurred at the very largest banks. One could say that their strategic response was, "If you can't beat them, join them." Freed from the constraints of the Glass-Steagall Act by incremental regulatory changes that were expanded and codified in the Gramm-Leach-Bliley Act of 1999, the very largest banking organizations have significantly increased their capital markets businesses, including arranging and underwriting securitizations, securities custody, prime brokerage, and both over-the-counter and exchange-traded derivatives. They have also made significant inroads into both traditional asset management and the management of hedge funds. Indeed, the largest commercial banks are now major competitors in many of the business lines that were historically viewed as the province of investment banks. Together, the very large commercial and investment banks have become indispensable to the efficiency and stability of the securities markets. For example, the $2 trillion hedge fund sector is critically dependent on a relatively small number of commercial and investment banks that serve as secured creditors and derivatives counterparties. And, as the financial market turmoil has revealed, banks provide liquidity support to various short-term financial markets, including the commercial paper market and markets for various types of tax-exempt debt. Competition from securities markets has also affected smaller banks significantly, though less dramatically than larger banks. For example, the portfolio share of commercial real estate loans, which are not amenable to standardization and therefore are difficult to securitize, has increased markedly. Setting aside the 100 largest banks, the share of commercial real estate loans in bank loan portfolios nearly doubled over the past 10 years and is approaching 50 percent. The portfolio share at these banks of residential mortgage and other consumer loans, which are more readily securitized, fell by 20 percentage points over the same period. The Implications for Financial Stability from the Recent Market Turmoil The changing business of the largest commercial banks means that threats to financial stability do not necessarily come from traditional sources such as a deposit run or a deterioration in a bank's portfolio of business loans. The largest banks' capital markets businesses have given rise to new threats to financial stability. These threats stem from banks' securitization activity, from the complexity of banks' capital markets activity, and from the services that banks provide to the asset-management industry, including hedge funds. And risks that are more traditional to banking, such as liquidity risk and concentration risk, have appeared in new forms. The securitization activity of the largest banks is often described as following an originate-to-distribute model. Chairman Bernanke described this model in some detail in a speech he gave last week in Richmond.2 In an originate-to-distribute model of banking, assets are originated to be packaged into securities, which are distributed broadly. However, in the recent market turmoil, problems arose at both ends of the originate-to-distribute chain as it was being applied to subprime mortgages. The quality of subprime origination declined because of a serious erosion in underwriting standards at banks and especially at nonbanks. Underwriting standards for subprime mortgages fell as loans were increasingly made on the basis of expected increases in collateral value, without a careful evaluation of the borrower's ability to repay. Several years of rapidly rising house prices had reduced the delinquency rates on mortgages with historically high loan-to-value ratios, making these mortgages look less risky than they, in fact, turned out to be. As loan amounts rose relative to the value of properties, the performance of the subprime mortgage sector as a whole became sensitive to even small declines in house prices, with the distressing results that we have seen since house price growth decelerated beginning in 2006. A similar decline in underwriting standards occurred in other market segments, such as the market for leveraged loans, where banks increasingly originated loans with less-stringent covenants through the first half of last year. More generally, insufficient appreciation that economic conditions might not always be benign and that trading conditions in markets might not always be highly liquid led to an underpricing of both credit and liquidity risks. At the other end of the originate-to-distribute chain, a good part of the risk associated with the securitization of subprime mortgages was not distributed into the market but was retained by banks. The most glaring example is their exposures to super senior tranches of collateralized debt obligations (CDOs) that had invested in subprime mortgage-backed securities. Super senior CDO tranches--the last to bear the costs of defaults on the underlying mortgages--were considered to be extremely safe investments, and little of the risk of these instruments was truly distributed into the market. Three things hindered the distribution of super senior CDO risk. First, underwriters sold some of the risk to off-balance-sheet vehicles, but they also provided explicit or implicit liquidity backstops to the vehicles. Much of this risk came back onto banks' balance sheets when liquidity pressures emerged in the second half of last year. Second, underwriters chose to retain some of the super senior exposure, in some cases reportedly because they met some resistance when they attempted to sell them at very slim spreads. The underwriters evidently misjudged the risk of those positions, in some cases because they relied too heavily on external triple-A ratings. Third, underwriters hedged some of the risk with monoline financial guarantors. But some of the guarantors took on so much subprime-related risk that their financial condition had become highly correlated with the performance of the subprime mortgage sector, which has called into question the effectiveness of those hedges. As I mentioned earlier, the growth of securitization is in large part a response to the growing demands of institutional investors for fixed-income securities. These investors clearly had a financial incentive to do better due diligence on the subprime risks they were taking on, but they largely failed to do so. We can only speculate as to why this was the case. I see three possibilities: First, they underestimated the potential for a nationwide decline in house prices; second, they relied on credit-rating agency analyses that have proven to be inadequate; or third, they simply misunderstood the risk of these often very complex securities. The complexity of CDOs is one example of a widespread increase in the complexity of the capital market activities in which the largest banks now engage. Some banks' failure to adequately manage this complexity has weakened financial stability in the current market turmoil. CDOs and other structured credit products can be very complicated. Among the CDOs that invested in subprime mortgage-backed securities, it was common for a single CDO to own hundreds of different mortgage-backed securities, each with its own pool of underlying mortgage loans. Clearly, the valuation of such products and the measurement and hedging of the risks they entail are very complicated. Securities pools reduce idiosyncratic risk--the potential for problems particular to individual borrowers to have a material effect on overall values--but they are quite subject to systematic risk from broad-based macroeconomic developments that affect all loans at the same time. I believe it is fair to say that the creation of new, innovative financial products outstripped banks' risk-management capabilities. As I noted earlier, some banks that chose to hold super senior CDO securities did so because they trusted in an external triple-A credit rating. Because some banks did not fully understand all aspects of these exposures, once the risks crystallized last year in a weak house price environment, compounded by widespread liquidity pressures in many markets, banks had to scramble to measure and hedge these risks. Another aspect of the changing business of banking with possible implications for financial stability is the growth of services that banks provide, including running their own asset-management businesses and providing prime brokerage services to hedge funds. Banks with asset-management businesses must manage the reputation risk that such businesses entail. Because institutional investors are naturally sensitive to the reputation of their asset managers, losses elsewhere in the bank can be compounded if they leave the bank's asset-management business exposed to a flight of business and a sharp reduction in fee income. An increase in the business that banks do with highly leveraged investors, like some hedge funds, leads to an increase in the attention that banks must pay to counterparty risk management. Liquidity risk is a familiar risk to banks, but it has appeared in somewhat new forms recently. While the originate-to-distribute model aims to move exposures off of banks' balance sheets, the risk remains that a sudden closing of securitization markets can force a bank to hold and fund exposures that it had originated with the intent to distribute. And in many cases when banks did distribute exposures, they did so to various off-balance-sheet financing vehicles in which they retained contractual and reputational liquidity exposures. These vehicles, like banks themselves, were funding longer-term assets with short-term liabilities, and, like banks, they were subject to a run when their lenders became concerned about the quality of the assets. Some banks wound up using their own liquidity to support financing vehicles that were no longer able to fund themselves on anything like the same terms and conditions as before the market turmoil began. And as banks made good on the implicit or explicit liquidity insurance they sold, they found themselves with larger balance sheets and less-robust capital cushions than they anticipated. As the banks' capital and liquidity cushions unexpectedly eroded, they became quite cautious about extending credit, a dramatic change from the more complacent attitudes of previous years. Concentration risk is another familiar risk that is appearing in a new form. Banks have always had to worry about lending too much to one borrower, one industry, or one geographic region. But as smaller banks hold more of their balance sheet in types of loans that are difficult to securitize, concentration risks can develop. Concentrations of commercial real estate exposures are currently quite high at some smaller banks. This has the potential to make the banking sector much more sensitive to a downturn in the commercial real estate market. The Private Sector Needs to Respond To protect their capital and liquidity, banks and other financial market participants are addressing the weaknesses revealed by market developments by becoming much more careful about the risks they are taking. This is a necessary process, but it has been a difficult one as well; it is reducing the values of some assets and tightening credit cost and availability across a wide range of instruments and counterparties, despite considerable easing in the stance of monetary policy. It is this tightening that is accentuating the downside risks for the economy as a whole. And in some sectors, as lenders seek protection against perceived downside risks, it is probably going further than is necessary to foster financial stability in the long run. But we will end up with a safer, more robust financial system. For banks, a safer and more robust financial system will be characterized by improved risk management that incorporates the lessons from the recent turmoil. Successful risk management looks comprehensively across business lines and is fully integrated into the decisionmaking of senior management. It identifies stresses and scenarios that might seem remote, but that could threaten safety and soundness. Banks' own self-interest clearly provides a strong incentive to improve risk management, but better risk management at the largest banks would benefit the broader financial system, too. A more resilient financial system will also require banks to strengthen all aspects of the originate-to-distribute model. They need to pay more attention to origination, including when they are distributing credits they have not originated. And they need to ensure that when they distribute risks into the market with securitization, the risks really are distributed and will not come back onto their balance sheet later. If the credits end up in off-balance-sheet entities, banks need to pay more attention to the capital and liquidity impact of any residual claim these entities may have on the banks, even where that claim may arise through a desire to protect the bank's reputation rather than through any contractual obligation. The structured credit products that are part of a safer banking system are likely to be simpler and more transparent. Recent experience has shown that more readily understood products would be in banks' own self-interest. Banks and investors must devote more effort to due diligence when investing in structured products, and they must avoid relying so heavily on credit rating agencies to do all their homework for them. Banks must continue to focus on improving their management of counterparty risks. During the financial market disruptions surrounding the hedge fund Long-Term Capital Management almost 10 years ago, counterparty risk was a central concern. Subsequently, a private-sector group called the Counterparty Risk Management Policy Group developed a set of best practices for counterparty risk that greatly helped to set the tone for the needed improvements. These efforts do not appear to have been wasted, as attested to by the lack of serious losses from defaults of hedge fund counterparties in the recent turmoil. However, banks do not appear to have followed those best practices for their counterparty relationships with monoline financial guarantors, where counterparty risk has crystallized into large losses. Banks must come to grips with the implications that their capital markets businesses have for liquidity risk management. While securitization can transform illiquid assets into more-liquid securities, risk managers must be more aware of the ways that securitization can become a drain on a bank's liquidity position in times of stress. Smaller banks, too, need to improve aspects of their risk management. They should take steps to manage any portfolio concentrations that may arise because competition from securitization is less intense in certain market segments. When they do increase the share of their portfolio in a given market segment above historical levels, they must ensure that their risk-management processes and controls are commensurate with the level and complexity of their exposures. All banks--large and small--need to consider whether they need greater capital cushions. The largest banks should consider whether their changing business model means that they need to hold more capital against some of the newer risks I discussed earlier. It is especially concerning that so many of these newer risks have arisen at the same time. Smaller banks must make sure their capital is sufficient to protect against the risk associated with the greater concentrations that have seemed to accompany the increased competition from securities markets. Banks might find the current circumstances to be especially favorable for raising new capital. Not only would more capital provide a cushion against the sorts of unexpected declines in creditworthiness and asset values that have marked recent months, it would also position banks well for expansion. The safer, more resilient financial system that will emerge from this episode is likely to be characterized by a greater reliance on bank financing, as borrowers and lenders take on board the weaknesses that have become evident in securities markets. It also is likely to offer more generous compensation for risk-bearing. For banks with plenty of capital, that adjustment process is likely to present a chance to pick up business that, appropriately managed, will prove quite profitable over time. I acknowledge that this is a formidable "to do" list for banks. But it has been a formidable episode of financial turbulence that has revealed major weaknesses in our financial system, including the business practices of many banks. And this episode has also left the regulators with many issues to consider. The Federal Reserve and Other Regulators Need to RespondAt the Federal Reserve and at other bank regulatory agencies, our job is to reinforce the incentives and actions that are building a more resilient financial system. We need to make sure that regulatory minimum capital requirements and liquidity management plans protect reasonably well against shocks becoming systemic. Our supervisory guidance needs to be in place to prevent backsliding when, over the coming years, the memories and lessons of the current market turmoil fade, as they certainly will. To these ends, we are reexamining a host of things ranging from Basel II to liquidity to transparency. Working with our domestic and international colleagues, we are looking to raise the Basel II capital requirements on specific exposures that have been troublesome, such as super senior CDOs of asset-backed securities and off-balance-sheet commitments. We are looking to the Basel Committee on Banking Supervision to update its guidance on liquidity management in light of the recent experience. And we and our supervisory colleagues are looking to require better disclosures of off-balance-sheet commitments and of valuations of complex structured products. Threats to Financial Stability from Outside the Banking SystemIn the past, commercial banks and securities markets could be considered as separate channels for credit intermediation. One important implication of this was that if one channel for credit provision became impaired, the other would usually be functioning and able to insulate, to a degree, overall credit provision and the economy from financial sector shocks. For example, when the depository credit channel became impaired in the late 1980s and early 1990s, many borrowers were able to turn to liquid securities markets to meet a substantial portion of their needs for credit. That isn't working in the current period of turmoil, and for the reasons inherent in our discussion so far. First, securities markets have become so large that commercial banks simply lack sufficient capital and balance sheet capacity to readily fill the gap when markets are impaired. We saw this initially in mortgage markets when the securitization of nonconforming mortgages seized up; banks stepped up to make more jumbo prime mortgages and hold them on their books, but the cost of such credit rose substantially, and the amount of lending was reduced. Second, banks themselves are more dependent on well-functioning securities markets, and as that dependence and the important role of banks as ultimate providers of funding to those markets became clearer, pressures on banks mounted. So, in August, the turmoil crossed into the banking system when banks were challenged to backstop asset-backed commercial paper conduits and structured investment vehicles; under these circumstances, they were no longer comfortable fulfilling their traditional lending roles, and they tightened lending terms substantially, becoming part of the problem of credit availability, rather than a solution to it. In our more security-oriented intermediation systems, both commercial banks and security markets seem to be critical to the stability of the financial system and the economy. Third, large commercial banks and investment banks have increasingly similar risk profiles, so that all are subject to the same risk-management challenges under the same circumstances. As the activities and risk profiles of large banks and securities firms have become increasingly similar, and as financial intermediation has run more through securities markets, we've certainly learned in the past month or so that it is not only commercial banks that can threaten financial stability. So we must worry about excessive leverage and susceptibility to runs not only at banks but also at securities firms. To be sure, investment banks are still different in many ways from commercial banks. Among other things, their assets are mostly marketable and their borrowing mostly secured. Ordinarily, this should protect them from liquidity concerns. But we learned that short-term securities markets can suddenly seize up because of a loss of investor confidence, such as in the unusual circumstances building over the past six months or so. And investment banks had no safety net to discourage runs or to fall back on if runs occurred. Securities firms have been traditionally managed to a standard of surviving for one year without access to unsecured funding. The recent market turmoil has taught us that this is not adequate, because short-term secured funding, which these firms heavily rely upon, also can become impaired. With many securities markets not functioning well, with the funding of investment banks threatened, and with commercial banks unable and unwilling to fill the gap, the Federal Reserve exercised emergency powers to extend the liquidity safety net of the discount window to the primary dealers.3 Our goal was to forestall substantial damage to the financial markets and the economy. Given the changes to financial markets and banking that we've been discussing this morning, a pressing public policy issue is what kind of liquidity backstop the central bank ought to supply to these institutions. And, assuming that some backstop is considered necessary because under some circumstances a run on an investment bank can threaten financial and economic stability, an associated issue is what sorts of regulations are required to make the financial system more resilient and to avoid excessive reliance on any such facility and the erosion of private-sector discipline. I don't have ready answers to these difficult questions. It is evident that the balance of market discipline and regulation is in the process of being adjusted to the reality of how our financial system has evolved. In my remarks, I've stressed the need for both private and public actions to build a more resilient financial system. But we need to make adjustments in such a way as to preserve the benefits of highly innovative financial markets where many advances have enabled risks to be better diversified and credit more readily available to more people. Whatever type of backstop is put in place, in my view greater regulatory attention will need to be devoted to the liquidity risk-management policies and practices of major investment banks. In particular, these firms will need to have robust contingency plans for situations in which their access to short-term secured funding also becomes impaired. Commercial banks should meet the same requirement. Implementation of such plans is likely to entail substitution of longer-term secured or unsecured financing for overnight secured financing. Because those longer-term funding sources will tend to be more costly, both investment banks and commercial banks are likely to conclude that it is more profitable to operate with less leverage than heretofore. No doubt their internalization of the costs of potential liquidity shocks will be costly to their shareholders, and a portion of the costs likely will be passed on to other borrowers and lenders. But a financial system with less leverage at its core will be a more stable and resilient system, and recent experience has driven home the very real costs of financial instability.

China Bans Funds from Mid-Term Bonds

China's securities watchdog orderedthe nation's funds not to buy unsecured corporate debt maturingin more than a year that's traded in the interbank market,according to a document obtained by Bloomberg News. The China Securities Regulatory Commission said in thedocument it needs more time to assess whether trading volumeswill be active enough for so-called medium-term corporate debt,after the central bank this month allowed the sales. The CSRC,which regulates funds' investments, didn't say whether banks,insurers and other corporations can still buy the debt. The notes ``have relatively longer maturities and theirliquidity requires further evaluation,'' said the documentissued by the CSRC's Funds Supervisory Department on April 22.An official in the department, who asked not to be identified,confirmed the issuance of the document and declined to elaborate. Global financial companies have been forced to makewritedowns after the collapse of trading in markets for commercial paper, collateralized debt obligation guarantees andmortgage-backed securities. China's interbank debt turnover ratio, which measurestrading volume over outstanding amount, was 1.34 in 2007, said areport by the China Government Securities Depository Trust &Clearing Co., the nation's biggest debt clearing house. Thatcompares to an average turnover ratio of about 15 for the U.S.bond market, based on data on the Web site of the SecuritiesIndustry and Financial Markets Association. Low Turnover Commercial paper, offered by companies due in less than oneyear, traded at a 4.2 times ratio at the end of last year, themost liquid of all types of debt in China's interbank market. The People's Bank of China, which regulates the nation'sinterbank market, issued a statement April 12 to allow companiesto offer interbank medium-term notes from April 25. Six agenciesor companies this week priced their first issues of three- andfive-year notes under the new rules. Issuers included China Ministry of Railway and China Minmetals Corp. Previously, companies could only issue commercial paper andfunds can still buy that debt. The document added that furtherdecisions will be made after watching the sale and trading ofthe new financing tool. The central bank also simplified the debt-issuance processfor companies by shifting its approval authority to registrationat the National Association of Financial Market InstitutionalInvestors, a trade group under its supervision. Four government agencies control companies' debt sales,which are the CSRC, the central bank, the State-owned Assets Supervision and Administration Commission and the NationalDevelopment and Reform Commission. The NDRC is the approver of so-called enterprise debt, orbonds issued by state-owned firms to fund infrastructureprojects. The SASAC said April 11 it must approve any bondissues by the 150 largest companies under its control, whichinclude China Mobile Communications Corp. and China NationalPetroleum Corp.

Street Seeks Credit-Default Safety Net

More than a dozen firms including investment banks, brokerage firms and futures exchanges are accelerating efforts to create a clearing entity that would function as the middleman between firms on both sides of a credit-default swap. The clearinghouse would guarantee payment on the contracts it handles, reducing the risk of a catastrophic ripple effect if one or more firms were unable to make good on their trades. Behind the push is growing worry about the runaway popularity of credit derivatives. The volume of credit-default swaps, which are private financial contracts that act as a form of insurance against bond and loan defaults, has surged to new highs. But last month's near collapse of Bear Stearns Cos. underscored the vulnerability of other firms that had trades with the Wall Street firm. Plans call for the credit-default-swaps clearinghouse to be operated by Clearing Corp., a Chicago futures-clearing firm that is backed by Goldman Sachs Group Inc., Citigroup Inc., J.P. Morgan Chase & Co., Deutsche Bank AG, German-Swiss futures exchange Eurex AG and other financial-services firms. The project is likely to be launched in the second half of 2008. Supporters say the operation would back the obligations of credit-default swaps, standing between dealers in such trades, just as clearinghouses now do for a wide variety of other investments. The behind-the-scenes clearing business is a lucrative and fast-growing area of Wall Street, especially for exchange operators. Regulators also believe that a "central counterparty" could reduce the risk of a financial epidemic triggered by problems at one financial institution. Barclays Capital earlier this year estimated the failure of a major credit-derivatives player could lead to losses of $36 billion to $47 billion across the financial system. But the inherent lack of transparency in the largely unregulated credit-derivatives market could make the task difficult. Unlike the stock, futures and options markets, where market prices of securities and contracts are widely available, credit-default swaps trade "over the counter" -- or away from exchanges -- and prices can vary from firm to firm. Hoping to overcome the pricing problems, Clearing Corp. is working with Markit Group, which collects credit-default-swap prices from multiple firms. It also plans to initially clear trades for indexes of credit-default swaps, which have terms that are more standardized than swaps on individual bonds. "We are intent on maintaining a vibrant over-the-counter market for credit-default swaps," says Athanassios Diplas, chief risk officer for global credit trading at Deutsche Bank. Under the Clearing Corp. plan, participating dealers would each put money in a fund to help cover trading losses if any one firm fails. To protect itself, the clearinghouse will require margin from each firm and could request more collateral based on market moves. Industry participants have been working on the plan for about a year and hope to hammer out details in time to clear trades this year. For most of its history, Clearing Corp. cleared Treasury and other futures contracts for the Chicago Board of Trade. It lost that business in 2003 when CBOT moved its clearing to the Chicago Mercantile Exchange. Clearing Corp. has since expanded from exchange-listed futures to the over-the-counter market. Last year, it restructured its shareholder base, adding some holders that specialize in over-the-counter trading. Meanwhile, CME Group Inc., which now owns the Chicago Merc and the Chicago Board of Trade, also wants to expand into the bigger over-the-counter market. In March, it bought Credit Market Analysis Ltd., a credit-derivatives-data provider. "We view that as an entree" into credit-derivatives trading or clearing, says Craig Donohue, the exchange company's CEO.

Soaring Food Cost, To Be Boosted Minimum Wages, and Sagging Consumer Spending Rattled Restaurant Business

The $558 billion restaurant industry is hitting rough times, squeezed by many of the same woes affecting other sectors of the economy: tightfisted consumers, scarce credit and surging commodity prices. Adding to the pressure is a big jump in the minimum wage starting this summer, which will boost wages by 12% in some states. That's sent the industry into its worst slump in decades. Many chains have scaled back expansion plans or cut costs by skimping on things like extra sauce and free sour cream. Some are shuttering sites and laying off workers. Private-equity firms, which plunged into the business earlier this decade using gobs of borrowed money, are now especially vulnerable as those debts come due. This week's earnings results, despite some glimmers of good news, paint a sobering picture. McDonald's Corp., the world's largest restaurant chain, saw U.S. sales at restaurants open at least 13 months fall 0.8% in March, the first decline in monthly same-store sales in five years. Brinker International Inc., parent of Chili's, says it lost $38.8 million in its latest quarter. Analysts expect that when Cheesecake Factory Inc. reports first-quarter earnings on Thursday, same-store sales will have dipped and profit will have been pressured by spikes in the cost of dairy products, a key component of the chain's 30 cheesecakes. Restaurants will be watching closely next week, when the first government tax-rebate checks go out, hoping people use that cash to eat out. The slowdown has broad implications for the economy. The industry employs 13.1 million people, making it the nation's third-largest employer, behind the U.S. government and the health-care industry, according to the National Restaurant Association, a trade group. Many of those jobs are held by the poor and immigrants who have few other options for work. Vicorp and Buffets Holdings Inc., which owns the Ryan's Steakhouse chain and filed for bankruptcy-court protection in January, together are closing about 110 restaurants and cutting 4,300 jobs. Both companies say more cuts could be in the offing. For consumers, the closing of their neighborhood restaurants may be one of the most visible signs of a slowing economy. The chains anchor strip malls and highway exits, busy street corners and suburban downtowns. Trying to ingratiate themselves with the community, many restaurants fill their lobbies with local high-school pennants and yearbook photos or sponsor little-league teams. Moody's Investors Service has downgraded seven prominent national and regional chains, including Landry's Restaurants and the parent of Pizzeria Uno, to its lowest liquidity rating -- the most restaurants to be given this rating at once since it was created in 2002. One in five companies that winds up on this list ultimately defaults. Representatives for Landry's and Pizzeria Uno declined to comment.

New Tax Law Allow Companies to Carry Back Mortgage Loans Losses

The Internal Revenue Service withdrew proposed regulationsthat had asserted that mortgage loans are capital assets and anylosses from them could be used only to offset capital gains. Theagency also said it wouldn't challenge companies that count suchlosses against ordinary income. Tax law generally allows companies to ``carry back'' losses realized this year to previous years and get a refund for earlier taxes paid or apply them to later years, known as a ``carryforward'' to reduce future liability. Carry backs currently are limited to two years; the Senate legislation would temporarily expand that to four. A House panel passed a separate relief measure that doesn't contain the provision.

International Banks in China

Goldman Sachs Group and UBS AG are currently the only two major global investment banks with the ability to underwrite shares on China's domestic markets. Beijing agreed late last year to reopen the market to new ventures and at least three global banks are at various stages of applying to form new ventures. These include Citigroup Inc., Credit Suisse Group and Morgan Stanley, which has long had little say in how CICC operates. It wants to sell its 34.3% stake in CICC to enter a new venture in which it will have greater control, although that process for the sale has stalled.

Libor Hits US Borrowers

The troubles of banks in Europe are pushing up an interest rate widely used in the U.S., prompting the idea of a U.S.-based alternative to that rate, known as the London interbank offered rate, or Libor. The problem: Payments on trillions of dollars in U.S. corporate and mortgage loans are set according to dollar Libor, but only three of the 16 banks that contribute their borrowing costs to calculate the rate are based in the U.S. That means the financial difficulties of European banks are having an outsized effect on U.S. borrowing costs, and could complicate the Federal Reserve's efforts to bring those borrowing costs down. A significant gap between borrowing rates reported by European and U.S. banks has opened up since last week, when many banks started raising their reported Libor rates. The banks' moves came as the British Bankers' Association, which oversees Libor, said it was investigating bankers' concerns that their rivals were understating their actual borrowing costs to avoid looking desperate for cash. On Friday, the gap between three-month dollar Libor and the average three-month borrowing rates for U.S. banks in the 16-bank Libor dollar panel reached 0.04 percentage point, its highest level since the financial crisis began in August. If sustained, that would represent an added $2.8 billion in annual interest costs on some $6.9 trillion in U.S. corporate and subprime-mortgage debt tied to Libor. It has since fallen, but analysts said it ultimately could increase to 0.10 percentage point as European banks' difficulties become fully reflected in their Libor quotes. Analysts attribute the sharper rise in European banks' borrowing rates to the fact that they're scrambling for dollars to pay off dollar-denominated debts. Pressure is particularly acute in Europe in part because it lacks analogs to such U.S. institutions as Fannie Mae, Freddie Mac and the Federal Home Loan Banks, which provide U.S. banks with access to additional funding.

Chian Cut Short Term Foreign Currency Loans to Reduce Hot Money

China ordered foreign and localbanks to rein in overseas borrowings in a bid to curbspeculative capital inflows, a document obtained by BloombergNews showed. Overseas loans with a maturity of less than a year will belimited to $12.7 billion by June for 23 foreign banks and to $8billion for 19 local banks, the State Administration of ForeignExchange, or SAFE, document showed. That's a reduction of 15percent for global lenders from the March-end levels, and 5percent for domestic lenders, said Xu Hanfei, an analyst atIndustrial Bank Co. in Shanghai. The new quotas are validthrough March 31, 2009. China's foreign-exchange reserves rose to a record $1.68trillion at the end of March, the central bank said on April 11,fueling concerns that inflows of speculative capital will hamperthe government's efforts to damp inflation close to the fastestin 11 years. ``Growth in foreign-exchange lending exceeded that of yuanloans from last year,'' said Li Huiyong, a foreign-exchange analyst at Shenyin Wanguo Research and Consulting Co. inShanghai. ``Short-term lending is one of the channels forinflows of so-called hot-money.'' A SAFE official said he was aware of the document, butwouldn't make further comments. Premier Wen Jiabao said last month that the government'stop priorities this year are curbing inflation and preventingeconomic overheating. The central bank has ordered lenders toset aside larger reserves three times this year, following sixinterest-rate increases in 2007. Inflation surged to 8.3 percentin March, little changed from 8.7 percent in March. ``Investors borrow dollars from banks and convert them intothe Chinese yuan,'' said Wang Qian, economist at JPMorgan Chase& Co. in Hong Kong. ``Even a simple deposit of the currencywould give them a nice return on investment.'' SAFE said in March last year that it would cut local banks'short-term foreign debt quotas to 30 percent of their 2006levels by March 2008 to stem foreign-currency inflows. Overseasfinancial institutions' short-term foreign debt quotas were cut``by a relatively small margin'' because of their limitedfunding sources, it said then, without giving details. Outstanding foreign-currency loans surged 56.9 percent froma year earlier to $268.8 billion at the end of March, accordingto central bank data. Outstanding short-term debt increased19.85 percent to $220 billion at the end of 2007 from a yearearlier, accounting for 58.9 percent of the total foreign debt, according to government data.

Japan Banks Return to Global Stage After A Decode and A Half of Retrenchment

Japan's big banks are quietly expanding their lending business in the global market as many U.S. and European banks, facing mounting losses from the credit crisis, begin to tighten their spigots. Thanks to their conservative styles adopted after their long struggle with bad loans in the 1990s and the early part of this decade, Japanese banks such as Mitsubishi UFJ Financial Group Inc., known as MUFG, and Sumitomo Mitsui Financial Group Inc., known as SMFG, have posted relatively narrow losses from securities affected by the U.S. mortgage problems. Now the banks, armed with huge assets gathered from Japanese savers, are turning this situation into an opportunity to become powerful suppliers of loans to fund costly acquisitions and infrastructure projects around the world. At Bank of Tokyo-Mitsubishi UFJ Ltd., the primary banking unit of MUFG, Japan's largest bank by both assets and market value, the balance of overseas lending jumped by roughly 20% in the last quarter of 2007 to 12 trillion yen, or about $115 billion, and has continued to grow this year. In March, it and Mizuho Financial Group Inc. were among the eight arrangers for a $3 billion loan taken out by India's Tata Motors Ltd. to pay for its acquisition of Ford Motor Co.'s Jaguar and Land Rover brands, according to people familiar with the deal. While MUFG and other Japanese banks are still far behind their Western peers in areas like investment banking, their growing presence in the loan market marks an important step forward as these banks slowly try to return to the global stage after a decade and a half of retrenchment. During Japan's asset boom in 1980s, these banks stirred fear among their Western rivals with splashy deals such as the acquisition of Union Bank of California by one of the predecessor banks of MUFG, and the purchase of a major stake in Goldman Sachs Group by one of SMFG's predecessors. But they were forced to spend the 1990s and the early part of this decade coping with their domestic bad-loan problems. During the past few years, the big banks have regained their financial health and seen their earnings grow. Yet their focus has been building domestic businesses in areas like wealth management and credit cards. The market turmoil has given Japanese banks a sudden edge in the world's loan market. While subprime-related losses forced big Western banks such as Citigroup and UBS AG to shrink their operations and raise money to mend their depleted capital basis, Japanese banks have remained awash with funds thanks to the nation's investors, many of whom prefer keeping money in bank deposits, rather than investing in stocks or bonds.

Fed need give more leeway to PE to bail out banks

In the case of National City, this was accomplished in ways that would have been virtually impossible during the savings-and-loan crisis of the late 1980s and early 1990s. Not only were private-equity funds such as Kohlberg Kravis Roberts and Warburg Pincus examining the books, but hedge funds and mutual funds were "brought over the wall" and given access to National City's confidential records. Once "wallcrossed" as they say on Wall Street, these potential buyers were able to move very quickly to shore up National City's gaping capital hole. Would this breadth and speed been available in the last crisis? Absolutely not, say people involved in the NatCity deal. In these unsettling months of crisis, that should be some reason for hope. It shouldn't be blind hope. There's no guarantee that the capital will be there for the next round of infusions. Here the government might make a difference. The first step would be to give private-equity firms more leeway in exerting control over a bank investment. Today they're largely limited to 9.9% stakes. The second would be a more controversial change of the accounting rules for bank acquisitions. When a bank acquires another, it has to take an immediate write-down on the value of bad loans, as opposed to writing them down over time. That rule means that healthy banks acquiring bad banks have to come up with a huge chunk of new capital. That was the primary reason why the likes of KeyCorp and Fifth Third Bancorp steered way clear of National City last week. It was also why banks were begging the Fed for a backstop on National City's bad loans. Luckily, the Fed's mettle wasn't tested. But eventually it will be. And when it is, take comfort in an old European saying that has already been proven: Planned disasters never happen.

Private Equity Snapp up Ailing Banks

Cleveland-based National City Corp.'s announcement Monday that it is getting $7 billion in capital to shore up its balance sheet is the latest sign that private-equity firms think there is big money to be made by investing in banks pummeled by bad loans and the economy. Private-equity firms raised about $550 billion of capital in 2007, adding roughly $150 billion more in the first quarter of 2008, according to data provider Private Equity Intelligence Ltd. The biggest firms have raised staggering amounts of capital, with KKR recently closing on a $17.6 billion fund and Blackstone amassing a $21.7 billion fund last year. Snapping up stakes in ailing banks represents a shift away from the big deals of recent years in which private-equity firms dominated the merger boom with a string of blockbusters. The credit crunch has shut down financing markets for leveraged buyouts, leaving the funds flush with cash. The recent bank deals are different than the traditional deals that private-equity firms typically hunt down. For example, private-equity players are minority shareholders in the banks, potentially limiting the sway that they can hold over management and strategic direction. The reason: Regulators don't permit nonbank investors to take a voting stake of greater than 9.9% in a bank. In most LBOs, private-equity firms buy the entire company, load it up with debt, and slash costs before taking it public or selling it to other investors. At smaller banks, private-equity firms are likely to increasingly use "special purpose acquisition companies" -- or SPACs -- to invest, says Gerard Comizio, a partner at law firm Paul Hastings Janofsky & Walker LLP. These so-called "blank check companies" raise money from public investors and then are free to use those funds to buy companies. There are 71 SPACs in the market for deals, and many are eyeing banks and other financial institutions, says Melissa Roberts, a vice president of quantitative research at Keefe, Bruyette & Woods.

Bank of America Q1 08

Overall --earnings declined to $1.21 billion from $5.26 billion a year earlier --The primary factors reducing first-quarter earnings were the following: • Provision expense increased by $4.78 billion from a year-ago, to $6.01 billion due to rising credit costs – particularly in the home equity, small business and homebuilder portfolios – including a $3.30 billion increase to the reserve. • Trading-related losses were $1.31 billion compared with income of $1.66 billion a year earlier, driven primarily by $1.47 billion in writedowns of collateralized debt obligations (CDOs) and $439 million in writedowns of leveraged loans. Trading-related losses were $5.15 billion in the fourth quarter of 2007, which included CDO-related writedowns of $5.28 billion. Credit --net charge off 2.7 bil (1.25% of avg loan), 1.4 bil (0.81%) Q1 07 (Q4 07 national net charge off 0.83%) --allowance 14.9 bil(1.71 of total loan), 8.7 bil (1.2%) (1.29 Q4 07 national) --> conservative allowance --non performing 7.8 bil (0.9% of loan) (1.4 Q4 07 national) -> lower than national, relative higher quality loans --Tier 1 capital 7.51%, 8.57% Q1 07

provision vs net charge offs

http://www.fool.com/investing/beginning/2007/04/09/whats-the-deal-with-bank-reserves.aspx Loan loss provisions When a bank makes 1,000 loans during the quarter, it knows from experience that, say, 1% of those loans will go bad. It doesn't know which ones will go bad -- it just knows from statistical experience that 10 of those loans will not be repaid, or will become slow-paying loans. Rather than waiting for the credit loss to occur, a bank uses its best judgment to account for those losses through the provision for loan losses, a non-cash charge to earnings. Here's a simplified income statement for Ohio-based KeyCorp (NYSE: KEY), highlighting the provision for loan losses. KeyCorp FY 2006 Net Interest Income 2,815 Provision for Loan Losses (150) Noninterest Income 2,127 Noninterest Expense (3,149) Earnings Before Taxes 1,643 Numbers in millions of dollars. Again, the $150 million loan loss provision is not a cash expense. Instead, that $150 million charge builds the loan loss reserve on the balance sheet. The reserve provides a cushion if and when customers don't repay their loans. Without this cushion, there's a chance the bank could be caught with little or no capital. Think of the reserve as a bucket of water that should stay full. Water leaks out of the bucket when the bank abandons hope of collecting on a loan (called a charge-off). Every charge-off causes the reserve to shrink. If this reserve gets too low, the bank replenishes the reserve with the provision for loan losses. Over time, provisions for loan losses should be about equal to charge-offs, ensuring that the reserve doesn't get too low. The bank can also recover previously charged-off loans, which adds to the reserve. On the way out of a recession, a bank can frequently lessen its loan loss provision on the income statement because recoveries of charged-off loans build up the loan loss reserve. Putting it all together The important things to remember are that the provision for loan losses builds the reserve, and charge-offs deplete the reserve. For example, KeyCorp's reserve fell in 2006, as net charge-offs outpaced the provision for loan losses: KeyCorp FY 2006 Reserve at beginning of year 966 Net charge-offs (170) Provision for loan losses 147 Reserve at end of year 943

Regional Banks Begin Paying Prices for Their Boomtime Expansion

Concentrating on auto loans, Sovereign offered some of the best terms around to car buyers in Arizona and eight other states far from Sovereign's home branches. "They came on like a tidal wave," says Steve Dancy, finance director at Mel Clayton Ford here. "It was a car dealer's dream." Now, two years after its expansion push, Sovereign has quit making auto loans outside the Northeast because too many borrowers fell behind on their bills. Losses on the bank's loans ballooned. In January, to conserve cash as it wrote off more bad loans, Sovereign eliminated dividend payments. On Tuesday, the bank is expected to announce a 40% drop in first-quarter earnings. Similar troubles are echoing through small and midsize banks across the U.S. In a bid to expand during the recent boom, many set up operations in unfamiliar markets or started pitching new products. Others, aiming to stave off encroachment by huge U.S. financial institutions, boosted their lending by offering easy terms or lower rates. Now the slowing economy is exposing bad timing and blunders. Big U.S. banks have received the lion's share of attention since the crisis began, due to their exposure to housing-related woes. But there's a growing sense that there's another shoe to drop: losses at smaller banks. Regional and local institutions mostly dodged the initial wave of troubles because many weren't exposed to the complex mortgage-backed securities that slammed the behemoths. As housing prices continue to erode and the economy weakens, they're taking their lumps now, too. Overall, profits at the 8,533 banks backed by the Federal Deposit Insurance Corp. dropped 84% to $5.8 billion in the fourth quarter, a 16-year low. Fewer than half of all banks posted a rise in net income for the full year. That hadn't happened since at least 1984, according to the FDIC. Despite the glum outlook, few analysts are predicting a repeat of the savings-and-loan crisis of the late 1980s and early 1990s, which led to the failure of more than 1,000 U.S. banks and cost taxpayers about $130 billion. Many of today's problems are occurring at small banks: The average asset size of the 76 financial institutions on the FDIC's "problem list" of banks getting extra regulatory scrutiny was $292 million as of Dec. 31. By comparison, Bank of America Corp., the largest U.S. bank, has $1.72 trillion in assets. Bank of America reports earnings Monday. Though delinquencies and losses have risen in many types of loans, both remain below peak levels. About 1.4% of all loans were between 30 and 90 days delinquent at the end of last year. That's the highest level since 1992 but still below 1990 and 1991, when more than 2% were delinquent, according to the FDIC. As a result, Sovereign now has 750 branches in eight states, with nearly $85 billion in assets. Its market value of about $4.4 billion is slight compared with Bank of America's $169 billion. The core of its business is traditional banking operations -- taking deposits, making loans to small businesses and pitching mortgages. Sovereign extended its best rates to buyers with credit scores above 700, say people familiar with the bank's strategy, while other banks typically started at scores of 730. (Credit scores generally range from 300 to 900.) Dealers also pitched Sovereign loans at 9% interest to some buyers with 620 credit scores; other banks would typically offer 14% rates to customers with scores of around 640, turning down those with anything lower. By the summer of 2007, Mr. Dancy says he was lining up more than 100 borrowers a month with Sovereign, compared with 40 apiece with the area's traditional lenders. "Sovereign absolutely was the lowest in terms of rates and terms," says Mr. Dancy. "I'm going to do whatever it takes to move my inventory." By year's end, Sovereign's auto-loan portfolio had grown to $7 billion, up from $4.9 billion in 2006, a rising share of its $57.8 billion in consumer and commercial loans. New markets accounted for more than half of the bank's new auto loans, as well as a majority of its losses on them. The bank wrote off $76.2 million in charges for auto loans, more than double its write-offs in 2006.

China Battles Image Woes

-- The protests and mutual recriminations between China and its foreign critics -- highlighted by more anti-Western demonstrations this weekend -- are exposing a stark disconnect between how China views itself and how many people abroad view China. Misunderstandings have multiplied as the opposing sides seem to consistently talk past each other. Foreign critics are focusing on issues, such as Beijing's policies in Tibet, that many Chinese feel ignore decades of broader economic and social progress in their country. Chinese students and citizens chant slogans and hold up banners, calling for boycotting French Carrefour supermarket in Xi'an, northwest China's Shaanxi province on Sunday. Condemnation of Chinese government policies is being received in China as attacking the nation as a whole, arousing widespread public resentment. The most vocal responses are then seen with alarm overseas as government-sanctioned nationalism run amok, further reinforcing negative images of China. Over the weekend, there were demonstrations against French retailer Carrefour SA involving thousands of people in several cities across China. They were part of a broader push for a boycott of the retailer, one of France's biggest investors in China, as punishment for the chaos of the Olympic torch relay in Paris, and for the purported support of the Dalai Lama -- widely vilified in China -- by one of the Paris company's shareholders. Carrefour has said it has no ties with the Tibetan spiritual leader, and pointed out that the vast majority of its products and employees in the country are Chinese. Many Chinese expected this summer's Olympics in Beijing to make 2008 a year for celebrating their country's re-entry to the international community, and its rising global status from three decades of economic and political reforms. The international furor instead is feeding a deepening disappointment. "Many Westerners still see China like the Stalinist-era Soviet Union. But most of them have never been here...today China is different," says Pu Chengchuan, a 21-year-old college senior in Beijing. He says China's human-rights records isn't perfect, but "it's a lot better than it used to be." Mr. Pu says he has hoped that the Olympics would "let the world understand China better," but now worries that "critics of China are going to use the Olympics for their own purposes." Some Western businesspeople fear that the divide could continue to widen, leading to tension within multinationals' operations or broader action against foreign companies that operate in China. "Foreign companies are indeed concerned and especially those companies that are highly visible in and outside of China," said James Zimmerman, chairman of the American Chamber of Commerce in China. Mr. Zimmerman urged "open and respectful dialogue" about the issues in dispute, but said "there are challenges to getting people with different points of view to sit down and talk." The backlash against foreign critics has also targeted Western media for alleged bias in their coverage of deadly antigovernment riots in the Tibetan capital of Lhasa last month and the resulting crackdown by Beijing. Over the weekend, Chinese students protested media bias in front of the German parliament in Berlin and thousands protested outside the Los Angeles offices of Time Warner Inc.-owned Cable News Network. China's government appears worried. The ruling Communist Party walks a fine line in handling outbursts of nationalism. As the self-appointed champion of national unity, it embraces, up to a point, popular expressions of nationalism -- but also fears that, unchecked, they could derail economic growth and ruffle foreign relations. In recent days, official commentary has urged citizens to apply their patriotic fervor in their daily work, and a front-page commentary Sunday in the People's Daily, the Communist Party mouthpiece, urged the "rational expression" of patriotism. In recent months, China has faced devastating winter storms, a plunging stock market and consumer-price inflation at 12-year highs. The criticism of China has only added to the frustrations. "Obviously, there is a cabal, a cold war against China!" proclaims a homemade video circulating on the Internet in recent days. China's government has seemed often unaware of how it is perceived abroad -- and often appeared far less capable than its opponents at getting its message across. "The recent events made me realize there is a huge information gap about China in this country," China's ambassador to the U.K., Fu Ying, said in a speech in London last week. Within China, the sense of injury from foreign critics is compounded by an education system that instills a deep sense of suspicion that Western powers are bent on weakening and dividing China, as they did in the 19th century. Protests advocating Tibetan independence mystify most Chinese, who have been taught all their lives that Tibet has long been part of China. And the deeply emotional Chinese response to the Tibet protests has also surprised some Westerners. "American people feel that freedom and self-expression are very important. Chinese people feel that national unity is very important," says Wang Jianshuo, 30 years old, who works for an Internet company in Shanghai and writes a blog in English and Chinese. "There is a big gap between the West and China on which values are more important. It's not right or wrong, it's just different." Many Chinese who are critical of their own government also feel Western condemnations of China fail to acknowledge its advances in recent decades, from lifting hundreds of millions of people out of poverty to expanding the freedoms -- albeit still limited -- that Chinese enjoy. Western critics "think China is still very closed and that Chinese people are under one-party control and [therefore] have no human rights," says Guan Xiao, a 52-year-old Beijing resident. Mr. Pu, the Beijing physics student, says his own background illustrates some of the progress China has experienced. Born in a poor farming village in China's northeast, he now attends one of China's top universities. Thanks to the Internet, he says, he and his classmates have access to a broad array of information, including some Western media. People like Mr. Pu and Mr. Wang, the Shanghai blogger, feel that China doesn't often get credit in the Western media for its recent progress. "When we were silent, you said you want us to have free speech. When we were silent no more, you say we were brainwashed xenophobics," reads an anonymous Internet posting now circulating among Chinese working in foreign companies, in Chinese, English and French. "What do you really want from us?" Often, Western critics and their Chinese respondents seem to be seeing entirely different things in the same events. Western accounts of the fracas surrounding the Olympic torch relay tend to emphasize the demands of pro-Tibet protesters, and have pointed to accusations of heavy-handedness by the blue-and-white-clad Chinese security guards accompanying the torch. For Chinese, the image that lingers from the Paris protests is of a slight, wheelchair-bound woman clasping the Olympic torch to her body as a man wearing a Tibetan-flag bandana tries to pull it away from her. Since then, the woman, a 28-year-old fencer named Jin Jing, has become a household name and media star, an icon for those who see China as a nation beset by unfair attacks. Looking for outlets for their anger at western critics, many Chinese are conflicted about the growing calls for boycotts and protests, but say such actions are the only way frustrated Chinese can get their message across. "The only thing we can do is to warn them and to give vent to our anger through their representatives in China, like with the boycott of Carrefour or French companies," says Ma Fei, 37, a businessman in the southern city of Shenzhen. Foreigners, he says, "especially those who don't live in China, just cannot understand how much the Olympics means to the Chinese people."

Slowdown of economy is taking toll on VC business

Venture capital funding dropped more steeply in New England than the nation as a whole in the first three months of 2008, as the slowing economy began taking a toll on entrepreneurial companies, according to the MoneyTree first-quarter report being released today. In the six-state region, the second-largest US venture hub after Silicon Valley, investments fell 24.1 percent to $721.4 million in the January-to-March period from $951.1 million in the prior quarter. It was the smallest outlay in New England since the second quarter of 2006. Nationally, venture outlays dropped 8.5 percent to $7.1 billion in the three months ending March 31 from the $7.8 billion invested in the previous quarter. First-quarter US investment totals were the smallest since the fourth quarter of 2006, according to the report prepared by the Thomson Reuters research house and the PricewaterhouseCoopers accounting firm for the National Venture Capital Association. "We see from early-stage investments that the economic slowdown has had an impact," said Nina Saberi, managing general partner for Castile Ventures, a Waltham venture capital firm. She cited an inhospitable climate for initial public offerings and a tougher market for acquisitions, two routes for cashing out of investments. But the outlays, while lower, remained in line with the $7 billion-plus level seen in each of the past five quarters as venture capitalists put money to work funding innovative companies. At least some of the decline appeared to be seasonal. Investment totals are typically lowest in the first quarter and highest in the second and fourth quarters, said John S. Taylor, vice president of research at the venture association. "Venture capitalists are still investing in new projects now, though with a sense of caution," Taylor said. Still, the trend was clearly downward. There were 922 financing deals in the quarter nationally, down from 1,045 in the fourth quarter of last year. There were 108 deals in New England, down from 118. Eleven of the 16 industry sectors tracked in the MoneyTree report drew fewer dollars, and 14 of the 16 saw fewer funding deals. Biotechnology attracted more venture money than any other sector in the first quarter, with $1.27 billion flowing into 126 deals. A close second was computer software, with $1.26 billion funding 234 deals. But outlays for both sectors, along with industrial and energy, clean technology, and Internet-specific investments, all tumbled from fourth-quarter levels. Two sectors that drew higher venture outlays in the first quarter were semiconductors and medical equipment. Funding for early- and late-stage companies declined in the first quarter, though funding rose for expansion-stage companies. James E. Thomas, partner at Thomas, McNerney Partners, a Stamford, Conn., venture firm focusing on healthcare and medical technologies, said venture capitalists are resigned to managing their portfolio companies more conservatively and for longer periods before they can "exit" by going public or selling to larger companies. He also warned of a regulatory environment that "is uncertain and frankly trending toward more regulation rather than less regulation," potentially souring the outlook for healthcare and medical start-ups. But with many venture firms still sitting on large pools of cash from limited partners such as pension funds and university endowments, this may simply be a period when investors are being more patient and selective, suggested Kevin Shaw, partner in charge of the Cambridge entrepreneurial services center for PricewaterhouseCoopers. "Given the economy we're in now, these are still pretty good results," Shaw said. "Venture capital firms know they have to stay in the game longer. So the investments today might be a little more conservative and selective, but they're not falling off a cliff."