Signs of the Economic Apocalypse, 12-10-07

From Signs of the Times:



Gold closed at 800.20 dollars an ounce Friday, up 1.4% from $789.10 at the close of the previous week. The dollar closed at 0.6822 euros Friday, down 0.2% from 0.6834 at the close of the previous Friday. That put the euro at 1.4658 dollars compared to 1.4633 the Friday before. Gold in euros would be 545.91 euros an ounce, up 1.2% from 539.26 for the week. Oil closed at 88.28 dollars a barrel Friday, down 0.5% from $88.71 at the close of the week before. Oil in euros would be 60.23 euros a barrel, down 0.6% from 60.62 for the week. The gold/oil ratio closed at 9.06 Friday, up 1.8% from 8.90 at the end of the week before. In U.S. stocks, the Dow closed at 13,625.58 Friday, up 1.9% from 13,371.72 for the week. The NASDAQ closed at 2,706.16 Friday, up 1.7% from 2,660.96 at the close of the week before. In U.S. interest rates, the yield on the ten-year U.S. Treasury note closed at 4.11%, up 17 basis points from 3.94 for the week.

No big movements in the markets last week. The unveiling of Bush’s plan to prevent housing foreclosures in the United States helped to counteract downward pressures on stocks. The surprise leak early last Monday of the National Intelligence Estimate (NIE) which stated that Iran’s nuclear weapons programs were disbanded in 2003 gave hope that the United States will resist pressure from Israel to attack Iran. That helped keep oil prices below their recent highs

U.S. Stocks Rise for 2nd Week on Bush Plan to Avert Recession

Elizabeth Stanton

Dec. 8 (Bloomberg) -- U.S. stocks posted their steepest two- week advance since September after President George W. Bush announced a plan to freeze some mortgage rates to prevent foreclosures from causing a recession.

Centex Corp. and D.R. Horton Inc. led homebuilders as they climbed the most in seven years. Intel Corp., Micron Technology Inc. and other semiconductor companies in the Standard & Poor's 500 Index rose the most since June following analyst predictions that demand for computers will increase. All 10 industries in the S&P 500 gained.

Stocks have rebounded after losing their 2007 gain at the end of last month, spurred by speculation the Federal Reserve will reduce interest rates to prop up the world's largest economy. The S&P 500 declined yesterday after a Labor Department report showed U.S. employers added more jobs than estimated in November, diminishing the odds that central bankers will cut their rate benchmark by half a point on Dec. 11.

“The economy is slowing, but it’s not falling off a cliff,” Jeremy Siegel, an economics professor at the University of Pennsylvania’s Wharton School of Business, said during an interview in New York. “That’s important for investors.”

The S&P 500 added 1.6 percent to 1,504.66, bringing its two- week gain to 4.4 percent and its advance this year to 6.1 percent. The Dow Jones Industrial Average rose 1.9 percent to 13,625.58. The Nasdaq Composite Index climbed 1.7 percent to 2,706.16.

Quarter-Point Cut

Ten-year Treasury yields had the first weekly gain since October, rising to 4.11 percent, as traders pared bets that the Fed will reduce its rate benchmark by more than a quarter point. Two-year yields rose to 3.10 percent.

Homebuilders in the S&P 500, which fell as much as 78 percent from their July 2005 peak through Nov. 27, added 17 percent for the steepest weekly advance since August 2000. Centex gained the most, climbing 24 percent to $25.81. D.R. Horton rose 16 percent to $13.86.

Bush announced on Dec. 6 an agreement between the government and the lending industry that would freeze rates for five years on some variable rate mortgages and provide assistance to as many as 1.2 million homeowners.

The government’s plan may help end the recession in the U.S. housing market, which is entering its third year. The number of Americans behind on their mortgage payments in the third quarter was the highest in 20 years, the Mortgage Bankers Association said Dec. 6.

‘Muddle Through’

“The economy will muddle through without tipping into recession,” said Joshua Feinman, chief economist in New York at Deutsche Asset Management, which oversees $798 billion. Growth will accelerate during the second half of next year, he said.

Intel gained the most in the Dow average, climbing 6.3 percent to $27.73. Thomas Weisel Partners LLC analyst Kevin Cassidy raised his rating on the world’s largest chipmaker to “overweight” and increased his 2008 profit estimate in part because of growing demand for computers from Brazil, Russia, India and China…

Payrolls rose by 94,000 in November, the Labor Department said yesterday. The jobless rate remained at 4.7 percent for the third month in a row. Economists predicted a gain of 80,000 jobs and an unemployment rate of 4.8 percent, according to the median estimates in a Bloomberg survey.

Sales at U.S. retailers probably rose in November as discounts and wage gains helped Americans cope with near-record fuel costs, economists said before reports this week.

“The economy from a numbers standpoint is stronger than what people’s perceptions are,” said Scott Fullman, director of investment strategy at Israel A. Englander & Co. in New York, a derivatives brokerage firm for institutional clients with combined assets under management of more than $100 billion…

Is the economy really stronger than people’s perceptions? Will the United States economy really avoid recession in 2008? Probably not. A recession is probably the best that can be expected. No doubt statistics, such as the recently released “better than forecast” employment numbers in the United States, have been massaged to make us feel better. But perception management can only go so far in masking reality.

The economy's last hurrah before that big sucking sound

Richard Benson

December 7, 2007

As 2007 wounds down, it’s time to reflect on how bogus government statistics along with Wall Street media hype have impacted the psychology and perception in the financial markets. Sheer disappointment is one way to describe what the financial markets will experience as the existing belief in a Goldilocks economy is challenged by sobering facts and a hard landing, yet to come.

Christmas is meant to be a festive and happy time of year spent with family and friends, but there is a dark side to this year’s holiday. The picture of the father, mother, son, or daughter pulling out the only credit card left that’s not maxed out in order to buy that special gift for a loved one, is not the face you’ll see portrayed in the media. The TV and newspapers show only affluent-looking preppy-faced Americans wearing pricey Italian shoes and sunglasses, shopping the malls and luxury stores for 50-inch flat screen TV’s, cashmere sweaters, Tiffany diamond rings and fancy chocolates. The media will avoid at all costs the large percentage of Americans on the brink of bankruptcy and foreclosure, living paycheck to paycheck, because there’s nothing Christmassy about that picture.

I have to wonder, though, if Americans are really shopping (i.e., spending money), or just looking for bargains at the major department stores that began running fire sales as early as October. Foreigners will undoubtedly be the luckiest group this season as they take full advantage of the declining dollar. Contrary to what you may have read in the American financial press about the declining dollar being good for America, you’ll read a different viewpoint in the foreign press, as many people overseas think America is getting what it deserves: a real comeuppance, as the dollar and our empire literally go down the tubes.

The US Economy is in terrible shape! Our government has been psychologically manipulating the American people every time they publish blatantly false data on employment and income that makes our economy look stronger than it really is. If the average American realized how bad things were, they might try to save more. But spending would collapse if they did, so the goal of the Bush Administration seems to be to hide any signs of a recession as long as possible.

If you don’t see it, it must not be there

For those familiar with the government releases, the Bureau of Labor Statistics ("BLS") just posted a benchmark data revision that showed the total number of workers employed on the payroll survey was 300,000 less than originally estimated for March 2007 (900,000 versus the 1,200,000 that was reported). By the time the dust settles, and later benchmark revisions come in for the whole year, it is likely that all of the jobs added by the BLS Birth/Death Model in 2007 will be fictitious. This could mean there hasn’t been any job growth at all! Without the fiction of job growth, you can imagine how much worse it will be for consumer income, spending, and sentiment not to mention business investment plans.

The reason employment is weak is because at least 40 percent of all job growth was tied directly or indirectly to housing. With housing in free fall, the solid job growth reported by the BLS Payroll Survey simply does not make sense.

The Department of Commerce keeps statistical estimates such as Personal Income, which is based on the estimated number of workers in the BLS Payroll Survey. So now, based on the revisions to the BLS Payroll Survey for March (and other data), revised Personal Income (wages, salaries, interest income, etc.) grew at an annual rate of only 1.6 percent in the second quarter of 2007, not the 4.5 percent originally reported. That’s three percent less in Personal Income. These imaginary workers with no Personal Income will not be shopping this December or anytime soon, so we can expect to see lower retail sales and corporate profits. Income never made, can't be spent.

As these pretend workers turn out to be a myth, they will eventually show up in the government statistics. When that happens, corporate sales will suffer and the financial markets will take notice. This is also a reminder that for statistics, the government's game is to report the false glowing numbers to the financial markets in the full light of day, and then report the corrections and horrible truth in the dead of night, and hope no one notices.

The big reason the economy is going over the cliff is not the direct result of the sub-prime mortgage debacle and the hundreds of billions in investor dollars that have been lost, although this is a major contributing factor. The reason, we focus on, is that the economy is already in recession as a direct result of homeowners having had that ATM ripped out of their house. Stories like the homeowner who purchased a home for $100,000 years ago but got carried away in the frenzy of the last decade by doing 4 cash out REFI’s, running their mortgage balance up to $625,000 while living large, are last year’s stories. That $800 billion a year in Mortgage Equity Withdrawal ("MEW") has come to a sudden end and with the average homeowner no longer living large off the house, the economy is left with that "big sucking sound".

With home prices falling, there frequently is no equity to take out! Potential borrowers don't have verifiable income to actually pay back a loan unless home prices are rising rapidly, so they can no longer buy or refinance. Meanwhile, with lenders asking for down payments, housing prices will just keep heading down for another year.

The US economy is continuing to weaken in many areas: The US Treasury has received lower income tax receipts forcing state and local governments to cut back because they’re coming up short; capital gains on home sales are falling as home prices fall; property tax receipts are also declining as assessed values go down; weak retail sales mean lower sales tax receipts; corporate profits are down, along with corporate taxes paid; and, many self-employed workers may be employed, but they’re not making anything or only half of what they used to.

Moreover, America is not the only country with an economic problem. The housing bubble is turning out to be worldwide, with a major impact on England and much of Europe. The biggest economic losers include the emerging markets, especially China. Don't believe for one second those Wall Street touts selling the notion that the emerging markets have "decoupled" from the US economy and their growth will lead the world forward without the American consumer. That’s hogwash. Where do you think their trade surpluses and big sales gains (driving investment in plants and equipment) came from anyway? From the American consumer and MEW! Take $800 billion of easy spending away from the American consumer and you're going to see a lot of blow back in lost sales by the emerging market countries, including China.

As the recession takes hold, I see this holiday shopping hype as the Economy’s Last Hurrah, but it’s not just the American economy that’s going to hear that "big sucking sound" in the New Year!

As Benson wrote above, it’s hard to imagine that a sharp downturn in the U.S. economy wouldn’t send the rest of the world into a recession as well. That has been made clear in the past few months when the world got a glimpse of how many non-U.S. banks were infected with U.S. subprime loans. But that effect will pale before what happens when the U.S. consumer runs out of money (credit).

‘Decoupling’ Debunked as U.S. Collapse Infects World

Simon Kennedy

Dec. 7 (Bloomberg) -- It turns out the U.S. economy matters after all.

The credit collapse and dollar decline that followed a surge in U.S. home foreclosures jeopardize expansions in the U.K., Canada and Germany, economists said. They also debunk “decoupling,” an argument advanced by analysts at Goldman Sachs Group Inc. and Morgan Stanley that the world wouldn’t suffer as it did during U.S. slowdowns in previous decades.

The Bank of England and Bank of Canada this week followed the Federal Reserve in cutting interest rates, and the European Central Bank lowered its growth forecast for next year. British policy makers reduced their benchmark rate yesterday, even after Governor Mervyn King expressed concern about inflation just two weeks earlier.

“Two thousand and eight will be the year of ‘recoupling’,” said Peter Berezin, an economist at Goldman in New York, explaining his firm’s about-face. “What began as a U.S.-specific shock is morphing into a global shock.”

Of the 38 countries they monitor, Goldman economists expect growth to slacken in 26 and strengthen in a dozen. That will cause global growth to slow to 4 percent next year from 4.7 percent this year, with Europe and Japan fading faster than the U.S., they say.

“There are a lot of risks out there,” Goldman Chief Economist Jim O’Neill said in an interview today.

Market lending rates have risen worldwide in the last three weeks as $70 billion of writedowns linked to defaults on U.S. subprime mortgages fanned international concern about the strength of financial institutions.

Roach Skeptical

Decoupling is “a good story, but it’s not going to work going forward,” Stephen Roach, chairman of Morgan Stanley in Asia, said in an interview in New Delhi on Dec. 2. His colleague, Stephen Jen, said in a report the previous week that because the possibility of a U.S. recession has increased, so has the chance that the rest of the world will falter.

Higher market rates pushed up the cost of lending everywhere, making it costlier for companies and consumers to fund new spending or investment. The cost of borrowing euros for three months, for example, this week rose to a seven-year high.

“Initially the impact of the subprime crisis was on the U.S. directly, but what we’re seeing now is a more insidious paralysis of credit conditions moving across different markets and economies,” said Brian Hilliard, director of economic research at Societe Generale SA in London.

Threat to Airbus

The dollar’s decline in sympathy with its economy is also exacting a price overseas. Airbus SAS may cut its 2 billion-euro ($3 billion) research budget to trim costs as the dollar’s dive becomes “life threatening” for the world’s largest planemaker, Chief Executive Officer Tom Enders said Nov. 23.

At the same time, U.S. consumers are starting to retrench in the face of declining home values and rising energy bills as oil prices near $100 a barrel. The Conference Board’s index of consumer confidence decreased last month to the lowest since the aftermath of Hurricane Katrina in 2005.

Wolseley Plc of the U.K., the world’s biggest distributor of plumbing and heating equipment, said Nov. 28 that first- quarter pretax profit through October fell almost 15 percent after U.S. revenue declined 10 percent.

“The American consumer is the big gorilla on the demand side of the global economy,” Roach said. “As the slowdown goes from housing to consumption, we’ll find the world is not as decoupled as it thinks.”

U.K. Cut

U.K. monetary policy makers yesterday cut their key rate for the first time in two years to 5.5 percent, pointing to deteriorating financial markets. In August, King said he was optimistic the turmoil wouldn’t hobble his economy.
The Bank of Canada identified “global financial market difficulties” as it lowered its main rate by a quarter point to 4.25 percent on Dec. 5.

While the European Central Bank is signaling no intention of cutting interest rates soon, Bank of France Governor Christian Noyer said Dec. 4 that there is now a “question mark” over his view of September that Europe would remain unscathed from the market rout.

Tai Hui, head of Southeast Asian economic research at Standard Chartered Bank Plc in Singapore, also doubts Asia’s economies can weather a collapse in U.S. consumer demand, with Hong Kong, Taiwan, Malaysia and Singapore at particular risk from reduced exports.

‘Need to See’

Bank of Japan Governor Toshihiko Fukui said this week that “we need to see how the U.S. consumer is affected” as he holds his key rate at 0.5 percent, the lowest among industrialized nations. Waning U.S. demand meant the Japanese economy grew an annualized 1.5 percent in the third quarter, almost half the preliminary estimate, the Cabinet Office said in Tokyo today.

On the other hand, Alex Patelis, head of international economics at Merrill Lynch & Co., is confident “the time has not yet come to call the end of this global upturn,” citing demand in emerging markets such as China and Russia.

Patelis predicts the world economy will grow 4.7 percent next year and 5.6 percent if the U.S. is excluded.

John Llewellyn, a senior economic policy adviser at Lehman Brothers Holdings Inc. in London, is unconvinced, arguing that if U.S. consumers buckle, so will growth elsewhere.

“Decoupling is a lovely idea, but I’ll only believe it when I see it,” he said.

China has the most at stake in whether or not the world economy can “decouple” from the U.S. But China itself is itself hiding huge amounts of bad debt.

The coming China crash

Martin Hutchinson

December 3, 2007

While the Chinese stock market, as measured by the China Securities Index 300, is down 18% since October 16, that follows a period of almost two years during which the CSI 300 had soared 535% since January 1, 2006. Chinese economic growth is currently running at over 11% and the big money is convinced that it will continue, while the country’s foreign exchange reserves are $1.4 trillion, the largest in the world.

A crash would appear to be imminent!

Bears on China have been common for the last decade, and their track record has not been good. To take just one unfair example, Henry Blodget, the former Internet genius, wrote in Slate in April 2005 “You’ve probably been daydreaming about the fortune to be made in Chinese stocks. Well, keep dreaming….you’ll eventually conclude that you could have done better selling insurance in Toledo.” That was about six months before the Chinese market took off, and if anybody has made 500% on their investment by selling insurance in Toledo during that period, I haven’t met him.

To see why a crash may be coming, it is worth examining the behavior of the China Investment Corporation, the $200 billion sovereign wealth fund set up by the Chinese government in September. Now $200 billion is a fair chunk of cash; you could almost buy all but three US corporations with that (at today’s prices, ExxonMobil, General Electric, Microsoft – there are 4-5 others including Google that barely top the bar.) Six weeks ago, the power of sovereign wealth funds was celebrated and China Investment’s moves into the market were awaited with bated breath.

Well, so much for that. A third of China Investment’s portfolio is to be invested in Central Huijin Investment Company, a purchaser of bad loans from the Chinese banks, and another third will recapitalize China Agricultural Bank and China Development Bank, to shape them up for privatization. $3 billion of the fund was invested in the private equity manager Blackstone in May – that may have bought China useful political contacts, but it is now worth $2 billion. And the remainder is being invested very carefully, primarily in US Treasury securities – which are also losing money steadily in yuan terms.

The lackluster investment strategy of China Investment exposes a central flaw in the Chinese economy, its lack of a rational system of capital allocation. For more than a decade, Chinese state-owned companies have made losses, and have been propped up by the banking system. Since 2004, loss-making state owned companies have been joined by overbuilding municipalities, erecting white-elephant office blocks in attempts to turn themselves into the next Shanghai. None of these losses have resulted in bankruptcy; instead the cash flow deficits have been covered by the Chinese banks. As a result, the Chinese banks have an enormous volume of bad loans -- $911 billion at May 2006, according to a later-withdrawn estimate by Ernst and Young, which must surely have ballooned to $1.2-1.3 trillion now.

That explains why China Investment is somewhat un-aggressive in its international investment strategy. China’s $1.4 trillion of reserves are in fact almost all required to prop up the banking system, when the inevitable liquidity crisis occurs. If the banks are to survive, China Investment will have to be followed by six more sovereign wealth funds of equal size, each of which will have to abandon its attempts to take over Exxon or Google and pour its money down domestic rat-holes.

A $1 trillion problem in subprime mortgages has caused even the US money market to seize up and has required frequent applications of sal volatile by the Fed. Since China’s economy is around one fifth the size of the United States’ the Chinese banking system’s bad debt problem is in real terms about five times that of the United States, about 40% of its Gross Domestic Product.

We have seen this movie before; the Japanese banking system’s bad debts after 1990 totaled around $1 trillion, about 30% of Japan’s GDP. The result was the bursting of the 1980s bubble and a period of little or no economic growth that lasted well over a decade. Admittedly the Japanese authorities made matters worse, by refusing to face up to their bad debt problem and issuing more government bonds to fund witless Keynesian public spending schemes.

Nevertheless, we can have very little confidence that the Chinese authorities, once the same problem stares them in the face, would do any better. After all, at least one of the alternative policy mixes, that tried by Herbert Hoover and the Federal Reserve in 1930-32, proved very much worse. Per Capita US Gross Domestic Product was no higher in 1940 than it had been in 1929, as in the Japanese case, but in the interval it had declined by a horrifying 28% and had recovered very slowly. If China faces the choice between a decade of stagnation, as in Japan from 1990-2003 and a decade of economic collapse, as in the United States from 1929-1940, it will rightly prefer the Japanese alternative.

It may not however have the choice. One of the factors that kept Japan out of real trouble in the 1990s was continued strong growth in the US and world economies; thus its magnificent export industries were able to continue growing, albeit at a slow rate, and provide a certain amount of traction for the economy as a whole. However, China will find it difficult to do the same, since the next decade does not seem likely to be a period of robust world growth, far from it. The United States seems fated to endure at least a few years of very sluggish growth due to its housing market crash, and Britain appears to be in a similar mess, so even relatively robust growth in the resurgent economies of Germany and Japan may not be sufficient to keep Chinese exports growing.

At that point, China will have two alternatives. It can allow the banks to work their way out of their bad loans, condemning the domestic economy to probably a decade of little growth and extremely tight credit (high Chinese savings would alleviate this problem, but they will be trapped in the Chinese banks because the authorities foolishly do not allow Chinese citizens to invest abroad.) Alternatively, it can inject more or less its entire foreign exchange reserves into the domestic banking system in order to recover its bad debts, which would allow the Chinese economy to continue expanding, but at a cost of devastatingly high inflation from the additional money pumped into the system (the $100 billion plus of Chinese bank initial public offerings carried out in 2006-07, pumped into the domestic economy, already appears to be worsening Chinese inflation and China Investment’s $130 billion will doubtless worsen the problem.)

We have seen societies with low economic growth, very high inequality (as China has now) and persistently high inflation; they are collectively known as Latin America. Since China also has much of the corruption that bedevils Latin America and its government lacks any genuine understanding of the free market and is increasingly dominated by special interests, it may indeed be fated to follow a Latin American growth path for the next few decades, with a tiny entrenched elite enriching itself at the expense of the disfranchised masses. That would be the worst possible outcome for the Chinese people, but it is not by any means impossible.

Many observers of the current US financial market downturn comfort themselves with the thought that the world now has more than one growth engine, and that China, with four times the US population, can because of its very high growth pull the world economy along sufficiently even when the US stalls. However, if China is about to incur the inevitable backlash from its recent debt and equity bubbles, during which practices have flourished that have no place in a well functioning free market, then we may be entering a world in which the two main growth engines of the last decade are both broken. Growth in such a world will be truly sluggish and inflation high, as the world struggles to cope with the effects of an excess of cheap money now grown toxic…

Those who say that the economy is better than perceptions of it are responding mostly to numbers showing how things are now. The pessimists are looking at what may be in the near future. The fundamentals haven’t changed much over the past several years, but general perceptions of the future, economic or otherwise, have gotten much more pessimistic. This is finding its way into the mainstream media. Articles like the following in the Washington Post would be hard to find a couple of years ago:

It's Not 1929, but It's the Biggest Mess Since

Steven Pearlstein

December 5, 2007

It was Charles Mackay, the 19th-century Scottish journalist, who observed that men go mad in herds but only come to their senses one by one.

We are only at the beginning of the financial world coming to its senses after the bursting of the biggest credit bubble the world has seen. Everyone seems to acknowledge now that there will be lots of mortgage foreclosures and that house prices will fall nationally for the first time since the Great Depression. Some lenders and hedge funds have failed, while some banks have taken painful write-offs and fired executives. There's even a growing recognition that a recession is over the horizon.

But let me assure you, you ain't seen nothing, yet.

What's important to understand is that, contrary to what you heard from President Bush yesterday, this isn't just a mortgage or housing crisis. The financial giants that originated, packaged, rated and insured all those subprime mortgages were the same ones, run by the same executives, with the same fee incentives, using the same financial technologies and risk-management systems, who originated, packaged, rated and insured home-equity loans, commercial real estate loans, credit card loans and loans to finance corporate buyouts.

It is highly unlikely that these organizations did a significantly better job with those other lines of business than they did with mortgages. But the extent of those misjudgments will be revealed only once the economy has slowed, as it surely will.

At the center of this still-unfolding disaster is the Collateralized Debt Obligation, or CDO. CDOs are not new -- they were at the center of a boom and bust in manufacturing housing loans in the early 2000s. But in the past several years, the CDO market has exploded, fueling not only a mortgage boom but expansion of all manner of credit. By one estimate, the face value of outstanding CDOs is nearly $2 trillion.

But let's begin with the mortgage-backed CDO.

By now, almost everyone knows that most mortgages are no longer held by banks until they are paid off: They are packaged with other mortgages and sold to investors much like a bond.

In the simple version, each investor owned a small percentage of the entire package and got the same yield as all the other investors. Then someone figured out that you could do a bigger business by selling them off in tranches corresponding to different levels of credit risk. Under this arrangement, if any of the mortgages in the pool defaulted, the riskiest tranche would absorb all the losses until its entire investment was wiped out, followed by the next riskiest and the next.

With these tranches, mortgage debt could be divided among classes of investors. The riskiest tranches -- those with the lowest credit ratings -- were sold to hedge funds and junk bond funds whose investors wanted the higher yields that went with the higher risk. The safest ones, offering lower yields and Treasury-like AAA ratings, were snapped up by risk-averse pension funds and money market funds. The least sought-after tranches were those in the middle, the "mezzanine" tranches, which offered middling yields for supposedly moderate risks.

Stick with me now, because this is where it gets interesting. For it is at this point that the banks got the bright idea of buying up a bunch of mezzanine tranches from various pools. Then, using fancy computer models, they convinced themselves and the rating agencies that by repeating the same "tranching" process, they could use these mezzanine-rated assets to create a new set of securities -- some of them junk, some mezzanine, but the bulk of them with the AAA ratings more investors desired.

It was a marvelous piece of financial alchemy, one that made Wall Street banks and the ratings agencies billions of dollars in fees. And because so much borrowed money was used -- in buying the original mortgages, buying the tranches for the CDOs and then in buying the tranches of the CDOs -- the whole thing was so highly leveraged that the returns, at least on paper, were very attractive. No wonder they were snatched up by British hedge funds, German savings banks, oil-rich Norwegian villages and Florida pension funds.

What we know now, of course, is that the investment banks and ratings agencies underestimated the risk that mortgage defaults would rise so dramatically that even AAA investments could lose their value.

One analysis, by Eidesis Capital, a fund specializing in CDOs, estimates that, of the CDOs issued during the peak years of 2006 and 2007, investors in all but the AAA tranches will lose all their money, and even those will suffer losses of 6 to 31 percent.

And looking across the sector, J.P. Morgan's CDO analysts estimate that there will be at least $300 billion in eventual credit losses, the bulk of which is still hidden from public view. That includes at least $30 billion in additional write-downs at major banks and investment houses, and much more at hedge funds that, for the most part, remain in a state of denial.

As part of the unwinding process, the rating agencies are in the midst of a massive and embarrassing downgrading process that will force many banks, pension funds and money market funds to sell their CDO holdings into a market so bereft of buyers that, in one recent transaction, a desperate E-Trade was able to get only 27 cents on the dollar for its highly rated portfolio.

Meanwhile, banks that are forced to hold on to their CDO assets will be required to set aside much more of their own capital as a financial cushion. That will sharply reduce the money they have available for making new loans.

And it doesn't stop there. CDO losses now threaten the AAA ratings of a number of insurance companies that bought CDO paper or insured against CDO losses. And because some of those insurers also have provided insurance to investors in tax-exempt bonds, states and municipalities have decided to pull back on new bond offerings because investors have become skittish.

If all this sounds like a financial house of cards, that's because it is. And it is about to come crashing down, with serious consequences not only for banks and investors but for the economy as a whole.

That's not just my opinion. It's why banks are husbanding their cash and why the outstanding stock of bank loans and commercial paper is shrinking dramatically.

It is why Treasury officials are working overtime on schemes to stem the tide of mortgage foreclosures and provide a new vehicle to buy up CDO assets.

It's why state and federal budget officials are anticipating sharp decreases in tax revenue next year.

And it is why the Federal Reserve is now willing to toss aside concerns about inflation, the dollar and bailing out Wall Street, and move aggressively to cut interest rates and pump additional funds directly into the banking system.

This may not be 1929. But it's a good bet that it's way more serious than the junk bond crisis of 1987, the S&L crisis of 1990 or the bursting of the tech bubble in 2001.

The fact that pessimistic talk is featured in the leading news outlets in the United States may be the best evidence that the plug is being pulled.

Signs of the Economic Apocalypse, 12-3-07

From Signs of the Times (sott.net):

Gold closed at 789.10 dollars an ounce Friday, down 4.5% from $824.70 at the close of the previous week. The dollar closed at 0.6834 euros Friday, up 1.4% from 0.6740 at the close of the previous Friday. That put the euro at 1.4633 dollars compared to 1.4838 the Friday before. Gold in euros would be 539.26 euros an ounce, down 2.8% from 554.23 for the week. Oil closed at 88.71 dollars a barrel Friday, down 10.7% from $98.18 at the close of the week before. Oil in euros would be 60.62 euros a barrel, down 9.2% from 66.17 for the week. The gold/oil ratio closed at 8.90 Friday, up 6.0% from 8.40 at the end of the week before. In U.S. stocks, the Dow Jones Industrial Average closed at 13,371.72 Friday, up 3.0% from 12,980.88 for the week. The NASDAQ closed at 2,660.96 Friday, up 2.5% from 2,596.60 at the close of the week before. In U.S. interest rates, the yield on the ten-year U.S. Treasury note closed at 3.94%, down six basis points from 4.15 for the week.

Encouraging week, in some ways, even if it is only temporary pause on the death spiral. Not only did gold and oil drop sharply and stocks rise, but plans to help people avoid losing their houses in foreclosure were announced by U.S. Treasury Secretary Paulson. Last week we asked the questions, “How many people can be evicted from their homes in foreclosure? Is there a ceiling, a certain percentage above which the system collapses, above which the exploited no longer give their consent to their exploitation? Will the system pull back before it reaches that point?” It seems that the ruling groups are worried about political problems arising from the housing crisis. There has been so much neglect of the problem for so long that any acknowledgement is welcome.

Paulson, Banks in Talks to Stem Surge in Foreclosures

By Alison Vekshin and Craig Torres

Nov. 30 (Bloomberg) -- U.S. Treasury Secretary Henry Paulson is negotiating an agreement with banks to stem a surge in foreclosures by fixing interest rates on loans to subprime borrowers, according to people familiar with a meeting he led yesterday.

Paulson, who will address a housing conference on Dec. 3, presided over a one-hour gathering at the Treasury Department in Washington with federal regulators, bankers and lobbyists. Citigroup Inc., Wells Fargo & Co. and Washington Mutual Inc. executives attended, said a person present, who spoke on condition of anonymity.

The Bush administration cut its forecast for economic growth yesterday, reflecting a deepening housing recession that's roiled financial markets since August. The Commerce Department reported the same day that the median price of a new house fell 13 percent in October from a year earlier, while fewer homes were sold than economists anticipated.

“One of the roles of Treasury is to say ‘come on, let’s get together and see what we can do,’” said Wayne Abernathy, executive director of financial-institutions policy at the American Bankers Association in Washington and a former Treasury assistant secretary. “You’re likely to come up with something that will work both in the marketplace and honor the sanctity of the contracts involved.”

Stocks Advance

Stocks climbed today on speculation Paulson’s efforts may help slow credit losses. They also gained after Federal Reserve Chairman Ben S. Bernanke said “renewed turbulence” in financial markets may hurt growth, reinforcing investors’ expectations for an interest-rate cut next month. The Standard & Poor’s 500 stock index rose 0.8 percent to 1,481.14 at the close in New York.

Paulson was joined yesterday by Federal Deposit Insurance Corp. Chairman Sheila Bair, Comptroller of the Currency John Dugan and Office of Thrift Supervision Director John Reich.

Bair has proposed letting borrowers with adjustable-rate subprime mortgages, who are living in their homes and unable to afford resets, get extensions on the starter rate for at least five years. They could also be offered 30-year fixed-rate loans. Reich prefers a three-year freeze.

Also represented at the meeting was the American Securitization Forum, which lobbies for investors, traders, underwriters, accounting firms, ratings companies and other institutions involved in the creation and sale of mortgage- backed securities.

Persuade Investors

U.S. Senator Charles Schumer said the challenge will be to persuade those who buy the securities to back Paulson’s effort.

“This is the first time that the Bush administration is working toward a solution that meets the magnitude of the problem,” Schumer, a New York Democrat, said in a statement.

“But there is a $64,000 question: Will investors go along with this plan?” he said. “And if not, can they be compelled to?” …

Delinquency Rate

Delinquencies on subprime mortgages, which account for less than 15 percent of the $11.5 trillion U.S. home mortgage market, climbed after what Fed officials labeled “lax” lending standards spread the past two years. Homeowners were behind on 17 percent of adjustable-rate subprime loans in June, compared with 4.2 percent for prime mortgages of the same type, Mortgage Bankers Association data show.

Financial firms are marking down about $66 billion related to the mortgage market, and Morgan Stanley this week ousted Co- President Zoe Cruz after the firm disclosed $3.7 billion of losses on mortgage-related securities.

The rout will get worse because defaults on home loans are likely to rise, analysts said. The FDIC estimates that 1.54 million nonprime mortgages valued at $331 billion will reset by the end of next year.

‘Down Another Level’

Rising defaults “will take the housing market down another level,” said Mark Zandi, chief economist at Moody’s Economy.com, who will attend the conference featuring Paulson next week. “In the context of an economy that is not in recession, but pretty close, we will be in a recession right in the teeth of a presidential election.”

An index of credit-default swaps tied to subprime-mortgage bonds rose today in a sign the perceived risk of owning the securities improved. The gauge, compiled by Markit, climbed about 1 point to 78, GFI Group Inc. prices showed.

President George W. Bush’s economic advisers yesterday cut their forecast for 2008 economic growth to 2.7 percent from a 3.1 percent rate projected in June. The unemployment rate will rise to 4.9 percent, compared with 4.7 percent previously estimated, according to the Council of Economic Advisers’ semi- annual forecast…

Mortgage-industry lobbyists have argued that an across-the- board solution is difficult to apply. Rewriting contracts also risks moral hazard -- encouraging borrowers to take on more debt in the expectation of being bailed out if needed later.

“It is really an indiscriminate procedure that would violate the terms of the contract that provide for loan-by-loan decision making,” George Miller, executive director of the American Securitization Forum, said in an interview this month. A broad approach would “significantly disrupt the reasonable expectation of investors” in the $7.1 trillion market for bonds backed by mortgages.

Well, we wouldn’t want to “significantly disrupt the reasonable expectation of investors,” would we? All joking aside, this kind of dilemma is becoming increasingly common for policymakers in the U.S. Bail out homeowners and stiff investors? Or vice versa? Avoid recession and stiff foreign holders of dollar assets? Or let interest rates rise to keep foreign central banks holding dollars and plunge the U.S. into severe recession?

Impending Destruction of the US Economy

Paul Craig Roberts

11/28/07

Hubris and arrogance are too ensconced in Washington for policymakers to be aware of the economic policy trap in which they have placed the US economy. If the subprime mortgage meltdown is half as bad as predicted, low US interest rates will be required in order to contain the crisis. But if the dollar’s plight is half as bad as predicted, high US interest rates will be required if foreigners are to continue to hold dollars and to finance US budget and trade deficits.

Which will Washington sacrifice, the domestic financial system and over-extended homeowners or its ability to finance deficits?

The answer seems obvious. Everything will be sacrificed in order to protect Washington’s ability to borrow abroad. Without the ability to borrow abroad, Washington cannot conduct its wars of aggression, and Americans cannot continue to consume $800 billion dollars more each year than the economy produces.

A few years ago the euro was worth 85 cents. Today it is worth $1.48. This is an enormous decline in the exchange value of the US dollar. Foreigners who finance the US budget and trade deficits have experienced a huge drop in the value of their dollar holdings. The interest rate on US Treasury bonds does not come close to compensating foreigners for the decline in the value of the dollar against other traded currencies. Investment returns from real estate and equities do not offset the losses from the decline in the dollar’s value.

China holds over one trillion dollars, and Japan almost one trillion, in dollar-denominated assets. Other countries have lesser but still substantial amounts. As the US dollar is the reserve currency, the entire world’s investment portfolio is over-weighted in dollars.

No country wants to hold a depreciating asset, and no country wants to acquire more depreciating assets. In order to reassure itself, Wall Street claims that foreign countries are locked into accumulating dollars in order to protect the value of their existing dollar holdings. But this is utter nonsense. The US dollar has lost 60% of its value during the current administration. Obviously, countries are not locked into accumulating dollars.

The reason the dollar has not completely collapsed is that there is no clear alternative as reserve currency. The euro is a currency without a country. It is the monetary unit of the European Union, but the countries of Europe have not surrendered their sovereignty to the EU. Moreover, the UK, a member of the EU, retains the British pound. The fact that a currency as politically exposed as the euro can rise in value so rapidly against the US dollar is powerful evidence of the weakness of the US dollar.

Japan and China have willingly accumulated dollars as the counterpart of their penetration and capture of US domestic markets. Japan and China have viewed the productive capacity and wealth created in their domestic economies by the success of their exports as compensation for the decline in the value of their dollar holdings. However, both countries have seen the writing on the wall, ignored by Washington and American economists: By offshoring production for US markets, the US has no prospect of closing its trade deficit. The offshored production of US firms counts as imports when it returns to the US to be marketed. The more US production moves abroad, the less there is to export and the higher imports rise.

Japan and China, indeed, the entire world, realize that they cannot continue forever to give Americans real goods and services in exchange for depreciating paper dollars. China is endeavoring to turn its development inward and to rely on its potentially huge domestic market. Japan is pinning hopes on participating in Asia’s economic development.

The dollar’s decline has resulted from foreigners accumulating new dollars at a lower rate. They still accumulate dollars, but fewer. As new dollars are still being produced at high rates, their value has dropped.

If foreigners were to stop accumulating new dollars, the dollar’s value would plummet. If foreigners were to reduce their existing holdings of dollars, superpower America would instantly disappear.

Foreigners have continued to accumulate dollars in the expectation that sooner or later Washington would address its trade and budget deficits. However, now these deficits seem to have passed the point of no return.

The sharp decline in the dollar has not closed the trade deficit by increasing exports and decreasing imports. Offshoring prevents the possibility of exports reducing the trade deficit, and Americans are now dependent on imports (including offshored production) for which there are no longer any domestically produced alternatives. The US trade deficit will close when foreigners cease to finance it.

The budget deficit cannot be closed by taxation without driving up unemployment and poverty. American median family incomes have experienced no real increase during the 21st century. Moreover, if the huge bonuses paid to CEOs for offshoring their corporations’ production and to Wall Street for marketing subprime derivatives are removed from the income figures, Americans have experienced a decline in real income. Some studies, such as the Economic Mobility Project, find long-term declines in the real median incomes of some US population groups and a decline in upward mobility.

The situation may be even more dire. Recent work by Susan Houseman concludes that US statistical data systems, which were set in place prior to the development of offshoring, are counting some foreign production as part of US productivity and GDP growth, thus overstating the actual performance of the US economy.

The falling dollar has pushed oil to $100 a barrel, which in turn will drive up other prices. The falling dollar means that the imports and offshored production on which Americans are dependent will rise in price. This is not a formula to produce a rise in US real incomes.

In the 21st century, the US economy has been driven by consumers going deeper in debt. Consumption fueled by increases in indebtedness received its greatest boost from Fed chairman Alan Greenspan’s low interest rate policy. Greenspan covered up the adverse effects of offshoring on the US economy by engineering a housing boom. The boom created employment in construction and financial firms and pushed up home prices, thus creating equity for consumers to spend to keep consumer demand growing.

This source of US economic growth is exhausted and imploding. The full consequences of the housing bust remain to be realized. American consumers lack discretionary income and can pay higher taxes only by reducing their consumption. The service industries, which have provided the only source of new jobs in the 21st century, are already experiencing falling demand. A tax increase would cause widespread distress.

As John Maynard Keynes and his followers made clear, a tax increase on a recessionary economy is a recipe for falling tax revenues as well as economic hardship.

Superpower America is a ship of fools in denial of their plight. While offshoring kills American economic prospects, “free market economists” sing its praises. While war imposes enormous costs on a bankrupt country, neoconservatives call for more war, and Republicans and Democrats appropriate war funds which can only be obtained by borrowing abroad.

By focusing America on war in the Middle East, the purpose of which is to guarantee Israel’s territorial expansion, the executive and legislative branches, along with the media, have let slip the last opportunities the US had to put its financial house in order. We have arrived at the point where it is no longer bold to say that nothing now can be done. Unless the rest of the world decides to underwrite our economic rescue, the chips will fall where they may.

Dr. Roberts was Assistant Secretary of the US Treasury for Economic Policy in the Reagan administration. He is credited with curing stagflation and eliminating “Phillips curve” trade-offs between employment and inflation, an achievement now on the verge of being lost by the worst economic mismanagement in US history.

The crux of the problem is the U.S. military machine, which the U.S. can no longer afford. At this stage of imperial decline, not only is that military providing no benefit to the American people, it no longer even benefits the U.S. Empire. The way it’s being financed will doom the American Empire. As Roberts bravely pointed out, it is being used to benefit the fantasy of an Israeli Empire. According to Mike Whitney, the idea back at the beginning of the decade was that both empires could be served by illegally invading countries in the Middle East:

A Dollar the Size of a Postage Stamp
Even Larry Summers Predicts Doom

Mike Whitney

November 27, 2007

Lately it seems as though everyone wants to take a poke at the dollar. Last week, it was the Brazilian supermodel who demanded euros for her jaunts on the catwalk instead of USD. The week before that, hip-hop impresario, Jay-Z, released a video dissin’ the dollar and praising the euro as the ‘baddest Dude in the ‘hood’.

Lambasting the greenback has become trendy. It’s a favorite pastime of politicians, too. At the November OPEC meeting in Riyadh, Iran’s president Mahmoud Ahmadinejad asked the assembled finance ministers to "study the feasibility of selling oil in another currency." Ahmadinejad disparaged the dollar as "a worthless piece of paper".

The fiery Venezuelan President, Hugo Chavez, followed Ahmadinejad’s lead predicting that the demise of the dollar would mean the "end of the Empire."

Hugo may be on to something. The dollar is America’s Achilles heel; if the dollar tanks, so does the empire. That means the taxpayer will have to foot the bill for Bush’s bloody-interventions in Iraq and Afghanistan, rather than the Chinese. That also means that the US will have to export something of greater value than Daisy Cutters and gulags. That could be a tall-order, now that Bush has boarded up the factories, hollowed out the industrial base, and outsourced 3 million manufacturing jobs. We’ll have to scrape the rust off the machinery and get back into the widget-making business like we were before the Free Trade fiasco.

Central banks across the globe are trying to figure out how to ditch their dollar reserves without triggering a stampede for the exits. No one wants to see that. But, then, nobody wants to be stuck with vaults full of Uncle Sam’s green confetti either. So, the question arises; What is the best way to divest oneself of $5.6 trillion (total USD held overseas) before the Lusitania capsizes?

Kuwait, Venezuela, Iran, Russia, and Norway have already opted to ignore the destabilizing effects of "conversion" from dollars and are in some stage of divestiture. Others will follow. The UAE, Bahrain, Qatar, Oman and Saudi Arabia are considering switching from the dollar-peg to a basket of currencies so they can hedge against the inflation that’s battering their economies. It’s only a matter of time before the Petrodollar System---which links the dollar to petroleum sales and creates a de facto "international currency"---unravels completely, precipitating the final collapse of Breton Woods.

Talk of America’s impending currency disaster is no longer relegated to the Internet blathershere. Mainstream journalists have joined the chorus and are sending up their own red flags. The UK Telegraph’s economics’s editor, Liam Halligan, made this grim observation in his recent article, "Bet Your Bottom Dollar Tensions Will Follow":

"The importance of "dollar divestment" cannot be overstated. At the very least it means the greenback has much further to fall - plunging the US into recession. But it begs a bigger, more alarming, question. How will Washington react to the end of the US hegemony?"

The dollar was savaged by the monetary policies of the Federal Reserve. The Fed’s policies were designed to coincide with Bush’s Middle East Crusade. They were supposed to work like two wheels on the same axle. The administration believed that, by 2007, the military would need only 30,000 or so troops to maintain security in Iraq. That would give Bush’s legions the chance to turn east and push on to the next target-state, Iran. If things went according to plan -- and no one thought the high-tech US war machine could be stopped -- the US would control two-thirds of the world’s oil. This would allow America to keep writing bad checks on green paper for the next century.

But then, of course, the plan hit a snag. The Iraqi resistance mushroomed, the US got bogged down in an "unwinnable" war, and the once-mighty dollar shriveled into nothingness. Now we’re at a turning point and our leaders are in a state of denial. Bush is still playing Teddy Roosevelt, while Paulson and Bernanke are just plain shell-shocked. They probably know the game is over. As the dollar continues to wither; the frustration is beginning to mount in Europe. Liam Halligan sums it up like this:

"Europe has finally had enough of America’s "benign neglect" dollar policy. As a large economic area, with a floating exchange rate, the eurozone suffers most. Over the past seven years, the single currency has risen by a shocking 82 per cent against the greenback. That’s hammered eurozone exports - provoking serious trade disputes between the EU and US, the world’s two biggest trading blocks. No wonder French President Nicolas Sarkozy describes America’s drooping dollar as "a precursor to economic war". (UK Telegraph, "Bet Your Bottom Dollar tensions Will Follow")

Sarkozy is leading the charge for "intervention"; the buzzword for shoring the greenback through exchange controls and buying up billions of dollars. But it’s a risky business; especially when net capital inflows -- which are the monthly purchases of US-backed securities and Treasuries --have gone negative for the last two months. That means the US isn’t attracting enough foreign investment to finance its trade deficit. So the dollar will have to fall to compensate.

So, how much loot is Sarkozy willing to put up to keep the dollar from slumping further -- $100 billion, $500 billion, $1,000 billion? And where’s the bottom?

The fact is, the greenback took a "header" down the stairwell and by the time it picks itself up, it could be eye to eye with the peso. Who knows? Maybe its time we all learned Spanish?

More than two-thirds of all sovereign foreign exchange holdings are denominated in dollars. When those dollars are converted into back into foreign currencies and start recycling into the US; we’re in deep trouble. Inflation will soar. Surely, the Fed must have known this day would come when they were pumping trillions of dollars into subprime mortgages and complex debt-instruments which served no earthly purpose except to fatten the bottom line for rapacious bankers and hedge-fund managers. The Fed also knew that the nation’s wealth was not being "efficiently deployed" for capital improvements on factories, technology or industry. Oh, no. That would have ensured that America would remain competitive in the global marketplace into the new century. Instead, the money was shoveled into the bottomless sinkhole of stucco homes with composition roofing and toxic credit default swaps.

And, despite the rise in stocks and the dollar last week, the housing collapse is still gathering steam, with headlines like New-Home Prices Take Biggest Dive Since 1970:Median Cost Tumbles 13 Percent, and, Foreclosures Piling Up. According to Martin Hutchinson, U.S. markets are in the early stages of a death spiral:

The Bear’s Lair: Spirals of death

Martin Hutchinson

November 26, 2007

Close observers of the US housing finance disaster in recent months will have noted a curious phenomenon. Companies such as Countrywide that were in late August regarded as rock solid have recently passed clearly into the danger zone while those like Fannie Mae and Freddie Mac that were regarded as potential market saviors have come under a cloud. In Britain Northern Rock, whose September bailout was said to be modest, involving little risk to the taxpayer has now turned into an immense 25 billion pound ($51 billion) potential black hole – real money even in the US economy let alone in the much smaller British one. This illustrates a deeply troubling quality of the largest downturns: the tendency for the free market to turn into a death spiral, in which even sound well-run institutions are engulfed.

Death spirals are fairly rare in financial history. The Wall Street Crash of 1929 was perhaps the most virulent example. After the first downturn, the market recovered for several months. Then the collapse of the Bank of the United States in December 1930, together with the further economic damage from the Smoot-Hawley Tariff caused a further collapse in confidence and activity that was concentrated in the banking sector, as relatively solid institutions followed the Bank of the United States into bankruptcy. The Federal Reserve failed to correct for the money supply contraction caused by the bank bankruptcies, leading the US economy further into the pit. The additional shove given by President Herbert Hoover’s 1932 tax increase was almost unnecessary; only the confidence brought by a new president (albeit with equally counterproductive economic policies) brought recovery from 1933. By the time the spiral was over, more than one fourth of the banks in the United States had gone bankrupt and the stock market had bottomed out at one tenth of its peak.

A second death spiral, with somewhat less dire economic consequences, occurred in Britain in 1973-74. Edward Heath’s government had removed the quantitative controls on bank lending in 1971, which resulted in an orgy of high risk lending against real estate, very similar to the recent episode in the US except that most of the loans were made against commercial real estate rather than housing. When the first major real estate lender, London and County Bank, collapsed in November 1973 another more conservative house, First National Finance (FNFC), was used as the epicenter of the “lifeboat” rescue organized by the Bank of England. However, the decline in confidence and real estate values quickly sucked FNFC into the maelstrom.

The lifeboat rescue fund grew larger and larger for more than a year as the stock market declined to record low levels, 70% below its 1972 high. Homebuilders such as Northern Developments, in no way involved in the original crash but dependent on bank lending, were dragged down. So were the two most important entrepreneurial finance houses, both internationally diversified and neither significantly involved in commercial real estate lending – Jessel Securities, founded by Oliver Jessel and Slater Walker, founded by Jim Slater.

Neither Jessel nor Slater had been aggressively run – indeed Jim Slater had begun de-leveraging a year before the crash, as he saw trouble coming – and no wrongdoing was proved against the head of either organization, yet by the end of 1975 both very substantial companies had gone bankrupt and neither founder played a significant further role in the British financial sector. This was a great pity: in losing Jessel and Slater Britain had lost not only their very able founders but the most aggressive entrepreneurial teams in the City of London, who might have been best able to compete against the foreign invasion when Britain deregulated the financial services sector in 1986.

The British experience of 1973-74 seems more like the current position in the United States. National policy is currently reasonably neutral, so far avoiding the twin dangers of protectionism and tax increases which caused the medium sized downturn of 1929-30 to turn into the Great Depression. The problem is concentrated in the property sector. However there are already worrying signs that the magic alchemy of modern finance, though such mechanisms as securitization vehicles whose funding falls apart and complex derivative securities that prove to be unsalable in a crisis, is causing the problem to metastasize. In the consumer sector, GMAC has reported problems with its automobile loan portfolio, while it appears that credit card debt quality is rapidly deteriorating. In the corporate loan sector, loans to aggressive leveraged buyouts have got in trouble, and loans to hedge funds and private equity funds have been sharply cut back. (The latter effect can be seen in the movement of the yen/dollar exchange rate from 120 to 108, as the hedge funds’ ”carry trade” positions have been de-leveraged.)

The “death spiral” characteristics of the current market are pretty clear. If Fed Chairman Ben Bernanke’s original estimate of subprime loan losses of $50-100 billion had been anywhere close to accurate, there would have been no problem. The market deals with difficulties of that size all the time, without significant effect on surrounding sectors. A few fringe operators go bankrupt, a few large houses show unexpected losses, and the overall market continues without a tremor. The collapse of the Amaranth hedge fund in September 2006 or that of Refco a year earlier were substantial events, causing losses to a number of those institutions’ business partners, but there was no question of any general market disturbance.

When the subprime problem first emerged in February, it appeared that it would also be limited. A number of subprime lenders, relatively insignificant institutions, were forced to shut down. However the general market appeared unaffected; its view appeared to be that the problem was localized and should have no effect on the real economy, nor even any great effect on the broader housing finance market.

August’s widening in Libor spreads, at which banks lend money to each other, should have told us that this problem would be different, and altogether more important. If leading banks were unable to assess each other’s credit quality for short term transactions then something much more serious was wrong than the collapse of a modest fringe sector of the housing finance market. The Fed’s chosen solution, dropping interest rates and pumping more money into the system, did not address the real problem and was thus useless, as it has since proved. It has only postponed the denouement for a few months and stored up further trouble with inflation.

Two factors are at play here. The first is sheer size. If as now appears likely the eventual losses in the home mortgage market do not total only $100 billion, but a figure much closer to $1 trillion, then the subprime debacle becomes something much more than a localized meltdown. $1 trillion of losses is 7% of US Gross Domestic Product. The market cannot absorb losses of that size without some major institutional bankruptcies or a lengthy recession. The closest equivalent problem is the savings and loan collapse of 1989-92; that caused a major housing downturn but only a minor recession. However its cost (mostly borne by the US taxpayer) of $176 billion was about 3% of 1990 US GDP, only half the size of the likely current losses on mortgage loans.

The second is lack of transparency, and the blow to confidence that comes from the dawning suspicion that a large portion of the derivatives and securitization mechanisms designed in the last quarter century are faulty. The unluckily timed implementation for years beginning after November 15 of FAS Rule 157, requiring banks to divide their assets into three levels according to their degree of marketability, has thrown an unwelcome spotlight on the problem. If Level 3 assets can be valued only by reference to an internal valuation model, and have been allowed to accrue value in banks’ financial statements for a decade or more (enabling hefty bonuses to their progenitors) then how do we know they are really worth anything close to what the model says, and how do we go about realizing them, in a market where confidence has vanished?

To ask those questions is to answer them. Since every incentive led bank mathematicians to devise models that maximized the reported value of the bank’s holdings, and since little or no market existed by which those values could be checked, it is likely that today those assets’ book values are highly overstated. Moreover, even in banks where the mathematicians and their bosses were scrupulously, even impossibly disinterested and intelligent, there still remains the problem that those assets are worth far less in a downturn, because their illiquidity makes them intrinsically unattractive in a market where liquidity has become once more important. Anyone who has attempted to sell venture capital positions in a bear market can attest to how rapidly and completely the value of such assets can disappear. It is thus perfectly possible that the true realizable value of “Level 3” holdings in a bear market is no more than 10% of their book value.

This immediately demonstrates the problem. Goldman Sachs, generally regarded as insulated from the subprime mortgage problem, has $72 billion of Level 3 assets; its capital is only $36 billion. If anything like 90% of the Level 3 assets’ value has to be written off, Goldman Sachs is insolvent. They do not have the option of acting like Nomura Securities did recently, selling everything possible and writing the remainder down to zero, because they would be without capital. Instead they are likely to be dragged kicking and screaming, quarter by quarter, to a gradual writedown and sale of their Level 3 assets, with their true position remaining undisclosed and obfuscated by meaninglessly optimistic statements by top management. Only the bonuses will survive, paid in cash and draining liquidity from the struggling company.

That’s what a death spiral looks like. The US survived the Great Depression, eventually, and Britain survived the 1973-74 debacle. However the market recovered only after it had plumbed depths previously thought impossible, at which even the soundest investments were trading far below their true value. After normality returned, the financial services landscape was very different, with many large and apparently solid houses having disappeared, a generation of participants reduced to driving taxis or selling apples and a generation of investors scarred by their losses and unwilling to return to the market. Emergency infusions of money, from the Fed or the taxpayers, generally do no good, only postponing the denouement and delaying the arrival of truly bargain price levels.

Such spirals of death represent the final definitive triumph of the Bears.

Hutchinson’s descriptions of valuation shenanigans by large investment banks is probably too generous to the banks. Hutchinson believes in “free market” neoliberal principals. Commentators on the left are better able to see the criminality involved:

Credit crisis reveals widespread accounting manipulation by top US banks

Joe Kay

27 November 2007

The developing credit crisis in the United States, linked to the bursting of the housing market bubble, is beginning to reveal the accounting manipulations employed by major US banks to engage in speculative activities and hide risks. Several major banks have already announced billions of dollars in losses associated with subprime mortgages, and in the next months are expected to announce tens of billions of dollars in further write-downs.

Among those most severely affected is Citigroup—an American financial conglomerate that is the world’s largest company measured by asset value. CNBC reported on Monday that Citigroup is planning major cost-cutting in response to its difficulties, with layoffs of up to 45,000 of the company’s approximately 320,000 employees.


In a statement, the bank insisted that reports involving specific numbers of layoffs were “not factual,” but acknowledged that the company is “planning ways in which we can be more efficient and cost effective to position our businesses in line with economic realities.” New cuts would come on top of 17,000 layoffs announced in April.

The announcement, coming amidst Wall Street nervousness over the ongoing credit crisis, sent Citigroup’s stock down more than 6 percent. Over the past six months, the price of the company’s stock has fallen nearly 50 percent. Citi led a steep market decline on Monday, with the Dow Jones Industrial Average falling nearly 240 points, more than wiping out its increase on Friday.

Chief among the “economic realities” behind Citigroup’s announcement is the credit crisis brought on by record defaults on home mortgages in the United States. Citigroup has already announced a $5 billion write-down related to home mortgages, which provoked the resignation of its CEO Charles Prince. It is expected to announce further losses of up to $11 billion in the fourth quarter.

The bank’s exposure could be much greater, however, as it may be forced to acknowledge losses that it had previously kept off its books. An article by Wall Street Journal reporter David Reilly on Monday (“Citi’s $41 Billion Issue: Should it put CDOs On the Balance Sheet?”) noted that the bank faces an “immediate threat” from troubles involving off-balance-sheet entities called collateralized debt obligations (CDOs)

The Journal notes that Citigroup “was one of the biggest arrangers of CDOs—products that pools debt, often mortgage securities, and then sell slices with varying degrees of risk.” The bank may be forced to bring these CDOs onto its balance sheet. “If Citigroup had to include an additional $41 billion in CDO assets on its books,” the Journal noted, “that could potentially spur a further $8 billion in write-downs, above and beyond those already signaled, according to a report earlier this month by Howard Mason, an analyst at Sanford C. Bernstein.”

Throughout the housing boom of the past several years, the CDOs, and related entities known as structured investment vehicles (SIVs), made substantial returns. SIVs are also off-balance-sheet entities, but are more open-ended, investing in other risky securities, including CDOs. Even those entities closely associated with banks have been nominally independent. The “independence” of these entities has been entirely fraudulent, however. They have been critical for the banks’ bottom line as sources of lucrative fees, buying up mortgages and other assets from their parent banks.

As the CDOs and SIVs have faltered with the collapse of the housing bubble, the banks have looked for ways to bail them out. The Journal notes, “Over the summer, [Citigroup] was forced to buy $25 billion in commercial paper issued by its CDO vehicles because investors were no longer interested in the paper. Citigroup already had an $18 billion exposure to these vehicles through other funding it had provided.”

The determination with which Citigroup and other banks have scrambled to bail out these investment entities is itself testament to the fact that they were never really independent to begin with.

Commenting on the way that major banks were able to shift their risks off their balance sheets, New York Times economic writer Floyd Norris noted in an article published November 16 (“As Bank Profits Grew, Warning Signs Went Unheeded,”), “Instead of being suspicious, many analysts believed that banks had found a new way to prosper. Making a loan and keeping it on the balance sheet until it was repaid was so old-fashioned. It was far better to collect fees for arranging transactions and passing on the risks to others.”

In fact, many of these risks were not really transferred. Norris notes that the banks often made arrangements (called “liquidity puts”) with the purchasers of their CDO securities that would allow the purchasers to sell the CDO securities back to the bank if there was no other market. “That risk may have seemed slight when the securitization market was booming. But now the banks are being forced to buy back securities for more than they are worth.”

In essence, the puts allowed the banks to sell CDOs and other assets without really selling them. Use of the puts actually increased as the housing market began to unravel, as it was necessary to provide the guarantees in order for the banks to get investors to buy mortgage-backed securities whose value was increasingly in question.

The legality of these operations is highly dubious, since part of the intention appears to have been to mislead investors regarding the financial health of the company. Even if the operations by banks were legal, the fact that they were not reported to investors was likely a violation of accounting rules.

According to Norris, Citigroup and Bank of America were among those banks that used “liquidity puts” heavily.

All of these arrangements amount to attempts by banks to gamble on risky investments without acknowledging the risks they were taking on. As the market for these investments has begun to collapse, the real extent of the losses is only beginning to reveal itself—and no one knows how severe the crisis really is.

Most banks were involved in such activities. Earlier this month, the Securities and Exchange Commission opened an investigation into investment bank Merrill Lynch that, according to the Wall Street Journal, is intended to examine how the bank “has been valuing, or ‘marking,’ its mortgage securities and how it has disclosed its positions to investors.”

In a November 2 article, the Journal reported that Merrill arranged one deal with a hedge fund to sell $1 billion in commercial paper related to mortgages, while giving the hedge fund the right to sell it back after one year at a set price. The newspaper later corrected its article to note that this deal, similar in many ways to the arrangements at Citigroup, was rejected because the bank determined that it was a violation of accounting rules.

Nevertheless, Merrill is highly exposed to the housing markets. Earlier reports suggested that Merrill hid its own exposure to the subprime mortgage crisis by shifting its assets to different parts of the company subject to less strict accounting regulations. (See “Wall Street hides impact of subprime mortgage meltdown”)

As late as July 2007 executives at the bank, including former CEO Stan O’Neal, were assuring employees that its mortgage risks were under control. At the end of October, Merrill announced a $7.9 billion write-down, which was followed by O’Neal’s departure.

The crisis facing banks is an international phenomenon. The stock market sell off on Monday was provoked in part by an announcement from British-based HSBC—Europe’s largest bank and the world’s fourth largest corporation in terms of assets—that it would bail out two of its SIVs and transfer their assets onto its balance sheet.

Since the credit crisis began in full force this summer, banks have scrambled to stave off a reckoning with the enormity of the losses involved. The hope has been that the economic crisis will be short-lived and that the housing market will eventually recover, restoring the value of the assets in question.

It is unlikely that this will happen, however, and there is an increasing likelihood of a recession. In an article published in the Financial Times on Sunday (“Wake up to the dangers of a deepening crisis”), Lawrence Summers, former Treasury Secretary in the Clinton Administration, warned, “[T]he odds now favor a US recession that slows growth significantly on a global basis.” Summers noted, “Forward-looking indicators suggest that the housing sector may be in free-fall from what felt like the basement levels of a few months ago.”

The initial revelations of accounting manipulations and indications of fraudulent activities are only a small indication of the extent to which the American economy is pervaded by financial speculation and out-and-out criminality.

It was the collapse of the dot-com boom in 2001 that ultimately unwound the elaborate structure of corruption at companies such as Enron, WorldCom, and Tyco. These companies were no longer able to perpetuate their fraudulent activities once the stock market ceased its continual upward march.

The major banks were heavily involved in the activities exposed at that time. In 2003, Citigroup and JP Morgan Chase were forced to pay out fines for aiding Enron in disguising loans as cash to reduce reported risk and liabilities, thereby defrauding investors. Essentially, the banks gave Enron loans, but cloaked these loans in an apparent purchase of assets. This manipulation improved Enron’s financial reports, which was beneficial for banks that were heavily invested in Enron stock. (See “Citigroup, Morgan Chase fined for Enron deals: corruption at the heights of American finance”)

The operations involving CDOs and SIVs bear a certain resemblance in that they too were evidently intended to disguise risk. Much of the risk was ultimately held by the bank itself, but this was not readily apparent to investors.

Though the banks were involved in the manipulations at Enron and other companies, the fraud was generally explained by the media and the political establishment as the product of a few “bad apples.” Several executives were put on trial and imprisoned, but the underlying conditions remained and the banks remained largely untouched. The dot-com bubble was quickly replaced by the housing bubble, which had the effect of extending the speculative mania of Wall Street to a much broader section of the economy.

The pervasiveness of accounting manipulation is closely linked to the increasingly dominant role that speculation has come to play in the American economy. Vast sums of wealth—including tens and hundreds of millions of dollars to top executives and hedge fund managers—have been made through mechanisms that are largely divorced from any relationship to actual production. The importance of these forms of speculative wealth accumulation has increased as the underlying health of the American economy has decreased.

The housing market has been a case in point, as a small layer of the population has made billions through high-risk loans to working class Americans who are now bearing the burden of a crushing level of debt. The loans have been used to transfer wealth into the hands of the ruling elite, and at the same time became a means of speculation.

Entities such as CDOs and SIVs were set up as a means for Wall Street to extract enormous profits, while at the same time cloaking the extremely fragile foundation for this supposed economic growth. As the housing market deflates, this whole structure is beginning to unravel.

Joe Kay and Paul Craig Roberts point out something important that is often overlooked. The U.S. economy has been producing less and less and the financial shenanigans are designed to conceal that fact while extracting wealth from the decline. The major area of creativity has been financial creativity which easily becomes financial criminality. Ran Prieur sees the good news in this. There is a lot of creativity waiting to be unleashed:

November 25. In the same way that we can get sexually frustrated, I think industrial civilization is full of people who are technically frustrated. The other day I made a few offhand comments about hauling shipping containers and cutting up girders and finding uses for abandoned steel-framed towers, and I got a small flood of technical advice about biodiesel trucks and DIY oxy-acetylene and pulley systems to raise dirt up buildings. I have no doubt that I could assemble a team of 100 people, from readers of this site, with the knowledge and inventiveness to turn the Sears Tower into a greenhouse with mobile ballistas to fight off invaders, constructed from rails left over from converting railroads into bike paths... or more likely you could all think of even better uses for old railroads and buildings. And yet here we are sitting at computers we didn't make, on chairs and in buildings we didn't make, doing jobs nobody likes to buy food we didn't grow. This is actually good news! As the dominant system breaks down, all this creative energy will be breaking out all over, and it will get harder for the jealous haters of life to crush it.