California Forgoes Insurance On Municipal Bonds

In an interesting twist, California sells $1 Billion of State bonds Forgoing Insurance.

California, the largest borrower in the U.S. municipal market, sold $1 billion of general obligation bonds without insurance, joining a growing number of issuers questioning the value of buying such coverage.

California joins New York City, Tallahassee and other state and local governments in re-evaluating the benefits of AAA bond insurance -- applied to almost half of all municipal bonds to lift their ratings, ease trading and guard against default. Credit-rating services are reviewing the insurers following their backing of debt linked to defaulted home loans.

"The premium to be realized from bringing a deal insured has widened out enough that a lot of these issuers are just saying, `Let's go uninsured,' if nothing else than just to test the waters," said Evan Rourke, a municipal portfolio manager at M.D. Sass Associates in New York.
A quarter of the $11.1 billion in California general obligation bonds issued so far this year carried policies guaranteeing timely payment of interest and principal from various companies, including MBIA Inc. and FGIC Corp.

Insurance Value

"We are buying a triple-A rating with insurance, and given the current situation, we have to wonder, are we really getting that value?" said Tom Dresslar, Lockyer's spokesman.

Three weeks ago, Tallahassee, Florida's capital, sold $154 million of sewer bonds uninsured, scrapping plans to buy Ambac's backing for the deal. New York City is planning to forgo buying insurance in a $100 million of variable-rate bond offering as soon as next week.

Well so much for the idea that Ambac (ABK) and MBIA (MBI) will raise rates to dig themselves out of the hole they are in. Given that their "guarantees" are essentially worthless, why should anyone bother with insurance? That seems to be what a number of states have decided.

Ambac and and MBIA executives said "they could slow new business or issue debt to meet new ratings agency requirements". See Will Ambac and MBIA Survive? for further discussion.

But it looks like business is slowing already and I doubt that is a good sign for either company. As for issuing debt, who would want it in this environment? If anyone did what would the price be?

Ambac and MBIA as well as financials in general rallied big today as if the bailout proposal by Paulson, the administration and various lenders will accomplish anything. But as I said in "temporary" mortgage freeze is doomed, that bailout plan will have negative benefits and is doomed from the start.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com
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"temporary" mortgage freeze is doomed

The Bush Administration is proposing a "temporary" freeze on interest rates in the latest misguided government intrusion into private business activity.

The Bush administration and major financial institutions are close to agreeing on a plan that would temporarily freeze interest rates on certain troubled subprime home loans, according to people familiar with the negotiations.

The plan is being negotiated between regulators including the Treasury Department and a coalition of mortgage-related companies including Citigroup Inc., Wells Fargo & Co., Washington Mutual Inc. and Countrywide Financial Corp. People familiar with the talks say the individual members have agreed to follow any agreement reached by the coalition, which is called the Hope Now Alliance.

Mr. Paulson, who is philosophically opposed to federal meddling in markets, at first rejected a sweeping approach to loan modifications when the idea was floated by Federal Deposit Insurance Corp. Chairwoman Sheila Bair. But he shifted his position recently. He told The Wall Street Journal last week that it would be impossible to "process the number of workouts and modifications that are going to be necessary doing it just sort of one-off."

Mr. Paulson had it right the first time. Even if is theoretically possible for such meddling to work, history shows that government meddling always makes things worse in actual practice. Also remember that the lion's share of the blame for this mess goes to the Fed and Congress. With that in mind, the likelihood that this bailout proposal actually makes anything better is infinitesimal.

Details are Sketchy

• The government and the coalition have largely agreed to extend the lower introductory rate on home loans for certain borrowers who will have trouble making payments once their mortgages increase.
• Exactly which borrowers will qualify for the freeze and how long the freeze would last are yet to be determined.
• Under one scenario, the freeze could run as long as seven years. The parties are developing standard criteria that would determine eligibility. The criteria should be finalized by the end of year.
• Treasury officials say financial institutions are likely to set criteria that divide subprime borrowers into three groups: those who can continue to make their payments even if rates rise, those who can't afford their mortgages even if rates stay steady, and those who could keep their homes if the maturity date of their mortgages were extended or the interest rates remained at the teaser rates. Only the third group would be eligible for help.

So now the lenders all get together and decide who can afford to pay what. I have a counter proposal. Why don't grocery stores all get together and decide how much customers can afford to pay for a loaf of bread? Seriously, that is what is being discussed here.

But let's get one thing straight right up front. This has nothing whatsoever to do with "saving people's homes". This is about saving financial institutions from collapse. And the plan will fail. It rewards those who cannot afford to pay. The details are not in yet but I suspect one measure of the ability to pay will be whether or not one is current on their loans.

Anyone who wants a freeze should stop paying their mortgage now. It's clear that lending institutions do not want those homes back. This is best explained by example, and the best example is on Calculated Risk's blog in Florida REO: Priced Below 2002 New Home Price.

That in a nutshell is why we have this panic proposal from Bernanke, the Treasury Department and a coalition of mortgage-related companies including Citigroup Inc. (C), Wells Fargo & Co. (WFC), Washington Mutual Inc. (WM) and Countrywide Financial Corp (CFC).

Lending institutions are in a panic about the possibility of taking on more REOs. (Real Estate Owned, in this case by foreclosure).

I am not opposed to the free market working out these kinds of solutions, but the free market would not have come up with this solution. That in and of itself is another reason it will fail. In fact, had we not had a Fed lowering interest rates to 1% to foster this credit bubble, the bubble would never have gotten this big in the first place.

How those collective minds think this plan will work is beyond me. Here are three simple reasons the plan will fail:

• This plan will encourage those on the edge to fall behind just to get a freeze.
  
• This plan will foster resentment from those not being bailed out.
• This plan is a transparent attempt to make people debt slaves forever.

Point number three above is really what this misguided plan is all about. It will fail because it is in the best interest of those underwater on their loans to make it fail. People are going to understand they are way upside down on their home loans, and those people along with everyone who resents others being bailed out will have every reason in the world to walk away. So walk away they will. Book it.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com
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Freeze Is On In Florida

On Wednesday in Florida School Fund Faces Bankruptcy Over ABCP I made a prediction: "The State of Florida will freeze withdrawals and come up with a hokey plan to fix things just as happened with ABCP in Canada."

So it was no shock that on Thursday Florida Halts Withdrawals From Local Investment Fund.

Florida officials voted to suspend withdrawals from an investment fund for schools and local governments after redemptions sparked by downgrades of debt held in the portfolio reduced assets by 44 percent.

The Local Government Investment Pool had $3.5 billion of withdrawals today alone, putting assets at $15 billion, said Coleman Stipanovich, executive director of the State Board of Administration, which manages the fund along with other short- term investments and the state's $137 billion pension fund.

"If we don't do something quickly, we're not going to have an investment pool," Stipanovich said at the meeting in the state capitol in Tallahassee. The fund was the largest of its kind, managing $27 billion before this month's withdrawals.

My Comment: You already don't have an investment pool. What you have is frozen toxic waste. Freezing toxic waste does not make it any less toxic. Furthermore, and as a friend emailed me today "there's no reason to keep an investment pool aside from a bunch of bureaucrats wanting to preserve their sinecures".

"The people who withdrew were right to withdraw," said Joseph Mason, finance professor at Drexel University in Philadelphia and a former economist at the U.S. Treasury Department.

"The people who trusted in the good faith of the pool's management were burned. This is a severe blow if not a death knell to the concept of state-run investment pools."

My Comment" Every one of these managers thought they were geniuses for eking out an extra .1-.2% annually. All of that has now been given back and then some.

The board met today to consider ways to shore up the fund, including obtaining credit protection for $1.5 billion of downgraded and defaulted holdings hurt by the subprime market collapse.

My Comment: It's far too late to be thinking about credit protection. For starters it's amazingly expensive now (it was cheap 8 months ago) but the second problem is you cannot trust the protection you will get.

Stipanovich raised the possibility of having the state pension fund shoulder the risk of some of the troubled securities with a credit-default swap, through which the retirement fund would guarantee the debt in exchange for an insurance premium.

"It will be a wonderful diversifier," Stipanovich said.

My Comment: It will not diversify anything. It will rob Peter to pay Paul. What kind of diversification is that?

The trustees discussed an exemption to the suspension in withdrawals that would allow cities and schools to take money from the pool to pay employees; it was rejected.

"It's not set up to pay payroll," Crist said.

Because the trustees' decision to freeze withdrawals was an oral vote, not based on approving a written document, it is possible exceptions will be made to allow municipalities to meet their payrolls, said State Board of Administration spokesman Mike McCauley.

My Comment: These conversations get loonier and loonier. I predicted "hokey". I have to take that back already. It's loony. They were actually discussing freezing the plan but making payroll payments from it based on a distinction between a written document and an oral vote. Would anyone but a bureaucrat desperate to shield himself from blame concoct such a strategy? Sheeesh.

Here are three simple questions: Don't you have to sell something to make payments? Can you sell something if it's frozen? Does it make any difference if the vote is oral vs. written?

Paychecks Threatened

Hal Wilson, chief financial officer for the school district in Jefferson County, located 30 miles (42 kilometers) east of Tallahassee, said he had decided not to pull the district's $2.7 million from the fund. He said he relied on assurances from the state board that the money would be secure for his 1,559-student school system, with 220 employees.

"I might not be able to pay our employees tomorrow," he said, referring to his $850,000 payroll. "I am sure that those money managers who withdrew all their funds are feeling really smug right now, thinking they did the right thing. But it left the rest of us holding the bag."

My Comment: Hal, you clearly forgot the first rule of panic: If you are going to panic, do so before everyone else does. In this case it probably is not even panic we are talking about. Rather it's ability to smell a rat.

The pool was created in 1982 to provide higher short-term returns for local schools and governments than were available at banks. Today, Crist suggested the pool's time may have passed.

My Comment: The time to stop chasing yield has long passed. Please consider GE's "enhanced" cash fund breaks the buck. "GE made an extra .1%+- or so for three years (.3%+- total) and now have given back 4% in one fell swoop." The situation in Florida looks far more serious.

Local Government Return Pools


click on chart for crisper image

The above chart is thanks to SBA Florida Investing for Florida's Future.

That chart was the pride and envy of the nation. I now wonder how many other plans got sucked into similar strategies.

Those left in the fund are going to bear the brunt of the losses. However, those losses are not possible to calculate at this time. The sad fact is there simply is no market for a lot of the junk remaining in the fund.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com
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Lenders Rapidly Tighten Credit

While everyone is focused on what the Fed will or won't do on December 11, a far more significant event is happening right now: Lenders are Rapidly Tightening the Flow of Credit.

Credit flowing to American companies is drying up at a pace not seen in decades, threatening the creation of jobs and the expansion of businesses, while intensifying worries that the economy may be headed for recession.

The combined value of two leading sources of credit — outstanding commercial and industrial bank loans, and short-term loans known as commercial paper — peaked at about $3.3 trillion in August, according to data from the Federal Reserve. By mid-November, such credit was down to $3 trillion, a drop of nearly 9 percent.

Not once in the years since the Fed began tracking such numbers in 1973 has this artery of finance constricted so rapidly. Smaller declines preceded three recessions going back to 1975; at other times such declines tended to occur in conjunction with an economic downturn.

Watch LIBOR

While the amateurs are pouring over every word the Fed says on interest rates policy as if any of it could be believed, the pros are watching LIBOR. In case you missed it Professor Depew addressed the question Why Should You Care About LIBOR? on November 16.

In a nutshell, LIBOR is about bank to bank willingness to lend. Increasing LIBOR rates show decreasing willingness to lend and/or an inability to lend (a lack of cash).

For more on the lack of cash theme, please see Where's the Cash?

With all the above in mind it should not be a shock to see LIBOR rising given that credit is contracting at the fastest rate ever going all the way back to 1973.

But it's not really the rate itself, but the spread between LIBOR and the Fed Funds Rate that shows stress. I talked about this idea on November 26 in LIBOR Rates Show Stress.

Here is a chart from that post.



click on chart for a sharper image

My comments on November 26 were as follows.

Six months ago the spread between the 1 month LIBOR and the Fed Funds Rate was a mere 7 basis points. The spread between the 3 month LIBOR and the Fed Funds Rate was a mere 11 basis points.

Today, the spreads are 30 basis points and 55 basis points respectively. They are also headed the wrong way compared to a month ago.

This is a sign that banks are reluctant to lend overnight to one another. They are holding onto to cash and treasuries which is driving up costs of overnight lending. Real cash is in short supply.

November 29 LIBOR



click on chart for a sharper image

The 1 month and 3 months spreads to the Fed Funds Rate are now 72 basis points and 62 basis points respectively with the yield on the 1 month higher the three month.

Inquiring minds may be asking "If LIBOR showed stress at 30 basis points what does 72 basis points show?" The answer is increasing risk of a major bank failure or major market dislocation.
As long as LIBOR stays elevated, this market is at extreme risk.

Dollar & Euro LIBOR Spreads

The LIBOR issue goes beyond the US.

In fact, it is worse in Europe as the following chart from the Financial Times shows.



That chart is now a few days old and LIBOR is higher today, however a quick glance is all it should take to see a nice correlation between LIBOR and stock market action. Right now, either LIBOR is wrong or the stock market is wrong because it is highly unlikely that the stock market keeps shooting up along with the recent increase in LIBOR spreads.

Text from the Financial Time article is interesting. It shows how twisted financial thought became.

The feverish financial innovation seen this decade has enabled banks to turn corporate and consumer loans into securities that have then been sold all over the world. Until recently it was presumed that this innovation had made banks stronger than before, because they had passed credit risk on to others.

Consequently, regulators and investors tended to presume that the main threats to stability in the modern financial world came not from banks but risk-loving players such as hedge funds. Recent events have, however, turned these assumptions on their head.

Instead, share prices of the banking groups have slid as it became clear that banks had offloaded less risk from their books as investors and regulators had presumed.
When the credit crisis first emerged this summer, many economists initially thought it would have limited impact on US growth. Some cited parallels with the events of 1998 surrounding Long Term Capital Management, a hedge fund that imploded: that an event shocked Wall Street but barely affected the wider American economy, let alone that of the world.

But it is now clear that the 2007 credit shock has implications that extend well beyond hedge funds or Wall Street. As the credit losses pile up, the banks’ capital resources are being squeezed – and that is forcing them to cut lending, particularly to riskier companies and consumers.

It is simply impossible for every player to offload risk, especially when risk was so embraced with leverage as it has been. Greenspan pounded the table on the virtues of offloading risk, but the miracle never came. In fact, the opposite has happened and as a result the entire financial system is at risk.

Long Range Affects Of Raining Liquidity

I happened to stumble on something that Professor Succo wrote in a buzz on 12/28/2006 that is very pertinent to this discussion:

As central banks rain liquidity (credit) down on markets, its long range effects eventually cause the very thing central banks are trying to avoid: deflation. The reason people don’t understand this is that it is cumulative; the accumulation of debt is in itself inflationary, but at a certain point it becomes unmanageable. Why is this?

Easy or free money (when central banks drive real interest rates below inflation rates) is irresistible. It wouldn’t be if people managed risk properly but they do not. Easy money causes competition for “projects” to increase; companies with free money take risk with it for less and less return. I am seeing deals getting done in LBO land and commercial real estate being built using very aggressive assumptions and low cap rates. With all that “money” out there, rates of return drops dramatically. Everyone is starved for income.

At the very time income and returns are dropping, debt is increasing. Less income with more debt means that eventually it gets impossible to service that debt.

Well here we are. It has become impossible to service that debt. Massively rising foreclosures in the residential sector should be proof enough. And the downturn in commercial real estate has just started. Bank capital is severely impacted already and supposedly we are not even in a recession yet. We soon will be and watch what happens to unemployment rates and additional credit impairments when we do.

The problems are now so huge that it does not matter what the Fed does with interest rates. Asset prices are dropping like a rock even though the stock market has not yet gone down for the count. With the enormous leverage in the system, credit and capital is being destroyed at a very fast clip and it will be destroyed at an even faster clip once the stock market and corporate bond market head south in a major way. Both will.

A key point in this mess is the Fed cannot provide capital (drop money out of helicopters) all it can do is provide liquidity. However, liquidity is not the problem here, solvency is.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com
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Where's the Cash?

With the mad scramble of Citigroup (C), Ambac (ABK) , MBIA (MBI) and other corporations to raise cash, and with banks reluctant to even lend to each other overnight, inquiring minds just might be asking Where the Heck Is all the Cash?

It's a good question too, so let's sneak a peak inside in the latest Fed report on Assets and Liabilities of Commercial Banks to see if we can find some clues.

November 23, 2007 Asset Highlights

Total Assets $10.734 Trillion

Loans and Leases $6.698 Trillion

• Commercial & Industrial Loans & Leasing $1.400 Trillion
• Real Estate Loans & Leasing $3.555 Trillion
  
• Consumer $.791 Trillion
• Security $.291 Trillion
• Other $.660 Trillion
  

Actual Cash $308 Billion
Other Assets $934 Billion.

November 23, 2007 Liability Highlights

Total Liabilities $9.617 Trillion

Deposits $6.683 Trillion
Transaction $606 Billion
Nontransaction $6.076 Trillion

Transaction Deposit are deposit against which check may be withdrawn. This includes demand deposits, Negotiable Order of Withdrawal (NOW) saving accounts on which check may be withdrawn, Money Market Deposit (MMD)which have limited check writing privileges.

Nontransaction Deposits are interest bearing account against which check can’t be written. This includes passbook savings accounts, small time deposits, and negotiable CDs.

The balance spread between assets and liabilities seems healthy on the surface but such analysis presumes the value of the loans, property, etc were marked to market when the asset side was totaled.

That health also presumes there will not be significant future deterioration in receivables. See FASB 157 Partial Deferral Implications for marking assets to market.

Let's leave that discussion for a later time and look at actual cash.

Demand Deposits



click on chart for a sharper image

Demand deposits are checking accounts. They are called demand deposits because the money is supposed to be available "on demand". The above chart shows roughly $300+- billion in deposits. The assets and liabilities numbers at the top of this post show there is $300+- billion in cash.

On the surface everything seems perfectly normal, but inquiring minds are now asking "What about sweeps?"

What are Sweeps?

Sweeps are automated programs that "sweep" funds from one type of account into another type of account automatically. In this case we are talking about programs that allow banks to "sweep" funds from checking accounts to other types of accounts such as savings accounts that allow money to be lent out.

Sweeps were initiated by Greenspan in 1994. Take a look at the above chart to see what has happened since then.

For more on sweeps, M1, M2,, savings accounts, and credit transactions, please see my post Money Supply - A Question About Credit.

The Fed has also written about sweeps.

Federal Reserve Board Data on OCD Sweep Account Programs

Since January 1994, hundreds of banks and other depository financial institutions have implemented automated computer programs that reduce their required reserves by analyzing customers' use of checkable deposits (demand deposits, ATS, NOW, and other checkable deposits) and "sweeping" such deposits into savings deposits (specifically, MMDA, or money market deposit accounts).

Under the Federal Reserve's Regulation D, MMDA accounts are personal saving deposits and, hence, have a zero statutory reserve requirement.

Retail sweep programs have substantially distorted the growth of M1, total reserves and the monetary base, as Chairman Greenspan noted in his July 1995 Humphrey-Hawkins Act testimony to the Congress.

Something For Nothing

If that is not bizarre enough for you, please consider this "win win" miracle of modern finance proposal.

Retail deposit sweep programs increase bank earnings by reducing the amount of noninterest bearing deposits that banks hold at Federal Reserve banks. A bank's transaction deposits beyond approximately the first $50 million are subject to a 10 percent reserve requirement ratio, which is satisfied by holding vault cash or noninterest-bearing deposits at Federal Reserve banks. In contrast, savings deposits are subject to a zero percent ratio.

Retail deposit sweep programs take advantage of this difference by "sweeping" transaction deposits into savings deposits—that is, relabeling transaction deposits as savings deposits for reserve-requirement purposes.

This "win-win" experience with retail deposit sweep programs—higher bank earnings without increased federal funds rate volatility—has led some members of Congress to propose relaxing regulatory constraints on retail deposit sweeping.

Proposed legislation would increase that limit to 24 transfers per month, more than one for each business day.

Such a change would be economically equivalent to reducing the reserve-requirement ratio to zero for banks with sweep programs—effectively, the end of binding statutory reserve requirements in the United States.

Wow! Let's lend out every penny. Why not? Who needs cash? Savings deposits already have a reserve requirement of zero, checking accounts are the next logical extension.

Inquiring minds are now asking "How much money are we talking about?" That's a good question too. As stated, 100% of savings deposits have been lent out. If you have money in a savings account it simply isn't there.

Savings deposit figures are readily available. However, checking deposit figures are grossly distorted by sweeps as discussed.

Sweeps Data

The Fed hides sweeps data in an obscure online publication called swdata. Scrolling to the bottom we see 759.8 billion in sweeps. That means only $300+- billion of $1.059+- trillion cash that should be available on demand is actually available on demand.

Inquiring minds will note that the data is now 2 months old. It is never less than two months old. I have no idea why it takes the Fed 2-3 months to post this data. I suppose we should be grateful they publish it at all.

M' vs. M1

When constructing the monetary aggregate I call M Prime (M') missing months are extrapolated because it is the best we can do.

M' is essentially (but not exactly) what M1 used to be before Greenspan allowed sweeps. It's pretty absurd that we have to do this but what the heck, it gives me something to write about. By the way, it took nearly a year to figure this all out.

Those interested in seeing the rationale behind M' can read Money Supply and Recessions. I should have another M' update out soon. Bear in mind that it typically changes very slowly.

Where's the Cash?

As for savings accounts, none of it is actually in your account. Reserve requirement on savings accounts are zero. 100% has been lent out.

As for checking accounts, most of the money you think is sitting in your checking account simply is not there either. Less than a third of it is there. Based on the "win win" success of sweeps to date, the financial wizards think that none of it should be there.

So where's the cash? You tell me. Perhaps it's sitting in SIVs, mortgages, lent to hedge funds, in asset backed commercial paper ABCP, or for conservative banks sitting in short term treasuries.

All I know is that money isn't where most people think it is: In their checking accounts.

By the way, the real extent of the problem is far worse that appears at first glance because with the miracle of fractional reserve lending, money that was "borrowed into existence" was lent out over and over again.

This was not a problem until now. As long as asset prices are rising banks have plenty of capital to lend. But now that bank balance sheets are impaired there is a mad scramble for cash but there isn't much cash anywhere except of course China, Japan, and the oil states, all sitting on huge US dollar reserves and not knowing what to do with them.

In the end, Citigroup had to be bailed out by Abu Dhabi, an obscure country that no one had heard of until several days ago when Petrodollars Returned Home. Expect to see more cash infusions like that, because there is little cash to be found here.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com
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Initial Unemployment Claims Jump

If the Fed was looking for an excuse to cut 50 basis points it found one as Unemployment Insurance Weekly Claims soared.

SEASONALLY ADJUSTED DATA

In the week ending Nov. 24, the advance figure for seasonally adjusted initial claims was 352,000, an increase of 23,000 from the previous week's revised figure of 329,000. The 4-week moving average was 335,250, an increase of 5,750 from the previous week's revised average of 329,500.

The advance seasonally adjusted insured unemployment rate was 2.0 percent for the week ending Nov. 17, an increase of 0.1 percentage point from the prior week's unrevised rate of 1.9 percent.

The advance number for seasonally adjusted insured unemployment during the week ending Nov. 17 was 2,665,000, an increase of 112,000 from the preceding week's revised level of 2,553,000. The 4-week moving average was 2,589,250, an increase of 20,500 from the preceding week's revised average of 2,568,750.

Continuing claims rose by 112,000 the highest mark since Dec 24, 2005.

The only debate now is how much the Fed cuts in December. If the next monthly jobs report is miserable and weekly claims remain elevated, the Fed is likely to cut 50 basis points.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com
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Moral Hazards And Fed Actions

I just finished reading the complete speech by Fed Vice Chairman Donald L. Kohn on Financial Markets and Central Banking.

Supposedly this ignited a rip-roaring rally on Wednesday but the reality is everyone knew a rate cut was coming anyway so there is no way this could have caused a rally. For more on this idea please see Non-Voting Plosser Sets Hawkish Tone.

The market rallied steeply because that is what bear market rallies do when they get as oversold as this market was.

More interesting to me was Kohn's discussion on Moral Hazards.

Moral Hazard

Central banks seek to promote financial stability while avoiding the creation of moral hazard. People should bear the consequences of their decisions about lending, borrowing, and managing their portfolios, both when those decisions turn out to be wise and when they turn out to be ill advised. At the same time, however, in my view, when the decisions do go poorly, innocent bystanders should not have to bear the cost.

To be sure, lowering interest rates to keep the economy on an even keel when adverse financial market developments occur will reduce the penalty incurred by some people who exercised poor judgment. But these people are still bearing the costs of their decisions and we should not hold the economy hostage to teach a small segment of the population a lesson.

To minimize moral hazard, central banks should operate as much as possible through general instruments not aimed at individual institutions. Open market operations fit this description, but so, too, can the discount window when it is structured to make credit available only to clearly solvent institutions in support of market functioning.

The Federal Reserve's reduction of the discount rate penalty by 50 basis points in August followed this model. It was intended not to help particular institutions but rather to open up a source of liquidity to the financial system to complement open market operations, which deal with a more limited set of counterparties and collateral.

Asymmetric Response Create A Moral Hazard

Kohn is disingenuous at best and a blatant liar at worst with that speech.

The Fed claims to seek "price stability" but idly stands by ant lets bubbles expand to amazing proportions. Then after the bubble pops, all of a sudden the Fed claims to be concerned about "innocent bystanders".

For starters, the only innocent bystanders are those who sat the bubble out. Everyone else was greedy, perhaps even willing participants to fraud.

The truly innocent were hurt many ways: They were robbed by the Fed's inflationary policies, they received inadequate interest for their cash savings, and property taxes soared while incomes did not. Those on fixed incomes suffered the most. On the other hand, the enormously wealthy benefited the most.

So let's be honest here. The Fed does really not care about those who were hurt. If it did, it would not have let the conditions that fostered this bubble brew as long as it did. The Fed is only concerned about a credit crunch that is affecting bank profits and bank's ability to lend.

That unfortunately is the harsh reality. Even if you choose not to believe that, the Fed's asymmetric actions are a moral hazard in and of themselves. By acting only after bubbles break rather than taking aim at the conditions that foster bubbles (loose credit standards fostered by setting interest rates too low), the Fed has an active policy that is guaranteed to bail out reckless lending institutions whenever they make mistakes.

And when market participants think they are going to be bailed out by the Fed, all kinds of ridiculous risks are taken. Now in a so called effort to protect the "innocent bystanders", those innocent bystanders are about to be punished a second time.

The only way to stop this cycle of bubble blowing is to abolish the Fed. There is only one candidate with that on his platform and that person is Ron Paul. I support Ron Paul.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com
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Commercial Real Estate Market Is Imploding

Deadbeat Commercial developers Signaled by Property Derivatives.

"Commercial real estate is a full-blown bubble that feels very much at a bursting point," said Christian Stracke, an analyst in London at CreditSights Inc., a fixed-income research firm. "There's a fairly toxic mix of factors at work."

The seven-year rally in offices and retail properties ended in September when prices fell an average of 1.2 percent, according to Moody's Investors Service. Banks worldwide are holding $54 billion of unsold commercial mortgages, according to data compiled by New York-based Citigroup Inc. that includes fixed and floating-rate debt.

Lenders are struggling to sell loans to investors after losses on debt backed by subprime mortgages to people with poor credit caused financial markets to seize up in July and August. Bonds with AAA ratings secured by properties ranging from the Sears Tower in Chicago to trailer parks in Delaware yield about 203 basis points more than similar maturity Treasuries, up from 92 basis points on Oct. 12, according to Morgan Stanley indexes.

The benchmark CMBX-NA-AAA index of derivatives tied to the safest commercial mortgage securities rose to 102 basis points from 44 a month ago. It costs $102,000 a year to protect $10 million of bonds backed by property loans against default, up from $44,000 a month ago.

Sales of debt secured by commercial mortgages tumbled 80 percent to $3.9 billion in October from a year earlier, data compiled by Bloomberg show. New securities backed by loans on buildings will fall 50 percent in 2008 from $220 billion this year, Moody's said Nov. 2.

My Comment: This is a full blown commercial real estate credit crunch. What else would one call an 80% decline? Furthermore, a 50% projected drop for all of next year is quite a contraction.

Real estate deals are coming apart at the fastest pace since September 2001, when the U.S. economy was shrinking, because banks are tightening standards for loans, said Robert White, president of Real Capital Analytics, a New York-based research firm.

About $15 billion of commercial property transactions of $10 million or more are under contract in the U.S., compared with about $70 billion at mid-year, White said. That's unusual because the number usually rises at year-end, he said.

Market is Imploding

More than 75 [deals] have been withdrawn because banks aren't lending, and that estimate is "probably conservative, because not all deals that blew up were well-publicized," White said.

"The commercial real estate market is imploding," said James Ortega, who manages $150 million at Saenz Hofmann Fund Advisory in Sao Paulo. Ortega has set trades to profit from a decline in property companies' shares. "We're about to experience a very significant correction."

My Comment: "Banks Aren't Lending" Fancy that. Large banks like Citigroup (C) are capital impaired. Citigroup could not do major commercial real estate deals now even if it wanted to. For more on this idea as well as the desperation at Citigroup please see Abu Dhabi Deal Raises Questions About Citigroup's Health and Petrodollars Return Home.

In Manhattan, the world's largest office market, the vacancy rate rose to 7.6 percent in October, the highest in a year, property brokerage Colliers ABR said. Rents increased 1.4 percent on average to $64.08 a square foot from September, the second-smallest month-to-month increase since June 2006.

My Comment: Blackstone (BX) has already admitted it may have "net losses for a number of years". Declining rents and rising vacancies are not going to help matters. See Commercial Real Estate Black Hole for more on Blackstone.

Subprime Similarities

Record-low interest rates in the past five years encouraged banks to loosen underwriting standards and caused prices to rise as much as 35 percent a year.

My Comment: This was obvious to the whole world and should have been obvious to Moody's, Fitch, and the S&P. Amazingly enough it either wasn't or they simply looked the other way. See Fitch Discloses Its Fatally Flawed Rating Model for more on fatally flawed models.

Banks provided loans that allowed borrowers to pay only interest, not principal, and lenders offered financing that exceeded property values, according to Moody's. The average loan-to-value ratio reached a record high of 117.5 in the third quarter for mortgages that were turned into bonds, from 90 in 2003, said Moody's, which bases its calculations on its own estimates of rental value.

Those are some of the same practices hurting the $10.7 trillion residential mortgage market, according to an annual survey in October by accounting firm PricewaterhouseCoopers and the Urban Land Institute in Washington.

My Comment: It was only a matter of time before this started to hit commercial real estate. And the key point here is that it is just starting. In baseball terms this is the top half of the first inning.

Bondholders helped feed demand for loans by purchasing a record $273 billion of securities backed by commercial mortgages this year, up from $95 billion in 2004, based on data compiled by Trepp LLC, a New York-based research firm.

Demand has dried up since July, when securities linked to subprime home mortgages contaminated credit markets and caused financial institutions to report losses or writedowns of more than $66 billion.

My Comment: Willingness to borrow and willingness to lend are both impacted. There is much pain to come. The declines in residential started out slow as well. Anyone remember the mantra "It's only subprime that affected?" The new mantra is "It's all subprime".

Banks also have about $283 billion of debt they provided to help finance leveraged buyouts in the U.S. and Europe that hasn't been sold, according to research by Charlotte, North Carolina-based Bank of America Corp.

My Comment: This is crucial. Banks will be lending impaired as long as they sit on this debt. If they dump it to get rid of it, they will take huge losses. If they sit on it, they will bleed capital and/or be lending impaired. Yes this is yet another Zugzwang for banks not strong enough to pull such "assets" on to the balance sheet.

IYR Weekly Chart



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Blackstone Daily Chart



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Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com
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Will Ambac and MBIA Survive?

JPMorgan (JPM) estimates that Bank CDO Losses May Reach $77 Billion.

Losses on collateralized debt obligations at the world's biggest banks may double to $77 billion, JPMorgan Chase & Co. analysts predict. Losses marketwide on CDOs linked to U.S. mortgages will reach about $260 billion, the New York-based JPMorgan analysts, led by Christopher Flanagan said in a report.

"One of the benefits of securitization is the offloading and global distribution of risk," the JPMorgan analysts wrote. "Ironically, this is now a capital markets hazard, since no one is sure where subprime losses lurk."

My Comment: Let me see if I have this straight.

• The risk was offloaded.
• Nobody knows to who.
• Nor do we know if those holding the risk are solvent and can pay up.

This is "One of the benefits of securitization"?

CDO sellers including Merrill (MER), Citigroup (C), UBS AG (UBS) and Deutsche Bank AG (DB) are taking losses on the "super-senior," or safest, pieces of the CDOs, according to JPMorgan. Writedowns on that debt should be between 20 and 80 percent, the analysts wrote.

JPMorgan's team of CDO research analysts led by Flanagan and Kedran Garrison was voted the best of its field in a poll by Institutional Investor magazine this year.

My Comment: How much help is it to determine after that fact that losses will be limited to a 60% range in the middle of the curve on debt rated the safest?

Bond insurers including Ambac Financial Group Inc. and MBIA Inc., which have "taken few reserves," own CDOs that have had $29 billion in losses, JPMorgan estimated.

My Comment: Perhaps without realizing it, JPMorgan just proclaimed Ambac (ABK) and MBIA (MBI) insolvent.

• As of the November 11 2007 10-Q MBIA had $6.96 billion in working capital.
• As of the November 09 2007 10-Q Ambac had $5.65 billion in working capital.
• Assuming JPMorgan is correct (or even in the ballpark), a combined $29 billion in losses makes the guarantees of those companies essentially worthless.

It's Too Late For Reinsurance To Work

It’s too late for reinsurance to do any good even as hard-hit bond insurers look to reinsurance for money.

Speaking at a Banc of America Securities bond insurer conference that was broadcast over the Internet, executives from Ambac Financial Group Inc. (ABK), MBIA Inc. (MBI) and Security Capital Assurance Ltd. (SCA) all said they could raise capital through reinsurance. Executives also said they could slow new business or issue debt to meet new ratings agency requirements.

My Comment: The amount of money that can be raised on the worst debt these insurers need to dispose of is negligible at this point. Perhaps they could offload the best of what they have, but where does that leave them other than insolvent?

As for slowing new business... You won't have to. The recession will do it for you. Business is slowing everywhere even as Bernanke calls the risks balanced.

The insurers face the prospect that each of the three major ratings agencies will demand higher capital requirements to provide a better cushion for potential losses.

My Comment: Moody's, Fitch, and the S&P are perpetually behind the curve and will forever remain behind the curve as long as they get paid by the companies whose debt they rate. By the time these companies are downgraded, bankruptcy will likely be less than a few months away. For more on this idea please see Time To Break Up The Credit Rating Cartel.

"Does the [market] implication carry water?" asked David Wallis, a senior managing director at Ambac. "I don't think it does. I have not read one report that reaches these sorts of numbers" on losses that are implied by current trading levels on bond insurers.

My Comment: David, please contact JPMorgan.

Sean Leonard, Ambac chief financial officer, said 85 percent of the company's portfolio was non-mortgage related and could be reinsured, which would free up capital to pay potential claims on its subprime coverage. The company already has reinsurance in place that gives it the option to increase coverage.

My Comment: So what? What are you going to do with your share of $29 billion in losses? Citigroup (C) sold nearly 5% of itself to raise $7.5 billion (See Petrodollars Return Home). Your market cap is a mere $2.21 billion. If you sold the whole company how much in the hole are you?

Ambac Daily Chart



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If that double bottom does not hold, be mentally prepared to kiss Ambac goodbye.

MBIA Daily Chart



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Security Capital Assurance Daily Chart



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It was a valiant fight but I fail to see how SCA can possibly survive.

As for the collective group, it's simply way too late for reinsurance to save Ambac, MBIA, and Security Capital Assurance. Each has greater CDO exposure than can possibly be covered by reinsurance. If any of them survive, it will not be on account of reinsurance.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com
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Florida School Fund Faces Bankruptcy Over ABCP

I spoke of the pending disaster for public school funds in general and Florida specifically on November 21 in SIV Debts A Disaster For Public School Funds.

As of that time Florida was still hiding losses on defaults. Not any more.

Amid rising asset backed commercial paper defaults, a Florida School Fund is Rocked by an $8 Billion Pullout.

Florida local governments and school districts pulled $8 billion out of a state-run investment pool, or 30 percent of its assets, after learning that the money- market fund contained more than $700 million of defaulted debt.

Orange County, home of Disney World, removed its entire $370 million from the pool on Nov. 16, two days after the head of the agency that manages the state's short-term investments disclosed the defaulted debt in a report delivered to Governor Charlie Crist.

The State Board of Administration manages about $42 billion of short-term investments, including the pool, as well as the state's $137 billion pension fund. Almost 6 percent, or $2.4 billion, of its short-term investments consist of asset-backed commercial paper that has defaulted. Those holdings include $425 million in Axon Financial, a structured investment vehicle, or SIV, according to state records.

About $19 billion remained in the pool this week after the unprecedented wave of withdrawals, which came after the State Board of Administration reported its holdings of downgraded debt to Crist at a Nov. 14 public meeting of his cabinet in Tallahassee. The disclosures followed a month of inquiries by Bloomberg News to Florida officials.

Word Spreads

"Knowing other people were pulling out, and that word was spreading, we looked at the potential for a run on the pool," said Orange County's Moye.

My Comment: Potential has turned into reality and the word is still spreading.

Should the withdrawals continue, Florida's pool may have to consider filing for bankruptcy protection, says John Coffee, a securities law professor at Columbia Law School in New York. "A bankruptcy could handle these kinds of problems if they feel they'll become insolvent,'' he said.

"I'd expect the pool is going to sue the people who sold them the commercial paper, saying the risks were hidden," he said.

Lehman Brothers Holdings Inc. sold Florida most of its now-default-rated asset-backed commercial paper. Lehman spokesman Randall Whitestone declined to comment.

My Comment: A lawsuit would be wasted money. Nothing will be recovered from Lehman.

At Crist's Nov. 14 cabinet meeting, Stipanovich said that while there was "disappointment" over recent downgraded investments, no local government had ever lost money in the pool since its creation in 1982.

My Comment: Well that trend is over.

Investor Confidence

Stipanovich also assured Crist and Florida Chief Financial Officer Alex Sink at that time that the pool maintained the confidence of its depositors.

"There are a lot of rumors flying around," testified Stipanovich. "I'm not aware that there have been any material outflows."

My Comment: Alex Sink and Stipanovich are living in fantasy land to be talking about confidence in the pool.

Because Florida's pool has been forced to quickly raise billions of dollars to meet withdrawal demands, it won't get top dollar for its asset sales, says Joseph Mason, professor of finance at Drexel University.

Mason, who has studied the history of bank failures, understands the rush by Florida municipalities to pull their money from the pool.

"The first people in the withdrawal line get 100 percent of their money," he said. "The loss is suffered by the people behind them in line. Since nobody wants to be at the end, you get a run on the pool."

My Comment: The first rule of panic is to do so before everyone else does. Mason clearly understands this principle.

Mason says while the state of Florida has a moral duty to cover any losses suffered by the pool participants, its own shaky finances will make that difficult. The fourth most- populous state, hurt by the housing slump, cut its revenue projections by 3.9 percent for the fiscal year ending June 30, and 5.2 percent for the following year.

"The state appears to have breached the trust of the investors by putting money in new kinds of debt its managers didn't fully understand, in their search for higher yields," Mason said.

My Comment: Breach of trust is putting things lightly.

I have a prediction: The State of Florida will freeze withdrawals and come up with a hokey plan to fix things just as happened with ABCP in Canada.

For more on the crisis in Canada and an idea of bailout plans that may be concocted here to address the issue please read Global Credit Crisis Canadian Style.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com
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Wells Fargo's $1.4 Billion Loan Loss

Wells Fargo sets aside $1.4 billion to cover loan losses, tightens lending standards, and plans to liquidate $11.9 billion portfolio.

Wells Fargo & Co., the second-largest U.S. mortgage lender, said late Tuesday that it will set aside $1.4 billion during the fourth quarter to cover higher losses on home-equity loans caused by deterioration in the real-estate market.

The special reserve covers an $11.9 billion portfolio of loans that the bank originated or acquired through indirect sources such as mortgage brokers, according to the bank. That portfolio will be sold off under the guidance of a dedicated management team, Wells added.

The company, which originated almost $150 billion of mortgages in the first half of 2007, also said that it will tighten lending standards further. While still lending directly to its customers, Wells said that it will stop originating and buying new home-equity loans from some of its previous, indirect sources.

'We believe it's prudent to further tighten our standards, to stop acquiring new loans in these segments and to manage the portfolio as a liquidating, nonstrategic asset' said John Stumpf, CEO Wells Fargo.

The $11.9 billion of home loans that were acquired through outside sources will now be liquidated. The bank already has stopped buying home-equity loans through so-called correspondent relationships, which include other financial institutions and mortgage companies.

In one word this is what John Stumpf, CEO Wells Fargo is describing: deflation. There is simply no other word for it.

Deflation is a decrease in money supply and credit. Wells Fargo is liquidating (cutting its losses in existing credit), while tightening lending standards for new credit.

Perhaps new credit at Wells Fargo exceeds the decrease in existing credit for a while, but the trend is clear and that trend is not just about Wells Fargo. Capital impairment is everywhere and capital impairment is going to restrict the ability of banks to lend whether Bernanke or anyone else likes it or not.

Take a look at Citigroup as Petrodollars Return Home. Citigroup raised capital at 11% interest in a desperation move to restore its balance sheet yet it is presumably offering prime loans at 7.5%. How long can this keep this up?

Bernanke and everyone else who is focused on capacity utilization, oil prices, the US dollar, wheat, or food at the local grocery store are simply focused on the wrong things.

The correct focus is on the ability and willingness of banks to lend, and the ability and willingness of consumers and businesses to borrow. Everything else is a sideshow.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com
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I Want My Buybacks Back

Corporations have squandered hundreds of billions of dollars over the past few years on stock buybacks.

One of the worst cases was Ambac which borrowed money to buyback shares right before it collapsed. I talked about Ambac in Stock Buybacks: A Good Thing Or Slipped DISCs?

Recently, Fannie & Freddie Were Clobbered Over Need to Raise Capital and Citigroup sold 4.9% of itself in an act of desperation to raise cash as reported in Petrodollars Return Home.

However, it's not just a handful of companies involved in poor decisions, Big Buybacks Are Haunting Many Firms.

Driven by billions of dollars in share buybacks, record-setting buyouts and a wave of mergers, the amount of stock in the market shrank by hundreds of billions of dollars in the past four years.

With the supply of stock down and demand strong, the market rallied. Now, as the economy slows and credit markets buckle, high-profile companies are cutting back on buybacks, and some wish they held on to the cash they gave back to shareholders.

Freddie Mac fell 29% on word that the mortgage company may halve its dividend and seek a capital infusion amid a record loss. Freddie might not be in this position if it hadn't bought back at least $1 billion of common stock earlier this year and replaced it with preferred shares.

Fannie Mae, the largest U.S. home-funding company, has tapped the markets more recently, raising $1.5 billion in less than two months by selling preferred stock. Fannie shares fell 25% yesterday and are at their lowest level since May 1996.

Countrywide Financial Corp., which spent $2.4 billion in the past year to repurchase its shares, was forced to sell a chunk of its stock to raise money.

Office Depot Inc., which bought back 5.7 million shares for an average price of $35 a share, said on its earnings call yesterday that it would like to buy its shares at the current price of $17.49, but can't. Office Depot fell 7% yesterday.

Home Depot Inc. said it will delay the rest of its massive stock-buyback plan, while investors in Citigroup Inc. have turned nervous about the health of the bank's balance sheet and capital levels, prompting management to say it isn't in the position to repurchase shares.

From the third quarter of 2002 to the second quarter of this year, more than $1.5 trillion of shares in nonfinancial companies has disappeared from the stock market through buybacks, mergers or buyouts, according to the Federal Reserve. The number hit a peak during the second quarter of this year, when nonfinancial companies retired a seasonally adjusted net $192.5 billion of shares.

Home Depot, for example, was downgraded in July by S&P to a triple-B-plus rating from A-plus. The rating agency specifically cited Home Depot's plans to finance a $22.5 billion share buyback through the proceeds of an asset sale and $12 billion in debt as the main reason for the downgrade. Last week, Home Depot, which already spent $10.8 billion on buybacks in the first three fiscal quarters of the year, said it believes "it is prudent to take a cautious stance with regard to the completion" of the buyback program.

Banks already are scaling back stock buybacks to conserve capital for other uses, like making loans to clients and setting aside money for bad loans. Further, the nation's largest financial institutions may need to use their balance sheets to fund loans for private-equity deals, because anticipated buyers for those loans have dried up, leaving the banks on the hook.

The capital issue is especially pressing at Citigroup, which recently saw a key measure of a bank's capital cushion, known as Tier One, fall below its target of 7.5% for the first time in years. The bank has said that it doesn't expect to repurchase shares until it restores its capital ratio in the middle of next year. While some have questioned whether Citigroup will have to consider cutting its dividend, the bank says it doesn't intend to do so. People familiar with the matter say there are other steps it can take to shore up its capital position.

Rethinking Buybacks

Investors Need to Look Closer at Share Repurchases, As Buybacks Don't Always Enhance Holder Value.

Repurchases, which some companies use borrowed money to pay for, don't always reduce share counts significantly, according to S&P equity analysts and study authors Stewart Glickman and Todd Rosenbluth.

For every 100 shares bought back during the study period from Jan. 1, 2006 to June 30, 2007, 78 shares were added as a result of the exercise of stock options, shares issued to fund acquisitions or for follow-on stock offerings.

The study found that 20 billion shares were repurchased during the period, which contributed to a mere 22 percent reduction in the total outstanding stock -- or 4.4 billion shares -- for the companies that were actively buying back stock.

Also, companies don't always buy their shares at a low price. More than one-third of companies have seen their stock price fall since repurchasing shares -- meaning they paid a premium. The stocks that dropped the most compared to the average prices paid for repurchases were Circuit City, KB Home, Pulte Homes, Centex and Countrywide Financial, according to the S&P study.

Most of the 423 companies that repurchased stock during the study period would have done better investing the cash in an S&P 500 index fund, or even more conservative holdings.

Let's build a list companies recklessly squandering capital from the above articles and other known happenings.

Squandered Money List

• Countrywide (CFC)
• Home Depot (HD)
• Citigroup (C)
• Fannie Mae (FNM)
• Freddie Mack (FRE)
• Ambac (ABK)
• MBIA (MBI)
• Circuit City (CC)
• KB Home (KBH)
• Pulte Homes (PHM)
• Centex (CTX)
• Toll Brothers (TOL)

Obviously that is a very short list of the worst offenders as there is not room to list 423 companies. And the most galling thing is that 78% of buybacks went for insider options. Shareholders got a mere 22% of the pie and most of that was wasted.

For all this corruption and graft, shareholders look the other way as executives grant themselves and the boards they sit on enormous salaries and perks. To top it off, insiders were massively bailing on their own shares while squandering shareholder money.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com
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Non-Voting Plosser Sets Hawkish Tone

When the Fed wants to set an untenable position it tends to do so with non-voting members. That is happening again today as Plosser doesn't soften hawkish tone on rates.

In a speech at the University of Rochester, Plosser said the Fed cannot resolve the cause of the tension in financial markets, uncertainty over the value of complex securities tied to subprime and other mortgages and who holds these derivatives.

"It is important to recognize that the Fed cannot resolve this price discovery problem. The markets will have to figure this out," Plosser said in his prepared remarks.

• "Arbitrarily lowering interest rates or providing liquidity to the market does not provide the answers the market seeks," Plosser said.
• Indeed, rate cuts might only delay the painful process, he said.
• Philadelphia Fed President Charles Plosser strongly suggested that he is not in favor of an additional rate cut at the next policy meeting on Dec. 11.

Plosner is correct that rate cuts will delay the recovery for the simple reason it will prolong the agony. Plosner should have stopped there. Instead he went on to talk about rebounds in mid-2008 and the economy recovering on its own. To that I say fat chance.

Furthermore, his statement that "The rise in oil prices and the simultaneous increases in a broader basket of commodity prices suggest that significant inflationary pressures exist in the economy and thus the Fed must be very vigilant," suggests that he does not know what inflation really is.

Credit is drying up and that is far more significant than oil prices.

With that in mind, Curve Watchers Anonymous is watching interest rate probabilities.

December FOMC Meeting Outcomes



What happens at the next FOMC meeting is going to depend on jobs. I suggest jobs will be bleak and point to another round of massive layoffs at Citigroup for what is likely to happen across the board in financials and retail. Thus, I expect another cut, no matter how misguided it may be. So does the above probability chart.

Does Plosser think he is fooling anyone? I don't.

The only problem is, investors are misguided if they think rate cuts are going to fix anything or reignite a love affair with either stocks or housing. Consumers and businesses alike are in no position to expand borrowing. Capital impairments are going to take a lot longer to fix than anyone thinks.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com
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Petrodollars Return Home

Last night I was watching the futures soar on news that Citigroup agreed to sell 4.9% of the company to Abu Dhabi in return for $7.5 billion in cash. See Abu Dhabi Deal Raises Questions About Citigroup's Health.

This morning Minyanville Professor Quint Tatro was talking about The Great Transfer of Wealth.

The problems the U.S. is facing today have come as a result of its own actions and it is now facing the consequences. This is nothing new and one can review many times in U.S. history when cycles have ebbed and flowed, resulting in booms and busts, the most recent being the technology bubble that came as a result of innovation, coupled with easy or cheap money and fueled by greed.

Now, however, it seems the U.S.' white knight has arrived and the U.S. will gladly accept the international community's assistance in working out its problems. Of course, this comes at a price and that is a transfer of this wealth at an incredible discount.

While I am still not sure how I feel about it all and I still need to process it quite a bit, my job as a market participant is not necessarily to over-analyze but to find a way to profit from it. I will be watching the financial stocks such as Citigroup, Washington Mutual (WM), Bank of America (BAC) to see how they handle today's news. If they can bounce from these levels I would suspect the S&P may start to find its footing, but if they cannot the blue light special may just have started.

Citigroup Deal Smells Of Desperation

Minyanville Professor Mark Bloudek is also talking about Citigroup in The Real Deal.

When I look at this deal it is quite interesting. First of all, it must be understood that this is effectively an equity deal because of the mandatory conversion provision. From the limited information I have been able to retrieve, it seems that Citigroup (C) is selling just under 5% of the company for approximately $5.7 bln. Why is it not the $7.5 bln that it is getting from the investors? Because Citi will have to pay interest on the $7.5 bln for just over two years, which will come out to approximately $1.8 bln. $7.5 - $1.8 = $5.7.

By my estimate, Citigroup has basically issued restricted equity (to be officially issued in two-plus years) at a price per share around the mid 20's when you take into account the 11% interest it is paying on the $7.5 bln. Additionally, Citi does get the benefit of using $7.5 bln now instead of only getting $5.7 bln now (if it had just done a straightforward equity deal), while paying $1.8 bln over the next two-plus years in interest.

All in all, this deal is a tough deal for Citi in my opinion because it smells like desperation. But don't be confused about the 11%. It is clear since the deal has mandatory conversion prices that the 11% interest rate is basically a discounting mechanism for the conversion price, which is why I say the equity was effectively issued in the mid 20's. It also must be noted that doing a convertible may have certain tax advantages for Citi instead of doing a straight equity deal in the 20's.

It should now be clear that Citigroup squandered tens of billions of dollars over the years buying back stock at inflated prices. The irony is that as petrodollars return home, foreigners get to buy in at an effective price in the mid-20's.

This is the price the US has to pay for the our spending sprees over the last seven years financed by China, Japan, and the oil producers. And what do we have to show for that spending spree? The answer is a sinking US dollar, neglected infrastructure, and a housing boom gone bust.

Given that foreign dollar reserves eventually have to come home, this deal is just a token down payment for what's to come.

On a side notes, I was asked this morning if foreign buying would support stock prices. The answer is that it won't. For every buyer there is a seller so "buying" never drives up prices except on the day of an IPO. Sentiment (willingness to take on risk and speculate) drives stock prices, not "buying". That sentiment is clearly waning.

The party is over. The US now must face the consequences.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com
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Abu Dhabi Deal Raises Questions About Citigroup's Health

Cash strapped Citigroup Sells Stake to Abu Dhabi Fund.

Citigroup said late Monday that the Abu Dhabi Investment Authority will invest $7.5 billion in the nation's largest bank, offering needed capital to offset big losses from mortgages and other investments.

The cash from the sovereign investment fund of the Gulf Arab state, which has been a beneficiary of this year's surge in oil prices, will be convertible into no more than 4.9 percent of Citigroup Inc.'s equity.

The Abu Dhabi investment, which was expected to close within the next several days, will be considered Tier 1 capital for regulatory purposes, helping Citi reach its goal of returning to its target capital ratios in the first half of 2008, the bank said.

The Investment Authority will receive equity units that pay an 11 percent annual yield until they are converted into Citigroup common shares at a price of up to $37.24 a share between March 15, 2010, and Sept. 15, 2011.

That announcement right on the heels of Massive Job Cuts shows just how bad things are at Citigroup.

Flashback November 1 2007
Analyst Raised Doubts About Citigroup's Dividend.

A longtime banking analyst said late last night that Citigroup may be forced to cut its dividend or sell assets to stave off what she said was a $30 billion capital shortfall, moves that could pull down its shareholder returns for several years.

The analyst, Meredith A. Whitney of CIBC World Markets, downgraded Citigroup’s stock to sector underperform, from sector perform, and called for the bank to bring precariously low capital levels more in line with its peers.

“We believe the stock will be under significant pressure and could trade in the low $30s,” she wrote. That would be as much as a 28 percent decline from yesterday’s $41.90

Citigroup’s management has said that it expects capital to return to its target levels in early 2008. It plans to use stock in its Nikko Cordial purchase, improving its balance sheet management, and not repurchasing stock until it bolsters its capital cushion.

Other banking and risk experts agree with Ms. Whitney’s analysis, however, and some suggest that it may even be conservative. Citigroup’s capital position “is too low based on the risks on the trading side but the kicker is that Citigroup is going to have a lot more losses” on the consumer side, said Christopher Whalen, the managing director of Institutional Risk Analytics. “It is going to be a one-two punch.”

Good call Meredith, on both stock price and on the need to sell assets.

The New Your Times offers this take on Abu Dhabi.

Citigroup announced last night that it was selling a $7.5 billion stake to a Middle Eastern sovereign fund in the latest bid to shore up its precariously low capital base.

Abu Dhabi’s 4.9 percent stake means that nearly 10 percent of Citigroup will be controlled by Middle Eastern investors. Prince Walid bin Talal already owns a roughly 5 percent stake after bailing out the company in the early 1990s.

The investment from Abu Dhabi underscores Citigroup’s precarious capital position, and also highlights the growing petrodollar wealth of Mideast countries, which are buying up assets and taking stakes in numerous American companies.

In addition to bolstering Citigroup’s capital base, which has dwindled to unusually low levels after a spate of acquisitions and recent credit market turmoil, the move should ease pressure on Citigroup’s dividend.

The company’s management has committed to maintaining its dividend while significantly bolstering its capital levels by the end of the second quarter of 2008.

Will this cure what ails Citigroup? It could if that was all that was needed but I doubt it. The "one-two punch” as described by Christopher Whalen has not even landed yet. It will.

Questions Raised

• Is Citigroup prepared for the mortgage mess to get far worse?
  
• What about losses on the consumer side as we slide into a severe recession?
• What happens when commercial real estate tanks?
  
• What happens when Citigroup needs another $7.5 billion, then another after that?
• When does the dividend get cut? (Citigroup denies that it will)
  
• Is Citigroup so bloated that it can afford another massive jobs cut?
  
• If not, then what business units have to be sold to downsize to the new number of employees?

Selling a 4.9% stake in the company is a step that is not taken lightly. Nor is another round of massive layoffs. All things considered however, Monday's news reports on Citigroup raise more questions than they answer. The one thing we do know for certain is that Citigroup was (and likely still is) severely capital restrained. On November 5th I said Citigroup Is Fighting For Its Financial Life. It still is.

Mike Shedlock / Mish
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Massive Job Cuts Expected At Citigroup

Citigroup fell under $30 for the first time in five years after CNBC reported the firm could lay off up to 45,000 staffers.

Citigroup, Wall Street’s largest financial services firms, is planning its second round of large-scale layoffs in less than a year.

People with knowledge of the matter have described the pending job reductions as "massive" and "large." The total number could reach as high as 45,000, these people estimate.

In a statement, Citigroup said: "We are engaged in a planning process in anticipation of our new CEO and our business heads are planning ways in which we can be more efficient and cost effective to position our businesses in line with economic realities. Any reports on specific numbers are not factual."

45,000 jobs, should it come to that, is one heck of a lot of jobs. I doubt most of those employees could find jobs quickly, at the same salary, or the same benefit levels.

Nonetheless, this is just a down payment on what's to come. Other financial institutions are sure to follow suit.

Rate Cuts Priced In

Another rate cut from the Fed is coming. It will do no more good than the last 3 did, but Bernanke will try anyway. Nothing like heading into a recession with rates already as low as 4.25 or possibly even 4.00%.

Don't expect any mortgage relief. Rates are still higher than a year ago and that does not even factor in credit standards that have tightened significantly.

On the next cut or two I would expect 15 year fixed mortgages to finally dip below what they were a year ago, and for 30 year rates to be about what they were a year ago. That is not much relief to cash strapped consumers.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com
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Yet Another Treasury Rally

Last Friday, I was talking about an economist survey suggesting treasury yields were heading North. This is what I wrote in Huge Treasury Rally Underway: Where To From Here?

I am amazed by that survey. What the heck are those economists possibly thinking? Stranger things have happened I suppose, but that is an extremely poor bet. In fact, if jobs come in exceptionally week, 10 year yields could drop to 3.75 or so.

It would take a huge jobs number to cause a treasury selloff like that predicted by the economists survey. In addition, mortgage rates will soar should that happen.

It is always dangerous to make specific predictions in a specific timeframe but I am going to give it a shot. The line in blue is what I think the curve will look like if the next jobs report comes in weak.

Yield Curve As Of November 23 2007



click on chart for a crisper image

At Noon today the curve was essentially flat and I talked about that in LIBOR Rates Show Stress. I took another look at the curve near the close. Here it is. To make things line up visually I am putting it in blockquotes even though I am not quoting anything.

Yield Curve As Of November 26 2007



Compare the green line with the blue line above.

No, I did not expect this in a week let alone one trading day. However, we are where we are and if jobs are weak we could see 30 year yields below 4. I am not calling for that now, but I do expect it sometime next year.

One thing this highlights: Surprises are most often in the direction of the prevailing trend. In this case, the trend is towards lower yields. As an aside, anyone who thinks this action portends rising inflation expectations must be reading the Bizarro World playbook.

Mike Shedlock / Mish
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