April 16, 2008 12:39PM

What Inning is the Great Credit Crunch In?

By Elizabeth MacDonald

Top executives of Goldman Sachs (GS) and Morgan Stanley (MS) now say respectively that the financials are in the fourth quarter or ninth inning of the credit mess. 

Yes, and all of the financials’ profit reports are as sweetly fresh as lilacs after rain, and their stock prices are really not careening around worse than the Jamaican bobsled team.

An admitted accounting geek, I have reported on quality of earnings for more than a decade. No way, no how am I an expert, when I hear that, it feels like my brain is starting to run out of my ears. I am just a journalist. But having researched this and talked to the pros as much as I can, my thinking on this is clear as a cold country creek.

There is still plenty enough voltage and not enough shock absorbers in the financials’ balance sheets to leave any Wall Street executive feeling as withered as a salted snail.

Which is why you’ll see the more circumspect Wall Streeters like Richard Fuld, chief executive of Lehman Brothers (LEH), and his chief financial officer Erin Callan carefully couch what’s going on by saying that, while the current financial crisis may be past its nadir, problems remain.

And which is why it’s passing strange that John Thain, chief executive of Merrill Lynch (MER), has been saying his beleaguered brokerage doesn’t need more funds after raising nearly $12.8b, although the Wall Street Journal says you can expect to see $6b-$8b in writedowns when it reports earnings tomorrow.

I must get this out of the way first. What’s really intolerable is the combination of finger wagging brimstone behavior and self righteous piety on what the world needs to do to fix the credit crisis coming from the likes of George Soros, a billionaire who has built his fortune on the backs of past crises, and a certain high level central banker instrumental in helping create this one, you know who I mean, weighing in like a self-serving cuckoo clock as well (as Abe Lincoln once said, “he can compress the most words into the smallest number of ideas of any man I ever met.”)

We are not out of the woods just yet. Banks are rapidly recapitalizing with infusions from sovereign wealth funds (some SWFs have seen their stakes drop 20% or more), from private equity firms, and either by selling assets or issuing new shares. Suffice it to say investor pain remains. Not just pain in the form of shareholder dilution–the negative G-forces in the form of damaged credit on bank balance sheets have created a Black hole from which no dividend can (or should) escape.

Here are the statistics. Anywhere from $360b to $460b of adjustable-rate loans are scheduled to reset this year. About 9m borrowers are upside down in their mortgages. Auction notices rose 32% year over year, a sign that defaulting homeowners are just walking away, market watcher Richard Suttmeier says. A cold calculation–borrowers, even those with decent credit scores, find it easy to walk away from their houses when their loans are close to or surpass the market value of the property.

And as the value of securities tied to mortgages nosedives, banks and investment houses will face more writedowns, which so far have totaled at least $245b since the beginning of 2007. Some estimates put the eventual cost at $460b. The IMF puts the credit losses overall at $945b. It’s anyone’s guess now. UBS (UBS) still has ropey assets on its balance sheet, some $31b. Goldman Sachs (GS), $96.5b, Morgan Stanley (MS), $78.2b.

So no more talk of innings or basketball quarters. This feels more like a basketball game’s shot clock.

But here’s what should most concern you. Hedge fund Greenlight Capital’s David Einhorn, as sharp a pencil as any when it comes to reading the financial statements, says investors may choke when they take a closer look at what’s really sitting on the financials’ balance sheet.

Remember how in the past couple of months how Carlyle Capital was on the brink of collapse, he asks? It used its balance sheet assets to do more borrowing, levering itself 30 to one against its assets. Same leverage ratio for Merrill. Same for Bear Stearns.

But Carlyle’s portfolio had triple-A rated government securities, historically the safest paper around, Einhorn notes. Chilling.

What’s even more perilous is what Einhorn found out that’s really going on with a critically important valuation metric used to assess the health of banks and brokerages. It’s called return on equity, the equity portion similar to what is an individual’s net worth. Einhorn says that banks count things such as preferred stock and subordinated debt as equity when calculating their leverage ratios. That’s like adding in, instead of subtracting out, your mortgages and auto loans to arrive at your own net worth.

If those items are knocked out as they should be, then the financials’ leverage to common equity is even higher than thirty times, Einhorn says.

And the financials consciously levered themselves to eye-watering levels because that is what they were incentivized to do, to maximize executive compensation, Einhorn says. More leverage means more revenues which means more compensation, especially at investment banks which pay out 50% of their revenues as bonuses are backpay.

And Einhorn adds that the banks and brokerages’ levered balance sheets hold items much dicier than government securities. They have stocks, bonds, various loans waiting to be securitized, pieces of structured finance transactions, derivative exposures of staggering notional amounts and related counter party risk, they have real estate, private equity.

Back to the IMF’s $945b figure for expected losses. That’s vs $750b in losses fm Japanese economic crises of 1990s. That $945b breaks down as follows: $556b for US residential loans and securities; $240b on commercial real estate securities. Corporate loans including leveraged loans are expected to account for $120b in losses, consumers add another $29b.

That $945b is about 8% of the US’s GDP vs 15% of Japan’s GDP. But whereas Japan’s banks bore almost all the losses, now places as far afield as Norway, the Artic, and entities such as pension funds, insurance companies and hedge funds will bear most of the losses from the credit crunch. Spread the pain, right?

So how long will it take The Great Credit Crunch to unwind? One 2003 study of post war housing busts in rich countries indicates that housing crashes coupled with banking crises last about four years. The housing busts in Sweden and Norway in the early ‘90s acted like an anvil on their balance sheets for years.

A bright spot: the IMF expects global growth to slow to a 3.7% growth rate from 4.9% in 2007. Not so bad, given the five years of hectic growth the world has seen–and still coming off a huge base. Besides, any slowdown might be a good thing, as it would dampen inflation now coming a cropper (I like that term, coming a cropper) in emerging markets.

April 3, 2008 6:31PM

The Brinkmanship at Bear Stearns

By Elizabeth MacDonald

Could Bear Stearns (BSC) have survived if the Federal Reserve had opened its discount window to it sooner? The answer: Doubtful. Was it right to rescue Bear Stearns (BSC)? The answer: Yes.

The dramatic details of the collapse of Bear Stearns, an 85-year old institution, will be taught in business schools for years to come. It’s a tale still unfolding–it’s a story that’s a must read for investors.

And it’s a story loaded with controversy. Here’s one of the biggest points of contention.

Bear Stearn’s chief executive officer Alan Schwartz said in testimony before Congress that the Federal Reserve could have stopped the fifth-largest U.S. securities firm from collapsing if the central bank had opened up its discount window sooner to lend money directly to investment banks, including Bear.

The Fed did so on March 14, after $10b was sucked out of Bear in one day, putting the firm on the brink of bankruptcy. JPMorgan Chase (JPM) stepped in and is now buying Bear for just $10 a share, down drastically from Bear’s peak of $170. JP only did so after it got a $30b loan from the Fed, backed by Bear securities that the two sides say were valued at $30b as of March 14. 

JP Morgan has agreed to absorb the first $1b of losses if the value of the assets declines, but taxpayers are at risk for the remaining $29b.

“It is highly, highly unlikely in my personal opinion that we would be in the situation we find ourselves in today” had the Fed opened its discount window sooner, Schwartz told members of the Senate Banking Committee. Opening the discount window to non-commercial banks was an historic move the Fed has not made since the Great Depression.

Let’s recap. Bear Stearns had $360b in assets and liabilities. It had $12b in shareholder equity, or net worth, to support that book of business. That’s operating on a shoestring. The bonds on its book were getting crushed by the subprime crisis, so much so that two of Bear’s own hedge funds went belly-up last July.

“We only allow sound institutions to borrow against collateral” at the Fed’s discount window, Timothy Geithner, president of the New York Federal Reserve, said in testimony. “I would have been very uncomfortable lending to Bear given what we knew at that time.”

Even if the discount window was opened to Bear sooner, the credit rating agencies were ready with their battle axe of a downgrade, and Bear would have sucked that window dry as it was hemorrhaging customers and cash.

Keep in mind Geithner’s quote for now, it’s important. Because the question is, if the Fed wasn’t comfortable with Bear’s collateral assets at its discount window, how can the Fed now be comfortable with the $30b in Bear securities used as collateral to back its $30b loan to JP to facilitate the deal? More on that in a minute.

What’s chilling is talk of the dangerous cascade of wipeouts that would likely have taken place if the country’s fifth largest investment house was allowed to collapse. 

If the Fed didn’t rescue Bear, a bankruptcy “would have touched off a chain reaction of defaults at other major financial institutions,” shaking the confidence in the credit markets, and hurting the mortgage market, the muni-bond market, even the student loan market, says JPMorgan Chase’s CEO Jamie Dimon. As Fed chairman Ben Bernanke says, thousands of counterparties to trades at Bear would have been slammed too. 

Let’s start at the beginning.

Though many say subprime writedowns at HSBC early in 2007 were the canary in the coal mine signaling the coming credit crisis, it was the collapse of Bear’s own two hedge funds, which had invested in subprime securities, last July that ignited the downward spiral in the credit markets still rocking the world of finance today. Bear Stearns had to bail out the funds and take possession of many of their holdings. The SEC immediately began monitoring Bear’s capital position.

Bear then hung its hat on a deal with China’s Citic Securities, where both sides of the aisle planned to swap $1b worth of investments in each other. Thinking that deal (which eventually never materialized) plus its $20b in capital was enough to get by with a $360b balance sheet, Bear meandered along. It’s unclear if Bear approached others for a capital infusion, and if potential investors turned away not liking what they saw.

Then Bear’s slow bleed began early this year. The firm’s capital position dwindled to $8.4b in January, then rose to $21b in March, notes Christopher Cox, chairman of the SEC.

Soon, fixed income and stock traders began hearing rumors that European financial institutions had stopped doing business with Bear.

And traders really started to back off in February through early March.

Hedge funds that had used Bear to borrow money and clear trades were withdrawing cash from their accounts, and large investment banks stopped accepting trades that would expose them to Bear. The firm’s liquidity evaporated, with cash balances insufficient to cover maturing debt.

On a 5:30 a.m. conference call on the morning of March 13 (Dimon’s 52d birthday), Geithner spoke with Treasury secretary Henry Paulson, Fed chair Ben Bernanke and other officials to figure out a course of action. The endgame: avoid bankruptcy at all costs. JPMorgan, being Bear’s clearing bank for its repo deals, was in on the process. The Fed had given Bear a 28-day, $25b non-recourse loan. Bear thought it could take the next 28 days to find a buyer.

But that day, $10b was withdrawn from Bear Stearns. Its financial resources plummeted from $12.4b to $2b on March 13 as customers, trading partners and investors fled. Bear was on the brink. Bankruptcy was imminent.

JP’s Dimon said Bear Stearns called JPMorgan on the evening of March 13, saying its cash was drying up, that it could not meet its obligations the next day and that it needed emergency help. JPMorgan then contacted the New York Federal Reserve, Dimon said.

The next day, Friday, any possibility that Bear could go it alone evaporated after three credit ratings agencies downgraded Bear Stearns. That sealed Bear’s fate for good. Customer flight accelerated, as contracts governing counterparty trades with Bear stipulate that those contracts must be broken in the event of a downgrade. Collapse was imminent if Bear didn’t find a buyer by that Sunday night.

That weekend, marathon negotiations began. Another buyer was “prepared to write a multibillion check to invest in equity,” but since that deal would have required another financial institution to help finance a buyout, it fell apart, Schwartz testified. Though he didn’t identify the potential buyer, word is the interested party was J.C. Flowers, the private equity shop.

Fearing panic selling when the Asian markets opened late Sunday night, Bear Stearns’s negotiating leverage “went out the window,” said Schwartz. JP’s Dimon then balked at the thought of his firm taking on the colossal amount of Bear’s liabilities, and rejected a deal. The Fed then stepped in with its initial $30b loan, and then JPMorgan agreed to buy Bear Stearns for $2 a share, or $236m. JPMorgan increased its offer to $10 a share a week later amid a revolt by the smaller firm’s shareholders, picking up a business with $360b in assets and liabilities.

“I tell people that buying a house is not the same as buying a house on fire,” Dimon testified (interestingly enough, the Fed lent Bear $25b under its new program of direct lending to investment banks, separate from the $30b to do the deal–$13b of the $25b was paid back over that weekend, with the Fed earning $4m in interest).

The Fed came up with as novel a rescue as it could. Using a creative read of section 13A of the Federal Reserve Act, the New York Fed agreed to lend JP $30b over 10 years at a small 2.5% rate, a loan backed by a similar amount of Bear Stearns’ assets. Never before had the Fed taken on mortgage-backed securities. If that portfolio drops in value, JP takes the first $1b in losses. If the portfolio zeroes out, the Fed takes a $29b hit.

And here’s what’s key. “By agreeing to lend against a portfolio of securities, we reduced the risk that those assets would be liquidated quickly, exacerbating already fragile conditions in the markets,” Geithner says. A fire sale would have created chaos in an already crazy market. Expect an orderly unwinding of those assets over a number of quarters.

Now the debate is just what is in that $30b pool of assets, given that the Fed is taking on this credit at a time when the government is already levered to the hilt, what with what is going on at Fannie Mae and Freddie Mac. The New York Fed hired Black Rock, 49% owned by Merrill Lynch, to cherry pick the best assets off of Bear’s books to use as collateral. Both sides signed a confidentiality agreement covering those assets–why tip your hand to the market and invite unwanted arbitrage?

Only broad descriptions are available. The Bear assets are collateralized mortgage obligations, the majority of which are obligations backed by the likes of Freddie Mac, as well as asset-backed securities with things like adjustable rate mortgages, as well as commercial mortgage-backed securities, collateralized bond obligations, and cash assets consisting of investment grade securities rated BBB- or higher.

But how sound is that $30b worth of collateral?

JP’s Dimon testified: “We could not and would not have assumed the substantial risks of acquiring Bear Stearns without the $30b facility provided by the Fed.” That comment led Sen. Robert Menendez to ask:  “JP Morgan would have never gotten involved [in the deal] but for your [the Fed’s] guarantee” that it would swallow $29b in Bear’s assets and not hit up JPMorgan for other collateral if those Bear assets zero out. Menendez wondered, is that a vote of confidence in these assets?

And remember what Geithner said at the outset, that “only sound institutions” can borrow against collateral at the discount window and that he would have been “uncomfortable” lending to Bear.

What suddenly turned Bear’s assets golden for the $29b loan, what turned those sows ears into silk purses over night?

Another issue is poor oversight. Clearly, the crazy quilt of banking regulations, many of which pre-date the Great Depression of the 1930’s, have not kept up. Critics argue that lax regulatory oversight was partly to blame for the subprime mortgage catastrophe that is now a global financial crisis.

But was there any talk in Congressional hearings of forcing investment banks to set aside much more in capital reserves? There was a little.

Any talk of forcing investment banks to pay premiums into an FDIC-style insurance pool, given that they can now access Fed money at the discount window? Yes, investment banks don’t take on deposits like commercial banks, instead, they operate on short-term funding in the repo market. Still, if derivatives can be devised with apparent ease, why not regulatory protections?

And was there any talk of forcing lenders to keep on their books the riskiest strips of their securities backed by mortgages they originate, an incentive to exert some oversight over delinquent borrowers? Not a whisper.

And if the Federal Reserve is acting pre-emptively to avoid recessions by cutting rates, will it pre-emptively yank the punch bowl from the drunks by hiking rates in good times?

And why can’t the regulators come up with guardrails that will pre-emptively stop such crises from blowing into the markets in the future? Yes Fed examiners now poring through the books at Morgan Stanley (MS), Merrill Lynch (MER), Goldman Sachs (GS), and JPMorgan Chase (JPM) work, but it’s oversight done after the fact. What can be done ahead of time?

Is the Fed creating “moral hazard” by letting Wall Street firms make big risky bets, knowing they will get a taxpayer-backed rescue if they fail? As is becoming uncomfortably common, the lender of last resort is not the Federal Reserve. It’s the US taxpayer.

April 1, 2008 4:08PM

What Congress Must Ask the Federal Clean-Up Crew

By Elizabeth MacDonald

Who knew Liza Minnelli had it in her when she said the following: “Religion is for people who are afraid of hell–spirituality is for people who have been in it.”

That quote came to mind on the news that Jimmy Cayne, chairman of the disgraced Bear Stearns (BSC), was consulting Jewish tradition to learn life lessons about the near-death experience of his firm.

As with most anyone who has endured outsized cataclysms of biblical proportions, I am now hearing from traders down on Wall Street that all they can do now is hold hands and pray.

But as for those who get paid to run the show, who their employees say did little to cauterize the bleeding, by, for example, raising capital for their distressed firms, let’s hope Washington sees through the newfound scruples of any such plaster-saint sentimentality.

That goes for the regulators, too. Soon taking to the microphones once again on Capitol Hill to talk about their repair jobs in the housing crisis are Federal Reserve chairman Ben Bernanke, Treasury Secretary Henry Paulson, and Christopher Cox, chairman of the Securities & Exchange Commission.

May common sense prevail. It’d be a winged bird of hope to think you won’t witness any narcoleptic, after-the-fact posturing, which at this late date ought to make you feel like you are chewing on aluminum foil.

Because what is occurring now is preposterous.

The financial system has been rocked back on its heels by booms and busts every decade or so since the late 19^th century. But the past ten years has seen a plague of them practically every other year.

The Asian flu crisis, the Russian debt crisis, the blow-up of the hedge fund Long Term Capital management, the dotcom implosion, the telecom crash, and now the meta-crisis of them all, the housing and credit meltdown. The US saw that the regulatory system was clearly broken back in 1995. Bureaucratic apathy, the idea that free markets don’t need guardrails, have brought both investors and taxpayers to the brink. Free markets, yes. A free for all, no.

The financial system has been on a drunken leveraging spree for the past decade, which could take longer than ten years to delever and unwind. And like fire up a rope, the debt spree has already roasted Bear Stearns (BSC) and threatens to take out other big players as well.

Such leveraging has created outsized profits and executive pay. Though the financial services industry’s share of total corporate profits stood at just 10% in 1980s, it grew to 40% at its height in 2007 thanks to the borrowing spree. Everyone likes an asset bubble on the way up, but when they blow, watch out.

Banks and investment houses have written off a total of about $215b to date in degraded inventory from the credit crisis, with tens of billions of dollars more in writedowns expected. Goldman Sachs (GS) says the amount will top out at $460b.

By the end of 2007, two-thirds of the subprime writedowns were booked at just ten banks and brokerages. They still have something like 60% of total exposures to bad subprime credit and about half the exposure to leveraged loans as well.

Sovereign wealth funds have lost nearly 40% of the $50b they’ve invested in places like Citigroup (C), Merrill Lynch (MER) and UBS (UBS). UBS has been hit the worst. It just announced $19b more in writedowns, with the total there now at $37.4b. The Swiss bank has already raised funds from Singapore’s SWF, which is why it’s jokingly now called the Union Bank of Singapore. More writedowns are expected at places like Citigroup and Merrill Lynch; Deutschebank says it expects to write down $4b in its first quarter.

But foreign money is balking, so expect more ultra-dilutive new equity offerings like the $4b just announced at Lehman Bros. (LEH), a new $15.1b equity offering at UBS, and the planned $20b total for mortgage finance giants Fannie Mae (FNM) and Freddie Mac (FRE) (a sum that is about a whopping two-thirds of their market caps).

It’s past the midnight hour. Congress ought to ask what regulators are doing to avoid the costly taxpayer-funded clean-up and investor dilution later on. Taxpayers deserve to get answers from the Paulson-Bernanke-Cox regulatory cleanup crew on the following:

*Mr. Paulson, under the new plan from the Treasury, the Federal Reserve will have much more power to regulate investment banks, but the plan says it will only curtail the risks when their actions “pose a threat” to the financial system. Why only when these outfits “pose a threat” to the system? Why not around the clock? What if just one bank or brokerage is engaging in excessive risk? Will the federal sheriffs ride in to Dodge City then?

*Mr. Paulson, under the new plan, how exactly will private equity firms and hedge funds be regulated, if at all? Will you at minimum force them to publish their balance sheets, so Wall Street can truly see how dangerously leveraged some of these shops are that they are lending to? And why aren’t these pools of capital regulated?

*Mr. Paulson and Mr. Cox, subprime loans only began to be securitized earlier in this decade. Does the Treasury plan do anything to stem the risky practice of bundling toxic subprime mortgages and selling them as Frankenstein securities rubberstamped with high credit ratings? The credit rating agencies got paid lots of money by Wall Street to hand out triple A ratings like Kleenex to truly bad securities. What are you doing to stop this dangerous practice? Why not force the credit rating agencies to publish an updated quarterly report card of their prior calls going back fifteen years?

*Mr. Paulson and Mr. Cox, do you plan to require that trading in credit derivatives be hauled out of the shadows and into the sunlight by having such trades brought on to a major exchange?

*Mr. Bernanke, Mr. Paulson and Mr. Cox, please walk us through the rescue of Bear Stearns (BSC). Let’s start with March 14^th, when Bear was essentially given a 28-day loan from the Federal Reserve to fix itself before the Fed-orchestrated JPMorgan Chase (JPM) deal came to pass. This marked an historic break–it was the first time the Fed let 20 unregulated investment banks access to loans from the Fed’s discount window. In effect, the Fed was now running with the wolves on Wall Street. Shouldn’t investment banks be forced to keep the same amount of capital reserves on the balance sheets as do commercial banks if they can now access the discount window?

*At the 11^th hour, the ratings agencies then cut Bear’s rating to junk status, causing counterparties to stop trading with Bear and fueling a run on the bank–counterparty contracts stipulate that any time a firm is downgraded to junk status, any such contract governing a counterparty trade is broken, forcing these outfits to stop doing business with Bear Stearns (BSC). Do you know the answer to why this move at the 11^th hour?

*To complete its shotgun wedding with the severely damaged Bear Stearns (BSC), JPMorgan Chase (JPM) got the New York Federal Reserve to backstop, via a non-recourse loan, $29b of the most illiquid securities on Bear Stearns’ balance sheet. Non-recourse, meaning JP is not on the hook for it.

A sweet deal hammered out by JPMorgan Chase (JPM) head Jamie Dimon, who sits on the board of the New York Federal Reserve. Isn’t this a conflict of interest?

*Mr. Bernanke, a record amount of government funds was used to bail out Bear Stearns (BSC), more than what was put at risk in the bailout of Continental Illinois in 1984, analysts note. The Fed promised to lend $29b to JP Morgan at a dirt cheap 2.5% over 10 years, which is renewable, so as to get JP to digest Bear’s damaged balance sheet. JP then used Bear’s collateralized debt obligations and other damaged assets as collateral.

So, Mr. Bernanke, the central bank now owns $29b in illiquid securities from Bear Stearns–meaning, as some analysts rightfully put it, the government has nationalized Bear’s losses by taking on this credit risk, on top of the credit risk it’s already taken on from Fannie and Freddie Mac (see next bullet point).

Is this a truly dangerous precedent? And what exactly is the nature of the assets JP used as collateral for the loan? Taxpayers only know that most of the investments were mortgage-backed securities and “related” items–does that include commercial real estate or Alt-A mortgages? Why the poor disclosure when the Fed ostensibly says it is now about transparency? Don’t taxpayers have a right to know? What discount to par were these assets marked down to? How much cushion is built into their current valuations? Were these exposures hedged, reducing potential taxpayer losses?

*This is the 75^th anniversary of the New Deal and the creation of the Federal Home Loan Bank board. The socialization of Bear Stearns’ losses and of housing finance has meant taxpayers are bearing credit risk in ways never before seen in the history of this country, through the government’s implicit guarantee of the mortgage finance companies Fannie Mae (FNM) and Freddie Mac (FRE).

Both have had a history of accounting misdeeds, totaling $11b. Both have been reporting record losses. But now the government is loosening their capital reserve standards so they can take on $200b more in mortgage debt as to stop the housing crisis. Already they both have a total of a microscopic $80b in reserves to back an eye-watering $1.7t. Taxpayers will foot the bill for their incompetence, as both have credit pipelines into the US Treasury. Should Fannie and Freddie be completely privatized? Should regulators at minimum stop Fannie and Freddie from paying out any dividends whatsoever?

*Mr. Bernanke, since the late ‘80s the Fed has been cutting off financial crises at the pass by acting pre-emptively, meaning, moving quickly to cut rates before disaster strikes. Since July 2007 the Fed has cut rates to 2.25% from 5.25%. Will you take pre-emptive action in good times to raise rates and reduce the expectation now entrenched on Wall Street that out-of-control bankers and brokers that the Fed will rescue them no matter what? Are you running out of ammunition to deal with the credit crunch?

*Mr. Cox, has the SEC studied whether the fair value rules are overstating losses on Wall Street? Do companies have a point when they say that a big slug of the losses they now post under fair value rules may never materialize since they won’t sell the assets until their value recovers? Or is this 20-20 complaining?

*To all three-shouldn’t you force lenders to keep a slice of the riskiest part of any debt securities they sell, from mortgage-backed bonds to securities backed by leveraged loans, on their balance sheet so they have an incentive to make sure no bad loans are made and that borrowers pay back their risky debt?

*As for investment banks now getting their mitts on Fed money via the discount window. Shouldn’t you force investment banks to pay an insurance-style premium similar to what the Federal Deposit Insurance Corp. charges regular banks to cover the cost of bailing out their deposits?

The way it could work is, those with solid capital and lower risk sluicing through their operations would pay less into the insurance pool. Isn’t it only right that the likes of Bear Stearns (BSC), Lehman Bros. (LEH) and Goldman Sachs (GS) pay a premium into the system if they get to now, risk-free, effectively foist their pathologically risky bets onto the rest of society? Bear didn’t pay a cent for its government bailout, so it’s no surprise to see Wells Fargo (WFC) tossing its hat into the ring hoping to get a merger deal backed by such free money as well.

*To all three, the Environmental Protection Agency set up a superfund to deal with hazard waste cleanup. Is it time for a housing superfund to buy defaulting toxic mortgages now poisoning the system, replacing them with more accommodating loans?

*To all three, given the deficit financing of this bailout, are you not creating another vicious cycle in the bond market that will cause mortgage rates to remain high, as loans are tied to long term bond rates? Are you at all concerned higher inflation is bearing down on the economy at a time when Social Security and Medicare are near bankrupt, when the first baby boomer got to retire this past January 1?

*And to all three–when will this government come out and support a strong dollar?

March 28, 2008 4:28PM

The Reality Check That Bounced

By Elizabeth MacDonald

Oliver Stone is doing a movie about George W. Bush.

That bit of news was a fitting end to last week’s kaleidescopic developments, straight off the fiction shelves.

Before I get to the week that was, I want to thank all of you who weighed in about my blog about listening to presidential candidate and Congressman Ron Paul. I am so deeply appreciative and grateful for all of your comments, I read them all and I am impressed with and admire your knowledge and passion.

I came here to Fox Business, the sister network to Fox News, just last October, and Fox Business gave me the honor of starting this blog this year. One thing rings through all of your responses–you deeply love this country and you are deeply worried. I hear you. Again, I thank you.

Please be aware that I am a flawed individual who is aware of my many limitations (on an hourly basis), please tell me when I am off the rails. I will do my level best. Know that I listen to everybody. I try to think things through, as I get an allergic skin reaction to knee-jerk, autopilot thinking.

I would like to see Dr. Paul debate all of the presidential candidates, not just John McCain (should Dr. Paul run as a third party candidate?). Though I may not agree with everything he says, I also don’t agree with what the other candidates say as well. Dr. Paul deserves a fair hearing, this country ought to hear what he has to say, especially about monetary and fiscal policy.

Here’s a recap of the week’s headspinning highlights: the Treasury Department plans to propose Monday that the Federal Reserve should get more oversight authority of all of the players in the financial markets, letting the central bank examine the books of any financial institution, not just banks; planned Congressional hearings into the Federal Reserve’s historic rescue of Bear Stearns and its handouts to investment banks, which it doesn’t regulate; the overleveraged, underwater Fannie Mae and Freddie Mac now needing to raise a total of $20b more via dilutive stock offerings, a whopping two-thirds of their market caps; scary talk about more bank write-downs; the weakening dollar; and oil veering toward $120.

But just as thinking that Oliver Stone’s movies are historically accurate is like thinking that the movie “Gone With the Wind” is a documentary, it is just as precarious to believe the fiction that the Bear Stearns-JP Morgan deal midwifed by the Fed signals the bottom of the market, as some media pundits wildly suggest.

It’s also just as cavalier to believe the analysts’ estimates of the writedowns in the financial sector stemming from the housing and credit crisis are etched in stone. They are all over the map, with stocks in Citigroup (C), Merrill Lynch (MER), Lehman Bros (LEH), Goldman Sachs (GS), JP Morgan Chase (JPM) and UBS (UBS) getting whipsawed (to get a handle on it, see my prior blog, “The Answer to Who’s Next on Wall Street”).

The writedowns will be sizable, to be sure, but the question is this: Might some of the writedowns be overstated, given cash flows are still coming in from loans backing these securities, securities the firms are being forced to write down because widespread panic has frozen the market for them?

And the broader policy issue: Will the Treasury secretary’s plan really put more guardrails on a free market that’s turned into a free-for-all? When will Congress stop its neat after-the-fact refereeing exhibited now in dealing with Wall Street’s very expensive, very messy, and personally enriching experiment at satisfying the government’s 100% homeownership dream? Will the Fed’s costly moves to revivify the financial’s balance sheets deadened by Frankenstein securities they created really work?

*THE REGULATORY FREIGHT TRAIN: Congress is hopping on it now, with the Treasury planning more oversight powers at the Federal Reserve of all financial institutions, not just banks. The Fed may become the sole regulator for both commercial and investment banks, following the collapse of Bear Stearns.  For now the proposals are taking the shape of letting the central bank scrutinize the books at all institutions–no sign yet of tough proposals, like whether credit derivatives would have to be listed on, say, the Commodities Futures Exchange, engendering more oversight.

Also hearings on Capitol Hill that may take a closer look at the Federal Reserve’s actions on Wall Street, including the forced nuptials between Bear Stearns (BSC) and JP Morgan Chase (JPM). No surprise that Jamie Dimon, who runs JP Morgan, is on the board of the New York Federal Reserve, which provided a $29b non-recourse backstop to the most illiquid parts of Bear’s balance sheets, now only protected by a $1bn cushion of first loss collateral from JPMorgan. Non-recourse, meaning, the Fed can’t hit up JP Morgan for this money, it has to auction those securities off and take a gain or a loss on them, not JP Morgan.

Tighter capital requirements for investment banks may also be in store–argument being if they can have access to the discount window, then they ought to face the same capital reserve requirements regular banks must meet. If the Fed is going to run with the wolves on Wall Street, then Wall Street needs to be tamed.

Also, as it stands now, the capital reserve levels the investment banks face from the Securities & Exchange Commission are roughly a third of what the Fed requires. Remember, banks in Japan dropped into a black hole in the ’90s because they didn’t have to set aside a sufficient amount in capital reserves to back their lending. The collapse of the banking sector in Japan led to that country’s lost decade of the ’90s, which it only surfaced from several years ago.

And despite what you hear that the Fed is only charged with printing money and that this backstop doesn’t hurt taxpayers, it does. The Fed gets to print money, with the US taxpayer paying the interest on the treasury bonds that the governement gives the Fed in exchange for printing a similar amount of dollar bills. The Fed also turns over to government coffers what it earns on the investments it holds in its portfolio. Taking a hit from Frankenstein securities means less money coming in those coffers from the Fed.

And printing more money to make up the difference–which taxpayers pay for in the form of inflation. Watch this quote: In 2002, then Fed board member Ben Bernanke, now the Fed chairman, said in a speech, “the U.S. government has a technology called a printing press…that allows it to produce as many U.S. dollars as it wishes at essentially no cost.”

*BEHIND THE BANK WRITE-DOWNS: The market is volatile because the accounting rules the financials use to book these write-downs for their securities backed by mortgages and other credit act more like a weathervane, auditors and accounting pros say (for the heated debate about what’s driving the record write-downs, see my prior blogs on the controversial accounting rules to book them, the fair market rules, “The Answer to Who’s Next on Wall Street,” “What’s Really Rocking the Stock Market,” and “In the Weeds”).

You’d have to have the training of a tornado forecaster at the National Weather Center to say with any certainty what the write-downs are going to look like, and some of these estimates already have been dreadfully wrong.

That was certainly true for the recent, way off-the-mark write-downs expected at Goldman Sachs and Lehman Bros., which came in lower than estimated. There will be losses, we just don’t know the size. No one does–hence the record volatility. Transparency works–so long as it’s accompanied by common sense.

Fights are breaking out between the companies and auditors, because the accounting rules say the companies have to get a price-tag for these securities that are backed by loans based on what the market says they are worth. That’s called ‘marking to market.’

Sounding like an Abbott and Costello routine, you can’t mark something to market when there is no market to market these securities in. “Everyone seems to be clueless when it comes to projecting how much still needs to be written off and how much longer this [market distress] will continue,” says economist Ed Yardeni. One thing you can bet on: More write-downs–again no one knows the dollar amounts–and thus more shotgun weddings between damaged financials.

*INFLATION: New numbers purport to show that inflation is not a problem. Not. Talk to any middle class family struggling with health care costs and tuition expenses, and they’ll tell you it is. Why is inflation a problem? Too many dollars, rising demand for commodities, plus, again, zero oversight, no where, none, for things like health care and tuition costs.

*GDP: GDP growth came in at a low six-tenths of a percent. Don’t know if that’ll get revised downward–if it does it’ll mean the tip of a recession. I saw a great study that says GDP should be considered on a per capita basis, to show how truly productive a country’s workers really are and to get a better window on how much an economy is growing.

In Japan, GDP per head increased at annual rate of 2.1% in the  past five years to ‘07, a bit better than the US’s 1.9% and a lot better than Germany’s 1.4%, the study says. And despite all the talk about Brazil and Russia being on fire, check this out. On this basis, Brazil increased 2.3% per capita per year since ‘03, a touch faster than Japan. Russia comes in at 7.4% per capita, but that’s because its petrodollars are pouring in while its population has been on the decline.

*THE DEMOCRATS AND TAX CUTS: In his speech on the economy last week, to punish what he thinks is “the investor class” on Wall Street, Democratic presidential hopeful and Senator Barack Obama says he wants to raise taxes on dividends and capital gains; so does Democratic presidential hopeful Senator Hillary Clinton. The presumptive Republican nominee, John McCain, still backs the Bush tax cuts.

Set aside for now the fact that the Bush tax cuts on capital gains and the death tax alone raised more revenue than President Bill Clinton’s tax hike on the upper bracket, analysts note.

For some time now, the Democrats have had no more sense than a flock of geese. That’s because hiking these taxes hurts Main Street, the most important investor class of all. Many senior citizens live entirely on dividend income alone; the middle class desperately needs its 401K and IRA money like never before because Social Security is in a ditch (thanks to the Democrats changing the law in the ‘60s so it could, for the first time, get its mitts on Social Security funds to spend on pork and to buy votes).

The Democratic candidates, in their blinkered concretism, stubbornly refuse to acknowledge human behavior. Investors sit on assets, including stocks, rather than sell and pay the capital gains tax, because capital gains taxes are voluntary. You don’t have to pay until you sell. Higher capital gains taxes keep frozen all sorts of economic activity. Hike taxes, you also get tax avoidance schemes going viral too–and massive loopholes written into the colossally inefficient tax code, a big tangled pile of barbed wire as it is. But we’d rather be a nation of tax lawyers and accountants. Both Obama and Clinton want to make it even more confusing with gimmicky credits that won’t buy you a bag of groceries for a month.

Obama and Clinton want to hurt Main Street with more taxes. “Why is Barack Obama so hell-bent on pursuing policies that would wreck America’s retirement savings?” asks Ryan Ellis, tax policy director at Americans for Tax Reform. ”Because, by and large, he doesn’t have any skin in the game.”       

How so? Obama is not part of the investor class because he’s reported no dividend income on his tax returns from 2001 to 2004, and just $2,754 in dividend income on his 2005 tax return and $1,188 on his 2006 return (Clinton has yet to release her returns).

Where are the John F. Kennedy tax-cutting Democrats? Lower taxes help the economy. Even the former Soviet satellite states like Estonia and Lithuania have enacted flat taxes. Lowering rates in our anti-growth, anti-entrepreneur tax code is the best non-inflationary liquidity in the galaxy. But as the Heritage Foundation notes, though we won the Cold war, Russia has a flat tax while we’re still stuck with America’s museum of mass confusion, the IRS.

*SILVER LINING: Weekly initial unemployment claims. In previous deep recessions, they tended to rise rapidly, over 400,000 toward 500,000, notes Yardeni. In the 1990-1991 recession, jobless claims hit 496,000 on a four-week moving average basis; in 2001-2001, it hit 489,000. The latest four-week average was only 358,000. Sigh of relief. For now.

March 26, 2008 10:37AM

Time to Listen to Ron Paul?

By Elizabeth MacDonald

Time to listen to Texas Congressman Ron Paul, the lone voice of reason in Congress today who’s got to feel like he’s shouting into a field of cotton with his repeated warnings about the dangers of a collapsing dollar, while the administration goes AWOL on the problem.

The dollar just hit a record intraday low against the euro on reports that consumer confidence levels have dropped to levels not seen since the post-Watergate era. It is down 7% year to date against the Chinese renminbi, it’s weaker than the Japanese yen and the Canadian loonie.

The joke is the greenback is now only stronger than the Mexican pesos and the Zimbabwe dollar, an overstatement for dramatic effect, to be sure.But since hitting a peak in 2002, the dollar has lost about a quarter of its value against a trade weighted basket of currencies.

A weak dollar acts as an anvil around the neck of the US economy and consumers. Rising inflation is essentially a tax on consumers, so are rising energy prices, and that double whammy threatens to undermine the purchasing power of the rebate checks due out in May–backed by printing even more dollars.

A bellwether event of significant import to our nation’s finances happened this past January 1 with little notice. That’s the day the first baby boomer was allowed to retire. A new federal report wearily warns once again for the umpteenth time that the nation faces some $60t in Social Security and Medicare unfunded liabilities alone.

We’ve heard time and again conservatives say deficits don’t matter. To say that deficits don’t matter is like saying ketchup is a vegetable or trees cause pollution.

The $406b the US pays annually in interest on the $9t in federal debt alone would rank as the world’s 30^th largest economy.

That annual interest cost surpasses the gross domestic product of Belgium, and is bigger than the GDP of Denmark and Hungary combined. The $406b would cover the annual cost of investigating Medicare fraud.

Stack all those one dollar bills making up our $9t deficit (and that doesn’t include the $60t in unfunded liabilities for Medicare and Social Security) and you would reach the moon and back. “Printing money cannot create wealth, if it could counterfeiting would be legal,” economist Brian Wesbury has said.

Even Milton Friedman, the Nobel Prize-winning economist and a forceful advocate for laissez-faire economics, got so sick of the way central bankers were willy nilly printing money in the ‘70s, he advocated that the government should replace the Federal Reserve with a computer. “Money is too important to be left to central bankers,” he quipped.

Broad zoom: The US economy has spent all of a year and four months in a downturn over the last two and a half decades. During that time we’ve seen a market crash of 22% in 1987, the S&L crisis, four wars, three financial crises (Mexico, Asian flu and Russian debt crises), the blow up of the hedge fund Long Term Capital, two asset bubbles (dot com and telecom). Since the Bush tax cuts of 2003, the US economy added the equivalent of China’s GDP–and government spending has boomed.

Now Federal Reserve chairman Ben Bernanke has both cut rates at a breakneck speed and pumped a massive amount of monetary stimulus into the markets to cure the credit crisis. I still think he is doing his level best to fix a crisis not entirely of his own making. The question now is, will Bernanke yank the liquidity punch bowl when the economy returns to trend growth in 2010 or 2011 as the central bank projects?

Let’s hope so, because the case for a weak dollar is, to me, well, weak. Namely, that a lame greenback softens the housing and credit crises as it fuels profits at US exporters whose goods are now dirt cheap in the eyes of foreign customers. Strong foreign sales at places like Boeing and Caterpillar reportedly added 1.4% to US growth in the second quarter of 2007. But exports make up just 13% of GDP. Consumers make up a larger 70%.

It’s no surprise consumer confidence is as weak as it was in the ’70s. LBJ had promised this country it could have both guns and butter in the ‘60s, so the Federal Reserve gunned the printing presses to pay for spending on entitlement programs and for the Vietnam war. For the first time, too, politicians got their mitts on taxpayers’ Social Security funds, after Democrats passed a so-called “unified budget” in the late ‘60s.

All that spending caused the dollar to nosedive in the 1970s amidst an oil embargo that sent oil costs, priced in dollars, soaring. Paul Volcker, then Fed chairman, enacted rapid rate hikes hitting 21% by 1979, and the Treasury went so far as to sell $6.4b in “Carter bonds,” largely denominated in Deutschemarks, to prop up the dollar. Gold got ripped off its mooring of an average $35 an ounce in the ‘70s, and in 1980 it hit a record $835 an ounce, around $2,250 in today’s prices.

Gold acts as a dew line for inflation. We essentially have a good handle on how much gold there is in the world and potentially below ground. When gold rises in price, it signals we are printing too many dollars, which indicates a concurrent drop in the greenback’s value. Over the last seven years, gold and oil prices have risen in lockstep, up 239% and 267% respectively. If the dollar had also risen in value at the same rate, oil would be selling at about $30 a barrel.

But now central bankers say that because of the weak dollar, they’ve seen capital losses carved out of an estimated $3.34t worth of US dollars they hold in foreign currency reserves; Japan holds the most dollars, China is second. The fear is they may unload these plunging greenbacks en masse to cut their losses and run–which would really tip the US into a protracted recession. Already reports out of China show government officials there willing to rotate future planned investments out of US treasurys into other investments.

Countries pegged to the dollar are rightly saying, too, that we are exporting inflation to their shores. Saudi Arabia is a land that has had nearly zero inflation since 1998, but recently inflation soared to 7% annually, despite the fact the country is flush with petrodollars.

Congressman Paul rightfully warns us when he says the US government has “systematically undermined” the US dollar by expanding “the money supply at will for financing war or manipulating the economy with little resistance from Congress–while benefiting the special interests that influence government.”

It’s not just the US gunning the mints. Goldman Sachs figures that three-fifths of the world’s broad money supply growth came from emerging economies over the past year or so. Three-fifths. That’s gigantic.

Goldman Sachs says the growth in Russia’s M3 measure of broad money grew 51% over the last year or so, India by 24%, and by 20% in China, Saudi Arabia, South Africa and Brazil. That’s three times as fast as the US and the rest of the developed world, and it’s faster than their GDP growth rates. It’s the fastest pace in decades.

All that loose money is pouring into commodities, stock exchanges around the planet as well as bond markets–it’s largely why our long-term bond yields have been historically low, spurring a dramatic increase in mortgage borrowing, as mortgage rates typically track the 10-year Treasury note.

Watch out here–emerging economies are just as susceptible to minting lots of money due to political pressures, including things like paying for wars, or calming local populations clamoring for higher pay and more jobs.

What can be done stateside?

The administration needs to state more emphatically that it supports a strong dollar. A stronger dollar would draw liquidity back into the credit markets, lower inflation risks, cut oil prices and restart economic growth, notes Bear Stearns economist David Malpass.

Presidential candidates vilify NAFTA and free trade, when the weak dollar is partly to blame for problems like jobs lost to overseas operations, Malpass adds.

“Empires fail because they run out of money, or more accurately, run out of the ability to spend or inflate,” Congressman Paul warns. “We need to control spending, immediately, before it is too late.”

March 25, 2008 12:41PM

How Congress Can Fix the Crisis

By Elizabeth MacDonald

It’s the question of the hour: How can Congress fix the housing and credit crisis? And where are we in this crisis? We’ve been talking about this issue on our morning show Money for Breakfast.

I don’t make it a habit of trying to call the end of the world and I don’t think we’re headed for the abyss. I also fully support a moonshot to Mars so we can pack all those recession fanatics on it so they can annoy each other into oblivion. It’s true, if you call a recession long enough, you can call yourself a seer, as someone once said–a stopped clock is right twice a day. Global growth is here to stay. 

Same for the market’s “bottom callers,” in full regalia now, telling us to expect an upswing, though beats me why if they’re that good, they’re even sticking around and not hitting the beaches on the Riviera.

The market hasn’t hit the bottom yet because housing hasn’t found its bottom yet. Do the math and we’re still in at best inning three. Congress is going to hold hearings next month on the crisis. There is a way for elected officials to get us out of this crisis and avoid future disasters.

First the parade of horribles. Foreclosed properties held by lenders accounted for 493,000 of all homes on the market in January. Again, that’s held by lenders, and that’s out of an estimated 3.3 million home-mortgage defaults in 2007 and 2008, with about two-thirds of those homeowners losing their homes, says Moody’s.com.

Western banks have taken about $180b in writedowns to date out of the projected $300b-$400b. And that’s only for subprime, it doesn’t include other credit problems like leveraged loans and other consumer installment credit. Credit problems are the reason why GDP growth rates will slow and return to trend at the earliest in 2010. Analysts estimate the economic cost to clean up the current crisis is $1.1T, or 9% of GDP–the bailout of Argentina cost 55% of GDP to fix, the S&L crisis here in the US cost 3% of GDP.

What to do now? Set aside the government bailouts–yes it’s unfortunate that traders, investors and borrowers like to be Milton Friedman, free-market types on the way up, but John Keynesian, “run to Uncle Sam” ninnies on the way down. Yes we privatize the gains and socialize the pain, hearing that now is like chewing tin foil. Yes we want as much homeownership as possible–but this is one heck of a grossly expensive, upside down way to get there.

Here’s a rundown of how Congress can fix the mess–and how it could save us grief in the future:

DON’T GET LOST IN THE WEEDS. Take heart in this broad-zoom perspective. The world is still in the early innings of globalization. Already, China, India, Indonesia, South America, places a generation ago considered dirt-poor, are now seeing explosive growth in the middle class. Some 1.8b new entrants are expected to join the middle class over the next 12 years. By 2010 the world’s middle class will make up 52% of the total world population, up from 30% now. As the middle class grows, that means burgeoning demand for things like healthier diets, better, more fuel efficient cars and gadgets. Global growth, in fits and starts, is here to stay.

BOOST IMMIGRATION. Ballooning housing inventory is now at a record levels, with foreclosure signs popping up like crabgrass in Nevada, Arizona, California, Florida–which is why the volume about government bailouts has turned up in these key swing states in this presidential election year. Strengthen the borders, absolutely, but boost LEGAL immigration. It’s good that teachers, firemen, policemen can now afford first-time homes. Hardworking immigrants can help pick up the slack, too (and let’s face it, can they help Social Security? Watch that debate in coming months as well). 

SUPPORT BUZZSAW BEN. Time to turn down the volume in Congress on the criticism of Federal Reserve Chairman Ben Bernanke–much of it is self-serving, arm-chair quarterbacking. Dramatic cuts in interest rates help homeowners facing some $350b in ARMs resetting, as the cuts lower the hikes in their monthly payments to an increase of about 10% from 25%. And Bernanke’s creative moves such as broadening the discount window and auction facilities to reliquefy bank balance sheets could cement his place in the history books as helping to soften a cataclysm set in motion by his predecessor Alan Greenspan, who kept rates too low for too long and disregarded growing subprime excesses while telling borrowers to take out riskier ARMs vs traditional fixed rate loans. “American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage,” Greenspan once said.

YANK THE LIQUIDITY PUNCH BOWL. To avoid inflation and repair the weak-dollar damage, Congress must fingerwag Bernanke by telling him to avoid tipping the economy into the bottomless liquidity punch bowl. He has to be ready to hike rates when the economy returns to trend in 2010 and 2011, as the Fed expects. The dollar is at its weakest since the era of floating exchange rates began in 1973, and inflation is coming a cropper. Central bankers would do well to heed the advice of Richard Fisher at the Federal Reserve Bank of Dallas: “Easy money is like truly tasty tequila, it’s tasty–but dangerous.”

BRING BACK SOME VERSION OF GLASS-STEAGALL. Originally enacted in 1933 after the crisis of the Great Depression, it took another crisis–the 1987 crash–to get bankers to start lobbying for its repeal, which took 12 years to do. The act separated the barbarians of Wall Street from the mahogany-lined board rooms of white shoe bankers. Since its repeal in 1999, which let banks compete for the first time in the securities industry, the free market banking system has turned into a disastrous free-for-all.

Banks lobbied hard to repeal this act soon after the 1987 crash as foreign competition from Japan bore down on them–Japan, whose banks did not face the same strict rules on maintaining capital reserves and whose calamitous lending helped foster the lost decade of zero growth in that country in the ‘90s.

Congress should ignore mindless, self-serving entreaties from the bankers now. Listen to what Dennis Weatherstone, president of J.P. Morgan, said in the late ‘80s: “I don’t think the repeal of Glass-Steagall should be seen as a way of providing relief for the banks,” adding, “rather, I think it should be seen as a way of making capital markets more efficient.” Abolishing Glass-Steagall let Citigroup make disastrous bets underwriting and trading mortgage-backed securities and collateralized debt obligations. Citi now faces potentially another $15b in write-downs on top of the $22b it’s already taken due to the housing and credit crisis. 

Footnote: Talking to top executives on Wall Street about the crisis, a number of them now brazenly finger the act’s repeal as the reason behind their woes, proving with age comes no maturity.

PUT UP THE GUARDRAILS. I’ve noted in prior blogs how deregulation shoved 3/4ths of Wall Street borrowing into the shadow lands, away from the prying eyes of regulators. If the investment houses want access to taxpayer-backed financing from the Federal Reserve, a historic move the central bankers have made, then these investment houses must meet commensurate capital reserve requirements that are forced on the big banks, which means new regulation forcing them to hold more capital on their balance sheets. Watch the securities industry lobbyists fight this one hard. They want all of the upside of taxpayer-backed funding with none of the downside.  

KEEP TABS ON LOANS. It’s been suggested that lenders should be forced under new regulation to keep the riskiest parts of securitized loans on their balance sheets, and I agree. Banks broke the last vestige of oversight of derelict borrowers when they sold these loans off the balance sheets and into the ether.

MORE HEDGE FUND DISCLOSURES. Congress should enact laws that would get the Securities & Exchange Commission to force hedge funds at minimum to publish their balance sheets so the brokerage houses can truly see how leveraged they are before risking their house money in loans to these funds. It’s what got Bear Stearns in trouble. Investment banks and hedge funds tend to blow out their leverage in boom periods, then dry out in bumpy times, spreading their hangover to the rest of us. With debt that amounts to half of all leverage outstanding, expect more collapses and shotgun weddings at these shops.

BRING CREDIT DERIVATIVES INTO THE LIGHT. Bring credit derivatives onto one of the major exchanges. Yes it’ll be costly, but transparency is better at catching future problems then wasting tax dollars fighting a financial nuclear winter.

REPORT CARD FOR THE RATINGS AGENCIES. Congress should force Moody’s Investors Service, Standard & Poor’s, Fitch Ratings, Egan Jones, all the ratings agencies to publish a report card on their prior ratings calls from now on. They’ve got a virtual monopoly on this business, time their feet is held to the fire.

STOP THE AFTER-THE-FACT REFEREEING. Congress, regulators, the government has found it a lot simpler to more or less let things happen. With bureaucratic apathy comes wasted tax dollars. Enough is enough.

March 24, 2008 11:30AM

Best Safe Haven Stocks Now

By Elizabeth MacDonald

You’re crazed about your stock portfolio now, because it seems like the economy is headed for a national nervous breakdown, right? A systemic credit crunch is underway, record bank writedowns are rocking the stock market, inflation is eating away at returns, and the euro, the Canadian loonie, the Japanese yen, all are flexing their muscles at record levels against the dollar.

What stocks could be safe havens now?

How about some stocks that throw off dividends?

It’s good to get both a stock that throws off decent returns and a dividend, when the dollar is toboggan sledding down like never before. I tend to like dividends for a variety of reasons. Number one, you get an income tax deduction on your dividend payouts. Plus dividends in most cases can be great proof that a company is doing pretty decently–else how could they have the cash flow to pay out the dividend?

But you want dividend stocks that are backed by solid quality of earnings. I asked Sageworks, a financial research firm in Research Triangle Park, NC, to pull together a list of the companies that it thinks have pretty solid quality of earnings that also throw off nice dividends. The companies below have decent liquidity, real cash, plus they are not overleveraged with debt, says Brian Hamilton, head of Sageworks. Here they are:

Of course, don’t expect dividends to last at the banks pounded by the credit crisis.

But watch what happens at the mere suggestion that dividends should be cut at these institutions–which is why they have been holding onto their dividends in a tight crab grip.

The largest U.S. banks saw their stock prices recently drop after remarks by Treasury Secretary Henry Paulson suggesting that banks may need to suspend dividend payments in order to shore up capital. “We are encouraging financial institutions to continue to strengthen balance sheets by raising capital and revisiting dividend policies,” Paulson said. After those remarks, JP Morgan Chase (JPM) soon dropped 4.43%, Bank of America (BAC) was down 3.56%, Citigroup (C) fell more than 5%, Washington Mutual fell almost 5% and Wells Fargo dropped 4%.

Paulson is essentially saying that banks should cut their dividends and instead use that money to plug the holes in their balance sheets blown out by record write downs from the credit crisis, totaling about $180bn so far. That’s a lot of dividend money that could be cut out of investors’ wallets–one report has it that the banks shelled out more than $110bn in cash dividends last year, up nearly 18% from 2006.

Banks are already slashing dividends. Washington Mutual (WM) has cut its dividend. Citigroup (C) cut its dividend by 40% last January, but it’s still paying out $1.28 a share this year, or $6bn it may need to plug some balance sheet holes. Mortgage financing giants Fannie Mae (FRM) and Freddie Mac (FRE) have slashed their dividends as well, to stabilize their balance sheets. Freddie Mac (FRE) cut its dividend on its common stock by 50% in November, but it still pays $1 annually or $650mn.

You don’t see brokerage firms listed on this table, because they tend to pay tiny dividends if at all. Brokerages tend to pay out a lot of their earnings towards year-end bonuses, so a 1% to a 2% yield is quite high for these guys.

There are other dividend plays to look at, too. Consolidated Edison (ED) has a nice 5.7% yield and is an evergreen in the business of power supply. US energy trusts are good, too, because they tend to pay out almost all their income to avoid paying taxes, plus oil prices are likely to remain high. Check out the Permian Basin Trust (PBT), a mix between oil and gas companies with a 12% yield.

Some companies, I think, would do well to raise their dividends. I agree with analysts who point to cash rich and dividend cheap tech companies, even those doing stock buybacks, as dividend announcements can be good for stock prices. Watch what happened to AT&T (T) when it raised its dividend recently and upped its share buy-back. The company’s stock rose almost 9% on the news, the most in five years.

Apple (AAPL) has piled up about $18.4bn of cash and equivalents as well as short-term investments on the balance sheet. Since it hardly ever buys other companies, some say it could probably afford a $6 or $7 special dividend, an announcement which might help its stock, beaten up of late.

Cisco (CSCO) can afford a 3% yield, analysts say, with its shares declining in value. Other profit machines can afford to boost their dividends. Exxon Mobil (XOM), the most profitable company in history, cheaps out with a yield of 1.5%. Don’t you think it can afford to more than double that amount to 4%?

March 20, 2008 1:42PM

Obama’s Little Speech Problem

By Elizabeth MacDonald

Read More

March 18, 2008 1:34PM

The Answer to Who’s Next on Wall Street

By Elizabeth MacDonald

Beating analysts expectations–expectations that companies routinely jawbone down–has shares in Lehman Bros. (LEH) and Goldman Sachs (GS) trading higher today, despite the fact their first-quarter profits fell more than 50% versus a year ago.

Brush aside the pixie dust. Don’t join the hallelujah chorus just yet, much as I’d personally like to, given that I am a long-term bull–I like to quote a buddy of mine who jokes that his epitaph on his tombstone is going to read “I’m in it for the long term.”

There is a little-known, little-understood but crucially important time-bomb of a profit figure that is swamping the net worth of Wall Street firms with red ink and putting their book values per share, one of the most important valuation measures for banks and brokerages, in intensive care.

It’s a relatively new number investment houses now must disclose beginning this past Jan. 1, according to new accounting rules. It’s a number Wall Street has been desperately submarining out of sight in their profit reports, hoping you’ll zip right by it.

It’s an issue we’ve been talking about on our morning show, Money for Breakfast, for months now, as the result helps answer the question on everyone’s lips: Who is next?

This earnings result has helped blow out the economic circuits at places like Citigroup and Merrill Lynch, it’s helped create a record $195b in writedowns at western banks. Its being held partly to blame for the meltdown at Bear Stearns, and it’s a big reason why the Federal Reserve threw Bear a $30b lifeline.

It is also partly why CEOs have been frog marched out the door, it has helped torch tens of billions of dollars out of investor portfolios and it has caused many market watchers to start applying Novocaine to their nerve endings. It’s the reason why Wall Street has sheepishly gone hat in hand to sovereign wealth funds in the Middle East and Asia.

It’s such a touchy number that Goldman didn’t disclose an updated figure for it in its recent profit release or on its earnings call today, waiting to do so weeks from now when it has to file its latest quarterly with the Securities & Exchange Commission. Lehman also didn’t print the figure in its earnings release, but disclosed the number on its earnings conference call this morning.

But with the help of Fox’s crack statistician and researcher, Jonathan Fallon, we got the figures for you. It’s important to hold onto these numbers, known as level 3 assets, in coming days, even if you don’t own shares in these companies, because the financials are causing chaos in the markets.

Note: Latest figures available. Source: Company filings; Lehman’s numbers were reported in the company’s conference call

The figures represent the value of the risky, illiquid mortgage- and credit-backed securities that companies can’t get price tags on because the markets for them are frozen solid, as traders have bolted in panic from all corners of the credit market. They are the zombie securities that are typically backed by the sub prime and other credit deals now defaulting left and right, dead loan walking.

Companies must deduct the changes in the value of these Frankenstein securities from their profits, causing steam pipes to burst. These securities, which are going belly up right and left, are already submerging shareholder capital (a company’s assets minus it’s liabilities, similar to your own net worth).

Now this isn’t to say that all of these assets will drop into a ditch. No one knows, it depends on the credit markets. All could be worthless–all could have value. Some analysts now say to figure out what future hits to earnings could be at each firm, multiply the level 3 assets by 15% to 20% to get a rough idea, those percentages equivalent to what the best guesses are about how much mortgage- and other credit-backed assets have further to drop (if you’re really bearish, raise those percentages). The resulting writedowns get carved out of both company profits and book value.

Level 3 assets provide one of the truest gauges of the speculative bender Wall Street was on during the housing bubble. And it proves we are still in the third inning of this crisis.

The level 3 bucket can hold other items, to be sure. For instance, Morgan Stanley and other firms generally classify private-equity investments as level 3, because private equity deals, being private, aren’t traded on any market.

But for the most part, level 3 assets are a no-man’s land, as they tend to be securities no one wants, which is why the firms tend to bury information about these holdings in footnotes using typeface that are the font size of pharmaceutical disclosures.

Because no one wants them, there is no market for them. And because there is no market for them, these holdings are priced based on top management’s best guess of what they think they are worth, using their own idiosyncratic, internal models, a “mark to market” valuation approach that has been jokingly redubbed “mark to  myth” or “mark to make-believe,” (see prior blogs “What’s Really Rocking the Stock Market,” and “The Bear Trap“). Level 3 assets are also the subject of a growing controversy in Washington, DC as the Securities & Exchange Commission mulls a plan to relax the accounting rules used to book them.

Lehman Bros. says its level 3 assets have lately dropped by $3b to $38.7b, after having more than doubled to $42b in the last six months of last year. Lehman in its most recent quarterly report took just a $1.8b “mark to market” haircut against earnings due to the market downturn in these holdings.

But $38.7b is still a big number, oustripping Lehman’s $24.8b in shareholder equity, or what’s generally understood as net worth. The number was of such concern that it was partly why Lehman has hastened in recent days to point out that it has not just a $2b credit line–a sign of the good faith and confidence its lenders have in its operations–but also that it has a “robust liquidity pool” of $34b plus other “unencumbered” assets of $64b to plug this black hole.

The numbers are pretty frightening–they show the financials still have a long way to go. For instance, Wall Streeters are now talking about just how vulnerable Merrill Lynch really is. The numbers show that Merrill has $41.4b in level 3 assets, far above its $31.9b in shareholder equity.

Check out the havoc level 3 assets have wreaked in the third quarter. These assets caused Morgan Stanley (MS) and Lehman Bros. to report earnings declines, and they helped create an $8.4b writedown at Merrill Lynch ($24.5b to date), triggering the largest losses in Merrill’s history.

Goldman Sachs has been better than its compatriots at disclosing its level 3 assets, being first out of the box to do so last summer, a full two quarters before new accounting rules forcing such disclosures began January 1. “We are in the asset valuation business, and we don’t think it’s possible to manage risk effectively if you don’t know the value of your assets and liabilities,” says a Goldman spokesman.

Goldman’s level 3 assets actually helped juice its earnings in its third quarter. It booked a 79% increase in third-quarter profit, the biggest on Wall Street at the time, even after it took a $1.48b loss from problematic high-yielding loan assets.

Goldman reaped a third quarter net gain of $2.94b from level 3 derivatives, $2.62b of which came from what are called “unrealized” or paper gains made from these derivatives trades that can’t yet be cashed out yet–likely because no one wants to give cash for this, shall we say, mysterious paper, according to excellent analysis by Fortune Magazine. 

Again, Goldman is not telling investors yet what its level 3 assets are right now. Investors have to wait a month or so for those numbers, to see how much of its profit figures came from such paper gains.

What we do know is that Goldman held a bigger slug of hard-to-value assets at the end of the third quarter than Citigroup (C), which, besides Bear Stearns, was among the hardest by the subprime meltdown.

Goldman’s level 3 assets accounted for 6.9% of the New York-based firm’s $1.05t total at the end of the third quarter 2007. Citigroup recorded 5.7% of its assets as level 3 on Sept. 30th.

However, Goldman’s exposure becomes more serious on closer look. For the full fiscal 2007 year ending November, Goldman had $69.2b in gross level 3 assets, with over half coming from the iced-over private equity and real estate investment market, which has left firms including Goldman stuck with loans.

Although the $69.2b is down from the $72b Goldman reported in the quarter ending in August, it is still 45% higher than the $47.6 b the company reported in February, and was 26% more than Goldman’s shareholder capital of $42.9b.

And the level 3 number can show how the credit crisis has clearly gone viral, which we’ve known for some months now. For instance, buried in  Morgan Stanley’s year-end financial results, you’ll see that the level 3 pot grew by about $7b due to problems with commercial loans–now of growing concern, too, as it’s largely been the residential housing sector that has caused lots of hair-tearing around the country.

March 16, 2008 7:35PM

The Bear Trap

By Elizabeth MacDonald

The news that Bear Stearns (BSC), near collapse on Friday, was bought by JPMorgan Chase for a breathtakingly low $236.2 million in an all-stock deal won’t calm rattled nerves in the market on Monday.

The deal price is nothing short of shocking and is causing whiplash-inducing double-takes on Wall Street. The bailout of Bear comes after the near-destruction of the 85-year old U.S. institution, the fifth largest investment bank in the country and the nation’s second largest mortgage bond shop. The deal’s price comes in at about $2 a share–Bear opened at $57 on Friday, but then suffered its biggest one-day drop in its history. So far this year, Bear has lost $6.8b in market capitalization.

The company announced late Sunday that it was cancelling its planned announcement of its first-quarter earnings today, after moving the date up from this Thursday.

All this, despite the fact that top Bear executives were out in force last year saying the company’s capital position was strong. Similar to Countrywide’s chief executive Angelo Mozilo’s bullish statements last summer and fall about the health of the nation’s largest mortgage lender, at a time when he wasn’t buying shares in the bank, he was selling millions of dollars worth of shares.

The government-orchestrated takeover of Bear Stearns is historic in a number of ways. The Federal Reserve and the Treasury Department oversaw the acquisition talks, with the Fed agreeing to guarantee up to $30b of Bear’s “less liquid” mortgage and other assets in a non-recourse deal, according to the companies’ release.

Aside from the fact that the Fed is helping JP do a virtually risk-free deal, the loan is the most dramatic expansion of the central bank’s lending authority since the 1930s. If the collateral backing the $30b loan drops in value, the central bank, meaning taxpayers, will bear the cost by taking on that bad paper. Also, the Fed’s five governors voted unanimously to waive for the first time ever the usual restriction on Fed loans to nonbanks, The Wall Street Journal reports. The Fed also just announced a quarter point cut in its key lending rate to financial institutions, its discount rate, down to 3.25% from 3.5%. I’ll be reporting this story and updating this blog throughout Monday. Read More