Financial Meltdown by luchinbhuto

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A Compendium of Articles and Editorials on the Credit Crisis and Bank Bailout Programs

October/November 2008

Credit Crisis Update
October 14, 2008

An Overview—from the NEW YORK TIMES
In the fall of 2008, the credit crunch, which had emerged a little more than a year before, ballooned into Wall Street’s biggest crisis since the Great Depression. As hundreds of billions in mortgage-related investments went bad, mighty investment banks that once ruled high finance have crumbled or reinvented themselves as humdrum commercial banks. The nation’s largest insurance company and largest savings and loan both were seized by the government. The channels of credit, the arteries of the global financial system, have been constricted, cutting off crucial funds to consumers and businesses small and large. In response, the federal government adopted a $700 billion bailout plan meant to reassure the markets and get credit flowing again. But the crisis began to spread to Europe, where governments scrambled to prop up banks, broaden guarantees for deposits and agree on a coordinated response. Origins The roots of the credit crisis stretch back to another notable boom-and-bust: the tech bubble of the late 1990’s. When the stock market began a steep decline in 2000 and the nation slipped into recession the next year, the Federal Reserve sharply lowered interest rates to limit the economic damage. Lower interest rates make mortgage payments cheaper, and demand for homes began to rise, sending prices up. In addition, millions of homeowners took advantage of the rate drop to refinance their existing mortgages. As the industry ramped up, the quality of the mortgages went down. And turn sour they did, when homebuyers had to leverage themselves to the hilt to make a purchase. Default and delinquency rates began to rise in 2006, but the pace of lending did not slow. Banks and other investors had devised a plethora of complex financial instruments to slice up and resell the mortgage-backed securities and to hedge against any risks — or so they thought. The Crisis Takes Hold The first shoe to drop was the collapse in June 2007 of two hedge funds owned by Bear Stearns that had invested heavily in the subprime market. As the year went on, more banks found that securities they thought were safe were tainted with what came to be called toxic mortgages. At the same time, the rising number of foreclosures helped speed the fall of housing prices, and the number of prime mortgages in default began to increase. The Federal Reserve took unprecedented steps to bolster Wall Street. But still the losses mounted, and in March 2008 the Fed staved off a Bear Stearns bankruptcy by assuming $30 billion in liabilities and engineering a sale to JPMorgan Chase for a price that was less than the worth of Bear’s Manhattan skyscraper. Sales, Failures and Seizures In August, government officials began to become concerned as the stock prices of Fannie Mae and Freddie Mac, government-sponsored entities that were linchpins of the housing market, slid sharply. On Sept. 7, the Treasury Department announced it was taking them over. Events began to move even faster. On Sept. 12, top government and finance officials gathered for talks to fend off bankruptcy for Lehman Brothers. The talks broke down, and the government refused to step in and salvage Lehman as it had for Bear. Merrill Lynch, which had not been previously thought to be in danger, sold itself to the Bank of America to avoid a similar fate.

On Sept. 16, American International Group, an insurance giant on the verge of failure because of its exposure to exotic securities known as credit default swaps, was bailed out by the Fed in an $85 billion deal. Stocks dropped anyway, falling nearly 500 points. The Government’s Bailout Plan The bleeding in the stock market stopped only after rumors trickled out about a huge bailout plan being readied by the federal government. On Sept. 18, Treasury Secretary Henry M. Paulson Jr. publicly announced a threepage, $700 billion proposal that would allow the government to buy toxic assets from the nation’s biggest banks, a move aimed at shoring up balance sheets and restoring confidence within the financial system. Congress eventually amended the plan to add new structures for oversight, limits on executive pay and the option of the government taking a stake in the companies it bails out. Still, many Americans were angered by the idea of a proposal that provided billions of dollars in taxpayer money to Wall Street banks, which many believed had caused the crisis in the first place. Lawmakers with strong beliefs in free markets also opposed the bill, which they said amounted to socialism. President Bush pleaded with lawmakers to pass the bill, but on Sept. 29, the House rejected the proposal, 228 to 205, with an insurgent group of Republicans leading the opposition. Stocks plunged, with the Standard & Poor’s 500-stock index losing nearly 9 percent, its worst day since Oct. 19, 1987. Negotiations began anew on Capitol Hill. A series of tax breaks were added to the legislation, among other compromises and earmarks, and the Senate passed a revised version Oct. 1 by a large margin, 74 to 25. On Oct. 3, the House followed suit, by a vote of 263 to 171. When the bill passed, it was still unclear how effective the bailout plan would be in resolving the credit crisis, although many analysts and economists believed it would offer at least a temporary aid. Federal officials promised increased regulation of the financial industry, whose structure was vastly different than it had been just weeks before. The first reactions were not positive. Banks in England and Europe had invested heavily in mortgage-backed securities offered by Wall Street, and England had gone through a housing boom and bust of its own. Losses from those investments and the effect of the same tightening credit spiral being felt on Wall Street began to put a growing number of European institutions in danger. Over the weekend that followed the bailout’s passage, the German government moved to guarantee all private savings accounts in the country, and bailouts were arranged for a large German lender and a major European financial company. When stock markets in the United States, Europe and Asia continued to plunge, the world’s leading central banks on Oct. 8 took the drastic step of a coordinated cut in interest rates, with the Federal Reserve cutting its two main rates by half a point. And after a week in which stocks declined almost 20 percent on Wall Street, European and American officials announced coordinated actions that included taking equity stakes in major banks. The action prompted a worldwide stock rally, with the Dow rising 11 percent on Oct. 13. The Crisis and the Campaign The credit crisis emerged as the dominant issue of the presidential campaign in the last two months before the election. On Sept. 24, as polls showed Senator John McCain’s support dropping, he announced that he would suspend his campaign to try to help forge a deal on the bailout plan. The next day, both he and Senator Barack Obama met with Congressional leaders and President Bush at the White House, but their efforts failed to assure passage of the legislation, which went down to defeat in an initial vote on Sept. 29, a week before it ultimately passed.

The weakening stock market and growing credit crisis appeared to benefit Mr. Obama, who tied Mr. McCain to what he called the failed economic policies of President Bush and a Republican culture of deregulation of the financial markets. With the crisis deepening in early October, Mr. Obama established his first clear lead in the polls and also pulled ahead in several critical swing states, with many voters telling pollsters they viewed Mr. Obama as more capable in handling the economy. Responding to the crisis during their second debate, on Oct. 7, Mr. McCain put forward a $300 billion plan authorizing the Treasury secretary to buy the mortgages of homeowners in financial trouble and replace them with more affordable loans. The Obama campaign responded that the Treasury had already been given this authority under the terms of the bailout plan.

A short history of modern finance
Oct 16th 2008 From The Economist print edition

The crash has been blamed on cheap money, Asian savings and greedy bankers. For many people, deregulation is the prime suspect The autumn of 2008 marks the end of an era. After a generation of standing ever further back from the business of finance, governments have been forced to step in to rescue banking systems and the markets. In America, the bulwark of free enterprise, and in Britain, the pioneer of privatization, financial firms have had to accept rescue and part-ownership by the state. As well as partial nationalization, the price will doubtless be stricter regulation of the financial industry. To invert Karl Marx, investment bankers may have nothing to gain but their chains. The idea that the markets have ever been completely unregulated is a myth: just ask any firm that has to deal with the Securities and Exchange Commission (SEC) in America or its British equivalent, the Financial Services Authority (FSA). And cheap money and Asian savings also played a starring role in the credit boom. But the intellectual tide of the past 30 years has unquestionably been in favor of the primacy of markets and against regulation. Why was that so? Each step on the long deregulatory road seemed wise at the time and was usually the answer to some flaw in the system. The Anglo-Saxon economies may have led the way but continental Europe and Japan eventually followed (after a lot of grumbling) in their path. It all began with floating currencies. In 1971 Richard Nixon sought to solve the mounting crisis of a large trade deficit and a costly war in Vietnam by suspending the dollar’s convertibility into gold. In effect, that put an end to the Bretton Woods system of fixed exchange rates, which had been created, at the end of the Second World War. Under Bretton Woods, capital could not flow freely from one country to another because of exchange controls. As one example, Britons heading abroad on their annual holidays in the late 1960s could take just £50 (then $120) with them. Investing abroad was expensive, so pension funds kept their money at home. Once currencies could float, the world changed. Companies with costs in one currency and revenues in another needed to hedge exchange-rate risk. In 1972 a former lawyer named Leo Melamed was clever enough to see a business in this and launched currency futures on the Chicago Mercantile Exchange. Futures in commodities had existed for more than a century, enabling farmers to insure themselves against lower crop prices. But Mr Melamed saw that financial futures would one day be far larger than the commodities market. Today’s complex derivatives are direct descendants of those early currency trades. Perhaps it was no coincidence that Chicago was also the centre of free-market economics. Led by Milton Friedman, its professors argued that Keynesian economics, with its emphasis on government intervention, had failed and that markets would be better at allocating capital than bureaucrats. After the economic turmoil of the 1970s, the Chicago school found a willing audience in Ronald Reagan and Margaret Thatcher, who were elected at the turn of the decade. The duo believed that freer markets would bring economic gains and that they would solidify popular support for the conservative cause. A nation of property-owners would be resistant to higher taxes and to left-wing attacks on business. Liberalized markets made it easier for homebuyers to get mortgages as credit controls were abandoned and more lenders entered the home-loan market.

Another consequence of a system of floating exchange rates was that capital controls were not strictly necessary. Continental European governments still feared the destabilizing effect of hot money flows and created the European Monetary System in response. But Reagan and Mrs. (now Lady) Thatcher took the plunge and abolished controls. The initial effects were mixed, with sharp appreciations of the dollar and pound causing problems for the two countries’ exporters and exacerbating the recession of the early 1980s. But the result was that institutions, such as insurance companies and pension funds, could move money across borders. In Britain that presented a challenge to the stockbrokers and marketmakers (known as jobbers) who had controlled share trading. Big investors complained that the brokers charged too much under an anticompetitive system of fixed commissions. At the same time, big international fund-managers found that the tiny jobbing firms had too little capital to handle their trades. The Big Bang of 1986 abolished the distinction between brokers and jobbers and allowed foreign firms, with more capital, into the market. These firms could deal more cheaply and in greater size. New York had introduced a similar reform in 1975; in America’s more developed domestic market, institutional investors had had the clout to demand the change long before their British counterparts. These reforms had further consequences. By slashing commissions, they contributed to the long-term decline of broking as a source of revenue. The effect was disguised for a while by a higher volume of transactions. But the broker-dealers increasingly had to commit their own capital to deals. In turn, this made trading on their own account a potentially attractive source of revenue. Over time, that changed the structure of the industry. Investment (or merchant) banks had traditionally been slim businesses, living off the wits of their employees and their ability to earn fees from advice. But the need for capital led them either to abandon their partnership structure and raise money on the stockmarket or to join up with commercial banks. In turn, that required the dilution and eventually, in 1999, the abolition of the old GlassSteagall act, devised in the Depression to separate American commercial and investment banking. Commercial banks were keen to move the other way. The plain business of corporate lending was highly competitive and retail banking required expensive branch networks. But strong balance sheets gave commercial banks the chance to muscle investment banks out of the underwriting of securities. Investment banks responded by getting bigger. Expansion and diversification took place against a remarkably favorable background. After the Federal Reserve, then chaired by Paul Volcker, broke the back of inflation in the early 1980s, asset prices (property, bonds, shares) rose for much of the next two decades. Trading in, or lending against, such assets was very profitable. And during the “Great Moderation” recessions were short, limiting the damage done to banks’ balance sheets by bad debts. As the financial industry prospered, its share of the American stockmarket climbed from 5.2% in 1980 to 23.5% last year (see chart 1). Risky business As banks’ businesses became broader, they also became more complex. With the help of academics, financiers started to unpick the various components of risk and trade them separately. Again, Chicago played its part. Option contracts were known in ancient history but the 1970s saw an explosion in their use. Two academics who had studied, or taught, at the University of Chicago, Fischer Black and Myron Scholes, developed a theory of option pricing. And the Chicago Board Options Exchange was set up in 1973 as a forum for trading. Whereas futures contracts lock in the participants to buy or sell an asset, an option is more like insurance. The buyer pays a premium for the right to exercise his option should prices move in a set direction. If prices do not move that way, the option lapses and the buyer only loses the premium. The Black-Scholes formula shows that an option’s value depends on the volatility of the underlying assets. The more the price moves, the more likely

the option is to be exercised. Calculating that volatility was made a lot easier by the growing power of computers. The next great development in risk management was the swap. Bond markets had been domestic, with buyers focusing on issuers from their home markets. That created the potential for arbitrage, issuing bonds in one currency and swapping them for another, creating lower interest rates for both borrowers. It was a short step from currency swaps to interest-rate swaps. Borrowers on floating (variable) rates could swap with those on a fixed rate. This allowed company finance directors (and speculators) to change their risk exposure depending on their view of where rates would go. Rather than pay each other’s interest costs directly, the payments would be netted out. The final stage emerged only in the past decade. A credit-default swap (CDS) allows investors to separate the risk of interest-rate movements from the risk that a borrower will not repay. For a premium, one party to a CDS can insure against default. From almost nothing just a few years ago, CDSs grew at an explosive rate until recently (see chart 2). Futures, options and swaps all have the same characteristic: a small initial position can lead to a much larger exposure. Futures contracts are bought with only a small deposit or margin; option sellers have to cover buyers’ losses, which may be many times the value of the premium; the net exposure of a swap counterparty may be smaller but the gross position will be huge, a problem if the counterparty defaults. This made it hard for regulators to keep track of a firm’s exposure. For years, therefore, they concentrated on improving the infrastructure of the market, making sure that deals were well documented or settled through a central clearing house (something yet to be achieved for CDSs). The biggest hiccup in the growth of the derivatives markets came after the 1987 stockmarket crash, when a technique known as portfolio insurance took a lot of the blame. This involved investors selling stock-index futures to protect themselves from falls in the value of their portfolios. The problem was that the two markets acted on each other; as the futures price fell, so did the cash value of shares, forcing institutions to sell more futures and so on. That prompted the American authorities to introduce “circuit breakers”, limiting the use of portfolio insurance at difficult times. Derivatives caused more embarrassment in the 1990s as naive local authorities, such as Orange County in California, and corporate treasury departments lost fortunes in contracts they did not understand. But gradually the authorities learnt to love these markets; Frankfurt, for example, competed hard to win trading in German government-bond futures away from London. The theory was that, by allowing business and investors to spread risk, both markets and economies would become more robust. Alan Greenspan, the chairman of the Fed from 1987 to 2006, was in the vanguard of this view. In his book, “The Age of Turbulence” (2007), he welcomed the growth of CDSs, arguing: “Being able to profit from the loan transaction but transfer credit risk is a boon to banks and other financial intermediaries which, in order to make an adequate rate of return on equity, have to heavily leverage their balance sheets by accepting deposit obligations and/or incurring debt. A market vehicle for transferring risk away from these highly leveraged loan originators can be critical for economic stability, especially in a global environment.” Securitization, which has been at the center of the current crisis, is another child of the 1970s. It involves bundling loans into packages that are then sold to outside investors. The first big market was for American mortgages. When homeowners pay their monthly

payments, these are collected by the servicing agent and passed through to investors as interest payments on their bonds. Again, the authorities encouraged this business as a means of spreading risk. Everybody appeared to win. Banks earned fees for originating loans without the burden of holding them on their balance sheets (which would have restricted their ability to lend to others). Investors got assets that yielded more than government bonds and represented claims on a diversified group of borrowers. No wonder securitisation grew so fast (see chart 3). These asset-backed securities became ever more complex. Securitisation eventually gave rise to collateralized debt obligations, sophisticated instruments that bundled together packages of different bonds and then sliced them into tranches according to investors’ appetite for risk. The opacity of these products has caused no end of trouble in the past 18 months. More fundamentally, securitisation opened a new route to growth for banks. No longer were commercial banks dependent on the slow, costly business of attracting retail deposits. Securitisation allowed them to borrow in the markets. Few imagined that the markets would not be open at all times. In 2007 Northern Rock, a British mortgage lender, was the first spectacular casualty of this false assumption; many more banks have been caught out in 2008. Asleep at the wheel? While all this was happening, regulators were not wholly passive. They had to deal with crises such as the failures of Drexel Burnham Lambert, which dominated the junk-bond market, and Baring Brothers, a British bank brought low by a rogue trader. But these were regarded as individual instances of mismanagement or fraud, rather than as evidence of a systemic problem. Even the American savings-and-loan crisis, an early deregulation disaster, was tidied up with the help of a bailout plan and easy monetary policy, and dismissed as an aberration. Rather than question the principle of deregulation, some governments redesigned their regulatory structures. Britain devised the FSA in 1997 (even taking away banking regulation from the Bank of England) in a conscious attempt to create a single supervisory body. In America the SEC shares authority with the Commodities Futures Trading Commission, the Federal Deposit Insurance Corporation, state insurance commissioners and so on. The authorities did make a more fundamental attempt to regulate the banks with the Basel accord. The first version of this, in 1988, established minimum capital standards. Banks have always been a weak link in the financial system because of the mismatch between their assets and liabilities. The assets are usually long-term loans to companies and consumers. The liabilities are deposits by consumers and investors that can be withdrawn overnight. A bank run is hard to resist, since a bank cannot realize its assets quickly; worse still, doing so—by calling in loans—may cause economic havoc by prompting bankruptcies and job losses. The Basel accord was designed to deal with a different problem: that big borrowers might default. It required banks to set aside capital against such contingencies. Because this is expensive, banks looked for ways around the rules by shifting assets off their balance sheets. Securitisation was one method. The structured investment vehicles that held many subprime-mortgage assets were another. And a third was to cut the risk of borrowers defaulting, using CDSs with insurers like American International Group. When the markets collapsed, these assets threatened to come back onto the balance sheets, a prime cause of today’s problems. It would be a mistake to argue that, had politicians rather than bankers been in charge, policy would have been more prudent. Indeed, politicians encouraged banks to make riskier loans. This was particularly true in America, where a series of measures, starting with the Community Reinvestment Act of 1977, required banks to meet the credit needs of the “entire community”. In practice, this was social policy: it meant more lending to poor people. Fannie Mae and Freddie Mac, the two government-sponsored giants of the mortgage market, were encouraged to guarantee a wider range of loans in the 1990s. The share of Americans who owned their homes rose steadily. But more buyers meant higher prices, making loans even less affordable to the poor and requiring even slacker lending standards. The seeds of the subprime crisis were sown, and the new techniques of securitisation allowed banks to make these loans and then offload them quickly.

Initially, the growth of homeownership was seen as a benign effect of deregulation, as was the ability of consumers to borrow on their credit cards, a habit they took to enthusiastically. The authorities largely welcomed this boost to consumer demand. In the 1970s and 1980s, they might have worried about the effect on inflation or the trade deficit. But technological change in the 1990s, and the impact of China and India in the 2000s, kept headline inflation down, while liberalized capital markets and Asian savings made external deficits easy to finance. In addition, those countries with big financial centers were delighted to have them because of the tax revenues they yielded. That hardly encouraged them to look too closely at the financial industry. Nor did it hurt that political parties in both America and Britain received a lot of contributions from financiers. Liberalization happened for many reasons. Often, regulators were simply trying to catch up with the real world— for instance, the rapid development of offshore markets. In addition, deregulation provided things that voters wanted, such as cheap loans. Each financial innovation that came along became the object of speculation that was fuelled by cheap money. Bankers and traders were always one step ahead of the regulators. That is a lesson the latter will have to learn next time. Amid the crisis of 2008, it is easy to forget that liberalization had good consequences as well: by making it easier for households and businesses to get credit, deregulation contributed to economic growth. Deregulation may not have been the main cause of the rise in living standards over the last 30 years, but it helped more than it harmed. Will the new, regulated world be as benign?

What Went Wrong
How did the world's markets come to the brink of collapse? Some say regulators failed. Others claim deregulation left them handcuffed. Who's right? Both are. This is the story of how Washington didn't catch up to Wall Street.

A decade ago, long before the financial calamity now sweeping the world, the federal government's economic brain trust heard a clarion warning and declared in unison: You're wrong. The meeting of the President's Working Group on Financial Markets on an April day in 1998 brought together Federal Reserve Chairman Alan Greenspan, Treasury Secretary Robert E. Rubin and Securities and Exchange Commission Chairman Arthur Levitt Jr. -- all Wall Street legends, all opponents to varying degrees of tighter regulation of the financial system that had earned them wealth and power. Their adversary, although also a member of the Working Group, did not belong to their club. Brooksley E. Born, the 57-year-old head of the Commodity Futures Trading Commission, had earned a reputation as a steely, formidable litigator at a high-powered Washington law firm. She had grown used to being the only woman in a room full of men. She didn't like to be pushed around. Now, in the Treasury Department's stately, wood-paneled conference room, she was being pushed hard. Greenspan, Rubin and Levitt had reacted with alarm at Born's persistent interest in a fast-growing corner of the financial markets known as derivatives, so called because they derive their value from something else, such as bonds or currency rates. Setting the jargon aside, derivatives are both a cushion and a gamble -- deals that investment companies and banks arrange to manage the risk of their holdings, while trying to turn a profit at the same time. Unlike the commodity futures regulated by Born's agency, many newer derivatives weren't traded on an exchange, constituting what some traders call the "dark markets." There were now millions of such private contracts, involving many of Wall Street's top firms. But there was no clearinghouse holding collateral to settle a deal gone bad, no transparent records of who was trading what. Born wanted to shine a light into the dark. She had offered no specific oversight plan, but after months of making noise about the dangers that this enormous market posed to the financial system, she now wanted to open a formal discussion about whether to regulate them -- and if so, how.

Greenspan, Rubin and Levitt were determined to derail her effort. Privately, Rubin had expressed concern about derivatives' unruly growth. But he agreed with Greenspan and Levitt that these newer contracts, often called "swaps," weren't exactly futures. Born's agency did not have legal authority to regulate swaps, the three men believed, and her call for a discussion had real-world consequences: It would cast doubt over the legality of trillions of dollars in existing contracts and create uncertainty over how to operate in the market. At the April meeting, the trio's message was clear: Back off, Born. "You're not going to do anything, right?" Rubin asked her after they had laid out their concerns, according to one participant. Born made no commitment. Some in the room, including Rubin and Greenspan, came away with a sense that she had agreed to cool it, at least until lawyers could confer on the legal issues. But according to her staff, she was neither deterred nor chastened. "Once she took a position, she would defend that position and go down fighting. That's what happened here," said Geoffrey Aronow, a senior CFTC staff member at the time. "When someone pushed her, she was inclined to stand there and push back." Greenspan and Rubin maintained then, as now, that Born was on the wrong track. Greenspan, who left the Fed job in 2006 after an unprecedented three terms, also insists that regulating derivatives would not have averted the present crisis. Yesterday on Capitol Hill, a Senate committee opened hearings specifically on the role of financial derivatives in exacerbating the current crisis. Another hearing on the issue takes place in the House today. The economic brain trust not only won the argument, it cut off the larger debate. After Born quit in 1999, no one wanted to go where she had already gone, and once the Bush administration arrived in 2001, the push was for less regulation, not more. Voluntary oversight became the favored approach, and even those were accepted grudgingly by Wall Street, if at all. In private meetings and public speeches, Greenspan also argued a free-market view. Self-regulation, he asserted, would work better than the heavy hand of government: Investors had a natural desire to avoid selfdestruction, and that served as the logical and best limit to excessive risk. Besides, derivatives had become a huge U.S. business, and burdensome rules would drive the market overseas. "We knew it was a big deal [to attempt regulation] but the feeling was that something needed to be done," said Michael Greenberger, Born's director of trading and markets and a witness to the April 1998 standoff at Treasury. "The industry had been fighting regulation for years, and in the meantime, you saw them accumulate a huge amount of stuff and it was already causing dislocations in the economy. The government was being kept blind to it." Rubin, in an interview, said of Born's effort, "I do think it was a deterrent to moving forward. I thought it was counterproductive. If you want to move forward . . . you engage with parties in a constructive way. My recollection was, though I truly do not remember the specifics of the meeting, this was done in a more strident way." Rarely does one Washington regulator engage in such a public, pitched battle with other agencies. Born's failed effort is part of the larger story of what led to today's financial chaos, a bipartisan story of missed opportunities and philosophical shifts in which Washington stood impotent as the risk of Wall Street innovation swelled, according to more than 60 interviews as well as transcripts of meetings, congressional testimony and speeches. (Born declined to be interviewed.) Derivatives did not trigger what has erupted into the biggest economic crisis since the Great Depression. But their proliferation, and the uncertainty about their real values, accelerated the recent collapses of the nation's venerable investment houses and magnified the panic that has since crippled the global financial system.

A New Chain of Risk Futures contracts, one of the earliest forms of a derivative, have long been associated with big market failures. Harry Truman's father was financially wiped out by agriculture futures, and rampant manipulation by speculators contributed to the market collapses of 1929. Regulators have long known that new trading instruments have a way of giving reassurance of stability in good times and of exacerbating market downturns in bad. Futures -- essentially, a promise to deliver cash or something of value at a later time -- are traded on regulated exchanges such as the Chicago Mercantile Exchange, regulated by the CFTC. But Born was not questioning bets on pork bellies or wheat prices, the bedrock of futures trading in simpler times. Her focus was the arcane class of derivatives linked to fluctuations in currency and interest rates. She told a group of business lawyers in 1998 that the "lack of basic information" allowed traders in derivatives "to take positions that may threaten our regulated markets or, indeed, our economy, without the knowledge of any federal regulatory authority." The future that Born envisioned turned out to be even riskier than she imagined. The real estate boom and easy credit of the past decade gave birth to more complex securities and derivatives, this time linked to the inflated value of millions of homes bought by Americans ultimately unable to afford them. That created a new chain of risk, starting with the heavily indebted homebuyers and ending in a vast, unregulated web of contracts worldwide. By appearing to provide a safety net, derivatives had the unintended effect of encouraging more risk-taking. Investors loaded up on the mortgage-based investments, then bought "credit-default swaps" to protect themselves against losses rather than putting aside large cash reserves. If the mortgages went belly up, the investors had a cushion; the sellers of the swaps, who collected substantial fees for sharing in the investors' risk, were betting that the mortgages would stay healthy. The global derivatives market topped $530 trillion as of June 30 this year, including $55 trillion in the suddenly popular credit-default swaps; that $530 trillion represents all contracts outstanding. The total dollars at risk is much smaller, but still a hefty $2.7 trillion, according to an estimate by the International Swaps and Derivatives Association. To make sense of those figures, compare them to the value of the New York Stock Exchange: $30 trillion at the end of 2007, before the recent crash. When the housing bubble burst and mortgages went south, the consequences seeped through the entire web. Some of those holding credit swaps wanted their money; some who owed didn't have enough money in reserve to pay. Instead of dispersing risk, derivatives had amplified it. The Regulatory Rift Born, after 30 years in Washington, found herself on President Bill Clinton's short list for attorney general in 1992. The call never came. Approached about the CFTC job four years later, she took it, seeing a chance to make a public service mark, colleagues say. For several years before Born's arrival at the futures commission, Washington had been hearing warnings about derivatives. In 1993, Rep. Jim Leach (R-Iowa) issued a 902-page report that urged "regulations to protect against systemic risk" as well as supervision by the SEC or Treasury. Sen. Donald W. Riegle (D-Mich.), while acknowledging that swaps helped manage risk, saw "danger signs, on the horizon" in their rapid growth. He and Rep. Henry Gonzalez, a Texas Democrat, introduced separate bills in 1994 that went nowhere. Mary Schapiro, Born's predecessor, made her own run at the issue through enforcement actions. In an earlier decade, President Ronald Reagan had described the CFTC as his favorite agency because it was small and it had allowed the futures industry to grow and prosper. Born swept into the agency, the least known of the four major regulators with primary responsibility for overseeing the nation's financial markets, determined to enforce its rules and tackle hard issues.

"One theory at the time was she was so disappointed not to be running Justice -- that she got this tiny agency as a consolation prize and was hell-bent to make it important. I'm not sure that was in her mind, but it was a point of criticism," said John Damgard, president of the Futures Industry Association. Damgard disagreed with Born's approach but said he respected her for fighting for her principles. Daniel Waldman, Born's law partner at Arnold and Porter and her general counsel at the futures commission, said Born let the industry know she meant business. "She got into a knock-down, dragout fight with the Chicago Board of Trade over the delivery points for soybean contracts," he recalled. "She believed it was her obligation under the statute to review decisions by the exchanges. If they didn't meet agency requirements, she was going to say so, not look the other way." Born didn't back off on derivatives, either. On May 7, 1998, two weeks after her April showdown at Treasury, the commission issued a "concept release" soliciting public comment on derivatives and their risk. The response was swift and blistering. Within hours, Greenspan, Rubin and Levitt cited their "grave concerns" in an unusual joint statement. Deputy Treasury Secretary Lawrence Summers decried it before Congress as "casting a shadow of regulatory uncertainty over an otherwise thriving market." Wall Street howled. "The government had a legitimate interest in preserving the enforceability of the billions of dollars worth of swap contracts that were threatened by the concept release," said Mark Brickell, a managing director at what was then J.P. Morgan Securities and former chairman of the International Swaps and Derivatives Association. Although Born said new rules would be prospective, Wall Street was afraid existing contracts could be challenged in court. "That meant anybody on a losing side of a trade could walk away," Brickell said. He spent months shuttling between New York and Washington, working on Congress to block CFTC action. "I remember getting on an overnight train and arriving at Rayburn by 5:30 a.m.," he said. "I watched the sun rise and then went to work on my testimony without a whole lot of sleep." Born, who testified before Congress at least 17 times, tried to counter the legal question by saying that regulation would apply only to new contracts, not existing ones. But she relentlessly reiterated her conviction that ignoring the risk of derivatives was dangerous.

In June 1998, Leach, who had become chairman of the House Banking committee, thrust himself into the regulatory rift. He herded Born, Rubin and Greenspan into a small room near the committee's main venue at the Rayburn House Office Building, thinking he could mediate. "This is the most unusual meeting I've ever participated in," Leach recalled. "I have never in my life been in a setting where three senior members of the U.S. government reflected more tension. Secretary Rubin and Chairman Greenspan were in concert in expressing frustration with the CFTC leadership. . . . She felt, outnumbered with the two against one." Leach thought the futures commission lacked the professional bench to handle oversight. He pressed Born not to proceed until the Treasury and the Fed could agree which agency was best suited to the role. "I tried to take the perspective of, 'I hope we can work this out,' " he said. "Both sides -- neither side, gave in." Rubin said, in the recent interview, that he had his own qualms about derivatives, going back to his days as a managing partner at Goldman Sachs. He later wrote in a 2003 book that "derivatives, with leverage limits that vary from little to none at all, should be subject to comprehensive and higher margin requirements," forcing dealers to put up more capital to back the swaps. "But that will almost surely not happen, absent a crisis." Asked why he didn't suggest stricter capital requirements as an alternative in 1998, Rubin said, "There was no political reality of getting it done. We were so caught up with other issues that were so pressing. . . . the Asian financial crisis, the Brazilian financial crisis. We had a lot going on." Crisis and Ice Cream When the warring parties faced off next, in the Senate Agriculture committee's hearing room July 30, 1998, it was not a neutral battleground to air their differences. Chairman Richard G. Lugar, an Indiana Republican, wanted to extract a public promise from Born to cease her campaign. Otherwise, Congress would move forward on a Treasury-backed bill to slap a moratorium on further CFTC action. The committee had to switch to a larger room to accommodate the expected crowd of lobbyists representing banks, brokerage firms, futures exchanges, energy companies and agricultural interests, according to a Lugar aide. A dubious Lugar opened the hearing by telling Born: "It is unusual for three agencies of the executive branch to propose legislation that would restrict the activities of a fourth." When the warring parties faced off next, in the Senate Agriculture committee's hearing room July 30, 1998, it was not a neutral battleground to air their differences. Chairman Richard G. Lugar, an Indiana Republican, wanted to extract a public promise from Born to cease her campaign. Otherwise, Congress would move forward on a Treasury-backed bill to slap a moratorium on further CFTC action. The committee had to switch to a larger room to accommodate the expected crowd of lobbyists representing banks, brokerage firms, futures exchanges, energy companies and agricultural interests, according to a Lugar aide. A dubious Lugar opened the hearing by telling Born: "It is unusual for three agencies of the executive branch to propose legislation that would restrict the activities of a fourth." Born would not yield. She portrayed her agency as under attack, saying the Fed, Treasury and SEC had already decided, "that the CFTC's authority should instead be transferred to and divided among themselves." Greenspan shot back that CFTC regulation was superfluous; existing laws were enough. "Regulation of derivatives transactions that are privately negotiated by professionals is unnecessary," he said. "Regulation that serves no useful purpose hinders the efficiency of markets to enlarge standards of living."

The stalemate persisted. Then, in September a crisis arose that gave credence to Born's concerns. Long Term Capital Management, a huge hedge fund heavily weighted in derivatives, told the Fed that it could not cover $4 billion in losses, threatening the fortunes of everyone from tycoons to pension funds. After Russia, swept up in the Asian economic crisis, had defaulted on its debt, Long Term Capital was besieged with calls to put up more cash as collateral for its investments. Based on the derivative side of its books, Long Term Capital had an astoundingly high debt-tocapital ratio. "The off-balance sheet leverage was 100 to 1 or 200 to 1 -- I don't know how to calculate it," Peter Fisher, a senior Fed official, told Greenspan and other Fed governors at a Sept. 29, 1998, meeting, according to the transcript. Two days later, Born warned the House Banking committee: "This episode should serve as a wake-up call about the unknown risks that the over-thecounter derivatives market may pose to the U.S. economy and to financial stability around the world." She spoke of an "immediate and pressing need to address whether there are unacceptable regulatory gaps." The near collapse of Long Term Capital Management didn't change anything. Although some lawmakers expressed new fervor for addressing the risks of derivatives, Congress went ahead with the law that placed a six-month moratorium on any CFTC action regarding the swaps market. The battle left Born politically isolated. In April 1999, the President's Working Group issued a report on the lessons of Long Term Capital's meltdown, her last as part of the group. The report raised some alarm over excess leverage and the unknown risks of the derivative market, but called for only one legislative change -- a recommendation that brokerages' unregulated affiliates be required to assess and report their financial risk to the government. Greenspan dissented on that recommendation.

MILESTONES--Risk and Regulation
1998 May: Over objections of other financial regulators, Born issues "concept release," questioning whether unregulated derivatives contracts should get government oversight like exchange-traded futures contracts do. 1999 November: Congress passes law to dismantle Depression-era Glass-Steagall law, which had separated commercial and investment banking. The law does not give the Securities and Exchange Commission authority to regulate investment bank holding companies, which were trading heavily in unregulated derivatives contracts. November: A President's Working Group report on derivatives recommended no CFTC regulation, saying that it "would otherwise perpetuate legal uncertainty or impose unnecessary regulatory burdens and constraints upon the development of these markets in the United States." June: Born leaves the CFTC, with no change in the regulation of derivatives. 2000 December: Commodity Futures Modernization Act passes. Championed by Sen. Phil Gramm (R-Tex.), the law bars the Securities and Exchange Commission, as well as the Commodity Futures Trading Commission, from issuing new regulations on unregulated derivatives. 2004 April: The Securities and Exchange Commission creates a voluntary program of oversight for investment bank holding companies. It gives the SEC its first comprehensive look at the large trading positions the firms had in unregulated derivatives and mortgage-related securities. 2005 September: The Federal Reserve Bank of New York holds discussions with derivatives dealers on creating a voluntary clearinghouse for unregulated derivatives trades. 2008 September: Insurance giant AIG is seized by the federal government after it's forced to scramble for cash to use as collateral for $440 billion in credit default swaps it sold. September: Lehman Brothers files for bankruptcy protection after other financial firms demand cash to protect their positions. March: Bear Stearns is rescued by J.P. Morgan Chase and a $29

billion federal government loan after other financial firms question its stability and demand cash to protect their positions with the firm.

By May, Born had had enough. Although it was customary at the agency for others to organize an outgoing chairman's going-away bash, she personally sprang for an ice cream cart in the commission's beige-carpeted auditorium. On a June afternoon, employees listened to subdued, carefully worded farewells while serving themselves sundaes. In November, Greenspan, Rubin, Levitt and Born's replacement, William Rainer, submitted a Working Group report on derivatives. They recommended no CFTC regulation, saying that it "would otherwise perpetuate legal uncertainty or impose unnecessary regulatory burdens and constraints upon the development of these markets in the United States." Toward Self-Regulation Throughout much of 2000, lobbyists were flying in and out of congressional offices. With Born gone, they saw an opportunity to settle the regulatory issue and perhaps gain even more. They had a sympathetic ear in Texas

Sen. Phil Gramm, the influential Republican chairman of the Senate Banking Committee, and a sympathetic bill: the 2000 Commodity Futures Modernization Act. Gramm opened a June 21 hearing with a call for "regulatory relief." Peering through his wire-rimmed glasses, he drawled: "I think we would do well to remember the Lincoln adage that to ask a society to live under old and outmoded laws -- and I think you could say the same about regulation -- is like asking a man to wear the same clothes he wore when he was a boy." Greenspan and Rubin's successor at the Treasury, Larry Summers, still held sway on keeping the CFTC out of the swaps market. But Treasury officials saw an opportunity to push forward on a self-regulation idea from the Working Group's November 1999 report: an industry clearinghouse to hold pools of cash collected from financial firms to cover derivatives losses. But the report had also called for federal oversight to ensure that riskmanagement procedures were followed. The swaps industry generally supported the clearinghouse concept. One amended version of the bill made federal oversight optional. Treasury officials scrambled to act, and a provision introduced by Leach requiring oversight prevailed. The House passed the bill Oct. 19, but then the legislation stalled. Gramm was holding out for stronger language that would bar both the CFTC and the SEC from meddling in the swaps market. Alarmed, SEC lawyers argued that the agency at least needed to retain its authority over fraud and insider trading. What if a trader, armed with inside knowledge, engaged in a swap on a stock? Treasury Undersecretary Gary Gensler brokered a compromise: The SEC would retain its antifraud authority but without any new rulemaking power. On the night of Dec. 15, with the nation still focused on the Supreme Court decision three days earlier that settled the 2000 presidential election in George W. Bush's favor, the act passed as a rider to an omnibus spending bill. The clearinghouse provision remained. At the time, it seemed like a breakthrough. A clearinghouse would have created layers of protections that don't exist today, said Craig Pirrong, a markets expert at the University of Houston. "An industry-backed pool of capital could have cushioned against losses while discouraging risky bets." But afterward, the clearinghouse idea sat dormant, with no one in the industry moving to put one in place.

'An Absolute Siege'
In 2004, the SEC pursued another voluntary system. This one, too, didn't work out quite as hoped. For years, Congress had allowed a huge gap in Wall Street oversight: the SEC had authority over the brokerage arms of investment banks such as Lehman Brothers and Bear Stearns, but were in the dark about deals made by the firms' holding companies and its unregulated affiliates. European regulators, demanding more transparency given the substantial overseas operations of U.S. firms, were threatening to put these holding companies under regulatory supervision if their American counterparts didn't do so first. For the SEC, this was déjà vu. In 1999, the SEC had sought such authority over the holding companies and failed to get it. Late in the year, Congress passed the Gramm-Leach-Bliley Act, dismantling the walls separating commercial banks, investment banks and insurance companies since the Great Depression. But the act did not provide for any SEC oversight of investment bank holding companies. The momentum was all toward deregulation. "I remember saying at the time, people don't get it -- the level of missed opportunities to address some of these problems," said Annette Nazareth, then the SEC's head of market regulation. "It was an absolute siege on regulation." Five years later, the European regulators were forcing the issue again. Restricted by Gramm-Leach-Bliley, the SEC proposed a voluntary system, which the big investment banks opted to join. The holding companies would be permitted to follow their own computer models to assess how much risk they were taking; the SEC would get access to make sure the complex capital and risk-management models were up to the job. At an April 28 SEC meeting, commissioner Harvey Goldschmid expressed caution. "If anything goes wrong, it's going to be an awfully big mess," said Goldschmid, who voted for the program. Last month, the SEC's inspector general concluded that the program had failed in the case of Bear Stearns, which collapsed in March. SEC overseers had seen Bear Stearns's heavy focus on mortgage-backed securities and over-leveraging, but "did not take serious action to limit these risk factors," the inspector general's report said. SEC officials say the voluntary program limited what they could do. They checked to make sure Bear Stearns was adhering to its risk models but did not count on those models being fundamentally flawed. On Sept. 26, with the economic meltdown in full swing, SEC Chairman Christopher Cox shut down the program. Cox, a longtime champion of deregulation, said in a statement posted on the SEC's Web site, "the last six months have made it abundantly clear that voluntary regulation does not work." It was too late. All five brokerages in the program had either filed for bankruptcy, been absorbed or converted into commercial banks. Second Thoughts On Sept. 15, 2005, Federal Reserve Bank of New York president Timothy F. Geithner gathered senior executives and risk-management officers from 14 Wall Street firms in the Fed's 10th-floor conference room in lower Manhattan for another discussion about a voluntary mechanism. Also arrayed around the wood rectangular table, covered by green-felt tablecloths, were European market supervisors from Britain, Switzerland and Germany. E. Gerald Corrigan, managing director of Goldman Sachs and one of Geithner's predecessors at the New York Fed, had reported in July that the face value of credit-default swaps had soared nine--fold in just three years. Without an automated, electronic system for tracking the trades or collateral to back them, the potential for

systemic risk was increasing. "The growth of derivatives was exceeding the maturity of the operational infrastructure, so we thought we would try to narrow the gap," Geithner said in an interview. Talks have continued on a range of issues, including how to set up a clearinghouse with reserves in case of default -- the same concept in the 2000 legislation -- and what kind of government oversight would be allowed. But three years later, there is no system in place. Some major dealers have preferred to go it alone, and no one in the government told them they couldn't. With last month's death spiral of American International Group, the world's largest private insurance company until it was seized by the government; regulators saw their fears play out. AIG had sold $440 billion in creditdefault swaps tied to mortgage securities that began to falter. When its losses mounted, the credit-rating agencies downgraded AIG's standing, triggering a clause in its credit-default swap contracts to post billions in collateral that it didn't have. The government swooped in to prevent AIG's default, hoping to ward off another chain reaction in the already shaky financial system. The economic crisis has added momentum to the Fed's attempts to organize a voluntary clearinghouse. Geithner held two meetings last week with several firms and major dealers interested in setting up such a mechanism. Last week, the Chicago Mercantile Exchange announced it would team with Citadel Investment Group, a large hedge fund, to launch an electronic trading platform and clearinghouse for credit-default swaps. Other private companies and exchanges are working on their own systems, seeing opportunities for profit in becoming a shock absorber for the system. The crisis has prompted second thoughts. Goldschmid, the former SEC commissioner and the agency's general counsel under Levitt, looks back at the long history of missed opportunities and sighs: "In hindsight, there's no question that we would have been better off if we had been regulating derivatives -- and had a clearinghouse for it." Levitt, too, thinks about might-have-beens. "In fairness, while Summers and Rubin and I certainly gave in to this, we were not in the same camp as the Fed," he said. "The Fed was really adamantly opposed to any form of regulation whatsoever. I guess if I had to do it over again, I certainly would have pushed for some way to give greater transparency to products which turned out to be injurious to our markets."

Key Players in the Battle over Regulating Derivatives

"The size and nature of this market create a potential for systemic risk to the nation's financial markets that requires vigilance by federal regulatory authorities." - Brooksley E. Born, chair, Commodity Futures Trading Commission, 1996-1999 Arrived at the CFTC determined to get her arms around the risk posed by the burgeoning growth of derivatives, so called because they are financial instruments that derive their value from other investments. "Regulation of derivatives transactions that are privately negotiated by professionals is unnecessary. Regulation that serves no useful purpose hinders the efficiency of markets to enlarge standards of living." - Alan Greenspan, chairman, Federal Reserve, 1987-2006 Opposed regulation of derivatives on free market grounds. Thought the CFTC had no legal authority to do so, and any CFTC proposal would threaten the legality of existing contracts. "Derivatives, with leverage limits that vary from little to none at all, should be subject to comprehensive and higher margin requirements... but that will almost surely not happen, absent a crisis." - Robert E. Rubin, Secretary of the Treasury, 1995-1999 Agreed with Greenspan that the CFTC had no legal authority to regulate derivatives. Voiced qualms about their risk and rapid growth, but saw no political will to take action.

"I guess if I had to do it over again, I certainly would have pushed for some way to give greater transparency to products which turned out to be injurious to our markets." - Arthur Levitt Jr., chairman, Securities and Exchange Commission, 1993-2001 Like Greenspan and Rubin, questioned CFTC jurisdiction over derivatives and feared a CFTC regulatory effort would cast doubt over the legality of existing derivatives contracts.

Decried Born's efforts as "casting a shadow of regulatory uncertainty over an otherwise thriving market." Lawrence Summers, Secretary of the Treasury, 1999-2001; previously undersecretary and deputy, 1993-1999 Opposed regulation when he took over from Rubin. -

"I think we would do well to remember the Lincoln adage that to ask a society to live under old and outmoded laws--and I think you could say the same about regulation--is like asking a man to wear the same clothes he wore when he was a boy." - Phil Gramm, Republican senator from Texas, 1985-2002; chairman, Senate Banking Committee, 1999-2001 Pushed through several major bills to deregulate the banking and investment industries, including the 1999 Gramm-Leach-Bliley act that brought down the walls separating the commercial banking, investment and insurance industries. "I have never in my life been in a setting where three senior members of the U.S. government reflected more tension. Secretary Rubin and Chairman Greenspan were in concert in expressing frustration with the CFTC leadership... [Born] felt, I'm confident, outnumbered with the two against one." - Jim Leach, Republican representative from Iowa, 1977-2006; chairman, House Banking Committee, 1993-2001 Tried to mediate in the regulatory rift, bringing Born, Greenspan and Rubin to his committee for a meeting.

"It is unusual for three agencies of the executive branch to propose legislation that would restrict the activities of a fourth." - Richard G. Lugar, Republican senator from Indiana, 1976-present; chairman, Senate Agriculture committee, 1995-2001 Held a hearing in July 1998 to encourage Born to back away from trying to regulate derivatives. Pointed out the adamant opposition of other regulators at the Fed, the Treasury and the SEC.

First, Let's Stabilize Home Prices
(with emphasis and underlines added) OCTOBER 2, 2008

By R. G LE NN HU B B A RD and C HR I S M AY E R We are in a vicious cycle: falling housing values cause losses on securities, which reduce bank capital, thereby tightening lending and causing house prices to fall further. The cycle has spread beyond housing, but the housing market is at the source of this problem and the best place to break up the adverse sequencing of cause and effect events that have evolved from it. (This is the key to ‘stopping the bleeding’ and stabilizing the housing market.) Housing starts are at their lowest level since the early 1980s, while simultaneously there are now more vacant houses than at any time since the Census Bureau started keeping such data in 1960. Millions of homeowners owe more on their mortgage than their house is worth. Foreclosures are accelerating. House prices continue to

fall, weakening household balance sheets and the balance sheets of financial institutions. But this can stop. The price of a home is partially dependent on the mortgage interest rate -- lower mortgage rates will raise housing prices over time. (However, this will only occur with dynamic market conditions in which houses are bought and sold on a regular basis in a rationale, steady and not speculation driven, housing market) We propose that the Bush administration and Congress allow all residential mortgages on primary residences (the key here is owner-occupied primary residences only! No vacation homes or condos bought for speculation would qualify) to be refinanced into 30-year fixed-rate mortgages at 5.25%; matching the lowest mortgage rate in the past 30 years, and place those mortgages with Fannie Mae and Freddie Mac. Corporate investors and speculators in real estate should not be allowed to qualify. The historical spread of the 30-year, fixed-rate conforming mortgage over 10-year Treasury bonds is about 160 basis points. So a rate of 5.25% would be close to where mortgage rates would be today with normally functioning mortgage markets. One of us (Chris Mayer) recently published a study showing that -- assuming normally functioning mortgage markets -- the cost of buying a house is now 10% to 15% below the cost of renting across most of the country. Rising mortgage spreads and down-payment requirements are both factors that are still driving down housing prices. We need to stop this decline. The direct cost of this plan would be modest for the 85% of mortgages where the homeowner owes less on the house than it is worth. (This could be a sticking point, as the entire property appraisal system has to be restructured away from the valuation based on comparable neighborhood sales and controlled through more direct regulation) Lower interest rates would have a positive impact on stopping the slide in values and mean higher overall house prices. The present day reality is that the government now controls nearly 90% of the mortgage market and can (and should) act on this realization. Remove the refinancing option and you can have lower rates without substantial cost to the taxpayer. Homeowners would have to give up the right to refinance their mortgage if rates fall, although homeowners could pay off their mortgage by selling their home (no prepayment penalties). For borrowers with lower credit scores, the mortgage rate would be greater than 5.25%, but it would be less than their current rate. (Individual credit scores, if truly important to the lenders, could also be adjusted upwards by a pre-determined factor for any previous diminution that can be shown as directly related to the current housing crisis.) Now, what about mortgages on homes that are worth less than the total amount of the loan? These mortgages could be refinanced into a 30-year fixed-rate loan to be held by a new agency modeled on the 1930s-era Homeowners Loan Corporation. New mortgages would be made of up 95% of the current value of a home. (95% loan-to-value is probably necessary under the circumstances; I’d prefer the more traditional and conservative 80% LTV. If a borrower is able to meet such a level, then the interest rate could be adjusted downward) The government might use two approaches to mitigate its losses. It could offer owners and servicers the opportunity to split the losses on refinancing a mortgage with the new agency. Servicers would have to agree to accept these refinancings on all or none of their mortgages, to avoid cherry-picking. (Yes) Or the government should take an equity position in return for the mortgage write-down so that the taxpayers profit when the housing market turns around. (Careful—a temporary government ownership position in the banks is acceptable but if they mean the loan service industry-this would unnecessarily complicate the structure of this work-out and keep the government bureaucracy involved in the private sector far longer than required. The loan servicing on any refinanced mortgages should stay with the banks for further market discipline) Our calculations based on deeds and Census data suggest that the total amount of negative equity for all owneroccupied houses is $593 billion. However, capping an individual's write-down to $75,000 would reduce the government's total liability to $338 billion and cover 68% of individuals with negative equity. (This is quite similar to the work-out we designed for depositors in Maryland — it shows that on an individual basis the negative equity is not that great and that no one would receive an inequitable level of relief over most others in the same deteriorating situation. Raising the $75,000 to a maximum of $100,000 would probably ‘capture’ over 85% of the borrowers eligible for this program. Variations on this theme could be structured to include retirees and perhaps include some state cost-sharing and/or property tax relief programs). Even this loss will be reduced as the proposal spelled out here raises housing values and economic activity, and contemplates loss sharing with

lenders, hopefully matching the experience of the old Homeowners Loan Corporation. While the net cost is modest compared with many plans on the table, it would require that the government could assume trillions of dollars of additional mortgages on its balance sheet. But we have already crossed this bridge with the explicit "conservatorship" of Fannie Mae and Freddie Mac. In any event, these mortgages would be backed by houses and the verified ability to repay the debt by millions of Americans. (This is by far the most important facet to any bad loan work out. Collateral (i.e. foreclosures) has never been a primary or effective source of repayment—loans must be repaid through earnings and cash flow). In addition, by putting a floor under house prices, this proposal would raise the value to taxpayers of trillions of existing (no one seems to wants to remember this fact—these loans have already been disbursed and they are the basis for all the mortgage-backed securities that have been created since!) home mortgage assets already owned or guaranteed by the FDIC, the Fed, the Treasury, Fannie Mae and Freddie Mac, among others. Improvements in household and financial institution balance sheets will increase investment and consumer spending, which will mitigate the extent of the current downturn. Americans, on average, spend about 5% of the equity of their homes on consumer goods and services. So if home prices increased 10% above where they would have been without government intervention, we estimate consumers will have an additional $100 billion annually to spend. (¿ Where is the actual cash for this presumed increase in consumer spending to come from?) In addition to focusing on the very real problem in the housing market, the plan could be implemented immediately. As a result of the U.S. government's conservatorship of Fannie Mae and Freddie Mac, origination of new mortgages can be financed quickly. Congress would have to raise the overall borrowing limit and approve the new federal purchases of negative equity loans. But it will likely take the Treasury much longer to buy troubled assets than Fannie and Freddie, and it would have to seek the involvement of many additional private actors, as opposed to using vehicles already in place. The decline in housing prices remains the elephant in the room in the discussion of the credit market deterioration. Let's start there.
Mr. Hubbard, dean of Columbia Business School, was chairman of the Council of Economic Advisers under President George W. Bush. Mr. Mayer is a professor of finance and economics and senior vice dean of Columbia Business School.

Mel’s Cogitations I’m sure many uninformed conservatives will see this proposal as a socialist program with overtones of nationalization—shades of FDR and all that. Most conservative Republicans will probably scream that this is a bailout of people who got into mortgages that they couldn’t afford in the first place and is rewarding their ‘bad behavior’ This is simply not true for the majority of people who find themselves on the brink of foreclosure—too many other economic factors enter into this debacle to make this obdurate claim stick. If one wants to get to the root of the problem, blame has to go all the way back to that uniquely American concept of homeownership—the entrenched belief that the great ‘American dream’ is some sort of constitutional right. Mix this belief with the greed of capitalism and worship to the false God of Ever Increasing Home Value, and there is more than enough blame for every participant. There is an element of moral hazard hidden in this proposal as regards the ‘unfairness’ of treating homeowners who; while they may be upside-down in their mortgage to value ratio—are nonetheless keeping current on their existing mortgages differently than those who must refinance in this manner or face foreclosure. Eligibility criteria and some sort of upside profit cap must be incorporated into to the program so that homeowners who do take advantage of this refinancing program (at lower rates and decreased values) do not gain unfairly over others when the market stabilizes and home values begin their predictable upward trend once again. This can easily be done with the involvement of Fannie and Freddie—who have not gone away. In fact using these two GSEs as the lender of last resort for weak mortgage assets (and forcing them to hold them on their books instead of immediately creating mortgage-backed securities) would effectively recapitalize them as well. Fannie and Freddie will be very significant partners in any mortgage workout program now that they are

essentially wards of the state exempt from the capital and market discipline constraints. They can immediately purchase assets out of the TARP, doing so with considerably more flexibility than anyone else of size The way the $700 billion ‘solution’ has been structured so far this approach may look to some like a bailout on top of a bailout. BUT this is not really the case as the Treasury already has the authority to allocate its new-found dollars into purchasing primary mortgages instead of the villainous third-level Credit Default Swaps (CDS) and other toxic derivatives that only covered up the true level of basic credit risk. The only question is whether or not Secretary Paulson will actually approach the problem on multiple fronts and exercise this option as part of a comprehensive plan or stick with the his stated goal to resolve the crisis through the credit markets as currently structured. In reality this approach is exactly the opposite of the current Save Wall Street program that has been falsely sold to the public as helping Main Street—and then could only pass Congress with the inclusion of an additional $100billion + in earmarks designed to help their cronies and get themselves re-elected. It should be better understood by all that the stock market. with all its direct and indirect investment assets, is merely a vehicle, even a sideshow, for the banking system to operate in today’s era of instant communications and globalization of risk. We must return to the fundamentals here and attack the problem, not only at the level of the capital markets, but at the level of the individual bank which originated the original primary mortgage and is critical to the financial well-being of the average person. Without consumer faith in the fundamental soundness in his local bank, the financial panic will rapidly become endemic. This type of program should be an integral component of the resolution as it is exactly what the whole bailout program should have been designed to do in the first place—Stop the bleeding and save the homeowners, not the investment bankers! In addition to directly involving the very people most affected by the collapse of the housing market, we should begin to see a revival of bank lending in all markets. Nonetheless, all should realize that instituting a program to resolve the multi-faceted mortgage market issues will, in itself. not provide the desired quick fix panacea that many desire. The long-term stabilization and possible recovery of the global capital markets will take years of further government interventions, both in terms of cash and a re-regulation of future activities. The critical slowdown in inter-bank funding and new credit extensions to small businesses would be reversed-although banks had best return to the fundamentals and be more conservative in whom they lend to and on what terms. The Federal Reserve has already taken steps to address this aspect of the problem, pledging to fund banks directly and/or buy several billion dollars worth of commercial paper themselves. Combined with the raising of the deposit insurance limits to $250,000.00 and the announced plans to invest in the recapitalization of commercial banks through direct equity purchases, these programs should go a long way in restoring faith in the financial sector from the true foundation of the system—the American consumers and taxpayers. It is politically interesting—but totally disingenuous; that McCain is trying to take credit for this ‘plan’ by declaring in the latest debate that he would ‘order’ the Treasury secretary to buy up all the ‘bad’ mortgages to ‘save the taxpayer’. As can be expected in this period of bizarre campaign rhetoric, his ‘idea’--half-baked and poorly expressed as it is, has hastily been politicized and is now so bastardized from the intention of the model proposed, as to be totally unrealizable. This is not his idea and in fact is not a new idea at all. I, as well as many others, have been thinking along these lines since late last year and these two professors have succeeded in structuring and articulating the main issues involved much better than I have ever been able to. In this time of crisis it is important that this process not be further politicized and that the operational details not be allowed to deter the serious consideration of the type of mortgage refinancing program proposed by professors Hubbard and Mayer as an integral part of the overall solution. At least under this program, there would be no extravagant costs for mortgage holders to attend a ‘work-out’ retreat at a spa resort, as did the AIG executives last month.
Mel Brown October 2008

The Engine of Mayhem There Are Dangers in Deleveraging Too Fast
October 13, 2008

It's easy to explain the continuing financial chaos -- and the failure of governments to control it -- as the triumph of psychology. Fear reigns, and panic follows. Everyone dumps stocks because everyone believes that everyone else will sell. Only rapidly falling prices attract sufficient buyers. All this is true. But it ignores the real engine of mayhem: "deleveraging." That's economic shorthand for purging the financial system of too much debt. Just how this deleveraging proceeds will largely determine the fate, for good or ill, of the crisis. The turmoil has already moved beyond "subprime mortgages," which (it now seems) merely exposed widespread financial failings. These were global, not just American, and their pervasiveness explains why leaders of the major economies have struggled, so far unsuccessfully, to fashion a common response. Alone, American subprime mortgages should not have triggered a global crisis. Losses are smaller than they seem. Mark Zandi of Moody's estimates that all U.S. mortgage losses will ultimately reach $650 billion. But that hefty amount pales against the value of all financial assets -- stocks, bonds, bank loans. For the United States, these totaled almost $60 trillion at the end of 2007; for the world, the comparable figure exceeded $250 trillion. Such a vast financial system should have absorbed the subprime losses without calamity. By way of contrast, the stock market's drop since its peak in October 2007 to Friday was $8.4 trillion, or 42 percent, reports Wilshire Associates. The official response to the subprime losses also seems larger than the problem. The government has taken over mortgage giants Fannie Mae and Freddie Mac; the Federal Reserve is pumping out short-term loans of $1 trillion or more; and Congress's $700 billion rescue allows the Treasury Department to buy subprime securities and to make direct investments in banks. Still, the situation has not stabilized; the crisis continues. It's as if more firefighters had arrived at a burning home and turned their hoses on the flames, but the conflagration raged anyway. What's going on? What we've discovered is that the real problem is bigger. Large parts of the financial system are too thinly capitalized and too dependent on unreliable short-term debt. Leverage ratios often reached 30 to 1 for investment banks and hedge funds (that is, $30 of debt for every $1 of capital). The presumption was that the MBA types had learned how to "manage risk." That false conceit backfired. Low capital didn't adequately protect against losses. Confidence and trust evaporated, because no one knew which institutions held suspect securities, how much the losses were and who was ultimately safe. Deleveraging -- a shift from excessive debt toward more capital -- is inevitable and desirable in the long run. The trouble is that, in the short run, it could destabilize the economy if it proceeds too rapidly. Consider stocks. Their plunge has been driven in part by hedge fund selling. Hedge funds often buy stocks by borrowing from their "prime dealers" -- firms such as Goldman Sachs and Morgan Stanley, which in turn borrow from commercial banks. If banks "deleverage" by reducing loans to prime dealers, then prime dealers tighten up on hedge funds, which react by selling stocks. "It's a big piece of why the stock market is down," says Michael Decker, former chief economist for the Securities Industry and Financial Markets Association and now co-head of the Regional Bond Dealers Association. All around the world, we see variants of this cycle. Countries could face crippling capital outflows. The yen "carry trade" -- borrowing at low interest rates in Japan and lending at higher rates in other countries -- is reportedly contracting. Iceland's main banks have been nationalized because they couldn't renew their short-term borrowings. But if credit is withdrawn too abruptly, the prices of stocks, bonds and other assets that it propped up -- and also the real economy of production and jobs -- will fall. And the effects feed on themselves. Hedge funds, for example, have been hit with high redemptions from investors: about 5 percent in September, 2 1/2 times normal, says Charles Gradante of the Hennessee Group. These compound selling pressures.

The present challenge is far more complicated than merely quarantining dubious mortgage-related securities. What's involved is a fundamental remaking of the global financial system, from one that was inherently fragile to one that rests on firmer foundations. But if the change proceeds too quickly and haphazardly, it risks a hugely destructive credit implosion. All the policies undertaken so far will ultimately be judged by whether they succeed in managing the transition and restoring confidence in financial markets that self-correct naturally -- as opposed to submitting to the continuing mayhem of uncontrolled deleveraging.

Intervention Is Bold, but Has a Basis in History
October 14, 2008

After a week of mounting chaos in financial markets around the globe, the United States took a momentous step that shifts power in the economy toward Washington and away from Wall Street. The government’s plan to prop up banks large and small — along with recent bailouts as well as guarantees to support business loans, money markets and bank lending — represents the most sweeping government moves into the nation’s financial markets since the Great Depression, and perhaps ever, according to economists and finance experts. The high-stakes program is intended to halt the worst financial crisis since the 1930s. If successful, it could long be studied by historians as a textbook case of the emergency role that government can play to rescue a teetering economy. “It is profound, and it is something of a shift back to the state,” said Adam S. Posen, an economist at the Peterson Institute for International Economics. “But is this a recasting of capitalism? I think what we’ll see is that the government acts as a silent partner and gets out as soon as it can.” Indeed, they say, many questions remain. Is the government picking winners in a plan that initially seems tilted toward the nation’s largest banks? What strings are attached to the investment in matters like executive pay? Will the move presage a more forceful government hand to control financial markets or will it be a brief stint as capitalism’s protector? The package does call for the government investments to be in three-year securities that the banks can repay at any time, when markets settle and conditions improve. “This is clearly a crisis measure in crisis times, but it’s a good thing there is a sunset provision that limits the length of the government’s investment,” said Richard Sylla, an economist and financial historian at the Stern School of Business at New York University. The United States is acting in step with Europe, where governments often take a more interventionist stance in economies and the financial systems are in the hands of a comparatively small number of banks. Britain took the lead last week, declaring its intention to take equity stakes in banks to steady them. In the last two days, France, Italy and Spain have announced rescue packages for their banks that include state shareholdings. The government’s plan is an exceptional step, but not an unprecedented one. The United States has a culture that celebrates laissez-faire capitalism as the economic ideal, yet the practice strays at times. Over the last century, the federal government has occasionally taken stakes in railways, coal mines and steel mills, and has even taken a controlling interest in banks when it was deemed to be in the national interest. The corporate wards of the state typically have been returned to private hands after short, sometimes fleeting, stretches under federal stewardship.

Finance experts say that having Washington take stakes in United States banks now — like government interventions in the past — would be a promising move to address an economic emergency. The plan by the Treasury Department, they say, could supply banks with sorely needed capital and help restore confidence in financial markets. Elsewhere, government bank-investment programs are routinely called nationalization programs. But that is not likely in the United States, where nationalization is a word to avoid, given the aversion to anything that hints of socialism. In past times of war and national emergency, Washington has not hesitated. In 1917, the government seized the railroads to make sure goods, armaments and troops moved smoothly in the interests of national defense during World War I. After the war ended, bondholders and stockholders were compensated and railways were returned to private ownership in 1920. During World War II, Washington seized dozens of companies, including railroads, coal mines and, briefly, the Montgomery Ward department store chain. In 1952, President Harry S. Truman seized 88 steel mills across the country, asserting that unyielding owners were determined to provoke an industry wide strike that would cripple the Korean War effort. That nationalization did not last long, though, because the Supreme Court ruled the move an unconstitutional abuse of presidential power. In banking, the government took an 80 percent stake in the Continental Illinois Bank and Trust in 1984. Continental Illinois failed in part because of bad oil-patch loans in Oklahoma and Texas. As the nation’s seventhlargest bank, Continental Illinois was deemed “too big to fail” by federal regulators, who feared wider turmoil in the financial markets. In the end, the government lost an estimated $1 billion on the bad loans it bought as part of the takeover of Continental, which eventually became part of Bank of America. The nearest precedent for the Treasury plan, finance experts say, are the investments made by the Reconstruction Finance Corporation in the 1930s. The agency, established in 1932, not only made loans to distressed banks, but also bought stock in 6,000 banks, at a cost of $1.3 billion, said Mr. Sylla, the N.Y.U. economist. A similar effort these days, in proportion to today’s economy, would be about $200 billion. When the economy stabilized eventually, the government sold the stock to private investors or the banks themselves — and about broke even, Mr. Sylla estimated. The 1930s program was a good one, experts say, but the government moved too slowly to deal with the financial crisis, which precipitated and lengthened the Great Depression. The lesson of history, it seems, is for Washington to move quickly in times of economic crisis with a forceful government intervention in the marketplace. And Ben S. Bernanke, chairman of the Federal Reserve, has studied the Great Depression and the policy miscues in those years. “The goal is to get the engine of capitalism going as productively as possible,” said Nancy Koehn, a historian at the Harvard Business School. “Ideology is a luxury good in times of crisis.” The traditional American reluctance for government ownership is not shared in other countries. After World War II, several European countries nationalized basic industries like coal, steel and even autos, which typically remained in government hands until the 1980s, when most Western economies began paring back the state’s role in the economy. Europe remains far more comfortable with government having a strong hand in business. So when Sweden, for example, faced a financial crisis in the early 1990s, the nationalization of much of the banking industry was welcomed. The Swedish government quickly bought stakes in banks, and sold most of them off later — a model of swift, forceful intervention in a credit crisis, financial experts say. “In Europe, the concept of the social contract is much more social — that is, socialist — than we’ve been comfortable with in America,” said Robert F. Bruner, a finance expert at the Darden School of Business at the University of Virginia.

“The obvious danger with anything that really starts to look like the government taking ownership or control of a significant piece of an industry is, Where do you stop?” Mr. Bruner said. “The auto industry is in dire straits and the airline industry is in trouble, for example.” “But the spillover effects from the crisis in the financial system are so great, pulling down the rest of the economy in a way that no other industry can, so that the potential cost of not doing something like this is immense,” Mr. Bruner said. How to Manage the Banks
October 15, 2008

The Treasury plans to invest up to $250 billion in individual banks and has already allotted half that amount to nine leading banks. For now, the key questions are: Will the plan work? And what consequences will it have for our financial system and our economy? Several issues bear examination. First, is this enough money? Citigroup, for example, is getting $25 billion. As of June 30, it had $2.1 trillion in assets and just $136 billion in capital; the new capital is only 1.2 percent of its total assets. If the problem is that falling asset prices could put banks' solvency at risk, the Treasury might have to commit more money. The Treasury has taken a major step toward restoring confidence in the global financial system. In truth, no one knows how much funding is needed. The reduction in lending (known as "deleveraging") underway throughout the world may lead to a sharp recession. Some European nations, which have large financial sectors and substantially greater leverage than in the United States, pose risks to all nations. The United States needs to be prepared to quickly shore up capital among banks, and potentially major insurance companies and other financial firms, if it appears the recession is deepening. The Treasury should abandon plans to buy troubled assets (this can be handled by Fannie Mae and Freddie Mac, as necessary) and keep the full $700 billion from the Troubled Asset Relief Program for financial-sector recapitalization if needed. Congress should amend TARP rules so the full $700 billion is available at the discretion of the president. Second, which banks should get new capital? Treasury official Neel Kashkari said Monday that equity injections would go only to "healthy banks," raising the possibility that the Treasury would invest in a small set of protected banks and allow them to acquire the assets of banks that fail. Today's term sheet, however, seems to open participation to any "qualifying financial institution." We agree that the Treasury should invest in any bank that needs capital, an approach that is arguably fairer and will ultimately ensure a more competitive system. Some banks that receive federal funds may ultimately fail. But it is essential that the Treasury not favor a handful of large banks. Third, how good an investment is this for taxpayers? The government is buying preferred shares, which carry a 5 percent dividend and do not dilute common shares, along with a small amount of warrants. In a narrow sense, the deal terms are much worse than the terms Warren Buffett negotiated when he invested in Goldman Sachs this month. (He received a 10 percent dividend and warrants to buy additional common shares at well below market prices.) But the Treasury has taken a sensible broader view—in leaving more for banks' other shareholders and creditors, it has taken a major step toward restoring confidence in the global financial system. Fourth, what role should the government play in managing the banks? A government recapitalization requires balancing the interests of the banks (or their shareholders), the taxpayer (as an investor), and the public good. The Treasury has deployed a relatively small amount of taxpayer money to a few banks, at least in the first phase, in a form that minimizes the impact on current shareholders and gives the government little influence on bank operations, since the new shares will have no voting rights. The British plan, by contrast, devoted more taxpayer money to gain a controlling interest in one major bank (RBS) and more than 40 percent of a newly merged bank (the combined Lloyds TSB and HBOS), with the right to appoint directors to both boards. It also imposed new controls over the banks, which risks politicizing

operations: As Britain enters what could be a major recession, there will be large pressures on partly nationalized banks to channel credit according to government's will. The United States, in contrast, is putting the full credibility of its balance sheet behind banks but giving them free rein to move on. Both plans have pitfalls. We taxpayers need to trust that the authorities are prepared to regulate the "ordained banks" with a much stronger hand than they have in the past. Congress should create a consolidated and powerful regulator that can stand up to the banks. All regulatory rules have to be rethought, given that any sizable financial institution is now seen as too interconnected to be allowed to fail. On balance, this US (and European) policy is likely to restore immediate confidence in banks. This is a remarkable shift from the rough treatment of shareholders and creditors at Lehman Brothers and AIG, which helped create the panic of the past few weeks. These new policies correct those errors. Now, let's hope the Treasury is done being fickle. Simon Johnson is a senior fellow at the Peterson Institute for International Economics and a professor at MIT. He is a cofounder of the Baseline Scenario.

Drama Behind a $250 Billion Banking Deal
October 15, 2008

The chief executives of the nine largest banks in the United States trooped into a gilded conference room at the Treasury Department at 3 p.m. Monday. To their astonishment, they were each handed a one-page document that said they agreed to sell shares to the government, then Treasury Secretary Henry M. Paulson Jr. said they must sign it before they left. The chairman of JPMorgan Chase, Jamie Dimon, was receptive, saying he thought the deal looked pretty good once he ran the numbers through his head. The chairman of Wells Fargo, Richard M. Kovacevich, protested strongly that, unlike his New York rivals, his bank was not in trouble because of investments in exotic mortgages, and did not need a bailout, according to people briefed on the meeting. But by 6:30, all nine chief executives had signed — setting in motion the largest government intervention in the American banking system since the Depression and retreating from the rescue plan Mr. Paulson had fought so hard to get through Congress only two weeks earlier. What happened during those three and a half hours is a story of high drama and brief conflict, followed by acquiescence by the bankers, who felt they had little choice but to go along with the Treasury plan to inject $250 billion of capital into thousands of banks — starting with theirs. Mr. Paulson announced the plan Tuesday, saying “we regret having to take these actions.” Pouring billions in public money into the banks, he said, was “objectionable,” but unavoidable to restore confidence in the markets and persuade the banks to start lending again. In addition to the capital infusions, which will be made this week, the government said it would temporarily guarantee $1.5 trillion in new senior debt issued by banks, as well as insure $500 billion in deposits in noninterest-bearing accounts, mainly used by businesses. All told, the potential cost to the government of the latest bailout package comes to $2.25 trillion, triple the size of the original $700 billion rescue package, which centered on buying distressed assets from banks. The latest show of government firepower is an abrupt about-face for Mr. Paulson, who just days earlier was discouraging the idea of capital injections for banks. Analysts say the United States was forced to shift policy in part because Britain and other European countries announced plans to recapitalize their banks and backstop bank lending. But unlike in Britain, the Treasury secretary presented his plan as an offer the banks could not refuse.

“It was a take it or take it offer,” said one person who was briefed on the meeting, speaking on condition of anonymity because the discussions were private. “Everyone knew there was only one answer.” Getting to that point, however, necessitated sometimes tense exchanges between Mr. Paulson, a onetime chairman of Goldman Sachs, and his former colleagues and competitors, who sat across a dark wood table from him, sipping coffee and Cokes under a soaring rose and sage green ceiling. This account is based on interviews with government officials and bank executives who attended the meeting or were briefed on it. Mr. Paulson began calling the bankers personally Sunday afternoon. Some were already in Washington for a meeting of the International Monetary Fund. The executives did not have an inkling of Mr. Paulson’s plans. Some speculated that he would brief them about the government’s latest bailout program, or perhaps sound them out about a voluntary initiative. No one expected him to present his plan as an ultimatum. Mr. Paulson, according to his own account, presented his case in blunt terms. The nation’s largest banks needed to begin lending to each other for the good of the financial system, he said in a telephone interview, recalling his remarks. To do that, they needed to be better capitalized. “I don’t think there was any banker in that room who was going to look us in the eye and say they had too much capital,” Mr. Paulson said. “In a relatively short period of time, people came on board.” Indeed, several of the banks represented in the room are in need of capital. And analysts said the terms of the government’s investment are attractive for the banks, certainly compared with the terms that Warren E. Buffett extracted from Goldman Sachs for his $5 billion investment. The Treasury will receive preferred shares that pay a 5 percent dividend, rising to 9 percent after five years. It will get warrants to purchase common shares, equivalent to 15 percent of its initial investment. But the Treasury said it would not exercise its right to vote those common shares. The terms, officials said, were devised so as not to be punitive. The rising dividend and the warrants are meant to give banks an incentive to raise private capital and buy out the government after a few years. Still, it took some cajoling. Mr. Kovacevich of Wells Fargo objected that his bank, based in San Francisco, had avoided the mortgagerelated woes of its Wall Street rivals. He said the investment could come at the expense of his shareholders. Mr. Kovacevich is also said to have expressed concern about restrictions on executive compensation at banks that receive capital injections. If he steps down from Wells Fargo after completing a planned takeover of Wachovia, he would be entitled to retirement benefits worth about $43 million, and $140 million in accumulated stock and options, according to James F. Reda & Associates, a executive pay consulting firm. Pay experts say the new Treasury limits would probably not affect his exit package. Mr. Kovacevich declined to be interviewed about the meeting. Kenneth D. Lewis, the chairman of Bank of America, also pushed back, saying his bank had just raised $10 billion on its own. Later, Mr. Lewis urged his colleagues not to quibble with the plan’s restrictions on executive compensation for the top executives. These include a ban on the payment of golden parachutes, repayment of any bonus based on earnings that prove to be inaccurate, and a limit of $500,000 on the tax deductibility of salaries. If we let executive compensation block this, “we are out of our minds,” he said, according to a person briefed on the meeting.

In an interview on Monday, before the meeting, John J. Mack said his bank, Morgan Stanley, did not need capital from the Treasury. It had just sealed a $9 billion deal with a large Japanese bank. During the meeting, Mr. Mack, Morgan Stanley’s chief executive, said little, according to participants. Mr. Paulson, however, was peppered with questions about the terms of the investment by other chief executives with experience in deal-making: Lloyd C. Blankfein of Goldman Sachs, Vikram S. Pandit of Citigroup, John A. Thain of Merrill Lynch and Mr. Dimon. Among their concerns were: How would the government’s stake affect other preferred shareholders? Would the Treasury Department demand some control over management in return for the capital? How would the warrants work? With the discussion becoming heated, the chairman of the Federal Reserve, Ben S. Bernanke, who was seated next to Mr. Paulson, interceded. He told the bankers that the session need not be combative, since both the banks and the broader economy stood to benefit from the program. Without such measures, he added, the situation of even healthy banks could deteriorate. The president of the Federal Reserve Bank of New York, Timothy F. Geithner, then proceeded to outline the details of the investment program. When the bankers heard the amount of money the government planned to invest, they were stunned by its size, according to several people. As they heard more of the details, some of the bankers began to realize how attractive the program was for them. Even as they insisted that they did not need the money, bankers recognized that the extra capital could be helpful if the economy became shakier. Besides, many of these banks’ biggest businesses are tied to the stock and credit markets; the quicker they improve, the better their results. Later, Mr. Pandit told colleagues that the investment would give Citigroup more flexibility to borrow and lend. Mr. Dimon told colleagues he believed the relatively cheap capital was a fair deal for his bank. Mr. Lewis said he recognized the prospects of his bank were closely aligned with the American economy. Mr. Thain was intrigued by the terms of the guarantee by the Federal Deposit Insurance Corporation on new senior debt issued by banks, participants said. He mentally calculated the maturities on debt issued by Merrill Lynch, to determine how the program could benefit his bank. For Mr. Paulson, selling the bankers on capital injections may not have been as difficult as overhauling a rescue program that had originally focused on asset purchases from banks. In the interview, Mr. Paulson said the worsening conditions made a change in focus imperative. “I’ve always said to everyone that ever worked for me, if you get too dug in on a position, the facts change, and you don’t change to adapt to the facts, you will never be successful,” he said in the interview. Mr. Paulson insisted that purchases of distressed assets would remain a big part of the program. But having allocated $250 billion to direct investments, the Treasury has only $100 billion left from its initial allotment of $350 billion from Congress to spend on those purchases. As the meeting wound down, participants said, the bankers focused more on contacting their boards before signing the agreement with the Treasury Department. With time running short and private space limited, some of the bankers left the Treasury building, heading for their limousines while speaking urgently into cell phones. “I don’t think we need to be talking about this a whole lot more,” Mr. Lewis said, according to a person briefed on the meeting. “We all know that we are going to sign.”


Rescued by Fannie Mae?
(Emphasis and underlining added) By Susan E. Woodward Washington Post Tuesday, October 14, 2008

The most important task of the Federal Reserve and the Treasury right now is to restore confidence in bank solvency -- hence the Treasury's move to spend the first $250 billion of the Troubled Asset Relief Program (TARP) buying ownership stakes in a range of banks. Nonfunctioning markets and dried-up liquidity are symptoms of universal suspicion of insolvency, and lending among banks will resume in earnest only when banks are known to be solvent. The original plan under TARP was for the Treasury to buy up suspect mortgage-related assets. Mortgages, by themselves or bundled into mortgage-backed securities, lack a functioning market. Any prices set in the near term are likely to be grossly below the true economic value (reached from holding until borrowers complete their payments or cash from foreclosures arrives). By buying stock in banks, the Treasury injects cash, allowing institutions to hang on to assets worth more than the market will pay for them now. In the immediate term, this both helps the banks and calms the markets. But it does not directly solve the underlying problem with the troubled mortgage securities. The true values of mortgage assets are generally thought to be a mystery. But little-mentioned among discussions of the subprime troubles and other aspects of the crisis is that the Treasury has access to the best resources in the business for estimating the hold-to-maturity values of mortgages and mortgage-backed securities. This team is at Fannie Mae, which the government now effectively directs. (Fannie and Freddie are government-owned special corporations and it should be a no-brainer for the Treasury to make full use of all their in-house resources—at no additional cost) Fannie has an underwriting and valuation shop with models for valuing mortgages that are up and running. Key inputs to these models are Fannie's own indexes of property values at the Zip code level -- others make do with prices in entire urban areas. The data needed are not difficult to assemble: current loan balances, the date loans were originated, original property value (or appraisal for refinances), loan type (fixed, adjustable rate, ARM features, loan length), borrower's credit score, Zip code and current loan status. (This data is currently available and should be used. Even if its only 85% accurate, it is still the best place to start this exercise. They should be able to produce an initial report that places a new valuation on a wide range of properties and quickly provide statistics that would show the final loss to be much less and therefore further calm the markets) These models project payments and proceeds from foreclosures and calculate the property's present value. Similar but less detailed models in recent academic work show that they do quite a good job of projecting defaults for prime and subprime loans, given changes in property values. Some argue that Fannie is discredited for this work because it, too, has losses on riskier mortgages. But Fannie's losses arose from a failure to reserve adequately for losses that were anticipated by its models. Fannie's business people overrode the risk managers when making the decision to keep reserves too low. The models were right. (Yes, fault the greed of the management and the excessive demands of Wall Street to keep ‘priming the pump’ with new paper for their securitized asset sales) In 1933, and even in 1989 during the savings-and-loan crisis, a quick revaluing of the majority of the nation's mortgage loans was not possible. Today, though, it is. In a few weeks, the right team could produce tens of millions of valuations, making a constructive plan of action quickly practical. (I agree!) Right now, many institutions are solvent but not obviously so. Prevailing confusion about the value of their mortgage holdings hobbles them in credit markets, which means nobody wants to lend to them and they quickly become insolvent. With valuations based on the best available current data, confidence would be restored in

banks with truly adequate capital, and their role in the credit market resumed. (This is so patently obvious, yet no one from Treasury or Congress has even hinted at such a vital first step) If more equity or government insurance is needed to secure confidence, this can be provided on terms reflecting informed mortgage values. (good) This step by itself could save taxpayers hundreds of billions of dollars unnecessarily pumped into institutions capable of dealing with mortgage losses on their own. It has not been the usual function of bank regulators to publish values of bank portfolios, but these are unusual times. There is no point in the Treasury buying stock in insolvent banks only to have it gobbled up by losses. (Exactly what most taxpayers fear) The Treasury will be more successful in containing the cost of using its new powers if it begins with the best available estimates of mortgages' hold-to-maturity values. Where solvency is confirmed, liquidity will follow. ( a basic truism in banking!) The original plan of simply buying assets would not have resolved the crisis. (As many knowledgeable people complained early on with the original bailout proposal and is now becoming generally known worldwide as the contagion of this crisis is affecting Europe and other major markets) But it had a nugget of truth -- the importance of knowing the true values of the questionable assets. Now that the plan has morphed to injecting banks with capital, those asset values are still paramount for the best use of Treasury's resources. No other institution has as much data, so well organized and ready to address the specific problem the Treasury confronts, as Fannie Mae. Turning to Fannie for help is Treasury's fastest and least costly option to help our financial markets resume normal operation. (absolutely—and it is a politically neutral move) The writer served as chief economist at the Department of Housing and Urban Development from 1987 to 1992 and as chief economist of the Securities and Exchange Commission from 1992 to 1995. The Global Financial Crisis Bank Nationalization? Not Quite
October 14, 2008

The United States government has now announced its plan to inject capital into the nation's banking system, in parallel to similar recent actions in Europe. Although the press has reported the plan will "partly nationalize the nine major banks" (Washington Post), there will not be much nationalization at all in a meaningful sense of the word. The early signs are that this action can restore confidence, whereas the announcement of TARP's (Troubled Asset Relief Program) purchase plan had failed to do so. The stock price surge on Monday (October 13, 2008), the fifth largest on record, reflected anticipation of a government plan to recapitalize banks and announcement of forceful similar measures in Europe. However, fundamental constraints on the capacity of the financial sector to expand credit seem likely to remain for some time. Although some of the nine large banks were reluctant to participate, Treasury Secretary Henry Paulson pressed them to do so for the good of the financial system, in order to avoid a stigma of weakness for any participating bank. The terms of the plan are as follows.  First, $125 billion from TARP will be used to purchase preferred shares in the nine largest banks, up to a ceiling of $25 billion or 3 percent of the amount of risk-weighted assets. JP Morgan and Citigroup both qualify for the $25 billion. Second, the shares will pay a coupon of 5 percent, which rises to 9 percent in the fifth year. Third, Treasury will receive warrants amounting to 15 percent of the capital injected in the bank, with the right to purchase the common stock in the future at the price on the day the warrants are issued. Fourth, participating banks cannot take tax deductions on more than $500,000 in salary paid to each top official, nor can they create new golden parachutes.

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Fifth, participating banks cannot raise dividends without government approval. Sixth, through a closing date of November 14, another $125 billion will be available for similar preferred equity purchases in the rest of the nation's some 8,000 banks, in amounts of 1 to 3 percent of riskweighted assets. Seventh, in addition to the bank capitalization plan, the Federal Deposit Insurance Corporation (FDIC) will extend its insurance coverage to newly issued bank debt (i.e. bonds, not just deposits), and to all noninterest-paying bank deposits (typically those of small businesses) regardless of the $250,000 limit.


Secretary Paulson opposed proposals for publicly supported bank recapitalization just a few weeks ago, in favor of purchasing mortgage-backed securities and other troubled assets. However, last week's stock market collapse and seizing up of interbank lending have forced the shift to potentially faster-acting injection of capital. Many economists have preferred such recapitalization over troubled asset purchase all along. But by diluting existing shareholders' equity (even using preferred shares, if tied to warrants at low prices), public capital injection risks pushing bank stock prices down (as has just happened in Royal Bank of Scotland and Lloyds). Falling stock prices are a powerful signal of bank weakness. There is even an academic literature that measures default probability by stock price weakness. What has happened, however, is that the bank stocks already fell so sharply that any further negative confidence effects from the dilution effect were likely to be dominated by the positive effects from improved confidence of bank survival with higher capitalization. The new plan would not inject capital in common shares, and the preferred shares would be nonvoting. So the fundamental feature of nationalization—government control—will be absent. That is all to the good, as the history of nationalized banking systems is one of "directed lending" disasters. Even the warrants represent minimal potential control of common shares. The 15 percent amounts to $18.75 billion (for the nine large banks), or 3 percent of their current stock market capitalization. More fundamentally, President Bush has emphasized that the program is temporary, so in the event of a successful outcome in which the warrants are exercised and make a profit for the taxpayer, the shares acquired will almost certainly be sold back to the private sector rather than being retained to establish a toehold for a nationalized banking system. All this being said, the influence of the government on these and other participating banks will rise to some extent (as illustrated by control over dividends). The underlying objective of the TARP as originally envisioned and now as recast to emphasize capital injection was to get the banking system back into a position to extend new loans to households, factories, and farms. It seems likely, however, that bank credit expansion will remain far below the pace of recent years even with the new recapitalization plan. Some slowdown was desirable: Bank credit growth rose from an average of 6.7 percent annually in the 1990s to an outsized 11.8 percent average in 2004–07. In contrast, this year the annual pace from March to September was only 2.5 percent. From the standpoint of individual bank prudence, shrinking the balance sheet in order to raise the ratio of capital to assets makes perfect sense under circumstances of far greater uncertainty and doubts about borrowing access. The more compelling immediate goal is to avoid further outright collapses at the heart of the financial sector, like that of Lehman Brothers. Policymakers would do well to concentrate on that systemic survival issue first and tread cautiously along the path of pressuring banks to expand lending—which could indeed become a form of "directed lending" and partial nationalization. In the meantime, firms seem likely to have to rely more on retained profits, and households more on saving, than in recent years, as part of a healthy process of deleveraging the US economy. Capitalism at Bay
Oct 16th 2008 From The Economist print edition

What went wrong and, rather more importantly for the future, what did not ONE hundred and sixty five years ago, a Scottish businessman set out his plans for a newspaper. James

Wilson’s starting point was “a melancholy reflection”: “while wealth and capital have been rapidly increasing” and science and art “working the most surprising miracles”, all classes of people were marked “by characters of uncertainty and insecurity”. Wilson’s solution was freedom. He committed his venture to the struggle not just against the protectionist corn laws but against attempts to raise up “barriers to intercourse, jealousies, animosities and heartburnings between individuals and classes in this country, and again between this country and all others”. Ever since, The Economist has been on the side of economic liberty. Now economic liberty is under attack and capitalism, the system which embodies it, is at bay. This week Britain, the birthplace of modern privatization, nationalized much of its banking industry; meanwhile, amid talk of the end of the Thatcher-Reagan era, the American government has promised to put $250 billion into its banks. Other governments are re-regulating their financial systems. Asians point out that the West appears to be moving towards their more dirigiste model: “The teachers have some problems,” a Chinese leader recently said. Interventionists are in full cry: “Self-regulation is finished,” claims France’s Nicolas Sarkozy. “Laissez-faire is finished.” Not all criticisms are that unsubtle (the more pointed ones focus on increasing the state’s role only in finance), but all the signs are pointing in the same direction: a larger role for the state, and a smaller and more constrained private sector. This newspaper hopes profoundly that this will not happen. Over the past century and a half capitalism has proved its worth for billions of people. The parts of the world where it has flourished have prospered; the parts where it has shriveled have suffered. Capitalism has always engendered crises, and always will. The world should use the latest one, devastating though it is, to learn how to manage it better. Extreme measures in the defense of liberty In the short term defending capitalism means, paradoxically, state intervention. There is a justifiable sense of outrage among voters and business people (and indeed economic liberals) that $2.5 trillion of taxpayers' money now has to be spent on a highly rewarded industry. But the global bailout is pragmatic, not ideological. When François Mitterrand nationalized France’s banks in 1981 he did so because he thought the state would run them better. This time governments are buying banks (or shares in them) because they believe, rightly, that public capital is needed to keep credit flowing. Intervening to prevent banking crises from hurting the real economy has a strong pedigree. Wilson’s son-in-law, Walter Bagehot, recommended that the Bank of England lend generously (but at a penalty rate) to illiquid banks (but not to insolvent ones). In modern times governments of every political stripe have had to step in. Ronald Reagan and Margaret Thatcher oversaw the rescues of Continental Illinois and Johnson Matthey. In the 1990s the Finns and Swedes nationalized banks—and privatized them again later. This rescue is on a different scale. Yet the justification is the same: the costs of not intervening look larger. If confidence and credit continue to dry up, a near-certain recession will become a depression, a calamity for everybody. Even if it staves off disaster, the bail-out will cause huge problems. It creates moral hazard: such a visible safety net encourages risky behavior. It may also politicize lending. Governments will need to minimize these risks. They should avoid rewarding the bosses and shareholders of the rescued banks. They must not steer loans to politically important sectors. And they should run the banks on a commercial basis with the explicit aim of getting out of the banking business as quickly as possible (and at a profit). From the taxpayer’s point of view, it might make sense to limit dividend payments to other shareholders until the government’s preference shares have been paid off. But governments need to avoid populist gestures. Banning bonuses, for instance, would drive good people out of companies that badly need them. The politicians all claim they understand this. Of course, they have no intention of revisiting Mitterrand’s mistakes, of trying to run the banks themselves, or of taking stakes elsewhere. Yet already voices (including Lady Thatcher’s Tory heirs) are pushing to limit executive pay. It will be a brave president who goes to Detroit and explains why the 45,000 well-paid folk at Morgan Stanley should get $10 billion of taxpayers' money, but the 266,000 people at General Motors should not. Brave too would be any politician who proposed deregulation as a solution to a public-sector problem. Smoot-Hawley in the rear mirror Given this, it is inevitable that the line between governments and markets will in the short-term move towards the

former. The public sector and its debt will take up a bigger portion of the economy in many countries. But in the longer term a lot depends on how blame for this catastrophe is allocated. This is where an important intellectual battle could and should be won. Capitalism’s defenders need to deal with two sorts of criticism. One has much more substance than the other. The weaker, populist argument is that Anglo-Saxon capitalism has failed. Critics claim that the “Washington consensus” of deregulation and privatizations, preached condescendingly by America and Britain to benighted governments around the world, has actually brought the world economy to the brink of disaster. If this notion continues to gain ground, politicians from Beijing to Berlin will feel justified in resisting moves to free up the movement of goods and services within and between their economies. Arguments for market solutions in, for instance, health and education will be made with less conviction, and dismissed with a reference to Wall Street’s fate. In fact, far from failing, the overall lowering of “barriers to intercourse” over the past 25 years has delivered wealth and freedom on a dramatic scale. Hundreds of millions of people have been dragged out of absolute poverty. Even allowing for the credit crunch, this decade may well see the fastest growth in global income per person in history. The free movement of non-financial goods and services should not be dragged into the argument—as they were, to disastrous effect, in the 1930s. A second group of critics focuses on deregulation in finance, rather than the economy as a whole. This case has much more merit. Finance needs regulation. It has always been prone to panics, crashes and bubbles (in Victorian times this newspaper was moaning about railway stocks, not house prices). Because the rest of the economy cannot work without it, governments have always been heavily involved. Without doubt, modern finance has been found seriously wanting. Some banks seemed to assume that markets would be constantly liquid. Risky behavior garnered huge rewards; caution was punished. Even the best bankers took crazy risks. For instance, by the end of last year Goldman Sachs, by no means the most daring, had $1 trillion of assets teetering atop $43 billion of equity. Lack of regulation encouraged this gambling. Financial innovation in derivatives soared ahead of the rule-setters. Somehow the world ended up with $62 trillion-worth of credit-default swaps (CDSs), none of them traded on exchanges. Not even the most liberal libertarian could imagine that was sensible. Yet the failures of modern finance cannot be blamed on deregulation alone. After all, the American mortgage market is one of the most regulated parts of finance anywhere: dominated by two government sponsored agencies, Fannie Mae and Freddie Mac, and guided by congressional schemes to increase home-ownership. The macro economic condition that set up the crisis stemmed in part from policy choices: the Federal Reserve ignored the housing bubble and kept short-term interest rates too low for too long. The emerging world’s determination to accumulate reserves, especially China’s decision to hold down its exchange rate, sent a wash of capital into America. There was something of a perfect storm in which policy mistakes combined with Wall Street’s excesses. Heavy regulation would not inoculate the world against future crises. Two of the worst in recent times, in Japan and South Korea, occurred in highly rule-bound systems. What’s needed is not more government but better government. In some areas, that means more rules. Capital requirements need to be revamped so that banks accumulate more reserves during the good times. More often it simply means different rules: central banks need to take asset prices more into account in their decisions. But there are plenty of examples where regulation could be counter-productive: a permanent ban on short selling, for instance, would make markets more volatile. Indeed, history suggests that a prejudice against more rules is a good idea. Too often they have unintended consequences, helping to create the next disaster. And capitalism, eventually, corrects itself. After a crisis investors (and for that matter regulators) seldom make exactly the same mistake twice. There are, for instance, already plans for clearing houses for CDSs. Turning back the incoming tide Sadly another lesson of history is that in politics economic reason does not always prevail—especially when the best-case scenario for most countries is a short recession. “Barriers to intercourse, jealousies, animosities and heartburnings” loom.

But it need not be so. If the bailouts are well handled, taxpayers could end up profiting from their reluctant investment in the banks. If regulators learn from this crisis, they could manage finance better in the future. If the worst is avoided, the healthy popular hostility to a strong state that normally pervades democracies should reassert itself. Capitalism is at bay, but those who believe in it must fight for it. For all its flaws, it is the best economic system man has invented yet. Rescuing the banks--But will it work?
Oct 16th 2008 From The Economist print edition

Meltdown may have been averted. But the crunch is not over THE global banking system has leapt from the fire into the frying pan. After yet another burst of dramatic interventions, governments are now furiously tackling the twin problems afflicting banks—solvency and liquidity. Their actions briefly pepped up stockmarkets, and, more importantly, stabilized credit markets. But on October 15th and 16th stockmarkets tumbled headlong once again amid concerns that the banks had been rescued too late to stop a slump in the world economy. For now, at least, a collapse in the banking system has been averted. On October 14th the American government held its nose and announced plans to invest $250 billion of taxpayers’ money into its banks, half of that into a group of nine of the industry’s most celebrated names. Smaller banks have until the middle of next month to apply for a share of the remaining $125 billion. More importantly for confidence, it also extended a sovereign guarantee for new bank debt and once again expanded the terms of its deposit guarantees. The American moves followed a rare burst of European decisiveness. On October 12th euro-area leaders committed themselves to the same potent mix of debt guarantees and recapitalization that Britain had unveiled, to much acclaim, the previous week. Governments are not stinting. Germany has set up a €500 billion ($680 billion) stabilization fund; France has pledged €360 billion; the Netherlands €200 billion. UBS, the Swiss bank, will receive SFr6 billion ($5.2 billion) of state capital to help it shed toxic assets. Britain itself has wasted no time in putting its cash to work, committing £37 billion ($64 billion) on October 13th to recapitalize its big banks. If ordinary shareholders do not take up their rights to new shares, the government could end up owning a majority stake in Royal Bank of Scotland and close to that in a merged Lloyds TSBHBOS. Central banks are also spraying money around more liberally than ever. On October 15th the Federal Reserve, the European Central Bank and the Swiss National Bank made available unlimited dollar loans. The Bank of Japan plans to offer unlimited dollar funds from October 21st on. Asian governments are also scrambling to shore up confidence. Australia and New Zealand have abandoned their purist stances on deposit insurance—they now have some. After slowly peeling back guarantees put in place during the Asian financial crisis a decade ago, Indonesia has expanded its deposit-insurance program. Hong Kong has moved to full deposit insurance. South Korea will allow greater investment (up to 10%) by the country’s big industrial groups in its banks, but its currency tumbled on October 16th after Standard & Poor’s, a rating agency, said the banks may fail to refinance their debts. The money markets took a measured view of all this action, but there were signs of improvement. The London Interbank Offered Rate (LIBOR) for three-month dollar loans fell for the third consecutive day on October 15th. Borrowing costs remain very high by historic standards, but the risk that banks will be unable to roll over their short-term funding has receded now that governments are, in effect, acting as counterparties. Credit-default swap (CDS) spreads on banks, a measure of their risk of bankruptcy, have tumbled Saving the banks from collapse is not the same as stopping a credit crunch, however. There is much to resolve before credit is flowing normally through the system. First, funding costs are likely to remain high. Investors’ nerves are shot. The “Ted spread”, the gap between three-month dollar LIBOR and the Treasury-bill rate, and a good indicator of risk aversion, stood at 4.2% on October 15th; it hovered at just 20 basis points (a fifth of a percentage point) in early 2007. Concern about banks’ creditworthiness may yet morph into worry about sovereign risk as the full cost of the various bailouts becomes clearer, especially if governments decide they also need to boost their economies with a fiscal stimulus. The approach of the calendar year-end, when banks need extra cash to help balance their books, will add to funding strains over the coming weeks.

The costs mount Governments’ debt guarantees are not free for the banks either. Many of them are rather expensive. Britain is charging 50 basis points plus the median CDS spread for a borrowing bank over the past 12 months. Germany is charging a flat rate of two percentage points. Some observers have expressed surprise that a fee is being levied at all. Despite government pleas that the banks get on with lending, officials may have worried about a splurge in debt issuance if the guarantees had been free. Further cuts in interest rates may help to bring down the cost of credit (and to bolster banks’ earnings by steepening the yield curve, the difference between shortand long-term interest rates). But in the meantime dearer borrowing is bound to have a continuing impact on the spending plans of companies and consumers. The second reason why credit is likely to remain gummed up is that banks still have reasons to husband capital. The injection of government money into American and British banks has set a new benchmark for capital ratios that banks elsewhere may now be judged by. Analysts at Keefe, Bruyette & Woods, an investment bank, reckon that other European banks would have to raise €70 billion-130 billion to match British levels. That is a disincentive to go on a lending spree. So little time, so much to fear In Britain and America, too, there are lots of reasons for caution. Banks remain weighed down by the same toxic assets that sparked this whole mess. The Americans still insist that they will dip into their $700 billion bail-out pot to buy up impaired assets, but the new capital injections will deplete their firepower. Accounting standard-setters have been arm-twisted into relaxing rules that force banks to mark certain assets to market, but in the long run that may hurt confidence in the health of bank balance-sheets, not help it. Bo Lundgren, one of the architects of Sweden’s much-vaunted 1990s bank bail-out, stresses the importance of transparent valuations of bad assets. In another difference with Sweden, where the economy had already been contracting for seven quarters before the government strongly intervened, the downturn in this economic cycle is still young. That means banks will suffer a new set of credit losses in coming months in areas such as credit cards, car loans and commercial property. Stresses in housing markets impose another constraint on lending: that may be why Sheila Bair, head of the Federal Deposit Insurance Corporation, an American bank regulator, broke ranks with her government and criticised the rescue plan for not addressing foreclosures. Banks may suffer from a crisis of confidence in emerging markets, too. Companies are perhaps the biggest concern of all, even though firms have borrowed less than consumers. Default rates remain low but are bound to climb as the economy worsens. This wave of corporate failures will add further stress to the battered CDS market. And, as governments focus their efforts on bailing out the banks, non-bank sources of financing are becoming more fragile. The costs of issuing commercial paper, a form of short-term debt heavily used by companies in America, will fall once a Fed facility for purchasing commercial paper is up and running on October 27th. Even so companies may well have to draw on uncommitted credit facilities with banks, expanding the size of bank balance sheets. “The idea that there will be a reboot of lending is not credible,” says George Magnus, an economist at UBS. Financial calamity may have been averted, but the world economy is still cooking up something very nasty.

Smaller Banks Resist Federal Cash Infusions
Washington Post, October 15, 2008

Community banking executives around the country responded with anger yesterday to the Bush administration's strategy of investing $250 billion in financial firms, saying they don't need the money, resent the intrusion and feel it's unfair to rescue companies from their own mistakes. But regulators said some banks will be pressed to take the taxpayer dollars anyway. Others banks judged too sick to save will be allowed to fail.

The government also said yesterday that it will guarantee up to $1.4 trillion of private investment in banks. The combination of public and private investment is intended to refill coffers emptied by losses on real estate lending. With the additional money, the government expects, banks would be able to start making additional loans, boosting the economy. President Bush, in introducing the plan, described the interventions as "limited and temporary." "These measures are not intended to take over the free market but to preserve it," Bush said. On Capitol Hill, lawmakers from both parties praised the plan and scrambled to take credit for writing provisions into the law passed almost two weeks ago that allowed the government to switch from buying bad loans to buying ownership stakes in banks. On Wall Street, bank stocks soared even as the broader market stayed flat while investors grappled with economic concerns. The Dow Jones industrial average was down 0.82 percent, or 76.62 points, to close at 9310.99 one day after its largest percentage gain in more than half a century. And in offices around the country, bankers simmered. Peter Fitzgerald, chairman of Chain Bridge Bank in McLean, said he was "much chagrined that we will be punished for behaving prudently by now having to face reckless competitors who all of a sudden are subsidized by the federal government." At Evergreen Federal Bank in Grants Pass, Ore., chief executive Brady Adams said he has more than 2,000 loans outstanding and only three borrowers behind on payments. "We don't need a bailout, and if other banks had run their banks like we ran our bank, they wouldn't have needed a bailout, either," Adams said. The opposition suggested that the government may have to continue to press banks to participate in the plan. The first $125 billion will be divided among nine of the largest U.S. banks, which were forced to accept the investment to help destigmatize the program in the eyes of other institutions. In rolling out the program, Treasury said it would make the rest of the money available to banks that requested it. Officials said they expected thousands of banks to participate. But both the American Bankers Association and the Independent Community Bankers of America said that they knew of few banks that planned to participate. "I'm not sure we've heard from any that want to participate," said Karen Thomas, vice president for government relations at the community bankers group, which represents about 5,000 banks. "That said, if any community banks do enroll, we anticipate it will be just a small minority." Federal regulators said they did expect some banks to volunteer, though none stepped forward yesterday. But they added that they would not rely on volunteers. Treasury will set standards for deciding which banks can be helped, and the regulatory agencies will triage the banks they oversee: The institutions faring best and worst will not receive investments. The institutions in the middle, whose fortunes could be improved by putting a little more money in the bank, will be pushed to accept the money from the government. "We will encourage institutions to apply," said John C. Dugan, the comptroller of the currency, who oversees most of the nation's largest banks. In return for its investments, Treasury will receive preferred shares of bank stock that pay 5 percent interest for up to five years. After that, if the companies haven't repaid the government's initial investment, the interest rate goes up to 9 percent. Participating banks cannot increase the dividends they pay to shareholders without federal permission, they must accept some limitations on compensation for their executives, and Paulson said the government would press companies to limit mortgage foreclosures. The government decided not to impose an explicit requirement that banks use their taxpayer dollars to increase lending. But regulators said they will watch banks closely. They also noted that banks have less reason to hoard money now that they can borrow more easily. Most important, however, they said, banks want to make money. "And the way that banks make money is by lending," Dugan said. Also yesterday, the Federal Deposit Insurance Corp. said it will create, essentially, two new insurance programs.

The basic insurance program still guarantees all bank deposits up to $250,000. A new supplemental program guarantees all deposits above $250,000 in accounts that don't pay interest. The program basically covers accounts used by small businesses. Some European governments had already guaranteed deposits, creating a competitive advantage for banks in those countries. Banking regulators also were concerned that small businesses were transferring deposits from community banks to larger institutions perceived as less likely to fail. Finally, small businesses contributed to the failure of Washington Mutual and the collapse of Wachovia by pulling uninsured deposits from those banks. The FDIC estimates that this new guarantee could cover up to $500 billion in deposits. Banks that sign up for the insurance -- and bankers agree that everyone will participate, for fear of ceding an advantage to rivals -- will pay a premium of 10 cents on every $100 in deposits. The combination of the existing and new guarantees will cover about 80 percent of the $7 trillion in deposits at the nation's banks. The bulk of the uninsured deposits are held in interest-bearing accounts, such as certificates of deposit, that tend to be marketed and regarded as investment products. Sheila C. Bair, chairman of the FDIC, said the agency considered guaranteeing all bank deposits but decided that any potential benefit was outweighed by the risk that a guarantee on interest-bearing accounts would attract a huge inflow of deposits currently held in money-market mutual funds. "We're trying not to stabilize one part" of the financial system "and destabilize another part," she said. Separately, the FDIC is creating an insurance program to encourage investment in banks by guaranteeing that investors won't lose money. Participating banks will pay the FDIC a fee of 75 cents on each $100 in debt that they sell to investors. The FDIC will guarantee through June 2012 the debt issued by participating banks before the end of June 2009. If the bank goes bankrupt, or defaults on its debt, the FDIC will pay the investors. To prevent banks from running up massive debts on the government's tab, the program limits banks to a 25 percent increase from their current level of borrowing. The FDIC estimates that the maximum amount of debt that banks could issue under the program is about $1.4 trillion. Bair also said that the FDIC may refuse to guarantee debt issued by banks with financial problems, though she declined to discuss specific criteria. Bair acknowledged that the new guarantees shelter banks from the immediate consequences of misbehavior because depositors and investors have no incentive to remove their money from an institution if they know that the government stands behind it. But Bair said the government's first priority was to stabilize the industry. "The risks of moral hazard were simply outweighed by the need to act and act dramatically and act quickly," Bair said. Dugan offered a slightly different perspective. "It just means we've lost one tool and we're going to have make sure that we compensate," he said. Cross-border banking--Divided we stand The ugly side of international banking
Oct 16th 2008 From The Economist print edition

IT is an odd sort of togetherness. European leaders gathered in Paris on October 12th and proclaimed a set of common principles for handling the financial crisis that underscored the impotence of supranational bodies. If the worst really is over, it is because national governments in Europe and beyond have reached deep into their own pockets, extending guarantees and injecting capital into domestic banks. That reality has brutally exposed the weaknesses in cross-border banking. One concern is about the safety of retail deposits held at branches of foreign banks. Banks that operate abroad under the European “passport” scheme, whereby deposit-guarantee schemes in the bank’s home country are the first port of call for foreign depositors, may well seem less attractive to savers in light of recent events. The collapse of the banking system in Iceland—a country that was recently listed as a spoof auction item on eBay—led the British government to make novel use of anti-terror laws to freeze Icelandic assets. It and the Dutch government have ended up lending money to Iceland so that their citizens can retrieve money from Landsbanki, one of the country’s nationalized banks.

Another concern is about burden sharing among countries in the event of a really big cross-border failure. The dismemberment of Fortis, a Belgo-Dutch bank, went relatively smoothly but as Simon Gleeson of Clifford Chance, a law firm, points out: “If you wanted to choose a group of countries to co-operate, the Benelux ones would be the ones you’d pick.” Other institutions, such as the big Swiss banks, would pose bigger problems. A third question is over liquidity. Many cross-border banks want to manage their liquidity centrally. That sounds fine unless an institution becomes insolvent and local offices suddenly need to stand on their own two feet. The European arm of Lehman Brothers did not even have its own bank account, but banked with its parent company. PricewaterhouseCoopers, the bank’s administrator in London, has had to open an account at the Bank of England in order to avoid using banks with a claim on Lehman’s estate. This awkward mix of national bailouts and cross-border contagion is not easily solved. A bank comprised of armor-plated local subsidiaries would satisfy regulators but threaten both economies of scale and the idea of the single market. Plans to beef up colleges of international supervisors, let alone to create a pan-European regulator, raise political questions. Spreading the costs of recapitalizing cross-border banks is also horribly tricky. In a forthcoming paper for the International Journal of Central Banking, Charles Goodhart and Dirk Schoenmaker, two academics, examine how European countries might agree to share this burden. Waiting to sort out the details of a rescue when crisis has struck makes it likely that some countries will duck their responsibilities. But agreeing on a formula for burden-sharing ahead of time would be particularly awkward for Britain, because its outsize share of EU banking assets could leave it on the hook for the cost of rescuing all sorts of banks (see chart). Europe may now be acting in concert, but it has a long way to go before it acts as one. The American economy--A spent force
Oct 16th 2008 From The Economist print edition

Ominous signs that the crisis will have a big impact on spending IT WAS, admitted Hank Paulson as he threw a $250 billion lifeline to American banks, objectionable to most Americans, himself included, to see the government owning stakes in private companies. He had no real alternative. But it would have been less objectionable had he been able to promise that the economy would escape a recession as a result. He could not. It may well be in recession already. The economy appears to have barely grown in the third quarter and the surge in financial stress that followed Lehman Brothers’ failure in mid-September will make things worse. The subsequent plunge in stocks on top of still-falling home prices could result in a 14% drop in household wealth this quarter, the largest on record, according to ISI Group, a broker. News that retail sales sank 1.2% in September triggered the biggest drop in the Dow industrials in 21 years on October 15th. If it were only wealth, construction and other tangible factors that were in decline, the recession could still be on the mild side—especially as oil prices are falling. But the credit crunch is a wild card. The experience of the Carter era suggests the effect of credit restraint can be large. In 1980 President Jimmy Carter imposed credit controls in a ham-fisted effort to reduce inflation: banks that exceeded targets for some types of loans such as for consumer purchases and mergers had to set aside extra reserves. Americans overreacted in a burst of patriotic fervor; credit usage plunged and GDP fell by an annualized 8%, the steepest quarterly drop in the past 50 years. Since then the influence of debt has probably grown as the economy has become more credit-intensive. Consumer and home-equity loans equaled 26% of annual personal consumption in the 1990s; they recently reached 36%. In the 1980s about half of homeowners had a mortgage; now about two-thirds do, says Ivy Zelman, a housing consultant. Meanwhile, the demand for bank credit by companies shut out of the commercial-paper market is straining balance-sheet capacity. In theory the government’s $250 billion rescue package for banks, levered ten-to-one,

could support $2.5 trillion of lending (total credit in the economy was $27 trillion as of June 30th). But no one expects so large an effect because banks are trying to delever and will probably build their reserves in anticipation of more loan losses as the economy worsens. Non-banks are a particular problem. The finance affiliates of the big carmakers, most prominently GMAC, 49% owned by General Motors, now face funding constraints, forcing them to raise underwriting standards and loan charges. Approvals for car-loan applications have fallen sharply (see chart). Non-banks can tap the Federal Reserve’s new commercial-paper guarantee program, but are not eligible for government capital. Credit-card debt continues to grow but in that business, too, lenders are cracking down in subtle ways, says David Robertson of the Nilson Report, an industry newsletter. One is to reduce unused credit limits on middle-to-higher-income borrowers who might use more credit if they lose their jobs. Surprisingly, mortgage-lending conditions may be improving. Under pressure from the federal government, Fannie Mae and Freddie Mac, the now-nationalized mortgage agencies, and the Federal Housing Administration, the program for low-income buyers, are stepping up their activity. A buyer can now obtain an FHA loan with as little as 3.5% down on a house costing up to $625,000—which would include most of the homes in the country. Ms Zelman reckons the FHA accounted for 22% of mortgage originations in the third quarter, up from 5% in all of 2007. The real problem, Ms Zelman says, is that almost a quarter of homeowners with mortgages have zero or negative equity in their homes. Householders, she says, have too much debt and must save more. It is, she says, not about credit. “It’s about a hangover from hell.” Circumventing the IMF International Principles Needed for Regional Financial Rescues In recent weeks, several governments stricken with financial emergencies have tried to circumvent the International Monetary Fund (IMF) by turning to Russia, China, Saudi Arabia, and other reserve-rich states for crisis finance. These moves underscore the need for common acceptance of a set of principles to guide bilateral and regional responses to countries requiring liquidity and balance-of-payments support during the present crisis. Such principles should be discussed and adopted at the high-level meetings scheduled over the coming weeks as part of the international response to the financial crisis. The pattern of turning to regional partners for help has been set by Iceland, Pakistan, and Hungary. Iceland tried to engage the Russian government in a rescue operation and tapped liquidity support from the Danish and Norwegian central banks. Pakistan approached China, Saudi Arabia, and the United Arab Emirates for emergency financing. Hungary, while in negotiations with the IMF, also secured liquidity support from the European Central Bank. Even if Iceland and Pakistan are driven into the arms of the IMF, which appears increasingly likely, the story does not end there. The Asia-Europe Meeting, to be held in Beijing during October 24–25, will present an opportunity for Asian leaders to caucus among themselves. President Gloria Macapagal-Arroyo of the Philippines has proposed that ASEAN+3 leaders meeting in Beijing consider the creation of an Asian rescue fund, a variation on the proposal for a common fund already under consideration. (ASEAN+3 comprises the 10 Southeast Asian members of ASEAN as well as South Korea, China, and Japan.) Even without any ne w arrangement, East Asian countries could at any time activate their existing swap lines under a net work of bilateral arrangements established eight years ago under the Chiang Mai Initiative (CMI).

The CMI was mostly, though not completely, linked to IMF programs. Any pooling of the CMI swaps into a common fund, which is being discussed in East Asia, has at least until now also been expected to be linked to the IMF. At present, the first 20 percent of the existing s wap lines can be disbursed in the absence of an IMF program. Regional financial arrangements that have lain dormant in other regions over the last several years could also be activated during this crisis. Members of the European Union that are not in the euro area and need balance-ofpayments support are obliged to consult the European Union before dra wing funds from the IMF. Beyond Hungary, several Central and Eastern European states that have joined the European Union since 2004 could also be seeking support in the near future. The United States could deploy its Exchange Stabilization Fund, which it has done in previous crises both within and outside the Western hemisphere. On the other hand, the expansion of regional financial facilities, especially in East Asia, and these recent country cases revive the specter of creditor conflict and underscore the need for clearly defined limits on freelancing in response to crises. I do not argue that it is necessary for all international balance-of-payments finance to be channeled through the IMF. Although we need strong international institutions, especially during crises, we must recognize that the Fund does not have a monopoly on economic wisdom and that regional lenders can play constructive roles. If regional groups or single governments wish to lend to countries confronting crises, the broader financial community should not block such arrangements—provided they adhere to a set of common principles. The last global financial crisis, during 1997–98, raised the specter of reserve-rich countries undercutting the conditionality of the IMF by lending directly to stricken states. The United States Treasury torpedoed the proposal of the Japanese Ministry of Finance to create an "Asian Monetary Fund" in Autumn 1997. In the event, most of the emergency finance that was disbursed bilaterally at that time was harnessed to IMF programs. When East Asian governments subsequently developed the CMI, they agreed that its bilateral s waps would be mostly linked to the IMF. However, the last decade has witnessed important changes that complicate the development of a disciplined common response this time around. China looms much larger and, with Japan, has accumulated unprecedented amounts of foreign exchange reserves. Chinese foreign assistance in Africa has undermined a consensus of other donors on conditions designed to support economic reform and good governance. The Russian government, which has also accumulated large reserve holdings, cannot be relied upon to support such norms either. Concerned that the IMF might be losing relevance, member countries have been negotiating changes to the governance of the institution to, among other things, give greater voting power to some of the East Asian states. But such reforms are moving slowly at best, and IMF quotas have not been increased since the 1997–98 crisis. Common principles should specify, in particular, that creditors (1) lend on sound conditionality or link to IMF conditionality, (2) do so transparently and report their arrangements to the IMF, and (3) avoid conflicts with their other multilateral obligations. Creditors might differ over what exactly constitutes "sound conditionality." Some countries will deserve easy conditions, in recognition that they suffer from an externally induced liquidity crisis. Other countries will deserve tough conditionality, in recognition that basic policy choices made them vulnerable and corrections are needed to stabilize. Such conditions should be decided in light of the economic facts in each case rather than by competition among creditors. More broadly, in times of financial tranquility as well as crises, standing regional arrangements should be revie wed by multilateral institutions periodically and coordinated with them. The North American Frame work Agreement and the European Medium-Term Financial Assistance, under NAFTA and the European Union respectively, would be subject to multilateral review just as would the CMI and other arrangements among emerging market and developing countries. Expansion of the number of official players in global finance complicates the ability to come to agreement on common principles, but this does not mean that agreement is necessarily out of reach. When they consider seriously the consequences of failing to redress vulnerabilities of borro wers, including the risk of default, governments that have nurtured regional alternatives to the IMF could well perceive their stake in the multilateralism more clearly. Last weekend, Presidents Bush, Sarkozy, and Barroso agreed to convene a set of high-level meetings dubbed "Bretton Woods II" to reform the global financial architecture. Discussing and adopting common principles to guide financial rescues under bilateral and regional arrangements and coordinate them with the IMF should be on their


Misplaced Blame
NYT Editorial October 15, 2008

In recent weeks, Republicans in Congress have been blaming a lot of things, besides themselves, for the subprime mortgage debacle. And many of these same Republicans have long wanted to abolish the Community Reinvestment Act, a landmark law that helped to rebuild some of the nation’s most desolate communities by requiring banks to lend, invest and open branches in low-income areas that had historically been written off. These two goals have converged in a new attempt to blame the law for the financial crisis. The act, passed in 1977, is one of the most successful community revitalization programs in the country’s history. According to a recent report by the National Community Reinvestment Coalition, an advocacy group in Washington, the act has encouraged lenders to invest more than $4.5 trillion in minority and low-income areas. This money helped to remake devastated neighborhoods like the South Bronx, helping to finance new housing and businesses. It has helped provide essential services in such neighborhoods, including medical centers and housing for the elderly and disabled — projects that the private sector too often refused to back. But you can hardly pick up a newspaper or turn on the television these days without hearing critics argue that the act created the current mess we’re in by forcing banks to lend to people in poor areas who were bad credit risks. Representative Steve King of Iowa has introduced legislation that would repeal the act. The charges do not hold up. First, how could a 30-plus-year-old law be responsible for a crisis that has occurred only in recent years? Then there’s the fact that the regulatory guidance issued under the reinvestment act and other banking laws actually impose restraints on the riskiest kinds of subprime lending. In addition, subprime lending was not driven by banks, which are covered by the act. Rather, most subprime lending was driven by independent mortgage lending companies, which the act does not cover, and, to a lesser extent, by bank affiliates and subsidiaries that are not fully covered by the act. By some estimates, nonbank lenders and bank affiliates and subsidiaries may have originated 75 percent or more of the riskiest subprime loans. A study released this week by the Center for Community Capital at the University of North Carolina in Chapel Hill shows that people of similar financial profiles were three to five times more likely to default when they received high-priced subprime mortgages than when they got bank loans made under the Community Reinvestment Act.

Sell-Offs Hurting Emerging Markets Investors Leave Nations in Lurch
October 18, 2008

Investors who helped build the financial boomtowns of developing countries in recent years are no w fleeing them, threatening to destabilize burgeoning economies and drag the world into a deep recession. More than $1.3 trillion in value has been wiped off emerging market stocks this year in cities such as Mosco w, Sao Paulo, Jakarta, and Osaka. There have been violent sell-offs of local currencies, a plunge in private equity investment, and a falloff in mergers and acquisitions. "There has been tremendous redistribution with the credit crunch. People are selling their higher risk assets -and emerging market equities qualify as higher risk," said Alec Young, international equity strategist for S&P Equity Research in New York. The massive and sudden withdra wal of money is leaving behind half-finished infrastructure projects, driving vast s waths of companies out of business, and pushing local currencies to new lo ws, analysts say.

In Mexico, the central bank has auctioned off $11 billion in foreign currency reserves since last week in an attempt to defend the peso, which recently hit an all-time low against the dollar. In Russia, finance officials unveiled a plan to buy up to $20 billion of shares to bolster a stock market that has plunged more than 73 percent from its peak. And in Pakistan, the government is seeking billions in emergency aid to avoid going bankrupt. Economists fear that emerging markets will prove to be the weak link in the global economy and that the collapse of one or more of them could create dangerous consequences for the rest of the world. "So far, the U.S. financial sector has been the epicenter of the global crisis. I fear that a hard landing in emerging markets assets and economies will become the second epicenter in the coming months," Stephen Jen, a managing director at Morgan Stanley, wrote in a report this week. The International Monetary Fund has forecast that world wide gro wth will slow significantly, from 5 percent in 2007 to 3.9 percent this year and to 3 percent in 2009. World Bank President Robert Zoellick has said that developing countries -- which are already suffering from the twin shocks of food shortages and high oil prices -are at a "tipping point." "A drop in exports will trigger a falloff in investments. Deteriorating financial conditions combined with monetary tightening will trigger business failures and possibly banking emergencies. Some countries will slip toward balance-of-payments crises," Zoellick said in a speech last week. The problems of emerging markets are also American problems. Many U.S. mutual funds and pension funds no w hold large stakes in emerging markets -- as much as 8 to 10 percent for some pension funds. Already this year the average emerging market stock fund is down nearly 53 percent, among the biggest losses of the fund categories tracked by Morningstar. At Wall Street firms such as Merrill Lynch and Goldman Sachs, emerging markets had been among the most popular specialties; the banks under wrote billions of stocks and bonds in Latin America, Asia and Eastern Europe. Private equity and venture capital firms rushed to set up satellite offices in remote parts of the world. As recently as the summer of 2007, California's Calpers, the nation's largest pension fund, was so optimistic about the future of emerging markets that it expanded its holdings, committing $500 million to tw o different emerging markets investment funds and more than $5 billion to stock holdings. Pension funds for Montgomery County, the District and practically every other public entity also dove into emerging markets investments. But the current crisis has exposed the vulnerabilities of some of these markets, which are suffering from a lack of availability of commercial loans, a fall in commodity prices, a shrinking of the export market, their own subprime mortgage problems -- or a combination of these problems. "We have counted on emerging economies, which collectively account for half of global GDP, to hold up. However, with the credit crisis reaching shores of emerging market countries, their gro wth is now likely to fall well below trend by the end of the year," Aaron Smith, an economist with Moody's, w rote in a note to clients last week. Smith's colleague, Tu Packard, said that the problem is that in the hierarchy of lending risk, emerging markets countries fall at the bottom: "There's only a limited amount of capital globally, and the big demand else where is cro wding out emerging markets." Several of the emerging economies that have been the most devastated by the financial crisis -- including Pakistan, the Baltic states, South Africa and Hungary -- were already in danger due to political instability, large external debts, narro w revenue bases and weak policies. While the economies of many African nations had been developing rapidly in recent years, they are no w suffering because of a sharp decline in the price of commodities and ra w materials they export. South Africa's banks are still lending, but its currency, the rand, has fallen sharply, as has its nascent stock market. In a statement during the annual meeting of the International Monetary Fund last weekend, Tito Mboweni, the governor of the South African central bank, said the global economic problems "threaten to undermine the policy gains we have made over the last decade, with the danger of pushing tens of millions over the poverty line."

The situation in Hungary is also precarious, with external debts almost equivalent to its GDP. The Hungarian bond market all but collapsed last week as investors disappeared and the government could not raise the money it needed. Hungarian Prime Minister Ferenc Gyurcsany said on Monday that it was seeking technical and financial assistance from the International Monetary Fund as a contingency measure. "We need the promise of this support so that in the end we need not have to use it," he said. Even the so-called BRIC countries -- Brazil, Russia, India and China, the economic po werhouses of the emerging w orld -- have been experiencing a slowdo wn. Brazil, the world's 10th largest economy, had ridden the wave of U.S. consumer spending to become one of the world's biggest manufacturing centers. The government insisted for months that it was weathering the crisis just fine, but last week it admitted that its economy was suffering because of a decline in commodity prices, which affect its farm products and iron ore exports. The nation's stock market plunged 11 percent on Wednesday. Brazil's companies borro w ed heavily in foreign currencies to finance their expansion. Now that their o wn currencies are plummeting, they are struggling to pay back the loans. One of the country's largest exporters, Sadia, said it lost $406 million on currency markets over the past year. That's more than the food company's entire profit for 2007. Brazilian Budget Minister Paulo Bernardo said this week that as a result the government may be forced to cut spending and social programs. Perhaps the only major economy that remains robust despite the crisis is China. While it is suffering from a collapse of its stock and real estate markets and a decrease in demand for its exports, many economists continue to argue that the global slowdo wn may actually be beneficial because China's economy had been in danger of overheating. Indeed, on Tuesday, the government announced that its foreignexchange reserves rose 32.9 percent at the end of September from a year earlier to a world record $1.906 trillion. Pakistani President Asif Ali Zardari arrived in China Tuesday on his first official state visit seeking economic assistance for what officials say is a serious financial crisis. "China is the future of the world," Zardari said, according to the official state ne ws agency. "A strong China means a strong Pakistan." How Lending Standard Changes Led to the Housing Boom/Bust
October 21, 2008

There is a general lack of understanding as to how the Housing boom and bust occurred, and why it led to the subsequent credit freeze. The situation is complex, and that is why we are still explaining this 3 years into the housing bust. Let me take another shot at clarifying this: Underlying EVERYTHING -- housing boom and bust, derivative explosion, credit crisis -- is the enormous change in lending standards. I am not sure many people understand the massive change that took place during the 2002-07 period. It was more than a subtle shift -- it was an abdication of the traditional lending standards that had existed for decades, if not centuries. After the Greenspan Fed took rates down to ultra-low levels, home prices began to levitate. More and more mortgages were being securitized -- purchased by Wall Street, and repackaged into other forms of bond-like paper. The low rates spurred demand for this higher yielding, triple AAA rated, asset-backed paper. In this ultra-low rate environment, where prices were appreciating, and most mortgages were being securitized, all that mattered to the mortgage originator was that a BORROWER NOT DEFAULT FOR 90 DAYS (some

contracts were 6 Months). The contracts between the firms that originated mortgages and the Wall Street firms that securitized them had explicit warranties. The mortgage seller guaranteed to the mortgage bundle buyer (underwriter) that payments were current, the mortgage holders were valid, and that the loan would not default for 90 or 180 days. So long as the mortgage did not default in that period of time, it could not be "put back" to the originator. A salesman or mortgage business would only lose their fee if the borrower defaulted within that 3 or 6 month contractually specified period. Indeed, a default gave the buyer the right to return the mortgage and charge back the lender the full purchase price. What do rational, profit-maximizers do? They put people in houses that would not default in 90 days -- and the easiest way to do that were the 2/28 ARM mortgages. Cheap teaser rates for 24 months, then the big reset. Once the reset occurred 24 months later, it was long off the books of the mortgage originators -- by then, it was Wall Street's problem. This was a monumental change in lending standards. It created millions of new potential home buyers. Why? Instead of making sure that borrowers could pay back a loan, and not default over the course of a 30 YEAR FIXED MORTGAGE, originators only had to find people who could afford the teaser rate for a few months. This was a simply unprecedented shift in lending standards. And, it is why 293 mortgage lenders have imploded -- all of these bad loans were put back to them. Note that the fear of this occurring is what was supposed to keep the lenders in line. The repercussion of this is why Greenspan believed the free market could self-regulate. (After all, people are rational, right?) One of the many odd lessons of this era is that, under certain circumstances, companies and salespeople will pursue short term profits to the point where it literally destroys the firm. If you want to point to the single most important element of the Housing boom and bust, this is it. Ultimately, these defaulting mortgages underlie the entire credit freeze. And, it would not have been possible without the Greenspan ultra-low rates, which made the teaser portion (the "2" of the 2/28) of these mortgages so attractive. Contrary to the cliché, failure is not an orphan in the current crisis -- it has 100s of fathers. But these four are the primary movers, the key to everything else: The perfect storm of ultra-low rates, securitization, lax lending standards and triple AAA ratings -- these are the key to how we ended up with the previous boom, followed by a bust, and ultimately, the credit freeze.

The bubble keeps on deflating
October 19, 2008

By now everyone knows that reckless and even predatory mortgage lending provoked the financial meltdown. But bad lending did not stop there. The easy money also fed a corporate buyout binge, with private equity firms borrowing huge sums to buy up public companies and pay themselves big dividends. The process was much like a homeowner who borrowed big for a house and then refinanced to pull out cash. In corporate buyouts, however, the newly private company was left with the fat loan, while the private equity partners got the cash. In keeping with the mania of the era, banks lowered their lending standards as they competed fiercely to make buyout loans. Lenders also did not worry much about being repaid, because they made money by slicing and dicing the buyout loans and selling them off in pieces to investors. All of this means that the United States needs to brace for yet another round of trouble: a potentially sharp increase in corporate bankruptcies. This time, U.S. government officials and Congress must not be taken by surprise. So far, relatively few companies have gone bust. But that is not necessarily a hopeful sign. Instead, loose lending has very likely allowed many troubled companies to postpone a day of reckoning - but not forever.

Under the lax terms of many buyout loans (deemed "covenant lite"), borrowers could delay payments, say, by issuing IOUs in lieu of payment or adding the interest to the loan balance rather than paying it. But when the loans come due and need to be repaid or refinanced, terms will no longer be so easy. The likely result will be defaults and bankruptcies. A rash of corporate bankruptcies would obviously be very bad news for employees and lenders, and for stockholders at troubled public companies, like the carmakers. It could also rock the financial system anew. As with mortgages, huge side bets have been placed on the performance of corporate debt via derivative securities, like credit default swaps. Derivatives are unregulated, so no one can be sure how widely a big or unexpected default would reverberate through the system. Various measures indicate elevated default risk at a range of businesses, including retailers, media companies, restaurants and manufacturers. A survey released this month by the Federal Reserve and other regulators is especially sobering. It looked at $2.8 trillion in large syndicated corporate loans held by U.S. banks at the end of June. Compared with a year earlier, the share of loans rated as problematic had risen from 5 percent to 13.4 percent. Regulators must continue to monitor possible bankruptcies. Even if they cannot prevent a failure, they can soften its impact by ensuring that it does not come as a shock, further spooking investors. Congress must prepare to deal with higher unemployment from corporate failures. In the coming lame duck session, lawmakers must extend jobless benefits for people who have exhausted their previous allotment. Congress must also be prepared to investigate large or particularly disruptive bankruptcies to identify both possible unlawful activity and regulatory lapses. So far, inquiries into the collapses of Bear Stearns, Lehman Brothers and American International Group have been little more than public hazing of corporate executives. What is needed is a serious effort to determine accountability and figure out what reforms are needed to make sure these disasters don't happen again.

Krugman: Let's get fiscal
October 17, 2008

The Dow is surging! No, it's plunging! No, it's surging! No, it's ... . Never mind. While the manic-depressive stock market is dominating the headlines, the more important story is the grim news coming in about America's real economy. It's now clear that rescuing the banks is just the beginning: The non-financial economy is also in desperate need of help. And to provide that help, we're going to have to put some prejudices aside. In the United States, it's politically fashionable to rant against government spending and demand fiscal responsibility. But right now, increased government spending is just what the doctor ordered, and concerns about the U.S. budget deficit should be put on hold. Before I get there, let's talk about the economic situation. Just this week, we learned that U.S. retail sales have fallen off a cliff, and so has industrial production. Unemployment claims are at steep recession levels, and the Philadelphia Fed's manufacturing index is falling at the fastest pace in almost 20 years. All signs point to an economic slump that will be nasty, brutish - and long. How nasty? The U.S. unemployment rate is already above 6 percent (and broader measures of underemployment are in double digits). It's now virtually certain that the unemployment rate will go above 7 percent, and quite possibly above 8 percent, making this the worst recession in a quarter-century.

And how long? It could be very long indeed. Think about what happened in the last recession, which followed the bursting of the late-1990s technology bubble. On the surface, the policy response to that recession looks like a success story. Although there were widespread fears that the United States would experience a Japanese-style "lost decade," that didn't happen: The Federal Reserve was able to engineer a recovery from that recession by cutting interest rates. But the truth is that we Americans were looking Japanese for quite a while: The Fed had a hard time getting traction. Despite repeated interest rate cuts, which eventually brought the federal funds rate down to just 1 percent, the unemployment rate just kept on rising; it was more than two years before the job picture started to improve. And when a convincing recovery finally did come, it was only because Alan Greenspan had managed to replace the technology bubble with a housing bubble. Now the housing bubble has burst in turn, leaving the financial landscape strewn with wreckage. Even if the ongoing efforts to rescue the banking system and unfreeze the credit markets work - and while it's early days yet, the initial results have been disappointing - it's hard to see housing making a comeback any time soon. And if there's another bubble waiting to happen, it's not obvious. So the Fed will find it even harder to get traction this time. In other words, there's not much Ben Bernanke can do for the economy. He can and should cut interest rates even more - but nobody expects this to do more than provide a slight economic boost. On the other hand, there's a lot the U.S. government can do for the economy. It can provide extended benefits to the unemployed, which will both help distressed families cope and put money in the hands of people likely to spend it. It can provide emergency aid to state and local governments, so that they aren't forced into steep spending cuts that both degrade public services and destroy jobs. It can buy up mortgages (but not at face value, as John McCain has proposed) and restructure the terms to help families stay in their homes. And this is also a good time to engage in some serious infrastructure spending, which the U.S. badly needs in any case. The usual argument against public works as economic stimulus is that they take too long: By the time you get around to repairing that bridge and upgrading that rail line, the slump is over and the stimulus isn't needed. Well, that argument has no force now, since the chances that this slump will be over anytime soon are virtually nil. So let's get those projects rolling. Will the next administration do what's needed to deal with the economic slump? Not if McCain pulls off an upset. What we need right now is more government spending - but when McCain was asked in one of the debates how he would deal with the economic crisis, he answered: "Well, the first thing we have to do is get spending under control." If Barack Obama becomes president, he won't have the same knee-jerk opposition to spending. But he will face a chorus of inside-the-Beltway types telling him that he has to be responsible, that the big deficits the government will run next year if it does the right thing are unacceptable. He should ignore that chorus. The responsible thing, right now, is to give the economy the help it needs. Now is not the time to worry about the deficit. __________ A RETRO ARTICLE FROM 1999—THE MOVE THAT STARTED IT ALL?

Fannie Mae Eases Credit to Aid Mortgage Lending
NYT September 30, 1999

In a move that could help increase home ownership rates among minorities and low-income consumers, the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders. The action, which will begin as a pilot program involving 24 banks in 15 markets -- including the New York metropolitan region -- will encourage those banks to extend home mortgages to individuals whose credit is generally not good enough to qualify for conventional loans. Fannie Mae officials say they hope to make it a nationwide program by next spring. Fannie Mae, the nation's biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people and felt pressure from stock holders to maintain its phenomenal growth in profits. In addition, banks, thrift institutions and mortgage companies have been pressing Fannie Mae to help them make more loans to so-called subprime borrowers. These borrowers whose incomes, credit ratings and savings are not good enough to qualify for conventional loans, can only get loans from finance companies that charge much higher interest rates -- anywhere from three to four percentage points higher than conventional loans. ''Fannie Mae has expanded home ownership for millions of families in the 1990's by reducing down payment requirements,'' said Franklin D. Raines, Fannie Mae's chairman and chief executive officer. ''Yet there remain too many borrowers whose credit is just a notch below what our underwriting has required who have been relegated to paying significantly higher mortgage rates in the so-called subprime market.'' Demographic information on these borrowers is sketchy. But at least one study indicates that 18 percent of the loans in the subprime market went to black borrowers, compared to 5 per cent of loans in the conventional loan market. In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980's. ''From the perspective of many people, including me, this is another thrift industry growing up around us,'' said Peter Wallison a resident fellow at the American Enterprise Institute. ''If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry.'' Under Fannie Mae's pilot program, consumers who qualify can secure a mortgage with an interest rate onepercentage point above that of a conventional, 30-year fixed rate mortgage of less than $240,000 -- a rate that currently averages about 7.76 per cent. If the borrower makes his or her monthly payments on time for two years, the one percentage point premium is dropped. Fannie Mae, the nation's biggest underwriter of home mortgages, does not lend money directly to consumers. Instead, it purchases loans that banks make on what is called the secondary market. By expanding the type of loans that it will buy, Fannie Mae is hoping to spur banks to make more loans to people with less-than-stellar credit ratings. Fannie Mae officials stress that the new mortgages will be extended to all potential borrowers who can qualify for a mortgage. But they add that the move is intended in part to increase the number of minority and low-income home owners who tend to have worse credit ratings than non-Hispanic whites. Home ownership has, in fact, exploded among minorities during the economic boom of the 1990's. The number of mortgages extended to Hispanic applicants jumped by 87.2 per cent from 1993 to 1998, according to Harvard University's Joint Center for Housing Studies. During that same period the number of African Americans who got mortgages to buy a home increased by 71.9 per cent and the number of Asian Americans by 46.3 per cent.

In contrast, the number of non-Hispanic whites who received loans for homes increased by 31.2 per cent. Despite these gains, home ownership rates for minorities continue to lag behind non-Hispanic whites, in part because blacks and Hispanics in particular tend to have on average worse credit ratings. In July, the Department of Housing and Urban Development proposed that by the year 2001, 50 percent of Fannie Mae's and Freddie Mac's portfolio be made up of loans to low and moderate-income borrowers. Last year, 44 percent of the loans Fannie Mae purchased were from these groups. The change in policy also comes at the same time that HUD is investigating allegations of racial discrimination in the automated underwriting systems used by Fannie Mae and Freddie Mac to determine the credit-worthiness of credit applicants. The Next World War? It Could Be Financial The global financial outlook grows more dire by the day: The United States has been forced to shore up Wall Street, and European governments are bailing out numerous commercial banks. Even more alarmingly, the government of Iceland is presiding over a massive default by all the country's major banks. This troubling development points not only to an even more painful recession than anticipated, but also to the urgent need for international coordination to avoid something worse: all-out financial warfare. The ramifications of Iceland's misery are probably more serious than people realize. The country's bank assets are more than 10 times greater than its gross domestic product, so the government clearly cannot afford a bailout. This is going to be a large default, affecting many parties. In the United Kingdom alone, 300,000-account holders face sudden loss of access to their funds, and the process for claiming deposit insurance is not entirely clear. There is now a risk that continued corporate and bank defaults within nations ... will lead to a chaotic series of national and local defaults. If governments don't respond with sensible, coordinated policies, there's a risk of financial war. But there's a broader concern. With European governments turning down his appeals for assistance, Iceland's prime minister, Geir Haarde, warned last week that it was now "every country for itself." This smacks of the financial autarchy that characterized defaulters in the financial crisis in Asia in the late 1990s. Similarly, when Argentina defaulted on its debt in 2001–02, politicians there faced enormous pressure to change the rule of law to benefit domestic property holders over foreigners, and they changed the bankruptcy law to give local debtors the upper hand. In Indonesia and Russia after the crises of 1998, local enterprises and banks took the opportunity of the confusion to grab property, then found ways to ensure that courts sided with them. This is a natural outcome of chaotic times. Iceland's promise to guarantee domestic depositors while reneging on guarantees to foreigners may be just a first step. British Prime Minister Gordon Brown's decision last week to sue Iceland over this issue may escalate the crisis. The use of counterterrorist legislation to take over Icelandic bank assets and operations in the United Kingdom also has a potentially dramatic symbolic effect. Most of the time, financial war of this kind is painful and costly. It will lead to decades of lower international capital flows and could have other far-reaching effects on politics and global peace. Unless the leading industrial countries take concerted action, there's a very real danger that we will all suffer more. In addition, we're now likely to see substantially more defaults and credit panics in smaller countries and emerging markets. After Iceland's fall, every creditor to other nations with large deficits and substantial external debt must be looking for ways to reduce its exposure. The obvious risks include much of Eastern Europe, Turkey and parts of Latin America. Russia's difficulties show that seemingly solvent countries can be high-risk: While the Russian central bank has gold and foreign exchange reserves of $556 billion, the private sector has recently built up an estimated $450 billion of debt. Creditors don't want to roll over the debt, so the government is using its reserves to do it. It has already ordered $200 billion channeled through state banks to companies repaying debt. If oil prices fall, a seemingly highly solvent country could quickly look nearly insolvent. Some other rising stars,

such as Brazil and even India, may have similar problems. Added to this are worrying signs that the credibility of U.S. authorities is on the decline. Despite Washington's moves to stabilize the financial system, credit and equity markets continue to drop. This pattern is reminiscent of the 1997–98 Asian crisis, when successive International Monetary Fund programs provided briefer and briefer respites from market routs in emerging economies. There is now a risk that continued corporate and bank defaults within nations, matched by large shifts in capital flows across nations, will lead to a chaotic series of national and local defaults. If governments don't respond with sensible, coordinated policies, there's a risk of financial war. Here are six steps toward avoiding a situation of "each nation for itself": 1. The world's leading financial powers—at a minimum, the United States, the United Kingdom, France and Germany—should jointly announce national plans to require recapitalization of banks (i.e., restructuring their debt and equity mixture) so that they have sufficient capital to weather a major global recession. How this is done can be determined internally by each nation, but this should be a common goal, so that citizens and companies can again trust their banks. 2. The countries should announce a temporary blanket guarantee on all existing bank deposits and debts. This will, in effect, promise creditors that they can safely expect the institutions to function until the recapitalization takes place, and it will help prevent the large flows of funds that could occur as some banks or countries conduct recapitalizations earlier than others. This guarantee should only be temporary (say, for six months). 3. The monetary authorities of these countries need to lower interest rates dramatically. Europe, Canada and the United States recently announced a coordinated 0.5 percent reduction in rates. This is a good start, but only a start. More will be needed, and it won't stop the credit crunch within or across countries. The events of the last nine months have set us on course for a global recession in which commodity prices will continue to fall and demand will remain weak. Inflation will be low, and deflation (falling prices) is a risk. More interest-rate cuts will be needed. 4. The monetary authorities also need to remain committed to pumping liquidity into the financial system as long as credit markets and interbank lending remain weak. This should be promised for at least one year. 5. All industrialized countries and most leading emerging markets should commit to a sizable fiscal expansion (at least 1 percent of GDP), structured to work within the local political environment, to offset the coming large decline in global demand. 6. Many families worldwide are going to have negative equity (i.e., mortgages larger than the value of their homes) due to declining home prices. There are going to be large-scale recriminations against lenders and politicians. The most affected nations, including the United States, the United Kingdom, Ireland and Spain, urgently need to develop programs to provide relief for homeowners, both to offset real hardship and to prevent a vicious downward cycle in home prices. It's important to prepare properly: Partial and piecemeal actions will no longer work. Actions by one country alone, and the current pattern of small steps, are no longer credible enough to change the tide: Markets need to be jolted out of their panic. It's worth bringing a sufficient mass of economic power to bear in a comprehensive program to unfreeze the markets. If the major powers of Europe and the United States were to implement such a program, we can be sure that other countries would follow suit, dramatically relieving fears of bank failure in these countries. We also need to let prices move to a level supported by the market, which unfortunately means that wealth is likely to decline even further. The events of the last six months will almost surely cause a recession, and large downward revisions in earnings estimates are a near certainty. The crisis has undoubtedly changed investors' perception of the risks of investing in equities and real estate. As we saw after the Asian crises, this can mean that stocks, bonds and other assets become very cheap, and it takes a long time for values to recover. Fiscal expansion and help to homeowners will reduce the pain from these losses, but it's important to be clear that the

success of the program should not be measured by rising asset prices. Finally, it's important for everyone to recognize that we are well past the days where even dramatic steps could have stopped the panic and prevented a major recession. A successful program will not prevent recession, and we will still see many personal, corporate and perhaps even national bankruptcies. Once the genie of panic and uncertainty is unleashed, it takes years to put it back in the bottle. What we need to do is to prevent a chaotic collapse arising from incomplete policies, lack of credibility and international financial warfare.

Preventing the next wave of foreclosures
October 18, 2008

Now that the government has "saved" Wall Street - at least for the moment - hasn't the time finally come to save Main Street too? The Treasury Department just pumped $125 billion into the country's largest financial institutions, and it promises to use another $125 billion - more, if necessary - to recapitalize regional and community banks. They are vital steps. This week, at long last, the credit markets thawed, at least a little, and the global recapitalization of the banking system is the reason. But the job isn't done yet. The government now needs to tackle what R. Glenn Hubbard, the former chairman of the Council of Economic Advisers under President Bush, calls "the elephant in the room": the continuing decline of housing prices. That decline means more and more homeowners are saddled with "impaired mortgages" (to use the current lingo), meaning their homes are worth less than what they owe on them. They didn't necessarily do anything wrong; they just bought a house near the peak of an unsustainable bubble. Now they have little economic incentive to keep making mortgage payments. Of course, millions of additional homeowners did make a big mistake: They took advantage of "liar loans" and other too-good-to-be-true deals to buy homes they couldn't afford. Many are still in those homes, hanging on for dear life. Many others have already faced foreclosure proceedings. I've seen estimates suggesting as many as one out of every six homeowners has a troubled mortgage. This is an enormous social problem. It is also a continuing economic problem. In the year since the crisis began, the world's financial institutions have written down around $500 billion worth of mortgage-backed securities. Unless something is done to stem the rapid decline of housing values, these institutions are likely to write down an additional $1 trillion to $1.5 trillion. In other words, we ain't seen nothin' yet. And please don't raise the specter of moral hazard, the notion that people who did dumb things need to take their lumps so they won't do it again. First of all, you would have to be an absolute idiot to repeat the folly of the housing bubble, even if you don't lose your house in the crisis. I contend that this financial crisis is going to cause an entire generation to become debt-averse, as our parents were after the Depression. Second, there is the question of justice. For Wall Street, which made plenty of its own dumb mistakes, moral hazard went out the window the minute the government realized what a catastrophic error it made when it allowed Lehman Brothers to go bankrupt. The government is not going to let another big institution fail. Why should homeowners have to pay more for their sins than Wall Street is paying for its sins? As anger across the country rises, this is becoming a political issue as well. Yes, there were lots of Americans who were not greedy or foolish during the housing bubble, and many resent the idea that their neighbors might get a bailout they don't deserve. They need to get over themselves. If housing prices keep falling, many millions of additional homeowners will find themselves, through no fault of their own, with underwater mortgages. Besides, foreclosures damage property values for everyone, not just those losing their homes. Finally, and perhaps most important, the housing bubble and its aftermath form the core problem from which all other problems flow. If the government doesn't do anything about it, the economy will remain in chaos. Banks will still be afraid to write mortgages, because they won't trust the value of the collateral. Giant financial institutions

will continue to post multibillion-dollar write-downs. And homeowners will continue to face the stark reality that their primary asset is in jeopardy. And yet, so far the government's response to this part of the crisis - the part that most directly affects voters, for crying out loud - has been anemic. The Hope for Homeowners program, signed into law in July, is both too complicated and too narrow. The new $700 billion bailout bill contains some toothless pleas to help homeowners. Efforts to jawbone the mortgage industry have largely failed. Just a few days ago, the chairman of the Federal Deposit Insurance Corp., Sheila Bair, publicly broke with her counterparts at the Treasury and the Federal Reserve and criticized the Bush administration for not doing enough for homeowners. "We're attacking it at the institution level as opposed to the borrower level, and it's the borrowers defaulting," she told The Wall Street Journal. "That is what's causing the distress at the institution level. So why not tackle the borrower problem?" Why not, indeed. It turns out there are plenty of plans out there to do just that. But not one has broken through to gain wide backing. For instance, both presidential candidates have homeowner assistance plans, but they are poorly conceived and would cost the government billions of additional dollars. Hubbard, now the dean of the Columbia University Graduate School of Business, and a Columbia colleague, Chris Mayer, say they believe the answer lies in having "the Bush administration and Congress allow all residential mortgages on primary residences to be refinanced into 30-year fixed-rate mortgages at 5.25 percent (matching the lowest mortgage rate in the last 30 years), and place those mortgages with Fannie Mae and Freddie Mac," as they wrote recently. A Yale economist named John D. Geanakoplos suggests a new system to "modify mortgage loans to keep homeowners in their homes," as he put it in a recent paper. He also says the government should give financial incentives to renters to buy homes - and thus create a floor for housing prices. Both of these ideas are far better than the proposals of the two candidates. But recently a proposal came across my desk that I believe is so smart, and so sensible, that I hope our nation's policymakers will give it a serious look. It comes from Daniel Alpert, a founding partner of Westwood Capital, a small investment bank. I have quoted Alpert frequently in recent columns, because he has been both thoughtful and prescient on the subject of the financial crisis. Here's his idea: Pass a law that encourages homeowners with impaired mortgages to forfeit the deed to their lenders but allows them to stay in the homes for five years, paying prevailing market rent. Under the law Alpert envisions, the lender would be forced to accept the deed, and the rent. After five years, the homeowner-turnedrenter would have the right to buy the home back, at fair market value, from the lender. There are so many things I like about this idea that I hardly know where to begin. Let's start with the fact that it doesn't require a large infusion of taxpayers' money. Indeed, it doesn't require any government money at all. It also doesn't let either homeowners or lenders off the hook, as many other plans would. The homeowner loses the deed to his home, which will be painful. The lending institution, in accepting prevailing market rent, will get maybe 60 or 70 percent of what it would have gotten from a healthy mortgage-payer. (Rents are considerably lower than mortgage payments right now.) That will be painful too. Moral hazard will not be an issue. As Alpert told me the other day, his proposal "admits the truth: The homeowner doesn't have equity, and the lender has taken a loss. They should exchange interest, but not in a way that throws the homeowner out in the street." Which is the other key part of his plan? It has the best chance of preventing, as he puts it, "the massive disruption of the economy and the social dislocation" that will come from large numbers of foreclosures. And it is the continuing foreclosures that are likely to cause housing prices to fall so hard that they will drop below the real value of the shelter.

That, of course, is exactly what happened during the bubble, albeit in reverse - prices wildly overshot the true value of the home - and it has to be prevented on the way down. Otherwise we face further economic calamity. Why did Alpert choose five years? Two reasons. First, he feels confident that housing prices will have stabilized by then. "We continue to have a growing population," he said. "And there is zero chance there will be a material increase in housing stock over the next five years that will exceed demand. Those two factors alone will cause housing to stabilize." Second, he says five years will give the renters enough time to get their financial affairs in order - to pay down their various debts and save enough to make the 10 percent down payment an FHA loan requires. (Many of the homeowners affected by this plan would be eligible for FHA loans, Alpert believes.) If they don't have enough for a down payment, they would have to leave, of course, but it would be far less disruptive to the economy than it would be right now, in the middle of the crisis. Does the plan have stumbling blocks? Sure it does. One obvious one is that ideologues will view its being mandatory as an improper "taking" of homeowners' property rights and a violation of the mortgage contract. But, as Alpert puts it, "the homes involved are economically without value to the existing homeowners." He adds, "What the plan buys is time to heal for both sides in a fairly equitable and controlled manner." Alpert calls his plan "The Freedom Recovery Plan." On my blog (, I have linked to Alpert's detailed description of how it would work, which runs eight pages. I have also posted a series of short "comments" that he sent me recently, which outline the severity of the problem. I encourage you to read both documents, and weigh in on the plan's merits. That goes for you, too, government policymakers. I acknowledge that this may not be the perfect solution. It may have some fatal flaw that neither Alpert nor I can see. But if you don't like this idea, it is incumbent upon you to come up with something better. Actually, it's long overdue.

The Freedom Recovery Plan for Distressed Borrowers and Impaired Lenders
Overview With the passage of the Emergency Economic Stabilization Act of 2008 (“EESA”), the twin housing and mortgage crises have now forced the government to directly battle, with massive financial intervention, the systemic implications for our banking (and shadow-banking) institutions. Notwithstanding the magnitude of government support that EESA will bring to the resolution of the credit and banking crises, the financial and social implications arising from the housing bubble, for homeowners and the broader economy, require the consideration of additional unconventional solutions that are not inconsistent with the rubric of our system of laws and property rights. Such solutions must also place less reliance on direct intervention from a heavily extended government (and its taxpayers). The Freedom Recovery Plan (the “Plan”) is a structured package of government and private-sector measures that amount to a national “workout” of the residential real estate elements of the overall crisis in the capital markets. The housing sector’s ongoing meltdown presents unique challenges that were not front and center in prior boom and bust cycles. Accordingly, special actions are necessary to limit the damage to vast population segments and the knock-on effects of such damage to our normally resilient financial sector and economy. That such actions should endeavor to maximize the role of the private sector should be self-evident to those with lingering concerns about the total costs to which the government has already committed. The Plan is designed to promote accelerated settlement, between borrower and lender, of impaired mortgages (as such impairment is described below). Settlements under the Plan would involve homeowner/borrowers, with impaired mortgage loans, voluntarily surrendering the deeds to their homes to their mortgagees in consideration

of the right of continued occupancy, as tenants, for a period of five years. The Plan would provide cost savings and incentives to both borrower and lender, as detailed below, so as to encourage them to settle without going through the very costly proceedings of foreclosure or bankruptcy. The federal government, in addition to providing certain tax incentives, would compel lender compliance with the Plan. The Plan has been formulated to adhere to five basic principles that: (a) Cause parties that took unwise risks to also take responsibility for their acts (i.e., no exacerbation of moral hazard; we’ve had enough of that with EESA’s passage); (b) Rely as little as possible on the government/taxpayers; (c) Strive to keep people in their homes; (d) Save lenders and borrowers the enormous costs of adversarial foreclosures; (e) Provide sufficient time for American families who are unable to afford continuing homeownership to work their way out of their mountain of debt and rebuild material savings. Unlike other voluntary solutions to the current housing correction, proposed or enacted to date, it is “as of right” from the homeowner’s standpoint; the lender must accept deed surrender from a home with a qualifying impaired mortgage, without penalty, subject to the Plan’s considerations and requirements. While this requirement may be somewhat controversial from the standpoint of property and contract law, it is substantially more legally benign than some recently advanced suggestions to grant courts the right to summarily reduce mortgage balances and interest rates on legally made and secured mortgage loans. In contrast, the Plan offers a complete workout solution that is equitable to the borrower and permits the lender to efficiently realize the full market value of its loan collateral. We are concerned that if performance in accordance with the Plan is not mandatory, lenders will continue to be resistant to realistic settlements – as has been the case under the several voluntary solutions promulgated to date. The Origin of the Crisis, in Unprecedented Debt Creation, Requires a Bespoke Solution The problem that has overcome the economy has its most recent roots in the creation of nearly $7 trillion of new residential real estate and consumer debt during the first six years of this decade. Much of this debt was created between 2004 and 2006, when U.S. savings rates turned negative. Simply put, this level of debt creation was unprecedented, more than doubling homeowner and consumer debt (credit cards and auto loans, for the most part) that existed at the end of 1999. The extension of this mountain of debt was enabled by a prolonged period during which the Federal Reserve Bank maintained its target Fed Funds rate at or below the rate of inflation, thus essentially providing a subsidy to borrowers (banks that borrowed from the Fed, and the institutions and individuals to which the Fed Funds were re-lent) and a massive incentive to borrow. The Fed’s policy went well beyond offsetting the shock to the economy that followed the 2000 crash of the technology stock bubble and the horrific impact of 9/11; it also engineered a new, and quite dangerous, asset inflation bubble in residential real estate, as well as in the value of businesses and commercial real estate assets acquired with billions of dollars of leveraged acquisition loans. Finally, lax and irresponsible lending standards and underwriting criteria in the mortgage-lending and mortgage-backed securities industries eliminated virtually all credit-oriented constraints on lending, resulting in a total suspension of disbelief in continuingly rising home prices and the decoupling of homes’ carrying costs from those of renting equivalent properties, all set against a backdrop of countervailing trends in personal incomes. That the ready availability of trillions of dollars of cheaply priced, loosely originated loans pushed residential real estate prices to unjustifiable levels is now generally appreciated. The magnitude of the problem, its ultimate impact on our economy and society, and what can actually be done by government and the private sector to put this behind us as swiftly as possible, were, until last month, drowned out by a combination of blind optimists and

well-meaning politicians who have suggested solutions that have proven to be either nonstarters or wholly inadequate. As with the debate, passage and enactment of EESA, the present situation demands a thorough understanding of what has transpired, the threats posed to our economy and financial security, and a path to resolution that can be employed with great dispatch—one that reduces the burden on the country’s general common wealth (the ordinary citizen and taxpayer). In fact, as the Plan promotes and accelerates resolution and settlement of impaired loans, it should reduce the government and U.S. taxpayer exposure that arises from bank intervention and recapitalization actions being taken under EESA, as set forth below. To resolve the U.S. housing crisis, it’s critical for home prices to return from their bubble-era levels to one that is consistent with pre-bubble historical ratios of housing prices to comparable rents and of median home prices to median incomes. The supply of homes available for sale and demand for them can achieve sustainable equilibrium (relative to available inventories) only at prices that reflect reasonable rent and income multiples. Note that price-to-rent multiples remained in a band of 14x and 16x for decades prior to the current one. At the housing bubble’s peak, price-to-rent multiples ballooned to more than 26x. There is, however, a material risk that home prices will considerably overshoot the mark of parity with rent- and income-driven values, if wave after wave of foreclosures continue to swell for-sale inventories. We are already seeing signs of this in some badly affected markets. Furthermore, continuing foreclosures will place additional financial and societal strains on the economy: The cost of adversarial foreclosure has grown to more than 25%, on average, of outstanding loan balances, and the displacement of families affected by foreclosure engenders its own economic and social strains. The Plan is designed to dramatically reduce the need for adversarial foreclosure and to eliminate, in the case of qualifying mortgages, the displacement of households and the addition of new inventory to the for-sale backlog.

Plan Elements The Freedom Recovery Plan for Distressed Borrowers and Impaired Lenders will encourage homeowners to seek out and settle with their mortgagees, without fear of being immediately dispossessed of occupancy. It is designed, among other provisions, to give borrowers an opportunity to reverse the debilitating practices of dissaving and over-consumption, as well as afford distressed homeowners a period within which to rebuild their financial lives and, ideally, redeem their homes. At the heart of the Plan is the “Recovery Lease”: a fixed-term (5-year) right of occupancy lease that will have certain unique features to benefit both landlord (the former lender, or a subsequent assignee of title to the home and the Recovery Lease) and tenant (the former homeowner, with no right of assignment or sublease). The Recovery Lease is the result of a settlement under the Plan, in which the lender becomes the sole owner of the home, while granting the borrower the right to retain home occupancy for the Recovery Lease’s duration (with no right of renewal), as well as the right to reacquire the home, at the lease’s end, at its then-fair market value (i.e., the price a third party would pay at the time). Underlying the notion of the Recovery Lease is a practical consideration: As many homeowners invested little to no equity when purchasing their homes—or, during the bubble, refinancing their homes to the point of eliminating all equity—the borrower has been a “homeowner” in name only. There is therefore no benefit to continued ownership under such circumstances (and, conversely, there are continuing and material risks to any lender maintaining a loan to any such disenfranchised and disinterested borrower).

We expect that a combination of steady rental income, tax benefits and the potential for capital gains on the resale of the homes to former homeowners or third parties (at the expiration of the Recovery Leases) will result in an active market for debt and equity investment in Recovery-Leased property in the short to medium term. The principal Plan elements, and the legislation required to enact them, would be as follows: I. Eligibility – Mortgage loans eligible for settlement under the Plan must involve some version of demonstrable impairment (a “Qualified Impaired Mortgage,” or “QIM”). The eligibility requirements’ intent is to eliminate, from the Plan’s mandatory settlement requirements, mortgage loans that are in default merely because of homeowner unwillingness to make payments, or are otherwise restructureable through ordinary non-mandatory, arms-length negotiation between lender and borrower. Accordingly, to be considered a QIM, a mortgage loan must satisfy one or more of the following tests: a. It must satisfy both of the following criteria: i. Have a prevailing accruing interest rate higher than [10]%; ii. Have an outstanding principal balance higher than 90% of the value of the underlying home at the time of the settlement. OR: b. It must satisfy both of the following criteria: i. Have an outstanding principal balance that is equal to, or higher than, 110% of the value of the underlying home at the time of the settlement; ii. Either: 1. the borrower can demonstrate and certify (under penalties of perjury) that the total of mortgage debt service, real estate taxes and homeowner’s insurance costs relating to the home constitute more than 40% of the homeowner’s normalized family gross income; or 2. the borrower can demonstrate and certify (under penalties of perjury) that the borrower or the borrower’s spouse/partner has lost his or her job, suffered a disabling medical condition, suffered the death of a spouse/partner, or has been divorced from and abandoned by a former spouse/partner—in all cases, after the mortgage loan was originally made. OR: c. The mortgage lender has issued to the borrower/homeowner a notice of default and intent to foreclose, and has commenced court proceedings for foreclosure. Notwithstanding the foregoing, mortgage loans will not automatically qualify as QIMs (x) if it can be demonstrated that a borrower made a material misrepresentation on his loan application, (y) if the property securing the mortgage is not the borrower’s primary residence; or (z) if at least three monthly payments were not received on the loan since its origination (i.e., the borrower does not have a history of making concerted efforts to pay). Any mortgage loan satisfying the criteria in a, b or c, above, shall be a QIM and shall give the borrower the right to participate in a settlement under the Plan, with the lender mandated to effectuate such settlement on the borrower’s request. Notwithstanding the foregoing, a settlement under the Plan shall be available to all borrowers and lenders, by mutual agreement, regardless of whether the above criteria are satisfied. II. Surrender of Deeds and Settlement of Mortgage Loan Obligations – Lenders will take title to homes settled under the Plan. The lender will release the borrower from any and all obligations associated with the

former loan and will take title as-is and without recourse to the former borrower. No interest, penalties or fees may be assessed by the lender in connection with the settlement. Lender and borrower shall mutually release each other from any preexisting claims or threatened claims at the time of the settlement. The only continuing relationship between lender and borrower shall be set forth in the Recovery Lease pertaining to the subject home. Trustees and mortgage servicers of mortgage securitizations will be required to comply with the Plan’s mandated settlement requirements, and the enacting legislation will contain a presumption that compliance with the Plan constitutes acting in the best interests of, and to maximize value for, holders of mortgage securities, and that legal challenges to Plan compliance on the part of trustees and servicers shall be barred as a matter of public policy. III. The Recovery Lease – Homeowners voluntarily surrendering the title to homes securing QIMs (or by mutual agreement between lender and borrower in the case of mortgage loans that are not QIMs) will be entitled to enter into Recovery Leases that provide for continued occupancy by the former homeowner. Recovery Leases will feature, among other provisions, the following terms and conditions: Term: Five years from the date of settlement with the lender. No rights of renewal or extension, even by mutual agreement of the parties. Any renewals or extensions subsequently agreed to will not enjoy the special protections and features of a Recovery Lease. Rent: Recovery Lease rents will be set at the level of comparable rents for the state, city and submarkets in which the leased property is located, with due respect given to the quality of the home. Critical to the Plan is the fact that the rental cost of homes in most markets is often significantly lower than the total carry costs of owning a home. Therefore, setting rents and prevailing levels will generally result in significant relief to former homeowners in terms of monthly housing costs. The Department of Housing and Urban Development, along with the housing departments of each state, will, for the duration of the housing emergency, empanel Rent Review Boards that shall be responsible for developing and maintaining rent matrices by zip code. For each (five-digit) zip code, an average per-square-foot rent level for each of four quality levels of homes (low, medium, high and luxury) will be established and revised annually. These average rents are not meant to control them; rather, they are meant to provide a guideline that reflects a market appraisal of rents in the open market. Recovery Lease Rents shall be mandated to be appropriate for the market and home quality of a Recovery Leased property, but in all events may not exceed 110% of the average market rents established and published by the Rent Review Boards (the “Maximum Rent”). A lower rent may result from arms-length negotiation between the former lender and the former homeowner. Rents may increase biannually under Recovery Leases, but in no event be higher than the prevailing Maximum Rent. The Rent Review Boards—or local sub-panels—will hear appeals from any tenant disputing a landlord’s compliance with the rent limitations and will be Mortgage debt service plus the costs of real estate taxes, insurance, and maintenance (and, in some markets, certain utilities) commonly borne by landlords empowered to mandate resetting of rents. All rents shall be “gross rents,” with the landlord bearing all real estate taxes, insurance premiums and maintenance expenses relating to the home. Utilities shall be borne by the parties to the Recovery Lease in accordance with local custom and practice. Transferability: The Recovery Lease shall not be transferable from the tenant to any other lessee or sublessee. The tenant must remain in occupancy of the property. The property and the Recovery Lease, however, are to be fully transferable by the former lender/landlord to any other party, subject to existence of the Recovery Lease. It is an express objective of the Plan that former lenders be encouraged to dispose of Recovery Leased homes to real estate investors in an orderly manner, and certain tax benefits are to accrue to investors in Recovery Leased homes, as set forth below, to maximize the value of such Recovery Leased property (based on its value as a rental property investment). Right of First Offer: 180 days prior to the expiration of the Recovery Lease, the tenant (former homeowner) shall have the exclusive right to acquire the home at the then-fair market value (determined by appraisal in

absence of an agreement between landlord and tenant). In the event the tenant fails to acquire the home prior to the expiration of the Recovery Lease, there shall be no further obligation of landlord to tenant, and the home can either be sold to a different buyer, free and clear, or leased to any tenant, with a rent determined at the landlord’s sole discretion. Termination: In the event the now-renting former homeowner is in arrears on rent for more than 30 days, he/she would be subject to eviction, as in the case of any lease. Sunset: Recovery Lease arrangements shall have a well-defined sunset, and the Plan shall permit Recovery Lease arrangements to be entered into for a period ending 18–24 months from the passage of enabling legislation. The purpose of this provision is to accelerate settlements into the shortest possible period so as to rapidly and aggressively move to stabilize the housing market. IV. Tax Law Modifications – To provide incentives to both lenders and homeowners to enter into settlements pursuant to the Plan, Congress shall enact legislation pursuant to which the following modifications shall be made to existing tax law: a. A new section of the Internal Revenue Code (“IRC”) shall be enacted to provide that lessees under Recovery Leases (former homeowners) shall be entitled to deduct from their ordinary income the rent paid on Recovery Leases. This provision is not intended to reverse the IRC Section 163(h)—the mortgage interest deduction—but is meant to level the playing field in connection with the former homeowner’s transition from homeowner to tenant. This provision will be revenue-neutral (or possibly revenue-enhancing) to the U.S. Treasury, inasmuch as the former homeowner was previously permitted to deduct all mortgage interest payable on his preexisting loan (whose interest payment is likely to have been greater than the rent payment under the Recovery Lease). b. The provisions of IRC Section 469, limiting losses from passive activity such as rental housing from offsetting ordinary income, shall be suspended in connection with the ownership of homes subject to Recovery Leases. Upon expiration or termination of a Recovery Lease for a property, further leasing activity in respect of such property will once again be governed in accordance with the existing provisions of IRC Section 469. While not necessarily revenue-neutral, the purpose of this provision is to enhance lenders’ ability to expeditiously sell Recovery-Leased property to third-party, non0institutional investors. c. The provisions of IRC Section 1250 shall be amended to provide that homes leased pursuant to Recovery Leases may be depreciated over the following periods, in contrast to present depreciation allowances: i. Rental property structural improvements (buildings) to be depreciated on a 17-year “double-declining” basis, as opposed to the 27.5-year straight-line basis currently permitted; ii. Appliances and other non-real property within Recovery-Leased homes to be depreciated over a 5-year “double-declining” basis, as opposed to the 5-year straight line basis currently permitted; iii. Landscaping and pavement on the site of Recovery-Leased homes to be depreciated on a 10-year “double-declining” basis, as opposed to the 15-year straight-line basis currently permitted. While not revenue-neutral, this provision is intended to enhance lenders’ ability to expeditiously sell RecoveryLeased property to third-party investors. Depreciation periods for homes subject to Recovery Leases shall revert to current schedules at the termination or expiration of the Recovery Lease with respect thereto. V. Regulatory Provisions – Banking, insurance and other regulated lenders will be required to mark loans settled under the Plan to the market values of the homes they have taken pursuant to the settlement. Lenders will be motivated to monetize homes subject to Recovery Leases as soon as possible to get the assets off their balance sheets in exchange for cash to improve regulatory capital. Nevertheless, Federal and State legislation should be promulgated to permit institutions to hold homes subject to Recovery Leases as “real estate held for investment,” rather than “real estate owned.”

VI. Other Government Agencies – It is expected that a combination of steady rental income, tax benefits and the potential for capital gains on the resale of the homes to the former homeowner or third parties (at the expiration of the Recovery Leases) will result in an active market for debt and equity investment in RecoveryLeased property in the short to medium term. Nevertheless, the enabling legislation promulgating the Plan should direct Fannie Mae and Freddie Mac to institute a favorably priced program to purchase and/or guarantee loans of up to 80% of the value of Recovery-Leased properties to qualified investors therein. Conclusion The housing bubble, and the contemporaneous overextension of $7 trillion of new credit to the consumer and householder earlier this decade, has placed unprecedented strain on the vast U.S. middle class. Incomes during the decade have declined in real terms, and certain costs of everyday life—healthcare, education and energy— have increased materially. This decade’s financial and economic tale includes two other factors that require emergency actions in the nature of the Plan: (i) (ii) a decline in net savings rates for the American middle class below zero (slightly below zero for the country as a whole, more so for the middle class)—meaning that U.S. citizens are, on average, dissaving by going increasingly into debt: and (ii) the substantial likelihood that more than $5–$6 trillion of home value (25% to 30% of the $20 trillion of aggregate home value at the peak of the bubble) will be eradicated as a result of the collapse in home prices—representing a devastating collapse of wealth in many U.S. markets, to say nothing of making millions of homes worth less than the mortgage loans outstanding against them.

While financial institutions can be rescued with capital infusions that allow credit to slowly be made available again, American families and their homes will require the benefit of considerable amounts of time to right themselves. Consumption must slow, along with reliance on credit, and savings and net worth must be painstakingly rebuilt. Homes will be revalued to the point of historical comparisons to rents and incomes, but such revaluation inherently runs the risk (actually, a certainty) of substantial disruption to the lives of families, if not their financial ruin, with the pendulum swinging considerably past the point of re-stabilization of home values and into the meltdown zone. The Freedom Recovery Plan is designed to ease America’s 75+ million homeowners through the economic devastation, keep them in their homes and minimize the burden on general taxpayers, which would result from a wholesale “bailout” of all homeowners and lenders. At its core, the Plan fosters what the markets will force upon the residential real estate industry and mortgage lenders. In the absence of such an impact buffering protocol, families, financial institutions and the U.S. government will suffer even greater pain and take longer to rebuild and move forward. THE ABOVE PLAN IS AN INTERESTING PROPOSITION - BUT IT SEEMS OVERLY COMPLICATED TO ME

Comments on The Freedom Recovery Plan by Daniel Alpert 1) If you believe that the housing crisis is cyclical in nature or the result of oversupply, none of what we are talking about will make any sense. a. Housing prices were bid up to unjustifiable heights by virtue of a flood of cheap — almost free — money in the form of debt. b. Prices had nothing to do with the value of the shelter itself. c. Prices disconnected from rental costs and from the ability of incomes to support the cost of homes on a sustainable basis. 2) Consequently, home prices are no more likely to “recover” their bubble era values than are real estate prices in Japan likely to recover their bubble era values, now some 65% below their highs, 18 years after the Japanese bubble burst.

3) So what you are left with is a pile of debt that exceeds the value of the collateral supporting it and cannot be repaid. And even among those borrowers who sincerely wish to stay current on their debt — the forces of recession threaten to limit their ability to do so. On a broader level, even those altruistic enough to want to stay current will eventually ask themselves why they are throwing good money after bad on an asset that won’t be worth anything to them. 4) Now that we have gotten realistic about saving our global banking system — which is comparatively easy in that all that is happening is the printing of more money by, or the extension of more credit to, sovereign governments for the purpose of recapitalizing institutions — it is time to tackle the decline in housing prices. 5) However, the government recapitalizing of banks is an open ended – and out of necessity MUST BE an open ended — commitment that will be very challenging to limit unless we immediately start about the real challenge of settling the losses on the massive amount of “primary” underlying debt. Failing to do that, the support obligation vis-à-vis the banks will literally or practically start to bankrupt nations (just think of the size of the US budget deficits over coming years and the potential impact to the credit of the US — not that the US will face bankruptcy, don’t interpret the comment in that way). While we are all out today praising the speed at which western nations have been able to turn on a dime from one policy initiative to another, the fact is the TARP and other initiatives won’t stop continued losses to our financial institutions. a. All of the derivative impacts — Mortgage Backed Securities, CDO’s and CDS’s — are being driven by the facts on the ground: the actual home mortgages themselves. b. This is all very different from the early 90’s commercial real estate crisis and much more difficult to solve – simply because the collateral we are talking about is the place our citizens go to rest their heads and raise their families. This is a crisis like none other. c. Moreover, the amount of leverage in the financial system is still horrifying – much of it derived from the housing and other financial asset bubbles (Marc Faber of the Gloom and Doom report noted in a CNBC interview today that “The U.S. economy’s debt to GDP has grown from 130 percent in 1980, to 350 percent at the present time,” — all with regulatory blessings). The deleveraging will continue and foster addition stress on asset and loan values d. We can’t just foreclose and liquidate. e. Soros pointed this out clearly in his op-ed piece in the FT on Monday – although he didn’t present any specific suggestions. Others, Wilbur Ross, for example, have also focused on the needs in this regard. 6) What must happen is threefold: a. We must strive to keep people in their homes not only for the social and societal implications but for the simple economic reality that further increasing of the number of vacant homes as sale inventory will bring about a crash that will take values well below the necessary readjustment to pre-bubble historical measures of home value. b. In order to minimize the open-ended commitment to support financial institutions, still only part way towards absorbing all of the eventual losses, we need to work to maximize recoveries and stabilize prices in a long term sustainable fashion so that we put this tragedy behind us and can get on with the business of real economic growth. c. With the taxpayer now essentially on the hook for all the major banking institutions, we need to develop a method of private transaction settlements that do not increase the burden on the taxpayer, but rather possibly reduce that burden. 7) The Freedom Recovery Plan does not seek to postpone the resolution with artificial government prices supports – that just makes it a problem for another day. The FRP seeks to bring in private investment capital as owners of homes leased to borrowers who have little to no (or negative) equity remaining. And, most importantly, the FRP seeks to give all existing homeowners a chance to get back into the ownership of their homes when they’ve gotten their financial houses in order. It is American to the core — fair, equitable and dependent on

individual initiative to fully realize its benefits – help for all (lenders and borrowers) but more help to those who will help themselves. 8) There’s an element of the Plan — the surrendering of deeds to homes — that may at first strike some as though we are Bedford Falls and old Mr. Potter is buying bargains from distressed sellers for fifty cents. Hardly the case. The homes involved are economically without value to the existing homeowners and the Mr. Potter’s will be taking significant losses in the settlements under the Plan, What the Plan buys is time to heal for both sides in a fairly equitable and controlled manner. Potential Problems: (1) a collapse in prices 5 years from now. (2) a large population of renters whose interest is not in the value of their home, but rather in that value declining over the next five years, thus making it more affordable for them under their option to purchase. (3) financial institutions that are losing money already depreciating assets beyond their ability to realize any tax advantage from that depreciation. Can they do more than just offset the “income” that is their rent? Depreciation for tax purposes was great when it wasn’t real (i.e. values really increased), but now it doesn’t provide nearly the same incentive. (4) Renters being “punished” for not having over extended during the bubble by not being given the same tax advantages vis-à-vis rent as those who did. Those whose homes have already been foreclosed will be similarly punished for not sticking it out in order to cash in on this plan. (5) Similarly, renters will be punished by an artificial inflation of the values of the homes that they might want to buy. (6) Builders may have an incentive to supply an already glutted market some time in the next 5 years. (7) The plan fails to address the fact that many of these people are in the wrong homes to begin with, i.e. too large, too expense, and too far from where they work, shop and play. Where is the element that shifts them into the homes where they should be living, but were “talked out of” by all the hype of the last few years? Depressed markets in urban areas where renters already predominate will be further hurt here. In contrast, market forces alone (i.e doing nothing) might well help to revitalize these areas and serve the common good in many ways like saving on energy and infrastructure by accommodating the residents who are newly displaced from the suburban homes that they believed they owned. Reader’s comments: I work for a non-profit which counsels prospective bankruptcy filers, and I cannot tell you how many people trusted that because they were lent some money, that the lender believed that they could repay it. No, they have never heard of the 30% of gross income guideline. If they were loaned 60% of their gross income as a monthly payment, they touchingly (maddeningly) believe the lender when the lender tells them they can repay it. The lender may have said, “Oh, you can re-finance before the ARM re-sets” - many mortgage brokers, unlicensed and untrained, may have actually believed this themselves. Truly, faith-based mortgage lending! Such is the state of financial literacy in this country. There have been many interesting proposals on the best way to stabilize housing values. All recognize that this is essential to any recovery. We must develop an approach that gives homeowners the ability to have confidence in their greatest store of wealth and their ability to access that store either through refinance for a sale. Any plan must reduce the number of homeowners losing their homes both as a way to protect them but at least as importantly to arrest the decline in asset values of mortgages held by financial institutions. Reduced foreclosures directly leads to fewer homes for sale and much less frictional cost to our economy from the entire process. Lastly, any new program must put developers and contractors back to work. With declining permits, we are already at best a year from any meaningful recovery of this most important segment of our national economy. Homebuilding jobs are local jobs. They immediately impact the local and national economy significantly. No recovery is possible without this segment of the economy participating if not leading.

There are many good ideas being circulated. Let’s look at another approach that would have a substantial and immediate impact on all players in this complicated picture. We need a simple, albeit costly approach, would replace the mortgage interest deduction with a corresponding credit. This credit would be limited to the first tier outstanding (perhaps $200,000), would be only for a portion of the obligation (perhaps 25%) and would be directly paid to loan holders by the Treasury if the mortgage rate was reduced to an acceptable rate (maybe the 5.25% 30 year rate in the plan suggested today). How would this help us out of our crisis? First, it would instantly make owning a home much more affordable option for a broad swath of the population, particularly those who benefit least, if at all, from the current mortgage interest deduction which is skewed to help those most well off the most. Secondly, there would be an immediate and substantial improvement in the value of assets held by financial institutions. Profitability, cash flow and capital ratios would all improve without direct government intervention in the capital markets. Thirdly, this approach would reduce the effective cost of a new home by an amount up to 20% . With banks now having more capital and developers having reduced risk, you would most likely see a reversal in the sickening decline in home construction. A reversal that is an absolutely necessary to condition to recovery. I will leave it to those who have access to reams of data to refine the elements of this approach. However, it is most important that we be both bold and simple to be effective.

Swapping secrecy for transparency
By Christopher Cox October 19, 2008

The historic volatility in the financial markets has raised important questions about the lack of meaningful regulation of financial instruments known as credit-default swaps. The $85 billion U.S. government rescue last month of the insurance conglomerate American International Group, for example, was needed in large part to protect those who held AIG's credit-default swaps and risked crushing losses if those instruments weren't honored. AIG had issued $440 billion in credit-default swaps - which are like insurance contracts on bonds and other assets that are meant to pay off if those assets default. But as markdowns on AIG's investments in subprime mortgages led to downgrades in its credit ratings, the holders of the credit-default swaps demanded more collateral, which AIG could not provide. As large as AIG's swaps exposure was, it represented only 0.8 percent of the $55 trillion in credit-default swaps outstanding - this total market is more than the gross domestic product of all nations on earth combined. Yet despite its enormous size, the credit-default swaps market has operated in the shadows. There is neither public disclosure nor any legal requirement for these contracts to be reported to the Securities and Exchange Commission or any other U.S. government agency. So government regulators have had no way to assess how much risk is in the system, whether credit-default swaps have been accurately valued or honestly traded, and when people issuing and trading them have taken on risk that threatens others. Because these instruments have been bought and sold widely and in many cases anonymously, they have trapped the large financial institutions in a web of transactions. This has created systemic risk that is particularly serious in the current stressful economic environment, contributing to a gravitational pull that stands to drag everyone down.

All investors - from individuals through their 401(k) plans to pension funds and asset managers - are paying a price today for the lack of oversight. We must urgently address the problems created by this unregulated environment. Credit-default swaps are not inherently good or evil. They play an important role in the smooth functioning of capital markets by allowing a broad range of institutional investors to manage the credit risks to which they are exposed. They are also a useful means for investors to signal their view of an entity's business prospects and creditworthiness. But America's markets function best when they are highly transparent, when everyone can see exactly which transactions are occurring and what the instruments being traded are worth. This gives investors confidence that they can accurately assess risk. Back in 2000, the U.S. Congress specifically decided not to regulate credit-default swaps. At that time, this market was just a few years old and still very small. For example, in 1999 a report by the President's Working Group on Financial Markets envisioned no systemic risk from such derivatives since "private counterparty discipline" - investors' natural desire to keep their own risks to a minimum - would work to protect the broader financial system. But the market for credit-default swaps has recently mushroomed. In just the past two years, it has doubled in size. And as the market has grown, private counterparty discipline has proven inadequate. As we have seen, individual market participants did not pay enough attention until it was too late. To place a value on credit-default swaps and the mortgage-related securities they insure, buyers and sellers of swaps relied too heavily on financial models that couldn't predict the mortgage market meltdown. They also trusted too much in the credit ratings of the securities and of the firms selling the credit-default swaps, and these ratings underestimated the risk. Congress needs to fill this regulatory hole by passing legislation that would not only make credit-default swaps more transparent but also give regulators the power to rein in fraudulent or manipulative trading practices and help everyone better assess the risks involved. Congress could require that dealers in over-the-counter credit-default swaps publicly report both their trades and the value of those trades. This would make the market more transparent, and make it easier for everyone engaged in credit-default swaps to assess their value. It would also provide regulators with the information they need to uncover unfair or fraudulent practices and to monitor risk. Then, the Securities and Exchange Commission should be given explicit authority to issue rules against fraudulent, deceptive or manipulative acts and practices in credit-default swaps. Finally, Congress could provide support for federal regulators to mandate the use of one or more central counterparties - financially stable clearance and settlement organizations - and exchange-like trading platforms for the credit-default swaps market. As it is now, it is often impossible even to know who stands on the other side of a swap contract, and this increases the risk involved. We at the SEC are already working with the Federal Reserve, the Commodity Futures Trading Commission and industry participants to accomplish these goals on a voluntary basis, using the authority we currently have. Because of the truly global nature of the over-the-counter derivatives market, we will need to work closely with governments in other major markets. The climate for such cooperation is good, because the cross-border impacts of the current market problems are obvious to all. Transparency is a powerful antidote for what ails our capital markets. When investors have clear and accurate information, and when they can make informed decisions about where to put their resources, money and credit will begin to flow again. By giving regulators the authority they need to bring the credit derivatives market into the sunshine, we Americans can take a giant step forward in protecting our financial system and the well being of

every citizen.
Christopher Cox is the chairman of the U.S. Securities and Exchange Commission.

Thomas L. Friedman: The great Iceland meltdown
October 19, 2008

Who knew? Who knew that Iceland was just a hedge fund with glaciers? Who knew? If you're looking for a single example of how the globalization of finance helped get us into this mess and how it will help get us out, you need look no further than British newspapers last week and their front-page articles about the number of British citizens, municipalities and universities - including Cambridge - that are in a tizzy today because they had savings parked in Icelandic banks, through online banking services like As Dave Barry would say, I'm not makin' this up. When I went to the Icesave Web site to see what it was all about, the headline read: "Simple, transparent and consistently high-rate online savings accounts from Icesave." But then, underneath in blue letters, I found the following note appended: "We are not currently processing any deposits or any withdrawal requests through our Icesave Internet accounts. We apologize for any inconvenience this may cause our customers." Any "inconvenience?" When you can't withdraw savings from an online bank in Iceland that is more than an inconvenience! That's a reason for total panic. So what's the story? Around 2002, Iceland began to free its banks from state ownership. According to The Wall Street Journal, the three banks that make up almost the entire banking system in Iceland "grew quickly on easy credit" and "their combined assets rose tenfold in five years." The Icelandic banks, while not invested in U.S. subprime mortgages, had gone on their own borrowing and lending binges, wooing savers from across Europe with 5.45 percent interest savings accounts. In a flat world, money can easily seek out the highest returns, and when word got around about Iceland, deposits poured in from Britain - some $1.8 billion. Unfortunately, though, when global credit markets closed up, and the krona fell, "the Icelandic banks were unable to finance their debts, many of which were denominated in foreign currencies," The New York Times reported. When depositors rushed to get their money out, the Icelandic banking system had too few reserves to cover withdrawals; so all three banks melted down and were nationalized. It turns out that more than 120 British municipal governments, as well as universities, hospitals and charities had deposits stranded in blocked Icelandic bank accounts. Cambridge alone had about $20 million, while 15 British police forces - from towns like Kent, Surrey, Sussex and Lancashire - had roughly $170 million frozen in Iceland, The Telegraph reported. Even the bobbies were banking in Iceland! So think about it: Some mortgage broker in Los Angeles gives subprime "liar loans" to people who have no credit ratings so they can buy homes in Southern California. Those flimsy mortgages get globalized through the global banking system and, when they go sour; they eventually prompt banks to stop lending, fearful that every other bank's assets are toxic, too. The credit crunch hits Iceland, which went on its own binge. Meanwhile, the police department of Northumbria, England, had invested some of its extra cash in Iceland, and, now that those accounts are frozen, it may have to reduce street patrols this weekend. And therein lies the central truth of globalization today: We're all connected and nobody is in charge. Globalization giveth - it was this democratization of finance that helped to power the global growth that lifted so many in India, China and Brazil out of poverty in recent decades. Globalization now taketh away - it was this democratization of finance that enabled the U.S. to infect the rest of the world with its toxic mortgages. And now, we have to hope, that globalization will saveth.

The real and sustained bailout from the crisis will happen when the strong companies buy the weak ones - on a global basis. It's starting. Last week, Credit Suisse declined a Swiss government bailout and instead raised fresh capital from Qatar, the Olayan family of Saudi Arabia and Israel's Koor Industries. Japan's Mitsubishi bank bought a stake in Morgan Stanley, possibly rescuing it from bankruptcy and preventing an even steeper decline in the Dow. And Spain's Banco Santander, which was spared from the worst of this credit crisis by Spain's conservative banking regulations, is purchasing America's Sovereign Bankcorp. I suspect we will soon see the same happening in industry. And, once the smoke clears, I suspect we will find ourselves living in a world of globalization on steroids - a world in which key global economies are more intimately tied together than ever before. It will be a world in which America will not be able to scratch its ear, let alone roll over in bed, without thinking about the impact on other countries and economies. And it will be a world in which multilateral diplomacy and regulation will no longer be a choice. It will be a reality and a necessity. We are all partners now.

Letter from Warren Buffett to the New York Times 16 October 2008
The financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary. So… I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities. Why? A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now. Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over. A little history here: During the Depression, the Dow hit its low, 41, on July 8, 1932. Economic conditions, though, kept deteriorating until Franklin D. Roosevelt took office in March 1933. By that time, the market had already advanced 30 percent. Or think back to the early days of World War II, when things were going badly for the United States in Europe and the Pacific. The market hit bottom in April 1942, well before Allied fortunes turned. Again, in the early 1980s, the time to buy stocks was when inflation raged and the economy was in the tank. In short, bad news is an investor’s best friend. It lets you buy a slice of America’s future at a marked-down price. Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497. You might think it would have been impossible for an investor to lose money during a century marked by such an extraordinary gain. But some investors did. The hapless ones bought stocks only when they felt comfort in doing so and then proceeded to sell when the headlines made them queasy.

Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible longterm asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts. Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later. In waiting for the comfort of good news, they are ignoring Wayne Gretzky’s advice: “I skate to where the puck is going to be, not to where it has been.” I don’t like to opine on the stock market, and again I emphasize that I have no idea what the market will do in the short term. Nevertheless, I’ll follow the lead of a restaurant that opened in an empty bank building and then advertised: “Put your mouth where your money was.” Today my money and my mouth both say equities.
Warren E. Buffett is the chief executive of Berkshire Hathaway, a diversified holding company.

Out of the Ashes
The Financial Crisis Is Also an Opportunity To Create New Rules for Our Global Economy
By Gordon Brown--October 17, 2008

This is a defining moment for the world economy. We are living through the first financial crisis of this new global age. And the decisions we make will affect us over not just the next few weeks but for years to come. The global problems we face require global solutions. At the end of World War II, American and European visionaries built a new international economic order and formed the International Monetary Fund, the World Bank and a world trade body. They acted because they knew that peace and prosperity were indivisible. They knew that for prosperity to be sustained, it had to be shared. Such was the impact of what they did for their day and age that Secretary of State Dean Acheson spoke of being "present at the creation." Today, the same sort of visionary internationalism is needed to resolve the crises and challenges of a different age. And the greatest of global challenges demands of us the boldest of global cooperation. The old postwar international financial institutions are out of date. They have to be rebuilt for a wholly new era in which there is global, not national, competition and open, not closed, economies. International flows of capital are so big they can overwhelm individual governments. And trust, the most precious asset of all, has been eroded. When President Bush met with the Group of Seven finance ministers last weekend, they agreed that we all had to deal with not only the issue of liquidity in the banking system but also the capitalization and funding of banks. It was clear that national action alone would not have been sufficient. We knew we had to send a clear and unambiguous message to the markets that governments across the world were prepared to act in a coordinated manner and do whatever was necessary to stabilize the system and address the fundamental problems. Confidence about the future is vital to building confidence for today. We must deal with more than the symptoms of the current crisis. We have to tackle the root causes. So the next stage is to rebuild our fractured international financial system. This week, European leaders came together to propose the guiding principles that we believe should underpin this new Bretton Woods: transparency, sound banking, responsibility, integrity and global governance. We agreed that urgent decisions implementing these principles should be made to root out the irresponsible and often undisclosed lending at the heart of our problems. To do this, we need cross-border supervision of financial institutions; shared global standards for accounting and regulation; a more responsible approach to executive remuneration that rewards hard work, effort and enterprise but not irresponsible risk-taking; and the renewal of our international institutions to make them effective early-warning systems for the world economy.

Tomorrow, French President Nicolas Sarkozy and European Commission President José Manuel Barroso will meet with President Bush to discuss the urgent reforms of the international financial system that are crucial both to preventing another crisis and to restoring confidence, which is necessary to get banks back to their essential purpose -- maintaining the flow of money to individuals and businesses. The reforms I have outlined are vital to ensuring that globalization works not just for some but for all hard-pressed families and businesses in all our communities. It is important, too, that in the international leaders' meeting that has been proposed we seek a world trade agreement and reject the beggar-thy-neighbor protectionism that has been a feature of past crises. There are no Britain-only or Europe-only or America-only solutions to today's problems. We are all in this together, and we can only resolve this crisis together. Over the past week, we have shown that with political will it is possible to agree on a global multibillion-dollar package to recapitalize our banks across many continents. In the next few weeks, we need to show the same resolve and spirit of cooperation to create the rules for our new global economy. If we do this, 2008 will be remembered not just as a year of financial crisis but as the year we started to build the world anew. The writer is prime minister of Britain.

South Korea to guarantee banks' foreign currency debts
October 19, 2008

South Korea announced measures Sunday to shore up its banks by guaranteeing their external debt and pumping more money into the financial system amid the global credit crisis. The government said it will provide up to $100 billion to secure banks' maturing foreign currency debt for three years on loans taken out from Oct. 20 this year until June 30, 2009. The announcement came as analysts have questioned South Korean banks' ability to acquire dollars to pay off maturing foreign loans amid the global credit crunch. Standard & Poor's Ratings Services said last week that it may downgrade its credit ratings for some of South Korea's biggest banks, citing concerns over their foreign currency funding. "The government and the Bank of Korea together will further provide enough additional dollar liquidity to the bank sector," Minister of Strategy and Finance Kang Man-soo told reporters. Kang, Financial Services Commission Chairman Jun Kwang-woo and Bank of Korea Gov. Lee Seong-tae made the announcement at a joint news conference. The government and Bank of Korea will also provide additional liquidity equivalent to $30 billion to the banking sector by utilizing foreign exchange reserves, the three officials said in a statement. The measures require approval by the National Assembly. Until that can be secured, either the Korea Development Bank or Korea Eximbank will provide the guarantees beginning Monday, they said. South Korean banks' foreign debt reaching maturity by the end of June 2009 is estimated at about $80 billion, the statement said. It did not say when that debt was taken out. The officials also announced other steps, including tax incentives for investors, but stopped short of wider measures taken in some other countries. "At the moment, it seems that recapitalization of financial institutions or expansion of deposit guarantees are not necessary," the statement said. The government has repeatedly said that there are no problems with the banking system or financial sector and that it has more than enough firepower in the form of its $240 billion in foreign currency reserves — the world's sixth largest — to see the country through the global crisis. Still, Kang said Sunday the government needed to act swiftly to avoid any potential problems. "If we take our time in (the) global financial market, our banks could be discriminated (against) or could be in a difficult situation," Kang said. The announcement, he added, was to ensure that the country will not end up "in that difficult position."

The government also reiterated its stance that fears about South Korea being vulnerable to the global crisis were overblown. "Korea's real economy and its financial sector are sound," the statement said. South Korea's benchmark stock index has fallen 38 percent in 2008, while the country's currency, the won, has declined almost 30 percent this year against the dollar.

Sweden guarantees $200 billion in bank loans to revive financial system
October 20, 2008

Sweden pledged on Monday as much as 1.5 trillion kronor to guarantee bank loans and created a fund that may buy shares in banks as it looks to revive lending in the financial system. The guarantee for the equivalent of $205 billion will cover "more or less all types of bonds, bank certificates and other loan obligations" with an original maturity of between 90 days and five years, the Finance Minister Anders Borg and Mats Odell, Sweden's financial markets minister, said in Stockholm. The U.S., the UK and the European Central Bank have made similar moves in the past two weeks to shore up banks and avoid financial gridlock. The policies have worked, with interbank interest rates now on their way back down. Libor for three-month loans in dollars fell 8 basis points to 4.42 percent on Oct. 17, capping the first weekly decline since July. "These measures will improve the liquidity situation," said Henrik Mitelman, chief strategist at Skandinaviska Enskilda banken in Stockholm. "It's a very ambitious program and includes a wider range of securities than the European program." Interbank lending had evaporated after Lehman Brothers Holdings filed for bankruptcy on Sept. 15, shattering confidence and sending corporate borrowing costs to record levels. Sweden's overnight interbank lending rate, or Stibor, reached a high of 6.475 percent on Oct. 6, before dropping back to 4.45 percent today, compared with the benchmark repo rate o 4.25 percent. Banks that get access to loans through the program will have to agree to restrictions on salary and bonus increases, the government said. Funds will initially be available until April 30 next year. The government also said it won't guarantee "complex and structured products." Under the plan, the government set aside 15 billion kronor in a stability fund to buy shares in banks if they are at risk of default and are "important to the broad financial system." The fund would buy preference shares with "strong voting rights." All financial institutions will have to pay a special stability fee once the market situation has improved, the government said. It will seek parliament's permission to become the owner of financial firms by force if needed. The government raised the guarantee on bank deposits to 500,000 kronor from 250,000 kronor on Oct. 6 to ease concern about the stability of the financial system. That is financed by an existing bank deposit guarantee fund which has 18 billion kronor. The government will also guarantee deposits at foreign banks with clients in Sweden if their respective governments are unable to do so, and widened the types of accounts covered. Sweden's central bank has said it will lend as much as 5 billion kronor to the Swedish unit of Kaupthing Bank, the largest bank in Iceland, after the subsidiary failed to meet payment obligations and was put up for sale.

In Good Times and Bad
October 20, 2008

A dozen years ago, James Grant -- one of the wisest commentators on Wall Street; wrote a book called "The Trouble With Prosperity." Grant's survey of financial history captured his crusty theory of economic predestination. If things seem splendid, they will get worse. Success inspires overconfidence and excess. If things seem dismal, they will get better. Crisis spawns opportunities and progress. Our triumphs and follies follow a rhythm that, though it can be influenced, cannot be repealed.

Good times breed bad, and vice versa. Bear that in mind. It provides context for today's turmoil and recriminations. The recent astounding events -- the government's takeover of Fannie Mae and Freddie Mac, the Treasury's investments in private banks, the stock market's wild swings -- have thrust us into fierce debate. Has enough been done to protect the economy? Who or what caused this mess? We Americans want instant solutions to problems. We crave a world of crisp moral certitudes, but the real world is awash with murky ambiguities. So it is now. Start with the immediate question: Has enough been done? Well, enough for what? If the goal is to prevent a calamitous collapse of bank lending, the answer is probably yes. Last week, the government guaranteed most interbank loans (loans among banks) and pressured nine major banks to accept $125 billion of added capital from the Treasury. Together, these steps make it easier for banks to borrow and lend. There's less need to hoard cash. But if the goal is to inoculate us against recession and more financial turmoil, the answer is no. We're probably already in recession. In September, retail sales dropped 1.2 percent. The housing collapse, higher oil prices (now receding), job losses and sagging stocks have battered confidence. Consumer spending may have dropped in the third quarter for the first time since 1991. Loans are harder to get because lax lending standards have been tightened. Unemployment, now 6.1 percent, may reach 7.5 percent or higher by the end of next year. Similar qualifications apply to financial perils. "The United States has an enormous financial system outside the banks," says economist Raghuram Rajan of the University of Chicago. Consider hedge funds. They manage perhaps $2 trillion and rely heavily on borrowed money. They've suffered heavy redemptions ($43 billion in September, reports the Financial Times). Selling pressures could destabilize the markets. There's also a global spillover. Brazil's stock market has lost about half its value since the spring. In this fluid situation, one thing is predictable: The crisis will produce a cottage industry of academics, journalists, pundits, politicians and bloggers to assess blame. Is former Fed chairman Alan Greenspan responsible for holding interest rates too low and for not imposing tougher regulations on mortgage lending? Would Clinton Treasury Secretary Robert Rubin have spotted the crisis sooner? Did Republican free-market ideologues leave greedy Wall Street types too unregulated? Some stories are make-believe. After leaving government, Rubin landed at Citigroup as a top executive. He failed to identify toxic mortgage securities as a big problem in the bank's own portfolio. It's implausible to think he'd have done so in Washington. As recent investigative stories in the New York Times and The Post show, the Clinton administration broadly supported the financial deregulation that Democrats are now so loudly denouncing. Greenspan is a harder case. His resistance to tougher regulation of mortgage lending is legitimately criticized, but the story of his low-interest-rate policies is more complicated. True, the overnight Fed funds rate dropped to 1 percent in 2003 to offset the effects of the burst tech bubble and the Sept. 11 attacks. Still, the Fed started raising rates in mid-2004. Unfortunately and surprisingly, long-term interest rates on mortgages (which are set by the market) didn't follow. That undercut the Fed and is often attributed to a surge of cheap capital from China and other Asian countries. There's a broader lesson. When things go well, everyone wants on the bandwagon. Skeptics are regarded as fools. It's hard for government -- or anyone -- to say: "Whoa, cowboys; this won't last." As the housing boom strengthened, existing home prices rose 50 percent from 2000 to 2006. Investment bankers packaged dubious loans in opaque securities. To their eventual regret, bankers kept many bad loans. Almost everyone assumed that home prices would rise forever, so risks were considered minimal. Congress allowed Fannie and Freddie to operate with meager capital. Congress also increased the share of their mortgages that had to go to low- and moderate-income buyers, from 40 percent in 1996 to 52 percent in 2005. This promoted subprime mortgage lending.

So Grant's thesis is confirmed. We go through cycles of self-delusion, sometimes too giddy and sometimes too glum. The consolation is that the genesis of the next recovery usually lies in the ruins of the last recession.

Bretton Woods, The Sequel?
Washington Post- October 20, 2008

The financial crisis is by no means over, but the urge to extract lessons from it already is irresistible. The Europeans have pressed successfully for a new Bretton Woods summit, modeled after the 1944 gathering that inoculated the world against a repeat of the Great Depression. Although the original Bretton Woods took place years after the Depression, Britain and France are bent on staging the new version within weeks. "Europe wants it. Europe demands it. Europe will get it," French President Nicolas Sarkozy said before jetting off to Camp David, where President Bush meekly gave in to him. The Bretton Woods analogy is contrived, to put it mildly. That summit created the World Bank to reconstruct Europe after the ravages of World War II. Today, bombed-out infrastructure is hardly the issue. Bretton Woods also created the International Monetary Fund, to support a system of fixed exchange rates. But the world has largely abandoned that system, and today's chief exchange-rate challenge is to move even further from Bretton Woods by persuading China to float its currency. Bretton Woods boosters assert that a global financial system needs global regulatory fixes. This claim deserves scrutiny. The fix that rightly commands widest support is moving the swap contracts between financial institutions onto centralized exchanges, so the collapse of one large player does not threaten others that entered into swaps with it. But this reform can be achieved with a minimum of international coordination. Countries can unilaterally establish swaps exchanges, and financial institutions all over the world can use them. The second fix on most reformers' lists is to shrink the pyramids of debt in the financial system. When a bank or a hedge fund buys $100 million of assets with $5 million in capital and $95 million in debt, a 5 percent loss is enough to wipe it out, forcing liquidation of the remaining $95 million worth of stocks or bonds in its portfolio. Such fire-sale liquidation has driven part of the recent market turmoil; it forces prices down and damages other debt-laden players, which then join in the selling. Although such debt, or "leverage," is certainly dangerous, a new Bretton Woods summit is not going to tame it. We know this because we've tried already. It took five years, not a handful of photo-op summits, to negotiate the so-called Basel II standards that govern leverage at banks, and the resulting deal proved ineffectual anyway. Daniel Tarullo, who has just published a Peterson Institute book on Basel, points out that the next attempt to control leverage may need to be broader. After the events of recent months, that is surely right. Given AIG's failure, the next round should probably encompass insurers. Given the vast growth of hedge funds, it should also cover some of them. Creating sensible leverage rules for such disparate institutions will be fiendishly complex, perhaps even impossible. So what might a new Bretton Woods conference usefully do? Well, it could reform the IMF, which has evolved from its original role into a rescue fund for collapsing currencies. During the emerging market crises of a decade ago, the IMF was central to all the bailouts. Its status has since dwindled. As my Council on Foreign Relations colleague Brad Setser notes, the Chinese have tried to muscle in on the IMF's turf by helping Pakistan. The Russians have tried to help Iceland. The European Union has helped Hungary. Reestablishing the IMF as the agreed provider of bailouts would be a worthwhile project. The IMF puts economic conditions on its loans while governments place political ones; we don't want to revive the cronyism of the Cold War, when countries from Cuba to Zaire could pursue absurd policies and know they would be bailed out because they were strategically useful. The irony is that Britain and France will be the first to resist a serious effort to revive the IMF. British Prime Minister Gordon Brown talks vacuously about giving the organization the role of creating an early-warning system for crises, even though this is what thousands of economic forecasters already try to provide. What Brown does not stress is that serious IMF reform needs to begin with the modernization of its board. Rising

powers such as China and India deserve more say. Declining powers need to give up some influence -- and that includes France and Britain. Of course there is a role for global cooperation. The coordinated interest rate cuts and bank rescues of recent days have been constructive. But it's worth remembering that after the last global crisis, in 1997-98, there was lots of grand talk about a new international financial architecture. In the end, the only important reforms were national ones. Governments ran budget surpluses and built up foreign reserves to protect themselves from the next shock. That shock has arrived, and we are about to find out if those changes were enough. One thing is certain: They were not the result of any international conference.

Banks Interested in Deal, Paulson Says
October 21, 2008

The federal proposal to invest $250 billion in financial institutions has drawn ''interest from a broad group of banks of all sizes,'' Treasury Secretary Henry M. Paulson Jr. said yesterday. His comments at a Treasury Department news briefing came after community bank executives around the country expressed dismay last week about the emergency program, saying they were not interested in the government's money and resented the intrusion. Treasury officials emphasized yesterday that they have allocated enough money to cover every eligible institution. The amount of federal money a bank may receive under the program is limited to 3 percent of the institution's "risk-weighted" assets, a measure of the bank's holdings. The next major challenge for the program is deciding which banks will be allowed to participate. Treasury has said repeatedly that it only wants to invest in ''healthy'' banks that are well-positioned to use the federal money to issue new loans. It does not want to invest in troubled banks that will only use the money for internal purposes. ''While many banks have suffered significant losses during this period of market turmoil, many others have plenty of capital to get through this period, but are not positioned to lend as widely as is necessary to support the economy,'' Paulson said. ''This program is designed to attract broad participation by healthy institutions.'' Treasury officials also said they did not foresee the multi-billion dollar program costing the U.S. government any money. ''This is an investment, not expenditure, and there is no reason to expect this program will cost taxpayers anything,'' Paulson said. In creating the program, Treasury officials grappled with the problem of how to make it attractive enough to get banks to participate, yet lean enough to protect taxpayers' dollars. The deal the government is proposing for banks is essentially this: In exchange for the government investment, the participating banks will offer the government preferred shares, which will pay 5 percent annually for the first five years. This interest rate is significantly lower than the prevailing rate of 8 to 10 percent for similar deals, Treasury officials said. Each participating bank will also give the government the right to buy common shares later. And the proposed deal requires participating institutions to impose limits on executive pay, although a senior federal regulator today said, ''I think you'll find that the constraints on the preferred shares are not really constraints.'' ''I think there is enormous incentive [for the banks to participate],'' said a senior Treasury official, who was not authorized by the department to be quoted by name. "There are good lending opportunities.''

While critics have charged that the investments mean the government will rescue any of the banks it has invested in, potentially costing the government more money and creating a "moral hazard," officials rejected the idea that these banks will automatically be protected against failure. ''I don't think an investment says anything about whether a bank will be allowed to fail,'' a senior Treasury official said.

3 Agencies Vie for Oversight of Swaps Market
October 21, 2008

The government is moving forward with its first significant effort to bring oversight to a vast, unregulated corner of Wall Street that has severely exacerbated the financial crisis. But a turf war is brewing among three leading federal agencies that have contrasting visions for how the $55 trillion market for speculative financial instruments known as credit-default swaps should be regulated. While the credit crisis has upended global financial markets and given a lift to advocates of heightened regulation, it has not resolved traditional disputes in Washington over how deeply the government should be involved in free markets. Some regulators say the market can operate largely on its own but simply needs more transparency. Others say that the credit crisis has exposed wide gaps in oversight that require a much more direct role by the government. The battle has mobilized the financial industry and lawmakers who are holding a hearing today on market regulation. Some industry players are lobbying sympathetic members of Congress for light oversight. Powerful financial firms, eyeing new fees, are campaigning to play a major role in running the market for swaps, which originated as a form of insurance against bond defaults but grew into a wildly popular vehicle for speculation. Last month, insurance giant American International Group nearly collapsed partly because it had issued $440 billion in swaps to traders around the world and was not going to be able to cover many of the promises it had made to cover defaults on debt. Government officials realized that swaps could pose a threat to the global financial system. AIG was kept alive by a $85 billion loan from the Federal Reserve, which grew a few weeks later to about $123 billion, the Fed's largest bailout ever for a single firm. "If there's a sense that another AIG could happen and a whole swath of financial institutions could be jeopardized, then the efforts to restore confidence are really undermined," said Henry Hu, a law professor at the University of Texas. "Without that confidence, there's no free flow of credit, and without the free flow of credit, there's a risk to the real economy." Regulators have much at stake as well. The focus in Washington on swaps presents an opportunity for the Securities and Exchange Commission to restore its reputation as an active supervisor of the markets after being criticized as lax during the early stages of the financial crisis, analysts said. The agency is considering regulating swaps with some of the same scrutiny it does for stocks and bonds. That could put it at odds with the Commodity Futures Trading Commission, which could inherit some oversight responsibilities under one industry proposal for establishing a new means of settling swap contracts. The commission's acting chairman told lawmakers at a hearing last week that current law exempts swaps from regulation and that "wholesale regulatory reform will require careful consideration." Meanwhile, the Federal Reserve Bank of New York is proceeding with its own plans to set up a private-sector process under its jurisdiction for settling swap contracts. The goal is to bring some transparency and stability to the market. The fate of the credit-default swap market will largely rest on how Congress defines these contracts in law.

The credit crisis has revealed how risky these swaps are without government oversight, said Rep. Barney Frank (D-Mass.), chairman of the House Financial Services Committee, which is holding a hearing on financial regulation today. "I understand why my Republican colleagues do not want to examine our failure to regulate credit default swaps [and other derivatives] and the other fruits of their deregulatory push," Frank said in a recent statement. "The results of that effort are now in -- a crisis that is sweeping the global economy and threatening tens of millions of working families." Originally, swaps acted like insurance policies for bond investors in case a company collapsed and could not pay back buyers of its bonds. To protect themselves against such defaults, bond investors could agree to pay a periodic fee to have another party cover the losses. Unlike stocks and bonds, credit-default swaps fell outside the government's purview largely because they are private contracts. A law backed by leading Republicans and passed by Congress in 2000 specifically exempted swaps from oversight by the SEC and CFTC, which oversees commodity trading. Since then, big hedge funds and other traders discovered that swaps could be traded and used to speculate on how close a company was to collapse. The market mushroomed. Its total value outgrew that of all publicly traded stocks combined. The swaps market began to affect the financial system in once unimagined ways. The SEC grew concerned that traders were using swaps to manipulate stock prices. In recent weeks, dramatic surges in swap contract prices to protect against a default by Morgan Stanley and other banks helped drive down their stocks. Industry officials, however, warned of the dangers of over-regulation and said swaps were not to blame for the crisis. "I think the clear effect is if further regulatory burdens are put on these instruments, people would look to trade them elsewhere around the world," said Robert Pickel, chief executive of the International Swaps and Derivatives Association. He said lawmakers were blaming swaps for the financial crisis just because they're complex. "But when you probe and further understand what's going on in the markets, especially in regard to imprudent lending, you'll see that those dots cannot be connected," he said. Lawmakers are divided on what should be done. Some want traders to meet strict capital requirements, referring to how much money an investor can borrow to buy a swaps contract. Others want to put all derivatives -- even those invented in the future -- under the oversight of the SEC, which could force traders to disclose detailed information to regulators on their activities. Still others are opposed to any additional regulation at all. In a hearing last week, Sen. Michael D. Crapo (R-Idaho), who sits on the Senate Agriculture Committee, said that it was important to make "sure that we allow capital to move freely and efficiently in a market system," but also that the government must protect against "inappropriate manipulation of markets." The House and Senate agriculture committees have oversight of the CTFC because of its history regulating farming commodities. There is also disagreement over who should be in charge. Members of the House Agriculture Committee said they would like the CFTC to watch the market. But Sen. Maria Cantwell (D-Wash.) said the CFTC is too close to private industry players. The CFTC "is just looking over the cliff that the American economy is falling into and saying: 'Let's just have self-policing.' It's absurd," she said, adding that she would prefer the SEC to have the job. "We are in this mess because the oversight agencies didn't do this job." Meanwhile, the New York Fed has been meeting with private companies to set up a private clearinghouse for swap trades that could be in operation by the end of the year.

The clearinghouse, for a fee, would act as an intermediary that would guarantee transactions between swaps traders. In order to make those guarantees, the clearinghouse would require traders to maintain a sufficient amount of capital in their accounts. That would make it difficult to trade swaps without having the resources to cover a contract should a default happen. One of the firms working closely with the New York Fed is the IntercontinentalExchange, or ICE, which plans to set up a clearinghouse in New York under the Fed's authority. ICE was established by some of the country's biggest banks, including Goldman Sachs and Morgan Stanley. Another firm, CME Group, is vying to set up a clearinghouse, which would be part of the operation the company now runs for trading commodities with CFTC oversight. The Fed could back one or both of the plans, according to industry and government officials familiar with them. If, instead, the SEC were granted new powers by Congress to oversee swaps, the agency could set up several exchanges, similar to the way stocks are traded on the New York Stock Exchange and Nasdaq. "I do think the SEC needs to work vigorously to work to reclaim some of its lost ground. Moving forward on credit derivatives and credit-default swaps is a legitimate area for them to start rattling their sabers a little bit," said James D. Cox, a law professor at Duke University.

U.S. Treasury to favor new bank mergers
October 21, 2008

In a step that could accelerate a shakeout of U.S. banks, the Treasury Department hopes to spur a new round of mergers by steering some of the money in its $250 billion rescue package to banks that are willing to buy weaker rivals, according to government officials. As the Treasury embarks on its unprecedented recapitalization, it is becoming clear that the government wants not only to stabilize the industry, but also to reshape it. Two senior officials said the selection criteria would include banks that need more capital to finance acquisitions. "Treasury doesn't want to prop up weak banks," said an official who spoke on condition of anonymity, because of the sensitivity of the matter. "One purpose of this plan is to drive consolidation." With bankers traumatized by the credit crisis and the loss of investor confidence, officials said, there are plenty of banks open to selling themselves. The hurdle is a lack of well-capitalized buyers. Stable national players like Bank of America, JPMorgan Chase, and Wells Fargo are already digesting acquisitions. A second group of so-called super-regional banks are well positioned to take over their competitors, officials said, but have been reluctant to undertake or unable to complete deals. By offering capital at a favorable rate, the government may encourage them to expand. In this category, industry analysts point to regional leaders, like KeyCorp of Cleveland; Fifth Third Bancorp of Cincinnati; BB&T of Winston-Salem, North Carolina; and SunTrust Banks of Atlanta. With $125 billion left over after investing in the nine largest banks, the Treasury secretary, Henry Paulson Jr., said there was enough capital to invest in every qualified bank. "We have received indications of interest from a broad group of banks of all sizes," he said at a news conference. "This program is not being implemented on a first-come, first-served basis."

Paulson did not address the issue of bank mergers in his remarks, but officials say it has been widely discussed within the Treasury, the Federal Reserve and the Federal Deposit Insurance Corp., which has been burdened in recent months by having to support teetering banks like Wachovia. Providing capital to help facilitate a merger, officials say, is also a way to track how the capital is used. Some analysts have questioned how much control the government can exert over its investment, when it is injected into banks in return for nonvoting preferred shares. "We think there will be pressure behind the scenes by Treasury to push together companies that should have merged months or years ago," said Gerard Cassidy, a banking analyst at RBC Capital Markets in Portland, Maine. "If you can create stronger companies, that is a positive." In selecting banks, Paulson said the Treasury would also rely on advice from the quartet of regulators who oversee the banking industry: the Fed, the FDIC, the comptroller of the currency and the Office of Thrift Supervision. But Paulson made clear that the final decision of who gets U.S. government money rests with the Treasury. And he reiterated that the government expected the banks that got money to lend it out rather than hoard it — putting in a special plea for homeowners with troubled mortgages. "We expect all participating banks to continue to strengthen their efforts to help struggling homeowners," he said. "Foreclosures not only hurt the families who lose their homes, they hurt neighborhoods, communities and our economy as a whole." The Treasury's bank rescue comes amid a rising clamor in Washington that the government should focus on helping mortgage holders directly. But officials say it is unlikely that the Bush administration will present a new plan for homeowners between now and the election. "There's no inexpensive, easy way to address the terms of people's mortgages," said Robert Shapiro, an economic consultant who is chairman of the globalization initiative of NDN, a left-leaning research group in Washington. "I think that's why they haven't addressed it." Most likely, he said, the campaigns of Senator John McCain and Senator Barack Obama will hone their own proposals. Then, if Congress reconvenes after the election in a lame-duck session, the new president-elect will try to push through a bill with new measures. Under the terms of the $700 billion rescue plan approved by Congress early this month, the Treasury has authority to purchase whole mortgages. Treasury officials also note that Paulson has pressed banks and loan servicers to show flexibility in modifying loans to avoid foreclosures. Still, Treasury's recent efforts have been almost wholly focused on stabilizing the banks — first by proposing to buy distressed assets from the banks, and later by injecting capital directly into them. There were some signs in the credit markets Monday that those efforts were paying off. On Monday, Paulson described a process for banks to apply for government investments that is little more complicated than the one-page term sheet he handed to the chief executives of the nation's nine largest banks at a meeting last week at the Treasury Department. The institutions, he said, must fill out a standardized two-page form and submit it to their primary regulator by Nov. 14. The Treasury will receive the applications, with a recommendation, from the regulator. Once it decides whether to inject capital, it will announce its investment within 48 hours. It will not disclose banks that withdraw or are turned down. The Treasury's program is open to large and small banks, as well as thrifts. Officials said they had received inquiries from other financial institutions, including insurance companies, but the plan did not provide for them.

Given the potential weakness of insurers, some analysts said the government should consider expanding the eligibility for capital injections. These analysts said $250 billion would not be enough. "They should see themselves as having $700 billion to recapitalize the industry in creative ways," said Simon Johnson, a former chief economist at the International Monetary Fund. While the Treasury's offer of capital is attractive, analysts cautioned that cash alone might not be enough to reshape the industry. Recent deals, they note, have featured distressed banks sold at fire-sale prices. "There are a lot of obstacles to mergers in the banking industry," Cassidy of RBC Capital Markets said. "I don't know how the government could persuade banks to do deals at below book value."

A bailout without dividends
By David S. Scharfstein and Jeremy C. Stein October 21, 2008

On Oct. 13, the chief executives of nine large American banks were called to a meeting at the Treasury Department. At the meeting, Secretary Henry Paulson offered them $125 billion from the federal government in exchange for shares of preferred stock. The chief executives accepted his terms. In some accounts of the meeting, Paulson is described as playing the role of the Godfather, making the banks an offer they could not refuse. But in one important respect, he was more Santa Claus than Vito Corleone: The agreement allowed the banks to continue paying dividends to common shareholders. Although there are many things to like about the government's plan, the failure to suspend dividends is not one of them. These dividends, if they are paid at current levels, will redirect more than $25 billion of the $125 billion to shareholders in the next year alone. Taxpayers have been told that their money is required because of an urgent need to rebuild bank capital, yet a significant fraction of this money will wind up in shareholders' pockets - and thus be unavailable to plug the large capital hole on the banks' balance sheets. Moreover, given their own equity stakes, the officers and directors of the nine banks will be among the leading beneficiaries of the dividend payout. We estimate that their personal take of the dividends will amount to approximately $250 million in the first year. Bank executives may argue that it is necessary for them to maintain dividend payments to support their stock prices and to make further capital-raising possible. This argument is dubious. In recent years, the fraction of American public companies that pay dividends has fallen drastically, to a level of around 20 percent. The ranks of the companies that do not pay dividends include some of the most profitable and (until recently) bestperforming market darlings, like Google. These companies have come to recognize what finance academics have been preaching for decades: for financially healthy firms, there is no particular imperative to pay dividends every quarter, because retained cash can always be paid out to shareholders later, or used to repurchase stock. So why would the banks want to maintain large dividend payouts when they've had such a hard time borrowing, are starved of cash, and the credit markets believe that they run a significant risk of defaulting? Shouldn't these distressed banks be marshalling all of the financial resources available to them to ensure their viability? Although dividends should be a matter of near indifference to shareholders of healthy companies, when companies are financially distressed there is a conflict of interest between shareholders and bondholders that leads shareholders to prefer immediate payouts.

Here's why: Each dollar paid out as a dividend today is a dollar that cannot be seized by creditors in the event of bankruptcy. For a distressed company, dividends are not in the interest of the enterprise as a whole (shareholders and lenders taken together), but only in the interest of shareholders. They are an attempt by shareholders to beat creditors out the door. The government should close the door by putting an immediate stop to the dividend payouts of any banks receiving direct federal support. The purpose is not just to be fair or to avoid unsavory appearances, but to improve the health of the banks and the economy. There is ample precedent for such a move by the government. When Chrysler was bailed out with government loan guarantees in 1979, the legislation explicitly prohibited Chrysler from making any dividend payments. All dividends on its common shares were suspended from 1980 to 1983. If the government is unwilling to take this step, then the boards of the banks should take it upon themselves to do the right thing. They may even have a legal obligation to do so, because courts have ruled that directors of financially distressed firms have a fiduciary duty to creditors as well as to shareholders. The creditors of the banks include not just those who have already lent them money, but also American taxpayers who put their money on the line by guaranteeing the banks' debts. From the perspective of this broader set of stakeholders, it is best to end dividend payments until the banks have returned to health.
David S. Scharfstein is a professor of finance at Harvard Business School. Jeremy C. Stein is a professor of economics at Harvard.

Argentina nationalizes $30 billion in private pensions
October 22, 2008

Argentina's government said Tuesday that it would seek to nationalize nearly $30 billion in private pension funds to protect retirees from falling stock and bond prices as the global financial crisis continues. The measure, confirmed in a speech in Buenos Aires late Tuesday by Cristina Fernández de Kirchner, Argentina's president, was criticized by political opponents and analysts as a move to shore up government coffers to try to head off a fiscal crisis in 2009, when Argentina might be struggling to make billions of dollars in debt payments. The announcement sent the Buenos Aires stock market, the Merval, down nearly 11 percent, and led analysts to question whether the nationalization, which is subject to approval by the Argentine legislature, puts property rights at risk and threatens the rule of law in the country. It may be the first time a Latin American government has expropriated cash. The move is expected to give the government breathing room as falling commodity prices drive down tax revenue from agriculture by as much as $6 billion next year, according to some estimates. Commodity prices have fallen as fears of a global slowdown have grown. Argentina's precarious fiscal situation predated the global financial crisis. Argentina is one of the world's top five exporters of beef, soy, corn and wheat, and falling prices for those commodities have diminished the government's main sources of revenue. The country spent much of its windfall during this decade's commodity boom paying off debts and subsidizing fuel and other consumer items to stimulate rapid growth.

Now it may face a struggle to pay some $22.4 billion in debt obligations and other payments due next year, Daniel Kerner, an analyst with Eurasia Group, a risk consulting firm, said. So far, other governments in South America, including Brazil's and Chile's, have said they will tap Central Bank reserves or stabilization funds amassed during the commodity boom to help important export industries withstand the global credit crisis. Kirchner characterized Argentina's move as government protectionism in line with bank bailouts in Europe and the United States. "We are making this decision in an international context in which the leading countries in and out of the G-8 are protecting their banks, while we are protecting our retirees and workers," she said in a televised speech. She dismissed criticism that the move was simply a grab for cash, noting that the private pension plan put in place 14 years ago had produced a low rate of return for holders this year. But analysts said the move could hurt Argentina. "This will be a major blow to the country's isolated capital markets, and will probably dampen consumer and investor confidence further," Kerner said. The opposition leader Elisa Carrió, who ran against Kirchner for president, told Radio Mitre on Tuesday that the government was trying to "loot the funds of retirees." According to the plan, all the assets in individual accounts would be transferred to the state's "pay as you go" system, and affiliation to the state system would be mandatory, effectively putting an end to the current dual system. Regional elections are scheduled for October 2009. By taking over the pension funds the government can continue to spend on programs that help it retain political support, which Kirchner lacks after a debilitating fourmonth strike by farmers over export taxes that ultimately ended in defeat for the government. If the move is approved, her government may have secured an important electoral asset, which could help guarantee Kirchner's political survival.

Federal Reserve adds to efforts to aid credit markets
October 21, 2008

Adding to its efforts to unclog the credit markets, the U.S. Federal Reserve said Tuesday that it would provide financing to shore up money market mutual funds, the consumer investments that have traditionally been considered as safe as government-guaranteed bank accounts. Under the program, the Fed will help buy up to $600 billion in short-term debt, including certificates of deposit and commercial paper that expires in three months or less. This type of debt has historically been used by money market funds seeking safe, conservative returns for their clients. But the recent market turmoil caused a prominent fund to fall below $1 a share, an extremely rare occurrence. Since that fund "broke the buck," many money market funds have had trouble selling assets to meet redemption requests. The new program "should improve the liquidity position of money market investors, thus increasing their ability to meet any further redemption requests and their willingness to invest in money market instruments," the Fed said in the statement. "Improved money market conditions will enhance the ability of banks and other financial intermediaries to accommodate the credit needs of businesses and households." It is the third program of this type that the Fed has announced over the past month in its effort to thaw out the frozen flow of credit.

U.S. hires 2 accounting firms The Treasury Department said Tuesday that it had chosen PricewaterhouseCoopers to be the auditor for its $700 billion bank rescue program. Ernst & Young will provide general accounting support, The Associated Press reported from Washington. The two firms will work on the part of the program that is handling the purchase of troubled assets from banks as a way of encouraging them to resume more normal lending. The Treasury said that Ernst & Young would be paid $492,006.95 initially while PricewaterhouseCoopers would be paid $191,469.27 initially. The two contracts last until Sept. 30, 2011.

One day doesn't make a trend
October 21, 2008

The banks aren't lending. And despite what you have heard, they probably won't start just yet. The stock market may be way up on expectations of a credit thaw on Wall Street — and there has already been a minor one — but don't hold your breath on Main Street. The dirty little secret of the government's $250 billion handout to nine banks to get them lending again is this: So far, they have stuffed it under their mattress like the rest of us. Need a mortgage? An auto loan? If you are a business or consumer, it's almost as hard to get a loan this week as it was last. Sure, there are some positive signs that the credit market is opening up a bit: Libor rates, the price at which banks lend to each other, have crept down in recent days, greasing the wheels of capitalism, or at least what's left of it. Some banks, like JPMorgan Chase and Citigroup, actually made loans to banks in Europe on Friday. These are all important steps on the way to a recovery. But make no mistake, the banks are doing the opposite of what Henry Paulson Jr., the Treasury secretary, sought when he virtually demanded that they accept the taxpayers' money: They are hoarding it. It's a bit like the government's sending out tax rebate checks and the consumers' not immediately running out and spending them. "Our purpose is to increase confidence in our banks and increase the confidence of our banks, so that they will deploy, not hoard, their capital," Paulson said in a statement Monday. "And we expect them to do so, as increased confidence will lead to increased lending. This increased lending will benefit the U.S. economy and the American people." Of course, with a $250 billion injection into America's biggest banks — not all of which were troubled — Paulson has a political sales job to do. And no requirements to lend were attached to the money. (Some banks may use the money to buy others.) But Paulson is making a big assumption about confidence, because until the real economy recovers — which could take more than a year — lending to Main Street is unlikely to return rapidly to normal levels. "It doesn't matter how much Hank Paulson gives us," said an influential senior official at a big bank that received money from the government, "no one is going to lend a nickel until the economy turns." The official added: "Who are we going to lend money to?" before repeating an old saw about banking: "Only people who don't need it." Indeed, if there's a reason the stock market went up Monday, it was because Fed chairman Ben Bernanke told Congress he was in favor of a second economic stimulus plan, a tacit acknowledgment that recent efforts to repair the financial system won't be enough to dig the economy out of its rut.

Think about it: troubled companies are still troubled companies. And while banks often stupidly throw money at questionable companies in good times, they shut off the spigot in bad times. On top of all that, the banks may still be in more trouble than they have disclosed. Indeed, the reason many may be holding onto the government's cash is because they expect things to get worse not just for the economy, but for themselves. Roger Bootle and Jonathan Loynes of Capital Economics in London wrote a sobering note on Monday about the cash infusions into European banks that may apply here as well. "We expect rising loan defaults and further asset write-offs over the next couple of years to practically wipe out the governments' capital injections, leaving banks back at square one," they said. "Given that banks will need to increase their capital in order to expand their lending book, these measures on their own are unlikely to prevent bank lending from stagnating." What else can government do? One of the last arrows in its quiver is the controversial idea of reducing the amount of capital banks must hold. That might make the banks more comfortable to lend, but it would put banks on an even less stable footing, and undermines the overall idea of injecting capital into banks in the first place. That is not to say that Paulson's $250 billion package won't be helpful to the economy. It is a smart plan to help to encourage bank lending, which may prevent the economy from spiraling downward even more into a prolonged depression. And it should keep some more banks from going bust, which would have only added fuel to what seemed like an out-of-control fire. But it is not a silver bullet. And the bailout also may be concealing another problem: Because the government gave money to both healthy and unhealthy banks, that may make it harder to tell which ones are in more trouble than the others. That's why banks have been so wary of lending to other banks. Although a key gauge of this psychology, the Libor rate, has improved since governments moved to repair the financial system, some banks are still worried they can't trust their counterparts to pay the loan back. Ken Lewis, the chief executive of Bank of America, in an appearance on "60 Minutes" on Sunday night, said in perhaps one of the most revealing comments of the credit crisis that the reason strong banks like his got $25 billion apiece was to help conceal the weakness of those that have fallen into dire straits. "If you have a bank in that group that really, really needed the capital, you don't want to expose that bank," Lewis said. Still, Lewis says he's bullish that things will eventually turn around, though he thinks we won't see a bottom until at least the first half of next year. And he suggested that banks won't keep money under the mattress forever. "You can make more money lending," he said. At least to people who don't need it.

Struggling to Keep Up as the Crisis Raced On

“I feel like Butch Cassidy and the Sundance Kid. Who are these guys that just keep coming?” — Treasury Secretary Henry Paulson Jr. It was the weekend of Sept. 13, and the moment Treasury Secretary Henry M. Paulson Jr. had feared for months was finally upon him: Lehman Brothers was hurtling toward bankruptcy — fast. Knowing that Lehman had billions of dollars in bad investments on its books, Mr. Paulson had long urged Lehman’s chief executive, Richard S. Fuld Jr., to find a solution for his firm’s problems. “He was asked to aggressively look for a buyer,” Mr. Paulson recalled in an interview.

But Lehman could not — despite what Mr. Paulson described as personal pleas to other firms to buy some of Lehman’s toxic assets and efforts to persuade another bank to acquire Lehman. With all options closed, he said, the government’s hands were tied. Although the Federal Reserve had helped bail out Bear Stearns — and was within days of bailing out the giant insurer American International Group — it could not help Lehman, even as its default threatened to wreak havoc on financial markets. “We didn’t have the powers,” Mr. Paulson insisted, explaining a decision that many have since criticized — to allow Lehman to go bankrupt. By law, he continued, the Federal Reserve could bail out Lehman with a loan only if the bank had enough good assets to serve as collateral, which it did not. “If someone thinks Hank Paulson could have made the Fed save Lehman Brothers, the answer is, ‘No way,’ ” he said. But that is not the way that many who have scrutinized his actions see it. Bankers involved say they do not recall Mr. Paulson talking about Lehman’s impaired collateral. And they said that buyers walked away for one reason: because they could not get the same kind of government backing that facilitated the Bear Stearns deal. In retrospect, they added, it was emblematic of the miscalculations by the government in reacting to the crisis. The day after Lehman collapsed, the Fed saved A.I.G. with an emergency $85 billion loan, but the credit markets around the world began freezing up anyway. It was at this point that Mr. Paulson — feeling outgunned by pursuers, like Butch and Sundance — decided he had to find a systemic solution and stop lurching from crisis to crisis, fixing one company’s problems only to find several more right behind. “Ben said, ‘Will you go to Congress with me?’ ” said Mr. Paulson, referring to the Federal Reserve chairman, Ben S. Bernanke. “I said: ‘Fine, I’m your partner. I’ll go to Congress.’ ” Seeing a Problem Earlier In nearly a century, no Treasury secretary has faced a more difficult financial crisis than that Mr. Paulson is contending with. For months, he and his team have been working around the clock, often seven days a week, trying — in vain — to keep it from deepening. In an hour-long interview with The New York Times, Mr. Paulson defended Treasury’s actions, saying that he and his aides had done everything they could, given the deeprooted problems of financial excess that had built up over the past decade. “I could have seen the subprime problem coming earlier,” he acknowledged in the interview, quickly adding in his own defense, “but I’m not saying I would have done anything differently.” History will be the final judge. But in contrast with Mr. Paulson’s perspective, other government officials and financial executives suggest that Treasury’s epic rescue efforts have evolved as chaotically as the crisis itself. Especially in the past month, as the financial system teetered on the abyss, questions have been raised about the government’s — and Mr. Paulson’s — decisions. Executives on Wall Street and officials in European financial capitals have criticized Mr. Paulson and Mr. Bernanke for allowing Lehman to fail, an event that sent shock waves through the banking system, turning a financial tremor into a tsunami. “For the equilibrium of the world financial system, this was a genuine error,” Christine Lagarde, France’s finance minister, said recently. Frederic Oudea, chief executive of Société Générale, one of France’s biggest banks, called the failure of Lehman “a trigger” for events leading to the global crash. Willem Sels, a credit strategist with Dresdner Kleinwort, said that “it is the clear that when Lehman defaulted, that is the date your money markets freaked out. It is difficult to not find a causal relationship.” In addition, Mr. Paulson and Mr. Bernanke have been criticized for squandering precious time and political capital with their original $700 billion bailout plan, which they presented to Congressional leaders days after the Lehman bankruptcy. The two men sold the plan as a vehicle for purchasing toxic mortgage-backed securities from banks and others.

But even after the House finally passed the bill on Oct. 3, markets remained in turmoil. It was not until Britain and other European countries moved to put capital directly into their banks, and the United States followed their lead that some calm returned. In the interview, Mr. Paulson said that even before the House acted, he had directed his staff to start drawing up a plan for using some of the $700 billion to recapitalize the banking system — something that Congress was never told and that he had publicly opposed. Why? Because in the week before the plan passed Congress, conditions deteriorated significantly, Mr. Paulson said. But many complain the worst of the turmoil might have been avoided if it hadn’t been for Mr. Paulson sticking with an original bailout plan that they viewed as poorly conceived and unworkable. “They were asking the most basic questions,” said one Wall Street executive who spoke to Treasury officials after the bailout bill was passed. “It was clear they hadn’t thought it through.” Senator Charles E. Schumer, Democrat of New York, who had called for an infusion of capital into banks in mid-September, said, “They are so much more on top of this recapitalization plan than they were about the auction plan.” Even as he defended his actions, Mr. Paulson said he was worried that some of the government’s moves could wind up haunting future Treasury secretaries. He pointed in particular to the decision to guarantee all bank deposits and interbank loans, something the United States did to keep pace with similar decisions in Europe. “We had to,” Mr. Paulson said. “Our banks would not have been able to compete.” But the federal guarantees could create “moral hazard” and simply encourage banks to take on dangerous risk, he acknowledged. “This is the last thing I wanted to do,” he said. Summer of Eroding Conditions The subprime mortgage debacle began emerging in the summer of 2007, about a year after Mr. Paulson left his job as head of Goldman Sachs and joined the Bush administration. But the true depth and extent of the losses did not become clear until earlier this year, Mr. Paulson said. “We thought there was a reasonable chance of getting through this,” he recalled. Then came the near failure in March of Bear Stearns, which was rescued in a takeover by JPMorgan Chase only after the Fed agreed to cover $29 billion in losses. That briefly lulled the markets into thinking the worst might be over. But during the summer, conditions deteriorated, and in early September the government was forced to take over Fannie Mae and Freddie Mac, the mortgage finance giants. With increasing speed, other problems emerged, most notably Lehman and A.I.G., which was also burdened with bad mortgage-related investments. Both became the focus of intense meetings the weekend of Sept. 13-14. Mr. Paulson, by then, had become frustrated with what he perceived as Mr. Fuld’s foot-dragging. “Lehman announced bad earnings around the middle of June, and we told Fuld that if he didn’t have a solution by the time he announced his third-quarter earnings, there would be a serious problem,” Mr. Paulson said. “We pressed him to get a buyer.” Here the views of Mr. Paulson and his critics start to diverge, over what transpired in marathon meetings with Wall Street executives at the Federal Reserve Bank of New York that weekend. Lehman officials said they believed the firm had not one but two potential buyers: Bank of America and Barclays, the big British bank. But both had conditions. Bank of America wanted the Fed to make a $65 billion loan to cover any exposure to Lehman’s bad assets, according to one person privy to the discussions who did not want to be identified because of their sensitive nature. Although this was more than double what the Fed had made

available to facilitate the takeover of Bear Stearns by JPMorgan, Bank of America justified the request on the grounds that Lehman was larger. Barclays also wanted a guarantee to protect against losses should Lehman’s business worsen before Barclays could compete its takeover. The government initially was not clear in telling Bank of America and Barclays that no help would be forthcoming, participants said. The New York Fed president, Timothy F. Geithner, in particular, was uncomfortable about drawing a line in the sand against government support for a Lehman takeover. Participants said they were left with the impression from Mr. Paulson and Mr. Geithner that the government might well provide help for a serious buyer, with Mr. Paulson also trying to get Wall Street firms to create a $10 billion fund to absorb some of Lehman’s bad assets. It remains unclear whether a more consistent message would have changed the outcome. But by Saturday, Bank of America, frustrated by the government’s unwillingness to commit to a deal, turned its attention to Merrill Lynch, which agreed to a takeover. Barclays, equally frustrated, walked away on Sunday, said the person with knowledge of the discussions. Mr. Paulson said in the interview that Treasury was not at fault. The $10 billion industry fund had not worked because executives in the room realized that bailing out Lehman would not end the crisis. There were too many other firms that needed help. “I didn’t want to see Lehman go,” Mr. Paulson said. “I understood the consequences better than anybody.” At a White House briefing on Sept. 15, Mr. Paulson shed no tears over Lehman’s failure. “I never once considered it appropriate to put taxpayer money on the line in resolving Lehman Brothers,” he told reporters. In the interview, however, Mr. Paulson said the main issue was whether it was legal. Under the law, the Fed has the authority to lend to any nonbank, but only if the loan is “secured to the satisfaction of the Federal Reserve bank.” When pressed about why it was legal for the Fed to lend billions of dollars to Bear Stearns and A.I.G. but not Lehman Brothers, Mr. Paulson emphasized that Lehman’s bad assets created “a huge hole” on its balance sheet. By contrast, he said, Bear Stearns and A.I.G. had more trustworthy collateral. People close to Lehman, however, say it was never told this by the government. “The Fed and the S.E.C. had their people on site at Lehman during 2008,” said a person in the Lehman camp. “The government saw everything in real time involving Lehman’s liquidity, funding, capital, risk management and marks — and never expressed any concerns about collateral or a hole in the balance sheet.” The aftermath of the Lehman bankruptcy was disastrous. “Lehman was one of the single largest issuers of commercial paper in the world,” said Joshua Rosner, a managing director at Graham Fisher & Company, referring to short-term debt issued by companies to finance day-to-day operations; this market locked up in the wake of Lehman’s failure. “How could you let it go bankrupt and not expect the commercial paper market to be completely crushed?” Why Bear Stearns but not Lehman, wonders Representative Barney Frank. Mr. Frank, Democrat of Massachusetts and chairman of the House Financial Services Committee, has generally been a supporter of Mr. Paulson during the crisis. “If it was the right thing to do, why did they do it only once?” he asked. In response, Mr. Paulson said that only now that the bailout bill has been passed does the government have the authority to intervene in a nonbank failure in cases of firms that lack adequate collateral, like Lehman. A Difficult Sell Lehman’s failure was followed by another strategic misstep by Treasury, critics say. They assert that Mr. Paulson initially pushed the wrong systemic fix: a bailout plan that revolved around buying up toxic securities, rather than putting capital into the banking system, a far more direct way of providing assistance.

Mr. Paulson rejects this view. In the interview, he cited several reasons he and Mr. Bernanke concentrated initially on purchasing distressed assets. First, he said, this plan had been in the works for months and was much further developed. “If we had felt going in that the right way to deal with the problem was to put equity in, we would have taken some time and developed a program,” he said. He also worried that Congress would not be receptive to the idea of Treasury taking an ownership stake in banks: “This is a very complicated and difficult sell. We want to put equity in, but we don’t want to nationalize the banks. And I don’t know how to sell that.” But he doesn’t dispute that he changed direction. Mr. Paulson said that by Oct. 2, as he was departing for a weekend getaway to an island with his family — his first weekend off in nearly two months — he told his staff, “We are going to put capital into banks first.” Although the bailout bill still had not passed, the financial markets had deteriorated. He did not, however, inform Congress of his change of heart, and the House debate revolved almost entirely around the asset-purchase plan. Just 11 days later, Treasury had come up with a plan to inject capital into the banks — which Mr. Paulson sold to the nation’s nine largest financial institutions on Oct. 13. “I can imagine being dinged for some things,” he said, “but not for moving that quickly.” He also defended Treasury’s recapitalization plan against critics who say that he did not extract a high enough price from the banks getting taxpayers’ money. “I could not see the United States doing things like putting in capital on a punitive basis that hurts investors. And we don’t want to run banks.” The Global Extent Asked what he might have done better, Mr. Paulson replied, “I could have made a better case to the public.” He added, “I never felt worse than when the House voted no” on the bailout plan Sept. 26, its initial rejection before ultimately passing the plan. As for Lehman, Mr. Paulson insisted that it was “a symptom and not a cause” of the financial meltdown that took place in recent weeks. The real problem, he contended, is that banks all over the world made wrong-headed loans that have now come back to haunt them. After meeting recently with European central bankers, he said, “the thing that took your breath away was the extent of the problem. Look at country after country that said they didn’t have a problem, and it turned out they had a huge problem.” Mr. Paulson added, “Ten years from now no one is going to say that this crisis was brought about because Lehman Brothers went down.”

Derivatives and Mass Financial Destruction
Complex financial products can be useful if regulated properly.
By Darrell Duffie October 22, 2008

Proposals for a makeover of the financial system include reform of the credit derivatives market, which offers over $50 trillion of default insurance coverage. Do investors need that much insurance, or is this mainly a dangerous casino operating under the radar of regulators -- until a major financial institution like AIG needs a bailout? What sort of reform is needed? The seller of protection in a credit derivatives contract receives premiums from the buyer of protection until maturity, or until default of the named borrower. Contracts are negotiated over the counter, not on an exchange, so it is difficult to know how much insurance exists on each borrower, or to know who has insured whom, and for how much.

That privacy is not unusual in the normal course of business contracts. What is unusual is the size of the potential claims. There is a public interest in knowing that systemically important sellers of protection have not overdone it. If a large bank or insurance company does not have enough capital to cover settlement claims, then its failure, or the threat of it, can cause mayhem, as we have just seen. The largest credit derivatives positions are held by big-bank credit derivatives dealers. Because they intermediate between buyers and sellers, dealers often have nearly offsetting positions. For example, according to J.P. Morgan's latest quarterly report, it had bought protection coverage on $5.2 trillion of debt principal, and sold protection on $5 trillion. The vast quantity of outstanding derivatives in the global market is therefore not a good gauge of the effective amount of insurance offered. Of the $532 trillion notional amount of financial instruments covered by over-the-counter derivatives in June of this year -- including credit derivatives, interest-rate swaps and equity derivatives -- the International Swaps and Derivatives Association estimates potential exposures to counterparties of $2.7 trillion. These exposures are further reduced by collateral held against the potential failure of counterparties. Of roughly $350 billion in credit derivative settlement claims that arose in Lehman's default, about $6 billion in actual settlement payments were scheduled for payment yesterday, after canceling offsetting claims. For illustration, suppose that Goldman Sachs had sold protection to the point that it owed $7 billion in Lehman settlement claims, and had purchased protection on which it was owed $7.5 billion. In this situation, Goldman would collect a net of $0.5 billion, unless a counterparty fails to pay. Suppose that one of Goldman's counterparties, say a hedge fund, had failed to pay Goldman a $100 million settlement claim. If Goldman had received the industry-average 65% collateralization from its counterparty, it would keep the collateral and be out $35 million. Goldman could then pursue additional recoveries as a claimant in the hedge fund's bankruptcy. The Depository Trust & Clearing Corporation, which keeps records of the majority of credit derivatives trades and settlements, reported yesterday that there were no payment failures on scheduled Lehman credit derivative settlements. So far, the credit derivatives settlement process has worked smoothly through several large defaults, but the safety of the settlement process could be improved significantly. Because dealers lay off such large positions with each other, a large fraction of their exposures is unnecessary. For example, suppose that Bank A is exposed to Bank B for $1 billion, while B is exposed to C for $1 billion, and C is exposed to A for $1 billion, all on the same underlying named borrower. That circle of exposures is eliminated if all three banks clear their positions with the same central clearing counterparty. Because Bank A is long and short by the same amount, it would have no settlement payment to make or to receive from the clearing counterparty. Banks B and C would likewise have no potential loss. In practice, exposures would not be offset so neatly, but a large fraction of them would. The Fed is pressing dealers to quickly establish clearing in credit derivatives. The dealers have expressed an interest in using their own clearing counterparty, the Chicago Clearing Corporation. Alternatively, they could clear credit derivatives with a new joint venture of the Chicago Mercantile Exchange and Citadel (a large hedge fund). Either way, regulators should ensure that a clearing counterparty is extremely well capitalized and has strong operational controls. Unfortunately, the urgency to set up clearing for credit derivatives may lead us to miss the opportunity to reduce exposures even further by clearing credit derivatives along with other forms of over-the-counter derivatives, such as interest-rate swaps and equity derivatives, which represent similarly large amounts of risk transfer. Regulators should press dealers to clear more types of derivatives with the same clearing house. That investors can benefit from a market for insurance against default risk does not seem controversial. The market premiums offered on credit derivatives also provide investors with "price discovery" of the financial health of corporations and sovereign states. (Although trading is private, samples of prices are disseminated by financial news services.)

There is a public interest in limiting the exposure of large, systemically important financial institutions, relative to their capital, whether from derivatives or from other forms of risk taking. We were supposed to have had such limits, but they were not effective, and will presumably be revisited by regulators soon. Regulators should also have access to more detailed information on the potential exposures of large financial players to each other. But general public disclosure of specific derivatives trades seems unnecessary in most cases, can lower incentives to invest efficiently, and runs counter to our norms for privacy. We do nothing like this in other financial markets, such as those for common stocks, except when positions are large enough to suggest the potential control of public corporations. (Derivatives do not carry control rights.) Public disclosure can nevertheless be a good disinfectant whenever sufficiently severe conflicts of interest lead to inefficient control of risk (moral hazard) or to unfair exploitation of counterparties. If a lender can largely insure itself against its borrower's default, it has lessened its interest in the financial health of the borrower, and may neglect to monitor the borrower. Default losses to the lender would be passed on to credit derivatives counterparties, who may not be aware of the conflict of interest. When unconstrained by good regulations, derivatives can be financial weapons of mass destruction. Our new regulations should be smart and surgical.
Mr. Duffie is a professor of finance at Stanford University's Graduate School of Business.

The Four Horsemen of Subprime Stupidity
Given the sums of money involved, it is no wonder that the multiple financial companies now facing financial collapse would like us to believe that their businesses are complex and special. They would have you believe that real rocket scientists diligently performing mathematical prestidigitation on trading floors where transactions unfold in split seconds are responsible for the current subprime crisis. At their bidding, ‘smart policy economists’ (an oxymora) are being used to provide learned explanations on their concerns about the opacity of pricing of these distressed financial products, and educating the public about the difference between mere risk and “Knightian uncertainty.” Yet the business mistakes of the major banks and investment houses in recent months really have little to do with the complexities of their products. Just as high-tech firms’ relative fortunes depend less upon the intricacies of airframe assembly and genetic engineering than upon strategic, marketing, and production decisions, the fault here is with basic risk management failures. Despite the pleas emanating from financial institution boardrooms across the land, public policy should not be guided astray into excessive restraint in the fundamentally necessary dispensing haircuts or in punishing the frauds that have occurred as a result of this effort at ‘distraction by financial complexity’. The major financial intermediaries in trouble all made some combination of four bad basic strategic and risk management calls. First, they blew their inventory management. There is a high correlation between the degree of trouble in which these firms find themselves, and the extent to which they kept on their books securitized assets in hopes of capital gains rather than selling them off. This kind of warehousing—practiced egregiously by Freddie Mac and Fannie Mae in direct exploitation of their implicit government guarantees—is no different than that of the grain broker or Beanie Babies distributor who gambles that the future price of their products will be higher than the price currently available in the markets. So the banks got caught short when that wager fell through and they did not rely solely on income from fees and markups on repackaging their inputs. Whatever the perceived difficulties of pricing their products, supervisory measures to force institutions with deposit guarantees and discount window access to provision for assets on their balance sheets are not rocket science. They just have to be enforced. Shades of the S&L crisis of the 1980’s when mortgage lenders looked more to their position as property investors cum home developer and seller than their regulated role as a straight mortgage lending. The lesson here is not to allow this to be turned into a brief against securitization itself. Current proposals to force intermediaries to retain some capital stake in their products when sold go exactly the wrong way. The

proper course of action would be to force these financial firms (and especially the agencies) to be intermediaries warehousing as little of their inventory as possible, getting securities off of their balance sheets as quickly as possible. A more regular, transparent and open sale of mortgage-backed securities would result in a more balance system of regular pricing adjustments for these securities and realign the risk profile of the lending institutions. The second major error was offering specialized products too tailored for specific customers. Every relationship business has to decide how much to specialize for clients versus how much to offer off-the-shelf; there is nothing special about financial services having to make this call either. On the popular MTV show “Pimp My Ride,” if the garage tricks out an NBA star’s ride to create a lime-green convertible Hummer with a rotating basketball on the hood and a Fresca dispenser in the back seat, and the prospective purchaser gets cut from the team before delivery, no one at the garage expects to be able to sell that car to someone else. The value is zero plus any spare parts upon disassembly. The same is true for financial firms if they sell a derivative on the weekly volatility of acid rainfall on soybeans longer than three centimeters in western Kansas--if Archer Daniels Midland decides not to buy it, the value is zero or something pretty close. These financial firms just have to grow up and realize that they made a marketing mistake by tailoring products too narrowly, and they have to return to some greater mass production or at least products with more than one potential purchaser. The regulators should be making these banks write down the products quickly at zero value, and then do the necessary recapitalization (plenty of foreign investors are available, as the United States told the Japanese in the 1990s). One cannot simultaneously express fear of a fire sale and state that there is illiquidity because these products have only one or two buyers. If there’s no substitutability, then there should be little price effect on more broadly marketable products by writing off these distressed assets Third, the banks and mortgage lenders did not live up to reasonable consumer standards in the products they sold to retail investors and borrowers. This has been well documented and remarked upon, as well as demagogued, so there is no point in belaboring it. But what this means is that borrowers should get rewritten mortgage contracts when what they were sold had a fraudulent design—the approach proposed by Congressman Barney Frank (D-MA)—that is based on the type of product sold, and not on the basis of ability to repay or of potential losses to the lenders (we have limited and direct safety nets for both of those types of distress). That criterion would also direct losses to the appropriate target of moral hazard concern: exploitative behavior. Finally, the financial firms underestimated the reputational spillovers that tied them to their products. This was most clear with the structured investment vehicles and other “off-balance sheet” vehicles with which they thought that they could maintain credit ties and brand identification, somehow without incurring the oft-misunderstood concept of reputation risk and consequently the reputational damage they are now suffering. On this, it again goes to basic business strategy—does BMW or Porsche contract out its name to a scooter maker to leverage its brand into new markets, and then really expect the scooter purchasers not to show up at their dealers for refunds and lawsuits if the wheels fall off? Luckily, this is one place where the market lesson and regulatory discipline seem to have it right, and the banks are now taking most of this SPV debt exposure back on to their balance sheets. Yes, the functioning of financial markets and particularly the core banking system do have special meaning for public policy. That uniqueness does not stem from the complexity of their products, however, but from the dependence of other activities in the economy upon their practices. All the more reason for regulators and central bankers to look beyond the supposed complexity of pricing products to the real sources of financial turmoil, calmly enforce write-downs, defend securitization, and go after fraud directly.

How to Restore Confidence in Our Markets --- a unified regulator would be a start.
October 22, 2008 By ARTHUR LEVITT

Our nation's financial markets are in the midst of their darkest hour in 76 years. We are in this situation because of an adherence to a deregulatory approach to the explosive growth and expansion of America's major financial institutions. Our regulatory system failed to adapt to important, dynamic and potentially lethal new financial instruments as the storm clouds gathered. There is now a total breakdown in the trust necessary for a free and functioning market. In response, we need to take dramatic and prompt action. For the past several months, there has been a debate about restructuring our financial regulatory architecture. Even in this environment that process could take many months, if not years. That's why we should move immediately to correct one of the most antiquated and dangerous flaws in that regulatory structure and merge the Securities and Exchange Commission (SEC) with the Commodity Futures Trading Commission (CFTC). For most of its nearly 75-year history, a strong SEC has been the investor's advocate. It has succeeded in maintaining investor confidence, helping to make our markets the envy of the world. Unhappily, over the past few years, the SEC has failed in this mission. Less well known to the broad investing public is the CFTC, since few individual investors are involved in the commodity markets. Yet what many people may be surprised to know is that the CFTC's responsibility includes financial products that are inextricably linked to our securities markets and the current meltdown -- derivatives, to name just one. It is now time to end the artificial distinction of differing regulatory schemes for economically equivalent markets. Combining the best of what each agency has to offer will improve what they do, resulting in a deeper economic understanding of how markets are functioning, and strengthening the guiding principles of transparency and investor protection. This newly empowered agency -- call it the Securities Futures Commission (SFC) -- would supervise markets (OTC, exchanges, boards-of-trade and municipal debt), broker-dealers, commodities merchants, investment banks (as boutique firms arise to fill the current void), accounting standards, rating agencies, mutual funds, hedge funds, corporate reporting, and the clearance and settlement systems. This new agency should be given an old mission with new powers. The SFC's mission should be investor protection, built upon tough enforcement and ensuring efficient financial markets. Its new powers should include enhanced authority over hedge funds, OTC products and rating agencies. For investment banks, the SFC should supervise their global business lines and be able to establish appropriate capital standards. This new agency also should be self-financing -- to be able to fund the types of programs and hire the talent necessary to keep up with the rapidly changing financial marketplace. To further insulate the SFC from political winds, the chairman, like the chairman of the Federal Reserve, should be appointed for seven years, and the commissioners should be appointed without regard to political party. This agency should also be allowed to have a formal advisory board consisting of representatives of investor groups, to help it maintain a focus on investors and their issues. This approach differs dramatically from the one proposed by Treasury Secretary Henry Paulson last year. He advocates gutting the SEC and the CFTC of their mandates, and placing the Federal Reserve and (mostly) Treasury at the helm of our markets. The Federal Reserve's responsibility is monetary policy and the stability of depository institutions, a mission often at odds with investor protection, and it should remain separate. Treasury is a political entity controlled by the president -- just imagine what our financial markets would look like if controlled by the White House. Trust in our institutions and faith in the system are not just theoretical niceties, they are imperative to the functioning of our markets. Creating a regulator that stands on the side of investors and oversees the broad market will help restore that trust.

Mr. Levitt was chairman of the Securities and Exchange Commission from 1993 to 2001.

How Lending Standard Changes Led to the Housing Boom/Bust
October 21, 2008

There is a general lack of understanding as to how the Housing boom and bust occurred, and why it led to the subsequent credit freeze. The situation is complex, and that is why we are still explaining this 3 years into the housing bust. Let me take another shot at clarifying this: Underlying EVERYTHING -- housing boom and bust, derivative explosion, credit crisis -- is the enormous change in lending standards. I am not sure many people understand the massive change that took place during the 2002-07 period. It was more than a subtle shift -- it was an abdication of the traditional lending standards that had existed for decades, if not centuries. After the Greenspan Fed took rates down to ultra-low levels, home prices began to levitate. More and more mortgages were being securitized -- purchased by Wall Street, and repackaged into other forms of bond-like paper. The low rates spurred demand for this higher yielding, triple AAA rated, asset-backed paper. In this ultra-low rate environment, where prices were appreciating, and most mortgages were being securitized, all that mattered to the mortgage originator was that a BORROWER NOT DEFAULT FOR 90 DAYS (some contracts were 6 Months). The contracts between the firms that originated mortgages and the Wall Street firms that securitized them had explicit warranties. The mortgage seller guaranteed to the mortgage bundle buyer (underwriter) that payments were current, the mortgage holders were valid, and that the loan would not default for 90 or 180 days. So long as the mortgage did not default in that period of time, it could not be "put back" to the originator. A salesman or mortgage business would only lose their fee if the borrower defaulted within that 3 or 6 month contractually specified period. Indeed, a default gave the buyer the right to return the mortgage and charge back the lender the full purchase price. What do rational, profit-maximizers do? They put people in houses that would not default in 90 days -- and the easiest way to do that were the 2/28 ARM mortgages. Cheap teaser rates for 24 months, then the big reset. Once the reset occurred 24 months later, it was long off the books of the mortgage originators -- by then, it was Wall Street's problem. This was a monumental change in lending standards. It created millions of new potential home buyers. Why? Instead of making sure that borrowers could pay back a loan, and not default over the course of a 30 YEAR FIXED MORTGAGE, originators only had to find people who could afford the teaser rate for a few months. This was a simply unprecedented shift in lending standards. And, it is why 293 mortgage lenders have imploded -- all of these bad loans were put back to them. Note that the fear of this occurring is what was supposed to keep the lenders in line. The repercussion of this is why Greenspan believed the free market could self-regulate. (After all, people are rational, right?) One of the many odd lessons of this era is that, under certain circumstances, companies and salespeople will pursue short term profits to the point where it literally destroys the firm. If you want to point to the single most important element of the Housing boom and bust, this is it. Ultimately, these defaulting mortgages underlie the entire credit freeze. And, it would not have been possible without the Greenspan ultra-low rates, which made the teaser portion (the "2" of the 2/28) of these mortgages so attractive. Contrary to the cliché, failure is not an orphan in the current crisis -- it has 100s of fathers. But these four are the primary movers, the key to everything else: The perfect storm of ultra-low rates, securitization, lax lending

standards and false triple AAA ratings -- these are the key to how we ended up with the previous boom, followed by a bust, and ultimately, the credit freeze.

US working on plan to help homeowners refinance
October 23, 2008

Federal regulators told Congress Thursday they're working on a plan that could help many distressed homeowners escape foreclosure in a global financial crisis that Federal Reserve Chairman Alan Greenspan warned will get worse before it gets better. Greenspan called the banking and housing chaos a "once-in-a-century credit tsunami" that led to a breakdown in how the free market system functions. Accused of contributing to the meltdown, but denying that it was his fault, Greenspan told a House panel the crisis left him — an unabashed free-market advocate — in a "state of shocked disbelief." The longtime Fed chief acknowledged under questioning that he had made a "mistake" in believing that banks in operating in their self-interest would be sufficient to protect their shareholders and the equity in their institutions. Greenspan called it "a flaw in the model that I perceived is the critical functioning structure that defines how the world works." His much-anticipated appearance came as committees in both the House and the Senate held competing hearings on the financial crisis. At one such forum, a senior Treasury official said the Bush administration intends to get a program to help struggling homeowners revise mortgages up and running soon. Neel Kashkari, who is overseeing the government's $700 billion financial rescue effort, told the Senate Banking Committee that the new plan could include setting standards for changing mortgages to make them more affordable and giving loan guarantees to banks that meet them. "We are passionate about doing everything we can to avoid preventable foreclosures," he said. Sheila Bair, chairman of the Federal Deposit Insurance Corp., told the same Senate panel that the government needs to do more to help tens of thousands of home borrowers avert foreclosure, including setting standards for modifying mortgages into more affordable loans and providing loan guarantees to banks and other mortgage services that meet them. "Loan guarantees could be used as an incentive for servicers to modify loans," Bair said. "By doing so, unaffordable loans could be converted into loans that are sustainable over the long term." The FDIC is working "closely and creatively" with the Treasury Department on such a plan, she said. Greenspan told the House Oversight Committee he was wrong in believing that banks would be more prudent in their lending practices because of the need to protect their stockholders. Greenspan, who stepped down in February 2006 after serving as Fed chairman for 18 1/2 years, was asked to explain his role in the crisis. Some critics have blamed him for contributing to the problem by leaving interest rates too low for too long and for failing to regulate risky banking practices. Committee Chairman Henry Waxman, D-Calif., suggested that Greenspan contributed to "irresponsible lending practices" by rejecting appeals that the Fed intervene to regulate a surging subprime mortgage industry. "The list of regulatory mistakes and misjudgments is long," Waxman said of oversight by the Fed and other federal regulators. "My question for you is simple," Waxman told Greenspan. "Were you wrong?" "Well, partially," Greenspan said. But he went on to assign the blame on soaring mortgage foreclosures on overeager investors who did not properly take into account the threats that would be posed once home prices stopped surging upward. He said what had been "a critical pillar to market competition and free markets did break down. And I think that, as I said, shocked me. I still do not fully understand why it happened." Committee members accused present and past federal regulators for not doing more to stop abusive practices or to go after wrongdoers. Christopher Cox, chairman of the Securities and Exchange Commission,

acknowledged to the House panel that "somewhere in this terrible mess, laws were broken." He said the government was doing the best it could to identify and pursue lawbreakers. In the hearing before the Senate panel, Kashkari, the Treasury official overseeing the government's $700 billion bailout program, said the administration was making "tremendous progress" in carrying out the bailout program enacted earlier this month. As a result, there have been "numerous signs of improvement in our markets and in the confidence in our financial institutions," he asserted. Still, Kashkari cautioned that "while there have been recent positive developments, the markets remain fragile." The administration must move to resolve the deepening financial crisis swiftly and aggressively, said Banking Committee Chairman Sen. Christopher Dodd, D-Conn. Otherwise, "volatility and paralysis" will reign in the markets, he warned. So far, the government has dealt only with the symptoms of the debacle, Dodd argued. Sen. Charles Schumer, D-N.Y., said that by not setting conditions on banks in return for the government injections of money, "We're feeding them a little too much dessert and not making them eat their vegetables." Schumer said he's "still not convinced" that banks receiving the government money should continue paying dividends to their shareholders.

Five Ways to Fix Our Financial Architecture
By Howard Davies October 23, 2008

Some urgent reforms need to be made to the architecture of international financial regulation, but talk of a second Bretton Woods conference is misleading. Neither the International Monetary Fund nor the World Bank is a financial regulator in the sense of being a body that sets the rules for and supervises individual institutions. Those important tasks are carried out by less glamorous entities such as the Basel Committee and the International Organization of Securities Commissions. The real issues relate to the way in which these bodies carry out their jobs. As government leaders grapple with the flaws in those processes, they need to keep five objectives in mind: First, we need a simpler set of mechanisms that better reflect the shape of today's markets. In a book on regulatory architecture published this year, David Green and I tried to describe the existing structures. They are impenetrably complex. When I became chairman of the United Kingdom's Financial Services Authority in 1997, the authority -- Britain's only financial regulator -- was a member of about 75 international bodies or committees. By the time I left in 2003, that number had doubled. One problem is that the global financial system is built in three silos: banking, securities and insurance. That structure no longer reflects reality. We know that risks are transferred between these silos and that insurance companies and brokers can pose systemic risk. We need simpler structures, with cross-sectoral coverage. Second, there is a big problem of legitimacy. The Financial Stability Forum, which sits at the center of the system (without much formal authority), includes the Netherlands and Australia but not China or India. Ten of the 13 members of the Basel Committee, which sets bank capital ratios, are from Europe; there is only one Asian member. The crisis presents a good opportunity to make these bodies more representative. If we do not allow China to participate in making the rules governing finance, how can we expect it to obey them? Third, the new system needs to move faster. It took the Basel Committee the better part of a decade to design the Basel II standards that banks are just beginning to implement. That's right: These guidelines on leverage and capital are already out of date before coming into service. Regulatory clocks must be speeded up.

Fourth, and most crucial, we need to build a new link between macroeconomic surveillance and regulation. That is where the IMF comes in. Looking back over the past decade, it is easy to find warnings of trouble ahead. The IMF's global financial stability reports included dark alarms about the unwinding of imbalances. The Bank for International Settlements has a better record, regularly pointing to asset price bubbles and systematic risk mispricing. But those warnings did not feed through into the setting of bank capital requirements. Such connections need to be made. We also need a mechanism that can induce banks to hold more capital in boom times, which would help to restrain the expansion and provide a softer cushion if and when prices begin to fall, and take other countercyclical precautions. In other words, if asset prices or risk spreads diverge significantly from their long-term trends, supervisors would impose an across-the-board capital supplement to reflect the potential cost to the banks of a subsequent decline in prices. Lastly, there is a need for new and sustained political leadership. The Group of Seven concerns itself with regulation only at times of crisis. For example, the Financial Stability Forum was created after the Asian crisis of the late 1990s, and then the finance ministers all but forgot about it until the end of last year. Perhaps a standing subcommittee of the G-7 could be given a permanent role overseeing financial regulation, with the FSF as its arms and legs. The forum is the only place where regulators meet central bankers, finance ministry officials and representatives of the international financial institutions. It brings all the right people together in a room. It should be renamed the Financial Stability Council, given a proper staff and empowered to give instructions to the sectoral regulators. If the G-7 ministers want this to happen, it can. Of course, better architecture is just the first step. Difficult problems such as how much capital is needed in the system and how to regulate liquidity remain to be solved. We need to grapple with unregulated firms and with the "black holes" of offshore centers. And in some countries, notably the United States, there is a desperate need for change in the domestic financial system. These issues present enough material for several summits. President Bush will not be there to see how this story plays out, but his successor will surely be spending much time with Nicolas Sarkozy and Gordon Brown. The writer is director of the London School of Economics and has served as deputy governor of the Bank of England.

Willie Sutton Goes to Harvard
By George F. Will October 23, 2008

"Because that's where the money is."-- Willie Sutton, when asked in 1934 why he robbed banks
Washington is having a Willie Sutton Moment. Such moments occur when government, finding its revenue insufficient for its agenda, glimpses some money it does not control but would like to. Sen. Charles Grassley (R-Iowa) and Rep. Peter Welch (D-Vt.) recently convened a discussion of how colleges and universities should be spending their endowments. Grassley, who says more than 135 institutions each have endowments of more than $500 million, says perhaps they should be required to spend 5 percent of those endowments each year. Welch has introduced legislation to require that percentage to be spent to reduce tuition and other student expenses. This government reach for control of private resources comes even though last year colleges and universities spent, on average, 4.6 percent of their endowments. Furthermore, most endowments are too small to be a significant source of captured money. Last fiscal year, Harvard's endowment, earning an 8.6 percent return, grew from $34.9 billion to $36.9 billion. Although less than the 23 percent return in the previous year, it was an excellent performance, considering the economic turbulence. But only 45 private institutions have endowments of more than $1 billion. Among the other 98 percent (1,565) of institutions, the median endowment is just $14 million. So government in a Willie Sutton mood would target the wealthiest institutions -- those that are the foundation of basic research that undergirds American prosperity, and that have the most generous financial aid programs for students.

Nowadays, much of politics consists of telling voters that the prices of many things they buy -- gasoline, health care, higher education -- are unreasonable. But demand for higher education has not declined, even though its price at many institutions has risen faster than the price of health care. Parents continue to pay rising tuition costs because they consider higher education a reasonable investment. They know that, today, wealth creation is driven by "human capital" -- trained minds -- and that "you earn what you learn." Daniel Mark Fogel told the Grassley-Welch panel that at the University of Vermont, of which he is president, 60 percent of undergraduates and 74 percent of this year's freshman class are from out of the state. They pay the nation's second highest nonresident tuition, which subsidizes the lower tuition paid by Vermonters and helps offset declines in state appropriations. Some Massachusetts state legislators, committing two of the seven deadly sins, are angry because tax revenue does not match their ambitions and are envious of Harvard. They suggest raising more than $1 billion annually with a 2.5 percent assessment on the nine colleges and universities in the state that have endowments of more than $1 billion. California legislators, disguising a third sin, avarice, as concern for "diversity," want to require large California foundations to report the race, gender and sexual orientation of their trustees, staff and grant recipients. Other state legislatures will emulate this step toward government control of the flow of philanthropy. So it goes. The almost erotic pleasure of spending money that others have earned and saved is one reason people put up with the tiresome aspects of political life. And now the government's response to the financial crisis, including the semi-nationalization of nine major banks, has blurred -- indeed, almost erased -- the distinction between public and private sectors. Hundreds of billions of dollars that the political class would have liked to direct for its own social and political purposes have been otherwise allocated. That allocation, by government fiat rather than by market forces, must reduce the efficiency of the nation's stock of capital. Which in turn will reduce economic growth, and government revenue, just as the welfare state -- primarily pensions and medical care for the elderly -- becomes burdened by the retirement of 78 million baby boomers. As government searches with increasing desperation for money with which it can work its will, Willie Sutton Moments will multiply. Government has an incentive to weaken the belief that the nation needs a vigorous and clearly demarcated sector of private educational and philanthropic institutions exercising discretion over their own resources. So the frequently cited $700 billion sum is but a small fraction of the cost, over coming decades, of today's financial crisis. The desire of governments to extend their control over endowments and foundations is a manifestation of the metastasizing statism driven by the crisis. For now, its costs, monetary and moral, are, strictly speaking, incalculable.

Taxonomy of trouble
Oct 23rd 2008

How are emerging markets suffering? Let us count the ways EVEN now, not every central banker is terribly impressed by the gravity of the financial crisis that has spread from Western banks to the emerging world’s shares, currencies and credit markets. In India the United Forum of Reserve Bank Officers and Employees—the central bank’s staff union—decided that October 21st was a good moment for its 25,000 members to abandon their posts in a dispute over pensions. The Reserve Bank of India (RBI) denounced it as an illegal strike. The union called it mass casual leave. A few months ago, many emerging economies hoped they could take mass casual leave from the credit crisis. Their banks operated far from where the blood was being shed. The economic slowdown evident in America and Europe was regrettable, but central bankers in many emerging economies, such as India and Brazil, were busy engineering slowdowns of their own to reverse high inflation. They were more interested in the price of oil than the price of interbank borrowing.

This detachment has proved illusory. The nonchalance of the RBI’s staff, for example, is not shared by the central bank’s top brass, who, a day before the strike cut the bank’s key interest rate from 9% to 8%, having already slashed reserve requirements earlier this month. Their staff’s complaint about pensions looked quaint on the day that Argentina’s government said it would nationalize the country’s private-pension accounts in what looked to some like a raid to help it meet upcoming debt payments. The IMF, which has shed staff this year because of the lack of custom, is now working overtime). The governments of South Korea and Russia have shored up their banking systems. Their foreign-exchange reserves, $240 billion and $542 billion respectively, no longer look excessive. Even China’s economy is slowing more sharply than expected, growing by 9% in the year to the third quarter, its slowest rate in five years. The emerging markets, which as the table shows enter the crisis from very different positions, are vulnerable to the financial crisis in at least three ways. Their exports of goods and services will suffer as the world economy slows. Their net imports of capital will also falter, forcing countries that live beyond their means to cut spending. And even some countries that live roughly within their means have gross liabilities to the rest of the world that are difficult to roll over. In this third group, the banks are short of dollars even if the country as a whole is not. Long before Lehman Brothers went bankrupt in mid-September, prompting the world’s money markets to seize up, the currencies of commodity exporters had already started to tumble. South Africa, a huge exporter of platinum and gold, has seen its currency fall further than any other this year except the Icelandic krona. Russia’s ruble peaked on July 16th as oil prices fell, and the Brazilian real began to slip a couple of weeks later. Brazil’s commodity exports amount to 9% of its GDP, according to Lombard Street Research, a firm of analysts. But its commodity firms, such as the oil giant Petrobras, account for over 40% of the stockmarket. Thus the fall in commodity prices has hit the bourses hard. A similar fate befell Russia, where the main indexes were already in decline after the country’s military misadventures in Georgia. India and China benefit from cheaper oil. India, for example, spent almost two trillion rupees ($48 billion) on crude imports in the five months from April to August. But even as their import bills fall, their export earnings are slowing. On October 22nd Tata Consultancy Services, India’s biggest informationtechnology company, announced that its net dollar profit in the latest quarter was almost 7% below the quarter before. India’s IT bosses are worried about getting paid by banks for work they have done for them. Goldman Sachs says that India’s trade deficit will subtract 1.5 percentage points from its GDP growth this fiscal year and next. A declining rupee will help India’s exports. China’s yuan, on the other hand, has held its own against the dollar, even as the greenback has strengthened recently. It may find itself reprising its stabilizing role during the Asian financial crisis, when it held fast to its dollar peg, even as its neighbors and competitors suffered currency collapses. Stephen Green of Standard Chartered calculates that China’s trade-weighted exchange rate adjusted for inflation abroad and at home, is now at its strongest since 1989. Morgan Stanley reckons the shares of emerging economies have never been as oversold. But foreign investors have punished some economies more harshly than others. The market for credit-default swaps, which insure against default on sovereign bonds has, for example, distinguished between countries running big current-account deficits (over 5% of GDP) and other more abstemious places. Of the four biggest emerging markets, Brazil, Russia, India and China, India has the largest current-account deficit, which widened to 3.6% of GDP in the second quarter. It bridged most of this gap with foreign-direct

investment. But its globetrotting companies also rely on raising money abroad, borrowing $1.56 billion externally from April to June. This borrowing has since become far more expensive. Russia has a hefty surplus on its current account, not a deficit. It earned $166 billion from oil and gas exports in 2007. Its economy should be flush with hard currency. In fact, Russia’s companies and banks are now scrambling to find dollars. The overseas liabilities of Russian banks now exceed their foreign assets by $103.5 billion (excluding net foreign direct investment in the industry), according to the country’s central bank. The country is not awash with petrodollars because the state taxes its energy earnings heavily, and sequesters its dollar takings in its central-bank reserves and its Stabilization Fund. As Rory MacFarquhar of Goldman Sachs has pointed out, Russia accumulated $560 billion in foreign-exchange reserves from 2000 to mid-2008, even as its banks and companies have added $460 billion to their external debt. Russia, in effect, lends dollars to Western governments, then borrows them back again from Western banks. Now those Western banks are suddenly reluctant to lend, which means Russia’s government will have to close the dollar-circuit itself. The central bank will deposit $50 billion of its foreign-exchange reserves in the stateowned Vnesheconombank, which will, in turn, lend that money to companies and banks faced with imminent foreign-debt payments. There is an irony here. The West’s financial institutions have long been hoping for sovereign-wealth funds, flush with petrodollars, to arrive as saviors. But Russia, at least, now needs all its sovereign wealth to save itself. Friedman: Bailout (and buildup)
October 22, 2008

The 2 is back. Last week, U.S. retail gasoline prices fell below $3 a gallon - to an average of $2.91 - the lowest level in almost a year. Why does this news leave me with mixed feelings? Because in the middle of this wrenching economic crisis, with unemployment rising and 401(k)s shrinking, it would be a real source of relief for many Americans to get a break at the pump. Today's declining gasoline prices act like a tax cut for consumers and can save $15 to $20 a tank-full for an SUV-driving family, compared with when gasoline was $4.11 a gallon in July. Yet, it is impossible for me to ignore the fact that when gasoline hit $4.11 a gallon Americans changed - a lot. Americans drove less, polluted less, exercised more, rode more public transportation and, most importantly, overwhelmed Detroit with demands for smaller, more fuel-efficient, hybrid and electric cars. The clean-energy and efficiency industries saw record growth - one of America's few remaining engines of real quality job creation. But with little credit available today for new energy start-ups, and lower oil prices making it harder for existing renewables like wind and solar to scale, and a weak economy making it nearly impossible for Congress to pass a carbon tax or gasoline tax that would make clean energy more competitive, what will become of America's budding clean-tech revolution? This moment feels to me like a bad B-movie rerun of the 1980s. And I know how this movie ends - with America's re-addiction to oil and OPEC, as well as corrosive uncertainty for the U.S. economy, trade balance, security and environment. "Is the economic crisis going to be the end of green?" asks David Rothkopf, energy consultant and author of "Superclass." "Or, could green be the way to end the economic crisis?" It has to be the latter. We can't afford a financial bailout that also isn't a green buildup - a buildup of a new clean energy industry that strengthens the U.S. and helps the planet. But how do we do that without any policy to affect the price signal for gasoline and carbon? Here are some ideas: First, Washington could impose a national renewable energy standard that would require

every utility in the country to produce 20 percent of its power from clean, nonCO²-emitting, energy sources - wind, solar, hydro, nuclear, biomass - by 2025. About half the states already have these in place, but they are all different. It would create a huge domestic pull for renewable energy if we had a uniform national mandate. Second, Washington could impose a national requirement that every state move its utilities to a system of "decoupling-plus." This is the technical term for changing the way utilities make money - shifting them from getting paid for how much electricity or gas they get you to consume to getting paid for how much electricity or gas they get you to save. Several states have already moved down this path. Third, an idea offered by Andy Karsner, former assistant secretary of energy, would be to modify the tax code so that any company that invests in new domestic manufacturing capacity for clean energy technology - or procures any clean energy system or energy savings device that is made by an American manufacturer - can write down the entire cost of the investment via a tax credit and/or accelerated depreciation in the first year. "I'm talking about anything from energy-efficient windows to water heaters to industrial boilers to solar panels, and the job-creating, manufacturing facilities that produce them - anything that makes us more efficient, lean and economically competitive and comes from a domestic, American source," said Karsner. He also suggests using some of the money from any stimulus package to directly incentivize and support states' efforts to implement and intelligently modernize their building codes to get already well-established national "best practices" quickly into their marketplaces. Lastly, America needs the next president to be an energy efficiency trendsetter, starting by reinventing the inaugural parade. Get rid of the black stretch limos and double-plated armored Chevy Tahoes inching down Pennsylvania Avenue. Instead, let the next president announce that he will use no vehicles on Inauguration Day that get less than 30 miles per gallon. He could invite all car companies to participate in the historic drive with their best available American-made, fuel-efficient, innovative vehicle. Finally, if Congress passes another stimulus package, it can't just be another round of $600 checks to go buy flat-screen TVs made in China. It has to also include bridges to somewhere - targeted investments in scientific research, mass transit, domestic clean-tech manufacturing and energy efficiency that will make us a more productive and innovative society, one with more skills, more competitiveness, more productivity and better infrastructure to lead the next great industrial revolution: ET - energy technology. A matter of life and debt
October 22, 2008

This week, credit has begun to loosen, stock markets have been encouraged enough to reclaim lost ground (at least for now) and there is a collective sigh of hope that lenders will begin to trust in the financial system again. But we're deluding ourselves if we assume that we can recover from the crisis of 2008 so quickly and easily simply by watching the Dow creep upward. The wounds go deeper than that. To heal them, we must repair the broken moral balance that let this chaos loose. Debt - who owes what to whom, or to what, and how that debt gets paid - is a subject much larger than money. It has to do with our basic sense of fairness, a sense that is embedded in all of our exchanges with our fellow human beings. But at some point we stopped seeing debt as a simple personal relationship. The human factor became diminished. Maybe it had something to do with the sheer volume of transactions that computers have enabled. But what we seem to have forgotten is that the debtor is only one twin in a joined-at-the-hip pair, the other twin being the creditor. The whole edifice rests on a few fundamental principles that are inherent in us. We are social creatures who must interact for mutual benefit and - the negative version - who harbor grudges when we feel we've been treated unfairly.

Without a sense of fairness and also a level of trust, without a system of reciprocal altruism and tit-for-tat - one good turn deserves another, and so does one bad turn - no one would ever lend anything, as there would be no expectation of being paid back. And people would lie, cheat and steal with abandon, as there would be no punishments for such behavior. Children begin saying, "That's not fair!" long before they start figuring out money; they exchange favors, toys and punches early in life, setting their own exchange rates. Almost every human interaction involves debts incurred debts that are either paid, in which case balance is restored, or else not, in which case people feel angry. A simple example: You're in your car, and you let someone else go ahead of you, and the driver doesn't wave or honk. How do you feel? Once you start looking at life through these spectacles, debtor-creditor relationships play out in fascinating ways. In many religions, for instance. The version of the Lord's Prayer I memorized as a child included the line, "Forgive us our debts as we forgive our debtors." In Aramaic, the language that Jesus himself spoke, the word for "debt" and the word for "sin" are the same. And although many people assume that "debts" in these contexts refer to spiritual debts or trespasses, debts are also considered sins. If you don't pay back what's owed, you cause harm to others. The fairness essential to debt and redemption is reflected in the afterlives of many religions, in which crimes unpunished in this world get their comeuppance in the next. For instance, hell, in Dante's "Divine Comedy," is the place where absolutely everything is remembered by those in torment, whereas in heaven you forget your personal self and who still owes you five bucks and instead turn to the contemplation of selfless Being. Debtor-creditor bonds are also central to the plots of many novels - especially those from the 19th century, when the boom-and-bust cycles of manufacturing and no-holds-barred capitalism were new and frightening phenomena, and ruined many. Such stories tell what happens when you don't pay, won't pay or can't pay, and when official punishments ranged from debtors' prisons to debt slavery. In "Uncle Tom's Cabin," for example, human beings are sold to pay off the rashly contracted debts. In "Madame Bovary," a provincial wife takes not only to love and extramarital sex as an escape from boredom, but also more dangerously - to overspending. She poisons herself when her unpaid creditor threatens to expose her double life. Had Emma Bovary but learned double-entry bookkeeping and drawn up a budget, she could easily have gone on with her hobby of adultery. For her part, Lily Bart in "The House of Mirth" fails to see that if a man lends you money and charges no interest, he's going to want payment of some other kind. As for what will happen to us next, I have no safe answers. If fair regulations are established and credibility is restored, people will stop walking around in a daze, roll up their sleeves and start picking up the pieces. Things unconnected with money will be valued more - friends, family, a walk in the woods. "I" will be spoken less, "we" will return, as people recognize that there is such a thing as the common good. On the other hand, if fair regulations are not established and rebuilding seems impossible, we could have social unrest on a scale we haven't seen for years. Is there any bright side to this? Perhaps we'll have some breathing room - a chance to re-evaluate our goals and to take stock of our relationship to the living planet from which we derive all our nourishment, and without which debt finally won't matter. The financial crisis—Into the storm
Oct 23rd 2008 From The Economist print edition

How the emerging world copes with the tempest will affect the world economy and politics for a long time

FOR much of the past year the fast-growing economies of the emerging world watched the Western financial hurricane from afar. Their own banks held few of the mortgage-based assets that undid the rich world’s financial firms. Commodity exporters were thriving, thanks to high prices for raw materials. China’s economic juggernaut powered on. And, from Budapest to Brasília, an abundance of credit fuelled domestic demand. Even as talk mounted of the rich world suffering its worst financial collapse since the Depression, emerging economies seemed a long way from the centre of the storm. No longer. As foreign capital has fled and confidence evaporated, the emerging world’s stockmarkets have plunged (in some cases losing half their value) and currencies tumbled. The seizure in the credit market caused havoc, as foreign banks abruptly stopped lending and stepped back from even the most basic banking services, including trade credits. Like their rich-world counterparts, governments are battling to limit the damage. That is easiest for those with large foreign-exchange reserves. Russia is spending $220 billion to shore up its financial services industry. South Korea has guaranteed $100 billion of its banks’ debt. Less well-endowed countries are asking for help. Hungary has secured a €5 billion ($6.6 billion) lifeline from the European Central Bank and is negotiating a loan from the IMF, as is Ukraine. Close to a dozen countries are talking to the fund about financial help. Those with long-standing problems are being driven to desperate measures. Argentina is nationalizing its private pension funds, seemingly to stave off default. But even stalwarts are looking weaker. Figures released this week showed that China’s growth slowed to 9% in the year to the third quarter—still a rapid pace but a lot slower than the double-digit rates of recent years. Blowing cold on credit The various emerging economies are in different states of readiness, but the cumulative impact of all this will be enormous. Most obviously, how these countries fare will determine whether the world economy faces a mild recession or something nastier. Emerging economies accounted for around three-quarters of global growth over the past 18 months. But their economic fate will also have political consequences. In many places—eastern Europe is one example—financial turmoil is hitting weak governments. But even strong regimes could suffer. Some experts think that China needs growth of 7% a year to contain social unrest. More generally, the coming strife will shape the debate about the integration of the world economy. Unlike many previous emerging-market crises, today’s mess spread from the rich world, largely thanks to increasingly integrated capital markets. If emerging economies collapse—either into a currency crisis or a sharp recession— there will be yet more questioning of the wisdom of globalized finance. Fortunately, the picture is not universally dire. All emerging economies will slow. Some will surely face deep recessions. But many are facing the present danger in stronger shape than ever before, armed with large reserves, flexible currencies and strong budgets. Good policy—both at home and in the rich world—can yet avoid a catastrophe. One reason for hope is that the direct economic fallout from the rich world’s disaster is manageable. Falling demand in America and Europe hurts exports, particularly in Asia and Mexico. Commodity prices have fallen: oil is down nearly 60% from its peak and many crops and metals have done worse. That has a mixed effect. Although it hurts commodity-exporters from Russia to South America, it helps commodity importers in Asia and reduces inflation fears everywhere. Countries like Venezuela that have been run badly are vulnerable, but given the scale of the past boom, the commodity bust so far seems unlikely to cause widespread crises. The more dangerous shock is financial. Wealth is being squeezed as asset prices decline. China’s house prices, for instance, have started falling. This will dampen domestic confidence, even though consumers are much less indebted than they are in the rich world. Elsewhere, the sudden dearth of foreign-bank lending and the flight of hedge funds and other investors from bond markets has slammed the brakes on credit growth. And just as booming credit once underpinned strong domestic spending, so tighter credit will mean slower growth. Again, the impact will differ by country. Thanks to huge current-account surpluses in China and the oil-exporters in the Gulf, emerging economies as a group still sends capital to the rich world. But over 80 have deficits of more

than 5% of GDP. Most of these are poor countries that live off foreign aid; but some larger ones rely on private capital. For the likes of Turkey and South Africa a sudden slowing in foreign financing would force a dramatic adjustment. A particular worry is Eastern Europe, where many countries have double-digit deficits. In addition, even some countries with surpluses, such as Russia, have banks that have grown accustomed to easy foreign lending because of the integration of global finance. The rich world’s bank bailouts may limit the squeeze, but the flow of capital to the emerging world will slow. The Institute of International Finance, a bankers’ group, expects a 30% decline in net flows of private capital from last year. A wing and a prayer This credit crunch will be grim, but most emerging markets can avoid catastrophe. The biggest ones are in relatively good shape. The more vulnerable ones can (and should) be helped. Among the giants, China is in a league of its own, with a $2 trillion arsenal of reserves, a current-account surplus, little connection to foreign banks and a budget surplus that offers lots of room to boost spending. Since the country’s leaders have made clear that they will do whatever it takes to cushion growth, China’s economy is likely to slow—perhaps to 8%—but not collapse. Although that is not enough to save the world economy, such growth in China would put a floor under commodity prices and help other countries in the emerging world. The other large economies will be harder hit, but should be able to weather the storm. India has a big budget deficit and many Brazilian firms have a large foreign-currency exposure. But Brazil’s economy is diversified and both countries have plenty of reserves to smooth the shift to slower growth. With $550 billion of reserves, Russia ought to be able to stop a run on the ruble. In the short-term at least, the most vulnerable countries are all smaller ones. There will be pain as tighter credit forces adjustments. But sensible, speedy international assistance would make a big difference. Several emerging countries have asked America’s Federal Reserve for liquidity support; some hope that China will bail them out. A better route is surely the IMF, which has huge expertise and some $250 billion to lend. Sadly, borrowing from the fund carries a stigma. That needs to change. The IMF should develop quicker, more flexible financial instruments and minimize the conditions it attaches to loans. Over the past month deft policymaking saw off calamity in the rich world. Now it is time for something similar in the emerging world.

Treasury To Invest In More Banks
October 24, 2008

The Treasury Department will announce as soon as today that a group of large regional banks have agreed to accept investments from the government, industry sources said. The new banks would join nine of the largest American banks, including Bank of America and J.P. Morgan Chase, which were forced to accept $125 billion in funding last week. Separately, the Treasury's plan to buy mortgage-related assets from banks appears to have stalled, industry sources said. Banks say that basic questions about the plan remain unanswered. Applicants to serve as asset managers have received little additional information from the Treasury in about a week, the source said. It is not clear, for example, whether banks that manage assets can also sell assets to the government. The latest developments underscore the sea change in the Treasury's approach to its $700 billion bailout of the financial industry. The asset-buying plan pitched to Congress starting last month has been set aside in favor of an initiative to invest at least $250 billion in banks, and possibly more, with almost no restrictions on how the banks can use the money. Treasury officials said yesterday that there would be no delay in the auction process and declined to comment on plans to announce more bank investments. The sources cautioned that the list of participants and the amounts of money were not final as of last night. They spoke on condition of anonymity because they were not authorized to speak for the participating institutions. The announcement of new participants in the bank investment plan, including Utah-based Zions Bancorporation, is intended to reassure the public, politicians and investors that the Treasury is making progress, the sources

said. It is also meant to show that regional banks are now volunteering to participate and to help jump-start the economy. Regional banks are major lenders to mid-size companies. But progress remains halting. The Treasury has yet to give federal money to the first nine banks because of continued legal wrangling over the details of the investment agreements. Assistant Treasury Secretary Neel Kashkari, the official responsible for the program, said in testimony before Congress yesterday that the next round of banks probably wouldn't get funding for "a few weeks." Banks that accept government investments must agree in return to issue the government shares of preferred stock, which pay annual interest of 5 percent, and warrants for shares of common stock, which allow the government to profit as the company's share price rises. Banks also must accept limits on executive compensation and cannot raise dividends without permission. Officials have publicly urged companies to increase their lending, to help revive the economy, but they privately concede that they cannot force banks to lend. Indeed, officials argue that for some institutions, the best use of the money may be plugging holes in the balance sheet or buying weaker banks. The sources said that at least one bank that applied for funding was denied by the government. As a result, banks that receive money are hoping investors will view the federal funding as evidence of good health. At the same time, investors may punish large regional banks that seem conspicuous by their absence from the next round of federal investments.

Greenspan Says He Was Wrong On Regulation
Lawmakers* Blast Former Fed Chairman
October 24, 2008

Alan Greenspan, once viewed as the infallible architect of U.S. prosperity, was called on the carpet yesterday, pilloried by a congressional committee for decisions that contributed to the financial crisis devastating world markets. The former chairman of the Federal Reserve said the crisis had shaken his very understanding of how markets work, and agreed that certain financial derivatives should be regulated -- an idea he had long resisted. When he stepped down as Fed chairman less than three years ago, Congress treated Greenspan as an oracle, one of the great economic statesmen of all time. Yesterday, many members of the House Oversight and Government Reform Committee treated him as a hostile witness. "You found that your view of the world, your ideology was not right, it was not working?" said Rep. Henry A. Waxman (D-Calif.), the committee chairman. "Absolutely, precisely," Greenspan said. "You know, that's precisely the reason I was shocked, because I have been going for 40 years or more with very considerable evidence that it was working exceptionally well." Greenspan alternately defended his legacy and acknowledged mistakes. Waxman asked whether the former chairman was wrong to consistently oppose regulating the multitrillion-dollar derivative market that has contributed to the financial crisis. "Well, partially," said Greenspan, before stressing the difference between credit-default swaps and other types of derivatives. With the global financial system unraveling, economists and political leaders are coming to doubt some of Greenspan's most closely held views: that markets can exact self-discipline, that central bankers should generally not try to prick bubbles in the price of houses or tech stocks, that a policymaker's most powerful tool to encourage growth is to stay out of the way. Even Greenspan seemed genuinely perplexed yesterday by all that had happened, hard-pressed to explain how formerly fundamental truths about how markets work could have proved so wrong.

Members of Congress who not long ago would seek Greenspan's blessing for their preferred public policies were at turns combative and disdainful. Rep. John Yarmuth (D-Ky.) called him a "Bill Buckner," referring to the Boston Red Sox first baseman who missed an easy ground ball against the Mets in the 1986 World Series, costing the team the game. The tough talk reflected a widening sense that some of Greenspan's apparent successes in managing the economy from 1987 to 2006 were in fact illusory, that they came at the cost of building the biggest credit bubble in world history. "Markets and societies move on belief systems," said James Grant, editor of Grant's Interest Rate Observer and a longtime critic of Greenspan. "The belief system of finance featured the notion that someone with unusual power to see around corners and through walls and into the future was running things, and that someone was Alan Greenspan." "His reputation was as inflated as were house prices in the early 2000s and tech stocks in the late 1990s," Grant said. Greenspan repeatedly used his control over the levers of the economy -- especially cutting interest rates -- to deal with problems. When the financial system in many emerging countries imploded in 1998, he cut rates to protect the U.S. economy. When the dot-com bubble burst, he used the same tack, even more aggressively. Indeed, the housing bubble, which was fueled by low interest rates, helped keep the 2001 recession relatively mild, as construction and other real estate-related activity soared in the first several years of this decade. But Greenspan's actions to keep the economy on an even keel may have made lenders complacent about risk, one of the factors that led them to expand lending in irresponsible ways. He acknowledged in testimony yesterday that the crisis is also a result of the fact that lenders base their models of credit risk on a 20-year period in which home prices were rising and the economy was strong. Economists are increasingly rethinking their views on whether central bankers should try to combat bubbles in the prices of assets, though not necessarily by using their power to set interest rates. "When bubbles cause huge problems is when they cause the financial sector to seize up," said Frederic S. Mishkin, a Columbia University economist and, until recently, Fed governor. "The right way to deal with that kind of bubble is not with monetary policy," but with bank supervision and other regulatory powers. Greenspan himself stressed the challenge of predicting the evolution of economic conditions. "The Federal Reserve had as good an economic organization as exists," Greenspan said. "If all those extraordinarily capable people were unable to foresee the development of this critical problem . . . we have to ask ourselves: Why is that? And the answer is that we're not smart enough as people. We just cannot see events that far in advance." But he deflected criticism, too. Responding to charges that the Fed did not regulate subprime lending aggressively enough, Greenspan said: "I took an oath of office when I became Federal Reserve chairman. . . . I said that I am here to uphold the laws of the land passed by the Congress, not my own predilections. . . . I think you will find that my history is that I voted for virtually every regulatory action that the Federal Reserve Board moved forward on. . . . And I was doing so because I perceived that that was the will of the Congress." In fact, it is almost unheard of for the Fed to move forward on regulatory policy if the chairman disagrees, and Congress at the time was often deferential toward Greenspan on financial regulation. In his time in office, Greenspan wielded both official and unofficial powers with an effectiveness that few other central bankers have matched. While endorsing some expanded regulation yesterday, such as requiring the companies that combine large

numbers of loans into securities to hold on to significant numbers of those securities, he also repeatedly retreated to his libertarian-leaning roots, and warned of the dangers of overreacting. "We have to recognize that this is almost surely a once-in-a-century phenomenon," Greenspan said, "and in that regard, to realize the types of regulation that would prevent this from happening in the future are so onerous as to basically suppress the growth rate in the economy and . . . the standards of living of the American people." Greenspan used the word "mistake" once during the five-hour hearing, which also included former Treasury secretary John Snow and current Securities and Exchange Commission Chairman Christopher Cox. "I made a mistake," Greenspan said, "in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms." * Lawmakers--a gaggle of hypocritical bastards!

Greenspan’s Lament

Do you think Alan Greenspan ever saw “Casablanca”? According to his testimony today, he is in “a state of shocked disbelief” over the discovery that foolish bank lending and inflated asset values have damaged the financial system. Claude Rains said it better when he discovered there was gambling going on at Rick’s place. The former chairman of the Federal Reserve Board — the man who kept telling us that there was no need to regulate credit default swaps because the banks could do a fine job of it themselves — even cites the Nobel prize committee in his defense: “In recent decades, a vast risk management and pricing system has evolved, combining the best insights of mathematicians and finance experts supported by major advances in computer and communications technology. A Nobel Prize was awarded for the discovery of the pricing model that underpins much of the advance in derivatives markets. This modern risk management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year because the data inputted into the risk management models generally covered only the past two decades, a period of euphoria. Had instead the models been fitted more appropriately to historic periods of stress, capital requirements would have been much higher and the financial world would be in far better shape today, in my judgment.” Mr. Greenspan pats himself on the back: “In 2005, I raised concerns that the protracted period of underpricing of risk, if history was any guide, would have dire consequences.” That makes his failure all the more appalling. If he knew that “dire consequences” were coming, why did the Fed not move to head them off? The answer is that the economic theory Mr. Greenspan subscribed to held that the central bank should react when prices of goods got out of control — we call that inflation — but should yield to the genius of markets when asset prices and credit markets do the same. Mr. Greenspan is right on one thing. The “whole intellectual edifice” collapsed. But he is wrong to blame it solely on the wrong inputs. It is too bad that Mr. Greenspan never appreciated the work of Hyman Minsky, who understood that stability is destabilizing, and that there will come times when the very calmness of markets, and lack of apparent risk, causes investors to take ever greater and greater risks. What was missing was a regulator who understood markets, rather than worshiped them.

AIG Has Used Much of Its $123 Billion Bailout Loan
October 24, 2008

The troubled insurance giant American International Group already has consumed three-quarters of a federal $123 billion rescue loan, a little more than a month after the government stepped in to save the company from bankruptcy.

AIG has borrowed $90.3 billion from the Federal Reserve's credit line as of yesterday, the bulk of it to pay off bad bets the company made in guaranteeing other firms' risky mortgage investments. That's up from roughly $83 billion AIG had borrowed a week ago, and the $68 billion level it reached a week before that. The news comes as the company's new chief executive warned Wednesday that the government's financial lifeline may not be enough to keep AIG afloat. The high volume of taxpayer funds that the trillion-dollar corporation tapped within five weeks also has others fretting that the largest government bailout in history may still not be adequate. AIG began reporting unusual multimillion-dollar losses this spring as a result of its heavy exposure to risky mortgages, and the U.S. Treasury decided that its failure would probably bring down several other major investment firms and banks whose fortunes were tied to AIG. But Wall Street analysts said this is a vulnerable juncture for the insurance giant. It's now in a deep trough -from which it may either emerge leaner and meaner or never return. "It can't be good that they have to pay out so much more money, " said insurance analyst David Schiff of Schiff's Insurance Observer. "They're obviously in a lousy spot." In exchange for control of the company, the Federal Reserve Bank of New York gave AIG an $85 billion loan Sept. 16 to keep it from bankruptcy. Earlier this month, the Fed reluctantly gave AIG $38 billion more in credit that was intended to keep the firm from drawing down the first Fed loan too quickly. Five weeks in, AIG is paying out money but has yet to make much. Its plans to sell major assets to pay off the government's loan have been frustrated by the lowered prices that interested parties are now willing to pay for its business divisions and the difficulty some have in getting financing for deals. New York Fed and AIG officials declined to comment on the situation. But sources close to the arrangement provided an illuminating breakdown: AIG has tapped $72 billion from the original $85 billion bailout. It has drawn down $18 billion of the additional $38 billion the Fed offered in credit liquidity for losses the company was suffering in securities lending. In an interview on "The NewsHour with Jim Lehrer" on Wednesday night, senior correspondent Ray Suarez asked chief executive Edward M. Liddy whether the government's loan would suffice. "I think so and I sure hope so," Liddy said. But Liddy added that there's no guarantee unless there's an improvement in the capital markets and companies regain their ability to raise money. AIG yesterday named Paula Rosput Reynolds, the former chief executive of property and casualty insurer Safeco, as its vice chairman and chief restructuring officer. Reynolds, who led Safeco's sale to Liberty Mutual six months ago, will oversee the sale of AIG's assets, the company said in a statement.

U.S. vows more help for homeowners
October 24, 2008

With foreclosures mounting, Bush administration officials said Thursday that they were preparing to step up efforts to help struggling homeowners. A senior policy maker told a Senate committee that the administration was working on a plan under which the government would offer to shoulder some of the losses on loans that are modified. The insurance program could cost tens of billions of dollars, according to a person briefed on discussions about the plan, and would be run by the Treasury Department under the $700 billion financial rescue bill Congress passed earlier this month. The remarks about the plan, made by Sheila Bair, the chairwoman of the Federal Deposit Insurance Corp., came as a new report showed that foreclosure filings jumped 71 percent in the third quarter from a year earlier. At the hearing, congressional Democrats criticized the administration for not doing enough to help homeowners even as the Treasury and Federal Reserve have moved to inject hundreds of billions of dollars into banks and the

financial system. Bair, who has been one of the most ardent proponents of loan modifications, acknowledged that more needed to be done. "We are behind the curve," Bair told the Senate Banking Committee. "We are falling behind. There has been some progress, but it's not been enough, and we need to act and we need to act quickly and we need to act dramatically." Details of the plan are expected in the next week or two. Bair told senators that policy makers were contemplating creating standardized loan modification practices that would be used by mortgage servicing firms, which handle billing and collection on behalf of investors and banks. Loans modified under those principles would qualify for a partial U.S. government guarantee. In other words, if homeowners defaulted on their loan again, part of the loss would be borne by the government. It was unclear whether investors or homeowners would have to pay premiums for that protection. Senator Christopher Dodd, Democrat of Connecticut and the chairman of the banking committee, commended the program, which he said he wrote into the rescue package in consultation with Bair. "This slender provision alone could help countless deserving Americans escape the foreclosure trap," he said. The guarantee program would be used alongside another element of the rescue plan that would have the government directly purchase and modify mortgages. Since late last year, the government has tried various approaches to limit foreclosures, but analysts say those efforts have not done enough to stem rising defaults. A recent analysis by Rod Dubitsky of Credit Suisse, showed that 44 percent of borrowers whose loans were modified but whose monthly payment did not decrease fell behind on payments again in the next eight months. By contrast, that rate was 15 to 23 percent for modifications that lowered payments, depending on which loan terms were changed. Why more loans are not being modified is the subject of heated debate. Some in the industry say it is hard to reach borrowers and many of them do not want to stay in their homes anyway. Advocates for low-income homeowners say servicing firms are overwhelmed by defaults. People on both sides acknowledge that further modifications are complicated because banks no longer hold most mortgages. Instead, they have been packaged into multi-layered securities. The administration's latest approach of guaranteeing loans appears to be intended to give the servicing firms an incentive to modify loans in ways that they may have been reluctant to do so far. The guarantee could strengthen the hand of firms in discussion with investors who are upset about modifications. Earlier this summer, Congress created another program, Hope for Homeowners, that also offers government guarantees, though under different terms. In that plan, servicing firms that willingly write down delinquent loans and pay a premium can have the loan refinanced by new mortgages that are guaranteed by the Federal Housing Administration. When homeowners eventually sell their homes, they have to share any profits with the government. In the Senate hearing, Brian Montgomery, the FHA commissioner, said that the program started operating on Oct. 1 but added that "it will take time for the lending community to get the program up and running." Earlier on Thursday, RealtyTrac, a default-tracking service, reported that foreclosure filings jumped by more than 71 percent in the third quarter, to 765,000, from the period a year earlier. There was a slight dip in filings in September, from August, but the company said that decrease was caused by new laws in some states like California and North Carolina that have delayed the start of some foreclosures. In Massachusetts, which enacted a 90-day moratorium on foreclosures three months earlier, default filings surged in September. RealtyTrac tracks foreclosures based on court filings in 2,200 counties. Critics have said that multiple court filings on each home inflate its statistics. RealtyTrac says it adjusts its data to account for multiple filings. At the White House, Bush's press secretary, Dana Perino, warned that the country was in for "a rocky road" on

"the employment front." She also said the administration expects next week's report on third-quarter gross domestic product "not to be a good one, and the next quarter could probably be tough as well." The remarks were significant, coming from a White House that has traditionally been reluctant to offer forecasts in advance of reports. But Perino said she was "just trying to be realistic."

Bailout Expands to Insurers
Treasury to Take Stakes in Firms as Distress Spreads Beyond Banks
October 25, 2008

The Treasury Department is dramatically expanding the scope of its bailout of the financial system with a plan to take ownership stakes in the nation's insurance companies, signaling new concerns about a sector of the economy whose troubles until now have been overshadowed by the banking industry, government and industry sources said. Insurers, including The Hartford, Prudential and MetLife, have pushed the Bush administration to include them in the plan. Many firms have taken losses from mortgage-related securities and other investments and are struggling to replenish their coffers. Government officials worry that the collapse of a major insurer could further destabilize the financial system because of the crucial role the companies play in backstopping a wide range of financial transactions, although the direct impact on holders of car, life and other insurance policies would be modest, industry officials said. The new initiative underscores the growing range of problems that Treasury is scrambling to address with the $700 billion allocated by Congress this month. The shape of the plan has changed repeatedly since Treasury Secretary Henry M. Paulson Jr. introduced it last month as an effort to rescue banks by buying their troubled mortgage-related assets. That original mandate has now been pushed aside by a plan to take equity stakes in banks and insurance companies, and other businesses are lobbying to be included. The government has been forced to expand the plan partly because the federal guarantees previously given some institutions, such as banks, have put other companies and financial sectors at a disadvantage, making them less attractive to uneasy investors. The government's power to choose winners and losers in the crisis was illustrated yesterday when the Cleveland-based bank National City was forced to sell itself when regulators turned down its request for a Treasury investment after deciding the firm was too weak to save, according to people familiar with the matter. Instead, the Treasury gave $7.7 billion to PNC Financial Services Group to help buy National City. It did not require that the money be used for new lending, the stated purpose of the government plan. PNC, which has a major presence in the Washington region, would become the fifth-largest bank in the country by deposits. Treasury officials yesterday backed away from plans to publicize a new round of investments in about 20 large regional banks over concerns that firms not on the list would be perceived as unhealthy and punished by investors. Capital One of McLean, SunTrust of Atlanta and KeyCorp of Cleveland are among the banks that will receive government funding, according to people familiar with the matter. Other banks are now free to make their own announcements, as PNC did yesterday. The cost of saving the country's largest insurer continues to rise. Senior managers at troubled insurance giant American International Group warned the Federal Reserve yesterday that the company would probably need more taxpayer money than the $123 billion in rescue loans the government has provided, according to two sources familiar with the private talks. AIG is having a painful time trying to pay off bad bets it made guaranteeing other companies' risky mortgage investments, which have lost much of their value. Five weeks after the government launched an unprecedented bailout to save the private company from bankruptcy, AIG has so far burned through $90.3 billion of government credit. The troubles at AIG highlight the difficulty of rescuing insurance companies after they begin to unravel. Each

week, AIG has faced multimillion-dollar collateral calls to pay off the mortgages and other assets it guaranteed, sources said. The calls were triggered largely because AIG's credit rating was sharply downgraded. The Federal Reserve Bank of New York and AIG declined to comment yesterday on the talks or to characterize AIG's situation. "In light of worldwide economic and financial conditions, we are in constant conversations with the Federal Reserve," said AIG spokesman Joseph Norton, who offered no further comment. The move to rescue other insurers raises questions about how much the government will need to spend to prop up the insurance sector and which part of the nation's financial system might need help next. "The big problem is whether the resources they've got available are sufficient as they expand to more and more sectors," said Roberton Williams, a budget expert at the Urban Institute. "Now that they're going to expand to certain insurance institutions, is there enough money to cover that? And what would be the next domino to fall?" If an insurer filed for bankruptcy protection, the direct impact on most consumers would probably be minimal. Most policies, such as car and home insurance, would be transferred to another company. But in many states, the cash value of life insurance policies and a widely held retirement insurance product called a fixed annuity is guaranteed only up to $100,000. The Emergency Economic Stabilization Act, approved by Congress and signed into law Oct. 3, permits Paulson to invest in any financial institution, including insurance companies. But when Treasury drafted rules for spending the first $250 billion to recapitalize banks, the program was limited to banks and bank holding companies. In order to buy stock in insurance companies, Treasury officials would have to redraft the rules for the program or create a new one. Insurers lobbied federal officials for inclusion in the program, arguing in part that it would "level the playing field" between banks and insurance firms. An industry trade group and several insurance companies have met with Treasury officials to discuss participation, industry sources said. Several insurers yesterday emphasized that their industry is less vulnerable to the mortgage-backed securities and other complex investments that have damaged the balance sheets of some banks. A recent report by Goldman Sachs noted that many insurers are struggling to raise enough capital to keep their credit ratings and meet regulatory requirements. Several major companies report earnings next week, putting their problems on public display. "These people are not in the same precarious position as AIG, but it would still be prudent for some of them to take on additional capital," Donn Vickrey of Gradient Analytics said. "Given how large the losses are and how long they've been building, they're running out of time." Treasury officials said yesterday that insurance companies organized as thrift holding companies are already eligible to receive federal money. That list includes most of the largest insurance companies. Industry sources said that the Treasury has formed a team to examine how it can help insurance companies that have no federal regulator. Many of these companies are subject to oversight by state authorities. "The life insurance industry is pleased to learn the Treasury Department is considering the inclusion of the life insurance industry in its Capital Purchase Program," said Frank Keating, president and chief executive of the American Council of Life Insurers. MBIA and Ambac, the country's largest bond insurers, are among those most at risk. Executives from the two companies met Tuesday in New York with their regulators to discuss options for winning help from the government, including getting capital injections. The day before the meeting, New York State Insurance Superintendent Eric Dinallo said bond insurers may need as much as $20 billion from federal coffers. Several economists said they were not surprised that Treasury has turned its attention to insurance companies,

which are as likely as banks to be heavily leveraged and exposed to the fallout from rampant foreclosures on residential mortgages. "It's the financial system in general" that's in trouble, said Alex J. Pollock, a former banker and resident fellow at the American Enterprise Institute. "Insurance companies are very important suppliers of credit to the rest of the economy and the rest of the financial system." Yesterday, the Financial Services Roundtable, a trade association for the largest financial firms, sent a letter to the Treasury urging the government to consider investments in a broader range of companies, including broker dealers, automobile companies, and foreign banks and insurance firms. Yet progress on the Treasury program remains halting. The roughly 20 regional banks joining it would be added to nine of the largest American banks, including Bank of America, Citigroup and J.P. Morgan Chase, which were forced to accept $125 billion in funding last week. But the Treasury has yet to give federal money to any of the banks because of legal wrangling over the details of the investment agreements. Assistant Treasury Secretary Neel Kashkari, the official responsible for the program, said in testimony before Congress this week that the next round of banks probably wouldn't get funding for "a few weeks." Banks that accept government investments must agree in return to issue to the government shares of preferred stock, which pay annual interest of 5 percent, and warrants for shares of common stock, which allow the government to profit as the company's share price rises. Banks also must accept limits on executive compensation and cannot raise dividends without permission. The PNC deal is the latest mega-merger orchestrated by the government to save a troubled bank. Previous rescues included Washington Mutual and Wachovia. Like Wells Fargo, which bought Wachovia, PNC will benefit from a recent rule change that allows it to use National City's losses to shelter income from taxes. PNC has been relatively untouched by the mortgage crisis. But the meltdown has caused deep losses for National City. PNC said it expects it could book $19.9 billion in losses, representing 17.5 percent of National City's loan portfolio.

Help for Homeowners, at Last?
October 26, 2008

For all the government’s actions to prop up the markets, credit tightened again last week and stocks sold off worldwide. Rather than confidence, fear of global recession has taken hold — and for good reason. Bush administration officials have failed to deal effectively with the root cause of the financial crisis — unaffordable mortgages peddled during the housing bubble and the mass foreclosures that have followed. The only ray of hope is that worsening conditions may finally force them to act. At a hearing on Thursday in the Senate Banking Committee, Sheila Bair, the chairwoman of the Federal Deposit Insurance Corporation, confirmed that the F.D.I.C. is working with the Treasury to streamline the reworking of troubled mortgages. The aim is to make the loans affordable over the long term so that borrowers can avoid foreclosure and keep their homes. Though details of the plan are not yet worked out, the outline calls for creating standardized criteria that would be used by mortgage servicers, the firms that handle collection and foreclosure proceedings for lenders and mortgage investors. Loans modified under the criteria would be eligible for a federal guarantee that would protect lenders and investors against default. (emphasis added-MSB) If the criteria are well established, defaults on the modified loans should not be a big problem. When the F.D.I.C. took over IndyMac Bank in California last summer, Ms. Bair established a streamlined program for 60,000 troubled loans from the failed bank. The program, which is yielding encouraging initial results, calls for modifications that lower a loan’s interest rate, extend the life of the loan or defer payment on a portion of the principal. Taken together, the modifications lower the monthly payment to no more than 38 percent of the borrower’s pretax income.

An IndyMac-like plan, on the federal level, would be significantly better than anything else tried so far. To date, servicers have been reluctant to amend loans, saying they could be sued by loan investors who might be disadvantaged by the modification. A government guarantee on the modified loan should reduce the risk of lawsuits. The new plan could also be up and running quickly, because the authority to offer the government guarantee was included in the bank bailout legislation passed this month. An IndyMac approach, with its emphasis on permanent changes to a loan’s terms, is also superior to ad hoc anti-foreclosure efforts of the past year that have focused on offering catch-up repayment plans. The administration has often cheered the proliferation of repayment plans as evidence of the mortgage industry’s willingness to work with troubled borrowers. But such plans often only delay foreclosure, because they do nothing to make the loan affordable over time. No single approach will solve the foreclosure problem. But Ms. Bair and the F.D.I.C. — an independent agency — deserve enormous credit for bringing a workable plan this far along in an administration resistant to such efforts to address the problems of homeowners. Congress should give the plan its full backing, and pursue other anti-foreclosure efforts. In a hopeful development at the hearing on Thursday, the Banking Committee chairman, Senator Christopher Dodd, the Connecticut Democrat, said he was considering a new round of anti-foreclosure legislation in November. That would include allowing bankruptcy judges to modify troubled loans under court protection — a much needed and long overdue change in policy. In the meantime, the Treasury would do well by the American public by going where Ms. Bair and the F.D.I.C. are leading.

They're shocked, shocked, about the mess
By Gretchen Morgenson October 26, 2008

MY hypocrisy meter conked out last week. It started acting up on Wednesday, spinning wildly as executives from the nation's leading credit-rating agencies testified before Congress about their non-roles in the credit crisis. Leaders from Moody's, Standard & Poor's and Fitch all said that their firms' inability to see problems in toxic mortgages was an honest mistake. The woefully inaccurate ratings that have cost investors billions were not, mind you, a result of issuers paying ratings agencies handsomely for their rosy opinions. Still, there were those pesky e-mail messages cited by the House Committee on Oversight and Government Reform that showed two analysts at S&P speaking frankly about a deal they were being asked to examine. "Btw — that deal is ridiculous," one wrote. "We should not be rating it." "We rate every deal," came the response. "It could be structured by cows and we would rate it." Asked to explain the cow reference, Deven Sharma, S&P's president, told the committee: "The unfortunate and inappropriate language used in these e-mails does not reflect the core culture of the organization I am committed to leading." Maybe so, but that was a lot for my malarkey meter to absorb. Then, on Thursday, my meter sputtered as Alan Greenspan, former "Maestro" of the Federal Reserve, testified before the same congressional questioners. He defended years of regulatory inaction in the face of predatory lending and said he was "in a state of shocked disbelief" that financial institutions did not rein themselves in when there were billions to be made by relaxing their lending practices and trafficking in exotic derivatives. Greenspan was shocked, shocked to find that there was gambling going on in the casino. MY poor, overtaxed, smoke-and-mirrors meter gave out altogether when Christopher Cox, chairman of the Securities and Exchange Commission, took his turn on the committee's hot seat. His agency had allowed Wall Street firms to load up on leverage without increasing its oversight of them. But he said on Thursday that the credit crisis highlights "the need for a strong SEC, which is unique in its arm's-length independence from the institutions and persons it regulates."

He said that with a straight face, too. There was more. Cox went on to suggest that his hapless agency should begin regulating credit-default swaps. This, recall, is that $55 trillion market at the heart of almost every big corporate failure and near-collapse of recent months. Trading in these swaps, which offer insurance against debt defaults, exploded in recent years. As the market for the swaps grew, so did the risks — and the interconnectedness — among the firms that traded them. During the years when these risks were ramping up unregulated, Cox and his crew were silent on the swaps beat. How exasperating. After all the time and taxpayer money spent trying to resolve the financial crisis, we're still in the middle of the maelstrom. The S&P 500-stock index was down 40.3 percent for the year at Friday's close. Yes, the problems are global, and made more complex by Wall Street's financial engineers. And a titanic deleveraging process like the one we are in, where both consumers and companies must cut their debt loads, is never fun or over fast. Still, as the stock market continues to grind lower, something more may be at work. And that something centers on trust and credibility, which have been lacking in corporate and government leadership in recent years. Like the boy who cried wolf, corporate and regulatory officials have issued a lot of hogwash over the years. Until recently, investors were willing to believe it. Now they may not be so easily gulled. Companies, even those in cyclical businesses, routinely told investors that the reason they so regularly beat their earnings forecasts was honest hard work — and not cookie-jar accounting. They were believed. Politicians proclaiming that the economy was strong and that the crisis would not spread kept our trust. Brokerage firms insisting that auction-rate securities were as good as cash won over investors — and, as we all know now, that market froze up. Wall Street dealmakers were fawned over like all-knowing superstars, their comings and goings celebrated. No one doubted them. Banks engaging in anything-goes lending practices assured shareholders that safety and soundness was their mantra. They, too, got a pass. Directors who didn't begin to understand the operational complexities of the companies they were charged with overseeing told stockholders that they were vigilant fiduciaries. Investors suspended their disbelief. And regulators, asserting that they were policing the markets, convinced investors that there was a level playing field. Is it any surprise that virulent mistrust seems to own the markets now? Janet Tavakoli, a finance industry consultant who is president of Tavakoli Structured Finance, said the stock market's gyrations are a result of a severe lack of confidence in the very officials who are charged with cleaning up the nation's mess. "It is not enough to throw money at a problem; you also have to use honesty and common sense," Tavakoli said. "In fact, if you leave out the last two, you are wasting taxpayers' money." What Tavakoli means by common sense is a plan that will force institutions to get a fix on what their holdings are actually worth. "If you are going to hand out capital, you have to first revalue the assets or take over so that you can force a mark to market," she said. "Force restructurings, mark down the assets to defensible levels and let the market clear." She also suggests that financial regulators impose a form of martial law, allowing them to rewrite derivatives contracts that bind counterparties to terms they may not even comprehend. "If I were queen of the world, I would wade in there with a small army of people and just start straightening out these books," she said. "Start stripping them down and simplifying contracts so people can start to understand what they own. It would be unprecedented, but so is everything else we are doing."

THAT move, which would begin the much-needed healing process for investors, would be unprecedented in another way. It might get the people who run our companies and our regulatory agencies into the business of telling the truth. Naïve, I know. But something to wish for — I'd like to give my hypocrisy meter a breather.

So when will banks give loans?
October 26, 2008

"Chase recently received $25 billion in federal funding. What effect will that have on the business side and will it change our strategic lending policy?" It was Oct. 17, just four days after JPMorgan Chase's chief executive, Jamie Dimon, agreed to take a $25 billion capital injection courtesy of the U.S. government, when a JPMorgan employee asked that question. It came toward the end of an employee-only conference call that had been largely devoted to meshing certain divisions of JPMorgan with its new acquisition, Washington Mutual. Which, of course, it also got thanks to the U.S. government. Christmas came early at JPMorgan Chase. The JPMorgan executive who was moderating the employee conference call didn't hesitate to answer a question that was pretty politically sensitive given the events of the previous few weeks. Given the way, that is, that Treasury Secretary Henry Paulson Jr. had decided to use the first installment of the $700 billion bailout money to recapitalize banks instead of buying up their toxic securities, which he had then sold to Congress and the American people as the best and fastest way to get the banks to start making loans again, and help prevent this recession from getting much, much worse. In point of fact, the dirty little secret of the banking industry is that it has no intention of using the money to make new loans. But this executive was the first insider who's been indiscreet enough to say it within earshot of a journalist. (He didn't mean to, of course, but I obtained the call-in number and listened to a recording.) "Twenty-five billion dollars is obviously going to help the folks who are struggling more than Chase," he began. "What we do think it will help us do is perhaps be a little bit more active on the acquisition side or opportunistic side for some banks who are still struggling. And I would not assume that we are done on the acquisition side just because of the Washington Mutual and Bear Stearns mergers. I think there are going to be some great opportunities for us to grow in this environment, and I think we have an opportunity to use that $25 billion in that way and obviously depending on whether recession turns into depression or what happens in the future, you know, we have that as a backstop." Read that answer as many times as you want — you are not going to find a single word in there about making loans to help the American economy. On the contrary: at another point in the conference call, the same executive (who I'm not naming because he didn't know I would be listening in) explained that "loan dollars are down significantly." He added, "We would think that loan volume will continue to go down as we continue to tighten credit to fully reflect the high cost of pricing on the loan side." In other words JPMorgan has no intention of turning on the lending spigot. It is starting to appear as if one of Treasury's key rationales for the recapitalization program — namely, that it will cause banks to start lending again — is a fig leaf, Treasury's version of the weapons of mass destruction. In fact, Treasury wants banks to acquire each other and is using its power to inject capital to force a new and wrenching round of bank consolidation. As Mark Landler reported in The New York Times earlier this week, "the government wants not only to stabilize the industry, but also to reshape it." Now they tell us. Indeed, Landler's story noted that Treasury would even funnel some of the bailout money to help banks buy other banks. And, in an almost unnoticed move, it recently put in place a new tax break, worth billions to the banking industry, that has only one purpose: to encourage bank mergers. As a tax expert, Robert Willens, put it: "It couldn't be clearer if they had taken out an ad."

Friday delivered the first piece of evidence that this is, indeed, the plan. PNC announced that it was purchasing National City, an acquisition that will be greatly aided by the new tax break, which will allow it to immediately deduct any losses on National City's books. As part of the deal, it is also tapping the bailout fund for $7.7 billion, giving the government preferred stock in return. At least some of that $7.7 billion would have gone to NatCity if the government had deemed it worth saving. In other words, the government is giving PNC money that might otherwise have gone to NatCity as a reward for taking over NatCity. I don't know about you, but I'm starting to feel as if we've been sold a bill of goods. The markets had another brutal day Friday. The Asian markets got crushed. Germany and England were down more than 5 percent. In the hours before the U.S. markets opened, all the signals suggested it was going to be the worst day yet in the crisis. The Dow dropped more than 400 points at the opening, but thankfully it never got any worse. There are lots of reasons the markets remain unstable — fears of a global recession, companies offering poor profit projections for the rest of the year, and the continuing uncertainties brought on by the credit crisis. But another reason, I now believe, is that investors no longer trust Treasury. First it says it has to have $700 billion to buy back toxic mortgage-backed securities. Then, as Paulson divulged to The Times this week, it turns out that even before the bill passed the House, he told his staff to start drawing up a plan for capital injections. Fearing Congress's reaction, he didn't tell the Hill about his change of heart. Now, he's shifted gears again, and is directing Treasury to use the money to force bank acquisitions. Sneaking in the tax break isn't exactly confidence-inspiring, either. (And let's not even get into the less-than-credible, afterthe-fact rationalizations for letting Lehman default, which stands as the single worst mistake the government has made in the crisis.) On Thursday, at a hearing of the Senate Banking Committee, the chairman, Christopher Dodd, a Connecticut Democrat, pushed Neel Kashkari, the young Treasury official who is Paulson's point man on the bailout plan, on the subject of banks' continuing reluctance to make loans. How, Senator Dodd asked, was Treasury going to ensure that banks used their new government capital to make loans "besides rhetorically begging them?" "We share your view," Kashkari replied. "We want our banks to be lending in our communities." Senator Dodd: "Are you insisting upon it?" Kashkari: "We are insisting upon it in all our actions." But they are doing no such thing. Unlike the British government, which is mandating lending requirements in return for capital injections, our government seems afraid to do anything except plead. And those pleas, in this environment, are falling on deaf ears. Yes, there are times when a troubled bank needs to be acquired by a stronger bank. Given that the U.S. government insures deposits, it has an abiding interest in seeing that such mergers take place as smoothly as possible. Nobody is saying those kinds of deals shouldn't take place. But Citigroup, at this point, probably falls into the category of troubled bank, and nobody seems to be arguing that it should be taken over. It is in the "too big to fail" category, and the government will ensure that it gets back on its feet, no matter how much money it takes. One reason Paulson forced all of the nine biggest banks to take government money was to mask the fact that some of them are much weaker than others. We have long been a country that has treasured its diversity of banks; up until the 1980s, in fact, there were no national banks at all. If Treasury is using the bailout bill to turn the banking system into the oligopoly of giant

national institutions, it is hard to see how that will help anybody. Except, of course, the giant banks that are declared the winners by Treasury. JPMorgan is going to be one of the winners and deservedly so. Dimon managed the company so well during the housing bubble that it is saddled with very few of the problems that have crippled competitors like Citi. The government handed it Bear Stearns and Washington Mutual because it was strong enough to swallow both institutions without so much as a burp. Of all the banking executives in that room with Paulson a few weeks ago, none needed the government's money less than Dimon. A company spokesman told me, "We accepted the money for the good of the entire financial system." He added that JP Morgan would use the money "to do good for customers and shareholders. We are disciplined to try to make loans that people can repay." Nobody is saying it should make loans that people can't repay. What I am saying is that Dimon took the $25 billion on the condition that his institution would start making loans. There are plenty of small and medium-size businesses that are choking because they have no access to capital — and are perfectly capable of repaying the money. How about a loan program for them, Dimon? Late Thursday afternoon, I caught up with Senator Dodd, and asked him what he was going to do if the loan situation didn't improve. "All I can tell you is that we are going to have the bankers up here, probably in another couple of weeks and we are going to have a very blunt conversation," he replied. He continued: "If it turns out that they are hoarding, you'll have a revolution on your hands. People will be so livid and furious that their tax money is going to line their pockets instead of doing the right thing. There will be hell to pay." Let's hope so.

The imperative of collaboration
By Felix G. Rohatyn and Allison Stanger October 24, 2008

The White House has wisely heeded the European Union's call for a new Bretton Woods and invited leaders from 20 nations to a summit meeting in Washington on Nov. 15. It was important that President Bush act quickly and it is equally important that the president-elect be represented at the summit. The health of the global economy is neither a partisan nor a national issue, and a window of opportunity exists now for creative multilateral action that will not be open indefinitely. Global financial markets have not been in greater disarray since the Great Depression. We all know what that downward spiral meant for world politics: Economic chaos bred political extremism, countries and individuals alike searched for scapegoats for their sudden turn of fortune, and world war served as the ultimate arbiter. Out of the ashes of destruction, the institutions of the international economy - the International Monetary Fund and the World Bank - were created in 1944 at Bretton Woods and played a significant role in taming financial markets, ushering in an era of unprecedented economic growth. The global economy has outgrown these institutions in their present form. Rather than requiring war, conflict and hardship before acquiescing in multilateral action as an act of desperation, we should seize the opportunity to work together on new institutions before the politics of economic despair are undeniably back in business. It may sound alarmist to speak of the necessity of cooperation to pre-empt bloodshed, but the way in which our current economic predicament differs from that of the inter-war period only increases the need to act immediately and decisively.

The globalization of finance, technology and information mean that the fates of countries and of individuals are interwoven in unprecedented fashion. The unraveling of those connections could be more disruptive and more devastating, and on a more massive scale, than anything we have ever collectively experienced. We have no way of knowing just how bad it could get or what countries will be hit the hardest, simply because the potential chain reactions of market forces have never before been so long or so all-encompassing. The enormity of what the developed economies could collectively lose creates a powerful incentive for international cooperation, especially before it becomes clear who the biggest losers are likely to be. 2008 is not 1944 for another important reason. In 1945, the United States had unmatched global power. Today, the United States is the world's biggest debtor nation and one of many serious contributors to world order. The financial meltdown provides the perfect opportunity for the United States to acknowledge that changed world and, in so doing, officially end the age of unilateralism that has played no small part in America's present economic predicament. A new Bretton Woods would provide as much a symbolic new beginning as a substantive one, and for that reason alone, Europe's call should be heeded. The substance of the global economic order's re-founding must be worked out collaboratively, but collective acknowledgment that the global economy has outgrown the regimen designed to keep it healthy is an important first step. A new agreement must insist on transparent procedures and limits on leverage so that the possibility of responsible financial action is restored. It must also consider ways to augment the powers of the IMF and World Bank. But the acknowledgment of the importance of collaboration at this critical moment is imperative. That's why it made no sense to squander good will arguing over whether the White House or the UN should sponsor the meeting. It can be both. The antiquated notion that the world needs one leader must itself be put to rest. For collaboration to produce a new rule set that binds all the players, all the players must be present at the creation. This is indeed the right time to invite China, Russia and India to join the conversation. Some Americans may be reluctant to follow Europe's lead rather than charting the course. It should not be unpatriotic to admit that Americans do not have a monopoly on good ideas. To believe that multilateral collaboration will bind the U.S. to some variant of European socialism also fundamentally misunderstands the constructed character of free markets. Markets may spontaneously arise, but they are inevitably framed by choices governments make. Since there is no global government to play this role for the global economy, governments must collaborate to approximate it. Participating in a new Bretton Woods simply means acknowledging the consequences of globalization and the urgent need for a sustainable financial architecture that encourages long-term over short-term thinking. Market fundamentalists may resist this call to unprecedented international cooperation, insisting that with just the right injection of capital, markets will govern themselves in the long run. But as John Maynard Keynes wisely pointed in 1923, in the long run, we are all dead. The risks of inaction were too high and the potential for corruption too great to have left the matter to bankers and markets alone. The U.S. government has an important role to play in a global partnership for peace and prosperity that seems within reach. We must rise to the challenge.

Felix G. Rohatyn is an investment banker and a former U.S. ambassador to France. Allison Stanger is the Russell Leng Professor of International Politics and Economics at Middlebury College and author of the forthcoming "Empire of the Willing: The Privatization of American Power." Redefining multilateralism
By Robert B. Zoellick October 24, 2008

September and October are shaping up to be hard months in a precarious year. A meltdown in financial, credit and housing markets. The continuing stress of high food and fuel prices and the dangers for poverty and malnutrition. Anxieties about the global economy. The events of September and October could be a tipping point for many developing countries. As always, the poor are the most defenseless. Voices around the world are blaming free markets. Others are asking about the failures of government institutions. We cannot turn back the clock on globalization. So we must learn the lessons from the past, as we build for the future. We must modernize multilateralism and markets for a changing world economy. Today's globalization and markets reflect huge changes in information and communications technology, financial and trade flows, mobility of labor, and vast new competitive forces. New economic powers are on the rise, making them stakeholders in the global system. They want to be heard. Private financial markets and businesses will continue to be the strongest drivers of global growth and development. But the developed world's financial systems, especially in the U.S., have revealed glaring weaknesses. The international architecture designed to deal with such circumstances is creaking. The New Multilateralism will need to be a flexible network. It must maximize the strengths of interconnecting institutions, public and private. It should be oriented around pragmatic problem-solving that fosters cooperation. Our New Multilateralism must build a sense of shared responsibility for the health of the global political economy and must involve those with a major stake in that economy. We must redefine economic multilateralism more broadly, beyond the traditional focus on finance and trade. Today, energy, climate change, and stabilizing fragile and post-conflict states are economic issues. They are already part of the international security and environmental dialogue. They must be the concern of economic multilateralism as well. The New Multilateralism will rely on national leadership and cooperation. But the G-7 is not sufficient. We need a better group for a different time; a core group of finance ministers who will assume responsibility for anticipating issues, sharing information, mobilizing efforts to solve problems, and at least managing differences. We should consider a new steering group including Brazil, China, India, Mexico, Russia, Saudi Arabia, South Africa and the current G-7, that holds regular formal and informal dialogues. The group should not just replace the G-7 with a fixed-number G-14, and should evolve to fit changing circumstances. We need this new network so that global problems are not just mopped up after the fact, but anticipated. The steering group will still need to work through established international institutions, but the core group will increase the likelihood that countries draw together to address problems. Just as the financial crisis has been international because of worldwide interconnectedness, reforms must be multilateral. Whether through an expanded Financial Stability Forum with the International Monetary Fund or the steering group, these financial supervisory issues will need to be addressed in a broader multilateral context. The New Multilateral Network must also interconnect energy and climate change. We need a "global bargain" among major producers and consumers of energy. There could be a common interest in managing a price range that reconciles interests while transitioning toward lower carbon growth strategies, a broader portfolio of supplies and greater international security. A climate change accord also will have to be supported by new tools. We need new mechanisms to support forestation, develop new technologies and encourage their rapid diffusion, provide financial support to poorer countries, assist with adaptation, and strengthen carbon markets. Dealing with the economic aftermath will be one of the foremost responsibilities of the next U.S. president. But this work is not about America alone.

Multilateralism is a means for solving problems among countries, with the group at the table able to take constructive action together. Fate presents an opportunity wrapped in a necessity: to modernize multilateralism and markets.

Robert B. Zoellick is president of the World Bank Group.
Treasury set to dish out financial rescue funds
October 27, 2008

The Treasury Department will start doling out $125 billion to nine major banks this week to get credit flowing again, giving a lift to U.S. markets on rising confidence that the government's moves would stave off a protracted recession. Investors overseas were less assured, though. Stocks fell sharply around the globe. Assistant Treasury Secretary David Nason said the deals with the nine banks were signed Sunday, and the government will make the stock purchases this week. The deals are designed to bolster the banks' balance sheets so they will begin more normal lending. The action will mark the first deployment of resources from the government's $700 billion financial rescue package passed by Congress on Oct. 3. The bailout package has undergone a major change in emphasis since it was passed by Congress. Treasury Secretary Henry Paulson decided to use $250 billion of the $700 billion to make direct purchases of bank stock, partially nationalizing the country's banking system, as a way to get money into the financial system more quickly. The plan is also aimed at clearing banks' balance sheets of bad assets. That effort has yet to begin although the administration expects to use $100 billion to purchase bad assets in coming months. The deployment of the first $125 billion to the major banks had been delayed while the government and the banks worked out the details for the purchases. Nason, a key architect of the rescue plan, said in an interview Monday on CNBC that those agreements had been signed late Sunday night. Treasury is also starting to give approval to major regional banks with the goal of getting another $125 billion in stock purchases made by the end of this year. KeyCorp, said Monday it would issue stock for a $2.5 billion infusion of capital from the government. SunTrust Banks Inc. also said it has received preliminary approval from Treasury for a $3.5 billion investment. In all, about 15 regional banks have received preliminary approvals for the government to make stock purchases. Treasury said it was allowing each bank to announce its own deal once preliminary agreements were reached. Treasury will announce the final deals on its Web site each day once all the paperwork is completed and signed. By law, Treasury must announce the agreements within 48 hours after they are signed. Treasury has given the go-ahead for stronger banks to use the money it receives in the rescue program to acquire weaker banks. That has prompted criticism the government should not be financing the consolidation of the banking system — in effect helping to choose winners and losers. As fears mounted of a prolonged and deep worldwide recession, a juggernaut of selling swept across world markets Monday, stripping billions of dollars of wealth from people across the globe. Major stock markets in Hong Kong, Tokyo, Britain, France and Germany slid, dragging down smaller bourses in emerging markets such as South Korea and the Philippines. Tokyo's Nikkei 225 index closed at its lowest since October 1982. But stocks rebounded on Wall Street. The Dow Jones industrial average started the day down nearly 90 points in the first few minutes of trading, but then stabilized, bolstered in part by a better-than-expected reading on new home sales and the Treasury announcement that the stock purchase program will begin this week. In early afternoon trading, the Dow Jones industrial average was up 125 points. The Federal Reserve will begin a two-day meeting Tuesday and many economists expect it to cut interest rates — perhaps to their lowest point in more than four years — with the hope of relieving some of the economic pain felt by many Americans. The Fed also began a major new initiative Monday to unclog frozen credit markets by purchasing commercial paper, the short-term loans that businesses use to fund their daily operations. The market for commercial paper

dried up after the bankruptcy of Lehman Brothers Holdings Inc. last month and other troubles in the global banking system. The biggest buyers of commercial paper are money market funds, some of which took big hits when Lehman collapsed. Net result: The convergence of a housing collapse and a lockup in bank lending has created the worst financial crisis in more than a half-century. With a recession seen as inevitable in the U.S., if not already under way, any Fed rate cut would be aimed at cushioning the fallout in the world's largest economy. Vanishing jobs and shrinking paychecks have forced U.S. consumers to cut back sharply. Millions of ordinary Americans have watched their 401(k)s and other nest eggs shrink and the value of their homes drop, making them feel in even worse financial shape. In turn, businesses have cut back on hiring and other investments as customers hunker down and credit problems make it harder and more costly to get financing. Not even China's mighty economy was immune to the rising recession anxiety. Its benchmark index slumped to its lowest level in more than two years as investors reacted to dismal earnings reports. Currency markets were unnerved by a statement from seven leading industrial nations Sunday warning of the "recent excessive volatility" in the value of the Japanese currency, which is rising against the U.S. dollar toward the 90 yen level and near 13-year highs. Dealers had one wary eye on central banks, watching whether they would intervene in currency markets to sell yen and prop up other currencies. The yen's rise threatens Japan's export-heavy economy by making its goods relatively more expensive. Shares of top Japanese exporters Toyota Motor Corp. and Sony Corp. were hit hard Monday. The losses came despite a report that the government was considering a massive capital injection into struggling banks in a bid to calm jittery financial markets. Investors fled to the safety of some types of government debt Monday. The price of gold — another traditional safe have in times of panic — rose. Investors around the world seemed largely unimpressed by government efforts to help lift market sentiment. South Korea's central bank cut its key interest rate Monday by three-quarters of a percentage point, its largestever reduction. The country's stock market benchmark Kospi ended with a 0.8 percent gain. Elsewhere, central banks in Australia and Hong Kong added funds to their markets to boost liquidity.

A new direction for American-style capitalism
October 26, 2008

It would be fairly easy to dismiss the gleeful boast by President Nicolas Sarkozy of France that American-style capitalism is over, to file it with French critiques of fast food and American pop culture. Except that the U.S. government now owns stakes in the nation's biggest banks. It controls one of the biggest insurance companies in the world. It guarantees more than half the mortgages in the country. Finance - the lifeblood of capitalism - has to a substantial degree been taken over by the state. Even Alan Greenspan, the high priest of unfettered capitalism and a former chairman of the Federal Reserve, conceded last week that he had "found a flaw" in his bedrock belief of "40 years or more" that markets would regulate themselves. "I made a mistake," he said. The question is what new direction capitalism should take. In a globally interconnected world, the U.S. cannot simply march back to the gray flannel capitalism of the 1950s and 1960s when regulations were tough and coddled monopolies dominated the corporate world. Still, the next president will have a chance, not to be missed, to reconsider some tenets of the freewheeling, deregulated version of a market economy that has dominated America since the Reagan administration. Financial deregulation enabled the boom-and-bust dynamic - removing barriers to capital flows, allowing unrestricted trading of abstruse financial products and letting financial institutions take on more and more debt. Cheap money, from China or the Federal Reserve, fueled the fire. But America's virtually unregulated shadow financial institutions - brokerages, hedge funds and other nonbank banks - played a particularly important role at the center of this process.

The solution will require rethinking the rules of finance. The amount of capital that banks must keep in reserve will have to rise; deregulated financial institutions will have to be regulated. Yet much more will be needed than just putting the bridle back on American banks. The next government must re-establish some notion of equity of opportunity. Investment is desperately needed in health care, education, and infrastructure. The social contract and the government's role in it should be reexamined. Addressing these challenges will be an enormous task - especially amid the recession that most economists expect over the next year or so. But they must be faced. Fixing finance is merely the start.

IMF pledges support for Ukraine and Hungary
October 27, 2008

Seeking to combat a spreading global financial crisis, the International Monetary Fund said Sunday it had reached a tentative agreement to provide Ukraine with $16.5 billion in loans and announced that emergency assistance for Hungary had cleared a key hurdle. The decisions were announced by IMF Managing Director Dominique Strauss-Kahn, who stressed that the 185nation lending agency would act with speed to provide support for countries whose economies are being buffeted by the crisis. Strauss-Kahn said the loan for Ukraine was designed to bolster confidence and noted that the assistance was sizable in relation to the country's borrowing rights with the IMF. In a separate announcement, Strauss-Kahn said the IMF staff had reached broad agreement with Hungarian authorities on a reform package that the country will implement as a condition for getting its own emergency loans from the IMF. Agreement on reforms is a necessary first step in receiving IMF assistance. Strauss-Kahn said the IMF was ready to approve a "substantial financing package" for Hungary within the next few days after all the details of the reform program are put in final form. He said the IMF's executive board would consider loans for Hungary under expedited procedures. He did not give a figure for how large the IMF loan to Hungary would be. In his comments on Ukraine, Strauss-Kahn said in a statement, "The IMF is moving expeditiously to help Ukraine and this program is focused on the essential upfront measures needed to maintain confidence and economic and financial stability." The decision to aid Ukraine came two days after the IMF announced it was supplying a $2 billion loan package to Iceland, whose banking system has collapsed amid the global credit crunch. Iceland, the first Western nation to receive IMF assistance in more than three decades, and Ukraine will both be given IMF loans in an effort to stabilize their economies. The IMF's executive board is expected to consider in the coming week ways to streamline its emergency loan programs as it braces for a stream of petitions from countries seeking support. President George W. Bush and other leaders of the Group of 20 major industrial and emerging market economies will meet in Washington next month to discuss ways to overhaul the global financial architecture to better cope with the financial crisis. The ongoing global turmoil has resulted in the biggest upheavals on Wall Street in 70 years and prompted Congress on Oct. 3 to pass a $700 billion rescue package for the U.S. financial system. Britain and other European nations have put forward massive resources to stabilize their countries' banks.

Strauss-Kahn said the agreement with Ukraine would be sent to the IMF's 24-member executive board for approval once the country's legislature has made changes to improve the way the government handles bank failures. He praised the reform package that Ukraine had worked out with an IMF staff team. "Ukraine has developed a comprehensive policy package designed to help the country meet the balance of payments needs created by the collapse of steel prices and the global financial turmoil and related difficulties in Ukraine's financial system," Strauss-Kahn said. Ukraine's Finance Ministry and its central bank said the loan would help shore up the country's flagging economic situation. "The support by the fund will promote an accelerated cooperation between Ukraine and other international financial organizations, strengthen the confidence of private investors and ensure stable operations of the banking system of Ukraine," the institutions said in a joint statement. If approved, the loan would be a crucial lifeline for the former Soviet republic, which is struggling to keep its financial system afloat amid the global economic crisis. Sharp declines in world prices for steel, Ukraine’s main export, and a steep drop in the value of its currency, the hryvna, have left many analysts speculating that the country faces dire economic straits. It comes on top of continuing political turmoil, with the country's leading politicians feuding ahead of new parliamentary elections scheduled for December. The world financial crisis has put heavy pressure on European currencies in recent days, with the British pound and the euro sagging on worries over Europe's exposure to emerging markets — particularly its crisis-stricken eastern neighbors. Sunday's IMF announcement came just two days after the Ukraine's National Bank announced that it would allow the official exchange rate for the hryvna to move closer to the market's exchange rate, fulfilling a key IMF condition. The hryvna has lost more than 20 percent in the financial crisis that has hit Ukraine hard. The currency fell to its historic low Thursday, trading at 6.01 per $1 on the foreign currency exchange. The fall was due to a shortage of foreign currency because of a 40 percent decline in exports and a run on banks that stripped the banking sector of $3.4 billion this month. The IMF loan is expected to help stabilize the financial sector, but the deepening political crisis threatened to block the deal. Allies of Prime Minister Yulia Tymoshenko broke parliament's electronic voting system Friday as they protested President Viktor Yushchenko's order to hold early elections. Tymoshenko and Yushchenko were allies during the tumultuous 2004 Orange Revolution mass protests that propelled Yushchenko to the presidency. But the two have turned into fierce rivals ahead of the scheduled 2010 presidential election. Yushchenko ordered a new parliamentary vote in December, but Tymoshenko is fighting to avoid the vote and retain her job.

Philip Bowring: Asia's dismal example
October 27, 2008

Last weekend's ASEM (Asia-Europe Meeting) summit in Beijing is evidence of how difficult reform of the world's financial system is going to be.

It is also evidence that high-sounding talk of "reform" can easily become a diversion from practical measures to halt the contraction in global demand. The ASEM gathering of 43 diverse states (plus the EU Commission and Association of South East Asian Nations secretariat) was never going to be a starting point for global financial reform. The timing of this biennial meeting just happened to present an opportunity for the group to try to set an agenda. President Nicolas Sarkozy, currently holding the EU presidency, and President Hu Jintao of China, succeeded in producing a statement calling for new rules governing international finance and an enhanced role for the International Monetary Fund. But attaching some specifics to those goals when 20 leading nations meet for a financial summit in Washington on Nov. 15 will be extremely difficult. The Bretton Woods financial system was designed not in a panic but very deliberately at a time when America's relative economic power was at its peak. There is no more consensus now on the way ahead than there was in 1971. In that year, Bretton Woods was first undermined when President Nixon ended the convertibility of the dollar into gold. Despite the Smithsonian Accord that followed that shock, it took time and much currency instability before the world adapted to the changed circumstances. The same is likely to happen now. It is all very well for Asia and Europe to agree on vague principles of reform, but as South Korea's president, Lee Myung Bak, pointed out, nothing can be achieved unless a trans-Atlantic consensus can be reached - and that looks very difficult. Over the past few weeks, Europe may have surprised itself with the ability of countries inside and outside the euro zone to act together to bail out banks. But agreeing on changes, particularly on cross-border financial regulation, involving many countries with different systems will be far more difficult. A lame duck U.S. administration can do little more than react to events. As for Asia, it has set a dismal example. For sure, the impact of the crisis in Asia is less than in the West - and that should remain the case. However, it should have been an opportunity for the major nations to show that the regional accords on currency stability and reserve-asset swaps agreed to in the wake of the Asian crisis of a decade ago meant a lot. But the two countries with the ability to lead have done almost nothing. The South Korean won has fallen by 40 percent against the Japanese yen since early September, and every currency in Southeast Asia has suffered a bout of jitters. Yet there has been scant sign of neighborly support to offset the exodus of cash-strapped Western investors from these markets, banks and currencies. In principle, the developing countries of Asia have the fiscal and foreign exchange positions that should enable them to sustain moderate economic growth, despite the collapse of Western demand. But without the overt backing of Japan and China they are likely to follow very conservative policies, fearing currency instability more than the impact of lower growth. China, Japan and Korea have agreed with the 10 ASEAN countries to establish an $80 billion liquidity fund. But this is small relative to their combined reserves of nearly $3 trillion and will not be established till mid-2009. India, meanwhile, faces big challenges on its own. For ASEM to call for the IMF to play a more active role is all very well. Some quick disbursement of funds to the worst impacted nations will help. But its resources, at around $350 billion, are at present far too small for today's circumstances. In the future, a new IMF-led liquidity creation system may well be needed as the U.S. current account deficit, the primary source of new global reserves, contracts. But, at best, that is a medium- term goal. In the shorter term,

China and Japan are the two countries best positioned to help sustain global growth through domestic demand stimulus (in China's case) and underwriting expansionist policies in the developing world. This may seem riskier for than buying more U.S. Treasury bills, but is likely to have far greater long term returns, and will ensure that Asian demand growth helps their own exports and expand their global influence. It is primarily up to the U.S. and Europe to mend their own financial systems and not to rely on Asians throwing more good money after bad. But it is primarily up to the Asian powerhouses to stimulate economic activity in a developing world that

Paul Krugman: The widening gyre
October 27, 2008

Economic data rarely inspire poetic thoughts. But as I was contemplating the latest set of numbers, I realized that I had William Butler Yeats running through my head: "Turning
hold." The widening gyre, in this case, would be the feedback loops (so much for poetry) causing the financial crisis to spin ever further out of control. The hapless falconer would, I guess, be Henry Paulson, the Treasury secretary. And the gyre continues to widen in new and scary ways. Even as Paulson and his counterparts in other countries moved to rescue the banks, fresh disasters mounted on other fronts. Some of these disasters were more or less anticipated. Economists have wondered for some time why hedge funds weren't suffering more amid the financial carnage. They need wonder no longer: Investors are pulling their money out of these funds, forcing fund managers to raise cash with fire sales of stocks and other assets. The really shocking thing, however, is the way the crisis is spreading to emerging markets - countries like Russia, South Korea and Brazil. These countries were at the core of the last global financial crisis, in the late 1990s (which seemed like a big deal at the time, but was a day at the beach compared with what we're going through now). They responded to that experience by building up huge war chests of dollars and euros, which were supposed to protect them in the event of any future emergency. And not long ago everyone was talking about "decoupling," the supposed ability of emerging market economies to keep growing even if the United States fell into recession. "Decoupling is no myth," The Economist assured its readers back in March. "Indeed, it may yet save the world economy." That was then. Now the emerging markets are in big trouble. In fact, says Stephen Jen, the chief currency economist at Morgan Stanley, the "hard landing" in emerging markets may become the "second epicenter" of the global crisis. (U.S. financial markets were the first.) What happened? In the 1990s, emerging market governments were vulnerable because they had made a habit of borrowing abroad; when the inflow of dollars dried up, they were pushed to the brink. Since then they have been careful to borrow mainly in domestic markets, while building up lots of dollar reserves. But all their caution was undone by the private sector's obliviousness to risk. In Russia, for example, banks and corporations rushed to borrow abroad, because dollar interest rates were lower than ruble rates. So while the Russian government was accumulating an impressive hoard of foreign exchange, Russian corporations and banks were running up equally impressive foreign debts. Now their credit lines have been cut off, and they're in desperate straits.

Needless to say, the existing troubles in the banking system, plus the new troubles at hedge funds and in emerging markets, are all mutually reinforcing. Bad news begets bad news, and the circle of pain just keeps getting wider. Meanwhile, U.S. policy makers are still balking when it comes to doing what's necessary to contain the crisis. It was good news when Paulson finally agreed to funnel capital into the banking system in return for partial ownership. But last week Joe Nocera of The New York Times pointed out a key weakness in the U.S. Treasury's bank rescue plan: It contains no safeguards against the possibility that banks will simply sit on the money. "Unlike the British government, which is mandating lending requirements in return for capital injections, our government seems afraid to do anything except plead." And sure enough, the banks seem to be hoarding the cash. There's also bizarre stuff going on with regard to the mortgage market. I thought that the whole point of the federal takeover of Fannie Mae and Freddie Mac, the lending agencies, was to remove fears about their solvency and thereby lower mortgage rates. But top officials have made a point of denying that Fannie and Freddie debt is backed by the "full faith and credit" of the U.S. government - and as a result, markets are still treating the agencies' debt as a risky asset, driving mortgage rates up at a time when they should be going down. What's happening, I suspect, is that the Bush administration's anti-government ideology still stands in the way of effective action. Events have forced Paulson into a partial nationalization of the financial system - but he refuses to use the power that comes with ownership. Whatever the reasons for the continuing weakness of policy, the situation is manifestly not coming under control. Things continue to fall apart.

No quick solution to financial crisis, Denmark shows
October 27, 2008

Denmark may be a small, out-of-the-way European nation, but as the first country to guarantee the deposits and liabilities of all its banks, its experience is sobering. The unwinding of the current financial crisis, Danes have found, will not come quickly or easily. Closely integrated into the global financial system, Denmark has discovered that ice-cold credit markets cannot warm up without easing elsewhere, too. And the same may prove true not just of smaller countries, but even some of the largest as well, like the United States, Japan and Britain. "This is a global phenomenon," said Tonny Andersen, the chief financial officer of Danske Bank in Copenhagen. "The unfreezing will be challenging." A sometimes skeptical member of the European Union that has so far refused to abandon its krone for the euro, Denmark is finding out what going it alone really means. Being a well-governed nation with a gilt-edged credit rating, however impressive in normal times, is not enough when global markets falter. On Monday, the National Bank of Denmark and the European Central Bank cemented the latest in a string of global currency swap agreements, emergency measures aimed at replacing a currency market that no longer functions. The ECB in Frankfurt will provide Denmark with 12 billion, or $15 billion, "as long as needed," the two central banks said in a statement. Denmark already has a swap line worth $15 billion with the U.S. Federal Reserve.

The Danish experience has underscored what American and European governments achieved with monumental bailout packages for banks - and what they did not. Standard & Poor's, the ratings agency, said in a report after the bailouts were passed that the disintegration of the financial system had been avoided. Economies would not go off a "credit cliff," but neither would bank lending resume quickly. "All these actions should restart the market," said Scott Bugie, managing director for financial services at Standard & Poor's. But, the report added, "it will take time to sink in." The vital statistics of the credit markets reflect historic levels of nervousness, with the Copenhagen Interbank Offered Rate, the benchmark for lending in krone, still near a record high. The Danish Parliament approved a blanket guarantee for all bank deposits and other liabilities on Oct. 10, less than a week after the opposition joined Prime Minister Anders Fogh Rasmussen in announcing the plan, and well before the United States and other European countries acted in bold but somewhat more limited ways. The intent in Copenhagen was to deliver an immediate boost to credit markets by demonstrating an ironclad consensus to support Danish banks. It didn't work. During that tumultuous week, in which European countries and the United States struggled to find their own responses to the crisis, Danish lending rates barely budged. Danes chalked it up to the distractions and assumed that things would improve once investors processed what had happened in Denmark. "We think the Danish banking sector is important, but I can see that this would not impress the rest of the world," said Lars Christensen, co-chief executive of Saxo Bank in Copenhagen. After the guarantee went into law, Danske Bank found that things were marginally better, Andersen said. It garnered $1 billion in loans from U.S. institutional investors and sold $500 million in commercial paper, a form of short-term debt, in the United States. Andersen also hit the road to sell the Danish guarantee package. Giving in to the inevitable Shakespearean image, he employed a presentation with a picture of a man peering at a skull with the caption: "Something rotten in the state of Denmark?" His answer was no. True, property prices are falling, particularly around red-hot Copenhagen. But strict mortgage underwriting standards have protected banks from the heavy losses of the sort linked to subprime lending in the United States. A 200-year-old system of standardizing and securitizing mortgages has kept the Danish market liquid, again in contrast to U.S. mortgage-backed bonds. The best explanation for a tight Danish credit market now, analysts said, is unreasonable fear. "It's the lack of risk appetite," said Peter Lauridsen, head of foreign exchange in Copenhagen at SEB, the large Scandinavian bank, "which sounds stupid, since there is simply no risk right now in Denmark." With the bank guarantees, the only additional risk that investors might fear is a depreciation of the krone against other currencies. With the globalization of financial markets, currency swap contracts - which allow investors to exchange one denomination for another, and match the transaction to the maturity of their loan - have lubricated global lending among banks.

In the past five years, Danish banks have generally loaned about $83.5 billion more than they have taken in deposits, forcing them to go to international capital markets to meet their needs. Typically, markets have been happy to oblige the creditworthy Danes. But the volatility in currency markets has led to a freeze-up on one "leg" - whether euro or dollar - of the Danish krone swap market. To unblock this conduit for interbank lending, the ECB furnished euros to ensure that anyone who lends to Danish banks can convert their kroner back into the world's second-most popular currency. That the Danish central bank is firmly committed to keeping the country's currency in lockstep with the euro - and raised interest rates twice in a single month to prove the point - matters little to panicky markets right now. "These are all related problems, all part of the liquidity chain," said Stephen Jen, global head of currency strategy at Morgan Stanley in London. "The normally most liquid markets in the most developed countries are frozen, so cross-border flows are even harder." The current turmoil is playing into the hands of the Danish leaders who believe that the time has come to jettison the krone in favor of the euro. But they still face an uphill battle to persuade a skeptical public. Rasmussen has said that he wants to hold a referendum on joining the euro zone before his term expires in 2011. Danish bankers, slogging through a crisis that shows no sign of ending, will be among the first to vote yes, they said. A poll published by Danske showed that a bare majority of the public - 50.1 percent - backs euro adoption. That is up from only a month ago, when partisans of the krone had the upper hand. "Even though the Danish economy is healthy, we are a small economy," said Andersen of Danske Bank. "And if you want a safe harbor in tough times, the euro is the right one for us."

Second Thoughts on the Bailout Bill?
October 27, 2008 By Joe Nocera

My friend and fellow financial columnist Don McNay, who has consistently opposed the bailout bill, wrote me an e-mail message this weekend that led with this question: “Your column strengthens my steadfast opposition to the bailout, but I am curious if you have changed your mind?” The answer is no. I have been horrified, for sure, at the lack of direction at the Treasury Department — first money was going to be used to buy mortgage-backed securities; then to recapitalize banks; and now, apparently, it is being viewed as a bludgeon to force weaker banks to merge with stronger ones (with Treasury getting to decide who lives and who dies). And I have become outraged at the duplicity of the government in making these shifts without coming clean with taxpayers — whose money, after all, it is. My column on Saturday was an expression of my growing anger at Treasury’s inept — and, at times, devious — response to the crisis. But I do not regret for a minute supporting the bailout plan’s passage in Congress. First of all, please recall, the financial system was on the verge of a meltdown, and the House’s initial rejection of the bill put the system right on the edge. It was important to pass the bill if for no other reason than to stem the panic. Second, the $700 billion that the Treasury has been authorized to spend is still a potentially tremendous weapon in the fight against this crisis. Even though this administration has not been able to figure out the best way to use it, that does not mean that the next administration will not do better. So, yes, I am still glad it passed, and I think, psychologically at least, it has made a bit of a difference — though not as much as it could have with better leadership. But in times like this, psychology matters. Now if the government would just do something about the root cause — the increasing home foreclosure rate. It is highly likely that Sheila Bair, the chairwoman of the Federal Deposit Insurance Corporation, will soon announce a plan to reduce mortgage payments for people in trouble and have the government guarantee them.

Still, the hour is late, and my guess is that any such broad plan will have to wait for the next president. Jan. 20 suddenly seems like a long way off.

1. October 27, 2008 1:34 pm I am puzzled by your response - or maybe simply puzzled by your low

expectations of the federal government. If there are no mandates about how the bailout money is to be used, the bailout package is a failure. Your Sunday article should have been front-page news. The bailout is nothing more than a giant treasury grab by big private banks. Reducing panic for a week in October is not an accomplishment. If Britain had the time and discipline to make mandates about how their bailout would happen, why not the United States Congress? Please keep reporting on this topic - but keep your standards high as to the duties of the federal government to protect taxpayer interests, not banking interests.
— Katie Scullion

2. October 27, 2008 2:02 pm The Times used to have a staff email list and the city room email. You (all) are now apparently protected against the great unwashed (that’s me). Question: do you know that Chase, now that it has tremendous amounts of my money and yours, are RAISING THE RATES on credit cards. Got one notice that the rate on the card I use as a back up, to cover checks if necessary is going up to about 29% OVER the prime? I have other Chase cards, but I haven’t had the courage to open those envelopes yet. You think, maybe, the other rates are going down??? Is Paulson moving to Chase after his Administration disappears? That would at least be out and out crookery, with nothing illegal (?) having been done. Maybe, Dick has put in a good word for him at Halliburton. (looks like I’ve screwed up the spelling) Or is this just the plain and simple chutzpah of W thinking? Is the govt. free now to take its money out? Sorry, but this was the only place I could find to ask the questions, some of course are more serious than others. Is there an article here. It seems there ought to be. — rd coleman 3. October 27, 2008 2:15 pm I’m confused about the “banks not lending” issue. N. GREGORY MANKIW and Ben Stein on Sunday said that the crisis is one of solvency not liquidity. If so, shouldn’t the banks use the money to save themselves or buy assets, rather than lend it out? — Chris Gilbert 4. October 27, 2008 2:22 pm Your analysis of the Bush-Cheney-Paulson reward to the Big Bank concerns was right on. In the meanwhile, millions of homeowners are still being foreclosed upon as the banks pretend they are doing something about it. Congress laid down like lambs to the slaughter when Paulson started whining. Once again, the lies and half truths of the Bush White House have overcome common sense in Congress. — hartman_john 5. October 27, 2008 2:35 pm Did You Know That Governments Invested In These Investments? Maybe I should just stop reading the news. From Bloomberg:

“No Bailouts”--These come in municipal bond and derivative deals that have turned poisonous. Unlike JPMorgan, which has benefited from federal bailouts, the towns and schools the bank has financed have received no help from Washington. In the midst of the Wall Street collapse, JPMorgan and Jamie Dimon, its chief executive officer, have stood as pillars. The bank helped the Federal Reserve bail out a tumbling Bear Stearns in March, as the U.S. Treasury pledged $29 billion to Dimon’s firm to cover losses. In October, JPMorgan took over failing Washington Mutual Inc., the largest savings and loan institution in the U.S., with $188 billion in deposits. Behind the glow of favorable publicity in which JPMorgan has basked, its municipal derivatives unit has operated in obscurity. The financings it arranged have sparked lawsuits from local governments alleging fraud.” So, let me see. Taxpayers are going to lose money in this crisis through actual investments, and then bailing out the investors. “As the credit crunch froze lending globally, causing stock markets to plunge, local officials who say they trusted JPMorgan faced a crisis of their own. Wall Street’s drive for profits over the past decade has backfired on towns, cities and counties that borrow in the $2.7 trillion municipal bond market. Financings arranged by JPMorgan and other banks are forcing hundreds of public agencies to spend billions of dollars they don’t have to pay for increased interest payments and penalties.” Why not? “For municipal governments, as for many of the financial institutions themselves, the opaque derivative deals have broken down. And taxpayers are left picking up the pieces.” I’m not making this up. — Don the libertarian Democrat 6. October 27, 2008 3:32 pm I guess I would have to adamantly disagree with your support of the plan. I do not LIKE that the government et. al are determining where my tax dollars are spent. A friend suggested that the money be divided among taxpayers and allow them to pay their own bills to the banks. That will strengthen the bank as well as allow the taxpayer to know where the money is going. Too often the process of government is not transparent because of the desegregation of centralized government. Some guy in a little office in Washington I have NEVER seen shouldn’t be messing with MY money. Also, do you save those who made bad choices? Yes the bank loaned them the money, but they should have known they couldn’t pay it back! — K Bailey 7. October 27, 2008 3:40 pm I don’t see how you could continue to support the bailout bill when the consequences have done nothing to alleviate the situation. The brokerage industry was becoming extinguished and this bill was a guise to rescue the titans of that industry (note Thain and his cohorts are still receiving a version of retention packages in the Merrill forced merger with BankAmerica). I read that no one can be held accountable for all these misdeeds but going forward maybe we need some people who have leadership talent and who really care about the financial direction of this country instead of all these Goldman and/or McKinsey alums. — Marjie Wertz 8. October 27, 2008 4:06 pm I truly believe that the way to get us out of this deficit is to pour money into things like highways and whatnot. Perhaps even these new fangled contraptions called zeppelins. Check out

this site and their revolutionary ideas This idea is not new, its a great idea but not a new one. The answers are not these huge revolutionary things but things that already exist but need tweaking. Another thing that would help our economy is to increase exports. Its simple math more money coming in is good. Why pay farmers not to farm? That’s a socialist idea not a capitalist idea. We are not capitalist nor do we truly believe in free trade. This means we have a mixed economy and that essentially means we are socialist…that however is an entire other can of worms. — David 9. October 27, 2008 5:25 pm “I think, psychologically at least, it has made a bit of a difference” That’s it? For $700 billion? A “bit” of a difference? Your support of the bailout is woefully thin in logic and substance. — Dan 10. October 27, 2008 6:11 pm I can appreciate the need for more free money in the economy and even that the banks are the more direct way to do that. I also appreciate the business side of how banks are not ethereal bodies of conscience and grace.. they are businesses and survive on our participation in their product. What I don’t appreciate is the redirection of funds that are supposed to help the situation when at the core, it is folks that got 9% fixed rate loans which are now paying 29.99%. The rules kept changing on them and they did not know enough or realize that these banks were resorting to skullduggery “opt-out” changes to their loan terms to hike the interest rate. Like a bad rider on a good legislative bill, they just squirmed their way through the “watch-out” filters and locked the consumers into a non-retractable position. Once there, the borrowers that did not know they had to “opt-out” kept getting their “fixed” rate loans jacked up for miscellaneous and often very ambiguously stated reasons to a point that they can’t make the payments and will never be able to pay down the principal much less pass credit scrutiny to purchase a home with a mortgage. Buying a little usury in every purchase was not what they thought they were walking out with it in paper or plastic. A fixed rate loan should be sacrosanct and the fact that no one has made any issue of this but wants to focus on the “big money” hype is ignoring the real basis for the problems the banks now face. Its one thing to hype a product to make it attractive to buyers but it is quite a different thing to intentionally misrepresent the product either before or after purchase. I think the IRS calls this the difference between avoidance and evasion of the truth. The first of this bailout money, if it really is intended to reach the real people in trouble, has to be to fix the fixes the banks have used to try to quietly hide their goofs and greed. Making more money available for “mortgages” when nothing is first done to insure that it won’t just be used as additional front money to extend the grasp of the banks with no constraints on its use, is just making the problem worse. — Emery Nash 11. October 27, 2008 9:10 pm Admit it. The bailout didn’t do a lick of good because it couldn’t. It was designed to treat a symptom, not the cause of the global meltdown. With mutual funds, hedge funds, pension funds, sovereign wealth funds all pouring money into equities, commodities, currencies, etc. without a corresponding increase in the value of those vehicles, what did you expect.

Either inflation, which started to rear its ugly head, or deleveraging (deflation), which happened because inflation would take too long. The big bubble (sum of all the little bubbles) has popped. Time to re-boot, folks. Admit it, Joe. The world has changed and you don’t know what to make of it. But don’t worry, we are all spectators in this show as the “market” works things out. — miguel 12. October 27, 2008 10:45 pm I don’t really understand anyone’s support of the bail out bill, or at least the expect results of the bill. This finical crisis seems to clearly point out the flaws in the American system. In fact if we assume that corporation’s main motivation is the amount of profit their making, then of course they are going to make risky investments, because the worst that could happen is that they will be bailed out by our tax money. Although I agree that it may be true that a bail out was the only means of keeping the American empire to have a fighting chance against its own greed and corruption. What i don’t understand is if the problem is unwillingness of banks to give loan why not put the money right into the banks. And if we must save corporate America why isn’t there an immediate change to government control. Is this all because of Americans fear of socialism, that the government will have too much control. Well it is true the government does need to be kept in check, but not by big business whose control of the country lead us here in the first place. So if we must save the system with a bail out plan, let us spend this money working toward new economic system that is for the interest of the majority, instead of its own. — Amato 13. October 28, 2008 2:08 am “First of all, please recall, the financial system was on the verge of a meltdown, and the House’s initial rejection of the bill put the system right on the edge.” I’m sorry, but this is utter nonsense. Much was made of the 777 point drop in the Dow the day after the House initially defeated the bailout bill, but the fact is that the Dow fell MORE THAN 2000 over the six days following the Senate’s passage of the bill. If that’s the cure, I’ll take the disease, thank you very much. The beauty of this farce is that the powers-that-be have set up an unfalsifiable assumption. If the economy continues to falter, they’ll say it would have been worse without the bailout. If the economy gets better, they’ll say, “See? It worked”. What a joke. — Brad Close 14. October 28, 2008 3:47 am Read Mike Mandel’s article in “Businessweek”: “It’s Not a Crisis of Confidence”. Home foreclosures were merely the first of the symptoms to show up, not the root cause of the financial meltdown. The market continues to drop, so I don’t see that the bailout has even made a difference psychologically. — Cathy 15. October 28, 2008 9:02 am. This is flat-out inane. Joe, you support the Fallout even though it’s
accomplished nothing, has no objectives, and has no accountability? This is simply the banks stealing money from taxpayers. This is not about “saving” anything or “preserving lending” of any sort — it simply ensures a bigger bonus for Jamie!

Your refusal to “believe” the facts that you see (as if that will change reality, a la the entire Bush administration) shows an appalling lack of personal integrity. Why oh why can’t we have a better press corps?

— Unsympathetic 16. October 28, 2008 10:50 am Like Dan (#9), I don’t follow your justification at all. Further explanation, please? — frank r 17. October 28, 2008 1:04 pm. I have a comment regarding your Saturday article “when will banks give loans”. As you so correctly pointed out, the Treasury gave JP Morgan a gift with Bear and WaMu. JPM will benefit for many years from the WaMu gift, both directly and indirectly. I have a WaMu mortgage and I want to know what JPM ended up paying (cents on the dollar) for that mortgage. Even if Wamu previously sold the mortgage, or if JPM has subsequently sold it, my current monthly payment is now running through the Wamu system, thus making JPM money. I have a plan. Value the benefit of all of the WaMu mortgage money that JPM now controls and determine an amount of the cost to JPM for my mortgage. My conservative estimate is that, on the high side, they paid no more than .20 cents on the dollar for it. So I’ll pay JPM .25 cents on the dollar to purchase my mortgage outright. JPM gets their .20 cents back and makes a 25% profit on the deal, and I own my house. Why should we, the taxpayer and WaMu mortgage holder, be penalized for funding a gift of which JPM will benefit now and for years to come. 25 years out from now JPM will make billions, maybe trillions off of this deal as money rolls through their system from mortgage payments. Everyone would benefit from what I am proposing: I would own my house, JPM would make a 25% profit, (at the net present value vs. future value) and think of how this would reinvigorate banks, if performing mortgage holders, with good credit, had the ability to go and refinance what was a 100k mortgage for 25k (for those who couldn’t pay it off). The world has changed so the rules can and should as well. I’m sure someone will say i am simplifying this, but couldn’t we use a little more simplicity. The select few banks will walk away with billions, while we’re stuck holding the bag for the full mortgage amount that these select few paid almost nothing to control for years to come. — Mike Paxson 18. October 28, 2008 1:49 pm Simply to state that it was necessary to have some help from the administration to stop the crisis. However, it seems the rule that when banks are fine the profits belong to the shareholders and administrators, but when they are in problems of liquidity and risk of failure the losses are charged to the tax payers. The people that are loosing their homes should receive a large amount of the 700 billion to pay for their homes, and the financial institutions only the amount to continue lending to industries and keeping the mortgages outstanding at a lesser value. — Manuel G. Rosas Keynesian Logic

"We are all Keynesians now," said President Nixon in the early 1970s, as he came to terms with deficit financing and a prices and incomes policy inspired by the economic doctrines of the great Cambridge economist John Maynard Keynes. In fact, he couldn't have been more wrong: Keynesianism was past its intellectual high watermark and was ceasing to be a guide for economic policy makers all over the world. Its death knell was sounded by the double whammy of the election of Margaret Thatcher in Britain (1979) and Ronald Reagan in America (1980). The American economy is almost certainly further down the recession road than Britain (or continental Europe). That was then, this is now – and British newspapers, in full "capitalism-in-crisis" mode, are carrying little potted biographies of Keynes and his economic doctrine. The British government is now talking openly about resorting to some old-fashioned Keynesian pump-priming by talking about bringing forward some major multi-billion dollar capital spending projects, from Crossrail (a massive new underground railway spanning London from east to west) to modernizing Trident, Britain’s nuclear deterrent to speeding up the construction of two new Queen Elizabeth class aircraft carriers. "We are all Kenyesians now," to coin a phrase. Expect similar demands from a Democratic-controlled Congress post-November 4th as the depth of America’s looming recession panics the politicians on Capitol Hill. A little history will be made here in Britain on Friday when officials announce a downturn in economic growth between July and September, for the first time in 16 years. Hence the revival of Keynes (dismayed free marketers should console themselves: it could be worse – in Germany, Karl Marx’s unreadable Das Kapital is soaring up the bestseller list!). The American economy is almost certainly further down the recession road than Britain (or continental Europe). So many Democrats will soon be dusting off their own copies of Keynes and calling for more federal spending programs. However, expectations of just what Keynesian economic policy can achieve should be limited. Its original exponent (other than Adolf Hitler) was Franklin D Roosevelt who, though elected in 1932 on a promise to balance the budget, quickly saw the nonsense of that and started to try to lift America out of the Great Depression with a public works program financed by federal borrowing. Though this did wonders for America's morale (and helped get FDR re-elected three times!) its effect on the economy and unemployment was marginal. U.S. dole queues only started to plummet when Roosevelt went on to a war economy footing as Hitler's War raged in Europe and he knew America could not forever avoid engagement in it. The most recent exponents of a Keynesian boost to the economy are the Japanese: they embarked on pumppriming on a massive scale undreamt of by FDR or Keynes in the aftermath of their banking crisis in the 1990s, which pushed the economy into a severe deflation. But no matter how much the Japanese government borrowed and spent – current net debt is still an incredible 195% of Japan's annual national wealth (American borrowing is around 60%) – the economy stayed mired between deflation and sluggish growth for years (it still is). The lessons of history are clear: a certain amount of Keynesian pump priming, of the right sort, won’t do any harm – but it probably won’t do much good either. In the end, recovery will only come when banks start to lend to businesses – especially small business – and the fall in house prices bottoms out, so that consumers feel inclined to spend again. None of that is going to happen very quickly, which is why this recession is likely to be shaped, not like a V but like a bathtub. The British plan to salvage its banks is far better than Washington’s. With the Dow continuing to plunge downwards like a tart’s knickers on Navy Day at Annapolis, it’s dawning on

Washington that the $700 billion Paulson bank bailout might not be all it’s cracked up to be. So here’s a suggestion for US policy-makers from good old Blighty (aka Great Britain). The aim of the Paulson plan is for the Feds to buy up all the toxic waste (i.e. bad loans) from the banks to clean up their balance sheets and encourage them to start lending to each other again. The problem is twofold: identifying the toxic waste (so much of the bad stuff is wrapped up with the good stuff and it’s almost impossible to disentangle); and then putting a price on it (expect much wrangling between the banks and the Feds). London might be pointing the way and America’s recent financial track record suggests it can’t afford to be too proud to learn from elsewhere. Even if you could resolve both problems, it will take time and time is something we don’t have when the markets are in such an unforgiving mood. You can get an idea of just how serious the financial crisis is now becoming in the real economy (where things are made and non-financial services, like food and transport, are offered) by realizing that Mattel, the toy car maker, now has twice the market cap of General Motors after yesterday’s Dow collapse. So here’s the suggestion: instead of the time-consuming and complicated process of buying up the banks’ toxic waste in the hope of freeing up inter-bank lending once more, the Feds should simply guarantee all inter-bank lending. The British government has just done this, to widespread plaudits. The British plans are no panacea—the London stock market continued to fall after they were unveiled on Wednesday and continues to plummet as I write this Friday morning. But the London markets nearly always take their lead from New York and are simply following in the wake of the Dow. It means the government taking on a whopping contingent liability—around $400 billion here in London, which means well over $1 trillion for it to work in America—but it’s a guarantee the government is giving, not a check it is writing. It would only have to dole out the dosh if things really went belly up—and the very existence of such a guarantee means they probably won’t. Risky, I know, but maybe not as risky as doing nothing. The idea is that, with Uncle Sam guaranteeing inter-bank lending, the banks have no excuse not to start lending to each other again. Confidence in the wholesale credit markets is restored and the banks then start lending to us again too. With the government guarantee it doesn’t matter that the banks still have toxic waste on their books—they needn’t be afraid of lending to each other—and over, say, the three-year life of such a guarantee, the banks can sort the bad loans out themselves (they created the mess, after all, so they can clean it up). That leaves the need for the banks to recapitalize their balance sheets and, given the state of investor sentiment towards financial institutions at the moment, the capital is unlikely to be raised in by the private sector by a rights’ issue. Here again the Brits are ahead of the curve: the government in London has agreed to pump $100 billion of taxpayers’ money into the banks to allow them to restructure and recapitalize in return for preference shares (i.e. non-voting so it’s not nationalization) which will pay a high rate of interest and (hopefully) be redeemed at a profit. Other European countries are now looking at Britain’s loan guarantees and recapitalizing schemes and planning to do the same for their banks. The International Monetary Fund, meeting in Washington today, is also keen on the idea. The Feds should have a look too. The solution to the current financial turmoil doesn’t lie in London but in Washington and New York. But London might be pointing the way and America’s recent financial track record suggests it can’t afford to be too proud to learn from elsewhere. Your pension, after all, probably depends on it.

Is it buying time for stocks?
October 29, 2008

Some of the most famous American investors, including Warren Buffett and John Bogle, have started to make the case that it's time to dive back into the stock market.

They are usually careful to add that they don't know what stocks will do in the short term. Yet their basic message is clear enough: Stocks are now cheap, irrational fears have been driving the market down lately, and people who buy today will be glad that they did. After a day like Tuesday, when the Dow Jones industrial average rose 10.9 percent, it's easy to see the merits of the argument. But there is another argument that deserves more attention than it has gotten so far. It's the bearish argument that is based neither on fears that the country may be sliding into another depression nor on gut-level worries about the unknown. It is based on numbers and history, and it has at least as much claim on reason as the bullish argument does. It goes something like this: Stocks are truly cheap only relative to their values over the past 20 years, a period that will go down as one of the great bubbles in history. If you take a longer view, you see that the ratio of stock prices to corporate earnings is only slightly below its long-term average. And in past economic crises - during the 1930s and 1970s - stocks fell well below their long-run average before they turned around. To make matters worse, corporate earnings have now started to plunge, too. Assuming that they keep dropping, stocks would also need to fall to keep the price/earnings ratio at its current level. As stocks were soaring on Tuesday afternoon, I called James Melcher to hear a dose of fact-based bearishness. Melcher is a hedge fund manager at Balestra Capital in New York. He wrote an essay for his clients two years ago that predicted the broad outlines of the financial crisis (and then arranged Balestra's portfolio accordingly). Like the bulls, he said that no one could know what the market would do in the short term. "But to think stocks are cheap now," he added, "is not rational." He went on: "In the last 20 years - and particularly in the last six or seven - you had the most massive creation of liquidity the world has ever known." Consumers went ever deeper into debt, thanks to loose lending standards, and a shadow banking system, made up of hedge funds and investment banks, allowed Wall Street to do the same. All that debt lifted economic growth and stock returns. "It was a nice party," Melcher said. "The problem is that all the bills are coming due at the same time." He thinks stocks could easily fall an additional 15 percent and maybe another 25 percent before hitting bottom. So who's right - the bears or the bulls? The smartest people in both camps, like Melcher, Buffett and Bogle, have a healthy dose of humility about their own conclusions. And when you dig into their arguments, you find that they are not quite as different as they first sound. But they are different, and it's worth taking a minute to dig into the numbers. There are any number of ways to measure the valuation of the stock market. Some examine prices relative to earnings, others are based on cash flow, a company's underlying assets or the total value of the market. But they tell a pretty consistent story right now. Stocks, which were fabulously expensive for much of the 1990s and this decade, no longer are. My favorite measure is the one recommended by Benjamin Graham and David Dodd, in their classic 1934 textbook, "Security Analysis." They urged investors to use a price/earnings ratio - stock prices divided by average annual corporate earnings - based on at least five years of earnings and, ideally, closer to 10. Corporate profits may rise or fall in any given year, but a share of stock is a claim on a company's long-term earnings and should be evaluated as such. Why not use a forecast of future earnings? Because they tend toward the fictional, as we are now seeing once again. The 10-year price/earnings ratio tells an incredibly consistent story over the past century. It has averaged about 16 over that time. There have been long periods when it stayed above 16 and even shot above 20, like the 1920s, 1960s and recent years. As recently as October 2007, when other measures suggested the market was reasonably valued,

the Graham-Dodd version of the ratio was a disturbing 27. But periods in which the ratio has jumped above 20 have always been followed by steep declines and at least a decade of poor returns. By 1932, the ratio had fallen to 6. In 1982, it was only 7. Then, of course, the market began to self-correct in the other direction, and stocks took off. After the big rally Tuesday, the ratio was just a shade below 16, or almost equal to its long-run average. This is a little difficult to swallow, I realize. Stocks are down 40 percent since last October, and every experience from the past 25 years suggests they now have to bounce back. But that's precisely the problem. Since the 1980s, stocks have always bounced back from a loss, usually reaching a high in relatively short order. As a result, the market has become enormously overvalued. As Robert Shiller, the economist who specializes in bubbles, points out, human beings tend to put too much weight on recent experiences. We think the market snapbacks of 1987 and the current decade are more meaningful and more predictive than the long slumps of the 1930s, 1940s and 1970s. Of course, anyone who made the same assumption in 1930 or 1975 - this just has to turn around soon - would have had to wait years and years until the investment paid off. Now, Buffett, Bogle and their fellow bulls know all this history, and they are still bullish. (Though I'd be more bullish, too, if I could get the favorable terms that Buffett did. In exchange for his money and his good name, Goldman Sachs and General Electric each guaranteed him an annual return of at least 10 percent.) So on Tuesday afternoon, I also called Bogle, the legendary founder of the Vanguard Group, the investment firm whose low-cost index funds have made a lot for a lot of people. He, too, prefers the 10-year price/earnings ratio, he said, but he did not think that it necessarily had to fall to the same bargain-basement levels it reached in the 1930s and 1970s. You can certainly see why that would be the case. Investors are well aware that the market fell to irrationally low levels during past crises, and they may not allow it to become so cheap this time around. Bogle also thinks that corporate profits will rebound nicely within a couple of years and likes the fact that interest rates are low. Low rates have often - though not always - accompanied bull markets. But it is his last argument that I think is the main one for most investors to focus on. "I'm not looking for a great bull market," he explained. There are some reasons to be optimistic about stocks, he said, "and I also look at the alternative." And, really, how attractive are the alternatives? Savings accounts and money market funds will struggle to keep pace with inflation. Bonds may, as well. Stocks, on the other hand, are paying an average dividend of about 3 percent, which is better than the interest on many savings accounts, and stocks are also almost certain to rise over the next couple of decades. If that is your time frame - decades, rather than months or years - this will probably turn out to be a perfectly good buying opportunity. In the shorter term, though, it's a much tougher call, and it involves a lot more risk.

Russian companies face serious liquidity risks, German agency warns
October 29, 2008

Russian companies, estimated to be holding $45 billion of debt that needs to be refinanced, face serious liquidity risks as domestic borrowing costs soar and foreign investors reassess the risk of doing business in Russia, according to Hermes, the German government's export credit guarantee agency. "We have to be extremely cautious when it comes to Russia," said Hans Janus, a board member of Hermes, which ranks Russia as its No. 1 market. "We will keep our lines open and stand ready to take additional business because it is our role to support German industry," Janus said during an interview. "But we will not take unsound risks onto our books."

Janus's warning came as European banks made it clear to Hermes and other state-backed export insurance companies during a conference in Berlin this week that they were not prepared to provide any long-term financing without insurance coverage. "The banks now are operating on a short-term basis," said Janus, which could place Hermes in a difficult situation, especially with regard to Russia. He said smaller Russian banks in the provinces could be faced with difficulties in refinancing, particularly longterm loans, because of the credit squeeze. Germany is Russia's largest trading partner, so Hermes is faced with the task of minimizing risks as the Russian economy starts feeling the full effect of the global financial crisis. At the same time, Hermes's task is to ensure that German companies can continue to do business in Russia. Germany last year exported 28 billion, or $36 billion, of goods to Russia, almost the same amount as it imported. More than 10 percent of those exports, or 3.24 billion, were guaranteed by Hermes. The insurance covers political risks like confiscation of goods, administrative measures and war as well as commercial risks including default and bankruptcy. Janus said the total outstanding risk facing the German government in this aspect of export financing for German companies doing business in Russia had risen to 7 billion in 2007 compared with 5.2 billion the previous year. The increase was in large part caused by the surge in German companies - particularly small and midsize ones specializing in machine tools and machinery - that have established businesses in Russia. He said it was still too early "for reliable feedback about Russian companies meeting their repayment obligations."

In a nation of shopkeepers, small businesses demand help
October 29, 2008

When John Banwell, who owns a professional cleaning business in England, asked his bank recently to renew his line of credit, he was shocked to learn that the interest rate had almost doubled. Banwell tried to tell the manager of his HSBC branch that he needed the overdraft of £20,000, or $32,000, to pay his four employees and his bills while he waited for his customers to pay him. He received a written apology, saying there was nothing the bank could do about his rate, which had risen to 7 percentage points above the prime lending rate. Banwell was able to borrow the money from a friend instead, but that did not solve his long-term problem: how to keep his business in the seaside town of Weymouth alive as credit tightened in the midst of an economic downturn. "Fuel and material costs have gone up and we'll have to increase our prices, but I'm afraid it may erode sales," Banwell said. "Money definitely should be made available where needed." The economic downturn is making life tougher for businesses of all sizes. But Britain, historically called "a nation of shopkeepers," has a special place in its heart for small business. And Banwell's experience is at the heart of a battle that has erupted between representatives of small businesses and the government over how much help companies should receive as the country enters its first recession in 17 years. Backed by a strong business lobby, the opposition Conservative Party and the two biggest tabloid newspapers in the country, small businesses are demanding more affordable credit and tax breaks after a multibillion-pound government bank bailout failed to free up credit immediately.

Although small businesses account for more than half of the British gross domestic product and employ more than 13 million people, their plea is controversial. The sector, arguably, faces the same problems of higher borrowing costs and declining consumer spending as larger companies. But some analysts said small businesses are more vulnerable to a downturn because they depend more on financing. "A large company has more options to raise money," said Philip Shaw, chief economist at Investec Securities in London. But others said smaller companies are actually at an advantage because they are more flexible and can adapt better to slowing demand. That may be true, but small businesses say they are feeling the pinch as banks introduce charges for processing overdraft applications, increase their fees for managing accounts or request additional collateral for loans, according to the British Chambers of Commerce. The changes are a result of higher interbank lending rates, a deteriorating economic outlook and the more conservative attitude by banks toward risk. The British government tried to free up credit by making its bailout of Royal Bank of Scotland, Lloyds TSB and HBOS this month dependent on the banks' returning to "2007 levels" of lending to small businesses. The chancellor of the Exchequer, Alistair Darling, met with executives of other major British banks this month to persuade them to reduce borrowing costs for smaller businesses. But instead of freeing up lending, the entreaties led to criticism by some investors that the government was repeating the mistake it had made during the economic boom: encouraging borrowing. "Businesses are anticipating banks will be supportive, reflecting the support they have received themselves," said Neill Thomas, head of debt advisory at KPMG in London. But "the reality for companies is the tap remains blocked," he added. "We expect only a trickle of liquidity to return to debt markets in the period through to Christmas." That would be bad news for many of the 4.7 million small businesses in Britain, and it infuriated those who helped turn small businesses from net borrowers to net depositors over the past 17 years. The owners of small companies keep £1.48 billion with their banks, making them one of the biggest groups of depositors. One of them is William Mullings, who runs a small jewelry store in London founded by his family in 1798. He is upset that the government bailed out the banks, which are now still reluctant to lend. "If you are running a business, any business, you should be able to do so without the help of the government," Mullings said. Higher borrowing costs are not the only problem for small businesses. They also struggle as customers increasingly fall behind with payments, sometimes up to several months. Late payments can be a matter of life and death for smaller businesses. The debate has started to threaten the Labor Party's close relationship with small business and has moved small businesses into the center of a feisty political debate between the two major British parties about economic competence. The government wants to be seen as a supporter of small businesses because they are perceived as "struggling, small and hard-working," said Robert Blackburn, professor of small business studies at Kingston University in London. "There are a lot of votes in small businesses and there is a realization that this is quite a powerful group of people." It is also widely believed that it will ultimately be small businesses that will lead Britain out of recession.

"People running Britain's small businesses are the lifeblood of our economy," said Peter Mandelson, the government's business secretary. The popularity of Prime Minister Gordon Brown has already taken a hit because many voters blame him for creating the borrowing and spending boom, and subsequent bust, during his time as Chancellor of the Exchequer. The government has pledged to pay its own bills to smaller businesses within 10 days, but David Cameron, the Conservative Party leader, called for more drastic steps. In an open letter to The Sun newspaper, Cameron suggested that small businesses should be allowed to delay payments of value-added taxes and backed a cut in their tax rates to help them cope with "the economic downturn made in Britain and designed by Gordon Brown." Demands by the Federation of Small Businesses went even further, including a £1 billion rescue fund for small businesses backed by the European Investment Bank and a policy of publicly identifying customers that pay late. At his cleaning shop in the south of England, Banwell seemed to take a pragmatic approach. "I have no problem with having to tighten the belt and don't think banks should be forced to lend more - they are businesses, too - but the belt tightening needs to be evenly spread," he said. Constraints on banks Global intervention efforts should steady the banking system but will also put big constraints on banks, the Bank of England said Tuesday, Reuters reported. In its twice-yearly financial stability report, the central bank also said losses from the crisis might be much less than many investors expected. The report was much more cautious than the bank's report in April, which gave an upbeat assessment of how severely the credit crunch would affect the economy.

Credit Crisis Slows Economy in Once-Hot Poland
October 27, 2008

Poles were jolted last week by the sudden discovery that they were not immune to the financial crisis contagion rippling across the globe. The plunging stock market here and the drastic weakening of the Polish currency proved, as in so many corners of the fast-growing developing world, how wrong they were. The go-go atmosphere in Poland has abruptly stilled to a cautious wait-and-see. Developers across the country have halted building projects for thousands of apartments as banks have grown stingy with lending. The boomtown energy here has been replaced by nervous eyeing of the once powerful zloty, as it retreats in value against the dollar and the euro. The daily newspaper Dziennik summed up the mood on Friday with a front-page headline, “Welcome to the Tough Times.” In a country that seemed to be on the fast track to full membership in the Western club, the question on everyone’s lips is, “Why us?” Emerging markets that seemed healthy, even thriving, barely a month ago are beginning to find themselves caught in the worldwide panic. This sharp turn has caught even the local financial guardians and experts by surprise, as they have clung to their indicators of fundamental economic soundness while forgetting that capital stampedes rarely tarry for fine distinctions. From Europe’s former Communist bloc to South America, fear and disbelief mingled with frustration that a breakdown in the United States mortgage market — one that most investors and institutions in emerging markets had avoided — was beginning to lead once again to their punishment at the indiscriminate hands of the capital markets.

“Everything is going down,” said Lukasz Tync, 28, an information technology consultant in Warsaw, who said he owned shares in 10 companies and several mutual funds and had been hit hard by five consecutive days of falling stocks at the Warsaw Stock Exchange. The country’s leading index was down 12.6 percent for the week and more than 50 percent for the year. “The thing is that there is no fundamental basis for such moves,” Mr. Tync said. “It’s just panic.” Adding to the pain, the zloty has fallen around 17 percent against the dollar over the past week, and more than 10 percent against the euro. The currency has fallen roughly 30 percent against the dollar in October. Economic experts are cutting growth forecasts. Poland is still considered relatively healthy compared with Hungary and Ukraine, which have been among the hardest hit. On Sunday, the two reached tentative agreements with the International Monetary Fund for loans and other assistance aimed at preventing their financial systems from collapsing. Ukraine will get a loan of at least $16.5 billion. The value of Hungary’s rescue package has not been specified. Still, alarm about Hungary and Ukraine has infected Poland. “A week ago, people would have told you that this is an oasis of calm and stability,” said Marek Matraszek, founding partner and managing director at CEC Government Relations in Warsaw, a political consulting firm for foreign investors. “They didn’t expect that the lack of confidence in Central Europe would bleed over from Hungary and Ukraine.” The bleeding has extended much farther. In South Africa, the price of platinum, a major earner of foreign exchange, has cratered, from more than $2,000 an ounce in June to less than $800 now, contributing to a sharp depreciation in that country’s currency. Brazil’s currency has fallen by more than 40 percent against the dollar since August. The Turkish lira has fallen by more than 30 percent against the dollar in recent weeks and almost 20 percent against the euro. Fuat Karatas, 41, a dental technician in Istanbul, buys some imported materials priced in euros but cannot pass on the rising price to customers, who pay in lira, he said. “Now with the euro going crazy, I have no idea how things are going to work out for me,” he said. “I just want to be able to keep my lab open, nothing more.” During more prosperous times the risks in emerging market countries were strongly underestimated, said Marek Dabrowski, president of the Center for Social and Economic Research in Warsaw. “Naturally, the global credit crunch and economic slowdown caused overshooting in the opposite direction,” he said. Emerging-market countries are hardly a homogenous group, but they face similar challenges. The outflows of investor capital driving down their stock markets and pressuring their currencies have occurred just as the demand abroad for their products, whether commodities like oil or manufactured goods like automobiles, has begun to weaken. But the crisis has not hit the streets right away, buttressing the confidence of many in affected countries that the problems are temporary and can be weathered. Some argue that the declining value of local currencies is even a plus, because it will help these countries sell more goods abroad by making them more affordable. “When the zloty was so strong, my import was profitable. Just now, I hope my exports will be improving,” said Krzysztof Izydorczyk, 52, owner of Comexpol, an importer and exporter of stainless steel products based in Katowice. In South Africa, Finance Minister Trevor A. Manuel gave a budget speech to Parliament last week, saying he had seen the warning signs of trouble and had taken appropriate action. But South Africa is not just facing unpredictable economic pressures. It is also at a perilous political moment, with a likely split in the governing African National Congress and a strong possibility that the unemployment rate will worsen. The economy had been weakening before the global crisis, according to Pieter Laubscher, chief economist at the Bureau for Economic Research at South Africa’s Stellenbosch University. The commodities boom had drawn investment into the country and had helped drive economic growth, Mr. Laubscher said, but that boom has now fallen victim to the worldwide slowdown.

In Brazil, leaders took pains to save wisely during the commodity boom, reform the country’s banking sector after a financial crisis in the late 1990s and diversify its trade partners. “This country has never been so prepared to face up to adversity as it is now, economically, politically and, I’d say, ideologically,” President Luiz Inácio Lula da Silva said early last week. But on Wednesday the government empowered state-controlled banks to buy stakes in private financial institutions. Although officials denied any private banks were in danger, the announcement fueled jitters that some could fail, helping send Brazil’s stock market down more than 10 percent that day. Poles had good reason to believe that they had avoided the stigma that causes investors in emerging markets to flee at the first hint of financial panic. Poland had joined the European Union and NATO, it was a close ally of the United States, it was growing robustly and enjoying swiftly rising living standards unimaginable under Communism. Experts say there was a consensus locally that Poland would not be affected by the crisis, and that membership in the European Union would buffer it from the worst of the shocks. That consensus has begun to break down. When the Central Bank of Hungary surprised markets last week by raising interest rates three percentage points to defend its currency, the vulnerability of Central and Eastern Europe received harsher scrutiny. Poland illustrates the illogic but also the relentless pressure this crisis has exerted, because in many ways it was in good shape. Compared with Hungary, Poland has higher growth, lower inflation, lower interest rates, less public debt relative to the size of its economy and a smaller share of foreign loans. Poland has stronger domestic demand than Hungary to prop up the economy as consumers among its Western trading partners cut spending. But Poland has not adopted the euro, which might have helped insulate it somewhat. Now the prime minister, Donald Tusk, says Poland hopes to by 2012. Government officials in Warsaw, including the prime minister, the central banker and the finance minister, have been saying that the Polish economy remains strong and that they expect markets to stabilize. Indeed, the latest economic news out of Poland has been largely positive. Retail sales rose 11.6 percent in September, compared with the previous year, and the unemployment rate, which exceeded 20 percent just five years ago, fell 0.2 percentage points last month, to 8.9 percent. At Miedzy Nami, a restaurant in downtown Warsaw, the owner, Ewa Moisan, said she had not seen a slowdown. Yet some customers said they were beginning to feel the pinch. The monthly payment for the apartment mortgage of one customer, Jarek Wiewiorski, has gone up by a fifth, to 1,800 zloty, about $600. “It’s not catastrophic, but it’s painful,” Mr. Wiewiorski, 40, said. “One minute it’s America, the next it’s Hungary, and then suddenly, it’s here.”

Central Banks Slashing Rates As Investors Flee
Global Pullback Could Affect Currency Markets
October 28, 2008

Central banks around the world are moving to further slash interest rates as they seek to contain the damage from the bursting of the biggest credit bubble in history. The Federal Reserve is poised to cut its benchmark rate for the second time in two weeks at a pivotal meeting in Washington on Wednesday, and the European Central Bank yesterday suggested that it would do the same next week. South Korea announced a dramatic rate cut yesterday, by three-fourths of a percentage point. Governments worldwide have already approved massive bailouts and stimulus packages to halt financial meltdowns. But the trouble spots in the United States and abroad continue to multiply. Yesterday, there were growing signs that the U.S. Treasury Department was close to extending its $700 billion rescue program to cover the ailing auto industry. Analysts said governments are trying to manage what has become the biggest threat to the global financial system -- a massive pullout by panicked investors from any holding they see as remotely risky. From consumers

to multibillion-dollar hedge funds, investors are cashing out to cover losses or guard against further damage by moving into safe havens such as U.S. Treasurys. Rate cuts, however, are not packing their usual punch. Normally, when central banks cut rates, it becomes cheaper for businesses and consumers to borrow money. But now, with banks and other financial institutions experiencing a severe crisis, lenders have been reluctant to extend credit at any price. The pullback by investors, known as deleveraging, is extending massive losses on global stock markets; the Hong Kong stock market on Monday had its biggest one-day percentage drop since 1989, and Tokyo's Nikkei fell to its lowest level in 26 years. Officials are growing increasingly concerned that the pullback is affecting currency markets, with economists warning of a growing disequilibrium in global exchange rates. Although confidence may be shaken in the American economy, foreign investors still see the U.S. dollar as more reliable than most other currencies, with the rush to the dollar sending its value soaring against the euro, the British pound and a host of emerging-market coins in recent weeks. As currencies weaken in emerging markets including Brazil, Mexico and South Korea, corporations in those countries that have foreign loans or other bets in dollars are being slammed as debts suddenly become more expensive to pay back. In Japan, the reverse is happening. Investors are burrowing into the yen, rapidly driving up its price against both the dollar and the euro. For much of the past decade, investors have borrowed yen -- at Japan's very low interest rates -- to buy positions in other currencies in emerging economies such as South Africa and Brazil, where yields have been far higher. The financial crisis has soured many of those bets. Investors are rushing back to the security of the yen and, in the process, driving up the currency's value. Just as the surge in the dollar is making Ford and General Motors cars more expensive overseas, the gain in the yen is doing the same to Sony televisions and Canon cameras just as global demand for them dwindles. The yen's swing has been so sharp that the Group of Seven industrialized nations warned yesterday of "possible adverse implications for economic and financial stability." That statement hinted at a possible joint intervention in currency markets to stabilize the yen, in a move similar to actions taken by central banks in 1995 and 1998. As early as Wednesday, the International Monetary Fund is set to rule on the creation of an emergency program to rush hard currency to emerging markets that have been burning through billions of dollars' worth of reserves in recent weeks to defend their currencies. The pool of money available, sources close to the talks said, could be augmented by contributions from nations sitting on trillions of dollars in cash reserves, such as Japan, China and the oil-rich Gulf states. The concern is that the rapidly falling emerging-market currencies could trigger the same kind of debt defaults and financial system collapses that swept across Asia in 1997, adding another layer to the globe's already severe financial problems. The IMF has already reached preliminary agreements on emergency loans for Hungary and Ukraine; the fund is additionally in talks to extend lifelines to Pakistan and several other developing nations hit hard by the crisis. "As their currencies go down, the debt in dollars for emerging economies is going up substantially, and that is very much like what happened 10 years ago in the Asian financial crisis," said C. Fred Bergsten, director of the Peterson Institute for International Economics. "Of course, it's a fear that that could happen again." Deleveraging is complicating attempts to stem the financial bleeding from the crisis. Asian banks, for instance, are reducing their holdings in the U.S. mortgage giants Fannie Mae and Freddie Mac. Yields on the bonds for the companies have recently jumped to their highest levels in more than seven months, driving up their cost of borrowing. That, in turn, could make mortgage rates for Americans more expensive. Global regulators are now looking for relief through monetary policy. Two weeks ago, the Fed was part of an emergency, coordinated rate cut that also included the European Central Bank, the Bank of England and several others. The head of the ECB, Jean-Claude Trichet, yesterday said that a cut is "possible" at next week's meeting, an extraordinarily direct statement from a central banker. Meanwhile, after announcing South Korea's

emergency interest rate cut, the country's central bank said more cuts were likely. "Domestic demand is faltering amid financial turmoil, and exports will likely slow down," said Lee Seong-tae, governor of the Bank of Korea. When the Federal Reserve's policymaking committee meets today and tomorrow, analysts widely believe, it will cut the target for the federal funds rate -- the rate at which banks lend to each other -- to 1 percent from 1.5 percent. If it does so, the rate would match the lowest level ever, reached in 2003. Such a move would signal the bank's resolve to combat the crisis using all possible means. In a speech two weeks ago, Fed Chairman Ben S. Bernanke affirmed that the central bank was willing to take unusually aggressive action, saying: "We will not stand down until we have achieved our goals of repairing and reforming our financial system and restoring prosperity." Ethan Harris, an economist at Barclays Capital, said the Fed is now mounting "a frontal assault on the credit crunch." That assault includes cutting rates; endorsing a fiscal stimulus package, which Bernanke did last week; and rolling out a wide range of programs to help bolster the flow of credit, such as one that began functioning yesterday to buy commercial paper, or short-term loans issued by companies. "You don't keep your powder dry," said Harris, noting that Bernanke as an academic years ago endorsed the idea of moving aggressively during a financial crisis. Another reason to cut rates is that inflation appears to be falling rapidly. That means Fed leaders don't need to worry as much about rising prices in the near future. There is a chance, though, that the central bank would cut its target only to 1.25 percent, given that it just cut rates by half a percentage point in an emergency meeting two weeks ago and it is unclear how much rate cuts are helping the economy.

Brown calls for larger IMF bailout fund
October 28, 2008

Prime Minister Gordon Brown of Britain grabbed the limelight from President Nicolas Sarkozy of France ahead of their meeting Tuesday, calling for China and the Gulf states to stump up more money to help the International Monetary Fund deal with the fallout of the credit crisis. Sarkozy, who met with Brown at the presidential Lanterne residence in Versailles, southwest of Paris, called Brown's proposal interesting and vowed to work "hand in hand" with the British prime minister - just as they had on a coordinated rescue plan for European banks. Sarkozy said that he also believed that the fund needed "additional means" to help ailing economies. "Our first priority at the moment is to stop the contagion to other countries, including in Eastern Europe where there are problems emerging," Brown said before the meeting with Sarkozy. The talks were arranged to prepare the European Union's position ahead of the Nov. 15 summit meeting in Washington, which is intended to explore ways to reorder the global financial system. Brown's appeal to resource-rich emerging economies to help pay for bailout plans highlights how stretched the Group of 7 industrialized countries have become in dealing with the global economic rout. It also laid the groundwork for the type of grand bargain that may take center stage at the November summit: In return for a greater voice in an overhauled financial architecture, large developing countries will be asked to make a greater contribution. The British leader, whose bank bailout plan has become a blueprint for the European Union and the United States, said the IMF needed a fund that was "substantially" larger than the current pool of $250 billion earmarked for nations in difficulty. Over the past month alone, several countries have appealed for emergency help, including Iceland, Hungary, Ukraine and Belarus. "There are lessons to be learned from what happened in the subprime market," Brown said. "We need to learn the lesson quickly. We will be looking at how we will reform the international financial system." In London earlier Tuesday, Brown said it was urgent to set up the IMF bailout fund "as quickly as possible."

It will have to be "the countries that have got substantial reserves, the oil-rich countries and others, who are going to be the biggest contributors to this fund," Brown said. "China also has very substantial reserves," he added. "There are a number of countries that actually can do quite a lot in the immediate future to make sure that the international community has sufficient resources to support countries that get themselves into difficulties." In an effort to sell his idea, Brown will travel to the Gulf region Saturday and confer with Prime Minister Wen Jiabao of China by telephone. Sarkozy, in welcoming Brown on Tuesday evening, said, "We both want concrete decisions to be made" so that the causes of the financial crisis would "never" happen again. Analysts warned that some of the countries cited as potential contributors might be more fragile than appeared at first glimpse. While Chinese banks are less exposed to the subprime U.S. mortgage assets that have caused problems elsewhere, the country's export-driven economy is vulnerable to falling demand in Western markets. Oil-rich Middle Eastern countries, meanwhile, are concerned that the recent slump in energy prices will deprive them of significant revenues in the months to come. The American political calendar could also stall any far-reaching agreements, analysts said. The new president is to be elected Tuesday but will only take office on Jan. 20.

As U.S. economy slows, credit card crunch begins
October 29, 2008

First came the mortgage crisis. Now comes the credit card crunch. After years of flooding Americans with credit card offers and sky-high credit lines, lenders are sharply curtailing both just as an eroding economy squeezes consumers. The pullback is affecting even credit-worthy consumers and threatens an already beleaguered banking industry with another wave of unprecedented losses after a gilded era in which it reaped near-record gains from the business of easy credit that it helped create. Lenders wrote off an estimated $21 billion in bad credit card loans in the first half of 2008 as borrowers defaulted on their payments. With companies laying off tens of thousands of workers amid the crisis, the industry stands to lose at least another $55 billion over the next year and a half, analysts say. Currently, the total losses amount to 5.5 percent of credit card debt outstanding, and could surpass the 7.9 percent that occurred after the technology bubble burst in 2001. "If unemployment continues to increase, credit card net charge-offs could exceed historical norms," Gary Crittenden, Citigroup's chief financial officer, said. Faced with sobering conditions, companies that issue MasterCard, Visa and other cards are rushing to stanch the bleeding, even as options once easily tapped by borrowers to pay off credit card obligations, such as home equity lines or the ability to transfer balances to a new card, dry up. Big lenders — like American Express, Bank of America, Citigroup and even the retailer Target — have begun tightening standards for applicants and are culling their portfolios of the riskiest customers. Capital One, a big issuer, for example, has aggressively shut down inactive accounts and reduced customer credit lines by 4.5 percent in the second quarter from the previous period, according to regulatory filings. Lenders are shunning consumers already in debt and cutting credit limits for existing cardholders, especially those who live in areas ravaged by the housing crisis or work in troubled industries. In some cases, certain lenders are even pulling in credit lines after monitoring cardholders who shop at the same stores as other risky borrowers or who have mortgages from certain banks. While such changes protect banks, some can come back to haunt consumers. The result can be a lower credit score, which forces a borrower to pay higher interest rates and makes it harder to obtain loans. A reduced line of

credit can also make it harder for consumers to manage their budgets since lenders have 30 days to notify their customers, and often do so only after taking action. The depth of the financial crisis has shocked a credit-hooked nation into rethinking its habits. Many families once content to buy now and pay later are eager to trim their reliance on credit cards. The Treasury Department, which is spending billions in taxpayer money to clean up an economic mess triggered in part by all sorts of easy credit, recently started an advertising campaign inviting consumers to check into the "Bad Credit Hotel," an online game that teaches the basics of maintaining good credit. At the same time, the fear factor among lenders has deepened just as the crisis makes it harder for some financially stretched consumers to wean themselves from credit cards for even basic needs, like gas and food. "We are not going to say, yahoo, this is over and extend credit like we did without fear," Jamie Dimon, JPMorgan Chase's chief executive, said on a recent conference call. "If you're not fearful, you're crazy." The credit worthy are no exception. American Express, which traditionally catered to more upscale cardholders, said it would be increasing the effective interest rates by 2 or 3 percentage points for a broad range of its credit card holders — a move that could, for example, push a 15 percent rate up to 18 percent. "We think it's prudent given the nature of those products and the economic environment we face," Daniel Henry, its chief financial officer said on a recent conference call. Some reward programs have also gotten stingier as lenders cut corners to save money. Card companies, for example, have taken to substituting Sony big-screen television with a cheaper brands as a way of lowering the cost of their redemption prizes. For less credit-worthy customers, issuers are pulling back on promotional offers that allowed borrowers to pay no interest for months as they try to get ahead of stiffer lending rules that have been proposed by U.S. government banking regulators and Congress. The regulations, while beneficial to consumers, will curb profits on their riskiest customers. JPMorgan said that it was withdrawing some of its teaser-rate loans that were only marginally profitable. Discover Financial shortened the duration of its zero-balance offers. And lenders, overall, are slowing the flood of mail offers to a trickle with moves that would translate for the average American household into about 13 fewer pieces of credit card junk mail a year than its peak in 2005. Mail offers to new and existing customers are on pace to drop below 8.4 billion pieces, the lowest level since 2004, according to Mintel Comperemedia, a direct marketing research firm. Online credit card applications have fallen for the first time in five quarters, in part because customers are receiving fewer mail offers that drive them to the Web, according to data from ComScore, an Internet marketing research firm. "We used to get a couple of offers a week, but I haven't seen a credit card offer in over a year," said Brett Barry, who owns a real estate agency outside Phoenix and described his credit record as strong. "What blows me away is these companies are in the business of extending credit, but they don't want to do it for me." Barry said that, without any notice, American Express has reduced the credit limit on his business and personal credit card at least four times in the last year, which he said had lowered his credit score. The moves have also made it difficult for him to manage his payroll and budget, he said. "Credit card issuers have realized that their market is shrinking and that there is no room for extra credit cards, so they have to scale back," said Lisa Hronek, a research analyst at Mintel. "People are completely maxed out with mortgages, home equity lines and credit card debt." At the same time, credit card profit margins have been narrowing, largely because lenders' own financing costs remain elevated as investors spurn credit card bonds, just as they did mortgages. Another factor is that the interest rates banks charge even credit-worthy borrowers, meanwhile, had come down in the wake of emergency actions taken by the Federal Reserve to ease the credit crisis.

Meanwhile, bank executives say consumers are starting to pull back on spending, a pattern that may become clear Wednesday when Visa reports its third quarter results. In previous downturns, banks could make up the missing profits by raising fees. This time, there may be less room to maneuver. "The last time credit costs spiked, the late fees were much lower so card issuers could turn to that and re-price more nimbly," a Morgan Stanley analyst, Betsy Graseck, said. "There is just more scrutiny now, and coming after subprime the mortgage crisis, the world is more sensitive to the way lenders behave."

EU prepares tight rules on credit rating agencies
October 29, 2008

EU officials are preparing the finishing touches to a draft law that is designed to prevent conflicts of interest between credit rating agencies and their clients. Under the plans, rating agencies would be required to make their working methods public and obey new rules on how staff members are paid and how long they can work with clients, according to a draft version of the proposal. The draft reflects harsh criticism made by European leaders, including President Nicolas Sarkozy of France, who blamed the agencies for failing to avert a meltdown in global financial markets. The plan, if approved, would end self-regulation for European credit rating agencies and would bring Europe more into line with the United States, where government has regulated the sector since mid-2007. Leading credit rating agencies like Moody's, Standard & Poor's and Fitch are used by investors as a guide to assessing the quality of assets. But the financial crisis has highlighted concerns that agencies were being paid by the companies whose creditworthiness they rate. "It is commonly agreed," the draft document said, "that credit rating agencies contributed significantly to the current market turmoil by underestimating the credit risk of structured credit products." It noted that the large majority of the products related to subprime mortgages were given the highest ratings and that agencies failed to adapt them when market conditions worsened. "The sometimes poor quality of ratings of structured finance instruments has considerably contributed to the current crisis," the draft said. The European internal market commissioner, Charlie McCreevy, plans to publish the new regulations next month. McCreevy, a strong supporter of free-market economics, has been attacked by socialist lawmakers in the European Parliament for failing to regulate earlier in the financial services area. His draft legislation, which needs approval by EU nations and the European Parliament, is designed to establish a single regulatory regime across the 27-member European Union. Under the plan, the country in which the rating agency is based would have primary responsibility for authorizing and supervising agencies. The Committee of European Securities Regulators, which brings together European watchdogs, would co-ordinate and advise. The laws would be based on an existing voluntary code drawn up by the International Organization of Securities Commissions. The legislation aims to prevent conflicts of interest and to force companies to disclose their working methods more clearly and to encourage the emergence of new agencies. Pay awards could not be connected to the revenue from the rated company. Legislation is inevitable, experts said, because self-regulation has failed, but some fear that McCreevy's plans may be going too far. "Policy makers have no choice than to regulate," said Karel Lannoo, chief executive officer of the Center for European Policy Studies in Brussels. "They cannot continue to say that agencies must follow a code of conduct because they have been saying that for 10 years." But he added that there was a risk of "micro-legislation" being too detailed for the sector and that the proposals would not help reduce the dominance of the big European rating firms. The commission has rejected the idea of lighter regulation.

"A legislative measure is the best option to ensure a common framework throughout the EU and an efficient counterbalance to other important third-country jurisdictions, notably the U.S.," the draft document said. Conflicts of interest would be prohibited within companies - or disclosed if they were unavoidable - and rating agencies would not be allowed to combine their work with consultancy, under the EU draft proposals. They would have to "allocate a sufficient number of employees with appropriate knowledge and experience to their credit rating activity." Pay would "be determined primarily by the quality, accuracy, thoroughness and integrity of their work." For companies with more than 50 staff members, a four-year time limit would be placed on work with individual clients to prevent relationships from becoming too close. There would then have to be a two-year break before the individual worked with the same client. The proposed law would also require credit rating agencies to disclose the methodologies and main assumptions that they use in the rating process.

Unfunded mandate The IMF adopts a more flexible approach
Oct 30th 2008

TIME was when a bail-out by the International Monetary Fund was a uniformly horrid experience. Cold-eyed, sharp-suited men pored over your country’s books, demanding painful structural reforms and bone-chilling fiscal stringency. Faced with the current turmoil in emerging markets, the fund now seems more like a generous uncle. Well-run countries now have fewer hoops to jump through to gain IMF money. On October 29th the fund announced the creation of a new short-term liquidity facility for the soundest emerging markets. The facility will disburse three-month loans to countries with good policies and manageable debts without attaching any of its usual conditions. The Federal Reserve added its considerable firepower to the rescue effort, announcing the establishments of $30 billion swap lines with each of the central banks of Brazil, Mexico, South Korea and Singapore. The fund’s traditional lending also comes with fewer strings attached. The IMF-led $25.1 billion bail-out of Hungary on October 28th was “fast, light and big”, in the words of one person involved. The rescue came just days after the fund agreed on a $16.5 billion package to shore up Ukraine’s collapsing economy, a prospect which seems to be unblocking the country’s wretchedly deadlocked politics. It is also standing by to help Pakistan. The huge international support package for Hungary is a shocking turn of fortune for Eastern Europe, a region that has enjoyed growth and stability for a decade. But a toxic combination of external debt and collapsing confidence left the economy floundering. Even spending cuts, tax increases, a €5 billion ($6.7 billion) loan from the European Central Bank and a sharp rise in interest rates, from 8.5% to 11.5%, had failed to calm the markets. The fund had tried to get the governments of Germany, Italy and Austria on board for the rescue. Their banks are most exposed to Hungarian borrowers (thanks to eager lending in euros and Swiss francs). Austria was willing to take part; Germany was not. So the IMF has put up $15.7 billion (to be agreed on at an IMF board meeting shortly), the European Union has added $8.1 billion, and the World Bank a further $1.3 billion. In return, all Hungary has to do is pass a law on fiscal responsibility that is already before parliament. The fund may be calculating that it is better to be lavish before a crisis than stringent after one. Iceland, which is negotiating a $2 billion bail-out from the IMF, is being forced to take some bitter medicine after the failure of its

banks. The central bank raised interest rates by a full six percentage points to 18% on October 28th, as trading resumed in the Icelandic krona after a suspension of nearly a week. The big uncertainty now is how many more fires the fund and other lenders must fight—and whether they can afford to do so. The IMF may well need more than the $250 billion it now has. Gordon Brown, Britain’s prime minister, wants countries with big surpluses, such as China and the oil-rich Gulf States, to contribute more. The fund’s backers, it seems, need to be as flexible as its new lending criteria.

Loans? Did we say we'd do loans?
October 29, 2008

According to Treasury Secretary Henry Paulson, the chief proponent of the big bank bailout, flooding the banks with taxpayers' money was supposed to get them to start lending freely again. And that, in turn, was supposed to stabilize the markets and prevent the downturn from being worse than it otherwise would be. It was not entirely clear from the start exactly how Paulson would ensure that things would go that way. Indeed, earlier this month, shortly after the bailout was enacted, The Times' Mark Landler reported that Treasury officials also wanted to steer the bailout billions to banks that would use the money to buy up other banks. Now, lo and behold, with $250 billion in bailout funds committed to dozens of large and regional banks, it turns out that many of the recipients of this investment from taxpayers are not all that interested in making loans. And it appears that Paulson is not so bothered by their reluctance. Paulson and the bailout recipients have some explaining to do. Congress should plan hearings as soon as possible - and take action to set a clear strategy. In his column on Saturday, Joe Nocera of The New York Times told about a conference call that he had listened in on recently between employees and executives of JPMorgan Chase. Asked how an infusion of $25 billion of bailout funds would change the bank's lending policy, an executive said the money would be used to buy other banks. "I think there are going to be some great opportunities for us to grow in this environment, and I think we have an opportunity to use that $25 billion in that way," the executive said. He added that the money could also be used as a backstop in case "recession turns into depression or what happens in the future." There was not a word about lending - not to businesses or homebuyers or car buyers or students or other consumers. Just the opposite. In response to another question, the executive said that the bank expected to continue to tighten credit. JPMorgan Chase is not alone. The Wall Street Journal reported on Tuesday that some regional-bank recipients of the bailout money had acknowledged that only a small portion would be used for loans and the rest for acquisitions and other purposes. It is prudent for government officials to encourage healthy banks to acquire weak banks. Doing so prevents bank failures and avoids the taxpayer costs and economic disruption that accompany such collapses. The problem is that the Treasury has refused to put conditions on the banks' use of the bailout funds, allowing them, in effect, to make purchases of banks that are not on the verge of failure. That could help to maximize the banks' profits - a worthy goal when the capital they are using is from private investors. However, when they're using taxpayer-provided capital, as they are now, Congress and the public have every right to require that the money be used to benefit the public directly, even if doing so crimps the banks' profits. If Treasury won't impose conditions, Congress must, including a requirement that banks accepting bailout money increase their loans to creditworthy borrowers and limit their acquisitions to failing banks, such as those listed as troubled by the Federal Deposit Insurance Corp. The bailout should not be an occasion for banks to make a killing. An even bigger problem is that the bailout was sold as a way to spur loans. If that never was - or no longer is -

the primary aim, Congress and the public need to know that. Lawmakers should not release the second installment - $350 billion - until they have answers and guarantees that the bailout money will be spent in ways that put the public interest first.

Treasury, FDIC near Deal on Mortgage Aid
U.S. Would Guarantee Distressed Home Loans
October 30, 2008

Negotiators for the Treasury and Federal Deposit Insurance Corp. are nearing agreement on a plan to have the government guarantee the mortgages of millions of distressed homeowners in what would be a significant departure for the federal rescue program, which has so far directed relief exclusively to banks and other financial institutions. The plan, which sources said could cover as many as 3 million homeowners in danger of foreclosure and cost $40 billion to $50 billion, would go well beyond previous government and private-sector initiatives. Critics say these have attracted too few lenders or offered too little aid to homeowners to stem the foreclosure crisis. But with economic anxieties continuing to mount and political pressure growing for expanded help to homeowners, federal officials could announce a new program to cover as much as $600 billion in mortgage loans in the coming days, sources said. They spoke on condition of anonymity because the negotiations were ongoing. Treasury officials confirmed yesterday that discussions were underway for homeowner aid but said that any figures remained fluid and that other options were under consideration, as well. Several sources said the mortgage program still faces resistance from the White House. A spokesman for President Bush said last night that the administration was analyzing various proposals. "We have been reviewing a number of housing proposals for some time and no decisions have been made on any of them," White House spokesman Tony Fratto said. "Any inference that we're 'nearing' a decision on any one of them is simply wrong." The possible details of the homeowner bailout emerged yesterday, another day of extraordinary measures by U.S. and foreign governments to arrest the financial crisis. The Federal Reserve cut interest rates for the second time in two weeks and, in a move that exposes it to the risk of lending to developing nations for the first time, said it would pump as much as $120 billion into the central banks of Mexico, Brazil, Singapore and South Korea. The International Monetary Fund said it would offer as much as $100 billion in emergency loans to developing countries staggered by investor flight and runs on their currencies and stock markets. Earlier this week, the European Central Bank said it would join the IMF and World Bank in a $25.1 billion bailout of Hungary and China's central bank cut the interest rate it controls. At the U.S. Treasury, a growing number of financial institutions and other companies have been lobbying to get a slice of the $700 billion federal bailout. Some foreign banks are asking to participate in the Treasury's bank investment program because "this is a global crisis," according to a letter from the Financial Services Roundtable, a trade association for large financial firms. The nation's two major bond insurers sent letters making suggestions on shaping the rescue plan, with one asking that the government cover a portion of their losses to prevent a "systemic implosion" of the economy.

Meanwhile, General Motors wants some of the rescue money to help it merge with Chrysler, and insurance companies have asked that they be given the same consideration that banks have received under the rescue. "Everyone has their hand out now," said a lobbyist who represents one of the industries recently in touch with the Treasury. The lobbyist declined to comment further for fear of hurting the industry's case. "It's a lot of money, and people are hurting." While the financial crisis is rooted in the ailing mortgage market and the wave of foreclosures sweeping the nation, none of the $700 billion rescue package approved by Congress has yet been targeted at struggling homeowners. On the campaign trail, Sen. John McCain (R-Ariz.) has proposed a program to help distressed homeowners by having the government issue new, federally guaranteed mortgages on more affordable terms. Under his plan, the government would absorb the troubled loans at face value and take the full loss rather than having lenders be responsible for any of it. FDIC Chairman Sheila C. Bair has been especially outspoken about helping borrowers. But yesterday, her agency said little publicly about the specifics of the plan being negotiated. "While we have had productive conversations with Treasury about the use of credit enhancements and loan guarantees, it would premature to speculate about any final framework or parameters of a potential program," said Andrew Gray, an FDIC spokesman. The issue has stirred political rancor. Critics of foreclosure aid doubt that a homeowner who took on an unaffordable loan is entitled to government help -- while those who have kept up with payments receive nothing. But some members of Congress seized upon the fact that the first $350 billion of the rescue package has been allocated not for homeowners but for financial institutions. "The key to our economic recovery is in addressing the root cause of this crisis -- the housing crisis," said Sen. Christopher J. Dodd (D-Conn.), chairman of the Senate Banking Committee. "Federal agencies and financial institutions must do more to modify the mortgages they hold in order to stop foreclosures and help families keep their homes." Under the program being discussed, banks or other lenders would agree to reduce the monthly payments of borrowers to a level they could afford. The payments could be reduced by lowering the interest rate, cutting the amount owed or extending the repayment period. The goal would be to help homeowners avert foreclosure. In exchange, lenders who agree to do this would get a government guarantee that they would be compensated for a portion of any losses should borrowers default on the reconfigured loans. One of the toughest issues facing negotiators is how to define which struggling homeowners should get a bailout. If the government guarantees relatively risky loans, it is more likely to face a steeper tab. So if the gap between a household's income and what it owes on a mortgage is large, for example, the government may shy away from guaranteeing the loan. Aware that how they define homeowner eligibility could cause a political furor, negotiators have struggled to come up with parameters that would be considered fair, a banking industry source said. One model could be the program the FDIC created after it took over IndyMac, a bank that failed after having made billions of dollars in risky mortgage loans. IndyMac works with any borrowers who are delinquent or in default on their loans or at risk of becoming delinquent. The goal is to change mortgage terms so borrowers must pay no more than 38 percent of their income to cover their mortgage costs, including principal, interest, taxes and insurance. Under the IndyMac program, a homeowner is excluded if the costs of reducing the loan payments exceed the costs of simply foreclosing on the home.

The financial crisis has prompted calls from a wide range of economic interests. Financial guarantee companies, for example, insure $1.4 trillion in state and municipal bonds, as well as $900 million in corporate and other debt. When backed by the bond insurance that these outfits offer, a company or local government can borrow money more cheaply. But the financial crisis has strained their balance sheets, and Moody's rating service says MBIA and Ambac Financial Group, the two largest in the industry, are "on review for downgrade." Citing the possibility of a "systemic implosion" if such companies fail, Ambac has asked that the Treasury support the industry by guaranteeing a portion of losses. The industry's cause is being championed by New York Insurance Superintendent Eric R. Dinallo, who has spoken on its behalf in an interview on CNBC and in speeches. Without a robust bond insurance industry, he has argued, it would be even more difficult for state and local governments to raise money for capital projects. Ambac expressed similar arguments in its letter to the Treasury. "Support that helps to stabilize the U.S. financial guarantors will have an exponentially positive impact for several critical sectors of the U.S. economy," Ambac's letter said. The Treasury is also facing pressure to allow foreign banks to participate in its premiere program. While the legislation authorizing the $700 billion rescue allows foreign banks to participate, the first rescue program defined by Treasury -- the so-called capital purchase program -- does not. Under that program, the government is investing $250 billion in banks in exchange for preferred shares that initially pay 5 percent annually, giving banks a relatively cheap source of capital. Other countries have adopted similar programs. So why should foreign banks be allowed to participate? "This is a global crisis," according to a letter from the Financial Services Roundtable to the Treasury. The organization represents large financial institutions, including some foreign banks such as UBS, Barclays, Union Bank of California, Citizens Bank and HSBC. "These companies play a large role in the U.S. economy," said Scott Talbott, vice president of the organization. "They have U.S. employees, they lend to U.S. taxpayers to pay for U.S. homes."

AIG has used billions from the Fed but hasn't said for what
October 30, 2008

The American International Group is rapidly running through $123 billion in emergency lending provided by the Federal Reserve, raising questions about how a company claiming to be solvent in September could have developed such a big hole by October. Some analysts say at least part of the shortfall must have been there all along, hidden by irregular accounting. "You don't just suddenly lose $120 billion overnight," said Donn Vickrey of Gradient Analytics, an independent securities research firm in Scottsdale, Arizona. Vickrey says he believes AIG must have already accumulated tens of billions of dollars worth of losses by midSeptember, when it came close to collapse and received an $85 billion emergency line of credit by the Fed. That loan was later supplemented by a $38 billion lending facility. But losses on that scale do not show up in the company's financial filings. Instead, AIG replenished its capital by issuing $20 billion in stock and debt in May and reassured investors that it had an ample cushion. It also said that it was making its accounting more precise. Vickery and other analysts are examining the company's disclosures for clues that the cushion was threadbare and that company officials knew they had major losses months before the bailout.

Tantalizing support for this argument comes from what appears to have been a behind-the-scenes clash at the company over how to value some of its derivatives contracts. An accountant brought in by the company because of an earlier scandal was pushed to the sidelines on this issue, and the company's outside auditor, PricewaterhouseCoopers, warned of a material weakness months before the government bailout. The internal auditor resigned and is now in seclusion, according to a former colleague. His account, from a prepared text, was read by Representative Henry Waxman, Democrat of California and chairman of the House Committee on Oversight and Government Reform, in a hearing this month. These accounting questions are of interest not only because U.S. taxpayers are footing the bill at AIG but also because the post-mortems may point to a fundamental flaw in the Fed bailout: the money is buoying an insurer — and its trading partners — whose cash needs could easily exceed the existing government backstop if the housing sector continues to deteriorate. Edward Liddy, the insurance executive brought in by the government to restructure AIG, has already said that although he does not want to seek more money from the Fed, he may have to do so. Fear that the losses are bigger and that more surprises are in store is one of the factors beneath the turmoil in the credit markets, market participants say. "When investors don't have full and honest information, they tend to sell everything, both the good and bad assets," said Janet Tavakoli, president of Tavakoli Structured Finance, a consulting firm in Chicago. "It's really bad for the markets. Things don't heal until you take care of that." AIG has declined to provide a detailed account of how it has used the Fed's money. The company said it could not provide more information ahead of its quarterly report, expected next week, the first under new management. The Fed releases a weekly figure, most recently showing that $90 billion of the $123 billion available has been drawn down. AIG has outlined only broad categories: some is being used to shore up its securities-lending program, some to make good on its guaranteed investment contracts, some to pay for day-to-day operations and — of perhaps greatest interest to watchdogs — tens of billions of dollars to post collateral with other financial institutions, as required by AIG's many derivatives contracts. No information has been supplied yet about who these counterparties are, how much collateral they have received or what additional tripwires may require even more collateral if the housing market continues to slide. Tavakoli said she thought that instead of pouring in more and more money, the Fed should bring AIG together with all its derivatives counterparties and put a moratorium on the collateral calls. "We did that with ACA," she said, referring to ACA Capital Holdings, a bond insurance company that filed for bankruptcy in 2007. Of the two big Fed loans, the smaller one, the $38 billion supplementary lending facility, was extended solely to prevent further losses in the securities-lending business. So far, $18 billion has been drawn down for that purpose. For securities lending, an institution with a long time horizon makes extra money by lending out securities to shorter-term borrowers. The borrowers are often hedge funds setting up short trades, betting a stock's price will fall. They typically give AIG cash or cashlike instruments in return. Then, while AIG waits for the borrowers to bring back the securities, it invests the money. In the last few months, borrowers came back for their money, and AIG did not have enough to repay them because of market losses on its investments. Through the secondary lending facility, the insurer is now sending those investments to the Fed, and getting cash in turn to repay customers.

A spokesman for the insurer, Nicholas Ashooh, said AIG did not anticipate having to use the entire $38 billion facility. At midyear, AIG had a shortfall of $15.6 billion in that program, which it says has grown to $18 billion. Another spokesman, Joe Norton, said the company was getting out of this business. Of the government's original $85 billion line of credit, the company has drawn down about $72 billion. It must pay 8.5 percent interest on those funds. An estimated $13 billion of the money was needed to make good on investment accounts that AIG typically offered to municipalities, called guaranteed investment contracts, or GIC's. When a local government issues a construction bond, for example, it places the proceeds in a guaranteed investment contract, from which it can draw the funds to pay contractors. After the insurer's credit rating was downgraded in September, its GIC customers had the right to pull out their proceeds immediately. Regulators say that AIG had to come up with $13 billion, more than half of its total GIC business. Rather than liquidate some investments at losses, it used that much of the Fed loan. For $59 billion of the $72 billion AIG has used, the company has provided no breakdown. A block of it has been used for day-to-day operations, a broad category that raises eyebrows since the company has been tarnished by reports of expensive trips and bonuses for executives. The biggest portion of the Fed loan is apparently being used as collateral for AIG's derivatives contracts, including credit-default swaps. The swap contracts are of great interest because they are at the heart of the insurer's near collapse and even AIG does not know how much could be needed to support them. They are essentially a type of insurance that protects investors against default of fixed-income securities. AIG wrote this insurance on hundreds of billions of dollars' worth of debt, much of it linked to mortgages. Through last year, senior executives said that there was nothing to fear, that its swaps were rock solid. The portfolio "is well structured" and is subjected to "monitoring, modeling and analysis," Martin Sullivan, AIG's chief executive at the time, told securities analysts in the summer of 2007. By fall, as the mortgage crisis began roiling financial institutions, internal and external auditors were questioning how AIG was measuring its swaps. They suggested the portfolio was incurring losses. It was as if the company had insured beachfront property in a hurricane zone without charging high enough premiums. But AIG executives, especially those in the swaps business, argued that any decline was theoretical because the hurricane had not hit. The underlying mortgage-related securities were still paying, they said, and there was no reason to think they would stop doing so. AIG had come under fire for accounting irregularities some years back and had brought in a former accounting expert from the Securities and Exchange Commission. He began to focus on the company's accounting for its credit-default swaps and collided with Joseph Cassano, the head of the company's financial products division, according to a letter read by Waxman at the recent congressional hearing. When the expert tried to revise AIG's method for measuring its swaps, he said that Cassano told him, "I have deliberately excluded you from the valuation because I was concerned that you would pollute the process." Cassano did not attend the hearing and was unavailable for comment. The company's independent auditor, PricewaterhouseCoopers, was the next to raise an alarm. It briefed Sullivan late in November, warning that it had found a "material weakness" because the unit that valued the swaps lacked sufficient oversight. About a week after the auditor's briefing, Sullivan and other executives said nothing about the warning in a presentation to securities analysts, according to a transcript. They said that while disruptions in the markets were

making it difficult to value its swaps, the company had made a "best estimate" and concluded that its swaps had lost about $1.6 billion in value by the end of November. Still, PricewaterhouseCoopers appears to have pressed for more. In February, AIG said in a regulatory filing that it needed to "clarify and expand" its disclosures about its credit-default swaps. They had declined not by $1.6 billion, as previously reported, but by $5.9 billion at the end of November, AIG said. PricewaterhouseCoopers subsequently signed off on the company's accounting while making reference to the material weakness. Investors shuddered over the revision, driving AIG's stock down 12 percent. Vickrey, whose firm grades companies on the credibility of their reported earnings, gave the company an F. Sullivan, his credibility waning, was forced out months later. Through spring and summer, the company said it was still gathering information about the swaps and tucked references of widening losses into the footnotes of its financial statements: $11.4 billion at the end of 2007, $20.6 billion at the end of March, $26 billion at the end of June. The company stressed that the losses were theoretical: no cash had actually gone out the door. "If these aren't cash losses, why are you having to put up collateral to the counterparties?" Vickrey asked in a recent interview. The fact that the insurer had to post collateral suggests that the counterparties thought AIG's swaps losses were greater than disclosed, he said. By midyear, the insurer had been forced to post collateral of $16.5 billion on the swaps. Though the company has not disclosed how much collateral it has posted since then, its $447 billion portfolio of credit-default swaps could require far more if the economy continues to weaken. More U.S. government assistance would then essentially flow through AIG to counterparties. "We may be better off in the long run letting the losses be realized and letting the people who took the risk bear the loss," said Bill Bergman, senior equity analyst at the market research company Morningstar.

Healthy countries to receive IMF loans
October 30, 2008

Just as the American financial crisis has gone global, so has the rescue effort. On Wednesday, the International Monetary Fund announced it would lend up to $100 billion to healthy countries that are having trouble borrowing as a result of the turmoil in the global markets. And the Federal Reserve said it would commit up to $30 billion each to Brazil, Mexico, South Korea and Singapore, to enable those countries to more easily swap their currencies for dollars. The coordinated measures are meant to restore confidence in emerging markets, where stocks and currencies have plunged in recent days as hedge funds and other investors pull out. Shares and currencies surged in places like São Paulo and Mexico City on Wednesday after the news. "It would just be a huge, unfortunate mistake if we allowed the stresses of the financial systems in the United States and Europe to spill over and unintentionally undermine these economies," said Charles Dallara, the managing director of the Institute of International Finance, a group of more than 300 global banks that pushed for the measures. Already, fragile economies in Iceland, Hungary and Ukraine have almost collapsed, and are receiving emergency loans from the fund. This new program — potentially one of the largest in the fund's history — is intended for countries with more sound finances and solid growth that suddenly face the threat of corporate or even government defaults as foreign investors flee.

Countries in this category, including Brazil, Mexico and South Korea, depend on foreign capital to finance trade and investments. Some have also borrowed heavily in foreign currencies, and the sharp declines in their own currencies make those debts much harder to repay. Under the program, countries could borrow five times the amount they are normally entitled to — $25 billion, in Brazil's case — without the strict conditions that normally accompany such loans. While the loans are for just three months, they can be rolled over three times, giving the countries close to a year to cover shortfalls. The loans will carry none of the strings that usually accompany fund money, including demands to raise interest rates and cut public spending. The Fed's move will allow South Korea, Singapore, Mexico and Brazil to increase the supply of scarce dollars circulating in those markets. The agreements are similar to swaps the Fed has set up with the Bank of Japan, the Reserve Bank of Australia, the European Central Bank and others to ease the credit crisis in developed economies. The Fed welcomed the fund's initiative. And the Treasury secretary, Henry Paulson Jr., said the measures showed deepening international cooperation two weeks before a meeting of world leaders in Washington to discuss the crisis. There had been rumors that the Fed and other central banks might help finance the fund's loan program. But Dallara said the Fed would have found that awkward, because the United States' contribution to the fund is channeled through the Treasury. The fund said it would finance these loans with its own resources, which total about $200 billion. It is soliciting more money from countries with hefty foreign-exchange reserves, like China, Japan and oil exporters. The fund has already agreed to lend $15.7 billion to Hungary, $16.5 billion to Ukraine and $2.1 billion to Iceland. It is in talks with Pakistan over a loan that could be even larger. The list of troubled countries will almost certainly grow. "We probably will need more resources," said Dominique Strauss-Kahn, the fund's managing director, at a news conference. "There is no way the fund can solve the problem on its own." The loan program greatly expands the fund's role in the crisis at a time when world leaders are starting a debate about how to fashion a new global financial framework. With Western countries burdened by their own costly rescue efforts, the fund seems likely to remain the major provider of support to emerging-market economies. That prospect troubles some critics, who contend that the fund is prescribing the same radical measures that caused unnecessary pain in some Asian countries during that region's financial crisis a decade ago. Iceland, they said, just raised its interest rate by 3 percentage points, to 18 percent, to try to stabilize its currency, which had been decimated after its banks failed. The interest-rate increase, fund officials said, was a condition of Iceland's emergency loan. "They used the same vocabulary they used in past crises: that we need to restore confidence," said Joseph Stiglitz, a Nobel Prize-winning economist who used to be the chief economist of the World Bank. "It doesn't restore confidence; it just leads to further bankruptcies." If the fund prescribes such remedies in a socially unstable country like Pakistan, he added, the risks would be enormous. Still, Stiglitz said he was encouraged by the new loan program. The government of Hungary warned on Wednesday that taking a loan from the fund would place burdens on the public. A former central bank governor, Peter Akos Bod, said he worried that the fund would press Hungary to

raise its interest rates, which are already high and which, he said, contributed to the habit of Hungarian companies and individuals of borrowing in foreign currencies. Suspicion of the fund is a global phenomenon: the Korean government declared it would not take any loans. Feelings there are still raw from the Asian financial crisis, during which the fund forced South Korea and other countries to raise their interest rates sharply. Strauss-Kahn, a former French finance minister, said he was aware of resistance stemming from the Asian crisis and was trying to tailor loans more closely to the conditions in the countries.

Fannie Asset Write-Down Raises Concerns Mortgage Giant's Action Increases Chances It Will Tap Government Funding
October 30, 2008

Mortgage finance giant Fannie Mae said yesterday that a class of assets that had made up a big part of its financial cushion in the months before the government took it over now effectively has no value. The announcement raises the probability that the government will need to put money into the firm and, experts said, signals that the company does not expect to make a profit in the foreseeable future. The government took over Fannie Mae and Freddie Mac in early September on concerns that the companies were becoming financially unstable and were unable to play their role supporting the nation's ailing mortgage market. Analysts had long questioned whether Fannie Mae and Freddie Mac were appropriately counting deferred tax assets as part of their financial cushions, known as capital. These assets are credits toward corporate taxes -- so long as the companies have profits they need to pay taxes on. But Fannie Mae and Freddie Mac have experienced big losses on mortgage bonds they own and guarantee. Fannie Mae said yesterday that it effectively is writing down "substantially all of the value of the deferred tax asset." At the end of the second quarter, its deferred tax asset was worth $20.6 billion, comprising nearly half its $47 billion in capital. Several accounting experts said that to write down the deferred tax asset, Fannie Mae had to decide that it probably wouldn't have any taxable income for which to apply the tax credits. "They're admitting they're not likely to generate profits in the foreseeable future," said Terrence J. Shevlin, professor of accounting at the University of Washington. Dartmouth accounting professor Richard C. Sansing said Fannie Mae's action does not mean it will never be able to use tax assets -- just that auditors currently believe the company is unlikely to. "The fact that they've written it down doesn't mean it's worthless," he said. "It just means there's more than a 50 percent chance they will never get any use out of it." Such large write-downs of deferred tax assets are rare but not unheard of. Late last year, General Motors said it was writing down $38.6 billion in deferred tax assets, accounting for much of a $39 billion loss in the third quarter. The extent of Fannie Mae's and Freddie Mac's losses will become clearer when the companies announce quarterly earnings next month. The government has agreed to backstop the companies if they falter. Freddie Mac has not yet made a determination on its $18.4 billion in deferred tax assets, but it already had a slimmer financial cushion, and removing the tax assets would put it on shakier ground.

"The analysis of deferred tax assets at Freddie Mac is ongoing," said Corinne Russell, a spokeswoman for the Federal Housing Finance Agency, the companies' regulator. Russell said Fannie Mae's decision on deferred tax assets was reviewed by the company's outside auditor. The companies have lost nearly $15 billion over the past year. Fannie Mae had $47 billion in capital at the end of the second quarter, on June 30. Freddie Mac had $37.1 billion in capital. Reducing those totals is unlikely to change how the companies do business, because of the government's backing. The FHFA has suspended capital requirements for the companies, but the figure still gives a helpful measurement of their financial conditions. To determine whether to pump money into the companies, the government relies on a measure known as shareholders' equity. If shareholders' equity is negative, the government will put money into the companies. Fannie's shareholder equity was $41.2 billion at the end of June. Freddie Mac's was $12.9 billion. Without counting deferred tax assets, Fannie Mae's shareholder equity would shrink to $21 billion. Freddie's would be negative $6 billion, prompting a government investment. In the months leading up to the companies' takeover, the firms and their federal regulator cited the capital positions in an effort to allay fears about their financial security. But during a summer probe of the companies' books, government officials grew concerned about whether the financial cushions were sufficient. In particular, the deferred tax assets drew scrutiny. Government-appointed Fannie Mae chief executive Herbert M. Allison Jr. and Freddie Mac chief executive David M. Moffett are reviewing a range of accounting policies at the company. At Fannie Mae, Allison decided the company had to be more forthright in how it reports information about the liquidity of certain assets. Some analysts say the decision on tax assets is just the start of a reassessment of the companies' true financial position. Some have questioned whether the companies have accurately put a value on other assets. "For now, Fannie and Freddie are wards of the state and the decision to address net deferred tax assets is part of the long-delayed reckoning with the downside impact of 65-to-1 leverage," Washington research firm Federal Financial Analytics said in a statement yesterday.

Banks to Continue Paying Dividends
Bailout Money Is for Lending, Critics Say
October 30, 2008

U.S. banks getting more than $163 billion from the Treasury Department for new lending are on pace to pay more than half of that sum to their shareholders, with government permission, over the next three years. The government said it was giving banks more money so they could make more loans. Dollars paid to shareholders don't serve that purpose, but Treasury officials say that suspending quarterly dividend payments would have deterred banks from participating in the voluntary program. Critics, including economists and members of Congress, question why banks should get government money if they already have enough money to pay dividends -- or conversely, why banks that need government money are still spending so much on dividends.

"The whole purpose of the program is to increase lending and inject capital into Main Street. If the money is used for dividends, it defeats the purpose of the program," said Sen. Charles E. Schumer (D-N.Y.), who has called for the government to require a suspension of dividend payments. The Treasury plans to invest up to $250 billion in a wide swath of U.S. banks in return for ownership stakes, which the government will relinquish when it is repaid. Among other restrictions, participating institutions cannot increase dividend payments without government permission. They also are barred from repurchasing stock, which increases the value of outstanding shares. The 33 banks signed up so far plan to pay shareholders about $7 billion this quarter. Companies generally try to pay consistent dividends and, at the present pace, those dividends will consume 52 percent of the Treasury's investment over the initial three-year term. "The terms of our capital purchase program were set to encourage participation by a broad array of financial institutions so they strengthen their financial positions," Treasury spokeswoman Michele Davis said. The Treasury's approach contrasts with decisions by foreign governments, including Britain and Germany, to require banks that accept public investments to suspend dividend payments until the government is repaid. The U.S. government similarly required Chrysler to suspend its dividend payments as a condition of the government's 1979 bailout. The legislation passed by Congress authorizing the Treasury's current bailout program is silent on the issue. The first nine participants were major banks, some running short on capital, that were told by Treasury officials earlier this month to sign on to the program for the good of the country. Their major shareholders are primarily institutional investors, such as pension funds and mutual funds, although a few wealthy individuals hold large stakes, such as Warren Buffett in Wells Fargo and Prince Alwaleed bin Talal in Citigroup. Several banks are on pace to pay more in dividends than they get from the government. The Bank of New York Mellon got $3 billion from the government on Tuesday. It will pay out $275 million to shareholders this quarter, and a projected $3.3 billion over the next three years. A spokesman declined to comment. At least a few banks have committed to reduce dividend payments at the same time they accepted government investments. SunTrust of Atlanta, which accepted $3.5 billion from the government, cut its quarterly dividend payments to about $188 million each quarter from about $272 million. The company described the cut in a statement as "the responsible thing to do." Zions Bancorp, which accepted $1.4 billion from the government, reduced its dividends by about 26 percent to $34 million. "This modification to our dividend will allow us to further strengthen our capital base," said chief executive Harris Simmons. Other banks participating in the government program said that they will not use the Treasury's money to pay dividends. They said dividends will be paid from other capital, primarily from their new profits in each quarter. Washington Federal, a Seattle thrift, accepted $200 million from the government. The company will pay its shareholders about $18 million in dividends this quarter, which puts it on pace for $216 million over the next three years. Chief executive Roy Whitehead said the company pays dividends from its quarterly profits, rather than its capital reserves. He said there was only one exception in the past three decades. Last quarter, he said, the company used $11 million in capital to maintain a consistent dividend payment. Still, Whitehead said "categorically" that the company would not use the government's investment to make dividend payments. Some experts questioned the distinction drawn by Whitehead between profits and capital.

"Thinking of them as separate things is kind of a spurious argument. It's all capital," said David Scharfstein, a finance professor at the Harvard Business School who has called for the government to require banks to suspend dividend payments. "Money that goes out the door is money that isn't available to shore up the banks' balance sheet." Scharfstein and others said that many banks clearly need to buttress their balance sheets. Large losses on mortgage-related investments have drained capital, and investors no longer have much interest in giving more money to banks. But several of the institutions accepting government money have continued to pay dividends in recent quarters even as they post large losses. Scharfstein said many banks should suspend dividend payments voluntarily. Some industry analysts, however, say that cutting dividends will make it even harder for banks to find new investors. Capital is basically the money a company keeps in its vaults. A dividend is a distribution of some of that money to shareholders. Companies typically pay dividends four times each year. The stability of dividend payments is important to investors. Some treat dividends as a source of regular income, others as a barometer of corporate health. As a result, companies generally try to match or raise their dividends each quarter. Some banks entered the current crisis with unblemished dividend histories dating back 30 years and more. The resistance to dividend cuts in part reflects the reality that the Treasury program is serving at least two purposes. In some cases, the money is going to companies that need help to survive. In other cases, the government is helping healthy companies to expand. Ed Yingling, chief executive of the American Bankers Association, said he was increasingly hearing from banking executives who feel they should not be forced to accept money with so many strings attached. He said these banks don't need the money, but they are willing to use it to increase lending, so long as they are not punished for doing so. "The government really needs to make up its mind what this program is," Yingling said. Unfunded mandate The IMF adopts a more flexible approach
Oct 30th 2008

TIME was when a bail-out by the International Monetary Fund was a uniformly horrid experience. Cold-eyed, sharp-suited men pored over your country’s books, demanding painful structural reforms and bone-chilling fiscal stringency. Faced with the current turmoil in emerging markets, the fund now seems more like a generous uncle. Well-run countries now have fewer hoops to jump through to gain IMF money. On October 29th the fund announced the creation of a new short-term liquidity facility for the soundest emerging markets. The facility will disburse three-month loans to countries with good policies and manageable debts without attaching any of its usual conditions. The Federal Reserve added its considerable firepower to the rescue effort, announcing the establishments of $30 billion swap lines with each of the central banks of Brazil, Mexico, South Korea and Singapore. The fund’s traditional lending also comes with fewer strings attached. The IMF-led $25.1 billion bail-out of Hungary on October 28th was “fast, light and big”, in the words of one person involved. The rescue came just days after the fund agreed on a $16.5 billion package to shore up Ukraine’s collapsing economy, a prospect which seems to be unblocking the country’s wretchedly deadlocked politics. It is also standing by to help Pakistan. The huge international support package for Hungary is a shocking turn of fortune for Eastern Europe, a region that has enjoyed growth and stability for a decade. But a toxic combination of external debt and collapsing confidence left the economy floundering. Even spending cuts, tax increases, a €5 billion ($6.7 billion) loan from

the European Central Bank and a sharp rise in interest rates, from 8.5% to 11.5%, had failed to calm the markets. The fund had tried to get the governments of Germany, Italy and Austria on board for the rescue. Their banks are most exposed to Hungarian borrowers (thanks to eager lending in euros and Swiss francs). Austria was willing to take part; Germany was not. So the IMF has put up $15.7 billion (to be agreed on at an IMF board meeting shortly), the European Union has added $8.1 billion, and the World Bank a further $1.3 billion. In return, all Hungary has to do is pass a law on fiscal responsibility that is already before parliament. The fund may be calculating that it is better to be lavish before a crisis than stringent after one. Iceland, which is negotiating a $2 billion bail-out from the IMF, is being forced to take some bitter medicine after the failure of its banks. The central bank raised interest rates by a full six percentage points to 18% on October 28th, as trading resumed in the Icelandic krona after a suspension of nearly a week. The big uncertainty now is how many more fires the fund and other lenders must fight—and whether they can afford to do so. The IMF may well need more than the $250 billion it now has. Gordon Brown, Britain’s prime minister, wants countries with big surpluses, such as China and the oil-rich Gulf States, to contribute more. The fund’s backers, it seems, need to be as flexible as its new lending criteria.

New worries grip Russian economy
October 31, 2008

At the start of the global financial crisis, Russian authorities insisted that they had ample cash reserves to weather any storm. But as sorrow has succeeded sorrow - plummeting oil prices, a 70 percent descent in stock markets here, a global credit crisis and a slow-motion run on this country's private banks - Russia has had to spend its reserves faster than anybody imagined. On Aug. 8, reserves peaked at just under $600 billion, the third largest in the world. By this week, they had fallen to $484 billion, as money flew out of government vaults to support the ruble, prop up the banking system and bail out the businesses of the rich Russians known as oligarchs. The fall this week - $31 billion - was the steepest so far. With no end to the global troubles in sight and a worldwide recession likely, which could further reduce oil prices, the question is: How long can Moscow keep this up before its reserves grow thin? Dark pictures are easy to paint. If oil prices continue to fall, the rising expectations that Russians have had for the last several years - the most prosperous in generations - will be foiled. Zero growth would pull the rug from under the hope for a middle-class life for millions, shrinking their horizons back to cramped apartments and garden plots. Already, Russian tour agencies have defaulted on payments to air travel companies - canceling, for some Russians, foreign travel that has come to be prized. "Possibilities that seemed accessible are now gone, perhaps for good," said Vladislav Sergeyev, 28, an art director at an advertising company. Even while insisting that their reserve cushion is adequate, Russian officials acknowledge that Russians are succumbing to some sense of anxiety. "It's all in people's minds," said Igor Shuvalov, a first deputy prime minister in Vladimir Putin's cabinet. Then he added, "For now, we have concrete statistics that we have no collapse, the situation is not developing dramatically, but we are all frightened together." Authorities, mindful of the risks, are tiptoeing around the signs of slippage in the domestic banking system. Russian state television tries to calm viewers with blasé coverage. Most notably, banks have been provided not only liquidity but also plenty of cash for ATMs. Amid the global fear, one thing still sets this country apart: The crisis of 2008 is just the latest in a long string of post-Soviet bank failures, financial swindles and economic collapses. Because so few Russians own stocks, the decline of the markets has not affected most of them directly. Instead, business people who relied on Western bank credit are now in the red, and foreign investors have fled to safer havens. But Russians' growing doubt that Moscow can keep writing checks is clear in growing distrust of private banks.

In the month of September, Russians withdrew 4 percent of deposits from private banks. Some went into state banks, perceived as more reliable, but about half remained in cash. Deposits dropped far more steeply in October: up to 30 percent for some private banks, according to an estimate by Citibank's Moscow office. About a dozen Russian banks have failed so far. And Russians have converted nearly $3.5 billion in ruble bank accounts into dollar bank accounts. By some measures, the Russian economy is still humming along; though it is expected to slow as oil revenue dwindles. September retail sales figures, the latest available, were 14 percent higher than a year earlier. The moribund stock market was up 19 percent on Thursday. (It has fallen so severely that authorities took to closing it for days at a time; the Micex exchange, Russia's largest, has been closed 15 times in October and September.) This week, the government downgraded its growth forecast for this year from 7.8 percent to a still robust 7.3 percent. Independent economists called that estimate optimistic. Still, most of the actual effects on ordinary Russian citizens have been few, so far. A truck maker and the largest Russian steel mill reduced their operating hours; a cell phone retailer announced layoffs; and auto and consumer loans are drying up. Skeptical of the financial system, some Moscow cafés have stopped taking credit cards. A dozen Russian banks have been bought by state banks in bailouts. The big risk here is a loss of faith among clients and subsequent bank runs, rather than structural troubles with liquidity. Because most Russians cannot send their money out of the country, they simply get it out of the bank. Anna Pukhova, an actress at Benefis, a small Moscow theater, withdrew her savings from Société Générale Vostok this month. "I decided not to wait until my bank closes down in Russia and withdrew all my money a couple weeks ago," she said. "I would rather lend my money to a friend who I trust than keep it in a bank, as I fear that in a few months there will be huge lines of people trying to withdraw cash, like in 1998." Perhaps because of that history, a widespread run on the banks — or, indeed, the grocery stores for some food rumored to be in short supply, as happened in the Ural Mountains in a panic run on salt in 2007 — may be a greater possibility here than in other societies. An opinion poll by the Levada Center in Moscow found that 40 percent of Russians who had bank accounts feared they could lose money to bank failure; most of those who feared for their accounts listed political and economic instability, or a devaluation of the currency as occurred in 1998, as their biggest worries. For a few frenzied weeks this fall, Natalya Sebeleva, a teller at Globeks, Russia's 35th-largest bank, disbursed great piles of rubles. Some customers withdrew as much as a million rubles, or $37,000, and carried it away in a briefcase to store at home. Others transferred money electronically to the state banks, like Sberbank and VTB, which are seen as more reliable. Yet even VTB is not immune: its chairman, Mikhail Zadornov, said Thursday that withdrawals had accelerated in October, Interfax reported. On Oct. 13, Globeks stopped disbursing cash and was taken over by a state bank, the foreign trade bank, which has become a vehicle for a $50 billion government bank bailout. At Globeks, it has guaranteed deposits that, nonetheless, remained frozen this week. Yekaterina Yakovleva, who worked at Globeks and was with another bank during the 1998 financial crisis until it closed and she lost her job keeps her savings in cash in her apartment. Irina Petrenko, 30, an employee of the South African franchise that brews Miller beer in Russia, said most Russians are just confused. "People are saying, 'Yes, a crisis, yes, but what should we do?' “she said. "There will be inflation, devaluation, the dollar will become stronger, and the dollar will become weaker. We don't know." She said friends had decided to buy furniture. "If you have a couch, at least you have a couch, even if you have no money." She added, "I try not to understand the economy, so I don't commit suicide."

Hank Paulson's $125 Billion Mistake
October 31, 2008

It was only a few weeks ago that most right-thinking economists and left-leaning bloggers were jumping on Treasury Secretary Hank Paulson for his plan to jump-start the markets in asset-backed securities by having the government buy them up at auction. Much better, they argued, to use the $700 billion to "recapitalize" the banking system, just as Gordon Brown was doing in Britain. Even the Federal Reserve thought that a better idea. So Paulson changed course, called in the nine biggest banks and "forced" them as a group to accept $125 billon in new capital. The critics patted themselves on the back for having been right all along. Now, many of the same people are shocked -- shocked! -- to discover that the banks aren't using the money to make new loans to households and businesses, as they had assumed, but are using it to maintain dividend payments to shareholders, pay this year's bonuses to executives and traders, or squirrel it away for future acquisitions. I hate to say it, but I told you so. Sprinkling money around a highly fragmented banking system when markets were panicked and everyone was scrambling to reduce leverage was always akin to shoveling sand against the tide. Certainly there are situations in which capital injections are necessary. In Britain, for example, there are only a handful of banks that matter, and those had their capital so depleted that there was no choice but to pour money into them, on onerous terms and with lots of strings attached. And certainly, as with PNC's purchase of National City, a dose of government capital can grease the takeover of a weak bank that might have otherwise failed and required government intervention. But making modest investments in dozens of banks, whether they needed it or not, produces little for the public beyond the small profit for the Treasury. What it does do, however, is open the door for every politician and populist to second-guess every decision and expenditure the banks make, based on the false assumption that everything they do is with "our money." Paulson's first mistake was in allowing himself to be diverted from his original strategy, which stood a good chance of establishing reasonable and credible market prices for asset-backed securities -- a necessary first step in attracting other buyers back into those frozen markets. That would take tremendous pressure off all banks, insurance companies, hedge funds and bond insurers, most of which now can't raise capital because nobody can even guess what the assets on their books are worth, forcing accountants and auditors to assume the worst. It also would get liquidity to those institutions that most need it. Paulson's second mistake was buying into the silly idea that it was crucial to attract all the big banks into the program so that any bank that might really need the money could avoid the stigma of having to ask for it. That's a surprising stance from a Treasury that claims to trust markets and encourage transparency. Nor does it square with recent evidence that investors are quite capable of sniffing out weak financial institutions long before managements come clean. Moreover, in trying to persuade banks that don't need the money to take it, the Treasury has wound up offering everyone the same sweetheart deal that gives the government little say in how the money is used or how the banks are run. That's particularly dangerous in the case of weaker banks, which might be tempted to take big risks in the hope of recouping past losses or to divert money to shareholders and executives before the inevitable government takeover. In the case of some of the stronger banks, however, much of the carping about bonuses and dividends and refusal to lend are a bit overblown. These are, after all, large institutions with many activities, some of which make money even as others lose it. Paying the bonuses to successful employees is not only fair but is also necessary to attract and retain top talent. It hardly serves the interest of taxpayers if all the banks they invest in wind up losing top talent to all the banks

they didn't. Moreover, banks like J.P. Morgan, Wells Fargo, State Street and the newly chartered Goldman Sachs remain highly profitable and well-capitalized. It ought to be up to them to decide whether to use those profits to add to capital reserves or pay them out in dividends and executive bonuses. We might not like their choices, or their values, but this is still a market economy, and these are still shareholder-owned companies. The industry hasn't been nationalized just yet. It is also useful to remember that the way banks make money is to lend it out, not hold it in the vault or invest it in low-yielding Treasury bonds. Hoarding is not generally a winning strategy for maximizing share prices or executive bonuses. It is also useful to remember what got us into this mess in the first place. If banks are using their new capital to reduce their own leverage, or are more cautious about whom they lend to, that's probably a good thing. Perhaps the worst part of this misguided effort to recapitalize the banking system is that it has prompted other industries to line up for similar sweetheart deals. Automakers, insurers, auto finance companies and local governments are already besieging the Treasury, and you can be sure that others are refining their pitch. One can only hope that the terms of future deals will be sufficiently onerous that going to the Treasury will be become a last resort, not a first instinct, for industries in trouble.

Fed adds $21 billion to loans for AIG
October 31, 2008

The American International Group said Thursday that it had been given access to the Federal Reserve's new commercial paper program, allowing it to reduce its reliance on a costlier emergency loan from the Fed. The company said it would be able to borrow up to $20.9 billion under the new program, raising its maximum available credit from the Fed to $144 billion under three different programs. The credit includes an earlier emergency loan of $85 billion from the Fed that carries a much higher interest rate. AIG's big borrowings underscore the company's bewilderingly rapid decline. When it suddenly faced a cash crisis in mid-September, the original estimate of the amount it needed was just $20 billion. A few days later, the Fed stepped forward with its $85 billion credit line. And now, the stunning size of that original bailout has grown by almost 70 percent. AIG's cash needs could grow even further. Much of the cash it needs is being used to meet collateral calls from its derivatives counterparties, and the precise collateral triggers and amounts are not public information. In general, the derivative contracts cost AIG more as the real estate markets decline. The company's financial products division did a lot of business in that type of derivative, called credit-default swaps. By the same token, if real estate prices rebounded, AIG has said, it could call some of the collateral back. In addition to the $85 billion credit line and the $20.9 billion commercial paper program, AIG has a $38 billion facility from the Fed that provides liquidity for the company's securities-lending business. AIG said on Thursday that it was currently using about $18 billion of this facility. By tapping the newest source of money from the Fed, AIG was able to reduce the amount it had borrowed under the original $85 billion line of credit, said a spokesman, Joe Norton. He said the company had currently drawn down $65.5 billion from that loan, compared with about $72 billion a week ago. The Fed extended the original $85 billion line of credit at a steep price. On the part of the loan that AIG draws down, it must pay an interest rate of 8.5 percentage points over the three-month Libor, an index rate for interbank lending. On the unused portion, AIG must pay a fixed rate of 8.5 percent. In addition, the Fed added a 2 percent commitment fee to the total balance when it started the loan. Norton said AIG had incurred interest and fees of about $331 million so far. The Fed also took a majority stake in AIG in exchange for the bailout, angering shareholders, who were almost completely wiped out.

The commercial paper program is much cheaper. The interest rate changes every day, but in the four days since the Fed started the program, the highest rate was just 3.89 percent. AIG is not the only participant. The Fed offered the program to all issuers of commercial paper in the nation to restart the stalled credit markets. Norton said AIG would use the newest source of funds for working capital, to refinance existing commercial paper, and to make voluntary prepayments on the $85 billion loan. He said that such voluntary prepayments would not reduce the total amount of the credit line available. If, by contrast, AIG sold business assets and used the proceeds to pay down the loan, Norton said, the $85 billion balance would be reduced accordingly.

Argentina's credit rating cut further as turmoil spreads
October 31, 2008

Standard & Poor's cut Argentina's sovereign credit rating for the second time in less than three months Friday, sending it deeper into junk bond territory on worries of greater investor risk. Citing heightened concerns about deteriorating economic and political environment and fiscal pressures, S&P cut the bonds to "B", six notches into junk bond territory. Argentina's new rating stands one notch above a clutch of ratings where a country's debt is considered to be predominantly speculative, hold substantial risk or be in actual default. S&P kept its outlook on Argentina as stable. In credit markets, the cost of insuring Argentine debt against default rose 112 basis points to 3985 points via five-year credit default swap. That means an investor would have to annually pay 39.85 percent of the face value of Argentine government bonds over a five-year period for the default insurance. Over the course of this week, the cost to insure Argentine debt has risen 7.4 percent, according to Markit. Argentina's center-left government last week announced a plan to nationalize private pensions, sending local financial markets into a tailspin and raising fresh doubts about the country's ability to weather the global financial crisis. Foreign investors read the plan as a desperate effort to find funds to meet billions of dollars of debt obligations next year. Some analysts have speculated that the funds takeover is a bid to stave off the prospect of default. Argentina defaulted on about $100 billion in debt in 2002 and reached agreement on a restructuring with most creditors in 2005. S&P credit analyst David Beers said: "The downgrade reflects our heightened concerns about the deteriorating economic and political environment in Argentina and the resulting increased fiscal stress." The agency said the government's unexpected proposal to transfer the private pension system back into government hands "has shaken the local financial markets and overall confidence". "Any significant fiscal slippage would complicate the government's financing program, possibly leading to a downgrade," Beers added. Argentine bonds have crumbled an average of 64 percent on average in local markets this month, hit by the pension plan and the international credit crunch. Local analysts said they did not see the S&P downgrade making much difference to investor sentiment, which is already low. "I don't think it will have much more impact on the economy and to a certain extent it was predictable," said Fausto Spotorno, an analyst at the Buenos Aires-based economic consulting firm Orlando Ferreres and Associates. Following the announcement, locally traded sovereign debt -- which ended higher Thursday after 11 straight losses -- traded down by an average of 0.5 percent in early trade.

Paul Krugman: When consumers capitulate
October 31, 2008

The long-feared capitulation of American consumers has arrived. According to Thursday's GDP report, real consumer spending fell at an annual rate of 3.1 percent in the third quarter; real spending on durable goods (stuff like cars and TVs) fell at an annual rate of 14 percent. To appreciate the significance of these numbers, you need to know that American consumers almost never cut spending. Consumer demand kept rising right through the 2001 recession; the last time it fell even for a single quarter was in 1991, and there hasn't been a decline this steep since 1980, when the economy was suffering from a severe recession combined with double-digit inflation. Also, these numbers are from the third quarter - the months of July, August, and September. So these data are basically telling us what happened before confidence collapsed after the fall of Lehman Brothers in midSeptember, not to mention before the Dow plunged below 10,000. Nor do the data show the full effects of the sharp cutback in the availability of consumer credit, which is still under way. So this looks like the beginning of a very big change in consumer behavior. And it couldn't have come at a worse time. It's true that American consumers have long been living beyond their means. In the mid-1980s Americans saved about 10 percent of their income. Lately, however, the savings rate has generally been below 2 percent sometimes it has even been negative - and consumer debt has risen to 98 percent of GDP, twice its level a quarter-century ago. Some economists told us not to worry because Americans were offsetting their growing debt with the ever-rising values of their homes and stock portfolios. Somehow, though, we're not hearing that argument much lately. Sooner or later, then, consumers were going to have to pull in their belts. But the timing of the new sobriety is deeply unfortunate. One is tempted to echo St. Augustine's plea: "Grant me chastity and continence, but not yet." For consumers are cutting back just as the U.S. economy has fallen into a liquidity trap - a situation in which the Federal Reserve has lost its grip on the economy. Some background: One of the high points of the semester, if you're a teacher of introductory macroeconomics, comes when you explain how individual virtue can be public vice, how attempts by consumers to do the right thing by saving more can leave everyone worse off. The point is that if consumers cut their spending, and nothing else takes the place of that spending, the economy will slide into a recession, reducing everyone's income. In fact, consumers' income may actually fall more than their spending, so that their attempt to save more backfires - a possibility known as the paradox of thrift. At this point, however, the instructor hastens to explain that virtue isn't really vice: In practice, if consumers were to cut back, the Fed would respond by slashing interest rates, which would help the economy avoid recession and lead to a rise in investment. So virtue is virtue after all, unless for some reason the Fed can't offset the fall in consumer spending. I'll bet you can guess what's coming next. For the fact is that we are in a liquidity trap right now: Fed policy has lost most of its traction. It's true that Ben Bernanke hasn't yet reduced interest rates all the way to zero, as the Japanese did in the 1990s. But it's hard to believe that cutting the federal funds rate from 1 percent to nothing would have much positive effect on the economy. In particular, the financial crisis has made Fed policy largely irrelevant for much of the private sector: The Fed has been steadily cutting away, yet mortgage rates and the interest rates many businesses pay are higher than they were early this year. The capitulation of the American consumer, then, is coming at a particularly bad time. But it's no use whining. What we need is a policy response.

The ongoing efforts to bail out the financial system, even if they work, won't do more than slightly mitigate the problem. Maybe some consumers will be able to keep their credit cards, but as we've seen, Americans were overextended even before banks started cutting them off. No, what the economy needs now is something to take the place of retrenching consumers. That means a major fiscal stimulus. And this time the stimulus should take the form of actual government spending rather than rebate checks that consumers probably wouldn't spend. Let's hope, then, that Congress gets to work on a package to rescue the economy as soon as the election is behind us. And let's also hope that the lame-duck Bush administration doesn't get in the way.

Some Banks May Tell U.S. to Keep Bailout Cash
October 31, 2008

Talk about biting the hand that feeds you. The American Bankers Association complained on Thursday that bankers around the country were “extremely upset” about how the Treasury Department was trying to offer them billions of dollars in fresh capital. “These bankers believe they are being asked — in some cases pressured — to participate in a program they did not want and do not need,” wrote Edward L. Yingling, president of the American Bankers Association, in a blistering letter to the Treasury secretary, Henry M. Paulson Jr. Saying he had “deep concerns with the lack of clarity about the program,” Mr. Yingling said the confusion had grown sharply this week over what the government’s purpose was. The bank-lobbying group said the main confusion was over whether the purpose of the program was to shore up healthy banks, as Mr. Paulson has insisted, or to rescue failing ones. Mr. Yingling said he was alarmed that lawmakers in Congress were criticizing the Bush administration for its reluctance to impose tougher restrictions on banks that accept government money. Some Democratic lawmakers have complained that banks are taking taxpayer money with one hand while paying out dividends to shareholders with the other. Some policy makers have also complained that banks are not lending enough and might be paying their executives too much. Since the Treasury Department introduced its plan, officials have stressed that their goal was to strengthen healthy banks and get them to revive their lending. Officials are also encouraging the takeovers of sick banks by healthy ones, as they did last week when the Treasury approved the bailout program’s purchase of $7.7 billion of preferred shares in PNC Financial Services and rejected an application from National City Bank, based in Cleveland. National City quickly agreed to a takeover by PNC. But the focus on healthy banks has created baffling contradictions. Healthy banks have been reluctant to take the government money, in part because they feared being stigmatized as needy or vulnerable. Mr. Paulson essentially strong-armed several of the country’s biggest banks into participating when he announced the program earlier this month. To attract healthy banks into the program, Treasury officials also imposed as few restrictions as possible for those that received money. Banks could still keep paying dividends. They had only limited restrictions on executive bonuses and compensation. And the government would not force the banks to make loans they did not want to make. But that only raised the question: why was the government trying to give those banks money in the first place? Andrew M. Cuomo, the New York attorney general, sent letters to the nine biggest financial institutions on Wednesday, demanding a “detailed accounting” of the next round of bonuses they planned to pay. Mr. Yingling said many healthy banks might want to take advantage of the Treasury’s offer, but not if they had to suspend dividends or accept restrictions on executive pay. “It would make no sense for a well-capitalized bank with solid earnings to agree to a program which would greatly lower the value of its stock,” Mr. Yingling wrote.

Help-for-Struggling-Homeowners Central

In my column this week, I mention, at least in passing, six plans that I’ve read that offer ideas for helping struggling homeowners, and in so doing stem the rising tide of foreclosures and stabilize housing prices, two things that are badly needed if the financial crisis is ever going to ease. (This of course doesn’t include the plan that has been put together by the Federal Deposit Insurance Corporation, which, pathetically, the Treasury Department and the White House still haven’t approved.) I’ve also seen a handful of other plans that deserve consideration that didn’t make it into this week’s column. So without further ado, here they are, in no particular order: The Columbia Business School Plan. That’s my name for it because its authors are R. Glenn Hubbard, the dean of the business school (and the former chairman of the Council on Economic Advisers under President Bush), and Christopher Mayer, a professor at the business school. Their idea is simplicity itself: allow all residential mortgages on primary residences to be refinanced into 30-year fixed-rate mortgages at 5.25 percent. Here’s how they describe it in The Wall Street Journal. The Peter Wallison Plan. Mr. Wallison, of the American Enterprise Institute, who may be the world’s greatest critic of Fannie Mae and Freddie Mac, thinks that now that the government has taken them over, it should use them to help homeowners. With a colleague, Ed Pinto, he explains his reasoning on the A.E.I. Web site. The American Homeowner Preservation Plan. This is the plan where this nonprofit organization uses taxexempt bonds to buy up mortgages and lease the homes back to the former homeowners. Here is a description of it. The James Grosfeld Plan. It is complicated but worth paying attention to. Mr. Grosfeld spend much of his career in homebuilding–he was the long-time chief executive of Pulte Homes–and besides, his is the only plan that would make money for the federal government. Here is his description. The Thomas Peterffy Plan. It doesn’t get any simpler than this. Mr. Peterffy argues that the only way we can move quickly enough — and help enough people — is to simply give every homeowner $250 a month for five years to help pay the mortgage on a primary residence. He describes it here. The William Browning Plan. This may be my favorite, for its sheer brevity and pithiness. Bill, an artist and former investment banker, has been a correspondent of mine for several years, and recently sent along this plan. And of course, there is Daniel Alpert’s Freedom Recovery Plan, and the William Hambrecht Plan, which I have talked about here, here, here and here. I would like to post the details of the William Frey Plan, but he hasn’t yet given me permission. (It is contained in a letter he wrote to Treasury Secretary Henry Paulson and the Federal Reserve chairman, Ben Bernanke.) If and when he does, I’ll add it to this list.

U.S. mortgage plan may aid many, but irk others
October 31, 2008

As the Treasury Department prepares a $40 billion program to help delinquent homeowners avoid foreclosure, it confronts a difficult challenge: not making the plan too tempting to people like Todd Lawrence. An airline pilot who lives outside Norwich, Connecticut, Lawrence has a traditional 30-year mortgage that he has no trouble paying every month. But, thanks to the plunging real estate market, he owes more on his house than it is worth, like millions of other people. If the banks, which frequently lent irresponsibly, and many homeowners, who often borrowed irresponsibly, are getting government assistance, Lawrence says he believes sober souls like him are also due a break. "Why am I being punished for having bought a house I could afford?" he asked. "I am beginning to think I would

have rocks in my head if I keep paying my mortgage." The plan, still under development by Treasury, is part of the economic rescue package passed by Congress earlier this month. It is aimed at aiding up to three million beleaguered homeowners by reducing their monthly payments. Washington and Wall Street are frantically seeking to stabilize markets by curtailing the onslaught of foreclosures. There are now at least four major plans to aid homeowners. But experts say it is difficult to design these programs in ways that reduce the indebtedness of the distressed without giving everyone else a reason to mail the keys back to their lenders. "If the lunch truly is free, the demand for free lunches will be large," said Paul McCulley, a managing director with the investment firm Pimco. More than 10 million homeowners are underwater like Lawrence, and their ranks are swelling. In theory, McCulley points out, underwater homeowners benefit when a neighbor is bailed out instead of surrendering his house to foreclosure. With a foreclosure, the owner becomes the bank, which will care for the house minimally. When the bank finally manages to unload the house months later, the fire-sale price will establish a new floor for the remaining neighbors. But the benefits of a bailout for his neighbors seem ephemeral to the 45-year-old Lawrence, especially because he figures the cost of helping them will come, one way or another, out of his pocket as a taxpayer. "I'm basically financing my own financial destruction," he said. Government officials say that homeowner bailouts are not a gift. For one thing, they assert, most mortgages will simply be revamped so the monthly payments become affordable for the next few years. Reductions in loan balances, which are drawing the most attention, will generally be a last resort. "This is not about trying to create fairness," said Michael Krimminger, special adviser for policy at the Federal Deposit Insurance Corp., which is working with Treasury on the latest plan. "The goal is to keep people in their houses." Still, he acknowledged, "a lot of people are angry because they feel some people are getting something they don't deserve." Going into default, whether as a gambit to get a loan modification or to get rid of a burdensome house payment, carries risks. Under some conditions, lenders have the right to sue a borrower for assets beyond the house itself. Then there is the inevitable blot on the borrower's credit record. Other factors are intangible: Many owners like their houses and neighborhoods and do not want to leave them. And many people, even as their retirement funds vaporize, consider paying their debts a moral obligation. Against those considerations must be measured the burden of paying a $500,000 mortgage on a property now worth $350,000."From a purely economic standpoint, there's not a whole lot to be gained from staying," said Rich Toscano, a San Diego financial adviser whose popular blog,, predicted the collapse. Homeowners are not the only ones weighing their options. Real estate investors are also wondering if they will be left behind. "We told our lenders that if you're writing down 90 percent of your portfolio, we want to be in on it," said Jason Luker, a principal at Cardinal Group Investments in San Diego. Cardinal owns homes that it rents out. "If all of our neighbors are getting bailed out despite their own bad decisions, arrogance or ignorance, and we're asked to keep playing by the rules for the sake of the greater good, I don't want to participate," Luker said. Peter Schiff, the president of Euro Pacific Capital in Darien, Connecticut, who prophesied doom before it became fashionable, says he thinks just about everyone who is underwater and has few other assets should stop paying. "If the government says, 'Prove that you can't afford your house and we'll redo your mortgage,' then people are going to try to qualify," Schiff said. In that situation, those who will benefit the most are the ones who, unlike Lawrence, spent far beyond their means who refinanced their houses and used the cash to buy toys and lavish vacations, or sometimes just to pay the bills. "You put something down, you have something to lose," Schiff said. "You put nothing down; you've got nothing to lose." Though hard numbers are scarce, estimates are that foreclosures will surpass one million this year. Losses on home loans are piling up faster than banks can deal with them. First Federal Bank of California said this week that as of June 30 it owned 380 foreclosed houses. It managed to sell 329 of them during the third quarter but acquired another 450.

This sense of rapidly losing ground underlies the urgency behind the Treasury's new plan, which is being developed even as various homeowner bailouts that were announced earlier are just getting under way. A White House spokeswoman, Dana Perino, said on Thursday that the plan was not "imminent" and that several different proposals were being considered. "If we find one that we think strikes the right notes and could meet all of those standards that we want to protect taxpayers, make sure that it's also fair and that it would actually have an impact, then we would move forward and we would announce it," Perino said. The Federal Housing Administration began Hope for Homeowners on Oct. 1, aimed at making as many as 400,000 mortgages affordable. Under the program, lenders will refinance loans to 90 percent of a house's current value, automatically giving the owner 10 percent equity. The loans will be insured by the government, which will take a share of any gain when the house is sold. If a sale occurs in the first year, the government takes it all. The second year, it takes 90 percent; and so on down a sliding scale. After five years, it takes half the gain. To guard against fraud, a spokesman for the housing agency said, borrowers will have to certify they did not "intentionally" default. The Hope Now Alliance, an initiative by a range of lenders, trade groups and counseling agencies, says it has aided 2.3 million borrowers in the last year. Nearly half of Hope Now's most recent workouts involved modifications of the original loan, including reducing the principal or the interest rate. Countrywide Financial says it will help 400,000 of its customers through the Nationwide Homeownership Retention Program, slated to begin in December. Countrywide, an aggressive lender during the boom, is now a division of Bank of America. The $8.4 billion program arose out of a legal settlement, but a Countrywide spokesman, Rick Simon, said the lender now realized that it was cheaper to keep owners in their homes than to let them go into foreclosure. But not every owner. The program, aimed at those spending more than a third of their household income on a mortgage, property taxes and insurance, is limited to borrowers with subprime and pay-option adjustable-rate mortgages — the worst of the many exotic loan types that proliferated during the boom. "Confusion or misrepresentation went into the marketing of these loans," Simon said. By contrast, a buyer with a standard 30-year mortgage "probably understood the terms." Countrywide says it will write down pay-option mortgages to as low as 95 percent of the current value of the home. The borrowers must either be in default or "reasonably likely" to default. "I guess they are forcing me to deliberately stop paying to look worse than I am," said one borrower with a Countrywide pay-option loan. "Crazy, don't you think?" The borrower, who lives in suburban Los Angeles, took nearly $200,000 in cash out of his house and then paid less than the monthly interest due on his new loan. He now owes about $350,000 on a house that is worth only $150,000. He asked not to be identified for fear he would not get a modification, which could reduce his mortgage to $142,500.

A Rescue Hindered by Politics
By JOE NOCERA November 1, 2008

Plans. Have I ever been inundated with plans. Deluged with them, actually. Two weeks ago in this space, I trumpeted an idea to help struggling homeowners stay in their homes from Daniel Alpert, a founding partner of Westwood Capital, a small investment bank. He had no personal stake in stemming the rising tide of foreclosures, but as someone who has spent his career in and around securitization and structured finance, he felt he had something useful to offer. Mr. Alpert devised what he called his Freedom Recovery Plan because he wanted to try to help ease the terrible financial crisis we’re in. In publicizing his plan, however, I opened a spigot I hadn’t known existed. It turns out that Mr. Alpert isn’t the only smart guy who has been thinking hard about how to keep people from getting tossed out of their homes. It is a problem that is getting worse by the day, with more than 107,000 foreclosures in September alone, and one of every five mortgages underwater, by some estimates, meaning the homes are worth less — often substantially less — than the mortgage.

(A quick refresher: the reasons it is important to tackle this problem are, 1. foreclosures hurt not only individual homeowners but entire neighborhoods and the American economy; 2. until housing prices stabilize, the financial crisis won’t end, because housing is at the root of it; and 3. keeping people in their homes is the quickest, most compassionate way to begin stabilizing home prices.) I heard, for instance, from William R. Hambrecht, the innovative founder of a firm that takes companies public through Dutch auctions, who believes that lenders should get equity in homes in return for reworking their mortgages, thus giving them some potential upside. Thomas Peterffy, the chief executive of the Interactive Brokers Group, believes the government should simply give every American homeowner $250 a month for five years to help pay the mortgage on their primary residence. James Grosfeld, the former chief executive of Pulte Homes, walked me through his smart, interesting proposal for the government to buy up pools of mortgages at a discount and refinance them through Fannie Mae and Freddie Mac. If his plan works — and his argument is very compelling — the government could even make a profit in the process. I found examples of nonprofit organizations, like American Homeowner Preservation, based in Cincinnati, that use tax-exempt bonds to buy homes and then lease them back to the former owners. I even discovered that the guy Barney Frank is planning to rake over the coals at a House Financial Services hearing he’ll be presiding over in a few weeks has a plan. The guy, William Frey, a broker-dealer in Greenwich, Conn., invested in a pool of toxic mortgages, along with hundreds of other investors. His big point is that because the contracts are so ironclad, and the interests of the various investors are diverse and often in conflict, there is no legal way to modify mortgages in those pools. He wrote a letter threatening to take action against any mortgage servicers who took steps to prevent foreclosures — thus raising Mr. Frank’s ire. Turns out that Mr. Frey had sent a letter to Treasury Secretary Henry M. Paulson Jr. and the Federal Reserve chairman, Ben Bernanke, seven months ago predicting that the government would have to take over Fannie Mae and Freddie Mac, but adding that the takeover offered the best way to help homeowners. Under his plan, which he outlined in the letter, the government would buy mortgages at face value, and then use Fannie and Freddie to write homeowners new, more affordable mortgages that reflected the current value of the homes. The government would have to absorb the difference between the original mortgages and the new ones. Mr. Frey acknowledged that it wasn’t fair that both borrower and lender were made whole, while the taxpayer had to take the loss. But he believes that the securitization contracts make it impossible to solve the problem any other way. “Theoretically, morally and logically, the investor should absorb the loss,” he said. “But how do you get the loss to them? I don’t see a way.” So yes, I’m swimming in plans — serious, smart, well-meaning plans that deserve consideration. And yet one plan is still missing. Where, oh, where is the government’s plan? It has been over a week since the Federal Deposit Insurance Corporation chairman, Sheila Bair, testified before the Senate Banking Committee, where she promised that a plan was on the way. “Everyone agrees that more needs to be done for homeowners,” she said, adding that the F.D.I.C. was in discussions with the Treasury and the White House about a plan. “There is a policy process under way,” she said. “We hope to be able to make some announcements soon.” In fact, Ms. Bair had hoped to be able to make the announcement that morning, in front of the committee. But the plan she has devised — and make no mistake, she is the driving force within the administration pushing to do something for homeowners — has been held up in endless wrangling with the Treasury and the White House. According to an article by Vikas Bajaj and Eric Dash in The New York Times on Wednesday, Ms. Bair’s plan would have the government absorbing half the losses on home mortgages when lenders agreed to lower the borrower’s monthly payment for at least five years. The government would also guarantee mortgages that were renegotiated at a lower rate, so that the lender would not have to take additional losses if the homeowner later

defaulted. The F.D.I.C. hopes to guarantee up to three million mortgages, at a cost that is estimated at around $50 billion. As I understand it, the money is not the hang-up. Mr. Paulson and Mr. Bernanke have shown themselves more than willing to use many, many billions of dollars to keep the financial system afloat. Indeed, The Times estimates that the federal government has committed an astonishing $1.5 trillion so far in loans, investments and guarantees to the banking system. No, the hang-up, apparently, is that aid is going to homeowners, not giant financial institutions, with the negotiations revolving around who will be eligible for the program and what will constitute an affordable new mortgage. Ms. Bair is arguing for a broad definition; the Treasury wants something narrow, which of course will mean fewer people will get help. This is hardly a surprise. One of the reasons previous efforts at helping homeowners have had such little success is precisely because the Treasury has insisted on defining the number of eligible homeowners as narrowly as possible. It is also, of course, maddening. When it comes to the nation’s financial institutions, the Treasury is willing to hand billions of dollars to healthy banks, like JPMorgan Chase and Wells Fargo, that don’t even want the money. (It did so to disguise the fact that other, weaker banks, like Citigroup, do need the money.) Yet, inexplicably, it seems to feel that homeowners have to be treated much more severely. The only legitimate reason for this is the one that my colleague David Leonhardt has put forth — that if the government says it is going to help homeowners in danger of foreclosing, it will create an incentive for a lot more homeowners to decide that they’re in danger of foreclosing. But I would argue that the country is far better served at this late date by erring on the side of generosity. Isn’t it better to let a few homeowners get relief who might not need it (just like JPMorgan!) than restricting the eligibility so narrowly that people in real trouble will not be able get their mortgages modified? Yet the Treasury instinctively prefers the latter. It is also deeply aggravating that the urgency the government showed a month ago, when the banking system seemed at risk, seems absent now that the issue is homeowners. It took the Treasury and the Fed all of 36 hours to put forth a plan for a systemic bailout of the financial system. Yet they still can’t agree on a plan to help homeowners; in fact, I hear that the Treasury is furious at Ms. Bair for getting out front of it on this issue, which may be another reason it won’t sign off on her plan. More and more, it seems as if Treasury is acting like the Federal Emergency Management Agency after Hurricane Katrina. I can’t say with any certainty that the F.D.I.C. plan is demonstrably better than the plans that have been sent to me over the transom these last few weeks. Like any complicated plan, the devil will be in the details. What I do know is that the F.D.I.C. has a deeper understanding of the mortgage and foreclosure problem — and a greater sense of urgency — than any other agency of government. In July, the F.D.I.C. became the conservator of a failing bank in California, IndyMac Federal. For the last few months, it has used the bank as a Petri dish to see whether it could make mortgage modifications on a broad scale. Although the process is still in the early stages, the answer appears to be yes. So far, more than 3,500 homeowners have accepted the F.D.I.C.’s offer of mortgage modification, with thousands more lined up behind them. What’s more, many of those mortgages were ones trapped in securitization pools. In fact, the F.D.I.C. told me that it had sent out notices to 9,000 homeowners with securitized mortgages, offering to modify them. “We can do this on securitizations,” said Michael Krimminger, the F.D.I.C.’s special adviser to the chairman for policy. “We can do it on a streamlined basis because we are applying a model.” The notion that securitization contracts would prevent mortgages from being modified was “a red herring.” If the F.D.I.C. can help IndyMac borrowers, then presumably it can help borrowers all over the country. So enough with “the policy process,” as Ms. Bair so politely calls it. The time has come for the Treasury to swallow hard, sign off on the F.D.I.C. plan and let Ms. Bair begin carrying it out as quickly as possible. To delay any longer isn’t just shortsighted. It’s inexcusable.

FDIC Chairwoman Sheila Bair earns respect amid banking crisis
Nov. 1, 2008

Hundreds of people desperate to withdraw money lined up outside the branches of IndyMac Bancorp after the California bank was seized in July by the Federal Deposit Insurance Corp. FDIC officials were stunned. The bank now belonged to the federal government. The deposits were insured by the FDIC. Bank runs were supposed to end once the government arrived. "It had just been so long since there had been a significant bank failure in the U.S.," FDIC Chairwoman Sheila Bair said. "People had just forgotten that banks fail." And, she added, they had forgotten about the FDIC. More than three months later, Bair and her agency have moved to the forefront of the government's response to the financial crisis working alongside Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke. A wide range of observers say the FDIC's recent actions may offer the best hope for limiting the consequences of the crisis. Bair's role in trying to solve the credit crisis has impressed Democrats on Capitol Hill. "She's going to be Treasury secretary someday," said Tim Adams, a former department undersecretary under President Bush who worked with Bair when she was an assistant secretary. Bair should supervise and coordinate the federal response to "the foreclosure crisis that continues to undercut economic recovery," Rep. Barney Frank of Massachusetts and Rep. Maxine Waters of California, both Democrats, wrote in a recent letter to Bush. The lawmakers said they have been "very impressed" with Bair's loan-modification efforts. The takeover of government-sponsored mortgage companies Fannie Mae and Freddie Mac, and the $700 billion bank-rescue plan brokered by Bair and signed by Bush, position the government to "maximize foreclosure mitigation," Frank and Waters wrote. Creating a position giving Bair greater responsibility "would improve the effectiveness of the efforts of the federal government at a time when prompt and efficient action is most needed," they wrote. The plan would not require Bair to leave her FDIC post, said Steve Adamske, a spokesman for Frank. A wide range of people who have worked with Bair, who took over the FDIC in 2006, describe her as well-suited to the challenge. They say she is principled and blunt without being confrontational. She has the talent, more often observed in diplomats than in banking regulators, for simultaneously communicating opposition to an idea and personal warmth for the holder of the idea. And she knows how to make a deal. Martin Eakes, chief executive of the Center for Responsible Lending, which seeks stricter mortgage regulations, described a meeting organized by Bair in early 2007 and attended by consumer advocates and mortgage executives. "There were some really heavy egos around that table, people with 30 and 40 years' experience in the minutia of mortgage loans, and she just moved that group in a way that I marvel at," Eakes said. "Had I pushed the same issues, I would have had everybody screaming at me." Nonetheless, Bair's relationship with the banking industry has sometimes been rocky. Bankers, subject to Bair's authority, are reluctant to talk about her publicly. Her first action at the FDIC was to raise the premiums banks must pay to insure deposits, an inherently unpopular idea. Bair, 54, who is married and has two children, was born in Wichita and went to the University of Kansas for a degree in philosophy and then for law school. Then she moved to Washington, D.C., to work for Sen. Bob Dole, R-Kan. One of her fellow staff members was Joshua Bolten, who would become chief of staff to Bush. Bair left Washington, D.C., intending to return. She unsuccessfully ran for a U.S. House seat in southeastern Kansas in 1990.

She spent the go-go 1990s working in the financial markets, as a regulator at the Commodity Futures Trading Commission and then as a lawyer at the New York Stock Exchange. Then, in 2006, she was called back to D.C. At the time, the FDIC was seen by observers as a Maytag agency. It had been two years since the last bank failure, the longest quiet stretch since the agency was created in 1933. Hundreds of FDIC employees had been laid off. Many banks were no longer required to pay insurance premiums because the money wasn't needed. Bair, however, soon decided that the sleepy days were ending. Old friends told her that aggressive lending practices were no longer a danger only to consumers but also to the industry. At Bair's direction, regulators bought a database of information about securitized loans. They saw an alarming pattern of disregard for traditional underwriting. By the spring of 2007, Bair was arguing with vigor, first in private meetings and then in public speeches, that the industry needed to modify loans on a massive scale — not only to help customers avoid foreclosure but also to help companies avoid the consequences of those foreclosures. Even many of Bair's critics applaud her recent performance. In September, the FDIC took over Seattle-based Washington Mutual and sold it to JPMorgan Chase and the FDIC brokered a deal to sell Wachovia to Citigroup that eventually fizzled. The two deals, involving banks with more than $1 trillion in assets, could cost the government nothing. To seal the Wachovia deal, the FDIC agreed to absorb any losses above $42 billion on a portfolio of Wachovia's most troubled loans in exchange for a $12 billion stake in Citigroup. (Wells Fargo outbid Citigroup a week later.) Experts say that combination of shared risk and shared reward offers a model for dealing with other troubled banks.

U.S. Said to Be Using Loose Rules in Bank Aid
November 1, 2008

As the government makes taxpayer funds available to banks weakened by the financial crisis, the criteria being used to choose who gets money appears to be setting the stage for consolidation in the industry by favoring those most likely to survive. But while the measures, closely guarded by Treasury Department officials, accommodate banks with top safety and soundness ratings, they also allow the government to apply a looser definition to some banks with lower ratings, according to two people briefed on the process. Some of those banks may have lost money over the past year, however, and should they fail the taxpayers’ investment would be wiped out. Analysts said that giving capital to such weaker banks could run against the spirit of Treasury Secretary Henry M. Paulson Jr.’s suggestion that the program was for healthy institutions. So far, at least 22 small and regional banks have been awarded more than $38 billion in capital. The Treasury is concerned that publicizing its selection criteria would lead to speculation about which small and medium-size banks may not be qualified to receive the aid, said the people with knowledge of the process. Some lawmakers are upset that the capitalization program, which the government described as a way to jumpstart lending, will end up culling banks in their districts. Regulators are applying a short list of criteria based on a secret ratings system they use to gauge a financial institution’s health. These yardsticks, known as Camel ratings, classify the nation’s 8,500 banks into five categories, where a ranking of 1 applies to those in the best shape and a 5 to those in the worst. Under the program, banks with a rating of 1 or 2 are essentially guaranteed to qualify for the investments, according to the people briefed on the process. Those in the bottom categories are unlikely to receive capital injections. As of June 30, that group included at least 117 financial institutions, mainly small banks and savings and loans, on the Federal Insurance Deposit Corporation’s list of problem banks. Approximately 2,500 to 3,500 banks, which likely have mid-tier Camel

ratings, are on the cusp of qualifying for the cash if they choose to apply, analysts said. Of those banks, those that have been profitable over the last year are the most likely to receive capital. Banks that have lost money over the last year, however, must pass additional tests. Federal banking regulators want assurances that banks are lending in low-income communities. They are also asking if a bank has enough capital and reserves to withstand severe losses to its construction loan portfolio, nonperforming loans and other troubled assets. Banks that fail to meet two of the guidelines are unlikely to receive the money, said a person with indirect knowledge of the process. But banks that have only one strike against them can lobby regulators for the cash. Several advisers to financial institutions also said that they were aware of banks that received capital with the understanding the banks would try to find a merger partner. They said other banks were urged to slash their dividend if they sought cash. The advisers were not authorized by their clients to speak, and did not name the banks. Both actions suggest that the government may be loosely defining what constitutes healthy institutions. Banks are also required to provide a specific business plan for the next two or three years and explain how they plan to deploy the capital. Regulators, however, say that they will not examine how the financial institutions actually use the cash. “There is no express statutory requirement that says you must make this amount of loans,” said John C. Dugan, the comptroller of the currency, one of the major banking regulators, said in a recent interview. “But the economics work so that it is in their interest to do so” and he noted that their actions would also “be open to the court of public opinion.” Still, many lawmakers are concerned that some banks appear to be holding on to the capital instead of immediately making loans to spur economic growth. “Any use of these funds for any purpose other than lending — for bonuses, for severance pay, for dividends, for acquisitions of other institutions, etc. — is a violation of the act,” Representative Barney Frank, Democratic of Massachusetts and chairman of the House Financial Services Committee, said in a statement on Friday.

Worrying about another Asian financial crisis
November 2, 2008

It used to be that we searched for economic icebergs in Asia. Now we are on the lookout for Icelands. Last month, Iceland became the first developed economy to seek aid from the International Monetary Fund since 1976. The country needed a $2.1 billion bailout after investors realized it wasn't running an economy, but a hedge fund. While Ukraine, Belarus, Hungary and Pakistan are also lined up at the fund's door, Iceland's woes are getting special attention. The thought that a Western European economy that once had an AA credit rating could implode is bringing back uncomfortable memories about Asia's crisis just over a decade ago. The question zooming around markets is this: If the worst-case outlook plays out and the crisis continues, could Asia experience another 1997? Equally important, will investors know it when they see it? Analysts like Mark Matthews of Merrill Lynch advise keeping an eye on banks. "Bank shares are the canary in the coal mine," he said. He pointed out that in 1997, shares of banks underperformed in Indonesia, South Korea and Thailand before all three nations asked for IMF bailouts. More recently, drops in banking stocks also preceded a broader realization of troubles in economies like Iceland and Hungary.

So if an Asian economy is on the cusp of an Iceland-like emergency, bank shares are the place to look. And here's the good news: The industry is holding its own. In the past 12 months, banking shares have outperformed the broader markets by 23 percent, Matthews said. Banks in Asia had only small amounts of the toxic debt now hurting their U.S. and European peers. In general, Asian banks are reasonably liquid and well capitalized. Nonperforming loans may rise as global growth slows, yet the most likely outlook isn't for a 1997-style crisis. South Korea may be an exception. Matthews said the outperformance of Korean banking shares in the past 12 months has been slight, "and more recently they have begun underperforming." Asia is anything but immune to this crisis. The cost of insuring emerging-market debt has soared over the past month, as investors fear that a deep U.S. recession will weigh on their export-dependent economies. Slowing growth in Europe, Japan and China means Asia might soon find itself with fewer buyers of its products. There also are problems today that were not present 10 years ago. The Asian crisis was an emerging-market phenomenon, leaving larger, developed nations less affected. The current one is moving in the opposite direction, from the United States and Western Europe, and is not being contained to any one region. As the turmoil spreads, all economies and markets will feel the pain. The U.S. Federal Reserve's decision to provide $30 billion each to the central banks of Brazil, South Korea, Mexico and Singapore shows just how universal this crisis is. Paul Donovan, the deputy head of global economics at UBS, wrote in a report to clients this past week that the Fed's decision to expand efforts to unfreeze credit to emerging nations was even more significant than its official interest-rate cut. The trouble is, the United States still may be entering a Japan-like period of stagnation. In cutting short-term rates to 1 percent this past week, Ben Bernanke, the Fed chairman, may have nudged the United States closer to the experience of Japan. The United States also is borrowing money so fast that it makes Ronald Reagan's administration seem downright debt-averse. President George W. Bush inherited a surplus when he took office, yet his policies have resulted in deficits and added $1.7 trillion to the national debt. Financing from nations like China allows the U.S. government, and its citizens, to live beyond its means. Yet the stability of China, the world's largest holder of foreign currency, is becoming less certain. On Oct. 29, the country's central bank reduced its benchmark one-year lending rate to 6.66 percent from 6.93 percent, and it may keep lowering rates as the global crisis drags down its exports and industrial production. Developing Asia has its own vulnerabilities. Growth rates are not the problem, with 7.9 percent in India, 6.4 percent in Indonesia, 6.3 percent in Malaysia, 4.6 percent in the Philippines, 4.3 percent in Taiwan and 3.9 percent in South Korea. Yet economies do hit icebergs, and things will cool if U.S. companies start laying off even more employees. The odds don't favor the next hedge-fund economy turning up in Asia. With the exception of Japan, Asian central banks generally have ample room to cut rates, the ratios of debt to GDP allow for latitude on tax policies; and large currency reserves offer a cushion. Asia is a very different place than it was in 1997. If the global turmoil worsens, though, Asia won't get off easily. But if the region is harboring an Iceland, banking stocks will provide an advance warning.

Iceland, Mired in Debt, Blames Britain for Woes
November 2, 2008

No one disputes that Iceland’s economic troubles are largely the country’s own fault. But there may be more to the story, at least in the view of Iceland’s government, its citizens and even some outsiders. As grave as their situation already was, they say, Britain — their old friend, NATO ally and trading partner — made it

immeasurably worse. The troubles between the countries began three weeks ago when Britain took the extraordinary step of using its 2001 antiterrorism laws to freeze the British assets of a failing Icelandic bank. That appeared to brand Iceland a terrorist state. “I must admit that I was absolutely appalled,” the Icelandic foreign minister, Ingibjorg Solrun Gisladottir, said in an interview, describing her horror at opening the British treasury department’s home page at the time and finding Iceland on a list of terrorist entities with Al Qaeda, Sudan and North Korea, among others. In a volatile economic climate, in which appearance matters almost as much as reality, being associated with terrorism is not a good thing. “The immediate effect was to trigger an almost complete freeze on any banking transactions between Iceland and abroad,” said Jon Danielsson, an economist at the London School of Economics. “When you’re labeled a terrorist, nobody does business with you.” The Icelandic Prime Minister, Geir H. Haarde, accused Britain of “bullying a small neighbor” and said the action was “very out of proportion.” In a recent speech in Beijing, Sir Howard Davies, a former deputy governor of the Bank of England and now the director of the London School of Economics, said that Britain had used a “beggar thy neighbor” approach to Iceland. And an online petition signed so far by more than 20 percent of Iceland’s population said the British prime minister, Gordon Brown, had sacrificed Iceland “for his own short-term political gain,” thereby turning “a grave situation into a national disaster.” Iceland’s financial problems had been brewing for some time. This past spring, the country’s banks, bloated with foreign deposits and debts, began to falter. This fall, as the financial crisis deepened, the government took over two of the country’s three largest banks. Britain’s government, alarmed about the tens of thousands of accounts held by its citizens, companies, local governments and charities, froze the British assets of one of the failed banks, Landsbanki. It also seized the assets of Kaupthing Singer & Friedlander, the British subsidiary of another Icelandic bank, Kaupthing. “The Icelandic government, believe it or not, told me yesterday that they have no intention of honoring their obligations here,” Alistair Darling, the chancellor of the Exchequer, declared the day Britain seized the assets. The Icelandic government disputed that, saying it was merely asking for time to make good on its obligations. Whatever the case, reaction was immediate and severe, particularly when Mr. Brown said the following day — inaccurately — that “we are freezing the assets of Icelandic companies in the U.K. where we can.” Iceland’s ambassador to Britain, Sverrir H. Gunnlaugsson, said in an interview that this statement was particularly damaging. “There was a perception in the U.K. press and among suppliers that everything Icelandic had been frozen,” he said. “The word was put out belatedly that this was not the case.” Icelanders say that it is now nearly impossible to get foreign currency into or out of the country. Many banks have refused even to transfer money to Iceland. Importers are having difficulty paying their foreign bills, and exporters are having trouble getting paid by their foreign customers. Many people in Iceland are also furious about what happened to Kaupthing Singer & Friedlander. The British government’s seizure of its assets precipitated the immediate collapse of its parent bank, Kaupthing, which the Icelandic government had been propping up and had hoped would survive. “Kaupthing was the last, best hope of the Icelandic banking system, and it was killed there and then,” Andres Magnusson, an editorial writer for Icelandic Financial News, said in an interview. “This really was the last straw. A lot of Icelanders are asking, ‘Excuse me: who’s the terrorist here?’ ” The bank’s collapse had repercussions beyond Iceland and Britain. More than 8,000 depositors, individuals and businesses, hold Kaupthing Singer & Friedlander accounts worth about $1.34 billion on the Isle of Man, money

they cannot get their hands on now — and may never. Iceland is in line to receive a $2 billion loan from the International Monetary Fund and is talking to other Scandinavian countries. It is not entirely friendless: it was recently offered a loan of about $52 million from the tiny Faroe Islands, for which it is very grateful, Mr. Gunnlaugsson said. The Icelandic government has pledged to make good on domestic bank accounts. But it is still fighting with Britain over how much it is obliged to pay — and how much it can afford to pay — to compensate customers with accounts in Icesave, Landsbanki’s British branch. Under European regulations, Iceland is obliged to pay 20,000 euros (about $25,000) to each individual account holder in Icesave. But the total, Ms. Gisladottir, the foreign minister, said, would amount to about 600 billion Icelandic kronur — only about $5 billion at today’s collapsed exchange rate but fully 60 percent of Iceland’s gross domestic product. “The compensation that we would give would be twice as much per head as the reparations Germany faced in the Treaty of Versailles after the First World War,” she said. “That is something we cannot afford.” The British government has guaranteed that individual British account holders will be compensated fully, which is why it is seeking to wrest as much money as possible from Iceland. But no such guarantees have been made to the British companies, local governments, charities and universities — including Oxford and Cambridge — that had Icesave accounts. That figure alone is well over a billion dollars. Iceland’s key interest rate now stands at 18 percent. The currency, the krona, has declined 44 percent in the last year. Mr. Danielsson, the economist, visited the country recently and found the situation grave. “Salaries are frozen, food prices are shooting up and they are laying off people left, right and center,” he said. “Companies are going bankrupt all over the place. It’s unimaginable how bad it is.” Ms. Gisladottir said Britain’s decision had sent Iceland back some 30 or 40 years, to a time when it was an isolated, poor country, dependent mostly on its fishing trade. “This is a major crisis,” she said. “We haven’t been in this situation for, probably, ever. We cannot solve it alone. We need solidarity from partners, from friendly countries, and we thought the U.K. was one of them.”

Argentina's Financial Roller Coaster
Country Threatened With Another Economic Slide Because of Internal Mistakes, World Crisis
November 2. 2008

At 75, Juan D'Ambrosio has seen it all in Argentina -- a populist strongman and military juntas, economic collapse and a bright, if perhaps fleeting, revival. Rakish in his black suit and slicked-back hair, he takes a break from a night of tango dancing to say he has also seen the current story before: a foreboding economic slide as Argentina is once more the victim of outside forces and its own series of familiar mistakes. So he shakes his head, yet again, as the worldwide economic meltdown threatens to batter a country long marked by great promise but even greater disappointments. Memories of good times are fresh for many Argentines, who have yet to recognize bad omens, from tumbling stocks to a credit rating on par with Bolivia, the continent's poorest country. With the government ill prepared for the swift drop in demand for Argentine products, President Cristina Fernández de Kirchner is trying to nationalize $25 billion in pensions in a plan many Argentines say is designed to provide a much-needed infusion of cash for her free-spending government. She says the takeover would save pensions from market forces. But the proposal has made matters worse, shaking markets and prompting Argentines who pay into private retirement funds to protest in the streets. "It is what all the governments have done, increase public spending when they have the money, but now the

money is short," explained D'Ambrosio, a retired bank worker who forgets his and Argentina's troubles by dancing the melancholic tango in the neighborhood dance hall. "Now they need the money, so we find ourselves in the same situation as before." As the financial storm has spread, emerging markets from South Korea to South Africa to Brazil have faced falling demand for their products, an inability to tap financial markets, lagging economic confidence, sliding stocks and a run on deposits. Economists, though, say this sprawling country of 40 million people may be particularly exposed because its $95 billion default in 2001, the biggest in history, means Argentina is virtually locked out of credit markets while its export-driven economy fails to generate the earnings the country needs. Argentina had been spending heavily, enjoying the windfall from a commodity boom that helped extricate the country from economic collapse six years ago and then provided the motor for an ambitious network of social programs. When the prices of soybeans and other mainstays in this agricultural powerhouse dropped by more than 40 percent in just weeks, the impact on Argentina's finances was immediate. It has been a familiar theme in this country. Populism and ideology have characterized governance since Juan Perón won power in 1946 and began widescale assistance to the working class. He so showered them with generous programs that some Argentines consider state aid and subsidies a birthright. But while the system delivered relative equality, it also encouraged Argentina to live beyond its means. Now, the Kirchners -- first Néstor Kirchner, who won office in 2003, and his wife, who succeeded him last year -have won a loyal following by expanding social programs while excoriating opponents as "oligarchs." Daniel Artana, chief economist at the Latin American Economic Research Foundation in Buenos Aires, said the problem is that the Kirchners did not create a special windfall fund like neighboring Chile did during the commodity boom. Instead, the government spent the extra money, he said. Officials are now scrambling, looking for financing to pay nearly $30 billion in debt that comes due in the next three years. "What looked before as an era of very high growth, now it can turn into an era of contraction in the economy and increasing unemployment," Artana said. "The economy grew a lot, but it was based on the assumption that commodity prices would be growing and growing forever. In a sense, it's like the subprime mess." He added: "I think what we didn't learn is the lesson that we have to be prudent." The Argentina of today, of course, is not the broken country of 2001, when millions were plunged into poverty, desperate officials froze bank accounts and one government after another collapsed. This elegant, venerable city has seen real estate prices rise, and its shops and restaurants are packed. The economy has posted growth rates averaging nearly 9 percent in the past five years, and 9 million people were pulled out of poverty. Many Argentines, convinced that economic prescriptions from Washington and the International Monetary Fund helped create the last economic crisis, see the Kirchners as trendsetters who have led their country on the path to prosperity. "The Kirchners have said they would save capitalism, and they have demonstrated with the results of their policies that we have a strong economy," said Augusto Medina, 44, a distributor of pharmaceutical products. "They have built roads and schools, things that have not been done in 50 years." But economists estimate inflation to be close to 25 percent -- the government puts it under 10 percent -- and confidence in the government's ability to pay its debts has been dropping. Credit agencies have taken notice, with Standard & Poor's on Friday lowering the country's debt ratings six levels below investment grade, signaling an increasing probability of default. Analysts say that while the situation may not be life-threatening for Argentina's economy, they fear that the government does not understand the depths of the problem, further eroding confidence. Though Argentina has $47 billion in international reserves, analysts say, dipping into it to resolve the financial situation could prompt

Argentines to exchange pesos for dollars. "The lack of confidence is a much more powerful force than having enough money to pay your dues over the next couple of years, or having high reserves," said Fergus J. McCormick, senior vice president at DBRS, a New York credit agency that downgraded Argentina last month. He said the underreporting of inflation is a particularly serious problem, which affects inflation-linked debt and influences lenders. "The government, through these policies, has eroded confidence in itself," he said. "It's sort of a self-imposed wound." Fernández de Kirchner has taken some recent, positive steps, pledging to pay $7 billion owed to creditor governments and allowing utility companies to hike low, subsidized rates. But McCormick, like other economists, has been spooked by the pension nationalization plan, which DBRS views as a "confiscation of personal assets." To the government, nationalizing is an urgent matter designed to safeguard pensions from the forces of the free market -- a way to put people ahead of companies. The funds are part of a system created in 1994 by then-President Carlos Menem, who embraced Washington's free-market prescriptions and whose reputation has been tarnished by corruption allegations. There are 10 million accounts in funds run by firms such as MetLife and Britain's HSBC, and nearly 4 million people are regular contributors. The funds are among the biggest holders of Argentine equities. Though Argentines have overwhelmingly chosen to participate in the private funds, they have been criticized for high commissions and low returns. Now, the government says market volatility is endangering the future of the retirement accounts. "Capitalization was a terrible idea," said Labor Minister Carlos Tomada, using the term Argentines employ to describe Menem's pension privatization. "The system of capitalization is based on falsehoods and broken promises." But the government's plans have generated high levels of anxiety, and not just in Argentina. Last week, U.S. District Judge Thomas P. Griesa blocked a transfer of pension fund investments out of the United States until he hears the case made by bondholders, who have a $553 million judgment against Argentina. In Buenos Aires, Argentines who are paying into the system, or work in the pension funds, protested. Analia Pastorino, 34, who works in a bank, has been contributing since she was 20. "I've been saving for my future for the last 14 years, and now they're trying to keep it to pay for the loans that the state has to pay," she said. "They just keep stealing from the people. They know what they're doing. They don't want to learn." Though the government has a legislative majority and is pushing for quick passage of its proposal, there is stiff and loud opposition from the likes of congressman Oscar Aguad. He called the government's moves hasty and improvised, and voiced fear about what could happen to the retirement funds once the state has control. "While the rest of the world has worked to strengthen markets," he said, "the Argentine economy does the opposite, taking money from wherever it can find it."

Effectiveness of AIG's $143 Billion Rescue Questioned
November 2, 2008

A number of financial experts now fear that the federal government's $143 billion attempt to rescue troubled insurance giant American International Group may not work, and some argue that company shareholders and taxpayers would have been better served by a bankruptcy filing. The Treasury Department leapt to keep AIG from going bankrupt on Sept. 16, and in the past seven weeks, AIG has drawn down $90 billion in federal bailout loans. But some key AIG players argue that bankruptcy would have offered more structure and greater protections during a time of intense market volatility. AIG declined to

comment on the matter. Echoing some other experts, Ann Rutledge, a credit derivatives expert and founding principal of R&R Consulting, said she is not sure how badly the financial system would have been rocked if the government had let AIG file for bankruptcy protection. But she fears that the government is papering over the problem with a quick fix that was not well planned. "What we see now are a lot of games by the government to keep these institutions going with a lot of cash," she said. "This is to fill holes in companies' balance sheets, and they're trying to hold at bay the charges that our financial system is insolvent." The deal that the Treasury and the Federal Reserve Bank of New York pressed upon AIG was intended to stop any domino effect of financial institutions falling because of their business ties to AIG. The rescue allowed AIG to provide cash to huge banks and other players who had invested in rapidly souring mortgages insured by the company. Early this year, investors had begun privately demanding that AIG pay off its billion-dollar guarantees. But in midSeptember, when the demands for cash reached a public crescendo, AIG had to admit that it didn't have enough cash on hand to meet the obligations. In the first weeks of its federal rescue, AIG has used the loan money to post collateral demanded by these firms, sources close to those deals say. "No one else benefits," former AIG chief executive and major shareholder Maurice R. "Hank" Greenberg wrote to AIG's current chief executive on Thursday. "Unless there is immediate change to the structure of the Federal loan, the American taxpayer will likely suffer a significant financial loss." Another concern is that in this depressed market, AIG, and the taxpayers that now own 80 percent of the company, will lose coming and going. The company may be forced to borrow additional federal funds for rising payouts to counterparties. Neither the government nor AIG is releasing information about the specific amounts paid to individual firms, but numerous credit experts say that the value of those mortgage assets is probably declining every week. That means AIG has to pay a higher price as part of its guarantees. The company also may be forced to sell many more assets at low, fire-sale prices. As part of its loan deal, AIG was to sell some assets -- valued at $1 trillion before the crisis -- to raise cash to pay off the loan. AIG's Financial Products division is the primary villain in the company's free-fall. It made tens of billions of disastrously bad bets on mortgage investments but may not have carefully hedged those bets or properly estimated its risk. The company's rapid burn of $90 billion also suggests that it grossly undervalued its obligations to counterparties in a worst-case scenario. In February, internal notes show; board members discussed a growing dispute between AIG Financial Products and Goldman Sachs about the value of those assets when Goldman called for AIG to post collateral. AIG's chief financial officer warned of "Goldman's acknowledged desire to obtain as much cash as possible." But AIG's external accountants warned that it was they who alerted management to the dispute, not AIG Financial Products, and that the division was not properly considering the market in its pricing. Rutledge warns that because there has been no public disclosure of AIG's payments to counterparties, it is impossible to know whether the pricing it is using now is proper. The Federal Reserve and its advisers have acknowledged privately that things are not going according to plan. As AIG has rapidly eaten through the loan money, the Fed has twice expanded its original $85 billion bailout -which itself was the largest government bailout of a private company in U.S. history. Earlier last month, the Fed reluctantly gave AIG $38 billion more in credit for securities lending to try to keep the firm from drawing down its first Fed loan too quickly. Then on Thursday, the Fed agreed to let AIG borrow $20 billion from a larger commercial paper bailout fund it had set up days earlier for all institutions that lend money to each other. If the company had filed for Chapter 11 bankruptcy protection, AIG could have frozen the crippling collateral calls, and shareholders would have had a chance at recovering some value from the company's 80 percent drop in stock price from earlier this year, said

Lee Wolosky, a lawyer for AIG's largest shareholder, Starr International. "AIG is nothing more than a pass-through being charged 14 percent interest," Wolosky said. "Company assets are eroding on a daily basis; asset sales have not begun and can only be at fire-sale prices in the current market." But David Schiff of Schiff's Insurance Observer said he could not see how bankruptcy would have been a better solution. "The point isn't to save AIG; it's to save the U.S. financial system. I think they were afraid to find out who else goes under if you let AIG fail," he said. "But right now, no one knows if this is going to work."

Reinventing a Markets Watchdog
By Christopher Cox November 4, 2008

The Securities and Exchange Commission was created in the wake of the stock market collapse of 1929 to help restore investor confidence and stabilize our markets. For three-quarters of a century, the SEC has performed its mission with extraordinary rigor through law enforcement; public company disclosure; and the regulation of exchanges, broker-dealers, investment advisers and other securities market participants. As Congress and the next administration consider the shape of regulatory reform, they should build on those traditional strengths of the SEC. But the status quo is clearly not sufficient. The regulatory architecture of the early 20th century did not anticipate and could not fully encompass the bewildering patchwork of unregulated financial instruments, exempted entities, competing legal fiefdoms and regulatory holes that has grown since then. The global financial crisis has exposed many of the weaknesses and holes in our regulatory system that are far greater and more consequential than was previously understood. The priority now must be to address those issues and rationalize that system. In doing so, legislators and policymakers should be guided by four core principles: closing regulatory gaps, providing clear statutory authority, consolidating regulatory agencies and increasing transparency. The most visible of the gaps in existing regulations is the $55 trillion notional market in credit default swaps, which lacks oversight and transparency. The risk to the market from these instruments would be far less if investors had the benefit of basic disclosures. The lack of transparency around credit default swaps played a role in the collapse of AIG and contributed to the crisis of confidence that has enveloped other financial institutions. Credit default swaps must be brought immediately into the regulatory framework. As states and municipalities increasingly face challenges in their finances, the lack of transparency in the market for municipal bonds presents growing risks. Municipal securities are specifically exempted from SEC disclosure requirements. Although the SEC has taken steps under its limited authority to increase oversight of this market, it needs more explicit authority. Congress should grant the commission expanded powers to this end. Other regulatory gaps persist, including a statutory divide at the SEC itself between the supervision of brokerdealers under the Securities Exchange Act of 1934 and that of investment advisers under the Investment Advisers Act of 1940. One significant effort to reconcile the supervision of these overlapping groups was struck down by the courts last year. Congress has an important opportunity to modernize this area in any reform plans. Congress should back regulation with the full force of statutory authority. In the Gramm-Leach-Bliley Act of 1999, Congress left a gap regarding investment bank holding companies that the SEC attempted to fill with a voluntary regulatory regime shortly before I became chairman. For credit rating agencies, even the industry's voluntary code of conduct lacked support in law until very recently. In particular, recent experiences make clear that voluntary regimes deprive the regulator of a mandate to force change. Reform legislation should steer clear of voluntary regulation and grant explicit authority where it is needed. We must address the problem of the U.S. financial regulatory system having too many agencies performing parallel functions -- an issue made worse by the fact that the various agencies operate under conflicting

legislation advanced by congressional committees with competing jurisdictions. To overcome the persistent jurisdictional conflicts, Congress should create a select committee with a charter to rationalize the system and eliminate institutional gaps and redundancies. One tangible outcome of such a process would be the consolidation of the SEC and the Commodity Futures Trading Commission into a single agency with a clear mandate to protect investors by regulating the markets in all financial instruments, including securities, futures and derivatives. Similar consolidation is needed in the banking arena, where a half-dozen federal regulators overlap not only with each other but with state agencies. Just as important as improved regulation in these areas is transparency for investors. Transparent markets require less outside intervention because investors can make rational decisions if they have complete and sound information. One factor that contributed to the recent turmoil was the lack of good information about financial institutions' exposure to troubled and illiquid assets, including subprime securities and credit default swaps. Also in need of additional transparency are troubled Fannie Mae and Freddie Mac, both of which are now under government control. Although recent legislation required Fannie and Freddie to comply with some of the SEC's rules, it did not subject them to the full disclosure requirements that private companies must follow. As Congress determines how Fannie and Freddie will emerge from government control, this is an omission that lawmakers must correct. For 74 years, the SEC has helped generations of Americans become participants and stakeholders in the freemarket system. Now, as Congress prepares to overhaul the entire financial regulatory system, we should build on the strengths of the world's foremost securities regulator. By filling critical gaps in its authority and consolidating duplicative regulatory roles, we can ensure that a robust and empowered SEC can continue to protect investors for generations to come.

The writer is chairman of the Securities and Exchange Commission. Tsunamis from Wall Street
November 3, 2008

Each day, global market trading begins in the Pacific Rim and Asia. But Wall Street and Washington, more than ever, are where the waves that have roiled shares around the world in recent months really get started. "The eyes of the global markets are on the U.S.," said Ramin Toloui, a portfolio manager at Pacific Investment Management Co. in Newport Beach, California. "The U.S. is the center of the storm and U.S. policy makers' responses are critical to navigating out of the storm." The numbers clearly back that up, said Frank Nielsen, executive director of MSCI Barra, a market analytics company in New York. "The data very nicely and scarily show that the U.S. is dominating the behavior of investors around the world," Nielsen said. "There has been no decoupling of markets at all during this crisis. It all seems to be driven on the basis of what happens day-to-day in the U.S." Indeed, Nielsen said, the degree of correlation between Wall Street and the rest of the world has increased; with the U.S. pulling down Asian and European markets as its sell-off accelerated and then helping propel a modest revival at the end of October. European stocks have been about 86 percent correlated with U.S. markets in recent months, Nielsen said, up from an average of 78 percent over the period July 2007 to April 2008. That means that 86 percent of the movement in European markets can be accounted for simply by looking at what happens on Wall Street. With Japan, the case is even more striking: The direct correlation has more than doubled, to about 65 percent in September from an average of 30 percent in the July to April period. And Nielsen said indications were that Japan's connection to Wall Street increased further in October, to about 80 percent.

Just like a crowd in a stadium standing up and sitting down in a continual wave, market movements make their way around the globe. As the day starts in the Pacific Rim and Asia, investors race to catch up with the previous day's close on Wall Street, where regular trading has just wrapped up a few hours earlier. European markets get started a few hours later, trading through the first half of the North American day, so even when European investors start out following Asia's lead, U.S. sentiment can turn things around. The rest of the world is closed during the last few hours of U.S. trading, when moves of hundreds of points in the Dow Jones industrial average have been common every since the collapse of Lehman Brothers in midSeptember. Those big swings often start the whole cycle over again when Asian markets open. And even when Wall Street is closed, global investors are paying attention to the United States. "Even before the U.S. market opens, dealers are keeping one eye on the S&P 500 index futures," said Frances Hudson, global strategist at Standard Life Investments in Edinburgh. Futures contracts on the broad S&P 500-stock index trade electronically 23 and one-half hours a day, giving global investors the opportunity to place bets on U.S. stocks around the clock. In recent weeks, S&P 500 futures have at times moved sharply in early European trading, helping to turn around market sentiment, both for the better and for worse. "There's a tendency always to think that leadership might be where you are," Hudson said. "British investors may tend to take a U.K.-centric view where the market leadership is." But it is American markets that are setting the pace, she said. In recent months, everyone has paid the price of the U.S. plunge. More than 46 percent of world stock market capitalization has evaporated this year, and market volatility has reached record levels since mid-September. In the United States, stock market capitalization is down almost 35 percent. Markets are "communicating" through a number of channels at present, said Toloui, the portfolio manager. "To the extent that policy measures tend to be announced during the U.S. trading day," he said, "that information is incorporated into the value of U.S. assets and then subsequently incorporated into Asia and Europe when those markets are open." In recent months, however, U.S. policy makers have made a point of timing announcements on some emergency moves before trading opened in Asia. There is another, less evident, means by which markets tend to follow one another, Toloui said, through leveraged institutions operating in multiple markets. "If you've taken losses in one part of your portfolio," he said, "you may need to raise cash overseas to reduce risk or meet a margin call." Toloui said there had also been a large-scale move away from the so-called "home bias" of global investors over the past few years, with investors in most countries increasingly willing to buy financial assets overseas. But with investors becoming increasingly fearful, the home bias has returned. "Americans are bringing home funds from overseas this year," Toloui said, "while foreign investors have been bringing home their funds from the U.S." Nick Sargen, chief investment officer at Fort Washington Investment Advisors in Cincinnati, said in an e-mail message that the Asian markets' tendency to follow the U.S. lead is grounded in a deeper reality: American consumers are the primary buyers of goods from many Asian businesses and Asian investors are the primary holders of dollars. It is not only global stock markets that have grown closer together. So have fixed-income markets. In recent years, securitized debt burst out of its national boundaries as well, with many European institutions becoming heavily involved in U.S. mortgage-backed securities. Consequently, while the subprime problem originated in the United States, its tentacles have spread to Europe and other parts of the globe. Still, for all the correlations among global markets, what is most surprising, said Hugh Young, a fund manager at Aberdeen Asset Management Asia in Singapore, is that Asian stocks have performed worse this year than their American and European counterparts. "Asian finances are strong, governments are sitting on cash, and consumers haven't taken on huge debt like in the West," Young said. "Statistically, Asia is in fine fettle. But markets are more connected now because

economies are more connected. Capital has become very fluid. The money flowing into Vietnam or China may not have been raised locally. It might have come from a hedge fund in London." Another explanation, analysts say, is that Asia, which was largely sheltered from the earlier market downturn in the United States, is simply catching up. Will the pattern continue once markets recover? That's hard to say, since troubled times tend to encourage even more herd behavior. Many shares may now be severely undervalued by historical measures, suggesting that some investors will generate big returns when asset prices return closer to traditional norms. But in the short term, they say, the risk remains that investors who stick out their necks - where ever they are trading - may get them chopped off.

No more economic false choices
By Robert E. Rubin and Jared Bernstein November 3, 2008

As economists and policy advisers try to sort out where we are, how we got here and where we must go for both the short term and the longer term, we are surrounded by polarizing dichotomies: Fiscal recklessness versus fiscal rectitude, capital versus labor, free trade versus protectionism. The next president, the prevailing wisdom goes, will have to choose between these polarities. But how real are these differences? Our view - and we come from pretty different analytical perspectives - is that in many important ways, they are false, and serve as more of a distraction than a map. Fiscal rectitude versus stimulus and public investment: The Bible got this right a long time ago (paraphrasing slightly): There's a time to spend, a time to save; a time to build deficits up and a time to tear them down. Though one of us (Rubin) is often invoked as an advocate of fiscal discipline, we both agree that there are times for fiscal discipline and times for fiscal largess. With the current financial crisis, our joint view is that for the short term, our economy needs a large fiscal stimulus that generates substantial economic demand. We also jointly believe that fiscal stimulus must be married to a commitment to re-establishing sound fiscal conditions with a multiyear program that includes room for critical public investment, once the economy is back on a healthy track. One of us (Rubin) views long-term fiscal deficits - in combination with a low national savings rate, large current account deficits and foreign portfolios that are heavily over weighted in dollar-dominated assets - as a serious threat to long-term interest rates and our currency and, therefore, to our economic future. The other (Bernstein) views these economic relationships as much weaker. At the same time, we both agree that our economic future also requires public investment in critical areas like education, health care, energy, worker training and much else. In our view, then, the next president needs to proceed on multiple tracks, with both the restoration of a sound fiscal regime and critical public investment. First, under the $700 billion program to support the financial system, the government will buy assets, whether in the form of equity injections or the purchase of debt from banks. And the real cost to the government is not the face value of those purchases but rather the budget authorities' estimate of the subsidy built into the price of those purchases given the risks that are involved. That number will be some relatively limited fraction of the total amount paid. Congress also included in the recent legislation an option for the next president to consider levying a fee on the financial services industry if the taxpayers' investment is not recouped. Second, certain public investment can help us meet our fiscal challenges. Most powerfully, the single largest factor in our projected fiscal imbalances are the health care entitlements Medicare and Medicaid, underscoring the fundamental importance of health care reform that expands coverage to more Americans yet constrains costs.

While plans that would accomplish these goals have some cost, by pooling risk and stressing cost effectiveness, they could more than pay for themselves by reducing the growth trajectory of our health care spending, in both the private and public spheres. One important policy question is what our fiscal objectives should be in terms of deficits and of the ratio of the national debt to the gross domestic product. In times like these, larger than normal budget deficits will add to the national debt. In more stable times, a budget deficit equivalent to roughly 2 percent of GDP will keep the debt-toGDP ratio constant, a legitimate fiscal policy goal. In flush times, a smaller deficit would lower the debt ratio and that might be desirable. We both agree that individual income tax rates and other taxes for those at the very top could be moved back to the rates of the Clinton era. It's worth remembering that rates at this level helped finance deficit reduction and public investment that contributed to the longest economic expansion in our history. In addition to restoring a sound fiscal regime, we could improve our personal savings rate and expand retirement security by establishing some kind of individualized account separate from Social Security, financed by an appropriate revenue measure. Also, we need to work with other countries toward equilibrium exchange rates, as part of redressing our current account imbalances. But the idea that we can't be fiscally responsible while undertaking public investment at the same time is a myth. Capital versus labor: Here again, for all their alleged friction, our dynamic and flexible capital and labor markets have combined to generate impressive productivity gains in recent years. The problem is that the benefits of this productivity growth have largely eluded working families. Though productivity grew by around 20 percent from 2000 to 2007, the real income of middle-class, working-age households has actually fallen $2,000, down 3 percent. One factor behind this outcome is the severely diminished bargaining power of many workers, and here the decline in union membership has played a key role. A true market economy should have true labor markets in which labor and business negotiate as peers. Many years ago, the economist John Kenneth Galbraith argued that collective bargaining was necessary so workers had the countervailing force they needed to bargain for their fair share of the growth they're helping produce. To re-establish that force, workers should be allowed to choose to be unionized or not. Tight labor markets, the kind we saw in the 1990s, are another source of bargaining power, helping to rebalance the claims of labor and capital on growth. Sound public policy, like public investment in education, health care, energy, infrastructure and basic research, financed by progressive taxation, can also drive strong growth and business confidence to invest and hire. Moreover, the policies that are requisites for strong growth also increase wages by better equipping workers to succeed in a global marketplace and by encouraging businesses to create jobs. Free markets versus regulation and protection: We both feel strongly that there are important lessons to be learned from the disruptions in our financial system; and that significant reforms are needed. The objective ought to be to optimize the balance between increasing consumer protection and reducing systemic risk on the one hand, and preserving the benefits of a market-based system on the other. We know, too, that Wall Street and Main Street are intimately connected. The consequences of the financial market crisis are profound for Americans in terms of lost jobs, lower incomes and reduced retirement savings. Measures to reform and strengthen the financial system should be evaluated by this measure: Do they ultimately translate into improving the jobs, incomes and assets of working Americans?

With respect to trade, the choice is not trade liberalization versus protectionism. Instead, as trade expands, we must recognize that protecting workers is not protectionism. We must better prepare our people to compete effectively and help those who are hurt by trade - not just dislocated workers, but those who find their incomes lowered through global competition. This means investing more of the benefits of trade in offsetting these losses, through more effective safety nets, including universal health care and pension coverage. Beyond that, while we share a commitment to helping workers deal with our new global challenges, one of us (Bernstein) would advocate provisions in trade agreements that are intended to protect workers, both here and abroad, and the other would have considerable skepticism about the likely effectiveness of those provisions for our workers. Public policy in all these areas - and a host of others - has been seriously deficient in recent years. It has led to a great increase in federal debt, inadequate regulatory protection against systemic risk and underinvestment in our people and infrastructure. Regressive tax policies have increased market-driven inequalities that could have been offset through progressive taxation. False choices, grounded in ideology, have kept us from effectively addressing all these issues. The next president must do his utmost to avoid being drawn into these Potemkin battles. At this critical juncture, we face both the most significant economic upheaval since the Depression and the longterm challenge of successfully competing in the global economy. We have no choice but to move beyond such false dichotomies and toward a balanced pragmatism whose goal is broadly shared prosperity and increased economic security.
Robert E. Rubin, Treasury secretary from 1995 to 1999, is a director of Citigroup. Jared Bernstein is a senior economist at the Economic Policy Institute and the author of "Crunch: Why Do I Feel So Squeezed?"

Nonetheless—The principal issues of stabilization of the US financial system and the recovery of the US mortgage market remain

New terrain for U.S. bailout panel
November 4, 2008

There was a rare moment of levity at the Treasury Department on Friday as the children of government workers scampered from office to office in Halloween costumes. A few minutes later, the children were gone and the hallways were retaken by grim-faced grown-ups — handing out tricks and treats of a different sort. The Treasury building is ground zero for the Bush administration's $700 billion rescue of the financial system — an ambitious, increasingly embattled program that passed an early milestone last week when the government wired the first $125 billion to the nine largest banks in the United States. Having been handed vast authority and almost no restrictions in the bailout law that Congress passed a month ago, a committee of five little-known government officials, aided by a bare-bones staff of 40, is picking winners and losers among thousands of banks, savings and loans, insurers and other institutions. It is new and unfamiliar terrain for the officials, who are making monumental decisions — a form of industrial policy, some critics say — that contradict the free market philosophy they usually espouse. Predictably, the process is stirring alarm from Capitol Hill to Wall Street. "People are always going to second-guess what you do," said David Nason, the assistant Treasury secretary for financial institutions, who designed the program and sits on the investment committee. "We don't have time to complain; we need to manage our time so we can make progress."

Other officials said it was premature to condemn the program, given that the first capital injections were made only last week. The Treasury's overriding goal, they said, is to stabilize the nation's financial system after its worst crisis since the 1930s. Among the problems, critics say, is that despite earlier promises of transparency, the process is shrouded in secrecy, its precise goals opaque. Treasury officials have refused to disclose their criteria for deciding which banks are healthy enough to get money — and which are too sick. And officials have yet to say they even have a broader strategy, though banking executives are convinced the government wants to encourage acquisitions of sick banks by healthy ones. Industry sources said that banks, after filing a two-page application, are assigned a ranking from 1 to 5 — with 1 or 2 essentially guaranteeing that they are eligible, and 5 insuring they are not — by their regulator. The five officials then make what can be a life-or-death decision, with a thumbs-down generally interpreted to mean that a bank was not healthy enough to survive on its own. The work is complex, far-reaching and telescoped into an impossibly tight timetable. And it is being done against the backdrop of a change of power in Washington, which will throw many of these people out of their jobs on Inauguration Day. "There is a real urgency to deploy this money quickly and effectively," said James Lambright, who took a leave three weeks ago as the president of the Export-Import Bank of the United States to become the interim chief investment officer of the rescue effort. A trim, self-confident former investment banker, Lambright, 38, is the chairman of a committee of relatively young officials — all are in their 30s or 40s — with backgrounds in law, banking or regulation. None of them could have expected this kind of responsibility; Lambright himself was a last-minute substitute after a previous appointee was kept in his old job. On Friday evening, Lambright was lugging a thick pile of folders — plus a pair of BlackBerrys and a cellphone — as he prepared for a Sunday afternoon meeting of the committee to select the next banks to receive capital infusions. With more than $80 billion left to spend, and hundreds of banks in line for it, the days, nights and weekends of the overworked, sleep-deprived Treasury staff members are a blur of meetings and conference calls, and constant pressure. "This is a four-ring circus," said Tim Ryan, a former director of the Office of Thrift Supervision, who helped run the savings and loan cleanup in the 1980s and 1990s. Already, critics from Capitol Hill to Wall Street are lashing out at the program, saying the banks are misusing the capital infusions by hoarding the money rather than lending it, as Treasury Secretary Henry Paulson Jr. urged in order to unclog the credit markets. The government, the critics say, is wrongly steering funds to banks to take over weaker rivals. The rescue program prodded one such merger last week, when Treasury agreed to inject $7.7 billion into PNC Financial Services and rejected an application for cash from National City, an ailing bank in Cleveland. The two announced a merger the same day that PNC was approved. "Where we are headed is credit allocation by the federal government," said William Poole, a former president of the Federal Reserve Bank of St. Louis. "It really reminds me of the morass we got into with wage-price controls in the 1970s." Critics also say that, by not barring banks from paying dividends or hefty bonuses, the Treasury is leading taxpayers to think their money is being spent frivolously. All this comes after Paulson abruptly shifted the focus of the program to injecting capital rather than buying distressed mortgage-related assets from the banks. This meant that Congress had never debated the details of how the government ought to carry out a recapitalization. The absence of that debate comes with a price. Treasury officials have been pressured by industry lobbyists to stretch the program to include insurance companies, transit agencies and even automakers. Indeed, the helter-skelter nature of the program is drawing so much criticism that even some of the bailout bill's biggest proponents on Capitol Hill are complaining that its legitimacy is being thrown into question. "What the

Treasury doesn't understand is the anger in the country about this," said Representative Barney Frank, Democrat of Massachusetts, the chairman of the House Financial Services Committee. Frank, who has scheduled oversight hearings later in November, warned that he might try to block the Treasury from getting the second $350 billion approved by Congress. Inside the Treasury — where officials shuttle between each other's offices on the building's southwest corner, facing the White House and the Washington monument — the view, not surprisingly, is different. They say the critics have not offered solutions about how to compel banks to lend money. The Treasury has to walk a fine line, officials add, since using brute force could lead to the banks making more bad loans, which is how they got into this mess. Treasury officials acknowledge their actions might speed a shakeout in the industry, even if that is not the main motivation. "The primary goal is not consolidation; the primary goal is to strengthen the system," said Michele Davis, the chief spokeswoman. "If consolidation strengthens the system, it's a positive." Bank executives say that increased lending depends on attracting more capital from private investors. To do that, it may be essential for a bank to strengthen its market position by making acquisitions. Suspending dividends could send investors running for the exits. Besides, they add, the bailout law only allows the government to stop banks from increasing dividends, not banning them outright. The committee — which also includes Neel Kashkari, interim head of the rescue program, and two other assistant secretaries, Anthony Ryan and Phillip Swagel — acts on a recommendation from the primary regulator of the financial institution. That could be the Federal Reserve Board, the Federal Deposit Insurance Corporation, the Comptroller of the Currency, or the Office of Thrift Supervision. What happens next, when the application and recommendation go to the Treasury, is largely a mystery. The criteria by which the Treasury decides which banks get money and which do not are secret. Nason said the process had to be confidential so that rejected banks did not suffer damage in the markets. Even to disclose the selection criteria could quickly destabilize banks perceived to have the wrong profile, he said. The committee members study financial statements and sometimes kick back applications to the regulators for more information. They also analyze the market in which a bank operates, looking for the mix of strong and weak banks. As the number of applications increases, Lambright said he was recruiting a team of banking analysts to help with the process. "When we move from a dozen banks to hundreds of banks, we'll need a system," Lambright said. He said his work at the Export-Import Bank, where he selected American exporters to receive trade financing, was good preparation for this job, even if he will hand out more money in a few weeks at the Treasury than his bank's entire $60 billion credit portfolio. Though Treasury officials are loath to require banks to lend, they do seem to be jawboning. "They must meet their responsibility to lend, and support the American people and the U.S. economy," Ryan told a securities industry conference last week. Frank said they should do more by requiring banks to show a dollar-for-dollar relationship between the government funds and increased lending. "If they lend out all the money they got from the government," he said, "they can do whatever they want with the rest. If they don't feel this is going to encourage lending, then don't take the money." It is the regulators, more than the Treasury Department, who are doing the coaxing by suggesting, for example, that a desired merger by a bank would be more likely to win approval if a bank participated in the capital injection program, industry executives said. The Treasury's approach has its defenders, among them a former senior Treasury official, Edwin Truman, who said he believed the people running the bailout were technocrats trying to shore up the system, not ideologues.

Donald Hammond, a longtime Treasury official who is the interim chief compliance officer of the program, said that, in any event, Congress had put in place layers of oversight. Hammond began his government career working on the bailout of the Chrysler Corporation. "This is more intense," he said.

Banks Alter Loan Terms to Head off Foreclosures
November 2, 2008

Even as political pressure builds in Washington for a sweeping program to help struggling homeowners, some banks are realizing that it may be good business to keep borrowers in their homes. On Friday, JPMorgan Chase became the latest big bank to pledge to cut monthly payments, by lowering interest rates and temporarily reducing loan balances for as many as 400,000 homeowners. Early in October, Bank of America, which acquired the large lender Countrywide, announced a similar effort aimed at 400,000 borrowers as part of a settlement with state officials. Though the measures encompass only a fraction of the nation’s troubled homeowners, analysts say they could become more instrumental in stemming the rising tide of foreclosures than the government’s plan to partly guarantee home loans. “The banks are doing the cost-benefit analysis,” said Gerard S. Cassidy, a banking analyst with RBC Capital Markets. “The banks don’t want these customers going into foreclosure because it is a costly and punitive way of trying to collect your money.” Roughly 1.5 million homes were in foreclosure at the end of June, and economists expect several million more borrowers may default in the coming year as housing prices erode and job losses rise. Nearly one in 10 mortgages is either delinquent or in foreclosure. Chase officials said their effort was not an act of charity or a response to government pressure. By renegotiating loans with borrowers, the bank is hoping to reduce the losses that it incurs in the foreclosure process and when it sells repossessed homes. Chase said it has already modified 250,000 loans since the start of 2007. “What we are doing is a process that just makes a lot of sense,” said Charlie Scharf, chief executive of retail financial services at Chase. “If the government can come in and help us find ways to modify more people that would be wonderful.” The bank, which will open 24 counseling centers and hire 300 employees to work with borrowers, will suspend foreclosures on loans it owns for at least 90 days while it puts its new policies into place at Chase and the two banks it acquired this year, Washington Mutual and Bear Stearns. Like other banks, Chase is largely aiming at loans that the bank owns and not the mortgages that it services on behalf of bond investors who own mortgage-backed securities. Banks have less leeway in changing the terms of loans packaged into securities, because contracts that govern them can be very restrictive. Those contracts could limit the impact of loan modification programs at Chase and other banks. For instance, Chase owns $350 billion of the $1.5 trillion in the home mortgages it services; the rest are owned by investors. Some hedge fund investors have threatened legal action if banks aggressively modify the loans that back bonds that they own. Mr. Scharf said the bank was working with investors to gain approval to modify more loans. Chase’s effort resembles a plan put in place at IndyMac after the Federal Deposit Insurance Corporation took it over in July. Chase’s program closely mirrors that template by lowering interest rates on existing mortgages and temporarily reducing the principal owed on loans. The goal would be to lower a borrower’s housing payments to 31 to 40 percent of disposable income. Sheila C. Bair, the chairman of the F.D.I.C., has said the agency may be able to help 40,000 of the 60,000 delinquent IndyMac borrowers. About 3,500 of those who have been approached have agreed to a modification. IndyMac owns most of those loans but it has been seeking permission from investors to modify other loans, as well. But the steps being taken by banks on their own could affect a much larger pool of troubled homeowners. “A clear consensus is emerging that broad-based and systematic loan modifications are the best way to maximize the value of mortgages while preserving homeownership — which will ultimately help stabilize home prices and the broader economy,” Ms. Bair said in a statement that applauded the announcement by Chase.

Mr. Scharf said Chase would also offer modifications to borrowers who were not currently delinquent but who the bank thought could be at risk of defaulting. For certain risky loans, it might offer to temporarily reduce interest rates to as low as 2 percent and calculate payments on a reduced loan balance for a few years. Bank of America agreed to make similar changes under a settlement of predatory lending practices with officials from 11 states, and agreed to permanently write down the amount owed on some mortgages. HSBC, another big bank, is also pre-emptively providing relief to some borrowers and has modified nearly 25 percent of its subprime mortgages. Mark Pearce, a banking regulator in North Carolina, said the government interventions at IndyMac and Countrywide were helping to set a good example for lenders like Chase that were now beginning to take a more aggressive approach to loan modifications. “It’s clear that they have studied IndyMac and the Countrywide settlement,” said Mr. Pearce, who is a deputy commissioner for banks in North Carolina. “Those public programs are leading other servicers to rethink how they are approaching these issues.”

Waiting for Banks to Lend Again May Require Patience
November 3, 2008

Why haven’t banks begun to lend? When the Bush administration finally persuaded Congress to approve the $700 billion Troubled Asset Relief Program in September, the main objective was for the Treasury to purchase the most “toxic” bank assets in order to get the banks to free up lending again. Later in October, the administration shifted course and decided the best way to achieve that objective was to use at least some of the funding appropriated by Congress to buy stakes in the banks themselves. But despite the promise of capital injections, anecdotal evidence suggests that the banks remain reluctant to lend, and in some cases are talking of using their new capital injections to buy other banks. The apparent disinclination of banks to open up the lending spigots is hard to measure, and it arises from a number of complicated factors. If you look at the bank balance sheet numbers, you see the volume of loans on banks’ balance sheets has been roughly constant throughout 2008.1 It is difficult to see what is going on in overall lending from the balance sheet levels, however, since the dollar volume of loans on banks’ balance sheets would only decline gradually even if banks cut off all new lending. The lending slowdown is more readily apparent if one looks at loan growth, which has been declining since the beginning of the year. Not surprisingly, the decline began earlier and has been steeper for real estate loans.2 As a rule, bank loans tend to lag the economic cycle, not lead. (2001 is something of an exception in this regard.) Accordingly, the worst of this economic downturn may be ahead of us. Moreover, increased borrowing does not necessarily portend an economic improvement because some forms of borrowing can rise during the early stages of recession. For example, some firms need to finance their accumulating inventories. The first point about bank behavior is obvious, but nonetheless is worth making. It is absurd to think that the equity injections announced just a couple weeks ago would have had any effect whatsoever by now. Second, the equity injections were surely intended to bring banks back up to a reasonable capital ratio (once all the losses are written off) of 8 to 10 percent. It would be interesting to know what the capital ratios are like now, but for that you have to look at the call report data and that takes a lot of time, effort, and expertise. It is reasonable to assume, however, that with all their reported losses, many banks remain seriously undercapitalized. Bringing them back up to decent capital ratios is a good idea because, as we know with the Savings and Loan debacle of the 1980s and 1990s, poorly capitalized institutions tend to do erratic things, including the pursuit of high-risk schemes in an effort to save themselves. Using the capital injections to make new loans would of course be beneficial to those who need the credit, but it would move those capital ratios back down again. It is understandable that banks would not want to do that, since they are surely concerned about

more losses coming down the pike. These charges have already jumped, and chances are they will continue to climb. And you can be sure that the regulators would like to see the banks maintaining an 8 percent plus capital ratios, especially now. Third: Another good reason to inject some public capital into the banks is because it will make it easier for them to raise fresh private capital. Investors hate to make equity investments in institutions whose probability of bankruptcy is nonzero. The reason is that, in the event of bankruptcy, debt holders get their money. This is known as the debt overhang phenomenon, and it is an important issue these days. If the public equity injections did nothing but facilitate private equity injections, they would have been worthwhile. Fourth: We never get to see the counterfactual. Suppose the banks get their capital injections, and lending continues to decline. Will the program have been a failure? Not necessarily. We don’t know—and we can never know—how bad the drop off in lending would have been in the absence of the capital injection, but it’s reasonable to conjecture that it would have been worse. One thing we do know is that poorly-capitalized banks tend to offer loans on less favorable terms than well-capitalized banks. Consequently, even if we agree that restarting bank lending is the criterion for judging the success of the capital injections, gauging their success is going to be difficult. Fifth: Who is to say that demand for certain kinds of loans isn’t falling? Is it reasonable to think that real estate developers are queuing up to obtain financing for new tracts of homes or mini-malls? The bottom line is that it is simplistic to expect the Treasury’s equity injection to affect bank lending right away. This is a long-term problem, and the equity infusion is a long-term remedy. Recall that in Japan, chronically undercapitalized banks dragged the economy into a decade-long period of stagnation. The best-case scenario is that rapid recapitalization will spare us that long adjustment process, and give us a shorter—two to three years?—period of stagnation.
Source: Board of Governors of the Federal Reserve, release H.8 (data accessed via the Federal Reserve Bank of St. Louis’s Fred database).

Kenneth N. Kuttner, professor of economics at Williams College, was a visiting fellow at the Peterson Institute for International Economics in 2005-07. Notes
1. As gauged by the data on “total loans and leases at commercial banks,” from the Fed’s H.8 release. 2. “Real estate loans at all commercial banks,” also from the Federal Reserve’s H.8 release.

Look at credit-default swaps reveals surprises
November 5, 2008

A window into the vast, murky world of credit-default swaps opened on Tuesday surprising.

and the view was a bit

The market for the instruments, which have played a significant role in the financial crisis, seems to be smaller than many analysts believed. And countries, not just companies, are often the subject of contracts that are used to protect investors against losses from defaults or simply to make bearish bets. That, anyway, is the impression given by a report released by the Depository Trust and Clearing Corp. that ostensibly provides the most data yet on this market. But the report does not shed any new light on which entities have sold protection through swaps and whether they have enough capital to meet their obligations, a crucial concern for policy makers. The depository corporation, which clears swaps and other financial transactions, said that it had cleared swaps providing coverage on $33.6 trillion in debt. In other words, investors have bought (or sold) protection on bonds and other debt totaling that much, an amount that is slightly greater than the $30.8 trillion of American bonds outstanding. Last month, the International Swaps and Derivatives Association estimated that nearly $47 trillion in swaps were outstanding as of June. That number might include transactions not cleared by the depository corporation.

The most default swaps have been written on the countries of Turkey, Italy, Brazil and Russia, according to the new data. They were followed by GMAC, the auto finance company that is partly owned by General Motors. Others in the top 10 include Merrill Lynch, Goldman Sachs, Morgan Stanley, General Electric Capital and Countrywide Home Loans. But that ranking does not account for contracts written on multiple units of the same companies. In a credit-default swap, a buyer of protection pays an insurance premium to a seller who agrees to cover any lost interest or principal on bonds or loans issued by companies, countries or other organizations. The buyers and sellers are typically securities firms, hedge funds, banks and insurance companies. Policy makers have been unnerved by the rise of the market because they are worried that sellers of protection may not have enough reserves to pay future claims and that default by one party could lead to a cascade of failures throughout the financial system. That fear led the Federal Reserve Board to extend an $85 billion bridge loan to the American International Group and prompted the Fed to arrange a sale of Bear Stearns to JPMorgan Chase. Both AIG and Bear Stearns had bought and sold billions in swaps. Industry officials, however, have argued that while the total amount of credit-default swaps appears large, many of the contracts offset one another. Many players in the market hedged their positions so if they had bought protection in one transaction they would sell it in another

Treasury Is Working To Widen the Rescue
A Dramatic Expansion Beyond Banking
November 7, 2008

The federal government is preparing to take tens of billions of dollars in ownership stakes in an array of companies outside the banking sector, dramatically widening the scope of the Treasury Department's rescue effort beyond the $250 billion set aside for traditional financial firms, government and industry officials said. Treasury officials are finalizing the new program, which could ultimately involve hundreds of billions of the $700 billion rescue package, though the initiative is unlikely to be announced until the end of next week at the earliest. Two industry sources familiar with the planning said the Treasury is holding off because it wants to make sure President-elect Barack Obama is on board and will not reverse the course once he takes office in January. But an administration official contested that explanation, saying the Treasury simply wants to give its initial bank plan a chance before injecting more money into the financial system. Since the announcement of the program to inject capital into banks, a number of industries, including automakers, insurers and specialty lenders for small businesses have approached the Treasury with hat in hand. Some have been turned away because they are not banks and thus not eligible for capital. The new initiative would make it easier for the Treasury to aid a wider variety of firms if their troubles put the wider financial system at risk, government and industry officials said. These companies would still have to be financial firms that fall under federal regulators. Several companies, including GMAC, an auto financing company, and CapitalSource, a commercial lender in Bethesda, are seeking ways to restructure themselves as banks or thrifts, which entails submitting to much tighter federal regulation. If other firms follow suit, the trend would vastly expand government oversight into a variety of industries. The Treasury is also making progress on an initiative that would provide relief to homeowners at risk of foreclosure. Several proposals are on the table, including one crafted by Sheila C. Bair, chairman of the Federal Deposit Insurance Corp., who wants to spend about $40 billion to modify the mortgages for as many as 3 million homeowners. But several government and industry sources close to the matter said Treasury officials view Bair's plan as flawed and are seeking ways to revise it. Designing these new programs is difficult because the Treasury will have to hand off the $700 billion rescue package, approved by Congress last month, to the new administration before officials have finished mapping out

how to use the money. Treasury officials said they have reserved space within its imposing building directly east of the White House for the Obama economic team to coordinate efforts but have not yet heard from his camp on who will staff the office. Obama has planned an emergency meeting of his senior economic team in Chicago today to discuss the global financial crisis. Industry sources and a former senior Treasury official said the department deliberately slowed the decisionmaking process on new rescue programs two weeks ago to accommodate the interests of the incoming administration. The complexity of the issues and a tremendous volume of input and requests for money from all kinds of industries also have complicated matters. "The last thing you want to do is start something and have the new guys unravel it in 60 days. It sends mixed messages to the markets," the former Treasury official said. "So I think the thinking was, 'Let's kick the can down the road to make sure we are on the right track.' " A Treasury official said the department has been briefing Obama on the crisis since late July and explaining the administration's approach to the crisis. But his position on the crisis is only one factor among many being considered by the Treasury, the official said. "Continuity is in the best interests of the markets and the economy," Treasury spokeswoman Michele Davis said. "But a change in an administration is likely to bring some changes, and we all recognize that." Treasury also wants to give its initial $250 billion program a chance to work, government officials said. Those who engineered this strategy think it is far too early to say whether it has worked but say it has shown enough promise to continue expanding the effort. The efforts have tentatively improved conditions in financial markets compared with the paralysis that was taking hold in the middle of last month. And while many on Capitol Hill have criticized decisions by some banks to use the federal money to take over weaker competitors, leaders of the Treasury and Federal Reserve see benefits to that activity because this has reduced uncertainty in the marketplace by resolving the fate of banks that otherwise would have failed. But officials at the Treasury and the Fed face a challenge in deciding who to help outside the traditional banking sector. With banks, the determination is simpler for regulators because they are more familiar with the operations of these firms. Officials have less experience overseeing other kinds of companies. The companies that have the best chance to receive government capital could be those that resemble banks -in that they borrow money and then lend it to businesses or consumers -- even if these financial firms are not chartered as banks. Treasury officials are trying to evaluate which companies could become a bank or thrift holding company and be viable in the long run with government help, as opposed to those fated to fail. Normally, the process of acquiring a charter as a bank or thrift holding company takes at least one month. But the Fed has shown a willingness to act much faster. Two months ago, it approved the conversion of investment banks Goldman Sachs and Morgan Stanley into bank holding companies in a matter of hours. Toni Simonetti, a spokeswoman for GMAC, said her company has few options for raising money other than from the government and is now applying to become a bank holding company. The company's financial troubles mean it cannot lend to dealerships that need loans to buy vehicles for their lots or to people who want to buy cars. "We've had such a difficult time getting access to funding," Simonetti said. "All of these financing tools are now at the government, but you have to be a bank holding company to have access to them. . . . We are definitely at the government's mercy." GMAC has been in close consultation with the Treasury and Fed about its plans to restructure, she said. GMAC and other firms could face difficulties because of a long-standing rule that a commercial business cannot

own more than 24.9 percent of a bank. General Motors owns a 49 percent stake in GMAC. Moreover, to become a bank holding company, firms would be required to raise more capital. The Fed would prefer they raise at least some private money in addition to any injection from the Treasury. Yet the troubled markets make it hard for a financial company to raise private capital. Some insurers, such as Prudential and MetLife, are organized as a bank or thrift and would be permitted to receive a capital injection from the government. Insurers that do not fit the definition, however, would have to restructure themselves to participate. Those who do not could be placed at a disadvantage. The Hartford Financial Services Group, the large Connecticut-based insurer, is not a thrift or a bank, but a spokeswoman said it would consider participating in a federal capital injection program. "We would evaluate participating, should it be available to us," Hartford spokeswoman Shannon LaPierre said. Likewise, executives with insurer Lincoln Financial Services Group signaled they would consider restructuring as well. In an earnings call last week, president and chief executive Dennis R. Glass was asked whether he'd be reluctant to become a bank holding company to participate in the federal program. "Based on what I know," he said, "the answer is we would do that."

How Merrill's thundering herd fell
November 9, 2008

"We've got the right people in place, as well as good risk management and controls." - E. Stanley O'Neal, 2005 There were high-fives all around Merrill Lynch headquarters in New York City as 2006 drew to a close. The firm's performance was breathtaking; revenue and earnings had soared and its shares were up 40 percent for the year. And Merrill's decision to invest heavily in the mortgage industry was paying off handsomely. So handsomely, in fact, that on Dec. 30 that year, it essentially doubled down by paying $1.3 billion for First Franklin, a lender specializing in risky mortgages. The deal would provide Merrill with even more loans for one of its lucrative assembly lines, an operation that bundled and repackaged mortgages so they could be resold to other investors. It was a moment to savor for E. Stanley O'Neal, Merrill's autocratic leader, and a group of trusted lieutenants who had helped orchestrate the firm's profitable but belated mortgage push. Two indispensable members of O'Neal's clique were Osman Semerci, who, among other things, ran Merrill's bond unit, and Ahmass Fakahany, the company's vice chairman and chief administrative officer. A native of Turkey who began his career trading stocks in Istanbul, Semerci, 41, oversaw Merrill's mortgage operation. He often played the role of tough guy, former executives say, silencing critics who warned about the risks the firm was taking. At the same time, Fakahany, 50, an Egyptian-born former Exxon executive who oversaw risk management at Merrill, kept the machinery humming along by loosening internal controls, according to the former executives. The actions of Semerci and Fakahany ultimately left their company vulnerable to the increasingly risky business of manufacturing and selling mortgage securities, say former executives, who requested anonymity to avoid alienating colleagues at Merrill. To make matters worse, Merrill sped up its hunt for mortgage riches by embracing and trafficking in complex and lightly regulated contracts tied to mortgages and other debt. And Merrill's often inscrutable financial dance was emblematic of the outsize hazards that Wall Street courted.

While questionable mortgages made to risky borrowers prompted the credit crisis, regulators and investors who continue to pick through the wreckage are finding that exotic products known as derivatives - like those that Merrill used - transformed a financial brush fire into a conflagration. As subprime lenders began toppling after record waves of homeowners defaulted on their mortgages, Merrill was left with $71 billion of eroding mortgage exotica on its books and billions in losses. On Sept. 15 this year - less than two years after posting a record-breaking performance for 2006 and following a weekend that saw the collapse of a storied investment bank, Lehman Brothers, and a huge U.S. bailout of the insurance giant American International Group - Merrill was forced into a merger with Bank of America. It was an ignominious end to America's most famous brokerage house, whose ubiquitous corporate logo was a hard-charging bull. "The mortgage business at Merrill Lynch was an afterthought - they didn't really have a strategy," said William Dallas, the founder of Ownit Mortgage Solutions, a lending business in which Merrill bought a stake a few years ago. "They had found this huge profit potential, and everybody wanted a piece of it. But they were pigs about it." Semerci and Fakahany did not return phone calls seeking comment. Bill Halldin, a Merrill Lynch spokesman, said, "We see no useful purpose in responding to unnamed, former Merrill Lynch employees about a risk management process that has not existed for a year." Typical of those who dealt in Wall Street's dizzying and opaque financial arrangements, Merrill ended up getting burned, former executives say, by inadequately assessing the risks it was taking with newfangled financial products - an error compounded when it held on to the products far too long. The fire that Merrill was playing with was an arcane instrument known as a synthetic collateralized debt obligation. The product was an amalgam of collateralized debt obligations (the pools of loans that it bundled for investors) and credit-default swaps (which essentially are insurance that bondholders buy to protect themselves against possible defaults). Synthetic CDO's, in other words, are exemplars of a type of modern financial engineering known as derivatives. Essentially, derivatives are financial instruments that can be used to limit risk; their value is "derived" from underlying assets like mortgages, stocks, bonds or commodities. Stock futures, for example, are a common and relatively simple derivative. Among the more complex derivatives, however, are the mortgage-related variety. They involve a cornucopia of exotic, jumbo-size contracts ultimately linked to real-world loans and debts. So as the housing market went sour, and borrowers defaulted on their mortgages, these contracts collapsed, too, amplifying the meltdown. The synthetic CDO grew out of a structure that an elite team of JPMorgan bankers invented in 1997. Their goal was to reduce the risk that Morgan would lose money when it made loans to top-tier corporate borrowers like IBM, General Electric and Procter & Gamble. Regular CDOs contain hundreds or thousands of actual loans or bonds. Synthetics, on the other hand, replace those physical bonds with a computer-generated group of credit-default swaps. Synthetics could be slapped together faster, and they generated fatter fees than regular CDOs, making them especially attractive to Wall Street. Michael Farrell is chief executive of Annaly Capital Management, a real estate investment trust that manages mortgage assets. A unit of his company has liquidated billions of dollars in collateralized debt obligations for clients, and he believes that derivatives have magnified the pain of the financial collapse.

"We have auctioned billions in credit-default swap positions in our CDO liquidation business," Farrell said, "and what we have learned is that the carnage we are witnessing now would have been much more contained, to use that overworked word, without credit-default swaps." The bankers who invented the synthetics for JPMorgan say they kept only the highest-quality and most bulletproof portions of their product in-house, known as the super senior slice. They quickly sold anything riskier to firms that were willing to take on the dangers of ownership in exchange for fatter fees. "In 1997 and 1998, when we invented super senior risk, we spent a lot of time examining how much is too much to have on our books," said Blythe Masters, who was on the small team that invented the synthetic CDO and is now head of commodities at JPMorgan Chase. "We would warehouse risk for a period of time, but we were always focused on developing a market for whatever we did. The idea was we were financial intermediaries. We weren't in the investment business." For years, the product that Masters and her colleagues invented remained just a mechanism for offloading risk in high-grade corporate lending. But as often occurs with Wall Street alchemy, a good idea started to be misused and a product initially devised to insulate against risk soon morphed into a device that actually concentrated dangers. This shift began in 2002, when low interest rates pushed investors to seek higher returns. "Investors said, 'I don't want to be in equities anymore and I'm not getting any return in my bond positions,' " said William Winters, co-chief executive of JPMorgan's investment bank and a colleague of Masters on the team that invented the first synthetic. "Two things happened. They took more and more leverage, and they reached for riskier asset classes. Give me yield, give me leverage, give me return." A few years ago, of course, some of the biggest returns were being harvested in the riskier reaches of the mortgage market. As CDOs and other forms of bundled mortgages were pooled nationwide, banks, investors and rating agencies all claimed that the risk of owning such packages was softened because of the broad diversity of loans in each pool. In other words, a few lemons couldn't drag down the value of the whole package. But the risk was beneath the surface. By 2005, with the home lending mania in full swing, the amount of CDOs holding opaque and risky mortgage assets far exceeded CDOs composed of blue-chip corporate loans. And inside even more abstract synthetic CDOs, the risk was harder to parse and much easier to overlook. Janet Tavakoli, president of Tavakoli Structured Finance, a consulting firm in Chicago, describes synthetic CDOs as a fanciful structure "sort of like a unicorn born out of the imagination." More important, she said, is that the products allowed dicier assets to be passed off as higher-quality goods, giving banks and investors who traded them a false sense of security. "A lot of deals were doomed from the start," Tavakoli said. By 2005, Merrill was in a full-on race to become the biggest mortgage player on Wall Street. A latecomer to the arena, it especially envied Lehman Brothers for the lush mortgage profits that it was already hauling in, former Merrill executives say. Lehman had also built a mortgage assembly line that Merrill wanted to emulate. Lehman made money every step of the way: by originating mortgage loans, administering the paperwork surrounding them and packaging them into CDOs that could be sold to investors. Eager to build its own money machine, Merrill went on a buying spree. From January 2005 to January 2007 it made 12 major purchases of residential or commercial mortgage-related companies or assets. It bought

commercial properties in South Korea, Germany and Britain, a loan servicing operation in Italy and a mortgage lender in Britain. The biggest acquisition was First Franklin, a domestic subprime lender. The firm's goal, according to people who met with Merrill executives about possible deals, was to generate inhouse mortgages that it could package into CDOs. This allowed Merrill to avoid relying entirely on other companies for mortgages. That approach seemed to be common sense, but it was never clear how well Merrill's management understood the risks in the mortgage business. O'Neal declined to comment for this article. But John Kanas, the founder and former chief executive of North Fork Bancorp, recalls the many hours he spent talking with O'Neal, Fakahany and other Merrill executives about a possible merger in 2005. "We spent a great deal of time with Stan and the entire management team at Merrill trying to learn their business and trying to explain our business to them," Kanas said. "Unfortunately, in the end we were put off by the fact that we couldn't get comfortable with their risk profile and we couldn't get past the fact that we thought there was a distinct possibility that they didn't understand fully their own risk profile." Kanas, who later sold his bank to the Capital One Financial Corporation, had many meetings with Fakahany, who was responsible for the firm's credit and market risk management as well as its corporate governance and internal controls. Former executives say Fakahany had weakened Merrill's risk management unit by removing longstanding employees who "walked the floor," talking with traders and other workers to figure out what kinds of risks the firm was taking on. Former Merrill executives say that the people chosen to replace those employees were loyal to O'Neal and his top lieutenants. That made them more concerned about achieving their superiors' profit goals, they say, than about monitoring the firm's risks. A pivotal figure in the mortgage push was Semerci, a details-oriented manager whom some former employees described as intimidating. He joined Merrill in 1992 as a financial consultant in Geneva. After that, he became a fixed-income sales representative for the firm's London unit. He later rose quickly through Merrill's ranks, ultimately overseeing a broad division: fixed income, currencies and commodities. Always carrying a notebook with his operations' daily profit-and-loss statements, Semerci would chastise traders and other moneymakers who told risk management officials exactly what they were doing, a former senior Merrill executive said. "There was no dissent," said the former executive, who requested anonymity to maintain relationships on Wall Street. "So information never really traveled." Beyond assembling its own mortgage machine and failing to police risks so it could book fatter profits, Merrill also dove into the CDO market - primarily synthetics. Unlike the CDO pioneers at JPMorgan who saw themselves as financial designers and intermediaries wary of the dangers of holding on to their products too long, Merrill seemed unafraid to stockpile CDOs to reap more fees. Although Merrill had a scant presence in the CDO market in 2002, four years later it was the world's biggest underwriter of the products. The risk in Merrill's business model became viral after AIG stopped insuring the highest-quality portions of the firm's CDOs against default.

For years, Merrill had paid AIG to insure its CDO stakes to limit potential damage from defaults. But at the end of 2005, AIG suddenly said it had had enough, citing concerns about overly aggressive home lending. Merrill couldn't find an adequate replacement to insure itself. Rather than slow down, however, Merrill's CDO factory continued to hum and the firm's unhedged mortgage bets grew, its filings show. The number of mortgage-related CDOs being produced across Wall Street was staggering, and all of that activity represented a gamble that mortgages underwritten during the most manic lending boom ever would pay off. In 2005, firms issued $178 billion in mortgage and other asset-backed CDOs, compared with just $4 billion worth of CDOs that used safer, high-grade corporate bonds as collateral. In 2006, issuance of mortgage and assetbacked CDOs totaled $316 billion, versus $40 billion backed by corporate bonds. Firms underwriting the CDOs generated fees of 0.4 percent to 2.5 percent of the amount sold. So the fees generated on the $316 billion worth of mortgage- and asset-backed CDOs issued in 2006 alone, for example, would have been about $1.3 billion to $8 billion. Merrill, the biggest player in the CDO game, appeared to be a cash register. After its banner year in 2006, it produced another earnings record in the first quarter of 2007, finally beating three rivals, Lehman, Goldman Sachs and Bear Stearns, in profit growth. But as 2007 progressed, the mortgage business began to fall apart - and the impact was brutal. As mortgages started to fail, the debt ratings on CDOs were cut; anyone left holding the products was locked in a downward spiral because no one wanted to buy something that was collapsing. Among the biggest victims was Merrill. In October 2007, the firm shocked investors when it announced a $7.9 billion write-down related to its exposure to mortgage CDOs, resulting in a $2.3 billion loss, the largest in the firm's history. Semerci was forced out, later landing at a London-based hedge fund, the Duet Group. Merrill's board also ousted O'Neal. On top of the $70 million in compensation he was awarded during his fouryear tenure as chief executive, O'Neal departed with an exit package worth $161 million. John Thain, a former Goldman Sachs executive who was also head of the New York Stock Exchange, was hired as Merrill's chief executive to try to clean up O'Neal's mess. But multibillion-dollar losses kept piling up, and Merrill was hard pressed to raise enough to replenish its coffers. "None of the trading businesses should be taking risks, either single positions or single trades, that wipe out the entire year's earnings of their own business," Thain said in January. "And they certainly shouldn't take a risk to wipe out the earnings of the entire firm." A month later, Fakahany left Merrill. Upon his departure, in a statement that Merrill issued, he said: "I leave knowing that the firm's financial condition is significantly enhanced and the new team is in place and moving forward."' Fakahany continued to receive a Merrill salary until the end of this summer; he does not appear to have received an exit package. Thain, meanwhile, sold off assets for whatever price he could get to try to salvage the firm. In August, he arranged a sale of $31 billion of Merrill's CDOs to an investment firm for 22 cents on the dollar. For the first nine months of this year, Merrill recorded net losses of $14.7 billion on its CDOs. Through October, some $260 billion of asset-backed CDOs have started to default. As the depth of Merrill's problems emerged, its shares plummeted. With Lehman on the verge of collapse, Wall Street began to wonder if Merrill would be next.

Some banks were so concerned that they considered stopping trading with Merrill if Lehman went under, according to participants in the Federal Reserve's weekend meetings on Sept. 13 and 14. The

U.S. bailouts need transparency
November 9, 2008

Optimism surrounding the election last week and the promise of a new crew in Washington ran smack into the reality that we are still mired in a wicked financial mess. The U.S. Labor Department reported Friday that the unemployment rate had jumped to 6.5 percent in October. And stocks are down 7 percent since Election Day. Investors are surely eager for change in the stock market and the economy - though, of course, a new team at the White House cannot make either turn on a dime. But the president-elect, Barack Obama, can send a message to investors and taxpayers that he has their best interests at heart. A strong first step would be to ensure that officials in charge of taxpayer-financed bailouts operate them with more transparency. And it would help the Treasury Department regain some public trust if the people running the bailouts were more forceful about extracting concessions from recipients of taxpayers' dollars. In short, the immediate opportunity of a new White House is to make sure that sweeping financial fixes are done properly, not just quickly. Recall that from the very start of this mess, major decisions have been made in a hurry, behind closed doors, with many of the participants unidentified. This has led to a natural suspicion among some analysts, financiers and politicians that special pleaders may be on the scene, securing special favors. The secrecy and opacity that have surrounded some of the trickier decisions - like allowing Lehman Brothers to fail while saving Bear Stearns - do not engender trust. They create distrust. Because taxpayers are financing these exercises, it seems only right that they know who was involved in the decisions, why the decisions were made and who the prime beneficiaries were. It has been awfully frustrating to watch taxpayers' money handed out to the same cast of characters - commercial banks and brokerage firms that put the United States in such financial peril. The decision to recapitalize the banks was wise. It is a necessary evil, alas, because making sure that money is available to finance a small business, buy a home or send a child to college is the best way to mitigate the impact of a recession. But that the Treasury seems to have attached no strings to the cash it handed to the big banks is inexplicably naïve and indulgent. Now we have the spectacle of banks hoarding taxpayers' cash or refusing to pass along to suffering consumers any of the savings reaped by the institutions' reduced lending costs. This is both unfair and a recipe for a backlash. Here is another way the Treasury should be tougher on the institutions that are holding their hands out: Force them to raise additional capital in the markets - and swiftly. It may be bitter medicine to issue shares at depressed levels, but this may also be the best opportunity to do so. Think back to what happened earlier this year with Freddie Mac, the giant mortgage finance company. In May, when its stock was trading at about $27, Freddie Mac said it would raise $5.5 billion by issuing common and preferred shares. The stock rallied on the news because investors recognized that the company's capital needs were pressing.

But Freddie Mac never did raise the money. And three months later, the government took it over. Had Freddie Mac secured that extra capital, taxpayers would be less vulnerable to the losses they might now face as part of the government bailout of the company. Lastly, a discussion is needed of how and when taxpayers may be able to get out of the bailout business. Although it is understandable that some of the financing programs instituted by the Federal Reserve Bank of New York are open-ended, setting no time limits on the cash spigot is unnerving. Consider the Fed's new commercial paper facility. It was set up Oct. 20 to free the stalled market for short-term funds on which so many companies rely for their daily operations. About $243 billion had been lent as of last week. And by all accounts, the program has helped to reduce the costs of borrowing in that market and helped get it moving again. Clearly the program is necessary now. But it should have some type of maturity date. The problem with an openended program is that when interest rates rise, the costs to the taxpayer do, too. There is a lesson to be drawn from the difficulties that companies experienced before the Fed stepped in, when they couldn't tap the short-term money market: A commercial economy as large as ours should not be built on a short-term funding apparatus.

U.S. overhauls rescue of AIG
November 10, 2008

The U.S. government announced an overhaul of its rescue of American International Group on Monday, saying it would purchase $40 billion of the company's stock, after signs that the initial bailout was putting too much strain on the ailing insurer. In a joint statement, the Federal Reserve and the Treasury said the move was necessary "in order to keep the company strong and facilitate its ability to complete its restructuring process successfully." The new measures, they said, would help the company and promote market stability while protecting the interests of the U.S. government and taxpayers. In the revised bailout, the Treasury Department will use the Troubled Asset Relief Program, the $700 billion U.S. financial system rescue plan, to buy $40 billion of newly issued AIG preferred shares. The government created an $85 billion emergency credit line in September to keep AIG from toppling and added $38 billion more in early October when it became clear that the original amount was not enough. As part of the revised bailout, the Federal Reserve said it would now reduce that credit line to $60 billion. When the restructured deal is complete, taxpayers will have invested and lent about $150 billion to AIG, the most the government has ever directed to a single private enterprise. It is a stark reversal of the government's assurance that its earlier moves had stemmed the bleeding at AIG. The revised deal is likely to intensify the debate in Washington over why some companies should be saved by the government while others are left to wither. Congress had authorized the Treasury to use the $700 billion to shore up financial companies. But just this weekend, Democratic leaders in Congress called on the Bush administration to drop its opposition to using some of that money to rescue Detroit automakers. The government's original emergency line of credit, while saving AIG from bankruptcy for a time, now appears to have added to the company's problems. The government's original short-term loan came with a high interest rate - about 14 percent - which forced the company into a fire sale of its assets and reduced its ability to pay back the loan, putting its future in jeopardy. The Fed said Monday that it would reduce the interest rate on that credit facility to three-month Libor plus three percentage points from the current rate of three-month Libor plus 8.5 points. Libor, the London interbank offered

rate, is a commonly used index that tracks the rates banks charge when they lend to one another. The fee on undrawn funds will be reduced to 0.75 point from the current rate of 8.5 points. The new deal makes the government a long-term investor in AIG, something that Treasury Secretary Henry Paulson Jr. had said he hoped to avoid. The government will also spend $30 billion to help AIG buy up a type of security called collateralized debt obligations that the company had agreed to insure against default. The securities are now held by institutional investors around the world. As their insurer, AIG has been forced to put up large amounts of cash as collateral as the global economy has soured and the securities seemed increasingly likely to default. The new arrangement calls for AIG to put the securities into a new entity, effectively removing them from the company's balance sheet. AIG would contribute $5 billion to the new entity, which would buy $70 billion of the securities at 50 cents on the dollar, or $35 billion. The remaining $30 billion of the purchase price would come from the government. Finally, the government will invest another $22.5 billion in AIG to help the company buy residential mortgagebacked securities that it also insured, and similarly place them into another entity off the company's balance sheet. AIG will put up $1 billion itself. The goal of both programs is to create separate entities to buy and hold the most toxic assets AIG had promised to insure, so that if their value continues to fall AIG will not have to include those losses in its own bottom line. The company has argued that the securities' falling value does not necessarily mean it has suffered a financial loss. Once AIG buys the securities back from its trading partners, it will no longer have to provide cash as collateral under the terms of its insurance contracts - and collateral has been eating up more of AIG's cash than anything else since the broad financial crisis began. AIG negotiated the original $85 billion revolving credit line with the Federal Reserve after its efforts to raise money from private lenders failed in the panic of mid-September. The amount that it needed ballooned in just a few days, as counterparties to AIG's insurance on complex debt securities laid claim to whatever collateral they could get. People briefed on the negotiations said before the announcement Monday that the $85 billion was thought at the time to be the maximum amount that AIG would need, including a little extra for a cushion. In exchange for making the loan, the Federal Reserve was promised a 79.9 percent stake in AIG. The Fed and the Treasury Department said Monday that the U.S. government "intends to exit its support of AIG over time in a disciplined manner consistent with maximizing the value of its investments and promoting financial stability." Edward Liddy, the insurance executive brought in to lead the company out of the crisis, initially said he believed the Fed money would be like water pouring into a bathtub - a lot might be needed at first, but eventually the tub would be filled and the faucet could be turned off. Since then, AIG has needed more money than expected, and it has not been able to sell subsidiaries quickly enough to pay down the loan as required. In addition to the $85 billion Fed loan and the $38 billion special lending facility, AIG recently said it had been granted access to the Fed's commercial-paper program, which is available to all companies that issued commercial paper before the credit markets seized up. AIG can borrow up to $20.9 billion under the program.

Even as the government works to solidify AIG's finances, elected officials have been demanding a fuller accounting of the company's business practices and executive pay structure. In October, the New York State attorney general, Andrew Cuomo, reached an agreement forcing AIG to freeze payments to former executives. "I find it hard to conceive of a situation that you could justify a performance bonus for management that virtually bankrupted the company," Cuomo said after the agreement was made. The move followed the revelation, in a congressional hearing convened by Representative Henry Waxman, a Democrat of California, that the former head of AIG's troubled financial products unit, Joseph Cassano, had been put on a retainer of $1 million a month after being dismissed in February. Waxman and Senator Charles Grassley, a Republican of Iowa, have demanded that AIG provide a more detailed accounting of its credit derivatives business.

A Quiet Windfall for U.S. Banks
With Attention on Bailout Debate, Treasury Made Change to Tax Policy
November 10, 2008

The financial world was fixated on Capitol Hill as Congress battled over the Bush administration's request for a $700 billion bailout of the banking industry. In the midst of this late-September drama, the Treasury Department issued a five-sentence notice that attracted almost no public attention. But corporate tax lawyers quickly realized the enormous implications of the document: Administration officials had just given American banks a windfall of as much as $140 billion. The sweeping change to two decades of tax policy escaped the notice of lawmakers for several days, as they remained consumed with the controversial bailout bill. When they found out, some legislators were furious. Some congressional staff members have privately concluded that the notice was illegal. But they have worried that saying so publicly could unravel several recent bank mergers made possible by the change and send the economy into an even deeper tailspin. "Did the Treasury Department have the authority to do this? I think almost every tax expert would agree that the answer is no," said George K. Yin, the former chief of staff of the Joint Committee on Taxation, the nonpartisan congressional authority on taxes. "They basically repealed a 22-year-old law that Congress passed as a backdoor way of providing aid to banks." The story of the obscure provision underscores what critics in Congress, academia and the legal profession warn are the dangers of the broad authority being exercised by Treasury Secretary Henry M. Paulson Jr. in addressing the financial crisis. Lawmakers are now looking at whether the new notice was introduced to benefit specific banks, as well as whether it inappropriately accelerated bank takeovers. The change to Section 382 of the tax code -- a provision that limited a kind of tax shelter arising in corporate mergers -- came after a two-decade effort by conservative economists and Republican administration officials to eliminate or overhaul the law, which is so little-known that even influential tax experts sometimes draw a blank at its mention. Until the financial meltdown, its opponents thought it would be nearly impossible to revamp the section because this would look like a corporate giveaway, according to lobbyists. Andrew C. DeSouza, a Treasury spokesman, said the administration had the legal authority to issue the notice as part of its power to interpret the tax code and provide legal guidance to companies. He described the Sept. 30 notice, which allows some banks to keep more money by lowering their taxes, as a way to help financial institutions during a time of economic crisis. "This is part of our overall effort to provide relief," he said.

The Treasury itself did not estimate how much the tax change would cost, DeSouza said. A Tax Law 'Shock' The guidance issued from the IRS caught even some of the closest followers of tax law off guard because it seemed to come out of the blue when Treasury's work seemed focused almost exclusively on the bailout. "It was a shock to most of the tax law community. It was one of those things where it pops up on your screen and your jaw drops," said Candace A. Ridgway, a partner at Jones Day, a law firm that represents banks that could benefit from the notice. "I've been in tax law for 20 years, and I've never seen anything like this." More than a dozen tax lawyers interviewed for this story -- including several representing banks that stand to reap billions from the change -- said the Treasury had no authority to issue the notice. Several other tax lawyers, all of whom represent banks, said the change was legal. Like DeSouza, they said the legal authority came from Section 382 itself, which says the secretary can write regulations to "carry out the purposes of this section." Section 382 of the tax code was created by Congress in 1986 to end what it considered an abuse of the tax system: companies sheltering their profits from taxation by acquiring shell companies whose only real value was the losses on their books. The firms would then use the acquired company's losses to offset their gains and avoid paying taxes. Lawmakers decried the tax shelters as a scam and created a formula to strictly limit the use of those purchased losses for tax purposes. But from the beginning, some conservative economists and Republican administration officials criticized the new law as unwieldy and unnecessary meddling by the government in the business world. "This has never been a good economic policy," said Kenneth W. Gideon, an assistant Treasury secretary for tax policy under President George H.W. Bush and now a partner at Skadden, Arps, Slate, Meagher & Flom, a law firm that represents banks. The opposition to Section 382 is part of a broader ideological battle over how the tax code deals with a company's losses. Some conservative economists argue that not only should a firm be able to use losses to offset gains, but that in a year when a company only loses money, it should be entitled to a cash refund from the government. During the current Bush administration, senior officials considered ways to implement some version of the policy. A Treasury paper in December 2007 -- issued under the names of Eric Solomon, the top tax policy official in the department, and his deputy, Robert Carroll -- criticized limits on the use of losses and suggested that they be relaxed. A logical extension of that argument would be an overhaul of 382, according to Carroll, who left his position as deputy assistant secretary in the Treasury's office of tax policy earlier this year. Yet lobbyists trying to modify the obscure section found that they could get no traction in Congress or with the Treasury. "It's really been the third rail of tax policy to touch 382," said Kevin A. Hassett, director of economic policy studies at the American Enterprise Institute. 'The Wells Fargo Ruling' As turmoil swept financial markets, banking officials stepped up their efforts to change the law.

Senior executives from the banking industry told top Treasury officials at the beginning of the year that Section 382 was bad for businesses because it was preventing mergers, according to Scott E. Talbott, senior vice president for the Financial Services Roundtable, which lobbies for some of the country's largest financial institutions. He declined to identify the executives and said the discussions were not a concerted lobbying effort. Lobbyists for the biotechnology industry also raised concerns about the provision at an April meeting with Solomon, the assistant secretary for tax policy, according to talking points prepared for the session. DeSouza, the Treasury spokesman, said department officials in August began internal discussions about the tax change. "We received absolutely no requests from any bank or financial institution to do this," he said. Although the department's action was prompted by spreading troubles in the financial markets, Carroll said, it was consistent with what the Treasury had deemed in the December report to be good tax policy. The notice was released on a momentous day in the banking industry. It not only came 24 hours after the House of Representatives initially defeated the bailout bill, but also one day after Wachovia agreed to be acquired by Citigroup in a government-brokered deal. The Treasury notice suddenly made it much more attractive to acquire distressed banks, and Wells Fargo, which had been an earlier suitor for Wachovia, made a new and ultimately successful play to take it over. The Jones Day law firm said the tax change, which some analysts could be worth about $25 billion for Wells Fargo. soon dubbed "the Wells Fargo Ruling," Wells Fargo declined to comment for this article. The tax world, meanwhile, was rushing to figure out the full impact of the notice and who was responsible for the change. Jones Day released a widely circulated commentary that concluded that the change could cost taxpayers about $140 billion. Robert L. Willens, a prominent corporate tax expert in New York City, said the price is more likely to be $105 billion to $110 billion. Over the next month, two more bank mergers took place with the benefit of the new tax guidance. PNC, which took over National City, saved about $5.1 billion from the modification, about the total amount that it spent to acquire the bank, Willens said. Banco Santander, which took over Sovereign Bancorp, netted an extra $2 billion because of the change, he said. A spokesman for PNC said Willens's estimate was too high but declined to provide an alternate one; Santander declined to comment. Attorneys representing banks celebrated the notice. The week after it was issued, former Treasury officials now in private practice met with Solomon, the department's top tax policy official. They asked him to relax the limitations on banks even further, so that foreign banks could benefit from the tax break, too. Congress Looks for Answers No one in the Treasury informed the tax-writing committees of Congress about this move, which could reduce revenue by tens of billions of dollars. Legislators learned about the notice only days later. DeSouza, the Treasury spokesman, said Congress is not normally consulted about administrative guidance. Sen. Charles E. Grassley (R-Iowa), ranking member on the Finance Committee, was particularly outraged and had his staff push for an explanation from the Bush administration, according to congressional aides. In an off-the-record conference call on Oct. 7, nearly a dozen Capitol Hill staffers demanded answers from Solomon for about an hour. Several of the participants left the call even more convinced that the administration had overstepped its authority, according to people familiar with the conversation.

But lawmakers worried about discussing their concerns publicly. The staff of Sen. Max Baucus (D-Mont.), chairman of the Finance Committee, had asked that the entire conference call be kept secret, according to a person with knowledge of the call. "We're all nervous about saying that this was illegal because of our fears about the marketplace," said one congressional aide, who like others spoke on condition of anonymity because of the sensitivity of the matter. "To the extent we want to try to publicly stop this, we're going to be gumming up some important deals." Grassley and Sen. Charles E. Schumer (D-N.Y.) have publicly expressed concerns about the notice but have so far avoided saying that it is illegal. "Congress wants to help," Grassley said. "We also have a responsibility to make sure power isn't abused and that the sensibilities of Main Street aren't left in the dust as Treasury works to inject remedies into the financial system." Carol Guthrie, spokeswoman for the Democrats on the Finance Committee, said it is in frequent contact with the Treasury about the financial rescue efforts, including how it exercises authority over tax policy. Lawmakers are considering legislation to undo the change. According to tax attorneys, no one would have legal standing to file a lawsuit challenging the Treasury notice, so only Congress or Treasury could reverse it. Such action could undo the notice going forward or make it clear that it was never legal, a move that experts say would be unlikely. But several aides said they were still torn between their belief that the change is illegal and fear of further destabilizing the economy. "None of us wants to be blamed for ruining these mergers and creating a new Great Depression," one said. Some legal experts said these under-the-radar objections mirror the objections to the congressional resolution authorizing the war in Iraq. "It's just like after September 11. Back then no one wanted to be seen as not patriotic, and now no one wants to be seen as not doing all they can to save the financial system," said Lee A. Sheppard, a tax attorney who is a contributing editor at the trade publication Tax Analysts. "We're left now with congressional Democrats that have spines like overcooked spaghetti. So who is going to stop the Treasury secretary from doing whatever he wants?"

Trade's Lending Lifeline
By James A. Harmon November 10, 2008

World economic leaders will gather in Washington Saturday for a summit to address the global financial crisis. It is no coincidence that Brazil, China, India and other emerging-market nations have not only been invited to the summit but are expected to play meaningful roles. The credit crunch, which began in the United States, has quickly spread to the developing world. The summit agenda will be dominated by monetary policy coordination and new roles for international institutions such as the International Monetary Fund. In his Nov. 3 op-ed, "Fairness for Emerging Markets," Kemal Dervis made the case for "making massive credit lines available" to most emerging-market economies. But if we are to limit the depth of the looming global recession, trade finance must also be on the agenda. Cross-border lending by banks based in developed countries fell at a record pace in the second quarter and continued its decline at an accelerated rate in the third quarter. One casualty is the drying up of trade finance, the lifeblood of $14 trillion annually in global commerce. Wachovia's recent troubles, for example, have already led to a sharp reduction in short-term trade finance lines to Latin America. Other banks are reassessing credit lines for trading with Asia, Africa and Eastern Europe. The credit crisis has moved into trade finance as largely a funding problem.

If bank lines were shut off, it would be devastating for the economies of the developing world. It would also have a boomerang effect on the United States and Europe, as key export markets -- and the jobs that go with them -disappeared. Fortunately, there are institutions already built to promote trade finance: export credit agencies. The ExportImport Bank of the United States was established by President Franklin D. Roosevelt in 1934, in the midst of the Great Depression. It is a "lender of last resort" that provides credit lines when private financial markets are not lending. Last year, the bank authorized more than $12 billion in guarantees and insurance to support U.S. exporters. Export credit agencies have helped mitigate a financial crisis before. In late 1997, banks were unwilling to provide credit to Asia after currency and equity markets there plunged. The U.S. Export-Import Bank confirmed letters of credit issued by 15 South Korean banks to support the purchase of raw materials and spare parts needed by Korean manufacturers. In February 1998, 20 official export credit agencies met in London to encourage each other to remain open and to offer new support to exports to Asia. The U.S. Export-Import Bank played its part by initiating a new program for South Korea that month. Within nine months, it supported 2,460 transactions worth more than $1 billion for U.S. exporters to sell to Korean firms (up from only $40 million the year before). Similar trade credit programs were launched for Indonesia and Thailand. These special short-term lending and trade credit insurance lines played a catalytic role in helping to build confidence in Asia at a critical time -- and helped the region rebound quickly. None of the Korean banks defaulted, and the entire Export-Import Bank Korean program cost American taxpayers not one dime. In the coming days, the U.S. Export-Import Bank and other export credit agencies should take the lead in getting trade finance flowing again. First, the export credit agencies should convene to share information and confirm credit availability for the pivotal months ahead. The World Trade Organization has called a special meeting of trade finance players for Wednesday, and the subject will be a major topic of discussion at next Monday's meeting of the Organization for Economic Cooperation and Development. But Saturday's summit is the venue to push for decisive action. Second, even though the Federal Reserve Bank's discount window is now available to non-bank institutions, the volume of credit needed suggests it is crucial to find a way for the Export-Import Bank to fund asset-based lenders who support thousands of small suppliers in connection to exports. The bank should institute a new and unprecedented, but temporary, program that provides short-term funding to intermediary lenders. Third, with credit markets largely closed, traditional financing sources for medium- and long-term commercial export finance are not available. The Export-Import Bank must revitalize its direct-lending programs, but in ways that continue to engage the institutional skills and delivery capabilities of commercial lenders. It is critical for global prosperity that trade financing -- be it keeping credit lines open, oiling the trade supply chain or direct funding -- remain vibrant during the financial crisis. A concerted effort by the U.S. Export-Import Bank and other export credit agencies can make a meaningful difference in how the real economy responds and recovers.

The writer is chairman of the Caravel Fund and served as president and chief executive of the Export-Import Bank of the United States during the Clinton administration. American Express to become bank holding company
November 11, 2008

American Express, the last big independent U.S. credit card company, said late Monday that it would transform into a bank holding company to strengthen its position in the market turmoil.

U.S. Federal Reserve banking regulators said they approved its application because of the "unusual and exigent circumstances" roiling financial markets and the company's interest in tapping up to $3.8 billion in government money. As a full-fledged bank, American Express would gain greater access to the Treasury Department's bailout plan for banks, a move that might allow it to lend more freely and perhaps acquire a larger deposit-taking institution. American Express customers are unlikely to notice the changes. But the announcement may also represent the end of financial companies operating a single line of business and depending on the capital markets for financing. Goldman Sachs and Morgan Stanley recently transformed themselves from investment banks to bank holding companies after being battered by the markets. Big lenders like GMAC, the finance company partly owned by General Motors, and General Electric's financial subsidiary have similarly been considering becoming banks. American Express executives have publicly maintained they did not need to become a bank holding company, although they also never completely ruled out that option. But when their financing costs soared as the commercial paper markets froze , the company increasingly recognized it needed to diversify its sources of financing. The company applied for banking holding company status about two or three weeks ago, according to a person with direct knowledge of the situation. Federal Reserve regulators sped up American Express's request because of the market turbulence and the company's desire to apply for the government investment program, which had a Nov. 14 deadline. Typically, the process can take 45 days or more; American Express got its license in about half that time. American Express had already operated a commercial bank and a savings bank supervised by U.S. regulators. But the bulk of its assets were not in those institutions. As a bank holding company, these assets are now under U.S. supervision, a move that expands the amount of financing it can request from the government. That means the bank could qualify for up to $3.6 billion of the Treasury Department's money, instead of just a small portion. "Given the continued volatility in the financial markets, we want to be best positioned to take advantage of the various programs the federal government has introduced or may introduce," said Kenneth Chenault, the chairman and chief executive of American Express. "We will continue to build a larger deposit base to broaden our funding sources." His announcement came as American Express reported a 24 percent drop in third-quarter profit and said it would slash 10 percent of its work force as it prepared to write off a larger pool of credit card loans. American Express wrote off about 5.9 percent of these loans in the third quarter.

Fannie Mae loses $29 billion on write-downs
November 11, 2008

Fannie Mae, the giant mortgage finance company, reported a big quarterly loss Monday and indicated that it could be forced to seek government financing early next year. The company's results suggested that home prices are far from a bottom and that the United States would probably have to pump tens of billions of dollars into Fannie Mae and its sister company Freddie Mac. U.S. regulators took control of the two companies in September and the Treasury Department said it would invest up to $100 billion in each but it had not yet put any money into the companies. Fannie Mae said it lost $29 billion, or $13 a share, in the third quarter, compared with a $1.4 billion loss in the period a year ago. Much of that loss was a result of a $9.2 billion charge for credit losses and a $21.4 billion write-down of deferred tax assets that will probably be worthless. "Credit losses are rising, and need for reserves is still increasing," said Moshe Orenbuch, an analyst who follows Fannie and Freddie for Credit Suisse. "This is bad news, not just for Fannie, but for the whole economy. The message from these results is that we're going to continue seeing housing problems for at least a year."

Fannie Mae said the number of loans in its portfolio that were in foreclosure or delinquent by more than three months jumped to 1.72 percent in September, up from 1.36 in June and 0.78 percent in September 2007. That increase tracks closely with falling home prices. Fannie Mae estimates that home prices have fallen 9.7 percent from their peak in the second quarter of 2006 and that they will fall a total of 19 percent before hitting bottom. The steep decline in home prices and rising delinquency rates suggested that Fannie and Freddie may need more capital than what analysts and policy makers previously thought, said Steve Persky, chief executive of Dalton Investments in Los Angeles. "Prices are going to decline and losses grow for the foreseeable future," he said. "If they are talking about taking money now, it means they are eventually going to take more than we probably expected over the long run." It is unclear how much money Treasury might have to put into the companies. Fannie Mae said it had $9.3 billion of capital after its write-downs. But the company said it would have a capital deficit of $46.4 billion if it calculated its securities on a "fair value basis," or according to what they would fetch in the market. Last month, the Federal Housing Finance Agency, the regulator that oversees Fannie Mae and Freddie Mac, eliminated minimum capital requirements on both companies while they are under U.S. government control to give them more flexibility. Policy makers need Fannie Mae and Freddie Mac to be healthy because the companies are financing about 70 percent of all home loans being made. When other agencies like the Federal Housing Administration are included, the U.S. government's share of the mortgage market climbs to as much as 90 percent.

Fannie, AIG Struggling After Federal Takeover Firms Report Massive Losses, Cite Shortcomings of Rescue
November 11, 2008

Two months after the government began taking over ailing financial companies, the two largest efforts have failed to go as planned, with the firms complaining that federal officials set overly strict terms and took other unhelpful rescue measures. Fannie Mae yesterday reported a $29 billion loss for the three months ended Sept. 30 and warned that the mission it was given by the government, to help revive the mortgage market, could be compromised unless the Treasury Department takes new steps to support the company. Fannie Mae chief executive Herbert M. Allison has approached the Treasury about providing more help, but Treasury Secretary Henry M. Paulson Jr. has demurred, according to three sources familiar with the discussions. The insurance giant American International Group, meanwhile, reported a $24.5 billion quarterly loss yesterday as the government agreed to offer it a more generous lifeline in the form of a new, $152 billion loan on easier terms. The government extended an $85 billion loan to AIG in September followed by $38 billion more in October, but the company has been eating away at it at an accelerating pace. The struggles of these two largely nationalized companies underscore the government's difficulty in intervening in private markets in a way that both protects taxpayers and ensures that the rescue efforts succeed. The government's experience in addressing the financial troubles at Fannie Mae and AIG offers a cautionary tale at a time when Washington is debating whether to extend the federal umbrella to Detroit automakers and other beleaguered firms. Before September, it had been a generation since the government took over a private company out of concern that its failure could endanger the U.S. economy. At both Fannie Mae and AIG, the reported losses largely reflected poor decisions by the companies before the government intervened.

But the willingness of the government to revise the rescue package for AIG and not, so far, for Fannie Mae reflects what's happened since. AIG has continued to hemorrhage despite the government's involvement. Fannie Mae has not. But while the government takeover has largely stabilized Fannie Mae, the federal actions have made it difficult for the company to expand its purchases of home loans, in turn undercutting its mission to boost the mortgage market. The government took a controlling stake in both AIG and Fannie Mae, along with Freddie Mac, when the Treasury bailed them out and imposed stiff terms on the help, sending a signal to the market that the Treasury would intervene only at a big cost to shareholders. In AIG's case, those terms, including relatively high interest rates, proved too tight as the company experienced far greater losses than the government had anticipated. To make interest payments on the loan, AIG had to borrow more money from other government sources, and the company's finances risked spiraling out of control. The plan announced yesterday expands the current AIG program to $152 billion. It also restructures it to make it easier for AIG to repay taxpayers and provides $40 billion in direct government investment. In Fannie Mae's case, the government offered in September to extend loans and make direct investments in the District-based company to allay concerns that it would collapse. But the conditions attached to those potential sources of capital made it difficult for Fannie Mae to tap them, in turn limiting its ability to pump money into the mortgage market. Yesterday, Fannie Mae went public with its concerns about this federal assistance. It warned that it "may prove insufficient" to allow the company to routinely pay off its loans or "continue to fulfill our mission of providing liquidity to the mortgage market at appropriate levels." Fannie Mae's reported loss of $29 billion, or $13 a share, was the single biggest loss for any U.S. company this year. It compared with a loss of $1.4 billion, or $1.56 a share, in the third quarter of 2007. More than two thirds of the loss resulted from writing down the value of deferred tax assets, which are credits that can be applied against income taxes. The company added that its difficulties had been further compounded by government actions after the takeover that made the task of supporting the housing market even tougher. In October, the government announced a series of steps to protect loans made to banks and big corporations. These loans to private banks, the company reported, may have become "more attractive investments" than loans to Fannie Mae, historically one of the safest investments. Although investors have long assumed that the government stands behind Fannie Mae, this guarantee is no longer as strong as those now explicitly provided to some other financial companies. Fannie Mae uses loans to buy up mortgages and mortgage bonds. "The U.S. government does not guarantee, directly or indirectly, our securities or other obligations," the company said. As the financial markets took a sharp turn for the worse in October, the government introduced a variety of protections for financial institutions. The Treasury Department, Fannie Mae and its regulator, the Federal Housing Finance Agency, initiated a series of discussions about what else the government could do to support the mortgage market. Fannie Mae had begun taking steps to make home loans more affordable, such as buying more mortgage bonds to put money into the market and eliminating fees it charged to insure loans. But the company was having trouble raising affordable, long-term funding in the debt markets -- the money it uses to buy mortgages. As a result, mortgage rates were rising. That was the opposite of what government officials intended when they took over Fannie Mae and Freddie Mac. The government could provide more support for Fannie Mae by buying the company's debt or making it easier for the company to get loans or capital directly from the Treasury.

But Paulson wasn't interested in renegotiating the terms of the department's agreement with Fannie Mae, according to sources who spoke on condition of anonymity because they were not authorized to disclose the discussions. "We have occasional discussions with [Fannie Mae and Freddie Mac] and FHFA as we monitor the mortgage market and look to address the housing correction," said Treasury spokeswoman Michele Davis. "We have received no recommendations from Fannie Mae." Peter J. Wallison, a former Treasury official and a fellow at the American Enterprise Institute, said the government was being foolhardy in failing to do more for Fannie Mae. "What is the reluctance on the part of Treasury to put money into Fannie and Freddie? We know they're going to lose money. So what?" he said. "Their objective is to help the housing market." Some financial experts have suggested that the government go even further and fully nationalize firms like Fannie Mae and Freddie Mac, allowing them to borrow at the same low rates the U.S. government can. In contrast to Fannie Mae, AIG won a new relief package after the initial bailout aggravated the company's difficulties. AIG, which has recorded $43 billion in losses on home mortgages, was facing bankruptcy in September when the government stepped in. To raise capital to pay back the government's initial loan, the chief executive appointed by the Treasury, Edward M. Liddy, planned to sell off some AIG subsidiaries, such as life insurance and airplane-leasing firms. But the falling stock market made that difficult by depressing the value of the company's shares. Meanwhile, the freeze in credit markets made it even harder for AIG to remain liquid and pay off debts. AIG was forced to put up billions of dollars to cover derivatives it had sold to investors. "It was obvious to me from Day One that the terms of that arrangement were really quite punitive in terms of the interest rate and the commitment fee and the shortness of it," Liddy said in a Bloomberg Television interview yesterday. "I started really about a week after I got here trying to renegotiate." Under the new plan, the government will inject $40 billion into AIG, a move similar to what it has done with U.S. banks. In addition, the government will help unload $52.5 billion in troubled assets on AIG's books while reducing the amount of the original loan and cutting its interest rate. "In September, when AIG had to be rescued, we did not have authority to purchase equity," said Davis, the Treasury spokeswoman. If the Treasury's financial bailout program had already been created, she added, "we would have purchased equity at that time."

Gov't launches sweeping new loan aid effort
November 11. 2008

As losses from bad loans continue to mount despite more than a year of government and industry focus, some of the giants of the mortgage industry, including Fannie Mae and Freddie Mac, yesterday unveiled another stepped-up effort to keep delinquent borrowers out of foreclosure. Government and lender efforts to stem foreclosures have been stymied by the sheer size of the problem. This program attempts to address that by using a simplified process for determining whether someone is eligible for a new loan. Instead of the standard cumbersome loan modification process, which can include reviewing a borrower's credit report and tax returns, the new plan focuses on the borrower's income and how much he or she can afford to pay. It also creates a formula for determining what a homeowner can afford, eliminating some guesswork.

Government officials said they expect the effort, dubbed the Streamlined Modification Program, to be able to help "hundreds of thousands" of homeowners. But the new program is also an acknowledgment that the industry's efforts to keep people in their homes have not kept up with growing foreclosure rates. "We are experiencing a necessary housing correction, and the sooner we work through it, the sooner housing can again contribute to our economic growth," Neel Kashkari, the interim assistant Treasury secretary for financial stability, said at a news conference. "Foreclosures hurt families, their neighbors, whole communities and the overall housing market," said James Lockhart, the housing finance agency's director. "We need to stop this downward spiral." “This is a big step forward that will make it easier to modify loans for the most at-risk homeowners so they will be able to avoid foreclosure and stay in their homes," said Faith Schwartz, head of Hope Now, an alliance of lenders that has spearheaded the industry's foreclosure response and will be advocating the new standards. The plan could have tremendous importance because Fannie Mae and Freddie Mac own or guarantee nearly 31 million U.S. mortgages, or nearly six of every 10 outstanding. Still, government officials did not have an estimate of how many people would qualify for the new program. Officials hope the new approach, which goes into effect Dec. 15th will become a model for loan servicing companies, which collect mortgage companies and distribute them to investors. These companies have been roundly criticized for being slow to respond to a surge in defaults. The program applies only to mortgages owned or guaranteed by Fannie Mae and Freddie Mac, which are involved with more than 50 percent of residential loans. But major lenders, including Bank of America, Wells Fargo and Citigroup, have agreed to apply the formula to loans they administer for Fannie Mae and Freddie Mac and are expected to extend it to their own loans, industry officials said. To qualify, borrowers would have to be at least three months behind on their home loans, and would need to owe 90 percent or more than the home is currently worth. Investors who do not occupy their homes would be excluded, as would borrowers who have filed for bankruptcy. A borrower who is 90 days delinquent will be eligible for a new loan with a payment that does not exceed 38 percent of his gross monthly income. To qualify, the homeowner must provide proof that he has suffered a hardship, such as losing a job that made it impossible to keep up with payments. The terms of the borrower's loan then could be extended from 30 years to 40 years, and if that is not enough, the interest rate could be reduced to as low as 3 percent to make the payments more affordable. The homeowner could be subject to an interest rate increase after a set time, depending on how low their new interest rate is. If those options don't reduce payments enough, part of the principal owed on the loan could be deferred until the end of the loan term. While lenders have beefed up their efforts to aid borrowers over the past year, their earlier efforts have not kept up with the worst housing recession in decades. And critics were quick to pour water on the latest plan. "Instead of a massive foreclosure prevention program, we wait for a homeowner to be in a failing position before doing anything, which often is too late," said John Taylor, president and CEO of the National Community Reinvestment Coalition. "It's been the foreclosures that have been driving the economic downturn and we've been saying that for 13 months now. To stop the bleeding is to end foreclosures," he continued. "But now that so many other sectors in the economy have fallen, I'm not sure if we're past the point of no return. It's appalling that they don't get." However, the new program also retains many of the practices that have frustrated other efforts to modify troubled loans. For example, it excludes borrowers who are current on their mortgages but face an interest rate increase that will make payments unaffordable. It also does not provide any new mechanism for reaching homeowners, who in about half of foreclosures have not talked to their lenders. By requiring the homeowner to be 90 days delinquent, the program fails to anticipate problems, said John Taylor, president and chief executive of the National Community Reinvestment Coalition, an activist group. "Why not 60 days? Why not 30 days? In fact, why not say that based on their income and this type of loan, we know

this family is going to be underwater in six months or sooner" and act before they fall behind, he said. "We really need a plan that thinks in proactive ways that gets ahead of the problem." The new program also retains many of the practices that have frustrated other efforts to modify troubled loans. For example, it excludes borrowers who are current on their mortgages but face an interest rate increase that will make payments unaffordable. It also does not provide any new mechanism for reaching homeowners, who in about half of foreclosures have not talked to their lenders. By requiring the homeowner to be 90 days delinquent, the program fails to anticipate problems, said John Taylor, president and chief executive of the National Community Reinvestment Coalition, an activist group. "Why not 60 days? Why not 30 days? In fact, why not say that based on their income and this type of loan, we know this family is going to be underwater in six months or sooner" and act before they fall behind, he said. "We really need a plan that thinks in proactive ways that gets ahead of the problem." Other critics state that while the government has indeed offered another plan to help troubled homeowners, once again, it doesn't go far enough. The plan announced Tuesday by federal officials and mortgage giants Fannie Mae and Freddie Mac sounds sweeping in its approach: Borrowers would get reduced interest rates or longer loan terms to make their payments more affordable—but there's a catch. The plan focuses only on loans that Fannie and Freddie own or guarantee. Fannie and Freddie are the dominant players in the U.S. mortgage market but represent only 20 percent of all delinquent loans. More than 4 million American homeowners, or 9 percent of borrowers with a mortgage were either behind on their payments or in foreclosure at the end of June, according to the most recent data from the Mortgage Bankers Association. The Federal Housing Finance Agency, which regulates Fannie Mae and Freddie Mac, is also still trying to persuade investor groups to adopt the program. Those investors own millions of loans that have been pooled together. The American Securitization Forum, an industry association for financial firms and investor groups, said it welcomed the program but did not say whether its members would sign on. "ASF is considering the loan modification approaches embodied in this plan, along with other recently announced plans," the group said in a statement. Government and industry officials drew parallels between the new program and a loan modification program launched by the Federal Deposit Insurance Corp. at the failed bank IndyMac. Like the IndyMac program, the primary focus of the new program is the affordability of the loan. But FDIC Chairman Sheila C. Bair, who has championed aggressive loan modification, said the latest proposal fell short of what was needed. "We are pleased that the protocols announced today draw from the loan modification metrics we have instituted at IndyMac. However, there are questions that remain about implementation," she said in a statement yesterday. " The plan falls short of what is needed to achieve widescale modifications of distressed mortgages." With the government spending billions to aid distressed banks, "we must also devote some of that money to fixing the front-end problem: too many unaffordable home loans," Democrats on Capitol Hill aren't satisfied, either. "When the loan is chopped up into a million pieces and any investor can block a modification from happening, a program like this will only scratch the surface of the mortgage crisis," said Sen. Charles Schumer, D-N.Y. Indeed, Tuesday's announcement comes too late for Troy Courtney, a 44-year-old San Francisco police officer. He moved out of his home in Mill Valley, Calif., at the start of this month — taking his children, three dogs and one cat with him — after failing at several to attempts to get a loan modification or a short sale — where the lender agrees to receive less than the loan is worth. Courtney worked overtime and tapped into his retirement account to try to catch up with two loans on his home. But in the end he couldn't convince Countrywide Financial, which managed the loan for Wells Fargo, to modify the loan. "I feel like I missed the boat," he said of the new efforts to help more homeowners. "I'm just mad at the whole system."

One reason the problem has been so tough to solve for borrowers like Courtney is that the vast majority of troubled loans were packaged into complicated investments that have proven extremely difficult to unwind. Deutsche Bank estimates more than 80 percent of the $1.8 trillion in outstanding troubled loans have been packaged and sold in slices to investors around the world. And it appears the majority of those loans will not be helped by the new plan. The remaining 20 percent are "whole loans," which are easier to modify because they have only one owner. Nevertheless, Tuesday's announcement coupled with recent and more aggressive strategies from the major retail banks are important steps to fix the housing crisis. After more than a year of slow and weak initiatives, there appears to be a serious effort to get at the heart of the credit crisis: falling U.S. home prices and record foreclosures. Citigroup announced late Monday it is halting foreclosures for borrowers who live in their own homes, have decent incomes and stand a good chance of making lowered mortgage payments. The New York-based banking giant also said it is also working to expand the program to include mortgages for which the bank collects payments but does not own. Additionally, over the next six months, Citi plans to reach out to 500,000 homeowners who are not currently behind on their mortgage payments, but who are on the verge of falling behind. This represents about one-third of all the mortgages that Citigroup owns, the bank said. Citi plans to devote a team of 600 salespeople to assist the targeted borrowers by adjusting their rates, reducing principal or increasing the term of the loan. Late last month, JPMorgan Chase & Co expanded its mortgage modification program to an estimated $70 billion in loans, which could aid as many as 400,000 customers. The New York-based bank has already modified about $40 billion in mortgages, helping 250,000 customers since early 2007. Bank of America, meanwhile, has said that starting Dec. 1, it will modify an estimated 400,000 loans held by newly acquired Countrywide Financial Corp. as part of an $8.4 billion legal settlement reached with 11 states in early October.

Stopping a Global Meltdown
(emphasis added)
C. Fred Bergsten, November 12, 2008

When the finance ministers of the world's top economies convened in Washington last month, around the annual meeting of the International Monetary Fund, they developed a remarkably successful international strategy for responding to the financial crisis, which had reached panic proportions in the markets. It was promptly implemented at the national level by all the key countries and quelled the worst of the anxieties. When the leaders of the top 20 of these countries meet on Saturday, they must build on that outcome by adopting a similarly global approach to counter the sharp downturn in the world economy that could otherwise become the most severe since the Depression. To do so, the Group of 20 must at a minimum do no harm. Any surfacing of significant conflicts over such contentious issues as internationalization of financial regulation would undermine confidence, which remains extremely fragile, dissipating the hard-won gains to date and throwing markets into a new tailspin. Leaders must, for example, avoid the temptation to agonize over who caused the crisis and recognize that, while the United States was clearly at its center, there is plenty of blame to go around. The most positive step the leaders could take would be to pledge to adopt fiscal stimulus programs amounting to at least 1 to 2 percent of most of their national economies. Such an injection of domestic demand throughout the G-20 would provide a critical spur to world economic expansion and substantially reduce the depth of the recession. China, which now accounts for more than one-third of all global growth, has demonstrated admirable leadership by announcing an expansion program of much greater magnitude. It is up to the United States and

Europe, in particular, to follow suit; an international commitment should help overcome internal opposition to such steps (especially in the United States and Germany). The G-20 should also disavow the imposition of any new trade distortions. It was a wave of protectionist trade measures, triggered by the infamous Smoot-Hawley tariff in the United States and quickly emulated by most Europeans, which converted the depression of the early 1930s into the Great Depression. China has recently adopted new export subsidies, a particularly unhelpful step by a country running the world's largest trade surplus and, despite its recent slowdown, the world's fastest growth rate. Any new outbreak of border restrictions or their domestic equivalents would threaten growth everywhere and further jeopardize market stability. The leaders also need to pledge at least $500 billion to augment the resources of the International Monetary Fund so it can meet the potential needs of developing countries hammered by the crisis. The IMF is already lending to Hungary, Iceland, Pakistan and Ukraine, but a longer queue is forming rapidly. Japan has offered $200 billion, and China, with reserves nearing $2 trillion, MUST be convinced to provide at least as much. The rich oil exporters, represented by Saudi Arabia at the G-20, should do so as well. The lenders would, of course, receive an IMF guarantee on their money and should welcome this alternative to (their normal collateral of dollar denominated) U.S. Treasury securities. The final component of the G-20 package should be the creation of working groups to address systemic issues that helped bring on the crisis, most of which require careful analysis and preparation before thoughtful action is feasible. The most obvious is financial regulation, which clearly broke down in the United States and numerous other countries [Duh—ya think?]; there is an important international dimension because of the cross-border nature of many financial institutions and market instruments ( this is the age of Globalization—even if some still think the world’s finances are controlled by Wall Street) Another is the failure of the IMF, and its major member countries, to anticipate the crisis and to initiate preventive actions (a fact not nearly as well noted as it should be!). A closely related third issue is the growing lack of political legitimacy of the IMF thanks to its gross underrepresentation of rapidly emerging Asian powers and the parallel over-representation, for historical reasons, of Europeans. (not to mention its overstaffing by narrow-minded economists who are incapable of thinking beyond their tried [and failed] past policies) Thoughtful analysis by the new working groups could tee up these issues for decisive action at future summits and help considerably in avoiding repetitions of today's predicament. It is difficult for the United States to lead the preparation of such a package, given the lame-duck status of President Bush (try dead-duck status), who is hosting the summit. It is critical, then, that President-elect Barack Obama concur (hell, his economic team should lead this dialogue) with the outcomes of the gathering, both to ensure their faithful pursuit in the future and to avoid internal U.S. rancor that could be as destabilizing for markets as conflict among the countries. Effective consultation between the outgoing and incoming administrations is central to the success of the gathering. So is active leadership from the Europeans, (who called for the meeting in the first place), and the Asians, who have the most dynamic economies and most of the money (I question this last assumption—the economies of Europe and Asia have proven to be just as weak and vulnerable as the US). History may regard this weekend as the beginning of a transition in global economic power as well as a milestone in resolving the crisis of 2008.

C. Fred Bergsten, director of the Peterson Institute for International Economics, was assistant Treasury secretary for international affairs from 1977 to 1981 and assistant for international economic affairs to the National Security Council from 1969 to 1971.
Paulson says troubled assets will not be purchased
November 12, 2008

Treasury Secretary Henry Paulson said Wednesday the $700 billion government rescue program will not be used to purchase troubled assets as originally planned. Paulson said the administration will continue to use $250 billion of the program to purchase stock in banks as a way to bolster their balance sheets and encourage them to

resume more normal lending. He announced a new goal for the program to support financial markets, which supply consumer credit in such areas as credit card debt, auto loans and student loans. Paulson said that 40 percent of U.S. consumer credit is provided through selling securities that are backed by pools of auto loans and other such debt. He said these markets need support." This market, which is vital for lending and growth, has for all practical purposes ground to a halt," Paulson said. The administration decided that using billions of dollars to buy troubled assets of financial institutions at the current time was "not the most effective way" to use the $700 billion bailout package, he said. The announcement marked a major shift for the administration, which had talked only about purchasing troubled assets as it lobbied Congress to pass the massive bailout bill. Paulson said the administration is exploring other options, including possibly injecting more capital into banks on a matching basis, in which government funds would be supplied to banks that were able to raise money on their own. The bailout money also should be used to support efforts to keep mortgage borrowers from losing their homes because of soaring default levels, he said. A proposal to have part of the bailout funds used to guarantee mortgages that have been reworked to reduce monthly payments for borrowers is an approach the administration continues to discuss, but Paulson did not announce that it would be adopted. Federal Deposit Insurance Corp. Chairman Sheila Bair has pushed for that approach. Speaking of the first-ever summit of leaders of the Group of 20 major industrial and developing countries, Paulson said this weekend's meeting needs to focus first on how to repair the financial system as a way to bolster the global economy. Paulson praised a new set of guidelines issued Wednesday by the Federal Reserve and other bank regulators, saying that they addressed a crucial issue of making sure that banks continue to lend at adequate levels.

Bailout Price Tag: $3.5T So Far, But 'Real' Cost May Be Much Higher
Nov 12, 2008

While the government is clearly spending a lot of taxpayers' money to bail out financial firms, the tally is even bigger than most Americans (economists and pundits included) are probably aware or willing to admit. The bailout bonanza has gotten so big and happened so fast it's the true cost often gets lost in the discussion. Maybe Hank Paulson and Ben Bernanke prefer it that way because the tally so far is nearly $3.5 trillion, and that's before a likely handout for the auto industry. Yes, $3.45 trillion has already been spent, as details: $2T Emergency Fed Loans (the ones the Fed won't discuss, as detailed here) $700B TARP (designed to buy bad debt, the fund is rapidly transforming as we'll discuss in an upcoming segment) $300B Hope Now (the government's year-old attempt at mortgage workouts) $200B Fannie/Freddie $140B Tax Breaks for Banks (as reported in the Washington Post 11.10) $110B: AIG (with it's new deal this week, the big insurer got $40B of TARP money, plus $110B in other relief) The rising cost of the bailout Although the price tag on the Treasury Department's Troubled Asset Relief Program is $700 billion, the full amount that the government has invested in its rescue effort for struggling financial institutions appears to be closer to $3.5 trillion. Bloomberg L.P. the parent company of Bloomberg News, said last week that it filed a lawsuit seeking information on the collateral that a group of banks pledged for some $2 trillion in emergency loans from the

Federal Reserve. Bloomberg asked a federal court in New York to require the Federal Reserve to disclose the identity of the banks that borrowed money through certain financing mechanisms, and to disclose what assets they pledged against those loans. Bloomberg filed the suit after the Federal Reserve said that it would deny Bloomberg's request for the information under the Freedom of Information Act. The financial firms that were eligible for some of the loans through the Federal Reserve included many of the same firms that split $125 billion in the first round of the Treasury Department's relief program. The Treasury Department has approved more than $170 billion in capital injections for banks that applied to sell preferred stock to the government. It has about $80 billion remaining for additional participants, who must submit their applications by Friday. The Treasury Department also announced Monday that it also is investing $40 billion in the preferred shares of American International Group Inc. The financing it part of a new plan to salvage an earlier rescue plan that was going awry. The revised plan brings the total assistance that AIG has received from the Federal Reserve and the Treasury Department to $150 billion. Bloomberg reported that the Federal Reserve made its $2 trillion in emergency loans under 11 different programs, eight of which were created in the past 15 months. The Treasury Department also made a little-noticed change to tax policy that experts say could save banks that merge with other banks as much as $140 billion in taxes. One of the biggest beneficiaries of the change would be Wells Fargo & Co., which is absorbing Wachovia Corp. in a deal spurred by the Federal Deposit Insurance Corp.'s concerns about Wachovia's solvency. According to an article Sunday in the Washington Post, Wells Fargo stands to save about $25 billion in taxes. Adding together the $170 billion that the Treasury Department has currently agreed to provide banks in additional capital, the $150 billion that the Treasury Department and the Federal Reserve are providing to AIG and the $2 trillion that the Federal Reserve has provided banks in emergency loans brings the total assistance to $2.32 trillion. If the estimated savings from the new tax breaks are included, the assistance would climb to $2.46 trillion. That total does not include other measures not focused directly on banks, such as Treasury Department's $200 billion in support for Fannie Mae and Freddie Mac, and the Federal Housing Administration's $300 billion HOPE for Homeowners program. _____ 4 Comments “A Modest Proposal”? Regarding the "Bailout", the correct thing to do would be to declare derivatives null and void. AIG is heavily loaded with these betting slips. Derivatives and "Credit Default Swaps" are nothing but fancy terms used to obfuscate the reality that these are nothing but bets. We are the casino and our "guests" have figured out how to scam us and we're letting them. Any other casino would escort these thieves out, which is what we should do by declaring them (derivatives) null and void. There is 1,000 TRILLION, or 1 QUADRILLION in derivatives outstanding - no one can or should attempt to begin to bail out that kind of money - it is just one big black financial hole. Check out An alternative would be to have the institutions simply refund the “premiums” or whatever the derivative obfuscating term is….. Billy Wen I don't understand why the Treasury is so protective of the data, the public needs to know. While the big banks are enjoying a nice windfall courtesy of the taxpayer's dollars the legitimate homeowners of America is suffering. Each week the value of our home goes down and nothing happening is really slowing that down. Why is it that the middle class is made to suffer while the rich gets bailed out? My home has lost over 50% of its value and about 20% of the owners in my neighborhood (Beaumont, CA) have had their homes foreclosed on! See for yourself the prices are dropping like a falling knife! Morph366 SOME NEW MATHS FOR UNDERSTANDING WHAT WENT WRONG AT AIG

It is becoming increasingly apparent from the scale of the revised AIG rescue plan announced yesterday, and the fact that there has still been no real “pricing” of the really toxic stuff by the TARP, that the financial engineers that created this monumental disaster were either unintentionally reckless beyond belief or, if the obfuscation was intentional, this must surely be counted as the largest theft ever perpetrated and taxpayers should be demanding ongoing investigations leading to criminal prosecutions. If we just focus on the more benign interpretation (i.e. that it was not malicious intention) one is forced to the conclusion that the mathematics that underlies all of the risk modeling that went into these structured products is absolutely flawed. Not just slightly wrong but fundamentally mis-conceived. The saddest part of the whole mess is the hubris and arrogance of the people that signed off on the assessments made by the “quants” of the likelihood of defaults and the probability distributions of financial accidents. Extreme events in time series data are of a completely different complexion to the tails of a normal distribution. If risk managers really insist on finding a bit of maths that can account for the likelihood of critical events taking place – such as collapses in real estate prices and implosions of liquidity – a better place to look would be the predator-prey modeling which has been conducted mainly in relation to bio and eco-systems. Predators eventually run out of sufficient prey and their populations decline substantially until there is a chance for the supply of prey to be replenished. At such time the predators can get back to business. This modeling gives rise to oscillations in the ratio of predators to prey and right now we are in a bear phase for the predators. One slight modification to the model needs to be made for the government rescue plans etc which will perhaps keep those marginal survivors from the last predation on a life support system long enough so that they can limp off and become ensnared in some new financially engineered scam. Tallying up the "true" cost of the bailout is difficult, and won't be known for months if not years. But considering $3.5 trillion is about 25% of the U.S. economy ($13.8 trillion in 2007) and the U.S. deficit may hit $1 trillion in fiscal 2009, hyperinflation and/or sharply higher interest rates seem likely outcomes down the road. At the very least, the possibility of the U.S. losing its vaunted Aaa credit rating -- which determines the Treasury's borrowing costs -- cannot be discounted. Moody's has already said it's not in jeopardy of being lowered. But we really can't put much stock in what Moody's -- or S&P or Fitch -- say after the subprime debacle, can we? More importantly, the price of credit default swaps on U.S. government debt has been on the rise since the bailout train got rolling, as Barron's reports. Foreclosure Relief Is Getting Lost In Fine Print of Loans
November 13, 2008

More than a year into the foreclosure crisis, whether a distressed homeowner is eligible for a more affordable mortgage can often come down to the fine print. That fine print in contracts that govern mortgages bundled into investment pools dominated a House Financial Services Committee hearing yesterday as lawmakers questioned whether lenders are doing enough to keep people in their homes. Millions of loans are held in these pools, called securitizations. They are governed by contracts that dictate what changes can be made to the loans. Lawmakers and industry officials debated yesterday the degree to which those agreements are making it difficult to modify a homeowner's loan and thus hampering foreclosure prevention efforts. Michael Gross, a Bank of America executive, told the committee that the rules vary depending on the investment group. Some "may prevent us from doing modifications that would benefit borrowers and investors," he said. Under some contracts, he said, "loan modifications are expressly disallowed." Lenders have had the most success modifying mortgages they own, lawmakers said, but run into trouble when they administer the loans held in pools for others, known as servicing. "Where we're running into a problem is with securitizations, and that's really the great majority of . . . mortgages that are in foreclosure or threatening foreclosures," said Rep. Spencer Bachus (R-Ala.).

Legislation may be needed to resolve these issues, said Rep. Barney Frank (D-Mass.), chairman of the Financial Services Committee. "We are getting some progress where the legal authority to modify is clear. It took a while, but it's coming," he said. But "we have not had that where there are servicers" that are administering the loans for investors. The mortgage crisis has grown too big for the industry to handle, said Thomas Deutsch, deputy executive director of the American Securitization Forum, an industry group for financial firms. "Macroeconomic forces bearing down on an already troubled housing market are simply too strong for private sector loan modification initiatives alone to counteract the nationwide increase in mortgage defaults and foreclosures," he said. The debate comes as the government response to the foreclosure crisis is evolving. Treasury Secretary Henry M. Paulson Jr. said yesterday that his agency is abandoning plans to buy toxic mortgage assets, which would have allowed it to pursue more aggressive loan modifications. That goal must be met another way, he said. "Maximizing loan modifications, nonetheless, is a key part of working through the housing correction and maintaining the quality of communities across the nation, and we will continue working hard to make progress here," he said. "Foreclosure prevention is something I'm going to keep working on right up until I leave." The Department of Housing and Urban Development is considering changes to a key loan modification program just a month after it was launched. The program, Hope for Homeowners, was expected to help 400,000 borrowers get new loans. But lenders have balked at a requirement to lower the principal owed on the loan to qualify for a refinancing deal under the program. So far the program has helped only 42 homeowners, and HUD now expects only 20,000 applications over the next year. "The administration is continuing to look at a range of options to reduce foreclosures," HUD spokesman Stephen O'Halloran said. Modifying mortgages not as simple as it sounds
November 12, 2008

It sounds simple in principle: find troubled homeowners, change their mortgages and help them keep their houses. But behind many mortgages sits a complex chain of parties that service mortgages or invest in them amid an array of complicated legal agreements. At a hearing of the House Financial Services Committee on Wednesday, legislators concerned about the rising tide of foreclosures encouraged the financial industry to alter the terms of more mortgages to keep people in their homes. They focused on mortgages that were sold in packages to outside investors like pension funds, hedge funds and insurance companies. The problem is that financial executives have competing views on whether mortgages that were packaged - or securitized, in industry parlance - can be modified or not. These mortgages are no longer owned by the banks that service them; they are instead owned by numerous investors, and some in the industry think the investors might sue banks that modify mortgages. "The servicers are telling me they're not in power at this time," said Representative Brad Sherman, Democrat of California. "You have 10 investors, and any one of them can allege, from a purely negligence standpoint, that the value of portfolio has not been maximized." At the hearing, panelists disagreed whether modification is allowed with bundles of mortgages that were resold. An executive from Bank of America said that the contracts behind some securitizations expressly prohibit changes to the underlying mortgages. The executive, Michael Gross, managing director of loan administration loss mitigation at Bank of America, said that banks have more flexibility to modify the rules in loans that they still hold. But an executive with the American Securitization Forum, an industry group, said that contracts did allow bundled mortgages to be modified. The forum is in discussions with a range of investors who bought mortgage

bonds to streamline the process of such modification, said Thomas Deutsch, deputy executive director of the group. "Servicers do have the legal authority, right and responsibility to modify loans in appropriate circumstances, even if those loans are in mortgage-backed security pools," Deutsch said. But Deutsch's assertion faced skepticism among lawmakers. Barney Frank, Democrat of Massachusetts and chairman of the committee, said he is hearing evidence that servicers are having trouble modifying loans that were securitized. "They can't get this worked out," Frank said. "Who am I going to believe? You or my own eyes?" Some hedge funds, including Greenwich Financial Services and Braddock Financial, told banks in October that they might sue the banks if they changed mortgages that were within mortgage bonds the hedge funds had purchased. Changes in the terms of mortgages underlying mortgage bonds can change how much those bonds are worth. The hearing came days after banks like JPMorgan Chase and Citigroup announced that they would modify more mortgages and a similar announcement by Fannie Mae and Freddie Mac, the government-backed home financing companies.

Lobbyists besiege Treasury for slice of the bailout pie
November 12, 2008

When the U.S. government said it would spend $700 billion to rescue the financial industry, it seemed to be an ocean of money. But after one of the biggest lobbying free-for-alls in memory, it suddenly looks like a dwindling pool. Many new supplicants are lining up for infusions of capital as sums of billions of dollars are channeled to other beneficiaries like the insurer American International Group and possibly soon to the credit card company American Express. Of the initial $350 billion that Congress freed up, out of the $700 billion in bailout money contained in the law that passed in October, the Treasury Department has committed all but $60 billion. The shrinking pie - and the growing uncertainty over who qualifies - has thrown the legal and lobbying establishment in Washington into a mad scramble. The Treasury is under siege by an army of hired guns for banks, savings and loan associations and insurers - as well as for improbable candidates like a Hispanic business group representing plumbing and home-heating specialists. That last group wants the Treasury to hire its members as contractors to take care of houses that the government may end up owning after buying distressed mortgages. The lobbying frenzy worries many traditional bankers - the original targets of the rescue program - who fear that it could blur, or even undermine, the government's effort to stabilize the financial system after its worst crisis since the 1930s. Among the most rattled are community bankers. "By the time they get to the community banks, there may not be enough money left," said Edward Yingling, president of the American Bankers Association. "The marketplace is looking at this so rapidly that those who have the money first may have some advantage." Adding to the frenzy is the possibility that the next Congress and White House could change the rules again. The president-elect, Barack Obama, has added his voice by proposing that the struggling automakers get U.S. government aid, which could mean giving them access to the fund - something that Treasury Secretary Henry Paulson Jr. has resisted.

Despite the line outside its door, the Treasury is not worried about running out of money, according to a senior official. It has no plans to ask lawmakers to free the second $350 billion of the rescue package during a special session of Congress, which could begin next week. That will limit the pot of money available, at least until the new Congress is seated in January. Meanwhile, the list of candidates for a piece of the bailout keeps growing. On Monday, the Treasury announced that it would inject an additional $40 billion into AIG, amid signs that the government's original bailout plan was putting too much strain on the company. American Express won approval Tuesday to transform itself into a bank holding company, making it eligible for an infusion. Then there is the National Marine Manufacturers Association, which is asking whether boat finance companies might be eligible for aid to ensure that dealers have access to credit to stock their showrooms with boats - costs that have gone up as the credit markets have calcified. Using much the same rationale, the National Automobile Dealers Association is pleading that car dealers get consideration, too. "Unfortunately, I don't have a lot of good news for them individually," said Jeb Mason, who, as the Treasury's liaison to the business community, is the first port of call for lobbyists. "The government shouldn't be in the business of picking winners and losers among industries." Mason, 32, a lanky Texan in black cowboy boots who once worked in the White House for Karl Rove, shook his head over the dozens of phone calls and e-mail messages he gets every week. "I was telling a friend, 'This must have been how the Politburo felt,"' he said. The congressional bailout law gave the Treasury broad authority to decide how to spend the $700 billion. Under the terms of the $250 billion capital purchase program announced in October, cash infusions are available to "qualifying U.S. banks, savings associations, and certain bank and savings and loan holding companies, engaged only in financial activities." That definition has grown to include private banks and insurers like Allstate and MetLife, which own savings and loans. It may also encompass industrial lenders like GE Capital and GMAC, the financing arm of General Motors, provided they win approval to reclassify themselves as banks or savings and loan holding companies. The Treasury set a deadline of this Friday for institutions to apply for capital investments, which has meant a grueling few weeks for already overworked officials like Mason. "Jeb is like the customer service agent at Verizon when the power lines go down," said Robert Nichols, president of the Financial Services Forum, a trade group for big institutions like Citigroup, Fidelity and Allstate insurance, some of which have received government money. The influential independent and community bankers group, which represents smaller institutions, won an extension of the deadline for privately held banks while the Treasury considered a way for them to participate in its program as well. The Treasury, several industry executives said, wants to avoid too strict a definition of eligible institutions, in case the Obama administration decides it wants to tweak the requirements for an investment, or even to overhaul the rescue program. Several lobbyists said the Treasury's model contract acknowledged the possibility that Congress could impose new requirements on recipients of the money. And some Democratic lawmakers have talked about further restricting executive compensation, shareholder dividends or other uses of the money as part of the deal. "We are like a tenant signing a lease contract with the landlord where the landlord can come back and change the terms after the fact, and in fact we are going to have a new landlord in a couple of weeks," said Yingling of the bankers association.

The first wave of lobbying came in early October when Paulson announced the plan to buy troubled mortgagerelated assets from banks. The Treasury said it would hire several outside companies to handle the purchases, and would dispense with government contracting rules. Law and lobbying firms that specialize in government contracting immediately fired dispatches to clients and potential clients explaining opportunities in the new program. Capitalizing on the surge of interest, several large firms, including Patton Boggs; Akin Gump; Fried, Frank, Harris, Shriver & Jacobson; and Alston & Bird, have set up financial rescue shops. Alston & Bird, for example, highlights its two biggest stars - two former senators, Bob Dole and Tom Daschle. Dole "knows Hank Paulson very well" and has been "very helpful" with the financial rescue groups, said David E. Brown Jr., an Alston & Bird partner involved its effort. "And of course, Senator Daschle is national co-chair of the Obama campaign," Brown added, noting that because Daschle was not a registered lobbyist, his involvement was limited to "high-level advisory and strategic advice." Ambac Financial Group, a bond insurer, never needed lobbyists before, said Diana Adams, a managing director. But its clients persuaded the company to hire two Washington veterans - Edward Kutler and John O'Rourke who helped arrange a recent meeting with Phillip Swagel, an assistant Treasury secretary. "We haven't really asked for much in the past," Adams said. Initially, the banks reacted coolly to the prospect of the government taking direct stakes in them. They worried about restrictions on executive pay, and whether there would be a stigma attached. In conference calls with industry groups, Mason helped explain the Treasury proposal - a job he and his colleagues did well, judging by the change of heart among banks. "The biggest surprise was how quickly it went from 'I don't need this,' to 'How do I get in?"' said Michele Davis, the head of public affairs at the Treasury, who is Mason's boss. Underscoring the many ways companies can take part in the rescue fund, the U.S. Hispanic Chamber of Commerce and other Hispanic business groups met with Paulson to push for minority contracts in asset management, legal, accounting, mortgage services and maintenance jobs, like plumbing and masonry. "They are going to need a lot of folks in minority communities that are able to service their own communities," said David Ferreira, head of government relations for the Hispanic Chamber of Commerce. As the automakers have pushed for government help, the trade groups for car dealerships and even boat dealerships are pressing their own cases. They argue that showrooms are feeling a squeeze between higher borrowing costs to finance their inventory and slowing consumer sales to move cars off the lot. "We have been encouraged by reports that Secretary Paulson is looking to broaden the program," said Mathew Dunn, head of government relations for the National Marine Manufacturers Association. On Friday, the National Automobile Dealers Association sent Paulson a letter urging him to keep them in mind. "A well-capitalized, financially sound dealer network is essential to the success of every automobile manufacturer," wrote Annette Sykora, a Slaton, Texas, car dealer and the chairwoman of the group. "Any government intervention should include provisions to preserve the viability of dealers." Some lobbyists, Mason said, had called him even though they did not have any clients looking to get into the program or worried about its restrictions. They were merely seeking intelligence on which industries would be deemed eligible for assistance. He suspects they represented hedge funds that wanted to trade on that information. Negative outlook-Credit-rating agencies

Europe misfires in its attack on the rating agencies
Nov 13th 2008 From The Economist print edition

IN AN age of e-mail every industry is likely to have a Henry Blodget moment. The one for rating agencies came in mid-October, when a rash of embarrassing correspondence emerged. Among them was the following exchange between two analysts: “That deal is ridiculous. We should not be rating it.” Back came his colleague’s answer: “We rate every deal…it could be structured by cows and we would rate it.” The conversation was more than mortifying. It cut to a central conflict bedeviling the industry: although ratings are relied on by investors and regulators as impartial measures, the rating agencies are paid by those they rate for their judgments. With their marks of approval stamped all over the most toxic assets poisoning the financial system, they were quickly blamed for helping cause the credit crunch. Some of that criticism has ebbed, but among those still carrying a cudgel is Charlie McCreevy, the European internal-market commissioner. On November 12th he released a draft law to regulate them and end what he acidly called their “charmed existence”. Some of Mr McCreevy’s rules on minimizing conflicts of interest are sensible. But some are wide of the mark. Regulators in each European country will be given the power to meddle with ratings that they do not like—the downgrade of an important bank or flag-carrying airline, for instance. If rating agencies can be too optimistic, imagine how much more so governments would be about their national treasures. Moreover, by tightening up registration and regulation of the rating agencies, Mr McCreevy may be moving in the wrong direction. Already they have too much power and influence; they get access to information that ordinary investors and stockmarket analysts do not; they also have a special place in the financial system because their ratings are integral to the regulation of financial firms such as banks, insurers and pension funds. This has created an oligopoly that lulls users of their ratings into a false sense of security and spreads moral hazard: investors tend to rely on the ratings rather than making credit judgments of their own. Yet the privileges come without commensurate responsibility. When rating agencies get things wrong they rely on a defense of free speech, saying that their ratings were merely the expression of an opinion. Tying them even more tightly into the regulatory system is likely only to exacerbate these contradictions by raising barriers to new entrants and making the rating agencies appear even less fallible. Much better would have been less regulation, more competition and a requirement that bond issuers release any information they provide to the rating agencies to the public. Then everyone would have had a chance to get what they all say they want: investors who think for themselves. Hank Paulson's latest response to the financial crisis More rabbits from the hat
Nov 13th 2008

As Hank Paulson buries one attempt to solve the financial crisis, he and regulators unveil two more. ONE of the most humbling features of the financial crisis is its ability to humiliate policymakers who, thinking that they have a bazooka in their closet, soon discover that it is a mere popgun. When Hank Paulson, the treasury secretary, first called for a $700 billion program to buy troubled mortgage assets (the TARP), markets sensed salvation; when Congress first rejected it, panic ensued. The program passed but by then America's mortgage crisis had become a global panic, dragging down banks and infecting all sorts of debt. No one seemed to care that in a few months the Treasury would be relieving banks of the mortgages that had started all the trouble. So on Wednesday November 12th Mr Paulson unceremoniously buried the idea. Instead he will devote the TARP to recapitalizing banks and non-bank financial institutions such as financing arms of America's big car companies(though not, for now, the carmakers

themselves). He also disclosed that the Treasury and the Federal Reserve are exploring the creation of a “liquidity facility” to buy top-rated securities backed by credit-card, car and student loans, and perhaps mortgages. Banks bundle many such loans into asset-backed securities, which they then sell on the capital markets. But that market has all but disappeared. “We are looking at ways to possibly use the TARP to encourage private investors to come back to this troubled market, by providing them access to federal financing while protecting the taxpayers' investment,” Mr Paulson said. But he also gave warning that this would take weeks to design and longer to get running. The same morning, America’s four federal bank regulators issued an unusual warning to banks: lend more or else. The regulators are usually preoccupied with keeping banks sound and warning them not to lend too loosely. No more. They issued an “interagency statement” saying it was “imperative” that banking organizations and regulators make sure that borrowers’ needs are met. Bank supervisors have been told to encourage banks to do so. The guidance carried a veiled threat: supervisors “will take action” if they find a bank is paying dividends that they deem too high for either a bank’s capital or its ability to meet borrowers’ needs. Banks could rightly protest that as long as they are healthy, their dividends are not the regulators’ business, but bank regulation is now simply another weapon in the government’s arsenal against the credit crunch. Mr Paulson has come under fire for not having sought to use public money to resolve the crisis sooner, and failing to recapitalize financial institutions at the outset, as many Democrats and independent economists urged. He responded on Wednesday by saying that he would not apologize for “changing an approach or a strategy when the facts change.” The former investment banker has not been indolent: his department has been a factory for acronyms since the crisis began. But most of those initiatives have either failed to get off the drawing board, such as the MLEC, which was aimed at relieving banks of their off-balance-sheet liabilities, or they have fallen short, such as the HOPE NOW Alliance for modifying mortgages. Critics say that Mr Paulson, because of ideology, has been slow to agree to commit public funds and to push government intervention. There is something to that, but it is not the full story. Mr Paulson is a dealmaker and, foremost, a pragmatist. He held back in deference to what he thinks the industry and Congress can stomach. He did not initially ask for public funds to buy mortgage assets out of fear that Congress would say no, shaking confidence. And he originally did not seek to invest equity in part thinking that banks would refuse the money for fear of looking weak. For the same reason, when he did agree at last to equity investments, he attached few conditions. With barely two months before Barack Obama becomes president, the actions of Mr Paulson and the Fed show some sign of easing the financial crisis. Libor, the rate charged on dollar loans between banks, has fallen sharply. But the financial crisis has spawned an economic crisis and an entirely new set of demands. The car companies are not “first-round” victims of the credit crunch the way Lehman Brothers and AIG were. They are second-round victims: the credit crunch has left millions of potential customers unable to finance car purchases, crushing sales for an already weakened industry. General Motors is now at risk of running out of cash within months. Mr Paulson yesterday said that the TARP should not be used for non-financial companies and Democrats in Congress should instead look to the recently enacted $25 billion loan program for the companies to invest in greener vehicles. His hesitation is understandable; unlike the banks, the car companies were not healthy before the recession hit, are less able to pay the federal government back its money and are less likely to cause contagion if they fail. “Any solution has got to be leading to long-term viability,” he said. One idea making the rounds is for the companies to file for bankruptcy protection and the federal government to provide them with “debtor in possession” financing to keep operating while they restructure themselves into smaller, leaner companies. But the companies are opposed to a bankruptcy filing, and with their time running out

and both Congress and Mr Obama sympathetic to their pleas, Mr Paulson may yet again have to recognize that the facts have changed. U.S. Treasury shifts focus of credit bailout
November 13, 2008

The Treasury Department on Wednesday officially abandoned the original strategy behind its $700 billion effort to rescue the U.S. financial system, as administration officials acknowledged that banks and financial institutions were as unwilling as ever to lend to consumers. But with a little more than two months left before President George W. Bush leaves office, Treasury Secretary Henry Paulson Jr. is hoping to put in place a major new lending program that would be run by the Federal Reserve and aimed at unlocking the frozen consumer credit market. The program, still in the planning stages, would for the first time use bailout funds specifically to help consumers instead of banks, savings and loans and Wall Street firms. (FINALLY—THEY ARE RECOGNIZING THE CORE OF THE PROBLEM!) Treasury officials said they hoped to invest about $50 billion from the bailout fund into the new loan facility, with the aim of helping companies that issue credit cards, make student loans and finance car purchases. As envisioned, the Treasury would put up about 5 percent of the money that a company would use for lending and private investors would put up perhaps 20 times that much by buying bonds issued by the new program. The news that the government will not buy soured mortgage assets, along with a string of poor corporate earnings, disheartened investors in the United States on Wednesday and in Asia on Thursday, sending U.S. markets down for a third straight day this week. The Dow Jones industrial average fell 411.30 points, or 4.7 percent, to close at 8,282.66. In Asia, the Japanese Nikkei 225 share average was down 5.2 percent and the Hang Seng index in Hong Kong dropped 6.6 percent Despite the mind-boggling amount of money that Congress has authorized the Treasury to spend $350 billion immediately, and another $350 billion that Congress would approve under a fast-track procedure — Paulson is running short of money and time. The Treasury has already committed about $290 billion. It has allocated $125 billion to the nine biggest American banks and investment banks; another $125 billion for publicly traded regional banks; and $40 billion to expand the existing bailout of American International Group, the insurance conglomerate that collapsed in September. Paulson alluded to the consumer credit plan vaguely in a news conference on Wednesday, and some Fed officials cautioned that they had seen few details. But Treasury officials said such a plan would give them the biggest bang for the buck and might be enacted within several weeks. Paulson conceded that he had scrapped the plan he originally sold to Congress in September, which was to have the Treasury Department buy hundreds of billions of dollars worth of illiquid mortgage-backed securities in order to free up banks to resume normal lending. (ALRIGHT!!) The program is still called the Troubled Asset Relief Program, or TARP, but it will not buy troubled assets. "Our assessment at this time is that this is not the most effective way to use TARP funds," Paulson said. Instead, Treasury will step up its program of injecting capital directly into banks and, for the first time, expand it to include financial companies that are not federally regulated banks or thrifts. Paulson made it clear he would not use Treasury money to help bail out the automobile industry, rebuffing pleas from General Motors, Ford and Chrysler as well as from top House and Senate Democrats.

But Paulson left open the prospect of providing backdoor support to the car companies by offering to recapitalize nonbank financial companies like GE Capital and CIT Financial, and the financing subsidiaries of Ford, Chrysler and GM House Democrats are already drafting legislation that would provide Detroit's Big Three with an additional $25 billion, on top of $25 billion in low-interest loans that are supposed to be used for retooling factories for energyefficient cars. "The consequences of a collapse of the American automobile industry would be particularly troublesome," said Barney Frank, Democrat of Massachusetts and chairman of the House Financial Services Committee. Frank said the assistance would come with strict conditions aimed at protecting taxpayers. Some Republican lawmakers have already objected, saying the effort would amount to throwing good money after bad. But the White House on Wednesday left the door open to a legislative compromise with Congress. "I know the automakers are important to the United States," Paulson said. "We care about the automobile industry." But he cautioned that "my focus is on the financial sector — getting credit going, getting lending going." White House and Treasury officials have been devising policy on the fly for months now, as what began as a panic over losses on subprime mortgages broadened into a crisis that wreaked havoc on Wall Street, at major commercial banks and in the broader economy itself. In September, Paulson went to Congress and urgently pressed for the authority to spend as much as $700 billion to unclog the nation's financial pipelines by buying up unsellable securities from banks and other financial institutions. But by the time Congress approved the bailout law in early October, Paulson and the chairman of the Federal Reserve, Ben Bernanke, were already shifting to a strategy he had actually opposed: buying equity stakes in American banks, a move that was reminiscent of European-style nationalization. As recently as a few days ago, Treasury officials insisted that they still intended to buy up the troubled assets. But by late October, it had become clear that Plan A had become little more than a sideshow. "Illiquid assets looked like the way to go," Paulson told reporters at a news conference on Wednesday. But as economic and financial conditions declined so rapidly, he said, that he had to change gears. "I will never apologize for changing the approach and the strategy when the facts change," he said. The change in strategy has had only limited impact on the frozen credit markets. The biggest improvement has been in the willingness of banks to lend to each other, a change that largely caused by the willingness of both the United States and European governments to guarantee bank deposits and interbank loans. But the market for commercial debt backed by consumer and business loans has remained at a near standstill since Lehman Brothers collapsed in September. Borrowing costs for credit card issuers are at least five percentage points higher than they were before the credit crisis began. Financing costs for automobile lenders are even higher. Even student loans that are guaranteed by the government have been difficult to finance. "You have a market that is frozen," said Alex Roever, an analyst at JPMorgan Chase. To stretch his resources, Paulson told reporters he was examining ideas to have private investors contribute capital alongside Treasury. Paulson also made it clear he did not want to use bailout money to refinance the mortgages of homeowners who are in danger of losing their homes to foreclosure. Democratic lawmakers and the chairman of the Federal Deposit Insurance Corporation, Sheila Bair, have been calling for the Treasury to spend $40 billion in a broad

mortgage-refinancing program. As envisioned by Treasury officials, the Federal Reserve would set up a special-purpose lending entity, which would lend cash to investors or companies that put up collateral in the form of consumer loans. The Fed might lend up to 80 percent of the value of those loans, providing a cushion for taxpayers against losses. The Treasury would contribute 5 percent to 10 percent of the money to finance the lending. But the Fed would raise most of the money by selling what is known as non-recourse commercial paper to investors. Treasury officials said the plan would allow them to leverage the government's money by as much as 20 to 1, meaning that the Treasury would provide 5 percent of the money and investors would provide 95 percent. Using $50 billion from the government rescue program, they said, could thus underwrite $1 trillion worth of lending for consumer loans. Such an arrangement would bear a similarity to exactly the highly leveraged, and eventually disastrous, specialinvestment vehicles that banks like Citigroup created to hold, among other things, securities backed by subprime mortgages. Although the Treasury would contribute only a small share of the money for such a program, analysts said the plan would only overcome investor fears if the Treasury or the Federal Reserve provided some kind of backstop against losses. If that were to be the case, taxpayers would be indirectly liable for the entire volume of lending. Fed officials appeared to be taken aback by Paulson's public reference to the idea, and cautioned that it was still in early development. "Both the structure and the parameters are under discussion and development," said Michele Smith, a spokeswoman for the Fed. Negative outlook-Credit-rating agencies Europe misfires in its attack on the rating agencies
Nov 13th 2008 From The Economist print edition

IN AN age of e-mail every industry is likely to have a Henry Blodget moment. The one for rating agencies came in mid-October, when a rash of embarrassing correspondence emerged. Among them was the following exchange between two analysts: “That deal is ridiculous. We should not be rating it.” Back came his colleague’s answer: “We rate every deal…it could be structured by cows and we would rate it.” The conversation was more than mortifying. It cut to a central conflict bedeviling the industry: although ratings are relied on by investors and regulators as impartial measures, the rating agencies are paid by those they rate for their judgments. With their marks of approval stamped all over the most toxic assets poisoning the financial system, they were quickly blamed for helping cause the credit crunch. Some of that criticism has ebbed, but among those still carrying a cudgel is Charlie McCreevy, the European internal-market commissioner. On November 12th he released a draft law to regulate them and end what he acidly called their “charmed existence”. Some of Mr McCreevy’s rules on minimizing conflicts of interest are sensible. But some are wide of the mark. Regulators in each European country will be given the power to meddle with ratings that they do not like—the downgrade of an important bank or flag-carrying airline, for instance. If rating agencies can be too optimistic, imagine how much more so governments would be about their national treasures. Moreover, by tightening up registration and regulation of the rating agencies, Mr McCreevy may be moving in the wrong direction. Already they have too much power and influence; they get access to information that ordinary investors and stockmarket analysts do not; they also have a special place in the financial system because their

ratings are integral to the regulation of financial firms such as banks, insurers and pension funds. This has created an oligopoly that lulls users of their ratings into a false sense of security and spreads moral hazard: investors tend to rely on the ratings rather than making credit judgments of their own. Yet the privileges come without commensurate responsibility. When rating agencies get things wrong they rely on a defense of free speech, saying that their ratings were merely the expression of an opinion. Tying them even more tightly into the regulatory system is likely only to exacerbate these contradictions by raising barriers to new entrants and making the rating agencies appear even less fallible. Much better would have been less regulation, more competition and a requirement that bond issuers release any information they provide to the rating agencies to the public. Then everyone would have had a chance to get what they all say they want: investors who think for themselves. _________________ AT LAST—AN APPROACH WORTH PURSUEING—THEY SHOULD APPLY THIS FORMULA TO OPPRESSVIE STUDENT LOAN PROGRAMS AS WELL! FDIC Loss Sharing Proposal to Promote Affordable Loan Modifications
November 13, 2008

Background Although foreclosures are costly to lenders, borrowers and communities, the pace of loan modifications continues to be extremely slow (around 4 percent of seriously delinquent loans each month). It is imperative to provide incentives to achieve a sufficient scale in loan modifications to stem the reductions in housing prices and rising foreclosures. Modifications should be provided using a systematic and sustainable process. The FDIC has initiated a systematic loan modification program at IndyMac Federal Bank to reduce first lien mortgage payments to as low as 31% of monthly income. Modifications are based on interest rate reductions, extension of term, and principal forbearance. A loss share guarantee on redefaults of modified mortgages can provide the necessary incentive to modify mortgages on a sufficient scale, while leveraging available government funds to affect more mortgages than outright purchases or specific incentives for every modification. The FDIC would be prepared to serve as contractor for Treasury and already has extensive experience in the IndyMac modification process. Basic Structure and Scope of Proposal This proposal is designed to promote wider adoption of such a systematic loan modification program: 1. By paying servicers $1,000 to cover expenses for each loan modified according to the required standards; and 2. Sharing up to 50% of losses incurred if a modified loan should subsequently re-default We envision that the program can be applied to the estimated 1.4 million non-GSE mortgage loans that were 60 days or more past due as of June 2008, plus an additional 3 million non-GSE loans that are projected to become delinquent by year-end 2009. Of this total of approximately 4.4 million problem loans, we expect that about half can be modified, resulting in some 2.2 million loan modifications under the plan. Details on Program Design Eligible Borrowers: The program will be limited to loans secured by owner-occupied properties. Exclusion for Early Payment Default: To promote sustainable mortgages, government loss sharing would be available only after the borrower has made six payments on the modified mortgage.

Standard NPV Test: In order to promote consistency and simplicity in implementation and audit, a standard test comparing the expected net present value (NPV) of modifying past due loans compared to the strategy of foreclosing on them will be applied. Under this NPV test, standard assumptions (details to follow soon) will be used to ensure that a consistent standard for affordability is provided. Systematic Loan Review by Participating Servicers: Participating servicers would be required to undertake a systematic review of all of the loans under their management, to subject each loan to a standard NPV test to determine whether it is a suitable candidate for modification, and to modify all loans that pass this test. The penalty for failing to undertake such a systematic review and to carry out modifications where they are justified would be disqualification from further participation in the program until such a systematic program was introduced. Reduced Loss Share Percentage for "Underwater Loans": For LTVs above 100%, the government loss share will be progressively reduced from 50% to 20% as the current LTV rises. If the LTV for the first lien exceeds 150%, no loss sharing would be provided. Simplified Loss Share Calculation: In order to ensure the administrative efficiency of this program, the calculation of loss share basis would be as simple as possible. In general terms, the calculation would be based on the difference between the net present value of the modified loan and the amount of recoveries obtained in a disposition by refinancing, short sale or REO sale, net of disposal costs as estimated according to industry standards. Interim modifications would be allowed. De minimis Test: To lower administrative costs, a de minimis test excludes from loss sharing any modification that did not lower the monthly payment at least 10 percent. Eight-year Limit on Loss Sharing Payments: The loss-sharing guarantee ends eight years of the modification. Impact of the Program: The table below outlines some of the basic assumptions behind the scale of the plan and its expected costs. To summarize, we expect that about half of the projected 4.4 million problem loans between now and year-end 2009 can be modified. Assuming a redefault rate of 33 percent, this plan could reduce the number of foreclosures during this period by some 1.5 million at a projected program cost of $24.4 billion.

FDIC Details Plan To Alter Mortgages Treasury Opposes Using Bailout Funds For