The Insolvency of Lehman and the Artifice of the Deal

"It is the aim of good government to stimulate production, of bad government to encourage consumption." - Jean Baptiste Say

Here is an english translation of a story about the KDB - Lehman discussions from a Korean news agency. It provides some fascinating insights into the deal. And a follow up story that shows that the deal is not dead, but downsized.

Here is a Korea, anxious to make its mark on the global financial stage after it rebounded from the Asian currency crisis of the 1990's. The former Lehman regional manager of the Seoul office is now chairman of the KDB and is anxious to buy it for the home team. At the end of the day, the Korean government nixes the deal after they get a closer look at the books and realize that KDB is probably going to get saddled with far more debt default expense than they realized.

A senior [Korean] government official said, "After a review of its account book, we found that its [Lehman's] insolvency was serious. Then if insolvency becomes more serious, we would have to pour additional funds. But we concluded that it was too risky for the KDB to take the deal."

The fellow at KDB was no doubt disappointed that the Korean government simply said 'no' to the deal, with the best interests of their people in mind.

The Korean bankers might start working on the strategy of regulatory capture, the co-option and corruption of the legislative and regulatory functions by the industry that they oversee, in order to fully enter into the spirit of the global financial industry.

In the meantime scaling the deal down to a more 'manageable amount' is de rigeur in deal-making circles. And so the saga continues, as shown in the second story down about renewed discussions between KDB and Lehman for a presumably smaller $6 Billion investment, without it appears informing the Dr. No's in the Korean government.

KDB 'Gives Up' on Buying Lehman
Aug.22,2008 06:44 KST
The Chosun Ilbo

Negotiations for Korea Development Bank to buy a stake in Lehman Brothers, the fourth largest U.S. investment bank, have collapsed. Rumors about the impending bankruptcy of the investment bank have been circulating on Wall Street in the wake of the U.S. subprime mortgage meltdown.

KDB and Lehman executives reportedly held secret negotiations until early August but hit a snag at the last stage. KDB has now given up on buying a stake in Lehman, but there is still the chance that a civilian Korean bank will take it over.

The president of one Korean bank said it was “marvelous” that Korean firms have even negotiated to buy America's fourth largest investment bank. “This is a sea change, compared with the financial crisis 10 years ago when we begged the U.S. for help,” he added.

Lehman Brothers began trying to sound out Korean firms in June. A few Lehman executives informally visited the Korea Investment Corporation, which had earlier invested $2 billion in Merrill Lynch. After feasibility studies and a review of investment opportunities, KIC judged that the American bank was not an attractive investment target.

But Lehman approached KDB about the time KIC said no to its offer. KDB chairman Min Euoo-sung, who had been chief of Lehman's Seoul branch for three years until right before he became KDB chief in June, pushed for the takeover deal. KDB continued negotiations with a plan to take over Lehman in cooperation with several other Korean banks.

A bank executive who participated in the negotiations, said, "We believed that if we buy a world-renowned financial firm for W7-8 trillion (US$1=W1,055), it will provide important momentum for Korea's financial industry to go global.”

The two sides had reportedly agreed that even after the takeover deal, the current American management system would be maintained.

According to international news reports, the takeover price proposed in the negotiations was 50 percent higher than Lehman's book value, and talks failed because KDB felt it was too high. (In fact this was probably not the case except on the most generous of descriptions, and the fact that on one level deals are always about price.' - Jesse)

A senior government official said, "After a review of its account book, we found that its insolvency was serious. Then if insolvency becomes more serious, we would have to pour additional funds. But we concluded that it was too risky for the KDB to take the deal."

KDB kept mum on details of negotiations on grounds that talks are not completely finished and it is also considering investing in two to three other American financial firms.

Min said it was “normal that several negotiations and ruptures occur before a takeover deal is successfully completed. In the current circumstances, we can't put all our cards on the table."

South Korea watchdog not told of Lehman talks-source
1 Sep, 2008, 0830 hrs IST,
The Economic Times

SEOUL: (Reuters) South Korea's financial watchdog has not been officially informed of renewed talks between Lehman Brothers and Korea Development Bank and has no plans to take any position before pricing is known, a senior regulator source said on Monday.

The comment came after Britain's Sunday Telegraph newspaper reported that Lehman was trying to raise as much as $6 billion in a share sale to KDB that could be concluded this week.

"We haven't received any official report about the deal's specifics, including the price," said the source, who declined to be identified.

The Unbearable Lightness of Being an Investment Bank

The substance of even the largest financial constructs and empires remains exceptionally ephemeral.

"Ubi sunt qui ante nos fuerunt?"

Merrill losses wipe away longtime profits
By Francesco Guerrera in New York
August 28 2008 23:32
The Financial Times

Merrill Lynch’s losses in the past 18 months amount to about a quarter of the profits it has made in its 36 years as a listed company, according to Financial Times research that highlights the extent of the global banking crisis.

Since the onset of the credit crunch last year, Merrill has suffered after-tax losses of more than $14bn as its balance sheet has been savaged by almost $52bn in writedowns and credit-related losses.

The $14bn in losses for 2007 and the first two quarters of 2008 equal half of Merrill’s profits since the beginning of the ­decade.

Merrill had the highest ratio of credit crunch losses to historical profits among 10 US and European financial groups analysed by the FT, which included Citigroup, JPMorgan Chase, Bank of America, Morgan Stanley, Goldman Sachs, Lehman Brothers, Bank of America, Credit Suisse and UBS.

UBS, which has lost more than $15bn during the crisis, had the second-highest ratio.

UBS and Merrill – a Wall Street pioneer that revolutionised finance with its “thundering herd” of retail brokers – declined to comment.

Since taking over from Stan O’Neal in November, John Thain, Merrill’s chief executive, has sought to shed toxic assets and replenish its balance sheet by raising almost $30bn of capital.

The size of the losses at Merrill and other Wall Street firms underlines the risks of an investment banking model that relied on complex securities and cheap leverage to drive profit growth. (This sounds like a general description of the US industrial policy since Reagan - Jesse)

Analysts have questioned whether standalone investment banks such as Merrill, Lehman, Morgan Stanley and Goldman will ever top the profit levels reached during the boom in securitisation, leveraged loans and mortgage-backed products.

“The mammoth writedowns suffered by investment banks across the globe show that their business model needs to change,” said Robert Gach, head of the global capital markets practice at Accenture, the consultancy.

Merrill’s historical profits were adjusted for inflation by using a methodology from www.measuringworth.com, an academic website.

The Oil Complex Buttons Down while the NYMEX Opens Early

Most U.S. Gulf oil output shut as Gustav threatens
Sun Aug 31, 2008 9:55am EDT
Reuters

U.S. crude oil fell from a record high $147.27 a barrel in July to close at $115.46 on Friday.

The New York Mercantile Exchange on Saturday moved up Sunday's start time for electronic trading of energy contracts to 2:30 p.m. EDT from 6 p.m. EDT. (To facilitate the evacuation of the oil shorts? Or to enable the spin that its no big deal and the Strategic Petroleum Reserve will provide emergency aid? Stay tuned. - Jesse)

Katrina and Hurricane Rita that followed on its heels destroyed 124 offshore platforms, temporarily shuttered about 30 percent of U.S. refining capacity and left nearly a quarter of offshore Gulf oil production shut up to nine months later.

The Gulf provides a quarter of U.S. oil output and 15 percent of natural gas production.

Shell, the region's largest producer at 370,000 barrels of oil equivalent per day, was shutting all offshore oil and natural gas production on Saturday.

BP said it was also shutting its Gulf production on Saturday, while Exxon Mobil Corp said 5,000 barrels of oil output and 50 million cubic feet per day in natural gas production was shut by Saturday morning.

PRODUCTION CUTS

Six Louisiana refineries that process 1,305,000 barrels per day of crude oil -- 7.4 percent of U.S. refining capacity -- were closing down for the storm, while a total of 12.4 percent of U.S. refining capacity had been affected in someway.

Mississippi River traffic south of New Orleans closed at 6 p.m. CDT. Ship channels into Lake Charles in west Louisiana and Beaumont and Port Arthur in east Texas planned to shut by Sunday night, cutting off crude oil shipments to refineries.

The Louisiana Offshore Oil Port, the only U.S. deepwater port capable of offloading giant oil tankers, stopped taking crude from ships on Saturday, a spokeswoman said, but continued to supply refiners from onshore crude oil tanks.

Gustav Intensifies to Category 4 Hurricane, May Turn More Deadly

FEMA says Gustav soon to be rated Category 5 storm
Aug 30 03:34 PM US/Eastern
By JENNIFER LOVEN
Associated Press Writer

WASHINGTON (AP) - The government's disaster relief chief says Hurricane Gustav is growing into a monster Category 5 storm. The storm that hit Cuba Saturday could reach landfall along the Gulf Coast by early Tuesday.

Federal Emergency Management Agency chief David Paulison told reporters several times at a briefing Saturday that the storm was strengthening into a Category 5 hurricane.

FEMA officials said Bill Read, the director of the National Hurricane Center, interrupted an afternoon teleconference involving the agency, Gulf Coast states and the National Weather Service to say he is going to issue a special advisory statement raising Gustav to Category 5. That means winds greater than 155 mph and a storm surge greater than 18 feet above normal.

Word about the Category 5 development reached FEMA shortly before Paulison briefed reporters.

THIS IS A BREAKING NEWS UPDATE.

Courtesy of Joe Bastardi, chief hurricane forecaster for AccuWeather – www.AccuWeather.com – here is the map every investor needs to keep at his or her fingertips. It shows the hurricane path that Bastardi says would cause the greatest damage to offshore and onshore energy facilities in the U.S. Gulf of Mexico. In an interview with EnergyTechStocks.com, Bastardi called it the path of the “Ultimate Storm.”

Energy experts say the ultimate storm would send spot oil and gas prices up sharply and keep them there for an extended period unless, by some miracle, the damage inflicted was only minor. (It would probably be several days before oil company personnel could conduct a full assessment.)

GDP Second Quarter Was More Likely Negative, Perhaps Remarkably So

This excerpt is from this week's Up and Down Wall Street commentary by Alan Abelson in Barron's. It echoes what we said in this blog immediately after the GDP revision for the second quarter came out.

We subscribe to Barron's and read it every week. We recommend it as a good weekly source of market news and commentary.

People do not like to accept that the government is misleading us with the economic numbers. It shakes their faith in their leaders and the system, and it creates the problem of having to think for themselves.

However, there are times when the case is so clear you just have to say what David Rosenberg of Merrill Lynch says at the end of Alan Abelson's column.

GDP, IN COMMON PARLANCE, stands for gross domestic product, or the aggregate value of all the goods and services produced on these blessed shores. Or, at least, that's what it used to mean in those long-gone days of yore, when life was simpler and government statistics credible. These days, alas, those initials more typically signify "gross deceptive pap."

The insidious change has not gone unremarked, both in this magazine and by more than one skeptical scanner of the turgid flow of numbers flowing out of Washington. Yet purportedly professional seers, who draw handsome paychecks for sifting through the unending streams of digits and making sense of them for hoi polloi like us, deferentially pass along the official numbers unsullied by even a modicum of analysis, as if they were holy writ, especially when they're upbeat.

A case very much in point was last Thursday's revised report on second-quarter GDP, which helped spark a nice, if something less than enduring, leap forward by the stock market. The initial version released in July posited that the venerable economic barometer had risen by 1.9% -- up from the first quarter's meager 0.9% gain, but obviously no great shakes.

Comes now the so-called preliminary estimate that claims second-quarter GDP grew by a much more robust 3.3%. That was hailed by the incorrigibly constructive contingent in the Street as evidence of the resiliency (favorite word) of the economy and prompted the thinned-out ranks of investors to put their worries and their plans for an extra-long weekend on hold and pile into stocks. Hooray! Hooray!

But even a cursory look at what they're drooling over reveals pretty thin gruel. Nothing, for sure, that would cause any sentient being to start humming "Happy Days Are Here Again." For the ostensibly better GDP showing is a mirage, conjured up by the usual suspects out of smoke and mirrors.

The key here is the GDP deflator, which purports to adjust GDP for the impact of inflation; it's a curious calculation in that, contrary to its moniker, it seems designed to do the exact opposite of deflating GDP.

Thus, according to this accommodating measure (accommodating, that is, if you're determined to put a good face on a dreary report), inflation grew at an improbably restrained 1.33% in April-June. And maybe it did -- but not in the good old U.S. of A. However, obviously more important than accuracy to those doing the calculating is this simple equation: The lower the deflator, the greater the growth of GDP.

John Williams of Shadow Government Statistics, whose incisive description of the decades of willful distortion of inflation by Washington we cited a few weeks ago, points out that the supposed 1.33% increase in the second quarter would represent the lowest inflation rate in five years. Must be that plain folks stubbornly refuse to recognize the dramatic drop in inflation, because, as Phil Gramm said, we're such a bunch of whiners.

Of course, even by the government's not entirely extravagant figuring, the consumer-price index was up a hefty 8% in the latest quarter. Perhaps the computer that tallies the CPI doesn't talk to the computer that measures the deflator.

By John's reckoning, "a second-quarter year-to-year contraction of 2.9% would have been more in line with underlying fundamentals, past methodologies and the ongoing recession."

He suggests that a more telling picture of the economy's progress or lack of it is the alternative to GDP, known as gross domestic income, or GDI. It's a rough equivalent of GDP but measures the nation's income instead of production.

According to John, after adjusting for inflation, GDI in the June quarter weighed in at an anemic 0.5%, atop negative growth in the preceding two quarters -- which, as it happens, meets the popular definition of a recession.

Friday's disclosure that personal income in July suffered its biggest decline in three years doesn't exactly portend a rebound in the third quarter, and certainly didn't come as a big surprise to John, who sees the outlook for the economy remaining glum, with no early end to the banks' solvency crisis, as he terms it, nor the inflationary recession.

THE ASTUTE ECONOMY-WATCHER for Merrill Lynch, David Rosenberg, also strongly advises digesting the suspect GDP report with a "very large grain of salt." Among other things, he casts a skeptical eye on how the report treats the decline in corporate profits. (We won't keep you in suspense: The answer is: "gingerly.")

More specifically, he notes, "national-account corporate profits declined at a 9.2% rate in the second quarter." For domestic industries, he goes on, profits are down 14.4% year over year.

But according to the GDP report, domestic nonfinancial profits fell at a much sharper 22% annual rate. The reason the drop in total corporate earnings was limited to 9.2% was that, David relates, profits in the financial sector, so claims the report, surged -- get this -- at a 27% annual rate.

His wonderfully eloquent comment:

"Are you kidding me?"

Charts in the Babson Style for the Week Ending 29 August 2008

US Dollar Weekly Charts

Bank Consolidation in Germany

Expect to see this continue as the credit crises continues to batter the financial industry. The actions of the Fed and Treasury have slowed the process a bit in the US by providing individual bailout services especially for the investment banks.

The 'wild card' will be the regional banks, and the potential loss of diversity and competition in the financial services sector.

Fewer corporations are holding more of the power in the media, communications and finance. We are probably nearing the end of this long term move of centralization.


Commerzbank set to buy Allianz's Dresdner
29 Aug, 2008, 1431 hrs IST
The Economic Times

FRANKFURT (Reuters) Allianz has agreed in principle to sell its Dresdner Bank unit to Commerzbank, a source familiar with the situation said on Friday, a deal that will fuse Germany's second- and third-biggest banks.

Commerzbank plans to take an initial 51 percent stake in Dresdner, then buy the remaining 49 per cent at a later stage, the source said.

Commerzbank had no comment. Allianz was not immediately available.

Lower Prices Send Sales of Physical Gold 'Skyrocketing' in India

Although it is tempting to view charts as abstractions with their own sets of rules, we need to remind ourselves occasionally that they are merely representations of the interactions of price with supply and demand in real markets as part of the price discovery process.

The lower price of gold in New York and London has caused sales of physical bullion to 'skyrocket' in India, a significant market.

These sales will tend to underpin the futures markets as more dealers take delivery. And so the physical market will react and possibly provide some discipline to the metal bears of Wall Street.

And this is why any attempt by Central Banks to permanently suppress the price of gold are doomed to eventual failure as long as markets remain open and buyers are allowed to take physical delivery.


Gold Makes Glittering Comeback
29 Aug, 2008, 0606 hrs IST,
Amrita Nair-Ghaswalla
Times of India

MUMBAI: Gold is enjoying a modern-day renaissance in the country. From retail sales of 300-400 kgs of gold bar per day at the start of 2008, demand has surged to 3,000 to 4,000 kgs per day. Barring the slight rise in price at the start of this week, most counters registered an unprecedented sale.

Gold's dip below Rs 12,000 per 10 grams early this month has sparked off widespread buying. From a high of Rs 13,900 for 10 grams around a month and half ago, the price of the yellow metal slipped to Rs 11,850 on Wednesday, ensuring droves of customers.

The demand for the metal has skyrocketed to such an extent that imports for the month of August alone are set to cross 100 tonne. Last August, the country imported 69 tonne of gold.

'' Ten days ago, the price was Rs 11,300 and retail outlets recorded consumer demand many times higher than that witnessed during 'Dhanteras' , the first day of Diwali, or 'Akshaya Tritiya' , when buying gold is considered auspicious,'' said Suresh Hundia of the Bombay Bullion Association.

India, the world's biggest buyer of bullion, is also set to increase its gold imports for the first time in nearly 12 months, analysts told TOI. Given that the first half of 2008 saw volatile gold prices driving down demand, the last few weeks have witnessed a sudden rush of imports....

World's Largest Refiner Runs Out of Krugerrands
By Claudia Carpenter
Bloomberg

Aug. 28 (Bloomberg) -- Rand Refinery Ltd., the world's largest gold refinery, ran out of South African Krugerrands after an ``unusually large'' order from a buyer in Switzerland.

The order was for 5,000 ounces and it will take until Sept. 3 for inventories to be replenished, said Johan Botha, a spokesman for Rand Refinery in Germiston, east of Johannesburg. He declined to identify the buyer.

Coins and bars of precious metals are attracting investors as a haven against a sliding dollar and conflict between Russia and its neighbor Georgia. The U.S. Mint suspended sales of one- ounce ``American Eagle'' gold coins, Johnson Matthey Plc stopped taking orders for 100-ounce silver bars at its Salt Lake City refinery and Heraeus Holding GmbH has a delivery waiting list of as long as two weeks for orders of gold bars in Europe...

Broad Money Supply Growth in the US Remains Robust and Inflationary

Considering the slowing GDP, the growth of the broad money supply figures, MZM and M2, remains exceptionally strong. We would expect the growth of the broad money supply to be a little closer to a steady growth in GDP. From the charts it appears obvious that the Fed stimulates money supply when the economy slows.

The money supply growth has been achieved in spite of the declining growth of commercial bank credit thanks in large part to the Fed, the Treasury and several of the foreign Central Banks. Money supply expands from many sources other than commercial bank lending.

G7 Plans to Support the US Dollar In Case of a Major Financial Failure

Report of US currency rescue plan
By Krishna Guha in Washington
August 28 2008 03:00
Financial Times

The US, Europe and Japan discussed the possibility of co-ordinated currency intervention to support the dollar during the Bear Stearns crisis in March, according to Japan's Nikkei online.

The US Treasury declined to comment on the report, which claimed the G7 had considered issuing an emergency communiqué during the weekend of March 15-16.

The Financial Times was unable independently to verify the Nikkei report. A G7 official said he understood there were some preparations for possible currency intervention during that period, but did not comment on any international talks.

As reported earlier in the FT, US and European policymakers have been concerned at various stages of the credit crisis about the possibility that, in an environment of persistent dollar weakness, a crisis at an individual financial institution could trigger a disorderly plunge in the US currency.

Such a disorderly decline would aggravate existing stress in other financial markets and could lead to foreign investors demanding a currency risk premium on all dollar assets, pushing up long-term US interest rates.

It would also increase the stain on economies such as the eurozone that have floating exchange rates, pushing up their own currencies to unsustainable levels.

This concern was acute at the time of the Bear Stearns crisis. G7 policymakers were in contact then and discussed potential spillovers in international markets.

However, in the event there was no emergency G7 statement. The G7 waited until their scheduled meeting on April 11 when they expressed concern about "sharp fluctuations in major currencies" and "their possible implications for economic and financial stability". They added: "We continue to monitor exchange markets closely, and co-operate as appropriate."

This statement marked a shift in international currency policy. Hank Paulson, US Treasury secretary, remained generally sceptical about currency intervention, but was careful not to rule it out in all circumstances.

Prior to March, US and European officials were at odds over currencies, with eurozone officials concerned about the decline of the dollar against the euro, but US officials broadly welcoming this as a prop to growth.

However, following the April 11 G7 meeting, US and European officials told the FT they were united in their support for a stronger dollar. Ben Bernanke, Federal Reserve chairman, joined Mr Paulson in talking in public about the US currency.

Policymakers believe a crisis at a financial institution is less likely to trigger a run on the dollar in an environment of general dollar strength. A stronger dollar also helps to curb oil and inflation, and support confidence in US assets.

Without another Bear Stearns-style crisis, currency intervention is unlikely, but if a similar crisis were to occur again and the dollar were to weaken precipitously, co-ordinated intervention is possible.

You Can Believe the GDP Revision for the Second Quarter...

You can believe today's GDP revision upwards to 3.3% growth for the second quarter to the extent that you accept that inflation is running at an annual rate of 1.2%, which is what was used for the deflator to calculate the GDP revision.

There is a profound mathematical relationship between higher GDP and the assumption of a lower rate of inflation.

In addition to the GDP figures, there are GDP deflators, which measure the change in prices in total GDP and for each component. Though the consumer price index is a more closely watched inflation indicator, the GDP deflator is another key inflation measure. Unlike CPI, it has the advantage of not being a fixed basket of goods and services, so that changes in consumption patterns or the introduction of new goods and services will be reflected in the deflator.

In short, the government economists have a SIGNIFICANT amount of latitude to make the GDP deflator appear to be what they wish it to be, and thereby to make real GDP growth achieve whatever growth objectives that they feel people will need to see to believe that the government is doing a good job, and that all is well.

And oh by the way...

Bank of England Sees Significant Downside Risk in the Credit Crisis

There are parallels between what we are experiencing now and what occurred in the 1930's and the 1970's as referenced in the attached. One must hope for the best but prepare for the likely eventualities, noting both the similaries and the differences. Stagflation appears to be the most likely outcome for now.

It would be in character for the Banks to offer us a solution that they think we cannot refuse. Recall that it was a credit crisis, the Panic of 1907 that ushered in the Big Fix, the Federal Reserve, in 1913.


Slowdown echoes Great Depression, says Bank's deputy chief
26 August 2008
By Gerri Peev
The Scotsman

THE severity of the current economic downturn has been likened to the Great Depression of the 1930s by the new deputy governor of the Bank of England.

The slowdown, which has threatened to plunge the world's major economies into recession, was likely to drag on for "some time", according to Charles Bean, Britain's second most senior banker.

And he raised the spectre cited by other economists that the combination of market upheavals and soaring oil prices could trigger conditions similar to the depression that started in the late 1920s and dragged on for a decade.

His warning came amid reports that the International Monetary Fund (IMF) has scaled back forecasts for global growth made just a month ago.

The IMF is predicting world growth of 3.9 per cent in 2008, compared to the 4.1 per cent estimated in its July World Economic Outlook. It also forecasts growth next year of 3.7 per cent instead of 3.9 per cent.

"It's fair to say that if you look at the shocks impinging on us this is at least as challenging a time as back in the 1970s," Mr Bean said at the annual conference of the world's top central bankers in Jackson Hole, Wyoming.

"Some people have said it's as big a financial shock as the Great Depression and as far as the oil shock goes the rise in oil prices is in the same order of magnitude that we had to deal with in the 1970s."

"Last year this was a financial crisis that we thought with a bit of luck would be over by the time of Christmas, but it has dragged on for a year and looks like it will drag on for some considerable time further yet," he said.

He and his colleagues are facing the biggest financial challenge of the last 40 years, with the threat of a slowing market and rampant inflation conspiring against the Bank to immediately cut interest rates.

Inflation is running at 4.4 per cent – more than double official targets – and is set to peak above 5 per cent driven by surging food, fuel and energy costs.

Even when the markets looked like they were improving, another "grenade explodes" bringing fear of sustainability to financial institutions, Mr Bean said.

"We have our fingers crossed but there is the recognition there is still quite a long way to go yet."
Mr Bean added that he hoped that the economy would grow next year, despite official figures last week signalling the end of a 16 year boom.

Inflation "should drop back" into next year, he said, in remarks that will fuel hopes for borrowers of interest rate cuts.

His warning was echoed by Sir Peter Burt, the former governor of the Bank of Scotland.

But Sir Peter appeared to take a swipe at new accounting rules imposed on banks and called for the government to ensure that no other financial institution would go bust.

"I hope the Bank of England are doing more than just crossing their collective fingers." he said.

Tough new rules made it more difficult for banks to lend and these rules had been like "pouring petrol onto a bonfire".

"The Bank of England must be prepared to act as lender of last resort. We cannot afford to let a major bank collapse," he told BBC Radio 4.

A bank closure would "lead to the dominoes falling like crazy" with knock-on effects for all parts of the economy.

The government's insistence that the newly nationalised Northern Rock pay off £25 billion in 12 months was taking that amount out of the mortgage market, he said.

David Kern, an economic adviser to the British Chambers of Commerce, said: "We certainly believe that the impact of the credit crunch is going to take some time to sort out and it may be prolonged.

"But if the right measures can be taken by the government and the monetary policy committee, they can avoid a major recession."

Vince Cable, the Treasury spokesman for the Liberal Democrats said Mr Bean's comments showed that the government and Bank of England were powerless to do much about the British economy which was "to a large extent in freefall".

Devastating outcome of collapse in confidence

IT STARTED with a stock market crash in the United States in October 1929, but soon no major industrialised nation was left untouched by what became known as the Great Depression.

The decade-long economic collapse was a time of runs on banks, falling prices and rising unemployment of a magnitude that has not been replicated since.

Thousands of investors lost their livelihoods when the New York Stock Exchange prices collapsed on Black Tuesday in October 1929. Within three years, shares had plunged to just one fifth of their 1929 values.

Nearly a third of US banks had failed by 1933, dramatically ending the speculative boom that had underpinned the 1920s.

This in turn knocked the confidence out of other parts of the economy, triggering a huge drop in production as the US imposed tariffs in the belief that this would protect it.

The impact soon spread to the United States' greatest dependents in the post First World War era.

The most affected was Germany, where the poor economic conditions had profound political consequences, with the rise of Adolf Hitler.

Britain's export sector was also hit and unemployment more than doubled from one million to 2.5 million in one year.

In industrialised cities such as Glasgow, a third of the working-age population was unemployed.

The Great Depression – a term coined by Lionel Robbins, a British economist who taught at the London School of Economics – was only ended by the militarisation in the run up to the Second World War.

Workers were needed to fulfil the generous armaments contracts .

Gold and Oil Long Term Weekly Charts

We view charts not as predictive, but as indicative of probabilities, and as a means of assessing and interpreting events as they unfold. The number of variables and the opportunity for exogenous events make this obvious. Life is indeed a school of probability.

Tropical Storm Gustav Heads into the Gulf Oil and Natural Gas Complex

The warm waters of the Gulf will intensify the storm to full hurricane status.

Goldman Sachs: the Dreadnought Shudders

Among investment banks, Goldman Sachs has been the Dreadnought, ploughing forward through troubled financial seas, stopping only to take a prize here and there, and deposit executives in key political postions throughout federal and state governments.

Can even the mighty Goldman shake and tremble in the face of troubled markets? We will have to wait and see when they report earnings. We are not betting against or for them. We'll prefer to watch for additional developments, including the NY Attorney General's probe noted below.

Goldman Profit Estimate Cut 45% by Morgan Stanley
By Poppy Trowbridge and Christine Harper

Aug. 27 (Bloomberg) -- Goldman Sachs Group Inc. had its third-quarter earnings estimate cut almost in half by Morgan Stanley analyst Patrick Pinschmidt, who said stock market declines will force the bank to revalue investments.

Pinschmidt said Goldman's third-quarter earnings will probably be $1.65 a share, down from his earlier prediction of $3. The New York-based bank may record a loss of $525 million on so-called principal investments, compared with a gain of $211 million a year earlier, he said in a note to clients today.

Goldman, the biggest and most-profitable U.S. securities firm, had its estimates reduced an average of $1.33 per share by 13 analysts this month because of decreased trading volume and a drop in stock prices. Pinschmidt's estimate is the second-lowest of 19 compiled by Bloomberg behind Atlantic Equities analyst Richard Staite, who lowered his per-share estimate today to $1.60 from $3. The average is $2.44.

``Goldman Sachs is not immune to difficult market conditions,'' Pinschmidt wrote. ``Significant declines in equity markets will take a toll on principal investment marks and principal trading strategies.''

Goldman has declined 28 percent in New York Stock Exchange composite trading this year. The shares fell $1.46, or 0.9 percent, to $153.73 at 9:53 a.m.

Principal investments at Goldman include private equity and real estate holdings, as well as stock in the Industrial and Commercial Bank of China Ltd., the nation's biggest lender. ICBC's shares have declined 18 percent since the end of May in Shanghai trading.

Record Decline

Pinschmidt's estimate for Goldman's third quarter, which ends Aug. 29, would represent a 73 percent drop in earnings per share compared with the firm's income of $6.13 a year earlier. That would be the steepest year-over-year earnings decline since Goldman went public in 1999. Pinschmidt rates Goldman stock ``over-weight.''

Lower values for residential and commercial mortgages are likely to require Goldman to take a $1 billion writedown, Pinschmidt said...

NY AG confirms probe into Goldman, Fidelity
Wednesday August 27, 1:10 pm ET
By Joe Bel Bruno

NEW YORK (AP) -- The New York attorney general's office said Wednesday it is investigating whether Fidelity Investments was given incentives by Goldman Sachs Group Inc. to sell auction-rate securities to investors.

Investigators are examining if Fidelity pitched auction-rate securities that were underwritten by Goldman Sachs because it received other services from the investment bank. A spokesman for New York Attorney General Andrew Cuomo confirmed the investigation, but declined to provide further details.

Higher Levels of 'Troubled Banks' as Financial Earnings Plummet

The worst is yet to come despite the soothing words coming from public officials. The US financial system is on a knife's edge, and the Treasury and Fed are on watch to intervene in the event that a domino-like collapse is ignited by a failed institution. We are entering the moment of maximum stress, wherein any significant external shock might ignite a string of failures and set off a plunge that will test the circuit breakers on the NYSE. Let's see what happens and hope for the best and a bit of luck.

Credit crisis: 117 troubled banks in US, highest level since 2003
27 Aug, 2008, 0330 hrs IST
The Economic Times of India

WASHINGTON: The number of troubled US banks leaped to the highest level in about five years and bank profits plunged by 86 percent in the second quarter, as slumps in the housing and credit markets continued.

Federal Deposit Insurance Corp data released on Tuesday show 117 banks and thrifts were considered to be in trouble in the second quarter, up from 90 in the prior quarter and the biggest tally since mid-2003.

The FDIC also said that federally-insured banks and savings institutions earned $5 billion in the April-June period, down from $36.8 billion a year earlier. The roughly 8,500 banks and thrifts also set aside a record $50.2 billion to cover losses from soured mortgages and other loans in the second quarter.

"Quite frankly, the results were pretty dismal," FDIC Chairman Sheila Bair said at a news conference, but they were not surprising given the housing slump, a worsening economy, and disruptions in financial and credit markets.

The majority of US banks "will be able to weather" the economic and housing storms, with 98 percent of them still holding adequate capital by the regulators' standards, Bair said.

Total assets of troubled banks jumped from $26 billion to $78 billion in the second quarter, the FDIC said, with $32 billion of the increase coming from IndyMac Bank, which failed in July - the biggest regulated thrift to fail in the United States.

"More banks will come on the (troubled) list as credit problems worsen," Bair said. "Assets of problem institutions also will continue to rise."

Nine FDIC-insured banks have failed so far this year, compared with three in all of 2007. More banks are in danger of collapsing this year, Bair and other FDIC officials said, and they expect turbulence in the banking industry to continue well into next year.

IndyMac's failure and others in the quarter reduced the federal deposit insurance fund from $53 billion to $45 billion. Bair said the agency will raise insurance premiums paid by banks and thrifts to replenish its reserve fund and bolster depositors' confidence.

The $50.2 billion set aside to cover loan losses in the April-June period was four times the $11.4 billion the banking industry salted away a year earlier. Nearly a third of the industry's net operating revenue went into building up reserves against losses in the latest quarter, according to the FDIC.

Except for the fourth quarter of 2007, the earnings reported Tuesday were the lowest for the banking industry since the final quarter of 1991, the agency said.

Concern has been growing over the solvency of some banks amid the housing slump and the steep slide in the mortgage market. The pressures of tighter credit, tumbling home prices and rising foreclosures have been battering banks of all sizes nationwide.

The FDIC has been keeping an especially close eye on banks and thrifts with high levels of exposure to the riskiest borrowers and markets, agency officials say, including subprime mortgages and construction loans in overbuilt areas.

Another area of potential concern: banks' holdings of preferred stock of troubled mortgage giants Fannie Mae and Freddie Mac. A government rescue of the companies, whose share prices have rebounded a bit this week after plummeting recently as they struggle with billions of dollars in losses from bad mortgages, could be costly for scores of banks that hold billions in their preferred shares.

"We're closely monitoring that situation," Bair said.

The FDIC said troubled assets - loans that are 90 or more days past due - continued to rise in the second quarter, jumping by $26.7 billion, or 19.6 percent, over the first quarter. It was the first time since 1993 that the percentage of total loans that were troubled broke 2 percent, at 2.04 percent.

The agency doesn't disclose the names of institutions on its internal list of troubled banks. On average, 13 percent of banks that make the list fail.

Pasadena, Calif.-based IndyMac was taken over by the FDIC on July 11 with about $32 billion in assets and deposits of $19 billion. It was the second-largest financial institution to close in US history, after Continental Illinois National Bank in 1984.

SP Hourly Futures Chart

Citigroup Settles Charges of Widespread Theft of Customer Funds

We can imagine how a large company might rationalize the actions that led to these charges. Customers have positive credit balances on their cards for a variety of reasons. Why not just "sweep" the cash into your own bank account, and use it as part of your leveraged reserves? The customer does not really need the money, right? Especially if they are "poor or recently deceased." You are merely 'borrowing it' with no harm done. Right? Clever. We're the Master's of the Universe, the smartest boys in the room.

We hate to use this example of Citigroup's bad behaviour when there are much better ones. Not all that long ago Citi was caught consciously manipulating the european bonds markets. They would come into a quiet market, sell a remarkably large amount of government bonds all at once to drive the prices down and run the stops of other traders, and then cover their shorts reaping a tidy little profit. Citigroup Embroiled in Bond Selling Scandal Sounds like standard operating procedure for the US futures and commodity markets to us.

But Citi is not an outlier. Anyone who thinks the brokerage and investment industry can be self-regulated, relying upon mature and enlightened self-interest, is either naive, corrupt, disingenuous, or misinformed. Wall Street has proven time and again that the lure of quick profits will cause them to subvert any and all oversight and prudent business principles. And there are many scams and frauds in the markets from a variety of smaller players as we all know. But it is the systemic frauds, the price manipulation and naked shorting, that is particularly insidious and destructive of free markets.

Strong independent regulators capable of investigating potentially criminal activity are needed and not a bunch of propeller heads or captive regulators. The Fed is utterly unequipped and incompetent to rein in these sharks as principle regulator. It would be like sending in the Schoolyard Safety Patrol to maintain order at a pedophiles convention.


AP
Citi pays $18M for questioned credit card practice
Tuesday August 26, 3:05 pm ET
By Madlen Read

NEW YORK (AP) -- Citigroup Inc. will pay nearly $18 million in refunds and settlement charges for taking $14 million from customers' credit card accounts, California's attorney general said Tuesday....

"The company knowingly stole from its customers, mostly poor people and the recently deceased, when it designed and implemented the sweeps," said Brown in a statement. "When a whistleblower uncovered the scam and brought it to his superiors, they buried the information and continued the illegal practice."

Citigroup, however, said in a statement that it voluntarily stopped the computerized "sweeping" practice in 2003, and that it also voluntarily began refunding customers before the settlement.

"We take issue with the state's characterization of our conduct and the parties' voluntary settlement," Citigroup said in a statement. "This agreement affirms our actions, and we are continuing to make full refunds to all affected customers," Citigroup said.

Citigroup shares rose 2 cents to $17.63 in afternoon trading.


Citigroup settles with California over credit card skimming
By Wallace Witkowski
MarketWatch
12:22 p.m. EDT Aug. 26, 2008

SAN FRANCISCO (MarketWatch) -- Citigroup Inc. settled charges that it stole from its customers using a computer program that skimmed positive credit card balances into the bank's general fund, according to the California Attorney General's office Tuesday. Under the settlement, Citigroup will return more than $14 million to customers with 10% interest, and pay California $3.5 million in damages and civil penalties.

Abu Dhabi Bank Sues Morgan Stanley, Bank of NY and Ratings Agencies for Fraud

Abu Dhabi bank sues in U.S. over risky investments
Mon Aug 25, 2008 6:36pm EDT

NEW YORK, Aug 25 (Reuters) - A United Arab Emirates bank sued Morgan Stanley, the Bank of New York Mellon Corp and ratings agencies Moody's and S&P on Monday, accusing them of fraud in operating a fund that collapsed in the U.S. credit crisis.

The lawsuit filed by Abu Dhabi Commercial Bank in U.S. district court in Manhattan said a complex deal known as the Cheyne Structured Investment Vehicle (SIV) was marketed by the defendants as highly rated and reliable, but they had hidden the risks.

"Instead of protecting the SIV and its investors as promised, defendants exposed the SIV to significant undisclosed risks," the lawsuit said. "Defendants knew the assets purchased and held by the SIV were risky and of poor quality. They further knew the models used to generate the high rates were flawed."

SIVs, which once held some $350 billion in assets, have played a major role in the U.S. credit crisis, after proving unable to refinance their short-term debts.

A series of SIVs are now selling off bank debt and assets such as asset-backed securities to try to pay back investors, a move that many see as further pressuring credit markets.

A deal was announced last month to restructure Cheyne, which at receivership was a $7 billion fund. Many investors who elected to stay in the restructured fund now have assets worth less than one-half of their former value, and the Abu Dhabi Commercial Bank's investment is worth zero now, the complaint said.

A spokeswoman for Morgan Stanley and a spokesman for Bank of New York Mellon declined to comment.

A spokesman for S&P parent McGraw-Hill Cos Inc declined comment, saying the company had not yet been served with the complaint.

A spokesman for Moody's Corp was not immediately available for comment.

SIVs used short-term funding, such as asset-backed commercial paper, to buy longer-term assets such as bank debt and asset-backed securities.

The bank brought the action on behalf of all investors who bought investment grade Mezzanine Capital Notes issued by Cheyne Finance PLC and its wholly owned subsidiary Cheyne Finance Capital Notes from October 2004 to October 2007.

"The ratings agencies intentionally, recklessly or negligently misled investors in Cheyne," according to the suit. "But for the ratings agencies violations of law, the capital notes never would have been issued."

Just a Pause for the Commodity Bull Market in the Collapse of Bretton Woods and the Pax Americana

The author of this thoughtful piece rests his argument for a resurgence in commodity prices on three pillars: oil is the heart of the commodity price bull market, oil is peaking in production, and overall demand for all commodities will continue to stress against supply levels even with reduced demand for the short term. Commodities trends and production increases are long cycle phenomena.

We have come to a similar conclusion but from a different path. The eye of the commodities storm has not been oil, and peak oil, but rather a collapsing international trade system based on the US dollar.

The heart of the problem is that trading increasingly worthless dollars for hard goods has been a nice protection racket with an amazingly long run under the Pax Americana. The non-G7 countries will stop accepting this arrangement, and the world will adjust.

The markets are searching for a replacement for the Bretton Woods II arrangement of dollars for oil and military protection. Increased demand and peaks in supply will merely accelerate and intensify the storm.

We think that this is already well underway, thanks in great part to the Clinton-Bush Administrations and their careless disregard for the stewardship which the US accepted with the world's reserve currency. The heightened sense of risk and volatility is because the world's markets do not yet see a viable, sustainable solution.

A new equilibrium that will underpin international trade will be discovered. But given the length and breadth of the status quo the seismic shocks of the adjustment may be quite convulsive, taking down more than a few major institutions. The epicenter for this global earthquake is somewhere between New York and Washington DC.


Commodity Bull's Not Dead, Just Resting
Vijay L Bhambwani
Daily News & Analysis - India
August 23, 2008 03:57 IST

Once the deliberate downward pressure on these assets eases, there will be a resurgence in prices

Recent days have seen an intense debate within the analyst community on the hot topic of the year — commodity prices. Many have started writing obituaries for the commodity bull and pronounced an end to the ascent in commodity prices. The impact on the corporate sector was advocated to be salutary and it was widely expected to signal an end to the woes of the equity investors....

I expect the post-US election year to be particularly tough on the global energy front as the supply-side constraints choke the optimists. Once the deliberate downward pressure on these hard assets is eased, there will be a resurgence in prices.

I am afraid the following rally may just surpass the recent one. In my humble opinion, the commodity bull is just taking a breather, forget his obituary for now. The future shock will lie not in rising commodity prices, but in not preparing for it.

A Perfect Storm of a Global Recession - Roubini

Roubini's analysis has been better than most. A worldwide recession is highly probable.

At some point we will most likely see competitive devaluations of currencies as countries vie for exports. We will see a de facto trade war, not explictly until much later in the cycle perhaps, but implicitly through policies and barriers more subtle than overt tariffs. The industrial policies of Japan and China are just a taste of things to come.

A currency devaluation is a very effective means of erecting trade barriers and encouraging exports. But without a global reference point the situation can quickly deteriorate into a relative competition with commodities assuming the more narrow prior position of gold, which would rise with the general tide of commodities. This will break the Central Bank's scheme to maintain Bretton Woods II.

This may be the fuel for the continuing stagflation despite flagging demand in the G7. The BRIC's will slow, but still maintain a positive growth. As currencies devalue the commodities may ironically become more expensive. We may see a repeat of the 1970's but on a global scale. That might be something for the economics professors to puzzle on for a few years as their models get marked to the markets.

The Perfect Storm of a Global Recession
by Nouriel Roubini
Project Syndicate

NEW YORK – The probability is growing that the global economy – not just the United States – will experience a serious recession. Recent developments suggest that all G7 economies are already in recession or close to tipping into one. Other advanced economies or emerging markets (the rest of the euro zone; New Zealand, Iceland, Estonia, Latvia, and some Southeast European economies) are also nearing a recessionary hard landing. When they reach it, there will be a sharp slowdown in the BRICs (Brazil, Russia, India, and China) and other emerging markets.

This looming global recession is being fed by several factors: the collapse of housing bubbles in the US, United Kingdom, Spain, Ireland and other euro-zone members; punctured credit bubbles where money and credit was too easy for too long; the severe credit and liquidity crunch following the US mortgage crisis; the negative wealth and investment effects of falling stock markets (already down by more than 20% globally); the global effects via trade links of the recession in the US (which still counts for about 30% of global GDP); the US dollar’s weakness, which reduces American trading partners’ competitiveness; and the stagflationary effects of high oil and commodity prices, which are forcing central banks to increase interest rates to fight inflation at a time when there are severe downside risks to growth and financial stability.

Official data suggest that the US economy entered into a recession in the first quarter of this year. The economy rebounded – in a double-dip, W-shaped recession – in the second quarter, boosted by the temporary effects on consumption of $100 billion in tax rebates. But those effects will fade by late summer.

The UK, Spain, and Ireland are experiencing similar developments, with housing bubbles deflating and excessive consumer debt undercutting retail sales, thus leading to recession. Even in Italy, France, Greece, Portugal, Iceland, and the Baltic states, frothy housing markets are starting to slacken. Small wonder, then, that production, sales, and consumer and business confidence are falling throughout the euro zone.

Elsewhere, Japan is contracting, too. Japan used to grow modestly for two reasons: strong exports to the US and a weak yen. Now, exports to the US are falling while the yen has strengthened. Moreover, high oil prices in a country that imports all of its oil needs, together with falling business profitability and confidence, are pushing Japan into a recession.

The last of the G7 economies, Canada, should have benefited from high energy and commodity prices, but its GDP shrank in the first quarter, owing to the contracting US economy. Indeed, three quarters of Canada’s exports go to the US, while foreign demand accounts for a quarter of its GDP. (This is why the loon will track US performance more closely than other commodity currencies as we have noted before - Jesse)

So every G7 economy is now headed toward recession. Other smaller economies (mostly the new members of the EU, which all have large current-account deficits) risk a sudden reversal of capital inflows; this may already be occurring in Latvia and Estonia, as well as in Iceland and New Zealand.

This G7 recession will lead to a sharp growth slowdown in emerging markets and likely tip the overall global economy into a recession. Those economies that are dependent on exports to the US and Europe and that have large current-account surpluses (China, most of Asia, and most other emerging markets) will suffer from the G7 recession. Those with large current-account deficits (India, South Africa, and more than 20 economies in East Europe from the Baltics to Turkey) may suffer from the global credit crunch. Commodity exporters (Russia, Brazil, and others in the Middle East, Asia, Africa, and Latin America) will suffer as the G7 recession and global slowdown drive down energy and other commodity prices by as much as 30%. Countries that allowed their currencies to appreciate relative to the dollar will experience a sharp slowdown in export growth. Those experiencing rising and now double-digit inflation will have to raise interest rates, while other high-inflation countries will lose export competitiveness.

Falling oil and commodity prices – already down 15% from their peaks – will somewhat reduce stagflationary forces in the global economy, yet inflation is becoming more entrenched via a vicious circle of rising prices, wages, and costs. This will constrain the ability of central banks to respond to the downside risks to growth. In advanced economies, however, inflation will become less of a problem for central banks by the end of this year, as slack in product markets reduces firms’ pricing power and higher unemployment constrains wage growth.

To be sure, all G7 central banks are worried about the temporary rise in headline inflation, and all are threatening to hike interest rates. Nevertheless, the risk of a severe recession – and of a serious banking and financial crisis – will ultimately force all G7 central banks to cut rates. The problem is that, especially outside the US, this monetary loosening will occur only when the G7 and global recession become entrenched. Thus, the policy response will be too little, and will come too late, to prevent it.

Regional US Banks are Heavily Invested in Fannie and Freddie Preferreds

This may help to understand the Treasury's next moves.

The banksters really do not want Fannie and Freddie to be bailed out and maintained in anything such as their current form. They want Fannie and Freddie's business, more precisely the fees from same. They also want the debt to be made whole.

The big banks do not care so much about the preferred stock. In fact, they might even be in favor of a haircut there, to set up some bargains for the coming wave of bank consolidations. But the Fed doesn't like it, because they see the domino risk to the system.

Again, this might help to explain the solutions that comes out of Washington and New York. There is significant maneuvering behind the scenes by the vested interests. Of course then there are the Democrats. Hank has a window of opportunity to settle the GSE's hash before he loses his grip on power. Let's see what happens.

Fannie and Freddie threat to banks
By Saskia Scholtes in New York and James Politi
The Financial Times
August 23 2008 03:00

Small regional US banks could face substantial writedowns if the government has to rescue Fannie Mae and Freddie Mac, the two giant US mortgage financiers.

Regional banks, together with US insurers, hold the majority of Fannie and Freddie's $36bn of outstanding preferred stock, which could be wiped out in the event of a government rescue.

Few banks have taken any writedowns on the preferred shares, which have lost more than half of their value since June 30. This could exacerbate the impact of losses on the preferred shares at a time when many banks are experiencing losses on residential construction loans and home equity portfolios.

Tom Priore, chief executive of Institutional Credit Partners, a boutique investment bank, said: "If the government takes a senior preferred stake, it will crystallise existing losses for the banks and add to them in a way that damages local lenders at a time when they can least afford it."

Fannie and Freddie's preferred stock ratings were cut by Moody's yesterday from A to Baa3. Moody's said the cut reflected the uncertainty surrounding how these securities would be treated if the US Treasury provided Fannie or Freddie with support and the reduced financial flexibility the two companies would have in the event of a Treasury intervention.

The rating agency said it saw the odds of such an intervention as increasingly likely, pushing Fannie and Freddie's stock prices down by a further 14.5 per cent and 8.25 per cent, respectively. Both stocks have lost more than 40 per cent of their market value this week on fears that government intervention is imminent.

"Given the GSEs more limited ability to raise capital and grow their portfolio to accomplish their public policy role in a time of mortgage market turmoil, we believe that there's an increased probability of actual support coming from the US Treasury," said Brian Harris, analyst at Moody's.

The Treasury was granted powers last month to extend its credit lines to Fannie and Freddie and invest in their debt and equity, but it has not given any further clarity on the structure a rescue for the companies might take.

Many analysts believe the most likely option is for the government to get preferred shares as part of any rescue, eliminating the value of common shares, and ranking higher than existing preferred shareholders, who will probably see their dividends cut.

Philadelphia-based Sovereign bank said this week it holds more than $600m in preferred stock issued by Fannie Mae and Freddie Mac, representing 0.78 per cent of its total assets.

Analysts at CreditSights said a full write-off of Sovereign's preferred stock in Fannie and Freddie could represent as much as four quarters of earnings. Sovereign executives warned there was a possibility they could take a significant writedown in the third quarter.

The Fed's Fatal Attraction with Wall Street Is a Source of Policy Error

Link to Buiter's Complete Paper Presented at Jackson Hole

Fed Attention to Wall Street `Dangerous,' Buiter Says
By John Fraher and Scott Lanman
Bloomberg News

Aug. 23 (Bloomberg) -- The Federal Reserve pays a ``dangerous'' amount of attention to the concerns of Wall Street, constraining its ability to influence the economy, former Bank of England policy maker Willem Buiter said.

``The Fed listens to Wall Street and believes what it hears,'' Buiter said today in a paper presented to the U.S. central bank's annual symposium in Jackson Hole, Wyoming. ``This distortion into a partial and often highly distorted perception of reality is unhealthy and dangerous.''

The central bank has drawn criticism from some officials in the U.S. and Europe by trying to end the yearlong credit crisis through an expansion of lending. The steepest interest-rate cuts in two decades risk stoking inflation, while the Fed has been too generous in aiding banks, Buiter said.

In addition to rescuing Bear Stearns Cos. from bankruptcy, the Fed created a program to swap Treasuries for mortgage bonds, opened up lending to Wall Street firms and reduced the premium for direct loans to commercial banks.

Buiter, a founding member of the Bank of England's independent rate-setting board in 1997, said the Fed's behavior over the past year represents an example of ``regulatory capture.'' In such a relationship, policy makers take on ``as if by osmosis, the objectives, interests and perception of reality of the vested interest they are meant to regulate and supervise in the public interest,'' he said.

Heated Debate

Buiter's paper sparked the most heated debate of any item on the two-day conference agenda. Bank of Israel Governor Stanley Fischer opened the question-and-answer session by holding up a fire extinguisher and saying, ``I asked the organizers for some technical assistance in dealing with this discussion.''

Former Fed Vice Chairman Alan Blinder said that the central bank's performance, while not flawless, has been ``pretty good under the circumstances.''

Fed Governor Frederic Mishkin, one the strongest advocates of the ``risk management'' approach to financial crises, said after Buiter's presentation ``there are a lot of unguided missiles that have been shot off.''

Under Bernanke and his predecessor, Alan Greenspan, the Fed has cut rates in response to falling stock prices more than is justified to safeguard economic growth, Buiter said. On Jan. 22, as global stock markets tumbled, the Fed slashed its overnight lending rate by 75 basis points.

Safeguard Economy

Bernanke has argued that policy makers' actions were necessary to safeguard the economy from the impact of the credit crisis. Greenspan engineered rate cuts in 2001 through 2003 at a time when joblessness climbed in the aftermath of the recession seven years ago. The Fed by law is mandated to achieve stable prices and maximize employment.

Buiter also criticized the Fed and other central banks around the world for not providing more information about the valuation of collateral they accept from banks.

Such information would allay concerns financial institutions will use public funds to subsidize financial institutions, he said. This is ``most acute'' in the case of some of the Fed's emergency lending programs created in the past year.

Two economists echoed Buiter's concern in another paper presented today, saying the Fed's program allowing institutions to swap Treasuries for mortgage bonds and other debt enables firms to ``window dress'' their balance sheets.

`Deception Easier'

``Financial institutions can hold low-quality securities for the period where no reporting is required,'' wrote Franklin Allen of the University of Pennsylvania and the University of Frankfurt's Elena Carletti. ``Temporarily increasing the supply of Treasuries makes this kind of deception easier. It helps remove market and regulator discipline.''

The financial crisis is also forcing the European Central Bank to rethink aspects of its money market operations, which provide a flexibility that has been favorably compared with programs at the Fed and the Bank of England.

The ECB plans to tighten collateral rules to head off the risk of abuse by some financial institutions, ECB council member Yves Mersch said in an interview today.

Buiter won some praise for openly confronting the Fed's record at its summer retreat in the Teton Mountains.

``Willem's papers don't pull punches, they have attitude,'' Blinder said. ``You have to give credit to a guy with the nerve to come here with black bears on the outside and the FOMC on the inside and be this critical of the Federal Reserve.''

China Expects Adequate Compensation for the Failure of Freddie and Fannie .... Or Else

A very crystal clear 'suggestion' indeed. Back your markers or its game over.

Freddie, Fannie Failure Could Be World `Catastrophe,' Yu Says
By Kevin Hamlin

Aug. 22 (Bloomberg) -- A failure of U.S. mortgage finance companies Fannie Mae and Freddie Mac could be a catastrophe for the global financial system, said Yu Yongding, a former adviser to China's central bank.

``If the U.S. government allows Fannie and Freddie to fail and international investors are not compensated adequately, the consequences will be catastrophic,'' Yu said in e-mailed answers to questions yesterday. ``If it is not the end of the world, it is the end of the current international financial system.''

Freddie and Fannie shares touched 20-year lows yesterday on speculation that a government bailout will leave the stocks worthless. Treasury Secretary Henry Paulson won approval from the U.S. Congress last month to pump unlimited amounts of capital into the companies in an emergency.

China's $376 billion of long-term U.S. agency debt is mostly in Fannie and Freddie assets, according to James McCormack, head of Asian sovereign ratings at Fitch Ratings Ltd. in Hong Kong. The Chinese government probably holds the bulk of that amount, according to McCormack.

Industrial & Commercial Bank of China yesterday reported a $2.7 billion holding. Bank of China Ltd. may have $20 billion, according to CLSA Ltd., the Hong Kong-based investment banking arm of France's Credit Agricole SA. CLSA puts the exposure of the six biggest Chinese banks at $30 billion.

`Beyond Imagination'

``The seriousness of such failures could be beyond the stretch of people's imagination,'' said Yu, a professor at the Institute of World Economics & Politics at the Chinese Academy of Social Sciences in Beijing. He didn't explain why he held that view.

China's government hasn't commented on Fannie and Freddie.

Yu is ``influential'' among government officials and investors and has discussed economic issues with Premier Wen Jiabao this year, said Shen Minggao, a former Citigroup Inc. economist in Beijing, now an economist at business magazine Caijing.

Investor confidence in Fannie and Freddie has dwindled on speculation that government intervention is inevitable. Washington-based Fannie has fallen 88 percent this year, while Freddie of McLean, Virginia, has slumped 91 percent.

Paulson got the power to make purchases of the two companies' debt or equity in legislation enacted July 30 that was aimed at shoring up confidence in the businesses. He has said the Treasury doesn't expect to use that authority.

The two companies combined account for more than half of the $12 trillion U.S. mortgage market.

US Dollar Weekly Charts With COT as of 19 August 2008

Weekly Dollar Chart with Commitments of Traders



Weekly US Dollar Chart with Moving Averages

Charts in the Babson Style for the Week Ending 22 August 2008

Stocks caught a bid at week's end as hopes of a purchase of Lehman Brothers by the Korean Development Bank had the financials leading a rally higher. No price or terms are specified.

Korean DB is said to be attracted to Lehman's books. "They are soft and smelly like a well aged kimchee," said one anonymous connoisseur of investment fare.

Bernanke's Strategy: Painting the Roses Red.

Bernanke's strategy is obvious. It is obvious because he has few choices left. He must paint the roses red, and hope that this will hold off the destructive rage of the Mad Queen.

The Fed will continue to prop up the US financial system while encouraging the economy to muddle through this recession with negative real interest rates.

Inflation doesn't matter to the Fed while they think they can control the public perception of our true financial situation, and especially the consequences.

The Fed feels confident that they know how to fight even a seriously strong inflation so they will let it pass for now. This is a fatal policy error. Volcker was a smart and determined Fed chairman, but he was also lucky.

That means no rate increases until next year at the earliest. The Fed is hoping that nothing unexpected happens to upset their plans. A big bank failure might cause a panic, so Ben and Hank will be working overtime to keep the lid on the problem, and try workouts behind the scenes.

The challenge is to define what a big bank failure really is. Was Bear Stearns a 'big bank failure' or a successful bailout? This is of immediate concern regarding Lehman Brothers which is in an obvious death spiral. Korea DB will not buy them for the 20 percent premium that Dick Fuld demands. So, a hostile takeover by a Fed friendly bank, similar to JPM - Bear, is most likely.

This will give us a look at who the other captive bank of the Fed might be if there is one. If you wish to know what a Captive Bank does besides serving as a wastebasket for other broken banks, read the blog entry just below about the manipulation of the markets.

There may be a role for well-connected predator banks as free lance mercenaries for the Fed's and Treasury's policy decisions. You keep what you kill. This appears to be the ongoing strategy of Hank's alma mater, Goldman Sachs.

A sign that the strategy is at work will be the creation of yet another bubble. Where it will be we cannot know yet. It may be in equities again. Or bonds. The Fed and Treasury are using asset bubbles as instruments of policy to act as a channel of liquidity and to provide the appearance of financial health to an increasingly moribund economy.

Each time the Fed intervenes in the monetary system we get a bubble somewhere, in some 'real world' asset or liability. As we continue forward the interventions and double-talk may become increasingly bold and obviously untrue, especially to outside observers. These are intelligent men, but increasingly desperate and frightened, serving an administration best described as an odd collection of mediocrities and eccentrics. What behaviour they may rationalize together will probably exceed all rational expectations.

The last bubble (or anti-bubble if you prefer) will be an economic depression, and end in a re-issuance of the Dollar, unless the Fed gets very lucky in their friends. By re-issuance we mean that the dollar will be revalued and replaced by something else, whether the amero or a freedom dollar. The precise timing is unknown.

But we have reached the point where at least a de facto default on our debt obligations is the only option. The continuing devaluation of the dollar is running out of steam.

Although there may be a short term liquidity crunch in the unwinding of leverage, the notion that the spectacular dollar debts of 50+ trillions will be paid for with an increasingly valuable dollar through a sustained monetary deflation is a fantasy. No debtor nation that is democratic would choose that course unless it was dominated by foreign powers.

The endgame is default.

The strategy for the rest of the world varies depending on who you are in relation to ground zero for the financial collapse. The most obvious strategy for all will be to limit exposure to the US and its debt deflation.

At the point when the dollar and the debt decouple all hell will break loose, and the system will be tested to its maximum. What replaces the US dollar as the world's reserve currency is more than incidental: it is pivotal. Whomever prints the gold makes the rules.

The empire will be given up in due course. The trick for the bigger players will be to stay out of its way as it happens, and above all to avoid falling into a conflict with the US where the strengths, though diminished, are still formidable.

Ben and Hank are going to try and bluff their way out of this, avoid major failures, and play for time until leverage unwinds and liquidation occurs in an orderly manner, and the economy begins to grow. Some of the other central banks will actively cooperate with the Fed, and some may go down in failure with the US as a result. There will be civil wars and popular revolutions in some countries because of this. Others will merely stand aside and bide their time. The US financial system remains highly precarious.

If you keep this model in mind the next few months and years might make more sense.


Bernanke expects inflation to ‘moderate’
By Krishna Guha in Jackson Hole, Wyoming
August 22 2008 15:14

The decline in the price of oil and the recent strength in the dollar is “encouraging” Ben Bernanke said on Friday at the start of the Federal Reserve’s annual retreat in Jackson Hole Wyoming.

The Federal Reserve chairman said the US central bank had based its strategy of running low interest rates on the assumption that commodity prices would ultimately stabilise, in part due to “slowing global growth.”

Mr Bernanke remarks on oil are the strongest to date and suggest the US central bank – which was initially very wary of reading too much into its decline – is starting to put more weight on the notion that oil may now have stabilised.

But Mr Bernanke said the inflation outlook “remains highly uncertain” not least because of the possibility that oil could rebound.

He said the Fed would “monitor inflation and inflation expectations closely” and would “act as necessary” to secure medium term price stability.

The Fed chief said the “financial storm” that broke a year ago “has not yet subsided” and said its effects on the broader economy were “becoming apparent” in the form of “softening growth and rising unemployment.”

His language suggests that the impact of the credit squeeze on the real economy is still unfolding and it is not likely that the economy will pull out of this soon.

Taken together, his comments underscore that the US central bank has no intention of raising interest rates in the near term, and could stay on hold through the end of the year if growth risks remain high and inflation and inflation expectations ease as expected.

This represents a softening of the Fed’s stance since the May to July period, when policymakers turned hawkish amid growing inflation fears and hopes that the markets and the economy were turning the corner.

However, Mr Bernanke did not suggest that the Fed thinks the inflation problem is over simply because oil has moderated. He said the “jump in inflation” was “in part” the product of a global commodity boom – suggesting other factors could be at work as well.

The Fed continues to retain an underlying orientation towards inflation risk, in large part because policymakers feel they have already addressed growth risks through big pre-emptive rate cuts, but are not protected against any revival in inflation danger.

Policymakers view core inflation (excluding food and energy) and inflation expectations as too high, and will seek to ensure that they decline in the months ahead as the economy weakens.

The Fed chairman told the assembled central bankers from 43 nations that reforms were needed to strengthen the financial system, reduce systemic risk and thereby minimise the “moral hazard” that firms could operate irresponsibly in the belief that they would not be allowed to fail.

He called for a “migration of derivatives trading toward more standardised instruments and the use of well-managed central counterparties.” Mr Bernanke said the Fed was working on ways to strengthen the resilience of the triparty repo market.

Mr Bernanke said Congress should consider giving the US central bank explicit authority to oversee payment systems, while granting Treasury authority to manage a special bankruptcy regime for non-commercial banks.

He said a shift towards a more “macroprudential” approach to regulation – that would consider the systemic implications of market behaviour – was “inevitable and desireable” but said it was necessary to be “realistic” as to how this would work