Bank warns of increased risks to the UK's financial system

By Jane Padgham

Published: 26 April 2007

The Bank of England issued a stark warning today that the dangers surrounding the UK's financial system have risen over the past nine months. It said benign economic conditions had made banks complacent about risk-taking, some companies were loading themselves up with worryingly high levels of debt, complex credit derivatives were untested in times of turbulence and some debt-laden households were showing "signs of stress". It said the recent US sub-prime mortgage crisis was a salutary reminder of how credit risk assessment can go disastrously wrong, and how participants can be hit by sharp reductions in market liquidity.

In its twice-yearly Financial Stability Report, the Bank said the financial system remained "highly resilient". But it urged banks to be alert to the growing risks and take them into account. It singled out the corporate bond market and its associated derivatives market, which has exploded in size in recent years, as particularly vulnerable.

The six key danger areas identified by the report are: unusually low premia for bearing risk, especially in credit markets; high and rising leverage in parts of the corporate sector; rising systemic importance of large complex financial institutions, ie. the big investment banks and securities houses; dependence of UK financial institutions on market infrastructures and utilities, for example the smooth running of the London Stock Exchange and the BACS clearing system; large financial imbalances among the major economies; high UK household sector indebtedness.

Sir John Gieve, the Bank's deputy governor for financial stability, said: "Financial markets have continued to be vibrant, core institutions are highly profitable and the economic outlook is favourable. But risk-taking is increasing, including through higher leverage, lower margin requirements and relaxation of covenants. The rapid growth in credit risk transfer markets [such as collateralised debt obligations] is also making more participants dependent on continuous market liquidity and could amplify the impact of shocks like a sharp reversal in credit spreads from their current low levels."

Sir John, a member of the Bank's Monetary Policy Committee, said there were few signs that America's sub-prime mortgage crisis would cross the Atlantic. He also played down fears that rising insolvencies and home repossessions could spark a housing crash and undermine financial stability. "We watch the housing market at the MPC every month and there are some signs of easing off," he said. "I don't see this [rising household debt] as likely to precipitate a financial crisis."

Banks traded heavily in CDS market on sub-prime contagion fears

Banks and financial services companies topped the list of most actively traded sectors in the US credit default swap market last month amid increasing concerns over the industry’s exposure to problems in the subprime mortgage market, GFI, the inter-dealer broker, said on Monday. A recent spike in late payments and defaults on home loans has prompted a flurry of CDS trading in banks and financial services companies with exposure to the troubled industry.

IMF Managing Director de Rato warns of financial risks

Cites Maxed Out movie on rising personal debt risk

By Finfacts Team
Mar 24, 2007, 09:25

IMF Managing Director Rodrigo de Rato

The International Monetary Fund (IMF) has warned that rising defaults on subprime mortgages that are held by high-risk borrowers in the United States, could impact on other areas of the US economy.

IMF Managing Director Rodrigo de Rato said in a speech at the Wharton School, University of Pennsylvania, on Friday, that the problems in subprime mortgage markets were one of three risky developments in financial markets, which could eventually affect the global economy.

However, he said that world economic fundamentals were currently strong, with growth set to continue its strongest sustained five-year since the late 1960s at close to 5%.

De Rato said that large increases in private equity buy-outs financed by a bigger proportion of debt, were a risk to economic stability, saying that if these deals turn tour, it could trigger a reappraisal of risk, which could ultimately lead to a tightening of credit for other corporate borrowers.

In addition, he said there were risks from large capital flows into emerging markets, especially bank-based flows into Eastern Europe and sub-Saharan Africa.

While the capital flows into these markets are welcome, they exposed the countries to dangers if investors bailed from riskier assets.

The problems in the subprime market means that about half a million Americans are likely to be unable to obtain mortgage financing over the next two years, according to the National Association of Realtors.

De Rato said that a recent movie, Maxed Out directed by a former Wharton student, graphically depicts the problem of credit card users being encouraged to take on substantial debt and then penalized with late fees and other charges. And the distress of financial markets in the face of the troubles in the sub-prime mortgage sector has its counterpart in hundreds of thousands of stories of individual distress.

The IMF chief referred to a report issued last week by the Mortgage Bankers Association, which revealed that over one half percent of all home loans entered foreclosure in the fourth quarter of 2006, the highest in the 37 year history of the association's survey. He said that these developments suggest a need to take a fresh look at lenders' underwriting standards and to educate borrowers in the risks that they are taking.

A still from the movie Maxed Out

Managing Director of the International Monetary Fund
at the Wharton School, University of Pennsylvania,
Philadelphia, Pennsylvania, March 23, 2007

1. It's a pleasure to be here. I would like to talk to you today about changes in financial risks, and how policy makers and institutions like the International Monetary Fund need to respond to these changes. We have seen a period of turbulence in the financial markets over the last few weeks, and I will talk a little about the implications of that. I will suggest that there are some developments in the global economy and in world financial markets that should reassure us, and some that should give us cause for concern. But today I would mostly like to focus on a development which is of longer-term significance: the shift of financial risks from the banking and financial sectors to individuals and families. I will also propose some steps that should be taken to respond to this shift in risk.

2. First, let me say a few words about the changing role of the International Monetary Fund in assessing financial risks. Our member countries face new opportunities and new risks from financial globalization, and the Fund is adapting to help them meet these challenges. We are intensifying our efforts to integrate our financial sector work, including on capital and financial markets, into our economic analysis. The increased importance of financial markets for growth and development for all countries is a major feature of the new world of globalization. It is of particular importance for emerging market countries, which have a lot to gain from financial integration but may also become more vulnerable in integrated global markets.

3. The Fund has been taking the lead in identifying strengths and vulnerabilities in the financial sector for many years, including through the launch of the Financial Sector Assessment Program in the late 1990's. Now we are advancing this work further. In our monitoring of individual countries' economies, we are enhancing the analysis of financial sector vulnerabilities and ensuring that this is reflected in our macroeconomic analysis and policy advice. In our monitoring of the global economy, we are devoting more attention to the linkages between the financial sector and real economy.

4. What does this analysis tell us about the current state of the global economy and the situation in financial markets? First, the economic fundamentals are good. The world has already seen several years of strong growth, and we in the International Monetary Fund expect that global growth will once again be close to 5 percent in 2007. This would be the strongest five-year span for the global economy since the late 1960s. In the United States, the speed of the expansion has eased—largely reflecting the slowdown in the housing market. But in the euro area growth momentum looks solid, and Japan's economy seems to have regained its footing. China and India continue to be engines of growth, and many other emerging market and developing countries are enjoying a continuation of the strong growth of recent years.

5. Notwithstanding a global economy which is essentially strong and stable, we have seen considerable financial market turbulence lately. I believe that this reflects a reappraisal of risk in some important areas—economic risks in the United States; currency risks relating to the Yen carry trade, and more recently risks in the U.S. mortgage market. All have given rise to concern among investors. This concern is not in itself a bad thing. The most dangerous time in financial markets is when no-one believes that they can lose. Recent movements in markets, despite their costs, will at least help to reduce any such complacency.

6. It is important that both investors and policymakers remain aware of economic and financial market risks. Among economic risks, oil supplies and prices remain vulnerable to geopolitical events. There is also the risk, which may still be insufficiently appreciated, of a disorderly adjustment of global payments imbalances. The risks of this are relatively low, but the costs would be high.

7. There are also some developments in the financial markets which could have implications for the global economy. Let me mention three of them.

• The first is now well known: the problems in sub-prime mortgage markets in the United States and the risk that these could impact other markets or affect other sectors of the U.S. economy.

• A second development which I see as a source of risk is the recent increase in large private equity buyouts financed by a rising proportion of debt. The risk from a financial stability perspective is that if some of these deals were to turn sour, this may trigger a reappraisal of risk which would curtail market access more broadly for lower-rated corporate borrowers. This could adversely affect investment and growth prospects.

• A third development is the very substantial flows of capital into emerging markets, especially bank-based flows into emerging Europe and portfolio flows into other regions, including sub-Saharan Africa. To the extent that such inflows reflect a reallocation of capital to productive investments they are welcome. But they also expose the countries concerned to an abrupt reversal of flows if investors suddenly become more risk averse.

In considering all of these risks, I would urge investors to exercise due diligence, regulators to remain vigilant and policymakers to keep in mind the potential for spillovers between markets, and from financial markets to economies.

8. Before leaving the subject of economic risks, let me mention one more, which I believe need to be taken more seriously by the public and by policy makers. This is the rise in protectionist sentiment. This has many manifestations. There is the doctrine of national champions in Europe. There are legislative proposals that aim to protect some industries through tariffs or other protectionist measures in the United States and elsewhere. Politicians and business people need to be more forceful in reminding the public of the benefits of trade. For example, studies indicate that trade liberalization, including trade deals under the GATT and the WTO, have lifted annual U.S. incomes by as much as US$750 billion. Indirect gains arising from investment and similar reforms have been of a similar magnitude. Moreover, U.S. firms engaged in trade tend to be more productive, have higher employment growth, and pay higher wages than domestically oriented firms.

9. I am concerned that if the world does not quickly move forward on trade, it risks moving backward, to the narrow nationalism that characterized the depression era. It is very important to bring the Doha Round to a conclusion that delivers ambitious reforms. In the United States, given the delays of the past year, completing the Doha Round will almost certainly require that Congress grant an extension of the U.S. administration's fast track negotiating authority. Such an extension could be accompanied by measures to help those adversely affected by structural changes in the economy, while strengthening the economy's adaptability. For example, trade adjustment assistance can both protect workers and facilitate their movement to growing industries. The terms of an extension of fast track are a matter for the U.S. Congress. But the results of the Congress's decision will be important not only for the United States but also for the rest of the world. I hope Congress will move quickly on this issue.

10. In responding to the economic and financial risks I have talked about, the Fund can take the lead in some areas—especially in identifying and warning about key economic and financial risks. But leadership is also needed from other public sector agencies around the world, and from the private sector.

11. Such leadership will be very important in addressing the consequences of another development, which I would like to talk about in the remainder of my remarks. This is the transfer of financial risks from financial institutions to a broad base of individuals. Of course, there is a sense in which individuals have always been at risk, since as citizens and members of society their fortunes rise and fall with the economy. But individuals are increasingly taking on financial risks much more directly. There are several ways in which this is happening.

• First, borrowing by individuals and households is much higher than in the past. Household financial obligations have grown with it. In the United States, they hit a record high of 19.4 percent of disposable income in the fourth quarter of 2006, despite the historically low interest-rate environment.

• Second, the role of banks has changed. Many banks no longer hold the bulk of the risk on the loans they make. Instead, banks transfer and diversify credit risks to other banks, insurance companies, mutual funds and hedge funds. A related development is the rapid growth of securitization of assets of all kinds: from mortgages to credit card loans, from corporate loans to aircraft leases.

• Third, the role of the financial intermediaries that are taking on the credit risk has changed. Where insurance companies and pension funds once held the risks themselves, the rise of non-guaranteed insurance savings products and the demise of defined benefit pension plans mean that individuals and households are becoming the ultimate holders of risk in the system in a much more direct way than in the past.

Each of these developments carries both benefits and risks. Let me take each in turn.

12. The broadening of credit brings with it opportunities that reach many more people than in the past. Many more people can finance a house, consumer durable purchases, a vacation, a business school education. This widens economic opportunities, and makes it possible for individuals to balance their consumption better over the course of their lives. The downside is that people sometimes take on too much debt. A recent movie, "Maxed Out" directed by a former Wharton student, graphically depicts the problem of credit card users being encouraged to take on substantial debt and then penalized with late fees and other charges. And the distress of financial markets in the face of the troubles in the sub-prime mortgage sector has its counterpart in hundreds of thousands of stories of individual distress. A report issued last week by the Mortgage Bankers Association revealed that over one half percent of all home loans entered foreclosure in the fourth quarter of 2006, the highest in the 37 year history of the association's survey. These developments suggest a need to take a fresh look at lenders' underwriting standards and to educate borrowers in the risks that they are taking.

13. Turning to the position of savers, the changing role of banks has changed significantly the risks that other institutions and individuals face. The growth of markets in credit risk transfer instruments, and the structured credit products that go along with them, has allowed banks to make loans and then transfer and diversify the associated credit risk to other institutions.

14. Loan securitization—the issuance of securities backed by loans—has similar effects on the transfer of risk. Issuance of loan securities has expanded from around $0.5 trillion in 2000 to $2.75 trillion in 2006; and it has become far more geographically widespread (from Mexico to Australia, and from Korea to Russia). This is transforming how banks in many parts of the world do business. Banks' willingness to lend and the rate at which they do so is increasingly being driven by the price they will receive for the loan when they sell it to the securities market. And much of the risk from these loans is now dispersed to other investors.

15. Both of these developments can be seen as enhancing financial stability, because bondholders, pension funds, life insurers, and hedge funds all have less exposure to short-term liquidity pressures and a greater ability to share losses with investors. But there are also some downsides. The first is lack of transparency. We know credit risk is being transferred, but it is often not clear who it is being transferred to, or whether the ultimate holders of these risks fully understand them and can manage them prudently. The second is that we do not know how well liquidity in credit risk transfer or securitized loan markets will hold up if the credit cycle turns down sharply and defaults become more common.

16. The need to get a better picture of what is going on in these markets is increased because risks do not stay with financial intermediaries. Instead, there is a further shift in risk from insurers and pension funds to individuals and families. In particular, the shift from defined benefit to defined contribution pension plans has placed more responsibility on households to manage investment portfolios and related risks. Such schemes allow individuals more flexibility, but the price they pay is absorbing market and other credit risks and also longevity risk more directly. Individuals now absorb risks as shareholders, investors in mutual funds, savers in non-guaranteed insurance savings products, and members of defined contribution pension schemes.

17. One implication of this is that regulators and supervisors need to take the new reality and the new vulnerability of savers into account. Regulatory and accounting reforms have helped to improve pension and insurance industry transparency, thereby reducing default risks. But they have also encouraged risk transfer to other investors, including hedge funds. There are now estimated to be more than 9,500 hedge funds—fourteen times more than in 1990. The investor base of hedge funds has also broadened, with about 30 percent of investment in them now coming from pension funds. Close attention will need to be paid to these changes. At present, the focus for supervisors should be on making the supervision of hedge funds' regulated counterparties more effective. But as the structure of markets changes, supervisors may need to adapt the framework of supervision to improve investor protection and reduce systemic risks and vulnerabilities. It will also be important to monitor developments in the global hedge fund industry from an international and multilateral perspective.

18. Another implication of the shift in the location of risk is that individuals and families need to take more responsibility for managing financial risks themselves. Therefore, they need to be educated consumers for financial information. Evidence from all around the world suggests that this is not happening at the moment. Let me give a few examples:

• Only 30 per cent of those surveyed in the United Kingdom can correctly calculate simple interest rates, and only 44 per cent reported a basic knowledge of pensions in 2004;

• 47 per cent of workers in the United States who have no savings still report themselves confident that they will have enough for retirement.

• A majority of French households consider themselves to be ill-equipped to choose an investment strategy;

• 65 per cent of Dutch households are unable to provide any estimate of their pension income on retirement;

Let me put this in a more personal way. You are students and graduates of one of the top business schools in the United States. How confident are you of your own ability to forecast your pension and insurance needs, and to work out the steps you need to take to meet them?

19. In these circumstances, it is unfortunate that while consumers are more in need of financial advice than ever before, they remain reluctant to pay for it directly. Perhaps this is because when it comes to financial advice, consumers doubt the impartiality of the advisors. Such doubts may be justified. Some financial advisors are paid to maximize sales or to push certain products.

20. However, there are actions that can be taken, and leadership is needed from all of the major players—governments, the private sector and regulatory authorities. Governments can encourage the teaching of financial literacy in schools and provide counseling for low-income groups. They can also promote default options in pension schemes, which would give people a simple and reasonably conservative option for saving for retirement, while giving people who want to save at different rates or take more risks the option of doing so. The private sector can provide more targeted products with transparent fee structures. Regulatory authorities can help to promote simple, easily understood investment products and menus which meet the needs of less sophisticated investors. Also, as neutral—and hopefully trusted—sources of advice on financial matters, regulators can coordinate the efforts of other parties and can publicize the best sources of advice on financial planning.

21. There have been success stories. For example, the Swedish authorities educated households about their new system of personal pension plans, so that only a small percentage said that they did not understand it. The U.K. Financial Services Authority has coordinated and publicized both government and private firms' efforts to better educate financially the British public, in order to fulfill the formal objective given to it by Parliament. But with an increased burden of risks falling on individuals, such efforts are needed elsewhere too.

22. I have spoken today about some of the changes in financial markets, and discussed some of their benefits and the risks that come with them. The message I want to leave you with is not that change should be resisted, but that all parties—governments, regulators, market participants and individuals—need to adapt to change. They need to pay attention to the new risks in the financial system, and to the fact that more of these risks are falling directly on individuals and families. I am confident that if sufficient attention is paid to this issue, there is sufficient ingenuity to meet these challenges.

Toxic Waste in the Sub-Prime Market: Waiting for the Bodies to Float Up

March 22, 2007

By ROBIN BLACKBURN

In recent times high-profile Wall Street investment banks have brought slick financial reasoning to the base art of loan-sharking. The most vulnerable Americans have been targeted for loans they can ill afford. Those with poor credit histories can be charged at double or treble the interest of a customer in good standing with the rating agencies. By the end of last year housing loans to six million unrated customers ­ 'sub-prime' mortgages ­ totalled $600 billion.

Three or four years ago Citigroup, Bear Stearns, Goldman Sachs, Lehman Brothers and HSBC acquired 'sub-prime' lenders ('loan sharks') which they historically regarded with disdain. Citigroup acquired Associates First Capital, and HSBC bought Household Finance, blazing a trail others were to follow. Finance houses have long teamed up with retailers to shower so-called gold and platinum cards on all and sundry with the hope of ratchetin up consumer debt - rising from 110 per cent of personal disposable income in 2002 to 130 per cent in 2006 - and subsequently charging an annual 18 or 20 per cent on money for which the banks are paying four or five per cent. Such hot rates of return gave the banks a taste for seamy lending. They discovered how to limit their own exposure, while raking in the charges, by re-packaging the debts as CDOs (Collateralised Debt Obligations) in which they capture the risk premium while sloughing off the risk.

With direct access to sub-prime mortgages, the banks and hedge funds bundle together and divide up the debt into ten tranches, each of which represents a claim over the underlying securities but with the lowest trench representing the first tenth to default, the next tranche the second poorest-paying tranche and so on up to the top tenth. Borrowers who can only negotiate a sub-prime mortgage have either poor collateral or poor income prospects, or both, and that is why they must pay over the odds. Of course the bottom tranche of the CDO ­ euphemistically designated the 'equity' ­ is very vulnerable but can still be sold cheaply to someone as a bargain. The purchaser will also be assured by those assembling the CDO that they can hedge the possibility of defaults in the 'equity tranche' by taking out insurance against it. The bank will ­for an extra fee ­ also arrange this insurance, making the entire 'credit derivative' product very complex and difficult to value.

The top tranches, and even many of the medium tranches, will be more secure yet will pay a good return. The chief executive of a mortgage broker explains: 'Sub-prime mortgages are the ideal sector for the investment banks, as their wider margins provide a strong protected cash-flow and the risk history has been favourable. If the investment bank packages the securities bonds for sale, including the deeply subordinated risk tranches, it can, in effect, lock in a guaranteed return with little or no capital exposureGenerally investment banks do not like lending money but they are good at measuring risk, parcelling this up and optimising its value.' For such reasons Morgan Stanley purchased Advantage Home Loans, Merrill Lynch bought Mortgages PLC and Lehman Brothers acquired Southern Pacific Mortgages and Preferred Mortgages.

The investment banks are playing a rapidly-moving game of 'pass the parcel'. Ideally the loans are bought one day, packaged over-night in India, and then sold on to institutional investors the next day. In recent months 'sub-prime' defaults have jumped. A Lehman Brothers analyst warns that some $225 billion worth of sub-prime loans will be in default by the end of 2007 but others say the figure will be nearer $300 billion. The 'equity tranch' is now dubbed 'toxic waste' by the insiders and analysts are waiting to see which bodies float to the surface. In early March the New York Stock Exchange suspended New Century Financial, a company which had taken on insurance obligations for submerged tranches of mortgage debt for most of the big banks.

The vulnerable in today's America certainly include the aged and unemployed who risk their one possession by re-mortgaging their home to an investment bank. But many of the middle class find themselves vulnerable too. In recent years they have lost health care and pension benefits and have been tempted by easy credit into purchases they discover they can ill-afford. The Wall Street Journal reports:

Last week, HCBCs chief executive officer, Michael Geoghegan, sought to dispel the notion that the bank had lowered its lending requirements. The typical customer of HSBC Finance Corp., which oversees the bank's U.S. consumer finance business, has an average household income of $83,000, is 41 years old, has two children and a home worth $190,000. Mr Geoghegan told investors: "This is Main Street America", he said'.

Helped by their role in packaging and selling such 'credit derivatives' as mortage-backed CDOs the banks achieved remarkably good profits right through the post-bubble trough and well into the subsequent recovery. However indebted consumers were not so good for non-financial corporations in the post-bubble era since demand was dampened - by 2003 18 per cent of the disposable income of US consumers was required to service debt and only a housing price boom and re-mortgaging maintained consumer purchasing power. Neither the Fed nor the SEC were keen to crack down on the mortgage bonanza because it helped to maintain consumer demand and market buoyancy. The default crunch will not only cause great unhappiness to the victims ­ who stand to lose their homes - it hurts the housing market and increases the chances of a downturn.

Robin Blackburn is the author of Age Shock: How Finance Is Failing Us (2007), a comprehensive account of risk and social insecurity in the age of financialization. See also Blackburn's, 'Financialization and the Fourth Dimension', New Left Review, May-June 2006. He can be reached at robinblackburn68@hotmail.com

New Century Gets Default Claims, Says It Lacks Cash; Fed warns of more subprime problems

Related
Fed warns of more subprime problems
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(Update8)

By Bradley Keoun and Yalman Onaran

March 12 (Bloomberg) -- New Century Financial Corp., the nation's second-biggest subprime mortgage lender, said it doesn't have the cash to pay creditors who are demanding their money, increasing speculation that the company will go bankrupt.

The New York Stock Exchange, citing the credit crisis, halted trading of New Century this morning until it decides whether to keep listing the company's securities. Shares of the Irvine, California-based company, already down 90 percent in 2007, lost half their remaining value in pre-market trading, and rivals fell as much as 25 percent today.

``They're one step closer to bankruptcy,'' said Bose George, an analyst at Keefe Bruyette & Woods in New York who rates the shares ``market perform.'' ``The only possibility for survival now is for someone, potentially an investment bank, to step in.''

New Century may be insolvent because too many of its own customers -- most of whom have poor credit histories or heavy debt burdens -- aren't repaying their loans. Bad U.S. subprime mortgages are at a seven-year high, forcing more than two dozen lenders to close or sell operations. Their woes may contribute to more than 1.5 million Americans losing their homes and 100,000 people losing their jobs, according to real estate executives, economists, analysts and a Federal Reserve governor.

New Century said in a federal filing it doesn't have funds to repay lenders including Morgan Stanley, Citigroup Inc. and Goldman Sachs Group Inc. The creditors want New Century to repurchase all outstanding mortgage loans they financed.

Shares Plunge

The company's shares traded for as little as $1.36 in pre- market trading, compared with $3.21 on Friday, a day when the stock hit an eight-year low. The company said March 2 that U.S. prosecutors in Los Angeles are investigating trading in New Century's securities before a Feb. 7 announcement that it planned to restate earnings. Investigators also are examining New Century's failure to properly account for the cost of bad loans.

``It's kind of the perfect storm,'' said Vince Arscott, an analyst in the financial institutions group at Fitch Ratings. ``You throw in accounting issues and delayed filings, you throw in a criminal inquiry, and then the whole secondary market is really sour on subprime.''

Rival lenders including Fremont General Corp., Accredited Home Lenders Holding Co., and NovaStar Financial Inc. have shed more than half their value this year, and Countrywide Financial Corp., the nation's biggest mortgage company, has tumbled 17 percent.

Ripple Effects

Accredited, which fell 28 percent today, was ``considered a better player in the space,'' said Matt Howlett, an analyst at Fox-Pitt Kelton in New York. ``But they're not immune to the deplorable conditions in the subprime space. You can't create any value in this market, and the likelihood of a sale, which we thought was really the only exit, just seems more unlikely every day.''

Fremont, which shut its subprime lending operations last week under pressure from U.S. regulators, lost 16 percent today. NovaStar shed 19 percent and Countrywide declined 2.7 percent.

Analysts including Merrill Lynch & Co.'s Kenneth Bruce predicted last week New Century will go bankrupt. New Century has used up cash as rising default rates forced it to buy back loans it sold to investors when borrowers didn't make their payments. The company said last week it's in talks with lenders and potential partners about refinancing or ``other alternatives.''

`No Assurance'

New Century's financing agreements have so-called cross- default provisions that trigger accelerated payments. Should all of its creditors force it to repurchase their loans, the total obligation would be about $8.4 billion, New Century said today.

``Medium, small-size players who were addicted to Wall Street financing are at most risk,'' said David Hendler, an analyst at CreditSights Inc. in New York.

Talks with lenders are continuing, and New Century can give ``no assurance'' that efforts to refinance the debt will succeed, the company said.

Standard & Poor's cut New Century's counterparty credit rating today to D, for companies that are in payment default, from CC.

New Century has received about $975 million of financing from Morgan Stanley. Part of the money from the New York-based securities firm was used to pay Citigroup Inc. about $717 million on March 8, after Citigroup demanded repurchase of its loans, New Century said in today's filing.

Subprime Loans

Subprime loans, a term applied to some of the riskiest home mortgages, are made to borrowers unable to qualify under traditional, more stringent criteria. The loans often carry interest rates 2 to 3 percentage points higher than regular mortgages and sometimes have low initial ``teaser'' rates that adjust higher in later years. Some lenders also lowered their standards last year to bolster revenue because slumping home sales had hurt demand.

The combination made the loans more prone to default, with delinquencies at more than 12 percent in the third quarter, according to the Mortgage Bankers Association. The Washington- based trade group is scheduled to release updated numbers for the fourth quarter tomorrow. Investors are increasingly shunning bonds backed by subprime loans.

``It's like a hot potato with these loans, no one wants them,'' Fitch's Arscott said.

OceanFirst Financial Corp., the holding company for OceanFirst Bank, said today it will revise 2006 earnings because buyers of some of its subprime loans are forcing the company to take them back. Borrowers of the loans -- which the bank offered starting last year through the Columbia Home Loans unit -- are already defaulting, the Toms River, New Jersey-based lender said. The loans offered to cover 100 percent of a home's value.

Countrywide's Report

Countrywide said late payments on home loans that it manages for others held steady last month. Loans at least 30 days past due remained at 4.71 percent of total loans serviced, the same as in January, the Calabasas, California-based company disclosed in monthly data released on its Web site. A year earlier, 4.29 percent of those loans were late.

Jim Shanahan, a senior analyst at Wachovia Capital Markets, cut his rating today on Countrywide to ``underperform'' from ``market perform.''

``While the origination and sale of subprime mortgages represents only a small part of the Countrywide story, we are more concerned that the weakness has spread to other sectors of the residential mortgage market,'' Shanahan wrote.

To contact the reporter on this story: Yalman Onaran in New York at yonaran@bloomberg.net ; Bradley Keoun in New York at bkeoun@bloomberg.net .

Last Updated: March 12, 2007 17:28 EDT

Waiting for the Global Financial Drama

Philip Bowring

02 March 2007

The two-day global equities market meltdown may well signal a much bigger future disaster

The script is complete. The dress rehearsal has been held. But the curtain has yet to go up on the first night of the Great Global Asset Price Collapse.

Markets have recovered some composure after the last two days of February. The steep drops can now be described as a correction, not a collapse. But the payback from sustained overindulgence still awaits. That is not to argue that every index from Dow Jones to Topix via silver futures and Singapore property is going to suffer the same fate. There are elements of the local as well as the global in every national market. But make no mistake: the global liquidity bonanza is the pre-condition for almost every asset market excess.

Don’t read too much into the fact that the recent wobble spread from China. The Chinese market remains among the most closed in the world. What the 9 percent Shanghai shock did was simply remind investors in other markets of how much they had risen in the past year. The Asian ones to suffer most, in addition to China and India, were those which have risen most steeply in recent months -- Malaysia and Singapore. Whatever the macro economic and corporate outlook, profit-taking was overdue. Indeed Asian markets including Korea and Thailand, Malaysia and Singapore look relatively less vulnerable to sustained declines than most.

Top of the worry list remains Mumbai. So it is no surprise to find that it has now fallen 12 percent from its high last month, and with lots more to come. Not only had the market risen fourfold since 2003 but the macro conditions in India are abysmal, with inflation at over 6 percent, the current account deteriorating sharply, bank lending excessive and, to cap it all, the government has just raised the tax on dividends.

Shanghai has better macro-economics to support it for the time being and the rise of the past year has been driven by an abundance of cash not credit to punters. But China’s investors are notoriously skittish and could well defeat any government efforts to stem price falls. Price earnings ratios are even higher than in India and profit growth looks likely to disappoint.

The rest of the world need not worry itself with either Mumbai or Shanghai, both primarily driven by local factors. Falls of even 50 percent would cause barely a ripple elsewhere. The world has plenty of other issues to worry about and the recent correction has pointed at the two major ones but without coming to a definitive conclusion as to if and when they will hit.

The first is the US consumer. Has the bonanza of the real estate cash-out come to an end? House prices have finally begun to slip and interest rates show no signs of falling – though real rates remain well below historical norms. Companies in the US, as almost everywhere, are cash-rich but showing little desire to increase investment – and household incomes are barely rising faster than inflation. Two things will happen when the US consumer-led boom stalls. Most obviously, imports will tend to fall, with a consequent knock-on effect for Asian exporters, China more than most because of the Chinese economy’s exposure to US-bound exports. Contrary to some current belief, it will not be question of the world catching cold when China sneezes, but of China catching a cold from the US.

Quite how much damage that will do to China’s own growth rate remains to be seen but given that China (and India) have been growing at unsustainably high rates, the downward shift could be severe. It will anyway be accompanied by a politically driven continued gradual appreciation of the yuan against the dollar which will squeeze Chinese corporate revenues and profits – and also those of US retailers like Wal-Mart which source heavily from China.

That brings up the secondary impact of the US consumer retreat: the narrowing of the current account deficit, which would reduce the pace of global liquidity creation. Growth of base money has been fuelled by a 15 percent plus increase in global reserve assets, still mostly held in dollars.

A weak US economy would have the secondary effect of causing most currencies, particularly the Asian ones which are conspicuously cheap (headed by the yen) to rise. In turn this would further contract the local liquidity expansion effects of the US deficit. The impact would be particularly felt by China, for whom the trade surplus is a key to over-rapid credit growth.

It would likely be less marked in countries such as Malaysia and Taiwan. Both seem candidates for currency appreciation and reduced current account surpluses. But the liquidity expansion effect of their huge current surpluses has been significantly offset by capital outflows, while China has had large net capital inflow in addition to its current surplus.

Apart from the US consumer, the other global party pooper will be Japan. Whether led by a change of heart by Japanese institutions or by fear replacing greed in the hearts of investment bankers and hedge fund gamblers, the huge outflow of yen will come to a halt. Indeed, for many with leveraged positions in the carry-trade it will be dramatically reversed.

The importance of a sudden rise in the yen, back to say 105 to the US dollar, would not be so much on its trade surplus or domestic profit, which is super-competitive at current low exchange rates. It is the sudden increase in the exchange-rate cost of borrowing Japanese savings. That will mean a sharp pullback in the global liquidity expansion by which Japanese savers have been financing consumer booms in the US, UK, Australia, New Zealand etc and driving interest rates in sickly emerging markets such as the Philippines to rock bottom levels.

Quite how fast all this happens is impossible to tell, if only because of the opaque nature of the credit derivatives business and the sheer size of currency hedging books. But once markets get a whiff of trouble, rout could follow and take some big institutions and funds down with it. There was a hint of panic this week even though the US consumer’s retreat is not yet a sure bet in the near term, and Japan’s weak-willed central bank has appeared to extend the life of the yen carry trade and by implication the Taiwan dollar and Swiss franc equivalents (both have been unnaturally weak despite huge current account surpluses).

So what does this say to investors? Will it take commodity markets down with stock markets as demand stalls simultaneously with the contraction in liquidity? Some impact in inevitable at least on base metals such as copper. But the overall impact on commodities may well be modest as investments in new production have lagged demand and new mines come on stream only slowly. Food commodity prices will be kept under upward pressure by demand from ethanol and biodiesel plants. Precious metals may even benefit as investors seek refuge from currencies as well as stocks.

But don’t rush out and buy Australia. Australian consumption and property prices are likely to suffer badly as the cost of sustaining its huge current account deficit increases just as commodity markets falter. Avoid the Aussie and NZ dollars which have been buoyed up by the carry trade.

The euro will probably get even stronger against the US dollar as the ECB keeps monetary policy quite tight even as the US heads for recession. But it has already risen so steeply since its nadir five years ago that a major new move seems unlikely. Ditto the Canadian dollar, which would also suffer from a commodity decline.

The currency action is going to be mostly in Asia and the yen will be the key. The NT dollar will not be far behind and may well strengthen against the yuan as well as the US dollar. Ditto the ringgit. Further appreciation against the US dollar is likely for the won, Singapore dollar and baht, but having led the way in Asian currency appreciation they will now likely lag.

So what does this scenario do for Asian stock, property and bond markets? Clearly exporters’ margins will be squeezed by weak US demand, a possibly faltering China and by currency appreciation. Reduced global liquidity should put upward pressure on interest rates but commodity-driven inflation is falling and stronger currencies will deter authorities from raising rates. So bond markets may be quite stable (except for the weaker countries like the Philippines and Indonesia). Stock markets can expect to suffer broadly but domestically-oriented issues including banks in most of Asia should not be badly hurt. (China and India excepted)

Indeed, Taiwan and Japan may well see repatriated funds invested in the property market. Hong Kong’s property market should also benefit from a weak currency vis-à-vis China.

As for Wall Street, the end of the consumer and property booms will see some horrendous casualties in the credit sector, retail and real estate. But some boring old manufacturing outfits would do really well out of a declining dollar and continued, if slower, growth in foreign markets, especially in Asia.

Perhaps the overriding question is not what the trend is going to be but how fast it will happen and hence how destabilizing. The impact of interest rate and currency adjustments has so far been gradual and un-alarming. If continued there will be no crisis but a slow but sure shift to a new trade and market equilibrium.

However, experience suggests that after such a long period of monetary expansion there will be a catharsis, not as severe as the 1997 Asian crisis but on a scale that spans the whole globe.

A shock to the system: It isn't only the economy, stupid

Market.view

Mar 4th 2007
From Economist.com

WILL the past week’s market sell-off prove to have been a seven-day wonder? The investment community quickly split into two camps. One group, which made frequent appearances on CNBC, a financial news channel, argued that the fall in share prices was a freak event. It maintained (unconsciously echoing President Herbert Hoover after the 1929 crash) that the “fundamentals of the economy are sound”.

The more bearish seized on the crash as a sign of a coming apocalypse. A notable member of this camp was Andrew Smithers, of Smithers & Co, who said the fall “could be the start of the second leg of the major bear market which started at the end of March 2000.”

Whether or not Mr Smithers turns out to be right, investors need to be wary of relying too much on economic fundamentals as a guide to the market’s immediate outlook.

For a start, the market is supposed to be a forecasting mechanism, so it may be warning of economic problems ahead. There were few signs of economic problems in March 2000 when the dotcom bubble popped, but a mild recession duly followed.

Second―a point made by Bill Gross, a bond guru at Pimco, a fund management firm―these days it is often the financial markets that are driving the economy, rather than the other way round.

Think about the rise in profits as a percentage of GDP in America and elsewhere. That has enriched companies and their shareholders at the expense of workers. But if workers are being squeezed, why hasn’t consumer demand been hit? Because consumers still feel wealthy thanks to the rise in share and (until recently) house prices.

Furthermore, look at the extraordinary success of the financial sector. Profits have been rising relentlessly and bonuses have been exceptional. In the UK, the financial sector is a vital driver of the economy, which is why the current government would be mad to drive it away by, for example, capping bonuses or attacking private equity.

But the financial sector’s success is driven by 20 years of rising asset prices and falling interest rates. Remember how the Federal Reserve rushed to cut rates when the financial sector was hit in 1998 and 2001. Think, also, how the Japanese economy struggled through the 1990s, thanks to its ailing banking system.

So it is the mechanics of the financial system itself that will determine the prospects for the markets. Here there are dangers. Banks have been disintermediated. They can no longer rely on taking deposits from retail customers and lending the proceeds at higher rates to business.

The corporate sector borrows from pension funds, insurance companies and the like. The banks merely arrange the deals. This transaction activity, covering everything from stockmarket flotations to complex derivatives, is a vital source of income, as is the trading of those instruments when issued.

Any shock that dries up liquidity is a threat to the financial sector, and the markets. Reduced liquidity means less issuance. A reluctance to hold illiquid assets means lower prices, a blow to the trading arms of the banks.

Hedge funds also provide liquidity to the markets, because they trade much more often than traditional investors. Dresdner recently estimated hedge funds delivered 15-20% of investment banking revenues. Hedge funds are natural buyers of illiquid assets (where prices are most likely to be incorrectly set) and also sellers of volatility.

Those who sell volatility (the equivalent of writing insurance on financial markets) receive a steady stream of premium income that looks impressively smooth to investors. Liquid and less volatile markets look safer and appear to justify higher prices.

We thus create a virtuous circle in which investment banks and hedge fund together drive volatility down and liquidity and prices up. But at some stage, this process cannot be pushed any further.

The risk is what happens when the process unwinds. Prices fall, causing hedge fund and investment banks to retreat from the markets; this reduces liquidity, implying lower prices and so on.

Perhaps the shock of February 27 was insufficiently drastic to send the process into reverse. But that is the risk that investors should be most concerned about. In the next few weeks, they should be looking for signs of distress in some of the less liquid areas of the markets, such as high-yield bonds and credit derivatives.

Correction: this could become a crash after all

As traders brace for fresh turmoil, soothing words may simply be hiding reality

Larry Elliott, economics editor
Monday March 5, 2007
The Guardian

With his low opinion poll ratings, George Bush needs a crash on Wall Street like a hole in the head. The days are ticking away towards the end of his presidency and the Pentagon is warning that unless the "surge" in Iraq works the United States could be heading for another Vietnam.

Little wonder, then, that Washington did its best to rubbish any suggestion that last week's turbulence on the financial markets amounted to anything more than a little temporary difficulty. In this, the Bush administration was ably supported by the great and good of New York - or at least that part of the financial elite that wasn't banged up for alleged insider trading last week by the securities and exchange commission. As ever, the same reassuring story was spun. Like a hypnotist faced with a sceptical member of the audience, the words were repeated over and over again. Listen, this is a correction not a crash. Relax, the fundamentals of the global economy are strong. Are you listening to me? There will be no recession in the US. Did you hear what I said? There will be no recession in the US.

---

---

By the end of the week, the trick seemed to have paid off. Ben Bernanke, the chairman of the Fed, had downplayed the risks of recession brought to the public's attention by his predecessor, Alan Greenspan. And the markets were gagging for reassurance. After all, if you've spent the past couple of years persuading yourself and clients that investing in the current climate is risk-free, the last thing you want to hear is that the glittering edifice of the global economy is a Potemkin village - the fake Crimean settlements set up to impress Catherine II. The dozen charged by the SEC are not the only ones guilty of rigging markets; they were just a bit more self-serving about it, that's all.

Naturally, the consensus may be right. The consensus tends to be right more often than it is wrong, which is why real crashes of the sort seen in October 1929 and October 1987 tend to be a rarity. Indeed, the big sell-off of 20 years ago did prove to be far less of a threat than was initially feared.

Even so, there are reasons for concern. One is that the soothing words were at odds with what happened in the markets. Wall Street suffered its biggest weekly fall in four years with the Dow Jones industrial average down 4.2%.

Banks raised the cost of the dodgy loans in the sub-prime market, and the contagion affected other markets. The cost of insurance against credit defaults rose sharply and there was a flight to quality assets. This may prove temporary; if the self-hypnotism works the financial markets may soon again be seeking out all sorts of rococo investments, amplified by derivatives, in the belief that they are risk-free.

This, in some ways, would be more worrying than a flight to quality or rising spreads on junk bonds, because the riskiest of all markets is the one where the players can see no risk.

A second concern is that the US may be in a lot worse shape than Wall Street - cocooned by its sky-high salaries and lucrative bonuses - realises. One view of the US economy since the early 1990s is a glorious renaissance built on the coming industries of the hi-tech revolution; another is that an unsustainable stock market was followed by a bust, and that in turn was followed by an unsustainable boom in the housing market that has also now gone bust. Sure, the Fed could respond to the threat of recession by cutting interest rates, but the traction gained by cheap money is going to be a lot less this time. Why? For one thing, the two debt-driven bubbles have left consumers enormously over-extended. For another, inflation in the asset markets has spilled over into general inflation. Cutting the cost of borrowing might have more of an impact on prices than it would on activity.

As Stephen Lewis of Insinger de Beaufort puts it, the real surprise, given what has been happening in the US housing market, is that consumer spending has held up so well. But there is a sense that the consumer is starting to run out of road, with spending propped up by the one-off impact of lower energy prices.

Charles Dumas at Lombard Street Research agrees, and says the increase in borrowing on credit cards rather than the rising value of real estate, is a sign that US consumers are drinking in the last-chance saloon. The vast majority of Americans don't have a yacht and a summer home in the Hamptons; they don't have stock options and they have not seen their salaries rise at 10, 50 or 100 times the current inflation rate.

Given Asia's export-dominated growth is heavily weighted towards the US, investors should be prepared for the 9% fall in Shanghai last Tuesday to be the first of many bad days.

"Household borrowing is the centre of the storm," says Dumas. "When economies fluctuate, services fluctuate gently, construction and manufacturing more violently. Construction we know about: the housing slump is now beginning to be reinforced by a business construction collapse. The US manufacturing sector is now called China, or Pacific-developing Asia more generally. The current US downswing must take the gloss off growth in that region, where asset markets are priced for perfection." A different perspective comes from Stephen King at HSBC. His view is that the global economy is now more than the United States and its satellites. Even if America does slide into recession, there is no reason to assume the rest of the world will follow.

This requires a radical re-think, since we have become accustomed, particularly since the collapse of the Soviet Union to assume the world is unipolar with the US the hegemonic power. King says the weaker domestic demand growth in the US last year did not seem to have knock-on effects elsewhere. Far from catching a cold when the US sneezed, the rest of the world went shopping. "Relative to our own forecasts, the big surprise last year was the strength of domestic demand growth, notably in Canada, Mexico, China, the Middle East, Germany and the UK."

On the face of it, this is a relatively reassuring interpretation of events. If there really has been a de-coupling going on under our noses, it is possible that a US recession could be isolated. Scratch beneath the surface, though, and King's thesis has some potentially serious long-term geo-political - and hence economic - consequences. What could be happening is that we are seeing the very gradual waning of US economic supremacy, with years of budget and trade deficits and two decades of excessive consumption chipping away at what is still a phenomenally powerful economy. Britain suffered from just this process in the final quarter of the 19th century; other nations were growing in strength and Britain was in the early stages of relative decline.

Paul Kennedy argued in the late 1980s that political power derives from economic power. The first doubts crept in for Britain when winning the Boer War in the face of determined resistance and guerrilla attacks proved a lot more difficult than London had blithely imagined. History may show that South Africa between 1899 and 1902 is a better parallel for America under Bush than is Vietnam.

larry.elliott@guardian.co.uk

Last Week's Financial Markets: What the Hell Happened?

March 3, 2007

By Bonddad
bonddad@prodigy.net


Below is a compilation of several posts on my blog. I've put these together in one mega-market post. I hope this helps to explain and assuage some fears out there.

The markets on Friday

Traders don't want to hold anything over the weekend in this market. Take a look at the last two bars of both the SPYs and QQQQs -- there's a ton of volume and a strong downtrend. In addition, the markets closed near their lowest point of the day. This indicates there is some pretty strong bearishness in the market right now.

SPY:

QQQQ:

A review of the week and daily charts

From Bloomberg:

U.S. stocks dropped to a three-month low, completing their worst week since January 2003, after a decline in consumer confidence magnified the risk profit growth will be wiped out by a recession.

Let's go to the charts in the following order: SPY, QQQQ, IWN

These charts highlight four points.

1.) Tuesday was the big day of losses with a sudden drop at the open and continued weakness throughout the day.

2.) Friday we drifted downward and closed on a low-point.

3.) The overall trend for the week is down.

4.) You can literally draw a line from the upper left to the lower right of each chart and have the line represent the week's trend.

Let's go the the daily charts, courtesy of stockcharts.

Here's the SPY:

1.) There is a big jump in volume above the preceding 3-4 months. This indicates sellers were looking to get out.

2.) The index closed below the 50-day SMA.

3.) The index clearly broke the 6-month uptrend and broke through previous support levels.

Here's a chart for the QQQQs

1.) There are 4 days of heavy selling on between 2-3 times the normal volume for the preceding 3-4 months.

2.) The index closed below the 50 day SMA.

3.) The QQQQs have traded in a range between (roughly) 42.50 and 45.50 for the last three months. We closed below that range on Friday.

Here's a chart for the IWNs

1.) We had the heaviest selling of the indexes here -- up to 5 times the norm for the last 3-4 months.

2.) The index closed below the 50-day SMA.

3.) The index broke through two uptrends -- one that started at the beginning of October and one that started at the end of January.

All of these indexes had long red bars with large volume. This means sellers are in control and looking to book profits.

Fundamental Reasons for the Sell-off

1.) The BEA lowered GDP estimates from 3.5% to 2.2%. First, this is a large revision. People will make entirely different economic assumptions about an economy growing at a 3.5% growth rate than an economy at a 2.2% growth rate. Secondly, this is the third quarter of sub-par growth, indicating we are definitely in the cooling off stages.

2.) New Home sales dropped 16%. There is a high margin of error with this number, so it can be revised upwards. However, the initial reading put the "the housing market has bottomed" people out to pasture.

3.) Durable goods orders dropped 7.1%. Even without transportation, this number dropped 3.1%.

4.) Weekly unemployment claims are ticking up. The 4-week moving average increased from 327,000 on February 10 to 335,000 in the latest report. However, bear in mind this is a noisy report and is subject to revisions etc...

5.)While personal income increased (a net positive) the core PCE inflation level increased .2%. This takes away fuel to the "Fed will lower interest rates soon" argument.

6.) Construction spending dropped .8% in January. This adds further fuel to the slowing housing market story.

7.) While existing home sales increase last month they did so because of a 5% December to January price decrease, a 3.1% year-over-year price decrease, a 3% increase in the month-to-month inventory and a 23% increase in year-over-year inventory. In other words, the high inventory figures are starting to hit prices and we still have a ton of homes to sell.

8.) Countrywide Financial announced 20% of the subprime loans they service are late with payments. This indicates there is probably more trouble ahead for an already troubled part of the economy.

The Bullish Argument Going Forward

This is the Barron's cover story this week (subscription required). The article makes some good points.

Before Tuesday, every major stock market in the world -- and nearly all the smaller markets -- were near 52-week highs. Most markets also were near record levels, with the notable exceptions of the Nasdaq Composite and Standard & Poor's 500, a reflection of the absurd valuations they had reached in the tech boom of 2000.

.....

A bullish Wien thinks the S&P 500 could hit 1,600 by year end, a 15% gain. He says U.S. stocks look attractive with the S&P valued at 15 times projected 2007 operating earnings. The Dow Jones Industrial Average trades at 14.4 times estimated "07 profits. Both the Dow and the S&P 500 are in negative territory for the year, with the industrials off 2.8% and the S&P 500 down 2.2%. The so-called earnings yield on both the S&P 500 and the Dow is close to 7%, which compares favorably with the 4.5% yield on 10-year Treasuries. The earnings yield is the inverse of the market's price-earnings ratio.

Companies continue to lift dividends and repurchase record amounts of stock in order to reward shareholders -- and stay out of the sights of private-equity shops on the prowl for new leveraged buyouts.

.....

HISTORY SUGGESTS THAT STOCKS MAY DO WELL in the next two months. There have been 38 days since 1979 when the S&P 500 has suffered a single-session loss of 3% or more. The average gain in the ensuing 60 days has been 6.9%, with the index rising in 31 of the 38 cases, according to Citigroup research.

There are some very solid technical arguments here. First, the market isn't cheap but certainly not expensive by historical standards. While corporate profit growth is expected to slow, it is still pretty healthy. And traders are conditioned to buy on dips, meaning there could be some buying nibbles at attractive technical levels over the next few weeks.

The article does state overall slowing economic growth is the primary reason the markets may not advance. This is a strong counter-argument. As I wrote above, there was a ton of bad economic news last week that provided the fundamental reason for the continued market weakness throughout the week. I think the market is starting to price in the slower growth scenario going forward.

I still think housing is the main wild card going forward. There is still a ton of inventory to clear and last week's numbers indicate it will take lower priced to do it. Housing starts are slowing, which means we will probably have a large amount of construction lay-offs in the coming months. However, the business construction sector may absorb some of these displaced workers if non-residential construction levels continue at current levels.

I wouldn't be surprised to see the market far more sensitive to bad economic news over the next few weeks. Up until last week, the market was able to shrug off some bad news, basically arguing that problems were contained within specific market sectors -- especially housing problems. However, I think we'll start to see some of housing issues -- especially in the mortgage area -- start to spread-out to other market sectors like financials (mortgage related issues) and consumer durables (furniture/appliances).

Food for thought

Insider-Trading Ring Bust May Fuel Hedge-Fund Concern

(Update1)

By David Scheer

March 2 (Bloomberg) -- The U.S. government's accusations that Morgan Stanley, UBS AG and Bear Stearns Cos. employees were central figures in an insider-trading ring illustrate why regulators and lawmakers are suspicious of Wall Street's relationship with hedge funds.

Prosecutors in New York and Washington yesterday laid criminal charges against 13 people, accusing an executive at UBS and a former compliance lawyer at Morgan Stanley of tipping off traders and brokers to new analyst ratings and secret takeover talks. Bear Stearns was home to at least four professionals who traded on information leaked from inside the two firms, according to a complaint filed by the Securities and Exchange Commission.

``Incidents like this strengthen the hands of those who are urging greater scrutiny of hedge-fund activities and their sources of information,'' said David Becker, a former SEC general counsel now in private practice at Cleary Gottlieb Steen & Hamilton LLP in Washington.

Legislators such as Senator Arlen Specter, the Pennsylvania Republican, want market watchdogs to take action amid mounting evidence of rampant insider trading. At least two studies show that stocks and derivatives regularly rise ahead of takeovers, and in the past week trading of options to buy shares of TXU Corp. and Hyperion Solutions Corp. surged in advance of announcements that they agreed to be acquired.

Incentive to Trade

Hedge funds are private pools of capital that allow managers to participate substantially in gains on the money invested. That pay structure creates an incentive for employees to trade in non-public information. Hedge-fund managers also are under pressure to boost returns that since 2000 have averaged half the industry's gains in the 1990s.

The temptation to cheat extends to the securities firms, which collect $10 billion a year in fees for providing prime- brokerage services to hedge funds.

``The larger the pot of gold the more likely that you'll entice someone into stealing,'' said William Portanova, a criminal-defense attorney and former federal prosecutor based in Sacramento. ``Good people convince themselves over a cocktail that it's a victimless crime and that they're merely collecting a few crumbs from the feast that no one will ever miss.''

Earlier this year, the SEC asked at least 10 Wall Street firms to turn over stock-trading records for the last two weeks of September, seeking to determine whether they leaked details about big stock trades to favored clients.

Boesky, Levine

The government said yesterday that it broke one of the biggest insider-trading cases since the 1980s. According to the SEC, which brought a civil suit against 14 defendants, the scheme stretched over five years, included hundreds of tips and produced more than $15 million in illegal profits.

The arrests ended ``one of the most pervasive Wall Street insider trading cases since the days of Ivan Boesky and Dennis Levine,'' said Linda Thomsen, who heads the Securities and Exchange Commission's enforcement division.

At a meeting at the Oyster Bar in New York's Grand Central Station in 2001, Mitchel Guttenberg, an executive director in UBS's equity-research department, and hedge-fund trader Erik Franklin hatched one of the schemes, the SEC claims.

Guttenberg, 41, offered to settle a $25,000 debt to Franklin, 39, by slipping him analyst ratings in advance, the agency said. To avoid getting caught, the men used disposable mobile phones to send each other coded messages, according to the SEC's complaint.

Bear Stearns Officials

At the time, Franklin was working at Bear Stearns and managing money for Lyford Cay Capital out of the firm's New York offices, prosecutors said. He and his colleague, David Tavdy, 38, made more than $4 million on inside trades in brokerage accounts they controlled. Three Bear Stearns brokers also traded on Guttenberg's tips, the complaint alleges.

``The actions described in the complaint are clear violations of our policies and procedures,'' said Russell Sherman, a spokesman for Bear Stearns. ``We have and will continue to cooperate with the investigation.''

Lyford Cay's investors included ``certain senior officials'' of Bear Stearns, according to the SEC. Sherman declined to name them.

Prosecutors also accused Randi Collotta, 30, a compliance officer at Morgan Stanley, of telling her husband Christopher Collotta, 34, and Marc Jurman, 31, a broker in Florida, about deals in 2004 and 2005 including Johnson & Johnson's failed $24.2 billion bid for Guidant Corp., UnitedHealth Group Inc.'s $8.2 billion acquisition of PacifiCare Health Systems Inc. and ProLogis's $5.5 billion purchase of Catellus Development Corp.

Illegal Trading

Jurman traded on some of the information and passed it on to others, generating thousands of dollars in profits that were passed back to the Collottas and others, according to the SEC complaint. Two of the Bear Stearns brokers benefited from the leaks at New York-based Morgan Stanley, the world's second- largest securities firm.

A study by Measuredmarkets Inc. in August showed that insiders may have traded illegally in advance of 41 percent of the largest U.S. acquisitions the previous year. Two months later, Credit Derivatives Research LLC found that credit-default swaps based on the bonds of 30 takeover targets, including four of the five biggest leveraged buyouts by that point in 2006, rose before deals were announced.

More recently, trading in options to buy shares of TXU Corp. surged more than seven-fold on Feb. 23 before CNBC said the company would be acquired in the largest-ever leveraged buyout. This week, the volume of options trading to buy shares of Hyperion Solutions Corp. rose almost sixfold before Oracle Corp. yesterday said it will buy the company for $3.3 billion.

Guilty Pleas

Four of the criminal defendants have pleaded guilty. Eight, including Guttenberg, pleaded not guilty in Manhattan federal court and were released on bail of as much as $500,000. No firm was criminally charged. All the defendants declined to comment, as did attorneys for Guttenberg and the Collottas.

Lawyers for Franklin, Jurman and Tavdy didn't return calls seeking comment.

Morgan Stanley spokesman Mark Lake said his company is ``outraged that a former employee allegedly stole confidential information,'' and the firm is cooperating with investigators. UBS also is cooperating, said Rohini Pragasam, a representative in New York for the Zurich-based bank.

Bear Stearns, based in New York, is the fifth-largest U.S. securities firm by market value.

Charlotte, North Carolina-based Bank of America Corp., the second-biggest U.S. bank, also is cooperating with the government investigation after one of its brokers was accused of collecting kickbacks in exchange for shares of new stock offerings, spokeswoman Shirley Norton said.

The SEC case is SEC v. Guttenberg, U.S. District Court for the Southern District of New York (Manhattan).

To contact the reporter on this story: David Scheer in Washington dscheer@bloomberg.net .

Last Updated: March 2, 2007 03:55 EST

The Big Meltdown: PAUL KRUGMAN - Financial Crisis

THE COMPLETE ARTICLE
THE NEW YORK TIMES
OP-ED COLUMNIST

The Big Meltdown

By PAUL KRUGMAN

Published: March 2, 2007

If we’re going to have a financial crisis, here’s how it will play out.

The great market meltdown of 2007 began exactly a year ago, with a 9 percent fall in the Shanghai market, followed by a 416-point slide in the Dow. But as in the previous global financial crisis, which began with the devaluation of Thailand’s currency in the summer of 1997, it took many months before people realized how far the damage would spread.

At the start, all sorts of implausible explanations were offered for the drop in U.S. stock prices. It was, some said, the fault of Alan Greenspan, the former chairman of the Federal Reserve, as if his statement of the obvious — that the housing slump could possibly cause a recession — had been news to anyone. One Republican congressman blamed Representative John Murtha, claiming that his efforts to stop the “surge” in Iraq had somehow unnerved the markets.

Even blaming events in Shanghai for what happened in New York was foolish on its face, except to the extent that the slump in China — whose stock markets had a combined valuation of only about 5 percent of the U.S. markets’ valuation — served as a wake-up call for investors.

The truth is that efforts to pin the stock decline on any particular piece of news are a waste of time.

Wise analysts remember the classic study that Robert Shiller of Yale carried out during the market crash of Oct. 19, 1987. His conclusion?

---MORE--

The World Drops Its Guard: Stephen Roach

Global
February 26, 2007

By Stephen S. Roach | New York

A new level of complacency has set in. It’s not just a financial-market thing -- extremely tight spreads on risky assets and sharply reduced volatility in major equity and bond markets. It’s also an outgrowth of the increasingly cavalier attitude of policy makers. That’s true not only of central banks but also -- and this is a major concern of mine -- by the global authorities charged with managing the world financial architecture. Meanwhile, by flirting with the perils of protectionism, politicians are ignoring some of the most painfully important lessons from history. After four fat years, convictions are deep that nothing can derail a Teflon-like global economy. That’s the time to worry the most.

I am especially concerned about a new lax attitude that has crept into the mindset of the so-called stewards of globalization -- namely, the IMF and the broad collection of G-7 finance ministers. Last spring, in an uncharacteristically bullish lapse, I became more optimistic on the global economy than I had been in a long time (see my 1 May 2006 essay, “World on the Mend”). I was especially encouraged that the Wise Men had finally woken up to the perils of ever-mounting global imbalances -- namely, the widening disparity between America’s gaping current account deficit and large and growing surpluses in China, Japan, Germany, and the major oil producers. With great fanfare at the April 2006 G-7 and IMF meetings, institutional support was thrown behind a new framework of multilateral surveillance and consultation -- in my view, materially raising the odds of an orderly, or benign, rebalancing of an unbalanced world.

Unfortunately, the multilateral approach is now rapidly losing momentum. The first joint consultations between the US, Europe, Japan, China, and Saudi Arabia were held last summer, and there was a noticeable lack of “deliverables” following this effort. IMF Managing Director Rodrigo de Rato’s mid-November 2006 report on the “work program” of the Fund’s executive board was a further disappointment, relegating the problems of global imbalances to just one paragraph of a 49-paragraph document. And in the past few months, many of the individual participants at the various G-7 finance ministries and central banks have admitted privately to a lack of progress and conviction in the multilateral approach. With the global economy and world financial markets turning in yet another good year, suddenly, the urgency to act is now seen as less critical by the stewards of globalization. Complacency has claimed an important victim -- thereby undermining the major rationale for my bullish change of heart on the global prognosis.

Meanwhile, central banks -- basking in the warm glow of success on the inflation-targeting front -- are pouring more and more fuel on the global risk binge. America’s Federal Reserve seems to settling for a long winter’s nap -- likely to keep monetary policy on hold through at least the end of this year, according to our US team. While the Fed has expressed repeated concerns about last year’s minor upside breakout of inflation, it has also been quick to stress the coming deceleration on the price front. We could well be in the midst of a period like that which prevailed in the early 1990s, when the US central bank left the federal funds rate unchanged at 3% for a 17-month stretch from September 1992 to February 1994. Unfortunately, that experiment did not end well for the financial markets, as one of the Fed first “normalization campaigns” led to the worst year in modern bond market history.

An inflation-targeting Bank of Japan seems to be of a similar mindset. That’s mainly because of the distinct possibility of a minor deflationary relapse, with year-over-year comparisons in the CPI likely to move from being fractionally positive (+0.1% in January) to slightly negative by March. Moreover, with the economy still judged to be on shaky foundations -- especially the ever-cautious Japanese consumer -- political pressure on the BOJ to refrain from any policy action has been intense. After having succumbed to that pressure in January, Governor Toshihiko Fukui appears to have expended great political capital in orchestrating the BOJ’s second baby step away from its anti-deflationary ZIRP campaign. In the end, a one-party Japan has little tolerance for central bank independence -- especially in light of a still very fragile state of affairs on the inflation front. I suspect, as does our Japan team, that the mid-February policy adjustment will be the last move of the BOJ for a long time.

That leaves the European Central Bank as the only one of the three major central banks that is likely to make any type of a policy adjustment in 2007. Elga Bartsch, our resident ECB watcher, puts the upside at 50 basis points of rate hikes. This suggests that European monetary authorities -- the most dogmatic of the inflation targeters in central banking circles -- believe they are now only two policy moves away from their own normalization objectives in a still low-inflation world. This view, of course, is predicated on the belief that the European economy continues to surprise on the upside. Should that view be drawn into question for any reason -- hardly a trivial possibility in light of the recent increase in the German VAT tax, the lagged impacts of euro appreciation, and the ripple effects of Italian fiscal consolidation -- the risks to the ECB policy path could quickly tip to the downside.

There’s nothing wrong with this picture from a strict inflation-targeting perspective. But that’s just the point, in my view. At low levels of inflation -- and persistent risks of deflation in Japan -- inflation targeting produces an exceptionally low level of nominal interest rates. That, in turn, continues to fuel the great liquidity binge that underpins an extraordinary degree of risk taking still evident in world financial markets. Central banks have circled the wagons in taking an agnostic position on this state of affairs. As a former senior central banker put it to me indignantly the other day, “Who are we to judge the state of markets?” That’s indicative of what I believe is a very narrow perspective of the role and purpose of central banking. Most importantly, it relegates financial stability to a secondary consideration at precisely the time when financial globalization and innovation could be inherently destabilizing.

The orthodox view of modern-day central banking is premised on the belief that hitting the narrow target of CPI-based price stability is sufficient to address anything else that might come along. Never mind that this approach has produced a most unfortunate string of asset bubbles -- first equities, now property, and next those that may well be bubbling up to the surface in the form of a tightly correlated compression of spreads on a host of risky assets (i.e., emerging market debt and high-yield corporate credit). Never mind the explosion of worldwide derivatives, whose notional value has now reached some $440 trillion (OTC and listed, combined) -- over nine times the size of the global economy. Central bankers will tell you that the liquidity and risk-distribution benefits of derivatives far outweigh the lack of transparency and limited information they have on the incidence and concentration of counter-party risk. Never mind the power of the carry trade, which has been given a new lease on life by the politically-compromised Bank of Japan. Never mind the potential “canary in the coal mine” that may well be evident in America’s sub-prime mortgage market. All in all, increasingly complacent central banks are telling us that these concerns are not actionable issues for monetary policy. That could well be a blunder of tragic proportions.

A similar complacency is evident on the political front. As the pendulum of economic power in the developed world has swung from labor to capital, the pendulum of political power is now swinging from the right to the left -- not just in the US but also in France, Germany, Italy, Spain, Japan, and Australia (see my 8 January 2007 dispatch, “Power Shift”). As pro-labor politicians now move into action, trade protectionism is increasingly getting the nod as a legitimate policy response. Nowhere is this more evident than in Washington D.C. I have spent a good deal of time in the US capitol the past couple of weeks and sense that Congress’s anti-China sentiment is most assuredly intensifying. The new Democratically-controlled Congress is not in a rush -- its momentum on trade policy, in general, and China, in particular, is methodical yet increasingly contentious. I have taken the other side in the debate at several forums in Washington -- but to little or no avail. This takes complacency to an even more worrisome level. US politicians feel completely justified in ignoring some of the most painful lessons of history. And, ironically, the broad consensus of investors feels equally justified in ignoring the possibility of a protectionist outcome. Such an inconsistency is yet another example of a world in denial.

I’ve been relatively constructive on the global outlook over the past 10 months. The call didn’t work out all that badly -- the world economy turned in another great year and, after a brief bout of risk-aversion last May, the markets did fine as well. That was then. New and worrisome political forces are coming into play at precisely the time when the stewards of globalization have gone back into hibernation. Meanwhile, central banks are refusing to take away the proverbial punchbowl when the party is getting better and better -- instead, egging on the risk-takers when risky assets are priced for all but the absence of risk.

Enough is enough -- from where I sit, it no longer makes sense to maintain an optimistic prognosis of the world. This is more of a structural call than a cyclical view. I remain agnostic on the near-term outlook, and certainly concede that the Goldilocks-type mindset currently prevailing could put more froth into the markets. But complacency is building to dangerous levels — always one of the greatest pitfalls for financial markets. And yet that’s precisely the risk today, as investors, policymakers, and politicians all seem to have dropped their guard at the same point in time. The odds have shifted back toward a more bearish endgame. I have a gnawing feeling we’ll look back on the current period with great regret.

Worst risk to market? Subprime mortgages

Related
Subprime housing game is over

Updated 2/27/2007 3:45 PM ET

By Sue Kirchhoff, USA TODAY

WASHINGTON — Growing trouble in the subprime mortgage industry poses the greatest risk to financial markets right now, according to a survey of business economists to be released Monday.

The forecast by the National Association of Business Economics (NABE), which polled 47 top economists, called the subprime sector a more serious concern than hedge funds, which came in second.

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Subprime mortgage lenders provide higher-priced loans to consumers with impaired credit. Defaults and delinquencies among subprime borrowers have jumped since late 2006, and a number of lenders have shut down or scaled back their operations.

On Wednesday, for example, shares of subprime lender NovaStar Financial plummeted more than 42% to $10.10 after it announced a fourth-quarter loss of $14.4 million. CEO Scott Hartman said in a conference call Tuesday that the company expects to recognize little, if any, taxable income through 2011.

While the NABE finding illustrates concern about escalating problems in the subprime sector, it doesn't mean economists expect the difficulties to spark broader financial stress. Overall, they expect steady economic growth in 2007.

"The outlook for consumer spending, which is the one that might be hit the highest by mortgage delinquencies and defaults, was actually revised upward," says Carl Tannenbaum, NABE president and an economist at LaSalle Bank.

The economists predict that the U.S. economy will expand at a 2.5% to 2.6% annual rate in the first half before accelerating to around 3% later this year. Growth is expected to average 2.8% for the year, in line with earlier NABE reports.

Housing will continue to be the biggest drag on growth. After five years of a boom market, housing starts have plunged in the past year.

The jobless rate, now 4.6%, is expected to inch up to 4.7%, the NABE says. Corporate profits, which rose by an estimated 19% last year after taxes, are projected to rise by a far more modest 5% in 2007.