Fed Defends The Indefensible

The Fed Defended Its Bear Stearns Rescue in testimony before the US Senate Banking Committee. Let's take a look.

"We judged that a sudden, disorderly failure of Bear would have brought with it unpredictable but severe consequences for the functioning of the broader financial system and the broader economy, with lower equity prices, further downward pressure on home values, and less access to credit for companies and households," Federal Reserve Bank of New York President Timothy Geithner said in testimony to the Senate Banking Committee.

"If you want to say we bailed out markets in general, I guess that's true," Mr. Bernanke told the Senate Banking Committee, adding the Fed's role in the rescue was necessary given the fragile state of financial markets. "Under more normal conditions we might have come to a different decision" with respect to Bear Stearns, Mr. Bernanke said.

My Comment: Sadly, no one bothered to ask Bernanke if what he did was legal, how many votes were required, who did vote, and why the Fed could not see this coming even though many predicted this would happen.

See Who's Holding The Bag? and scroll down to the section Warren Buffett vs. Greenspan for discussion of Buffett's opinion "The rapidly growing trade in derivatives poses a 'mega-catastrophic' risk"

Responding to a separate question during a hearing of top U.S. regulators on the Bear Stearns rescue, New York Fed President Timothy Geithner said he's doubtful that a new auction facility created by the Fed for investment banks would have helped Bear Stearns escape failure.

"It's not obvious to me that lending freely" to Bear Stearns "would have been a prudent act" by the Fed, Mr. Geithner told members of the Senate Banking Committee.

My Comment: Geithner hedged his bet but I won't. It should be perfectly obvious that lending freely" to Bear Stearns "would NOT have been a prudent act". The whole thing was illegal as it was. The Fed tried to skirt the illegality by lending to JP Morgan on behalf of Bear Stearns. Yet the Fed accepted Bear Stearns assets as collateral. And it put taxpayers at risk to do so.

Bear Stearns CEO Alan Schwartz appeared to contradict Mr. Geithner, telling U.S. lawmakers that the firm may not have failed if the Fed had opened its discount window to investment banks earlier.

Mr. Schwartz, testifying before the Senate Banking Committee, said confidence in Bear Stearns may not have evaporated so quickly had the Fed made liquidity available for all investment banks before being forced to provide emergency funds for his firm last month.

My Comment: What a bunch of nonsense. What are we to do, have the Fed start lending to every corporation, or just those who overleverage themselves to the point they threaten the whole system? And comparing capital levels to other corporations who took equally silly risks is simply no excuse.

"On the evening of Thursday, March 13, 2008, I took part in a conference call with representatives from the Securities and Exchange Commission, the Board of Governors of the Federal Reserve, and the Treasury Department," Mr. Geithner told lawmakers.

"On that call, the SEC staff informed us that Bear Stearns' funding resources were inadequate to meet its obligations and that the firm had concluded that it would have to file for bankruptcy protection the next morning," Mr. Geithner said.

My Comment: Does this sound like a liquidity issue to you? It sure doesn't to me. This is clearly a solvency issue.

"Bear Stearns would have failed without this effort, and the consequences could have been disastrous," Mr. Dimon told the committee in remarks prepared for delivery. "The idea that the Bear Stearns fallout would have been limited to a few Wall Street firms just isn't so."

He said J.P. Morgan couldn't and wouldn't have entered the transaction without the Fed's backstop, but that it was the firm's obligation as a "responsible corporate citizen" to help stem potential systemic risk if it could.

"We did not cherry pick the assets in the collateral pool," Mr. Dimon said. "The assets taken by the Fed consist entirely of loans that are current and domestic securities rated investment grade.

My Comment: This is galling. Everyone is praising the quality of the assets offered to the Fed as collateral, but JPMorgan would not take them outright. Why not? And while the Fed is on the hook for fallout from those assets, what about the other assets JPMorgan picked up for next to nothing? What are those worth? Was JPMorgan acting like a "responsible corporate citizen" or a vulture financing corporation?

And please, don't make me gag over the term "investment grade securities". Bear Stearns itself was investment grade. It went bankrupt overnight.

"There was, simply put, a run on the bank," said Mr. Schwartz, who told CNBC two days before the rescue that Bear Stearns wasn't in the midst of a liquidity crisis.

He said a lack of confidence, rather than a lack of liquidity was to blame for the run on Bear Stearns.

My Comment: Of course there is no confidence. Why should there be confidence? Two Bears Stearns hedge funds went to zero while Bear Stearns was attempting to unload across the globe the very ABCP garbage those hedge funds were stuck in. There has been writedown after writedown at banks and brokerages. People are walking away from homes. Unemployment is rising. Assets are being hidden off the books in SIVs. Very little is marked to market. And Bear Stearns was leveraged to the hilt. There is not going to be confidence for years. Why should there be?

The mess we are in was not caused by lack of confidence, the mess was caused by greed, rampant overconfidence within corporations, and foolish overconfidence in the Fed's ability to bail out anyone big enough to mater. Overconfidence drove banks and brokerage houses to leverage up on garbage that is now imploding. Sadly, the Fed did everything it could all along the way to encourage such risk taking. This of course makes the Fed the root cause of this mess.

Confidence vs. Liquidity

Bear Stearns CEO said "lack of confidence, rather than a lack of liquidity was to blame for the run on Bear Stearns."

Let's explore that idea with a flashback look at statements made by Punk Ziegel analyst Richard Bove as discussed in Confidence vs. Liquidity.

Bove: Investors and banks already have the cash to buy risky loans and investments, he said.

Mish: Disagree strongly. Banks and lending institutions are essentially "all in". In fact, with leverage they are more than "all in" as a Duration Mismatch is Causing Severe Stress Everywhere Banks are very short of cash as what we are seeing is tantamount to margin calls in illiquid assets. But as Bove suggests, borrowing from the Fed at a marginally lower rates does not fix that problem.

Bove: "There is no liquidity problem, but a serious crisis of confidence."

Mish: Disagree strongly. Liquidity (in the form of credit) and confidence are two sides of a double headed coin as well as two sides of a double tailed coin. Confidence and liquidity are both cowards that flee when problems arise. As long as there was confidence in housing there was plenty of credit for loans. Once confidence in housing dropped, liquidity did too. The same scenario is now playing out in junk bonds and LBOs. There is no liquidity without confidence and nor is there confidence without liquidity.

Overconfidence and anything goes liquidity work hand in hand. One look at covenant lite deals, junk funding for stock buybacks, and enormous LBOs that make no economic sense should be proof enough. When confidence died, so did liquidity for the deals.

The only thing that can restore confidence is the very thing the Fed refuses to do: let the free market work.

Caroline Baum had interesting comments about how the Fed handled matters in Fed Should Clarify Link to Bear Stearns Assets.

Watching the evolution of Fed policy in the last six months from focused on inflation to fearful of systemic risk; the series of aggressive, rapid-fire rate cuts; the creation of an alphabet soup of new lending facilities [TAF, TSLF, PDCF]; and the orchestration of a fire sale of Bear Stearns to JPMorgan, one has to wonder about the Fed's M.O. It all has a make-it-up-as-you-go-along quality.

Please see Fed Uncertainty Principle for my comments on the above, additional thoughts on the illegality of the Fed's actions, and a complete theory on self reinforcing observer/participant feedback loops at the Fed and how that distorts the market.

One thing should be clear in all this, the SEC's Open Invite For Corporations To Lie and the Fed's "make-it-up-as-you-go-along" policy are not going to restore confidence. The market may be bouncing now, but don't confuse a bear market rally with restored confidence.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List

Fed Uncertainty Principle

Most think the Fed follows market expectations. Count me in that group as well. However, this creates what would appear at first glance to be a major paradox: If the Fed is simply following market expectations, can the Fed be to blame for the consequences? More pointedly, why isn't the market to blame if the Fed is simply following market expectations?

This is a very interesting theoretical question. While it's true the Fed typically only does what is expected, those expectations become distorted over time by observations of Fed actions.

For example: If market participants are expecting the Fed to cut on weakness and the Fed does, market participants gets into a psychology of expecting more cuts on more weakness. Here is another example: If market participants expect the Fed to cut rates when economic stress occurs, they will takes positions based on those expectations. These expectation cycles can be self reinforcing.

The Observer Affects The Observed

The Fed, in conjunction with all the players watching the Fed, distorts the economic picture. I liken this to Heisenberg's Uncertainty Principle where observation of a subatomic particle changes the ability to measure it accurately.

To measure the position and velocity of any particle, you would first shine a light on it, then detect the reflection. On a macroscopic scale, the effect of photons on an object is insignificant. Unfortunately, on subatomic scales, the photons that hit the subatomic particle will cause it to move significantly, so although the position has been measured accurately, the velocity of the particle will have been altered. By learning the position, you have rendered any information you previously had on the velocity useless. In other words, the observer affects the observed.

The Fed, by its very existence, alters the economic horizon. Compounding the problem are all the eyes on the Fed attempting to game the system.

The Fed cannot change the primary trend in interest rates. However, the Fed can exaggerate the trend, temporarily slow it, or hold the trend for an unreasonably long period of time after the market (without Fed distractions) would have acted. This leads to various distortions, primarily in the direction of the existing trend.

A good example of this is the 1% Fed Funds Rate in 2003-2004. It is highly doubtful the market on its own accord would have reduced interest rates to 1% or held them there for long if it did.

What happened in 2002-2004 was an observer/participant feedback loop that continued even after the recession had ended. The Fed held rates rates too low too long. This spawned the biggest housing bubble in history. The Greenspan Fed compounded the problem by endorsing derivatives and ARMs at the worst possible moment.

In a free market it would be highly unlikely to get a yield curve that is as steep as the one in 2003 or as steep as it was just weeks ago when short term treasuries traded down to .21%. In other words we would not be in this mess without the Fed, or if we were, the mess would at least be smaller than the one we are in.

Would the market on its own accord be setting rates at the current Fed Funds Rate of 2.25? It's possible, but there is no way to tell.

It's even possible the Fed is behind the curve by not acting fast enough. This is of course all guesswork. I don't know, you don't know, and the Fed does not know what to do. This is part of the "Fed Uncertainty Principle" and a key reason why the Fed should be abolished. After all, how can you give such power to a group of fools that have clearly proven they have no idea what they are doing?

The Fed has so distorted the economic picture by its very existence that it is fatally flawed logic to suggest the Fed is simply following the market therefore the market is to blame. There would not be a Fed in a free market, and by implication there would be no observer/participant feedback loop.

The Fed hints at "possibility" of recession. We are already in one.

Today's headline reads Bernanke Nods at Possibility of a Recession.

In his bleakest economic assessment to date, the Federal Reserve chairman, Ben S. Bernanke, said Wednesday that the American economy could contract in the first half of 2008, meeting the technical definition of a recession, and he encouraged Congress to help homeowners caught up in the mortgage crisis.

My Comment: Bernanke is passing the buck. If housing continues to collapse Bernanke will attempt to blame Congress rather that point the finger at the number one culprit in this mess: The Fed, for micromanaging interest rates and blowing bigger bubble after bigger bubble.

Mr. Bernanke, testifying before the Joint Economic Committee on Capitol Hill, said the economic situation had weakened since the Fed last reported at the end of January but that it could revive later in 2008 because of the $150 billion spending and tax cut package enacted this year.

“It now appears likely that real gross domestic product, or G.D.P., will not grow much, if at all, over the first half of 2008 and could even contract slightly,” he said. “We expect economic activity to strengthen in the second half of the year, in part as the result of stimulative monetary and fiscal policies.”

My Comment: Bernanke clearly does not understand what is happening, or if he does, he is not telling the truth about it.

Uncertainty Principle Corollary Number One: The Fed has no idea where interest rates should be. Only a free market does. The Fed will be disingenuous about what it knows (nothing of use) and doesn't know (much more than it wants to admit), particularly in times of economic stress.

According to America's Research Group "Seventy percent of consumers who have received their 2007 income tax refund are using it to pay off credit cards and bills, the first time in 20 years that figure has topped 50 percent." See March Auto Roundup And Retail Sales Forecast for more on this topic.

Think you are going to get stimulus out of Bush's stimulus plan? Think again.

In separate comments, Mr. Bernanke went further than he had in the past, suggesting that the Fed would remain aggressive and vigilant to prevent a repetition of a collapse like that of Bear Stearns, though he said he saw no such problems on the horizon.

My Comment: Supposedly the Fed could not see the possibility of a derivatives chain reaction coming until after it started, even though this has been openly discussed in the news media for years.

Please see Who's Holding The Bag? and scroll down to the section "Warren Buffett vs. Greenspan" for a clear warning about derivatives.

By the end of his comments, it was also clear that he and the Fed were not entirely pleased with the “blueprint” for regulatory changes issued on Monday by the Treasury secretary, Henry M. Paulson Jr.

That proposal called for an overhaul and consolidation of the financial regulatory system. The Fed chief, in an almost classic case of damning with faint praise, said Mr. Paulson’s blueprint was “a very interesting and useful first step” for Congress to consider.

My Comment: The Fed is angling for still more power. This is a very dangerous situation.

Uncertainty Principle Corollary Number Two: The government/quasi-government body most responsible for creating this mess (the Fed), will attempt a big power grab, purportedly to fix whatever problems it creates. The bigger the mess it creates, the more power it will attempt to grab. Over time this leads to dangerously concentrated power into the hands of those who have already proven they do not know what they are doing.

Mr. Bernanke, making his first public comments about Bear Stearns, spent a considerable amount of time defending the Fed’s actions in arranging for Bear Stearns to be acquired by JPMorgan Chase at a fire-sale price, and with the help of a $30 billion loan from the Fed.

Providing new details about the deal, which was arranged behind closed doors during the weekend of March 15, Mr. Bernanke said he and his colleagues at the Fed did not know until March 13 that Bear Stearns faced bankruptcy and that they quickly realized a failure to act would create a global crisis.

My Comment: It's clear the Fed acted illegally. I will have more on this below.

“With financial conditions fragile, the sudden failure of Bear Stearns likely would have led to a chaotic unwinding of positions in those markets and could have severely shaken confidence,” he said. “The company’s failure could also have cast doubt on the financial positions of some of Bear Stearns’s thousands of counterparties and perhaps companies with similar businesses.”

My Comment: Clearly the Fed learned nothing from the collapse of Long Term Capital Management (LTCM) to have allowed banks like JPMorgan (JPM) take on trillions of dollars worth of derivative positions.

Uncertainty Principle Corollary Number Three: Don't expect the Fed to learn from past mistakes. Instead, expect the Fed to repeat them with bigger and bigger doses of exactly what created the initial problem.

Caroline Baum Blasts Fed Decisions

Caroline Baum hit one out of the park with her assessment of how the Fed handled the Bear Stearns problem. Please consider Fed Should Clarify Link to Bear Stearns Assets.

Watching the evolution of Fed policy in the last six months from focused on inflation to fearful of systemic risk; the series of aggressive, rapid-fire rate cuts; the creation of an alphabet soup of new lending facilities [TAF, TSLF, PDCF]; and the orchestration of a fire sale of Bear Stearns to JPMorgan, one has to wonder about the Fed's M.O. It all has a make-it-up-as-you-go-along quality.

Faced with what it thought would be a series of cascading financial failures if Bear Stearns went down, the Fed probably knew what it wanted to do, knew it had to do it quickly, and then had to figure out "how to get it done within the confines of its legal structure," DeRosa [a partner at Mt. Lucas Management Co.] said. "The Fed used legal sleight of hand to reconcile what they wanted to do with what they're permitted to do by law."

Bernanke is sure to be grilled about his actions when he testifies before the Joint Economic Committee of Congress today and the Senate Banking Committee tomorrow. A wee bit more transparency would be nice.

Then again, if the Fed is acting first and finding legal cover later, there's a benefit to keeping the details murky.

Fed's Actions Blatantly Illegal

John Hussman has this to say in his weekly column Why is Bear Stearns Trading at $6 Instead of $2?

The Federal Reserve decided last week to overstep its legal boundaries – going beyond providing liquidity to the banking system and attempting to ensure the solvency of a non-bank entity. Specifically, the Fed agreed to provide a $30 billion “non-recourse loan” to J.P. Morgan, secured only by the worst tranche of Bear Stearns' mortgage debt. But the bank – J.P. Morgan – was in no financial trouble. Instead, it was effectively offered a subsidy by the Fed at public expense. Rick Santelli of CNBC is exactly right. If this is how the U.S. government is going to operate in a democratic, free-market society, “we might as well put a hammer and sickle on the flag.”

The Fed did not act to save a bank, but to enrich one. Congress has the power to appropriate resources for such a deal by the representative will of the people – the Fed does not, even under Depression era banking laws. The “loan” falls outside of Section 13-3 of the Federal Reserve Act, because it is not in fact a loan to either Bear Stearns or J.P. Morgan. Bear Stearns is no longer a business entity under this agreement. And if the fiction that this is a “loan” to J.P. Morgan was true, J.P. Morgan would be obligated to pay it back, period. The only point at which the value of the "collateral" would become an issue would be in the event that J.P. Morgan itself was to fail. No, this is not a loan. It is a put option granted by the Fed to J.P. Morgan on a basket of toxic securities. And it is not legal.

Not only was the action illegal, the vote itself was illegal. The Fed needs 5 members to vote on such actions and only 4 members were present. Fed Governor Mishkin was missing in action. Was he opposed to this illegal hijacking? There was an excellent discussion of this idea in the comments section of the California Housing Forecast.

This leads us to....
Uncertainty Principle Corollary Number Four: The Fed simply does not care whether its actions are illegal or not. The Fed is operating under the principle that it's easier to get forgiveness than permission. And forgiveness is just another means to the desired power grab it is seeking.

Let's Recap.

Fed Uncertainty Principle:
The fed, by its very existence, has completely distorted the market via self reinforcing observer/participant feedback loops. Thus, it is fatally flawed logic to suggest the Fed is simply following the market, therefore the market is to blame for the Fed's actions. There would not be a Fed in a free market, and by implication there would not be observer/participant feedback loops either.

Corollary Number One:
The Fed has no idea where interest rates should be. Only a free market does. The Fed will be disingenuous about what it knows (nothing of use) and doesn't know (much more than it wants to admit), particularly in times of economic stress.

Corollary Number Two: The government/quasi-government body most responsible for creating this mess (the Fed), will attempt a big power grab, purportedly to fix whatever problems it creates. The bigger the mess it creates, the more power it will attempt to grab. Over time this leads to dangerously concentrated power into the hands of those who have already proven they do not know what they are doing.

Corollary Number Three:
Don't expect the Fed to learn from past mistakes. Instead, expect the Fed to repeat them with bigger and bigger doses of exactly what created the initial problem.

Corollary Number Four:
The Fed simply does not care whether its actions are illegal or not. The Fed is operating under the principle that it's easier to get forgiveness than permission. And forgiveness is just another means to the desired power grab it is seeking.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List

March Auto Roundup And Retail Sales Forecast

March Auto sales were a disaster across the board. Let's take a look.

Ford Sales down 14%

Ford's US sales down 14 percent in March

• U.S. sales fell 14 percent
• Truck and SUV sales fell 16 percent
• Ford Expedition fell 34 percent
• F-Series pickup fell 24 percent
• Car sales were down 10 percent

Small cars fared best as consumers focused on fuel efficiency. The Ford Focus saw sales jump 24 percent for the month.

GM Sales Down 13%

GM March U.S. sales fall an adjusted 13 percent

General Motors Corp (GM) said on Tuesday that its U.S. sales fell an adjusted 13 percent in March to 282,732 vehicles and left intact its second-quarter production forecast.

GM Blames Consumer Confidence

"I think the main weakness is consumer confidence," said GM sales chief Mark LaNeve. "It's (mortgages) resetting. It's worry about the news. It's presidential candidates telling you how bad it is. It's Bear Stearns."

"The compact cars and the new crossovers are really what is carrying most manufacturers," said Jesse Toprak, executive director of industry analysis for Edmunds.com, adding that the industry-wide sales decline was in line with his expectations.

"Consumers want to buy cheaper, more gas efficient vehicles," Toprak said.

If only presidential candidates would stop telling everyone how bad things were, then everyone would be rushing out to buy a Camaro.

Then again perhaps consumers are broke, have no job, have no job prospects, and gas prices are through the roof.

GM says still expects second-half U.S. recovery

General Motors Corp still expects the U.S. economy to recover in the second half of 2008, pulling industry-wide auto sales higher, an executive said on Tuesday.
GM sales analyst Mike DiGiovanni, speaking to reporters and analysts on a conference call, said he saw "early signs" that the U.S. market was steadying.

My Comment: Is this some kind of April Fool's Joke?

Separately, GM North American sales chief Mark LaNeve said GM's inventory of full-size pickup trucks was "more than adequate" despite a five-week-old strike at supplier American Axle & Manufacturing Holdings Inc that has idled 30 GM plants.

My Comment: And it will be more than adequate if the strike lasts another 15 weeks. Who wants full sized pickups? GM ought to be thankful for that strike or they would be ramping up for a nonexistent second half recovery.

Toyota Sales Down 3.4%

Toyota says U.S. March sales down adjusted 3.4 percent

Toyota Motor Co on Tuesday posted a 3.4 percent decline in March sales after adjusting for two fewer sales days in the month compared with a year earlier.

The automaker, ranked No. 2 in the U.S. market by sales, said its Toyota-brand sales were down 2.9 percent. Sales for the Japanese automaker's luxury Lexus brand were down 6.9 percent, it said.

Toyota said its car sales were up 1.5 percent in the month, while truck sales dropped by 8.8 percent in March.

Retails Sales Estimates Cut

Bloomberg is reporting U.S. Retailer Group Cuts Sales Estimate Second Time.

A U.S. retailer group cut its March sales estimate for a second time as shoppers concerned about job security and the worst housing slump in a quarter century cut apparel spending.

Retail sales probably fell or were little changed in the month, down from last week's prediction of 1 percent growth, the International Council of Shopping Centers and UBS Securities LLC said today.

"We've been in a recession ever since October," said Britt Beemer, chairman of America's Research Group in Charleston, South Carolina. "I'm predicting a very soft next 14 months in consumer spending until Memorial Day in May of 2009."

Tax Refunds

Seventy percent of consumers who have received their 2007 income tax refund are using it to pay off credit cards and bills, the first time in 20 years that figure has topped 50 percent, according to Beemer. People who may have never seen the inside of a Wal-Mart are now buying groceries there, he said.

"In my 29 years of research, consumers are doing exactly what they said they are going to do: they're not spending," Beemer said in a telephone interview. He said his firm interviews 8,000 to 15,000 consumers a week.

This is a stunning announcement: "Seventy percent of consumers who have received their 2007 income tax refund are using it to pay off credit cards and bills, the first time in 20 years that figure has topped 50 percent."

Anyone who thinks Bush's economic stimulus package will work is sadly mistaken.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List

April Fool's Offering At Lehman

With much fanfare Lehman was bragging that it does not need capital but raised it anyway simply to prove it could. Clearly this is nonsense, but here is the story as reported by Bloomberg: Lehman to Sell $3 Billion of Shares to Raise Capital.

Lehman Brothers Holdings Inc. is selling at least $3 billion of new shares to bolster capital and squash speculation about a cash shortage that pushed the stock down 42 percent this year.

Lehman, the fourth-biggest U.S. securities firm, will offer 3 million convertible preferred shares, the company said in a statement today. Demand for the shares was already three times greater than the amount offered as of 6:30 p.m. in New York, according to a person familiar with the offering who declined to be identified before the sale is completed tomorrow.

"We still maintain that we don't need capital, but we've realized that perception is the dominant issue in today's markets," Chief Financial Officer Erin Callan said in an interview. "This is an endorsement of our balance sheet by investors."

Merrill Lynch & Co., Citigroup Inc. and Morgan Stanley have also raised cash from investors after more than $200 billion of writedowns and losses tied to the collapse mortgage markets at the world's biggest financial companies.

April Fool's Offering

Professor Bennet Sedacca on Minyanville has a more believable version of the story:

Lehman (LEH) is announcing a $3 billion convertible preferred to 'institutional investors'. In other words, retail will never get their hands on the paper and it is likely a way for LEH to pay back some clients with a cheap deal.

If everything is so rosy, and just a few months back, LEH announced it was going to buy 100,000,000 shares at around $65 a share (stock it never bought) then why would it dilute itself at $37?

Because it has to.

Expect more of this folks. Lots of it.

Fool's Day Offering Over Subscribed

Institutional investors were so excited by deal that Lehman offered another million shares. Bloomberg is reporting Lehman Gains as $4 Billion Share Sale Calms Investors.

Lehman gained 18 percent after the New York-based firm increased the size of the deal to 4 million convertible preferred shares from 3 million and said it had enough demand for 14 million. The stock climbed $6.70 to $44.34 at 4:15 p.m. in New York Stock Exchange composite trading.

Investors who bought the new shares are betting Lehman will escape the fate of rival Bear Stearns Cos., which agreed to sell itself last month for a fraction of its market value after a run on the company. The shares pay a coupon of 7.25 percent, or 4 times the rate available on 2-year Treasury notes, and are convertible to stock when Lehman shares reach $49.87.

"The ability to raise over $3 billion in capital in a difficult environment represents a vote of confidence from the equity markets," Sandler O'Neill & Partners analyst Jeffrey Harte said.

Lehman can buy back the preferred shares after five years. Regular shares pay a quarterly dividend of 17 cents, or the equivalent of an annual yield of about 1.5 percent. The conversion will dilute outstanding shares by 7 percent, according Wachovia Corp. analyst Douglas Sipkin.

The $14 billion demand coming from investors last night got the "message out loud and clear" about trust in the firm, Chief Financial Officer Erin Callan said in an interview with CNBC television.

The investment bank is sharing information on short-sellers of its stock with the Securities and Exchange Commission, Callan said. The SEC is investigating whether some investors have been spreading false rumors about Lehman while benefiting from a drop in the share price. Short-sellers borrow stock to sell, with the expectation that they can buy them cheaper as the price falls.

Fools Cheer Loud And Clear

So the market cheered a 7% shareholder dilution by a company that does not need capital but raised it anyway at 7.25% interest. It's fitting that this story began on April Fool's Day, but the next time Lehman raises money it does not need, shareholders will not be cheering so loudly.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List

Dollar, Stocks Rally As Banks Replenish Capital

Equities shares rallied along with the US dollar, and precious metals were smacked in the wake of massive bank writedowns at UBS and Deutsche Bank.

Let's take a look at UBS and Deutsche Bank starting with the record $19 billion writedown at UBS.

UBS AG, battered by the biggest writedowns from the collapse of the U.S. subprime mortgage market, reported a 12 billion-franc ($11.9 billion) first-quarter loss and said Chairman Marcel Ospel will step down.

UBS rose the most in two weeks in Swiss trading after announcing plans today to seek 15 billion francs in a rights offer to replenish capital, on top of 13 billion francs already raised from investors in Singapore and the Middle East. Zurich-based UBS will write down $19 billion on debt securities, bringing the total to almost $38 billion since the third quarter of 2007.

"Behind closed doors they have been cleaning up very swiftly and the capital increase will put them back onto a solid foundation," said Joerg de Vries-Hippen, who oversees about $26 billion, including UBS shares, as chief investment officer for European stocks at Allianz Global Investors in Frankfurt. Still, "it will take years to repair the bank's reputation," he said.

Raising capital again will mean UBS has to renegotiate the terms of the mandatory convertible bond it sold to GIC and the Middle Eastern investor.

Raising capital a second and third time gets to be expensive. It appears that UBS had ratchet provisions in the deal with GIC.

For more on ratchet provisions, please see Cost of Capital "Ratchets Up" at Citigroup and Merrill.

$3.9 Billion Writeoff At Deutsche Bank

Bloomberg is reporting Deutsche Bank to Write Down EU2.5 Billion in Quarter.

Deutsche Bank AG, Germany's biggest bank, will write down 2.5 billion euros ($3.9 billion) of loans and asset-backed securities and said markets are deteriorating. "Conditions have become significantly more challenging during the last few weeks," Deutsche Bank said today in a statement.

Deutsche Bank gained in Frankfurt trading on speculation the worst of the losses in the banking industry may almost be over. The German bank, which increased earnings in 2007, said a week ago its 2008 pretax profit target is under threat because of "difficult" market and economic conditions.

"The subprime crisis is catching up to Deutsche Bank," said Konrad Becker, a Munich-based analyst at Merck Finck & Co. who recommends holding the shares. "This means that Deutsche Bank is at risk of reporting a first-quarter pretax loss."

"The immediate stock reaction is hope among investors that we've touched bottom," said Derek Chambers, an analyst at Standard & Poor's Equity Research in London who has a "hold" rating on Deutsche Bank.

The Market Reaction

It's not the news that matters, it's the market's reaction to it. In this case the dollar rallied, equities rallied, and precious metals sank.

Bloomberg is reporting Dollar Advances Most in Almost Two Weeks as UBS Seeks Capital.

The dollar rose the most in almost two weeks against the euro after UBS AG said it will raise about $15 billion, signaling the world's biggest financial institutions can ride out the freeze in credit markets.

The U.S. currency also appreciated against the yen after a Bank of Japan report showed a slump in business confidence in March. The euro also weakened after Deutsche Bank AG said it will take a record $3.9 billion writedown and described market conditions as "significantly more challenging."

"U.S. banks have already disclosed their problems and now Europe is following suit," said Geoffrey Yu, a currency strategist at UBS who says the euro may decline to $1.47 by the end of the quarter. "It's time for value investors to come in and buy the dollar at its lows while the euro is starting to feel the transmission effects from the U.S. slowdown."

"The news out of the rest of the world is just as bad, if not as worse, as in the U.S.," said Adam Cole, the London-based head of currency strategy at Royal Bank of Canada, the nation's biggest lender. "The dollar bear market is in its final stages and at some point, we'll see a substantial bounce."

"Global growth is recoupling to U.S. growth and other central banks will have to start to play catch-up in terms of rate cuts," said David Forrester, a Singapore-based currency economist at Barclays, which forecasts the dollar to gain to $1.50 per euro in three months.

With the dollar rallying and the market unconcerned about additional writedowns (at least for the moment), one might expect gold and silver to tank. And indeed that's what's happening.

April Gold



click on chart for sharper image

Silver



click on chart for sharper image

Gold and silver corrections tend to be very sharp. Just like this. What we do not know is if this is the start of something very serious, or if it's just another quick scary pullback. What we do know is European banks are arguably in as bad a shape as some US banks, the US$ may (or may not) have caught a bid, and gold and silver seasonality are unfavorable through July. All in all, it's not a great environment for metals.

Is the Bottom In Equities In?

It's extremely unlikely. The biggest most reckless financial experiment in the history of the world cannot be corrected in a six month stock market decline. The structural problems still exist: Unemployment is poised to soar, credit card and home equity writeoffs are coming, commercial real estate is headed south big time, and there is a huge problem with marking to market $500 trillion in derivatives that could waterfall at any time. However, none of that is today's business.

Today's business is UBS, Deutsche Bank, and Lehman successfully raised capital, the US dollar rallied, and the bulk of the subprime problems may now be behind us or at least postponed for a later date. I talked about this idea in Closer Look At The ARMs Reset Problem.

Of course the Alt-A and Pay Option ARM problems are as bad if not worse than the subprime problem was, but the market does not seem worried about that now.

All in all, there was simply too much bearishness at the end of the first quarter. Those playing for a bounce, got one. Time will tell how far the bounce goes. And time may be more important than price. The markets declined for six months, so the markets can easily rally for two, even if the bulk of the rally is now be behind us.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List

Closer Look At The ARMs Reset Problem

There's a detailed set of slides breaking down the woes in the housing market out from Real Estate Consulting. Although it's an interesting report, a pair of back to back slides from that presentation appears to be off the mark.

Here are the slides in question. A discussion of those slides follows.



click on chart for sharper image



click on chart for sharper image

The first chart states "ARM loans made in 2004-2006 will create huge reset problems in 2007-2009". The second chart specifically points out loans made in 2005-2006.

Let's start with a discussion of Adjustable Rate Mortgages (ARMs). ARMs are based on an index rate, typically 1-year treasuries or 1-year LIBOR, plus a margin amount (e.g. the treasury rate + 2.75%) .

The interest rate is fixed for an initial period (3 years for a 3-1 ARM, 5 years for a 5-1 ARM, etc.) but then floats with the index, adjusted periodically (typically yearly).

The margin amount varies lender to lender and it does not change when a loan resets.

With that background, here are charts and tables of treasury rates and LIBOR for the last 10 years. We will use the rate tables to see what's likely to happen when mortgages reset.

One Year Treasury Rates

click on chart for sharper image

One Year Treasuries Table



click on chart for sharper image

One Year LIBOR Table



click on chart for sharper image

The previous three charts courtesy of Money Cafe.

An important word about the above tables:

Initial rates on any given day may be based on factors other than the index rate at that time. In cases where lenders were aggressive, initial rates may have been lower than implied above, creating more of a reset problem down the road. In cases where lenders were more cautious, initial rates may be slightly higher than implied, creating a more beneficial situation when rates reset.

Specific circumstances vary day by day and lender to lender. Thus, the above tables are best used as a guideline as to what took place, as opposed to an absolute mathematical reference point.

Current Quotes as of March 29

• 1 Year Treasuries - 1.56
• 1 Year LIBOR - 2.52

3-1 ARMs Analysis

Based on the above table, 3-1 treasury based ARMs initiated in 2005-2006 would likely reset lower. I stress likely because initial rates on any given day may be based on the above caveat on day to day conditions, lender specific conditions, etc.

3-1 LIBOR based ARMs initiated in 2005-2006 would also likely reset lower and again with the same caveat repeated about day to day conditions, lender specific conditions, etc.

In general, loans originated in 2005-2006 simply do not appear to be a problem. In fact, the reset of 3-1 ARMs from those years may provide economic stimulus. This statement may not apply in every case but it should be true for many, if not most cases.

3-1 ARMs prior to 2005 have already reset. So those problems, whatever they were, have already been faced.

5-1 ARMs Analysis

5-1 ARMs analysis is more difficult. However, we can say that the above charts clearly show that loans originated in 2003-2004 are more likely to be problematic than loans originated in 2005-2006.

Here is an analysis from my Certified Mortgage Planning Specialist friend:

"Most of the 5/1 ARM’s I reviewed that originated in 2003 had start rates between 4% and 5.125%. This makes it hard to lump them all together to state they will in aggregate reset higher or lower. Some of this will depend on points paid to reduce the original interest rate. Many of these loans will reset marginally higher than they were before. However, the situation is far better now than it was even a few short months ago where it appeared virtually every loan in this group would reset much higher."

While likely to be net negative to the borrower, 5-1 ARM adjustments from 2003-2004 are not likely to be the end of the world. Some may even benefit. Looking ahead, adjustments on 5-1 arms for 2005-2006 are likely to be consumer friendly based on the above tables.

However, 5-1 ARMs from 2005-2006 will not reset until 2010-2011. Those loans are simply not today's problem.

Principal Payments Needs To Be Factored In

There is still one more issue to address, and that is higher payments when the interest only period ends. For example, a 5-year ARM loan typically goes from interest only payments to interest + principal amortized over 25 years on the first rate reset. Likewise a 3-year ARM loan typically goes from interest only payments to interest + principal amortized over 27 years on the first rate reset. Some ARMs have a 10 year interest only period which postpones this particular problem.

Many of those in 3-Year ARMs with principal and interest payments will see their total mortgage payment drop. This is especially likely for loans originated in July of 2005 or later. However, those paying interest only for three years may see their total payments rise.

For others, especially those in 5-year ARMs, there could be payment shock even if the interest rate drops. Once again, it will be the 2003-2004 loans that will prove to be more problematic.

Where Is The Reset Problem?



click on chart for sharper image

Poof!

The Fed vaporized much of the ARM reset problem in 2008-2009 by slashing interest rates. This is especially true for those in 3-1 ARMs. It is highly likely the Fed's panic rate cuts in early 2008 were made with this in mind.

Looking ahead, and assuming rates stay low, those in 3-1 ARMs originated in 2006 are likely to see significant resets lower. This would be economically stimulative as long as other conditions are stable.

Unfortunately, other conditions will not be stable. I believe unemployment is going to soar, commercial real estate is going to plunge, and the stock market is likely to keep heading south. Given rampant overcapacity everywhere, I see no economic force to create jobs. All of this is going to further pressure housing prices and the economy in general.

Look Ahead to 2010-2011

Looking ahead to 2010-2011 I see a different set of problems.

Those problems are Alt-A and Pay Option ARMS. And that is where the liar loans (no-doc loans) are hidden. Liar loans are likely to blow up long before we get to 2011. I discussed a particular Alt-A pool in WaMu Alt-A Pool Revisited and WaMu Alt-A Pool Deteriorates Further.

The pool discussed above originated in May 2007, and was 92.6% rated AAA. The most recent update shows the pool is already 25.3% 60 day delinquent or worse, 13.35% in foreclosure, and 4.44% REO (Real Estate Owned). The problem is easy to spot: only 11.27% of the pool had full doc. The rest of the pool was liar loans. The pool may not be representative a representative sample of Alt-A pools. However, it does illustrate the type of problems one would expect to see with liar loans. And those problems are both big and growing.

Pay Option ARMs (POAs) pose additional problems. The first problem is that over 80% of POA mortgagees only make the minimum payment. Given that minimum payments typically do not cover interest owed, the loan balance increases every month. This is called negative amortization, and it has been going on for years.

Negative amortization is compounded by falling home prices. At some point, typically 110-125% of the mortgage, an enormous gotcha kicks in. That gotcha requires a fully indexed fully amortized principal and interest payment, amortized over the remaining years. People who could only afford the minimum payment will be forced to pay principal, plus interest, on top of a loan balance that has been growing monthly. Good luck on lenders getting all their money back on those loans.

The second problem in regards to POAs is that a huge portion of these loans originated if the least affordable, biggest bubble areas, like Florida, California, Las Vegas, etc. From a lender's perspective that hugely increases the likelihood of default as well as the size of the problem should default occur.

Mortgage Reset Scare

There are lots of mortgage problems for sure, but right now loans resetting from 2005-2006 do not appear to be among those problems. Nor are 3-1 ARMs in general a problem. 5-1 ARMs specifically from 2003-2004 are more problematic as noted above, but even then, lower interest rates on which those products are typically aligned have alleviated some of the concern.

However, people are worried, especially after hearing about the mortgage rate reset time bomb for a number of years.

Unfortunately, there are companies attempting to take advantage of the mortgage reset scare by offering "special rates" to refinance now. Those "special rates" are in cases much higher than where they would automatically readjust to.

I discussed this sad situation in Dear Citigroup Customer ....

If you have an ARM about to reset, or know someone who is in that situation, please pass along the above link. There is no excuse for major banks to be attempting to take advantage of distressed borrowers, whether it is legal or not.

There was a very nice discussion of the Citigroup mortgage rate reset issue from an operational standpoint on the Practical Risk Management blog.

Inquiring minds may wish to read Operational Risk – Improper Disclosure By Citigroup Mortgage. The article discusses a potentially serious breach of fiduciary responsibility by Citigroup, possible RESPA violations, potential violations of Reg. Z, and likely violations of internal procedures.

Anyone who feels aggrieved by the actions of Citigroup (or any other lender) may wish to contact http://www.consumergripes.net/

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List

WaMu Alt-A Pool Deteriorates Further

I have been tracking a particular WaMu Alt-A mortgage pool for a couple of months. The pool is known as WMALT 2007-0C1.

In Evidence of "Walking Away" In WaMu Mortgage Pool, I wrote about data January.

About a week ago, by popular request, I did a February update in WaMu Alt-A Pool Revisited. I could have waited. March data is now available. The following screen shot is thanks to "YV".

WMALT 2007-0C1 March Picture



click on chart for sharper image

January Pool Stats

• 19.3% 60 day delinquent or worse
• 13.15% Foreclosure
• 1.83% REO

February Pool Stats

• 22.69% 60 day delinquent or worse
• 11.62% Foreclosure
• 3.56% REO

March Pool Stats

• 25.3% 60 day delinquent or worse
• 13.35% Foreclosure
• 4.44% REO

Note the above progression. This cesspool from May of 2007, was 92.6% originally rated AAA, even though loans had full doc only 11% of the time. In less than one year, the pool was 25.3% 60-day delinquent or worse. Of that 25.3%, 13.35% is in foreclosure and 4.44% is bank owned real estate.

The problem should be clear. In no way shape or form, should any package of liar loans been rated AAA.

Lehman Alt-A Pools Downgraded

MSN Money is reporting Moody's downgrades certain Lehman XS Alt-A deals.

Moody's Investors Service has downgraded the ratings of 279 tranches from 27 Alt-A transactions issued by Lehman XS Trust Series. One hundred sixty two downgraded tranches remain on review for possible further downgrade. Additionally, 97 tranches were placed on review for possible downgrade.

The ratings were downgraded, in general, based on higher than anticipated rates of delinquency, foreclosure, and REO in the underlying collateral relative to credit enhancement levels.

This action is just a start. Expect far more downgrades in Alt-A mortgages. Prime mortgages will follow suit as well.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List