More Banks Abandon Paulson's Super-SIV Plan

HSBC was the first major player to say no to the Super-SIV bailout program by directly providing $35 billion in funding to SIVs.

HSBC said it's moving Cullinan Finance and Asscher Finance, the two SIVs, onto its balance sheet to prevent a forced liquidation of what it called "high-quality assets." If HSBC did not make the move, the vehicles were at risk of triggering market value or net asset value restrictions that would've prompted sales of the debt portfolios. The bank said it is providing up to $35 billion in funding, and its balance sheet will expand by $45 billion.

On December 3 WestLB, HSH Nordbank Bail Out $15 Billion of SIVs.

WestLB provided a credit line for its $11 billion structured investment vehicle called Harrier Finance to repay commercial paper, the Dusseldorf-based bank said in an e-mailed statement today.

HSH Nordbank said it will provide backup funding to cover all commercial paper issued by its 3.3 billion- euro ($4.8 billion) Carrera Capital SIV, spokesman Reinhard Schmid said in an interview.

By contrast, Citigroup, the largest manager of SIVs, said it will avoid any steps that would force it to consolidate the companies on its balance sheet.

MBIA Inc., the largest bond insurer, has cut its Hudson- Thames Capital SIV to about $400 million from $2 billion by asking capital note holders, who own the lowest ranking debt, to buy the fund's assets, Chief Financial Officer Chuck Chaplin said last week.

Treasury Secretary Henry Paulson has been working with Citigroup Inc., Bank of America Corp. and JPMorgan Chase & Co., the biggest U.S. banks, to form an $80 billion "SuperSIV" fund to help avoid forced sales by buying SIV assets. The Treasury aims to have the master liquidity enhancement conduit, or M-LEC, running by yearend.

"Every day that goes by we are seeing more restructuring and liquidity provision by sponsors," Shah said in an interview today. "The longer M-LEC takes, the less of a need there will be for it."

Markets Move Faster Than Bureaucrats

While Paulson is hoping to have a bailout plan in place by the end of the year, the only participants left to bailout might be Citigroup (C), Bank of America (BAC), and JPMorgan (JPM).

What's left of Paulson's Super-SIV plan has more holes in it than a stack of colanders. Obviously the market moves faster than bureaucrats.

Why don't Citygroup, Bank of America, and JPMorgan take the assets onto the balance sheet like the other banks are doing? Because they can't. At least Citigroup can't. Citigroup already had to sell 4.9% in equity to Abu Dhabi in return for $7.5 billion in cash as noted in Petrodollars Return Home.

Indeed, the Citigroup / Abu Dhabi deal smells of desperation, a thought noted by Professor Mark Bloudek in Citigroup: The Real Deal.

So why was CDO exposure so secret?

The real outrage of the credit crunch has been in the way major banks disclosed potential losses. The next credit scandal is there are billions more in undisclosed risk.

Citigroup had off-balance sheet conduits with assets totaling $73 billion as of Sept. 30. Almost every major banks has significant conduit exposure. But if conduits are becoming a problem, banks are not saying much about it in their financial statements.

So why was CDO exposure so secret?

Banks typically arranged and sold CDOs to investors, so the sold ones would not appear on their balance sheets. In quarterly financial statements, companies disclose their "variable interest entities," or VIEs. These are entities to which a company has actual or potential economic exposure. When it comes to inadequate CDO disclosures, the VIEs that matter are those that are not consolidated on a company's balance sheet.

This is partly the fault of the accounting rule -- something called FIN 46-R -- that governs off-balance sheet VIEs. The big problem is that it doesn't force companies to disclose realistic estimates for losses. Under FIN46-R, companies must disclose their maximum loss exposure. That sounds like a conservative approach, but in practice it isn't. That's because banks often add comments in financial statements that effectively tell investors not to take these maximum loss numbers seriously.

Take a look at Citigroup's second quarter filing, posted Aug. 3, which was well into the summer credit meltdown. In it, the bank said actual losses from its unconsolidated VIEs, which included $75 billion of CDOs, were "not expected to be material." It has since estimated losses could be between $8 billion and $11 billion (which is most definitely material).

So the question becomes: Did banks have a good idea of what off-balance-sheet CDO losses would be before they were disclosed? The answer to that is: Almost certainly.

Is protection of Citigroup itself the only reason left for the Super-SIV?

I think so and Fortune is raising the same issue in Why Citi can't take the high road over credit mess.

As soon as the SIVs got into trouble in the summer, the most obvious solution was for the banks affiliated with the SIVs to take them onto their balance sheets. The fact that none of them did so straight away raised a red flag over the SIV mess.

Instead, the U.S. Treasury sponsored a move driven by Citigroup, J.P. Morgan Chase and Bank of America to set up a new, larger Super SIV that would buy up assets from the SIVs that came under pressure. Since Citigroup has by far the largest exposure to SIVs - its seven SIVs held $83 billion of assets as of Sept. 30 - the Treasury's Super-SIV looked very much like a way of supporting Citigroup.

As more banks drop support for the Super-SIV bailout plan, it is becoming increasingly clear the only remaining purpose for the plan is to keep Citigroup from having to put SIVs on its balance sheet.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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Deflationary Credit Downturn Is Underway

In the US, Credit flowing to American companies is drying up at a pace not seen in decades. This idea was discussed in Lenders Rapidly Tighten Credit.

The same thing is happening in the UK there are Pleas for rate cut as interbank loans dive.

The sterling interbank market has collapsed at the fastest rate in modern history, prompting pleas for immediate rate cuts from a chorus of top British economists.

• "This is one hell of a shock to the financial system," said Professor Tim Congdon, a leading monetarist at the London School of Economics. "A market that has taken 30 years to build has completely imploded in a matter of months. Lenders have been squeezed savagely. We've moved into a different era," he said.
  
• Mr Congdon called for a half-point cut to the interest rate to 5.25pc when the Monetary Policy Committee meets this week, warning that the M4 money supply is slowing fast and might contract over the next six months.
  
• Patrick Minford, a professor at Cardiff University, called for a three-quarter point cut, accusing the MPC of "standing idly by" as three-month Libor spreads rocketed by 75 basis points - a severe tightening of credit.
• SMPC member Peter Warburton, from Economic Perspectives, called for a half-point cut, with further easing in the New Year. "A profoundly deflationary credit downturn has taken hold," he said. "Recent weeks' dramatic events have infected urgency into the situation."

What the above British economists are talking about is LIBOR or the rate at which banks lend to one another. Not only is there a shock going on in the UK, the same shock is occurring in the US. Indeed LIBOR spreads are at 75 basis points in the US as well as the following chart shows.

LIBOR As Of December 3



click on chart for sharper image

One month LIBOR is 75 basis points above the Fed Funds Rate.
One month LIBOR is 221 basis points above the 3 month Treasury note.
15 year mortgages are only 2 basis point higher than 1 month LIBOR.

You can get a 15 year mortgage at nearly the same rate banks are willing (in this case reluctantly willing) to lend money to each other overnight. This is rather amazing.

For a refresher course on LIBOR please see Professor Depew's column Why Should You Care About LIBOR?

The important point here is that LIBOR which normally trades at 7-10 basis points above the Fed Funds Rate is now a whopping 75 basis points above the Fed Funds Rate in the US and 75 basis points above the BOE Funds Rate in the UK as well.

UK M4 vs. US M3

I find it interesting that M4 money supply in the UK is slowing fast and might contract over the next six months. M4 in the UK is roughly equivalent to the discontinued M3 in the US.

M3 in the US is still soaring as shown by the following chart from Bart at Now and Futures.

M3 As Of November 30



click on chart for sharper image

Bart had this comment on M3: "Most of the large growth in M3 lately has been in flows into CDs and Money Market Funds, a normal occurrence during financial turmoil."

I talked to Paul Kasriel a week or so ago and asked him about M3 and he felt the growth was in part due to companies tapping credit lines.

Is there a mad dash for cash while those lines of credit are still good?

Meanwhile, banks themselves are very strapped for cash. Please see Where's the Cash? for more on this idea. Whatever the reasons, banks are very reluctant to part with cash and proof is one month LIBOR.

Zero Hour

These are very unusual conditions to say the least and Professor Sedacca is saying No Toto, Credit Markets Not in Kansas Anymore.

I have written many times about the concept of ‘Zero Hour’ (recall the wonderful lyrics from Elton John in Rocket Man: “She packed my bags last night pre-flight, Zero hour nine am”). Zero Hour was the concept of Barry Banister at Legg Mason (LM) that dealt with the interplay of debt growth and GDP growth. When we are in a debt-induced, asset-based economy, “Are we there yet?” means arriving at Zero Hour, which is a scary proposition. For those unfamiliar with the concept of ‘Zero Hour’, it is the moment at which creation of new money no longer has an impact on GDP, or the real economy.

“Are we there yet?” Perhaps the U.S. is. If not, it is close or, at a minimum, it is on its way there. Zero Hour. How do we know we are at zero hour? We know we are because M3 has now exploded to an 18% year over year rate while the Fed has downgraded 2008 GDP growth expectations to 1.8-2.5%. Yes, money is growing at a rate ten times that of new economic output.

Yield Curve As Of December 1



click on chart for sharper image

Plunging yields across the entire curve while the Fed is harping about inflation and M3 is exploding is yet another sign we are no longer in Kansas.

Note the strong similarity between the yield curve in 2000-2001 and 2006-2007. The yield curve itself suggests we are already in a recession regardless of what the GDP says. One thing is certain: The treasury market is expecting more rate cuts.

The interaction of M4, M3, the yield curve, and LIBOR both in the US and abroad are signs of an impending major market dislocation or bank failure of some kind. If this stress in not alleviated soon, we will literally be in crash conditions.

On the other hand, if these conditions, most importantly LIBOR, temporarily return to normal, perhaps we have a Santa rally. Regardless of what happens in December, the problems are too many and to severe to be permanently fixed by anything other than a major recession and deflationary writedown of debt.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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Paulson's Plan Is Nothing But Lip Service

Barclays and UBS AG bond analysts say Paulson Subprime Plan Offers Little Aid.

Paulson's plan is aimed at borrowers with "steady incomes and relatively clean payment histories" who are able to repay adjustable-rate loans only if their payments don't rise, he said today at a conference in Washington. In a later interview, he wouldn't "put a number" on how many loans would be affected.

Few homeowners may qualify for the proposed aid and many are likely to default even before rates reset higher, Barclays analysts wrote in a report today.

"The subprime reset plan, as it currently stands, is unlikely to be a big help," New York-based Barclays analysts Ajay Rajadhyaksha and Sharon Greenberg wrote.

Most borrowers who would be helped by the plan would have their loans reworked without a coordinated effort, UBS's Thomas Zimmerman wrote Nov. 30. Details of the Paulson proposal haven't been announced.

Only 12 percent of all securitized subprime adjustable-rate loans in California would qualify for fixed payments under a similar agreement between the state and four mortgage servicers last month, the Barclays analysts wrote, based on an announcement saying the deal applies to borrowers who occupy homes, have been making on-time payments and can't afford higher rates.

Assuming that half of subprime balances default or are repaid before rate resets, another 30 percent of borrowers don't qualify because they've missed payments and 20 percent of modified loans eventually default anyway, the Paulson plan only eliminate losses of 60 cents per $100 of subprime loans, versus a total that may be as high as $18 to $20, they wrote.

"I think it's lip service and essentially not meaningful," said Michael Burry, president of Cupertino, California-based hedge-fund firm Scion Capital LLC, which manages about $1 billion. "It will only help those who don't need to be helped."

Industry Insider Email

I find the above article interesting in light of an email I received from an industry insider this weekend who wishes to remain anonymous. Here goes:

The homeowner bailout sounds a lot better in the headlines than it does when you dig deeper. For instance, HomEq reports that for every 5,000 resets that come in every month, only 1,000 meet standards to even begin loan modification, and of those only 10% of borrowers actually begin the process. That's 2% of all borrowers undergoing resets.

One of the problems is that in many cases, a W2 is required, and many of these homeowners are reluctant to provide one since they presumably lied about their income to qualify for a mortgage. Still others are in trouble not because of the reset, but because they can't even afford their teaser rate. Many in foreclosure won't pick up the phone when contacts are attempted from lenders.

And that's before we even talk about getting servicers to sign off on the proposal, deciding which of the millions of homeowners in trouble deserves help, and moral hazards of the plan on the part of borrowers who might stop making payments in hopes of getting a freeze and of lenders who might decide to shun the MBS market completely if the government is going to force them to modify contracts. And even for those who do get a government-aided freeze, all this will do is keep them in an underwater home for longer, making them permanent debt slaves on a bad asset.

Other bailouts don't inspire much confidence either. Citigroup, Freddie Mac and E*Trade had to offer extremely generous terms to get more capital. It's bad enough that we're at the mercy of Asia and OPEC countries for the treasury market, but now they're making inroads on our premier financial institutions too.

As E*Trade sold asset-backed securities at 27 cents on the dollar, will this put more pressure on other institutions to give more realistic marks on their portfolios, leading to more writedowns? How are institutions like Freddie Mac supposed to make any money when it now costs them over 8% to borrow? And how are rate cuts going to help anything when what the system needs is "more balance sheet," and there's none to be found, and in fact credit continues to contract?

Supposedly the terms of the deal are not finalized but details and discussion items seem to have leaked out. Whether or not any particular detail makes it to the final plan or not is irrelevant.

What matters is the plan is doomed to fail just as I predicted in "temporary" mortgage freeze is doomed.

The plan will fail because it is in the best interest of those underwater on their loans to make it fail. This is what happens when borrowers have no skin in the game. Hoards of people borrowed money with 0% down. If they had 20% down or even 10% down they would be reluctant to walk away from that loss. Instead, borrowers have a chance to walk away debt free after being 10's or even 100's of thousands of dollars underwater. Who in their right mind would not want to jump on that?

Oddly enough, the new IRS plan to not tax homeowners on forgiven debt actually encourages homeowners to walk away. Does any government scheme ever work? I think not, and Paulson's Lip Service will not fare any better.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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Earnings Recession Has Arrived

U.S. corporate profits are in a recession, and the entire economy may not be far behind.

Slower sales and higher energy and labor costs are forcing companies from Bear Stearns Cos. to Pitney Bowes Inc. to reduce spending and hiring. Their efforts to keep earnings from eroding even further raise the risk that the economy, already weakened by the steepest housing slide since 1991, may shrink sometime next year.

"The earnings recession has already arrived," says David Rosenberg, North America economist for Merrill Lynch & Co. in New York. "We are going to see an economic recession in '08."

Corporate profits, as measured by the Commerce Department, fell at an annual rate of $19.3 billion in the third quarter from the second, as domestic earnings dropped by $41.2 billion. The drag from sagging U.S. sales and huge writedowns offset robust earnings abroad, fueled by the weak U.S dollar. The fourth quarter may be an even bigger bust.

"In the third quarter, the tide shifted, and for the worse," says Joseph Quinlan, chief market strategist for Bank of America Corp. in Charlotte, North Carolina. "The domestic-profits squeeze is in its early stages and will be severe enough to overwhelm strong foreign earnings."

Caterpillar Inc. of Peoria, Illinois, the world's largest maker of bulldozers and excavators, shocked investors in October when it said it expected the economy to be "near to, or even in recession" in 2008.

Job Cuts

Bank of America, JPMorgan Chase & Co., Bear Stearns, Citigroup Inc., Lehman Brothers Holdings Inc. and Morgan Stanley have announced some 25,000 job cuts so far this year. Gustavo Dolfino, president of New York executive-search firm Whiterock Group LLC, said in a Nov. 20 interview he expects them to fire thousands more.

Claims for unemployment benefits jumped to a nine-month high in the week ended Nov. 24. Economists polled by Bloomberg forecast that data to be released Dec. 7 will show payroll growth slowed to 70,000 in October from 166,000 in September, while the jobless rate rose.

"We see a significant slowdown in the growth of jobs and equipment spending in 2008," says Allen Sinai, chief global economist for Decision Economics in New York.

Sinking Boat Sales

Scarce credit could make things even tougher for companies such as Brunswick Corp. of Lake Forest, Illinois, maker of Bayliner boats. The firm is cutting 170 jobs as it struggles with what Chief Executive Officer Dustan McCoy suggested might be the weakest U.S. boat market since 1965.

Is China The Savior?

There was an interesting article in the Financial Times with Fred Smith, chief executive of FedEx.

FT: Do you believe that global growth is going to offset and help the US mitigate the effects of a slowdown?

MR SMITH: Sure, our international business is very strong, we’ve been saying that for a long time and in many parts of the world stronger than the United States.

FT: Even so, the last quarter you had to say that overall things were going to be tougher, because of the US.

MR SMITH: I’m not saying that it doesn’t make any difference, certainly not to FedEx, because it is still the majority of our revenue, so over time our international business is growing much faster.

What I am saying is that the growth elsewhere helps cushion the shock, but nothing can displace a slow down in the United States. I don’t care how optimistic people are about China or anything else, it’s still 25 per cent of the world’s economic activity, so when it slows down, it’s going to have an effect.

FT: Even from as global a company as it gets, FedEx?

MR SMITH: Of course.

GM Increases Incentives Amid Sales Decline

November sales plunge 11% at GM which ended three months of increases.

"Brisk headwinds from the soft economy are making tough sailing for automakers as they try to turn around their U.S. business," said Pete Hastings, a fixed-income analyst at Morgan Keegan & Co. in Memphis, Tennessee. "It looks like it's going to be tough for a while."

GM incentives increased 2.6 percent to $3,136 and Ford fell 0.4 percent to $3,191, Edmunds said. Chrysler retained the highest totals, at $3,360 per model, with an 8.2 percent gain.

U.S. auto sales may not rise again until late spring or early summer, said Michael Robinet, an analyst at CSM Worldwide Inc. in Northville, Michigan. "We're still in the doldrums with respect to credit" and fuel prices, he said.

GM, Caterpillar, FedEx, Brunswick, and a multitude of financial companies are all reporting declining sales or declining earnings. Boat sales, car sales, truck sales, shipping, and construction equipment are all in a pullback. Job declines are sure to follow. In many cases they are already.

Professor Depew was talking about The Profit Recession in today's Five Things.

• Profits for S&P 500 companies fell almost 25% on a per-share basis in the third quarter, the biggest year-over-year decline in almost five years, the article noted.
• The problem with being a finance-based economy and no longer a manufacturing economy, however, is that we really need those finance-engines to run smoothly in order to generate solid economic growth.

So far we have a housing recession, an earnings recession, and auto recession. It will not be long before adjectives are no longer needed in front of recession.

Discounting a bogus GDP number that pins inflation at .8%, we are for all practical purposes there already. No matter how strong China and India remain, they cannot pick up the slack if the US, UK, and EU all headed for the big "R".

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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Sell Now Ask Questions Later

Concern over asset backed commercial paper is still growing. The State of Florida has frozen assets in the Florida School Fund as noted in Freeze Is On In Florida. Now Maine Treasurer Lemoine Criticizes Merrill for Subprime Bet.

"I have deep concerns about the recommendations and the process by which that (paper) was delivered to us," Maine state Treasurer David Lemoine told Reuters in an interview. "What was in the background at Merrill Lynch for funneling that [Mainsail II] suggestion through their broker to us for purchase?"

Mainsail II assets were frozen in late August.

While Maine has not lost any money on the Mainsail II investment yet, Lemoine said it will take weeks if not months for the investment to be unwound carefully.

"If there is no harm, there is no foul. We need to see how it unfolds eventually in terms of the payment process," Lemoine said, declining to say how he might move against the New York investment bank and its brokers.

"As a practical matter, we are not using commercial paper anymore and so we are not dealing with any brokers, including Merrill Lynch," Lemoine said. Instead, some of Maine's short-term cash is now being invested in fully collateralized bank deposits, which earn the state less money, but are deemed very safe.

Odds the there being no losses in are Mainsail II zero. And speaking of zeroes, the odds are overwhelming that the current investment value of Mainsail II is closer to zero than to 50% of the original investment regardless of how "carefully" unwound the investment is.

As a practical matter asset backed commercial paper is dead and is not coming back. The flight to the safety of cash is on.

Run on Montana Fund

Following in the footsteps of Florida, a Run on a Montana Fund is now in progress.

Montana school districts, cities and counties withdrew $247 million from the state’s $2.4 billion investment fund over the past three days after officials said the rating on one of the pool’s holdings was lowered to default. The fund, managed by the Montana Board of Investments, holds $90 million in Axon Financial, a structured investment vehicle, or SIV, that was cut to “D” by Standard & Poor’s amid the collapse of the subprime mortgage market.

Seattle Based King County Pool Is Exposed To Mainsail II

SIV Debts have been a Disaster For Public School Funds.

King County finance director Ken Guy says he thought the fund was making a safe investment when it bought $53.5 million in commercial paper of an SIV-lite called Mainsail II in July. Mainsail failed to make payments to investors, including King County, on Oct. 4.

Sell Now Avoid The Freeze

Canada is still coming to grips with its frozen, now partially unfrozen ABCP mess as detailed in Global Credit Crisis Canadian Style, Minyan Mailbag: Money Frozen In Yukon, and Commercial Paper In The Unfrozen North.

It's too late for some districts in Florida as emergency funding is needed to pay teachers.

Schools in America are being forced to seek emergency loans to pay teachers after a multi-billion dollar state-run investment fund was forced to freeze withdrawals as the credit crisis takes hold.

Jefferson County school district was one of at least six school districts in Florida forced to take out last-minute loans to pay teachers after their requests for withdrawals were refused.With the size of the fund reduced to $14bn and continuing uncertainty about the level of sub-prime mortgages the fund was exposed to, its manager, the Florida State Board of Administration, was forced to close the books.

"If we hadn't done something quickly we would not have had a fund at all," said Coleman Stipanovich director of the Florida State Board of Administration.The State Board is considering ways of shoring up the fund including tapping into its $137bn public sector pension fund. Unsurprisingly the idea has met with stiff opposition from union officials representing public sector workers.

Managers of the Florida scheme, the largest of its type in the country, are to hold an emergency meeting on Tuesday to discuss how they can put in place a system to allow emergency withdrawals.

Marked To Reality

Why yes, this is yet another Zugzwang.

Florida officials want to freeze the fund but they need to pay the bills. Paying the bills means marking to reality any assets that are sold.

For more on the concept of what marked to reality means, please see E*Trade Marked To Reality - What Happens If Citigroup Is?

What I expect Florida to do is sell off assets worth full value or nearly full value leaving increasing concentrated toxic waste left in the fund over time. Perhaps in an effort to decrease toxicity, local taxes will be raised or new sin taxes implemented. Either way, someone has to pay for this mess. All freezing the fund accomplishes is a delay of one problem while creating new ones such as inability to pay teachers.

Looking ahead I expect to see a run on and/or a freeze in the Seattle-based King County Investment Pool fund. Who wants their assets to be frozen? Certainly those that get out first will be in the best shape as the situation in Florida proves.

The problem goes beyond school funds to the very heart of where many store money. While not a money market but rather a short term institutional bond fund, GE's "enhanced" cash fund willingness to break the buck may have been a key event.

I am wondering how much longer the likes of Legg Mason (LM), Wachovia (WB), and Credit Suisse (CS) are going to be willing to support their money market funds.

By the way, who wants to find out? This is what Hal Wilson, CFO for Jefferson County Florida had to say about his decision not to withdraw based on assurances from the state board that the money would be secure:

"I might not be able to pay our employees tomorrow," he said, referring to his $850,000 payroll. "I am sure that those money managers who withdrew all their funds are feeling really smug right now, thinking they did the right thing. But it left the rest of us holding the bag."

When it comes to Asset Backed Commercial Paper problems Sell Now, Ask Questions Later sure seems like a reasonable strategy.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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Eurozone Dilemma

There is an interesting article in the Telegraph by Liam Halligan stipulating The credit crunch could crush the euro. Let's take a look:

The credit crunch is hammering the US, which now faces a likely recession. Things don’t look great for the UK either; here growth could plunge to 1 per cent next year. The reason the eurozone now worries me is the emerging picture of sharply rising consumer prices on the one hand, and falling output on the other. Just like the Bank of England, the European Central Bank will on Thursday try to set monetary policy not only to deal with inflation, but also bolster growth.

Eurozone base rates are likely to be held at 4 per cent – for the sixth month in a row. Most observers think if they do shift this week, the only possible move is up.

That’s because, despite the credit crunch, the ECB’s rhetoric has remained very hawkish. But, in reality, eurozone policy makers now face a classic growth-inflation dilemma – one they share with other Western central banks.

My Comment: The odds of the ECB hiking are remote given the following:

• The ECB is set to pump cash over liquidity concerns.
• French President Nicolas Sarkozy comments about America's drooping dollar as "a precursor to economic war" has talk so heated that some want the EU to intervene in the currency markets. See Currency Twilight Zone for more on this idea.
• The mess with European Interbank Covered Bonds Trading

In light of the above the next move by the EU is way odds on to be lower.
Halligan continues:

The ECB’s predicament is made worse, though, by the euro/dollar exchange rate, and the single currency’s structural flaws. These two unique aspects of the region’s quandary are why its prospects are more gloomy than assumed.

Evidence that eurozone growth is souring is now coming thick and fast. In Germany, the region’s powerhouse, retail sales fell 3.3 per cent between September and October we learnt last week – with consumer spending frail in many other member states too. Europe’s bellwether Economic Sentiment Indicator also fell for the sixth consecutive month.

With weakening global demand slowing industrial growth, the eurozone’s crucial manufacturing sector is starting to suffer as well. The closely-watched IFO index of German business sentiment is well below its December peak. Europe’s PMI industrial index has also dropped close to 50 – a value which, in previous years, has provoked interest rate cuts.

But the ECB will have a big problem lowering rates this Thursday – or anytime soon – because eurozone inflation jumped to 3 per cent in November, up from 2.6 per cent the month before. Inflation has almost doubled since the summer – with rising oil and food costs causing consumer prices to balloon.

My Comment: Once again we have someone confusing prices with inflation. However, central bankers make the same mistake which is one of the reasons we are in the mess we are in. The ECB will not want to cut. Then again, neither does the Fed. In the end they both will.

When inflation surfaces, as it did last week, the markets think the ECB will hike rates – so the euro goes up even more. That then further undermines exports and growth – making it even harder for the bank to raise rates to deal with inflation.

This, in turn, forces the ECB to at least maintain its hawkish rhetoric – certainly compared with the Bank of the England and America’s Federal Reserve – which pushes the euro up anew. This is a conundrum the eurozone can’t seem to escape. And as inflation rises, and the dollar keeps falling, the ECB becomes more and more boxed in.

Something has to give. And it may be that desperate measures are needed.

My Comment: Inflation does not surface in a week unless money supply and credit surfaces in a week. On the other hand, if something has to give then something will give by definition. In this case what is likely to give is a panic move by the Fed to slash rates. It will not help. The UK will join in and the ECB will be forced to join whether it wants to or not.

After all, sceptics like me have always said the operational viability of the single currency won’t be known until the system is tested by a serious downturn. That moment may now come soon.

My Comment: That moment will indeed come soon. The EU will not be immune to a recession in the US and UK as well as a slowdown in China.

Interest rate spreads between government bonds in France, Spain, Germany and Italy have lately got wider and wider. In other words, believe it or not, the markets are increasingly betting on the eurozone breaking up – as political tensions rise, and the needs of inflation-averse nations like Germany can’t be reconciled with much weaker debt-driven members like Ireland and Spain.

Could it happen? Why not? Every other currency union in the history of man has broken up – unless, like the US and UK, it has been preceded by generations of political union, and held together with a federal tax system.

It sounds far-fetched, I know. But the ultimate victim of this sub-prime crisis could be nothing less than the single currency’s existence.

My Comment: I doubt it. The EU has problems but a breakup of the Euro will create more problems than it would solve.

Along with the European Central Bank, the Bank of England will decide on interest rates this Thursday. The "Old Lady", like the ECB, is expected to hold. But, again, there is an outside chance of a December cut. And that chance is steadily growing.

In a telling phrase, Bank of England Governor Mervyn King told MPs on Thursday that a sense of "on-going fragility" now pervades our financial markets. The months ahead, he said ominously, will be "rather uncomfortable".

For many, discomfort is already here - not least because of fears that the housing market is finally turning. Prices dropped 0.8 per cent in November, says the Nationwide, the steepest monthly fall for more than 12 years. Yes - on an annualised basis, property values still grew by almost 7 per cent. But separate Bank of England data also showed that mortgage approvals during October slumped to a 32-month low - with lenders struggling to fund, and reluctant to extend, new loans.

My Comment: Willingness to lend is affected by Northern Rock. Willingness to borrow will be affected by a sentiment change in the UK when borrowers begin to realize housing is not a one way ticket north. That sentiment change is long overdue and when it comes the BOE will have as much luck fighting the housing bust as the Fed. In one word "none". By the way, it appears that sentiment change is finally underway and it's a long way down too.

When buyers' access to credit is hobbled, it is right to ask just where the demand will come from to keep property prices firm. No wonder the latest Telegraph/YouGov poll reports two-thirds of voters now worry about a serious downturn. As the economic outlook worsens, of course, the case for a rate cut grows. The trouble is, as King points out, that with oil and food prices surging, inflation remains a "serious threat".

My Comment: If credit is hobbled and consumers stop spending the idea that inflation remains a serious threat is mistaken. Furthermore, if consumers are indeed genuinely worries about a downturn, they will cause one by not spending. It is a change in sentiment that drives a downturn not a downturn driving sentiment.

In October, CPI inflation jumped from 1.8 to 2.1 per cent - much higher than expected and above the Bank's 2 per cent target. And last week, early evidence emerged that price rises during November hit a 10-year high.

Retailers are now aggressively passing-on input cost rises, according to an authoritative CBI survey. And yet consumers are continuing to spend.

"There is certainly a risk," King told MPs, responding to that survey, "that the MPC won't be able to keep inflation close to target in the wake of further commodity and energy price rises." That doesn't sound like the prelude to an interest rate cut.

My Comment: Which is it? Are consumers genuinely concerned or they just saying so. Retailers can only pass on costs if consumers continue to buy. Non-discretionary items like food and energy are the wrong focus. The right focus was speculation in housing, rising asset prices, etc. Like the Fed, the ECB and the EU ignored those building bubbles. There is a price to pay now and that price is deflation. All this talk if rising inflation is enormously overstated especially if consumers throw in the towel.

King is right to worry. I applaud his hawkish stance. To cut rates when inflation is above target, and rising, smacks of panic. But I have a sneaking suspicion the MPC just might vote for a rate cut this Thursday - even if that means, once again, King himself is outvoted.

My Comment: I applaud the stance for the simple reason rates cuts will not do any good. The entire world is in a credit bubble and it's best to let it pop and for the free market to take care of things. But that is no more likely to happen in the EU or UK and the US.

And as inter-bank rates tighten further this week, and the money markets squeal, more MPC members will jump.

My Comment: Bingo.

Recommended reading for those who think inflation is about prices.

• Inflation: What the heck is it?
• Interview with Paul Kasriel

The current credit crunch should be enough to convince anyone that inflation expectations are overblown. But it's not. I guess that is the way it simply must be.

If everyone saw the threat (like Greenspan did in 2001), they would likely be wrong. Greenspan was ignoring ability and willingness of consumers to spend and ignoring rising asset prices that allowed it. Now that housing is collapsing, jobs are weakening, and consumers spending less, the talk is of rising inflation because of oil prices. That talk is misguided.

Housing bubbles exist in the US, UK, EU, as well as Canada. Those housing bubbles fueled demand for all kinds of goods and services as well as proving enormous numbers of jobs. Now that commercial real estate is slowing there is simply no source of jobs to pick up the slack.

The bubble in the US has popped and evidence is picking up that other countries will soon be following suit. When that happens and the ECB starts cutting, talk of the Euro becoming THE reserve currency will be exposed for the nonsense that it is. Nonetheless, the end of the US dollar hegemony is now in sight. How that ultimately plays out is not today's concern, but I doubt it leads to a complete breakup of the EU.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com
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E*Trade Marked To Reality - What Happens If Citigroup Is?

In a mark to reality event long overdue, Wall Street portfolios are hurt by E*Trade Firesale.

E*Trade Financial Corp's firesale of mortgage-backed securities has conjured up a new worst-case scenario for Wall Street's portfolio of subprime assets by knocking their value even lower.

Financial analysts on Friday said E*Trade got anywhere from 11 cents to 27 cents on the dollar for its $3.1 billion portfolio of asset-backed securities. The portfolio sale was part of a $2.5 billion capital infusion from a group led by hedge fund Citadel investment Group.

"The portfolio sale, one of the few observable trades of such assets, has very clear, generally negative, implications for the valuation of like assets on brokers' balance sheets," Credit Suisse analyst Susan Roth Katzke said.

Citigroup investment bank analyst Prashant Bhatia said E*Trade actually received 11 cents on the dollar for its portfolio, if you factor in that the brokerage received $800 million in cash minus 85 million shares it issued. He said that implies Citadel's received stock compensation worth about $450 million, leaving E*Trade with only $350 million for its $3.1 billion portfolio.

Goldman Sachs analysts said they were surprised by the size of the discount on the E*Trade portfolio because 73 percent of the assets were backed by prime mortgages, or loans to people with solid credit.

Marked To Reality

This is what happens when assets that were marked to model finally get marked to reality. The implication are ominous. While admitting using simplistic analysis Credit Suisse analyst Susan Katzke estimates the following writedowns based on what happened at E*Trade, assuming pricing at 26 cents on the dollar.

• Merrill Lynch (MER) could take a $9 billion after-tax hit to the valuation of assets underpinned by subprime mortgages.
• Citigroup's (C) after-tax write-down could be $26 billion.

Note that in reference to Merrill Lynch, Susa Katzke said $9 billion was related to subprime. Note that 73% of E*Trades portfolio was prime. That is quite a haircut on so called prime paper.

In Citigroup Fighting For Its Financial Life I noted Citigroup had $134.8 Billion in level 3 assets and a whopping $939 billion in level 2 assets. Here is the chart again for convenience:

Citigroup Assets By Class



Would it be so hard to believe that those $355 billion in Level 2 derivatives if "marked to matrix" would be worth 10% less if marked to reality?

Citigroup SIVs

Citigroup's latest 10-Q had this to say:

Citigroup has no contractual obligation to provide liquidity facilities or guarantees to any of the Citi-advised SIVs and does not own any equity positions in the SIVs. The SIVs have no direct exposure to U.S. sub-prime assets and have approximately $70 million of indirect exposure to sub-prime assets through CDOs which are AAA rated and carry credit enhancements. Approximately 98% of the SIVs' assets are fully funded through the end of 2007. Beginning in July 2007, the SIVs which Citigroup advises sold more than $19 billion of SIV assets, bringing the combined assets of the Citigroup-advised SIVs to approximately $83 billion at September 30, 2007. See additional discussion on page 46.

The current lack of liquidity in the Asset-Backed Commercial Paper (ABCP) market and the resulting slowdown of the CP market for SIV-issued CP have put significant pressure on the ability of all SIVs, including the Citi-advised SIVs, to refinance maturing CP.

While Citigroup does not consolidate the assets of the SIVs, the Company has provided liquidity to the SIVs at arm's-length commercial terms totaling $10 billion of committed liquidity, $7.6 billion of which has been drawn as of October 31, 2007. Citigroup will not take actions that will require the Company to consolidate the SIVs.

Those paragraphs appear to be an attempt to whitewash Citigroup's exposure. SIVs are off balance sheet assets partially owned by Citigroup. While Citigroup it may not have to provide funding, if those SIVs lose money Citigroup will lose money.

However, because those assets are off balance sheet, Citigroup does not have to mark those losses to market. Citigroup desperately does not want those SIVs on their balance sheet. Nor does Paulson, nor does anyone else who is involved in SIVs. Quite simply Citigroup cannot afford to have those assets on its balance sheet. That is how I interpret Citigroup's statement "Citigroup will not take actions that will require the Company to consolidate the SIVs."

The implications are obvious: the Super-SIV bailout is nothing more than A Fraudulent Attempt at Concealment. More details are out since then, with Paulson Announcing Super-SIV Failure Already. While the Super-SIV bailout has already failed, Citigroup is so over-leveraged it can't bring those assets onto its balance sheet. If it did, it would have to mark them to market.

Citigroup's Leverage Problem

Citigroup's funding strategy is based on liquidity and leverage concerns.

Citigroup Inc. said late Friday that it has reduced the assets of so-called structured investment vehicles (SIVs) the bank sponsors. Assets in the SIVs the company advises have declined to $66 billion as of Nov. 30 from $83 billion at the end of September, a Citigroup spokesman said in an e-mailed statement.

"The funding strategy for Citi-advised SIVs remains unchanged from the disclosures in our third quarter 10Q filing," he added. "We continue to focus on liquidity and reducing leverage."

Moody's Investors Service said earlier on Friday that it may downgrade the ratings of some SIVs sponsored by Citi, including Sedna Finance and Zela Finance.

This past week Citigroup gave up close to 5% of its equity in a panic move to shore up capital in return for a $7.5 billion in cash. I talked about this in Petrodollars Return Home.

But what happens when they need another $26 billion as Credit Suisse analyst Susan Katzke is suggesting? What happens if those level 2 assets were marked to market? What happens if Citigroup has to bring those SIVs back on to its balance sheet? What happens when Moody's, Fitch, and the S&P continue downgrading CDOs? What happens now that credit card losses are rising and commercial real estate is tanking?

To reduce further leverage by selling assets, Citigroup will have to mark any assets its sells to reality at a time when nearly all asset classes are under attack. Good luck reducing leverage.

Citigroup had $127 billion in equity "on paper" as of September 30th 2007 . The closer one looks at this the more suspect that equity is.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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