Overhang Of LBO Debt

The LBO Market is in ‘disarray’ after Harrah’s upset.

The leveraged loan market begins the week in “disarray” following the collapse of efforts to syndicate $14bn of the debt used to finance the $30bn buy-out of Harrah’s Entertainment, bankers say.

The group of banks backing buyers Apollo Management and Texas Pacific Group are having trouble selling on the leveraged buy-out debt to third parties. With the bulk of the debt remaining on their books, the banks are sitting on a sizeable loss.

The freeze in the debt market means they now face larger potential losses on other big buy-outs, such as BCE and Clear Channel Communications, and will be more desperate to get out of the financing commitments on those deals.

Banks are already saddled with more than $150bn of unsyndicated debt, most of it LBO-related, according to S&P data. Virtually every loan-backed buy-out deal done in the past few months is trading well below 90 cents on the dollar.

My Comment: Underwriting fees was a big source of profits last year. Now banks are stuck holding the bag on deals nobody wants. Think this is just a blip in profits? Think again.

Credit Suisse, under pressure to get its lending exposures down, sold about $1bn of its share of the debt ahead of the agreed schedule, infuriating the other banks. Credit Suisse informed fellow members of the syndicate of its intention in early January, according to one person familiar with the matter.

“There is no contractual obligation,” this person added. “We cannot concede control over our own capital.” That may be the pattern in future deals. “The Harrah’s precedent frees other underwriters to deal with situations as they see fit,” noted Standard & Poor’s Weekly Wrap.

My Comment: This looks like a case of "New Rules". Credit Suisse did not want to go down with the ship. Who's next?

“The market is in total disarray,” said the head of debt capital markets at one major Wall Street firm. Another senior banker involved in the deal added: “The last 10 days have been the worst ever. There is a complete buyers’ strike.”

My Comment: There's not a buyer's strike. There's a seller's strike. There are plenty of buyers, just not at the expected prices. It's the same story in the housing market. Everyone wants the price they could have gotten 6 months ago. That price is no longer available. Seller's need to be more reasonable about expectations.

Ironically, the Federal Reserve’s dramatic 1.25 percentage point cut in interest rates in January contributed to Harrah’s problem, because loans are floating rate and with benchmarks such as Libor dropping, returns to investors fall proportionately.

The Fed rate reduction also meant lower returns on earlier deals to finance the mega buy-outs of the last few months, including the loans on deals such as First Data and Alltel.

The head of debt at one private equity firm said: “Technical factors haven’t been fixed and the bad macro outlook has kicked in.

My Comment: One has to laugh at the irony of this. The Fed, by attempting to bail out homeowners, has instead hurt the commercial real estate deals. The residential market is long past saving.

“Even if you are comfortable with the individual credit, why bid when the market is going lower?”

Why bid when the market is going lower?

That last sentence says it all. Attitudes have changed. Attitudes are critical. See Changing Social Attitudes About Debt and The Business of Walking Away for more about attitudes.

It was changing attitudes that sunk home prices. Now attitudes are impacting LBOs in a major way. This is just the beginning of the unwinding of attitudes towards both consumption and risk.

A Crash Course For Bernanke about attitudes is now in progress.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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Citigroup's Strange New Definition Of "High Risk"

Leave it to Citigroup (C), the bank that has gotten virtually nothing right for years, to come up with strange definition of "higher than acceptable risk".

The Times Online is reporting Prudent customers risk losing credit cards.

CREDIT card customers who pay off their balance each month are as much risk from being cut off by their lender as those that have lost control of their spiraling debts. Credit checking agencies say banks are beginning to weed out customers with faultless borrowing histories because they can make little profit on them.

It comes as credit card company Egg was accused of withdrawing cards from some of its most responsible customers as part of a cull of those said to have a "higher than acceptable risk profile".

The lender, part of US investment bank Citigroup, wrote to 161,000 customers - 7% of its total base - last week to warn them their cards would be withdrawn in 35 days. They can still repay balances over time.

Royal Bank of Scotland, which has 11m credit cards in use under brands including Natwest, Mint and Tesco Personal Finance, said: "The credit card is there for people to use as they want. We don't want customers that aren't managing their credit card."

Credit card providers have become more discerning about who they accept as new customers in recent years. Two years ago only about one in three of applicants for new cards were declined. That figure has since risen to nearly 50%. Barclaycard now turns down more applicants than it accepts.

Citigroup Only Wants Patsies

If those customers are profitable, it is dumb to cancel their cards. If they are unprofitable, then perhaps Citigroup should have instituted an annual fee to cover the costs.

Here's the deal. As long as customers are charging something, Citibank should be collecting a fee from the merchant for each transaction. If the merchant fees do not cover processing costs, then perhaps Citigroup has yet another problem to address (transaction processing costs are out of line with industry averages).

In contrast to Citigroup, the Royal Bank of Scotland "does not want customers who aren't managing their credit card."

Citigroup seems to have decided that it would rather have no money than some money from those customers it just turned away. Who cares if their customers are the "ideal patsies" or not as long as they are profitable? Well, I guess Citigroup does. This is yet another poor decision in a long line of poor decisions by Citigroup.

Take The Mirror Test

Look in the mirror and ask yourself if you have a Citicard and routinely carry a balance on it. If you answer yes to both questions, then Citigroup considers you a patsy. And you are a patsy.

By the way, this same mirror test applies to Visa, MasterCard (MA), and Discover Card (DFS) as well. Those who routinely carry a balance on any card are patsies. Those who carry balances on cards with two-cycle billing are double patsies. For more on the two cycle billing ripoff, please see Read the Fine Print On Credit Cards.

Note: Visa and MasterCard make money on fees, they do not hold credit card debt. It is not Visa or MasterCard that will be in trouble if consumers default. Rather it is those taking the risk by holding the debt.

Refuse To Pay High Interest Rates

In the truth is stranger than fiction department, here is an Open Letter to WaMu from someone refusing to pay their VISA card due to the 26% interest rate imposed on someone with allegedly perfect credit.

Dear WaMu executives:

I am hereby informing you that I stopped paying my $8,000 WaMu VISA card. It SHOULD be illegal to charge a 26% interest rate for any credit card debt and I’m hoping that this Open Letter will draw the legislators’ attention to your vile business practices.

While I sympathize with the idea that a 26% interest rates amounts to usury, the correct response would have been to pay the card off and move the account elsewhere. If that person's credit was perfect before, it sure is not perfect now. Ruining your credit over a matter of principle is simply not a good move. Nor is carrying an $8,000 balance in the first place. The way to avoid high interest rates is simple. Don't carry a balance.

Back to Citigroup. I have worked at banks, lots of banks, for lots of years. I know this story full well. Two years from now, Citigroup is likely to get the bright idea to win back customers it recently lost no matter how much it costs. This assumes of course, that Citigroup is still in one piece. With decisions like this one, they won't be.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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Fallout From US Slowdown Hits Canada

The US housing slowdown has brought about a need for Major Furniture Liquidations in Canada and the US.

Liquidation World Inc. (TSX:LQW) today announces a number of new major furniture liquidations being offered throughout its stores in Canada. The recent and dramatic changes to the US housing market, precipitated by the sub-prime mortgage crisis, have impacted a number of major US furniture vendors.

Maurice Chelli, SVP Merchandising said: "The US housing slowdown has had ripple effects in the furniture sector. As a result we have recently acquired several million dollars worth of furniture inventories and we are continuing to see new opportunities almost on a daily basis. The result is a wide array of high quality furniture being liquidated throughout our Canadian outlets.

While these same economic factors are causing price deflation in the North American furniture market in general, the sheer volume of deals has put us in the position of being able to choose the deals that deliver the best value to our customers. In one recent example, we sold more than a million dollars worth of living room furniture for less than $500,000.00. For the value-driven Canadian consumer, there has never been a better opportunity to purchase household furniture."

No Profit In Liquidation Business

Inquiring minds might be wondering if the liquidation business is booming. Let's take a look at Liquidation World's Fiscal 2007 Results.

• Canadian operations recorded a net loss of $6.7 million ($0.81 per share) versus net earnings of $1.3 million ($0.16 per share) in fiscal 2006.
  
  
• In the US, revenue for the year declined by 4.9% to $28.2 million from $29.7 million in fiscal 2006. US operations recorded a loss of $5.0 million for the year versus net earnings of $0.2 million in fiscal 2006.
  
  
• In the US, revenue for the year declined by 4.9% to $28.2 million from $29.7 million in fiscal 2006. US operations recorded a loss of $5.0 million for the year versus net earnings of $0.2 million in fiscal 2006.
  
  
• In the fourth quarter of fiscal 2007, the Company announced that it would wind down its US operations and forecasted a loss of $1.5 to $2.5 million related to the closure.
  
  
• Subsequent to year end the Company closed 15 of its 18 US outlets.

Liquidation World Liquidates US Operations

In spite of the supposition that "there has never been a better opportunity to purchase household furniture" it seems there is no profit in the liquidation business.

With that, Canadian based Liquidation World had no choice but to liquidate its US operations.

Canadian Economy Shows Strains From US Slowdown

The Financial Post is reporting Canadian economy beginning to show the strain.

Canada's manufacturing and forestry sectors may already be in recession and the U.S. slowdown and spike in the Canadian dollar are beginning to have a greater impact on the broader economy, with the mining and wholesale trades contributing to weaker economic growth in November, new figures show.

Canadian gross domestic product (GDP) slowed to 0.1% in November from 0.2% in October, resulting in an annualized growth rate of 2.7%, Statistics Canada figures showed yesterday. The pace of growth is not expected to pick up anytime soon, with the Bank of Canada predicting growth of 1.8% in 2008.

"It's clear that Canada's economy is not immune to the weakness south of the border and the strong Canadian dollar," Sal Guatieri, senior economist at BMO Capital Markets, said.

The agricultural and forestry industry took the biggest hit in November, declining 0.4% for an annualized contraction of 3.8%.

"There's really no sign of a recovery in forestry products," Mr. Guatieri said, adding growth in one of that industry's main markets, the housing sector, was also slowing.

Mining growth fell 0.4% in the month and was down 0.7% on the year. Manufacturing activity declined by 0.3% in November, but remained slightly higher over the year at 0.2%. While wholesale trade fell 0.1%, but maintained a healthy annualized growth rate of 8.8%.

Paul Ferley, assistant chief economist at RBC Capital Markets said the Bank of Canada will likely cut interest rates from 4% to 3% over the next six months as the U.S. slowdown "will likely put additional downward pressure on the pace of activity in Canada."

In spite of an enormous housing bubble in Canada, speculation is that Bank of Canada will cut interest rates from 4% to 3%. How far down the road to ZIRP Canada is willing to follow the US remains to be seen.

The further the Bank of Canada is willing to cut, the more pressure there will be to unwind various carry trades.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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Merrill Lynch Opens Legal Hornet's Nest

Bloomberg is reporting Merrill Sued for Fraud by Massachusetts Over CDO Sale.

Merrill Lynch & Co. violated Massachusetts securities laws by selling the city of Springfield "inappropriate" collateralized debt obligations that lost 91 percent of their value, Secretary of State William Galvin alleged in a lawsuit filed today.

The sale was "illegal," Galvin's enforcement office said in a 25-page complaint. The regulators are seeking sanctions against New York-based Merrill and the two brokers who sold the CDOs to Springfield, Carl Kipper and Manuel Choy. The brokers no longer work for Merrill, the firm said today.

"At the time of the sale Kipper and Choy did not discuss the risks of owning CDOs with the city even though those risks were well know to Merrill Lynch," the complaint alleges. Galvin declined to comment on the lawsuit.

Springfield joins a growing list of governments and their agencies, from Florida to Washington state, that have been burned by mortgage-linked securities such as CDOs. The market for CDOs has collapsed amid surging subprime loan defaults, hurting their credit ratings and, in the case of Springfield, making them virtually impossible to sell.

"We are puzzled by this suit," said Mark Herr, a Merrill spokesman, in a statement. "We have been cooperating with Mr. Galvin's office in its inquiry."

"After carefully reviewing the facts, we have determined the purchases of these securities were made without the express permission of the city," Merrill said in a statement yesterday after agreeing to reimburse the city. "As a result, we are making the city whole and we have taken appropriate steps internally to ensure this conduct is not repeated."

Hornet's Nest Of Litigation Opened

Merrill Lynch (MER) may have opened a legal hornet's nest by agreeing to reimburse Springfield $13.9 million.

Merrill Lynch & Co. will pay the city of Springfield $13.9 million to settle a dispute over investments that soured and became the focus of investigations by state regulators, the two sides said Thursday

The brokerage firm said in a statement released late Thursday that it settled after a review showed Springfield officials never gave explicit permission to invest in the securities, many of which were related to the troubled subprime mortgage market.

"Merrill Lynch is crediting the city of Springfield with approximately $13.9 million in cash, the full original purchase price of CDO investments that have been under dispute," Mayor Domenic J. Sarno, Springfield Finance Control Board Chairman Chris Gabrieli and Coakley said in a joint statement.

Is the situation unique to Springfield?

By agreeing to reimburse Springfield for any reason, lawsuits are bound to be pouring in from everywhere. The case of Springfield centers around authorization as well as failure to deliver a prospectus.

However, once the lawsuits start flying, Merrill Lynch will have to prove in court that Springfield was unique. Also coming into play will be the question of whether or not Merrill Lynch knew the investments it was selling were inappropriate.

Not only were they inappropriate, Merrill Lynch and others were caught up in their own Ponzi scheme.

Wall Street CDO Hairball

The Columbia Journalism Review is reporting WSJ shines light on Wall Street 'hairball'.

The Wall Street Journal on December 27 headlined “Wall Street Wizardry Amplified Credit Crisis.” Reporters Carrick Mollenkamp and Serena Ng dive into how Merrill Lynch created a so-called mezzanine CDO (made up of middle-rated bonds) named “Norma,” recruited a Long Island penny-stock impresario to run it, and in its small way helped to undermine the global financial system. It’s one of the best explanatory pieces yet on how these financial instruments that were supposed to spread risk concentrated it instead.

As the Journal says:

But Norma and similar CDOs added potentially fatal new twists to the model. Rather than diversifying their investments, they bet heavily on securities that had one thing in common: They were among the most vulnerable to a rise in defaults on so-called subprime mortgage loans, typically made to borrowers with poor or patchy credit histories. While this boosted returns, it also increased the chances that losses would hit investors severely.

Why would anyone buy it? To get a higher rate for a bond with the same safety rating as corporate or Treasury bonds. Why would rating agencies (e.g. Standard & Poor’s, Moody’s) rate them so highly? Well, not to be too cynical, but the companies seeking the ratings pay the bills.

Tangled hairball. House of cards. Call it what you will, it was spit out or stacked up by the shamans on Wall Street, who used this financial voodoo to earn huge fees from underwriting these securities.

That’s how the $1.5 billion Norma CDO came about.

A key to the Journal story’s success is that it scored an interview with Corey Ribotsky, the Long Island-based penny-stock broker, whom Merrill set up as a “CDO manager” to recruit investors and administer Norma. Ribotsky hooked up with Merrill at a Long Island club after meeting a criminal defense lawyer who introduced him to a Merrill bond salesman.

Why was Merrill Lynch essentially setting up businesses for such outside CDO managers—and why Ribotsky, who’s being sued by three separate companies for manipulating their stocks? The Journal doesn’t answer this directly, and there may be another story there. Still, his quotes are priceless:

“It sounded interesting and that’s how we ventured into it,” Mr. Ribotksy says.

Well, there you go.

The Journal reveals that Norma was comprised of derivatives and securities that Merrill itself had underwritten:

Such cross-selling benefited banks, because it helped support the flow of new CDOs and underwriting fees. In fact, the bulk of the middle-rated pieces of CDOs underwritten by Merrill were purchased by other CDOs that the investment bank arranged, according to people familiar with the matter. Each CDO sold some of its riskier slices to the next CDO, which then sold its own slices to the next deal, and so on.

That circular cross-selling also multiplied the impact of housing defaults. The Journal cites a UBS study saying banks sold CDOs made up of derivatives worth three times more than the value of the underlying, asset-backed securities.

The banks are getting stuck with billions of dollars in losses in large part because they kept the “safest” parts of the CDOs on their books, since their low yields attracted few buyers. Since they concentrated CDOs in areas that have been slammed—like BBB-rated subprime securities—their values have taken huge hits. The Journal says mezzanine CDOs could account for up to three-quarters of the losses of the biggest banks like Citigroup and Merrill.

While the best mortgage-crisis stories may be yet to come, this one certainly helps untangle that hairball a bit.

What Hath "Norma" Wrought?

The Securities Law Firm of Klayman & Toskes placed this Notice to All Merrill Lynch Customers Who Invested in Norma CDO I Ltd on February 1.

The Securities Law Firm of Klayman & Toskes, P.A. announced today that it is investigating the damages sustained by institutional and retail customers in a collateralized debt obligation ("CDO") called Norma CDO I Ltd. ("Norma"). Norma, brought into existence by Merrill Lynch, bet heavily on the success of the sub-prime market. Just nine months after it sold about $1.5 billion in securities to its investors, the value of Norma has been decimated in the collapse of the housing market and is reported to be worth only a fraction of its original value.

Presently, K&T is investigating how Merrill Lynch and others marketed Norma, and whether the brokerage firm properly disclosed the risks of Norma to its customers. Further, K&T is looking into whether Norma was suitable for the institutional and retail customers that invested in the product.

Hidden Swap Fees Hit School Boards

Bloomberg is reporting Hidden Swap Fees by JPMorgan, Morgan Stanley Hit School Boards.

This story involves cash the strapped Erie City School District in Pennsylvania. James Barker is the superintendent of the district.

In an "offer too good to be true", and was, David DiCarlo, an Erie-based JPMorgan Chase banker, talked Barker and the school district into a credit default swap. The swap gave the school district an upfront $750,000 and a huge nightmare down the road. Let's pick up the rest of the story from Bloomberg.

What New York-based JPMorgan Chase didn't tell them, the transcript shows, was that the bank would get more in fees than the school district would get in cash: $1 million. The complex deal, which placed taxpayer money at risk, was linked to four variables involving interest rates. Three years later, as interest rate benchmarks went the wrong way for the school district, the Erie board paid $2.9 million to JPMorgan to get out of the deal, which officials now say they didn't understand.

JPMorgan's Chief Executive Officer Jamie Dimon declined to say if he thought the bank's fee disclosure was proper and whether the bank acted in a fair, responsible and moral manner in Erie. Banker DiCarlo declined to comment.

My Comment: Declining to comment is a comment. Jamie Dimon has to know the fees in question are not fair and that JPMorgan dot act in a "moral manner" to the school districts. However, morals and legality are two different things. At the heart of the issue will be a legal requirement to disclose fees. This will no doubt be settled in court.

The Pennsylvania deals show that school districts routinely lose when making derivative deals. They pay fees to banks that are as much as five times higher than typical rates and overpay advisers by as much as 10-fold. That means banks often underpay schools on upfront amounts, as JPMorgan Chase did in Erie, public records show. And school officials aren't always well served by their supposedly independent advisers, whose fees are paid by the banks selling the deals -- only if the sale is made.

My Comment: This opens up still another legal attack. If the so called independent advisers represented the brokerage houses and/or proper disclosures were not made, both the brokerage houses and the independent advisers are going to find themselves in court.

Christopher Cox, chairman of the U.S. Securities and Exchange Commission, says he's concerned that municipalities are taking on more risk than in the past when they raised money primarily from bond sales.

"It's a serious issue, not only in Pennsylvania but across the country," says Cox, 55, who has headed the SEC since 2005. "That is what we have seen repeatedly. More often than not, the municipalities aren't configured to have financial sophisticates in charge of these offerings -- and the result is that the firms are the only ones who know what's going on."

The banks that arrange these deals create the swap contracts before pitching them to schools. Using software programs designed for valuing swaps, they calculate prices for which they can sell them after a school signs a contract. That's how the banks make money. For example, if a bank agrees to pay a district $800,000 in a deal it valued at $2 million, it could reap $1.2 million for itself and middlemen.

"They load it off instantly," says Taylor, who's now on the advisory board of Rockwater Municipal Advisors LLC, an Irvine, California-based investment firm.

Banks hedge their risk in derivative deals by making trades to cover possible losses to school districts. The banks make their money from fees, regardless of interest rate movements.

The reason Erie and other districts don't know how much the bank makes from a deal is because banks don't tell them, the records show.

My Comment: These kinds of deals and the fees they generate are now dead in the water. Regardless of the litigation outcome, such predatory practices will stop. Together with collapsing leveraged buyouts (LBOs), and with commercial real estate headed into the sewer, what's obvious is that profits at the brokerage houses has peaked this cycle.

While the SEC doesn't regulate derivatives, it has authority to oversee how banks conduct transactions. SEC Chairman Cox says all financial firms should tell clients what their fees are before signing any deals.

"Brokers and advisers should disclose their compensation and conflicts of interest to their customers, and to the extent that they are regulated by the SEC, they must," he says.

Cox also says school district officials have a responsibility to the public and to bond investors to ensure their advisers are actually independent and acting in the best interests of taxpayers. "To the extent that municipalities are participating in transactions they are not qualified for, there is an obligation to get good independent advice," he says.

My Comment: What Cox seems to be saying is that both parties are at fault. There is plenty of ground here for future litigation.

In many cases, the banks repeatedly sell more derivatives to replace old ones. In Bethlehem, Pennsylvania, JPMorgan and Morgan Stanley sold the school district eight swaps on just two bond issues, records show.

"It sure looks a lot like churning," Yang [head of research at financial advisory firm Andrew Kalotay Associates Inc.] says. Churning is a term used to describe how stockbrokers or insurance agents sometimes continually sell and resell the same or similar products to clients in order to make more in fees. "Doing more than one swap against a single bond issuance definitely benefited the swap adviser and bank, but probably not the school district."

Other Pennsylvania school districts are paying banks excessive fees. Bethlehem, 50 miles north of Philadelphia, is also a former steel-making center. With a population of 72,000, the city has maintained its historic buildings.

So far, the [Bethlehem] district has taken in about $900,000 from the deals, Bloomberg data show. That compares with $3 million in transaction fees. Lestrange and Access made $630,000 each for arranging the swaps, according to school district records. New York-based Morgan Stanley made $840,000 and JPMorgan received fees totaling $900,000, Bloomberg data show.

Lestrange and Access earned a fee 10 times more than the Easton Area School District, Bethlehem's neighbor, paid its adviser on a comparable interest-rate swap in 2004.

The rates the banks charged Bethlehem were twice the average for comparable swaps deals. In this kind of swap, in which both sides pay floating interest rates, a bank calculates its fees by subtracting an amount from the rate it will pay.

"It's obscene," says Peter Shapiro, managing director of South Orange, New Jersey-based adviser Swap Financial Group, who doesn't advise Pennsylvania school districts. "What is going on in Pennsylvania?"

Hornet's Nest Recap

• Merrill Lynch, Citigroup, and others clearly sold products not suitable for retail customers to retail customers. However, these companies are likely to maintain they did so in "good faith".
• Fees and risks were not properly disclosed. The issue of undisclosed fees may prove to be extremely fertile ground for litigation.
• Inappropriate relationships by so called "independent advisers" will come under legal scrutiny.
• There will be grounds for lawsuits for recommendations that amount to "churning".
  
• A mammoth wave of lawsuits against Bear Stearns (BSC), Merrill Lync (MER), Citigroup (C), Lehman (LEH), Morgan Stanley (MS), Goldman Sachs (GC), JPMorgan (JPM) and others is likely on the way.
• By agreeing to reimburse Springfield, Merrill Lynch may have inadvertently opened the door for more litigation.
  

Merrill Lynch, Citigroup and other got caught up in their own CDO Ponzi schemes once the pool of greater fools ran out. A hornet's nest of litigation is now on the way. Legal bees will be buzzing over this for a long, long time.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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Microsoft Panics, Overpays For Yahoo

The tech news of the day is Microsoft offers $31-share, $44.6 billion, for Yahoo.

In a dramatic move that could significantly reshape the Internet industry, Microsoft Corp. on Friday offered to buy Yahoo Inc. for $44.6 billion in an effort to team up on online-advertising juggernaut Google Inc.

Microsoft (MSFT) said its "compelling" offer of $31 a share, in half cash and half stock, represents a 62% premium to Yahoo's (YHOO) closing price Thursday. Yahoo's market value has been pared recently by continued poor performance, stirring speculation that such an acquisition offer was imminent.

In a brief statement, Yahoo said it "will evaluate this proposal carefully and promptly in the context of Yahoo's strategic plans and pursue the best course of action."

The bid underlines the importance of the online advertising market to Microsoft, which company executives say could double to $80 billion within three years.
In addition to search advertising, a combined Microsoft and Yahoo would also present a stronger competitor to Google in market of advertising networks that extend beyond the companies' own Web sites.

Google on Thursday disclosed some recent difficulty in its network, saying that it has struggled to present advertisements on social networking sites such as partner MySpace.com that attract active user interest.

But earlier this week, Yahoo posted a sharp drop in fourth-quarter profit and said it would trim its workforce. The results dented Yahoo's stock, sending the shares to their lowest level since October 2003 and making the company more vulnerable to buyout offers.

Overall, Microsoft said its combination with Yahoo could generate annual savings of $1 billion, driven by research-and-development critical mass, operational efficiencies and increased value for advertisers.

Microsoft Panics

The offer is "compelling" alright, but only for Yahoo. Let's start with the idea that Microsoft might generate annual savings of $1 billion. It will take a long time at that rate to justify paying $44.6 billion in cash and shares.

Microsoft Balance Sheet


click on chart for sharper image

With a hat tip to Professor Jeffery, here is a table of Search Share Rankings from Nielsen.



click on chart for sharper image

Microsoft blew all of its cash on hand to pick up less than 18% of the search engine market. Microsoft and Yahoo combined only have a 31.5% share compared to Google's (GOOG) 56.3% share.

The Big Picture

Barry Ritholtz has many questions about Microsoft Takeover Bid for Yahoo!

Why is Ballmer & Co. paying such a big premium? Does this imply the entire Tech market is hugely undervalued -- or is Microsoft (MSFT) desperate to catch up with Google (GOOG)?

Answering his own questions, and which I am in agreement, Barry concludes:

Mister Softee's biggest cash cows -- Windows and Office -- look shakier than they ever have. There are real competitors for PCs (Apple, Linux) and lots of free or nearly free office software (Open Office, Google Apps). I assume Microsoft is projecting out current trends 5 and 10 years; they might truly believe that if they can't compete in the online search/advertising space, they are in trouble.

Here's the ironic part: The 2 most visible losers in the search area may be getting together -- and somehow, that's worth 150 point swing to the Dow futures.

I guess the negativity isn't quite as excessive as some people claim!

Reasons To Own Microsoft Shrink

One of the reasons to own Microsoft was that someday it would do something intelligent with its huge cash hoard. So far it has attempted to prop up its share price with huge special dividends, and now it is willing to part with every penny on its balance sheet to buy Yahoo!

With this offer, Microsoft has somehow decided this is the bottom for tech. I disagree. Furthermore, it is extremely unlikely that anyone else could possibly come up with $44 billion to buy Yahoo in this market climate. So what's the rush?

Heading into a consumer led recession was Yahoo!'s ad revenue going to significantly jump? No Chance! Even Google is struggling to grow.

Everyone, including Microsoft is underestimating how deep this recession is going to get and what that might do to earnings. Had Microsoft waited, it might have been able to get Yahoo! for 1/3 or even 1/4th the current offer.

Yahoo!Finance (the only thing I ever use Yahoo for), shows the P/E of Yahoo to be 55. That is hugely overpaying even in a good environment, and is preposterous heading into a recession that figures to be both long and nasty.

Microsoft panicked and it wasted its cash on hand in doing so. I see no other reasonable way of looking at it. This deal is not good news for Microsoft shareholders. Longer term, it's not good news for tech at all. When the real time comes to buy, companies like Microsoft will have already blown their cash.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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Jobs Contract as 2007 Job Growth Revised Away

The Jobs data for January is now in. Yesterday in Jobless Claims Spike, Spending Slows, More Rate Cuts Coming I called for jobs contraction to start the year.

None of the 80 economists surveyed by Bloomberg News predicted a decline.

The drop in payrolls in January was the first since August 2003. The median forecast was for a payrolls gain of 70,000, compared with an initially reported increase of 18,000 in December. Forecasts ranged from gains of 5,000 to 160,000.

Jobs did contract and here is the report as noted by this report: U.S. Payrolls contracted by 17,000 jobs in January.

Nonfarm payrolls fell by an estimated 17,000 in January, the Labor Department said. This is the first decline since August 2003. The decline in payrolls was much weaker than the 85,000 increase that had been expected by Wall Street economists surveyed by MarketWatch.

The labor market has clearly deteriorated. Job growth has averaged 41,000 over the past three months, compared with an average of 109,000 in the first quarter of 2007. The report contradicts the January employment survey released on Wednesday by ADP that estimated that 130,000 private sector jobs were created in January.

2007 Data Revised Much Lower

As I expected 2007 job growth revised lower.

U.S. nonfarm payrolls grew 95,000 per month in 2007, a slower pace than the 110,000 previously reported. The job market started 2008 on the wrong foot, with 17,000 jobs destroyed, the government said in the release. For all of 2007, employment rose by 1.137 million, the slowest job growth since 2003, when hiring picked up again after a "jobless recovery."

The level of employment in December 2007 was revised lower by 376,000 on a seasonally adjusted basis to 138.1 million, based on more up-to-date information from quarterly tax returns by businesses.

Revision Highlights

• Goods-producing industries were revised down by 233,000 to 22 million.
• Construction payrolls were revised down by 63,000 to 7.5 million.
• Factory payrolls were revised down by 176,000 to 13.7 million.
• Services producing industries were revised down by 125,000 to 116.1 million

Birth Death Adjustments For 2007

The new CES Net Birth/Death Model table lops of the first quarter of 2007. So let's have one last look at the 2007 table as shown in my December 2007 Jobs post Unemployment Soars as Private Sector Jobs Contract. Also shown below are a few of my comments at the time.

Birth Death Adjustments For 2007



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The BLS birth/death model has added jobs 11 consecutive months now. This includes financial activities in an environment where business capex spending has been weak, housing has been horrid, and over to 210 lenders have gone out of business or stopped writing loans according to Implode-O-Meter. In spite of horrible housing conditions, the BLS has assumed there have been more business births than deaths in 9 of the last 11 months in construction.

The BLS birth/death model has now added 1,305,000 jobs to the economy since February. That model remains somewhere in outer space.

January 2008 Birth Death Adjustments



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Poof. In one fell swoop 378,000 of 1,305,000 birth/death added jobs were revised away. That amounts to 29% of the total jobs assumed to be created by the model in 2007. The number is not high enough. It will either be revised lower or differences will be "worked in" by the BLS over time. This economy is far weaker than most economists think.

The Employment Situation Report January 2008

Here is the official BLS Employment Situation Report.

Both nonfarm payroll employment, at 138.1 million, and the unemployment rate, at 4.9 percent, were essentially unchanged in January, the Bureau of Labor Statistics of the U.S. Department of Labor reported today. The small January movement in nonfarm payroll employment (-17,000) reflected declines in construction and manufacturing and job growth in health care.

Notice how the BLS purposely trys and put a positive spin on things by calling jobs "essentially unchanged". Losing 17,000 jobs is an actual disaster.

Nonfarm Payrolls February 2005-January 2008



Job growth has clearly stalled. I expect it to contract. Even a flatline of jobs going forward is a disaster. It takes 150,000 new jobs a month just to keep up with birth rates.

Establishment Data January 2008



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The details show the only bright spots were health services and service providing. Looking forward, I expect service providing to start showing weakness. Nursing and health care jobs are likely to remain in demand with the aging of the baby boomers.

Revisions in total nonfarm employment for 2007, seasonally adjusted



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Although I did not find it worthwhile, Interested parties can read the BLS Report On Revision Methodology.

Table A-12 Alternative Measures Of Unemployment



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Table A-12 is where the rubber meets the road when it comes to unemployment. In order to keep the "official" unemployment rates low, the folks at the BLS dreamed up new categories of workers such as "marginally attached".

Marginally attached workers are persons who currently are neither working nor looking for work but indicate that they want and are available for a job and have looked for work sometime in the recent past. Discouraged workers, a subset of the marginally attached, have given a job-market related reason for not looking currently for a job. Persons employed part time for economic reasons are those who want and are available for full-time work but have had to settle for a part-time schedule.

Classification U-6 is how unemployment actually feels to the average Joe on the street. On a seasonally unadjusted basis, that figure is close to 10%.

By the time the reported unemployment numbers get to 6.5% or higher, I am looking for line U-6 to head towards 14%

The recession of 2008 is going to be both long and nasty. In order to shore up falling profits as consumer spending declines, look for increasing numbers of mass layoffs in 2008. Also keep in mind that Countrywide And Chase Have Shut Off The Cash Spigot.

With this backdrop, bank balance sheets are going to get hammered with more REOs and credit card defaults as consumers will have no means of paying bills. There is no way "Fiscal Stimulus" of $800-$1200 per household can possibly overcome this set of factors. Things That "Can't" Happen are about to.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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Countrywide And Chase Shut Off The Cash Spigot

Those attempting to tap into home equity are finding the spigot has been shut off.

Countrywide Financial Corp. (CFC) sent letters to 122,000 customers last week telling them they could no longer borrow against their credit lines because the total debt on the home exceeded the market value of the property. The lender says it is using computer modeling to determine which of its customers would have their cash spigot shut off.

My Comment: In a related matter, Calculated Risk recently posted an interesting chart of Mortgage Equity Extraction (MEW) as a percentage of disposable personal income. Let's take a look.



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Calculated Risk is estimating about $145 billion in MEW for the fourth quarter. It's not unreasonable to assume 1/3 or perhaps even 1/2 of that MEW will be shut off by tightening lending standards in conjunction with falling home prices. Let's be cautious however, and assume only 1/4 of MEW is shut down. Voilà! The entire economic stimulus program will be consumed by a slowdown in MEW extraction alone ($145 billion total over 4 quarters).

Among the lenders tightening as the Fed loosens, Chase Home Lending (JPM), which has been slowly raising credit standards since last summer, will start imposing new guidelines Monday that further restrict who will be granted a home equity line, the company said. This week, California homeowners can tap as much as 90% of the equity in their homes. Starting Monday, however, Chase won't let homeowners in certain parts of the state -- including Los Angeles, Orange and Imperial counties -- borrow more than 70% of the value of their homes.

My Comment: The 70% rule will put a dead halt to MEW and HELOC extraction for nearly all of Los Angeles, Orange and Imperial counties. Anyone needing cash out financing to pay the bills in those counties is simply out of luck.

At the same time, Fannie Mae, the giant government-sponsored mortgage investor, this month told lenders that sell it mortgages that they couldn't loan as much money to homeowners in areas that have had significant price declines, including much of Southern California. The company reduced its maximum "loan to value" ratio in those areas by five percentage points.

One result of Fannie Mae's change: On a highly promoted Bank of America loan that charges no upfront fees to borrowers, the maximum loan amount is now 90% of a home's value, down from 95%, bank spokesman Terry Francisco said. And on a program that gives mortgages to firefighters and police, the limit has been reduced to 95% from 100%.

Bloomberg shows 15 year mortgage rates at 4.97%. As with home equity loans, catch it if you can. I spoke with Michael Dorff at Trans World Financial about mortgage rates. His phone has been ringing for days from people seeing the drop in the Fed Fund rates hoping to get a better deal. Most can't. To get even a 5.25% rate requires 1.25% to 1.5% in points. A year ago there were a lot of no point deals available.

However, those in existing LIBOR based loans are benefiting. And with 125 basis points in cuts from the Fed in 8 days, the Fed has negated a lot of the impending ARM reset problem. Then again, many people cannot afford the loans they are in. Rising unemployment will also significantly exacerbate the problem.

Rare Greenspan Moment

It does not happen often and when it does it is usually striking: On occasion, Greenspan actually says something that makes sense. The China Post is reporting Former Chair Greenspan doubts 'major' Fed role as risk reprices.

"Global forces can now override most anything that monetary and fiscal policy can do," he said in the interview, adding it was "absolutely" more difficult for the Fed to react to financial-market turmoil than was the case 20 years ago. "The resources of central banks relative to the size of global forces have markedly diminished."

I concur with the above on account of global wage arbitrage, the ease of moving operations to another country then out again (see Dell Walks Away), and also because of peak oil and emerging market demand for global resources.

However, the primary reason the Fed will fail is changing social attitudes towards debt. More evidence of changing attitudes can be found in the The Business of Walking Away.

In the interview, Greenspan quickly recovered to his typical post chairman pattern of attempting to absolve himself of blame with the following statements.

Instruments such as subprime mortgage-backed securities generally have been a "very significant plus in this global world and will continue to be so," Greenspan said. "A number of these have failed. They have failed because they were nontransparent."

Why Subprime Failed

• Greenspan held interest rates too low too long. 1-3% interest rates were too tempting to both consumers and lenders.
• The rating agency model is such that Moody's, Fitch, and the S&P all were paid on volume of deals analyzed rather than accuracy of rating. This sad situation was brought about by government sponsorship of the rating agencies. See Time To Break Up The Credit Rating Cartel for more details.
• Greenspan himself became a cheerleader for ARMs at the worst possible time for consumers.
• Government sponsorship of the ownership society.
• The HUD, GSEs, and 300 or affordable housing programs.

With the MEW and HELOC spigots constricted, and with massive cuts in state budgets, the fiscal stimulus proposal is doomed from the start.

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