The Banks Are Already Insolvent

[w14]

Auditors are in a difficult position in these post-Enron days, with the demise of Arthur Andersen on everyone’s mind. If they refuse to rubber-stamp the banks’ fictitious valuations, the banks will collapse, but if the auditors allow the fiction, they run the risk of being severely punished for malfeasance.

So Peter Spencer of Ernst & Young’s Item Club argues that the British “government must suspend a set of key banking regulations at the heart of the current financial crisis, or risk seeing the economy spiral towards a future that could ‘make 1929 look like a walk in the park’.”

The regulations mean that banks forced to take off-balance sheet assets from troubled structured investment vehicles on to their books had little choice but either to raise money from abroad or cut back dramatically on their spending, he said.

Spencer tries to blunt the clear meaning of his statement, by claiming that the banks are refusing to lend to each other, not because they are insolvent, but rather that they are being prevented from lending to each other because the regulations are overly restrictive. The regulations he blames are the capital requirements set by the international Basel agreements, which require the banks to have an 8 percent capital reserve, which Spencer said should be cut to about 6 percent.

He dismissed as “window dressing” the move announced by central banks around the world this week to pump extra money into the money markets and increase the type of collateral they will accept in return, in an effort to get them running again.

“This won’t get to the core of the problem: the fundamental lack of collateral. As these problems drag on, the consequences for the macro-economy of not relaxing [the Basel regulations] are unthinkable.”

In reality, its absurd to suggest that a mere 2 percent reduction in capital requirements would head off a crisis that would make 1929 look like a “walk in the park.” What the auditors are really saying is that, as the rules are currently constituted, the banks are already insolvent, and that the capital requirements must be lowered so that the auditors can certify their books for one more year.

[Fredfredson]

US banks abandon massive fund for credit crunch
1 hour ago

http://afp.google.com/article/ALeqM5...HsoAQA0M6jsXVA

WASHINGTON (AFP) — Leading US banks abandoned Friday a joint plan to create a massive fund aimed at easing the global liquidity squeeze due to lack of interest in the market.

Bank of America, Citigroup and JPMorgan Chase had announced in October a plan to create a single "master-enhanced liquidity conduit" to buy up troubled debt with adequate collateral.

The banks reportedly wanted to pump in between 75 billion and 100 billion dollars into the fund, which would buy assets from "structured investment vehicles," or SIVs, which have been hit by the credit squeeze.

But the banks, in a joint statement, said the plan would not go forward.

"Based upon the feedback that the bank consortium and the advisor have received from domestic and global liquidity sources and from prospective SIV participants, they have determined the vehicle is not needed at this time," the statement said.

The plan, which was backed by US Treasury Secretary Henry Paulson, was seen as a major effort by the private banking sector to help restore normal credit conditions after turmoil earlier this year sparked by losses and a lack of confidence in subprime mortgage assets.

It was aimed at reopening credit lines for borrowers with good credit who have been hurt by fears about spreading woes from the subprime credit crisis.

The plan was facilitated by US Treasury officials in an effort to help unblock credit in the face of a squeeze that had prompted lenders to scale back many types of lending.

The fund is aimed at helping restore normal credit conditions for mortgage securities, but also for short-term corporate loans many firms need to meet payroll and other day-to-day expenses.

[Francois Cellier]

From CNN Money

Bond insurer defaults threaten big banks

Downgrades of bond insurers like ACA could have damaging ripple effects throught the financial system

By Katie Benner
December 20 2007: 11:43 AM EST


NEW YORK (Fortune) -- Wall Street banks may inject cash into ACA Financial Guaranty Corporation, which was dramatically downgraded to junk while nearly the entire bond insurance industry was put on negative credit watch by S&P yesterday.

But don't believe for a second that the bailout team of CIBC, Merrill Lynch, and Bear Stearns believe in the company or its business model. They're just trying to avoid another round of extremely damaging write downs on top of the $76 billion in losses that securities firms and banks have posted this year. "The reality, which is clear to Wall Street though obviously not to Washington, is that any such infusion would be a clear attempt to avoid having to recognize losses tied to monoline counterparty exposures," Josh Rosner, managing director at the research firm Graham Fisher, said in a research report issued today.

He adds that the move is the latest in a growing list of strategies banks have used avoid growing economic losses throughout the current economic crisis. The possible ACA bailout is a perfect example of this hypothesis. When ACA's debt went from A to CCC, the move also hit Canadian bank CIBC (which Fortune predicted in November). CIBC said it may immediately write down $1.7 billion of the $3.5 billion in mortgage holdings guaranteed by ACA, which were part of CIBC's roughly $10 billion in hedged collateralized debt obligations.

These CDOs were not included in previous write downs because, though sullied by bad mortgage debt, they were supposedly insured or hedged by entities like ACA. Now that ACA can't backstop the losses, the credit ratings on those bonds will fall, and result in losses.

Merrill Lynch (MER, Fortune 500), one of the biggest banks with exposure to ACA's woes, may have used credit default swap contracts with the insurer's parent company ACA Capital to hedge market risk on $5 billion in CDOs, according to a Nov. 5 analyst report by Lehman's Roger Freeman. If ACA Capital (ACAH) defaults on its contracts, Freeman said Merrill Lynch could immediately take a $3 billion loss. Neither CIBC (CBC) nor Merrill returned calls for comment.

S&P estimates that ACA will need to pay out $2.85 billion on exploding securities, but it only has about a $650 million cushion. Now that its rating has been cut, it is required to post at least $1.7 billion in capital to guard against this threat, and management says it doesn't have the money. So for CIBC or Merrill, which faces nearly $5 billion in losses if ACA craters, why not put money into a $1.7 billion pool split with Bear Stearns that could right the beaten up insurer and improve its rating?

Rosner believes that the strategy breaks down if the underlying mortgages in the bonds deteriorate even more than expected by S&P. Given the past few months of subprime turmoil, exacerbated by the fact that ratings agencies have been asleep at the wheel, it seems a foregone conclusion that the risks will be greater than S&P estimates.

In that case, the monolines would still be underfunded even after their cash injections and "any such infusions would be throwing bad money after good since the monolines would ultimately be downgraded and losses would nonetheless have to be recognized by the counterparties," Rosner writes.

The stakes are very high given that the other big bond insurers are on S&P's negative watch list and that Fitch is in the process of scrutinizing the industry and expected to downgrade. As more bond insurer ratings are cut, banks will have to write down losses on the securities they guaranteed. Bloomberg estimates that an industrywide downgrade would lead to $200 billion in losses. The two biggest guarantors alone, MBIA and Ambac Financial Group, stand behind about $652 billion and $546 billion in debt respectively that could fall in value if those companies are downgraded. S&P estimates that MBIA (MBI) faces $3.1 billion in losses on securities backed by subprime mortgages, that Ambac faces a $1.8 billion loss and Financial Guaranty Insurance Co. could take a $2.2 billion hit.

By virtue of their business model and high credit ratings (until ACA's downgrade they were all among the highest investment grade), none of these companies have the capital to cover these losses. "What's significant about ACA is that it's the first monoline to blow up. There's nothing materially different about Ambac, FGIC, MBIA or XL Capital. They all have the same problem, that they are highly leveraged, have risky exposures and inadequate reserves. It's just a question of degree," says Bill Ackman, founder Pershing Square, a hedge fund that has long been short MBIA and negative on the bond insurance industry.

Banks are exposed to bond insurance problems in other ways. Bear Stearns' merchant banking group owns 29% of ACA Capital. The stock was delisted from the New York Stock Exchange and trades at about 65 cents a share over the counter, down from about $15 this summer. Bear did not return calls for comment.

The monolines are not required to put up collateral when doing business with Wall Street because of their high credit ratings. But that all changed as they started insuring riskier products. ACA and other firms were often required to find counterparties with strong balance sheets to back them up when they insured the exotic bonds that Wall Street became addicted to in recent years.

CIBC, Barclay's and perhaps other banks were willing to be the backstops for a small fee (some believe as little as 5 or 6 basis points). Barclays says its exposure is minimal and has faith that the monolines will meet their obligations.

While a cash infusion to struggling bond insurers may keep downgrades and write downs from happening right now, at the end of the day the bonds, insured or not, are full of worthless paper. Someone will have to pay, whether it be a bank a bond insurer or some other party. "What we're seeing now is a valuation crisis," says Sylvain Raynes, a former Moody's analyst and principal at the structured finance consultancy R&R Consulting. "Wall Street is a big wheel that is moving the same losses in a circle and only postpones the ultimate reckoning and makes it much worse."

[Francois Cellier]

Fom the Washington Post

Credit Crisis Hits Top Bond Insurer

By STEPHEN BERNARD
The Associated Press
Thursday, December 20, 2007; 5:00 PM


NEW YORK -- The credit crisis spread to the nation's largest bond insurer Thursday, sending shares of MBIA Inc. plunging and calling into question the safety of tens of billions of dollars of company and local government debt held by investors.

The Fitch Ratings service warned that it might cut its rating on MBIA in the next six weeks if the company cannot find $1 billion in new capital. That followed a disclosure by MBIA that its investment holdings included more than $30 billion in some of the riskiest types of mortgage debt.

One analyst said he was shocked by the magnitude of such an investment bet by the insurer.

A call seeking comment from MBIA officials at the company's headquarters in Armonk, N.Y., was not returned immediately Thursday.

For the last decade, Wall Street firms have profited by bundling and selling pools of mortgages, auto loans, credit card bills and more to investors. The riskiness of these securities was thought to be offset by the promise from insurers like MBIA that they would step in to make principal and interest payments if issuers defaulted.

Because default rates have been low, bond insurers' earnings and share prices had soared _ until recently. The fear now is that if MBIA or competitors like Ambac Financial Group Inc. and Financial Guaranty Insurance Corp. are unable to pay what could be a surge in claims on debt issues gone bad, it could overwhelm the already-suffering credit markets.

MBIA shares plummeted more than 26 percent Thursday, falling $7.07 to $19.95 and wiping out more than $880 million in market capitalization.

MBIA is the largest of the "AAA" bond insurers, those that are viewed by rating agencies as having so much financial and claims-paying strength that they deserve the highest rating.

Because of its size, many analysts have warned of dire consequences for the bond market if MBIA is downgraded, which would effectively prevent it from issuing new policies.

Some analysts questioned why MBIA strayed from insuring municipal bonds into riskier mortgage-backed debt. But Thursday's market reaction was focused on how it invests its capital _ not on the insurance policies it wrote.

In a release late Wednesday, MBIA said its total exposure to bonds backed by mortgages and collateralized debt obligations in its investment holdings _ funds generated from premium income and held in reserve to pay potential claims _ is about $30.61 billion.

CDOs are complex instruments that combine slices of assets and other debt. Included in that exposure is a pool of about $8.14 billion in CDOs backed by a combination of other CDOs and mortgages, which some analysts consider the riskiest part of an investment portfolio.

Another credit rating agency, Standard & Poor's, said it fully incorporated MBIA's exposure to mortgage bonds and CDOs when it affirmed the insurer's "AAA" rating Wednesday. But S&P did place the company on a negative outlook, which means it views the company as having a one-in-three chance of being downgraded in the next two years.

The action on MBIA was one of a handful of bond insurer warnings and downgrades S&P made Wednesday, the sum of which S&P said could lead to a fundamental change in the way the bond insurance industry operates. In particular, it downgraded insurer ACA Capital to "CCC" from "A," a move that affected billions of dollars in municipal bonds nationwide.

The value of the mortgage-backed bonds and CDOs has been declining rapidly in recent months as the underlying debt has increasingly defaulted. Many CDOs and mortgage bonds are backed by subprime mortgages, given to customers with poor credit history, which have been among the worst-performing loans.

Morgan Stanley analyst Ken Zerbe said the size of MBIA's exposure was surprising and riskier than he previously thought. Zerbe questioned why MBIA waited to detail its positions. He recommends avoiding investing in all bond insurers until they can accurately assess the final size and scope of their mortgage and CDO losses.

Citi Investment Research analyst Heather Hunt said the disclosure of the $8.14 billion of the riskiest CDOs was a "disappointment" and MBIA is in an "extremely volatile situation," but in the end the exposure will not be as bad as it first appears.

Hunt added that based on the current stock price, investors estimate MBIA will lose more than $7.5 billion after taxes from its total mortgage and CDO exposures.

[Fredfredson]

Crisis may make 1929 look a 'walk in the park'
Last Updated: 5:22pm GMT 23/12/2007Page 1 of 3

http://www.telegraph.co.uk/core/Cont...&site=1&page=0


As central banks continue to splash their cash over the system, so far to little effect, Ambrose Evans-Pritchard argues things are rapidly spiralling out of their control

Twenty billion dollars here, $20bn there, and a lush half-trillion from the European Central Bank at give-away rates for Christmas. Buckets of liquidity are being splashed over the North Atlantic banking system, so far with meagre or fleeting effects.

As the credit paralysis stretches through its fifth month, a chorus of economists has begun to warn that the world's central banks are fighting the wrong war, and perhaps risk a policy error of epochal proportions.

"Liquidity doesn't do anything in this situation," says Anna Schwartz, the doyenne of US monetarism and life-time student (with Milton Friedman) of the Great Depression.

"It cannot deal with the underlying fear that lots of firms are going bankrupt. The banks and the hedge funds have not fully acknowledged who is in trouble. That is the critical issue," she adds.

Lenders are hoarding the cash, shunning peers as if all were sub-prime lepers. Spreads on three-month Euribor and Libor - the interbank rates used to price contracts and Club Med mortgages - are stuck at 80 basis points even after the latest blitz. The monetary screw has tightened by default.

York professor Peter Spencer, chief economist for the ITEM Club, says the global authorities have just weeks to get this right, or trigger disaster.

"The central banks are rapidly losing control. By not cutting interest rates nearly far enough or fast enough, they are allowing the money markets to dictate policy. We are long past worrying about moral hazard," he says.

"They still have another couple of months before this starts imploding. Things are very unstable and can move incredibly fast. I don't think the central banks are going to make a major policy error, but if they do, this could make 1929 look like a walk in the park," he adds.

The Bank of England knows the risk. Markets director Paul Tucker says the crisis has moved beyond the collapse of mortgage securities, and is now eating into the bedrock of banking capital. "We must try to avoid the vicious circle in which tighter liquidity conditions, lower asset values, impaired capital resources, reduced credit supply, and slower aggregate demand feed back on each other," he says.

New York's Federal Reserve chief Tim Geithner echoed the words, warning of an "adverse self-reinforcing dynamic", banker-speak for a downward spiral. The Fed has broken decades of practice by inviting all US depositary banks to its lending window, bringing dodgy mortgage securities as collateral.

Quietly, insiders are perusing an obscure paper by Fed staffers David Small and Jim Clouse. It explores what can be done under the Federal Reserve Act when all else fails.

Section 13 (3) allows the Fed to take emergency action when banks become "unwilling or very reluctant to provide credit". A vote by five governors can - in "exigent circumstances" - authorise the bank to lend money to anybody, and take upon itself the credit risk. This clause has not been evoked since the Slump.

Yet still the central banks shrink from seriously grasping the rate-cut nettle. Understandably so. They are caught between the Scylla of the debt crunch and the Charybdis of inflation. It is not yet certain which is the more powerful force.

America's headline CPI screamed to 4.3 per cent in November. This may be a rogue figure, the tail effects of an oil, commodity, and food price spike. If so, the Fed missed its chance months ago to prepare the markets for such a case. It is now stymied.

This has eerie echoes of Japan in late-1990, when inflation rose to 4 per cent on a mini price-surge across Asia. As the Bank of Japan fretted about an inflation scare, the country's financial system tipped into the abyss.

In theory, Japan had ample ammo to fight a bust. Interest rates were 6 per cent in February 1990. In reality, the country was engulfed by the tsunami of debt deflation quicker than the bank dared to cut rates. In the end, rates fell to zero. Still it was not enough.

When a credit system implodes, it can feed on itself with lightning speed. Current rates in America (4.25 per cent), Britain (5.5 per cent), and the eurozone (4 per cent) have scope to fall a long way, but this may prove less of a panacea than often assumed. The risk is a Japanese denouement across the Anglo-Saxon world and half Europe.

Bernard Connolly, global strategist at Banque AIG, said the Fed and allies had scripted a Greek tragedy by under-pricing credit long ago and seem paralysed as post-bubble chickens now come home to roost. "The central banks are trying to dissociate financial problems from the real economy. They are pushing the world nearer and nearer to the edge of depression. We hope they will eventually be dragged kicking and screaming to do enough, but time is running out," he said.

Glance at the more or less healthy stock markets in New York, London, and Frankfurt, and you might never know that this debate is raging. Hopes that Middle Eastern and Asian wealth funds will plug every hole lifts spirits.

Glance at the debt markets and you hear a different tale. Not a single junk bond has been issued in Europe since August. Every attempt failed.

Europe's corporate bond issuance fell 66pc in the third quarter to $396bn (BIS data). Emerging market bonds plummeted 75pc.

"The kind of upheaval observed in the international money markets over the past few months has never been witnessed in history," says Thomas Jordan, a Swiss central bank governor.

"The sub-prime mortgage crisis hit a vital nerve of the international financial system," he says.

The market for asset-backed commercial paper - where Europe's lenders from IKB to the German Doctors and Dentists borrowed through Irish-based "conduits" to play US housing debt - has shrunk for 18 weeks in a row. It has shed $404bn or 36pc. As lenders refuse to roll over credit, banks must take these wrecks back on their books. There lies the rub.

Professor Spencer says capital ratios have fallen far below the 8 per cent minimum under Basel rules. "If they can't raise capital, they will have to shrink balance sheets," he said.

Tim Congdon, a banking historian at the London School of Economics, said the rot had seeped through the foundations of British lending.

Average equity capital has fallen to 3.2 per cent (nearer 2.5 per cent sans "goodwill"), compared with 5 per cent seven years ago. "How on earth did the Financial Services Authority let this happen?" he asks.

Worse, changes pushed through by Gordon Brown in 1998 have caused the de facto cash and liquid assets ratio to collapse from post-war levels above 30 per cent to near zero. "Brown hadn't got a clue what he was doing," he says.

The risk for Britain - as property buckles - is a twin banking and fiscal squeeze. The UK budget deficit is already 3 per cent of GDP at the peak of the economic cycle, shockingly out of line with its peers. America looks frugal by comparison.


Maastricht rules may force the Government to raise taxes or slash spending into a recession. This way lies crucifixion. The UK current account deficit was 5.7 per cent of GDP in the second quarter, the highest in half a century. Gordon Brown has disarmed us on every front.


In Europe, the ECB has its own distinct headache. Inflation is 3.1 per cent, the highest since monetary union. This is already enough to set off a political storm in Germany. A Dresdner poll found that 71 per cent of German women want the Deutschmark restored.

With Brünhilde fuming about Brot prices, the ECB has to watch its step. Frankfurt cannot easily cut rates to cushion the blow as housing bubbles pop across southern Europe. It must resort to tricks instead. Hence the half trillion gush last week at rates of 70bp below Euribor, a camouflaged move to help Spain.

The ECB's little secret is that it must never allow a Northern Rock failure in the eurozone because this would expose the reality that there is no EU treasury and no EU lender of last resort behind the system. Would German taxpayers foot the bill for a Spanish bail-out in the way that Kentish men and maids must foot the bill for Newcastle's Rock? Nobody knows. This is where eurozone solidarity stretches to snapping point. It is why the ECB has showered the system with liquidity from day one of this crisis.


Citigroup, Merrill Lynch, UBS, HSBC and others have stepped forward to reveal their losses. At some point, enough of the dirty linen will be on the line to let markets discern the shape of the debacle. We are not there yet.

Goldman Sachs caused shock last month when it predicted that total crunch losses would reach $500bn, leading to a $2 trillion contraction in lending as bank multiples kick into reverse. This already seems humdrum.

"Our counterparties are telling us that losses may reach $700bn," says Rob McAdie, head of credit at Barclays Capital. Where will it end? The big banks face a further $200bn of defaults in commercial property. On it goes.

The International Monetary Fund still predicts blistering global growth of 5 per cent next year. If so, markets should roar back to life in January, as though the crunch were but a nightmare. There again, the credit soufflé may be hard to raise a second time.