Japan's 1990s history repeating in US now

Reprinted from Business Times

THE current crisis in the United States and European financial systems seems to be growing similarly to Japan's banking crisis of the late 1990s and early 2000s.

Although the current crisis developed much faster than Japan's crisis, the key mechanism is the same - changes in the prices of real estate that were used as collateral for bank lending. The further development of the crisis will crucially depend on the evolution of these real estate prices. How far will housing prices in the US fall? If we base our projections on the trend line of the 1990s, they should pick up by 2011 at the latest. But this reasoning reminds me of a similar mindset in the early 1990s in Japan. When Japan's real estate bubble burst in 1991, the trend line indicated that land prices would bottom out around 1995, when in fact they continued to decline steadily for 12 more years.

Japan experienced more than a decade of continuous land-price declines and low productivity growth. The decade-long stagnation seems to be the result of a protracted external diseconomy that set in due to uncertainty and fear surrounding the payment system.

Banks and firms in Japan felt the fear of not being paid in full when they expanded lending because some of their customers hid the fact that they were insolvent. If insolvent agents stick around, healthy agents are forced to face uncertainty and fear. They hesitate to start new transactions with unknown trading partners. Their reluctance results in the shrinkage of the economy-wide division of labour among firms and industries, lowering growth of aggregate productivity. The lower productivity, in turn, drives down asset prices even further and increases the number of insolvent agents, reinforcing the persistence of uncertainty and fear. We may refer to this external diseconomy, or vicious cycle, as 'payment uncertainty'.

While the payment uncertainty that has spread through the global interbank market in the last several weeks may be contained by bank-capital injections and government guarantees, the challenge now is to prevent payment uncertainty from spreading to the real sector (ie, businesses and households). Japan's policy failures in the 1990s offer several instructive lessons.

Debt restructuring necessary to prevent a vicious cycle

Debt relief and rehabilitation of viable but debt-ridden firms and the liquidation of nonviable firms are crucially important to wipe out the payment uncertainty from the economy and restore market confidence. If zombie firms stick around in the market, uncertainty and business shrinkage will linger on. Capital injections into banks are just a beginning.

Stringent asset evaluation and sufficient write-offs

Stringent and conservative evaluation of the toxic assets should be the premise behind bank-capital injections and debt restructuring. I suspect that the current capital injections in the US and Europe may not eradicate the payment uncertainty unless they are accompanied by sufficiently stringent asset evaluations. Financial regulators should establish task forces for asset evaluation and push financial institutions to recalculate their asset values conservatively enough so that the market can rely on their numbers. The regulators may have to employ financial engineers (eg, former employees of the Lehman Brothers) as investigators and let them analyse the risk and losses of the toxic derivative securities by 'reverse engineering'.

Purchase of bad assets by public asset management companies

If bad assets are disposed of by distress selling in the market, stringent asset evaluation will result in a vicious cycle of debt deflation: distress selling causes asset prices to decline further, which in turn accelerates the distress selling of assets. To stop the vicious cycle of debt deflation, the governments struggling with the financial crisis should establish asset management companies, public entities that purchase and hold the bad assets. The purchase and freezing of toxic assets is necessary to stop debt deflation. The public entities should then restructure the bad assets and sell them off gradually after the market stabilises.

Fiscal stimulus packages may not work

One big lesson from Japan's 1990s is that Keynesian policy per se did not work for the financial crisis due to the collapse of asset prices. While Japan undertook huge fiscal stimulus packages repeatedly in the 1990s, the government did not pursue a serious policy effort to make banks dispose of their nonperforming loans. As a result, a huge amount of hidden nonperforming loans swelled under implicit collusion between the government and banks. Naturally, the payment uncertainty and economic shrinkage persisted for years. The essential problem was the spreading of payment uncertainty, and policies centred on public works and tax cuts were not direct enough to attack the problem, though they were temporarily effective at mitigating the severity of the economic downturn. Direct debt relief for mortgage borrowers and distressed (but viable) firms, along with fiscal assistance for the liquidation of nonviable firms, are straightforward, cost-effective fiscal policies much more capable of wiping out the payment uncertainty than standard public works and tax cuts.

Suspension of mark-to-market accounting has side effects

The development of huge nonperforming loans in Japan was made possible by the virtual nonexistence of mark-to-market accounting for bank assets. Although suspension of mark-to-market accounting may temporarily calm the panic, it may also enable and seduce bankers to hide their toxic assets from regulators and market participants. If bankers hide bad assets, zombie firms will persist and the payment uncertainty will remain, setting the stage for very low long-term economic growth in the coming years.

The global nature of the current crisis seems to posit interesting points in the arguments for international policy coordination. As the external diseconomy of payment uncertainty affects economies all over the world, the cost to eradicate this diseconomy should be borne worldwide. This normative argument may be justified from the following efficiency point of view: To minimise the prospective tax distortions caused by huge fiscal outlays for global financial rescues, it may be optimal for the world as a whole to let emerging market economies with high prospective growth and solid fiscal positions, such as China and India, bear a considerable amount of the fiscal cost of global financial rescues. (The social surplus generated by the international policy coordination should be shared by both developed and emerging market countries after the crisis is over.) To bear the cost to stabilise the world economy matches with the national interests of China and other emerging economies, since otherwise they should suffer from much greater economic and noneconomic costs for adjusting to shrinkage of the US and European economies.

One idea to cement this global coordination would be the establishment of a new international fund, like the IMF, which could be called the 'Financial System Stabilisation Fund' or 'World Dollar Stabilisation Fund'. The Fund should be established as a temporary organisation to stabilise the current financial crisis, and eventually be dissolved and merged into the IMF in the next three years or so. Emerging market countries would invest public money, which may be their huge stocks of foreign reserves and/or may be raised by issuing new bonds, in the Fund. The Fund could then make loans to the governments of the US and major European countries affected by the financial crisis. The affected governments would use the loan proceeds to make fiscal expenditures needed for injecting capital into their banks and restructuring the debt of their domestic borrowers.

The G8 meeting with emerging market countries, scheduled to be held in New York in November 2008, would be a good occasion to coordinate the global cost distribution for the resolution of the current financial crisis.

Black October 2008, SGP market capitalisation shrank

IT has been more than three years since the companies listed on the Singapore Exchange felt so small - and they can blame October's massive sell-offs for this. The month just gone by saw $123.5 billion slashed off Singapore's stock market capitalisation as global jitters persisted and recession fears came true. The gloom will hover for some time as market observers say the worst is yet to come.

As the Q3 earnings season peaks only in November and more fund redemption can be expected with two months to go till year-end, analysts say that unpredictability is still the name of the game. The combined value of the 781 companies on the SGX stood at a three-year low of $391.5 billion yesterday evening, 24 per cent lower than the $514.9 billion recorded end-September.

Thus far this year, Singapore's stock market has shed over $200 billion, or 35 per cent of its capitalisation. Market value has not plunged this low since end-May 2005's market cap of $387.5 billion. After a roller-coaster month, the Straits Times Index ended yesterday at 1794.20 points, 23.94 per cent down from the 2358.91 points recorded after September's last trading session and a 48.23-per cent fall from the start of the year.

The number of billion-dollar stocks on Singapore's bourse shrank to 60 in October from 74 in September, while the number of stocks with a market value below $200 million rose to 610 in October from September's 584.

Just 102 listed counters, including those which had suspended trading, escaped having their market cap cut last month.

The three local banks' share prices have slumped on news of earnings downgrades, and all three ended October with market values slipping under $20 billion.

DBS Group was the worst hit as shares plunged to a five-year low earlier this week. Its market cap has tumbled 34.3 per cent to $16.7 billion in the past month. Oversea Chinese Banking Corporation's market cap fell 31.7 per cent to $15.3 billion while United Overseas Bank, which reported bleak Q3 earnings yesterday, saw its market value drop 22.5 per cent to $19.8 billion.

Property developers felt the heat too. Keppel Land, which recently reported a fall in Q3 profit, slid out of the top 50 rankings as its market cap fell 34.6 per cent to $1.3 billion. CapitaLand and City Developments, too, saw market value diminish by 6.9 per cent and 28.3 per cent to $8 billion and $5.7 billion respectively.

Volatile commodity prices meant the commodity stocks continued to suffer. Noble Group lost up to half its market value in the course of October. Its share price has since rebounded on forecasts of record profits, so it closed October 21.8 per cent down with a market cap of $3.4 billion.

Palm oil player Golden Agri-Resources fell 39.7 per cent to $1.9 billion and Olam fell 30 per cent to $2.2 billion. Wilmar International, the sixth largest stock on the exchange, slid a comparatively slight 1.6 per cent to finish with a market cap of $15.7 billion.

Shipping and offshore players Keppel Corp and SembCorp Marine also fell 42.9 per cent and 40.5 per cent, to $7.1 billion and $3.7 billion respectively. SIA fell 22.1 per cent to $13.1 billion.

Goh Mou Lih, head of research at Westcomb Securities, said: 'I think the turbulence isn't over yet; we're headed towards more volatility.'

Stephanie Wong, head of research at Kim Eng said: 'I'm hopeful for a gradual restoration of order in the financial markets. With interest rates trending south, corporates should breathe a little easier.'

According to a Citi equity strategy report released last week, 'bear markets typically do not hit bottom until the economy is at or past the worst quarter of a recession'. Citi economists expect the sharpest contraction in Singapore's economy in year-on-year terms to come only in the first quarter of next year.

In which case, the bear market has some way to go yet.

Gold bear is no match for Indian brides

On Friday Oct 24, 2008, cash gold had an "outside reversal day." That is, a lower low. but a higher high and a higher close than on Thursday.

That was unique among the commodities. Furthermore, gold managed to go up even though the S&P 500 Index was down 3%. That may be unprecedented.

Traditionally, the role of India, by far the world's largest bullion importer, judging the state of Indian demand by the premiums to world gold shown in the domestic Indian gold market. It's worked well in the post-2000 gold run-up and has even caught recent rallies.

Late last week, reported Indian premiums became huge. "With the exception of the late August/early September period this year, premiums like this have never been seen since the Indian gold trade was liberalized in the late 1990s."
The Indian currency, the rupee, has slumped 10% this month. That is why the premiums that appeared in late August at $800 did not reappear until gold reached the low $700s last week.

This past weekend, a couple of recent Indian newspaper stories documenting the recent demand surge for physical gold. Conclusion: "Unless the rupee collapses, pushing world gold down further will be extremely difficult."

Unfortunately, that trend line was part of a bear market channel that the Privateer was obliged to establish a couple of weeks ago. And the drop it reversed was the biggest shown on this chart, which goes back to 1982. See chart below.

The Privateer's commentary raises an issue which has been intriguing, and frustrating, the gold bug community. It complains of "the huge 'shear' between the price of 'paper gold' on the futures markets and the almost total unavailability of physical gold in the REAL markets. Gold of any nature, whether bar or bullion or numismatic coin, is all but unavailable at ANY price and has been so for nearly three months now. And when it is available, the prices being asked by the sellers bear no resemblance to the prices being quoted in the futures markets. A cursory glance at the U.S. site eBay [where there's a secondary market in gold coins] will show this clearly."

Why is this occurring? Because the refineries cannot handle the conversion of central bank 400-ounce bars into the sizes and shapes the public buys fast enough to meet their demand.

Arguably, this physical offtake is countering the central banks' widely-rumored effort to break down the gold price by massive dumping, aimed at eliminating a symptom of financial system stress.

None of this will frighten the Indians. They buy gold because their brides wear gold jewelry.

But, India-watchers say, Monday Oct 27, 2008 is the key Hindu festival of Diwali

Indian retailers are hoping that volatile stock markets will drive demand for gold coins, medallions and bars rather than just jewellery during the peak festival season in the world's largest market for the precious metal.

Key commodities are going up, the weaker dollar is driving investors back in.

Though international gold prices have fallen below $800 an ounce, the price level that triggered a buying scramble in August, consumers are buying only as much jewellery as they feel is needed for festivals and marriages.

"People are waiting for prices to fall still further," said Pawan Choksi, an Ahmedabad-based bullion dealer. "Lots of investors have changed their preference from buying jewellery to gold coins."

The World Gold Council recently estimated the size of India 's gold coin market at about 100 billion rupees ($2 billion).

Popley Jewellers, a prominent domestic jewellery chain, said that for the first time it launched gold coins during the festival season under the name "Popley Swiss Gold." "The bullion part of our business has certainly picked up, and we are hopeful the jewellery part will also soon pick up," said Rajiv Popley, director of Popley group.

"Our bullion sales have increased by 35 percent over last year in terms of weight," he said, without disclosing specific figures.

Many corporates bought small gold coins as gifts during Diwali when the gold price fell to around $700 last week, Popley said.

Diwali, the Hindu festival of lights, was celebrated on Tuesday. It is considered the most important festival among a string of others that begin in September, when it is considered auspicious to buy gold.

Traditionally, gold buying slows after the festival, but continues at a moderate pace in the marriage season, during which families gift brides gold as lifetime savings.

Ajay Mitra, managing director of the World Gold Council's India office, forecast the coins business would see revenues of about 3 billion to 5 billion rupees ($62 million to $103 million) over the next six months on sales of about 75 to 76 tonnes.

Mitra said revenues were likely to reach 10 billion rupees over the next three years. Global financial market turmoil has rocked Indian stock markets, driving the main index <.BSESN> down almost 47 percent in 2008 as foreign funds withdraw.

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US Fed cut rates to 1%, and open for more

Fed made the right move when it cut rates, but it will still be some time before the housing market stabilizes

The Federal Reserve on Wednesday slashed overnight interest rates and left the door open for more cuts -- all part of an effort to return confidence to investors so that a weak economy doesn't crater.

In its statement, the Federal Open Market Committee said it had unanimously decided to cut its benchmark target interest rate by a half of one percentage point to 1% and clearly signaled it was considering further cuts. This signal came in a statement saying that the main risk facing the economy was weak growth.

Any more rate cuts would bring the funds rate to its lowest level since July 1958.

Today's move, which was expected, follows a series of initiatives by the Fed and the Bush Administration to push cash into frozen credit markets, hoping to spur lending. As a result, the Fed has doubled the size of its balance sheet in the past month. At the same time, the Treasury has begun acquiring stakes in major financial institutions.

In addition, the Fed agreed to buy commercial paper from non-financial companies for the first time since the Great Depression. The Fed has also introduced a new fund to assist money markets.

In their official statement, Fed officials said the pace of growth has slowed "markedly" and the extraordinary financial market stress could put the economy at greater risk.

Inflation had moderated and should move even lower, the Fed said.

The FOMC said it "will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability."

Importantly, the Fed statement drew no line in the sand at the 1% funds rate target, raising the possibility that rates may move lower.

While the move raises lots of technical questions about having rates so low, many analysts said these matters are of less concern than ending the credit crunch.
The Fed's statement issued at the end of its two-day meeting was remarkable for its pessimism.

"The intensification of financial market turmoil is likely to exert additional restrain on spending, partly by further reducing the ability of households and businesses to obtain credit," the statement said.

On the other hand, the outlook for prices was quite benign, the statement said.
"In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate in coming quarters to levels consistent with price stability," the statement said.
Many economists say that the next big threat for the central bank could be deflation, where prices fall sharply. This can be just as damaging for an economy as inflation.

Former Fed governor Frederic Mishkin has called for the central bank to consider announcing a public floor below which it will not let the inflation rate fall.
How low can they go?

Ian Shepherdson, chief U.S. economist at High Frequency Economics, said the "downbeat" statement from the Fed caused him to pencil in another half-point rate cut at the Fed's next formal meeting on Dec. 16.

But John Derrick, director of research at the mutual-fund company U.S. Global Investors Inc., said he thought the Fed would hold steady at 1% for the foreseeable future.

Derrick said the Fed cut rates today simply to give the market a shot of confidence and the statement was just an accurate description of the near-term outlook.
With interest rates so low already, economist at RBS Greenwich Capital, said the rate cut was a "side-show" and that the main event is the aggressive new measures undertaken to shore up the crumbling global financial system.

Analysts see some improvement in credit markets, but not much. The important London interbank lending rate remains well above the Fed funds rate.

The Fed said it was confident that all of the government actions would restore the markets to health.

"Recent policy actions, including today's rate reduction, coordinated interest rate cuts by central banks, extraordinary liquidity measures, and official steps to strengthen financial systems, should help over time to improve credit conditions and promote a return to moderate economic growth," the statement said.

Fed watchers have begun to discuss other extraordinary steps the Fed could take to help ease the stress in financial markets.

Scott Anderson, chief economist at Wells Fargo, said the Fed could directly purchase longer-term Treasuries, corporate bonds or mortgage-backed securities if the Fed funds rate cuts "don't do the trick" of lowering the average interest rate on corporate and consumer borrowing.

The Fed move comes 21 days after the global coordinated half-point rate cut with major central banks in Europe and Canada.

Earlier Wednesday, the central banks of China and Norway lowered their target rates.
Some analysts said today's rate cut would put pressure on the European Central Bank to follow suit next week. The Bank of England is also expected to cut rates again.

On the technical side, Fed officials also voted to lower the discount rate to 1.25%. This is the rate at which banks can borrow from the central bank.

"Interest rate cuts do matter," Jim Cramer told the viewers of his "Mad Money" TV show.

He said that no matter what the nay-sayers may say, rates cuts are exactly what the markets need.

Cramer said there are only two types of people who feel interest rate cuts are insignificant: the academics, who are grossly behind the curve, and those who short the market and profit handsomely from a panicky market.

These people, he said, have no sense of history and don't remember 2003, when extremely low interest rates supercharged the U.S. economy out of a recession and crisis.

The Federal Reserve is on board at last, said Cramer, although it came "a year too late."

He said the Fed's statement that it's no longer worried about inflation should give the Chinese and European central banks the fuel they need to follow suit and further juice up the U.S. economy.

Cramer said the rally in stocks will be sustainable if the rest of the world cuts rates. If they don't, all bets are off.

Cramer noted today's rate cut means individuals and businesses will find it cheaper to borrow money because the federal funds rate is tied to the banks' prime rate.

The lower rates also allow the banks to make more money on what they lend. And with savings and money markets earning less, more money will eventually flow back into stocks.

Cramer said it would also be huge news for the housing market and the economy if the federal government were to buy 3 million residential mortgages.

The move, part of his plan for fixing the economy, would finally allow the housing market to stabilize and stop the relentless home price depreciation spiral, he said

With US Fed rate at 0%, it's official. US is Japan.

At least when it comes to monetary policy. The Federal Reserve's decision to slash interest rates by a half percentage point to 1% on Wednesday to help boost the economy was snubbed by the stock market, even though it had demanded the cut like a petulant child for more than two weeks.

There was nothing the Fed could do, and it's likely the European Central Bank will fall in line next week, as well as the Bank of Japan on Friday. Central bankers know they need to show coordination and the ability to do something -- anything -- in the teeth of this bear market.

But Bernanke is quickly running out of monetary bullets, with the risk of having to take the extraordinary step of someday lowering interest rates to zero just a bank run or two away right now. Japan, which spent five unproductive years at zero between 2001 and 2006 before boosting to a half percentage point, is now talking about a quarter point cut and possibly a return to zero, even though it didn't work last time.

The economic theory behind zero rates, called quantitative monetary easing -- a term so heinous it isn't recognized by my computer's spell check -- allows a central bank to run monetary policy by focusing on money supply instead of the cost of the money, i.e. interest rates.

It also means that Joe the Plumber and his elderly parents would get nothing on their savings account or certificates of deposit, which so many people depend on for their fixed-income lifestyles. How's that for an invitation to go out and spend?

Arguably, it was a dramatic easing of interest rates after the tech bubble collapsed that plunked us into the systemic soup in the first place, allowing people to take out mortgages at ridiculous rates and Wall Street to make a killing by packaging the mortgages and playing various rates off each other. But it won't work this time around. Nobody's lending, and nobody is borrowing.

Next week, we'll find out how many Americans bought new cars in October. Estimates vary, but it's likely to be about the same number of people who attend a Sen. Ted Stevens rally this weekend. Some analysts predict it will be the worst month ever for the automakers, with sales falling between 30% and 50% year over year.

Why combining General Motors Corp. and Chrysler, other than to get private equity firm Cerberus off the hook, is considered a good way to sell more cars is beyond me. Even if people wanted to buy, they can't get the financing.

That brings us to the major problem the Federal Reserve and the Treasury face if they want to get this bailout out of the showroom. They have to get the banks to start lending the money they've been given by the taxpayers. Hoarding the cash, waiting for another wave of bad loans to come as the economy gets worse, just feeds the bear.

Congress is right to be concerned about this, and to force the Treasury to press Wall Street and the banks to get lending again. Instead of freaking out about banker bonuses, just tie the bonuses to how much money their institutions lend, not how much they make. Yes, over-lending got us into this mess, but the global economic engine remains stalled, and needs to be jump started.

Interest rates at 1.5%, or 1%, or zero aren't going to do that for us. I suspect even Ben Bernanke realizes that by now. It's time to start cracking heads.

Big pension funds and young investors might be able to wait the months or years it might take for the stock market to come back, but for many Americans, it's not about whether to sell or hold stocks now. It's about getting enough cash to make payments at the end of this month, tomorrow. Just ask the poor savers whose money is still tied up in The Reserve Fund, the money market fund that froze assets last month after a run. See New York Times story.

Americans are going into this election next week as angry as they've been in a long time. Bankers, politicians and economists would be wise not to mess with them.

What if a country goes belly up and go default

29 Oct 2008

THE global financial market is like a rich, generous but occasionally paranoid great uncle. Normally, this benevolent great uncle sprinkles money calmly and wisely throughout the family, taking a careful reading of risk and potential investment reward.

Painful bite
In an alarming number of nations, the amount of dubious debt held by the domestic banking system dwarfs the country's GDP. This is particularly true in such emerging capitalist economies as Hungary, Iceland, Belarus, Ukraine and Pakistan. If an emerging market collapses, the damage won't be limited to just one. But every so often, a deep paranoia overtakes him. Panicked, he turns off the spigot.

Why? Sometimes he thinks his relatives are not telling him everything he needs to know. Other times, paranoia sets in because the facts of a relative's scenario don't add up.

Today the great uncle has reached a level of paranoia not seen since the 1930s, and the massive 'shock and awe' campaign of bold rescue efforts from the world's wealthiest countries has not calmed him down. The world financial market still thinks that the numbers don't add up.

This is primarily because of a new and fast-moving blip on the global radar screen: the growing concern that entire countries could default on their financial obligations.

While Washington frets about bank failures and the potential collapse of the corporate sector, the financial market is far ahead of it. Global markets are now fixated on the economic, social, political and foreign policy shipwrecks that could be triggered if waves of country defaults sweep across the world.

In an alarming number of nations, the amount of dubious debt held by the domestic banking system dwarfs the country's GDP. This is particularly true in such emerging capitalist economies as Hungary, Iceland, Belarus, Ukraine and Pakistan.



That's scary. In the past, some emerging market economies have defaulted (Argentina comes to mind) and managed to survive without dragging the rest of the world off a cliff. But things are different today. The global financial system itself is on life support. If an emerging market collapses, the damage won't be limited to just one country.

The root of today's credit crisis is not that the world lacks money; the world is awash in cash, with US$6 trillion sitting idly in global money markets alone. But if countries start to fail, the remainder of the world's investment capital could be spooked out of productive investments as well.

Nor do we have the tools to avert disaster. The International Monetary Fund's resources are a pittance compared to the financial exposure of the countries in most danger. And as a result of the industrialised world's government bailouts and bank guarantees, there won't be any more capital for emerging markets that are still flailing.

Take, for example, a country as large and powerful as

Germany: Deutsche Bank's assets represent 80% of the nation's GDP.
Switzerland: the assets of the bank UBS represent 450% of the country's GDP.

The financial exposure of the British banks is similarly alarming:

Barclays PLC's assets amount to more than 100% of the United Kingdom's GDP,
Royal Bank of Scotland's holdings reach 140% of British GDP.

These countries aren't even the biggest worry. That honour goes to the nations of Eastern Europe and some of the undercapitalised Asian countries. But globalisation means we're all connected. If Hungary were to default on its financial obligations, Austria's banks would soon collapse. If that happened, Germany's banks might well follow suit.

There's plenty to fret about in Asia, too. Pakistan is facing default. Many investors worry about South Korea as well: Its exports are plummeting, and foreign investors are fleeing an already weak stock market. In an emergency, would the South Korean government, or even the IMF, have the resources to come to the rescue? We can't be sure.

Jittery global markets

American investors wouldn't be of much use, either. After all, what banker in today's partially taxpayer-owned, soon-to-be-politicised financial system would want to testify before Congress about a risky loan to some small foreign country when safe domestic investments had been available? Note, too, that the slowdown in securitisation - the slicing and dicing of assets to be sold as securities - will add to this potential mess. In the past, the much-maligned process funnelled huge amounts of capital to the developing world. That's not going to be happening anymore, at least not for a while.

No wonder global markets are so jittery about the prospect of countries defaulting.

The rich, developed countries enjoy huge resources that can save them from financial collapse. But those resources are not unlimited. In Europe, taxes as a percentage of GDP have grown to 43 per cent (compared to roughly 20 per cent for the United States).

Translation: If Hungary, Pakistan or South Korea went broke and European governments were forced to raise taxes to finance a bailout, the economic pain would be excruciating.

That is why the 'shock and awe' of the current bank bailout efforts hasn't yet stabilised world financial markets. Investors suspect that the problem is just too expensive to confront. The IMF estimates that global banks have already lost US$1.4 trillion. By the time the world fully enters into recession next year, global bank losses will almost certainly have increased dramatically. Some experts expect them to reach a whopping US$5 trillion.

So the question remains: Do the world's governments have the resources to take on such a massive rescue operation? The global markets aren't sure.

Our next president, beginning the day after the election, needs to call for global contingency plans in case countries collapse - because the financial market will bet against the global economy as long as this uncertainty exists. Eliminate that uncertainty, or at least show how the world economy will cope with such calamities, and our policy-makers can return to the thorny job of cajoling our bankers into lending again.

The great uncle is not assuming that the worst is over.

The fall of the Mighty

Reprinted from Business Times

THERE was something pathetic about the testimony by Alan Greenspan, the former chairman of the Federal Reserve, before the House of Representative's Committee on Oversight and Government Reform last Thursday.

Here was the man, who only a few years ago was treated as the Oracle of Delphi by his groupies when he deigned to visit Capitol Hill, was suddenly finding himself subject to harsh criticism and even mean ridicule by the same lawmakers who had worshipped at the feet as the High Priest of American capitalism during most of the roaring 1990s.

The members of the Congressional forum who were cross-examining the 82-year-old ex-central banker sounded at times like inquisitors in a religious tribunal or in a Stalin-era show-trial, pressing a beaten-down witness to confess his sins and to repent.

'You had the authority to prevent irresponsible lending practices that led to the sub-prime mortgage crisis. You were advised to do so by many others,' said Representative Henry Waxman, a Democrat and head inquisitor on the Congressional committee. 'Do you feel that your ideology pushed you to make decisions that you wish you had not made?'

And, indeed, the man who once upon a time was hailed by pundits as the Maestro and the Master of the Universe sounded very apologetic, as though he was pleading for forgiveness. 'Yes, I've found a flaw. I don't know how significant or permanent it is. But I've been very distressed by that fact.'


Former US Federal Reserve Chairman Alan Greenspan told Congress on Thursday 23 Oct 2008, he is 'shocked' at the breakdown in US credit markets and that he expects the unemployment rate to jump.

Despite concerns he had in 2005 that risks were being underestimated by investors, 'this crisis, however, has turned out to be much broader than anything I could have imagined', Mr Greenspan said in remarks prepared for delivery to the House of Representatives Committee on Oversight and Government Reform.

'Those of us who have looked to the self-interest of lending institutions to protect shareholder's equity (myself especially) are in a state of shocked disbelief,' he said.

Banks and other financial institutions need public support, such as the recently approved US$700 billion bailout package, to avoid serious retrenchment, he said.

Mr Greenspan was hailed as one of the most accomplished central bankers in US history when he retired in January 2006.

However, his decision to keep interest rates low during his final years at the Fed has been blamed in part for the housing bubble and crash that has led to the current deep financial crisis.

The former Fed chair said stabilisation of US housing markets - a necessary precondition for the economy to heal - is 'many months in the future'.

At the heart of the breakdown of credit markets was the securitisation system that stimulated appetite for loans made to borrowers with spotty credit histories, he said.

'Without the excess demand from securitisers, subprime mortgage originations (undeniably the original source of crisis) would have been far smaller and defaults accordingly far fewer,' he said.

'The consequent surge in global demand for US sub-prime securities by banks, hedge and pension funds supported by unrealistically positive rating designations by credit agencies was, in my judgment, the core of the problem,' he added.

For the Democrats, Mr Greenspan's Congressional testimony and his ensuing grilling by the lawmakers provided an opportunity to bash the successful drive by the Republican free marketeers promoted by the Fed under Mr Greenspan to deregulate the financial markets. The Democrats blame deregulation for the mess on Wall Street and have focused on the need to reassert government intervention in the markets as part of their agenda in the presidential and Congressional elections. Public opinion polls indicate that most voters seem to be receptive to the Democratic message.

But on another level, Mr Greenspan - who was an intellectual disciple of Ayn Rand, the libertarian novelist and philosopher who celebrated laissez faire capitalism in her writings - created the impression during his appearance that he was experiencing a crisis of faith, suggesting that perhaps he 'made a mistake' when he believed that the financial institutions could be self-regulating.

Hence, a few pundits on the political left compared Mr Greenspan's comments to those made by disgruntled former communists during the 1950s who publicly admitted that their ideological faith had been challenged by reality. But these pundits may be overstating their case by arguing that Mr Greenspan was a free-market doctrinaire and that betrayed by his capitalistic God, he is now defecting to the (ideological) enemy's side.

Working side by side with both who led the efforts to deal with the market crash of 1987 and the dotcom bust crisis of 2000 as well with a series of global financial crises in the 1990s, Mr Greenspan has always exhibited a pragmatic modus operandi. If anything, the former Fed chief has never contested the policy embraced by several Congresses that encouraged consumers through tax benefits and subsidies to buy homes, instead of following Ms Rand's view that choices in the housing market should be made by consumers and financial institutions.

Similarly, Mr Greenspan didn't follow free-market principles when he used the power of the Fed to keep interest rates low and pump cash into the financial markets after 2001. These government-backed policies as much as the deregulatory steps embraced by Washington in the 1990s clearly contributed to the joint housing and financial crises; they provided incentives to consumers and business to make irresponsible choices.

At the same time, it would be an exaggeration to suggest that Mr Greenspan, together with the rest in Washington, is now slouching towards socialism. Even at the height of Reaganism, Washington never abandoned the main tenets of the welfare state that it had adopted in the 1940s. At most, American policy- and law-makers have modified these tenets through some forms of deregulation and tax cuts while maintaining government control of large parts of the economy.

Mr Greenspan did play a role in that process, and now that the pendulum is turning back to the other side, he, like the rest of Washington, is adjusting to a new reality. What's really distressing is we now discover that in addition to not being an intellectual giant, Mr Greenspan was also never a profile in intellectual courage. How the mighty have fallen!

World financial system still at risk

Hedge funds, insurance companies and turmoil in emerging economies still pose threats to Britain's financial system, the Bank of England warned in its twice-yearly report on financial stability Tuesday.

The report estimated total mark-to-market losses on financial assets by banks in the United States, Britain and the euro zone at around $2.8 trillion.

"The instability of the global financial system in recent weeks has been the most severe in living memory. And with a global economic downturn underway, the financial system remains under strain," said John Gieve, the bank's deputy governor for financial stability, in a statement accompanying the report.

However, recent steps aimed at stabilizing the system, including the British government's commitment to provide billions of pounds in capital to beleaguered banks and guarantees for new debt, as well as extraordinary measures by the Bank of England and other central banks to provide liquidity to the strained financial system, appear to be easing tensions, the report said.

"These exceptional interventions by governments and central banks should help to stabilize the banking system in the period ahead," the report said. "While there are still risks in the wider financial system, the immediate response to the measures has been positive."

Still, the tone is much more cautious and gloomy than the central bank's May report, which argued that financial markets reflected fears that were likely to prove overblown.

In May, Gieve argued that "the most likely path ahead is that confidence and risk appetite will return gradually in the coming months."

Hedge-fund worries
The latest report warns that leveraged investors, such as hedge funds, could forced to further liquidate asset holdings due to tighter credit conditions. The report noted that funds have seen additional funding pressures recently due to redemption requests.

There is a risk that redemption requests could increase, the report said.
Many hedge funds operate "gates" that limit aggregate redemptions in any quarter, the report noted. That's strained the so-called funds of hedge funds, or FOHFs, which invest in an array of funds.

The gates operated by other hedge funds make it difficult for the FOHFs to secure the liquidity needed to meet their own redemption requests. FOHFs often have liquidity lines with banks that they can draw upon in such circumstances.

"This would transfer the need for liquidity from FOHFs to banks," the report warned, noting that hedge-fund liquidity needs may be partly behind sales of developed-country and emerging-market equities.

Insurance companies could pose a risk if the value of their investments falls below regulatory capital requirements or if the firms see their credit ratings downgraded, the report said.

And Iceland's recent bank and currency crisis underscores the threats posed by a heavy reliance on external funding, the report said. Similar problems have erupted in Central and Eastern Europe, although not to the same degree as Iceland, the bank noted.

"As well as the risks to these countries, adverse developments in emerging-market economies could put fresh strains on financial systems in developed countries," the report said. "For example, large banks in developed economies with international operations could be exposed to significant credit losses."

The report warned that over the long run, banks must make structural changes in their balance sheets, including a move toward financing a bigger proportion of customer lending through customer deposits. The bank noted, however, that such efforts would be constrained by cost, with increased competition for customer deposits already pushing up the cost of such funding.

Banks also need to hold a larger buffer of liquid assets, the report said. It warned that such adjustments go hand in hand with reduced lending to homes and businesses, although intervention by authorities could help smooth the adjustment.

"In summary, banks still need to deal with the legacy of overextended balance sheets. This means reducing leverage further and reducing reliance on short-term wholesale funding," the report said. "Both are consistent with a period of tighter credit conditions for the real economy, compared to the period prior to the turmoil."

8 Decades have passed since great crash, confidence and trust still an issues

28 Oct 2008, On Black Thursday, Oct. 24, 1929, Richard Whitney, chief floor broker for J. Pierpont Morgan, strode onto the trading floor of the New York Stock Exchange, where he would later serve as president, headed to the post where United States Steel was trading -- which, like virtually every stock on the exchange, was in all but total freefall. He proclaimed in a stentorian voice: "I bid 205 for 10,000 steel."

A gasp spread across the trading floor, especially as Whitney made the rounds of other posts, spreading the largesse -- AT&T Inc , Anaconda Copper, General Electric Company -- a total of $130 million ($1.6 billion today) raised from a private pool of bankers who'd gathered in Morgan's offices after the crash that followed the opening bell.

Trust is the foundation on which the global economic system is based. I'm not persuaded that we've come very far in that respect since 1929.

For a moment, the market stabilized. The Dow Jones Industrial Average INDU, which had plunged to 272 from 381, rebounded to close at 299. Still, it was just a brief pause. By the next Tuesday, the Dow was back down to 230, bottoming at 41.22 on July 8, 1932. It was still in double digits when World War II began nearly a decade later. It took us nearly 22 years -- to Sept. 5, 1951 -- to return to the very 272 where the Dow had plunged on Black Thursday.

Much, of course, is different now -- far different, from that catastrophic moment. Black Thursday itself took place, after all, in those long ago days before market circuit breakers, before big government bailouts. Richard Whitney's action back then was a dramatic gesture. And it worked ... for a nanosecond.

It failed to work, I would contend, because of the lack of a simple, yet fundamental commodity -- trust. Alas, that's the same commodity that seems to be so lacking today.

By the time Black Thursday rolled around, America -- indeed much of the world -- had lost trust in the system, its mechanisms and especially its players. In 1928, 491 U.S. banks had already failed. In 1929, another 642 closed their doors. By the time the banking system began to stabilize, some 9,000 banks had gone bust, wiping out the life savings of millions of Americans.

Runs on these banks, and the lack of a federal deposit insurance system, had evaporated depositors' trust in the system. Without trust that their deposits would be safe and their jobs secure, people stopped spending. Layoffs multiplied as companies found fewer customers to buy their products here. And worse was in store.

The same crisis was spreading across the globe. Countries, like banks, began pulling into protective shells. Rather than seek cross-border cooperation that might help companies find customers abroad, governments began to erect ever higher and more protective barriers, like the catastrophic Smoot-Hawley Tariff. Signed into law June 17, 1930, it only intensified misery around the globe as America's trading partners retaliated. America's exports and imports plunged by more than half.

Trust is the foundation on which the global economic system is based. I'm not persuaded that we've come very far in that respect since then.

What's different? This time, the government jumped in at the outset. Before a host of banks could fail, precipitating a cascading run on the remaining, solvent institutions, governments in the U.S., Europe and Asia stepped up with big bailouts. Still, we can't see or feel the bailouts -- not yet, at least. So for the moment we behave as though they don't exist. Trying to buy a house? Well, it is still difficult, if not impossible, to get a mortgage.

At the same time, companies have begun contracting, rather than expanding. A friend who is a senior partner in a large, multi-national law firm tells me that not only has merger activity dried up in its offices around the world from London to Moscow, but capital finance as well -- a critical lubricant of the international financial system.

With companies unable or unwilling to raise new funds to expand, with little or no confidence there will be customers there if they do grow and create jobs, then we are indeed in for a long freeze.

Still, other elements of the equation of trust could help bail us out. Certainly, we've become a cynical bunch -- "show, don't tell" is the watchword today. Show us there's liquidity in the system, don't tell us. Show us there are bargains in the stock market, don't tell us. Today, we are also far better, and more instantly, informed than any of our forebears were three-quarters of a century ago.

While better, quicker information means that misery can spread more quickly around the globe, it may also mean that relief could spread more quickly as well.

Cycles may well turn out to be sharper, yet shorter, then before. As we monitor daily, weekly, monthly and quarterly the profits and prospects of our corporations, our job losses (and gains), our shopping habits and patterns, rebuilding the trust that we lost so rapidly in the age of Google may also be easier and faster -- more global as well -- than ever before.

It may also be the only real hope we have.

Consumer confidence at all time low

28 Oct 2008; Results of the Conference Board's consumer confidence index for October, which was based on responses to questionnaires sent to consumers at the end of September and collected through the middle of October, fell to a record low (dating back to 1967) of 38, from 61.4 in September. The results reflect the obvious: the weak economy, the housing market and the financial crisis. The previous record low was 43.2 in December 1974.

October's 23.4-point decline was the third-largest ever; the two other declines occurred in the early 1970s. These figures will reinforce the negative tone on Wall Street, although they can hardly be viewed as a shock and a game-changer, given all that has happened of late.

The indices on current conditions and expectations both fell sharply, but the index on expectations fell the most, to 35.5 from 61.5. The index on current conditions fell to 41.9 from 61.1. Consistent with these declines, major components on business conditions (the worst since 1992) and employment (the worst since 1993) were extremely weak. For example, just 8.9% of respondents said that jobs were "plentiful," compared with 37.2% who said jobs were "hard to get." In September, 12.6% said jobs were plentiful and 32.2% said jobs were hard to get.

Only 7.4% of respondents said that they expected employment to increase over the next six months. When this is combined with the recent spike in jobless claims, it appears an odds-on bet that upcoming job statistics will be very poor. Job losses are likely to move toward 200,000 per month with occasional spikes lower now and then. This is a well-known concept by now, which is to say that the markets are prepared for bad employment news, perhaps just as in past recessions when jobs data were ignored at the midpoint of recession.

Interestingly, plans to purchase a home increased to 2.7% of respondents from 2.3% in September, possibly reflecting lower prices.

Plans to purchase both a range and clothes dryer increased, possibly reflecting consumers' newfound ability to stand the heat.

Plans to travel abroad increased, reflecting the strengthening of the U.S. dollar.

Importantly, expectations on inflation 12 months hence increased to 6.9% from 6.2%, suggesting that the benefit of the recent plunge in energy prices has yet to sink in. The benefits of falling energy costs are still in the pipeline.

Fed cut rate have little effect on market

Wall Street Journal - The Fed is about to give financial markets a placebo.

Federal Reserve policy makers Wednesday are widely expected to cut their target for the federal-funds rate, an overnight bank-lending rate, to 1% from 1.5%, back to its historic lows of 2003 and 2004.

Such low rates should be rocket fuel for stocks, boosting economic growth and corporate profits. Lower Fed rates can help corporate bonds, too, though they typically hurt Treasuries, as investors worry about the potential for inflation.

This time, however, cutting the rate target has all the import of snipping the ribbon on a new construction project.

The fed-funds rate already is well below the Fed's target and has been for most of the past month. Since the Fed cut its target to 1.5% on Oct. 8, the interest rate has traded above that level only once and has been below it the rest of the time. On several days, it has traded below 1%.



The Fed manipulates the fed-funds rate by buying and selling bonds and other securities. Lately, these open-market operations have been on steroids, and the moves, along with some technical factors, have caused the Fed to temporarily lose full control of the funds rate.

Fortunately, that doesn't matter much now. With the world shedding debt and parking cash, money supply is draining from the system, and the Fed's extraordinary efforts are just enough to replace it.

"When a water system fails, the first thing to do is to re-establish pressure in the water lines," says Bruce McCain, chief investment strategist at Key Private Bank, which is part of KeyCorp.

The Fed has little choice but to cut rates Wednesday lest it disappoint market expectations. But until the demand for money starts to rise again in the broader economy, for example when lending picks up, rate cuts will have little lasting effect on markets.

Dow rally on hope of Fed rate cut

A frenzied buying spree sent US shares soaring on Tuesday with the second-largest point gain in history for blue chips amid hopes for a rate cut and easing of a global credit crunch.

The Dow Jones Industrial Average rocketed 889.35 points (10.88 percent) to finish at 9,065.12. The gain was eclipsed only by a 936-point advance on October 13, and was the sixth largest in percentage terms for the blue-chip Dow.

The Nasdaq jumped 143.57 points (9.53 percent) to 1,649.47 and the broad-market Standard & Poor's 500 index leapt 91.59 points (10.79 percent) to 940.51.

The surge came amid a strong rebound in global markets but a huge acceleration at the end of the session took market participants by surprise.

"There does not appear to be a specific news item to account for the surge," analysts at Briefing.com said, adding that the gains were "compounded by short-covering."

A so-called "short squeeze" occurs when traders with short positions, betting on falling stocks, are forced to buy to avert heavy losses. A similar short-covering rally pushed up Germany's DAX by 11 percent on Tuesday with many traders caught short on Volkswagen shares.

The market action came as the US Federal Reserve opened a two-day meeting expected to deliver a cut in the federal funds rate aimed at stimulating flagging growth and easing the credit crisis. Some analysts also expect the US cut to be followed by reductions by other central banks.

Augustine Faucher at Moody's Economy.com predicted a half-point cut on Wednesday followed by another half-point reduction in December to lower the funds rate to 0.5 percent, which would be the lowest level since the rate began in 1954.

"Further rate cuts would make it very inexpensive for banks to borrow from one another. The Fed is hoping that low rates, along with efforts to increase liquidity, will spur greater lending and borrowing, unfreezing credit markets."

He said that the combination of Fed interest rate cuts, increased liquidity, and fiscal stimulus "will be enough to bring the economy out of recession in the second quarter of next year" but added that "the financial system remains on edge and worries about global recession continue to increase."

Others noted that bargain hunting had been expected after brutal declines of 40 percent or more this year.

"If you have been standing over by the punch bowl, it looks to me like it's time to ask someone to dance," said John Wilson at Morgan Keegan ahead of the opening.

"Taken in toto, the indicators we monitor are at levels that in the past have pointed to a good rally, if not a major turn."

The market was able to shake off a shockingly weak report on consumer confidence.

The Conference Board index on consumer confidence plummeted to a record low of 38.0, down from 61.4 in September, signalling more retrenchment by consumers.

"The collapse in confidence is directly tied to perceptions about economic conditions and that is likely to mean that households will keep their wallets closed," said Joel Naroff at Naroff Economic Advisors.

Total regulatory failure on Lehman

Jim Cramer wonders about the total regulatory failure on Lehman when a $65 billion fix could have avoided $1 trillion in damage.

Greenspan acknowledged a flaw in his regulation

Former Federal Reserve Chairman Alan Greenspan told a congressional committee on Thursday that the financial crisis is a "once-in-a-century credit tsunami" on Thursday and acknowledged "a flaw" in his perception of the boom period that he oversaw as Fed chief.

Greenspan has received much criticism for supporting low interest rates and lax regulation, which helped fuel the subprime lending spree that led to the current economic malaise. The former Fed chief noted that he raised concerns in 2005 that prevalent risk-taking could have "dire consequences," but said he did not expect the level of panic that has occurred.

"This crisis ... has turned out to be much broader than anything I could have imagined," he said in remarks to the House Committee of Government Oversight and Reform. "It has morphed from one gripped by liquidity restraints to one in which fears of insolvency are now paramount. Given the financial damage to date, I cannot see how we can avoid a significant rise in layoffs and unemployment."

Legislators hammered away at Greenspan, criticizing his laissez-faire ideology and his failure to predict how excessive risk-taking on risky mortgage securities and their complex derivatives could create a financial meltdown. Committee Chairman Henry Waxman (D., Calif.) pointedly asked the former Fed chief whether he was wrong, and Greenspan acknowledged that he had been "partially" wrong about the need to regulate credit-default swaps.

Greenspan predicted a rough road ahead for the U.S. economy, as consumer spending further contracts, lending standards remain strict and home prices continue to fall for at least "many months." Greenspan said he was in "a state of shocked disbelief" that his theory about lending institutions was flawed. He believed financial firms would act responsibly on their own to protect their viability and shareholders' interest.

Instead, strong demand for securitized subprime mortgage loans led lenders to believe that the market liquidity did not expose them to great risk. Greenspan noted that credit-ratings agencies also failed to see the ensuing storm once that liquidity dried up. That caused more uncertainty about securities' pricing and quality, as more delinquencies, defaults and foreclosures stacked up.



To counteract this trend, Greenspan said it will be necessary to require institutions that securitize mortgages to "retain a meaningful part" of those assets. While other regulatory changes are needed, Greenspan predicted that they will "pale in comparison" to the impact that the market's own aversion to risk and tightened standards will have.

While lawmakers were quick to point out Greenspan's role in inflating the housing bubble, others say there is plenty of blame to go around.
Indeed, the failed mortgage-finance giants Fannie Mae and Freddie Mac were government-supported entities whose main objective was to promote homeownership to low-income and minority Americans. The GSEs were pushed by lawmakers to loosen standards and buy riskier mortgages whose debtors may not have documented their income or provided other evidence that they could afford the home.

"That's one of the gross misperceptions here," says Rich Yamarone, director of economic research at Argus Research. "You have these lawmakers waving their fingers at [Greenspan], but they're the ones who adopted all the policies that turned into this. When do we get to turn the tables and wave our fingers at the lawmakers who allowed anybody who wanted to have a home to buy a home -- whether they had a job or income or anything else?"

Yamarone says he has "the highest respect" for Greenspan because he did "an incredibly great job," but adds that "to think he could sidestep any blame for this, that would be inappropriate."

Rep. Ron Paul (R., Texas), a free-market conservative and former presidential contender, goes a step further to say that the existence of a federal bank that sets monetary policy -- rather than the market setting interest rates itself -- is flawed. Paul says the housing bubble was "preventable," but that the Fed and Congress created the financial crisis because they set "artificially low interest rates" while "insisting that subprime mortgages should be made."

"I don't think he offered any solutions and I don't think he admitted that he caused all the trouble," Paul says of Greenspan's testimony. "I think it's more of the same."

Robert Shapiro, chairman of Sonecon and former undersecretary of commerce under President Bill Clinton, says that as Fed chairman, Greenspan undoubtedly knew that the demand for securitized mortgages was "based on a bubble" and that risky assets were being purchased with excessive leverage.
Indeed, some of the country's biggest financial institutions, including Bear Stearns, Countrywide Financial, IndyMac, Lehman Brothers, Fannie, Freddie, AIG, Merrill Lynch, Washington Mutual and Wachovia, have collapsed or been rescued due to the enormous burdens of housing-related assets.

Stronger firms like Bank of America, JPMorgan Chase, Citigroup, Morgan Stanley and Goldman Sachs are still standing, but also suffered losses as a result.

Shapiro says the "single most important thing" Greenspan could have done as Fed chairman would have been to "go to Congress and Treasury and insist that these derivatives be regulated and that there be capital requirements for them and for the purchase of securitized mortgages."

Still, Greenspan on Thursday took effort to lament the need for stricter regulation, as well as the loss of the subprime mortgage market, which opened the doors of homeownership to citizens otherwise barred from that American dream. But he also predicted that once the crisis passes, the country will "reemerge with a far sounder financial system" without the risky financial instruments that helped cause the decline.

"The financial landscape that will greet the end of the crisis will be far different from the one that entered it little more than a year ago," said Greenspan. "Investors, chastened, will be exceptionally cautious."

AIG dominoes effects a bank run across the globe

Reprinted from Daily Wealth

Saturday, October 4, 2008. -- Something very strange is happening in the financial markets. And I can show you what it is and what it means.

If September didn't give you enough to worry about, consider what will happen to real estate prices as unemployment grows steadily over the next several months. As bad as things are now, they'll get much worse.

They'll get worse for the obvious reason: because more people will default on their mortgages. But they'll also remain depressed for far longer than anyone expects, for a reason most people will never understand.

What follows is one of the real secrets to September's stock market collapse. Once you understand what really happened last month, the events to come will be much clearer to you..

Every great bull market has similar characteristics. The speculation must – at the beginning – start with a reasonably good idea. Using long-term mortgages to pay for homes is a good idea, with a few important caveats.

Some of these limitations are obvious to any intelligent observer... like the need for a substantial down payment, the verification of income, an independent appraisal, etc. But human nature dictates that, given enough time and the right incentives, any endeavor will be corrupted.

This is one of the two critical elements of a bubble. What was once a good idea becomes a farce. You already know all the stories of how this happened in the housing market, where loans were eventually given without fixed rates, without income verification, without down payments, and without legitimate appraisals.

As bad as these practices were, they would not have created a global financial panic without the second, more critical element. For things to get really out of control, the farce must evolve further... into fraud.

And this is where AIG comes into the story.

Around the world, banks must comply with what are known as Basel regulations. These regulations determine how much capital a bank must maintain in reserve. The rules are based on the quality of the bank's loan book. The riskier the loans a bank owns, the more capital it must keep in reserve.

Bank managers naturally seek to employ as much leverage as they can, especially when interest rates are low, to maximize profits. AIG appeared to offer banks a way to get around the Basel rules, via unregulated insurance contracts, known as credit default swaps.

Here's how it worked: Say you're a major European bank... You have a surplus of deposits, because in Europe people actually still bother to save money. You're looking for something to maximize the spread between what you must pay for deposits and what you're able to earn lending.

You want it to be safe and reliable, but also pay the highest possible annual interest. You know you could buy a portfolio of high-yielding subprime mortgages. But doing so will limit the amount of leverage you can employ, which will limit returns.

So, rather than rule out having any high-yielding securities in your portfolio, you simply call up the friendly AIG broker you met at a conference in London last year.

"What would it cost me to insure this subprime security?" you inquire. The broker, who is selling a five-year policy (but who will be paid a bonus annually), says, "Not too much." After all, the historical loss rates on American mortgages is close to zilch.

Using incredibly sophisticated computer models, he agrees to guarantee the subprime security you're buying against default for five years for, say, 2% of face value.

Although AIG's credit default swaps were really insurance contracts, they weren't regulated. That meant AIG didn't have to put up any capital as collateral on its swaps, as long as it maintained a triple-A credit rating. There was no real capital cost to selling these swaps; there was no limit. And thanks to what's called "mark-to-market" accounting, AIG could book the profit from a five-year credit default swap as soon as the contract was sold, based on the expected default rate.

Whatever the computer said AIG was likely to make on the deal, the accountants would write down as actual profit. The broker who sold the swap would be paid a bonus at the end of the first year – long before the actual profit on the contract was made.

With this structure in place, the European bank was able to assure its regulators it was holding only triple-A credits, instead of a bunch of subprime "toxic waste." The bank could leverage itself to the full extent allowable under Basel II. AIG could book hundreds of millions in "profit" each year, without having to pony up billions in collateral.

It was a fraud. AIG never any capital to back up the insurance it sold. And the profits it booked never materialized. The default rate on mortgage securities underwritten in 2005, 2006, and 2007 turned out to be multiples higher than expected. And they continue to increase. In some cases, the securities the banks claimed were triple-A have ended up being worth less than $0.15 on the dollar.

Even so, it all worked for years. Banks leveraged deposits to the hilt. Wall Street packaged and sold dumb mortgages as securities. And AIG sold credit default swaps without bothering to collateralize the risk. An enormous amount of capital was created out of thin air and tossed into global real estate markets.

On September 15, all of the major credit rating agencies downgraded AIG – the world's largest insurance company. At issue were the soaring losses in its credit default swaps. The first big write-off came in the fourth quarter of 2007, when AIG reported an $11 billion charge. It was able to raise capital once, to repair the damage. But the losses kept growing. The moment the downgrade came, AIG was forced to come up with tens of billions of additional collateral, immediately. This was on top of the billions it owed to its trading partners.. It didn't have the money. The world's largest insurance company was bankrupt.

The dominoes fell over immediately. Lehman Brothers failed on the same day. Merrill was sold to Bank of America. The Fed stepped in and agreed to lend AIG $85 billion to facilitate an orderly sell off of its assets in exchange for essentially all the company's equity.

Most people never understood how AIG was the linchpin to the entire system. And there's one more secret yet to come out.

AIG's largest trading partner wasn't a nameless European bank. It was Goldman Sachs.

I'd wondered for years how Goldman avoided the kind of huge mortgage-related write downs that plagued all the other investment banks. And now we know: Goldman hedged its exposure via credit default swaps with AIG. Sources inside Goldman say the company's exposure to AIG exceeded $20 billion, meaning the moment AIG was downgraded, Goldman had to begin marking down the value of its assets. And the moment AIG went bankrupt, Goldman lost $20 billion. Goldman immediately sought out Warren Buffett to raise $5 billion of additional capital, which also helped it raise another $5 billion via a public offering.

The collapse of the credit default swap market also meant the investment banks – all of them – had no way to borrow money, because no one would insure their obligations.

To fund their daily operations, they've become totally reliant on the Federal Reserve, which has allowed them to formally become commercial banks. To date, banks, insurance firms, and investment banks have borrowed $348 billion from the Federal Reserve – nearly all of this lending took place following AIG's failure. Things are so bad at the investment banks, the Fed had to change the rules to allow Merrill, Morgan Stanley, and Goldman the ability to use equities as collateral for these loans, an unprecedented step.

The mainstream press hasn't reported this either: A provision in the $700 billion bailout bill permits the Fed to pay interest on the collateral it's holding, which is simply a way to funnel taxpayer dollars directly into the investment banks.

Why do you need to know all of these details?

First, you must understand that without the government's actions, the collapse of AIG could have caused every major bank in the world to fail.

Second, without the credit default swap market, there's no way banks can report the true state of their assets – they'd all be in default of Basel II. That's why the government will push through a measure that requires the suspension of mark-to-market accounting. Essentially, banks will be allowed to pretend they have far higher-quality loans than they actually do. AIG can't cover for them anymore.

And third, and most importantly, without the huge fraud perpetrated by AIG, the mortgage bubble could have never grown as large as it did. Yes, other factors contributed, like the role of Fannie and Freddie in particular. But the key to enabling the huge global growth in credit during the last decade can be tied directly to AIG's sale of credit default swaps without collateral. That was the barn door. And it was left open for nearly a decade.

There's no way to replace this massive credit-building machine, which makes me very skeptical of the government's bailout plan. Quite simply, we can't replace the credit that existed in the world before September 15 because it didn't deserve to be there in the first place. While the government can, and certainly will, paper over the gaping holes left by this enormous credit collapse, it can't actually replace the trust and credit that existed... because it was a fraud.

Lessons learnt from the 1929 Market Crash

Analysts say investors had better beware false rallies like the one that occurred after the market crash nearly 80 years ago.

Current global financial crisis was a long time coming

Reprinted from The Straits Times

Wed, Oct 15, 2008; HOW did things get so bad so fast? Truth is, the current global financial crisis was a long time coming.

Huge current account surpluses built up in Asia and other countries after the 1997-98 financial crisis funded huge US budget and current account deficits ushered in by the election of President George W. Bush in 2000.

Aided by a Republican Congress until the 2006 mid-term elections, the Bush administration embarked on expensive foreign wars and chalked up large domestic expenditure without requiring Americans to pay for them.

Instead, foreign borrowing allowed taxes to be cut while the Federal Reserve under Mr Alan Greenspan kept interest rates too low for too long, which, added to foreign capital inflows, made cheap money available to all. Not surprisingly, personal savings rate fell to below zero, stocks boomed and an asset bubble developed, most notably in the housing market.

Believing that housing values would not fall, Americans bought more expensive houses. Some invested in multiple properties with borrowed money, a major reason for the excess supply now weighing on the housing market's recovery.

Home equity loans also enabled Americans to borrow against the rising value of their homes for current consumption. Economists call this a 'positive wealth effect'. People spend more as their assets rise in value even if their real incomes stagnate or decline, as they have done for more than 96 per cent of US workers since 2000.

At the same time, a US administration preaching free-market principles while practising fiscal profligacy pursued an agenda of financial (and other) deregulation. This encouraged the 'financial innovation' that gave us sub-prime mortgages, collateralised debt obligations, credit default swaps and other complex instruments, not to mention the amazingly high leverage ratios and risk tolerance that came along with them.

It is this house of cards that has now come crashing down, dragging the whole world economy with it.

Could all this have been predicted? It was - by many, including my University of Michigan colleague, the late Edward Gramlich, a Fed governor from 1997 to 2005. He repeatedly and unsuccessfully tried to persuade Fed chairman Greenspan to crack down on excessive and predatory mortgage lending practices.

But predictable and predicted though it was, the crash, when it came, was precipitated by a coincidence of factors that produced a 'perfect storm'. The debt-fuelled US economic boom caused the current account deficit (the excess of exports over imports) to balloon to nearly 7 per cent of GDP by 2006.

This exerted continuous downward pressure on the US dollar and foreign creditors found better outlets for their surplus funds elsewhere - in Europe as well as in emerging markets whose own export-led boom was itself partly the result of insatiable US appetite for imports.

The depreciating dollar and rising commodity prices increased US inflation, requiring the Federal Reserve, as well as other central banks, to accelerate raising interest rates in 2006, even as the US economy was beginning to slow down.

Soaring oil prices in the past two years aggravated nervousness about the economy. Oil-dependent sectors such as auto makers, airlines and tourism were badly hit and began laying off people. And some sub-prime mortgage holders with adjustable rate mortgages found themselves unable to service their mortgages at the higher rates.

While the proportion of such defaulting sub-prime mortgages was small, they had been packaged together with 'regular' mortgages in mortgage-backed securities. Rated as low-risk securities, they had been issued, distributed, insured and held by many blue-chip financial institutions. Greed too often trumped prudence in these largely unregulated private-market transactions.

As the defaults began, uncertainty about the riskiness of individual securities rose. The lack of transparency and the lack of understanding of the securities themselves led to a 're-pricing of risk' and a brutal downward spiral of 'de-leveraging'.

Financial institutions, fearful that they may be holding unacceptably risky assets, began unloading them into increasingly illiquid markets, while 'mark-to-market' accounting rules rapidly eroded balance sheets and capital bases. This forced the afflicted institutions to raise more capital. In the end, capital simply dried up as investors were unwilling to throw good money after bad, not knowing what they were buying.

Thus ensued the current vicious global credit crunch. Banks are no longer willing to lend to each other, due to a lack of trust. If banks cannot get credit from each other, neither can corporations and households.

Eventually, various sectors grind to a halt as credit transactions evaporate.

In this environment, the policy actions and inactions of the US government, including its flawed public communications, not only failed to reassure markets, but also injected a further sense of panic. Savings withdrawals and investment redemptions contributed to bank failures and plunging stock prices.

Ideological objections from both the left and right to 'government bailouts' as well as a lack of understanding by a furious electorate on the verge of a momentous presidential election further heightened overall uncertainty. And thus we had a perfect storm.

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Sovereign wealth funds targeting Asia and Middle East

Reprinted from Global Investor Magazine

Oct-24-2008; Sovereign wealth funds (SWFs) are shifting investments away from the United States and Europe and into the Middle East and Asian economies, according to research released by the global consulting firm Monitor Group.

The trend, first picked by Monitor in a report earlier this year, indicates that SWFs are not exploiting current US or European downturns, but are focused on building opportunities in potentially lucrative emerging markets in the Middle East and Asia. Investments in these regions accounted for 68% of the total value of all publicly-traded deals in this period.

In the second quarter of 2008, funds in the Monitor SWF transaction database executed 43 deals totalling $26.5 billion, compared with 42 deals totalling $58.3 billion during Q1.

SWFs continued to invest actively in emerging markets. In Q2, more than half the deals and funds invested were in emerging markets. SWFs carried out 26 deals and invested $15 billion in BRIC and non-OECD countries. Half of the deals by value were in real estate in Q2. Real estate had the largest number of deals (12) and the highest investment ($13.7 billion) in Q2 2008.

Investment in North America has dropped dramatically. In Q2, just four deals totalling less than $1 billion were received by North America, a steep drop from the seven deals totalling $23 billion during the previous quarter.

Another discernible shift in the last period reviewed has been a move away from financial services. SWFs carried out 10 deals and invested $4 billion in the financial services sector during Q2 2008. In the previous quarter, funds carried out 13 deals totalling $43.4 billion.

"Our transaction data shows that SWFs have focused recent equity investment away from volatile geographic markets and sectors, like North America and financial services, and are instead seeking more attractive returns in emerging markets and other sectors, including real estate," said William Miracky, senior partner of Monitor Group.

Monitor Group collected and investigated data on the 17 SWFs originally identified in the June report entitled "Assessing the Risks: The Behaviours of Sovereign Wealth Funds in the Global Economy." Only nine of the 17 had publicly-reported deals in Q2.

The value of the deals was relatively evenly split between Middle Eastern and Asia-Pacific funds. The five Middle Eastern funds made 25 deals with a reported value of $13.5 billion in Q2, or 51% of the total SWF spend for the quarter. The four Asia-Pacific funds made 20 deals with a reported value of $12.9 billion.