Saturday, October 25, 2008

The Bear of Wall St

Morgan Stanley Asia chairman Stephen Roach talks to Vikram Khanna about the global financial crisis and where it's headed.

FOR several years now, Stephen Roach, Morgan Stanley's chairman for Asia, has been flashing the orange light on the state of the US economy. In press articles, research reports, speeches and interviews, he's been hammering home his gloomy message: the US consumer is overstretched, the stock and property markets are in bubble territory, the US current account deficit is out of control and this party can't keep going on.

The party did, however, go on far longer than he predicted. As stocks and property values kept rising, Mr Roach, a former economist at the US Federal Reserve, earned himself a reputation as 'the perennial bear'. Market optimists would murmur 'there he goes again' everytime he spoke.

But then, around August last year, the bubble burst, the markets went into a tailspin, culminating in a financial meltdown and a near collapse of the Western world's banking system. It was an outcome that surprised even the great bear himself.

'In the last 35 years of my working life, I've been through five recessions and about 12 crises,' says Mr Roach, sitting across from me in a conference room at Morgan Stanley's Church Street office. 'This one is by far the worst.'

'But the question now is not to look back - other than to try to understand how we got here - but to look to where we're headed.'

While the worst may be over in terms of the financial contagion, there's lots more trouble to come in terms of the repercussions on the real side of the US and global economy, he says, and that will feed back into financial markets and financial institutions. 'So it's possible that we will have more episodes of distress bordering on panic.'

Two-stage process

The feedback loop from the financial crisis to the real economy will be a two-stage process, according to Mr Roach, starting with the United States. 'The US over the last 10 years has become a bubble-dependent economy,' he says. 'First equities, and then property and credit. It has grown well beyond its means as the current account deficit indicates, and has funded that growth by extracting purchasing power from overvalued property. And the extraction process has been fuelled by a credit bubble. So now, both the bubbles have burst and the economy is correcting.'

'The contraction is concentrated on consumers. We saw a very sharp decline in personal consumption in the third quarter of this year. And that's very unusual because personal consumption is something that hasn't declined in 17 years.'

Mr Roach points out that the second stage of the feedback loop to the real economy lies in the linkages between the American consumer and export-dependent economies around the world, especially in Asia. 'Developing Asia is slowing pretty much across the region and those adjustments have only just begun. And that's because America's moving into a multi-year consumption adjustment, and there's no other consumer out there to fill the void.'

He pulls out a chart which shows that if you stack up the consumption of China, Japan and India, the total still comes to barely two-thirds of US personal consumption in 2007.

'Developing Asia's exports relative to GDP have never been higher,' he says. 'So the region gets hit - it's just simple math.'

And how deep will America's recession be? Mr Roach reckons that it will be deeper than the recession of the early 1980s, which saw peak-to-trough declines of 2.5 to 3 percentage points of GDP.

'We've had a 14-year period in the US where consumption has grown by 4 per cent a year on average in real terms,' he says. 'It's the biggest consumption binge in recorded history. In the next three to four years, the average growth in consumption demand will be one to 2 per cent.

That means US GDP growth will average about 1.5 per cent over that period, given that consumption is about two-thirds of the economy. That's a huge slowdown. By way of reference, in Japan's lost decade during the 1990s, its growth rate was about one per cent. So this is not going to be a whole lot different.'

Mr Roach has been criticised for drawing parallels between what happened in Japan and what's happening now in the US.

He acknowledges that the two economies are very different. 'But there are a few things in common,' he adds. 'Both had huge bubbles bursting. And both had horrible monetary policies.'
'We have made major mistakes at the Fed in the last 10 years,' he points out. 'Two in particular. One was condoning asset bubbles under the false premise that we can always clean up the mess afterwards. Well, look at the mess today - not a good paradigm there. Second, we completely dropped the ball on the regulatory front. We let ideology drive our willingness to intervene in the development of those very complex financial instruments and structures. We failed to make the distinction between financial innovation, which would have been good, and financial engineering, which turned out to be bad. We just assumed that anything complex is an example of American ingenuity.'

'But these financial weapons of mass destruction, as Warren Buffet and Larry Summers have called them, almost brought our system to its knees.'

As for who's to blame, Mr Roach has this to say: 'Everybody's jumping down Wall Street's throat saying we were the problem. Sure, we deserve our share of the blame. But let's not forget one thing. We put central bankers on this planet to be the cops, to blow the whistle when things go wrong. And blinded by ideology and politics, they just went along for the ride.'

What of the future? In particular, to what extent can policies help cushion the coming downturn? That depends, says Mr Roach. 'Last spring, the US Congress enacted tax rebates. Americans were spent out, with no savings and record debt and it was an attempt to keep the magic alive. So the answer to economic hardship was to tell Americans, go buy another flat-screen plasma TV. That's the wrong policy.'

'Now there's a consensus forming in the US Congress that we're going to need another stimulus package right after the election. And if that package is the same recipe of trying to keep the consumption binge up, we're in trouble. This is our problem. We spend too much, we save too little, we run massive current account deficits. We can't go down that road any more.'

'So this will be a real test for the new president, even before he's sworn in. The question is, what kind of fiscal policy will he support? If he supports a policy aimed at sustaining excess consumption, he would fail his first leadership test. If, on the other hand, he supports a policy that is pro-saving, pro-infrastructure, that injects money into the economy and provides some income support for those feeling the pain most acutely, then we've got a chance.'

And what approach should Asian countries adopt in dealing with this crisis? Mr Roach has supported expansionary policies to boost domestic demand. But there is a prior step, he says.
'You need to be mindful of the risks that were painfully prevalent here 10 years ago. We all know that Asia's fundamentals are much better today. But this is a very lethal global contagion. It can attack a country, it can attack a group of countries. It can attack an asset class, it can attack a group of asset classes.'

'The Korean won is under a lot of pressure. Will that be confined just to Korea? Or could it spread throughout the region? Korea has many characteristics that set it apart from many other countries. It has a current account deficit and is a debt-intensive economy. So you would hope that the markets would not generalise this to the region as a whole.'

'But look, that's logic. When you have contagion in such a crisis, logic gets thrown out. Investors shoot first and ask questions later.'

What then should the region do? 'It needs to develop a game plan for a coordinated policy response,' he says. 'If you have a crisis and stand together in numbers and act with collective resolve, you have a much better chance of tempering very powerful market forces.'

Speaking of collective resolve, there have been calls for a global economic summit and indeed, US President George W Bush has invited the leaders of 20 countries to a meeting in New York in mid-November to address the crisis.

'A summit would be a good thing,' says Mr Roach. 'We've gone too long down the road of globalisation to not have a global architecture to govern the system. I don't think the IMF or the World Bank are up to the task.'

As for what architecture would be appropriate for the world economy, Mr Roach thinks global fiscal and monetary tools are the need of the hour. 'You also need global regulatory oversight, and a system of well-designed early-warning indicators of global crises. But the most important thing you need is enforcement mechanisms: a system of rewards and penalties that can change behaviour. That's where it could get stuck. Because that would require individual nation states to abdicate some of their own enforcement, and countries just don't want to do that.'

Difficult ride

Meanwhile, Mr Roach believes investors are in for a difficult ride. 'For the average investor with a shorter-term horizon and limited resources than a Warren Buffet, this is a tough climate to put money to work,' he says. 'We don't know if we're through the worst. The psychology of equity markets has really been brutally disrupted. While it looks like the worst of the financial contagion is behind us, it's going to take a much longer time for the markets to heal up after what we've been through in the last month.'

'Obviously there are stocks that have been beaten down to below their intrinsic value and on anything other than an end-of-the-world scenario, they look attractive. But there are other stocks where earnings expectations are still too optimistic. So I would remain cautious.'

Despite the fact that the best bull runs start during recessions, he prefers to remain tilted to the bearish side. 'Normal recessions present investors with great opportunities, but the question is, is this a normal recession? I think it's deeper. Even if it were a deeper recession with a good healthy recovery, this would be a good buying opportunity. But the risk is, this is a deeper recession with disappointing and anaemic recovery prospects. And buying stocks when you don't have any visibility on recovery, that's a big risk.'

There are policy risks too. In one form or another, the US and European governments and central banks have pumped well over a trillion dollars into their economies. For the moment, this is helping to offset the withdrawal of private credit. But once private credit gets going again, central banks, in particular, will have to face up to the prospect of soaring inflation. 'They must then start withdrawing liquidity,' says Mr Roach. 'We can't run a system where we make emergency injections of liquidity permanent.'

'This will be the challenge for (Fed chairman) Ben Bernanke. If he is a clone of Alan Greenspan, he will be unwilling or unable to withdraw the stimulus, and will have to deal with serious problems down the road. But if he is cut from a different cloth, he'll do it and the system will go off life-support and figure out how to adapt. It's called tough love,' he adds, with a wry smile.
But in starting to raise rates in what could still be a recession, wouldn't Mr Bernanke get screamed at?

'That's just too bad,' says Mr Roach. 'In theory we have independent central bankers who are not supposed to care if people scream at them. Greenspan cared a lot when anybody so much as raised a finger. But his predecessor, Paul Volcker, couldn't care less.

'You think it was easy for Volcker to attack the double-digit inflation of the late 1970s? Believe me, I was working at the Fed at that time, and it wasn't easy at all. There were howls of protest all over the country. There was a blockade around the Fed's office building in Washington. But Volcker never flinched.

'So, we're now at a leadership moment,' he says. 'A leadership moment for politics and a leadership moment for central banking. You don't get too many of those.'

Tuesday, October 21, 2008

Are we in danger of turning Japanese?

Japan's stock market lost more than three quarters of its capital over two decades - it might be enough to bring tears to the eyes of even the most inscrutable investor.

'Pushing on a string'' might sound like a daft if harmless activity but I fear it will be seriously bad news for all of us if the phrase ever enters mainstream usage.

Devotees of the dismal science of economics use it to describe the point at which interest rate cuts and other attempts to boost activity - such as pumping billions into bust banks - fail to restore confidence.

For a Chancellor or Prime Minister to discover he is pushing on a string is akin to a sailor being blown onto a leeward shore and, seeing he is running out of sea room, discovering that the auxiliary engine will not start.

I first heard the phrase nearly 20 years ago when the Japanese stock market began its long decline from a peak of 38,000 in the Nikkei index, despite a series of increasingly desperate rate cuts. It came to mind again this week when the Tokyo market fell by another 11pc overnight to stand below 8,500 on Thursday. Losing more than three quarters of your capital over two decades might be enough to bring tears to the eyes of even the most inscrutable investor.

While we should always take a long-term view of equity-based investment, there is a limit to what human flesh can bear - or, as the economist John Maynard Keynes put it: "The market can stay irrational longer than you can stay solvent.''

Here and now, the Japanese experience is a terrifying reminder that some stock market sagas do not have a happy ending - as I pointed out in this newspaper in August, 2007, when the credit crunch began to bite.

Again, in an article headed "Western banks sink in the shadow of the rising sun'' in March this year, I wrote: "First there was Northern Rock in Newcastle; now there is Bear Stearns in New York. With banks being bailed out by taxpayers on both sides of the Atlantic, no wonder investors have that sinking feeling.

"While government intervention has prevented either bank going bust, it might be dangerously complacent to underestimate the seriousness of the global credit crisis. At worst, we could be looking at a repeat of what happened in Japan 19 years ago. Then, as now, banks got into trouble with rash lending against what proved to be grossly inflated property values.

"Before the bubble burst, the ground occupied by the Imperial Palace in Tokyo was valued at rather more than all the real estate in California and the shares on the Nikkei index were briefly priced at more than all those in America.

"Bearish analysts say the main reason that the market has failed to recover is that Japanese banks were propped up by government intervention, which allowed huge losses on bad debts to remain unrealised. International institutions were not fooled and the guilty banks have been unable to borrow - or lend - on normal terms since then.

"Once confidence has been destroyed it is very difficult to restore. Without confidence, there can be no credit - at any price.

"Nobody knows what share prices will do next week or next year. That does not matter for most pension savers who do not plan to retire next week or next year. History strongly suggests the best returns will be received by those who wait for the odds to work in their favour. Selling now will certainly turn paper losses into real ones.''

That is as true now as it was then. Unfortunately, it is also a fact that shares in London have lost about a third of their value since then.

No wonder more people are beginning to worry about parallels with the Land of the Rising Sun - and whether its past may foreshadow our future.

Ian CowieLast Updated: 4:54PM BST 20 Oct 2008

Sunday, October 19, 2008

Ten ways to survive a bear market: The credit crunch is hurting but it is not the end of the world and there are wasy to survive a bear market.

While share prices plunge and bears – or pessimists – rule the stock market, analysts are seeking comfort from their history books. They scrutinise charts of previous slumps, hoping for clues on how to survive stock market shocks and beat the bears.

Experts believe that lessons from history can stop us repeating the mistakes we have already made, and give us some tips on how to do better in future. Statistics show that no stock market downturn lasts forever. They also show that, even when downturns are swift and terrible, the way up can also come quickly.Current stock market shocks have been likened to everything from the 1970s oil crisis to the Great Depression.

"This downturn is new," says stock market historian David Schwartz. "But it is important to realise that every downturn is new. They are never exactly the same."

However, he claims that there are lessons to be learnt from studying what happens in the past. Schwartz says that he is confident that things are looking up, and that he expects to be buying shares in the next fortnight. "I have been sitting on the sidelines," he says.

Here are 10 tips from history to help investors survive, and maybe even profit from, current volatility;

1. This is not the end of the world.
It might seem like it, but the banking crisis is neither the end of the world, nor of capitalism, as we know it. The current events have been compared to the 1980s crash, the 1970s oil shock, and, most scarily, the Great Depression. However, even during the Great Depression, there were only two years during which equities – defined as shares broadly reflecting the composition of the London Stock Exchange – produced a negative return. There has only been one time during the last century when putting your money in the bank would have beaten equities over an 18 year period. That was when investors bought shares just before the First World War, and then sold them during the Depression. The longer the period of investment, the more likely it is that shares will provide a better return than cash. The lesson we can take from this is that now is not the time to panic if you already hold shares. Cutting your losses now will only crystallise them from paper losses to very real ones.

2. The stock market is forward thinking.
The events of this week have made us more wary about prolonged global recession – which may depress the stock market for some time to come. But it is when the economy is in recession that the stock market will rise. "People should remember that every rally starts when the economy is in recession, not when everything is a bed of roses," says Nigel Parsons, investment manager of Bestinvest. "Stock market rallies do not happen when everything is well in the world." During the recession of the late 1980s and early 1990s, the UK stock market hit its low-point in the autumn of 1989 and started climbing – two years before the UK gross domestic product hit bottom. Economic recovery only started in earnest in 1993. "Investors need to remember that the market may turn before there is much to cheer about in the economy as a whole," says Tony Stenning of BlackRock. Similarly, in the Great Depression, 1932 and 1933 were times of high unemployment and economic difficulty. The stock market, however, produced a positive 34 per cent return in 1932 and a 25 per cent return in 1933 – although this does not take inflation into account. Therefore, if you want to capitalise on the stock market's return to strength, or even mitigate the falls you have already been exposed to, do not wait until the economy has recovered. You will have missed your chance.

3. A partial recovery in the stock market comes quickly – but full recovery will take a long time.
Analysing previous downturns shows that the market tends to recover half of the value that it has lost relatively quickly, whereas the rest will take far longer. During the Great Depression, the stock market lost 85 per cent of its value. It gained half of that value back within four years and four months, but took over 21 years to regain its previous highs. Shorter bear markets also follow this pattern. During the 1970s oil crisis, the market lost 44 per cent of its value. It recovered 50 per cent of this in five months, but took a further 5 years and four months to recover the rest. These trends tend to form pronounced V shapes in stock market charts which are then followed by a slow climb upward. They mean that investors hoping to cash in on a return to stock market highs need to be in the market at the right time, otherwise they will miss the fastest part of the stock market bounce.

4. It's time in the market, not timing that market that counts.
It's an old adage, but you hear it so often because it's true. If you want to profit from the bottom of the market, be prepared to invest before the market hits rock bottom, and be prepared to stay in. Stenning points out that investing regularly pays dividends. "Anyone who had a regular monthly savings plan during the equity downturns of the early 1990s or 2000s would have been pleased with the outturn a few years later," he says. No matter how many charts you analyse, you are never going to manage to buy at the very bottom of the market and sell at the top. By investing regularly you should be able to smooth out the downturns in the market over the longer term.

5. There are indicators that could help you predict when the market will turn.
Stock market history buffs point to a variety of indicators when trying to work out how far the market will fall. One is the crossover between dividends and gilt yields. At present £100 invested in company shares would give you more in dividend payments than benchmark Government debt. Some investors say this only happens when shares fall too fast, and signals a good time to buy. Another is the VIX index – also known chirpily as the Fear Index. This is a measure of volatility, and it showed its biggest leap ever last week. Experts say that peaks in the VIX are often accompanied by a short-term stock market rally. However, those of us looking for long-term stability will be looking for a lower VIX value, as an indication of greater stability. At the time of going to press the VIX has fallen slightly from peaks of 69.95 to 54.9. However, this is still very high compared to numbers in the low twenties in August and September, suggesting that there is more volatility to come.

6. The first rally is often not an indicator of immediate recovery.
Monday's stock market rally was extraordinarily strong but was followed by setbacks later in the week. According to Fidelity, in percentage terms Monday's rally was the second-best biggest rise for the FTSE 100 since 1984, and the fourth-best day on the FTSE All-Share Index since 1969. However, the first big stock market rallies are often isolated incidents, and not the beginning of a true recovery. The charts show large rises in 1987 directly after Black Monday. But a true recovery was still some time away. Simon Ward, chief economist at New Star, says the current market somewhat resembles the bear markets between the first and second world wars. A chart extrapolating from this suggests a near-term rally, followed by an extended plateau. If this extrapolation was correct then the market would then lurch down to a bottom around the levels reached in 2003. A sustainable recovery would occur only in 2011. "It would be unwise to place too much weight on mechanical historical comparisons but the suggestion of an imminent base followed by an extended sideways movement is plausible," he says. Valuations are now low – the price to book ratio of UK non-financial stocks is at levels last reached in 1992 – but buyers are likely to be slow to return after the confidence-shattering events of recent months."

7. Corporate debt will recover first.
When investing in a bear market, some sectors are likely to prove more resilient in a protracted downturn. Others are likely to recover quickly when the market turns. Parsons claims that corporate debt is one of the first investments to recover. "At the moment you can get yields of between seven and eight per cent on secure corporate debt," he says. "That is way more than on government stock." For most small investors, the easiest way to invest in corporate debt is through a bond fund. Some of these, including Axa Sterling's Corporate Bond Fund, F&C's Strategic Bond and Extra Income funds and Old Mutual Dynamic Bond funds have been hit by the collapse of Lehman, whose bonds became worthless. Both Justin Urquhart Stewart at Seven Investment Management and Mark Dampier at Hargreaves Lansdown are optimistic on investment grade corporate debt. Dampier says there is an awful lot of bad news already priced into corporate bonds and that they may be looking better value, though he adds that we are not out of the woods yet.

8. Some shares weather the storm better than others.
History suggests that the first stocks to come out of a downturn are usually found in five sectors: industrials, consumer durables, materials, information and financials. These are the same sectors that tend to fall furthest in a downturn. "Property is the last sector to come out of a downturn," says Parsons. This position is further confused by the role of Government in banking at present, so the trick is to look for companies with strong balance sheets and which pay good cash dividends. Jeremy Batstone-Carr, analyst at Charles Stanley, suggested that with a recession inevitable it is important to consider companies whose earnings are uncorrelated to economic cycles. We have been keen on pharmaceuticals stocks and healthcare companies," he says. "We like Glaxo – it has reliable growth prospects, good cash flow and a strong balance sheet." He also suggests mining stocks for those with a long-term view and more appetite for volatility. Neil Woodford, fund manager at Invesco Perpetual, also likes classic defensive stocks such as tobacco, pharmaceuticals and some telecoms, as well as the oil sector. Other stocks to look at include companies that will do well out of a consumer downturn. JD Wetherspoon, the pub company, has done well on the stock market already this year for one reason: it offers cheap drinks. Exactly what consumers are looking for at the moment.

9.The gold price is a measure of consumer fear.
During a financial crisis, the price of gold rises, because it is seen as the last safe haven. During the last few weeks, some investors have even been trying to buy gold on eBay because there has not been enough to go round. Traditionally, it has been one of the safest investments during financial turmoil. In 1973 it cost $60 an ounce, but hit $650 in 1981. However, it has been quite volatile during the current crisis. Gold did very well during the financial crises of the 1970s, but in the current crisis the price has moved around a fair bit. About a year ago, the gold price was $667 (£370) an ounce, and it rose to a peak of more than $1,000 on March 17 – coinciding with the collapse of Bear Stearns investment bank. However, since then the price has fallen and was trading around $848 this week. For long-term investors, there are various ways of holding gold, either in a fund or in the metal itself. A cheap way of tracking the gold price is through an exchange traded fund (ETF). In the five years they have been available, they have provided a cost-effective and easy way for investors to gain exposure to gold without physically owning it.
ETFs are not technically funds, because they follow a single security that is traded on the London Stock Exchange. They track the gold price and can be traded daily – all you pay is the dealing charge of around 0.4 per cent. Another option is a gold account. Gold bullion banks offer two types of gold account – allocated and unallocated. An allocated account, such as that offered by, is like keeping gold in a safety deposit box and is the most secure way to invest in physical gold. The gold is stored in a vault owned and managed by a recognised bullion dealer or depository. With an unallocated account, investors do not have specific bars allotted to them. One advantage of unallocated accounts has been the absence of any storage or insurance charges, because the bank reserves the right to lease out the gold. A gold fund is a pool of shares of gold-mining companies. In theory, when the gold price rises, gold miners should do well and share prices should climb. There are a few funds to pick from, with the most popular being BlackRock's £1.7bn Gold & General fund, which invests in the shares of gold-mining companies as well as other commodity businesses. However, for those who believe the stock market will recover quickly, it is worth noting that gold does not provide any income, and they may do better in the long-term with equity investments.

10. Only a few fund managers will beat the bear market.
Citywire has identified fund managers who have a proven record of beating bear markets in the past. They may be worth a look. Graham Birch from BlackRock Gold & General, dubbed Goldfinger by his peers, is one such manager. Others include Neil Woodford at Invesco Perpetual High Income, Richard Woolnough at M&G Strategic Corporate Bond fund, Bill Mott at Psigma, and Edward Bonham Carter at Jupiter.

By Rosie Murray-West Last Updated: 1:36PM BST 17 Oct 2008

Tuesday, October 14, 2008

Financial crisis: If you thought the worst was over think again

The roar was visceral: a gutsy grunt of defiance. For a few heady minutes on Friday afternoon, traders on the floor of the New York Stock Exchange cheered aloud as they briefly heaved the stock market into positive territory.

The effort was Herculean: a dwindling band of optimists pouring billions of dollars into a few selected shares in the hope of encouraging others to rally round. Twice they succeeded, only to see the forces of panic overwhelm them each time.

Finally, New York closed for the weekend, once again in the red: bringing temporary relief to a global rout that has reduced the value of most international markets by a fifth in just five brutal days.

Listening to the animal language of the trading pit, it is easy to forget that securities trading is just a mathematical invention – nothing but the abstract agglomeration of pricing data.

The sober Reuters wire service wrote on Friday of investors being “castrated”. Scandinavian bank Enskilda warned clients that markets were “at riot point”. “It’s like someone cancelled gravity yesterday,” added one London trader.

Goldman Sachs boss and Wall Street cheerleader Lloyd Blankfein spoke of “unlimited pessimism”. Surely no mere human construct can behave so uncontrollably?

The sense that humanity is instead grappling with a monster – a marauding Godzilla leaping from Tokyo to London then Wall Street, in single bounds – is compounded by the apparent failure of both national and international rescue attempts.

It feels an age since the US and UK governments each committed £400,000,000,000 of our money to bailing out the markets: the euphoria that followed lasted barely hours.

Hopes that the G7, IMF or EU will do much better this weekend are almost as low as the markets themselves. Our biggest guns are bouncing harmlessly off this force of nature.

For many bystanders, the drama is compelling. Newspapers and TV channels report the crisis much as they did Hurricane Katrina or the Indonesian tsunami: a mixture of shock, awe and lots of computer-generated graphics. We know in our hearts that this will hurt us all, but the lingering feeling that the world has changed for ever in just 30 days leaves us giddy.

The anxiety is also contagious. No matter how secure one’s personal finances, it is impossible not to feel a frisson of panic at the thought that bank ATM machines might run out of cash, or pay-cheques might vanish into the ether: both very real prospects until the Government stepped in to underwrite the bank clearing system on Tuesday. Even now, there are scenarios so destabilising they are barely mentioned.

Our fear explains why Friday’s sell-off was so brutal. This delayed reaction to a month of almost unbelievably bad news in the credit markets was driven primarily by ordinary investors – Mr & Mrs Average finally deciding to cash in their pension nest egg for fear it might be cracked beyond repair by Monday.

All round the world, fund managers reported a huge surge in customers demanding their money back. The professionals panicked long ago.

Ironically, the worst of the financial crisis may, just possibly, have passed. Friday also exhibited many of the hallmarks of what market historians call “capitulation” – the moment when even the optimists lose hope.

The sad lesson of past stock-market crashes is that the point when ordinary punters finally realise it is time to get out usually marks the point when it is time for the smart money to get back in again.

But the difference now may be in what happens beyond the financial markets. Usually, a banking crisis follows some form of economic crisis: lenders are hit by wave after wave of customer bankruptcies until they themselves cannot take any more and topple over. This time, the banking collapse has preceded the recession.

Although the crisis started with the default of some sub-prime mortgages in the US, the scale of the global market losses (and government bail-outs) long ago exceeded the size of the initial defaults.

Instead, last week’s stock market rout marked the point when the usual direction of cause and effect was reversed: now it is the real economy that is expected to take its cue from the markets.

Countries could be next to see their solvency questioned. Iceland is already seeing its currency under attack. Difficult places such as Pakistan, Ukraine and Kazakhstan are looking vulnerable – with devastating consequences for political stability.

Even Britain and the US are seeing the price of credit protection soar as investors worry whether they can afford to bail out the banking system.

Then there is the commodity boom. A bubble in the market for oil is coming to an equally abrupt end, as the slowing world economy reverses the imbalance of supply and demand that drove crude to such giddying prices only a few months ago.

Mining companies were also among the biggest casualties of last week’s stock-market collapse because investors expect China to cease its breakneck industrial growth.

General Motors, once the world’s largest carmaker, is one of several colossal companies on the verge of bankruptcy. It has already temporarily shut down its European factories to preserve its precious cash reserves.

The knock-on effects on the rest of the manufacturing world are rippling out rapidly. Companies bought by private-equity investors are especially vulnerable because they typically rely on a ready supply of debt.

In Britain, there is particular weakness in the property, construction and retail industries. Quite apart from more systemic problems in the banking industry, the loss of thousands of highly-paid financial jobs in the City will deal a devastating blow to London’s economy. Job losses will further impact consumer spending – leading to yet more job losses.

Scary as it may sound, in many ways this is more familiar territory than the pure financial crisis of recent weeks. Economic recessions come and go every few years and we know that the downward spiral cannot continue forever.

This downturn may last longer than that of the early 1990s, but anyone who remembers the horrors of the 1970s knows we are still a long way from three-day weeks and the lights going out.

The real mystery is how the negative feedback loop in the financial markets became so devastating. How could this domino effect happen so quickly?

How could we lose control of something we designed to serve us? One answer is that this is what happens when we allow debt to get out of hand. This is not a natural disaster, but a man-made calamity caused by excessive leverage.

To see the multiplying effects of leverage in action, just look at the behaviour of our big banks in recent days. The reason they have stopped lending cash to each other is not just because they fear for the survival of others, but because they desperately need whatever cash they have to meet mounting obligations of their own.

Last month’s collapse of Lehman Brothers, for example, caused a delayed stampede for cash on Friday because the banks who had offered insurance against a Lehman bankruptcy were forced to pay out. Similarly, the big banks are facing huge calls from some of their big business customers.

These customers long ago arranged emergency overdraft facilities in case other means of finance became temporarily unavailable. Suddenly, everyone wants money out of the banks at the same time.

All the while, the banks’ ability to raise fresh money is being crippled by the fall in the value of their own share prices. Watching these pillars of the financial community lose 25 per cent or more in value during a single day is a huge deterrent to anyone thinking of putting money on deposit , let alone invest directly in new bank shares. For this reason, even the Government rescue plan is looking more problematic by the day.

The plan, outlined by Gordon Brown and Alistair Darling on Tuesday, envisaged banks first turning to their own shareholders for more funds, and then asking the taxpayer to top up any shortfall.

Yet the subsequent fall in the share prices of Royal Bank of Scotland and HBOS has made the numbers harder to square. Ultimately, if the sum of money injected by the Government exceeds the market value of the bank, it becomes hard to describe the process as anything other than nationalisation.

So far, the Government has avoided using the 'n’ word at all costs – not least as it tries to encourage other governments to inject money directly into their banks, too.

Prime Minister Brown has drawn a clear distinction between what happened to Northern Rock and Bradford & Bingley – which were taken fully into public ownership – and what he expects to see at HBOS, RBS and others – which will be more akin to a temporary investment.

But the vexed question this weekend is why the price of shares in these companies has continued to tumble since the Government announcement. Surely if investors believed the public stood four-square behind them, they would stop panicking?

Unfortunately, they haven’t. Worse still, investors may well be behaving perfectly rationally in continuing to dump bank shares. Given the colossal demands on bank cash both now and for the foreseeable future, and given the growing gap between these demands and the cash available, it is quite possible that several of our biggest banks are literally worthless. In this case, nationalisation becomes the only alternative.

The implications for the future of the banking industry hardly bear thinking about. Running two big mortgage lenders (Northern Rock and B&B) is quite enough for the Treasury already, but being placed in charge of a major clearing bank like RBS could require the type of Whitehall intervention in the economy not seen for a generation.

The politics of it all are not pretty, either. Taxpayers might be able to afford it (just) but they are not going to like it. Bonuses are also set to become a toxic political issue just as they proved a toxic financial issue.

It is easy to say that the bankers directly involved should lose their bonuses – or their jobs – but what about others who have made money, or the sought-after professionals necessary to pick up the pieces?

Wall Street legal fees for handling the Lehman bankruptcy are estimated to cost more than $900 million (£530m) – with some lawyers charging $950 an hour each. How will that go down in Britain when compared with typical public-sector salaries?

Meanwhile, those who work in the City can only look on with horror. Some remain frantically busy. An unlucky few have already been made redundant. Most are simply staring, like the rest of us, in slack-jawed horror at the screens in front of them.

Until this passes, all normal rules of business, such as seeking to maximise the return on investment, are suspended. “It’s not the return on our money we’re worried about any more,” said one banker last week. “It’s the return of our money.”

By Dan Roberts

Saturday, October 11, 2008

Party Like It's 1929

Thursday's calamitous chain reaction on Wall Street continues this morning in Asia and Europe. In Japan, the Nikkei slumped another 9.6 percent Friday, the New York Times reports, on a perfect storm of events. Asian "investor sentiment was battered by the overnight rout on Wall Street, confirmation that Singapore has slid into recession and news of a financial-sector bankruptcy in Japan," the NYT writes. There were similarly deep plunges in Europe with markets in London, Paris, and Frankfurt all opening at least 9 percent down, the BBC writes. Back in the States, investors are still trying to make sense of the market's 20-percent drop in the past seven days. The Dow on Thursday sunk to its lowest level in five years, below 9,000, the Wall Street Journal reports, adding "the decline leaves America in one of its worst bear markets in decades, a slump that is triggering comparisons to long-running declines of the 1930s and 1970s." Market pundits say we've entered a "secular" bear market. Looking to today's open in the United States, market watchers will keep an eye on an auction scheduled today to settle the liabilities on the credit default swaps of Lehman Bros. The price tag, calculates the BBC's Robert Peston, could reach $400 billion, a sum that would add further financial strain to "banks, insurers, hedge funds and other financial institutions", oh, and the U.S. Treasury.

The turmoil in the markets and accompanying credit crisis has Britain's Prime Minister Gordon Brown calling for a globally coordinated effort to save the world's banking system. He writes in the London Times that at the upcoming G7 and IMF meetings, world leaders "must lay down the principles and the new policies for restructuring our banking and financial system all around the globe." The Brown plan to inject capital directly into banks is now being mulled in the U.S., the NYT reports. The U.K. sunk 50 billion pounds in new capital into its banks on Wednesday, "the equivalent, relative to the size of the economy, of a $500 billion program here," writes Paul Krugman in an op-ed piece in today's NYT. Perhaps the U.S. can apply for IMF aid. The Guardian reports "Dominique Strauss-Kahn, the IMF's managing director, said he had a war chest of $200 billion at his disposal, which he could make available to desperate governments within a fortnight."

The Mack attack continues—John Mack that is. Just days after fighting back against Capitol Hill, the CEO of Morgan Stanley was staring down what the NYT calls a "renewed assault in the stock market, where its share price plummeted near 26 percent." The WSJ pulls no punches, writing, "The sharks are circling closer to Morgan Stanley." Even though the bank expected a $9 billion investment boost from Mitsubishi UFJ next week, investors are spooked because the Japanese bank's "purchase price of $25 a share now is roughly double Morgan Stanley's closing stock price Thursday." Another day, another $9 billion loan from the Fed to AIG, which saw its stock price take a 25 percent battering yesterday. "The Fed had no idea the capital markets would seize up and the stock markets would keep falling; both put AIG in a severe cash bind," a person involved in the rescue talks told the WSJ. Sticking with banking turmoil, Citigroup has walked away from the Wachovia acquisition, ceding the United States' fourth largest bank to Wells Fargo. Citi's rationale? It was worried "about the quality of some of Wachovia's assets."

"Can GM make it?" That's the blunt headline of a Business Week piece assessing the auto giant's survival on a day when its stock fell 30 percent and its "market cap stood below what it was in 1929 and down more than 94 percent from its 2000 peak of $52.4 billion." GM is not alone; shares in Ford fell 21.8 percent yesterday as both companies were battered by a "dire new forecast for global vehicle sales," writes the NYT. Leading auto-industry analysts J. D. Power & Associates "cut its forecast for United States sales this year to 13.6 million vehicles, a 16 percent decline from last year’s total, and it said 2009 sales could fall as low as 13.2 million." Certainly oil traders have little confidence in the near future for the auto or any other industry for that matter. Crude oil dropped to $82 a barrel yesterday.

And, the Icelandic contagion continues to spread. In a remarkable lesson in just how deep this crisis has infiltrated every part of the economy, the Guardian reports that more than 100 community councils, charities, and police forces in Britain have 1 billion pounds tied up in collapsed Icelandic banks. Iceland, teetering on the brink of a "national bankruptcy," refuses to honor overseas deposits, creating a nasty diplomatic spat between Britain and Iceland. The U.K. responded by invoking its anti-terror laws to freeze U.K.-based assets of the latest failed Icelandic bank Landsbanki, the BBC reports. The last time relations were so cold between the two countries was the "cod wars" of the early 1970s, the FT reports, when an Icelandic gunboat sunk British fishing trawlers in the North Atlantic.

Finally, as the world scrambles to put some perspective on the financial meltdown, consider this new green economic report commissioned by the European Union that claims "the global economy is losing more money from the disappearance of forests than through the current banking crisis," as the BBC describes it. The annual cost of forest loss? Somewhere between $2 trillion and $5 trillion.

By Bernhard Warner and Matthew Yeomans Posted Friday, October 10, 2008

Understanding the TED spread

One measure that is being used to summarize the strain in financial markets is the TED spread. This is calculated as the gap between 3-month LIBOR (an average of interest rates offered in the London interbank market for 3-month dollar-denominated loans) and the 3-month Treasury bill rate. The size of this gap presumably reflects some sort of risk or liquidity premium. I was interested to break the TED spread down into identifiable components to try to get a better understanding of what may be responsible for its recent behavior.

The TED spread over the last 5 years is plotted below; for a longer time series see Bespoke Investment Group. Historically the spread typically stayed under 50 basis points. However, it's usually been above 100 basis points since the credit events of August 2007, and reached 300 several times during the last two weeks. [Ted spread, Bloomberg on Sept 28.]

The overnight interest rate on loans between banks in the U.S. money market is the fed funds rate, whose average value is set as the primary target of U.S. monetary policy. There is also an overnight LIBOR rate, whose borrowers and lenders include some of the same banks that participate in the U.S. federal funds market, albeit a little earlier in the day. As a first step to understanding the LIBOR-TBILL spread, I was curious to look at the difference between the overnight LIBOR rate and the fed funds target. This had a rather impressive spike September 16-17.

Why would a bank want to borrow overnight dollars for 5-6% in London when it could be assured of obtaining those same funds for 2% later that day in New York? For one thing, the situation was sufficiently chaotic two weeks ago that many banks in fact were unable to borrow in New York at 2%. The effective fed funds rate (a volume-weighted average of all the known U.S. trades on a given day) was 2.64% on Sept 15 and 2.80% on Sept 17, despite the Fed's intention to keep these numbers around 2.0. Somebody who was worried about how these days were going to unfold may have quite rationally bid quite a bit to secure the funds early. Or perhaps the U.S. banks dropped out of the London market altogether. In any case, a one- or two-day spike in this overnight rate is not that big a deal, since even a few hundred basis points (at an annual rate) is not that much money on a one-day loan. Following that impressive but brief spike, overnight LIBOR is now back to 2.31%, a modest 31 basis points over the Fed's target.

One can break the TED spread down into separate components using the following accounting identity. Let LIBOR3 denote the 3-month LIBOR rate, LIBOR0 the overnight rate, TARGET the fed funds target, and TBILL the 3-month Treasury bill rate. The TED spread is defined as

which can be rewritten as


As just discussed, the middle term above, LIBOR0 - TARGET, is at the time of this writing back to usual values, so the bloated value for the TED spread must be coming from a combination of the first and last terms. Indeed on Friday, the spread between the 3-month and overnight LIBOR rate stood at 145 basis points:

(LIBOR3 - LIBOR0) = 1.45

Why is the 3-month rate so much higher than the overnight rate? It certainly can't be an expectation that the Fed's target for the overnight fed funds rate is about to increase. If the Fed makes a move over the next 3 months (and it very well could), it would be for a decrease, not an increase, in the target. The LIBOR term spread must therefore be interpreted as some sort of a liquidity or risk premium. If I lend you funds overnight, I should have a pretty good idea of whether there's some news coming within the next 24 hours that would prevent you from repaying. I may correctly judge that risk to be small. But over the next 3 months, who knows what might happen? If I were a risk-neutral lender, and I thought there was a 0.36% chance that a currently sound bank may go completely bankrupt over the next 90 days, I'd want a 145-basis point (annual rate) premium on the 3-month loan as compensation. If I were risk averse, I would require that 145-basis-point compensation even with a much lower probability of default.
Or, it may be that I'm afraid I myself might be exposed to some severe credit event over the next 3 months, and would be better off keeping any extra cash in Treasuries rather than lending them 3 months unsecured. I would describe this consideration as a "liquidity premium" as opposed to a "risk premium".

If leading financial institutions are making these sorts of assessments of the probabilities of risk or liquidity needs, it bespeaks a very unsettled financial market that is apt to function poorly at channeling funds to any of the other inherently risky economic investments whose funding is vital for a functioning economy.

But this risk/liquidity premium only accounts for half of the TED spread. The remainder is due to the gap between the fed funds target (currently 2.0%) and the yield on 3-month Treasuries (now under 1%). This is the other part of the "flight to quality" just discussed. But on the other hand, the (TARGET - TBILL) gap is also a deliberate choice of policy. The Fed could simply lower its target for the fed funds rate, and chase the T-bill rate down to zero, if it wanted.
What's the downside to that? Here's the next shoe that could drop: the financial dislocations could lead to a perception by global investors that the U.S. is no longer a safe place to be putting their capital, which could add a currency crisis component to the present financial turmoil. Greg Mankiw notes this report:

China's government moved to calm financial markets Thursday and denied a report that it had ordered mainland banks to curb lending to U.S. banks, a day after rumors of financial stability led to a run on a Hong Kong institution.

Calm again for the time being, I guess. But if a cut in the fed funds rate leads to rapid dollar depreciation and commodity inflation, it could be pulling the trigger on something even scarier than what we've seen so far.

Not an attractive set of options on the menu for the FOMC.

From Econbrowser

Don't Watch the Dow

Generations of Americans have been trained to follow the Dow Jones Industrial Average for a quick snapshot of how the economy is performing or is expected to perform. There's a lot that's ill-advised [1] about that habit, but, most importantly, attending to the ups and downs in the Dow won't tell you much about the current financial crisis. Ours is a crisis of credit: Financial firms are unwilling to lend to each other (at all-but-exorbitant rates) for fear that borrowing firms may fail or that they themselves may need the cash to fend off their own crisis.

Whereas the hourly fortunes of the Dow or any stock index are, at best, indirect reflections of this reluctance to lend, the TED Spread [2] measures credit conditions directly. Bloomberg tracks the TED Spread here [3]. What sounds like second-rate Nutella is actually the difference between the interest rate banks charge each other on three-month loans and the interest rate on three-month U.S. Treasury bills.

Why TED? The T comes from "T-bill," shorthand for short-term Treasury bills, and the ED comes from "eurodollar contracts." Because interbank lending is international, loans between banks are often called eurodollar transactions. The three-month interbank interest rate is what an American bank can expect to receive for a dollar loan to a European bank (or any other bank, for that matter-"euro" is just a bad substitute for global here), or vice versa. Not surprisingly, interest rates on loans between banks are higher than the interest rate on T-bills. The higher interest rate on interbank loans compensates for the fact that a short-term loan to a bank is riskier than a short-term loan to the U.S. government.

The TED Spread typically stays under 50 basis points (half a percentage point). Things got atypical in August 2007, when subprime mortgage troubles began making waves in the U.S. housing market. The spread moved above 100 basis points, climbing above 300 basis points in the more recent tumult surrounding the Emergency Economic Stabilization Act.

What explains the big spread? It's due, in part, to all of the toxic assets [4] the Treasury hopes to soak up from the financial system with the $700 billion Congress freed up last week. Lenders in the interbank market need an exceptionally high interest rate to extend credit to banks that may be overexposed to bad assets, pushing the interest rate on interbank loans further above the rate on three-month Treasuries. If the borrowing bank were to fold in the ensuing three months, the lender would find itself snared in the mess.

The spread reflects falling yields for three-month Treasury bills as well. As toxic assets poisoned the balance sheets of Bear Sterns, Fannie, Freddie, Lehman, and AIG, investors sought refuge in the relative safety of treasuries, paying higher prices for the three-month bills and accepting lower yields (even negative [5] yields at one point).

If the Treasury's program works as planned, it will remove a substantial bloc of toxic assets from the financial system and stabilize the prices for those that remain on banks' balance sheets. The stabilization should restore some confidence among both banks and financial markets in general. If so, we'd expect interbank lending rates to come down and Treasury yields to rise as investors stop worrying and start moving money back into equities, corporate bonds, money market mutual funds, and the like.

Thus, the TED Spread should fall. If not, it will remain unusually high, possibly rising even further. Of course, we can't expect the financial crisis to improve if the U.S. housing market gets worse. Keeping on eye on the Case-Shiller [6] home price indices (and related futures [7]) will give you an idea of whether or not policy-makers stand a chance.

By brandon.fuller
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Steam Bath

Iceland: a transit point between Greenland and Britain in the board game Risk to some, a source of lush adventurous pop music for others, and a blank to many. The small, rocky outcropping of 300,000 people and (allegedly) 500,000 sheep usually doesn’t get our attention. But this week, the banking crisis that has swept across North America and Europe is dealing a mortal blow to the entire country. The government nationalized or took control of its three biggest banks this week, its debt has been downgraded, and its plunging króna currency is barely trading on the international market. The crisis has even taken on a geopolitical tint; our NATO ally is in talks with Russia for a 4 billion euro loan, a move that would nearly double its foreign-currency reserves. Why are Iceland’s banks so big, and why are they, the currency, and the national economy in such trouble today?

Quite simply, leverage. Like a light-swinging baseball player who’s just discovered creatine, Iceland’s banks bulked up on foreign deposits and ventures to the point where they dwarfed the rest of the economy. The country’s external debt, driven largely by bank obligations, is estimated at nearly $120 billion, six times the country’s GDP. Paul Rawkins of Fitch Ratings (which just downgraded much of Iceland’s bank company debt [1] to a junklike CCC rating) points to a liberalization of the sector at the beginning of the 2000s. The domestic deposit base was small, so banks went abroad to look for investment opportunities. They succeeded, becoming major players in retailing and pharmaceuticals, taking big stakes in ventures ranging from Saks Fifth Avenue to the West Ham soccer club in England. They drew depositors from other countries with attractive interest rates and aggressive marketing—in the United Kingdom, 45 local councils [2] are thought to have large deposits in Icelandic banks. Because the banks were profitable (realizing an overall return on equity as high as 40 percent [3] in 2006), the Icelandic government’s touch stayed gentle. Foreign-currency accounts almost quadrupled in 2006 alone.

And when the global credit crunch approached, Iceland’s banks weren’t ready, their currency wasn’t trusted enough, and there was no one left to turn to. Salacious stories circulate [4] about a January meeting in the capital city of Reykjavík in which hedge-fund managers allegedly openly discussed their bets on a downward turn for the Icelandic economy. Whether or not investors’ actions against Iceland were coordinated, the effects were dramatic. By the spring, the currency had already lost more than one-quarter of its value, leading to a decline in purchasing power at home. As other countries and banks acted to bring their own money back home, Icelandic banks couldn’t meet their obligations. Jon Levy, an analyst in the Eurasia Group, says, “It’s not necessarily the case that these were poorly run banks. They are highly dependent on interbank markets and other sources of global-capital allocation.” After bulking up, the banks were drained and lost all their strength.

No one cast them a rope. The U.S. Federal Reserve opened a currency-swap agreement [5] with Scandinavian counterparts Norway, Sweden, and Denmark in late September, allowing them to draw on U.S. currency if needed. Iceland’s central bank, which had been looking for suitors, was excluded. While the government was on solid ground, running its own surpluses, it’s so small that it can’t plow billions into the financial sector like bigger countries can. Iceland’s banking industry is big and international, all right, but not so big that we can’t let it fail, it seems.
It’s somewhat bewildering that Iceland turned itself, effectively, into a giant hedge fund, because—brace yourself—its fundamentals really are strong. Fisheries, although declining, remain the largest sector, and marine products make up more than half of all exports [6]. Aluminum smelting is a big and growing business, with the value of aluminum exports almost doubling from 2002 to 2005. Renewables constitute more than 75 percent [7] of the country’s domestic energy supply, and talk continues [8] that Iceland can switch to a hydrogen-based economy with growing international interest to follow. And all these exports bring in badly needed foreign currency. But none of these sectors was as attractive as finance, which metastasized into lavish construction projects and high living at home as newly flush Icelanders tried to figure out how to spend their banking-sector profits.

Iceland’s crisis is rippling beyond the island. British Prime Minister Gordon Brown is threatening to freeze Icelandic assets in the United Kingdom and has already seized U.K. deposits [9] at one Icelandic bank. Big retailers could be sold off [10] as Icelandic investment vehicles try to bring some needed currency back home. A Russian loan could, according to the Eurasia Group, give Russia an inside track on Icelandic auctions for offshore oil and gas exploration and production expected next year. Seafood-industry analyst John Sackton of told The Big Money that Icelandic banks were among the few to take a chance on financing fisheries ventures, which are volatile due to fluctuating catches—many of these are now in question [11]. And there’s already renewed clamoring for Iceland to join the euro, which would protect it from runs on its currency.

There’s a resilience in many Icelanders that could help them weather all of this despite the prospect of national bankruptcy and the inevitable pain the country will suffer. Örvar Þóreyjarson Smárason of the experimental band múm says, “I think going through a storm like this will be positive for Iceland in the end. Get people’s feet back on the ground, there is so much more to life than consumption.” Or Icelanders could turn to their history. In Independent People, Nobel Prize-winning author and national hero Halldór Laxness traced the travails of Bjartur the farmer. He pays off the last of his debts in the final chapter—a simple victory in a harsh land.

By karim.bardeesy
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Sunday, October 5, 2008

Channeling Paulson: The bailout will soon be a reality. Only Henry Paulson knows what happens next.

It's been 14 days since Henry Paulson injected the mega-bailout into all of our lives. Fourteen days since he lumbered on stage at the Treasury Department to propose a rescue plan of hundreds of billions of dollars. Fourteen days since the presidential race was thrown upside down. Fourteen days since the country started explicitly living under a threat of a total credit drought. Fourteen days since the country saw its elected leaders promise salvation, fail to deliver, and promise it all over again.

And yet, 14 days later, we still don't know much about how the bailout is actually going to work.
The man in control of it all is Henry Paulson-the former CEO of Goldman Sachs and the new symbol of American capitalism. Despite two weeks of back-and-forth on the bill, Paulson is nearly as short on bailout details as he was when we began this process. Part of this is necessity-he didn't know the kind of leeway Congress was going to give him to work with-and part of it is prudent policy-this whole plan has been so rushed that there's no reason to commit to a tactic when an entirely new strategy could emerge. There's a nagging thought, though, that Paulson himself doesn't yet know what he's going to do.

The bill itself doesn't provide any help. It demands Paulson explain how this whole thing is going to work two days after the first troubled assets are purchased. At that point, Paulson must outline the following details:

1) Mechanisms for purchasing troubled assets
2) Methods for pricing and valuing troubled assets
3) Procedures for selecting asset managers
4) Criteria for identifying troubled assets for purchase
(The above order is the one Congress proposed in the legislation. Let's hope Paulson thinks in a more logical sequence. We'd recommend starting with No. 4 and working his way up.)

For now, all of this leaves us, the American public, scraping for some answers. Referring to that elementary series of questions we learned in grade school-who, what, where, when, why, and how-the only one that's been explicitly answered is why. We know that Paulson thinks we're all destined for Hooverville if we don't vacuum troubled assets from bank sheets. When the House shot down the bailout last week, Paulson's mantra sounded like it was stolen from Heroes. Save the bailout, save the world.

So, 14 days since Paulson originally proposed the plan, it's worth trying to answer the other five questions.

When is all of this going to happen?
Nobody knows for sure. The bill does not impose a timeline on Paulson, but he's been very adamant about the fierce urgency of now. Still, it will probably be at least a few weeks, based on a call between the Treasury Department and bankers last Sunday (before the first bill failed). The stunning, paraphrased transcript, courtesy of Dealbreaker:

Q: Mike Holt, Boston Co.: When will the Treasury start purchasing these assets? Wednesday? A couple weeks?A: A few weeks, several weeks, once Congress passes bill.Q: But some people will fail before that?A: We understand. So, expect some Darwinian havoc for a few weeks even after the bailout bill passes. Without fully forged tools, the Treasury Deptartment will be handcuffed and unable to save failing banks. Reminder: According to Paulson, the bailout is necessary because without it, banks will fail.

Who is going to run this thing?
Nobody knows for sure. The bill says that the Treasury can contract out for portfolio managers to manage the superfund. Paulson can also bring in the expertise of the FDIC, according to the bill, but it doesn't seem to make much sense given the FDIC manages banks, not hedge funds-which is what the bailout pool would be. In a conversation with the Treasury Department, The Big Money was led to believe that it would be a job for somebody from the private sector. Knowing Paulson and his ties to Wall Street, we imagine that he'll bring in a bold-faced name to assuage the markets and inspire confidence. Whoever comes in will still report to Paulson but will presumably operate the superfund day to day in something called the "Office of Financial Stability." Anti-anxiety medication will be handed out at the door.

What kind of assets are we going to buy?
Nobody knows for sure. The bill mandates a purchase of "troubled assets from any financial institution." Interpreted loosely, that could mean tax dollars could be spent purchasing a depressed, yet invaluable, bank employee. The bill does emphasize mortgages and mortgage-backed securities in several places, so expect those to be the first to be purchased, according to TBM's talks with the Treasury Department. But expect whole mortgages to be gobbled up, probably by the government's new Rottweilers, Fannie Mae and Freddie Mac. We've already seen the government help out with troubled credit-default swaps when they bailed out AIG, so that's a possibility, as well. The opportunities are endless!

How much are we going to pay for these assets?
Nobody knows for sure. The bill gives Paulson total control in the matter as long as he writes a memo or two on the subject. Two main options: The government pays market value (not very much) or original value (way too much). If we go with the first avenue, we'll probably use a reverse auction, which would allow the government to buy toxic assets at the lowest price and establish a price floor for the assets in the broader marketplace. Warren Buffett is a staunch ally of this option. That route, though, may not inject enough capital-read: new cash-into the financial sector. Without new capital, we're told banks still won't feel comfortable lending out new credit. If the government is convinced the banks need more money, then they're more likely to purchase the assets straight off and more likely to pay higher prices in the range of what the assets were once worth. Ben Bernanke and Paulson refused to shoot down this option during testimony last week and seemed to favor it at some points. (During other moments, they seemed to favor reverse auctions.) Some econopundits are furious about the potential harm to taxpayers, but it may be a necessary move if initial market-rate purchases don't grease the wheels.

Where will all of the bailed-out banks be headquartered-in the United States?
Nobody knows for sure. The bill says any bank headquartered anywhere in the world is eligible for the bailout even if they don't do business in the United States. The, uh, money quote from the legislation:

To the extent that such foreign financial authorities or banks hold troubled assets as a result of extending financing to financial institutions that have failed or defaulted on such financing, such troubled assets qualify for purchase under section 101.

We don't know whether Paulson will act upon that possibility. At first, he suggested he didn't want foreign banks included, then backtracked once he realized that whole globalization thing applied. Paulson's actions, most likely, will depend on what other governments and central banks do around the world. The European Union rejected a plan to create a rescue fund for their banks. If nobody else purchases toxic assets abroad, the United States may be forced to fill the international void.

After all the wrangling, though, we do know one thing for sure. There will be a bailout. Fourteen days from now, maybe we'll find out what that means.

By Chadwick Matlin Posted Friday, October 3, 2008 - 1:32pm [he_big_money171:]

Let Buffett Run the Bailout Or at least try and get the good deals he gets.

The Senate's approved version of the $700 billion financial rescue legislation, laden as it is with tax breaks and other help for special interests, begs a question: Who could run this huge fund of taxpayers' money without getting distracted by the power that comes with so much money and the potential for political interference?

Warren Buffett's name should be high on the list. Sure, the legendary investor and chairman of Omaha, Neb.-based Berkshire Hathaway almost certainly has more rewarding things to do. But it's worth a hypothetical look at how he might go about it.

To start with, he clearly thinks taxpayers could eventually do just fine with the Troubled Asset Relief Program, as Treasury Secretary Hank Paulson's rescue package is called. "I would love to have 1 percent of the action," he told CNBC on Wednesday-he said that was the most he could afford-and believes the rescue is likely to make money.

Provided, Buffett added, that the Treasury takes banks' troubled mortgage-related assets off their hands at market prices. That's a crucial caveat. In congressional testimony, Federal Reserve Chairman Ben Bernanke wavered on this point, suggesting the TARP fund might buy assets at above their current market prices.

How prices will be set for the TARP's purposes is an elephantine and as yet unanswered question. Buy at today's fear-laden market prices, and it could force banks that haven't yet written down assets sufficiently to take big losses-perhaps big enough to put them out of business, exactly what the plan is supposed to avoid. But buy at prices that are too generous, and the Treasury's plan would unjustly let the shareholders and executives of troubled banks off the hook while also making it less likely that taxpayers eventually make money on the deal.

This is where the TARP's recently added provisions for taking equity interests in banks come in-and where Buffett's deal-making skills, as recently demonstrated with both Goldman Sachs and General Electric, would matter most. The $5 billion that the Sage of Omaha invested in Goldman and the $3 billion he has stumped up for GE are in the form of dividend-earning preferred stock. In both cases, the preferred stock comes with warrants over an equivalent dollar amount of common shares-essentially, the right to buy shares at around the current price at any time in the next five years.

This is a neat structure for investors and representatives of taxpayers eager to protect against possible losses. It's much less risky than buying common stock, the owners of which receive no dividends until Buffett's are paid in full and who are first in line to take losses. And the warrants also amplify any upside as and when share prices rise.

There's a good argument that recapitalizing banks this way, rather than buying dodgy assets at all, would be the most efficient use of taxpayers' money. But the TARP as it stands involves both elements. The advantage of taking investments through preferred stock and warrants as well as buying assets is that it makes the asset pricing question slightly less critical.

Why? If the Treasury fund buys mortgages and other distressed securities at prices that are painfully low for banks, at least the banks can expect a capital infusion to help cover losses. And if the fund's managers are too generous, they stand to collect at least some of the difference by sharing in banks' stock price gains.

Buffett also appears to have scored bargains. Aside from collecting 10 percent dividends on his preferred stock investments in both Goldman and GE, his warrants to buy their shares are worth, according to standard option pricing models, billions extra.

The idea is catching on. In return for backstopping certain losses on Citigroup's purchase of Wachovia's banking operations, the FDIC collected $12 billion in Citigroup preferred stock and warrants.

Buffett said during his CNBC appearance that the House of Representatives should pass the TARP this time around-he called the state of financial markets "a national emergency." Assuming that happens, Paulson will have to work out how to put the legislation into practice. The lessons from Goldman, GE, and Citigroup may help in part. And while he may not be able to have Buffett, it could well make sense to try to think like him.

By Richard Beales Posted Thursday, October 2, 2008 - 12:39pm [the_big_money171:]