'Everybody's Business Making Sense of a Scared New World'
'America Gets Depressed By Thoughts Of 1929 Revisited'
'Worries Grow Of Deeper U.S. Recession'
U.S. Economy 'Unambiguously In Recession'
'If the Bailout Comes, Watch For A Dollar Dive'
'The Next Big Plan From The Bernanke Politburo'
'Fed Up: Bernanke Joins G-7 To Stem Global Financial Meltdown'
'Government Is The Largest U.S. Employer'
IMF Says U.S. Crisis Is 'Largest Financial Shock Since Great Depression'
'The Black Death Of Financial Collapse'
'Wanta Save the Economy? Give Workers A Raise'
'An Economy Built On Lies'
'Retailing Chains Caught In A Wave Of Bankruptcies'
'Dollar Falls To Record Against Euro as EU Inflation Quickens'
'The Madness Of Ben Bernanke'
'Fourth-Largest U.S. Bank Resorts To Emergency Fundraising'
'The End of the World as You Know It'
'A Trillion Dollar Rescue For Wall Street Gamblers'
World stock markets this week survived the nastiest test yet of a slow-moving but relentless crisis that has now persisted since credit markets suddenly seized up last July. The latest move towards the edge of the abyss came as the Federal Reserve was forced to help engineer a rescue for Bear Stearns, Wall Street's fifth-largest investment bank.
The news prompted a brief period of panic last Monday. Traders digested the news that Bear, worth $171.50 per share last year, had been sold for $2 per share. Fresh from the profits made betting against Bear, many hedge funds then turned their attention to the fourth-biggest investment bank, Lehman Brothers, whose shares also endured a precipitate decline.
But then the selling stopped. Wall Street seemed to rally to Lehman's defence. After reaching a trough shortly after 1pm on Monday, Lehman's share price more than doubled in less than 24 hours. It was part of an impressive rally that buoyed markets in the US, Europe and Asia.
By Thursday's close, the S&P 500 had gained 6 per cent from its low on Monday, while the S&P financials index, covering the US financial sector - the centre of global concern - had gained 18 per cent to stand at its highest level of the month. Even if it remained 30 per cent down from the peak it hit last year, this gave grounds for some optimism.
Meanwhile, foreign exchange markets staged a dramatic shift, with the dollar rallying by 3 per cent after falling to historic lows, while commodity prices tumbled from historic highs.
That in turn led to a new wave of speculation: had Bear's collapse, and Lehman's near-death experience, finally signalled a stock-market bottom? Several analysts put out commentaries boldly making that prediction. A note from UBS, headed "Ready for a rally", was typical. The Federal Reserve joined in with its biggest ever cut proportionate to its main target interest rate, and shares enjoyed an upward surge.
At the centre of almost all the arguments was the notion of "capitulation": the idea that market extremes are driven by excesses of emotion rather than market fundamentals. When investors finally panic and shares fall as swiftly as they did on Monday, this can often be a sign that the last optimists have given up. That is classically a signal that shares have been sold down to a "bedrock" cheap valuation, prompting new investors to start looking for bargains.
The collapse of an institution as big as Bear Stearns is a significant and rare event. Previous such incidents, optimists say, have come shortly before market bottoms. Turbulence continues for a short while but, once the worst has finally happened, markets are at last ready to move forwards. By this argument, Bear's collapse has lanced the boil for this market and paved the way for a rebound. JPMorgan published an analysis last week showing that after the last four big Wall Street collapses (Continental-Illinois in 1984; Drexel-Burnham Lambert in 1990; Kidder Peabody in 1994; and Long-Term Capital Management in 1998), the S&P 500 was up a year later by an average 10 per cent.
Unfortunately, the historical parallels look stretched. The case of LTCM, for example, revolved around a stricken hedge fund that was plainly the centre of the market's difficulties. Once it was resolved, the market could rally. Bear Stearns was nowhere near as central to the market's current difficulties.
Another argument that we are near the bottom comes from an analysis of the economy. Stock markets try to predict macroeconomic trends, and historically, they have generally done so successfully. Thus, when the US economy is headed for recession, as many believe it is today, share prices tend to hit bottom and start to rise some months before economic activity begins to recover. By this seemingly perverse logic, the two consecutive months of falling payrolls to start this year might actually be positive for equities.
James Paulsen, equity strategist at Wells Capital, points out that in the recessions of 1970, 1975 and 1990, the stock market's recovery started within weeks of the second month of falling employment. In 1980 it started even earlier.
Mr Paulsen admits that this is not fail-safe. It did not work for the recession of 2001, which was relatively mild. The stock market entered that recession at historically excessive valuations, and needed longer to reach a low. This theory might not work if the current slowdown turns into a long and deep recession.
Many commentators still argue that this will be a very mild recession. So it is quite possible that stocks have not yet discounted the worst of what is to come. But generally stock markets do seem to start their recoveries fairly early in a recession.
More substantively, optimists point to the strenuous attempts by the fiscal and monetary authorities to deal with the problem, particularly in the US. The Federal Reserve has introduced several innovative ways of funding banks and brokerages in the past few months as it fights the problems in the money markets and it has also made unprecedentedly swift cuts in its target interest rates.
The federal government will oblige with its "fiscal stimulus" package of tax rebates, which will deliver about $600 each into the pockets of US taxpayers over the next few months. "The markets are responding to the strong policy actions taken by the administration and the Federal Reserve, helping to restore confidence," says Larry Kantor, head of research at Barclays Capital.
Earlier in the crisis, the Fed had been more sensitive to the political implications of bailing out rich Wall Street bankers. William Poole (below), governor of the St Louis Fed, said last August that "punishment" had been "meted out to those who have done misdeeds and made bad judgments," in what was seen as a message that market participants should not expect help from the Fed if they ran into trouble. More broadly, the Fed said as recently as October that it thought the risks of inflation were as great as those of a slowdown in growth - normally a coded message telling the market it should not bank on any more interest rate cuts.
In this version of events, the Fed's attitude contributed to the sell-off in stocks, and so its new determination to avert further carnage could show that the bottom has at last been reached.
So-called "technicians" - who study the market by looking at patterns in charts rather than at fundamentals such as earnings or macroeconomic growth - also suggest there is reason for optimism. Throughout the turbulence of the past six months, the S&P 500, the world's most widely tracked index, has never closed more than 20 per cent down from its all-time peak in October last year. It has come close to doing so several times. This can be seen as a positive, as it appears that the market has set a level (a "resistance level" in the jargon) below which it cannot fall. Whenever this is approached, buyers emerge. Once traders believe that a bottom has been found this way, they become much more confident.
Also, the scale of the rallies in recent days gives grounds for confidence. According to Mary-Ann Bartels, technical analyst at Merrill Lynch, the S&P 500 enjoyed two days in the space of a week when it gained more than 3 per cent, and when more than 90 per cent of stocks were up. This is very rare: the last two times such events happened so close together were in July 2006 and November 1987, which both turned out to be significant market bottoms.
The problem with these arguments is that on all the occasions when the market was about to hit its "resistance" line, there has been external intervention of one kind or another from the Fed. Thus these strong days may indicate a response to news, rather than telling anything about the internal forces of the market.
There is evidence - notably from a Merrill Lynch survey last week - that many fund managers have high cash balances that they are keeping on the sidelines. This would provide the fuel for a rally.
Valuation also offers some glimmers that an end to the crisis is in sight. Price/earnings multiples are low: for the S&P, they are currently at about 20, compared with an average since 1990 of about 24, according to Bloomberg. But thanks to falls in earnings, multiples have actually risen since last August.
However, the most popular method for valuing stocks is to compare them with the yields on bonds. If bonds are cheap, offering a high risk-free yield, the traditional theory holds that stocks become less attractive. Recently, bond yields have dropped to very low levels as investors seek low-risk assets during the crisis. On that basis, equities do indeed look under-valued.
Unfortunately, again, this argument is not as persuasive as it sounds. Bonds tend to have a low yield for a reason - the likelihood of a recession. If economic activity slows down, more people buy bonds, and yields fall, but that is still bad news for stocks.
Another issue concerns earnings. Analysts entered the year with what appeared to be wildly optimistic estimates for the profits US companies could make. That has dramatically reversed in recent weeks, at least as far as the current quarter is concerned. While analysts expected S&P 500 companies' earnings to grow at 5.7 per cent at the turn of the year, that has now turned into a forecast for a decline of 7.8 per cent, year on year.
However, this is concentrated in the financial sector, where Wall Street is braced for a fall of 49 per cent in profits. It is debatable whether valuations yet reflect the risks a recession would pose for the earnings of companies beyond banks and brokers.
Finally, optimists dismiss the notion that stocks will have to fall because credit is in the midst of a renewed sell-off. Throughout the market drama of the past few months, stocks have tended to follow credit downwards, with a lag of a few weeks.
Optimists point out that the credit market now implies almost unprecedented levels of default. According to Deutsche Bank, prices available in the credit market imply that European investment-grade companies will default at the rate of about 16 per cent over the next five years. The worst default rate in any five-year period since 1970, according to Moody's, is 2.4 per cent.
Implicit default rates for the UK and the US are even higher. Thus, either the world's economy is heading for a recession without parallel since the second world war, or prices in the credit market are being driven more by the lack of liquidity - as nobody is willing to buy credit - than by the fundamentals.
If the story of the credit market is about lack of liquidity, then it should recover once confidence returns. On this argument, it is the price of credit that needs to increase to be in line with stocks, not the other way around.
Pessimists have an array of arguments against the case that the worst is over. First, the Fed has completely changed the way it goes about lending in the past few weeks. Trust between banks has broken down, and problems in the money markets show that this is not improving. The view is taking hold that this crisis is a turning point that will lead to fundamental changes in the way the financial system works, rather than another downturn in an established cycle.
If this is right, the crisis could have a long way to run. Even if it is wrong, so many people currently fear this kind of scenario that no lasting recovery will be possible until the uncertainty has been put to rest.
There is also a fear that the weaker stock market will at some point become self-reinforcing. Americans have savings concentrated in equities, generally in vehicles (such as 401(k) pension plans) whose value is very transparent. When receiving valuations monthly, they are acutely aware of the damage done to their wealth. That could affect spending.
But the biggest problem is that almost all optimists ignore the central issue: the housing market. There is ample evidence that house prices have further to fall. That will be bad for the economy and will also inflict fresh damage on the credit market.
The uncertainty caused by concerns over US house prices is one reason why equity investors who are used to picking out undervalued companies are finding this hard to do. "The actual fundamentals [on many retail stocks] haven't been that bad, but the investor sentiment is so bearish," says Whitney Tilson, founder of T2 Partners. "If you're investing in anything related to the US consumer, you'd certainly want to be following what's going on in the housing markets. The macro factors are what is driving the stock prices and it doesn't matter if our individual stock level analysis is right."
Mr Tilson expects "at least" two more years of falling home prices and very high rates of mortgage default and foreclosure.
Jeffrey Rosenberg, credit strategist at Bank of America, says: "The inability of the Fed to directly impact the underlying source of uncertainty - the erosion in housing - may lead to only a temporary reprieve in market uncertainty."
Perhaps the most convincing argument that we are not yet at the bottom is that so many people think that we are. The clamour to call an end to the crisis in recent weeks in itself shows that optimism has not been extinguished. History's worst bear markets have been punctuated by many rallies when people thought the worst was over.
The collapse of the Dow Jones Industrial Average after 1929, and of the Nasdaq Composite after 2000, saw falls of about 80 per cent over three years. And yet both saw several "bear market rallies" when the index recovered by 20 per cent or more. Hope springs almost eternal.
In both cases the declines ended with the markets bumping along for a while, and then making advances that went unremarked at first. As Ian Harnett of Absolute Strategy puts it: "We'll know we've hit the bottom when we look and see that share prices are a lot higher than they were a few months ago - we won't know at the time."
The case for a bear market rally in the next few weeks looks strong, provided the market can avoid more bad news on the credit front. But it looks hard to call a bottom. One sceptical analyst says: "The bottom will come when everyone at last gives up ever trying to find it." That moment, unfortunately, is not yet in sight.
IN light of recent events, I present to you Stein's Laws of Modern Financial Markets:
The quantity ME is always greater than the variable U.
The constant M (for Money) is always greater than the variable T (for Truth).
In any otherwise inexplicable financial event, the people who profit from it may be understood to have caused it.
Let's start at the beginning. As far as we know to date - and this could well change - we are not in a recession. Unemployment is far below recession levels, as are new claims for unemployment payments. The number of hours worked has barely budged from its highs. In the most recent reporting quarter (the fourth quarter of 2007), there was still positive economic growth, though barely.
Unless a recession is whatever a reporter or a pundit calls it, it is two consecutive quarters of economic decline. That is the historical definition, by the National Bureau of Economic Research, and we don't yet have a better one.
In other words, we won't know until summer whether we are in for a recession. We may well be, and nothing would be less surprising. But as a matter of definition, we simply cannot be in one yet.
Corporate profits are not at the peak levels of late-2006 and early- and mid-2007, but they are still very high by historical standards. This, too, will surely change, but it hasn't yet, and we have no good way to predict how much the change will be.
There is only one really weak sector: housing. But it's coming off of roughly five years of unparalleled boom, and has always been highly cyclical. Agriculture, minerals extraction and refining, and almost all exports are startlingly strong. In other words, the real-world economy of the nation is not bad.
There is, however, a serious disconnect when we move over to the world of the financial markets, where chaos reigns. There is havoc in the brave new world of trading securitized mortgages. This is said to result from startling losses in the subprime mortgage market, and surely some of it does. But the fall in the indexes that measure subprime mortgages dwarfs the actual losses so far in those mortgages - or even the predicted losses.
There is havoc in the market for municipal bonds, though there has not been one notable muni default in at least five years, unless it happened while I was in a deep sleep. There is total anarchy in the market for muni- and corporate-auction short-term securities even though, again, there has not been one notable default. And there is trembling in corporate bonds, though the default rate on these - even on junk corporates - is at a historic low, and close to nil.
Yet the stock and credit markets reel. The investment banks teeter, and one falls into a cruel grave. The Fed steps in with ever more liquidity and reassurances, and the markets still gyrate wildly. Even great experts proclaim they don't understand this market.
Here is a stab at it: What's new this time isn't the scope of the subprime losses. We had far worse losses in the technology crash. What's new is not the collapse of a junk class of securities. We had that when the Milken empire collapsed and the economy hardly budged.
The new part is the hedge funds and the changing of Wall Street from a financing entity to a market manipulation entity. The new part is hedge funds with (supposedly) $1.5 trillion in capital, immense hedge funds within banks and investment banks. The new part is that they have so much money and so much selling power that they can do what capitalists really want and love to do: to make money not by betting on the markets, but by controlling the markets, by putting so much sell side (and occasionally buy side) firepower in play that they know they will move the markets. This takes all that annoying uncertainty out of it.
The task of the hedge funds is to find a weak spot in the market, and to put so much pressure on it that they can move it down, scare other players into selling (with the endless help of guileless journalists), wreak havoc with the markets' indexes and then create that much more selling. Once the process starts rolling, it's shooting fish in a barrel.
Just think of what the short sellers did to Bear Stearns. It's true that Bear Stearns's fabled risk management was not up to par in its portfolio. But it's also true that without the hedge fund heavies of great wealth and great gossip beating them to the ground, Bear would surely have "shlepped it through, as we say.
How do I know this is happening? First, it's the only explanation that fits the facts. Second, it's human nature. Third, much of it has been reported. I am just putting it together and turning it into laws of finance.
This is important for two reasons. One, if market manipulators terrify the banks, lending will slow, and the economy will really falter. It won't be rumor. It will happen.
Second, as the hedge funds change the stock market into a chamber of horrors, the retirement hopes of tens of millions of Americans will be dashed, and the stock market as a place for sensible Americans to place their money for long-term growth will be destroyed. The stock market will be just a place for the sharks to eat one another, instead of eating us little fish, as they have been doing lately. (To be fair, they also eat one another when they can, and do not always act in concert by any means - but when they do, look out below.)
WHAT to do? Laws requiring far more transparency in hedge fund trading are needed. They need to be enforced. And, second, there are laws against schemes and artifices to defraud. The current Securities and Exchange Commission basically ignores them.
It just might be time to use them. Careful and prudent investigation of market manipulation would calm the waters. At present, we have basically turned over the securities markets to the Crips and the Bloods. It's time to reclaim them for semi-decent people.
Ben Stein is a lawyer, writer, actor and economist. E-mail: ebiz@nytimes.com.
When Americans get worried about the economy, their thoughts turn to the Great Depression of the 1930s. And when an eminent US economist, Martin Feldstein, says America is possibly facing its most serious recession since the second world war, those worries are heightened. Could there be a rerun of the Great Depression?
The names may not be familiar to British audiences but in America they resonate enormously. Bear Stearns, the investment bank that went belly-up last weekend, survived the 1929 Wall Street crash and the Great Depression. JPMorgan, the bank that came to its rescue, is a Wall Street legend.
JPMorgan was the target of anticapitalist terrorists in 1920. They placed a bomb outside its office, leaving one scion of the banking dynasty with shrapnel in his bottom. It was Jack Pierpoint Morgan, son of the original JP, who is said to have got worried about the stock market when his shoeshine boy started giving him share tips, and it was at JPMorgan's offices that Wall Street's movers and shakers gathered to try to stem the 1929 crash.
Winston Churchill was on a visit to New York in 1929 on one of the worst days for share prices. Churchill was surprised not to see more frenzy among the brokers until he was told that rules prevented them from running, shouting or gesticulating. Churchill did witness something, though, that has become part of the grim history of the era: a man jumping to his death from a nearby hotel window.
The 1929 crash followed a long, debt-fuelled boom for the American economy, the Roaring Twenties. People wanted cars, radios and the other trappings of the new consumer era and borrowed to buy them. The radio age was even more powerful in its impact than the dotcom era of a few years ago.
Americans thought their economy had been transformed. Irving Fisher, one of the country's most distinguished economists, opined shortly before the crash that was to see stock prices eventually drop by 90% that shares had reached "a permanently high plateau".
A serious recession in modern times would be when gross domestic product (GDP) falls by 3% or 4% over two years. Between 1929 and 1932 America's GDP fell by 32%.
Herbert Hoover, America's supine president, was powerless. Some 9,000 banks, accounting for nearly half of America's banking capital, failed. Unemployment soared and stayed high, with little social protection for the victims. This was the "Buddy, can you spare a dime?" era.
John Steinbeck's novel, The Grapes of Wrath, tells the story of a family of poor Oklahoma sharecroppers and their futile journey from the dust bowl to a new promised land in California. It was published 10 years after the crash and was hugely powerful in its impact.
The effect on Britain was smaller but still profound. The inter-war years led to mass unemployment and misery, epitomised by the Jarrow march of 1936.
Could it happen again? The point man in the current crisis, Ben Bernanke, chairman of the Federal Reserve, also happens to be an expert on the era. The big mistake the authorities made in the late 1920s and early 1930s, he believes, was to allow so many banks to fail, guaranteeing a slump in the wider economy. This was compounded by other errors, including protectionism.
Bernanke's task now is to ensure that banks are topped up with enough liquidity to keep lending. The Bank of England has come round to the same view.
In 1932, Franklin D Roosevelt campaigned successfully for the presidency with the slogan that Americans had "nothing to fear but fear itself". There is a powerful echo of that now.
A growing number of economists have a U.S. downturn already figured into their forecasts.
But now the stunning meltdown of a top Wall Street investment bank and stubbornly persistent financial market turbulence has called that into question, raising fears that severe problems in housing and the nation's bedrock financial system could cripple the economy and wallop many millions of Americans.
No less an authority than former Federal Reserve Chairman Alan Greenspan wrote this week that "the current financial crisis in the U.S. is likely to be judged as the most wrenching" since the end of World War II.
Other noted economists are also sounding alarms. Harvard professor Martin Feldstein, the former head of the National Bureau of Economic Research, said recently he believes the country is now in a recession and it could be a severe one.
While it will be many months before the bureau's cycle dating committee, the unofficial arbiter of when recessions begin and end, makes its own ruling, a growing number of private economists already have a downturn figured into their forecasts. They are generally calling for a mild recession that will end this summer when the economic stimulus checks going to 130 million households start getting spent.
But the severe credit crisis that erupted last August -- and claimed its biggest victim this past weekend with the forced sale of Bear Stearns Co. -- is raising doubts about those mild forecasts.
"Bear Stearns was a clear wake-up call. It resonates with everybody and highlights the severity of the stresses in the financial system," said Mark Zandi, chief economist at Moody's Economy.com.
What got people's attention was how quickly Bear Stearns, the nation's fifth largest investment bank, could go from a stock market value of about $3.5 billion when the market closed on March 14 to being sold at the bargain-basement price of about $236 million two days later.
The Federal Reserve rushed in to take unprecedented actions. It provided a $30 billion line of credit to facilitate the sale and is employing Depression-era provisions that for the first time are providing direct Fed loans to investment banks. Most analysts said the Fed was justified and that its efforts highlighted the severity of the dangers facing the financial system.
The turmoil produced wild swings on Wall Street this week with the Dow Jones industrial average surging on Tuesday after the Fed aggressively cut a key interest rate only to plunge on Wednesday on renewed worries about the economy and then to stage a 262-point gain on Thursday. Markets were closed Friday.
More turbulence is expected in coming weeks because there remains a great deal of uncertainty about how many more victims the credit crisis will claim.
The problems began last year with rising defaults on mortgages as a housing slump intensified, but they have now spread to other parts of the credit markets with institutions growing fearful about making other types of loans.
It is the ability to get credit that makes the financial system and the economy it supports function. When banks stop lending to other institutions that, like Bear Stearns, depend on credit to conduct their day-to-day operations, the results can be catastrophic.
"We can't afford to stagger from one day to the next without knowing what large financial institution might be the next to go down the tubes because of a lack of liquidity. That is way too dangerous a game," said Lyle Gramley, a former Fed board member who is now an economist with the Stanford Financial Group. "It is possible that we could be entering the worst recession of the post World War II period. The threat is certainly there."
Because of Bear Stearns, many analysts are raising the odds that a 2008 recession could be worse than expected.
"The potential freezing up of the financial system could have pretty negative ramifications on bank lending which would have negative ramifications on consumer and business spending," said Nariman Behravesh, chief economist at Global Insight, a Lexington, Mass., forecasting firm. He said he had upped the chances of a worse-than-expected recession to 40 percent, up from 25 percent odds before Bear Stearns.
David Wyss, chief economist at Standard & Poor's in New York, said he now has a worst-case-scenario in which the country could endure a double-dip recession in which the economy would briefly recover this summer, helped by the $168 billion in tax relief, only to quickly slip back into a downturn. Under this scenario, the economy's total output, as measured by the gross domestic product, would drop by 2.2 percentage points, making it the third worst recession in the post World War II period.
The worst recession in recent decades, in terms of lost output, occurred in the 1973-75 period of oil shocks, when GDP fell by 3.1 percent, followed by the 1981-82 recession, when GDP dropped by 2.9 percent.
By contrast, in the last two recessions output fell by 1.3 percent in the 1990-91 downturn, and a tiny 0.3 percent in the 2001 recession, making that slump the mildest in the post-war period in terms of lost output. The 2001 downturn lasted just eight months.
Wyss' baseline forecast calls for the 2008 downturn to trim GDP by just 0.5 percent and last for nine months, from last November until August.
Under that forecast, unemployment, which hit a low in this expansion of 4.4 percent and now stands at 4.8 percent, will rise to around 6 percent, meaning 1.5 million people will lose their jobs. Under the worst-case forecast, unemployment jumps to 7.5 percent, meaning 3 million people would be tossed out of work.
"There would be bigger drops in the stock market and in home prices than we are now anticipating and more people out of work," Wyss said. "There would be a lot of pain all the way around."
While they are developing worst-case-scenarios, Wyss and other economists said they still believe the balance has not tipped from their more benign main forecasts. One thing that gives them hope is the expectation that Congress and the Bush administration, having acted so quickly to pass the first stimulus package, will move quickly, especially in an election year, to pass a second package if needed.
Also, analysts said the Bear Stearns crisis, which has already prompted the Fed to move more aggressively, will also probably trigger a bigger response on the part of Congress and the administration in offering help to homeowners to keep them from losing their homes because of mortgage defaults.
"Historically, when policymakers have acted in a concerted and aggressive way, that signals that we are nearing the end of the crisis," said Zandi. "If that occurs this time and the financial markets stabilize in the next few months, then the economy will suffer, but it won't be a prolonged and severe recession."
Central banks on both sides of the Atlantic are actively engaged in discussions about the feasibility of mass purchases of mortgage-backed securities as a possible solution to the credit crisis.
Such a move would involve the use of public funds to shore up the market in a key financial instrument and restore confidence by ending the current vicious circle of forced sales, falling prices and weakening balance sheets.
The conversations, part of a broader exchange as to possible future steps in battling financial turmoil, are at an early stage. However, the fact that such a move is being discussed at all indicates the depth of concern that exists over the health of the banking system.
It shows how far the policy debate has shifted in recent weeks as the crisis has spread to prime mortgage assets in the US and engulfed Bear Stearns, the investment bank.
The Bank of England appears most enthusiastic to explore the idea. The Federal Reserve is open in principle to the possibility that intervention in the MBS market might be justified in certain scenarios, but only as a last resort. The European Central Bank appears least enthusiastic.
Any move to buy mortgage-backed securities would require government involvement because taxpayers would be assuming credit risk. There is no indication as yet that the US administration would favour such moves. In the eurozone it would require agreement from 15 separate governments.
One argument among policymakers and bankers has been that new international rules have exacerbated the credit squeeze by requiring assets to be valued at their current record lows rather than at face value.
But a strongly held view at one European central bank is that it is not "mark-to-market" accounting that is to blame for severe weaknesses in banks' balance sheets but that prices of MBS securities have fallen to levels that imply unrealistically high rates of default.
If public authorities were to buy and hold sufficient mortgage-backed securities - rather than simply lend against them as they have until now - at prices well below face value but above current prices, they would set a floor in the MBS market.
The Fed does not believe that the point has yet been reached when such drastic action is necessary and considers the discussions it has had with its counterparts to represent "blue-sky thinking" rather than the formulation of a definitive policy proposal.
Fed officials are monitoring the impact of the latest barrage of Fed liquidity moves and interest rate cuts. They also believe the US has not exhausted all the options short of wholesale public intervention and further intermediate steps are available to them.
These could include still more aggressive use of the Fed's own balance sheet to boost liquidity in the markets.
Analysts say the US government also has plenty of scope to boost support for the markets indirectly through the Federal Housing Administration or Fannie Mae and Freddie Mac.
The UK lacks these institutions, which could be one reason why the Bank of England is keenest to explore outright intervention. The UK government has already become heavily involved in buying mortgages since September with the recent nationalisation of Northern Rock, the mortgage lender.
Michael Coogan, the director-general of the UK's Council of Mortgage Lenders, said this week: "Demand for mortgages remains strong but cannot be fully met from existing funding sources." He predicted higher prices and reduced lending.
It is not just central banks that think the MBS market prices are too low and imply a unrealistic level of mortgage default. Some US states' pension funds are investing small sums in the mortgage market.
Robert Gentzel, a spokesman for the Pennsylvania State Employees' Retirement System, told the AP news agency: "Some of the securities that have dropped in value were really very solid securities."
New York: Evidence of US recession mounted on Thursday with reports showing Mid-Atlantic factory activity in its worst slump since the start of the Iraq war and more workers claiming jobless benefits.
Separately, the private Conference Board reported its forecasting gauge fell for the fifth straight month in February, bolstering the view that the US economy has stalled and could face a contraction.
The Economic Cycle Research Institute, a New York-based independent forecasting group, added a further note of pessimism, saying the US economy is "unambiguously" in a recession.
A government report showed the number of US workers filing initial claims for unemployment aid climbed 22,000 last week, while the overall number on the benefit rolls rose a three-and-a-half year high a week earlier.
Factory activity in the US Mid-Atlantic region shrank for the fourth consecutive month in March, according to the Philadelphia Federal Reserve Bank's business activity index, which came in at minus 17.4 this month. "The key message from this survey is that things are quite bad, but that sentiment has, so far, weakened further than hard activity," Ian Shepherdson, chief US economist at High Frequency Economics in Valhalla, New York, said about the Philly Fed report.
Worst fears
Even so, the Philly Fed index was up from February's dismal reading of minus 24.0. It also beat econ-omists' forecasts and investors' worst fears, which cheered the stock market. But it marked the longest streak of contractions since the February-to-May stretch of 2003.
On Wall Street, stocks rose, while the dollar extended gains versus the euro and Japanese yen. Prices of government bonds, which usually benefit from signs of economic weakness, slipped after the report.
Together with weakness in other regional data, the Philly Fed survey suggests the national manufacturing sector could post another contraction in March after shrinking for two of the three months through Feb-ruary.
The Organisation for Economic Co-operation and Development also said US economic growth is grinding to a halt, stung by what could be the worst housing slump on record.
The Conference Board said its Leading Economic Indicators index fell 0.3 per cent, meeting analyst expectations and following a 0.4 per cent drop in January, which was originally reported as a 0.1 per cent decline.
LONDON (Reuters) - If the United States bails out the financial system by buying mortgage debt directly, the price just might be surging inflation and a dollar crisis.
Calls are increasing for the government, either directly or via the Federal Reserve, to cut the knot of the credit crisis at a stroke by buying up mortgages that banks and investment banks are finding difficult to finance.
If the United States bought mortgage debt at or very near 100 cents on the dollar, despite the fact that much of it is trading well below that, it would allow banks to pay back loans used to finance these holdings.
If done in sufficient size, say $800 billion (400 billion pounds) or $1 trillion, it would relieve the terrible pressure on bank balance sheets and allow other credit markets, like those for corporate loans, to return to something approaching equilibrium.
That in turn would make Fed monetary policy more effective in the sense that banks would be able to increase lending and pass on interest rate reductions.
Of course this is a radical step, and way beyond the Fed's already extraordinary policy of swapping mortgages held by banks and some investment banks for easy to finance Treasuries.
It is also hugely risky in terms of the Fed's obligation to maintain stable prices. Putting aside moral hazard -- many foolish borrowers and lenders would thus be given a free ride -- and depending on how such a bailout was done, it could stoke inflation to levels intolerable to foreign creditors, provoking a sharp fall in the dollar as they sought safety elsewhere.
Such a bailout would either have to be paid for by taxes, which seems unlikely, or would involve issuing more government debt or effectively expanding the money supply.
"There would be an inflationary impact because of the huge introduction of credit," said Philip Gisdakis, strategist at Unicredit in Munich.
"It's not $50 billion; we are talking about more like $1 trillion. This injection of capital you need will have consequences for the U.S. economy."
A bailout of that size is very likely to stoke inflation, which is already uncomfortably high, by effectively creating more dollars and putting them into circulation.
"If it's too big there will have to be an element of monetisation, with the Fed financing it," said Tim Drayson, economist at ABN AMRO in London.
"Monetisation is rising from what was a small likelihood to what is now an increasing risk."
To be sure, there is no political consensus for a major bailout, which is openly opposed by the Bush administration and would face serious difficulties gaining agreement in an election year. The U.S. Treasury said on Wednesday that proposals it had seen would do more harm then good.
That is partly why there has been such a startling turn around on allowing Fannie Mae (FNM.N: Quote, Profile, Research) and Freddie Mac (FRE.N: Quote, Profile, Research) to take on more risk and buy more mortgages. While their debt has an implicit government guarantee, they are shareholder owned.
But the $200 billion in new lending allowed to Fannie and Freddie by their regulator, The Office of Federal Housing Enterprise Oversight, might not prove enough.
IMPERFECT WORLD, IMPERFECT OPTIONS
The Fed's current policy of financing mortgage bonds, involving another $200 billion, has its limits as well. When that sum is exhausted, analysts estimate that it will have $300-400 billion of balance sheet capacity left before it either has to issue debt or purchases become inflationary.
If that happens, it would undoubtedly be with explicit approval of the Treasury.
"That would be a big expansion in the monetary base, which would have serious inflation consequences, not least foreigners' perception of the U.S. and the credibility of the Fed," said Drayson.
"You could see widespread dumping of dollar assets which would make the inflation self-fulfilling."
The question of how deep a dollar fall that implies is really in the hands of the United States' foreign creditors, like China and the Gulf states. Because they peg their own currencies to the dollar, exporting more to the United States than they import, they are regular dollar buyers.
A falling dollar causes inflation for them, a price thus far they have been willing to bear as a cost of a profitable trading relationship.
But eventually, if inflation and a dollar fall interact toxically, support from abroad might just dry up.
"If (foreign creditors) decide that they are not going to accept the inflationary policies of the Fed, you could see a pretty disorderly collapse," said Drayson.
"If we are talking a trillion dollars plus (bailout), it will be quite hard to avoid inflation as a consequence of that."
There are, of course, also consequences to the alternative course, which may lead to a round of failures by financial institutions.
In either event, the stakes are high. (James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)
"Instead of just propping up bankrupt banks, the governments should be democratising them - mobilising their assets to stimulate the productive economy, repairing infrastructure, researching and developing new markets, and refitting western economies to combat climate change." - Iain MacWhirter, "The Red Menace"By Mike Whitney,
The Federal Reserve is presently considering an emergency operation that is so risky it could send the dollar slip-sliding over the cliff. The story appeared in the Financial Times earlier this week and claimed that the Fed was examining the feasibility of buying back hundreds of billions of dollars of mortgage-backed securities (MBS) with public money to restore investor confidence and clear the struggling banks' balance sheets. The Fed, of course, denied the allegations, but the rumors abound. Currently the banking system is so clogged with exotic investments, for which there is no market, they can't perform their main task of providing credit to businesses and consumers. Bernanke's job is to clear the credit logjam so the broader economy can begin to grow again. So far, he has failed to achieve his objectives.
Since September, Bernanke has slashed interest rates by 3 percent and opened various auction facilities (Term Securities Lending Facility, the Term Auction Facility, the Primary Dealer Credit Facility, and the new Term Securities Lending Facility) which have made $400 billion available in low-interest loans to banks and non banks. He has also accepted a "wide range" of collateral for Fed repos including mortgage-backed securities and collateralized debt obligations (CDOs) which are worth considerably less than what the Fed is offering in exchange. But the Fed's injections of liquidity have not solved the basic problem which is the fall in housing prices and the persistent downgrading of mortgage-backed assets that investors refuse to buy at any price. In fact, the troubles are gradually getting worse and spreading to areas of the financial markets that were previously thought to be risk-free. The credit slowdown has also put additional pressure on hedge funds and other financial institutions forcing them to quickly deleverage to meet margin calls by dumping illiquid assets into a saturated market at fire-sale prices. This process has been dubbed the "great unwind".
In the last six years, the mortgage-backed securities market has ballooned to a $4.5 trillion dollar industry. The investment banks are presently holding about $600 billion of these complex debt instruments. So far, the banks have written-down $125 billion in losses, but there's a lot more carnage to come. Goldman Sachs estimates that banks, brokerages and hedge funds will eventually sustain $460 billion in losses, three times greater than today. Even so, those figures are bound to increase as the housing market continues to deteriorate and capital is drained from the system.
The Fed has neither the resources nor the inclination to scoop up all the junk bonds the banks have on their books. Bernanke has already exposed about half of the Central Bank's balance sheet to credit risk. ($400 billion) But what is the alternative? If the Fed doesn't intervene, then many of country's largest investment banks will wind up like Bear Stearns; DOA. After all, Bear is not an isolated case; most of the banks are similarly leveraged at 25 or 35 to 1. They are also losing more and more capital each month from downgrades, and their main streams of revenue have been cut off. In fact, many of Wall Street's financial titans are technically insolvent already. The generosity of the Fed is the only thing that keeps them from bankruptcy.
It's generally accepted that the market for MBS will not improve until housing prices stabilize, but that's a long way off. Mortgages are the cornerstone upon which the multi-trillion dollar structured investment market rests, and that cornerstone is crumbling. If housing prices continue to fall, the MBS market will remain frozen and banks will fail; it is as simple as that. No one is going to purchase derivatives when the underlying asset is losing value. The Bush administration is pushing for a "rate freeze" and other clever ways to keep homeowners from defaulting on their mortgages, but its a hopeless cause. The clerical work needed to change these complex mortgages is already proving to be a daunting task. Plus, since 60 percent of these mortgages were securitized, it is nearly impossible to change the terms of the contracts without first getting investor approval; another fly in the ointment.
Also, the tentative plans to expand Fannie Mae and Freddie Mac, so they can absorb larger mortgages (up to $729,000 jumbo loans) is putting an enormous strain on the already-overextended GSE's. By attempting to reflate the housing bubble, the administration will only increase the rate of foreclosures and put the two mortgage behemoths at risk of default without any clear sign that it will help.
Yesterday's release of the Case/Schiller Index of the 20 largest cities in the country, shows that housing prices have slipped 10.7 percent in the last year while sales were down 23 percent year over year. That means that retail equity of US homes just took a $2 trillion haircut. Still, prices have a long way to go before they catch up to the 50 percent decline in sales from the peak in 2005. From this point on, prices should fall and fall fast; following a trajectory as steep as sales. Many economist expect housing prices to drop at least 30% (Paul Krugman and G-Sax) which means that $6 trillion will be shaved from aggregate home equity. In a slumping market, many homeowners will be better off just "walking away" from their mortgage instead of making payments on an asset of steadily decreasing value. Who wants to make monthly payments on a $500,000 mortgage when the current value of the house is $350,000? It's easier to pack the kids and vamoose then waste a lifetime as a mortgage slave. Besides, the Bush administration has no interest in helping the little guy stay out of foreclosure. Its a joke. All of the rescue plans are designed with just one purpose in mind; to save Wall Street and the banking establishment. Period.
There is a widespread belief that Bernanke has been proactive in addressing the turmoil in the credit markets. But it's not true. The Fed chairman has simply responded to events as they unfold. The collapse of Bears Stearns came just weeks after the SEC had checked the bank's reserves and decided that they had sufficient capital to weather the storm ahead. But they were wrong. The bank's capital ($17 billion) vanished in a matter of days after word got out that Bear was in trouble. The sudden run on the bank created a risk to other banks and brokerages that held derivatives contracts with Bear. Something had to be done; Rome was burning and Bernanke was the only man with a hose.
According to the UK Telegraph: "Bear Stearns had total (derivatives) positions of $13.4 trillion. This is greater than the US national income, or equal to a quarter of world GDP - at least in "notional" terms. The contracts were described as "swaps", "swaptions", "caps", "collars" and "floors". This heady edifice of new-fangled instruments was built on an asset base of $80bn at best.
On the other side of these contracts are banks, brokers, and hedge funds, linked in d