General & Special

 (***)Our Risky New Financial Markets Tremors from America's quaking subprime mortgage market have spread throughout the financial world. This latest disturbance in global financial markets is neither isolated nor idiosyncratic. It points to deeper, enduring changes in the structure of our markets -- changes that have profoundly altered the behavior of market participants in ways that tend to encourage risk-taking beyond prudent limits. Just as troubling is the failure of official policy makers to effectively rein in such excesses, leaving our financial system vulnerable to similar turmoil in the future. The principal structural driver behind this and similar financial tribulations is the massive growth of financial markets, combined with a plethora of new credit instruments. By any measure, current financial activity -- new financing or secondary market trading volume -- dwarfs the past. The outstanding volume of nonfinancial debt now exceeds nominal GDP by $15 trillion, compared with $6 trillion a decade ago. Traditional credit instruments such as stocks, bonds and money-market obligations have been joined by a long and diverse roster of new obligations, many of them extraordinarily complicated. Along with the arcane tranches of mortgages that recently garnered attention are a myriad of financial derivatives, ranging from those traded on exchanges to tailor-made products for the over-the-counter market.

Fear makes a welcome return “At particular times a great deal of stupid people have a great deal of stupid money. . . At intervals. . . the money of these people – the blind capital, as we call it, of the country – is particularly large and craving; it seeks for someone to devour it, and there is a ‘plethora’; it finds someone, and there is ‘speculation’; it is devoured, and there is ‘panic’.” Walter Bagehot.*

Panic follows mania as night follows day. The great 19th-century economist and journalist, Walter Bagehot, knew this better than anybody. Lombard Street, his masterpiece, is dedicated to the phenomenon. It is devoted, too, to how central banks should deal with its results. Ours has been a world of the “no income, no job, no assets” 100 per cent mortgage; of the “do what you like with our money, as long as you pay the fees” covenant-light loan; and of the “in go poor credits and out comes a triple A-rated security” financial alchemist. It has been a world of confidence, cleverness and too much cheap credit. This is not new. It is as old as financial capitalism itself. The late Hyman Minsky, who taught at the University of California, Berkeley, laid down the canonical model. The process starts with “displacement”, some event that changes people’s perceptions of the future. Then come rising prices in the affected sector. The third stage is easy credit and its handmaiden, financial innovation. The fourth stage is over-trading, when markets depend on a fresh supply of “greater fools”. The fifth stage is euphoria, when the ignorant hope to enjoy the wealth gained by those who came before them. The warnings of those who cry “bubble” are ridiculed, because these Cassandras have been wrong for so long. In the sixth stage comes insider profit-taking. Finally, comes revulsion.

Hold tight: a bumpy credit ride is only just beginning Central bank intervention last Friday to inject liquidity into the global financial system did not mark the beginning of the end of financial market turmoil. It was merely the end of the beginning. Liquidity injections will not deliver lengthy respite. The next phase of market volatility will be more vicious than before, led by downgraded ratings on credit instruments and followed by further dislocation in the credit markets that will spill over to equity markets.

Credit markets are the big brother of equity markets. In the US and Europe, capitalisation of private debt securities is a combined $28,000bn (€21,000bn, £14,000bn), compared with $23,000bn in equity markets. Although rating downgrades will be a consequence of existing anxieties about credit quality, they will have knock-on effects. Substantial parts of the credit markets are priced off these ratings. This presents rating agencies with serious conflicts of interest that will move centre stage when investors start looking for a scapegoat. Rating downgrades will convert risks into losses. Lossmaking credit funds will suffer redemptions, forcing fund managers to dump well-performing parts of their portfolios as well. Loan covenants will require rated entities to inject liquidity on a downgrade. Where central banks are pushed to ease liquidity more aggressively than their inflation objectives may suggest, currencies will weaken. The yen will rebound.

Those who are older than the trading floor average will have seen this before. But what makes this credit cycle more complicated and perhaps more hazardous is the very thing that the former Federal Reserve chairman Alan Greenspan and others argued had made financial systems safer: the securitisation of credit. Securitisation brings benefits. But in these circumstances it will make the down cycle more severe and will transmit systemic risks along untraditional paths that may prove less sensitive to interest rate cuts than in the past.

·         Moody's Warns of LTCM-Scale Hedge Fund Collapse as Debt Market 'Seizes Up'

You know you’ve arrived when your central strategic concerns get major NPR coverage.

·         Central Banks and the Moral Hazard of Bad Bets Morning Edition, August 14, 2007 · The Federal Reserve injected $62 billion into the banking system last week, and $2 billion Monday, in the hope of calming credit worries. The next step to help the economy: to lower interest rates, says Bob Rose, executive editor of Smart Money. The European Central Bank and the Bank of Japan have intervened with large doses of cash as well. But the role central banks have in stabilizing markets is complicated, as Rose told NPR's John Ydstie. While sending the message that it doesn't want a recession, a move to cut rates would "essentially bail out people who have made bad decisions, or taken risks — and the risks have blown up," Rose said. The result, Rose says, is that the Fed is walking a fine line, between maintaining order in the markets and solving the problem too soon — which could encourage more speculation and irresponsible behavior.

·         Credit Crunch Could Stall Private-Equity Deals All Things Considered, August 7, 2007 · The end of easy credit is hitting private equity firms especially hard. These are companies that aren't traded on the stock market and have fewer regulations — such as government-mandated earnings reports. They often produce huge returns, buying other companies on the cheap, hoping to sell them later for a profit. Philip Coggan, capital markets editor for The Economist, talks with Andrea Seabrook about the effects of worries about defaults on private equity acquisition.

And you’ve really made the big time when you get covered on MSN Money in the column specifically written for beginners !

• How analysts missed a meltdown The case of now-bankrupt American Home Mortgage shows why you can't wait for the experts. By the time many Wall Street analysts said sell, the company was collapsing.

Poole Says Only `Calamity' Would Justify Rate Cut Now -- William Poole, president of the St. Louis Federal Reserve Bank, said the subprime mortgage rout doesn't threaten U.S. economic growth, and only a ``calamity'' would justify an interest-rate cut now. Poole, who confers regularly with regional business contacts, said in an interview yesterday that ``no one has called up and said the sky is falling.'' The best course is for officials to assess economic figures, including the August jobs report, when they next convene on Sept. 18, he added. The comments suggest a reduction at or before the September meeting isn't the certainty that futures traders assume. Reports this week showed increases in retail sales and industrial production in July, while exports surged the prior month. Economists predict that revised government figures will show growth in the second quarter exceeded 4 percent. ``It's premature to say this upset in the market is changing the course of the economy in any fundamental way,'' Poole, 70, said in the interview at the bank's St. Louis headquarters. ``If the Federal Reserve were to act when it turns out there is no impact, then clearly the market would say these guys really don't have the intelligence they need to have a policy actually based on solid evidence.'' His comments were the first by a Fed official since the U.S. central bank joined counterparts in Europe and Asia to inject emergency funds after a surge in money-market rates. The Fed has added $71 billion of reserves in the past five trading days.

·         Fed Cuts Discount Rate to 5.75 Percent to Ease Credit Crunch -- The Federal Reserve, in an unscheduled announcement, cut its discount rate and said it's prepared to take further actions to ``mitigate'' damage to the economy from the rout in global credit markets. The central bank reduced the rate at which it makes direct loans to banks by 0.5 percentage point to 5.75 percent. Policy makers kept their benchmark federal funds rate target unchanged at 5.25 percent. It's the first reduction in borrowing costs between scheduled meetings of the Federal Open Market Committee since 2001 and Ben S. Bernanke's first as Fed chairman.

Investment & Markets

CDOs: Waiting for the Next Shoes to Drop From a risk management perspective, MHP and MCO look a lot more fragile when it comes to financial and reputational exposure than do leading investment banks focused on the mortgage sector like BSC or Lehman Brothers (NYSE:LEH). Unlike a financial institution, publishing companies such as MHP and MCO lack the capital cushion and access to liquidity with which to absorb large financial losses. Even though the ratings agencies reportedly charged up to three times the customary fees for CDO ratings, this compared to the fee charged for a similar size bond issue, there still is not enough money in the proverbial cookie jar to offset the added risk from these complex structured assets. Indeed, wouldn't it be a delicious irony if one or both of the major ratings agencies were forced into bankruptcy due to legal claims made regarding CDOs? As Bloomberg noted back in May of 2007: "When it comes to CDOs, rating companies actually do much more than evaluate them and give them letter grades. The raters play an integral role in putting the CDOs together in the first place." The illusion of an investment-grade credit rating resulted in roughly a trillion dollars worth of subprime and other non-investment grade mortgages being packaged and sold to the Buy Side. We discount the recent market upset that has seen some commentators claim, irresponsibly in our view, that CDOs have little or no value. If you consider the situation more calmly, then a haircut of 25-30% or some $250 to $300 billion in aggregate principal loss, seems reasonable to us -- at least for starts. And that's just the basic loss, not counting punitive damages and costs.  Given the above estimate of aggregate losses to the Street, the bad news coming from BSC seems just the beginning. True, the folks at BSC have been generating headlines, but there are still dozens of Sell and Buy Side firms that have yet to come to Jesus when it comes to the CDO fisasco. We are still very early in the process of unwinding the excesses of the past several years. Bottom of the first inning, to be precise.  But that does not mean that the Sell Side firms are standing still. One well-placed reader of The IRA reports that the top Sell Side firms are closing down a couple of hedge funds a day in an effort to staunch the bleeding from CDOs.

·        Moody's, S&P Lose Credibility on CPDOs They -- Moody's Investors Service and Standard & Poor's, the arbiters of creditworthiness, are losing their credibility in the fastest growing part of the bond market. The New York-based ratings firms last month gave a new breed of credit derivatives triple-A ratings, indicating they were as safe as U.S. Treasuries. Now, investors are being offered as little as 70 cents on the dollar for the constant proportion debt obligations, securities that use credit-default swaps to speculate that companies with investment-grade ratings will be able to repay their debt.

·         An ECB Put?  Both the European Central Bank and the Federal Reserve intervened heavily in money markets last week to keep short term rates from shooting higher as the supply of interbank funds was constricted. The ECB’s intervention meant banks weren’t forced to borrow at penalty rates, and the Fed could have intervened more effectively by offering unlimited funds at the Fed funds rate, says Robert Eisenbeis, retired research director at the Atlanta Fed. In his time in that position, Mr. Eisenbeis advised the Atlanta Fed president on monetary policy, periodically listened in on the daily morning call between senior Fed staffers and the New York Fed’s open markets desk, and studied the European banking, monetary and financial regulatory systems. Here are his thoughts:

Goldman Wagers On Cash Infusion To Show Resolve Goldman Sachs Group Inc.'s injection of $2 billion into one of its flagging hedge funds opens a new window on the difficulties even some of the world's premier financial players are having as credit-market anxiety infects a widening circle of investors.After a week when financial markets were spooked by losses in several Goldman funds -- among other startling setbacks in the financial world -- the big investment bank yesterday said three of its funds have seen the net value of their assets fall a total of about $4.7 billion so far this year.Goldman announced just before New York's financial markets opened that it led a high-profile group putting $3 billion into Goldman's Global Equity Opportunities Fund. The fund, worth $3.6 billion before the new money arrived, lost more than 30% of its value last week during one of the market's most turbulent stretches in years, Goldman said. The move, which the firm described as a solid investment that will pay off in time, helped calm markets. But it also amounts to a bold gamble by one of Wall Street's most respected names: By drawing attention to its conviction that this is a turning point -- and by bringing some heavyweight investors on board -- Goldman is betting it can shore up confidence in one of the worst-hit areas of the market and pave the way for a rebound.

• Goldman `Quant' Fund Reduces Fees to Woo Investors After 28 Percent Drop
• Goldman Says `Quant' Funds Need Different Strategies After August Losses

The Market's Persistent Uncertainty

Each generation imagines itself to be more intelligent than the one that went before it, and wiser than the one that comes after it.
-George Orwell
Seldom does the market thread the needle and hook the shorts as it did on Monday's open and then let them off the hook so quickly, unless there is serious liquidation backstopping the bears. And as a serious change in character: the back of the sell-the-rally mentality has not been broken. It has not even been bruised. Markets around the world attempted to respond to Fed injections but the reality is that many of the best and brightest funds are in trouble and down on the year. Consequently, every rally attempt is viewed as an opportunity to sell.
With risk managers assuming a refreshingly novel role of actually managing risk, every rally must be sold: it's a case of machine bites man, man bites machine. No one wants to be a hero with financial tomahawks zipping through the air lest they lose their scalps or worse, their jobs. If Wall Street doesn't like uncertainty, it abhors chaos. Although the wagons may have been temporarily circled, it seems no one can positively, absolutely connect the dots according to the brave new world of Stat Quant. It seems no one can truly explain the DNA of some derivatives' incestuous ancestry and the havoc their mutated offspring may provoke. No one wants to be a hero here: where once financial pioneers staked claims, now investment bankers see the plains littered with the bodies of pioneers. No one wants to get trampled by the march of the machines, the regime of the Black Boxes goose-stepping through Tape Town.

Mid-Market Deals Feel The Credit Crunch, Too Middle-market buyout deals are experiencing the same problems raising debt as their multi-billion-dollar counterparts, with a number of smaller deals having trouble securing debt at the desired prices and some deals being pulled altogether. At least 10 outright buyouts, dividend recapitalizations or debt refinancings are having a difficult time finding buyers for their paper, according to several middle-market lenders. Among the deals having trouble are MidOcean Partners' buyout of Bushnell Outdoor Products Inc., a maker of binoculars, telescopes and other optical equipment; as well as Graham Partners' planned purchase of Schneller Inc., a maker of decorative laminates, these people said. The credit crunch is similar to the problems that some mega-buyout shops are having raising debt to fund multi-billion dollar deals, such as the buyouts of First Data Corp. and Chrysler Corp., as problems in the subprime mortgage markets have essentially frozen the debt markets. Traditional mid-market lenders, like collateralized loan obligation funds, or CLOs, are reducing their commitments, while banks and other lenders are demanding more conservative capital structures and better prices. "Leverage is moving down a bit, while cost is moving up," Daniel Duffy, co-president of the corporate finance group at CapitalSource Finance LLC, said. Lenders say the upper limit for digestable debt ratios is now around 4.75 times earnings before interest, taxes, depreciation and amortization, down from some 6.2 times Ebitda in the second quarter, according to Standard & Poor's Leveraged Commentary & Data. The new level is more in line with multiples seen in 2005 and 2006.

Private equity still drawing big investors Even as the debt crunch is putting deals on hold, long-term investors are still flocking to buyout funds. -- Amid the freeze on private equity deals, big investors like pension funds and college endowments are still plowing money into buyout funds, suggesting they still see opportunities for outsized returns. Buyout funds have already raised $139 billion globally so far this year and are on pace to exceed the $212 billion raised in 2006, according to London-based research house Private Equity Intelligence.

Another record year of fundraising comes just as the buyout boom has come to a grinding halt. A push back in the debt markets that began in late June has erupted into a full-blown credit crunch, with financing for leveraged buyouts now at a standstill.

Credit crunch: Blackstone smells opportunity President Tony James says the private equity firm has an eye on debt that has been oversold in the market.-- The debt markets may be creating trouble for some leveraged buyout deals, but private equity titan Blackstone is sniffing out opportunities. The private equity firm is keeping an eye on the debt of buyout deals that have come under financing pressure, Blackstone President and Chief Operating Officer Tony James said Monday.

• Beazer's Rocky Ride Set to Continue Beazer's recent disclosure of accounting irregularities is expected to accelerate an SEC probe of the home builder.
• Countrywide's Woes Multiply Countrywide shares fell 13% after a Merrill analyst issued a sell rating and fueled worries about the mortgage-lender's ability to cope with the credit crunch.
• Countrywide Taps $11.5 Billion Credit Line to Shore Up Its Available Cash

Quant quake shakes hedge-fund giants Goldman, Renaissance, AQR see losses, but also sense opportunity. -- Some of the largest firms in the $1.5 trillion hedge-fund industry have been hit this month by big losses among so-called quantitative funds, which use computer models to generate trading ideas. The turmoil reached "historical" proportions last week, according to one hedge-fund executive, but now many of these same firms are saying there's money to be made when dislocated markets recover.

• A Crisis in Parallel Universe Greed and financial recklessness in the online universe doesn't look all that different than they do in the real world, as shown by the meltdown of Ginko Financial -- which exists only in cyber world Second Life.
• Did 'Quants' Miss the Boat on LBO Boom? Quant fund managers and the models they use to find market-beating stock trades may have missed something everyone else noticed -- the LBO boom.
• KKR Financial Slumps After Firm Sells Mortgage Loans at $40 Million Loss
• A KKR affiliate sought to delay repayment of $5 billion in short-term debt held by 15 money-market funds as the mortgage crisis hit the Wall Street titan

Asia Decoupled? Now There's a Subprime Concept: -- So, Asia finally unshackled itself from the U.S. economy. Riiiight! Financial contagion oozing from the U.S. wiped out the Nikkei 225 Stock Average's gains for the year; that benchmark was down 7.2 percent this year as of 2:14 p.m. in Tokyo. The Morgan Stanley Capital International Asia-Pacific Index lost 2.5 percent on Wednesday alone. Arguments that Asia has decoupled from the U.S. suddenly look, dare I say, rather subprime.  Yes, Asia is a very different place than a decade ago. Banks, Japan's included, are healthier and carry significantly less debt. On top of that, the region amassed some $3 trillion of currency reserves. Asia has so much cash available to fend off crises that government investment funds are being created to take more advantage of it. That's just one of the many ironies a decade after Asian's financial crisis. Another is how U.S. woes now threaten Asia, not the other way around. One more is that Asia may soon be gobbling up distressed U.S. assets, the way U.S. investors did in Asia in the late 1990s. First, though, Asia's export-dependent economies must gauge just how much damage their growth will get from the U.S. troubles.

·         Yen Rises to Highest Since 2006 Against Dollar; Investors Flee Carry Trade

·         Global Stocks Tumble on Credit Concern, Led by Deutsche Bank; Bonds Climb