There are a lot of uncertainties permeating the market right now, not the least of which is healthcare reform. Will that reform entail a public option that could add $1 trillion to the deficit?  How is reform going to be financed?  And is it going to mean higher costs for employers across the board, or just the healthcare insurers?

Investing is made infinitely more difficult when 18% of U.S. gross domestic product (GDP) is hanging in the balance.

And you still have to consider:

• That unemployment is likely to keep rising, perhaps over 10%.
• That the U.S. Federal Reserve’s policy of quantitative easing is slowing down.
• That there is almost certainly a second wave of home foreclosures on top of the current commercial real estate epidemic.
• And that retail sales are still a long way from recovery.

There is also reason to believe that the U.S. dollar will continue to be weak, though it probably won’t sell off precipitously.

The U.S. dollar has weekend against the Euro lately, having fallen 0.8% Friday.  Technically speaking the chart shows a traditional “cup and handle” formation that could lead to an acceleration of the dollar’s downward trend.  Gold prices, up about 13% Friday, confirm this trend and could soon break through the $1000/oz resistance.

Fundamentally, if the economy – encumbered by high unemployment and a relapse of the housing market – does not pick up the dollar could be further imperiled.

Weakness in the dollar will also be affected by the Fed’s withdrawal of liquidity, which is likely to proceed at a gradual pace.

Finally, diversification away from the dollar among the world’s central banks is taking place, albeit at a slower pace than many analysts have suggested, and that too, is weakening the dollar.

Let’s concede that there is no currency that could supplant the dollar as the world’s major reserve currency. So, it’s unlikely that the world’s central banks will simply abandon the dollar anytime soon. However, we must also acknowledge that a reduction in the weightings of the U.S. dollar within central bank reserves is already underway.

An Aug. 14 article by BNP Paribas currency strategist Ian Stannard in Euromoney recently described this gradual shift in currency reserves.  The article noted that only 62.5% of global currency reserves are in U.S. dollars, down from about 66% in 2005.

So I do not anticipate a sudden shift in central bank reserves, but rather a continuation of the measured restructuring we’ve seen so far. Thus, the slow weakening trend in the U.S. dollar is likely to continue.

So, in this very uncertain investment scenario, I prefer to go for more secure returns in bonds.  And we can achieve great diversification at a cheap cost with the iShares iBoxx $ Investment Grade Corporate Bond Fund (NYSE: LQD).

For starters, its weighted average coupon of 6.26% offers a current yield slightly north of 6% at today’s prices.  Investors are assuming interest rate risk, which means that if interest rates climb, the value of the bond has to come down.  But in the short term, there is no immediate threat of inflation.

Looking at the major holdings of the fund – which has no single position that accounts for more than 1.26% of its total holdings – I see some names that have demonstrated continued stability and others that have shown recent signs of improvement, such as American Express Co. (NYSE: AXP).  So I do not expect any major credit spread hiccup here.  I certainly do not see any hiccup that a 6.26% coupon would not compensate for.

For an additional hedge against dollar weakness, I suggest you revisit my June 8 recommendation of the iShares SPDR Gold Trust ETF (NYSE: GLD). You may also consider buying a bit of the PowerShares DB US Dollar Index Bearish (NYSE: UDN) fund.  Do not go overboard. Err on being light, rather than heavy on hedging, since timing currency moves is very difficult.

Recommendation: buy iShares iBoxx $ Investment Grade Corporate Bond Fund (NYSE: LQD) at market.  Consider hedging part of the US dollar risk by buying the iShares SPDR Gold Trust ETF (NYSE: GLD) and PowerShares DB US Dollar Index Bearish (NYSE: UDN). Both funds should account for a fraction of your position.  Have a 5% stop loss on UDN (**).

Source: Buy, Sell or Hold: The iShares iBoxx $ Investment Grade Corporate Bond Fund

Obama as Prime Mover will have to turn the chaos in America’s housing and mortgage market into harmonious order. Then He has to single-handedly leap a tall legacy of toxic assets in a single bound, freeing up banks to lend by buying all of their dodgy assets.

It’s a big ask. But if anyone can do it, He can. Especially when He’s got America’s credit rating to abuse!

Reordering the financial universe is not cheap. It takes a lot of energy and a lot of matter in the form of new U.S. dollars. Reuters reports that, “Goldman Sachs estimated that it would take on the order of $4 trillion to buy troubled mortgage and consumer debt. That number could shrink if the program were limited to only certain loans or banks, but it could also grow if other asset classes such as commercial real estate loans were included.”

How much is $4 trillion? “At $4 trillion, that would be the equivalent of nearly 1/3 of U.S. gross domestic product. If the government had to fund that amount by issuing additional debt, it would intensify investor concerns about massive supply scaring off demand.”

Yes. You can imagine the world’s main owners of dollar-denominated reserve assets (China, Japan, the Petro states) would be intensely concerned about a $4 trillion increase in dollar denominated debt. But wait a tick…

It’s one thing to say you might need to float as much as $4 trillion in debt to fund your bad bank. It’s another thing to sell that debt? Who will buy it? Even these days, $4 trillion is a lot of capital to loan. Maybe that number has been floated to make a smaller number, say $2 trillion, look small by comparison.

Good news everyone! The Bad Bank is going to cost us half as much as we thought!

If the ‘big bang’ goes off this week, what will it mean for Planet U.S. Dollar? Or Planet Gold? Well, as our friend Steve Belmont in Chicago reported on Friday, gold is moving toward a day of reckoning after trading in a range for the last ten months. It will either break out much higher, Steve says, or buckle. We’ll be watching.

Did you notice the obnoxious change in political rhetoric this weekend? You knew Barrack Obama was going to give it to Wall Street, calling executives “shameful” for getting bonuses while their firms received TARP money. Remember, by the way, the TARP money was forced on some firms in an effort to boost confidence in the overall plan.

We normally try to keep a reserved, ironic, and sceptical air when reading the statements of politicians. Most of them are not worth taking seriously. But every once in a while, you get the scent of something so noxious and dangerous that you have to put aside humour and call it what is. Today is one of those days.

Now, the populist shame game is to be expected. That’s not a big deal. What’s more alarming is the bilge and claptrap spilling from Kevin Rudd’s gob and what it may mean for your ability to preserve and create wealth in the coming years.

In The Monthly, Rudd plants a Neo-Marxist flag in the ground of the current debate with the kind of jargon-laden elitist preening that makes academic critics of the free market (who’ve never spent a day in the business world creating value) so nauseating.

Specifically, Rudd writes that, “The time has come, off the back of the current crisis, to proclaim that the great neo-liberal experiment of the past 30 years has failed, that the emperor has no clothes. Neo-liberalism, and the free-market fundamentalism it has produced, has been revealed as little more than personal greed dressed up as an economic philosophy.”

Why not proclaim, since he is apparently in the position to make such proclamations, that the experiment in paper money and the deliberate policy of inflation it implies is theft? It is bureaucratic lust for power and authority disguised as monetary policy? It’s also, at its heart, the belief that one or a few people in government know better than you how you should lead your life.

Leave it to Rudd and the resurgent global Left to use the present crisis as an occasion to expand their political ideology of government power and wealth confiscation. Despite the fall of the Berlin Wall in 1989, Marxism never really went away. It ensconced itself in Western universities and colleges, and in the careerism of the political class, which believes it is entitled to govern by virtue of its intellectual superiority and the moral justness of its anti-market position.

Their strategy, as always, is to control the rhetorical high ground by framing the discussion in populist terms and making an enemy of “greedy capitalists.” Don’t get us wrong. There are plenty of greedy capitalists to go around, or to go to jail. In fact, many more of them would be going out of business if the government would quit propping them up with taxpayer money. This generation of corporate executives shares plenty of blame for playing fast and loose with the corporations they were supposed to be stewards of. They over-levered, over-speculated, and over-paid themselves.

But Rudd is an ignoramus of the lowest order to say that current events somehow negate the last thirty years of globalisation, or three hundred years of economic growth and the division of labour. Tens of millions have been lifted out of poverty. Hundreds of millions have more economic and political freedom than ever before.

These results can only be the product of a system in which risk taking entrepreneurs have access to capital and savings, allocated through competitive markets where firms that deliver real value to consumers thrive and those that don’t fail. That system has worked for 300 years of Western history to create wealth, choice, and opportunity.

Shame on Kevin Rudd for calling that “market fundamentalism”, as if belief in the institutions that create wealth and liberty is akin to the same kind of religious fundamentalism that permits suicide bombing. If there is a more offensive use of rhetoric to equate two vastly different things, we haven’t seen it.

But the Neo-Marxists are back on the march. And they are probably coming for your wages and pension sometime soon. Make no mistake about it. 2009 is the year the Neo-Marxists have been waiting for.

It is their chance to undo all the perceived evils of Thatcher and Reagan. There would be plenty of those to undo, of course, not least the idea that deficit spending is morally permissible. But the real push by the Neo-Marxists is to use the present occasion to expand the scope and reach of government power into your private life, so they can tell you what to do, what to watch, what to eat, what car to drive, and ultimately, what to think or say.

This will be disguised as better more “parental” regulation to achieve more equality and social justice. But behind the false populist outrage and the elevated language of idealism, it’s just another push for government elites to expand their ability to compel you to live the life they think you should lead.

The simple regulatory response to all this is to reduce the amount of leverage available to financial players. Reduce margin lending in shares. Let bankers get back to making prudent loans in the housing market based on what a buyer can actually repay, rather than letting the government subsidise subprime lending because it’s politically desirable.

There are other sensible regulatory responses to the mess. But they will be discarded in favour of grandiose and over-reaching plans to redesign the entire world in some utopian image. A “big bang”? Really. Does that mean they’re going to blow things up and call it a “fix?”

What we’re getting at is that it’s going to be a tremendous challenge to withstand this push in the next few years, mostly because it will have so much popular support from people with no brains who believe in fine sounding speeches and appreciate getting tax rebates/credits/handouts from the government. The first battle in the war on wealth creation is wealth redistribution, whether you like it or not.

It would be more honest if the Left just came out and said something like, “The last ten years have been a huge wealth transfer from the middle class to Wall Street and from the developing world to the developed world. We’re going to try and reverse all that now because we know it’s our best shot in the last thirty years to get some back. So here we come! Open your wallet and shut your mouth!”

Neo-liberalism isn’t the culprit in all this. What does that word even mean? Isn’t Rudd using it because it sounds like Neo-Conservatism? And everyone knows that Neo-conservatism is evil, therefore Neo-Liberalism must be evil too!

The real evil of the last thirty years is the vast expansion of credit in the world that changed personal and corporate incentives. The plunge in the cost of capital-encouraged by governments and Central Banks-set of an orgy of bad risk taking, quietly condoned by regulators and politicians who all benefitted in some way from housing/commodity/trade booms.

But now the credit cycle has turned. The Credit Depression is upon us. And Comrades Rudd and Obama will try and use it for the next great push in the Neo-Marxist dream, one world government with one world currency. More on that tomorrow!

Source: Marxism Marches On

The decline of the global financial services industry from its unsustainable 2006 peak may produce a similar effect in a once economically thriving country – Britain.

Thirty years ago, Britain had its own rust-belt problems. The British automobile industry, a shining star until the Morris Motor Co.’s Lord Nuffield died in 1963 (remember 1959’s hot new model, the Mini?), was subjected to a series of government-directed merger deals in the 1960s, and the resulting mess, British Leyland, was nationalized in 1975, amid appalling losses.

The steel industry was nationalized in 1950, denationalized in 1954, and nationalized again in 1965; not surprisingly, the political football became a byword for high costs, strikes and inefficiency. Even Rolls-Royce Ltd., Brian’s premier high-tech company and maker of both luxury automobiles and aircraft engines, was effectively bankrupted and forced into public ownership in 1971.

In 1979, however, Margaret H. Thatcher became prime minister. Whereas her American contemporary, U.S. President Ronald Reagan, had little direct effect on U.S. industry, Thatcher had a huge direct effect on the shape of the British economy – she had little option, since the government owned so much of it. She forced British Leyland to shrink drastically, privatized British Steel, British Telecom and Rolls-Royce, and dramatically downsized British Coal after a yearlong face-off with the miners union.

At the same time, she deregulated the City of London’s financial-services business on a supposed “level-playing-field” basis, allowing foreign banks to dominate it and effectively putting the 200-year-old London merchant banks out of business.

Thatcher’s restructuring of British manufacturing, together with her tax cuts and government spending restraint, put Britain on a growth path that lasted a generation. Even after her Labour Party political opponents under Tony Blair gained power in 1997, growth continued, although government spending began creeping back upwards, and is now slightly above its 1970’s peak as a percentage of the economy.

Her restructuring of the City of London brought immense wealth to London itself, as huge global banks deployed increasing amounts of resources to growing their London-based international finance businesses. By 2006, London was rivaling New York as a financial center, even though the base of British domestic business was a fraction of that available from the giant U.S economy.

Traders, hedge fund managers, private-equity managers and dealmakers in general were paid fabulous sums. Since London residents were not liable to British tax on their non-U.K. income, the city also attracted footloose glitterati of all kinds, from the Indian steel billionaire Lakshmi Mittal to the seedier but immensely rich top members of the Russian mafia.

In the United States, financial services doubled its share of gross domestic product (GDP) and trebled its share of Standard and Poor’s 500 Index profits between 1980 and 2006; in London, the growth was even greater and its dominance of the economy more extreme. House prices, too, became far more overblown in Britain than in any but the most speculative areas of the United States.

The 2006 celebrations of the twentieth anniversary of the Financial Services Act of 1986, Thatcher’s deregulatory bombshell, rejoiced in London’s newfound wealth, sneered at the relative impoverishment of Britain’s provinces and missed one key weakness of the economy: Almost none of the major institutions generating such fabulous wealth were owned or headquartered in Britain.  When London-based “masters of the universe” wanted to speak to those controlling the huge amounts of capital they deployed, they had to pick up the phone to New York, Frankfurt, Paris, Tokyo or Dubai.

Now, the financial services business is in trouble. What’s more, the parts of the business in which London specialized are in most trouble. Securitization and derivatives were the two immediate causes of the credit crisis, while the 50% declines in the emerging-market stock markets have made the exorbitant fees of the private-equity and hedge-fund managers seem extortionate.

It is now abundantly clear that the financial services sector has incurred gigantic losses and that even when those losses have been subsidized by some unfortunate group of taxpayers, the sector is likely to end up being far smaller than it was. In fact, as a share of the economy the sector will probably end up being only a little larger than it was back in the 1970s.

For Britain, this has three appalling costs.

First, the assets of its financial services sector are around 400% of its GDP, below only the much smaller Iceland, Switzerland and Ireland and twice the U.S. ratio (and most Swiss banks were notably cautious in the bubble). Because of the importance of Britain’s financial sector, its bank bailouts need to be nearly as large as those in the United States, yet its tax base is only one quarter the size.

Second, the downsizing of financial services will produce an immensely damaging decline in British asset prices, particularly those of London and southeast England housing, in which so many middle-class Britons have invested their entire life savings (investing in the stock market is much less embedded there than it is here in the United States). That will have a further unpleasant effect on bank loan portfolios, pension and insurance assets and the British tax base, which will deepen the economic downturn.

Third, and most serious, since the British financial services sector is almost entirely controlled from overseas, there is very little long-term reason why it should remain in Britain. After all, it’s not as if London’s climate is particularly attractive except to aficionados, while its infrastructure is appalling.  The product areas in which London-based houses appeared to have a particular expertise have mostly been shown to be over-elaborate Ponzi schemes.

Even if the top management of a German, American or Japanese bank wishes to keep its stable of overpaid London financial whiz kids, it will have to deal with enormous shareholder and political opposition to do so. The Lehman Brothers Holdings Inc. (LEHMQ) bankruptcy, in which money was remitted at the last moment to the United States, so that London-based employees and creditors fared far worse than those in New York, is symptomatic of the “hollowing-out” process that is likely to continue for several years. Even the Russian mafia may find it prefers somewhere warmer.

Eventually, probably after a steep decline in the value of the British pound sterling and a major reorganization of the British economy, and at the cost of an enormous increase in British government debt, the inventive and entrepreneurial British will no doubt find new ways to make a living. In the meantime, I wouldn’t put my money there.

Source: Great Britain – The “Rust Belt” of Global Finance

This newest economic infusion follows a $700 billion banking system bailout package that was unveiled in late October. At least half the cash has been injected directly into U.S. banks and insurance companies, firing off a flurry of takeover deals – with more expected to come. And it precedes an anticipated package being designed by the new economic team that’s been assembled by President-elect Barack Obama. That package is still in its formative stages, but estimates of its ultimate size range from $500 million to $1.2 billion.

The $800 billion package unveiled by the Fed and Treasury Department yesterday consisted of several parts.

In one statement, the Fed announced it would purchase as much as $500 billion in mortgage-backed securities backed by the three government-chartered lenders: Fannie Mae (FNM), Freddie Mac (FRE) and Ginnie Mae. It will also buy another $100 billion in direct debt issued by those firms.

Beginning next week, the Fed’s primary lenders will auction off as much as to $100 billion of the housing-related debt. Selected asset managers will conduct purchases of as much as $500 billion of mortgage-backed security debt, hoping to have all those purchases completed by the end of the year.

“This action is being taken to reduce the cost and increase the availability of credit for the purchase of houses, which in turn should support housing markets and foster improved conditions in financial markets more generally,” the Fed wrote in a statement.

In a separate statement, the central bank announced the establishment of Term Asset-Backed Securities Loan Facility (TALF), a $200 billion program that will support asset-backed securities (ABS) – loans often taken for students, car owners, credit card holders and small businesses. One caveat: To be eligible, ABS exposure must be “newly or recently originated” by U.S.-based people and companies.

“Continued disruption of these markets could significantly limit the availability of credit to households and small businesses and thereby contribute to further weakening of U.S. economic activity,” the Fed said in its second statement. “The TALF is designed to increase credit availability and support economic activity by facilitating renewed issuance of consumer and small business ABS at more normal interest rate spreads.”

The Treasury Department will provide $20 billion of that from the $700 billion TARP initiative.

These packages are the latest in a series of aggressive rescue measures to unfreeze credit markets, but it also more than doubles the amount of debt the government is taking on.

“They’re trying to put funds into the system, trying to unfreeze these markets,” William Poole, the former St. Louis Fed president, said in an interview with Bloomberg Television. “Clearly, the Fed and the Treasury are beginning to take a large amount of credit risk.”

A Wider Target

Through TARP, the Fed’s initial efforts involved taking stakes in lenders – making investments of as much as $25 billion in such banks as Citigroup Inc. (C), in return for a special class of preferred shares that gives the government an ownership interest.

But instead of using the government money to resuscitate lending, banks are instead using it to gobble up weakened banks that didn’t get aid.

At the end of the day these buyout deals are bad ones no matter how you evaluate them, says R. Shah Gilani, a retired hedge fund manager, an expert on the U.S. credit crisis, and the editor of the Trigger Event Strategist, a newsletter that identifies trading opportunities emanating from financial-crisis “aftershocks.”

“Why in the name of capitalism are taxpayers being fleeced by banks that are being given our money to grow their businesses with the further backstop of more of our money having to be thrown to the FDIC when they fail?” Gilani asked. “Consolidation does not mean that bad loans and illiquid securities are somehow merged out of existence. It means that they are being acquired under the premise that a larger, more consolidated depositor base will better be able to bear the weight of those bad assets. What in heaven’s name prevents depositors from exiting when the merged banks continue to experience massive losses and write-downs? The answer to that question would be … nothing.”

These new federal measures focus on the wider target – the people and businesses whose collective debt defaults are hampering the lenders. Consumer spending accounts for 70% of U.S. economic activity. So any measures that induce consumers to spend could have an expansionary effect on an economic system that’s widely believed to already be in a recession.

“Nothing is more important to getting through this housing correction than the availability of mortgage finance,” U.S. Treasury Secretary Henry M. “Hank” Paulson Jr. said at a press conference yesterday, Bloomberg News reported.

And the onslaught on foreclosures have fueled a record decline in home prices, which actually dropped 17.4% in September from a year earlier, according to the S&P/Case-Shiller home-price index. Among the hardest-hit areas, Phoenix and Las Vegas lead with home prices falling 31.9% and 31.3%, respectively, The Wall Street Journal reported.

Miami, Los Angeles and San Diego were close behind, falling 28.4%, 27.6% and 26.3%, respectively.

Declining home and property values are crimping consumer confidence and, hence, spending.

Source: Fed Announces $800 Billion in Homeowner, Consumer and Small Business Aid

Fannie and Freddie, the nation’s two-largest mortgage holders, will target loans in which borrowers are 90 days or more delinquent, and have high loan-to-income ratios, Bloomberg News reported. The companies may offer homeowners reduced interest rates and longer terms of as much as 40 years to trim monthly payments. By rewriting the terms on some overdue loans, homeowners won’t have to pay more than 38% of their monthly income on housing payments, officials from the U.S. Treasury Department and the Federal Housing Finance Agency said at a news conference in the nation’s capital yesterday.

It’s the government’s most aggressive move yet in its battle to reverse the rising tide of mortgage defaults and home foreclosures, MarketWatch.com reported.

“Foreclosures hurt families, their neighbors, whole communities and the overall housing market,” said James B. Lockhart III, director of the Federal Housing Finance Agency. “We need to stop this downward spiral.”

The plan centers upon Fannie and Freddie because they are than operating under a government conservatorship, and because the two entities own or back roughly $5 trillion in loans, CNNMoney.com reported. The federal government took over the two government-sponsored enterprises back in September – not because of worries about the fading U.S. housing market, but because of concerns that foreign central banks in China, Japan, Europe, the Middle East and Russia might stop buying our bonds, a Money Morning investigative report showed. Fannie Mae on Monday reported a third-quarter loss of $29 billion.

The initiative expands efforts by the Hope Now Alliance, a group that U.S Treasury Secretary Henry M. “Hank” Paulson Jr. helped create last year. Hope Now is made up of investors, advocacy groups, and mortgage lenders and servicers such as Citigroup Inc. (C) and Wells Fargo & Co. (WFC). The past success rate for “curing” delinquent loans with modifications similar to what was proposed yesterday was about 50% for both prime and subprime mortgages.

“With such broad adoption, this new protocol will be a standard for the industry to quickly move homeowners into long-term sustainable mortgages,” Neel Kashkari, the U.S. Treasury’s interim assistant secretary, and the architect of much of the housing legislation aimed at easing the U.S. real estate crisis, said in a prepared statement.

MBA Chief Economist Jay Brinkman conceded that “we realize that a number of those can’t be saved because of the borrower’s situation. But if we can save half of them, that’s a good result.”

While a number of major banks – including Citigroup, JPMorgan Chase & Co. (JPM) and Bank of America Corp. (BAC) – have announced loan-modification programs in recent weeks, those financial institutions hold only a fraction of the nation’s mortgages compared with Fannie and Freddie.

Federal agencies have been slow to present their own plans to modify the loans of millions of “at-risk” homeowners – despite calls from congressional representatives and harsh criticism from housing advocacy groups. Those critics want the government to take a more direct role in preventing foreclosures.

Under the new program, mortgages on owner-occupied homes that are at least 90-days past due with a loan-to-value of 90% or more will be eligible for the streamlined modification, MarketWatch reported. Homeowners who are “underwater” – owe more on their home than it is worth – will be eligible. However, homeowners who purposefully default on their mortgage to get a modification will not be eligible. Borrowers who want to know if they qualify should contact the company they make their payment to each month – called the “servicer.”

To encourage them to take part in this program, these servicers will be paid a fee of $800 to modify loans.

Even with this program, the borrower ultimately still will be responsible for paying the full amount of the principal borrowed. The program is only designed to defer payment on part of that principal to make the monthly payment affordable, experts say.

Lockhart said the program would apply to loans guaranteed by Fannie or Freddie, including prime, Alt-A and subprime mortgages. Other kinds of loans may also be covered. Lockhart urged the private-label mortgage industry to adopt the modification plan as well, MarketWatch reported.
The program will start by Dec. 15.

Moody’s Economy.com (MCO) forecasts that even with loan modification programs, 1.6 million Americans will lose their homes this year either in a foreclosure or distressed sale, and another 1.9 million are projected to lose their homes in 2009, CNNMoney.com said.

Source: Government Rolls Out Long-Sought-After Anti-Foreclosure Program

With the nation’s economic landscape laid to waste, it should be no surprise that home foreclosures were soaring, too: Residential real-estate foreclosures doubled between 1926 and 1929 – before the Great Depression actually began. According to a new study by the Federal Reserve Bank of St. Louis, the foreclosure rate jumped from 3.6 per 1,000 mortgages in 1926 to 13.3 in 1933. In that year, in fact, 1,000 home mortgages were being foreclosed each day.

By Jan 1, 1934, as many as half of all residential mortgages were delinquent, putting them at risk of foreclosure.

Clearly something had to be done, elected officials believed. In an attempt to slow that surge, 27 states changed key laws in a way that created a temporary moratorium on foreclosures. Still other state and municipal governments passed permanent measures that made it tough for aggrieved lenders to foreclose on properties whose mortgages were delinquent.

With the benefit of hindsight, it’s not at all clear that the benefits of these moves outweighed the costs – many of which were unintended, says Daniel C. Wheelock, a St. Louis Fed economist and the author of the new research study, “Changing the Rules: State Mortgage Foreclosure Moratoria During the Great Depression.” The study appears in the November/December issue of the St. Louis Fed’s Review magazine, which covers national and international economic developments – especially when there’s a monetary impact.

“Governments cause both immediate and long-term effects when they rewrite the terms of contracts between private parties,” Wheelock wrote. “One immediate effect of mortgage-relief legislation during the Depression was reduced [disclosure rates on farms, which were being hit even harder than the residential real estate sector]. However, over the longer run, foreclosure moratoria and other changes in mortgage laws may have made loans costlier or more difficult to obtain” for future borrowers.

Indeed, the study shows that future borrowers had to face a marketplace where loan capital was in short supply and interest rates were sky high. Lenders made loans tough to get – and then charged a lot for them via high interest rates – because they needed to compensate for the very real possibility that these new laws would restrict their ability to foreclose on delinquent loans.

Fast-forward 74 years, to 2008. Nearly 1% of U.S. home mortgages entered foreclosure during the first quarter; by the time that three-month stretch came to an end, nearly 2.5% of all U.S. mortgages were in foreclosure.

And the news keeps getting worse. In the July-September quarter, 18% of all properties with a mortgage were “underwater” – that is, worth less on the market than what the owner owed on the loan, data supplier First American CoreLogic Inc. told BusinessWeek. It gets worse. That statistic represents more than 7.5 million properties, and another 2.1 million mortgages were within 5% of shifting “upside down.”

All told, nearly a quarter (23%) of U.S. mortgages were underwater or were in a near-negative-equity position. Nevada (48%) and Michigan (39%) led the nation with the highest percentages of negative equity, followed by Florida (29%), Arizona (29%), California (27%), Georgia (23%), and Ohio (22%).

In late July, U.S. President George W. Bush signed the Housing and Economic Recovery Act of 2008, whose provisions included a $300 billion increase in Federal Housing Administration loan guarantees – which were designed to induce lenders to refinance delinquent home mortgages.

A foreclosure-prevention mentality took hold, with loan modification plans and programs such as Hope for Homeowners becoming increasingly common, HousingWire.com reports. Such states as Massachusetts, as well as some local cities, have sought to put foreclosure moratoriums in place; federal legislators, too, have tried to get in the act.

A tentative Bush Administration plan aimed at keeping as many as 3 million homeowners who are behind on their mortgages from losing their houses will be difficult to administer, and could end up costing the country hundreds of billions of dollars more than the plan’s architects expect, a Money Morning contributing editor and credit-crunch expert says.

R. Shah Gilani, a retired hedge-fund manager and Money Morning contributing editor who is emerging as an expert on the worldwide financial meltdown, noted that the plan was apparently still that – a plan. Even so, he said that “any bailout plan that directly addresses foreclosures is political posturing that will ultimately be overwhelmed by inevitable economic realities.”

The plan – which would be part of the $700 billion banking-system rescue package the government approved early this month – would cost $40 billion to $50 billion, with the money being used to cover future losses on loans that are deemed eligible for federal support.

The New York Times carried the first reports of the Bush Administration’s new housing rescue proposal last Thursday. According to the newspaper report, this program would be the most sweeping and direct government initiative aimed at home-loan borrowers since the financial crisis started last year.

Unfortunately – at least with respect to the contentions made by the St. Louis Fed study – this program is a classic foreclosure-moratorium initiative.

As proposed, the federal government would incur half the loss on a home loan if the mortgage company that controls the loan agrees to lower the borrower’s monthly payment for at least five years. On any given loan, the mortgage company would reduce the payment borne by the homeowner by writing off part of the loan balance, reducing the loan’s interest rate or changing other loan terms, sources told The Times.

In this case, the devil truly will be in the details: Trying to take a massive rescue plan – and matching the benefits up with individual homeowners – may be just too much to ask, Money Morning’s Gilani says.

“Who will be eligible, how will that be determined, what will happen when prices continue to fall and mortgage holders eventually walk away” are just some of the tough questions a workable plan would have to answer, Gilani said. Plus, “is the government going to shackle them to their mortgages the same way they’re shackling taxpayers to all these other ill-begotten bailout schemes?

When it comes to the idea that money from the federal government’s Troubled Assets Relief Program (TARP) may be used to manage a bailout of troubled mortgages, all options are still on the table, and the plans under consideration have been stuck in the negotiating room for some time, HousingWire reported.

In a story earlier this week, The Wall Street Journal suggested that “disagreements over how to structure a federal foreclosure-prevention program are complicating and potentially delaying what is likely to be the Bush Administration’s last attempt to forestall sliding home prices.”

According to another HousingWire report, one plan that may be gaining some support is the idea of a federal subsidy for troubled borrowers. On Sunday night, a source near the Pennsylvania office of U.S. Sen. Robert P. Casey, D-Pa., provided the housing news service a copy of a memo that’s said to have sparked some of the ongoing negotiations now taking place.

The memo outlines the mechanics of a mortgage bailout that would cost as much as $441 billion, relying primarily on a three-year subsidy for troubled borrowers that would be repaid in five years, with interest. At that point, the participants would likely be able to sell their homes or refinance the mortgages at amounts that would enable them to repay the loan.

The subsidy plan reportedly represents the thoughts of Assured Guaranty Ltd. (AGO) Chief Executive Officer Dominic J. Frederico, who had been asked by legislators to provide his thoughts a few weeks earlier.

Other proposals are being studied, as well.

No matter what shape or form they take, however, Wheelock, the economist, warns that there will be a price to pay. There’s something to be said for allowing the marketplace to work – and an operational free market includes defaults and foreclosures, with the end result being that only the strongest borrowers remain in the end.

It’s a lesson we should have learned during the Great Depression, Wheelock says.

Wrote the St. Louis Fed economist: “The [foreclosure] moratoria reduced … foreclosure rates in the short run, but they also appear to have reduced the supply of loans and made credit more expensive for subsequent borrowers. The evidence from the Great Depression demonstrates how government actions to reduce foreclosures can impose costs that should be weighed against potential benefits.”

Source: Study of Great Depression  Shows Intervention Postpones Foreclosures, But Causes Mortgage Rates to Spike

And it gets worse. That increase in borrowing costs will spread to other parts of the global debt market, representing an across-the board threat to corporate, institutional and sovereign borrowers. If interest rates remain high and interbank lending remains tight, the credit crisis is not likely to recede.

This raises two key questions. Are desperate times prompting desperate measures? Is LIBOR being manipulated by banks that are trying to make their financial positions appear better than they really are?

If that’s the case, it’s one more reason the credit crisis will fester and spread undetected: The artificially low interbank lending rates removed a key “early warning” indicator, leading investors to believe the credit market was healthy when it actually wasn’t.

The Lowdown on LIBOR

LIBOR, or the London Interbank Offered Rate, is arguably the most important interest rate in the world. It is used to calculate the interest rates on hundreds of billions of dollars of corporate debt, mortgages and innumerable other loan products – including hundreds of trillions of dollars of derivatives.

It is important to understand that LIBOR is a “reference” rate, meaning it isn’t imposed on a borrower by any regulation or law. Developed in the middle 1980s, LIBOR is the benchmark rate banks use when they offer to lend unsecured money to other banks in the London wholesale money market.

LIBOR was created to make sure that banks that offer loans with “floating” – or adjustable – interest rates know just what their constantly changing cost-to-borrow actually is.

Lenders offering floating or adjustable rate loans typically charge borrowers a “spread” above LIBOR. When you hear: “Your cost on this loan is three-month LIBOR plus 5,” it means the lender is charging you the three-month LIBOR rate – plus an additional five percentage points. If three-month LIBOR is 4%, your actual rate is 9% (4% + 5% = 9%). If your loan re-sets in the future, it will do so based on the LIBOR rate that day – plus an additional five percentage points.

LIBOR is calculated for 15 different loan durations, ranging from overnight to a year, and is listed in 10 different currencies. For this discussion, we are focusing on only the dollar LIBOR rate, which is the rate, in terms of dollar borrowings, that banks theoretically charge each other when buying and selling dollars in the London market.

Each morning, “panels” of banks submit loan data to Thomson Reuters PLC (ADR: TRIN) in London, usually by 11:10 a.m. London time, and Reuters (a news, information, data and market quoting service corporation) calculates LIBOR, which is subsequently published each day by the British Bankers’ Association (BBA).

Subverting the System

That brings us to the current problem in the LIBOR market: As Money Morning has previously reported, there’s substantial evidence that LIBOR is being “managed.” This has been happening and the BBA is actively looking into it. In fact, several months ago, when the BBA announced it was speeding up its probe, LIBOR jumped.

The dollar LIBOR rate, or “fixing,” as it is known, is calculated based on the submission of quotes from 16 major world banks. The banks send in data as to what they paid, or could pay, to borrow from other banks at each maturity level. Reuters throws out the four highest and four lowest quotes, and calculates the average of the eight that remain to come up with the dollar LIBOR fixing.

If banks are seeking to charge one another higher rates, that’s telling us one of two things. Either:

• Banks don’t have excess cash to lend.
• Or they are unwilling to lend freely to other banks, which they fear are facing potential troubles because of bad loans, defaulted mortgages, and other pending hits to their capital and threats to their solvency. [Pending hits to capital could include anticipated higher foreclosure rates brought on by mortgage re-sets].

No bank wants to admit it is being charged a premium to borrow: That sends a bad signal. If a reporting bank submits data that shows its own borrowing costs are higher than average, it will very likely raise questions about that institution’s financial strength and stability – the kind of uncertainty that recently brought down such financial institutions as The Bear Stearns Cos. [now part of JP Morgan Chase & Co. (JPM)], and Lehman Brothers Holdings Inc. (LEHMQ).

So what might that bank do? Since the submitting banks providing data to Reuters are on the “honor system,” maybe this institution has an incentive to not submit its actual borrowing costs? Maybe this bank submits rates at which it could borrow – which it is permitted to do, by definition, under the submitting rules – if those rates are lower by virtue of only being a quote it received?

Maybe this bank – and the rest of its brethren – would like to keep LIBOR lower than the interbank rate should actually be, realizing that if rates rise, bad-loan exposure increases. And if bad-loan exposure increases, derivative exposure will escalate, too. What if U.S. ARM re-sets (based on LIBOR) bump up the interest-rate charges that already-strapped homeowners have to pay? What will more foreclosures do to already-battered bank balance sheets?

We already know the answers to those questions.

Since the interbank-lending markets here in the United States have not been freed up, the U.S. Treasury Department and the U.S. Federal Reserve have gone to extraordinary lengths to thaw out the frozen markets and get credit flowing across the economy. Included in their buckshot-pattern arsenal of misguided turnaround initiatives is one that forces the largest U.S. banks to borrow directly from the government. That initiative hasn’t helped because banks are simply afraid to lend to other banks because of the problem of toxic balance sheets and future loan-loss probabilities. Worst of all, no bank’s balance sheet has become a single bit more transparent. Nor will that ever happen if we do away with fair-value, mark-to-market accounting.

But, last Friday, at the same time Citigroup Inc. (C) reported November re-sets on adjustable rate mortgages will exceed $24 billion – which can only lead to further mortgage defaults – it was also revealed that some of the banks our government gave money to actually lent it to banks in London. Strange? Not really.

When JP Morgan, Citigroup and other big U.S. banks place money with London banks, specifically banks that submit borrowing cost statistics to Reuters that ultimately determines the LIBOR fixing, could it be that there’s more than free-flowing lending going on? Did the London banks lend any of the pittances that the U.S. banks lent across the pond?

By simple virtue of actually having more money to lend, and without any lending between themselves, London banks have the cover to say: “There’s money available to borrow, but we didn’t borrow any, but we could have borrowed and the cost to us would have been lower than it has been.”

So, they submit to Reuters the lower cost at which they could have borrowed and, presto, the LIBOR fixing is lowered.

Blueprint for a Turnaround

Desperate times, it has been said, require desperate measures.

While it is imperative that credit flows freely here and around the world, the desperate and manipulative measures that banks, the Treasury Department and the Federal Reserve are employing are the equivalent of the Air Force using a carpet-bombing campaign when it’s clear that a couple of smart bombs would do a better job. As a result, U.S. taxpayers are being bombed into a deeper, wider and steeper crater from which it will be very difficult – if not impossible – to climb out of.

There’s just not enough dirt to fill in the craters created by the repeated pounding of the errant policy bombs, as well as the disinterested and abetting regulation, unencumbered Wall Street greed and the profligate orgy of spending that’s come to define Main Street.

Fixing this massive problem – of which LIBOR is just an element – will take time. But we can start by taking all the lobbyists, ex-legislators and ex-regulators and their former staff members (and perhaps some current legislators who are serial enablers of such problems, and who enrichen themselves each time along the way) and burying them in the craters as we fill the holes in.

That rant aside, devising an actual fix for our problems starts by understanding just what it was that caused them. We can assign blame later. For now it’s far more important to stop the flood of red ink that’s washing down Main Street.

Understanding LIBOR and what’s really going on is critical to understanding the motivation and maneuvering of the players that have us headed for a worldwide financial Armageddon.

Source: Fears of Mortgage Rate Re-Sets May Fuel LIBOR Manipulation and Mask Deeper Banking System Problems

Editors Note: This is the ninth installment of an ongoing series in which retired hedge-fund manager R. Shah Gilani breaks down the credit crisis for readers.

“May was the third straight month where we’ve seen a month-to-month increase in foreclosure activity and the 29th straight month we’ve seen a year-over-year increase,” James J. Saccacio, chief executive officer of RealtyTrac, said in a statement.

Home foreclosures jumped 7% in May from April and are up a whopping 48% year-over-year with 261,255 filings this past month according to RealtyTrak’s U.S. Foreclosure Market Report. That figure includes all homes that either received default or auction sale notices or were repossessed by the bank.

Nevada had the highest percentage of foreclosures with California, Arizona and Florida close behind. These markets were some of the hottest during the housing boom from 2000 to 2005.

“It’s definitely a different kind of market than what we got used to a couple years ago,” Devin Reiss, owner of Realty 500 Reiss Corp. in Las Vegas, told Bloomberg News. “We used to sell homes in a day. Now 50% of our sales are foreclosures.”

With a large supply of housing inventory already glutting the market, the influx from foreclosed homes is going to add to the housing markets woes.

Foreclosures will account for 30% of national home sales this year as 1.2 million foreclosed single-family homes will eventually enter the market, Michelle Meyer and Ethan Harris, economists at Lehman Brothers Holdings Inc. (LEH) in New York, wrote in a recent research report. They estimate foreclosed properties, which typically sell for about 20% less than other homes, will depress home prices nationally by 6%, Bloomberg reported.

Battered U.S. consumers are already struggling to deal with soaring gas and food prices. Losing the family home will tax already stretched incomes to the limits, delaying any possible recovery for the U.S. economy.

Source: Home Foreclosures Continue to Soar Delaying U.S. Economic Recovery

RealtyTrac Chief Executive James J. Saccacio said the 243,353 foreclosure filings last month was the highest since his firm began tracking the data in January 2005, The Wall Street Journal reported.

“Although only about 2% of households nationwide are in foreclosure, these properties contribute to already bloated inventories of homes for sale, and put downward pressure on home values,” Saccacio noted.

Nationwide, one in every 519 households received a foreclosure notice.

California, Florida, Nevada and Arizona were the hardest-hit states. California had the highest number of total filings with 64,683 properties falling into foreclosure while Nevada had the highest foreclosure rate, with one in every 146 households filing for foreclosure.

And while current foreclosure levels are at record highs, Saccacio expects the situation to get worse. The credit markets remain tight, making it difficult for overextended homeowners to obtain refinancing that might help them to avoid foreclosure.

“Loan modification isn’t working,” Ira Rheingold, executive director of the National Association of Consumer Advocates in Washington, told Bloomberg News. “It’s extremely difficult for a homeowner to talk to a servicer and even if they do, it’s hard to get the servicer to change the terms. You get voice-mail hell, they don’t return calls, you can’t get a live person on the phone.”

At the same time that consumers are finding it hard to obtain needed financing, the high level of housing inventory, currently at an 11-month supply, is making it very difficult for distressed homeowners to sell.

Saccacio stated that he expects foreclosure filing levels to “remain high and even increase” through the end of the year, particularly “given the number of loans due to reset through the middle of 2008 and the continuing weakness in home sales.”

In fact, banks will continue to seize about 60,000 properties a month through December, Bloomberg reported. At that rate, about 1 million U.S. homes, or 25% of all homes for sale, could be bank-owned, Rick Sharga, RealtyTrac’s executive vice president of marketing, said in an interview.

Source: Home Foreclosures Continue to Rise 

The buck declined even more against the Canadian loonie, which appreciated better than 1% against its neighbor currency. Canada’s dollar is perceived as backed by more in the way of natural resources and therefore my be sounder than the U.S. version.

Some grim earnings reports helped deflate the buck. First, Fannie Mae reported a much wider-than-expected first-quarter loss of $2.2 billion, as credit-related problems hit it hard. The mortgage giant also said it needs to raise $6 billion in new capital.

Then, D. R. Horton, one of the nation’s largest home builders, reported a $1.3 billion quarterly loss as housing weakness and turmoil in mortgage markets continued to hammer its bottom line.

Additionally, Big Ben Bernanke made the news when in a speech he issued a warning that increasing home foreclosures could further harm the economy. Um, could?

Assessing the economic impact of foreclosures, Bernanke said that, “It is important to recognize that the costs of foreclosure may extend well beyond those borne directly by the borrower and the lender.” Wow, didn’t know that.