Monday, December 31, 2007

Recession or not, Middle America will continue to feel the pinch in 2008

From The Times
December 31, 2007

Recession or not, Middle America will continue to feel the pinch in 2008
The decline in the housing market that led to the squeeze on lending is widely expected to carry over into the new year – and it is not the only pressure on the US economy

A small 1950s bungalow in Stockton, California, is up for sale for $169,950. Sitting off a quiet road dotted with American flags, the Funston Avenue home has two bedrooms, one bathroom and a covered porch.

It was built as part of President Truman’s Fair Deal, a federal promise to guarantee economic opportunity and housing for America’s servicemen returning from the war.

Sixty years on, however, the American Dream has turned into a nightmare. The bungalow’s value has fallen by $110,000 in two years and the family who live in it have fallen so far behind with their rising mortgage repayments that they have been foreclosed by the bank.

This family’s story is a common one in the neighbourhood, which houses the bank workers and civil servants who zoom up Highway 205 to commute for two hours each day to and from the pricier city of San Francisco.

According to David Sousa, the real estate broker who is selling the house, the number of properties up for sale in the area has risen from around 1,800 two years ago to about 8,000 now. Most of those properties are in the process of being repossessed by mortgage lenders. Moreover, there is no sign that the residents of Stockton are past the worst. Their lot seems a far cry from the town’s sunny motto: “Stockton’s Great, Take a Look!”

Stockton is one of America’s foreclosure capitals – according to RealtyTrac, in November one in 99 households had entered the foreclosure process, six times the national average. “One of the biggest challenges we face is that the number of foreclosures have left the market saturated with unsold property,” Mr Sousa said. He estimated that prices were falling at “between half and 1 per cent a month” and said that that local mortgage lenders had been so overwhelmed by the number of repossessed homes on their books that they are trying to sell, that real estate brokers – estate agents to you and me – cannot get a decision from them for at least 30 days over whether they will accept an offer price.

So how bad can America’s housing market get? Robert Shiller, of Yale University, one of the world’s leading economists, thinks that the property market could continue to deteriorate “for years”, with the estimated $1 trillion-worth of losses in the market, ballooning to “three times” more. Professor Shiller, who famously predicted the top of the dot-com boom, told The Times at the weekend that the likelihood of Americans having to endure a Japan-style recession with property values declining for years is a “realistic scenario”.

“At the same time as this slowdown, the stock market is highly priced and we have high oil prices. There are a lot of negatives. We are facing a substantial possibility of a big recession,” he said.

This month, the S&P Case/Shiller house price index showed that property values had fallen in October at their fastest rate for six years, with all 20 of the cities monitored showing a decline. In some states, such as Florida, California and Arizona, property prices have fallen by 40 per cent in the past two years.

A world away from the Ivy League office of Professor Shiller, Max Spann, a property auctioneer in New Jersey, told the same story. The bulk of assets that went under Mr Spann’s hammer three years ago used to be agricultural land or government buildings in New York State, New Jersey and Pennsylvania. Now, most of his business is from builders trying to get rid of unsold new homes and banks desperate to remove repossessed homes from their books.

“The situation has really got worse,” Mr Spann said. “We are getting calls from the banks. The last thing lenders want to do is take back real estate. All the time that property is on its books, it is accumulating tax demands and is potentially a declining asset. They are using auctions to get out of that position.” Mr Spann’s business has doubled each year in revenues for the past three years, and he is expecting sales to triple in 2008.

“I think the real estate market will continue to slide at this rate in 2008 and 2009. And that’s all provided that there isn’t a recession. If that happens, all bets are off,” he said.

Yet the housing slowdown is not the only risk to America’s economy. One of the biggest threats is neatly expressed in marketing material welcoming visitors to Stockton, “California’s Sunrise Seaport – twinned with Foshan, Guangdong”. The closeness between the American town and one of China’s fastest-growing cities underlines America’s growing dependence on an economy that is expected to apply the brakes in 2008.

Carl Weinberg, chief economist at High Frequency Economics, believes that China poses one of the greatest threats to the health of the US economy and could force America to slow next year. “The American and Chinese economies are now inextricably linked,” he said. “The US imports a quarter of a trillion dollars-worth of goods a year from China. There is now a new leader on China’s state council and we are expecting them to impose harsh measures next year to slow their economy. They could well introduce fiscal measures with real teeth, like blocking exports of mobile phones, for example. A slowdown in China would have big repercussions for us. The risks could be awful.”

Mr Weinberg is still sanguine about America’s prospects next year and insists that its economy is far from facing a catastrophe. “The odds of a recession are still slim,” he said, explaining that while growth looks to have slowed sharply since the third quarter of 2007, from 4.9 per cent to about 1 per cent in the fourth quarter, the US Federal Reserve is likely to stave off a sharper slowdown by cutting rates by another 1 per cent to about 3.25 per cent next autumn. He forecasts that even though unemployment will rise next year, he is expecting the percentage of the workforce unable to find a job to rise from 5.1 per cent to about 5.3 per cent in 2008.

While the forecasts of some of Wall Street’s top number-crunchers suggest that America may avoid a nasty recession, it is unlikely to feel that way for many families across the United States. Americans, who for the past two years have spent more than they took home for the first time since 1933, are arguably at their most financially vulnerable for generations. The risk that Americans may be forced to tighten their belts, dampening consumer demand, is a real one, now that they are confronted with a decreasing value of their homes, rising fuel prices and uncomfortably high food costs.

The milk price has doubled this year, to keep pace with the soaring cost of maintaining a dairy herd. Corn prices used to feed dairy cattle have doubled because of the rising demand for corn to ferment to make ethanol, the biofuel.

Amy Green, the proprietor of the Ivanna Cone Ice-cream Emporium in Lincoln, Nebraska, has raised her ice cream prices by 37 per cent in the past 18 months. “Everything has gone up. All the raw materials that I need to run my business have risen – the butterfat, the milk, the sugar and the fuel. I had to pass on the rising costs,” she said.

Ms Green, who at the height of summer makes 600 gallons of ice cream a week, said that the fuel price was so prohibitive that her suppliers would not deliver her goods for an order of less than $500: “We’re a small firm. I have to be really creative at finding ways to get my orders up to $500. I’m only ordering small items like spoons and ice cream cones.”

One of her neighbours, Mike Biggs, a third-generation cattle farmer just west of Lincoln, told The Times that business had been very difficult this year. Mr Biggs, who feeds up his 10,000 cows from about 500lb to as much as 1,400lb, explained that the volatility in corn prices and the rising fuel price meant that it had become very challenging to manage the farm’s costs. “The increase in the corn price was not anticipated. The rises meant that a lot of us got caught in the middle,” he said.

Rising food and fuel costs, increasing health insurance and declining property values have made economists jumpy about whether America’s consumers will continue to drive the economy.

The plight of the swath of struggling Americans has not gone unnoticed.

According to research compiled over the past three years by Harvard University, Middle America is experiencing the most severe financial hardship for more than five decades, and Edward Wolff, Professor of Economics at New York University, predicts that the squeeze on the middle classes would get tighter as banks are expected to tighten their lending criteria in the wake of this summer’s credit crisis.

Professor Wolff said: “These families are just not going to be able to take out additional debt. Credit-card companies and auto-loan groups are just going to start saying no.” He said that Americans had not been profligate in their spending – “they’re not expanding consumption, they are just trying to tread water”. He said that median household income has nose-dived by 7 per cent between 2000 and 2004, increasing only 6 per cent between 1983 and 2004.

Americans are being delivered a grim New Year warning, Professor Shiller said: “People aren’t scared yet – but once all this unwinds, they will be.”

Perils for US

Key risks to America's economy in 2008

— Rising energy prices

— Middle East unrest

— Rising food prices

— Worsening financial markets

— Slowdown in China

Source: Carl Weinberg, High Frequency Economics

Wall Street braces itself for more sub-prime misery

From The Times December 31, 2007
Tom Bawden in New York

New year celebrations may not always usher in a better year. As Wall Street reflects on the misery of the past six months – the credit crisis, sub-prime losses, executive sackings and share-price slides – many say that the worst is yet to come.

As Goldman Sachs pointed out last week, Citigroup still has an estimated $25 billion (£12.5 billion) of collateralised debt obligations (CDOs) on its books, the bundled packages of sub-prime loans that are now perceived as so risky they are effectively worthless.

Merrill Lynch, which is expected to admit to writedowns of almost $12 billion in the fourth quarter alone, has about $8 billion of CDOs in its portfolio. According to Goldman estimates, JPMorgan is exposed to around $5 billion of the securities.

Even though American banks have collectively written off at least $60 billion in combined sub-prime-related securities, James Owers, Professor of Finance at Georgia State University, says that “the worst credit crunch in modern history still has some way to go yet . . . The repercussions will eventually be more widespread than the savings and loan crisis.” (This occurred in the 1980s and led to the closure of 1,000 American building societies, with the loss of $150 billion).

The bank also thinks that its rivals are unlikely to be able to hope that they can offset the misery of their sub-prime investments with revenues from investment banking and M&A, both of which it expects to stagnate in 2008.

Yet while few Americans are likely to feel sympathy with Wall Street bankers, they may worry that banks’ reluctance to take on more risk and extend credit lines to American businesses could push the country into recession. Moody’s Investors Service pointed out to clients last week: “The continued uncertainty of what land-mines remain on bank balance sheets has the potential to spill over into restricted lending to industrial firms.”

The fallout from the sub-prime mortgage meltdown has hit all lending. Private equity firms have been hit particularly hard because, typically, they finance about two thirds of each leveraged buyout with debt in high-risk deals that, in this climate, are causing the banks to balk.

The impact on private equity deals has been enormous. Some deals that were agreed before the credit crunch took hold, such as the takeover of Home Depot’s building supplies unit by a consortium including Carlyle, saw their prices cut dramatically – in that case, by $2 billion. Other deals collapsed as the private equity firms were unable to secure financing or were not prepared to complete the transaction. In October, Kohlberg Kravis Roberts and Goldman Sachs walked away from their $8 billion takeover of Harman International, the audio speaker maker. JC Flowers’s bid to buy Sallie Mae, the student lender, for $26 billion, fell through.

Risk on Wall Street

— Citigroup Tipped to cut dividend by 40 per cent and to write off $18.7bn in Q4. Expected to raise up to $10bn of new capital. Sitting in $25bn of CDO investments

— Merrill Lynch Expected to write off $11.5bn in Q4; still exposed to $8bn in CDOs

— JPMorgan Expected to write off $3.4bn in Q4; still exposed to $5bn of CDOs

Source: Goldman Sachs Note December 26 2007

Top economist says America could plunge into recession

From The TimesDecember 31, 2007
Suzy Jagger in New York

Losses arising from America’s housing recession could triple over the next few years and they represent the greatest threat to growth in the United States, one of the world’s leading economists has told The Times.

Robert Shiller, Professor of Economics at Yale University, predicted that there was a very real possibility that the US would be plunged into a Japan-style slump, with house prices declining for years.

Professor Shiller, co-founder of the respected S&P Case/Shiller house-price index, said: “American real estate values have already lost around $1 trillion [£503 billion]. That could easily increase threefold over the next few years. This is a much bigger issue than sub-prime. We are talking trillions of dollars’ worth of losses.”

He said that US futures markets had priced in further declines in house prices in the short term, with contracts on the S&P Shiller index pointing to decreases of up to 14 per cent.

“Over the next five years, the futures contracts are pointing to losses of around 35 per cent in some areas, such as Florida, California and Las Vegas. There is a good chance that this housing recession will go on for years,” he said.

Professor Shiller, author of Irrational Exuberance, a phrase later used by Alan Greenspan, the former Federal Reserve chairman, said: “This is a classic bubble scenario. A few years ago house prices got very high, pushed up because of investor expectations. Americans have fuelled the myth that prices would never fall, that values could only go up. People believed the story. Now there is a very real chance of a big recession.”

He pointed out that signs at the beginning of 2007 that had indicated that some states were beginning to experience a recovery in house prices had proved to be false: “States such as Massachusetts had seen some increases at the beginning of the year. Denver also looked like it had a different path. Now all states are falling.”

Until two years ago, each of America’s 50 states had experienced a prolonged housing boom, with properties in some – such as Florida, California, Arizona and Nevada – doubling in price, fuelled by cheap credit and lax lending practices to borrowers who ordinarily would not have been able to secure a mortgage. Two years ago, the northeastern states of America became the first to slide into a recession after 17 successive interest-rate rises between June 2004 and August 2006 hit the property market.

Last week, new numbers from the S&P/Case Shiller index showed that house prices had declined in October at their fastest rate for more than six years, with homes in Miami losing 12 per cent of their value.

Existing-Home Sales Edged Up In November, but Still Weak

By JEFF BATER
December 31, 2007 10:21 a.m.

WASHINGTON -- Existing-home sales managed a small climb during November, the first increase in nine months, but that didn't change the overall bleak picture for the ailing housing industry.

Home resales rose to a 5.00 million annual rate, a 0.4% increase from October's revised 4.98 million annual pace, the National Association of Realtors said Monday. October's rate was originally estimated at 4.97 million.

The median price of a previously owned home was $210,200 in November, down 3.3% from $217,300 in November 2006. The median price in October this year was $206,900.

The NAR said disruptions in mortgage availability and pricing peaked in August, which caused sales to slow in subsequent months. The November resales increase was the first since February 2007; the sales level of 5.00 million was in line with Wall Street expectations.

"Near term, existing-home sales should continue to hover in a narrow range, just as they have since September, and that's good news because it'll be a further sign that the housing market is stabilizing," NAR chief economist Lawrence Yun said.

The housing slump has been a drag on the economy for nearly two years. In the third quarter, the economy roared despite the burden. But in the fourth quarter, which ends with the year, the economy is seen much weaker, restrained by the dead weight of housing. New-home sales retreated to a 12-year low in November, the government reported last week; that is, sales of single-family homes decreased by 9.0% to a seasonally adjusted annual rate of 647,000, the lowest since 621,000 in April 1995.

Get alerts for breaking news -- such as Fed moves, major world events and big mergers -- delivered straight to your desktop. Alerts will appear in a small window on your screen, much like an instant-messaging window. See a sample and get more information.Also receding are prices for new homes. Falling prices can chill consumer spending, which makes up 70% of U.S. economic activity as measured by GDP. When consumers watch the value of their homes shrink, they tend to feel less wealthy, a mood that can act as a damper on spending plans and, in turn, slow economic growth.

But on a bright note, data from Freddie Mac show the average 30-year mortgage rate was 6.21% in November, down from 6.38% in October.

"Mortgage interest rates are near historic lows and the most current data shows decelerating price declines, along with a modest reduction in the number of homes on the market," Mr. Yun said.

Inventories of homes fell 3.6% at the end of November to 4.27 million available for sale, which represented a 10.3-month supply at the current sales pace. There was a 10.7-month supply at the end of October, revised from a previously estimated 10.8 months.

Regionally, existing-home sales were mixed in November. Sales rose 10.3% in the West and were unchanged in the Midwest. Demand fell 2% in the South and 3.3% in the Northeast.

Write to Jeff Bater at jeff.bater@dowjones.com

Sunday, December 30, 2007

Shiller: Fed to Cut Rates Below 3 Percent

Courtesy of MoneyNews.com

The housing crisis will likely continue for another five years before hitting bottom.

As a result, the Federal Reserve will cut rates regularly this year, predicts Yale economics professor Robert Shiller.

Shiller, who was spot-on in forecasting the bursting of bubbles in the stock market in 2000 and then the housing market this year, sees the Fed slicing the federal funds rate below 3 percent from 4.25 percent currently.

"We’re continuing to see a weakening of the housing market,” Shiller says in an interview with Bloomberg News.

"What’s new is the record territory for the rate of decline. It’s faster than the worst part of the last cycle in the early 1990s.”

As for the housing crunch’s impact on the economy, Shiller foresees a softening, but not a meltdown. "Despite the disaster in the housing market and high oil prices, people are still spending.”

Personal spending soared 1.1 percent in November, the biggest rise in more than two years.

Still, Shiller thinks the housing crunch will drag the economy down enough to make the Fed cut the fed funds rate on overnight interbank loans to less than 3 percent next year. This year, the Fed lowered the rate one percentage point to 4.25 percent.

"I’m at odds with the fed funds rate futures market and most people, but I see a sequence of rates cuts in 2008,” Shiller says.

The S&P/Case-Shiller index for October showed the average price of homes in 20 major metropolitan markets plunged 6.1 percent in from a year earlier, the biggest drop since the index began in 2001.

"That momentum will continue in 2008, because in the real estate market, historically you see accelerations in the rate of decline,” Shiller says.

"That’s different from the stock market, which is largely a random walk.”

What we’re now witnessing is the unraveling of the biggest housing boom in U.S. history, indeed in the history of the entire world, Shiller says. From March 1997 to February 2007, home prices in the 20 metro markets jumped at an annual rate of 10.93 percent.

"The psychology finally unraveled,” Shiller says. "But it’s not just psychology. There was a lot of construction. Now there’s a huge inventory of unsold homes. It’s hard to see how market will pick up with this overhang.”

The amount of homes up for sale in October represented an 8.5-month supply, up a whopping 20 percent from 7.1 months a year earlier.

"I don’t expect any sudden change in the trend, because we’re not talking about professional Wall Street investors,” Shiller says.

"Most of us don’t make decisions fast, so the market doesn’t turn on a dime. Prices might not bottom out for another five years.”

The five-year forecast makes him an outlier, Shiller acknowledges. "The Chicago futures market predicts an increase for housing prices starting in 2009.”

"That’s typical of what others think. But I’m a historian and don’t see any reason for a bottom in 2009.”

The current credit market crisis represents a natural outgrowth of the housing bubble’s burst, Shiller says.

"Loans were made very freely in the early 2000s. Now with prices falling, people are starting to default, so we’re getting a seizing up of credit markets.”

Unemployment May Rise, Factories Slow: U.S. Economy Preview

By Bob Willis

Dec. 30 (Bloomberg) -- Employers in the U.S. hired fewer workers in December and the unemployment rate rose, signaling one of the few remaining bright spots in the economy dimmed heading into 2008, economists said before reports this week.

Payrolls rose by 70,000 after increasing 94,000 in November, according to the median forecast in a Bloomberg survey of economists before a Jan. 4 government report. The jobless rate probably rose to 4.8 percent, the highest level in more than a year.

The figures may raise concern that wage gains, which have kept American consumers afloat, will weaken in coming months. Other reports this week are likely to show existing-home sales matched a record low in November and manufacturing almost stalled this month, suggesting the housing recession was spreading throughout the economy heading into the new year.

``In a slow-motion fashion, we're beginning to see more spillover,'' from the real-estate slump, said Edward McKelvey, senior U.S. economist at Goldman, Sachs & Co. in New York. ``It will be the dominant issue of '08.''

The December gain would put the total payroll increase for 2007 at 1.4 million, the fewest in four years. The jobless rate stood at 4.5 percent at the end of 2006.

The hiring slowdown became more pronounced as the year progressed and the housing slump deepened. An average 147,000 jobs a month were created from January through May, compared with 94,000 in the six months to November.

Housing's Influence

Residential construction has fallen for seven consecutive quarters, weakening job growth as builders, mortgage companies and manufacturers reduce staff.

The collapse of the subprime mortgage market in August hastened firings at financial companies. Seattle-based Washington Mutual Inc., the largest U.S. savings and loan, said earlier this month it will eliminate 3,150 jobs as mortgage losses increased.

Manufacturers are also cutting back as sales of building materials, appliances and furniture weaken, reflecting the slump in home sales.

Factory payrolls shrank by 15,000 workers this month, economists said the jobs report may show. That would cap an almost 200,000 drop in manufacturing employment for the year.

The Institute for Supply Management's factory index fell to 50.5 this month, an 11-month low, from 50.8 in November, the Tempe, Arizona-based group may report Jan. 2, according to economists surveyed. A reading of 50 is the dividing line between expansion and contraction.

Services to Slow

ISM's index of service industries that make up the nearly 90 percent of the economy may have dropped to the lowest level since March. The non-manufacturing gauge fell to 53.5 in December from 54.1 the prior month, according to a Bloomberg survey. The report is due Jan. 4.

The world's largest economy will grow at a 1 percent pace in the fourth quarter after expanding at a 4.9 percent rate the previous three months that was the strongest since 2003, according to the median estimate of economists surveyed earlier this month. Growth for all 2008 is projected at 2.3 percent.

A report tomorrow from the National Association of Realtors may show existing home sales in November were unchanged at an annual rate of 4.97 million units for a second month, according to the survey median. That's the lowest since the Realtors began keeping records in 1999 and 31 percent down from a September 2005 peak.

Risk to Spending

The weaker housing market is forecast to undermine consumer spending, which makes up two thirds of the economy, as falling property values leave owners feeling less wealthy and with less equity to tap for extra cash.

Retailers have placed fewer orders with Black & Decker Corp. this quarter because consumers are buying fewer tools for home remodeling projects as the housing slump enters its third year.

``We are seeing the U.S. economy slowing,'' said Alexander M. Cutler, chief executive officer at Eaton Corp., the world's second-largest maker of hydraulic equipment, in a Dec. 21 interview.

So far, income gains have helped prevent a collapse in consumer spending. The Labor Department is forecast to report hourly wages grew 0.3 percent on average in December after rising 0.5 percent the prior month. Year-over-year, average hourly wages probably rose 3.6 percent after a 3.8 percent gain in the prior 12-month period, economists said.

Investors project the Federal Reserve will lower its benchmark rate a quarter point at the end of January, its fourth consecutive rate decline since September, as it seeks to head off recession.

Minutes of the Fed's Dec. 11 meeting, when policy makers lowered the target rate to 4.25 percent, will be issued on Jan. 2. At the time, some investors were disappointed the central bank didn't drop the rate even more.



Bloomberg Survey

===========================================================
Release Period Prior Median
Indicator Date Value Forecast
===========================================================
Exist Home Sales Million 12/31 Nov. 4.97 4.97
ISM Manu Index 1/2 Dec. 50.8 50.5
Construct Spending MOM% 1/2 Nov. -0.8% -0.4%
Initial Claims ,000's 1/3 Dec. 30 349 345
Factory Orders MOM% 1/3 Nov. 0.5% 0.5%
Nonfarm Payrolls ,000's 1/4 Dec. 94 70
Unemploy Rate % 1/4 Dec. 4.7% 4.8%
Manu Payrolls ,000's 1/4 Dec. -11 -15
Hourly Earnings MOM% 1/4 Dec. 0.5% 0.3%
Hourly Earnings YOY% 1/4 Dec. 3.8% 3.6%
ISM NonManu Index 1/4 Dec. 54.1 53.5
==========================================================
To contact the reporter on this story: Bob Willis in Washington at bwillis@bloomberg.net

Last Updated: December 30, 2007 09:39 EST

Saturday, December 29, 2007

Wizardry Amplified The Credit Crisis

By Carrick Mollenkamp and Serena Ng
From The Wall Street Journal Online

In recent years, as home prices and mortgage lending boomed, bankers found ever-more-clever ways to repackage trillions of dollars in loans, selling them off in slivers to investors around the world. Financiers and regulators figured all the activity would disperse risk, and maybe even make markets safer and stronger.

Then along came Norma.

Norma CDO I Ltd., as its full name goes, is one of a new breed of mortgage investments created in the waning days of the U.S. housing boom. Instead of spreading the risk of a global home-finance boom, the instruments have magnified and concentrated the effects of the subprime-mortgage bust. They are now behind tens of billions of dollars of write-downs at some of the world's largest banks, including the $9.4 billion announced last week by Morgan Stanley.

Norma illustrates how investors and Wall Street, in their efforts to keep a lucrative market going, took a good idea too far. Created at the behest of an Illinois hedge fund looking for a tailor-made bet on subprime mortgages, the vehicle was brought into existence by Merrill Lynch & Co. and a posse of little-known partners.

In its use of newfangled derivatives, Norma contributed to a speculative market that dwarfed the value of the subprime mortgages on which it was based. It was also part of a chain of mortgage-linked investments that took stakes in one another. The practice generated fees for a handful of big banks. But, say critics, it created little value for investors or the broader economy.

"Everyone was passing the risk to the next deal and keeping it within a closed system," says Ann Rutledge, a principal of R&R Consulting, a New York structured-finance consultancy. "If you hold my risk and I hold yours, we can say whatever we think it's worth and generate fees from that. It's like...creating artificial value."

Only nine months after selling $1.5 billion in securities to investors, Norma is worth a fraction of its original value. Credit-rating firms, which once signed off approvingly on the deal, have slashed its ratings to junk.

The concept behind Norma, known as a collateralized debt obligation, has been in use since the 1980s. A CDO, most broadly, is a device that repackages the income from a pool of bonds, derivatives or other investments. A mortgage CDO might own pieces of a hundred or more bonds, each of which contains thousands of individual mortgages. Ideally, this diversification makes investors in the CDO less vulnerable to the problems of a single borrower or security.

The CDO issues a new set of securities, each bearing a different degree of risk. The highest-risk pieces of a CDO pay their investors higher returns. Pieces with lower risk, and higher credit ratings, pay less. Investors in the lower-risk pieces are first in line to receive income from the CDO's investments; investors in the higher-risk pieces are first to take losses.

But Norma and similar CDOs added potentially fatal new twists to the model. Rather than diversifying their investments, they bet heavily on securities that had one thing in common: They were among the most vulnerable to a rise in defaults on so-called subprime mortgage loans, typically made to borrowers with poor or patchy credit histories. While this boosted returns, it also increased the chances that losses would hit investors severely.

Also, these CDOs invested in more than simply subprime-backed securities. The CDOs held chunks of each other, as well as derivative contracts that allowed them to bet on mortgage-backed bonds they didn't own. This magnified risk. Wall Street banks took big pieces of Norma and similar CDOs on their own balance sheets, concentrating the losses rather than spreading them among far-flung investors.

"It is a tangled hairball of risk," Janet Tavakoli, a Chicago consultant who specializes in CDOs, says of Norma. "In March of 2007, any savvy investor would have thrown this...in the trash bin."

Penny Stocks

Norma was nurtured in a small office building on a busy road in Roslyn, on the north shore of New York's Long Island. There, a stocky, 37-year-old money manager named Corey Ribotsky runs a company called N.I.R. Group LLC. Mr. Ribotsky came not from the world of mortgage securities, but from the arena of penny stocks, shares that trade cheaply and often become targets of speculation or manipulation.

N.I.R. and its affiliates have taken stakes in 300 companies, some little-known, including a brewer called Bootie Beer Corp., lighting firm Cyberlux Corp. and water-purification company R.G. Global Lifestyles. Mr. Ribotsky's firms are in litigation in New York federal court with all three companies, which claim N.I.R. manipulated their share prices. Through its lawyer, N.I.R. denies wrongdoing and has accused the companies of failing to repay loans.

Mr. Ribotsky's firm attracted the attention of Merrill Lynch in 2005. The top underwriter of CDOs from 2004 to mid-2007, Merrill had generated hundreds of millions of dollars in profits from assembling and then helping to distribute CDOs backed by mortgage securities. For each CDO Merrill underwrote, the investment bank earned fees of 1% to 1.50% of the deal's total size, or as much as $15 million for a typical $1 billion CDO.

To keep underwriting fees coming, Merrill recruited outside firms, called CDO managers. Merrill helped them raise funds, procure the assets for their CDOs and find investors. The managers, for their part, choose assets and later monitor the CDO's collateral, although many of the structures don't require much active management. It was an attractive proposition for many start-up firms, which could earn lucrative annual management fees.

Mr. Ribotsky's entry into the world of CDO managers began at Engineers Country Club on Long Island. There, in 2005, he met Mitchell Elman, a New York criminal-defense lawyer who specializes in drunk-driving and drug cases. Mr. Elman introduced Mr. Ribotsky to Kenneth Margolis, then a high-profile CDO salesman at Merrill, according to people familiar with the situation. Mr. Elman declined to comment.

'It Sounded Interesting'

Mr. Margolis, who in February 2006 became co-head of Merrill's CDO banking business, played a key role in seeking out start-up firms to manage CDOs. He put Mr. Ribotsky in contact with a few people who had experience in the mortgage debt market. They included two former Wachovia Corp. bankers, Scott Shannon and Joseph Parish III, who left Wachovia and established their own CDO management firm.

Mr. Ribotsky decided to team up with Messrs. Shannon and Parish. "It sounded interesting and that's how we ventured into it," Mr. Ribotsky says. Messrs. Parish and Shannon declined to discuss specifics of Norma.

Together the trio set up a company called N.I.R. Capital Management, which over the next year or so took on the management of three CDOs underwritten by Merrill.

In 2006, Mr. Ribotsky says Merrill came to N.I.R. with a new proposition: One of the investment bank's clients, a hedge fund, wanted to invest in the riskiest piece of a certain type of CDO. Merrill worked out a general structure for the vehicle. It asked N.I.R. to manage it.

"It was already set up when it was presented to us," Mr. Ribotsky says. "They interviewed a bunch of managers and selected our team."

The CDO would be called Norma, after a small constellation in the southern hemisphere. According to people familiar to the matter, the hedge fund was Evanston, Ill.-based Magnetar, a fund that shared its name with a powerful neutron star. Magnetar declined to comment.

On Dec. 7, 2006, Norma was established as a company domiciled in the Cayman Islands. N.I.R., as its manager, would earn fees of some 0.1%, or about $1.5 million a year.

Norma belonged to a class of instruments known as "mezzanine" CDOs, because they invested in securities with middling credit ratings, averaging triple-B. Despite their risks, mezzanine CDOs boomed in the late stages of the credit cycle as investors reached for the higher returns they offered. In the first half of 2007, issuers put out $68 billion in mortgage CDOs containing securities with an average rating of triple-B or the equivalent -- the lowest investment-grade rating -- or lower, according to research from Lehman Brothers Holdings Inc. That was more than double the level for the same period a year earlier.

Buying Protection

For Norma, N.I.R. assembled $1.5 billion in investments. Most were not actual securities, but derivatives linked to triple-B-rated mortgage securities. Called credit default swaps, these derivatives worked like insurance policies on subprime residential mortgage-backed securities or on the CDOs that held them. Norma, acting as the insurer, would receive a regular premium payment, which it would pass on to its investors. The buyer of protection, which was initially Merrill Lynch, would receive payouts from Norma if the insured securities were hurt by losses. It is unclear whether Merrill retained the insurance, or resold it to other investors who were hedging their subprime exposure or betting on a meltdown.

Many investment banks favored CDOs that contained these credit-default swaps, because they didn't require the purchase of securities, a process that typically took months. With credit-default swaps, a billion-dollar CDO could be assembled in weeks.

Multiplying Risk

In principle, credit-default swaps help banks and other investors pass along risks they don't want to keep. But in the case of subprime mortgages, the derivatives have magnified the effect of losses, because they allowed bankers to create an unlimited number of CDOs linked to the same mortgage-backed bonds. UBS Investment Research, a unit of Swiss bank UBS AG, estimates that CDOs sold credit protection on around three times the actual face value of triple-B-rated subprime bonds.

The use of derivatives "multiplied the risk," says Greg Medcraft, chairman of the American Securitization Forum, an industry association. "The subprime-mortgage crisis is far greater in terms of potential losses than anyone expected because it's not just physical loans that are defaulting."

Norma, for its part, bought only about $90 million of mortgage-backed securities, or 6% of its overall holdings. Of that, some were pieces of other CDOs mostly underwritten by Merrill, according to documents reviewed by The Wall Street Journal. These CDOs included Scorpius CDO Ltd., managed by a unit of Cohen & Co., a company run by former Merrill CDO chief Christopher Ricciardi. Later, Norma itself would be among the holdings of Glacier Funding CDO V Ltd., managed by an arm of New York mortgage firm Winter Group.

A Winter Group official said the company declined to comment, as did Cohen & Co.

Such cross-selling benefited banks, because it helped support the flow of new CDOs and underwriting fees. In fact, the bulk of the middle-rated pieces of CDOs underwritten by Merrill were purchased by other CDOs that the investment bank arranged, according to people familiar with the matter. Each CDO sold some of its riskier slices to the next CDO, which then sold its own slices to the next deal, and so on.

Propping Up Prices

Critics say the cross-selling reached such proportions that it artificially propped up the prices of CDOs. Rather than widely dispersing exposure to these mortgages, the practice circulated the same risk among a relatively small number of players.

By early 2007, Norma was ready to face the ratings firms. Different slices of CDOs get different ratings because some protect the others from losses to defaults. A "junior" slice might take the first $30 million in losses on a $1 billion CDO, while a triple-A "senior" slice would not be affected until losses reached $200 million or more.

But the system works only if the securities in the CDO are uncorrelated -- that is, if they are unlikely to go bad all at once. Corporate bonds, for example, tend to have low correlation because the companies that issue them operate in different industries, which typically don't get into trouble simultaneously.

Mortgage securities, by contrast, have turned out to be very similar to one another. They're all linked to thousands of loans across the U.S. Anything big enough to trigger defaults on a large portion of those loans -- like falling home prices across the country -- is likely to affect the bonds in a CDO as well. That's particularly true for the kinds of securities on which mezzanine CDOs made their bets. Triple-B-rated bonds would typically stand to suffer if losses to defaults on the underlying pools of loans reached about 10%.

Easy Credit

When rating companies analyzed Norma, though, they were looking backward to a time when rising house prices and easy credit had kept defaults on subprime mortgages low. Norma's marketing documents noted plenty of risks for investors but also said that CDO securities had a high degree of ratings stability.

Beyond that, rating firms say they had reason to believe that the securities wouldn't all go bad at once as the housing market soured. For one, each security contained mortgages from a different mix of lenders, so lending standards might differ from security to security. Also, each security had its own unique team of companies collecting the payments. Yuri Yoshizawa, group managing director at Moody's Investors Service, says the firm figured some of these mortgage servicers would be better than others at handling problematic loans.

In March, Moody's, Standard & Poor's and Fitch Ratings gave Norma their seal of approval. In its report, Fitch cited growing concern about the subprime mortgage business and the high number of borrowers who obtained loans without proof of income. Still, all three rating companies gave slices comprising 75% of the CDO's total value their highest, triple-A rating -- implying they had as little risk as Treasury bonds of the U.S. government.

Merrill and N.I.R. took Norma to investors. Together, they produced a 78-page pitchbook that bore Merrill's trademark bull. Inside were nine pages of risk factors that included standard warnings about CDOs. The pitchbook also extolled mortgage securities, which it noted "have historically exhibited lower default rates, higher recovery upon default and better rating stability than comparably rated corporate bonds."

Most importantly, though, Norma offered high returns: On a riskier triple-B slice, Norma said it would pay investors 5.5 percentage points above the interest rate at which banks lend to each other, known as the London interbank offered rate, or Libor. At the time, that translated into a yield of over 10% on the security -- compared with roughly 6% on triple-B corporate bonds.

Network of Contacts

Mr. Ribotsky says the selling required little effort, as Merrill drummed up interest from its network of contacts. "That's what they get their fees for," he says.

Norma sold some $525 million in CDO slices -- largely the lower-rated ones with higher returns -- to investors. Merrill declined to say whether it kept Norma's triple-A rated, $975 million super-senior tranche or sold it to another financial institution.

Many investment banks with CDO businesses -- Citigroup Inc., Morgan Stanley and UBS -- frequently kept or bought these super-senior pieces, whose lower returns interested few investors. In doing so, they bet that the top CDO slices, which typically comprised as much as 60% of the whole CDO, were insulated from losses.

By September, Norma was in trouble. Amid a steep decline in house prices and rising defaults on mortgage loans, the value of subprime-backed securities went into a free fall. As increasingly worrisome delinquency data rolled in, analysts upped their estimates of total losses on subprime-backed securities issued in 2006 to 20% or more, a level that would wipe out most triple-B-rated securities.

Within weeks, ratings firms began to change their views. In October, Moody's downgraded $33.4 billion worth of mortgage-backed securities, including those which Norma had insured. Those downgrades set the stage for a review of CDOs backed by those securities -- and then further downgrades.

Mezzanine CDOs such as Norma were the hardest hit. On Nov. 2, Moody's slashed the ratings on seven of Norma's nine rated slices, three all the way from investment-grade to junk. Fitch downgraded all nine slices to junk, including two that it had rated triple-A.

Worse Performances

Other mezzanine CDOs, including some underwritten by other investment banks, have had worse performances. Around 30 are now in default, according to S&P. Norma is still paying interest on its securities. It is not known whether it has had to make payouts under the credit default swap agreements.

Ratings companies say their March opinions represented their best read at the time, and called the subprime deterioration unprecedented and unexpectedly rapid. "It's one of the worst performances that we've seen," says Kevin Kendra, a managing director at Fitch. "The world has changed quite drastically -- and our view of the world has changed quite drastically."

By mid-December, $153.5 billion in CDO slices had been downgraded, according to Deutsche Bank. Because banks owned the lion's share of the mezzanine CDOs, they bore the brunt of the losses. In all, banks' write-downs on mortgage investments announced so far add up to more than $70 billion.

For larger banks, holdings of mezzanine CDOs could account for one-third to three-quarters of the total losses. In addition to the $9.4 billion fourth-quarter write-down Morgan Stanley just announced it would take, Citigroup has projected its fourth-quarter write-down could reach $11 billion. UBS said this month it would take a $10 billion write-down after taking a $4.4 billion third-quarter loss.

Merrill, for its part, took a $7.9 billion write-down on mortgage-related holdings in the third quarter. Analysts expect it to write down a similar amount in the current quarter, which would represent the largest losses of any bank. News of the losses have led to the ouster of CEO Stan O'Neal and Osman Semerci, the bank's global head of fixed income. Mr. Margolis left this summer.

Mr. Ribotsky says he doesn't have plans to do any more CDOs at the current time. "Obviously, we're not happy about the occurrences in the marketplace," he says.



Email your comments to rjeditor@dowjones.com.

Equity capital markets poised for boost

By Rachel Morarjee

Published: December 28 2007 18:52 | Last updated: December 28 2007 18:52

Equity capital markets will get a boost next year from financial institutions seeking to shore up their tattered balance sheets and from private equity firms looking for an exit from earlier investments, bankers said.

“What looks very likely for 2008 is a wave of capital increases by financial institutions in the EMEA region [Europe, the Middle East and Africa] looking to repair their stretched balance sheets,” said Viswas Raghavan, head of international capital markets at JPMorgan.

With the share prices of some of the biggest investment banks down by as much as a third from their summer highs, troubled financial institutions will be reluctant to issue straight equity that would dilute their share prices further.

Instead, like Citigroup, many are likely to look at convertible bonds which can be changed into equity at a later date, allowing existing shareholders to cash in on any upside and giving the issuer the benefit of a tax deduction on the coupon.

“There will much more activity in the Tier 1 space next year,” said David Lyon, a managing director in the financial institutions group at Barclays Capital. “In order to bolster their capital ratios, banks will continue to issue a variety of flavours of Tier 1 securities, including fixed interest, preference shares and convertible instruments.

“Issuing equity is the most expensive option,” he said.

Given the current tumult in the wider credit world and the cautious sentiment in the equity markets, convertible bonds are likely to become a speedy, cost-effective and liquid financing alternative.

“2007 has been a great year for global convertible volumes and we expect more of the same in 2008,” said Mr Raghavan.

With liquidity in credit markets at a low ebb, private equity firms may increasingly look to initial public offerings as the swiftest exit route from investments made over the last three or four years.

John Crompton, head of EMEA equity capital markets at Merrill Lynch, said that IPO activity could be increasingly driven by private equity in the coming year.

Public equity markets are the least damaged of all of the major pools of capital. With private equity-driven takeovers hit by weakness in the credit market, corporates which were previously priced out of the market could become bidders again, using their equity as currency.

“This will see a wave of acquisition financing, providing a boost to equity capital markets activity,” Mr Raghavan said.

Copyright The Financial Times Limited 2007

Friday, December 28, 2007

It may pay to keep on eye on overseas residential markets

Homes away from home
By Thomas Kostigen, MarketWatch
Last update: 7:28 p.m. EST Dec. 26, 2007

SANTA MONICA, Calif. (MarketWatch) -- Some investment analysts such as Bill Gross of Pimco say we're in a recession here in the United States. But overseas it looks like times are booming. And that means foreigners are looking at opportunities here, which in turn poses opportunity for U.S. investors.

Two large foreign investors are bailing out financial institutions here from their exposure to losses in the domestic subprime mortgage market. Asia and Middle Eastern companies and countries seem to be putting capital to work in every corner of the world. And the global superrich are redefining what it means to be super rich. (In London it means a million-dollar salary just to lead an average affluent lifestyle, a recent survey shows.)

Sort of all makes us look poor in the grand scheme of things.

But where we are "poor" also means we have opportunity, particularly in the real estate sector. Here's why: trepidation.

Sales and values of real estate on the whole in the U.S. may have sunk. But it's largely not because of lack of demand; it's largely because of hesitation of demand.

There's a big difference between the two. It means there is a lingering lag in the market, not an outright stall. At the first blush of renewed energy, the real estate market will bounce back.

Wealthy investors are still putting their dollars to work in the market, which means allocations to real estate as an investment class haven't gone away altogether.

Instead, sales of high-end homes have soared. Like with any investment class, it's best to take a look at global supply and demand not just domestic variance.

If equities were on the outs with investors, that would spill around the world and the asset class itself would be out of favor, meaning fewer people would be buying and selling stocks. Same thing with bonds, or commodities ...or real estate.

But that isn't happening. Prices of homes in certain high-end sections of London, for example, have risen between 25% and 35% this year, according to the Financial Times. There is an Indian, Asian, and Middle Eastern boom of development too.

Strong price increases in London are "giving the elite the confidence to invest heavily in the properties," the FT says.

Confidence-building is what any market is about. There is enough capital to push about and increase prices in virtually every capital market. What makes some markets soar and others dribble is confidence.

To be sure, confidence in U.S. properties has waned. But for how long? When wealthy investors from abroad look to invest in the agents of markets -- the Merrills, UBSs and the like -- how long before they then take it to the next level of the game and invest directly?

With the value of the U.S. dollar low and real estate prices dropping, it isn't hard to imagine foreigners taking bigger positions in properties here as part of their overall portfolios. Meanwhile, they wait...wait...wait...Then they'll buy large when prices get low enough.

Prices are quickly getting low enough

I'm betting that Miami and southern Florida will kick-start the trend. There, prices and sales volumes are down 25% or more in hot areas. What happens when values fall 50%? That should catch some foreign investors' attention.

With the largest segment of the population retiring and likely headed South, too, there is long-term viability to the bet.

It's worth following the buying patterns of wealthy individuals and foreign institutions when it comes to their investments in real estate. Confidence will build again. This time maybe just more slowly, but it will come back.

Investment resolutions for 2008 should be to spot bottoms -- and then buy. Those with capital have already begun.

Home sales plunge, feed recession fears

By JEANNINE AVERSA, AP Economics Writer

WASHINGTON - The housing market plunged deeper into despair last month, with sales of new homes plummeting to their lowest level in more than 12 years.

The slump worsened even more than most analysts expected, heightening fears that the country might be thrust into a recession.

New-home sales tumbled 9 percent in November from October to a seasonally adjusted annual sales pace of 647,000, the Commerce Department reported Friday. That was the worst sales pace since April 1995.

"It was ugly," declared Richard Yamarone, economist at Argus Research. "It is the one sector of the economy that doesn't show any signs of life. It doesn't look like there is any resuscitation in store for housing over the next year," he said.

The housing picture turned out to be more grim than most anticipated. Many economists were predicting sales to decline by 1.8 percent to a pace of 715,000.

By region, sales fell in all parts of the country, except for the West.

In the Midwest, new-home sales plunged 27.6 percent in November from October. Sales dropped 19.3 percent in the Northeast and fell 6.4 percent in the South. In the West, however, sales rose 4 percent.

Over the last 12 months, new-home sales nationwide have tumbled by 34.4 percent, the biggest annual slide since early 1991, and stark evidence of the painful collapse in the once high-flying housing market.

"I think you can classify what we are seeing in the housing market as a crash," said Mark Zandi, chief economist at Moody's Economy.com. "Sales and home prices are in a free fall. The downturn is intensifying."

The median sales price of a new home dipped to $239,100 in November. That is 0.4 percent lower than a year ago. The median price is where half sell for more and half for less.

On Wall Street, the Dow Jones industrials, after an erratic session, managed to squeeze out a small gain even as the grim home sales report added to some investors' angst. The Dow closed up 6.26 points at 13,365.87.

Would-be home buyers have found it more difficult to secure financing, especially for "jumbo" mortgages — those exceeding $417,000. The tighter credit situation is deepening the housing slump. Unsold homes have piled up, which will force builders to cut back even more on construction and look for ways to sweeten the pot to lure prospective buyers.

"A lot of borrowers are being disqualified for loans. If you can't qualify for a mortgage the game is over. For those who do qualify, it takes longer to get loans," said Brian Bethune, economist at Global Insight.

The housing market has been suffering through a severe slump following five years of record-breaking activity from 2001 through 2005. Sales turned weak as did home prices. The boom-to-bust situation has increased dangers to the economy as a whole and has been especially hard on some homeowners.

Foreclosures have soared to record highs and probably will keep rising. A drop in home prices left some people stuck with balances on their home mortgages that eclipsed the worth of their home. Other home buyers were clobbered as low introductory rates on their mortgages jumped to much higher rates, which they couldn't afford.

Problems in housing are expected to persist well into 2008 — a major election year.

The housing and mortgage meltdowns have raised the odds that the country will fall into a recession. And, the situation has given Democrat and Republican politicians_ including those who want to be the next president — plenty of opportunities to spread blame around.

The economy's growth is expected to have slowed sharply to a pace of just 1.5 percent or less in the final three months of this year. Former Federal Reserve Chairman Alan Greenspan recently warned that the economy is "getting close to stall speed." The big worry is that the housing and credit troubles will force individuals to cut back on spending and businesses to cut back on hiring and capital investment, throwing the economy into a tailspin.

To help bolster the economy, the Federal Reserve has sliced a key interest rate three times this year. Its latest rate cut, on Dec. 11, dropped the Fed's key rate to 4.25 percent, a two-year low. Many economists are predicting the Fed will lower rates again when they meet in late January.

"The risks are as high as they've ever been during this expansion that started in late 2001 that the economy will fall into a recession," said Bethune. "The odds are now nudging up close to the 50 percent mark."
___

On the Net:

New-home sales report: https://www.esa.doc.gov/ei.cfm

Greenspan: Global Economy Going into ‘Reverse’

Breaking News from MoneyNews.com

Former Federal Reserve Chairman Alan Greenspan repeated his argument this week that the world’s central banks have lost control over long rates – but suggested that global economies would slow, a factor which should eventually support higher rates.

Interest rates now are set by the supply of investment money worldwide, a force much larger than the concerted efforts of central banks, including the Fed, Greenspan said in an interview with National Public Radio.

"We and all other central banks lost control of the forces directing higher prices in homes,” Greenspan said.

Nevertheless, he implied, long rates could rise going forward as economies slow and less money is sloshing around looking for a home.

"What I point out is that we’re in a turning phase and that the extraordinary improvements that have occurred in the world economy in the last 15 years are transitory, and they’re about to change,” Greenspan said.

"So, I think this whole process will begin to reverse,” he said.

Global economic growth has brought "hundreds of millions” of people out of abject poverty, particularly in Asia, the former Fed chief pointed out, and that has been the result of market forces at work.

"The most extraordinary example is China. China is moving towards capitalism. It doesn’t say that, obviously, it can’t. But that’s precisely what it’s doing,” Greenspan said.

Nevertheless, Greenspan argued, rising inequality of income is creating new problems, and declining U.S. education standards, especially in math and science, are doing harm to the historic "balancing” of income levels.

Greenspan also took on critics who have pointed out his own poor record at predicting recession, despite sitting at the helm of the U.S. monetary authority for nearly two decades.

"The record of forecasting not only of myself and of companies I have developed – but of the profession as a whole – is not particularly spectacular,” Greenspan said. "I’ve been forecasting since the early 1950s. I was as bad then as I am now.”

Yet he cautioned again that the elements for a downturn are in place, and reiterated his warning that a recession is more likely than not.

The key is human psychology, which cannot yet be measured well enough to predict without that prediction affecting the outcome by giving markets time to adjust and avoid recession, Greenspan said.

"What I have to forecast is that something will happen which is unexpected, which will knock us down,” Greenspan said. "The odds of that happening, I think, are rising, because we are getting in vulnerable areas.”

U.S. Economy: Sales of New Homes Tumble 9% to 12-Year Low

By Bob Willis

Dec. 28 (Bloomberg) -- Sales of new homes in the U.S. fell to a 12-year low in November, pointing to bigger declines in construction that will hinder economic growth in 2008.

Purchases dropped 9 percent to an annual pace of 647,000 and October sales were revised lower, the Commerce Department said today in Washington. Last month's sales were weaker than the lowest forecast in a Bloomberg News survey of economists.

Treasury notes extended their rally and traders added to bets that the Federal Reserve will cut interest rates again in January to prevent a recession. New-home sales are down 25.4 percent so far this year, heading for the biggest annual decline since at least 1963.

``This gives a dire picture of the U.S. housing market,'' said Dana Saporta, an economist at Dresdner Kleinwort in New York. ``The weakness of the housing industry does raise the risk of recession.''

A separate report showed the National Association of Purchasing Management-Chicago's index of American business activity rose this month as new orders increased. The group's index climbed to 56.6, from 52.9 the previous month.

The deepest housing recession in 16 years will worsen as discounts fail to lure buyers and mounting foreclosures swell the glut of unsold properties, economists said. Falling property values may cause consumer spending to cool, increasing the odds the expansion will falter in 2008.

``The most important implication of this is it's going to drive down construction outlays and that's a direct effect on GDP,'' said Neal Soss, chief economist at Credit Suisse Group in New York.

Yields Retreat

The yield on the benchmark 10-year note fell 9 basis points to 4.11 percent at 10:21 a.m. in New York. The dollar weakened against the euro and stocks pared their advance. The Standard & Poor's Supercomposite Homebuilding Index, which includes KB Home, Pulte Homes Inc. and D.R. Horton Inc., declined 2.8 percent to 306.44.

A Bloomberg survey of 68 economists forecast sales would fall to an annual pace of 717,000 from a previously reported 728,000 rate in October, according to the median estimate. Economists' forecasts ranged from a low of 685,000 to a high of 750,000. Government records only go back to 1963.

Sales of new homes were down 34 percent from the same time last year, the biggest 12-month drop since January 1991. The median price fell 0.4 percent from November 2006 to $239,100.

The number of homes for sale at the end of November decreased 1.8 percent to 505,000, the fewest in two years. Still, because sales dropped even more, the inventory of unsold homes at the current sales pace jumped to 9.3 months from 8.8 months in October.

Regional Picture

Purchases fell in three of four regions, led by a 28 percent plunge in the Midwest. Sales dropped 19 percent in the Northeast and 6.4 percent in the South. They rose 4 percent in the West.

The housing recession has deepened since the August turmoil in subprime mortgages led to a worldwide credit shortage. Stricter borrowing standards and a freeze on lending to borrowers with poor credit put mortgages out of reach for more potential buyers. That's driving home prices lower, weakening sales as people hold out for even bigger reductions.

Sales of new houses will probably tumble 8.9 percent in 2008 after a 25 percent drop this year, according to a Dec. 13 forecast from Fannie Mae, the largest mortgage buyer. Sales of new homes in November were 53 percent down from their July 2005 peak.

Prices Decline

Home prices in 20 metropolitan areas fell 6.1 percent in the 12 months to October, the most in at least six years, according to a report this week by S&P/Case-Shiller. The decline raises the risk that more Americans will walk away from properties that are worth less than they owe, economists said.

Lehman Brothers Holdings Inc. is forecasting prices will fall at least 15 percent from peak to trough. By that measure, the S&P/Case-Shiller index is down 6.6 percent so far.

With sales and prices falling, foreclosures rose 68 percent in November from a year earlier. They may continue surging in 2008 as mortgages for some subprime borrowers with adjustable rates reset.

As foreclosures throw more homes onto the market, homebuilders such as Hovnanian Enterprises Inc., New Jersey's largest, are scaling back.

Hovnanian plans to ``pare down our inventories in virtually all our markets,'' Chief Executive Officer Ara Hovnanian said on a conference call Dec. 19. ``It will be a difficult year.''

Construction

Housing starts are near a 14-year low and have fallen 48 percent since their January 2006 peak. Declining home construction has subtracted from economic growth for the last seven quarters, and economists are expecting the drag to continue in 2008.

The weaker housing market is also forecast to undermine consumer spending, which makes up two thirds of the economy, as falling property values leave owners feeling less wealthy and with less equity to tap for extra cash.

The odds of recession have increased since the credit markets froze as a result of the subprime crisis. The economy will expand at a 1 percent annual pace in the fourth quarter after growing at a 4.9 percent rate from July through September, according to the median forecast of economists surveyed this month by Bloomberg News.

`The probability of recession is 50 percent for next year at some point,'' Martin Feldstein, head of the National Bureau of Economic Research, which determines when contractions start and end, said in a Dec. 14 interview. ``We could see a downturn starting sometime in the spring or the second quarter of next year.''

To contact the reporter on this story: Bob Willis in Washington at bwillis@bloomberg.net

Last Updated: December 28, 2007 11:15 EST

U.S. Economy: Sales of New Homes Tumble 9% to 12-Year Low

By Bob Willis

Dec. 28 (Bloomberg) -- Sales of new homes in the U.S. fell to a 12-year low in November, pointing to bigger declines in construction that will hinder economic growth in 2008.

Purchases dropped 9 percent to an annual pace of 647,000 and October sales were revised lower, the Commerce Department said today in Washington. Last month's sales were weaker than the lowest forecast in a Bloomberg News survey of economists.

Treasury notes extended their rally and traders added to bets that the Federal Reserve will cut interest rates again in January to prevent a recession. New-home sales are down 25.4 percent so far this year, heading for the biggest annual decline since at least 1963.

``This gives a dire picture of the U.S. housing market,'' said Dana Saporta, an economist at Dresdner Kleinwort in New York. ``The weakness of the housing industry does raise the risk of recession.''

A separate report showed the National Association of Purchasing Management-Chicago's index of American business activity rose this month as new orders increased. The group's index climbed to 56.6, from 52.9 the previous month.

The deepest housing recession in 16 years will worsen as discounts fail to lure buyers and mounting foreclosures swell the glut of unsold properties, economists said. Falling property values may cause consumer spending to cool, increasing the odds the expansion will falter in 2008.

``The most important implication of this is it's going to drive down construction outlays and that's a direct effect on GDP,'' said Neal Soss, chief economist at Credit Suisse Group in New York.

Yields Retreat

The yield on the benchmark 10-year note fell 9 basis points to 4.11 percent at 10:21 a.m. in New York. The dollar weakened against the euro and stocks pared their advance. The Standard & Poor's Supercomposite Homebuilding Index, which includes KB Home, Pulte Homes Inc. and D.R. Horton Inc., declined 2.8 percent to 306.44.

A Bloomberg survey of 68 economists forecast sales would fall to an annual pace of 717,000 from a previously reported 728,000 rate in October, according to the median estimate. Economists' forecasts ranged from a low of 685,000 to a high of 750,000. Government records only go back to 1963.

Sales of new homes were down 34 percent from the same time last year, the biggest 12-month drop since January 1991. The median price fell 0.4 percent from November 2006 to $239,100.

The number of homes for sale at the end of November decreased 1.8 percent to 505,000, the fewest in two years. Still, because sales dropped even more, the inventory of unsold homes at the current sales pace jumped to 9.3 months from 8.8 months in October.

Regional Picture

Purchases fell in three of four regions, led by a 28 percent plunge in the Midwest. Sales dropped 19 percent in the Northeast and 6.4 percent in the South. They rose 4 percent in the West.

The housing recession has deepened since the August turmoil in subprime mortgages led to a worldwide credit shortage. Stricter borrowing standards and a freeze on lending to borrowers with poor credit put mortgages out of reach for more potential buyers. That's driving home prices lower, weakening sales as people hold out for even bigger reductions.

Sales of new houses will probably tumble 8.9 percent in 2008 after a 25 percent drop this year, according to a Dec. 13 forecast from Fannie Mae, the largest mortgage buyer. Sales of new homes in November were 53 percent down from their July 2005 peak.

Prices Decline

Home prices in 20 metropolitan areas fell 6.1 percent in the 12 months to October, the most in at least six years, according to a report this week by S&P/Case-Shiller. The decline raises the risk that more Americans will walk away from properties that are worth less than they owe, economists said.

Lehman Brothers Holdings Inc. is forecasting prices will fall at least 15 percent from peak to trough. By that measure, the S&P/Case-Shiller index is down 6.6 percent so far.

With sales and prices falling, foreclosures rose 68 percent in November from a year earlier. They may continue surging in 2008 as mortgages for some subprime borrowers with adjustable rates reset.

As foreclosures throw more homes onto the market, homebuilders such as Hovnanian Enterprises Inc., New Jersey's largest, are scaling back.

Hovnanian plans to ``pare down our inventories in virtually all our markets,'' Chief Executive Officer Ara Hovnanian said on a conference call Dec. 19. ``It will be a difficult year.''

Construction

Housing starts are near a 14-year low and have fallen 48 percent since their January 2006 peak. Declining home construction has subtracted from economic growth for the last seven quarters, and economists are expecting the drag to continue in 2008.

The weaker housing market is also forecast to undermine consumer spending, which makes up two thirds of the economy, as falling property values leave owners feeling less wealthy and with less equity to tap for extra cash.

The odds of recession have increased since the credit markets froze as a result of the subprime crisis. The economy will expand at a 1 percent annual pace in the fourth quarter after growing at a 4.9 percent rate from July through September, according to the median forecast of economists surveyed this month by Bloomberg News.

`The probability of recession is 50 percent for next year at some point,'' Martin Feldstein, head of the National Bureau of Economic Research, which determines when contractions start and end, said in a Dec. 14 interview. ``We could see a downturn starting sometime in the spring or the second quarter of next year.''

To contact the reporter on this story: Bob Willis in Washington at bwillis@bloomberg.net

Last Updated: December 28, 2007 11:15 EST

Thursday, December 27, 2007

Mortgage applications fall to lowest in a year

By Lynn Adler
Thu Dec 27, 10:35 AM ET

NEW YORK (Reuters) - U.S. mortgage applications sank last week to the lowest level since the end of last year despite falling borrowing costs, an industry trade group said on Thursday.

The Mortgage Bankers Association's seasonally adjusted mortgage application index fell 7.6 percent in the week ended December 21 to 603.8 -- its lowest reading since falling to 575.6 in the December 29, 2006 week.

The MBA's weekly indexes have been exaggerated on the high side much of the year. Borrowers facing stricter loan standards often apply numerous times in search of getting one request approved.

The applications slump this week and last, however, appears to more closely reflect the status of ailing housing sales.

Even after the two-week plunge which followed a steep increase in the last week of November, applications are just slightly weaker over the past month when accounting for volatility, notes Michelle Meyer, economist at Lehman Brothers.

"I wouldn't look at the levels per se because they don't correlate well with home sales," she said. "I would say the housing shock is about half-way over, I think we still have a big correction ahead of us."

Demand for both home purchase and refinancing applications dropped last week, as they did the prior week, when total loan requests slid 19.5 percent while interest rates climbed.

Loan requests for home purchases in the latest week dropped 6.6 percent to 394.5, a low since mid-February, according to the trade group.

"This represents one of the lowest figures in the past year, remarkable for a series that should have upward bias given the consolidation in the industry and the incentive to file multiple applications when credit availability tightens up," Goldman Sachs analysts wrote on Thursday.

The MBA's seasonally adjusted refinancing applications index fell 8.5 percent to 1,915.3 last week, its weakest point since early September.

"Maybe late in 2008 we'll see some markets beginning to recover," said Gregory Miller, chief economist at SunTrust Banks in Atlanta, on Wednesday prior to the MBA report.

"But for the nation as a whole, I think the end of 2008 is probably as optimistic as one would want to get," he said. "More likely, we'll be well into 2009 before we start describing this housing cycle as 'in recovery."'

Home prices posted their largest annual drop on record in October, according to the Standard & Poor's/Case-Shiller national index on Wednesday.

Prices will have to drop considerably more before the industry makes meaningful headway in selling off an unwieldy supply of unsold homes, many analysts contend.

"Tighter mortgage lending standards, falling consumer confidence and a sharp drop in speculative purchases have all taken bites out of buyer demand, forcing sellers to adjust by cutting prices," said Mike Larson, real estate analyst at Weiss Research Inc in Jupiter, Florida, after the S&P/Case-Shiller report was released. "There's no reason to expect an imminent turnaround."

Home applications trailed off last week despite falling mortgage rates. One-year adjustable mortgages tumbled 45 basis points in the week to 6.03 percent, the lowest since mid-November.

Fixed 30-year mortgage rates averaged 6.10 percent last week, down 8 basis points, the association said.

Snapshots of November's new home sales will be reported by the Commerce Department on Friday and of existing house sales by the National Association of Realtors on Monday.

New home sales likely fell to an annual rate of 720,000 last month from 728,000 in October, based on a Reuters poll. Existing home sales are seen unchanged at an annual 4.97 million pace, the lowest since the NAR began tracking single-family and condominium sales jointly in 1999.

(Reporting by Lynn Adler, editing by Gary Crosse)

Pimco's McCulley Says Fed to Cut Rates at Most of 2008 Meetings

By Daniel Kruger

Dec. 27 (Bloomberg) -- The Federal Reserve will reduce interest rates at every policy setting meeting ``for the next two to three quarters,'' Pacific Investment Management Co.'s Paul McCulley said in a note released today to clients.

The central bank will act to ``truncate both the length and the severity'' of a contraction in lending, McCulley said in the note, dated Dec. 21. The Fed will reduce its target rate for overnight loans between banks from 4.25 percent to 3 percent or lower, he wrote.

Policy makers next meet on Jan. 30 and gather again in March, April, June, August and September. McCulley first said the Fed will lower its overnight lending rate between banks to below 3 percent in November. In April, he said the housing ``recession'' would lead the central bank to lower its target.

Interest-rate futures traded on the Chicago Board of Trade show traders see 80 percent odds that the central bank will reduce rates to 4 percent on Jan. 30, compared with 100 percent odds on Dec. 13.

McCulley helps manage more than $700 billion at Newport Beach, California-based Pimco, a unit of Munich-based insurer Allianz SE.

-- Editor: Liedtka

To contact the reporter on this story: Daniel Kruger in New York at dkruger1@bloomberg.net

Last Updated: December 27, 2007 13:12 EST

Wednesday, December 26, 2007

U.S. Economy: Home Prices Declined at Faster Pace (Update3)

By Joe Richter and Courtney Schlisserman

Dec. 26 (Bloomberg) -- Home prices in 20 U.S. metropolitan areas fell in October by the most in at least six years, raising the risk that more Americans will walk away from properties that are worth less than they owe.

Values fell a greater-than-forecast 6.1 percent from October 2006, the S&P/Case-Shiller home-price index showed today. The decrease was the biggest since the group started keeping year-over-year records in 2001.

Prices will continue falling as record foreclosures put even more homes on the market while stricter lending rules make financing tougher to get. Declining values also pose a risk to consumer spending by making it harder for owners to tap home equity for extra cash.

``You are likely to see more people giving up on their loans as they end up with little or no equity in their homes,'' said Abiel Reinhart, an economist at JPMorgan Chase & Co. in New York. ``It's one more factor that weighs on the path of consumption.''

Compared with a month earlier, home prices dropped 1.4 percent, the biggest one-month decline since records began. The figures aren't seasonally adjusted, so economists prefer to focus on the year-over-year change.

The median forecast of 12 economists surveyed by Bloomberg News projected a 5.7 percent decline after the index dropped 4.9 percent in the 12 months ended in September.

Manufacturing Slumps

A report from the Federal Reserve Bank of Richmond today also showed manufacturing in its region contracted for the second time in three months in December. Combined with earlier reports this month that showed factory activity slowed in New York and also shrank in the Philadelphia region, the reports suggest the housing slump is filtering through the economy.

Seventeen of the 20 cities in the S&P/Case-Shiller index showed a year-over-year decline in prices, led by 12 percent slumps in Miami and Tampa, Florida. Three cities, Charlotte, North Carolina, Seattle and Portland, Oregon, showed an increase from a year earlier.

All 20 areas covered showed a drop in prices compared with September.

``There is no silver lining'' in the report, said David Blitzer, chairman of the index committee at Standard & Poor's, in an interview on Bloomberg Television. ``If you look across the cities, more often than not, the bigger the run-up, the more it comes down. There is no clear sign of a bottom in these numbers.''

Robert Shiller, chief economist at MacroMarkets LLC and a professor at Yale University, and Karl Case, an economics professor at Wellesley College, created the home-price index based on research from the 1980s.

Prices to Worsen

The housing market may continue to weaken as an increase in foreclosures adds to a glut of unsold homes on the market, spurring sellers to cut prices, economists said.

``With supply overhang enormous and mortgage financing tougher to obtain, home prices are going to decline considerably further in the quarters ahead,'' said Joshua Shapiro, chief U.S. economist at Maria Fiorini Ramirez Inc., a New York forecasting firm.

Lower home prices may also threaten spending. This holiday shopping season is forecast to be the weakest in five years, according to the National Retail Federation. A jump in November sales and a rush of last-minute purchases the weekend before Christmas probably weren't enough to change that outlook, according to analysts.

Stocks dropped following the reports and later pared losses. The S&P 500 index rose 1.2 points, or 0.1 percent, to close at 1,497.66 in New York. The supercomposite homebuilder index gained 0.3 percent.

Fewer Sales

Figures later this week from the Commerce Department may show new homes sold at an annual rate of 718,000 in November, down from October's 728,000 rate, based on the median estimate of economists surveyed by Bloomberg News.

Sales of new houses probably will fall 8.9 percent in 2008 after a 25 percent drop this year, according to a Dec. 13 forecast from Fannie Mae, the largest mortgage buyer.

``The market is too challenging to make predictions for fiscal 2008,'' Ara Hovnanian, chief executive officer of Hovnanian Enterprises Inc., said on a conference call on Dec. 19. ``It will be a difficult year.'' The Red Bank, New Jersey- based company reported a net loss of $467 million for the three months ended Oct. 31.

Residential investment has subtracted from economic growth for the past seven quarters. Home building dropped at a 20.5 percent annual pace in the third quarter, the most since 1991.

The S&P/Case-Shiller index and another by the Office of Federal Housing Enterprise Oversight track the same home over time and more accurately reflect price trends, economists said.

Price gauges from the Commerce Department and the Realtors group can be influenced by changes in the types of homes sold. Higher sales of cheaper homes relative to more-expensive properties will bias the figures down.

To contact the reporters on this story: Joe Richter in Washington at jrichter1@bloomberg.net Courtney Schlisserman in Washington at cschlisserma@bloomberg.net

Last Updated: December 26, 2007 16:47 EST

Tuesday, December 25, 2007

Online Sales Slip Below Forecast

Breaking News from MoneyNews.com

Online sales numbers out just before Christmas missed forecast growth rates and trailed last year’s increase.

Online buying was up 19 percent between Nov. 1 and Dec. 21, reaching $26 billion, according to comScore, the online spending tracker in Reston, Va.

That’s off from the 20 percent increase comScore had predicted for the period and down from 25 percent growth the year before. It’s also the first time sales did not exceed 20 percent growth since comScore began tracking the figure in 2002.

Rising gasoline and good prices are making a dent in online shopping, just as it has done so far for bricks and mortar retailers.

Consumer sentiment hit 75.5 for December, according to the Reuters/University of Michigan index. That’s the lowest point since October 2005.

The online buying survey excludes travel, auction sides like eBay and big corporate purchases done online.

Last-minute shopping gave the index a bump.

“We are continuing to see online spending strength as we get deeper into the season, with the most recent five-day span ending December 21 exhibiting a 25-percent growth rate versus year ago,” said comScore Chairman Gian Fulgoni.

Nevertheless, Dec. 10 — known as “Green Monday” — will remain the biggest spending day of the year online, at $881 million spent on that day alone.

“At this point of the season, the heaviest online spending days are now well behind us. However, with some online retailers offering deliveries before Christmas for orders placed by December 22, and in-store pickup available for orders placed on Christmas Eve, we expect to see above average growth rates continue through the holiday,” Fulgoni said.

It probably isn’t helping that Americans are falling behind on credit-card debts they already have.

The value of credit card accounts at least 30 days late jumped 26 percent to $17.3 billion in October from a year earlier at 17 large credit card trusts examined by the Associated Press.

That represented more than 4 percent of the total outstanding principal balances owed to the trusts on credit cards that were issued by banks, such as Bank of America and Capital One and for retailers like Home Depot and Wal-Mart.

"Debt eventually leaks into other areas, whether it starts with the mortgage and goes to the credit card or vice versa," Cliff Tan, a visiting scholar at Stanford University and an expert on credit risk, told the AP. "We're starting to see leaks now."

Jim Rogers: Bernanke in Over His Head

Newsmax.com

Investment guru Jim Rogers says the U.S. economy is either in recession or on the brink of it, and that America’s political leaders already know it.

"The American economy is already in recession or very close to it, and the administration knows this but is lying to the public," investment guru Jim Rogers said this week.

He told the Israeli business newswire The Globes that it might take six months for the recession to unavoidably apparent. He added that Fed Chairman Ben Bernanke is unlikely to do much about it — except perhaps make inflation worse.

"He's an academic with no experience in capital markets. All he has learned is to print money,” Roger said.

"Many have tried this here and elsewhere in the world, including in Israel, and he will discover what others have learned before him: It causes inflation,” Rogers said.

Rogers has little positive to say about "Helicopter Ben,” referring to a Bernanke speech made before he was named Fed chief, in which Bernanke cited Milton Friedman’s theory that the Fed could offset deflation by tossing cash out of helicopters if need be.

Bernanke would be better off letting the free market work than stepping in deeper, Rogers said.

If he was in charge, Rogers added, the central bank would be the first to go.

"We were once a country that loaned money. Today we're drowning in debt, and the U.S. owes another $1 trillion every 15 months,” Rogers said.

"Our enemies think about how to exploit this situation to harm us,” Roger said.

Rogers pulled no punches on Bernanke’s predecessor, Alan Greenspan, either.

"Greenspan told Congress that he saw no bubble when even my mother could see it. It sometimes seemed to me that Greenspan was saying in interviews things that he heard on CNBC, which was quoting him,” Roger said.

Best Blue-Chip Real Estate Investments

Matt Woolsey, 12.07.07, 6:00 AM ET
Forbes.com

While gambles on up-and-coming neighborhoods and new developments paid off for many real estate investors during the boom, housing markets across the country are now awash with unsold condos and suffering from sluggish sales.

But this is not the case for homeowners in so-called "blue chip" neighborhoods. Properties in these well-established spots have held on to and increased in value over the last 17 years. They include segments of Pacific Palisades in Los Angeles, areas of Chicago and parts of University Park in Dallas. In these spots, the median home sale price has grown, in that time, by 440%, 236% and 148%, respectively.

In search of these and other "blue-chips," Forbes.com looked at home appreciation data from NeighborhoodScout.com, a Rhode Island-based real estate research firm that tracks these numbers at the Census-tract level. It revealed the spots in the country's 15 largest metros which show the greatest total historical appreciation since 1990. After all, a truly robust market can weather market downturns and grow during market spikes, no matter how many cycles it goes through.

Complete List: America's Blue-Chip Neighborhoods

We constrained our data set in two ways. Neighborhoods had to post prices in the city's median range or above in 1990, and the majority of homes in the neighborhood had to be built before 1990. Otherwise, the list would be filled with two kinds of false positives: areas infiltrated with the abandoned-warehouse-turned-high-rise, where property values easily might have shot up 2,000%, but where none of these homes really appreciated, and those filled with new construction.

While good for urban renewal, new construction doesn't indicate areas are becoming more valuable, just that expensive homes are parachuting in. A true blue-chip neighborhood is of high quality and stands the test of time, regardless of how much new construction or re-zoning the government leverages as incentive for builders.

NeighborhoodScout.com aggregates its data on the Census-tract level, which are, effectively, neighborhoods as defined by the Census Bureau. ZIP codes, another common method of measurement, are defined based on mail delivery efficiency, and thus often cut across very different neighborhoods. The Census-defined neighborhood is purely geographical, which makes the data more precise.

Behind The Numbers

In some cases, our blue-chip picks encompass a city's priciest area. This was the case with New York, where a swathe of the Upper East Side, in the East 70s, was found valuable in 1990 and has appreciated by 325% since then. Of course, stability and strong, consistent growth gets cooked into the neighborhood's $2.45 million median home price tag.

None of the neighborhoods on our list are particularly cheap. Even by California standards, the Sea Cliff area of San Francisco and Pacific Palisades in Los Angeles command top dollar, drawing median rates of $2.2 million and $3.1 million, respectively.

Still, in some places, the strongest-growing parts of town were middle- or upper-middle-class areas that were a good value in 1990, have exploded in value since, and are presently proving they can withstand the downward draft.

Good examples? Laurelhurst in Seattle and the Brickell Avenue/13th Street area of Miami. Neither neighborhood can be called the most expensive part of town, but both have been strong and steady gainers, appreciating 216% and 471% respectively since 1990.

Another consideration for some blue-chip areas: the range of housing prices. In the Embassy Row section of Washington, D.C., there's little available much below the $2.84 million median price. But head to the Walnut Street and Third Street section of Philadelphia, and you'll find townhouses listing above $2 million--but you'll also notice that about 30% of the homes for sale are available for between $340,000 and $670,000. Goes to show that, while the homes are smaller, and are often apartments, they represent affordable buying opportunities in many blue-chip neighborhoods.

The prices are high, but you get what you pay for--especially when it comes time to hang out the "For Sale" sign.

Crisis may make 1929 look a 'walk in the park'

Last Updated: 11:02pm GMT 23/12/07
Telegraph UK

As central banks continue to splash their cash over the system, so far to little effect, Ambrose Evans-Pritchard argues things are rapidly spiralling out of their control

Twenty billion dollars here, $20bn there, and a lush half-trillion from the European Central Bank at give-away rates for Christmas. Buckets of liquidity are being splashed over the North Atlantic banking system, so far with meagre or fleeting effects.

As the credit paralysis stretches through its fifth month, a chorus of economists has begun to warn that the world's central banks are fighting the wrong war, and perhaps risk a policy error of epochal proportions.

"Liquidity doesn't do anything in this situation," says Anna Schwartz, the doyenne of US monetarism and life-time student (with Milton Friedman) of the Great Depression.

"It cannot deal with the underlying fear that lots of firms are going bankrupt. The banks and the hedge funds have not fully acknowledged who is in trouble. That is the critical issue," she adds.

Lenders are hoarding the cash, shunning peers as if all were sub-prime lepers. Spreads on three-month Euribor and Libor - the interbank rates used to price contracts and Club Med mortgages - are stuck at 80 basis points even after the latest blitz. The monetary screw has tightened by default.

York professor Peter Spencer, chief economist for the ITEM Club, says the global authorities have just weeks to get this right, or trigger disaster.

The central banks are rapidly losing control. By not cutting interest rates nearly far enough or fast enough, they are allowing the money markets to dictate policy. We are long past worrying about moral hazard," he says.

"They still have another couple of months before this starts imploding. Things are very unstable and can move incredibly fast. I don't think the central banks are going to make a major policy error, but if they do, this could make 1929 look like a walk in the park," he adds.

The Bank of England knows the risk. Markets director Paul Tucker says the crisis has moved beyond the collapse of mortgage securities, and is now eating into the bedrock of banking capital. "We must try to avoid the vicious circle in which tighter liquidity conditions, lower asset values, impaired capital resources, reduced credit supply, and slower aggregate demand feed back on each other," he says.

New York's Federal Reserve chief Tim Geithner echoed the words, warning of an "adverse self-reinforcing dynamic", banker-speak for a downward spiral. The Fed has broken decades of practice by inviting all US depositary banks to its lending window, bringing dodgy mortgage securities as collateral.

Quietly, insiders are perusing an obscure paper by Fed staffers David Small and Jim Clouse. It explores what can be done under the Federal Reserve Act when all else fails.

Section 13 (3) allows the Fed to take emergency action when banks become "unwilling or very reluctant to provide credit". A vote by five governors can - in "exigent circumstances" - authorise the bank to lend money to anybody, and take upon itself the credit risk. This clause has not been evoked since the Slump.

Yet still the central banks shrink from seriously grasping the rate-cut nettle. Understandably so. They are caught between the Scylla of the debt crunch and the Charybdis of inflation. It is not yet certain which is the more powerful force.

America's headline CPI screamed to 4.3 per cent in November. This may be a rogue figure, the tail effects of an oil, commodity, and food price spike. If so, the Fed missed its chance months ago to prepare the markets for such a case. It is now stymied.

This has eerie echoes of Japan in late-1990, when inflation rose to 4 per cent on a mini price-surge across Asia. As the Bank of Japan fretted about an inflation scare, the country's financial system tipped into the abyss.

In theory, Japan had ample ammo to fight a bust. Interest rates were 6 per cent in February 1990. In reality, the country was engulfed by the tsunami of debt deflation quicker than the bank dared to cut rates. In the end, rates fell to zero. Still it was not enough.

When a credit system implodes, it can feed on itself with lightning speed. Current rates in America (4.25 per cent), Britain (5.5 per cent), and the eurozone (4 per cent) have scope to fall a long way, but this may prove less of a panacea than often assumed. The risk is a Japanese denouement across the Anglo-Saxon world and half Europe.

Bernard Connolly, global strategist at Banque AIG, said the Fed and allies had scripted a Greek tragedy by under-pricing credit long ago and seem paralysed as post-bubble chickens now come home to roost. "The central banks are trying to dissociate financial problems from the real economy. They are pushing the world nearer and nearer to the edge of depression. We hope they will eventually be dragged kicking and screaming to do enough, but time is running out," he said.

Glance at the more or less healthy stock markets in New York, London, and Frankfurt, and you might never know that this debate is raging. Hopes that Middle Eastern and Asian wealth funds will plug every hole lifts spirits.

Glance at the debt markets and you hear a different tale. Not a single junk bond has been issued in Europe since August. Every attempt failed.

Europe's corporate bond issuance fell 66pc in the third quarter to $396bn (BIS data). Emerging market bonds plummeted 75pc.

"The kind of upheaval observed in the international money markets over the past few months has never been witnessed in history," says Thomas Jordan, a Swiss central bank governor.

"The sub-prime mortgage crisis hit a vital nerve of the international financial system," he says.

The market for asset-backed commercial paper - where Europe's lenders from IKB to the German Doctors and Dentists borrowed through Irish-based "conduits" to play US housing debt - has shrunk for 18 weeks in a row. It has shed $404bn or 36pc. As lenders refuse to roll over credit, banks must take these wrecks back on their books. There lies the rub.

Professor Spencer says capital ratios have fallen far below the 8 per cent minimum under Basel rules. "If they can't raise capital, they will have to shrink balance sheets," he said.

Tim Congdon, a banking historian at the London School of Economics, said the rot had seeped through the foundations of British lending.

Average equity capital has fallen to 3.2 per cent (nearer 2.5 per cent sans "goodwill"), compared with 5 per cent seven years ago. "How on earth did the Financial Services Authority let this happen?" he asks.

Worse, changes pushed through by Gordon Brown in 1998 have caused the de facto cash and liquid assets ratio to collapse from post-war levels above 30 per cent to near zero. "Brown hadn't got a clue what he was doing," he says.

The risk for Britain - as property buckles - is a twin banking and fiscal squeeze. The UK budget deficit is already 3 per cent of GDP at the peak of the economic cycle, shockingly out of line with its peers. America looks frugal by comparison.

Maastricht rules may force the Government to raise taxes or slash spending into a recession. This way lies crucifixion. The UK current account deficit was 5.7 per cent of GDP in the second quarter, the highest in half a century. Gordon Brown has disarmed us on every front.

In Europe, the ECB has its own distinct headache. Inflation is 3.1 per cent, the highest since monetary union. This is already enough to set off a political storm in Germany. A Dresdner poll found that 71 per cent of German women want the Deutschmark restored.

With Brünhilde fuming about Brot prices, the ECB has to watch its step. Frankfurt cannot easily cut rates to cushion the blow as housing bubbles pop across southern Europe. It must resort to tricks instead. Hence the half trillion gush last week at rates of 70bp below Euribor, a camouflaged move to help Spain.

The ECB's little secret is that it must never allow a Northern Rock failure in the eurozone because this would expose the reality that there is no EU treasury and no EU lender of last resort behind the system. Would German taxpayers foot the bill for a Spanish bail-out in the way that Kentish men and maids must foot the bill for Newcastle's Rock? Nobody knows. This is where eurozone solidarity stretches to snapping point. It is why the ECB has showered the system with liquidity from day one of this crisis.

Citigroup, Merrill Lynch, UBS, HSBC and others have stepped forward to reveal their losses. At some point, enough of the dirty linen will be on the line to let markets discern the shape of the debacle. We are not there yet.

Goldman Sachs caused shock last month when it predicted that total crunch losses would reach $500bn, leading to a $2 trillion contraction in lending as bank multiples kick into reverse. This already seems humdrum.

"Our counterparties are telling us that losses may reach $700bn," says Rob McAdie, head of credit at Barclays Capital. Where will it end? The big banks face a further $200bn of defaults in commercial property. On it goes.

The International Monetary Fund still predicts blistering global growth of 5 per cent next year. If so, markets should roar back to life in January, as though the crunch were but a nightmare. There again, the credit soufflé may be hard to raise a second time.