Bank of the United States

Citigroup cuts a deal with its new bosses on Capitol Hill.

At first glance, Citigroup's endorsement last week of a Senate plan to allow bankruptcy judges to break mortgage contracts looks like a scene from "Goodfellas."

AP

Since October, the government has invested $52 billion in Citi, while agreeing to eat up to $249 billion in losses on the bank's toxic real estate portfolio. And so it's really hard to say no when those Washington "investors" call for a favor. In the 1990 Martin Scorsese movie, a restaurant owner realizes too late that a partner big enough to protect him is big enough to take everything he has. As Ray Liotta narrates, "Now he's got Paulie as a partner. Any problems, he goes to Paulie. Trouble with a bill, to Paulie . . . But now he has to pay Paulie."

The problem with Citi's capitulation is that it means that not just Citi will have to pay the Beltway outfit if the bill passes. Other banks, borrowers and taxpayers will also suffer. In fact, this deal is looking more and more like a case of Citi colluding with its new political owners in order to force competing banks to break contracts and take more losses. This kind of politicized banking is precisely why the Bank of the United States was shut down in the 19th century.

After years of resisting, Citi has suddenly signed off on Senator Dick Durbin's plan to allow judges to rewrite mortgage contracts for borrowers in Chapter 13 bankruptcy. Under the Illinois Democrat's plan, which is earmarked for inclusion in the pending stimulus bill, judges could reduce the amount of principal, lower the interest rate, and change the length of the mortgage term.

Until Washington embraced the politics of housing panic, even sensible Democrats recognized that allowing such mortgage "cramdowns" was a terrible idea, sure to punish future borrowers with higher rates as lenders calculate the increased risk. The Congressional Budget Office warned in January 2008 that such a change could result in higher interest rates for homeowners and bigger caseloads in bankruptcy courts. In 2007, 16 House Democrats signed a letter opposing similar legislation.

They realized that the consequences would fall hardest on those hoping to buy a home, if markets logically respond by setting mortgage interest rates closer to those on, for example, auto loans or credit cards. A bankruptcy judge is now free to reduce amounts owed on many types of consumer debt. For mortgages, the iron-clad requirement to pay off the loan or lose the house is precisely to encourage lower rates on a less risky investment.

Supreme Court Justice John Paul Stevens described the importance of this principle in 1993 in Nobelman v. American Savings Bank: "At first blush it seems somewhat strange that the Bankruptcy Code should provide less protection to an individual's interest in retaining possession of his or her home than of other assets. The anomaly is, however, explained by the legislative history indicating that favorable treatment of residential mortgages was intended to encourage the flow of capital into the home lending market."

Mr. Durbin argues that borrowers won't be able to enjoy the benefits of a cramdown until they first make an effort to negotiate new terms with their lenders before declaring bankruptcy. Also, to counter the perception that they are harming the mortgage market, Mr. Durbin and Senate colleagues Chris Dodd and Chuck Schumer are proposing that cramdowns only be available for mortgage contracts signed before their bill becomes law. But of course lenders will have every reason to assume that, whenever the going gets tough, Washington will let future borrowers break contracts too.

Mr. Durbin and his allies have tried and failed several times to break the cramdown opposition, and they believe Citi finally gives them the club to prevail. As Mr. Schumer noted in a press release, "Citigroup's support means that the dam has broken across the banking industry. We now have a real chance to pass this legislation quickly." Talking point number one for Democrats is that if giant Citigroup is for this plan, why would anyone oppose it?

In fact, Citigroup may support this plan precisely because it isn't a big player in the mortgage market. Sure, it has some dodgy mortgage-backed securities on its books, but they've been written down and the feds cover 90% of losses beyond $29 billion in any case. When it comes to making loans, however, Citi originates less than 10% of American mortgages.

Citi is falling further behind J.P. Morgan Chase, which acquired Washington Mutual; Wells Fargo, which acquired Wachovia; and Bank of America, which bought Countrywide. J.P. Morgan's mortgage business is now twice the size of Citi's, while Wells and BofA each originate almost three times as much dollar volume as Citi. So in agreeing to Mr. Durbin's offer, Citi is also volunteering its competitors to write down more mortgages, giving Citi a comparative advantage.

But the unintended consequences could make even Citi rue the day it got in bed with the goodfellas on Capitol Hill. If the possibility of this refinancing-via-bankruptcy encourages more people to declare bankruptcy, that would mean additional losses on Citi's credit cards and auto loans.

Having spent the past year committing taxpayer trillions to support American banks, Washington now seems not to mind at all if its latest bailout drives up bank losses on mortgages, credit cards and other loans. The Senate could soon make Paulie look like a reasonable business partner.

Merrill Lynch says rich turning to gold bars for safety

Merrill Lynch has revealed that some of its richest clients are so alarmed by the state of the financial system and signs of political instability around the world that they are now insisting on the purchase of gold bars, shunning derivatives or "paper" proxies.

By Ambrose Evans-Pritchard
Last Updated: 10:32AM GMT 09 Jan 2009

Rich investors are spurning gold exchange traded funds in favour of krugerrands.

Gary Dugan, the chief investment officer for the US bank, said there has been a remarkable change in sentiment. "People are genuinely worried about what the world is going to look like in 2009. It is amazing how many clients want physical gold, not ETFs," he said, referring to exchange trade funds listed in London, New York, and other bourses.

"They are so worried they want a portable asset in their house. I never thought I would be getting calls from clients saying they want a box of krugerrands," he said.

Merrill predicted that gold would soon blast through its all time-high of $1,030 an ounce, and would hit $1,150 by June.

The metal should do well whatever happens. If deflation sets in and rocks the economic system it will serve as a safe-haven, but if massive monetary stimulus gains traction and sets off inflation once again it will also come into its own as a store of value. "It's win-win either way," said Mr Dugan.

He added that deflation may prove the greater risk in coming months. "It's very difficult to get the deflation psychology out of the human brain once prices start falling. People stop buying things because they think it will be cheaper if they wait."

Merrill expects global inflation to hover near zero, with rates of minus 1pc in the industrial economies. This means that yields on AAA sovereign bonds now at 3pc will offer a real return of 4pc a year, which is stellar in this grim climate. "Don't start selling your government bonds," Mr Dugan said, dismissing talk of a bond bubble as misguided.

He warned that the eurozone was likely to come under strain this year as slump deepens. "There is going to be friction as governments in the south start talking politically about coming out of the euro.
I don't see the tensions in Greece as a one-off. It is a sign of social strain in countries that have lost competitiveness."

Reform plan raises fears of Bank secrecy

The Bank of England will be able to print extra money without having legally to declare it under new plans which will heighten fears that the Government will secretly pump extra cash into the economy.

The Bank of England will be able to print extra money

The Government is set to throw out the 165-year old law that obliges the Bank to publish a weekly account of its balance sheet – a move that will allow it theoretically to embark covertly on so-called quantitative easing. The Banking Bill, which is currently passing through Parliament, abolishes a key section of the law laid down by Robert Peel's Government in 1844 which originally granted the Bank the sole right to print UK money.

The ostensible reason for the reform, which means the Bank will not have to print details of its own accounts and the amount of notes and coins flowing through the UK economy, is to allow the Bank more power to overhaul troubled financial institutions in the future, under its Special Resolution Authority.

However, some have warned that it means: "there is nothing to stop an unreported and unmonitored flooding of the money market by the undisciplined use of the printing presses."

It comes after the Bank's Monetary Policy Committee cut interest rates by half a percentage point, leaving them at the lowest level since the bank's foundation in 1694.

With the Bank rate now at 1.5pc, most economists suspect the Government and Bank will soon be forced to start quantitative easing – directly increasing the quantity of money in the economy – in a drastic attempt to prevent a recession of unprecedented depth.

Although the amount of easing is likely to be limited, news of this increased secrecy will spark comparisons with Weimar Germany and Zimbabwe, where uncontrolled use of the central banks' printing presses ultimately caused hyperinflation.

The Bank said it will still publish details of its balance sheet, but, significantly, the data – the main indicator of the extent of quantitative easing – will not be presented until more than a month has elapsed. For instance, under the new terms of the law, if the Bank were to have embarked on a policy of quantitative easing last month, the figures on this would not be published until the end of this month.

The reforms, which are likely to be implemented later this year, will make the Bank of England by far the most secretive major central in the world, experts said.

In the US, where the Federal Reserve has already cut rates to close to zero and started quantitative easing, the main way to track its purchases of securities and the expansion of its balance sheet is through precisely these same weekly accounts.

"Quite why the Bank has to keep its operations so shrouded in secrecy is a mystery to me," said Simon Ward, economist at New Star. "This [reform] will make it much more difficult to track what the Bank is doing."

Among the details which will no longer be published are those revealing the extent to which London's banks are using the Bank's deposit facilities – a yardstick of pressure in the financial system.

Debating the issue in the House of Lords recently, Lord James of Blackheath, a Conservative peer, said: "Remove [this] control and there is nothing to stop an unreported and unmonitored flooding of the money market by the undisciplined use of the printing presses.

"If we went down that path we would be following a road which starts in Weimar, goes on through Harare and must not end in Westminster and London. That is the great fear that the abolition of that section will bring about – but the Bill abolishes it."

Government to hold 43.4 pct of Lloyds-HBOS bank

LONDON (Reuters) - The state is to take a 43.4 percent stake in the combined Lloyds TSB-HBOS bank after shareholders largely shunned both lenders' rights issues, the two banks said on Monday.

Existing shareholders bought just 0.5 percent of the new Lloyds shares offered in its rights issue, and 0.24 percent of the HBOS shares, leaving the government to buy up the remainder, the banks said.

The government agreed to underwrite the two lenders' capital raisings as part of its 37 billion pound bailout of the banking sector in October last year.

The low level of shareholder participation in the Lloyds and HBOS rights issues was expected, as both banks' shares had fallen below the price at which new stock was offered to the market.

By 11:05 a.m. British time, Lloyds shares were up 5 percent at 138.2 pence, below the rights price of 173.3 pence. HBOS shares were 4 percent higher at 82.9 pence, compared with a rights price of 113.6 pence.

"We understand that many existing shareholders did not participate because of the divergence between the offer price and the current market price," Lloyds TSB Chief Executive Eric Daniels said in a statement.

"We are pleased that the capital raising process has completed and that the new combined group will have a strong financial position."

CAPITAL STRENGTH

The twin rights issues will raise about 17 billion pounds in capital for the combined bank, buffering it against potential further losses on risky credit-related assets, as well as an anticipated rise in bad debts this year as the UK succumbs to recession.

Lloyds' takeover of HBOS, brokered by the government in September last year after a dramatic slump in HBOS' share price threatened to undermine consumer confidence in the bank, is expected to complete on January 19.

The combination is expected to clear one of its final administrative hurdles later on Monday when it gains the approval of a Scottish court.

The acquisition will create a dominant retail financial services group controlling a third of all UK current accounts and 28 percent of the country's mortgages, and would under ordinary circumstances have been blocked by competition regulators.

The outlook for the enlarged bank, named the Lloyds Banking Group, hinges on the extent to which bad debts and write downs against risky assets held by HBOS offset projected cost savings of at least 1.5 billion pounds.

"It's a classic short-term risk, long-term value trade-off," said Oriel Securities analyst Mike Trippitt.

"The power of the group in a normal market will be quite big, but the near term concern is the risk it's taking with the toxic waste on HBOS' balance sheet."

The state already holds a 58 percent stake in Royal Bank of Scotland after its shareholders spurned a similar government-sponsored rights issue in November.

The government's bailout of the banking sector was designed to prevent major lenders going bust as a wave of defaults against U.S. sub-prime mortgages paralysed wholesale credit markets, depriving banks worldwide of a key source of funding.

UK Financial Investments, the body set up by the government to manage its bank holdings, will shortly appoint four non-executive directors including Glen Moreno, the chairman of media group Pearson, the Sunday Telegraph reported at the weekend.

IRS May Push for Tax Compliance in Virtual Worlds

The IRS soon may keep a closer watch on the thousands, if not millions, of small firms and the self-employed that have sprouted up in virtual worlds.

The nation's taxpayer advocate, who recommends to the IRS how to improve the average consumer's tax-paying process, released her annual report Wednesday describing some of the most serious problems encountered by taxpayers as well as some issues that the IRS should proactively address.

Taxpayer advocate Nina Olson listed the usual perennial suspects -- telling the IRS it should simplify the tax code and improve its working with taxpayers experiencing financial difficulties, among many other things.

But she also told the agency that it should "proactively address emerging issues such as those arising from virtual worlds." Her report said that about $1 billion in real dollars changed hands in computer-based environments during 2005. Additionally, more than 16 million people are said to have active subscriptions in these worlds, "many of which have their own virtual economies and currencies."

But Olson said the IRS hasn't effectively been able to respond to taxpayer inquiries about how to report transactions associated with them. "Economic activities in virtual worlds may present an emerging area of tax noncompliance, in part because the IRS has not provided guidance about whether and how taxpayers should report such activities," said Olson's report. She suggests that to improve voluntary tax compliance, the IRS issue guidance addressing how taxpayers should report economic activities in virtual worlds.

The bond bubble is an accident waiting to happen

The bond vigilantes slumber. As the greatest sovereign bond bubble of all time rolls into 2009, investors are clinging to an implausible assumption that China and Japan will provide enough capital to keep the happy game going for ever.

They are betting too that debt deflation will overwhelm the effects of near-zero interest rates across the G10 and nullify a £2,000bn fiscal blast in the US, China, Japan, Britain, and Europe.

Above all, they are betting that the Federal Reserve chief Ben Bernanke will fail to print enough banknotes to inflate the US money supply, despite his avowed intent to do so.

Yields on 10-year US Treasuries have fallen to 2.4pc – a level that was unseen even in the Great Depression. This is "return-free risk", said bond guru Jim Grant.

It is much the same story across the world. Yields are 1.3pc in Japan, 3.02pc in Germany, 3.13pc in Britain, 3.26pc in Chile, 3.47pc in France, and 5.56pc in Brazil.

"Get out of Treasuries. They are very, very expensive," said Mohamed El-Erian, the investment chief at the Pimco, the world's top bond fund, in a Barron's article last week.

It is lazy to think that China, Japan, the petro-powers and the surplus states of emerging Asia will continue to amass foreign reserves, recycling their treasure into the US and European bond markets.

These countries are themselves bleeding as exports collapse. Most face capital flight. The whole process that fed the bond boom from 2003 to 2008 is now going into reverse.

Woe betide any investor who misjudges the consequences of this strategic shift.

Russia has lost 27pc of its $600bn reserves since August. The oil and metals crash has left the oligarchs prostrate. China's reserves fell $15bn in October. Beijing has begun to fret about an exodus of hot money – disguised as foreign investment in plant. The exchange regulator is muttering about "abnormal" capital flows out of the country.

China's $1,900bn stash of foreign bonds is a by-product of holding down the yuan to boost exports.

This mercantilist ploy is no longer necessary, since the currency is weakening. Beijing needs the money at home in any case to prop up the Chinese economy – now in trouble. Even Japan has slipped into trade deficit.

Clearly, the US and European governments cannot rely on Asia to plug the $3,500bn hole in their budgets this year.

Asians are just as likely to be net sellers of their bonds. Which implies that central banks may have to "monetize" our deficits.

James Montier, from Société Générale, has examined US bonds back to 1798. Yields have never been this low before, except under war controls in the 1940s when the price was set by dictate.

That episode is not a happy precedent. The Fed drove the 10-year bond down to 2.25pc, much as it is doing today with mortgage bonds. It helped America win World War Two, but ended in tears for bond holders in 1946 when inflation jumped to 18pc.

Mr Montier said yields have averaged 4.5pc over two centuries, with a real return of around 2pc. By that benchmark, the market is now banking on a decade of deflation.

Investors have drawn a false parallel with Japan's Lost Decade, when bond yields kept falling, forgetting that Tokyo waited seven years before resorting to the printing press. Mr Bernanke has no such inhibitions. He has hit the nuclear button in advance.

"Today's yields are woefully short of the estimated fair value under normal conditions. There maybe a (short-term) speculative case for buying bonds. However, I am an investor, not a speculator," he said

Of course, we may already be so deep into debt deflation that bonds will rally regardless. Fresh data suggest that Japan's economy contracted at a 12pc annual rate in the fourth quarter of 2008; the US, Germany, and France shrank at a 6pc rate, and Britain shrank at 5pc.

If sustained, these figures are worse than 1930, though not as bad as the killer year of 1931. The UK contraction from peak to trough in the Slump was 5pc. Gordon Brown will be lucky to get off so lightly.

The Fed's December minutes reek of fear. The Bernanke team is no longer sure that stimulus will gain traction in time.

The Fed's "Monetary Multiplier" has collapsed, falling below 1. This is unthinkable. We are in a liquidity trap.

So yes, printing money is not as easy as it looks, but to conclude that the Fed cannot bring about inflation is a leap too far.

The Fed has only just started to debauch in earnest, buying $600bn of mortgage bonds to force home loans down to 4.5pc. US mortgage rates have dropped 150 basis points in two months.

My tentative guess is that Bernanke's blitz will "work" – perhaps later this year. Markets will start to look beyond deflation. They will remember that the Fed is boosting its balance sheet from $800bn to $3,000bn, and that it sits on an overhang of bonds that must be sold again.

"The euthanasia of the rentier" will wear off, to borrow from Keynes. That is when the next crisis begins.