High-yield/macroeconomics (fka YIELD)

[Preciouslife1]

Credit Crunch/The Fed's Fix
Liz Moyer, 03.10.08, 6:00 AM ET

http://www.forbes.com/2008/03/07/fed-bernanke-banking-biz-wall-cx_lm_0310subprime.html?feed=rss_news

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The Fed said on Friday it would increase its March term auction program by $40 billion in an effort to flood the banking system with cash and reignite lending between banks that are keeping the world's financial system stalled. The response on trading floors? Ho-hum.

The Fed is working overtime trying to fix the banking system. The problem: It can't. Only the market can do that now.

"Liquidity is good, but that was more of the August story," says Michael Feroli, an economist at JPMorgan Chase (nyse: JPM - news - people ). "Now the deeper, more chronic problem has set in, and that's the capital problem."

Banks are busy reducing leverage and shoring up their capital, and the effects of both are cascading through the financial markets. Hedge funds and mortgage lenders are faltering on margin calls by skittish lenders. Banks aren't picking up the slack in demand in the auction rate market. Borrowing terms for even the most creditworthy of companies and individuals are getting more onerous.

Estimates about the magnitude of the financial system's losses keep going up. Last week, UBS (nyse: UBS - news - people ) put it at $600 billion. On Friday, a team of analysts from Friedman Billings Ramsey said the financial industry needed to raise $1 trillion in permanent capital.

Regulators, including a Fed governor, were out talking this week about their desire for banks to raise additional capital from private investors. Banks have already raised more than $50 billion, mostly from overseas investment funds.

The most recent term auction, at which the Fed lent $30 billion, was oversubscribed by more than 2-to-1. Joseph Mason, a finance professor at Drexel University, says, "This is not a liquidity crisis, it's a credit crisis."

Mason thinks there's a better way out. "Some value-destroying firms and even banks, themselves, can and should fail through the process of improving financial market transparency and liquidity," he said in a presentation last month.

A Fed spokesman had no comment Friday.

One of the problems is the limited number of things the Fed can do to get banks to lend again. As Fed Chairman Ben Bernanke has acknowledged, the Fed is good at slowing down an economy, but not so good at prodding it back to life. The most recent Fed data on lending shows it is going up, but there is a debate about how voluntary that lending is. Much of it could be from previously extended credit lines that are now being drawn down.

But hope springs eternal. There were rumors this week that the federal government would step in and explicitly guarantee the debt of Fannie Mae (nyse: FNM - news - people ) and Freddie Mac (nyse: FRE - news - people ), a rumor the government quickly denied. But the fact that the rumor was going around shows just how much the banking sector wants to see some form of a bailout.

Regulators are anticipating a surge in bank failures after a period of unprecedented calm.

There will be other changes coming that will make a more lasting impact on the financial sector.
Banks are shying away from the securitization model that got so popular in the last few years, and which led to the lending bubble. More assets will be held on balance sheet, and banks will likely hold more reserves against them.

On Thursday, Citigroup (nyse: C - news - people ), which itself has written down more than $20 billion in exposures to mortgage securities, derivatives and leveraged loans, said it would contract its mortgage lending by $45 billion this year and wouldn't make certain types of riskier mortgages it once made, all the better to cut its losses.

Prince Alwaleed Bin Talal must be rather perturbed with Citi's precipitous drop and his billions in paper losses...camel meat helper anyone?

Thornburg Mortgage (nyse: TMA - news - people ), a major originator of jumbo adjustable-rate loans, is faltering after missing margin calls on its mortgage securities holdings. On Friday, it said it couldn't make $610 million in margin calls and that has "raised substantial doubt" about its ability to survive.
The company restated 2007 results and took a $429 million charge to adjust the value of its mortgage holdings.

Merrill Lynch (nyse: MER - news - people ) said Wednesday it was shutting down the First Franklin (nasdaq: FFHS - news - people ) mortgage unit it bought for more than $1 billion from National City (nyse: NCC - news - people ) in December 2006. Lehman Brothers (nyse: LEH - news - people ) has also shut down mortgage units.

Commercial real estate is the next big worry.
In Senate testimony earlier this week, the comptroller of the currency's office, which regulates nationally chartered banks, said one-quarter of community banks under its oversight have commercial real estate concentrations that exceed thresholds recommended by a group of financial regulators.

Analyst Brad Hintz of Sanford C. Bernstein reckons that it's only the early stages of the de-leveraging and that the peak of the pressure will happen sometime over the next six months. "Buy your ammo and canned goods," he likes to joke.
The markets won't come back until the relentless selling is over, and investors standing awash in cash return to the market.