3SOF

Important article ;)

http://www.howestreet.com/articles/index.php?article_id=5068

The Collapse of the Great Ratings Scam

Right now, tens of thousands of ratings are issued for virtually every major bond, loan and debt in America. They're the brains and nervous system of our nation's entire credit markets. And the credit markets, in turn, are larger than all of our stock markets combined.

So when the integrity of these ratings is compromised, credit market pandemonium could be the result.

And, unfortunately, that's precisely the situation we're facing today. But it didn't happen overnight. It's the consequence of ...

Four Long-Standing Deceptions by the
Nation's Most Prominent Rating Agencies

We're talking about Fitch, Moody's and S&P. And their deceptions, when fully exposed, could emerge as the next major threat to the economy: "

Washington Post has it now.

It's Not 1929, but It's the Biggest Mess Since - washingtonpost.com:

http://www.washingtonpost.com/wp-dyn/content/article/2007/12/04/AR2007120402186.html?nav=hcmodule

From the article:

"With these tranches, mortgage debt could be divided among classes of investors. The riskiest tranches -- those with the lowest credit ratings -- were sold to hedge funds and junk bond funds whose investors wanted the higher yields that went with the higher risk. The safest ones, offering lower yields and Treasury-like AAA ratings, were snapped up by risk-averse pension funds and money market funds. The least sought-after tranches were those in the middle, the "mezzanine" tranches, which offered middling yields for supposedly moderate risks.

Stick with me now, because this is where it gets interesting. For it is at this point that the banks got the bright idea of buying up a bunch of mezzanine tranches from various pools. Then, using fancy computer models, they convinced themselves and the rating agencies that by repeating the same "tranching" process, they could use these mezzanine-rated assets to create a new set of securities -- some of them junk, some mezzanine, but the bulk of them with the AAA ratings more investors desired."

MBIA Tumbles on $8.1 Billion of CDOs, Fitch Warning

http://www.bloomberg.com/apps/news?pid=20601087&sid=ahJS.RmS5aMs&refer=worldwide

"More than $2 trillion of insured securities would lose their AAA ratings amid mass downgrades of bond guarantors"

"We are shocked management withheld this information for as long as it did,'' Ken Zerbe, an analyst with Morgan Stanley in New York, wrote in a report yesterday. MBIA simply did not disclose arguably the riskiest parts of its CDO portfolio to investors.''

Buffett Swoops Into Bond Insurance ;)

Bond issuers will flock to Buffet just to keep their AAA ratings even though it may cost more.

Bonded by Buffett

http://www.businessweek.com/bwdaily/dnflash/content/dec2007/db20071228_263014.htm?chan=rss_topStories_ssi_5

Struggling Players

Big players in the business, such as MBIA (MBI) and Ambac Financial Group (ABK), have been struggling amid anxieties about potential defaults on bonds and other debts they guarantee are supported by subprime mortgages. As a major part of their business, such outfits guarantee the bonds issued by government entities to finance public works such as schools and sewer systems. Even though their risks for government-bond defaults are small, their exposures in other areas are worrying investors and rating agencies and forcing them to seek hefty dollops of capital to preserve their high ratings.

Why top mark is not always top notch

http://www.ft.com/cms/s/0/c5fbb68e-bfe7-11dc-8052-0000779fd2ac.html

The loss of the US government's top-notch triple-A credit rating, if it ever came to pass, would be a hugely symbolic blow to the status of the world's economic and political powerhouse.

Yet any debate about the merits of the US government's rating must reflect the fact that the triple-A stamp of approval has less and less meaning for investors. The credit crisis triggered by the growth in risky mortgage lending has dispelled the myth that a triple-A credit rating is a guarantee of security.

Instead, many of the complex debt structures used in recent years by banks and other financial institutions to disperse the risks associated with lending to people or companies, and which were rated triple-A, proved vulnerable to problems with the assets underpinning them. As a result, there have been hundreds of triple-A bonds, mostly complex structured instruments, downgraded in recent months.

"Triple-A [debt] has been the worst affected part of the market relative to its previously perceived credit quality," said Siobhan Pettit, analyst at Royal Bank of Scotland, in a recent report.

There are few companies with triple-A credit ratings. Yet there are many investors, such as pension funds or local governments, who want to invest their money as safely as possible. Some of these investors have lost money due to unexpectedly risky exposures.

In the government debt markets, the meaning of a top credit rating can be higher than in the corporate world. The US government's debt, for example, is owned by central banks, sovereign wealth funds and other important investors around the world. Some of these investors will place funds only in assets with a top credit rating.

"If you take away the cosmetic of a triple-A rating [for US government debt] you will discover it is not cosmetic at all," said Dan Fuss, fund manager at Loomis Sayles. "At the margin, buyers will go elsewhere."

Yet even the government debt markets are no strangers to different valuations of triple-A ratings: after the introduction of the euro in Europe, debt issued by Germany was regarded as safer than that of, for example, Italy, even though their ratings were the same.

This week, the diverging values to investors of triple-A companies was highlighted. Warren Buffett's Berkshire Hathaway, which has a big role in insurance, is one of the few US companies with a triple-A rating.

Mr Buffett has recently decided to enter the market for insuring bonds issued by municipalities. Bond insurers such as MBIA and Ambac who dominate the market have been hit by huge losses due to exposure to securities backed by risky mortgages - and are hanging on to their triple-A ratings. As a result, Mr Buffett was paid a higher premium by a New York municipal borrower to insure its debt than the borrower was willing to pay MBIA or Ambac.

The role rating agencies have played in failing to assess correctly the thousands of complex bonds they rated triple-A has come under scrutiny. Regulators and politicians have called for a change in the rules. This debate is likely to accelerate, especially if the credit crisis in the US deepens and further triple-A credit ratings bite the dust.

Monoline Insurers Sink On Credit-Rating Reviews

http://online.wsj.com/article/SB120058159100297695.html?mod=googlenews_wsj

Pressure continues to build on U.S. bond insurers, as Moody's Investors Service and Standard & Poor's signaled fresh consideration of companies' all-important AAA ratings and markets soured further on the sector amid deepening losses.

The reports sent shares of the nation's two biggest bond insurers plunging for a second-straight day. Market leader MBIA Inc. was recently down 25% to $10.08, while Ambac Financial Group Inc. sank 44% to $7.25 after dropping 38% Wednesday, a decline which cost the company more than $800 million in market capitalization.

Moody's said late Wednesday that it had placed its ratings on Ambac on review for a downgrade, after the country's second-largest bond insurer significantly stepped up its expected losses from insuring complicated securities backed in some cases by subprime mortgages. Moody's also said it will be evaluating "in the near term" the extent to which its ratings of other firms in the industry will be affected by the sector-wide pressures that produced the losses at Ambac.

"In view of the uncertainty generated by Moody's surprising announcement, Ambac is assessing the impact of this action on the company's previously announced capital plan," Ambac said Thursday.

Less than a month after completing a review of the highest-rated U.S. bond insurers to assess whether they held enough capital to deserve their stellar ratings, ratings company Standard & Poor's also is beginning to re-evaluate the sector's ratings to take into account its new, more dire view of the U.S. housing market downturn. The review should be completed by the end of next week, a spokeswoman said.

"The market stresses contributing to Ambac's recent financial and organizational announcements are also evident at other financial guarantors, particularly those with significant mortgage and mortgage-related CDO exposures," Jack Dorer, a managing director at Moody's, said in a release.

Bond insurers have been rocked by concerns they could be hurt by guarantees they've written on complex debt securities that have plunged in value. Banks that have used those guarantees to hedge exposures have taken charges of at least $6 billion to reflect concerns bond insurers -- particularly junk-rated ACA Capital Holdings -- won't make good on their commitments. On Thursday, Merrill Lynch wrote down $3.1 billion in the value of its hedges.

Ambac said Wednesday it expects to report a loss of $5.4 billion on its portfolio of credit derivatives. In addition, Ambac conceded that it expects to see actual losses of $1.1 billion on some collateralized debt obligations linked to subprime mortgages, backing away from its long insistence that losses would be primarily on paper only.

To plug the hole, Ambac plans to sell at least $1 billion in securities and will cut its dividend by two-thirds. It also said Chairman and Chief Executive Bob Genader has resigned after 20 years at the company. The loss, and Mr. Genader's departure, troubled Moody's.

"This is a significant change in Ambac's view of the ultimate losses to be realized from these transactions," Moody's wrote. "This loss significantly reduces the company's capital cushion and heightens concern about potential further volatility within Ambac's mortgage and mortgage-related CDO portfolios."

Fitch Ratings put Ambac's AAA rating on watch for a downgrade last month, warning the company had four to six weeks to raise $1 billion. Without the capital, Fitch said Ambac would fall short of its requirements to hold AAA ratings.

The AAA rating is crucial for Ambac's business of insuring securities. Ambac has guaranteed principal and accumulated interest on $556 billion of debt, including mortgage bonds. Fitch has been more aggressive than other ratings agencies. Ambac said its current capital position meets or exceeds the AAA capital requirements of both Standard & Poor's and Moody's Investors service.

Fitch used similar language with MBIA, which last week raised another $1 billion in new capital and said it will slash its dividend by 62%.

MBIA Bonds Lose Value

MBIA's $1 billion in notes, sold Friday at 100 cents on the dollar with a 14% coupon fixed for five years, were trading Wednesday at 90 cents on the dollar, yielding 17%, according to Wayne Schmidt at AXA Investment Management. The hefty yield may not bode well for Ambac's capital raising efforts.

Fitch affirmed MBIA's AAA rating Wednesday and removed its ratings from negative-ratings watch. Fitch hasn't yet commented on Ambac's planned equity offering, but said Wednesday when it announced MBIA's rating that if the market migrates away from the use of bond insurance, MBIA and many of its competitors may have difficulty expanding their businesses in the future.

"Financial guarantors such as MBIA are facing heightened challenges and uncertainties with respect to ultimate subprime-related losses, their competitive positioning, as well as the critical demand and pricing for their products, including municipal bond insurance policies," Fitch said in its report.

The ratings agency also said Wednesday that it will continue to monitor the bond-insurance landscape in the coming months, and if negative fundamental trends appear to be enduring, the agency will reconsider its rating outlook on MBIA specifically or financial guarantors in general.

Still, the agency noted that "fundamental trend for bond insurance could stabilize during 2008, as companies look to streamline their portfolios and focus greater attention on less capital intensive and more stable asset classes at acceptable returns on capital."

Morgan Stanley analyst Ken Zerbe questioned whether Ambac would be able to accomplish its planned equity offering and questioned how much the company might try to raise. "First, the company has only guided toward raising "at least" $1 billion of equity and equity-linked securities," Zerbe said, adding that it is "unclear if the company will actually be able to raise the equity," due to investor hesitance.

At the heart of the crisis is concern about bond insurers' decision in recent years to stray from their core role guaranteeing municipal debt to providing guarantees on complicated debt securities amid a boom in structured finance. Many of those securities are underpinned by subprime mortgages that are plummeting in value.

Ambac guaranteed $38 billion of debt linked to subprime mortgages, or poor quality home loans, which have fueled the ongoing credit freeze. The company is also exposed to $45 billion of other mortgage investments.

Standard & Poor's, in a report released Tuesday, pointed to "the growing economic consensus that U.S. home-price declines will be larger than previously forecasted and that the slump in the U.S. housing market is expected to last far longer than previously anticipated."

S&P said as a result it has made "fundamental changes" to its assumptions for U.S. residential mortgage-backed securities that could affect bond insurer ratings.

Insurer Of Bonds Loses Top Rating

http://www.washingtonpost.com/wp-dyn/content/article/2008/01/18/AR2008011803592.html

Without its flawless rating, Ambac may now find it nearly impossible to attract business, analysts said. Rombach and others questioned whether Ambac could even stay afloat. Some analysts said the move by Fitch would trigger downgrades by the other two major credit rating agencies, Moody's and Standard & Poor's, which have been reviewing the ratings of Ambac and its peers.

"The Fitch downgrade only exacerbates Ambac's difficulties in their ability to write business as well their ability to access capital or other capital-like instruments," said Dick Smith, managing director of global bond insurance ratings at Standard & Poor's. He said S&P was already focused on those issues as it conducts its review.

Moody's warned Thursday it was also reviewing the ratings of MBIA, the largest bond insurer, citing "growing concern about the potential volatility" in the performance of mortgage-related securities and "the corresponding implications for MBIA's risk-adjusted capital adequacy." Moody's decision came even after MBIA had carried out its own $1 billion debt issue.

Great thread boatguy. I understand the problems go much deeper than the sub-prime. Sub-prime is a smoke screen to cover up the much bigger problems in the financial markets. Thanks for the posts.

uc.

Thanks UC.

Looks like tomorrow may be one for the record books :-[

U.S. stock futures point to major decline on re-open

http://www.marketwatch.com/news/story/stock-futures-pointing-sharp-losses/story.aspx?guid=%7B9A894790%2D5D69%2D48C6%2D8303%2D18EE41CA5D1C%7D

LONDON (MarketWatch) -- If futures contracts traded on a day when U.S. stocks weren't even due to open are anything near accurate, then markets will be in for a major decline on Tuesday, with concerns about bond insurers and the health of financial institutions dragging markets lower.

March contracts on the Dow Jones Industrial Average traded 482 points lower to 11,624.

Good reading....I applaud you for the diligence.

I'm thankful I'm currently mostly cash with the exception of a few short positions.


Jody

Thanks Jody, I'm 85% cash myself.

Banks May Need $143 Billion for Insurer Downgrades

http://www.bloomberg.com/apps/news?pid=20601087&sid=aXYHj_zLrIXA&refer=home

From the article:

" Banks will need at least $22 billion if bonds covered by insurers led by MBIA Inc. and Ambac Assurance Corp. are cut one level from AAA, and six times more  :o  for downgrades by four steps to A, Paul Fenner-Leitao wrote in a report published today. Barclays' estimates are based on banks holding as much as 75 percent of the $820 billion of structured securities guaranteed by bond insurers.

``This is a huge amount, but the assumptions we use are also very aggressive,'' Fenner-Leitao in London said in a telephone interview. The estimate shows how bank capital could be diminished in the event of significant downgrades, he said.

The risk of a deeper capital shortfall may help explain why New York's Insurance Superintendent Eric Dinallo is trying to arrange a bank-led bailout of the bond insurers. Downgrades would cast doubt on the credit quality of $2.4 trillion of bonds the industry guarantees.  "

Dinallo's Rescue Plan Focuses on Ambac

http://www.bloomberg.com/apps/news?pid=20601087&sid=aVDZmYRHBVsk&refer=home

"One of Dinallo's proposals to rescue the company would have banks and securities firms act as reinsurers of bonds and securities that Ambac guarantees, one of the people said. Ambac would pay an upfront fee in return for a promise that the banks would reimburse it if insurance-related losses exceeded an agreed-upon limit, the person said.

Another option would be for banks to provide the bond insurer with capital to help it pay claims. The banks discussing a possible Ambac rescue also include Royal Bank of Scotland Group Plc, Wachovia Corp., Barclays Plc, Societe Generale SA, BNP Paribas SA and Dresdner Bank AG, one of the people said."


"Federal regulators may object to letting banks prop up Ambac because the maneuver may artificially delay writedowns of debt holdings, said Joshua Rosner, managing director at New York-based research firm Graham Fisher & Co.

``Those losses might ultimately happen anyway,'' Rosner said in an interview last week."

Ackermann Says Bond Insurers Threaten Debt `Tsunami'   :o :o

http://www.bloomberg.com/apps/news?pid=20601087&sid=aLl6BMPB_juQ&refer=home

"Deutsche Bank AG Chief Executive Officer Josef Ackermann said rating downgrades for bond insurers pose risks that could match the U.S. subprime market collapse.

"It could be a tsunami-like event comparable to subprime,''

It is bad practice to rely on the judgment of those whose misjudgments have caused the current crisis''  Ackman wrote in the letter dated Feb. 5.

European Central Bank President Jean-Claude Trichet rejected Ackermann's characterization of the potential fallout from bond insurer downgrades.

Bond Insurer Seeks to Split Itself, Roiling Some Banks

http://online.wsj.com/article/SB120308290353671507.html?mod=hps_us_whats_news

By LIAM PLEVEN, KAREN RICHARDSON and CARRICK MOLLENKAMP
February 16, 2008; Page A1

The beginning of a messy endgame to the bond-insurance crisis may be underway, and the industry that emerges could look very different from the one that bet big on subprime mortgages.

On Friday, FGIC Corp., holding company for the nation's third-largest bond insurer, told the New York State Insurance Department that in effect it wants to split up the business. The idea would be to create a new company to insure safe municipal bonds and for the existing one to keep responsibility for riskier debt securities already insured, such as those tied to the housing market.

The move may help regulators protect investors who have municipal bonds insured by the firm. But it could also force banks who are large holders of the other securities to take significant losses. Some banks that have been talking with FGIC in recent weeks to bolster the firm were taken aback by the announcement and could yet try to block it, say Wall Street executives.

Either way, the move is a further sign that the industry could retreat from insuring some of the complex financial instruments that fueled the recent housing boom.

If the market settles down, that would be good news for local governments that have been dragged into the subprime-mortgage mess. They would like to see competition among financially solid bond insurers, so that the cost of insuring their municipal bonds remains low.
[Eliot Spitzer]

"Certain aspects of the business model almost certainly will not look the same at the end of the year," said New York State Insurance Superintendent Eric Dinallo, who has been consulting with the bond insurers about new regulations that will cover what risks they can assume.

Already, MBIA Inc., the largest bond insurer in the country, has been forced to raise more than $2.5 billion in capital in an attempt to preserve its triple-A credit rating. Ambac Financial Group Inc., the second-largest, has also been talking with banks about a possible rescue plan.

Additional pressure came from New York Gov. Eliot Spitzer, who told Congress on Thursday that bond insurers have three to five days to find a solution to their problems before regulators could step in. Lawyers for insurers and banks are expected to work through the U.S. holiday weekend.

Bond insurers have been around for decades, but little noticed by the public. They built their business by promising to repay interest and principal on bonds issued by municipalities if the municipalities defaulted. The insurance made the borrowing cheaper. Now, the insurers have become a linchpin of the financial system, backing more than $2 trillion worth of securities.

Riskier Business

The industry plunged deeper into riskier business lines in recent years, including insurance for securities backed by subprime mortgages. The downturn in the mortgage market has exposed them to potentially sizeable losses. That has, in turn, called into question whether they can maintain the triple-A ratings that are critical to their business, and has forced some to go looking for more money.

Holders of the debt securities -- ranging from banks to ordinary investors -- also have a lot at stake because the value of the securities hinges in part on the rating of the insurer. That's one reason regulators have been trying to rally banks to help rescue the insurers.

FGIC has already lost its top-notch triple-A rating from all three major ratings firms. Moody's Investors Service on Thursday cut FGIC's triple-A financial-strength rating by six notches to A3, with a warning that it could be cut to the lowest investment-grade level of Baa if FGIC's strategic and capital plans had "an unfavorable outcome."

Mr. Dinallo told Congress on Thursday that the department would consider letting bond insurers split themselves in two, effectively giving his imprimatur to the idea.

On Friday morning, FGIC's general counsel, Ed Turi, notified Mr. Dinallo's department of its intent "to begin the process" of creating a new bond insurance company in New York. That would require the department to issue a license. If it gets a license, the new insurer will support public bonds previously insured by FGIC and seek new municipal-bond business, the company said.

Mortgage insurer PMI Group Inc. owns a 42% stake in New York-based FGIC, while private-equity firms Blackstone Group Inc. and Cypress Group each hold 23%. FGIC insured about $315 billion in debt as of Sept. 30, including about $31 billion backed by mortgages.

FGIC's move caught at least some of the banks in the group that have been negotiating with it by surprise, according to a person familiar with the situation. Banks that own securities insured by FGIC face the risk of write-downs if FGIC is downgraded further, because the value of securities it insures could fall further.

Incentive for Infusion

FGIC's move could serve as an incentive to get the banks to step up to the plate on a cash infusion for the company. In the past, regulators have said dividing the insurers is a last resort and urged the banks to put in fresh capital.

Calyon, the investment-bank arm of Credit Argicole SA, is leading the bank group. A Calyon spokeswoman declined to comment.

The full bank group has had only tentative discussions with FGIC. One question that has dogged the group is whether the principal negotiating partner should be FGIC, its shareholders or regulators.

The banks learned of the split-up plan Friday by seeing it reported on CNBC, this person said, calling it a "bizarre situation."

All of the banks have hired legal counsel and are prepared to go to court. The person familiar with the situation said FGIC's move could result in "instant litigation." FGIC didn't respond to queries about the banks' reaction to Friday's announcement.

One plan the parties are discussing involves commuting, or effectively tearing up, the insurance contracts the banks entered into with FGIC, according to another person familiar with the matter. In exchange, FGIC would pay the banks some amount to offset the drop in value of those securities, or give them equity stakes in the new municipal-bond insurance company.

Some observers questioned whether the breakup plan would be fair to all FGIC policy holders. It would probably help municipal governments, because the entity insuring their debt would be healthier, while hurting those who mainly relied on FGIC to insure riskier securities. Also unclear is how the ratings services would treat the two insurers after a split.

"You're trying to unscramble the egg," said William Schwitter, chairman of the leveraged-finance practice at law firm Paul Hastings. "When you take a balance sheet that is supporting a variety of obligations and try to split it in two, it's difficult."

Mr. Schwitter, who isn't involved in the FGIC negotiations, noted that many investors who bought bonds supported by FGIC insurance probably had no idea the company could be split later.

However, if a breakup is endorsed by the New York Department of insurance, that could limit the legal liability.

One other wild card: If FGIC splits into two, it could throw into turmoil potentially billions of dollars of bets that banks, hedge funds and other investors have made on whether FGIC would default on its own debt. If FGIC is split, it isn't clear how those "credit default swaps" would be valued, since one half of the new company would have a higher risk of default than the other.

--Aaron Lucchetti contributed to this article.

Citigroup Shareholders' Relief May Not Last as Capital Dwindles

http://www.bloomberg.com/apps/news?pid=20601087&sid=avUb49fO8dzY&refer=home

From the article:

Downgrades

Standard & Poor's said it is reviewing Citigroup's rating for a possible downgrade, noting that earnings may be further depressed by loss reserves on the bank's loan portfolio. Fitch Ratings lowered the company's rating one level to AA- from AA, with a negative outlook. Fitch cited deteriorating earnings in the consumer business and investment bank losses.

"Citigroup's so-called Tier 1 capital ratio -- a measure of its ability to withstand loan losses -- fell to 7.7 percent at the end of March, the New York-based bank said yesterday. Citigroup says it needs a 7.5 percent ratio to provide a margin of safety and preserve its credit ratings."

"We're in a recession, they have a huge consumer book, and there's huge double-digit-billion provisions that they're going to have to take in the next 18 months to two years,'' CreditSights Inc. analyst David Hendler said. ``They're undercapitalized for their risk.''

MBIA-Ambac charade near an end

MBIA (MBI) and Ambac (ABK) reacted with predictable dismay to Wednesday's news that they may soon be downgraded by Moody's. Shares of the bond insurers fell more than 15% in heavy trading after the agency said the "most likely outcome" of its review is the loss of the companies' treasured triple-A insurer financial strength ratings. But the prospect of a long-threatened downgrade had little effect on the broader market, which only a few months ago was deeply concerned about the ramifications of a monoline downgrade.

That's not to say the companies are taking the news particularly well. MBIA said it "disagrees" with the possible downgrade, despite the hefty losses it has taken in recent quarters. It resolved to blame Moody's for its problems, saying it "can only conclude that the requirements for a triple-A rating continue to change." The company conceded that it has had little success writing new business in recent months, but it lays that at the feet of the ratings agencies as well.

"Our business volume had been slowly building since the affirmation of our ratings by S&P and Moody's in late February," MBIA says. "However, when Moody's announced on May 13th its intent to revise its assumptions on 2005-2007 vintage subprime second lien mortgage products, our new business production again dropped precipitously."

For its part, Ambac said it is "disappointed" but offered investors a thimbleful of hope by saying it has "no current plans to raise additional capital." Of course, you'd have to sell an awful lot of Ambac shares at $2.49 a pop to raise any serious money. And both MBIA and Ambac have long insisted the risks in their portfolios have been vastly overstated by skeptics talking their books.

But there are those who have been saying for some time the bond insurers should simply accept their fate and figure out how to operate as double-A or single-A-rated entities, rather than further diluting their shareholders in the name of fleeting success in managing the expectations of the ratings agencies.

Andrew Moloff, chief investment officer at MBIA and Ambac shareholder Evercore Asset Management, wrote in a January letter to Ambac's board that pursuing a plan to raise new capital with shares trading at multiyear lows "amounts not so much to raising capital as it does to a sale of the company at an extremely depressed price." Ambac proceeded to raise $1.5 billion in March anyway, in an offering that Evercore and other existing shareholders bought into in a bit of unhappy dollar-cost averaging.

Since then, Ambac and MBIA shares have dropped even further, as real estate prices continue to slide, raising the prospect of further mortgage defaults and additional losses on the mortgage-backed securities the companies insure. Even Ambac's success in March in raising capital didn't cause business to tick up, because "issuers seeking insurance have thus far opted to insure with competitors with stable triple-A ratings," Ambac said back in April. With the long-awaited downgrade finally at hand, perhaps Ambac and MBIA can stop posturing about what's the right rating for them and figure out how to win back some customers.

SEC blows whistle on bond raters

Regulator says Standard & Poor's, Moody's, Fitch had 'serious shortcomings' in identifying risks in mortgage-backed securities.

http://money.cnn.com/2008/07/08/news/economy/sec_bond_raters/index.htm?section=money_latest&referer=sphere_related_content&referer=sphere_related_content

NEW YORK (CNNMoney.com) -- Government officials said Tuesday that the country's three largest credit raters failed in their reviews of subprime mortgage-backed securities.

In a press conference in Washington, D.C., on Tuesday, U.S. Securities and Exchange Commission Chairman Christopher Cox said that the agency's 10-month examination found failures by the three largest firms - Standard & Poor's, Moody's Investors Service (MCO) and Fitch Ratings (FIM).

"After an extensive examination of the adequacy of the credit ratings agencies ... we uncovered serious shortcomings in these firms," said Cox.

The $5 billion-a-year ratings industry plays an important role, issuing ratings on the creditworthiness of companies and securities so investors can determine the risks of a particular investment. But the three largest firms have been criticized for failing to identify risks in securities backed by subprime mortgages.

Cox cited a lack of disclosure, improper and inadequate documentation of policies, and insufficient attention to conflicts of interest as reasons behind their failure to identify those risks. He said the agencies were unable to keep up with the explosion in complex securities, especially subprime mortgage-backed securities.

"Sometimes the firms deviated from models and procedures, and sometimes they cut corners when not properly staffed," said Cox.

Since August, the SEC has been investigating inadequacies in the credit rating agencies. They looked at hundreds of thousands of internal records and e-mails that dated as far back as January 2004.

Still, the findings in the report were hardly surprising.

"This wasn't groundbreaking," said H. Sean Mathis, managing director of the boutique investment bank Miller Mathis. "It was more a critique of process rather than a framework to go forward."
New regulation

The three major credit raters downgraded thousands of mortgage-backed securities in 2008. The agencies were publicly criticized by Congress and others as those securities plummeted in value after mortgage delinquencies rose astronomically over the past year.

The SEC voted 3-0 last month to tentatively approve rules that would "promote ratings with integrity and curb the questionable practices that contributed to the credit market turmoil," according to Cox. The new regulations are designed to stem conflicts of interest, expand disclosure in the rating industry and encourage new firms to enter.

Earlier in June, Moody's, S&P, and Fitch also reached a cooperation agreement with New York state Attorney General Andrew Cuomo in an attempt to overhaul the firms' incentives for providing their services.

"The good news is many of these problems have been fixed in real time," said Cox. "Each firm has agreed to meet our measures."

Prior to the recent regulations, multiple credit raters would review a residential mortgage-backed security, but only one company would get paid for its services - most often the one that offered the best rating. As a result, ratings agencies benefited from relaxing their ratings standards in order to get the business.

With the old model, many investors purchased a security they believed to be safe because they had pristine AAA ratings, but in fact many of the assets were of poor quality.

The new agreement would force servicers to pay for every review of their securities - regardless if they end up using the rating - in an attempt to limit the conflicts of interest in the $5 billion-a-year credit-rating industry. That means that a credit rater could offer a harsh rating of a security and would still get paid.

But some say the new regulations do not go far enough. Many critics of the industry say that credit raters should not receive payments at all for the securities they review, and that the incentives led to the the raters' inability to predict the risks of subprime mortgages.

"I don't think the SEC has gotten there yet on this issue," said Mathis. "The regulations will have a slight positive effect, but the key is not to [micromanage] the rating process but to set a good framework."
Openness and transparency

S&P, Moody's and Fitch each said they would continue working with regulators.

"We remain dedicated to helping restore confidence in our capital markets, and we look forward to working with the commission as we take these additional steps," said an S&P spokesman.

For its part, Moody's said through a spokesman that it "has initiated a wide range of reforms that refine our analytical methodologies ... to enhance ratings performance quality and expand the usefulness of our ratings, research and analytical tools for all market participants."

A Fitch spokesman said that "Fitch continues to view a number of the SEC's recently proposed rules regarding the practices of credit rating agencies as a positive step forward ... and is currently in the process of updating its policies, procedures and code consistent with the recent SEC proposals." To top of page

Triple-A Failure- New York Times

http://query.nytimes.com/gst/fullpage.html?res=9900EFDE143DF934A15757C0A96E9C8B63&scp=11&sq=moody%27s&st=nyt

The Ratings Game

In 1996, Thomas Friedman, the New York Times columnist, remarked on ''The NewsHour With Jim Lehrer'' that there were two superpowers in the world -- the United States and Moody's bond-rating service -- and it was sometimes unclear which was more powerful. Moody's was then a private company that rated corporate bonds, but it was, already, spreading its wings into the exotic business of rating securities backed by pools of residential mortgages.

And it begins.... :-[

Stocks drop sharply as financials slide on Fitch warning of AIG downgrade

NEW YORK (AP) -- Stocks sank in thin trading Monday as worries about the credit ratings of American International Group Inc. weighed on the financial sector. The major indexes each fell about 2 percent, including the Dow Jones industrial average, which was off about 250 points.

Bond prices jumped as investors fled to the safety of government debt.

AIG was the steepest decliner among the 30 stocks that make up the Dow industrials after Fitch Ratings warned Friday that it might cut its ratings on the insurer. The stock fell $1, or 5 percent, to $18.87.

The financial sector has struggled as some homeowners have fallen behind on mortgage payments. A report Monday by a trade group for real estate agents showed that the number of unsold properties reached an all-time high in July. However, the National Association of Realtors' findings that sales of existing homes increased 3.1 percent in July was much stronger than Wall Street had expected.

The news arrived as volume remains light, with many traders taking time off in the last week of August. Sean Simko, head of fixed income management SEI Investments, said that the stock and bond markets are likely showing outsize reactions because of the low volume.

"There's just too much uncertainty out there creating all this volatility. And what's adding to the volatility is we're entering this holiday period. The swings are exaggerated by the light volumes," he said.

In midday trading, the Dow industrials fell 245.89, or 2.15 percent, to 11,382.17. The Dow surged nearly 200 points Friday as oil tumbled more than $6 a barrel -- its biggest percentage drop in more than four years -- and after Federal Reserve Chairman Ben Bernanke said inflation pressures are likely to moderate.

Broader stock indicators also fell Monday. The Standard & Poor's 500 index declined 24.77, or 1.94 percent, to 1,267.43, and the Nasdaq composite index fell 50.48, or 2.12 percent, to 2,364.23.

Bonds jumped Monday as stocks fell. The yield on the benchmark 10-year Treasury note, which moves opposite its price, fell to 3.78 percent from 3.87 percent late Friday. The dollar rose against other major currencies, while gold prices fell.

Light, sweet crude rose 47 cents to $115.06 per barrel on the New York Mercantile Exchange. Stocks staged a big rally Friday after crude tumbled more than $6 a barrel, its biggest percentage drop in more than four years. Investors have welcomed easing energy prices because they hope that will boost consumer spending, which accounts for more than two-thirds of the U.S. economy.

Financial stocks fell after federal regulators on Friday closed Columbian Bank and Trust Co. in Kansas, which had been struggling with losses on soured real estate loans. It marked the ninth failure this year of a federally insured bank. Columbian Bank said reported $92 million in delinquent loans in the second quarter, pointing to a "volatile real estate market."

Among financial names declining Monday, JPMorgan Chase & Co. fell $1.16, or 3.1 percent, to $36.51, while Suntrust Banks Inc. fell $2.46, or 5.8 percent, to $40.25.

Simko said volatility in the market, while fanned by light volume, isn't likely to abate until Wall Street gets a sense that credit troubles, inflation and the generally soft economy are on the mend.

"You really need to see a resolution to those three issues or at least some type of clear picture to those issues," he said.

Nation's Financial Industry Gripped by Fear

http://www.nytimes.com/2008/09/15/business/15street.html?_r=1&ref=business&oref=slogin

Fear and greed are the stuff that Wall Street is made of. But inside the great banking houses, those high temples of capitalism, fear came to the fore this weekend.

As Lehman Brothers, one of oldest names on Wall Street, appeared to unravel on Sunday, anxiety over the bank's fate — and over what might happen next — gripped the nation's financial industry. By late afternoon, Merrill Lynch, under mounting pressure, entered into talks to sell itself to Bank of America.

Dinner parties were canceled. Weekend getaways were postponed. All of Wall Street, it seemed, was on high alert.

In skyscrapers across Manhattan, banking executives were holed up inside their headquarters, within cocoons of soft rugs and wood-paneled walls, desperately trying to assess their company's exposure to the stricken Lehman. It was, by all accounts, a day unlike anything Wall Street had ever seen.

In the financial district, bond traders, anxious about how the markets would react on Monday, sought refuge in ultrasafe Treasury bills. Greenwich, Conn., that leafy realm of hedge fund millionaires and corporate chieftains, felt like a ghost town. Greenwich Avenue, which usually bustles on Sundays, was eerily quiet.

A year into the financial crisis, few dreamed that the situation would spiral down so far, so fast. Only a week ago, the Bush administration took control of Fannie Mae and Freddie Mac, the nation's two largest mortgage finance companies. Then, before anyone could breathe a sigh of relief after that crisis, Lehman was on the brink.

As details of Lehman's plight began to trickle out on Sunday, the worries deepened that big financial companies might topple like dominoes. Bank of America began discussions to buy Merrill Lynch, the nation's largest brokerage and the next firm coming under pressure.

"I spent last weekend watching Fannie and Freddie die. This weekend it was Lehman," said one longtime Wall Street executive.

The rat-a-tat-tat of bad news has frayed nerves up and down Wall Street. "People are just weary," said another executive. And even more ill tidings loom. Thousands of employees at Lehman are likely to be laid off, casting them into one of the worst Wall Street job markets in years. Other banks are cutting back, too.

Even employees who manage to hold on are likely to make a lot less money this year. Bonuses are not only going to decrease; for many, they will evaporate completely.

While people were stunned by the near collapse of Bear Stearns in March, they were flabbergasted that Lehman, a respected firm with a 158-year history, could be brought to its knees. Many were equally shocked by the downfall of Richard S. Fuld Jr., Lehman's chairman and chief executive.

"Everyone thought Bear Stearns was a bunch of cowboys; it made sense what happened," said another executive. "But this is the great Dick Fuld. This is not supposed to happen to Lehman Brothers."

Many Wall Street executives struggled to draw parallels to the current crisis. The collapse of the junk bond powerhouse Drexel Burnham Lambert in 1991 seems small by comparison, as does the 1998 failure of the big hedge fund Long Term Capital Management.

On Sunday, as the heads of major Wall Street banks huddled for a third day of emergency meetings at the Federal Reserve Bank of New York, many rank-and-file employees were at work in their offices.

"It's all hands on deck," said one senior banker.

At hedge funds, analysts worried that investors would rush to withdraw their money.

As a precaution, Wall Street banks have taken the extraordinary step of hiring advisers to assess the impact of the possible bankruptcies of other big financial institutions.

The mood could darken even further this week as several big Wall Street banks report what are expected to be grim quarterly results.

The problems the industry faces are myriad. Mortgage assets that both commercial and investment banks hold on their balance sheets continue to decline in value as potential buyers wait for prices to fall even further and sellers balk at prices being offered. At the same time, revenues from bread and butter Wall Street businesses like debt and equity underwriting and proprietary trading are sliding in a softening economy at home and abroad.

"I have not seen a quarter like this since 2001," said Meredith Whitney, analyst at Oppenheimer. "And the expense bases at the banks are still built for 2006-style revenues. So the clash of these two things is going to produce the kind of quarter we have not seen in some time."

Some thought that Merrill Lynch's sale of $30.6 billion worth of mortgage-related securities in July to the private equity group Lone Star for $6.7 billion (75 percent of which was provided as a loan by Merrill) would unleash a torrent of similar sales. That has not happened.

Big investment groups like Pacific Investment Management Company have put together "vulture" funds worth at least $70 billion to buy distressed assets. So far, not many sales have happened amid a buyer's strike.

Part of the fear gripping Wall Street is the "who's next" game. After the collapse of Bear Stearns it was Lehman. After Lehman, many worry Merrill might be next.

Those who bet on a rebound in financials are getting clobbered. In March, O'Shaughnessy Asset Management, a $9 billion quantitative money management group, started investing in financials and the group continues to add to its portfolio. "We're patient and we keep buying," said Jim O'Shaughnessy, chairman and chief executive of the firm.

Mr. O'Shaughnessy created a proxy index of financials to test the performance of previous financial stock routs and recoveries dating back to 1964. The average return for the 20 worst 12 month periods was -34.96 percent. In the last year, through June 30, his proxy index was down 31 percent.

But Mr. O'Shaughnessy is betting on the rally.

In the subsequent one- and three-year periods after those drastic declines, his index rose an average 30.5 percent and an annualized 19.7 percent. "Financials falling out of bed has happened in the past," he said. "I'm interested in what happens after they crash and burn."

That strategy has not yet panned out this year. The O'Shaughnessy Dividend fund, which heavily invests in financials, is down 17.2 percent through July 30 compared with a 15.2 percent drop in the Russell 1000 value index. The three-year compounded return through July 30 is 6.5 percent, compared with 2.4 percent for the Russell 1000.

By contrast, hedge funds that continue to short financials (betting their prices will fall) are still performing well. Goshen Investments, a $200 million fund seeded by Tiger Management, is up 35 percent through the end of August, according to one investor. The fund has large short positions in American brokerage firms, European banks and American exchanges. Christopher Burn, founder of the fund, declined to comment.

EOD

EOD 9/17

In 2004, SEC exempted five firms from required capital/debt ratio regulations. They are: Bear Sterns, Lehman Brothers, Merrill Lynch, Morgan Stanley, and Goldman Sachs.

http://bigpicture.typepad.com/comments/2008/09/regulatory-exem.html


How SEC Regulatory Exemptions Helped Lead to Collapse
Thursday, September 18, 2008 | 06:00 AM

   
    The losses incurred by Bear Stearns and other large broker-dealers were not caused by "rumors" or a "crisis of confidence," but rather by inadequate net capital and the lack of constraints on the incurring of debt.

    --Lee Pickard, former director, SEC trading and markets division.


Is Financial Innovation just another word for excessive and reckless leverage?

Apparently so.

As we learn this morning via Julie Satow of the NY Sun, special exemptions from the SEC are in large part responsible for the huge build up in financial sector leverage over the past 4 years -- as well as the massive current unwind

Satow interviews the above quoted former SEC director, and he spits out the blunt truth: The current excess leverage now unwinding was the result of a purposeful SEC exemption given to five firms.

You read that right -- the events of the past year are not a mere accident, but are the results of a conscious and willful SEC decision to allow these firms to legally violate existing net capital rules that, in the past 30 years, had limited broker dealers debt-to-net capital ratio to 12-to-1.

Instead, the 2004 exemption -- given only to 5 firms -- allowed them to lever up 30 and even 40 to 1.

Who were the five that received this special exemption? You won't be surprised to learn that they were Goldman, Merrill, Lehman, Bear Stearns, and Morgan Stanley.

As Mr. Pickard points out that "The proof is in the pudding — three of the five broker-dealers have blown up."

So while the SEC runs around reinstating short selling rules, and clueless pension fund managers mindlessly point to the wrong issue, we learn that it was the SEC who was in large part responsible for the reckless leverage that led to the current crisis.

You couldn't make this stuff up if you tried.

Here's an excerpt from The Sun:

    "The Securities and Exchange Commission can blame itself for the current crisis. That is the allegation being made by a former SEC official, Lee Pickard, who says a rule change in 2004 led to the failure of Lehman Brothers, Bear Stearns, and Merrill Lynch.

    The SEC allowed five firms — the three that have collapsed plus Goldman Sachs and Morgan Stanley — to more than double the leverage they were allowed to keep on their balance sheets and remove discounts that had been applied to the assets they had been required to keep to protect them from defaults.

    Making matters worse, according to Mr. Pickard, who helped write the original rule in 1975 as director of the SEC's trading and markets division, is a move by the SEC this month to further erode the restraints on surviving broker-dealers by withdrawing requirements that they maintain a certain level of rating from the ratings agencies.

    "They constructed a mechanism that simply didn't work," Mr. Pickard said. "The proof is in the pudding — three of the five broker-dealers have blown up."

    The so-called net capital rule was created in 1975 to allow the SEC to oversee broker-dealers, or companies that trade securities for customers as well as their own accounts. It requires that firms value all of their tradable assets at market prices, and then it applies a haircut, or a discount, to account for the assets' market risk. So equities, for example, have a haircut of 15%, while a 30-year Treasury bill, because it is less risky, has a 6% haircut.

    The net capital rule also requires that broker dealers limit their debt-to-net capital ratio to 12-to-1, although they must issue an early warning if they begin approaching this limit, and are forced to stop trading if they exceed it, so broker dealers often keep their debt-to-net capital ratios much lower.

Chalk up another win for excess deregulation . . .

>

Source:
SEC's Old Capital Approach Was Tried - and True
Lee A. Pickard
SECTION: VIEWPOINTS; Pg. 10 Vol. 173 No. 153
American Banker, August 8, 2008 Friday
http://www.americanbanker.com/article.html?id=20080807ZAXGNH3Y&queryid=2110207978&

Ex-SEC Official Blames Agency for Blow-Up of Broker-Dealers
They constructed a mechanism that simply didn't work'
JULIE SATOW,
NY Sun, September 18, 2008
http://www.nysun.com/business/ex-sec-official-blames-agency-for-blow-up/86130/

American Banker excerpt after the jump.

Lee A. Pickard, former director, SEC trading and markets division, on Leverage and Net Capital exemptions :

    A brutal combination of bad financial decisions and serious misjudgments about the inherent value and liquidity of securitized instruments, coupled with the use of excessive leverage, contributed to the demise of Bear Stearns and seriously weakened the capital structure of other major broker-dealers.

    The Securities and Exchange Commission oversees the financial condition of all broker-dealers, and it used from 1975 to 2004 a "net capital rule" as its primary tool to ensure that broker-dealers had adequate capital bases and sufficient liquidity.

    The rule, which I participated in formulating, required that every broker-dealer compute its net capital daily by doing two things. First, it had to value all liquid assets at market prices and then subject that value to a "haircut" of a specified percentage, depending on the assets' expected market risk. (A 30-year Treasury bond was carried for net capital purposes at 94% of its market value because changes in interest rates would affect its market value; riskier securities were subject to bigger haircuts.) Second, the broker-dealer was limited in the amount of debt it could incur, to about 12 times its net capital, though for various reasons broker-dealers operated at significantly lower ratios.

    The SEC's basic net capital rule, one of the prominent successes in federal financial regulatory oversight, had an excellent track record in preserving the securities markets' financial integrity and protecting customer assets. There have been very few liquidations of broker-dealers and virtually no customer or interdealer losses due to broker-dealer insolvency during the past 33 years.

    Under an alternative approach adopted by the SEC in 2004, broker-dealers with, in practice, at least $5 billion of capital (such as Bear Stearns) were permitted to avoid the haircuts on securities positions and the limitations on indebtedness contained in the basic net capital rule. Instead, the alternative net capital program relies heavily on a risk management control system, mathematical models to price positions, value-at-risk models, and close SEC oversight.

    As the SEC itself has noted, this alternative program requires significant judgment, as contrasted with the numerical tests and capital charges (the haircuts) imposed on broker-dealers under the basic net capital rule. The alternative approach also requires substantial SEC resources for complex oversight, which apparently are not always available.

    The SEC has maintained that the Bear Stearns collapse was precipitated by rumors and an unprecedented crisis of confidence, driven by lack of liquidity for the large securities positions it held. If, however, Bear Stearns and other large broker-dealers had been subject to the typical haircuts on their securities positions, an aggregate indebtedness restriction, and other provisions for determining required net capital under the traditional standards, they would not have been able to incur their high debt leverage without substantially increasing their capital base.

    The losses incurred by Bear Stearns and other large broker-dealers were not caused by "rumors" or a "crisis of confidence," but rather by inadequate net capital and the lack of constraints on the incurring of debt.

    The SEC should reexamine its net capital rule and consider whether the traditional standards should be reapplied to all broker-dealers. Moreover, broker-dealer losses should give the SEC pause regarding its recent proposal effectively to abandon the objective debt ratings of nationally recognized statistical rating organizations in favor of "subjective" tests of broker-dealers in determining adequate levels of regulatory net capital.

    As the Bear Stearns collapse showed, no broker-dealer is "too big to fail" — unless the federal government comes to the rescue.

Insiders Detail How Bottom Line Drove Credit Ratings

http://www.propublica.org/article/insiders-detail-how-greed-drove-credit-ratings-926/

When it comes to diagnosing the root of the current financial crisis, the main culprits have become familiar: mortgage lenders and Wall Street banks. The lenders loosened lending standards and then passed the risk on to Wall Street, where mortgage-backed securities became all the rage. But that narrative ignores an important link in that chain: the major credit rating agencies, particularly Moody's and Standard & Poor's. During the mortgage boom, the agencies gave much of the risky securities their highest credit rating, effectively preserving the illusion that they were risk-proof.

In a two-part investigative series (Part I & Part II), Bloomberg focuses on just how the two agencies got things so wrong. It's an exhaustive examination, involving frank, on-the-record criticisms from a number of former Moody's and S&P supervisors and analysts, and it points to one easy answer: money. Nobody wanted to "kill the golden goose," as one executive put it. Faulty analytical models and inadequate staffing played a role, Bloomberg reports, but these are peripheral compared to the overriding conflict of interest revealed by the pieces.

Moody's and S&P, public companies, get fees from their clients (the banks that packaged the securities) for grading the securities. And starting in 2000, Bloomberg reports, the companies began aggressively shifting their focus from informing investors to drumming up business. The easiest way to do that was to keep the client happy, and nothing made a client happier than a AAA credit rating, the gold standard.

And how to arrive at that AAA rating? As one former S&P senior analyst puts it, "My mandate was to find a way. Find the way."

The pressure was real. Citing former Moody's managers, Bloomberg reports that in 2000 one Moody's executive "visited Wall Street banking customers to pledge a closer, more cooperative relationship and asked whether any of his analysts were particularly difficult to work with."

As a result of finding a way, the two companies were having a very profitable decade before everything began to collapse in 2007. Structured finance products, backed by mortgages or other forms of fixed-income assets, were all the rage. "The rating companies earned as much as three times more for grading complex structured finance products...as they did from corporate bonds," Bloomberg reports. "Through 2007, they had record revenue, profits and share prices...By 2000, structured finance was the companies' leading source of revenue, their financial reports show."

Of course, this couldn't last forever. It's been a steep decline:

    [T]he New York-based companies stamped out top ratings on debt pools that included $3.2 trillion of loans to homebuyers with bad credit and undocumented incomes between 2002 and 2007. As subprime borrowers defaulted, the companies have downgraded more than three-quarters of the structured investment pools known as collateralized debt obligations issued in the last two years and rated AAA.

The pieces are full of remarkably candid admissions by some of the former analysts that the ratings were essentially fictional. (An SEC report in July (PDF) on the agencies also revealed some of this: in one e-mail uncovered by regulators, an analyst at an unnamed rating agency complained that her firm's model didn't capture "half" of the deal's risk, but that "'it could be structured by cows and we would rate it.'") The agencies' complex models were simply a way, says S&P managing director Frank Raiter, of avoiding knowledge of the "underlying asset." He was essentially told "to just guess" at the value of these complex securities, to "put anything down," he says. And even if he'd known the right answer, it wouldn't have mattered:

    "We knew the delinquencies were bad," he says. "The fact was, if we could have hired a supreme being to tell us exactly what the loss was on a loan, they wouldn't have hired him because the Street wasn't going to pay us extra money to know that."

The analysts apparently hoped that their machinations wouldn't catch up with them. "Let's hope we are all wealthy and retired by the time this house of cards falters," as one analyst wrote in a December 2006 e-mail revealed in the SEC report. The companies have shaken up their leadership and say they've reformed their practices. And of course, the house of cards has collapsed.

Goldman Sachs urged bets against California bonds it helped sell


The Wall Street titan's activities could have harmed taxpayers, officials say.

http://www.latimes.com/business/la-fi-goldman11-2008nov11,0,4172569,full.story

Goldman, Sachs & Co. urged some of its big clients to place investment bets against California bonds this year despite having collected millions of dollars in fees to help the state sell some of those same bonds.

The giant investment firm did not inform the office of California Treasurer Bill Lockyer that it was proposing a way for investment clients to profit from California's deepening financial misery. In Sacramento, officials said they were concerned that Goldman's strategy could raise the interest rate the state would have to pay to borrow money, thus harming taxpayers.

"It could exaggerate people's worries about our credit," said Paul Rosenstiel, head of the public finance division of the treasurer's office.

Such worries would tend to drive down the price of California bonds. That, in turn, would drive up the interest rate the state and its municipalities pay to borrow money. An increase of a single percentage point on a $1-billion bond issue would cost taxpayers an additional $10 million a year in interest.

That's especially troublesome at a time of severe budget turmoil and tight credit. Gov. Arnold Schwarzenegger has warned that the state could run out of cash as early as February.

Some experts said the investment bank's actions, while not illegal, might be inappropriate. "That's not a good way to do business," said Geoffrey M. Heal, professor of public policy and business responsibility at Columbia University. "They've got a conflict of interest and they're acting against the interest of their customers. . . . You act in the interests of your clients. You don't screw them, to put it bluntly."

Goldman declined to discuss the details of its trading strategy. "We continue to support our clients and underwrite transactions," spokesman Michael DuVally said in an e-mail response to written questions on Oct. 28. He said Goldman "as a firm" was no longer giving the trading advice to clients. He declined to elaborate.

Goldman's strategy was embodied in a 58-page report presented to institutional investors in September. The document, stamped "Proprietary and Confidential," was obtained by ProPublica, a New York-based nonprofit organization specializing in investigative reporting. This article was reported jointly by ProPublica and the Los Angeles Times.

Goldman stood to profit from several aspects of California's borrowing, which involves the sale of bonds to investors. First, it collected millions of dollars in fees for bringing the bonds to market and finding buyers. Then it marketed a financial instrument known as a credit default swap that is essentially an insurance policy against a bond default.

The bond investor buying the instrument pays a fee in exchange for a promise of a full refund of the bond's face value should a state such as California abruptly refuse to pay back what it owes. Such defaults are extremely rare -- California, for example, has never defaulted -- but the swaps' prices rise as states or municipalities slide into tough times economically.

Goldman, according to sources familiar with municipal bond trading, has been a leading dealer in municipal credit default swaps. The New York-based firm was trying to expand that niche market into one with broader appeal to major investors.

The company also is an important underwriter of California municipal securities. Over the last five years, it has earned about $25 million in underwriting fees from California issues.

The 58-page document advised big investors how they could profit from -- or hedge against losses in -- financial markets that had become extremely volatile and unpredictable. The firm advised "shorting" -- that is, betting on a price decline -- in markets for corporate junk bonds, European banks, the euro and British pound currencies, and U.S. municipal bonds.

Several large states, including California, faced "worsening fiscal outlooks," the report said. It cited the recent bankruptcy of the Bay Area city of Vallejo as evidence of the "worsening fundamentals of municipal finances."

Meanwhile, muni bond insurers were suffering credit downgrades, it noted, which undermined the quality, and therefore the prices, of the bonds they had insured. And the credit crunch was forcing big investors such as hedge funds to dump their muni bond portfolios, driving down the bonds' prices.

Goldman recommended making the short bets via credit default swaps, a market in which it played a major role.

These instruments are designed to allow investors and speculators to hedge, or insure against, the risk that bond issuers or other debtors might default on their obligations. In their customary form, they are contracts that require their sellers -- in this case Goldman Sachs -- to buy back from a swap holder a defaulted bond at 100 cents on the dollar, thus insuring against any loss.

In that way, the swaps could be beneficial to the market, encouraging risk-averse investors to buy more municipal bonds. But like derivative securities in general, they can be dangerous to hold. That's because they are often highly leveraged. A small investment can buy coverage on bonds worth much more. If defaults rise to unexpected levels, the swap sellers could be hard-pressed to make good on their promises.

The perils of the credit default swap market were brought home this year, when they were instrumental in the collapse of Lehman Bros. Holdings, American International Group and Bear Stearns. Lehman and AIG were rumored to owe far more than they could pay on swaps they had sold. Meanwhile, the prices of default swaps on the three firms soared, signaling to investors that the firms might be in trouble. Investigations continue into whether those swaps may have been manipulated to undermine confidence in the firms and drive them out of business.

"By encouraging people to buy swaps, you're pushing up the price of those and making it more expensive to insure against the default on the bond that you're buying," Heal said. "The fact that such coverage has gone up in price will signal to the investor that the riskiness of the bond has increased, even if that's not true. Even if the underlying financial situation of the state has not, in fact, changed."

Indeed, what some traders found perplexing about the push for a market in municipal credit default swaps was that muni defaults almost never happen.

Goldman was a leader in the effort to build up the market for the muni swaps. In May, when the financial information firm Markit introduced a municipal CDS index to give swap traders a benchmark to set prices, Goldman was listed as one of the seven dealers participating in the rollout.

For some time before that, Lockyer told The Times, Goldman had "regularly urged" California to trade in the municipal swaps itself, ostensibly to hedge the state's risks as a bond issuer. Lockyer refused.

The trading strategy that Goldman pitched to institutional investors was apparently crafted in the spring and summer. The company may have hoped to parlay the swaps market into more activity in municipal bond trading, which is traditionally light because muni investors tend to hold the bonds to maturity.

Theoretically, the swaps index could lure speculators into the muni market, a development that would create much more fluctuation in daily prices, which in turn would generate revenue for trading desks at Goldman and other investment firms.

Lockyer and Rosenstiel said they became aware of the introduction of the muni swaps index but had not detected an effect on trading or pricing of California bonds.

But they also said the market was so complex, and the conditions affecting municipal bond prices so numerous, that it might be difficult to identify any specific cause for a given price change in California debt issues.

"The existence of the credit default swap market in muni bonds has the potential to hurt muni issuers," Rosenstiel said, "but it also has the potential to help muni issuers, and I don't think we have enough experience to know which is which."

He acknowledged that it was not unusual for a full-service investment firm such as Goldman Sachs to have to navigate among potential conflicts of interest.

"Investment banks bring issuers and investors together," he said. "Securities law has recognized the potential for a conflict of interest in playing both roles."

Under the law, the solution is for the parts of the firm dealing with either side to be isolated from each other so that information does not improperly flow between them to benefit one set of clients more than another. There is no evidence that the wall was breached in this case. Assuming such protection was in place, Lockyer said that fear of market manipulation was unfounded.

Still, Heal said he was surprised by Goldman's actions. "Goldman Sachs has a reputation as behaving in a responsible manner . . . and I don't think this is consistent with their traditions," he said.

"States are going to have to cut back on education, social services, a whole range of things because of the lack of credit. This is not just a Wall Street thing. This is going to affect the lives of less affluent people in the states that are affected."

In any case, there are signs that the muni swap index has been a bust. Tom Graff, managing director of Baltimore-based Cavanaugh Capital Management, said that by the end of August the index had failed to attract much business. It was destined "for oblivion," he said, in part because muni defaults were so rare.

A Must Read

A very good article I found very interesting.

Perhaps a good ending to my participation at this website. It was fun while it lasted!

I still enjoy reading through the threads and studying Melf's TA.

Good luck all!

The End

The era that defined Wall Street is finally, officially over.

http://www.portfolio.com/news-markets/national-news/portfolio/2008/11/11/The-End-of-Wall-Streets-Boom?tid=true

Betrayed!

How Moody's sold its ratings - and sold out investors

http://www.mcclatchydc.com/227/story/77244.html

By Kevin G. Hall | McClatchy Newspapers

WASHINGTON -- As the housing market collapsed in late 2007, Moody's Investors Service, whose investment ratings were widely trusted, responded by purging analysts and executives who warned of trouble and promoting those who helped Wall Street plunge the country into its worst financial crisis since the Great Depression.

A McClatchy investigation has found that Moody's punished executives who questioned why the company was risking its reputation by putting its profits ahead of providing trustworthy ratings for investment offerings.

Instead, Moody's promoted executives who headed its "structured finance" division, which assisted Wall Street in packaging loans into securities for sale to investors. It also stacked its compliance department with the people who awarded the highest ratings to pools of mortgages that soon were downgraded to junk. Such products have another name now: "toxic assets."

As Congress tackles the broadest proposed overhaul of financial regulation since the 1930s, however, lawmakers still aren't fully aware of what went wrong at the bond rating agencies, and so they may fail to address misaligned incentives such as granting stock options to mid-level employees, which can be an incentive to issue positive ratings rather than honest ones.

The Securities and Exchange Commission issued a blistering report on how profit motives had undermined the integrity of ratings at Moody's and its main competitors, Fitch Ratings and Standard & Poor's, in July 2008, but the full extent of Moody's internal strife never has been publicly revealed.

Moody's, which rates McClatchy's debt and assigns it quite low value, disputes every allegation against it. "Moody's has rigorous standards in place to protect the integrity of ratings from commercial considerations," said Michael Adler, Moody's vice president for corporate communications, in an e-mail response to McClatchy.

Insiders, however, say that wasn't true before the financial meltdown.

"The story at Moody's doesn't start in 2007; it starts in 2000," said Mark Froeba, a Harvard-educated lawyer and senior vice president who joined Moody's structured finance group in 1997.

"This was a systematic and aggressive strategy to replace a culture that was very conservative, an accuracy-and-quality oriented (culture), a getting-the-rating-right kind of culture, with a culture that was supposed to be 'business-friendly,' but was consistently less likely to assign a rating that was tougher than our competitors," Froeba said.

After Froeba and others raised concerns that the methodology Moody's was using to rate investment offerings allowed the firm's profit interests to trump honest ratings, he and nine other outspoken critics in his group were "downsized" in December 2007.

"As a matter of policy, Moody's does not comment on personnel matters, but no employee has ever been let go for trying to strengthen our compliance function," Adler said.

Moody's was spun off from Dun & Bradstreet in 2000, and the first company shares began trading on Oct. 31 that year at $12.57. Executives set out to erase a conservative corporate culture.

To promote competition, in the 1970s ratings agencies were allowed to switch from having investors pay for ratings to having the issuers of debt pay for them. That led the ratings agencies to compete for business by currying favor with investment banks that would pay handsomely for the ratings they wanted.

Wall Street paid as much as $1 million for some ratings, and ratings agency profits soared. This new revenue stream swamped earnings from ordinary ratings.

"In 2001, Moody's had revenues of $800.7 million; in 2005, they were up to $1.73 billion; and in 2006, $2.037 billion. The exploding profits were fees from packaging . . . and for granting the top-class AAA ratings, which were supposed to mean they were as safe as U.S. government securities," said Lawrence McDonald in his recent book, "A Colossal Failure of Common Sense."

He's a former vice president at now defunct Lehman Brothers, one of the highflying investment banks that helped create the global crisis.

From late 2006 through early last year, however, the housing market unraveled, poisoning first mortgage finance, then global finance. More than 60 percent of the bonds backed by mortgages have had their ratings downgraded.

"How on earth could a bond issue be AAA one day and junk the next unless something spectacularly stupid has taken place? But maybe it was something spectacularly dishonest, like taking that colossal amount of fees in return for doing what Lehman and the rest wanted," McDonald wrote.

Ratings agencies thrived on the profits that came from giving the investment banks what they wanted, and investors worldwide gorged themselves on bonds backed by U.S. car loans, credit card debt, student loans and, especially, mortgages.

Before granting AAA ratings to bonds that pension funds, university endowments and other institutional investors trusted, the ratings agencies didn't bother to scrutinize the loans that were being pooled into the bonds. Instead, they relied on malleable mathematical models that proved worthless.

"Everyone else goes out and does factual verification or due diligence. The credit rating agencies state that they are just assuming the facts that they are given," said John Coffee, a finance expert at Columbia University. "This system will not get fixed until someone credible does the necessary due diligence."

Nobody cared about due diligence so long as the money kept pouring in during the housing boom. Moody's stock peaked in February 2007 at more than $72 a share.

Billionaire investor Warren Buffett's firm Berkshire Hathaway owned 15 percent of Moody's stock by the end of 2001, company reports show. That stake, largely still intact, meant that the Oracle from Omaha reaped huge financial rewards while Moody's overlooked the glaring problems in pools of subprime mortgages.

A Berkshire spokeswoman had no comment.

One Moody's executive who soared through the ranks during the boom years was Brian Clarkson, the guru of structured finance. He was promoted to company president just as the bottom fell out of the housing market.

Several former Moody's executives said he made subordinates fear they'd be fired if they didn't issue ratings that matched competitors' and helped preserve Moody's market share.

Froeba said his Moody's team manager would tell his team that he, the manager, would be fired if Moody's lost a single deal. "If your manager is saying that at meetings, what is he trying to tell you?" Froeba asked.

In the 1990s, Sylvain Raynes helped pioneer the rating of so-called exotic assets. He worked for Clarkson.

"In my days, I was pressured to do nothing, to not do my job," said Raynes, who left Moody's in 1997. "I saw in two instances -- two deals and a rental car deal -- manipulation of the rating process to the detriment of investors."

When Moody's went public in 2000, mid-level executives were given stock options. That gave them an incentive to consider not just the accuracy of their ratings, but the effect they'd have on Moody's -- and their own -- bottom lines.

"It didn't force you into a corrupt decision, but none of us thought we were going to make money working there, and suddenly you look at a statement online and it's (worth) hundreds and hundreds of thousands (of dollars). And it's beyond your wildest dreams working there that you could make that kind of money," said one former mid-level manager, who requested anonymity to protect his current Wall Street job.

Moody's spokesman Adler insisted that compensation of Moody's analysts and senior managers "is not linked to the financial performance of their business unit."

Clarkson couldn't be reached to comment.

Clarkson's own net worth was tied up in Moody's market share. By the time he was pushed out in May 2008, his compensation approached $3 million a year.

Clarkson rose to the top in August 2007, just as the subprime crisis was claiming its first victims. Soon afterward, a number of analysts and compliance officials who'd raised concerns about the soundness of the ratings process were purged and replaced with people from structured finance.

"The CEO is from a structured finance background, most of the people in the leadership were from a structured finance background, and it was putting their people in the right places," said Eric Kolchinsky, a managing director in Moody's structured finance division from January 2007 to November 2007, when he was purged, he said, for questioning some of the ratings. "If they were serious about compliance, they wouldn't have done that, because it isn't about having friends in the right places, but doing the right job."

Another mid-level Moody's executive, speaking on the condition of anonymity for fear of retribution, recalls being horrified by the purge.

"It is just something unthinkable, putting business people in the compliance department. It's not acceptable. I was very upset, frustrated," the executive said. "I think they corrupted the compliance department."

One of the new top executives was Michael Kanef, who was experienced in assembling pools of residential mortgage-backed securities, but not in compliance, the division that was supposed to protect investors.

"What signal does it send when you put someone who ran the group that assigned some of the worst ratings in Moody's history in charge of preventing it from happening again," Froeba said of Kanef. Clarkson and Kanef, who remains at Moody's, were named in a class-action lawsuit alleging that Moody's misled investors about its independence from companies that paid it for ratings.

Kanef went after Scott McCleskey, the vice president of compliance at Moody's from the spring of 2006 until September 2008, and the man that Moody's said was the one to see for all compliance matters.

"It's speculation, but I think Scott was trying to get people to follow some rules and people weren't ready to accept that there should be rules," Kolchinsky said.

McCleskey testified before the House of Representatives Oversight and Government Reform Committee on Sept. 30 and described how he was pushed out on the heels of the people he'd hired.

"One hour after my departure, it was announced that I would be replaced by an individual from the structured finance department who had no compliance experience and who, to my recollection, had been responsible previously for rating mortgage-backed securities," McCleskey testified.

His replacement, David Teicher, had no compliance background. SEC documents describe him as a former team director for mortgage-backed securities from 2006 to 2008.

McCleskey had raised concerns about the integrity of the ratings process, and Moody's had excluded him from meetings in January 2008 with the Securities and Exchange Commission about the eroding quality of pools of subprime loans that Moody's had blessed with top ratings.

SEC officials, however, didn't bother to seek out McCleskey, even though he was the "designated compliance officer" in company filings with the agency. The SEC maintains that its officials met with Kanef because he was McCleskey's superior.

SEC spokesman Erik Hotmire said that officials met with Kanef because "we ask to interview whomever we determine is appropriate."

Another former Moody's executive, requesting anonymity for fear of legal action by the company, said the agency might've understood what was going wrong better if it had talked to the hands-on compliance officials.

"If they had known he'd (Kanef) come from structured finance, the conflict of having him in that position should have been evident from the start," the former executive said.

Others who worked at Moody's at the time described a culture of willful ignorance in which executives knew how far lending standards had fallen and that they were giving top ratings to risky products.

"I could see it coming at the tail end of 2006, but it was too late. You knew it was just insane," said one former Moody's manager. "They certainly weren't going to do anything to mess with the revenue machine."

Moody's wasn't alone in ignoring the mounting problems. It wasn't even first among competitors. The financial industry newsletter Asset-Backed Alert found that Standard & Poor's participated in 1,962 deals in 2006 involving pools of loans, while Moody's did 1,697. In 2005, Standard & Poor's did 1,754 deals to Moody's 1,120. Fitch was well behind both.

"S&P is deeply disappointed in the performance of its ratings on certain securities tied to the U.S. residential real estate market. As far back as April of 2005, S&P warned investors about increased risks in the residential mortgage market," said Edward Sweeney, a company spokesman. S&P revised criteria and demanded greater buffers against default risks before rating pools of mortgages, he said.

Still, S&P continued to give top ratings to products that analysts from all three ratings agencies knew were of increasingly poor quality. To guard against defaults, they threw more bad loans into the loan pools, telling investors they were reducing risk.

The ratings agencies were under no legal obligation since technically their job is only to give an opinion, protected as free speech, in the form of ratings.

"As an analyst, I wouldn't have known there was a compliance function. There was an attitude of carelessness, or careless ignorance of the law. I think it is a result of the mentality that what we do is just an opinion, and so the law doesn't apply to us," Kolchinsky said.

Experts such as Columbia University's Coffee think that Congress must impose some legal liability on credit rating agencies. Otherwise, they'll remain "just one more conflicted gatekeeper," and the process of pooling loans — essential to the flow of credit — will remain paralyzed and economic recovery restrained.

"If (credit) remains paralyzed, small banks cannot finance the housing demand. They have to take them (investment banks) these mortgages and move them to a global audience," said Coffee. "That can't happen unless the world trusts the gatekeeper."

Phase two of the greatest fraud in history.  >:(

The enormous mortgage-bond scandal

http://blogs.reuters.com/felix-salmon/2010/10/13/the-enormous-mortgage-bond-scandal/

You thought the foreclosure mess was bad? You're right about that. But it gets so much worse once you start adding in a whole bunch of parallel messes in the world of mortgage bonds. For instance, as Tracy Alloway says, mortgage-bond documentation generally says that if more than a minuscule proportion of notes in a mortgage pool weren't properly transferred, then the trustee for the bondholders can force the investment bank who put the deal together to repurchase the mortgages. And it's looking very much as though none of the notes were properly transferred.

But that's not even the biggest potential problem facing the investment banks who put these deals together. It also turns out that there's a pretty strong case that they lied to the investors in many if not most of these deals.

I mentioned this back in September, and I've been doing a bit more digging since then. And I'm increasingly convinced that the risk to investment banks isn't only one of dodgy paperwork; there's also a serious risk of massive lawsuits from the SEC or other prosecutors, as well as suits from individual mortgage investors.

The key firm here is Clayton Holdings, a company which was hired by various investment banks — Goldman Sachs, Bear Stearns, Citigroup, Merrill Lynch, Lehman Brothers, Morgan Stanley, Deutsche Bank, everyone — to taste-test the mortgage pools they were buying from originators.

Here's how it would work:

First, the bank would put in a winning bid for the pool of mortgages, with the intention of slicing it up into mortgage bonds and selling those bonds off to investors at a profit.

After submitting the winning bid, the bank would commission Clayton to take a closer look at a representative sample of loans in the pool. Clayton controlled as much as 70% of the market for this service, which is known as third-party due diligence. But Clayton's not at fault here, and the problem is likely to apply no matter who performed this service.

The size of the representative sample would vary according to the size of the loan pool; it could be anywhere between 5% and 35% of the loans in the pool. Essentially, Clayton would go back to the loans, one by one, and re-underwrite them after the fact, checking that the originator's underwriting standards were in fact being upheld.

Clayton would either accept or reject the loans it was looking at, according to whether or not they met underwriting standards. Here's the results of what it found for one bank, Citigroup; the chart comes from this document filed with the Financial Crisis Inquiry Commission. I'm just using Citi as an example, here; all banks behaved in basically exactly the same way.

citi.tiff

Look at the first line. Clayton reviewed 1,280 loans on behalf of Citigroup in the first quarter of 2006. Of those, it accepted 554 outright: they lived up to the originator's underwriting standards. It also waived another 144, on the grounds that there were mitigating factors (a large downpayment, say). And it rejected 582 for a rejection rate of 45%.

This kind of information was valuable to Citigroup: it showed them that the quality of the loan pool was much lower than you'd think just by looking at the ostensible underwriting standards.

Armed with this information, Citigroup would do two things. First of all, it would take those 582 rejects and put most of them back to the underwriter. Essentially, they said, the loans weren't as advertised, and they didn't want them. But Citi would still keep some of them in the pool.

But remember that Clayton had tested only a small portion of the loans in the pool. So Citi knew that if there were a bunch of bad loans among the loans that Clayton tested, there were bound to be even more bad loans among the loans that Clayton had not tested. And those loans it couldn't put back to the originator, because Citi didn't know exactly which loans they were.

If there had been any common sense in the investment banks, that would have been the end of the deal. But there wasn't. Rather than simply telling the originator that its loan pool wasn't good enough, the investment banks would instead renegotiate the amount of money they were paying for the pool.

This is where things get positively evil. The investment banks didn't mind buying up loans they knew were bad, because they considered themselves to be in the moving business rather than the storage business. They weren't going to hold on to the loans: they were just going to package them up and sell them on to some buy-side sucker.

In fact, the banks had an incentive to buy loans they knew were bad. Because when the loans proved to be bad, the banks could go back to the originator and get a discount on the amount of money they were paying for the pool. And the less money they paid for the pool, the more profit they could make when they turned it into mortgage bonds and sold it off to investors.

Now here's the scandal: the investors were never informed of the results of Clayton's test. The investment banks were perfectly happy to ask for a discount on the loans when they found out how badly-underwritten the loan pool was. But they didn't pass that discount on to investors, who were kept in the dark about that fact.

I talked to one underwriting bank — not Citi — which claimed that investors were told that the due diligence had been done: on page 48 of the prospectus, there's language about how the underwriter had done an "underwriting guideline review", although there's nothing specifically about hiring a company to re-underwrite a large chunk of the loans in the pool, and report back on whether they met the originator's standards.

In any case, it's clear that the banks had price-sensitive information on the quality of the loan pool which they failed to pass on to investors in that pool. That's a lie of omission, and if I was one of the investors in one of these pools, I'd be inclined to sue for my money back. Prosecutors, too, are reportedly looking at these deals, and I can't imagine they'll like what they find.

The bank I talked to didn't even attempt to excuse its behavior. It just said that Clayton's taste-testing was being done by the bank — the buyer of the loan portfolio — rather than being done on behalf of bond investors. Well, yes. That's the whole problem. The bank was essentially trading on inside information about the loan pool: buying it low (negotiating for a discount from the originator) and then selling it high to people who didn't have that crucial information.

This whole scandal has nothing to do with the foreclosure mess, but it certainly complicates matters. It's going to be a very long time, I think, before the banking system is going to be free and clear of the nightmare it created during the boom.

$2tn debt crisis threatens to bring down 100 US cities

Elena Moya, guardian.co.uk

http://www.guardian.co.uk/business/2010/dec/20/debt-crisis-threatens-us-cities

Overdrawn American cities could face financial collapse in 2011, defaulting on hundreds of billions of dollars of borrowings and derailing the US economic recovery. Nor are European cities safe – Florence, Barcelona, Madrid, Venice: all are in trouble

More than 100 American cities could go bust next year as the debt crisis that has taken down banks and countries threatens next to spark a municipal meltdown, a leading analyst has warned.

Meredith Whitney, the US research analyst who correctly predicted the global credit crunch, described local and state debt as the biggest problem facing the US economy, and one that could derail its recovery.

"Next to housing this is the single most important issue in the US and certainly the biggest threat to the US economy," Whitney told the CBS 60 Minutes programme on Sunday night.

"There's not a doubt on my mind that you will see a spate of municipal bond defaults. You can see fifty to a hundred sizeable defaults – more. This will amount to hundreds of billions of dollars' worth of defaults."

New Jersey governor Chris Christie summarised the problem succinctly: "We spent too much on everything. We spent money we didn't have. We borrowed money just crazily. The credit card's maxed out, and it's over. We now have to get to the business of climbing out of the hole. We've been digging it for a decade or more. We've got to climb now, and a climb is harder."

American cities and states have debts in total of as much as $2tn. In Europe, local and regional government borrowing is expected to reach a historical peak of nearly €1.3tn (£1.1tn) this year.

Cities from Detroit to Madrid are struggling to pay creditors, including providers of basic services such as street cleaning. Last week, Moody's ratings agency warned about a possible downgrade for the cities of Florence and Barcelona and cut the rating of the Basque country in northern Spain. Lisbon was downgraded by rival agency Standard & Poor's earlier this year, while the borrowings of Naples and Budapest are on the brink of junk status. Istanbul's debt has already been downgraded to junk.

Whitney's intervention is likely to raise the profile of the issue of municipal debt. While she was an analyst at Oppenheimer, the New York investment bank, in October 2007 she wrote a damning report on Citigroup, then the world's largest bank, predicting it would cut its dividend. She was criticised for being too pessimistic but was vindicated when the bank was forced to seek government support a year later. She has since set up her own advisory firm and is rated one of the most influential women in American business.

US states have spent nearly half a trillion dollars more than they have collected in taxes, and face a $1tn hole in their pension funds, said the CBS programme, apocalyptically titled The Day of Reckoning.

Detroit is cutting police, lighting, road repairs and cleaning services affecting as much as 20% of the population. The city, which has been on the skids for almost two decades with the decline of the US auto industry, does not generate enough wealth to maintain services for its 900,000 inhabitants.

The nearby state of Illinois has spent twice as much money as it has collected and is about six months behind on creditor payments. The University of Illinois alone is owed $400m, the CBS programme said. The state has a 21% chances of default, more than any other, according to CMA Datavision, a derivatives information provider.

California has raised state university tuition fees by 32%. Arizona has sold its state capitol and supreme court buildings to investors, and leases them back.

Potential defaults could also hit Florida, whose booming real estate industry burst two years ago, said Guy J. Benstead, a partner at Cedar Ridge Partners in San Francisco. "We are not out of the woods by any stretch yet," he said.

"It's all part of the same parcel: public sector indebtedness needs to be cut, it needs a lot of austerity, and it hit the central governments first, and now is hitting local bodies," said Philip Brown, managing director at Citigroup in London.

In Europe, where cities have traditionally relied more on bank loans and state transfers than bonds, financing habits are changing. The Spanish regions of Catalonia and Valencia have issued debt to their own citizens after financial markets shut their doors because of the regions' high deficits. Moody's cut to the rating of the Basque country on Friday left it still within investment grade but noted "the rapid deterioration in the region's budgetary performance in recent years". It said it expected it to continue over the medium term.

In Italy, Moody's and S&P have threatened to downgrade Florence, while Venice has been forced over the past few months to put some of the palazzi on its canals up for sale to fund the deficit.

"Cities are on their own. Governments won't come to their rescue as they have problems of their own," said Andres Rodriguez-Pose, professor of economic geography at the London School of Economics. "Cities will have to pay for their debts, and in some cases they will have to carry out dramatic cuts, such as Detroit's."
California crunch
Vallejo, a former US navy town near San Francisco, is still trying to emerge from the Chapter Nine bankruptcy protection it entered in 2008.

The city, now a symbol of distressed local finances, is still negotiating with the unions, which refused to accept a salary cut plan two years ago. Paul Dyson, an analyst with the Standard & Poor's credit agency, said Vallejo, which is mostly a dormitory town for Oakland or San Francisco employees, did not have enough local industry to sustain its finances and property tax – a major source of local income – plunged with the collapse of the real estate market. The S&P credit-rating agency has a C rating on the town – the lowest level.

With a population of about 120,000, Vallejo has $195m (£125m) of unfunded pension obligations and has to present a bankruptcy-exit plan to a Sacramento court by 18 January. Since 1937, 619 local US government bodies, mostly small utilities or districts, have filed for bankruptcy, Bloomberg News recently reported. US cities tend to default more than European municipalities as they usually rely on bonds issued to investors, which enter into a default if the creditor misses payments. European towns, by contrast, traditionally depend on bank loans and government bailouts.