Wednesday, April 30, 2008

Defaults Rising Rapidly For 'Pick-a-Pay' Option Mortgages

April 30, 2008; Page B4

As the growth in subprime mortgage delinquencies appears to be slowing, lenders are seeing a rapid rise in defaults on a type of mortgage that gives consumers with good credit several different monthly-payment options.

These mortgages, which are sometimes known as "pick-a-pay" or payment-option mortgages but are generically called option adjustable-rate mortgages, are turning out, in some cases, to be even more caustic than subprime loans, in part because the loan balance and the monthly payments on some loans is growing even as home prices are falling.


The News: Lenders are seeing a rapid rise in delinquencies for option ARMs.

The Background: The loans became popular during the housing boom because of their low minimum payments.

The Problem: Many borrowers now say they didn't understand features of the loans.

These loans have become the focus of investigations and a spate of lawsuits by borrowers who believe they were misinformed about the mortgages' complicated structure. Losses on option ARMs could be "in some cases close to subprime" mortgage levels, according to a recent report by Citigroup.

On Tuesday, Countrywide Financial Corp. said that 9.4% of the option ARMs in its bank portfolio were at least 90 days past due, up from 5.7% at the end of December and 1% a year earlier. Countrywide also reported that it had charged off $125 million of these loans in the first quarter, compared with $35 million a quarter earlier. Bank of America Corp. said last week that it will stop making option ARMs altogether after it completes the acquisition of Countrywide Financial, which in recent years has been the largest originator of these loans.

Washington Mutual Inc. reported earlier this month that option ARMs account for 50% of prime loans in its bank portfolio, but 70% of prime nonperforming loans. At Wachovia Corp., non-performing assets in the company's option ARM portfolio, which was acquired with the company's purchase of Golden West Financial Corp., climbed to $4.6 billion in the first quarter from $924 million a year earlier.

Nationwide, delinquencies on subprime loans -- at about 28% as of February, according to First American CoreLogic -- remain much higher than for option ARMs. But recent reports from mortgage securitizations suggest that subprime delinquencies have started going bad at a lower rate while delinquencies on option ARMs are speeding up.

Unlike subprime loans, which went to people with weak credit, option ARMs were generally given to borrowers considered to be lower-risk. But lending standards weakened in recent years and many borrowers now have little or no equity. Many lenders reduced the teaser rates on these loans as home prices climbed, making them appealing to borrowers looking to make the lowest monthly payment possible.

Now, with home prices dropping in California, Florida and other markets where option ARMs were popular, a growing number of borrowers with these loans now owe more than their homes are worth, one reason delinquencies are climbing, lenders say.

Meanwhile, at FirstFed Financial Corp., 30% of borrowers whose loans recast to this higher level fell behind on their payments in the fourth quarter. Most other lenders won't see large numbers of resets until at least 2009 or 2010.

Many borrowers now say they didn't understand the features of the loan. For example, borrowers who make the minimum payment on a regular basis can see their loan balance grow and their monthly payment more than double when they begin making payments of principal and full interest. This typically happens after five years, but can occur earlier if the amount owed reaches a predetermined level -- typically 110% to 125% of the original loan balance.


"My sense is that many option ARM borrowers are in a worse position than subprime borrowers," says Kevin Stein, associate director of the California Reinvestment Coaliton, which combats predatory lending. "They wind up owing more and the resets are more significant."

Option ARM sales practices have become the subject of investigations by attorneys general in California, Colorado and Illinois and a number of private lawsuits.

Some borrowers say they weren't suited for these loans or that the terms were poorly disclosed. Edward Marini, a 63-year-old disabled Vietnam veteran, took out a $280,000 option ARM from Countrywide Financial when he refinanced the mortgage on his 2,000-square-foot home in Little Egg Harbor, N.J., in 2005, pulling out cash to pay off some debts. "The way I understood it was that I would have a really low payment for five years," says Mr. Marini.

Mr. Marini recently received a note from Countrywide that his payment, now about $1,300 a month, would jump to about $3,800 next year, well above his $3,250 a month in disability payments. Mr. Marini, who owes more than his home is worth, says he was turned down by Countrywide for a refinance and, more recently, for a loan modification. "I didn't think they would even pull this kind of stuff on someone who is on a fixed income," he says.

In a lawsuit seeking class-action status filed in U.S. District Court in Los Angeles, Mr. Marini and other borrowers allege that Countrywide put them into option ARMs that were "inappropriate and unsuitable." Mr. Marini wasn't told that his loan balance would rise if he made the minimum payment, says his attorney, Joe Whatley Jr. A Countrywide spokeswoman said the company's policy doesn't comment on pending litigation.

Other borrowers say they were provided with misleading disclosures. "It was a widespread practice for originators not to be honest about the true terms of the loans [in disclosures] to borrowers," says Jeffrey Berns, an attorney in Tarzana, Calif., who has filed lawsuits seeking class-action status against more than 50 companies that sold option ARMs.

Countrywide Loss Focuses Attention on Underwriting

Voltron says: No duh. Look how long this took to hit the main stream media.

Evidence of Abuses
By Outside Brokers;
A Fraud in Alaska

Countrywide Financial Corp. reported an $893 million loss for the first quarter, amid mounting evidence of serious problems with its underwriting of many home loans.


A federal probe of Countrywide, the nation's largest mortgage lender, is turning up evidence that sales executives at the company deliberately overlooked inflated income figures for many borrowers, people with knowledge of the investigation say.

Some of the problems are surfacing in a mortgage program called "Fast and Easy," in which borrowers were asked to provide little or no documentation of their finances, according to these people and to former Countrywide employees. Both Countrywide and Fannie Mae, the government-sponsored company that bought many of the loans, classify the loans as "prime," meaning low-risk.


Follow the documents through a fraud case that used the Fast and Easy system1, and take a closer look at a sales document2 Countrywide used to market the loands.

Fast and Easy borrowers aren't required to produce pay stubs or tax forms to substantiate their claimed earnings. In many cases, Countrywide didn't even require loan officers to verify employment, according to an October 2006 presentation by Countrywide's consumer-lending division. That left the program vulnerable to abuse by Countrywide loan officers and outside mortgage brokers seeking loans for customers who might have been turned away if their finances had been more closely scrutinized, according to three current and former Countrywide senior executives and to several mortgage brokers who arranged loans through the program.

The quarterly financial results, which included $3.05 billion of credit-related charges, did not provide details about the performance of the company's "no-doc" loans, including the Fast and Easy ones. Late payments increased across the board: About 36% of "subprime" loans to people with weak credit records were at least 30 days overdue, up from 20% a year before. For all loans serviced by Countrywide, a category mostly made up of prime loans, the delinquency rate was 9.3%, nearly double the year-earlier 4.9%.

In early January, as fears mounted that declining home values and rising defaults had left the company close to collapse, Countrywide agreed to be taken over by Bank of America Corp. in a stock swap valued at about $4 billion.

A Fannie Mae spokesman says that the performance of Fast and Easy loans originated by independent mortgage brokers has deteriorated, and that Fannie is phasing out the purchase of such loans.

A spokesman for Countrywide says that Fast and Easy loans are not plagued by defaults. As of March 31, about 3% of Fast and Easy loans were 30 days or more overdue, compared with 3.5% for Countrywide's fully documented prime loans, he says. Fast and Easy borrowers, he says, had to meet credit standards that were tougher than those for prime loans requiring full documentation.

In recent years, about one-third of all Countrywide prime mortgages eligible for sale to Fannie Mae were Fast and Easy.

During a conference call with investors last July, Countrywide acknowledged that Fast and Easy loans were riskier than fully documented prime loans. A chart provided to investors showed that a borrower who wasn't required to document income would be at least 50% more likely to fall behind on payments than a similar borrower who did provide documentation.

The Federal Bureau of Investigation is looking into a wide variety of Countrywide mortgages that didn't require full documentation, not just the Fast and Easy loans. People involved in the inquiry say the FBI has concluded that extensive fraud occurred on the loans, and they are looking into whether the company violated securities law by failing to disclose that to investors.

On Feb. 15 Countrywide announced it was overhauling Fast and Easy to require more scrutiny of borrower income. In a statement last week about its plans for Countrywide, Bank of America said that once its acquisition is completed later this year, it will "significantly curtail" certain loans that don't require full documentation.

Originally, the rules for Fast and Easy required a credit score of at least 700 -- a level attained by more than half of the nation, according to Fair Isaac Corp., which designed the scoring system. The Fast and Easy program covered only fixed-rate mortgages, not riskier adjustable-rate loans. Interest rates were lower than on other loosely documented mortgages because Fast and Easy loans were offered only to borrowers deemed relatively safe -- based on a variety of risk factors assessed by Countrywide's underwriting software.

Brian Koss, who oversaw Countrywide lending offices in New England for four years, says Countrywide executives encouraged Fast and Easy partly because it was cheaper to produce loans with less paperwork.

Originally, borrowers were required to make at least a 10% down payment. But the light paperwork requirements appear to have opened the door to problems.

In late 2001, mortgage broker Kourosh Partow got a job in Countrywide's Anchorage, Alaska, office, despite being under investigation for lending abuses in Wisconsin, where his license was revoked several months later. Mr. Partow began writing Fast and Easy loans for another person who was speculating in real estate, federal prosecutors later said.

"In each instance, Partow simply falsified the borrower's income and often bank accounts so as to make it appear that the borrower easily qualified for the loan program offered by Countrywide with no further internal checks necessary," the Justice Department said in a filing last summer in federal district court in Anchorage.

Countrywide sold some of the loans originated by Mr. Partow to Fannie Mae, and neither firm detected the fraud for years, according to documents filed in the case.

By the time Countrywide began a push in 2003 to expand loan volume, say two former executives, it had relaxed its lending standards, including for Fast and Easy. The minimum credit score for Fast and Easy borrowers fell to 680 from the original 700. And the loans could now be made for as much as 95% of the estimated value of the home, up from the original 90%.

In early 2006, Countrywide executives discovered that the FBI was investigating Mr. Partow for fraud. Mr. Partow had submitted paperwork stating that one borrower, Agim Delolli, made $24,000 a month as president of a construction company, court documents show. For another loan ten months later, he had said Mr. Delolli made $15,000 a month as a car dealer.

In June 2006, Countrywide fired Mr. Partow. After Mr. Delolli agreed to testify against him, prosecutors "determined that Agim was not culpable," says Mr. Delolli's lawyer, Pam Sullivan. Last year, Mr. Partow pleaded guilty in federal court to mortgage fraud and conspiracy. (See how documents in the case showed the fraud.7)


Kevin Fitzgerald, a lawyer for Mr. Partow, said his client believes his two-year prison sentence was unduly harsh given the prevalence of income-inflation at Countrywide and other firms.

Even when the housing market began to cool, Countrywide kept Fast and Easy open to a wide array of borrowers. The program was extended to adjustable-rate mortgage products, according to an Oct. 26, 2006, Countrywide sales presentation. (Take a closer look at the sales presentation.8)

A Fannie spokesman agreed that the verification of employment wasn't required on all loans, but added that Countrywide was expected to verify employment details on a "sampling" of loans. The Countrywide spokesman said his company fulfilled that obligation.

The program was also extended to second mortgages.

Mortgage brokers and former Countrywide executives say brokers and Countrywide employees eventually figured out that if they had borrowers who might have trouble qualifying for a desired loan on the basis of their income, Fast and Easy would allow them to inflate that income and ensure an approval.

John Sipes, a former loan officer at Countrywide in Los Angeles, said sales agents loved the loan. "In the good old days, that was the best loan we had at Countrywide," he says. Borrowers were required to sign a form allowing Countrywide to verify their incomes with the Internal Revenue Service, but "they never really checked," he says.

Tuesday, April 29, 2008

Hedge fund manager David Einhorn on Lehman

Voltron says: Most of the article is about Carlyle Captial and Bear Stearns the last two pages are about Lehman. He's short LEH, MCO and MBI.

Ben Stein's take on it from the new york times is here:

Monday, April 28, 2008

Free Subscription

Voltron says: You can sign up to automatically get voltron's GASG blog posts by email (no spam) for free using the form below which will also be permanently on the bottom of the right column.

Enter your email address:

Delivered by FeedBurner

Sunday, April 27, 2008

Heading back to Iraq

I'll keep updating the GASG.


Thursday, April 24, 2008

Lehman Brothers Seen As Cheap Recovery Bet

Voltron says: despite the title, the author warns against Lehman.

Shares in Lehman Brothers Holdings Inc. have rallied from lows seen during the Bears Stearns Cos. crisis, and some investors see the investment house as a cheap way to bet on any eventual markets recovery.

Lehman's stock rallied Thursday on the New York Stock Exchange, rising about 6% to close at $46.38.


But a deeper look at Lehman's most-recent results shows that the broker's reliance on one-time, noncash gains could make any earnings recovery more difficult than some investors think. Lehman racked up about $1.6 billion in pretax gains thanks to changes in hard-to-value equity assets, mortgage-servicing rights and the value of its own debt, which may be tough to repeat.

So, investors should be cautious when it comes to Lehman's stock, which is trading at a price that is 1.18 times book value -- or a firm's net worth -- the lowest valuation among the four big brokers: Goldman Sachs Group tops out the list with price-to-book ratio of 1.95 times; Merrill is at 1.75 times; and Morgan Stanley is at 1.65.

While no broker reported stellar first-quarter numbers, Lehman's greater reliance on some noncash gains that appear hard to repeat may explain part of this valuation discount. It could also suggest that the firm's future earnings power is depleted.

Chief Financial Officer Erin Callan, in a statement, said, "Our earnings were below our prior periods given the challenging markets; however, the diversified revenue generation capability of the underlying franchise was evidenced by our second best-ever revenue run rate."

The biggest one-off item in Lehman's fiscal first quarter that ended in February was a pretax, unrealized gain of $695 million related to an increase in hard-to-value equity positions.

Lehman also booked a $364 million pretax gain on changes in the value of mortgage-servicing rights, which are treated as an asset because they represent the future cash flows from fees borrowers pay to the companies that collect mortgage payments.

The value of these rights changes depending on expectations of things like the future direction of interest rates, risk associated with mortgages and, most importantly, the likelihood that investors will prepay their loans.

When expected prepayments decline, holders of servicing rights see gains. Prepayment rates have been dropping since last year because fewer people can refinance mortgages.

Lehman also posted $600 million from declines in the value of its own debt. The firm wasn't unique in this regard: Merrill booked $2.1 billion this way. But, with worries about the big brokerage houses receding, and the price of their debt stabilizing or improving, such gains are unlikely in coming quarters and could reverse.

Wednesday, April 23, 2008

MBIA's swan song

Voltron says: as CNBC's Cramer (the mad money guy) said "Ambac is a $6 stock that just reported a $11 per share loss." Will Moody's and S&P continue the farce and maintain the AAA credit rating of Ambac and it's competitor MBIA?

Huge article on Moody's in NYTimes Magazine

Voltron says: No new information here but it's always notable when this information pops up prominently in the main stream media. The sheeple start to notice. It's a good article for those of you just "tuning in".

Farewell, MBIA. We hardly knew ye.

Condé Nast Portfolio

Ambac Not Yet Back

Big loss shows a long road is still ahead for bond insurers.

They have held on to their valuable triple-A ratings, but the big bond insurers are not out of the woods yet.

The No. 2 bond insurer, Ambac Financial Group, today reported a $1.66 billion loss in its first quarter after losing $1.73 billion on credit derivatives.

The loss of $11.69 per share was much wider than analysts' forecasts and compared with a profit of $213.3 million, or $2.02 per share, in the quarter a year earlier

Much of the loss on credit derivatives—$940 million—was on collateralized debt obligations tied to mortgages.

"The housing-market crisis continues to disrupt the global credit markets, and our credit derivatives and direct-mortgage portfolios were severely impacted once again," Michael Callen, Ambac's chief executive, said. "While we realize that these are disappointing credit results, we continue to believe that the capital raise and strategic business actions taken during the quarter will enable us to get beyond this credit market."

Last month, Ambac said it would raise at least $1.5 billion in new capital by selling common stock and equity units. The plan disappointed investors, but it reassured the credit-ratings agencies Moody's and Standard & Poor's, who maintained their triple-A ratings on the company. For bond insurers, a triple-A rating is the engine of their business. That rating provides a blanket of protection for states and municipalities that issue bonds, allowing them to pay a lower interest rate

For Ambac and its larger rival, MBIA, their business and stock price has been whipsawed by concerns that their exposure to C.D.O.'s and other structured financial products leave them vulnerable to billions of dollars in mortgage-related losses. Both have shored up their capital and shifted their focus back to their core business of muni-bond insurance.

The question now is whether that business can be the profitable money machine it once was.

Callen said "we have recently started to see some business come our way in the municipal markets."

But a number of people, including Bill Gross of Pimco and Jesse Eisinger in the February issue of Condé Nast Portfolio, have questioned the need for municipal-bond insurance. Some big issuers, like the state of California, have recently agreed.

Bloomberg News, citing Thomson Financial data, notes that Ambac insured just 1 percent of municipal bonds sold during the first quarter while a smaller competitor, Financial Security Assurance Inc., a unit of Dexia SA of Brussels and Paris, took 65 percent of the market.

Why Moody's is up

Moody's net falls 31 pct, ratings demand tumbles

Wed Apr 23, 2008 8:02am EDT

By Jonathan Stempel

NEW YORK (Reuters) - Moody's Corp (MCO.N: Quote, Profile, Research), the parent of Moody's Investors Service, on Wednesday said quarterly profit fell 31 percent, a smaller decline than expected, as market turmoil depleted demand for rating mortgages and structured credit products.

Net income fell to $120.7 million, or 48 cents per share, from $175.4 million, or 62 cents per share, a year earlier. Operating profit fell 35 percent to $199.3 million.

Revenue dropped 26 percent to $430.7 million, including a 57 percent slump from structured products, which include such things as collateralized debt obligations and complex debt.

Analysts on average had expected a profit of 35 cents per share on revenue of $416.9 million, according to Reuters Estimates.

"Revenue results in the first quarter clearly reflect the difficult credit market conditions in which we are operating," Chief Executive Raymond McDaniel said in a statement. "We remain cautious about the likely pace and strength of recovery in credit markets in 2008."

Moody's still expects 2008 profit per share of $1.90 to $2.00, with revenue declining by a mid- to high-teens percentage. It lowered its forecast to that level on March 11.

The New York-based company said it expects weakness to continue this quarter, with "modest improvement in market liquidity and issuance conditions" later in the year.

Moody's and McGraw-Hill Cos Inc's (MHP.N: Quote, Profile, Research) Standard & Poor's have suffered as the housing crisis has caused demand to disappear for a wide variety of debt, thereby reducing demand for ratings.

Those agencies, and to a lesser extent Fimalac SA's (LBCP.PA: Quote, Profile, Research) Fitch Ratings, have been criticized for assigning high, often "triple-A," ratings to risky securities, and then cutting ratings too fast once they realized they erred.

On Tuesday, U.S. Securities and Exchange Commission Chairman Christopher Cox said his agency is examining public disclosures on structured products, and how rating agencies managed conflicts of interest.

Major rating agencies are paid by issuers whose securities they rate. Lawmakers in Congress have called on the SEC to tighten oversight. State attorneys general have also been inquiring into the industry.

Moody's has said it might change how it rates structured products. This could lead to Moody's ditching its 21 letter grades, which range from "Aaa" to "C," for numerical ratings.

Billionaire Warren Buffett's Berkshire Hathaway Inc (BRKa.N: Quote, Profile, Research) (BRKb.N: Quote, Profile, Research) is Moody's largest investor, with a 19.5 percent stake at year-end, according to Thomson ShareWatch.

Moody's shares closed Tuesday at $38.17 on the New York Stock Exchange. Through Tuesday, the shares had risen 2 percent this year, but were down 50 percent from their 52-week high set last May 31.

Tuesday, April 22, 2008

SEC to consider tighter regulations on rating agencies

Voltron says: Moody's is finally feelin' some heat.


By Alan Zibel, AP Business Writer

Securities and Exchange Commission to consider tighter regulations for S&P, Moody's, Fitch WASHINGTON (AP) -- The Securities and Exchange Commission is considering new rules to limit conflicts of interest in the credit rating industry, a key financial player under scrutiny for not sounding the alarm about risky mortgage investments soon enough.

SEC Chairman Christopher Cox said at a Tuesday hearing of the Senate Banking Committee that the government may soon create rules to ban credit rating agencies from doing consulting work for issuers of debt.

The regulations haven't been developed yet, but Cox told lawmakers that he saw no reason why such work "could not be prohibited."

The industry, dominated by Standard & Poor's, Moody's Investors Service and Fitch Ratings, has been roundly criticized for failing to accurately assess -- and warn investors about -- the risks that mortgage investments posed to financial markets. The credit crisis has led to more than $200 billion in write-downs taken by banks and financial firms over the last year.

Critics say the agencies are vulnerable to conflicts of interest because they are paid by the companies whose bonds they rate. In response, agencies say they are strengthening protections against conflicts. For example, S&P says it is establishing an ombudsman's office.

However, only Fitch sent its chief executive to the hearing, which irked several lawmakers. The other two sent less-senior executives to Capitol Hill.

Senators suggested Tuesday that the government should suspend credit rating agencies' government licenses if they consistently give ratings that turn out to be inaccurate.

Sen. Richard Shelby of Alabama, the committee's senior Republican, compared the rating agencies to doctors. "If they're incompetent, they jerk their licenses," Shelby said, adding that by being "consistently wrong" on mortgage investment risks, credit rating agencies have contributed greatly to the financial debacle we have today."

Cox told lawmakers that the SEC plans to issue a report by early summer on the rating agencies, focusing on how they managed conflicts of interest and whether they gave too-high ratings for risky investments.

The SEC, which has assigned about 40 staff members to look at rating agency activities, is reviewing hundreds of thousands of pages of rating agency records and e-mail messages.

They've already found several cases in which rating agencies failed to disclose conflicts of interest, some as recently as this year, Cox said.

In 2006, President Bush signed a bill designed to encourage the SEC to allow more competitors in the field and to boost government oversight of the credit rating agencies. The agency is developing rules to expand oversight of the agencies under that law.

Cox said the industry was hampered by a lack of competition among rating agencies, but expressed hope that increased competition in the industry -- as encouraged by the 2006 law -- would improve the quality of ratings.

He also said the SEC's new rules may require the rating agencies to disclose detailed information about mortgage assets that underpin the securities they rate.

Rating agencies have downgraded thousands of mortgage-linked securities over the past nine months, as U.S. mortgage delinquencies have soared and the value of those investments plummeted.

Executives at S&P, Moody's and Fitch said they are cooperating with the SEC to improve the quality of their analysis and have changed numerous business practices in response to the mortgage mess.

Fitch's chief executive, Stephen Joynt, acknowledged his company's failure to anticipate housing and mortgage market problems.

"It will be a long and difficult road to win back market confidence," Joynt said.

Separately, the Securities Industry and Financial Markets Association, Wall Street's biggest lobbying group, said Tuesday it formed a task force to look at credit rating issues and will exam the current model in which debt issuers pay for ratings.

The task force is being led by Boyce Greer, president of the fixed income and asset allocation division at Boston-based mutual fund operator Fidelity Investments, and Deborah Cunningham, chief investment officer at Pittsburgh-based Federated Investors Inc.

Lehman gives free put options on condos

Voltron says: see my comments at the end.

From the Wall Street Journal:

In a move that speaks volumes about the glut in the condominium market, Lehman Brothers Holdings Inc. is promising some luxury-condo buyers their money back after three years of ownership.

The offer applies to some 200 condo units, priced between $480,000 and $2 million, in West Bay Club, a Lehman-owned resort community in Estero, Fla., near Naples on the Gulf of Mexico.

In an effort to jump-start sales in a skittish market, Lehman says that for every buyer until June 1, it will guarantee that the resort will either sell or buy back the residence at the "full cost of the purchase price three years after closing."

The gamble is that prices will recover during that time, and buyers will hold on to their condos.

A spokeswoman for Lehman said no one was available to discuss details of the guarantee program, which appears to exclude 10 penthouse units in two towers.

Jack McCabe, a real-estate consultant in Deerfield Beach, Fla., said other developers desperate to move unsold condo inventory might have to follow Lehman's lead in offering price guarantees as market values continue to slide and thousands more condo units in Florida come on line this year.

Voltron says: Lehman has lost their freakin' minds! I never heard of any plan as insanely desperate. Is lehman going to be around in three years?

Monday, April 21, 2008


Voltron says: another great post and video from Mr. Mortgage:

S&P, BofA and Fitch all concur that the 'Home Equity Implosion' is knocking on, or kicking down rather, the front door.

The delinquency and default crisis with Home Equity Lines/Loans will only grow from here. It is the 'negative equity effect' in full force...many people just will not continue to pay for a massively depreciating asset, especially in cases when the first mortgage maybe an exotic where the payments are increasing!

The update from S&P below came out this morning. On its own it doesn't say much unless you track such things. But when combined with what BofA said in its earnings call this morning and with what Fitch said last month about big banks deadly home equity exposure, it provides a clear path to where all of this is headed - home equity lines/loans are right up there with the Pay Option ARMs as being the next big 'implosion'.

Our nations largest banks holds the majority of these loans. Click the links below and it will all become clear.

Consumers...there maybe relief for you coming soon if you have a home equity loan!

Standard & Poors Home Equity Update Released Today

Download FITCH_HOME_EQUITY_WOES.2008.03.14.pdf

BofA Earnings Call Excerpts...

"Credit quality in our consumer real estate business mainly home equity deteriorated sharply. The problems to date have been centered in higher LTV home equity loans. Our largest concentrations are in California and Florida [40% of portfolio]. 82% of the net charge offs related to loans where the borrower was delinquent and had little or no equity in the home. Loans with the greater than 90% CLTV on a refreshed basis currently represent 26% of loans versus 21% in the fourth quarter. We believe net charge offices in home equity will continue to rise given softness in the real estate values and seasoning in the portfolio. Two issues that is playing home equity and could drive losses are a prolonged deterioration in home values and further deterioration in the economy."

Vacancies Soar In Commercial Real Estate Bust

Voltron says: SRS holders, keep the faith!

From: Mish's global economic analysis

Given the pullback in consumer and corporate spending, and it should not be surprising to see Big rise in unoccupied office space.

Office vacancies rose sharply in the first quarter, a trend that is expected to continue as a result of layoffs and new construction adding to supply. According to the real estate services firm Grubb & Ellis, first-quarter office vacancies rose to an average 13.6% nationally, up from 13% in the previous three quarters.

“With demand turning negative at the same time that the construction pipeline will deliver the 94 million square feet still underway, vacancy is expected to peak at 18% by the end of 2009,” Grubb & Ellis economist Robert Bach wrote in a research note today.

In addition, about 15.1 million square feet of new construction was completed during the first quarter. But net absorption—the amount of new space coming to market that found tenants—came in at a slim 1.8 million square feet. That’s the lowest rate of absorption since the second quarter of 2003, Grubb & Ellis said. Of the 57 markets tracked by Grubb & Ellis, vacancies rose in 42 locales and fell in 15.
Commercial Construction Bust

David A. Rosenberg, chief economist at Merrill Lynch is reporting Commercial construction boom turns bust.
Commercial construction has rolled over, driven by the substantial tightening in credit conditions that started late last year. Banks materially tightened lending standards for commercial and industrial loans in the fourth quarter of last year, and by the first quarter they were at a historic high. The regression work we did earlier this year suggested that it took about 2-3 quarters for a tightening in credit to have an impact on building, and the rollover we’re now seeing is about right on cue.

click on chart for sharper image

Architectural Billings Collapse

What tells us that the construction rollover is not an event on the horizon but a present day reality is the massive slide in commercial site payrolls since the end of last year and the unprecedented rollover in architect billings. The nonresidential construction sector has shed 40,000 jobs since the end of 2007, the deepest cuts since 2002 when nonresidential building was posting double-digit quarterly declines. And, architect billings in the C&I space have been in free-fall since December – the three-month annualized rate was -77.4% as of February.

San Diego Microcosm

Rich Toscano (aka Professor Piggington) is writing Employment Goes Negative.
San Diego employment has just decreased on a year-over-year basis, falling by 1,700 jobs between March 2007 and March 2008.

That is a very small drop in the grand scheme of things, representing a decline of just .1 percent. But it's the first time in a long time that employment has turned negative at all. The data I pulled from the Employment Development Department website goes back to the year 2000, and it shows that even during the recession and slowdown that took place at the beginning of this decade, the weakest month showed a year-over-year increase of 2,300 jobs.

click on chart for sharper image
Eye of the Hurricane

Mike Morgan provided a long awaited update on the Florida housing situation last weekend. I talked about it in Eye of the Housing Hurricane - Mike Morgan Update. Here is a snip about commercial real estate in Florida.
Commercial and retail property are also becoming casualties in the back half of the hurricane. Drive through just about any Florida market to see all the For Lease signs on commercial property. Real-estate agents, lawyers, builders, contractors, mortgage brokers, insurance companies, furniture stores and all the rest are going out of business and leaving a flood of office and commercial inventory vacant.

The condo market? Do you really want to hear anything about the devastation that the lenders and local municipalities are facing over the collapse of the condo market? That’s like adding a Class 5 tornado to the Category 5 hurricane over Florida.
Shopping Center Vacancies

The hard evidence is now in. There can no longer be any denial about what is happening in commercial real estate.

click on chart for sharper image

The above chart is from Shopping Center Economic Model Is History.

Inquiring minds will want to take a look at the number of bankruptcies, unplanned store cutbacks, and the resultant glut of corporate real estate space presented in the above link.

A wave of regional bank failures is headed our way because of leverage to commercial real estate. The Fed can do nothing to stop it.

Debt may be a factor in suspicious house, car fires

Voltron says: this isn't as entertaining as the "Rotisserie program" of an LA car salesman who was convicted of dozens of counts of conspiring to burn customer's old cars in order to sell them a new car.

By Ken Bensinger
Los Angeles Times Staff Writer

April 21, 2008

Some folks celebrate their last home mortgage payment by setting fire to their loan agreement. Lately, some people behind on their mortgages are simply setting fire to their homes.

In what appears to be the latest symptom of the nation's mortgage meltdown and credit crisis, insurers, law enforcement officials and state agencies nationwide report a jump in home and automobile fires in the last year believed to have been set by owners unable to pay their debts. The numbers are small, but they're leading the insurance industry to scrutinize more closely what seem to be accidental blazes.


Rising Tide of Level 3 Assets: Disaster Waiting to Happen

From Seeking Alpha
By Jennifer Yousfi

In the first quarter, Goldman Sachs Group Inc. (GS) packed another $27 billion worth of illiquid assets onto its balance sheet - a 39% increase that brought the total to $96 billion.

And Goldman wasn’t alone. Morgan Stanley (MS) reported that these hard-to-value/hard-to-sell assets soared 45%, reaching $32 billion. For Lehman Brothers Holdings Inc. (LEH), the first quarter increase was $500 million, bringing its total to $42.5 billion.

The balance-sheet holdings in question are known as "Level 3" assets. And with the smoke from the subprime-mortgage crisis still hanging over Wall Street like the fallout from a nuclear missile strike, some industry observers are worried that the difficult-to-sell Level 3 assets are little more than a crisis-in-waiting that’s standing in the wings of the U.S. financial-services sector.

And now that banks and brokerages are well into their first-quarter earnings reports, it’s clear that the amount of these tough-to-value assets are climbing on the balance sheets of such banking-sector stalwarts as Goldman, Merrill, Lehman - and others, too.

But the real question is - why?

That question has put investors back on the defensive.

Money Morning Contributing Editor Martin Hutchinson - an expert on the international debt markets - had a succinct answer.

"Level 3 assets are yet another disaster waiting to happen," Hutchinson said in an interview.

Accounting rules require financial firms to price the assets on their balance sheets at a so-called "fair value." As part of that, financial assets are broken down into three categories, or "levels," based upon how liquid the assets are and, in turn, how easy they are to value, or price:

  • Level 1 assets are fully liquid, and easy to price.
  • Level 2 assets can be priced with the benefit of "comparable assets."
  • And Level 3 assets are completely illiquid and nearly impossible to price.

In the attempt to explain what’s happening in the market - in short, why the amount of Level 3 assets are increasing on financial-sector-firm balance sheets - two theories have emerged. And neither one bodes well for the longed-for end to the global financial crisis that was kicked off by the collapse of the subprime mortgage sector.

One of two things is occurring. Either:

  1. Investment banks are reclassifying Level 2 assets as Level 3 assets, for a reason we’ll explain momentarily.
  2. Or the brokerage firms are inflating their estimates for the value of Level 3 assets already on their books.

Even worse - it could be a combination of both.

Prior to the current credit mess, mortgage-backed securities were priced according to Markit’s ABX Index, which used the average weight of four series in the index to track the price of housing derivatives. But once the subprime market collapsed, the ABX Index plunged - and has yet to recover.

With the first scenario, rather than mark down its Level 2 assets to the current abysmal levels of the ABX, Goldman has decided to simply reclassify those assets as Level 3 assets, experts say. If there isn’t an actual "market" in which to sell the securities, the banks don’t have to write down the price of the assets; indeed, they can list any value they want, theoretically.

"Goldman is the one house that hasn’t had any losses," Money Morning Contributing Editor Martin Hutchinson said in an interview. "That, in itself, is suspicious."

This kind of thinking might seem shocking to a non-Wall Streeter, but it’s common practice in modern accounting.

In the second scenario, some experts say it’s possible the investment banks are inflating the price of the level 3 assets already on their books. Since, in theory, there is no market for a Level 3 asset, they are impossible to "mark-to-market." Financial firms use various in-house pricing models to determine a price for these assets. The firms would likely argue stridently that the pricing models they employ are valid and can be fully justified. But the reality is that - in the end - the price they mark down in the corporate ledger is basically a made-up number.

Boosting the value of assets can staunch a bleeding balance sheet. We’ve seen the damage $300 billion worth of mark-to-market write-downs has done to the global financial sector.

After all that carnage, imagine what a reversal of this write-down hemorrhaging could mean?

"If you can make up a higher price, you can pay yourself a higher bonus," Hutchinson said.

At the same time, firms such as Goldman also boosted the collateral they can use to secure loans, even though no one is likely buy that collateral - not at any price. But with the U.S. Federal Reserve’s new lending program, investment firms such as Goldman can use Level 3 assets to secure highly liquid U.S. Treasury loans.

The bottom line is that you just don’t know if you can trust the valuation of Level 3 assets. In a true recession, it’s possible the value of those assets could go as low as zero.

With Level 3 assets currently representing 14% of Lehman’s total assets, and 13% of Goldman’s, a recession that drops the bottom out of the market could mean billions more in additional write-downs.

"People are concerned about Level 3 [assets] because of possible write-downs, though it isn’t all necessarily losing value," Erin Archer, a senior equity research analyst at Thrivent Financial for Lutherans, told Bloomberg News. "We aren’t out of the woods yet when it comes to write-downs and the profitability of brokers."

Thrivent holds shares of Goldman, Morgan and Lehman among the $73 billion it has under management.

Analyst Whitney Thinks Wells Fargo Needs Reserves, Capital

By Ed Welsch, Dow Jones Newswires

NEW YORK -(Dow Jones)- While investors are now getting used to banks holding their hands out for capital reinvestments, they may be surprised if a consistent performer such as Wells Fargo & Co. (WFC) comes begging.

But that's exactly what may happen, according to Oppenheimer & Co. analyst Meredith Whitney.

Whitney believes that Wells Fargo is under-reserved by at least $4.5 billion as of Monday and will need to raise capital to restore its balance sheet this year and perhaps by even more in 2009. The analyst has won acclaim in recent months for her accurate calls that Citigroup Inc. (C) and Wachovia Corp. (WB) would have to cut their dividends.

A Wells Fargo spokeswoman wasn't immediately available to comment. Other analysts have pointed to the bank's continued exposure to consumer debt as a source of concern, but were generally comforted by the bank's diversification and the strength of its loan portfolios.

Shares of the San Francisco-based bank may take an especially harsh beating if Whitney's prediction turns out to be true, since investors are generally positive about the stock following its better than expected first-quarter results last week. Through Friday, Wells Fargo shares had risen more than 9% since the bank reported results on Wednesday. Shares were down 2.3% in pre- market trading Monday.

Whitney cut her estimate of Wells Fargo's 2008 profit to $1.20 a share from $ 2.15 a share, making hers the lowest estimate on the Street and leaving it well below the average estimate of $2.34 a share.

"Given our now dramatically below consensus estimates, we believe few if any are anticipating what we believe to be the inevitable consequence of Wells' current reserve position," she told clients in a research note Monday.

Whitney bases her estimates on a historical study of Wells Fargo's charge-off rates, which she says during the first quarter exceeded the bank's loan loss reserves for the first time since at least 1990. She assumes that credit conditions will continue to deteriorate, forcing the bank to increase its reserves to offset the growing number of charge-offs.

"If losses continue to accelerate past the 2Q, our well below Street estimates will prove too optimistic," she wrote.

A capital raise from Wells Fargo may also throw cold water on last week's rally, in which the broad stock market rose on mediocre but better-than-expected first-quarter earnings at banks including Wells Fargo and JPMorgan Chase & Co. ( JPM). The results also gave a boost to the broader S&P 500, which rose 4.7% last week, recovering from the shock of General Electric Co.'s (GE) earnings miss April 11.

Following Wells Fargo's earnings release Wednesday, Moody's Investors Service reaffirmed the bank's Aa1 credit rating, saying it "has avoided the market pitfalls that plagued its peers," but noted that "nevertheless it does hold an $ 83.6 billion home-equity portfolio."

Charge-offs on home-equity loans have been rising, leading to growing concern among bank investors. Whitney points out in her research that Wells Fargo changed its charge-off policy to 180 days from 120 days beginning in April, which she believes will only delay the reported increase in home-equity losses for a quarter. Wells Fargo said it shifted the policy in order to give debtors more time to deal with their financial problems and keep them in their homes.

Other analysts were also concerned that growing charge-offs at Wells Fargo and its change in the way it accounts for them, but many remained positive about the bank's prospects. "Although credit quality deteriorated in the quarter, we believe it is clear that Wells Fargo's residential real estate loan portfolios are generally performing better than those of other large banks," Bear Stearns said last week. Of 24 analysts tracked by Thomson Financial, 17 still issued recommendations on Wells Fargo equivalent to buy or hold, with 11 analysts at buy or strong buy.

This will be an election issue

Voltron says: nothing new in this story, except the fact that it is appearing in a radical liberal blog. It's a good review of the facts.

The trillion-dollar mortgage time bomb

Voltron says: Fannie Mae and Freddie Mac ARE NOT government agencies. The term "Government Sponsored Entity (GSE)" is a term that was literally made up by the press and has no legal meaning and does not appear in any legal document, law or charter. President Bush said in the past that the government WAS NOT responsible for bailing out Freddie and Fannie. Since that time the government has tried to force them to loan more money, so that does make some kind of a bailout more likely. A bailout would probably mean the shareholders get nothing. There has been so much corruption and accounting irregularities at those companies that a bailout may be politically impossible even for any possible future democrat party president (God forbid).

Risks are rising that Fannie Mae and Freddie Mac may need a government bailout that could cost far more than previous rescues.

By Chris Isidore, senior writer

NEW YORK ( -- Among the nightmares lurking around the corner for the already battered housing and credit markets would be a meltdown at mortgage financing giants Fannie Mae and Freddie Mac.

Although few are predicting an imminent need for a bailout just yet, credit rating agency Standard & Poor's recently placed an estimated price tag on this worst case scenario -- $420 billion to $1.1 trillion of taxpayer's money.

This dwarfs how much it cost to help banks during the savings and loan crisis of the late 1980's and early 1990's. That cost taxpayers about $250 billion in today's dollars.

S&P added that saving Fannie (FNM) and Freddie (FRE, Fortune 500) might cost so much that the federal government's AAA credit rating, the top possible rating, might even be at risk. If that was lost, then all federal government borrowing would become more expensive.

Fannie Mae and Freddie Mac both help the mortgage market function by purchasing pools of loans and packaging them into securities.

So it is crucial for the mortgage industry for the two agencies to continue functioning smoothly.
The two companies are known as government-sponsored entities because they have Congressional charters, which implies that the federal government is behind them.

Fannie did not comment about the S&P report. According to a statement from Freddie, the firm said the S&P report was just "a scenario analysis, not a prediction" and added that "Freddie Mac remains a well capitalized company."

Victoria Wagner, a S&P credit analyst who worked on the report, said S&P isn't predicting that Fannie and Freddie would necessarily need a bailout at this time.
But she and other analysts are concerned about the impact more problems could have on the mortgage market since the two companies have become increasingly important to the health of the industry. Both companies are forecast to report more losses this year due to declining home prices and rising mortgage defaults.

Risks increasing

Wagner pointed out that at the end of January, 82% of all mortgages in the U.S. were backed by one of the firms, up from only 46% in the second quarter of 2007.

Fannie and Freddie primarily back so-called conforming loans, those made to borrowers with good credit and large down payments. But even limited exposure to subprime loans hasn't stopped them from running up huge losses as home prices tumbled and foreclosures soared.
And Fannie and Freddie's role in the mortgage and real estate markets is likely to grow, as Congress recently allowed them to back larger mortgages, up to $729,750, up from the previous limit of $417,000.

The Office of Federal Housing Enterprise Oversight (OFHEO), which regulates both firms, also recently lowered the capital requirements for Fannie and Freddie in an effort to pump $200 billion more into the credit markets.

The new loan limits will increase the risks and losses for Fannie and Freddie, said Wagner and other experts.

The high priced markets where homeowners and buyers need larger loans are now the ones seeing steep home price declines. And the default rates on larger loans are greater than the smaller loans that had previously been the core of their business.

"I don't think the message is a bailout is necessary or imminent," Wagner said. "But they're facing this increased role at a time that their own credit performance is suffering from the rifts in the housing and mortgage markets. They're both projecting much higher losses than we've seen in some time."

Some see bailout as more likely

But other experts expect that declining home values will force more borrowers who have a Fannie- or Freddie-backed loan to stop making payments in the coming months, rather than continuing to make payments on a home now worth less than their loan balance.

Rising job losses may also make it difficult for other borrowers who formerly had good credit to stay current on their mortgage payments.

"The real fundamental problem is real estate prices have been falling and they might fall substantially more," said Robert Shiller, a Yale University economist who argued for years that a bubble was forming in real estate prices. "OFHEO and Fannie and Freddie never considered the possibility of a massive real estate correction."

Some economists suggest that if investors start to see problems in the performance of loans backed by Fannie and Freddie, they'll dumping them. And that would force the federal government to step in.

"I would say there's at least a 50-50 chance of some sort of bailout. I'm not saying it will necessarily cost $1 trillion, but they'll need some kind of help, and it very well could happen this year," said Dean Baker, co-director of the Center for Economic and Policy Research
Investors are signaling growing concern as well. The yield premium for securities backed by Freddie and Fannie compared to the yield on Treasury bills has grown to about 2.25 percentage points from 1.7 percentage points at the beginning of the year. That's a sign that the investors see a greater risk of Fannie and Freddie running into bigger problems.
And OFHEO, in its annual report this week, said that while Fannie and Freddie have made progress clearing up accounting problems that had dogged both firms, they remain "a significant supervisory risk."

The agency added that since current home price declines are without precedent, the firms will have a difficult time correctly pricing the risk of the mortgages they're backing.

But Jaret Seiberg, financial services analyst for policy research firm Stanford Group, said Fannie and Freddie ultimately should be able to weather the storm though simply because there is no question that the government would bail them out.

So there shouldn't be a crisis of confidence about their future in the way that there was for investment bank Bear Stearns before the Fed stepped in and agreed to back $29 billion in potential losses so JPMorgan Chase (JPM, Fortune 500) could buy Bear Stearns (BSC, Fortune 500).

"What has allowed Fannie and Freddie to continue to operate when the private mortgage-backed security market dried up is their implicit government guarantee," said Seiberg.

Sunday, April 20, 2008

Wells Fargo has $83 billion in home equity exposure

from Blown Mortgage by

In Moody’s affirmation of Wells Fargo’s Aaa credit rating the rating agency pointed to the health of Wells Fargo’s $83.68 billion home equity portfolio as a key driver in the company’s rating. If this portfolio should see degradation then the bank’s rating could suffer, said Moody’s in a press release.

From Moody’s press release about Wells Fargo’s credit rating:

MUMBAI, Apr. 18, 2008 (Thomson Financial delivered by Newstex) — Moody’s Investors Service said Wells Fargo & Co. (NYSE:GWF) (NYSE:JWF) (NYSE:WSF) (NYSE:WPF) (NYSE:WFC) has avoided the market pitfalls that plagued its peers but added that key rating drivers still center on the credit performance of its $83.68 billion home-equity portfolio and its capital trends.

Currently, Moody’s said the credit performance of the portfolio is within its broad expectations.

Moody’s rates WFC’s senior debt at the holding company ‘Aa1.’ The bank’s financial strength rating is ‘A’ and its deposits are rated ‘Aaa.’ The rating outlook is stable.

‘Nevertheless, we continue to revisit our loss estimates in light of the historically weak housing market, especially in California where WFC has a $31 billion exposure,’ the rating agency said.

How are the home equity loans holding up?

There has to be some serious discussion around these home equity loans. What percentage are basically uninsured at this point? Which of these are in a negative equity area? While the loans may still be performing there has to be some serious questioning about their long-term chances of full repayment. Most HELOC’s and seconds were issued during the boom with the belief that they would be repaid during a refinance of the property as values increased. Now with prices depreciating the banks have frozen many of the lines to try to limit exposure - but exposure remains.

I’d love to see a distribution of Wells’ $31 billion California exposure by zip code. That could be an exceptionally telling graph.

Don’t expect the rating to hold

There is no question that the equity portfolio will experience degradation. The question is how much? With nearly half of all exposure in California, it is tough for me to see how Wells can maintain the quality of that portfolio in such a negative equity environment. If Moody’s is pinning their rating on, among other things, the health of this portfolio I would anticipate seeing a downgrade as we get further in to this housing meltdown and prime borrowers who start feeling the affects of the credit crunch, shrinking job market, etc. come under pressure to make the payments on those free-floating equity debts.

Saturday, April 19, 2008


Here Comes the Next Mortgage Crisis

Thursday, April 17, 2008

Peter Schiff pwns Mike Norman

Voltron says: Click on the link below to watch d0^chebag Mike Norman get schooled on his own show by Peter Schiff

Mr Mortgage on CNN

Voltron says: getting some serious cred

Wednesday, April 16, 2008

Mr Mortgage on Alt-A

Voltron says: I can't say enough good things about Mr Mortgage. He's been in the mortgage industry for 20 years and he does his research and shows where he gets all his data. He's been right on the money and is specifically dimeing out Lehman, JP Morgan Chase and Wells Fargo. The market was up today because of lies and disinformation. The CEO of JP Morgan said we are 80% through the subprime crisis. True, but the Alt-A crisis hasn't even begun. The Alt-A crisis is going to be WORSE than the subprime crisis.

WSJ: LIBOR is a lie

Voltron says: This has BIG implications for borrows, lenders and speculators since everything is based on LIBOR.

The Wall Street Journal


Bankers Cast Doubt On Key Rate Amid Crisis


LONDON -- One of the most important barometers of the world's financial health could be sending false signals.

In a development that has implications for borrowers everywhere, from Russian oil producers to homeowners in Detroit, bankers and traders are expressing concerns that the London inter-bank offered rate, known as Libor, is becoming unreliable.


Libor plays a crucial role in the global financial system. Calculated every morning in London from information supplied by banks all over the world, it's a measure of the average interest rate at which banks make short-term loans to one another. Libor provides a key indicator of their health, rising when banks are in trouble. Its influence extends far beyond banking: The interest rates on trillions of dollars in corporate debt, home mortgages and financial contracts reset according to Libor.

In recent months, the financial crisis sparked by subprime-mortgage problems has jolted banks and sent Libor sharply upward. The growing suspicions about Libor's veracity suggest that banks' troubles could be worse than they're willing to admit.

The concern: Some banks don't want to report the high rates they're paying for short-term loans because they don't want to tip off the market that they're desperate for cash. The Libor system depends on banks to tell the truth about their borrowing rates. Fibbing by banks could mean that millions of borrowers around the world are paying artificially low rates on their loans. That's good for borrowers, but could be very bad for the banks and other financial institutions that lend to them.

True Borrowing Costs

No specific evidence has emerged that banks have provided false information about borrowing rates, and it's possible that declines in lending volumes are making some Libor averages less reliable. But bankers and other market participants have quietly expressed concerns to the British Bankers' Association, which oversees Libor, about whether banks are reporting rates that reflect their true borrowing costs, according to a person familiar with the matter and to government documents. The BBA is now investigating to identify potential problems, the person says.

Questions about Libor were raised as far back as November, at a Bank of England meeting in which United Kingdom banks, the firms that process bank trades and central bank officials discussed the recent financial turmoil. According to minutes of the meeting, "several group members thought that Libor fixings had been lower than actual traded interbank rates through the period of stress." In a recent report, two economists at the Bank for International Settlements, a sort of central bank for central bankers, also expressed concerns that banks might report inaccurate rate quotes.

On the Agenda

A spokesman for the BBA, John Ewan, said the trade group is monitoring the situation. "We want to ensure that our rates are as accurate as possible, so we are closely watching the rates banks contribute," Mr. Ewan said. "If it is deemed necessary, we will take action to preserve the reputation and standing in the market of our rates." Libor is expected to be on the agenda of a bankers' association board meeting on Wednesday.

In a recent research report on potential problems with Libor, Scott Peng, an interest-rate strategist at Citigroup Inc. in New York, wrote that "the long-term psychological and economic impacts this could have on the financial market are incalculable." Mr. Peng estimates that if banks provided accurate data about their borrowing costs, three-month Libor would be higher by as much as 0.3 percentage points.

A small increase in Libor can make a big difference for borrowers. For example, an extra 0.3 percentage points would add about $100 to the monthly payment on a $500,000 adjustable-rate mortgage, or $300,000 in annual interest costs for a company with $100 million in floating-rate debt. On Tuesday, the Libor rate for three-month dollar loans stood at 2.716%.

Libor has become such a fixture in credit markets that many people trust it implicitly. Concerns about its reliability are "actually kind of frightening if you really sit and think about it," says Chris Freemott, a Naperville, Ill., mortgage banker who depends on Libor to tell him how much his firm, All America Mortgage Corp., owes First Tennessee bank for a credit line that he uses to make loans.

The Libor system was developed in the 1980s. Banks were looking for a benchmark that would allow them to set rates on syndicated debt -- corporate loans that typically carry interest rates that adjust according to prevailing short-term rates. By pegging lending rates to Libor, which is supposed to represent the rate banks charge each other for loans, banks sought to guarantee that the interest rates their clients pay never fall too far below their own cost of borrowing.


Banks typically set their lending rates at a certain "spread" above Libor: A company with decent credit, for example, might pay an interest rate of Libor plus one-half percentage point. A risky "subprime" mortgage loan might carry an interest rate of Libor plus more than six percentage points.

Today, Libor rates are set for 15 different loan durations -- from overnight to one year -- and in 10 currencies, including the pound, the dollar, the euro and the Swedish krona. They serve as the basis for payments on trillions of dollars in corporate loans, mortgages and student loans. Libor rates are also used to set the terms of more than $500 trillion in "derivatives" contracts such as interest-rate swaps, which companies all over the world, including U.S. mortgage guarantors Fannie Mae and Freddie Mac, use to protect themselves against sudden shifts in the difference between long-term and short-term interest rates.

When banks want to borrow money, they contact banks directly or phone a loan broker, such as ICAP PLC in London. Much of the interbank lending takes place between 7 a.m. and 11 a.m. London time. In broker speak, a bank might ask for a "yard" -- one billion in a designated currency. Brokers communicate with bank clients by phone or through desktop voice boxes, which are faster. At ICAP, brokers track bids and offers by looking up at a big whiteboard above the trading floor, where a "board boy" posts information. The actual rates at which banks borrow from each other are known only to the lenders and borrowers, and possibly to their brokers.

Every morning by 11:10 London time, "panels" of banks send data to Reuters Group PLC, a London-based business-data and news company, on what it would cost them to borrow a "reasonable amount" in a designated currency. The dollar Libor panel, for example, consists of 16 banks, including U.S. banks Bank of America Corp. and J.P. Morgan Chase & Co. and U.K. banks HBOS PLC and HSBC Holdings PLC. Reuters uses the reported borrowing rates to calculate Libor "fixings." To reduce the possibility that any bank could manipulate an average by reporting a false number, Reuters throws out the highest and lowest groups of quotes before calculating averages.

Justin Abel, global head of data operations for Reuters, said in a statement that his company's role is solely to calculate fixings based on the information provided by banks. "It is their data alone we distribute. Reuters is purely the facilitator," he said.

Wary of Lending

The global financial crisis that began last summer has made it more difficult for banks to package and sell all kinds of loans as securities, as well as to issue bonds and short-term IOUs to investors. Increasingly, banks have turned to the interbank market to borrow cash. But their mounting losses on mortgage securities and other investments have raised fears that a major institution could go bust. That's made banks increasingly wary of lending to one another.

[Calculating Libor]

Such jitters have made many banks unwilling to extend loans to each other for more than one week. As a result, the rates they quote for loans of three months or more are often speculative, because there's little to no actual lending for that time period, brokers say. "It amounts to an average best guess," says Don Smith, an economist at ICAP, the London broker of interbank loans and derivatives.

These bank problems are proving costly to other kinds of borrowers around the world. One way to measure the rough cost is by comparing the three-month Libor rate with an interest rate that doesn't reflect worries about banks' financial health -- such as the yield on a three-month Treasury bill, which is backed by the U.S. government. The gap between the two stood at 1.58 percentage points Tuesday, and has averaged 1.39 percentage points since the crisis began in August. In the five years before the financial crisis started, it averaged only 0.28 percentage points.

Citigroup's Mr. Peng believes banks could be understating even those abnormally high Libor rates. He notes that the Federal Reserve recently auctioned off $50 billion in one-month loans to banks for an average annualized interest rate of 2.82% -- 0.1 percentage point higher than the comparable Libor rate. Because banks put up securities as collateral for the Fed loans, they should get them for a lower rate than Libor, which is riskier because it involves no collateral. By comparing Libor with that indicator and others -- such as the rate on three-month bank deposits known as the Eurodollar rate -- Mr. Peng estimates Libor may be understated by 0.2 to 0.3 percentage points.

Other Benchmarks

In one sign of increasing concern about Libor, traders and banks are considering using other benchmarks to calculate interest rates, according to several traders. Among the candidates: rates set by central banks for loans, and rates on so-called repurchase agreements, under which borrowers provide banks with securities as collateral for short-term loans.

In a report published in March by the Bank for International Settlements, economists Jacob Gyntelberg and Philip Wooldridge raised concerns that banks might report incorrect rate information. The report said that banks might have an incentive to provide false rates to profit from derivatives transactions. The report said that although the practice of throwing out the lowest and highest groups of quotes is likely to curb manipulation, Libor rates can still "be manipulated if contributor banks collude or if a sufficient number change their behaviour."