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Brokers threatened by run on shadow bank system

Regulators eye $10 trillion market that boomed outside traditional banking

By Alistair Barr, MarketWatch

Last update: 2:37 p.m. EDT June 20, 2008

Comments: 295

SAN FRANCISCO (MarketWatch) -- A network of lenders, brokers and opaque financing vehicles outside traditional banking that ballooned during the bull market now is under siege as regulators threaten a crackdown on the so-called shadow banking system.

Big brokerage firms like Goldman Sachs , Lehman Brothers , Morgan Stanley and Merrill Lynch , which some say are the biggest players in this non-bank financial network, may have the most to lose from stricter regulation.

The shadow banking system grew rapidly during the past decade, accumulating more than $10 trillion in assets by early 2007. That made it roughly the same size as the traditional banking system, according to the Federal Reserve.

While this system became a huge and vital source of money to fuel the U.S. economy, the subprime mortgage crisis and ensuing credit crunch exposed a major flaw. Unlike regulated banks, which can borrow directly from the government and have federally insured customer deposits, the shadow system didn't have reliable access to short-term borrowing during times of stress.

Unless radical changes are made to bring this shadow network under an updated regulatory umbrella, the current crisis may be just a gust compared to the storm that would follow a collapse of the global financial system, experts warn.

Such vulnerability helped transform what may have been an uncomfortable correction in credit markets into the worst global credit crunch in more than a decade as monetary policymakers and regulators struggled to contain the damage.

Unless radical changes are made to bring this shadow network under an updated regulatory umbrella, the current crisis may be just a gust compared to the storm that would follow a collapse of the global financial system, experts warn.

"The shadow banking system model as practiced in recent years has been discredited," Ramin Toloui, executive vice president at bond investment giant Pimco, said.

Toloui expects greater regulation of big brokerage firms which may face stricter capital requirements and requirements to hold more liquid, or easily sellable, assets.

'Clarion call'

"The bright new financial system -- for all its talented participants, for all its rich rewards -- has failed the test of the market place," Paul Volcker, former chairman of the Federal Reserve, said during a speech in April. "It all adds up to a clarion call for an effective response."

Two months later, Timothy Geithner, president of the Federal Reserve Bank of New York, and others have begun to answer that call.

"The structure of the financial system changed fundamentally during the boom, with dramatic growth in the share of assets outside the traditional banking system," he warned in a speech last week. That "made the crisis more difficult to manage."

On Thursday, Treasury Secretary and former Goldman Chief Executive Henry Paulson said the Fed should be given the authority to collect information from large complex financial institutions and intervene if necessary to stabilize future crises. Regulators should also have a clear way of taking over and closing a failed brokerage firm, he added. See full story.

Banking bedrock

The bedrock of traditional banking is borrowing money over the short term from customers who deposit savings in accounts and then lending it back out as mortgages and other higher-yielding loans over longer periods.

The owners of banks are required by regulators to invest some of their own money and reinvest some of the profit to keep an extra level of money in reserve in case the business suffers losses on some of its loans. That ensures that there's still enough money to repay all depositors after such losses.

In recent decades, lots of new businesses and investment vehicles have evolved that do the same thing, but outside the purview of traditional banking regulation.

Instead of getting money from depositors, these financial intermediaries often borrow by selling commercial paper, which is a type of short-term loan that has to be re-financed over and over again. And rather than offering home loans, these entities buy mortgage-backed securities and other more complex securities.

A $10 trillion shadow

By early 2007, conduits, structured investment vehicles and similar entities that borrowed in the commercial paper market and bought longer-term asset-backed securities, held roughly $2.2 trillion in assets, according to the Fed's Geithner.

Another $2.5 trillion in assets were financed overnight in the so-called repo market, Geithner said.

Geithner also highlighted big brokerage firms, saying that their combined balance sheets held $4 trillion in assets in early 2007.

Hedge funds held another $1.8 trillion, bringing the total value of asset in the "non-bank" financial system to $10.5 trillion, he added.

That dwarfed the total assets of the five largest banks in the U.S., which held just over $6 trillion at the time, Geithner noted. The traditional banking system as a whole held about $10 trillion, he said.

"These things act like banks, but they're not." — James Hamilton,Economics professor

While acting like banks, these shadow banking entities weren't subject to the same supervision, so they didn't hold as much capital to cushion against potential losses. When subprime mortgage losses started last year, their sources of short-term financing dried up.

"These things act like banks, but they're not," James Hamilton, professor of economics at the University of California, San Diego, said. "The fundamental inadequacy of their own capital caused these problems."

Big brokers targeted

Geithner said the most fundamental reform that's needed is to regulate big brokerage firms and global banks under a unified system with stronger supervision and "appropriate" requirements for capital and liquidity.

Financial institutions should be persuaded to keep strong capital cushions and more liquid assets during periods of calm in the market, he explained, noting that's the best way to limit the damage during a crisis.

At a minimum, major investment banks and brokerage firms should adhere to similar rules on capital, liquidity and risk management as commercial banks, Sheila Bair, chairman of the Federal Deposit Insurance Corp., said on Wednesday.

"It makes sense to extend some form of greater prudential regulation to investment banks," she said.

Separation dwindled

After the stock market crash of 1929, the U.S. Congress passed laws that separated commercial banks from investment banks.

The Fed, the Office of the Comptroller of the Currency and state regulators oversaw commercial banks, which took in customer deposits and lent that money out. The Securities and Exchange Commission regulated brokerage firms, which underwrote offerings of stocks and corporate bonds.

This separation dwindled during the 1980s and 1990s as commercial banks tried to push into investment banking -- following their large corporate clients which were selling more bonds, rather than borrowing directly from banks.

By 1999, the Gramm-Leach-Bliley Act rolled back Depression-era restrictions, allowing banks, brokerage firms and insurers to merge into financial holding companies that would be regulated by the Fed.

Commercial banks like Citigroup Inc. , Bank of America and J.P. Morgan Chase signed up and developed large investment banking businesses.

However, big brokerage firms like Goldman, Morgan Stanley and Lehman didn't become financial holding companies and stayed out of commercial banking partly to avoid increased regulation by the Fed.

Run on a shadow bank

The Fed's bailout of Bear Stearns in March will probably change all that, experts said this week.

Bear, a leading underwriter of mortgage securities, almost collapsed after customers and counterparties deserted the firm.

It was like a run on a bank. But Bear wasn't a bank. It financed a lot of its activity by borrowing short term in repo and commercial paper markets and couldn't borrow from the Fed if things got really bad.

Bear's low capital levels left it with highly leveraged exposures to risky mortgage-related securities, which triggered initial doubts among customers and trading partners.

The Fed quickly helped J.P. Morgan Chase, one of the largest commercial banks, acquire Bear. To prevent further damage to the financial system, the Fed also started lending directly to brokerage firms for the first time since the Depression.

"They stepped in because Bear was facing a traditional bank run -- customers were pulling short-term assets and the firm couldn't sell its long-term assets quickly enough," Hamilton said. "Rules should apply here: You should have enough of your own capital available to pay back customers to avoid a run like that."

Bear necessity

A more worrying question from the Bear Stearns debacle is why customers and investors were willing to lend money to the firm in the absence of an adequate capital cushion, Hamilton said.

"The creditors thought that Bear was too big to fail and that the government would step in to prevent creditors losing their money," he explained. "They were right because that's exactly what happened."

"This is a system in which institutions like Bear Stearns are taking far too much risk and a lot of that risk is being borne by the government, not these firms or the market," he added.

The Fed has lent between $8 billion and more than $30 billion each week directly to brokerage firms since it set up its new program in March. Most experts say this source of emergency funding is unlikely to disappear, even though it's scheduled to end in September.

"It's almost impossible to go back," FDIC's Bair said on Wednesday.

With taxpayer money permanently on the line to save big brokers, these firms should now be more strictly regulated to keep future bailouts to a minimum, Bair and others said.

"By definition, if they're going to give the investment banks access to the window, I for one do believe they have the right for oversight," Richard Fuld, chief executive of Lehman, told analysts during a conference call this week. "What that means, though, particularly as far as capital levels or asset requirements, it's way too early to tell."

Super Fed

Next year, Congress likely will pass legislation forcing big brokerage firms to be regulated fully by the Fed as financial holding companies, Brad Hintz, a securities analyst at Bernstein Research and former chief financial officer of Lehman, said.

Legislators will probably also call for tighter limits on the leverage and trading risk taken on by large brokers, while demanding more conservative funding and liquidity policies, he added.

Restrictions on these firms' forays into venture capital, private equity, real estate, commodities and potentially hedge funds may also follow too, Hintz warned.

This may undermine the source of much of the surging profit generated by big brokerage firms in recent years.

A newly empowered "super Fed" will likely encourage these firms to arrange longer-term, more secure sources of borrowing and even promote the development of deposit bases, just like commercial and retail banks, the analyst explained.

This will make borrowing more expensive for brokerage firms, undermining the profitability of businesses that require a lot of capital, such as fixed income, institutional equities, commodities and prime brokerage, Hintz said.

Such regulatory changes will cut big brokers' return on equity -- a closely watched measure of profitability -- to roughly 15.5% from 19%, Hintz estimated in a note to investors this week.

Lehman and Goldman will be most affected by this -- seeing return on equity drop by about four percentage points over the business cycle -- because they have larger trading books and greater exposure to revenue from sales and trading. Goldman also has a major merchant banking business that may also be constrained, Hintz added.

Morgan Stanley and Merrill Lynch will see declines of 3.2 percentage points and 2.2 percentage points in their return on equity, the analyst forecast.

If you can't beat them...

Facing lower returns and more stringent bank-like regulation, some big brokerage firms may decide they're better off as part of a large commercial bank, some experts said.

"If you're being regulated like a bank and your leverage ratio looks something like a bank's, can you really earn the returns you were making as a broker dealer? Probably not," Margaret Cannella, global head of credit research at J.P. Morgan, said.

Regulatory changes will be unpopular with some brokerage CEOs and could result in a shakeup of the industry and more consolidation, she added.

Hintz said the business models of some brokerage firms may evolve into something similar to Bankers Trust and the old J.P. Morgan.

In the mid 1990s, Bankers Trust and J.P. Morgan relied more on deposits and less on the repo market to finance their assets. They also operated with leverage ratios of roughly 20 times capital. That's lower than today's brokerage firms, which were levered roughly 30 times during the peak of the credit bubble last year, according to Hintz.

However, both firms soon ended up in the arms of more regulated commercial banks. Bankers Trust was acquired by Deutsche Bank in 1998. Chase Manhattan Bank bought J.P. Morgan in 2000.

Housing crisis brings Wall St arrests, veto threat

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WASHINGTON (Reuters) - The U.S. housing crisis produced its first high-profile Wall Street arrests on Thursday, while the Bush administration called for broadening the Federal Reserve's powers over investment banks and said it has charged hundreds of people in a mortgage fraud probe.

At the same time, the White House issued a surprise veto threat against a Senate bill aimed at preventing hundreds of thousands of foreclosures. The threat signaled more partisan warfare on Capitol Hill as homeowners struggle.

Two former managers for Bear Stearns Cos Inc. (BSC_pf.N), itself a recent victim of bad bets on mortgage securities, were arrested and indicted on securities fraud charges in New York in connection with the $1.4 billion collapse of two hedge funds.

Ralph Cioffi, 52, and Matthew Tannin, 46, each pleaded not guilty. In a scene reminiscent of Enron-era scandals, the men surrendered to officials and were paraded in handcuffs in front of onlookers en route to their arraignment on Thursday.

The two were charged with defrauding investors by concealing problems that led last year to the disintegration of the two hedge funds. That event raised fears about risky subprime mortgages and helped usher in a global credit crunch that governments around the world are still sorting out.

With falling home prices and rising foreclosures, the U.S. Justice Department said it charged more than 400 people in a 3-1/2-month, national probe. Dubbed "Operation Malicious Mortgage," it involved $1 billion in losses and 144 cases, mostly of lending fraud and foreclosure and bankruptcy scams.

The department's get-tough display came amid rising fears the housing slump is pushing the economy into recession -- an issue playing a prominent role in the presidential race.

Both contenders -- Illinois Democratic Sen. Barack Obama and Arizona Republican Sen. John McCain -- are making economic recovery central to their campaigns.

"No one can predict when the fiscal chaos in housing will end, but it doesn't look like we will be done any time soon," said David Abromowitz, a senior fellow at the Center for American Progress, a think tank in Washington.

"Trillions of dollars in lost family home equity ... has been wiped out for many families in just a short time. We would expect this to impact lives and put a drag on the economy well past the day when foreclosures slow and prices stop falling."

FED EXPANSION URGED

U.S. Treasury Secretary Henry Paulson on Thursday urged broad new powers for the Federal Reserve over investment banks, following actions taken by the U.S. central bank in March that changed its relationship with Wall Street.

In March, the Fed helped broker a takeover of Bear Stearns by JPMorgan Chase & Co (JPM.N) and guaranteed a $29 billion loan to facilitate the deal out of concern a Bear Stearns bankruptcy could trigger a financial panic.

It was the first time since the Great Depression of the 1930s that the Fed, which regulates commercial banks, had stepped in to rescue a nondepository institution. The Fed also set up a special credit line to make emergency loans to major investment banks in an effort to ease credit market strains.

In an opinion piece in The Wall Street Journal on Thursday, Securities and Exchange Commission Chairman Christopher Cox said decisions must be made on whether and how long to maintain the emergency lending program, scheduled to expire this fall.

Another SEC official told a congressional panel on Thursday that the investor protection agency and the Fed have nearly completed a formal agreement to oversee investment banks until Congress can set up a permanent system through legislation.

CONGRESS DEBATES

It looked unlikely that Congress would tackle such complex structural issues this year, given the difficulties it was having agreeing on legislation to help homeowners.

The White House issued a surprise veto threat against a Senate bill that would, like a similar bill already passed by the House of Representatives, create a new fund to underwrite up to $300 billion of failing home loans. It would also offer billions of dollars in emergency housing relief.

Proponents say the bill could save 400,000 homeowners from foreclosure. But the Bush administration House objected to a provision that would give state and local governments money to buy and fix foreclosed properties.

Congressional leaders were trying to hammer out a final bill and send it to President George W. Bush before lawmakers leave town at the end of next week for the July 4 holiday.

Some House Republicans also threatened to stall a final version of the housing bill, demanding more information about preferential mortgage terms given to two Democratic senators by Countrywide Financial Corp (CFC.N).

"Given the questions around Countrywide, preferential loans need to be investigated," House Republican leader John Boehner told reporters. "To think that we're going to move a housing bill with these questions looming I think is irresponsible."

Greenspan says U.S. economy on brink of recession

Thank you very much for your insight, Maestro, you would know indeed...

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OHANNESBURG (Reuters) - Former U.S. Federal Reserve Chairman Alan Greenspan warned on Tuesday the U.S. economy was “on the brink” of a recession.

He said via video link to an investment conference in Johannesburg the chances of that economy falling into recession were more than 50 percent and a rebound was unlikely.

Asked if the U.S. economy was in recession, Greenspan said: “We are on the brink”. “A rebound at this stage is not something I think is in the immediate outlook,” he added.

The Shrinking Influence of the US Federal Reserve

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The Shrinking Influence of the US Federal Reserve

By Gabor Steingart in Washington

Humiliation for Mr. Dollar: Ben Bernanke, the chairman of the United States Federal Reserve Bank, faces a general investigation by the International Monetary Fund. Just one more example of the Fed losing its power.

The United States Federal Reserve Bank, or Fed, seems as much a part of America as Coca-Cola or Pizza Hut. But at least one difference has become apparent in recent days. While the pizza chain and soft-drink maker are likely to expand their scope of influence in the age of globalization, the US central bank is finding that its power is shrinking.

AFP

The US Federal Reserve.

No Fed chief in US history has been forced to submit to the kind of humiliation that Ben Bernanke is facing.

This is partly down to circumstances. Inflation is going up and up, and this year's average will likely top 4 percent. But this time Mr. Dollar is also Mr. Powerless. He can raise interest rates in the fall, or he can pray, which would probably be the better choice. At least prayer would not prevent the US economy from growing, a highly likely outcome if interest rates go up.

After years of growth, the United States is now on the brink of a recession, one that is more likely to be deepened than softened by a tight money policy. Investments will automatically become more expensive, consumer spending will be curbed and economic growth will slow down, immediately affecting unemployment figures and wages.

The textbook conclusion is that this will stabilize the value of money, because no one will dare demand higher wages or higher prices. But the macroeconomics textbooks are no longer worth much in the age of globalization. Modern inflation is driven by the global scarcity of resources. Nowadays purchasing power exceeds purchasing opportunity. Most of all, there is not enough oil, and too few raw materials and food products. These increasingly scarce resources are becoming the focus of disputes among many people and billions of dollars are at stake.

This is why the price of a barrel of crude oil (159 liters) has increased from $25 (€16) in 2002 to $135 (€87) in 2008. And it is also why the price of corn has tripled in the same time period, while that of copper has almost quintupled.

If the inflation introduced in the United States is excluded, a small miracle is revealed, namely something approaching price stability. Adjusted for inflation, prices are in fact rising by only 2.3 percent. If this were the extent of it, the Fed chief could simply blink like an old watchdog and go back to sleep. Instead, he is barking loudly, which is his job. But he has lost his bite, because the Fed's interest rate policy can do nothing about the scarcity of goods.

AFP

US Federal Reserve chairman Ben Bernanke. The entire US financial system is to come under the scrutiny of the IMF

Embarrassing Investigation

Some of Bernanke's personal adversaries are also contributing significantly to his current humiliation. In the past, the chairman of the Federal Reserve was a pope among the priests of the financial elite. But unlike his predecessor Alan Greenspan, Bernanke is finding that his policies are not universally accepted, even within the Fed.

The last seven decisions reached by the Federal Open Market Committee, which sets monetary policy, were accompanied by a growing number of dissenting votes. Bernanke's critics say that with his policy of cheap money -- in other words, recurring rate reductions -- he in fact helped fuel the inflation problem he is now trying to combat.

Another problem for Mr. Dollar is that it will be several months before his actions take effect. Officials with the International Monetary Fund (IMF) have informed Bernanke about a plan that would have been unheard-of in the past: a general examination of the US financial system. The IMF's board of directors has ruled that a so-called Financial Sector Assessment Program (FSAP) is to be carried out in the United States. It is nothing less than an X-ray of the entire US financial system.

As part of the assessment, the Fed, the Securities and Exchange Commission (SEC), the major investment banks, mortgage banks and hedge funds will be asked to hand over confidential documents to the IMF team. They will be required to answer the questions they are asked during interviews. Their databases will be subjected to so-called stress tests -- worst-case scenarios designed to simulate the broader effects of failures of other major financial institutions or a continuing decline of the dollar.

Under its bylaws, the IMF is charged with the supervision of the international monetary system. Roughly two-thirds of IMF members -- but never the United States -- have already endured this painful procedure.

For seven years, US President George W. Bush refused to allow the IMF to conduct its assessment. Even now, he has only given the IMF board his consent under one important condition. The review can begin in Bush's last year in office, but it may not be completed until he has left the White House. This is bad news for the Fed chairman.

When the final report on the risks of the US financial system is released in 2010 -- and it is likely to cause a stir internationally -- only one of the people in positions of responsiblity today will still be in office: Ben Bernanke.

This Recession, It's Just Beginning

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This Recession, It's Just Beginning

By Steven Pearlstein
Friday, June 27, 2008; D01

So much for that second-half rebound.

Truth be told, that was always more of a wish than a serious forecast, happy talk from the Fed and Wall Street desperate to get things back to normal.

It ain't gonna happen. Not this summer. Not this fall. Not even next winter.

This thing's going down, fast and hard. Corporate bankruptcies, bond defaults, bank failures, hedge fund meltdowns and 6 percent unemployment. We're caught in one of those vicious, downward spirals that, once it gets going, is very hard to pull out of.

Only this will be a different kind of recession -- a recession with an overlay of inflation. That combo puts the Federal Reserve in a Catch-22 -- whatever it does to solve one problem only makes the other worse. Emerging from a two-day meeting this week, Fed officials signaled that further recession-fighting rate cuts are unlikely and that their next move will be to raise rates to contain inflationary expectations.

Since last June, we've seen a fairly consistent pattern to the economic mood swings. Every three months or so, there's a round of bad news about housing, followed by warnings of more bank write-offs and then a string of disappointing corporate earnings reports. Eventually, things stabilize and there are hints that the worst may be behind us. Stocks regain some of their lost ground, bonds fall and then -- bam -- the whole cycle starts again.

It was only in November that the Dow had recovered from the panicked summer sell-off and hit a record, just above 14,000. By March, it had fallen below 12,000. By May, it climbed above 13,000. Now it's heading for a new floor at 11,000. Officially, that's bear market territory. We'll be lucky if that's the floor.

In explaining why that second-half rebound never occurred, the Fed and the Treasury and the Wall Street machers will say that nobody could have foreseen $140 a barrel oil. As excuses go, blaming it on an oil shock is a hardy perennial. That's what Jimmy Carter and Fed Chairman Arthur Burns did in the late '70s, and what George H.W. Bush and Alan Greenspan did in the early '90s. Don't believe it.

Truth is, there are always price or supply shocks of one sort or another. The real problem is that the underlying fundamentals had gotten badly out of whack, making the economy susceptible to a shock. The only way to make things better is to get those fundamentals back in balance. In this case, that means bringing what we consume in line with what we produce, letting the dollar fall to its natural level, wringing the excess capacity out of industries that overexpanded during the credit bubble and allowing real estate prices to fall in line with incomes.

The last hope for a second-half rebound began to fade earlier this month when Lehman Brothers reported that it wasn't as immune to the credit-market downturn as it had led everyone to believe. Lehman scrambled to restore confidence by firing two top executives and raising billions in additional capital, but even that wasn't enough to quiet speculation that it could be the next Bear Stearns.

Since then, there has been a steady drumbeat of worrisome news from nearly every sector of the economy.

American Express and Discover warn that customers are falling further behind on their debts. UPS and Federal Express report a noticeable slowdown in shipments, while fuel costs are soaring. According to the Case-Shiller index, home prices in the top 20 markets fell 15 percent in April from the year before, and Fannie Mae and Freddie Mac report that mortgage delinquency rates doubled over the same period -- and that's for conventional home loans, not subprime. United Airlines accelerates the race to cut costs and capacity by laying off 950 pilots -- 15 percent of its total -- as a number of airlines retire planes and hint that they may delay delivery or cancel orders of new jets from Boeing and Airbus. Goldman Sachs, which has already had to withdraw its rosy forecast for stocks, now admits it was also too optimistic about junk bond defaults, and analysts warn that Citigroup and Merrill Lynch will also be forced to take additional big write-downs on their mortgage portfolios.

Meanwhile, General Motors, already reeling from a 28 percent plunge in the pace of auto and truck sales, now confronts the fact that it won't get any help this time from GMAC, its once highly profitable finance arm, which is reeling from an increase in delinquencies on home and auto loans. With the carmaker hemorrhaging cash, whispers of a possible default sent the price of insuring GM bonds soaring on the credit default market.

You know things are bad when middle-class Americans have to give up their boats and Brunswick, the nation's biggest maker of powerboats, is forced to close 10 plants and lay off 2,700 workers.

For much of the year, optimists took comfort in the continuing strength of the technology sector and exports to fast-growing countries around the world. But even those bright spots have dimmed.

Tech stocks got hammered yesterday after software maker Oracle and BlackBerry maker Research in Motion warned that the pace of corporate orders had slowed.

And both India and China raised interest rates and bank reserves sharply in an effort to tame inflation and slow their overheated economies, even as the air continued to rush out of their real estate and stock market bubbles.

Like the rain-swollen waters of the Mississippi River, this sudden surge of downbeat news has now overflowed the banks of economic policy and broken through the levees of consumer and investor confidence. At this point, there's not much to do but flee to safety, rescue those in trouble and let nature take its course. And don't let anyone fool you: It will be a while before things return to normal.

U.S. Stocks Tumble, Sending Dow to Worst June Since Depression

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U.S. Stocks Tumble, Sending Dow to Worst June Since Depression

By Michael Patterson

June 26 (Bloomberg) -- U.S. stocks tumbled, sending the Dow Jones Industrial Average to its worst June since the Great Depression, as record oil prices, credit-market writedowns and a slowing economy threatened to extend a yearlong profit slump.

General Motors Corp., the largest U.S. automaker, plunged the most in three years as Goldman Sachs Group Inc. advised selling the stock and crude rose by $5 a barrel. Citigroup Inc. led the KBW Bank Index to an almost 10-year low as Goldman said the lender may report an $8.9 billion second-quarter charge and cut its dividend. Research In Motion Ltd., maker of the BlackBerry, posted its biggest drop since 2001 on concern competition with Apple Inc.'s iPhone is reducing earnings.

The Standard & Poor's 500 Index plunged 38.82, or 2.9 percent, to 1,283.15, its biggest drop in three weeks. The Dow decreased 358.41, or 3 percent, to 11,453.42, its lowest since September 2006. The Nasdaq Composite Index sank 79.89, or 3.3 percent, to 2,321.37, its worst loss since January. Almost nine stocks fell for each that rose on the New York Stock Exchange.

``Most investors are going to sit on the sidelines until they're more certain the sharks have left the waters and it's safe to go back in,'' said Bruce McCain, the Cleveland-based head of investment strategy at Key Private Bank, which oversees about $30 billion. ``The write-offs have been far worse than anyone would have imagined.''

Nike Earnings

All 10 industry groups in the S&P 500 retreated at least 1 percent as Nike Inc. said U.S. earnings dropped and Oracle Corp. predicted the slowest sales growth since 2006, adding to concern that consumers and businesses are cutting back as the economy expands at the weakest pace in five years.

Earnings at companies in the S&P 500 slid 18 percent on average in the first quarter, the third straight retreat, according to data compiled by Bloomberg. Analysts project profits will drop 8.9 percent this quarter, according to a Bloomberg survey last week.

The Dow has slumped 9.4 percent this month, its worst June since an 18 percent tumble in 1930 during the Great Depression. All 30 companies have posted losses in the month as oil surged, the unemployment rate jumped to the highest since 2004 and concern grew that global financial firms will add to $400 billion of subprime-related writedowns.

The Dow's retreat today erased all the gains since mid- March that were spurred by JPMorgan Chase & Co.'s rescue of Bear Stearns Cos., a drop in the Federal Reserve's benchmark interest rate to 2 percent and the central bank's new lending programs for securities firms.

Citigroup, Merrill

Citigroup dropped $1.18, or 6.3 percent, to $17.67 today, the lowest level since October 1998. Goldman added the biggest U.S. lender by assets to its ``conviction sell'' list and lowered its recommendation on U.S. brokerages to ``neutral'' from ``attractive,'' saying the pace of deterioration in the industry ``appears to be far worse than'' it originally anticipated.

Merrill Lynch & Co., the third-largest U.S. securities firm, declined $2.41 to $33.05, a five-year low. Goldman analysts predicted the company will post a $3.55-a-share loss in 2008, compared with their previous estimate for an 8-cent profit.

The Financial Select Sector SPDR Fund, a so-called exchange traded fund that tracks U.S. financial stocks, lost 3.6 percent to $20.90, the lowest since March 2003. The shares, known by their XLF ticker, were the fourth most-traded among stocks and ETFs in New York today. The KBW Bank Index of 24 companies dropped 3.9 percent to 60.20, the lowest since October 1998.

`Ugly Day'

``It's another ugly day,'' said James Dunigan, the Philadelphia-based chief investment officer at PNC Advisors, which manages $70 billion. ``Until we get through another round of disclosures and through earnings season, the safest place is on the sidelines.''

Research In Motion plunged $18.88, or 13 percent, to $123.46. Second-quarter earnings will be as low as 84 cents a share, the company said. That missed the average prediction by analysts of 92 cents, according to a Bloomberg survey. The report marked Research In Motion's first earnings disappointment in five quarters.

Apple shares declined $9.13, or 5.2 percent, to $168.26, the lowest since April 23.

GM fell $1.38, or 11 percent, to $11.43, the steepest slide since March 2005 and lowest price since 1974. Lear Corp., the second-largest maker of vehicle seats, lost $2.97, or 16 percent, to $15.15. Goldman downgraded both stocks to ``sell'' from ``neutral.''

`Escalating Headwinds'

``We expect escalating headwinds from volume/mix pressures driven by gas prices, falling confidence and tightening credit,'' Goldman wrote in a research note.

GM and Chrysler LLC may face a cash crunch next year as U.S. sales decline on a slowing economy and rising gasoline prices that push buyers toward more fuel-efficient vehicles, Fitch Ratings said yesterday.

Chrysler spokesman Dave Elshoff said in an interview today that the company has no plans to file for bankruptcy, countering speculation in financial markets.

Companies in the S&P 500 that rely on discretionary consumer spending lost 3.5 percent as a group after oil prices jumped to $139.64 a barrel on Libya's threat to cut production and OPEC's prediction that prices may reach $170 by the summer.

Nike retreated $6.47, or 9.8 percent, to $59.50, the biggest drop since February 2001. The world's largest athletic- shoe maker said pretax income in the U.S. declined 10 percent to $390.7 million in the three months that ended May 31. U.S. orders through November were unchanged.

Oracle, Lennar

Oracle slipped $1.13 to $21.42. The world's second-largest software maker expects first-quarter profit before some items of 26 cents to 27 cents a share. Analysts predicted 27 cents, according to the average of 16 estimates in a Bloomberg survey. Sales will rise between 18 percent and 20 percent, Oracle said.

Lennar Corp. spurred declines in homebuilders after the company reported a loss that exceeded analysts' estimates as it cut prices to attract buyers. The shares fell $1.23, or 8.4 percent, to $13.34. The S&P Supercomposite Homebuilding Index lost 5.6 percent as all 15 of its companies retreated.

The VIX, as the Chicago Board Options Exchange Volatility Index is known, climbed for the first time this week, gaining 13 percent to 23.93. The index, which measures the cost of using options as insurance against declines in the S&P 500, reached the highest level since June 11. The VIX is still 26 percent below its five-year closing high in March.

Economy Watch

The U.S. economy expanded at an annual rate of 1 percent in the first quarter, capping the weakest six months of growth in five years, the Commerce Department said today. The revised gain in gross domestic product was up from a preliminary estimate of 0.9 percent issued last month.

Initial jobless claims totaled 384,000 in the week ended June 21, unchanged from the previous week's tally that was higher than previously estimated, the Labor Department said. The total number of people collecting benefits rose by 82,000 to 3.139 million in the week ended June 14, the highest since February 2004.

Bed Bath & Beyond Inc. climbed $1.22, or 4.3 percent, to $29.79 for the top gain in the S&P 500. The largest U.S. home- furnishings retailer reported profit that fell less than analysts estimated because of higher sales.

European stocks tumbled, sending the Dow Jones Stoxx 600 Index down 2.6 percent, as Belgium-based lender Fortis scrapped its dividend and said it will sell shares. Asian stocks advanced.

Treasuries rose on speculation credit-market losses will prevent the Fed from increasing borrowing costs later this year. The dollar declined to the weakest level against the euro in more than two weeks.

The Dow Jones Wilshire 5000 Index, the broadest measure of U.S. shares, fell 2.8 percent to 13,125.12. Based on its decline, the value of stocks decreased by $477.5 billion.

``It's the end of the quarter, oil is up and you've got a continued bashing of financials,'' said David Heupel, who helps oversee about $60 billion as a portfolio manager at Thrivent Financial for Lutherans in Minneapolis. ``Plenty of fuel for the fire today.''

OPEC has no influence on oil prices, according to Gazprom chief

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Russia's biggest energy company has warned that oil prices will end at a 'radically' new level and that OPEC has little influence over the price of crude.

Alexey Miller, chief executive of Gazprom, said that the global economy is facing "a great surge in oil and gas prices" that will "end with prices at a radically new level."

	Gazprom's Alexey Miller expects the surge in oil to continue

His comments to the Financial Times came as oil surged to a new high of $141.98, leaving prices more than double where they were 12 months ago and casting a shadow over the prospects for the global economy this year and next.

Mr Miller also dismissed hopes that the Organization of Petroleum Exporting Countries can do much to bring prices down. "Not a single decision has been passed of late that would really influence the global oil market," he said.

Gordon Brown and President George W Bush have both lobbied OPEC, and in particular its biggest producer Saudi Arabia, to ramp up production.

Saudi's decision to increase production has done little to bring oil lower as fears for global supply and the weaker dollar help to drive prices higher.

Oil prices: A complete Q&A

Oil rise hits global markets

Mr Miller expects increasing competition for the world's gas and other energy resources to drive oil to $250 a barrel next year.

Outlining Gazprom's future, Mr Miller said the company's target was to reach a market capitalisation of $1,000bn (£503bn), as the "most influential in the energy business".

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The Russian group is benefiting from high domestic prices he said, but also plans to expand into the Americas, Asia, Europe and Africa.

Mr Miller said: "We see North America as a region of our strategic interests", revealing that Gazprom is in the process of "creating a new configuration of gas supplies" to the US and Canada. The group hopes to break into the American market in 2014.

RBS issues global stock and credit crash alert

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The Royal Bank of Scotland has advised clients to brace for a full-fledged crash in global stock and credit markets over the next three months as inflation paralyses the major central banks.

"A very nasty period is soon to be upon us - be prepared," said Bob Janjuah, the bank's credit strategist.

A report by the bank's research team warns that the S&P 500 index of Wall Street equities is likely to fall by more than 300 points to around 1050 by September as "all the chickens come home to roost" from the excesses of the global boom, with contagion spreading across Europe and emerging markets.

	RBS warning: Be prepared for a 'nasty' period

Such a slide on world bourses would amount to one of the worst bear markets over the last century.

RBS alert: Quotes from the report

Fund managers react to RBS alert

Support for the euro is in doubt

RBS said the iTraxx index of high-grade corporate bonds could soar to 130/150 while the "Crossover" index of lower grade corporate bonds could reach 650/700 in a renewed bout of panic on the debt markets.

"I do not think I can be much blunter. If you have to be in credit, focus on quality, short durations, non-cyclical defensive names.

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"Cash is the key safe haven. This is about not losing your money, and not losing your job," said Mr Janjuah, who became a City star after his grim warnings last year about the credit crisis proved all too accurate.

RBS expects Wall Street to rally a little further into early July before short-lived momentum from America's fiscal boost begins to fizzle out, and the delayed effects of the oil spike inflict their damage.

"Globalisation was always going to risk putting G7 bankers into a dangerous corner at some point. We have got to that point," he said.

US Federal Reserve and the European Central Bank both face a Hobson's choice as workers start to lose their jobs in earnest and lenders cut off credit.

The authorities cannot respond with easy money because oil and food costs continue to push headline inflation to levels that are unsettling the markets. "The ugly spoiler is that we may need to see much lower global growth in order to get lower inflation," he said.

Morgan Stanley warns of catastrophe

More comment and analysis from the Telegraph

"The Fed is in panic mode. The massive credibility chasms down which the Fed and maybe even the ECB will plummet when they fail to hike rates in the face of higher inflation will combine to give us a big sell-off in risky assets," he said.

Kit Jukes, RBS's head of debt markets, said Europe would not be immune. "Economic weakness is spreading and the latest data on consumer demand and confidence are dire. The ECB is hell-bent on raising rates.

"The political fall-out could be substantial as finance ministers from the weaker economies rail at the ECB. Wider spreads between the German Bunds and peripheral markets seem assured," he said.

Ultimately, the bank expects the oil price spike to subside as the more powerful force of debt deflation takes hold next year.

Barclays warns of a financial storm as Federal Reserve's credibility crumbles

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US central bank accused of unleashing an inflation shock that will rock financial markets, reports Ambrose Evans-Pritchard

Barclays Capital has advised clients to batten down the hatches for a worldwide financial storm, warning that the US Federal Reserve has allowed the inflation genie out of the bottle and let its credibility fall "below zero".

"We're in a nasty environment," said Tim Bond, the bank's chief equity strategist. "There is an inflation shock underway. This is going to be very negative for financial assets. We are going into tortoise mood and are retreating into our shell. Investors will do well if they can preserve their wealth."

Barclays Capital said in its closely-watched Global Outlook that US headline inflation would hit 5.5pc by August and the Fed will have to raise interest rates six times by the end of next year to prevent a wage-spiral. If it hesitates, the bond markets will take matters into their own hands. "This is the first test for central banks in 30 years and they have fluffed it. They have zero credibility, and the Fed is negative if that's possible. It has lost all credibility," said Mr Bond.

	Strategists at Barclays accuse Ben Bernanke of a policy blunder

RBS issues global crash alert

Read more by Ambrose Evans Pritchard

The grim verdict on Ben Bernanke's Fed was underscored by the markets yesterday as the dollar fell against the euro following the bank's dovish policy statement on Wednesday.

Traders said the Fed seemed to be rowing back from rate rises. The effect was to propel oil to $138 a barrel, confirming its role as a sort of "anti-dollar" and as a market reproach to Washington's easy-money policies.

The Fed's stimulus is being transmitted to the 45-odd countries linked to the dollar around world. The result is surging commodity prices. Global inflation has jumped from 3.2pc to 5pc over the last year.

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Mr Bond said the emerging world is now on the cusp of a serious crisis. "Inflation is out of control in Asia. Vietnam has already blown up. The policy response is to shoot the messenger, like the developed central banks in the late 1960s and 1970s," he said.

"They will have to slam on the brakes. There is going to be a deep global recession over the next three years as policy-makers try to get inflation back in the box."

Barclays Capital recommends outright "short" positions on Asian bonds, warning that yields could jump 200 to 300 basis points. The currencies of trade-deficit states like India should be sold. The US yield curve is likely to "steepen" with a vengeance, causing a bloodbath for bond holders.

David Woo, the bank's currency chief, said the Fed's policy of benign neglect towards the dollar had been stymied by oil, which is now eating deep into the country's standard of living. "The world has changed all of a sudden. The market is going to push the Fed into a tightening stance," he said.

Gazprom chief expects 'radical' change in oil price

More comment and analysis from The Telegraph

The bank said the full damage from the global banking crisis would take another year to unfold.

Rob McAdie, Barclays' credit strategist, said: "The core issues have not been addressed. We're still in a very large deleveraging cycle and we're seeing losses continue to mount. We think smaller banks will struggle to raise capital. We're very bearish - in the long-term - on high-yield debt. The default rate will reach 8pc to 9pc next year."

He said investors had taken their eye off the slow-motion disaster engulfing the US bond insurers or "monolines". Together these firms guarantee $170bn of structured credit and $1,000bn of US municipal bonds.

The two leaders - MBIA and Ambac - have already been downgraded as the rating agencies belatedly turn stringent. The risk is further downgrades could set off a fresh wave of bank troubles. "The creditworthiness of many US financial institutions will decline in coming months," he said.

The bank warned that engineering and auto firms we're likely to face a crunch as steel and oil costs surge. "Their business models will have to be substantially altered if they are going to survive," said Mr McAdie.

A small chorus of City bankers dissent from the view that inflation is the chief danger in the US and other rich OECD countries. The teams at Société Générale, Dresdner Kleinwort, and Banque AIG all warn that deflation may loom as housing markets crumble under record levels of household debt.

Bernard Connolly, global startegist at Banque AIG, said inflation targeting by central banks had become a "totemism that threatens to crush the world economy".

He said it would be madness to throw millions out of work by deflating part of the economy to offset a rise in imported fuel and food prices. Real wages are being squeezed by oil, come what may. It may be healthier for society to let it happen gently.

Quote of the day

If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around them will deprive the people of all property until their children wake up homeless on the continent their fathers conquered. The issuing power should be taken from the banks and restored to the people, to whom it properly belongs.

– Thomas Jefferson, Letter to Treasury Secretary Albert Gallatin (1802)

Morgan Stanley warns of 'catastrophic event' as ECB fights Federal Reserve

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The clash between the European Central Bank and the US Federal Reserve over monetary strategy is causing serious strains in the global financial system and could lead to a replay of Europe's exchange rate crisis in the 1990s, a team of bankers has warned.
"We see striking similarities between the transatlantic tensions that built up in the early 1990s and those that are accumulating again today. The outcome of the 1992 deadlock was a major currency crisis and a recession in Europe," said a report by Morgan Stanley's European experts.

Jean-Claude Trichet is taking a hard line on rates
Just as then, Washington has slashed rates to bail out the banks and prevent an economic hard-landing, while Frankfurt has stuck to its hawkish line - ignoring angry protests from politicians and squeals of pain from Europe's export industry.
Indeed, the ECB has let the de facto interest rate - Euribor - rise by over 100 basis points since the credit crisis began.
Just as then, the dollar has plummeted far enough to cause worldwide alarm. In August 1992 it fell to 1.35 against the Deutsche Mark: this time it has fallen even further to the equivalent of 1.25. It is potentially worse for Europe this time because the yen and yuan have also fallen to near record lows. So has sterling.

Morgan Stanley doubts that Europe's monetary union will break up under pressure, but it warns that corked pressures will have to find release one way or another.
This will most likely occur through property slumps and banking purges in the vulnerable countries of the Club Med region and the euro-satellite states of Eastern Europe.
"The tensions will not disappear into thin air. They will find fault lines on the periphery of Europe. Painful macro adjustments are likely to take place. Pegs to the euro could be questioned," said the report, written by Eric Chaney, Carlos Caceres, and Pasquale Diana.
The point of maximum stress could occur in coming months if the ECB carries out the threat this month by Jean-Claude Trichet to raise rates. It will be worse yet - for Europe - if the Fed backs away from expected tightening. "This could trigger another 'catastrophic' event," warned Morgan Stanley.
The markets have priced in two US rates rises later this year following a series of "hawkish" comments by Fed chief Ben Bernanke and other US officials, but this may have been a misjudgment.
An article in the Washington Post by veteran columnist Robert Novak suggested that Mr Bernanke is concerned that runaway oil costs will cause a slump in growth, viewing inflation as the lesser threat. He is irked by the ECB's talk of further monetary tightening at such a dangerous juncture.

The contrasting approaches in Washington and Frankfurt make some sense. America's flexible structure allows it to adjust quickly to shocks. Europe's more rigid system leaves it with "sticky" prices that take longer to fall back as growth slows.
Morgan Stanley says the current account deficits of Spain (10.5pc of GDP), Portugal (10.5pc), and Greece (14pc) would never have been able to reach such extreme levels before the launch of the euro.
EMU has shielded them from punishment by the markets, but this has allowed them to store up serious trouble. By contrast, Germany now has a huge surplus of 7.7pc of GDP.
The imbalances appear to be getting worse. The latest food and oil spike has pushed eurozone inflation to a record 3.7pc, with big variations by country. Spanish inflation is rising at 4.7pc even though the country is now in the grip of a full-blown property crash. It is still falling further behind Germany. The squeeze required to claw back lost competitiveness will be "politically unpalatable".
Morgan Stanley said the biggest risk lies in the arc of countries from the Baltics to the Black Sea where credit growth has been roaring at 40pc to 50pc a year. Current account deficits have reached 23pc of GDP in Latvia, and 22pc in Bulgaria. In Hungary and Romania, over 55pc of household debt is in euros or Swiss francs.
Swedish, Austrian, Greek and Italian banks have provided much of the funding for the credit booms. A crunch is looming in 2009 when a wave of maturities fall due. "Could the funding dry up? We think it could," said the bank.

America's Berlin Wall

America's Berlin Wall

International taxation
America's Berlin Wall
Jun 12th 2008 HONG KONGFrom The Economist print edition
Congress increases the ransom expats must pay to escape the taxman
QUEUES of frustrated foreigners crowd many an American consulate around the world hoping to get into the United States. Less noticed are the heavily taxed American expatriates wanting to get out—by renouncing their citizenship.
In Hong Kong just now, they cannot. “Please note that this office cannot accept renunciation applications at this time,” the consulate's website states. Apart from sounding like East Germany before the fall of the Berlin Wall, the closure is unfortunately timed. Because of pending legislation on President Bush's desk that is expected to become law by June 16th, any American who wants to surrender his passport has only a few days to do so before facing an enormous penalty.

That penalty is buried in an innocuous piece of legislation with the veto-proof name, Heroes Earnings Assistance and Relief Tax (HEART) act. The new law means active American soldiers will benefit from tax relief. To pay for that, Congress has turned on expats, especially those who, since new tax laws in 2006, have become increasingly eager to give up their citizenship to escape the taxman.

Under the proposed legislation, expatriates surrendering their citizenship with a net worth of $2m or more, or a high income, will have to act as if they have sold all their worldwide assets at a fair market price. If the unrealised gains on these assets exceed $600,000, capital-gains tax will apply. A study by the Congressional Budget Office guesses that the new law will progressively net the government up to $286m over five years. It is unclear, however, why people would suffer the consequences if they did not expect to save money in the long run by escaping American taxes.

That expats want to leave at all is evidence of America's odd tax system. Along with citizens of North Korea and a few other countries, Americans are taxed based on their citizenship, rather than where they live. So they usually pay twice—to their host country and the Internal Revenue Service. As this makes citizenship less palatable, Congress has erected large barriers to stop them jumping ship. In 1996 it forced people who renounced citizenship to continue paying income taxes for an extra ten years. Theoretically, the new law allows for a cleaner break.
But even as the law tries to prevent people from renouncing their citizenship, it may have the opposite effect. Under the new structure, it would make financial sense for any young American working overseas with a promising career to renounce his citizenship as early as possible, before his assets accumulate. For everyone else, plunging stock and property prices mean now may be as good a time as any to hand back the passport, says Kurt Rademacher, a partner at Withers, a global tax-planning firm.

In Hong Kong the temptation for Americans to switch citizenship is particularly strong, because of the territory's low taxes. On the other hand, banks and other firms who want to hire Americans may find it harder to do so, even though greater China is one of the world's fastest-growing regions. It places Americans in the awkward position of weighing their patriotism against their vocation.