The Problem With Dubai

Dubai World, builder of man-made palm tree shaped islands and lover of other absurdly ostentatious and expensive property development projects, has run into a bit of a problem. Lacking oil, or any other valuable commodities, it fueled its building ambitions by issuing debt, piles of it, roughly $60 billion or so. Banks were eager to lend because government-backing of Dubai World's debt was implied. So when Dubai World came out with its shocking announcement right before the Thanksgiving holiday that it just wasn't in the mood to pay its debt investors anymore, markets around the world were miffed and sold off. They regained their composure a bit when all those savvy analysts and commentators assuredly pointed out that a $60 billion debt default was no big deal. The markets had overreacted blah blah blah.

But this is a big problem: it's not the size of the debt but the wider implications of a sovereign nation defaulting on its debt. This morning, the Government of Dubai said that it would not stand behind its wholly-owned subsidiary Dubai World. So much for that implied government guarantee. For the past year, vast government guarantees have boosted markets around the world on the belief that sovereign nations don't default. There's no need to actually do any due diligence into the value of the assets backing the debt if the government is just going to step in and bailout the lenders. Except that sometimes, governments change their minds. Certainly emerging markets have been guilty of this in the past, so you'd think investors would have learned their lesson. But with near-zero interest rates permeating the globe, it's that much easier to ignore these risks and plow head-first into risky investments, some with a host of massive unfinished construction projects around the world, just because some government is supposed to bail you out. Not all bailouts will stand the test of time. Defaulting on your debt is theoretically supposed to make it extremely difficult for you to borrow money at reasonable interest rates in the future, if at all. But if a few adventurous sovereigns start to do it, then the stigma related to default might just go away. So how does that make you feel about Fannie and Freddie's debt? GE Capital's? How about GMAC?

Data and More Data

First the good news:

• Case-Shiller was up again, for the fourth month in a row. It's true that a .27% increase in prices from the prior month is nothing to write home about, but still better than a decline. Year-over-year, prices were still down 9.36%.

Now the not-so-good news:

• Third quarter GDP was revised lower from an initially ebullient 3.5% rate to a less perky 2.8% annual rate. The downward revision was mostly due to a widening of the trade deficit and lower consumer spending than initially estimated.

In obvious news:

• Just in case you've spent the last year and a half on Mars, the WSJ reports that lots of folks are upside down on their mortgages, around one out of four US homeowners. The good news is if we keep allowing borrowers access to 3.5% down-payment financing courtesy of the FHA, and prices tick down a bit more, it's going to get worse.
• Also in the Journal, a report on how banks have trillions in debt coming due, $7 trillion by 2012 and $10 trillion by 2015, and how this could prove to be a bit of a problem when borrowing costs go higher once a.) FDIC guaranteed debt matures b.) interest rates head higher because the Fed has ended its QE program and/or c.) buyers of bank debt actually start to care about credit risk again.

In can-we-really-beat-this-dead-horse-anymore??? news:

• For those with a strong stomach, yet another article on how "difficult" the AIG bailout has been for the government to manage, and how frustrated everyone in the administration is. Blah blah blah, griping over pay, blah blah blah.

Existing Homes Sales Surge

Existing home sales were up 10.1% to a 6.1 million annual pace in October, proving that if you give people sub-5% mortgages requiring only a 3.5% downpayment AND hand them checks for $8,000, they will buy houses. Inventories fell to a seven month supply and the median was down year-over-year by 7.1% to $173,100. Thanks to all the government subsidies, even if technically you didn't buy a home in October, you still sort of bought a home for someone else in October. In any event, the plan seems to have worked by artificially stimulating demand for housing. It will be interesting to see if this type of enthusiasm can continue when all of the stimulus plans expire.

In the meantime, enjoy the market rally and your turkey. Blogging may be a bit sparse this week, depending on material.

Goldman's Shareholders Finally Speak Up About Bonuses

So far, Goldman bonus anger has spewed forth mainly from the lips of legislators, angry mobs, and pregnant women who can't get access to the swine flu vaccine. Lloyd Blankfein has been making the media rounds, which everyone knows he hates to do, defending the firm's aggressive pay practices by pointing out that the firm paid back the TARP, never needed the money anyway, and would've made a mint even without an AIG bailout, FDIC guaranteed funding, zero interest rates blah blah blah. Mr. Blankfein probably never thought any of the hot air would lead to anything. After all, Goldman is pretty used to getting what it wants. But lo and behold, folks that actually matter, who aren't just spouting rage to get reelected, might take action to limit Goldman's plans to shell out record bonuses to its employees: shareholders. The problem is that shareholders fund Goldman's annual pay extravaganzas. The more Goldman pays out in bonuses, the less it retains for shareholders in the form of earnings. Somehow shareholders of Goldman and other investment banks have put up with this reality, until now that is.

According to the WSJ, some of Goldman's largest shareholders are miffed. They want more of the pie. Apparently, despite record net income and compensation, earnings per share will be 22% lower than 2007 and roughly equal to 2006 earnings due to dilution from the 100 million share issued in the past year to bolster its financial position. So if you're going to dilute them, then at least ratchet back on the record payouts to employees. Fair point. An even more interesting tidbit is that a little-noticed change in the company's financial statement increased the firm's total head count by adding temps and consultants, thus making comp per-employee appear to look less than it actually is. In response to shareholder's ire the company's spokesman said that shareholders "have historically been more focused on the absolute return on equity and on book value per share growth." Looks like times are changing.

Delinquencies and Foreclosures Rise on Prime Mortgages

The MBA released its National Delinquency Survey today and the findings were not pretty. The delinquency rate for mortgage loans on one-to-four unit residential properties rose to a seasonably adjusted rate of 9.64% of all loans outstanding as of the end of the third quarter of 2009, up 40 basis points from the second quarter and 2.65% from a year ago. The combined percentage of loans in foreclosure or at least one payment past due was 14.41%, the highest ever recorded in the MBA delinquency survey.

While subprime began the mortgage mess we're in, the latest increases in delinquencies were driven by prime and FHA loans. 33% of foreclosures started in the third quarter were on prime fixed-rate loans and those loans were 44% of the quarterly increase in foreclosures. Option ARMs are lumped together with prime adjustable loans, which helps explain why the foreclosure rate on those loans exceeded the rate for subprime fixed-rate loans for the first. Both fixed and adjustable subprime loans saw decreases in foreclosures.

The foreclosure rate on FHA loans also increased, despite the large increase in the number of FHA-insured loans outstanding. The foreclosure rate was 1.31% for FHA loans.

The MBA's Chief Economist, Jay Brinkman, maintains that: "The outlook is that delinquency rates and foreclosure rates will continue to worsen before they improve," with a persistently high unemployment rate being the main culprit. He adds that "Job losses continue to increase and drive up delinquencies and foreclosures because mortgages are paid with paychecks, not percentage point increases in GDP." He's pretty eloquent for a mortgage banker eh?

Calculated Risk has great graphs, as usual.

Housing Starts, More on Fannie and Freddie

Housing starts fell 10.6% in October to a seasonally adjusted 529,000 annual rate. Building permits also declined. Those ever-accurate economists were forecasting a 1.7% increase in starts so this number was disappointing to say the least. It seems as if builders are reluctant to break ground on new projects with inventories and vacancies on existing properties sitting at record highs. With both the expiration of the housing tax credits and the end of Fed's aggressive purchases of MBS looming on the horizon, it's not surprising that builders are hesitant. It seems like their time and money is better spent coming up with new programs to lobby the government for, rather than building houses.

Good article in the WSJ about Fannie and Freddie's involvement in the apartment market. If you thought that Fannie and Freddie were just doing their civic duty to prop up the residential mortgage market, you're wrong. The housing behemoths are also huge lenders to multifamily projects. How huge? They did 84% of all multifamily lending in 2008. The 2008 numbers don't scare me quite so much since at least underwriting was tightened up a bit by then and nobody else was lending. What does scare me is the 43% of market share the combined companies had in 2007 and 34% in 2006, back when banks like Lehman brothers were still around doing moronic deals. For example, Fannie and Freddie helped finance the massive and overpriced Archstone Smith apartment LBO by lending $9 billion to the deal. Or my vote for the dumbest real estate transaction of the bubble, Tishman's $5.4 billion purchase of Stuyvesant Town, where Fannie and Freddie purchased $1.5 billion in CMBS from that deal. I'm not sure I understand exactly how financing bloated leveraged buyouts became part of their mission statement, but it was a bubble and fortunately taxpayers are here to clean up the mess. The good news is that Fannie and Freddie's apartment building loans only add up to around $300 billion, which is a mere drop in the bucket compared to the $5 trillion of single-family loans that they back. It always helps to put these things in perspective, doesn't it?

Fed Lousy Negotiator During AIG Crisis

So why did the Fed pay off AIG's couterparties at 100 cents on the dollar during AIG's meltdown late last year? Many of us critical of the Fed's drastic and opaque actions with respect to AIG, which it didn't even regulate or have authority to lend to, lie awake at night pondering this question. According to a government audit by the special inspector general for the TARP, the answer is that the folks at the Fed are terrible negotiators. Apparently the Fed called up AIG's counterparties late last year, asked them to cancel the swaps and take a haircut on the securities, the counterparties refused and demanded they be paid 100 cents on the dollar. The Fed said "Ok. Fine." That's your government working hard for you, as it shoveled multiple billions of dollars to Goldman Sachs, Merrill Lynch, Soc Gen, Calyon and others. Just keep that in mind next time you ever wonder who the Fed is really working for. Clearly, its allegiances lie with the big banks.

I've never actually taken a negotiations class, but common sense tells me that when you have even the tinniest bit of leverage, you use it to get a better deal. When you hold all the cards, you squeeze the living daylights out of the counterparties. Of course, when you have none, you cave. A fine example of someone who did a terrible job of negotiating was former CEO of Lehman Brothers, Dick Fuld. Mr. Fuld kept pretending that he had leverage, insisting on a ridiculous price for Lehman during its final days. Yet everyone knew he had no leverage, but Mr. Fuld refused to cave, costing him his firm. That's lousy negotiating taken to the opposite extreme. In the Fed's case with AIG's counterparties, the Fed held all the cards. Or rather, all the money. At the time, the Fed was the only game in town. Had it let AIG collapse, AIG's counterparties would've lost multiple billions of dollars. Why the Fed didn't use its leverage remains a complete mystery to me, despite its lame explanations in the inspector general's report.

In a letter accompanying the inspector general's report, the Fed claims it "acted appropriately" in its dealings with AIG's counterparties. It said its intervention in the insurer was designed to prevent a system-wide collapse. Curiously, it couldn't use its leverage as a regulator because it was acting on behalf of AIG. So instead of protecting the interests of taxpayers, whose money the Fed seems to have no trouble risking at every turn, it was protecting the interests of the bankrupt insurer that blew itself up through sheer greed and stupidity.

According to the WSJ's account of the inspector general's report, AIG's counterparties played hardball with the Fed because the Fed had already made it clear it wouldn't allow AIG to go bankrupt. They claimed they were contractually due the full value of the securities and that they had a fiduciary duty to their shareholders. Lucky for them, the Fed fell for it. The article goes on to say that the Fed's lack of leverage was rooted in decisions it made earlier in the fall, in September 2008, when the Fed felt confident that the banking industry would solve AIG's problems. After Lehman's failure, it tried to get the banks to pony up $75 billion for a loan to AIG, during which time AIG tried unsuccessfully to get the banks to accept less than full payment to cancel the swaps it had written. When those negotiations fell apart, the Fed itself lent the insurer $85 billion and then took over negotiations in early November to try to get the banks to accept haircuts. With the exception of UBS, who agreed to a 2% haircut, the banks refused. The Fed then decided that the only way to stop the cash bleed was to buy out the securities at par and cancel the swaps. There was another way, of course. It could've just given the banks the finger and let AIG fail. But then that's what a good negotiator would've done.

Retail Sales Better Than Expected, Sort Of

US retail sales rose 1.4% in October, much better than anticipated by our already optimistic analyst friends on Wall Street. Equity markets are higher, as everyone celebrates with glee that people are still willing to spend with abandon despite record high unemployment rates. One somewhat major detail glossed over by the optimists is that the 1.4% gain is from September to October, and September was revised down to a 2.3% loss from a previously estimated 1.5% tumble. So maybe this retail sales report was a bit lackluster after all. Excluding autos, other sales rose just 0.2%. Year-over-year retail sales are down 1.7%. Nifty charts available at Calculated Risk for those who like to visualize their economic statistics.

GM Shows Improvement, Only Loses $1.15 Billion

GM posted a $1.15 billion loss for the shortened third quarter and confirmed plans to accelerate repayments to the US and Canadian governments. The good news is that this loss was better than the $2.5 billion it punted last year. Furthermore, the automaker actually had positive cash flow to the tune of $3.3 billion instead of burning through $6.9 billion, like it did in last year's third quarter. But still, the automaker supposedly shed its burdensome cost structure in bankruptcy, emerged from Chapter 11, benefited from the government's massive cash-for-clunkers subsidy and it still lost money? Sorry, but color me not wildly impressed by this quarter's earnings report.

Nevertheless, an improvement is an improvement, so I'll give GM bonus points for that. Unfortunately, GM lowered its expectations for US auto sales in 2010 to 11 million to 12 million from the 12.5 million forecast in April. It expects global sales to come in between 62 million and 65 million sales. As for the loans that GM is planning to pay back to the US and Canadian governments, it will use other money it received from the government to pay back the borrowing. Just like a ponzi scheme, but it only requires one eager participant.

FHA Reserves Below Minimum

The FHA's capital-reserve fund fell to $3.6 billion as of September 30th, leaving reserves at just 0.53% of the $685 billion in total loans insured by the FHA. This is far below the 2% requirement level that the FHA said it had breached months ago. The Secretary of HUD, Shaun Donovan, downplayed the FHA's problems and claims that the FHA won't need a federal subsidy except under the most severe economic scenarios. Like 10% unemployment, maybe? The problem is that projected capital losses in 2009 were worse than the most pessimistic assumptions from last year's review, so really, I'm not sure we should trust Mr. Donovan's reassurances of the agency's solvency.

Apparently, this is what happens when the government tries to prop up a mortgage market that was initially propelled aloft by private no-downpayment mortgages to people with terrible credit. While FHA-insured mortgages require small downpayments, they are still offered to borrowers with lousy credit. The only difference between FHAs and Alt-As is that FHA mortgages have very low fixed rate mortgages, so there is no surprise doubling or tripling of payments a few years down the road. Unfortunately, default rates on FHA insured mortgages are surging, proving that minimal downpayment mortgages to borrowers with terrible credit are extremely high risk, even with a fixed rate. The '08 vintage already has a 15% delinquency rate, handily outpacing earlier years' vintages. Furthermore, the volume of loans insured by the FHA jumped 75% in the 2009 fiscal year to more than a quarter of the mortgage market, from a mere 2% in 2006. During the second quarter the FHA backed nearly half of all mortgages made to first-time home buyers. No matter how much HUD tries to downplay it, it is inevitable that we will be bailing out the FHA too. So, sure the housing market is stabilizing. But at what cost to the rest of us?

Benmosche Backtracks

AIG's feisty and possibly manic depressive CEO has backtracked on his threat to quit after just three months on the job. In an internal memo, conveniently leaked to the press, and aimed at assuaging employees' fears of losing all of his talent after only getting a taste of it, Mr. Benmosche wrote that he remains "totally committed to leading AIG through its challenges." Well, maybe except for when he's on vacation in Croatia. Or, maybe except for if he's not getting paid $10.5 million for his trouble. Or, if it means having to suffer more indignities at the thought of some Paz Czar telling him how he can pay his employees. But other than that, he's really committed.

According to the FT, a meeting last week in New York between AIG's directors, led by Mr. Benmosche, told Ken Feinberg (aka "Pay Czar") that his recent decision to slash salaries for 12 of its top executives by more than 90% was leading to high level departures and upsetting employees morale. That's interesting, because I can only think of one thing more upsetting to employee morale than getting a cut in salary and that would be bankruptcy. The great thing about your employer going bankrupt is that you not only lose your job, but you now become an unsecured creditor for any accrued benefits that you had tied up in the company. Then you get to join the other 8 million or so people who've been laid off in the past year and a half. Or better yet, you get to join the many, many people who have exhausted their unemployment benefits and are taking huge cuts in pay just to get a job. In any event, Mr. Feinberg replied that AIG "did not get" the fact that it had been bailed out with billions of dollars in taxpayers' funds. Nice response, Mr. Feinberg. At least somebody gets it.

What's interesting about this whole brouhaha over pay is that there is a brouhaha over pay going on. Mr. Benmosche has been on the job for three months and all we're doing is arguing over pay, as if pay is the most important thing going on at AIG. Furthermore, AIG is using comp as a way to insist that somehow paying people more is going to miraculously make the company earn over $120 billion in the next few years to pay back the government. It's just not going to happen. With the huge rally in credit spreads and the stock market in the past six months, AIG should be making multiple billions now if it had a shot of ever paying the money back. Sure the company turned a $455 million profit this quarter, but so what? Every time it sells off a unit, it takes another huge hit to earnings, because it seems everything was carried at extremely optimistic valuations on its books. So, I say, let the talent leave, replace it with others who want or need the job and wind the damn thing down and put it out of its misery.

Bear, AIG and Other Headlines

• Ralph Cioffi and Matthew Tannin, the two former Bear Stearns hedge fund managers were found not guilty of securities fraud and insider trading. Ever since these two bozos were arrested, I've marveled that somehow they wound up as the only ones prosecuted for securities fraud from the credit crisis. After all the obvious mortgage fraud, horrendous underwriting, bogus creation of securities, stupid AAA ratings granted by the rating agencies, not to mention major conflicts of interest from certain regulators with crucial decision making powers, somehow all prosecutors could come up with were these two clowns. Two former salesman who had dreams of hedge fund greatness, who discovered in a few short years that they were really really lousy money managers. In any event, the jury didn't buy the prosecution's case, which is amazing considering how much average Americans are dying to see Wall Streeters burned at the stake.
• AIG's CEO Robert Benmosche, who has spent a whopping three months at the helm of the beleaguered insurer, told the board that he is considering stepping down. Apparently, he is really mad that the government is interfering with his ability to run the company like he wants. Pretty unbelievable that the government, which owns 80% of AIG, due to a massive $125 billion or so infusion into the otherwise bankrupt insurer would have the nerve to interfere with how the company is run. I'm not quite sure why anyone would actually care if Mr. Benmosche stays or goes. So far his biggest accomplishments have been taking a two week vacation in Croatia during the first two weeks on the job, threatening to quit when his $10.5 million pay package wasn't yet approved, and then publicly insulting various regulators with outlandish comments that no sane CEO would ever make. Here's hoping that when Mr. Benmosche does retire, he goes back on his meds.
• US Treasury Secretary Tim Geithner said Wednesday that maintaining a strong dollar is "very important" for our country's economy. Then he was caught winking at Ben Bernanke. Meanwhile, the dollar fell through 15-month lows and gold hit new highs.
• Chris Dodd, chairman of the Senate banking committee, introduced a new bill that would strip the Fed of its powers and create a single banking regulator. Naturally, neither the Fed nor the FDIC are happy about losing some of their powers, but when you've spent years asleep at the switch while the banking industry created a massive bubble, maybe you shouldn't be the one in charge next time. The bill does include a new Consumer Financial Protection Agency, which the Republicans (i.e. the banking industry) adamantly oppose, but it does not call for the break-up of large banking institutions.

Lifestyles of the Formerly Employed

The WSJ has an interesting article today about unemployed Americans who have blown through severance and savings in order to maintain their lifestyles who are finally waking up to a new downsized reality. The article is merely anecdotal, with no statistics, but it offers a harsh look at how the length and depth of this recession is truly worse than others we have faced in the past couple of decades. It seems that the recent spate of quick and light recessions has lulled many Americans into an overoptimistic sense of their future prospects. Even when these avid consumers lose their jobs, they continue to spend as if they had jobs, refusing to face the realities of much worse job prospects at lower levels of compensation.

The WSJ introduces us to Paul Joegriner, who was laid off in March 2008 from his CEO position at a small bank that paid $200,000 a year. Mr. Joegriner is not unemployable, in fact he has turned down several job offers in hopes of finding one that matches his former rate of pay. In the meantime, the family has blown through most of its $100,000 in savings and has only recently begun to cut back on fancy vacations, expensive Porterhouse steak dinners, and other amenities. One would think that a 44-year old who used to make $200,000 a year would have more than a year and a half's worth of savings, but the family is upside down on the mortgage on its primary residence, as well as two investment properties that produce no cash flow. So it seems as if poor investment decisions are also an issue. Furthermore, he recently turned down an out-of-state job offer because it didn't include severance pay. "I just couldn't take the risk," says Mr. Joegriner, of uprooting his family just to get laid off again. Although somehow, taking the risk of continuing to be unemployed in this economy is somehow a better idea. To summarize: no revenues, plus excessive spending, plus poor investment decisions, plus lousy risk management skills, equals the kind of guy you'd want to hire to run a bank, right?

For those interested in more stories of BMW-driving, $150 haircut-wearing, $200-a-month flower-budgeting, $36-a-bottle case of wine-purchasing types who are unemployed and have blown through their severance, just click on the link above. The article has many examples of folks who earned far less than $200,000 a year, who are just waking up to the reality that they can no longer live beyond their means. No more cash-out refis, because there's no equity in the house. No more zero percent credit card transfer offers in the mail, because banks aren't passing along their gift from the Fed. Investment portfolios are still battered, even with the recent rally. Fortunately, the government is offering some relief by extending unemployment insurance benefits up to 20 weeks. This should help soften the blow for the 1.3 million or so whose benefits are set to run out by the end of the year. Unfortunately, $150 haircuts are no longer an option.

Treasury Nixes Sale of Fannie Tax Credits to Goldman

Apparently, there is only so much humiliation the Treasury can take from the profiteers of Goldman Sachs. While the Treasury's investment in Fannie continues to bleed cash out of its eyeballs, Goldman Sachs has money coming out of its ears. The folks at Goldman have daily meetings trying to figure out what on earth they are going to do with all the money they keep making, and then during those meetings, they just keep coming up with more ideas on how to make more money! Like buying tax credits from Fannie. After all, there is no way in hell Fannie is ever going to make another penny and everyone hates to waste a good tax credit. Really this is all in the interest of tax efficiency.

Not so fast, says the Treasury. According to a letter Treasury sent Fannie, selling the $2.6 billion in tax credits would cost taxpayers more than the company would gain from the sale. So the Treasury has nixed the sale. Fannie claims to be reviewing the decisions, whatever that means. When the Treasury owns you, I'm not sure how much of a say you get in these matters. Poor Goldman is stuck writing a big check to the government. Although, I'm sure their tax guys already have a few more tricks up their sleeves.

Fannie and AIG: The Dogs of the TARP

All of those optimists who think the US government is going to make a killing on its TARP investment have yet to take a look at Fannie's latest earnings report, released yesterday after the close. The good news is that Fannie actually reported a narrower loss than in last year's third quarter. The bad news is that the loss was still $18.87 billion. Really, how excited can an investor get over the phrase "losses narrowed to a mere $19 billion?" The loss was primarily due to a $22 billion increase in credit-loss provisions and foreclosed-property costs due to spiking delinquency rates. The mortgage giant put in its quarterly request for more money from the government, this time a puny $15 billion.

So really, why should anyone care about Fannie anymore? It's barely a public company since the government seized the mortgage giant and put it into conservatorship last September. Fannie Mae is the mortgage market. In fact, Fannie, Freddie and FHA loans account for approximately 95% of mortgage issuance this year. Earnings reports from Fannie and Freddie aren't merely company earnings for investors in those firms, but they are important barometers of the economy. Spiking delinquencies and foreclosures for Fannie's properties paint a rather bleak picture of the state of the housing market, one that counteracts all the bullish carping of those who believe that a few months of slightly higher medians for housing prices means it's back to the boom years of 2005. The government is keeping the housing market alive. And it's costing us a pretty penny.

In other Fannie news, the WSJ reports that Fannie has introduced the "Deed for Lease" program, a new program that allows delinquent borrowers to transfer their property to Fannie Mae in exchange for a lease. Borrowers-turned-tenants will pay market rents, which in many cases are much lower than their mortgages and might be offered extensions when their lease expires. The hope is that allowing delinquent borrowers to stay in their homes will keep another wave of foreclosures from hitting the market and depressing prices further, causing yet more homeowners to go upside down on their mortgages thus continuing the endless downward spiral in housing prices. The program is only offered to those who are seriously delinquent, which seems to create an enormous incentive for those who are upside-down but current on their mortgages to stop paying so they too can remain in their house for much lower monthly payments. Furthermore, it doesn't really solve the problem of the massive losses that Fannie needs to take when owners who paid too much for their homes hand the properties over to Fannie. It just delays the loss recognition for a few years (depending on how Fannie chooses to account for it, and everyone knows Fannie is famous for its scrupulous accounting.) Unless, of course, housing prices miraculously rebound and Fannie can just sell its mounting inventory for a huge profit in a few years. Yeah, right. Other than those minor pesky issues, I think it's a great idea.

Finally, we get to AIG. The formerly highly regarded insurance conglomerate that everybody loves to hate on. AIG posted a highly anticipated profit of a whopping $455 million. Of course, compared to the year-earlier loss of $24.47 billion, these results were spectacular. New CEO Robert Benmosche did not miss the opportunity to pat himself on the back, remarking that AIG's results "reflect continued stabilization in performance and market trends." Yeah, AIG will be out of the $120 billion hole in no time. Mr. Benmosche's strategy is to become more patient in selling off all of those valuable businesses AIG owns. You know, like the airline leasing business, AIG's "crown jewel," which is looking for a new buyer along with just about every other airline leasing operation in existence that is currently up for sale. That crown jewel that just had to borrow money from AIG (i.e. the government) because it couldn't refinance its debt. On the horizon is another $5 billion charge the company plans to take as it closes an SPV connected to its foreign life-insurance business to pay off $25 billion of its New York Fed credit line. Then there's the investment company Primus Financial Holdings that AIG sold last quarter for $2.15 billion, its biggest sale globally so far. The company will book a $1.4 billion fourth-quarter loss on that sale. Seems like the CDS book wasn't the only thing on AIG's books being mismarked.

Unemployment Hits 10.2%

Nonfarm payrolls fell by 190,000 last month, with the largest job losses in construction, manufacturing and retail. Since the beginning of the recession in December 2007, the number of unemployed has increased by 8.2 million. The unemployment rate hit 10.2%, the highest rate in 26 years. The employment picture continues to be very weak and threatens the nascent recovery. Raging bulls claim that employment is always a lagging indicator, which is definitely true. But there is a big difference between recovering from a 6% unemployment rate and a 10% unemployment rate. Zero interest rates don't seem to be doing the trick.

Productivity, Jobs and the Fed

• Jobless claims declined by 20,000 to 512,000 for the week ended Oct 31, the lowest level since Jan 3. Continuing claims fell by 68,000 to 5,749,000. Some improvement in the employment picture, but still pretty high numbers overall. Tomorrow's employment report should be more enlightening.
• Productivity rose at a 9.5% annual rate last quarter. Naturally, companies are more efficient as they are shedding employees left and right and those left behind are forced to pick up the slack. The hope is that companies will eventually return to hiring once they've squeezed the lifeblood out of their remaining employees.
• Yesterday's decision from the Fed wasn't terribly surprising. The central bank left rates unchanged and promised The Street not to raise them for an "extended period of time" unless they sense inflationary pressures brewing. Although many (World Bank, IMF Nouriel Roubini, just to name a few) are worried about brewing bubbles popping up in asset classes around the world, the Fed has made it clear that it doesn't care about such silly things. After all, the Fed didn't care about the mother of all credit bubbles that inflated between 2005-2007, so why should it start caring now? We have all the rescue vehicles we need in place. We'll just bail everybody out again when we have to, right?
• When I said that the Fed promised The Street it wouldn't raise rates for an extended period of time, I was being very specific. It is a promise to the Street, because Wall Street is benefitting the most from the zero interest rate, quantitative easing, free money bonanza. That is why we keep seeing articles with headlines such as "Goldman Benefits From Trading Bonanza" in the FT today, as well as "Big Bonuses Are Back For Many on Street" from the WSJ.

Wells Fargo Attempts Loan Mods With Option ARMs

I will give Wells Fargo bonus points for trying to make the best out of a rather dicey loan portfolio. Known as a conservative lender through most of the insane lending of the housing boom, Wells Fargo inherited a the toxic portfolio of option ARMs when it chose to purchase Wachovia in a fire sale last year. The bank is being proactive by introducing loan mods to deal with the pesky problem underlying most option ARMs: borrowers used them to purchase homes they couldn't actually afford and once the minimum payment resets higher, the borrowers will default. Wells Fargo is attempting to solve the problem by converting option ARMs into interest only loans that will defer balances for as long as six to 10 years. The bank is essentially extending the minimum payment period on the option ARM because it knows that the borrower would otherwise default if the payment were allowed to adjust to the fully amortizing amount. Also known as "kicking the can down the road" this strategy clings to the hope that either housing prices will stage a miraculous recovery in the next few years, or that the borrower's financial situation will improve dramatically so that he can meet higher mortgage payments in the future. In reality it is just delaying the inevitable and allowing Wells to take smaller writedowns in the present against the souring portfolio. Wells Fargo claims that it is keeping borrowers in their homes, which, I suppose is slightly better than having to deal with yet another foreclosure. However, the fundamental problem of borrowers being upside down on their mortgages and having a rather large financial incentive to walk away remains.

RBS and Lloyds Receive Yet More UK Government Funding

It's hard enough keeping track of the latest nuances of the US banks' various government bailouts, paybacks, comp battles etc. Who has time to keep an eye on the UK? But today's headlines from across the pond are fairly ominous and worth mentioning. RBS and Lloyds will receive a total of $51 billion in a second bailout from UK taxpayers. RBS is set to receive 25.5 billion pounds bringing the government's ownership stake up to 84% from 70%. Lloyds is opting to do most of its new capital raising from money managers, accepting roughly a quarter of the 21 billion from the government, allowing the mortgage lender to avoid near-nationalization. However, both banks have agreed not to pay cash bonuses to any employees earning more than 39,000 pounds this year. That is quite a concession. In fact, the scrooges at the UK Treasury make the US Pay Czar look like the tooth fairy. Mark my words, nobody from AIG is going be lured away by 39,000 pounds in cash and the balance of comp in RBS or Lloyds stock.

In any event, bailouts of this size from two of the UK's largest banks foreshadow worse to come for some of our problem banks. They're in the same business, just in different countries. RBS has essentially been nationalized, and Lloyd's is struggling to avoid the same ultimate fate. Think of RBS as the Citibank of the UK and Lloyds as the Bank of America. Both Bank of America and Lloyds/HBOS pursued disastrous value destroying mergers when it appeared that the worst would be over. Right before things got much worse. I am absolutely shocked that financial stocks in the US are taking this news in stride today. But it's not the first time that the recent bullishness of this market has surprised me.

Goldman Shopping For Fannie Tax Credits

Ever the savvy financial engineer, Goldman Sachs is seeking to purchase unused tax credits from Fannie Mae. It's a simple idea really. Fannie, the former mortgage giant now 80% owned and controlled by the US government, has punted close to $38 billion in the first half of the year. Meanwhile, the folks at Goldman are swimming in dough thanks to ridiculous amounts of easy money tossed their way courtesy of the Fed, FDIC and the Treasury. Goldman is merely being tax efficient and trying to cut its bill a bit with some fancy accounting footwork. Besides, there's no way Fannie is ever crawling out of the hole and has no use for the mounting tax credits sitting on its books.

The only small problem with the plan is that it doesn't look or sound quite right to all of those angry plebians carrying pitchforks that are out for Goldman's hide. Why should Goldman be allowed to skip out on paying its tax bill after it's already received so much help from Uncle Sam? So the government is scrutinizing the deal and trying to determine whether it is worth the political furor that is sure to follow if it swaps some of the tax credits with Goldman for cold hard cash to help boost Fannie's bottom line. I personally don't care one way or the other. What difference does it make if Goldman gives money directly to the IRS or to Fannie? It all winds up in the same bucket. If Treasury is smart, it will just price the tax credits so that there is no financial benefit to doing the deal and Goldman will just pay its taxes directly. Problem solved. Given what an incredibly poor job Treasury has done so far negotiating its deals with Wall Street Banks (i.e. handing out 100 cents on the dollar to terminate the AIG swaps and doling out TARP funds without any restrictions, just to name two) it's hard to imagine it will negotiate a savvy deal this time around. After all, if there were no financial benefit, Goldman wouldn't be itching to do a deal. My advice to Goldman? Just pay your damn taxes and try to stay out of the papers.