Fannie and Freddie Bring Credit Crisis to Defcon One

14/7/2008 analysis

We are at a critical point in the economic history of the United States. I know of no other way to put it. The events of last week were of a character that we've never seen before. On Friday mortgage lender IndyMac Bancorp became the second largest federally insured financial company to fail after it got hit by a bank run. The Federal Deposit Insurance Corporation took it over.

That news may be a big story, but is totally overshadowed right now by the teetering collapse of Fannie Mae and Freddie Mac. Both are in danger of going under and the Bush administration, Federal Reserve, and Treasury Department are now meeting on a daily basis to figure out what to do.

On Sunday the Federal Reserve and Treasury Department announced that they were going to allow the Federal Reserve Bank of New York to lend to Freddie and Fannie at 2.25% - the discount rate that Wall Street Commercial banks receive. They also said they are going to seek authority from Congress to expand their current $2.25 billion line of credit to each company.

According to Reuters, "Sunday's announcements are likely to raise anew criticism that the government should have moved sooner to rein in the two companies, especially since investors widely assumed they would be bailed out if they got into trouble."
"The government denied it, but what was seen by investors as an implicit guarantee of support allowed Fannie and Freddie to borrow at rates only slightly higher than the Treasury -- and lower than what their banking competitors had to pay."
"This really blows away the notion of an implicit guarantee," independent banking consultant Bert Ely said of the Treasury's plan to ask Congress to allow it to make equity investments in Fannie Mae and Freddie Mac. "It suggests a greater concern about how these companies are doing. It says the problems are deeper. It gets to the solvency of the companies, not just the liquidity."

There is no news that would be worse than the collapse of these two institutions and such an event if it happens will have ramifications for the economy and stock market for years to come. Fannie and Freddie buy mortgages and then package them into bonds, which they guarantee. They then sell the bonds to investors, including mutual funds, hedge funds, pensions, annuities - just about any institutional investor you can think of. Odds are that if you own a mutual fund or annuity that you indirectly own a security backed by one of these two institutions. The two of them combined own half of America's twelve trillion in outstanding mortgages and their failure would be the implosion of the entire financial system.

People have worried about problems in these two institutions for years. Five years ago Armando Falcon, the head of the government agency that overseas Freddie and and Fannie wrote a report that said that the two companies would experience a "financial calamity" if real estate prices were to fall at all due to excess leverage and poor accounting standards. His report took two years of research and was controversial at the time. The day it came out housing stocks had a temporary drop on huge volume. In response to the report the Bush administration fired Falcon. Don't think for a second though that the Bush administration is somehow solely responsible for this mess. There is plenty of blame to go around and one would have to start at the Senate and several powerful Senators on the Banking Committee that are literally owned by the banks. "Angelo's Angel" being one of the worst. If these politicians had done their job the country wouldn't be in the fix it is in now.

Others have warned about what a collapse of Freddie and Fannie would mean. Warren Buffett has made statements in the past that he feared the failure of Fannie and Freddie could set off a "derivatives time bomb" that would implode the whole financial system. By insuring over half of the mortgages in the country they are two big to fail. This is serious situation folks. We've never seen anything like it before.

Earlier last week former St. Louis Federal Reserve President William Poole said the companies are basically "insolvent" and may need a government bailout. The falling housing prices and foreclosures have caused Fannie alone to lose $6.85 billion in the past year, which in turn is eating away at its balance sheet. Both Fannie and Freddie closed on Friday at a combined market cap of $15 billion and thanks to massive leverage own over $5 trillion dollars worth of mortgages. In comparison the largest US commercial banks such as Bank of America and JP Morgan have market caps of around 10% of their total assets. Congress encouraged Fannie and Freddie to over leverage themselves - and so has the Federal Reserve in the past 10 months - to try to cushion the collapsing real estate market. Of the $5 trillion that sits on Fannie and Freddie balance sheets only $1.6 trillion is listed on its balance sheet. The rest of it is listed "off" the balance sheet in much the same way that Bear Stearns listed its "Level 3" assets on its balance sheet. The two companies must constantly borrow money just to operate. If borrowing costs rise or they have to make good on the securities they insure than they can fail. Of course this is exactly what has been happening.

According to Bloomberg, "Freddie Mac owed $5.2 billion more than its assets were worth in the first quarter, making it insolvent under fair value accounting rules... The fair value of Fannie Mae's assets fell 66 percent to $12.2 billion, data provided by the Washington-based company show, and may be negative next quarter."
Both companies need to raise billions of dollars to stay afloat and that is where their problem lays. Because both shares are in collapse it is impossible for them to raise the money they need by issuing stock or by issuing bonds.

On Thursday the New York Times reported that the Bush administration is meeting around the clock to come up with plans to deal with this crisis. They have a plan outlined for the government to directly bail out the two companies by taking them over if necessary. The government would then insure their bonds and securities with taxpayer money or by raising money through the issuance of Treasury bills. A report by Standards and Poors projects that such a scenario would cost the government $1 trillion dollars and would force the agency to lower the creditworthiness rating for the Federal Government, because it would mean a huge increase to the national debt.

In other words you and I through higher taxes and higher inflation thanks to the money printing that will be necessary to bail out these two companies would be forced to suffer the consequences to pay for the mistakes of the bankers. To get a size for what $1 trillion means it amounts to about $30,000 for every man, woman, and child in the United States.

The ramifications of such a scenario would be dire. We've seen inflation explode thanks to the Fed lowering interest rates at the fastest rate ever to try to stem the credit crisis it helped create by keeping rates too low for too long, which created the real estate bubble and whole mess we are in right now. Now imagine the rate of inflation accelerating even more as up to a $1 trillion dollars gets printed in a Fannie and Freddie bailout.

Foreigners would lose confidence in the bond market and gold prices would skyrocket. The stock market would continue to drop as a side effect. On Friday, as talk of such a bailout floated all over Wall Street and the media, bonds did indeed sell off. There is no news or event that could be worse than a government bailout. It would send a message to the entire world that the Federal Reserve and the US government will print any amount of money or do anything to protect the interest of bankers the dollar be damned. Such a bailout would put the government directly in the mortgage business. It's a kin to communism. Or communism for the rich and well connected.

Of course neither the Bush administration or anyone else wants things to get that point. No one wants the government to take over the two companies and become responsible for their liabilities, but preparations are being made by those in charge to do this if things get to that point. My take is that this crisis is going to continue for the next several weeks and we are going to see repeated assurances by officials that everything is fine.

They are trapped in a confidence game where all they can do is make statements to make everyone think that everything is ok while they work behind the scenes to try to raise enough money for the two companies to keep them in business in the form of special loans or a preferred stock deal with the government or a foreign government or sovereign fund like Citigroup did with Abu Dhabi.

The problem is will it work? Fannie Mae and Freddie are suffering from the nationwide decline in real estate prices, which shows no sign of coming to an end over the next year. Can they survive another year of losses? If the market thinks not then the market is likely to punish them right now. Attempts to keep them glued together over the next few weeks will then fail. I pray it doesn't come to that.

The gyrations in these two stocks and repeated statements that all is fine will dominate the markets and news for the weeks to come. The credit crisis has moved to Defcon one and there is simply no way out now
Mike Swanson

Who is Rupert Murdoch

In recent years, Australian-born billionaire Rupert Murdoch has used the U.S. government's increasingly lax media regulations to consolidate his hold over the media and wider political debate in America. Consider Murdoch's empire: According to Businessweek, "his satellites deliver TV programs in five continents, all but dominating Britain, Italy, and wide swaths of Asia and the Middle East. He publishes 175 newspapers, including the New York Post and The Times of London. In the U.S., he owns the Twentieth Century Fox Studio, Fox Network, and 35 TV stations that reach more than 40% of the country...His cable channels include fast-growing Fox News, and 19 regional sports channels. In all, as many as one in five American homes at any given time will be tuned into a show News Corp. either produced or delivered." But who is the real Rupert Murdoch? As this report shows, he is a far-right partisan who has used his empire explicitly to pull American political debate to the right. He is also an enabler of the oppressive tactics employed by dictatorial regimes, and a man who admits to having hidden money in tax havens. In short, there more to Rupert Murdoch than meets the eye.

In 2003, Rupert Murdoch told a congressional panel that his use of "political influence in our newspapers or television" is "nonsense." But a close look at the record shows Murdoch has imparted his far-right agenda throughout his media empire.

MURDOCH THE WAR MONGER: Just after the Iraq invasion, the New York Times reported, "The war has illuminated anew the exceptional power in the hands of Murdoch, 72, the chairman of News Corp… In the last several months, the editorial policies of almost all his English-language news organizations have hewn very closely to Murdoch's own stridently hawkish political views, making his voice among the loudest in the Anglophone world in the international debate over the American-led war with Iraq." The Guardian reported before the war Murdoch gave "his full backing to war, praising George Bush as acting 'morally' and 'correctly' and describing Tony Blair as 'full of guts'" for his support of the war. Murdoch said just before the war, "We can't back down now – I think Bush is acting very morally, very correctly."

MURDOCH THE NEOCONSERVATIVE: Murdoch owns the Weekly Standard, the neoconservative journal that employed key figures who pushed for war in Iraq. As the American Journalism Review noted, the circulation of Murdoch's Weekly Standard "hovers at only around 65,000. But its voice is much louder than those numbers suggest." Editor Bill Kristol "is particularly adept at steering Washington policy debates by inserting himself and his views into the discussion." In the early weeks of the War on Terror, Kristol "shepherded a letter to President Bush, signed by 40 D.c= opinion-makers, urging a wider military engagement." [Source: AJR, 12/01]

MURDOCH THE OIL IMPERIALIST: Murdoch has acknowledged his major rationale for supporting the Iraq invasion: oil. While both American and British politicians strenuously deny the significance of oil in the war, the Guardian of London notes, "Murdoch wasn't so reticent. He believes that deposing the Iraqi leader would lead to cheaper oil." Murdoch said before the war, "The greatest thing to come out of this for the world economy...would be $20 a barrel for oil. That's bigger than any tax cut in any country." He buttressed this statement when he later said, "Once [Iraq] is behind us, the whole world will benefit from cheaper oil which will be a bigger stimulus than anything else."

MURDOCH THE INTIMIDATOR: According to Agence France-Press, "Rupert Murdoch's Fox News Channel threatened to sue the makers of 'The Simpsons' over a parody of the channel's right-wing political stance…In an interview this week with National Public Radio, Matt Groening recalled how the news channel had considered legal action, despite the fact that 'The Simpsons' is broadcast on sister network, Fox Entertainment. According to Groening, Fox took exception took a Simpsons' version of the Fox News rolling news ticker which parodied the channel's anti-Democrat stance with headlines like 'Do Democrats Cause Cancer?'" [Source: Agence France-Press, 10/29/03]

MURDOCH THE NEWS EDITOR: "When The New York Post tore up its front page on Monday night to trumpet an apparent exclusive that Representative Richard A. Gephardt would be Senator John Kerry's running mate, the newspaper based its decision on a very high-ranking source: Rupert Murdoch, the man who controls the company that owns The Post, an employee said yesterday. The Post employee demanded anonymity, saying senior editors had warned that those who discussed the Gephardt gaffe with other news organizations would lose their jobs."

Just as Fox claims to be "fair and balanced," Rupert Murdoch claims to stay out of partisan politics. But he has made his views quite clear – and used his media empire to implement his wishes. As a former News Corp. executive told Fortune Magazine, Murdoch "hungered for the kind of influence in the United States that he had in England and Australia" and that meant "part of our political strategy [in the U.S.] was the New York Post and the creation of Fox News and the Weekly Standard."

MURDOCH THE BUSH SUPPORTER: Murdoch told Newsweek before the war, Bush "will either go down in history as a very great president or he'll crash and burn. I'm optimistic it will be the former by a ratio of 2 to 1…One senses he is a man of great character and deep humility."

MURDOCH THE BUSH FAMILY EMPLOYER: As Slate reports, Murdoch "put George W. Bush cousin John Ellis in charge of [Fox's] Election Night vote-counting operation: Ellis made Fox the first network to declare Bush the victor" even as the New Yorker reported that Ellis spent the evening discussing the election with George W. and Jeb Bush. After the election, Fox bragged that it attracted 6.8 million viewers on Election Night, meaning Ellis was in a key position to tilt the election for President Bush.

MURDOCH THE MIXER OF BUSINESS AND POLITICS: James Fallows of the Atlantic Monthly points out that most of Murdoch's actions "are consistent with the use of political influence for corporate advantage." In other words, he uses his publications to advance a political agenda that will make him money. The New York Times reports that in 2001, for example, The Sun, Britain's most widely read newspaper, followed Murdoch's lead in dropping its traditional conservative affiliation to endorse Tony Blair, the New Labor candidate. News Corp.'s other British papers, The Times of London, The Sunday Times and the tabloid News of the World, all concurred. The papers account for about 35% of the newspaper market in Britain. Blair backed "a communications bill in the British Parliament that would loosen restrictions on foreign media ownership and allow a major newspaper publisher to own a broadcast television station as well a provision its critics call the 'Murdoch clause' because it seems to apply mainly to News Corp."

MURDOCH THE NEW YORK CITY POLITICAL BOSS: The Columbia Journalism Review reported that during New York Mayor Rudolph Giuliani's first term "News Corp. received a $20.7 million tax break for the mid-Manhattan office building that houses the Post, Fox News Channel, TV Guide and other operations. During Giuliani's 1997 reelection campaign, News Corp. was also angling for hefty city tax breaks and other incentives to set up a new printing plant in New York City. Most dramatically, Giuliani jumped in to aggressively champion News Corp. when it battled Time Warner over a slot for the Fox News Channel on Time Warner's local cable system…Three years into Giuliani's first term, veteran Village Voice political reporter Wayne Barrett asked Post editorial page editor Eric Breindel if the paper had run a single editorial critical of the administration; Breindel, he says, admitted it had not. According to Barrett, the paper pulled off a perfect four-year streak" of not one critical editorial. [Columbia Journalism Review, 6/98]. Rupert Murdoch thinks of himself as a staunch anti-communist. But a look at the record shows that when his own profits are on the line, he is willing to do favors for the most repressive regimes on the planet.

MURDOCH THE DEFENDER OF REPRESSIVE REGIMES: The last governor of Hong Kong before it was handed back to China, Chris Patten, signed a contract to write his memoirs with Murdoch's publishing company, HarperCollins. But according to the Evening Standard, when "Murdoch heard that the book, East and West, would say unflattering things about the Chinese leadership, with whom he was doing satellite TV business, the contract was cancelled. It caused a furor in the press - except, of course, in the Murdoch papers, which barely mentioned the story." According to BusinessWeek, internal memos surfaced suggesting the canceling of the contract was motivated by "corporate worries about friction with China, where HarperCollins' boss, Rupert Murdoch, has many business interests." [Evening Standard, 8/13/03; BusinessWeek, 9/15/98]

MURDOCH THE APOLOGIST FOR DICTATORSHIPS: Time Magazine reported that while Murdoch is supposedly "a devout anti-Soviet and anti-communist" he "became bewitched by China in the early '90s." In an effort to persuade Chinese dictators that he would never challenge their behavior, Murdoch "threw the BBC off Star TV" (his satellite network operating in China) after BBC aired reports about Chinese human rights violations. Murdoch argued the BBC "was gratuitously attacking the regime, playing film of the massacre in Tiananmen Square over and over again." In 1998 Chinese President Jiang Zemin praised Murdoch for the "objective" way in which his papers and television covered China. [Source: Time Magazine, 10/25/99]

MURDOCH THE PROPAGANDIST FOR DICTATORS: While Murdoch justifies his global media empire as a threat to "totalitarian regimes everywhere," according to Time Magazine, Murdoch actually pays the salary of a top TV consultant working to improve the Chinese government's communist state-run television CCTV. As Time notes, "nowadays, News Corp. and CCTV International are partners of sorts," exchanging agreements to air each other's content, even though CCTV is "a key propaganda arm of the Communist Party." [Source: Time Magazine, 7/6/04]

MURDOCH THE ENABLER OF HUMAN RIGHTS VIOLATORS: According to the LA Times, Murdoch had his son James, now in charge of News Corp.'s China initiative, attack the Falun Gong, the spiritual movement banned by the Chinese government after 10,000 of its followers protested in Tiananmen Square. With Rupert in attendance, James Murdoch called the movement a "dangerous" and "apocalyptic cult" and lambasted the Western press for its negative portrayal of China's awful human rights record. Murdoch "startled even China's supporters with his zealous defense of that government's harsh crackdown on Falun Gong and criticism of Hong Kong democracy supporters." Murdoch also "said Hong Kong democracy advocates should accept the reality of life under a strong-willed 'absolutist' government." It "appeared to some to be a blatant effort to curry favor" with the China's repressive government. [LA Times, 3/23/01]

MURDOCH THE HIDER OF MONEY IN COMMUNIST CUBA: Despite a U.S. embargo of communist Cuba, the Washington Post reports, "News Corp.'s organizational chart consists of no less than 789 business units incorporated in 52 countries, including Mauritius, Fiji and even Cuba." [Washington Post,

12/7/97]. From union busting to tax evading, Rupert Murdoch has established a shady business record that raises serious questions about his corporate ethics.

MURDOCH THE UNION BUSTER: The Economist reported that in 1986 Murdoch "helped smash the British print unions by transferring the production of his newspapers to a non-union plant at Wapping in East London." The move "proved to be a turning-point in Britain's dreadful industrial relations." AP reported Murdoch specifically "slashed employment levels" at the union plant and said he would "dismiss the 6,000 striking workers" who were trying to force concessions out of the media baron. The London Evening Standard called the tactics "the biggest union-busting operation in history." [Sources: The Economist, 4/18/98; AP, 1/27/86; Evening Standard, 11/12/98]

MURDOCH THE CORPORATE TAX EVADER: The BBC reported that "Mr. Murdoch's die-hard loyalty to the tax loophole has drawn wide criticism" after a report found that in the four years prior to June 30, 1998, "Murdoch's News Corporation and its subsidiaries paid only $325 million in corporate taxes worldwide. That translates as 6% of the $5.4 billion consolidated pre-tax profits for the same period…By comparison another multi-national media empire, Disney, paid 31%. The corporate tax rates for the three main countries in which News Corp. operates - Australia, the United States and the UK - are 36%, 35% and 30% respectively. Further research reveals that Mr. Murdoch's main British holding company, News Corp. Investments, has paid no net corporation tax within these shores over the past 11 years. This is despite accumulated pre-tax profits of nearly $3 billion." [Source: BBC, 3/25/99]

MURDOCH THE LOVER OF OFFSHORE TAX HAVENS: When a congressional panel asked if he was hiding money in tax havens, including communist Cuba, Murdoch responded "we might have in the past, I'm not denying that." The Washington Post reports, "through the deft use of international accounting loopholes and offshore tax havens, Murdoch has paid corporate income taxes at one-fifth the rate of his chief U.S. rivals throughout the 1990s, according to corporate documents and company officials." Murdoch "has mastered the use of the offshore tax haven." His company "reduces its annual tax bill by channeling profits through dozens of subsidiaries in low-tax or no-tax places such as the Cayman Islands and Bermuda. The overseas profits from movies made by 20th Century Fox, for instance, flow into a News Corp.-controlled company in the Caymans, where they are not taxed." [Source: Congressional Testimony, 5/8/03; Washington Post, 12/7/97]

MURDOCH THE ABUSER OF TAX LOOPHOLES: Even though Murdoch changed his citizenship in order to comply with U.S. media ownership rules, many of his companies have remained Australian, allowing them "to utilize arcane accounting rules that have pumped up reported profits and greatly aided Murdoch's periodic acquisition sprees." IRS officials point out that "U.S.-based companies face U.S. taxes on their offshore subsidiaries in the Caymans and elsewhere if more than 50 percent of the subsidiary is controlled by American shareholders. But that doesn't apply to News Corp., an Australian company." [Source: Congressional Testimony, 5/8/03; Washington Post, 12/7/97]

China Oil Price

China’s energy markets can most accurately be described as operating under the principles of managed market-based economy. Gasoline prices have been heavily controlled and the prices for key energy resources such as coal are not exactly set by the market.. But nor is the government any longer able to completely control energy prices as it once did. Last week China’s NDRC lifted the prices of gasoline, diesel oil, aviation kerosene and electricity (Xinhua). At 18 per cent, the price rise was the largest ever one day price rise for gasoline in China, and the first price rise since November (CNBC).

So what’s behind this sudden energy price adjustment?
The two key objectives of energy price control are price stability and clearing the market (supply matching demand). But covering energy shortfalls when there is rapidly rising demand at home and abroad is inconsistent with maintaining price stability. This is fundamentally why the NDRC cannot hold prices stable permanently: and energy shortages have become a larger problem than price rises. But what explains the timing and size of the price adjustment now

To be sure, there is no simple answer.

Under a price regime like the one that controls China’s energy markets, the policy authorities have to balance several competing voices as they try to achieve two conflicting objectives in a rising market. They would be keenly aware of pressures in the global market and the global wave of protests over rising fuel costs in response. But they also have to deal with active lobbying from domestic oil refineries whose profits are squeezed when the cost of their inputs rises but the price of their product is fixed. Getting this right is a balancing act where no one is left happy. Yet the interests of the Chinese oil refineries is not so straightforward as it seems. China’s largest fuel companies not only operate the vast majority of China’s refineries, they also produce much of China’s oil and dominate the retail distribution of gasoline. And they are responsible for importing most of the oil not produced domestically.

When Sinopec (0386.HK: Quote, Profile) and PetroChina (601857.SS: Quote, Profile) lobby the NDRC to raise gasoline prices, they focus on the profits and viability of their refining arm, which PetroChina’s 2007 Annual Report described as incurring heaving losses leading to the cessation of production in certain areas. However Sinopec not only imports oil from other suppliers but also has foreign oil assets of its own. It is a significant player in the international and Chinese oil business dealing in international prices, as well as a supplier to its domestic refineries into controlled markets. From Sinopec’s 2007 Annual Report (pdf), Sinopec’s before tax profit last year was almost RMB83 billion (about AU$13-14 billion). PetroChina has a larger proportion than Sinopec of its business in oil production rather than refining. PetroChina reported in its 2007 Annual Report before tax profits of just over RMB200 billion (around AU$33-34 billion). So when oil companies complain that prices are too low, consumers in China, like consumers everywhere, point to the Chinese oil companies’ massive profits.

China’s oil prices remain much lower than international market prices. The result of this price spread is higher demand for oil in China (and higher demand for complementary goods such as cars) but less incentive for Chinese refineries to increase production. Sinopec and other large retailers such as PetroChina have been restricting petrol sales for months, sometimes restricting sales to only selling enough for 45km of driving. There’s no profit at this end of the Chinese market for Chinese oil companies. Long queues of trucks waiting for petrol have become common sights in many parts of China. Independent retailers are forced to raise their prices to remain in business, but they only sell to loyal customers for fear of being reported for price gouging (Reuters).

Last week’s price rise will have some impact on the pace of growth in demand. The large refiners will likely allow petrol to flow again, calculating that another price rise is not on the immediate horizon. It may also reduce some of the diplomatic pressure from other oil importing countries on China. And it is another sign that as China becomes more and more enmeshed in the international market, the pressure for market reform at home becomes irresistible. So China will have to deal with the larger problem with its energy markets eventually. But when and how? That is a problem left for another day, the political economy of which will be at least as complicated as that which saw the lift in Chinese gas prices last week.

The Rule 144A

Since passage of the Securities Exchange Act of 1933, firms seeking to raise external capital and avoid the registration requirements and oversight of the U. S. Securities and Exchange Commission (SEC) have done so through private placements. The Securities Act of 1933 makes a fundamental distinction between distributions of securities (primary offerings) and transactions in securities. Offerings that involve the distribution and underwriting of securities are viewed as public offerings and require registration. To qualify for an exemption from registration, issuers and purchasers of private placements must meet certain conditions.5 Under Section 4(2) and its safe harbor of SEC Regulation D, issuers can qualify for an exemption from registration if they place securities with accredited investors and a limited number of individual investors who intend to hold the securities for investment purposes.

Less recognized, however, is that the exemption granted to the issuer does not extend to the purchasers of private placements. Because the SEC recognized that financial intermediaries could effectively distribute securities through resales of private placements, prior to Rule 144A purchasers of private placements were restricted in their ability to resell them. An institution purchasing private placements could resell them if they subsequently registered the securities or if they could establish that the purchase was motivated for investment purposes. One guide that the SEC has traditionally relied upon to establish “investment intent” is the length of time a purchaser holds a security. Typically, resales of private placements could be sold without registration, if the purchaser held the securities for at least two years.6 The net effect of these rules was to significantly inhibit resale opportunities and liquidity for purchasers of private placements.

Rule 144A lifts registration requirements for resales of private placements as long as the security is sold to qualified institutional buyers (QIB). Under the initiative, the SEC recognized that certain buyers were able to “fend for themselves” in obtaining and processing information about an issuer. As a consequence, the QIB market is limited to large financial institutions and other accredited investors. The requirements to qualify as a QIB are as follows:

1. An institution (e.g., an insurance or investment company, or pension plan) that owns or invests at least $100 million in securities of non-affiliates,

2. A bank or savings and loan (S&L) association that meets condition 1a. and also has an audited net worth of at least $25 million,

3. A broker or dealer registered under the Exchange Act, acting for its own account or for that of QIBs that own and invest at least $10 million in securities of non-affiliates, or

4. An entity whose equity holders are all QIBs.

Post enactment of Rule 144A, registration applied only to “public offers,” which were defined to concern individual investors rather than QIBs. Under this interpretation, resale’s of private placements under Rule 144A no longer involve a public offering, and thus do not require registration. Instead Rule 144A resales to QIBs now constitute transactions which fall outside of the reach of the 1933 Act. The easing of resale restrictions was motivated by a belief that institutional investors were able to independently obtain and process information about 144A securities.

However, while Rule 144A eliminates certain disclosure requirements, it would be incorrect to say that it requires no disclosure. Generally speaking, Rule 144A requires issuers to provide a brief statement of the issuer’s business, its products and services, and financial statements (balance sheet, profit and loss, and retained earnings statements) for the preceding two years.

The financial statements must be audited to the extent possible, although formal reconciliation to Generally Accepted Accounting Principles (GAAP) is not required. This information requirement does not apply to companies reporting under the Exchange Act of 1934 (as these firms are already subject to SEC disclosure), foreign government issuers, and foreign private issuers that have applied for a home country exemption (Rule 12g3-2(b)) on a voluntary basis.

A home country exemption allows an international firm to fulfill the Rule 144A information requirement by providing an English translation of the financial statements used in its own country. Companies with home market exemptions often are subject to on-going disclosure in their home markets but the level of disclosure is not typically as strict as that required by the U.S. The remainder of firms, not subject to on-going disclosure in their home market or the U.S., must meet the general Rule 144A information requirements outlined above. This latter group is likely to have the least available information and present the greatest challenge to QIBs in judging their quality. International 144A issues differ in another important respect from domestic 144A issues. Fenn (2000) and Livingston and Zhou (2002) find that over 97 percent of domestic 144A issues are accompanied by simultaneous application for registration rights.

This procedure allows debt to be placed immediately in the 144A market and within 60 days the issuer must exchange the Rule 144A security with a registered security. Registration of the security permits debt to be subsequently resold to individual investors in addition to QIBs. Registration rights also subject the issuer to on-going SEC disclosure. As a result, Livingston and Zhou (2002) suggest registration rights significantly improve the liquidity of Rule 144A issues by expanding the pool of buyers.11 For international issuers, registration rights involve increased disclosure and the costs of preparing U.S. GAAP financial statements. These costs are likely to be substantially higher for international issuers than for domestic issuers whose financial statements must already comply with U.S. GAAP. Consequently, few international issuers apply for registration rights.

The foregoing discussion leads to several hypotheses about the potential differences in offering yields between 144A and public debt issues. The SEC has argued that full disclosure is in the public’s interest and, consistent with this, studies have shown that investors pay higher prices for securities that provide greater information and transparency (e.g., Amihud and Mendelson 1986). Since more 144A debt is exempt from public disclosure, the offering yield could be higher due to a lack of transparency relative to public debt issues. Alternatively, market participants in the 144A market could be able to achieve a satisfactory level of disclosure irrespective of government regulations.

The 144A market involves institutional investors, and if QIBs are able to extract equivalent information or possess the capability to adequately judge credit quality on the available information, ceteris paribus, there should be no difference in the costs of borrowing between the markets. Finally, the debt contracting literature suggests that private lenders can possess an informational advantage over participants in the public debt market. The information advantage a lender enjoys typically stems from its ability to observe inside information about the borrower, (e.g., see Carey et al. 1993; and James 1987). This advantage is less likely to occur in the 144A market due to the overlap of buyers for 144A and public debt. Anecdotal evidence suggests that investment banks market both types of debt to a similar list of institutional clients. Thus the purchasing institutions appear to have similar capacities to evaluate 144A and public debt.

Even without an information advantage, some elements of the debt contracting literature could hold in the 144A market. Information intensive claims that typify the private placement market can impose high monitoring costs on a lender, and for such claims private debt can be less costly than public debt. To the extent 144A debt reflects more uncertainty, information intensity, or other elements of complexity, it can be more cost effective to market these issues to a smaller group of buyers and, hence, lower yields could be associated with Rule 144A debt.

Sinking Fund ?

First, understand that a sinking fund provision is really just a pool of money set aside by a corporation to help repay a bond issue. Typically, bond agreements (called indentures ) require a company to make periodic interest payments to bondholders throughout the life of the bond, and then repay the principal amount of the bond at the end of the bond's lifespan.

For example, let's say Cory's Tequila Company (CTC) sells a bond issue with a $1,000 face value and a 10-year life span. The bonds would likely pay interest payments (called coupon payments) to their owners each year. In the bond issue's final year, CTC would need to pay the final round of coupon payments and also repay the entire $1,000 principal amount of each bond outstanding. This could pose a problem because while it may be very easy for CTC to afford relatively small $50 coupon payments each year, repaying the $1,000 might cause some cash flow problems, especially if CTC is in poor financial condition when the bonds come due. After all, the company may be in good shape today, but it is difficult to predict how much spare cash a company will have in 10 years' time.

To lessen its risk of being short on cash 10 years from now, the company may create a sinking fund, which is a pool of money set aside for repurchasing a portion of the existing bonds every year. By paying off a portion of its debt each year with the sinking fund, the company will face a much smaller final bill at the end of the 10-year period. As an investor, you need to understand the implications a sinking fund can have on your bond returns. Sinking fund provisions usually allow the company to repurchase its bonds periodically and at a specified sinking fund price (usually the bonds' par value) or the prevailing current market price. Because of this, companies generally spend the dollars in their sinking funds to repurchase bonds when interest rates have fallen (which means the market price of their existing bonds have risen), as they can repurchase the bonds at the specified sinking fund price, which is lower than the market price.

This may sound very similar to a callable bond, but there are a few important differences investors should be aware of. First, there is a limit to how much of the bond issue the company may repurchase at the sinking fund price (whereas call provisions generally allow the company to repurchase the entire issue at its discretion). However, sinking fund prices established in bond indentures are usually lower than call prices, so even though an investor's bond may be less likely to be repurchased via a sinking fund provision than a call provision, the holder of the bond with the sinking fund stands to lose more money should the sinking fund repurchase actually occur.

As you can see, a sinking fund provision makes a bond issue simultaneously more attractive to an investor (through the decreased risk of default at maturity) and less attractive (through the repurchase risk associated with the sinking fund price). Investors should review the details of a sinking fund provision in a bond's indenture and determine their own preferences before investing their money into any corporate bond

Money market systems

What does it mean when the Fed (and other countries) inject money into the banking system? Does this mean the government is printing money to get itself out of jam? Doesn't such an action create inflationary consequences? If so, wouldn't lowering interest rates be an at least equally effective mechanism? It seems to me that of those two mechanisms, even though both have inflation consequences, the lowering of interest rates would help the end consumer quicker.

The Federal Reserve, like all central banks, has several tools at its disposal to pump more money into the banking system (or drain it out), which helps to grease the economy and the financial markets — or slow them down.

Contrary to popular notion, printing physical reserve notes (currency) isn’t the most important mechanism. (Thanks, anyway, to those readers who kindly remind us that the Fed's secret manipulation of illegitimate, 'fiat' currency is root cause of the world's economic and financial ills.) Most of the ‘money’ that flows through the global financial markets is actually electronic data moving from one account to another.

One of the broadest tools the Fed can apply to the supply of money in the system is raising or lowering the amount of reserves that banks are required to hold in their accounts. Raising reserves means banks have to hold onto more money, which tends to tighten credit. This works fine as long as the borrowing you’re trying to manage is coming from banks. These days, much of the credit at the center of the current financial turmoil is coming not from banks but from the global money markets, where bonds are bought and sold and the market sets interest rates.

That’s where the other two main weapons in the Fed’s arsenal come in: 1. raising or lowering short-term interest rates and, 2. what are called “open market” transactions. Setting interest rates is the most visible and important tool because it essentially sets the “wholesale” cost of money. If you make money cheaper, it tends to move more quickly through the system. So if the economy is sluggish, a rate cut perks things up. If the economy is strong, raising rates is supposed to prevent the economy from picking up too much speed. Under those circumstances, too much money in the system feeds inflation..Open market transactions are more limited, but have a more immediate impact. That’s why the Fed turns to these when the financial markets get into trouble, as it did on Friday. The specific mechanics of open market moves are pretty simple.

The Fed operates a trading desk in New York through which is can buy or sell bonds. If it buys bonds, the broker-dealer that sold them gets cash in return. That cash then flows through the system. If the Fed wants to soak up money, it sells bonds from its account — taking cash from the dealer that bought them and taking it out of the system (or "draining" money.) The Fed maintains its own account, so any money being “injected” into the system is not coming directly from the tax dollars collected by the Treasury. Sometimes, the Fed will restrict these transactions to short-term “repurchase agreements” (or repos) which means the party on the other end of the trade agrees to reverse it after a few days or weeks. This means the shot in the arm is temporary — after the market settles down the money comes back out of the system to avoid pushing inflation higher. In the case of last Friday’s "injection" the Fed did something a little unusual. Ordinarily the bonds it offers to buy or sell are good old U.S. Treasuries; the Fed has lots of them lying around. But because the current breakdown in the credit markets is caused by bonds backed by subprime mortgages, those are the bonds the Fed specifically went shopping for (some $38 billion worth, to be exact).

Until the Fed stepped in, there were virtually no buyers for these things, because investors have all but given up trying to figure out what — if anything — they’re worth. Until it's clear how many more mortgage holders are going to default on their loans, it hard to know where things will shake out. But, based on recent sales, it turns out these bonds may be worth as little as a third of what they were supposed to be worth.

The Fed may have put out the fire for now. But the larger worry is that the banks, investment funds and hedge funds that are holding billions more of these bonds may now have to book those losses. And since the hedge funds holding these bonds are not regulated by the Fed, it’s anyone’s guess just who is holding them and how much damage was done by the collapse in their value.

Some holders, including Bear Stearns and the French bank Paribas, have already let Wall Street have the bad news. But there are almost certainly more shoes to drop before the current credit crunch runs its course.

What is the difference between Dow Jones, Nasdaq, and S&P 500? I know what they are but do buyers have the option to choose which stock exchange to buy or sell from? So if I have an E*TRADE account which market am buying from?

The Dow Jones Industrial average is a market scorecard with just 30 stocks maintained by Dow Jones & Co., the publishers of the Wall Street Journal, soon to be part of Rupert Murdoch’s News Corp. Dow Jones doesn’t handle stock trades, it just covers the markets and provides all kinds of market data.

The Standard and Poor’s 500 index is a market-weighted average of 500 stocks picked by the editors at Standard and Poor’s, which is a part of the publisher McGraw Hill. They also don’t handle stock trades.

The Nasdaq (originally the National Association of Stock Dealers Automated Quotations) began as a network of dealers that bought and sold stocks over the phone. Today, the Nasdaq is operated over a big computer network that is tied into brokers and individual investors who trade online. In some cases, the computer matches up the trade. In other cases, dealers who specialize in certain stocks that are listed on the Nasdaq exchange “make a market” in that stock — which means they match orders from buyers and sellers.

The other major U.S. stock trading site is the New York Stock Exchange, which has a physical trading floor with “specialists” who work at trading posts matching up buy and sell orders for specific stocks. Generally, the companies that are listed on the NYSE are larger than those listed on the Nasdaq.

Other U.S. stock exchanges include the American Stock Exchange (AMEX) and several regional exchanges. Some companies are listed on more than one exchange. When you deal with an online brokerage like E*TRADE, you can choose how you’d like to have your order routed. If you don’t, the brokerage decides for you and the trade is handled by an independent dealer.

In the case of E*TRADE, about half the “non-directed” orders for NYSE listed stocks are handled by E*TRADE’s own capital markets operation. Other dealers that clear trades for E*TRADE are Knight Capital Markets, the Chicago Stock Exchange, Citidel Derivatives and Direct Edge ECN. Many dealers pay brokerages to steer trades their way so they can get the commissions, a practice known as “payment for order flow.” Brokerages are required to disclose how orders are routed and how much they receive for steering trades.