(James Saft is a Reuters columnist. The opinions expressed are his own)

Activity in the U.S. housing market has bottomed - a huge plus for the economy - but a recovery in prices will not be sustained and the threat from real estate to bank capital remains acute.

We are over the worst, but only because of massive official support, support that will soon ebb. That could lead to a relapse, especially among more expensive houses, but nothing along the lines of what we have suffered so far.

The news has been good.

Newly built homes sold in July at the fastest pace in ten months, up 9.6 percent, in U.S. Commerce Department data on Wednesday. This echoes a fairly good showing in last week’s data on sales of existing homes which are selling at the fastest pace in almost two years.

Miraculous to say, prices now look to be rising, at least as recorded by the Case-Shiller home price index which rose 2.9 percent between the first and second quarters, the biggest jump in close to four years.

This all comes as a huge relief. You can construct an argument that we are now most of the way through the most painful adjustment in house values and sales activity since around the time great clouds of dust blanketed the mid-west in the 1930s.

There is no doubt that a pickup in activity, even from very low levels, will be helpful for the economy and will gently support the services and construction sectors as well as theconsumption of durable goods.

But the supply of housing, though it has dropped, remains high and is probably under-measured given a large “shadow” inventory of both repossessed houses and houses of frustrated sellers which will come back on to market to meet and probably exceed any pickup in demand.

In the more bombed out areas of the U.S. - think Las Vegas and Cleveland - it is easier to come to terms with the idea that prices will now rise.

Demand is coming not just from first time buyers but more importantly from cash investors looking, not to flip as prices rise, but to get a decent income stream from renting. These investors are a healthy part of the process of turning a marginal group of house-owners back into renters.

It is hard to look at the national data, especially at the higher end where inventory in many areas is measured in years of supply not months, and conclude that we will not see any more falls.

“Perhaps a respite is in order, but with the true underlying unsold inventory near 12 months’ supply, which is double what would typify a balanced housing market, it would seem like wishful thinking that we have suddenly achieved a fundamental low in real estate values,” David Rosenberg, of Gluskin, Sheff told clients.

THE GOVERNMENT GIVETH…

The recovery in housing, such as it is, has to be seen in the context of the absolutely heroic support it has received from government.

The Federal Reserve has slashed interest rates to unfathomable lows, and not content with that, also intervened directly in mortgage markets, buying something on the order of $750 billion net of mortgage securities in an attempt to drive down mortgage rates.

The Fed has a 2009 target of buying up to $1.25 trillion of agency mortgage backed securities, $300 billion of Treasuries, and $200 billion of agency debt, all of which is keeping effective borrowing rates 0.5 to 1.0 percentage points lower than they would otherwise be. That program may be extended into next year, but not in size, given a well justified fear by the Fed that such intervention invites tighter political oversight.

So, all things being equal, mortgage rates may rise relative to prevailing rates, unless of course the securitization machine rises from the dead.

An $8,000 tax fillip for first time buyers is definitely a factor behind increased turnover and improving prices, particularly at the lower end. But that program is due to expire November 30.

Like the “cash-for-clunkers” plan for cars these programs partly encourage pent up demand to get off the sidelines but also simply move some activity forward in time. Look for a bit of a slump as the effect, which is now at its height, wears off.

Late paying borrowers are proving far less likely to get back on track than they were in previous cycles, according to a recent report from ratings agency Fitch. This argues for a continuing supply of houses coming back onto the market as foreclosures, especially in light of the poor success of mortgage modification programs.

To be sure, things are better now than they have been and the very steep falls in price make housing less of a one way bet.

The real estate market is usually seasonal, with a spring spurt and a winter freeze. This year we’ve seen the return of the spurt, but the freeze to come may buckle some foundations.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. )

(James Saft is a Reuters columnist. The opinions expressed are his own)

A proposal to give banks, hedge funds and private equity firms “affordable” credit default swap-based insurance against market panics will be very effective: it will effectively encourage even more risk taking and turn the next crisis into one about government credit.

Global central bankers assembled at the Jackson Hole conference last week heard the proposal, by two Massachusetts Institute of Technology economists Ricardo Caballero and Pablo Kurlat. Their idea is that most of the damage in panics is due to a combination of investors overestimating the damage during a market seizure and policy-makers being too slow to pull the trigger on bailouts.

The solution, therefore, is to send the banks into the next panic ready armed with a Fed-backed get out of jail free card which the authorities can activate at a moment’s notice.

This is akin to looking at a bunch of toddlers riding motorcycles and deciding that what will really improve the situation is putting them all in crash helmets.

The proposal emphasizes “Knightian uncertainty,” which it says impairs markets during panics, as investors price in the worst about those risks which they cannot measure.  Remove this uncertainty, and hey Presto, you’ve cheapened the cost of the whole bubble business.

“The main antidote to fear is prime, government-backed insurance against what investors fear,” according to Caballero and Kurlat.

“The silver lining of this diagnosis is that providing such insurance is inexpensive for the government, as once the panic subsides the real losses are much smaller than those initially feared by investors.”

There are a few assumptions there, so let’s take them one by one.

First, we don’t know that markets were wrong to assume last year that bank losses would be catastrophic. Banks are performing better, but only within a context of having either an explicit or implicit government guarantee. We do not know how well their underlying assets will ultimately perform, or even if the assumptions made in the stress test will prove true. We only know that in making those assumptions and standing behind them, the government has removed risk for private investors.

Second, we do not know that the level of these losses will be affordable for governments to bear. Look at Iceland for a prime example of what can happen. The U.S. has taken on very real and very scary public liabilities in order to end the crisis. There is no guarantee that these are affordable or that U.S. creditors will keep faith.

THE FUTURE IS MORAL HAZARD

Caballero and Kurlat also say that the cause of panics is fundamentally unknowable, a surprise. While its hard to say now where the next one will come from, there are plenty of people out there who were patiently explaining where this one was going to be centered: real estate. People who ignored this advice did so for many reasons, but one thing in common many shared was that they were getting rich out of the bubble or hoped to.

This brings us to the main reason not to create these crisis swaps; they will only encourage people to take on more risk. If we effectively assume that all panics are essentially false alarms we will encourage an unwarranted confidence in risk managers and investors. Add in prospect of profits and bonuses and you have a prescription for ever expanding leverage, bubbles and crises.

The authors say that policy makers react too slowly, and compare their plan to placing defibrillators in public places to save the lives of heart attack victims. But unlike human beings, all of whom we want to save, sometimes its better if banks are allowed to die, much less hedge funds. Shareholders and bondholders, unlike life, are not sacred.

The proposal also argues that leverage in the system was not excessive, at least when compared to the last recession in 2001. But of course by 2001 the amount of leverage had already began to expand, helped along the way by deregulation. Try running the numbers compared to 1985 or 1965 and you will reach a different conclusion.

None of this is to say that financial innovation is a bad thing, or that leverage is to be altogether eliminated. But there is in markets a growing hope that we are all awakening from a bad dream. That’s a delusion.

Financial panics are not nightmares to be ignored, but like chest pains, warnings to be heeded.

“In the end, the conventional common sense response to financial crisis - better regulation, rein in leverage, increase transparency, etc., is not such a bad one,” Harvard economist Ken Rogoff wrote in response to the proposal.

I couldn’t agree more. Let’s get the kiddies off the bikes, and the sooner the better.

( At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

– James Saft is a Reuters columnist. The opinions expressed are his own –

The explosion in company pension fund shortfalls in Britain nicely illustrates issues which will dominate economics and investment in coming years: the re-pricing of risk, a disillusionment with equity markets, and the boom in savings these shortfalls will help to drive.

Under current accounting rules, the pension funds of companies in Britain’s FTSE 100 index are together 96 billion pounds ($170 billion) underfunded, more than double the deficit of a year ago and an all-time record, according to a report from pension fund consultants Lane, Clark & Peacock.

This is partly for the very positive reason that people are living longer but principally because of the dire performance of financial markets, especially equities, over the past year.

To make matters worse, the surge in corporate bond spreads, which are used to calculate the current value of pension plans’ future liabilities to retirees, has actually minimised how underfunded British pension plans look when accounting measures are applied. Minimised how underfunded they look, but not how underfunded they are.

One of the net results of all this is that companies are getting out of the pension providing business as fast as they can, pushing employees into plans where the saver takes all of the investment risk and the company is purely a contributor and a facilitator.

Individuals are less able to take the long view and hold riskier assets like equities during downturns, meaning they are more likely to hold more in cash and bonds than are company pension plans.

Individuals are also going to be increasingly aware of the shortfalls of the pensions they have coming, which will push the savings rate still higher.

A growing awareness that we are going to live a very long while will also support this. It’s nice to live to 90, but it takes savings to fund that old age, even if you plan to work until you are 70.

Put simply financial markets have been fantastically volatile during the past two years, making it difficult to figure out how much to save and even tougher to figure out how much those savings might earn over the longer term.

Amazingly, more companies in the Lane, Clark survey raised their estimates of long-term returns from equities than cut them in the past year. But even after a huge rally in recent months, five and ten year returns in many of the world’s equity markets look pretty uninspiring, especially if you apply any kind of penalty for the very extreme level of volatility.

Assumptions about equity market returns will likely fall in coming years and more pension funds and individual retirement savers will ease up on the percentage of their portfolios they allot to shares.

SAVINGS UP, CONSUMPTION DOWN

One of the key false assumptions of the pre-credit crisis age was that we lived in a newly tame economic era. This conditioned people to save less and take on more risks, as borrowers, lenders or investors. This leveraged economy grew more quickly than a more conservative one, and we rationalised away the risk by saying that better macro-economic policies meant we were in a new era where rainy days were fewer and less severe.

That obviously has been proved wrong, and the results are written in the pension plans deficits. We live in a more volatile, riskier world than we believed. As that realisation spreads, and as many retirees find they have too little in savings, behaviour will change in important ways.

A growing awareness of the fragility of growth and the volatility of markets will not just change the behaviour of investors but also others.

Banks, as we’ve already seen, are going to want more security and a better margin. That will crimp growth. Companies will be more cautious in how they borrow, invest and expand. That too will crimp growth. This is not a bad thing, but it is bad if you have a business or personal plan that is predicated on very high growth.

All investors will be less comfortable with equity risk, and as individuals will bear more of those risks alone, they will accentuate a trend away from equity investment.

But more powerfully, the fact that there is no benevolent company or government which can fund our 25 year retirements will push all of us to save more, as well as to be more cautious with how we invest the money we do save.

This will have a big dampening effect on economic growth, especially in the ageing West, and isn’t likely to be very helpful to long term equity valuations either.

Monetary and fiscal policy can work against these forces, as we’ve seen, and can ease the transition, but they can’t do it by themselves forever.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. )

(James Saft is a Reuters columnist. The opinions expressed are his own.)

Repeat after me: “I believe in a strong dollar as the primary global reserve currency, I believe in a strong dollar as the primary global reserve currency.”

Better hope it works, because the current debate over a far-in-the-future new monetary system may bring on a here-and-now dollar selloff and a whole new leg of the crisis.

Sadly, what worked when the children espoused their faith in Tinkerbell may not for a currency backed by the full faith and credit of a debtor nation which has socialised its banking system’s risk and needs to sell trillions in further debt to pay that and other bills.

Russia, India and, most significantly, China have all questioned the U.S. dollar’s central role in global trade and currency reserve management in the run-up to this week’s meeting of the Group of Eight industrialized nations in Italy. The future, it seems, is not greenback.

Russian President Dmitry Medvedev termed the system based on the dollar “flawed.” Suresh Tendulkar, a top Indian economic advisor said he was telling India to reduce the dollar’s weighting in setting the value of the rupee, comparing the situation to the classic “prisoner’s dilemma.”

It’s a good comparison, and as such makes his advice, and his choosing to make it public, puzzling. In the prisoner’s dilemma, two people are held for a crime and, being held apart, must decide whether to rat the other out. If both remain silent, they each get six months’ jail time, if one implicates the other he goes free and the other gets ten years, if both turn on one another they both get five years.

If holders of U.S. dollars can somehow maintain confidence in the currency, the value of their reserves will be protected, but the temptation to get a first mover’s advantage and get out while the getting is good may be overwhelming, though it will only work for that individual if everyone else more or less keeps faith.

Because, if they don’t the selloff could be so disorderly and damaging to the global economy that it will make concerns over the value of reserves look silly.

China, for its part, seems to be furiously paddling in both directions at the same time; saying that the dollar will retain its central status for “years to come” while also doing things like setting up a system to allow companies to settle cross border trades in yuan.

Writing in a newspaper published by the Chinese central bank, Li Ruogu, Chairman of the state-run Export-Import Bank of China said that Special Drawing Rights (SDRs), a unit of account used by the International Monetary Fund, could be molded to serve as a more representative global settlement unit, based on a basket of currencies. This echoes suggestions made by Chinese officials in March and can leave little doubt that the Chinese are preparing for a very different future.

“The financial crisis caused the global economy to suffer heavy losses and it also let us clearly see how unreasonable the current international monetary system is,” Li, a former central bank vice governor, said.

WHAT’S THE ALTERNATIVE?

He’s right, the old set up under which China kept its currency weak and U.S. borrowing rates lower than they otherwise would be made it too easy for the U.S. to load up on debt and almost surely was the fundamental underlying driver that led to the sub-prime mortgage crisis. It created conditions under which the huge risk management failure within banking was more likely. After all, when money is cheap and people are desperate for a bit extra yield, bad loans will begin to look safe.

Of course there are no credible current alternatives to the dollar at this point; not the euro, which might fracture or grow, or the yen or even the Chinese yuan.

And there is the danger: the very knowledge that the current dispensation is under review, and for extremely sound reasons, means that there is a small but dangerous chance that it unravels, that holders of dollars and buyers of U.S. debt lose faith leading to an uncontrolled fall in the dollar and in dollar-based assets.

It is all very similar to the banking crisis. A bank is only sound so long as we believe it to be, and the dollar, given the U.S’s weak fundamental position is only strong and worth holding so long as holders keep faith.

Really all we are observing is the continuation of the banking crisis on another plane. Last year the world lost faith in the U.S. banking system. The U.S., feeling it had no alternative, stepped up as effective guarantor of its banks and its financial system.

Well and good, and here’s hoping it works. It only will succeed however if faith in the U.S. and its dollar remain.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

– James Saft is a Reuters columnist. The opinions expressed are his own –

The U.S. faces a lengthening series of request from industries and interests seeking shelter under the Troubled Asset Relief Program, most of which it should dismiss out of hand.

YRC Worldwide, a large trucking company, told the Wall Street Journal it will seek $1 billion in TARP funds to help relive it of its pension obligations.

YRC said that about half of the $2 billion it will owe in pension payments over the next four years covers the costs of retirees who worked not for it but for other companies, now vanished, that are part of a multi-employer pension plan.

That’s certainly an irony but doesn’t seem to be the basis for a claim on the public purse.

YRC is not systemically important and its pension woes, presumably the result of negotiation and free agreement, must be its own responsibility.

Next up: states and municipalities.

California Treasurer Bill Lockyer has asked Tim Geithner to provide assistance under the TARP, warning of a hit to public services and infrastructure if the money is not forthcoming.

Lockyer wants the TARP to provide insurance to banks who themselves provide insurance backstopping California’s short-term borrowings. That insurance would cover the banks in the event of a default by California making the deals a surefire moneymaker for the banks.

Lockyer says that because of the credit crunch the banks are imposing too high fees for their letters of credit. That is true, but only up to a point.

The real issue is that California, because of the recession and its own decisions about taxing and spending, is not a particularly good bet.

While California is most certainly systemically important, and while keeping government spending ticking over in a recession is arguably a good thing, this plan is not the way to do it.

As proposed, it is a subsidy to California and to the banks, or in other words one subsidy too far. Like so many other of the government actions during the crisis, this short-circuits market discipline and encourages risk taking in search of private gain but with public insurance.

If the U.S. wants to bail out California, by all means do it, but take responsibility for the decision and do it directly.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. –

– James Saft is a Reuters columnist. The opinions expressed are his own –

The recession will soon be dead, laid to rest alongside the idea of the “Great Moderation”, a set of hopeful assumptions that underpins expectations about economic growth and asset valuations.

This, when investors, bankers and executives ultimately realise it will cause them to pull in their horns, take less risks and be less willing to pay high prices for assets.

Economists, observing that since the 1980s recessions have been mild and short and expansions long and robust, developed the theory that better economic management, namely cutting rates in the aftermath of bubbles, globalisation and, get this, improvements in financial markets, had led to a sort of best-of-all-possible-worlds “Great Moderation”, in which economic volatility fell and with it the risk premia required for holding financial assets.

This little theory has, needless to say, come somewhat unstuck during the current downturn which has been great but far from moderate.

This raises the uncomfortable possibility that the last 25 years of good times were just a bit of luck, or even worse, an artificially engineered consumption binge with central banks and governments playing a role similar to what Chicago tavern keepers used to do — opening up early so last night’s patrons can have a quick nip to take the edge off on the way into work.

It’s a debate which is far from academic and its outcome will influence much more than the actions of central bankers and regulators.

While financial market volatility has been a feature during the past decades, the idea, or at least the feeling, of the Great Moderation has seeped into the culture, influencing the behaviour of actors across the economy.

A corporate manager is going to be more likely to leverage up and go for the big hit if he feels as if most recessions are mild and short, in the same way that a consumer will buy a boat on credit or an investment property for the same reasons. If the weather never gets that cold why waste money on insulation?

What if these people now decide that the universe is a less friendly place and that they ought to, heaven help us all, save a considerable amount against the day?

This is really about volatility, which, because it can tend to ruin you, is expensive. Most investment or economic management strategies have at their heart attempts to limit or cushion volatility. And so, if we really can expect more volatility in the economy we can expect it to find expression in a lower ceiling for economic growth, leverage and asset prices.

IT AIN’T NECESSARILY SO
Of course, the current debacle may be just one data point rather than a trend, a view financial markets seem to have adopted. That is more or less the argument of Larry Summers and the U.S. administration, who are betting that this is the kind of thing that happens only very rarely.

This is a version of the 100-year storm argument beloved of company managers trying to explain why their results are so poor; the implication is you could not have been expected to plan for a freak storm and once it is past it is back to the good times.

This thinking lies behind the strategy of making financial conditions so easy that people are tempted to borrow and invest. It just might work, and we just might have a sharp and long recovery which generates enough revenue to pay off the public debts we are now racking up.

But two other possibilities, both speculative, spring to mind.

One is that deleveraging proves to be not just an event but a state of mind. As in Japan, people may simply decide that they’ve had enough risk, thank you very much, leading to a weak recovery, a relapse and then a quandary about how best to pay off the bills we’ve recently run up.

The other is that the current mix of policy, deep cuts in interest rates, deficit spending and quantitative easing, the effects of which are little understood, ends up breeding volatility of its own, probably in inflation.

The cost of that volatility will be an unpleasant surprise to the investors now bidding up the prices of shares and managers now preparing to invest for expansion, and one that might lead them to at last act more conservatively.

Add to arguments for a new “Great Immoderation”  that emerging markets will almost certainly be more of a driver of global economic growth under most of the reasonable scenarios in the coming decade. Emerging markets historically are more volatile and if as they grow to be a bigger piece of the pie are likely to make overall growth more volatile.

None of this takes away from the essentially good news that the recession looks to be ending soon, but higher economic volatility will hang heavy over the recovery and the cycle to come.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.–

– James Saft is a Reuters columnist. The opinions expressed are his own –

While they have avoided the opprobrium heaped on bankers during the bear market, traditional active fund managers have quietly been proving that they too are often highly paid destroyers of value.

Active managers have few bushes left to hide behind, and the release of a new report from Standard & Poor’s uproots one of the few left: that somehow they provide protection during down markets, being able to go into cash and defensive stocks.

Check out the study for the gory details but the takeaway is that across styles and markets the majority of active fund managers, often the vast majority, simply can’t manage money well enough to make up for their own costs and the costs of all of those trades.

Over the five year market cycle 2004-2008, the S&P 500 outperformed 71.9 percent of actively managed large cap funds and most active funds in each of the nine U.S. domestic equity style boxes were outperformed by indices during the disaster of 2008.

At least casinos offer free drinks and valet parking.

Beyond tighter regulation and controls on leverage, a good outcome from the current morass would be a fundamental re-think by holders of capital about what exactly it is they are paying for from investment managers. Diversification? Not really, with so many closet index funds out there.

And spare me the argument that active managers earn their keep by holding company management’s feet to the fire. With precious few exceptions, this simply is not happening and arguably is a common good which individual investors are unwilling to pay for.

Most individual investors would likely be better off paying an annual fee for an asset allocation check-up and simply putting the advice to use via ETFs or index funds.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund –

– James Saft is a Reuters columnist. The opinions expressed are his own –

Efforts to reflate the economies of the U.S. and Britain are running into one potentially major problem; the bond market.

Appetite for government debt in recent sales has been very poor, raising the cost to the two governments of borrowing and blunting their efforts to bring down market interest rates by buying back their debt.

This is a big risk for British and U.S. efforts to rescue their economies, and could be yet another self reinforcing downward force if holders of government debt get the frights.

Both countries are running hugely expansionary fiscal stimulus programs that will need to be paid for by gargantuan sales of government debt. At the same time both have such low official interest rates, 0 to 25 basis points for the U.S. and

50 basis points in Britain, that they are engaging in purchases of their own debt, or quantitative easing, in the hope that this lowers rates for consumers and businesses and encourages money to be spent or invested.

It is impossible to know exactly how effective the policy is, after all we don’t know what rates would be without it. We can though see two things clearly; there are lots of sellers when the U.S. and Britain seek to buy their own bonds, but when it comes to the far larger operation of issuing bonds to fund ongoing needs, investors are markedly less enthusiastic. The U.S. Treasury got a very poor response on Tuesday when it auctioned $6 billion of 9-year, 9-month inflation-indexed notes at a yield of 1.589 percent, better terms for investors than similar issues on the secondary market at the time. Of particular note was the fact that so-called indirect bidders, mostly foreign central banks, stepped up for just 26.1 percent of the sale, as against 47.2 percent at the last such auction in January, which was before the policy of Fed purchases of Treasuries was announced.

Mohammed El-Erian of leading bond investor PIMCO told CNBC that government bonds were “not worth owning right now” because of the “tremendous” amount of debt the U.S. will have to sell.

The Fed will buy up to $300 billion worth of longer-dated Treasuries over the coming months to help keep interest rates low throughout the economy but at the same time it is buying from a market that is well aware that the Treasury needs to sell some $2 trillion of debt this year.

Speaking in Tokyo, it was clear that Dallas Fed governor Richard Fisher is aware of foreign investor’s concerns and has been seeking to reassure:

“Demand for U.S. Treasuries … will be determined by their attractiveness relative to alternatives and they may be judged more, rather than less, attractive under most reasonable future scenarios,” he said on Wednesday.

The Fed is determined to “short-circuit” any inflationary consequence of its balance sheet growth, and is in the process of acquiring new tools to help, he said.

“We realize … we are at risk of being perceived as monetizing the fiscal largess of Congress,” Fisher said.

Exactly. And while some might argue that the higher interest rates the U.S. may be paying will inflate away unpayable debts, this is perception that if anchored among investors, can very easily take on an extremely dangerous momentum of its own.

IT’S NOT EASY BEING BRITAIN

Similarly, the Bank of England intends to buy up to 75 billion pounds of assets, mostly gilts, over three months, but similarly Britain plans to issue a record 147 billion pounds of gilts in the coming financial year. There is also the possibility of more issuance to come if an upcoming budget includes new provisions for simulative spending.

Britain was unable to sell more than 100 million pounds of 40 year gilts at the end of March, the first such failure since 1995, and had to make heavy concession at an auction earlier this week.

All in all, it’s a sort of strange mirror to the criticism that is made of temporary stimulus measures; that because taxpayers can tell they will be forced to pay in future for the goodies they are given now they may save, blunting the impact of the stimulus. In the same way, today’s bond buy backs will need to be financed via tomorrow’s taxes, bond issues or eroded via inflation, making the current path of policy a very difficult tightrope.

It may be that in a world of poor alternative investments both countries can sell their debts at reasonable prices, but along with and interacting with currency moves, it is an important vulnerability.

The bond market vigilantes, who used to enforce a rough and sometimes destructive justice, may be saddling up again.

– James Saft is a Reuters columnist. The opinions expressed are his own –

A look at credit insurance prices for U.S. banks shows that market thinks the government’s mouth is writing checks its body can’t or won’t cash.

Despite a blistering rally in bank shares and Herculean efforts by the U.S. to build confidence in its financial sector, the price of insuring some leading banks’ debt against default has increased markedly in recent weeks.

That tells us that bond investors have serious doubts about the popular perception that the United States won’t allow systemically important institutions to fail, or in saving them in some form won’t make bond holders take substantial losses.

Since the KBW index of bank shares began a 65 percent rally on March 6 the cost of insuring Citigroup for five years via a credit default swap has risen to an annual payment of 627 basis points from 470, meaning it costs 6.27 cents to insure every dollar. Wells Fargo 5-year CDS stand at 292.5 basis points, as against 240 on March 3 and 120 at the end of December, while Bank of America’s ended last week at 355, exactly where it was on March 6 but 50 above its March 3 level.

The people buying this insurance fear if a big bank fails over the coming five years, or needs further buttressing with public money, the bill will be too large for the U.S. to bear, either politically or otherwise. That implies that there could be burden sharing by creditors, either through some sort of divvying up of the remaining assets or through forced or government orchestrated conversions of debt into equity.

OPTIONS

The options for the U.S. aren’t particularly attractive. As pointed out by Tyler Cowen in the New York Times here for the U.S. to simply fess up and say it stands behind all bank debt is to take on a gargantuan liability and to effectively neuter bond holders as a force for market and company discipline.

If the U.S. were to allow someone big to go down and make bond holders suffer too, there is a legitimate fear that creditors to the banking system would stage a disorderly wildcat strike which could bring down many healthy institutions.

It is very similar to the situation last year when the U.S. took Fannie Mae and Freddie Mac into government conservatorship and did everything short of explicitly guaranteeing the two mortgage lenders’ debt. But that wasn’t enough for the markets, specifically the Chinese, who lightened up on Fannie and Freddie bonds, making mortgage rates higher than they otherwise would have been and hampering monetary policy. Ultimately the U.S. was forced to use the Federal Reserve to buy up Fannie and Freddie debt directly as a means of keeping mortgage finance flowing.

BURDEN SHARING

Remember too that these are 5-year credit default insurance contracts, so the same cast of characters might not even be in charge when the bills come due. The range of outcomes is pretty wide and so it’s no surprise people want insurance.

It is possible too that the CDS market is distorted or deluded; after all these might be the same people who are paying good money to insure against U.S. sovereign default, an event that might happen but would surely leave very few counterparties with the ability to make good claims.

To be sure, this doesn’t create funding problems for banks at this stage. They are able to sell bonds backed by the Federal Deposit Insurance Corp’s rather hopefully named Temporary Liquidity Guarantee Program. If those CDS spreads don’t come down it isn’t going away any time soon. It has already been extended into 2012 and I’d expect more in due course.

So, the U.S. is likely to continue to make soothing noises to bank creditors while saying nothing too specific or legally enforceable, all the while hoping that something, anything, turns up. That might work.

COSTS

However, the current fudge imposes its own costs. Banking is a long-term business built on trust. The very existence of concerns among creditors will breed them among clients and will tend to undercut a bank’s ability to get new business and hold on to the old. Lack of trust is a vicious cycle.

So should the U.S. force creditors to pay their share if a major bank needs rescuing? My heart says people should bear responsibility for their decisions and pay the costs. But even the most puritanical capitalist should be extremely worried about what holding this particular group of vested interests responsible for their mistakes might mean for the rest of us.

Remember too that the rather successful Swedish bank bailout made creditors whole, but hit equity holders and management. I’d settle for that.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. –

– James Saft is a Reuters columnist. The opinions expressed are his own –

U.S. bank operating earnings are going to have a hard time outrunning credit losses, making the massive rally in bank shares look ready to be marked-to-market.

A series of positive statements about profitability in the early part of the year from major U.S. banks, notably Bank of America, Citigroup and JP Morgan helped to spring a rally in the beaten down sector, as investors bet that with government assistance they could earn their way out of their troubles.

The KBW bank index has enjoyed a blistering rally, rising 51 percent from its March 8 low, though it is still down almost 40 percent from where it ended 2008.

To be comfortable with that, you have to believe two difficult things; that investors will value the earnings banks are now making as if they were sustainable and that banks won’t be swamped by credit losses and potential forced dilutions of shareholders.

“We are unconvinced that the banks have turned a corner,” FBR Capital Markets analyst Paul Miller wrote in a note to clients. “Investors who believe that the recent financial rally is here to stay expect that most banks will remain profitable.

We expect that profitability at these banks will be driven by favorable fixed-income trading revenues, as well as mortgage banking revenues.”

In some ways, balance sheets aside, it’s a pretty good time to be a bank in America. Competition has thinned out and margins should fatten commensurately.

U.S. bank profits from trading and mortgage banking are both problematic. Trading income, because it varies wildly, is hard to predict and hard to value.

If the past two years has taught us anything, it’s that paper profits can evaporate and risks can be hard to spot.

On the positive side, the fact that banks are now putting less balance sheet to work as market makers means that those banks which still operate can make considerably more on the difference between where they buy and sell securities. But given the huge uncertainty about who will be around in a year’s time, especially given the by its nature unpredictable role of government, its hard to know how much competition there will be or even how much capital banks will be forced to hold against trading activities.

LOAN COLLECTING BLUES

Mortgage banking is also going to be bigger this year. The Mortgage Bankers Association predicts refinancing will total $1.96 trillion and purchase loans increase $821 billion, which could make it the fourth-biggest year on record. This is mostly because the Fed has driven interest rates down in a bid to reflate the economy. That makes it profitable for many Americans to refinance their mortgages and is luring a much smaller number back into the house purchase market despite falling prices.

But again mortgage banking is a notoriously tough business, and though a scarcity of lending capital has driven fees up, the record of banks in the U.S. engaging in it profitably is not good.

Mortgage banking, as distinct from mortgage lending, is the business of originating loans, these days almost exclusively for Fannie Mae or Freddie Mac in exchange for a fee and the right to earn more fees by collecting payments in exchange for servicing the loan for the lender.

But the mortgage servicing right that a bank gets when it makes the loan is usually recognized as income based on the current value of the cash it is expected to generate over time.

That means that banks that originate lots of mortgages show huge gains in income during refinancing booms. It does not mean, however, that they necessary make money out of the deal. Servicing rights can go wrong in many ways.

First, people can stop paying their loans back. The servicer usually has to advance the first few payments if a borrower is late and doesn’t get the money back until the loan is resolved. It’s also a lot more expensive to service bad loans than regular payers, making the economics of the business particularly tough right now.

Banks can also lose out if loans are refinanced sooner than they expect, robbing them of the future fees they were counting on.

And what about credit losses? Unemployment, which drives losses on commercial loans, on mortgages and on consumer loans, will be going up for some considerable time.

For example, the baseline forecasts released by the Organization for Economic Cooperation and Development (OECD) this week were considerably more bearish than even the “more adverse” numbers being used to run the U.S. stress tests now being run on banks.

Blog Calculated Risk does a nice job running the numbers here, but the highlight has to be the third q here, but the highlight has to be the third quarter, where the OECD is predicting an economy shrinking by 1.9 percent, as against a rather miraculous recovery to minus 0.2 percent in the “tough” scenario used by Geithner et al. Similarly, the unemployment rates predicted by the severe stress test are lower than the OECD base case all the way out to the end of 2010.

So then, it won’t be the stress test that undoes many banks, it will be reality.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. —