This interesting anecdote via the Big Picture:

A long/short hedge fund manager of my acquaintance went to short some Morgan Stanley (MS) via a B/D that clears through Wachovia:

The Trader comes back: "Wait a second -- that's on the list -- I can't short that."

The Fund Manager says: No, I don't want to Naked Short it, we have already located a borrow -- this is a clean, legitimate short sale.

Trader: Nope, we clear through Wachovia -- and it's on the list - NO SHORTING THESE 19 PRIMARY DEALER NAMES -- PLUS FANNIE AND FREDDIE -- AT ALL.

Fund Manager: That's ridiculous -- how can you not execute a legitimate borrowed short?

Trader: Wachovia. Dems da rulez. You have to go elsewhere.

Fund Manager: Consider it done.

As we noted last week, the SEC has banned naked shorting of 19 financial stocks, including Fannie Mae and Freddie Mac - so either the fund manager misheard or Wachovia's list includes another two stocks. Any guesses which two? Wachovia was not on the SEC list, so that could be one - plus WaMu, perhaps?

But the SEC ban doesn't block normal shorting, so this is Wachovia acting on its own initiative. Interesting to know if any other banks are following the same policy.

Citigroup, as well as UBS and Merrill Lynch, is under investigation for mis-selling auction rate securities - and has now been accused of destroying evidence. (FT, via Naked Capitalism)

...Citi “repeatedly and persistently committed fraud” by misrepresenting auction rate securities as safe and cash-equivalent investments, said David Markowitz, chief of the office’s Investor Protection Bureau, in a letter sent to the bank on Friday.

After receiving a subpoena in mid-April for records under New York’s powerful Martin Act, Citi had “destroyed” recordings of related telephone conversations and failed to notify authorities – even though it learnt in mid-June that tapes had been destroyed, the letter claimed...

News comes in that the French police have put Jerome Kerviel's assistant under investigation:

He is accused of "knowingly helping Jerome Kerviel to record fictitious operations" at the bank in 2007 and early 2008. The filing gives officials times to investigate and later decide to drop charges or go trial...
Investigators have already filed preliminary charges against Kerviel for forgery, breach of trust and illegally accessing the bank's computers.
An internal investigation by SocGen released to the public in May said it found "signs of internal complicity" by Mougard.

We covered the unfolding case in detail - Reports highlight SG weaknesses
SG moves on
Police question second SG employee

As in, you shouldn't read these if you have a high one...

At Freddie Mac, Chief Discarded Warning Signs
Insiders come out of the woodwork to blame Syron - and Congress

Companies Tap Pension Plans To Fund Executive Benefits
Weakening the pension plans as they do so...

Greenspan warns of more bank bail-outs
Don't overregulate, everything's fine, Greenspan says

Just pausing to round up the last few big serious documents -

from the BIS, a credit risk transfer study (original document here)

from Sifma, a flogging for the credit rating agencies (original document here)

from Gerald Corrigan's CRMPG III, demands for better risk monitoring (original document here)

from the BBA, an announcement that Libor is super, thanks for asking! and doesn't need changing at all. (original document here) My favourite part has to be the discussion of possible underreporting of borrowing costs. Briefly, earlier this summer people started to distrust Libor - partly because there were rumours that contributing banks were underreporting their borrowing costs in order not to appear in trouble. Serious, if true.

But it can't be true, the BBA says - we know this because we asked the contributing banks and they all said they weren't doing it.

I think comment would be superfluous at this point.

Tanta at Calculated Risk points out that, while US subprime delinquencies and foreclosures peaked around the start of the year, alt-A defaults are still rising - and could hurt bank balance sheets. The line to follow is from Jim Finch:

When someone tells you the current crisis is "near the end", ask them which end.

Or possibly from Vietnam counterinsurgency legend John Vann:

On one of his trips back to the U.S. in December 1967, Vann was asked by Eugene Rostow, an advocate of more troops and senior Johnson administration official, whether the U.S. would be over the worst of the war in six months: "Oh hell no, Mr. Rostow," replied Vann, "I'm a born optimist. I think we can hold out longer than that."

The $2.85 billion Credit Suisse mismarking problem from earlier this year has brought the bank a £5.4 million fine. Meanwhile, across the road, The Other Swiss Bank is making CS look good. (So, that's: possible breaches of US securities law; an internal reshuffle; depositors pulling out of the "flagship" wealth management arm; possible US tax evasion; continuing losses; ARS...)

Felix Salmon picks up the worst mixed metaphor yet seen in the subprime crisis:

"It was a great ride for a lot of investors but eventually the music stopped and someone had to pay the piper," says Mr Kane. "What was supposed to be a liquid asset becomes a ball and chain around your neck when you owe more than the market value of the property."

You see, it's only when the chips are down and the balloon goes up that you discover who's been swimming in the nude, and who's managed to dodge the bullet. Any earlier, and you're just counting your chickens before the final whistle.

With the biggest three players - UBS, Citi and Merrill Lynch - already given in, the other banks involved in the auction-rate securities misselling business are hastening to follow; the FT reports that JP Morgan and Morgan Stanley are close to an agreement which would see them buy back around $10bn in ARS at par. Wachovia is still holding out against a repurchase deal - perhaps because its financial position is rather weaker, as MarketWatch suggests:

... "This company's mantra was grow, grow, grow," Gerard Cassidy, an analyst at RBC Capital Markets, said in an interview. "They were so focused on wanting to be in the trillion-dollar asset club for banks that they cut corners."
Until now, most analysts and investors have focused on Wachovia's $122 billion portfolio of so-called pick-a-pay mortgages, inherited from the infamous acquisition of lender Golden West at the height of the housing boom in 2006. These kinds of negative-amortization mortgages allowed borrowers to pay less than the required monthly amount, increasing the size of the loan. As house prices slump, more of these home loans are souring.
But Wachovia also has more than $200 billion in commercial loans that could trigger even more losses if the U.S. economy slides into recession, according to Cassidy.
"This is more frightening to me because it's bigger," he said...

An optimist would say "Ah, well, these banks will have learned their lesson now - next time they will be more wary of stretching the truth about the securities they sell!"

No, they won't. Once we're through this downturn, exactly the same sort of thing will happen again. The central problem is that there are endless classes of securities which appear safe and liquid during good times, but then dry up or explode when the economy slows down. And, given the incentives that banks and their employees operate under, they will sell these securities as fast as possible when times are good, and hope to be out from under by the time the downturn comes - if, indeed, they even look that far ahead. Incentives matter, and the only way to change this behaviour is to change - by regulatory force if necessary - the incentive structure of the banking industry, so that both banks' and individual employees' incomes depend on performance over the long term, not simply over a quarter.

But, you know, don't hold your breath on that one.

Risk has looked at the Northern Rock fallout a couple of times recently - in this profile of the FSA's financial stability head, David Strachan, and most recently in this report of the Treasury's response.

The report included proposals for giving authorities powers for “stabilisation”, to avoid reaching the position where a financial firm becomes insolvent and needs to be taken into public ownership. Suggested actions include forced part-private ownership, which could be facilitated through property and share transfers to a private sector purchaser or a bridge bank. In the case of using a bridge bank, it would only operate until a private sector solution could be arranged or the possibility has been thoroughly explored. A time frame of up to 12 months in which to find such a solution is suggested.

It's worth remembering, of course, that the collapse of Northern Rock came virtually out of nowhere. Before 2007, the last bank run in British history was triggered by the aftermath of the US Civil War, for heaven's sake. Have we got any reason to expect the next one to be along sooner?

As anticipated, JP Morgan and Morgan Stanley have also settled - par buybacks and a total of $60 million in fines.
Here's Andrew Cuomo's statement. And here, sent over by Restricted Stock Partners in the US (thanks for that) is a table summing up all the settlements so far.

And an interesting item from the FT - Merrill Lynch could be dodging UK tax for the next 60 years after funnelling all its CDO losses through its London office.

...and agrees to buy back auction rate securities. Merrill Lynch is now the only holdout...

The FT warns of a coming peak in maturing bank debt - the banks will have to raise hundreds of billions in replacement funding at much higher rates:

Battered US financial groups will have to refinance billions of dollars in maturing debt over the coming months, a move likely to push banks’ funding costs higher and curb their profitability, say bankers and analysts.

The banks’ need to raise capital to offset mounting credit-related losses is forcing them to pay higher interest rates to entice investors.

No wonder that "a survey of 146 banks, investors and hedge funds found that nearly 60% [actually 57% - ac] expect another major financial services firm to collapse within the next six months, and 15% think it will happen in six to 12 months..."

73% of financial players expect another major (in context, Bear Stearns-level) collapse by September 2009? Impressive...

... "What's that you're sprinkling on your carpet?"
"It's elephant powder. It's to keep away wild elephants."
"But we're in London. There aren't any wild elephants anywhere near us."
"You see? It works!"

...anyway. Back in July, the SEC announced that it had worked out why financial stocks were falling. No, it wasn't the multi-billion dollar losses and writedowns combined with a slackening economy, the liquidity crisis or the widespread revelations of incompetence and fraud. It was, the SEC said, straight-faced, because of too much naked shorting. Accordingly, it banned naked shorting in a list of 19 financial services firms - including most but not all the major US investment banks. Floyd Norris (via Felix Salmon) has had a look at whether the measure had any effect, and, in the best traditions of the New York Times, has come down firmly on both sides of the question.

Following up on a few developing stories, these are worth a look:

Expect more bad news on CDOs in the fourth quarter, the FT says

Stress over ARS buybacks - how ignorant were the brokers?

"Major US banks will fail" according to Kenneth Rogoff

Don't panic, Europeans! says this discussion paper from the Fed. You may think that your banks are taking huge losses from subprime. But, in fact, they're only taking their fair share - European banks aren't actually any more exposed to US mortgages than they are to any other asset class.
Also, the total losses in the long term for foreign investors will be only $75 billion.

Of course, by the time we get there, the banks will have reported total mark to market losses of, ahem, $475 billion. That's what you get for dealing in an opaque market...

The markets reckon there's a 75% chance he'll keep his word on the GSEs, Brad DeLong calculates. Given yesterday's Freddie Mac bond issue, priced at 113bp over Treasuries...

It is hard to see a bankruptcy of Freddie Mac costing its bondholders more than 1/5 of their capital. That means that risk-neutral investors would have to rate the odds of a Freddie Mac bankruptcy over the next five years at 1/4 or they would be willing to hold five-year Freddie Mac debt at a higher price than they are.

The Koreans reportedly fail to come through for Lehman - now what? asks Edward Harrison...

And - Time for the ECB to turn off the tap, says Wellink:

Ever since the credit crisis erupted a year ago, central banks have pumped tens of billions into the market to avoid a systemic crisis. "There has been an adequate response," Wellink said. "But there must be a limit to how long you can do this. There comes a point when the market takes over. "

How the FBI spotted the subprime crisis coming in 2004. Unfortunately, its attention was diverted by the need to concentrate on more serious problems such as illegal immigrants...

And Michael Shedlock lists the top 10 (actually 11 due to the weakening dollar) US institutions in trouble.

Well, despite what we wrote last week, Fannie Mae and Freddie Mac are up today. Even the news that JP Morgan is marking down its holdings by 50% hasn't shaken 'em; looks like the successful fundraising has improved everyone's opinions.

The Karachi stock exchange's management has had a stroke of genius. (Or some sort of stroke, anyway.) Stock prices have been falling fast, so, as of today, they won't be allowed to fall any further - no sales will be permitted below yesterday's closing price. (via CR)
Meanwhile, another look at the effect of the no-naked-shorting rule on Risk News: Short sales climb in wake of SEC injunction lapse

There's a fascinating piece of research out from Capital Economics (not, alas, available online) that's attracting a good deal of comment. This article sums up the results, and the study's author talks about them to the FT here.

...it is unlikely that banks will raise all the capital they need to keep expanding their balance sheets at recent rates. As a result, they will have to rein in their lending. “If UK banks fail to raise any more capital than the £20bn ($37bn) raised so far, lending could contract by 7%... Even if lending to UK firms and households just bore its fair share of a 7% drop in bank assets, lending would fall by £60bn, equal to 5% of GDP."

Most attention is understandable on the macro implications - 50% drop in house prices and a contraction over 2009 - but the bank funding angle is also interesting. So far UK banks have raised £20 billion, and in order to avoid a borrowing crunch they'll need another £45 billion, or to sell off a considerable amount of assets (£450 billion worth) or to reduce lending by 7%. Or some combination of the three. Treasury offices face a very hard time.

Thomas Kirchner goes into details about why, exactly, banks like JP Morgan are allowed to hold so much GSE stock in the first place - which is news because they've just written it down by 50%...

In general, banks are barred from investing in equity securities. However, the government made Fannie and Freddie preferred stock a “permissible” investment to create a sufficiently large market for these securities.
Of course, making the stock “permissible” didn’t necessarily make it attractive, so regulators had to pull another trick. Under the risk-based capital rules, national banks may carry agency preferreds at a 20 percent risk weighting, while state-chartered banks and OTS-regulated savings associations must apply a 100 percent risk weighting. This means that banks only have to hold 1.6% or 8% capital against their investments (or should we say ‘speculation’?) in Fannie and Freddie preferred stock...
why exactly did banking regulators award this favorable treatment for GSE preferred equity? They did so because otherwise, there would have been no market to place $36 billion of preferred stock... at the time when OFHEO had imposed a capital penalty on the GSEs, and forced them to raise additional capital - in preferred stock...
Now that Fannie and Freddie are in trouble, the government is in a bind. After encouraging banks to buy FNM/FRE preferred by loosening regulations, they cannot easily make the banking sector take $36 billion of writedowns on securities that banks only invested in because of strong government incentives. Bailing out preferred investors is less a question of moral hazard than of credibility of bank regulators...

The FDIC is doing its bit to help the softening job market and the commercial real estate sector, Bloomberg reports:

The Federal Deposit Insurance Corp. is preparing to sign a five-year lease to add five floors of space at its Dallas regional office as the agency prepares to increase scrutiny of failing and troubled U.S. banks.

The federal agency ... will add 125,000 square feet to the 185,000 square feet it rented last year ... That agency will add about 300 staff at the building, including some of the 69 retirees it is bringing back to help handle the increased workload, said spokesman Andrew Gray.

(via CR again!)

According to this Reuters story:

"We have energy companies buying to protect rigs in the Gulf with the cat-in-the-box product ... while (coastal contracts) cover the landfall of the storm, and are being bought by insurers, reinsurers and hedge funds," Patrick Gonnelli, president of Carvill Capital Markets, said in a phone interview.
On Thursday, Gustav was forecast to strengthen into a hurricane in coming days as it neared the Gulf of Mexico, home to a quarter of U.S. crude oil production and 15 percent of its natural gas output.
Gonnelli said others are buying derivatives "on pure speculation because it (Gustav) looks like it is going to go into the Gulf."

We covered the contracts at their launch last year and in depth later the same year.