Financial Firms,
Capital Depleted,
Hunt for Cash

Citigroup Board Spurns
Overture About Merger,
Gets Abu Dhabi Money

By ROBIN SIDEL, KAREN RICHARDSON and DAVID ENRICH
November 28, 2007; Page A1

As Citigroup Inc. was dealing with billions of dollars in mortgage-related losses and the departure of Chief Executive Charles Prince, it got an unexpected call from a prominent investment banker suggesting a merger with Bank of America Corp.

Citigroup’s board dismissed the informal approach “totally out of hand,” and no discussions have taken place, says a person familiar with the matter. “When you’re looking for a CEO, that’s no time for a transaction,” this person says.

Bank of America says it never authorized a formal overture to Citigroup.

Citigroup’s board, meanwhile, gave a green light to a smaller transaction — a $7.5 billion capital infusion from an investment arm of the Abu Dhabi government. In exchange, the Abu Dhabi Investment Authority will receive a 4.9% stake in the form of convertible stock.

More broadly, the Abu Dhabi deal shows that after years of doling out money to corporate clients and consumers, financial companies now need some fresh cash of their own.

Faced with massive losses linked to the subprime-mortgage crisis and accompanying credit crunch, several of the nation’s financial institutions — from Wall Street investment firms to bond insurers — are assessing their need for new sources of capital. And they are likely to intensify their fledgling efforts in coming months amid signs that they could face billions of dollars in additional losses as the mortgage-market fallout persists.

“It’s a bitter pill to swallow to admit that the problems in the market have reached the point that companies that traditionally could fund themselves now need external sources of capital,” says David Honold, who invests in financial stocks at Turner Investment Partners in Berwyn, Pa.

Of course, one way to tap external capital is to merge operations. The merger boom that fizzled out this summer was driven by cheap and plentiful financing in the debt markets and a booming stock market. With credit increasingly tight and the stock market looking shakier, Wall Street may now see a round of opportunistic deal making.

Bank of America, based in Charlotte, N.C., has long been one of the most opportunistic acquirers in the banking industry. In the past couple of years, it has scooped up retail bank FleetBoston Financial Corp., credit-card issuer MBNA Corp., wealth-management firm U.S. Trust Co. and, most recently, LaSalle Bank.

This wasn’t the first time Citigroup received an overture involving Bank of America; it got a feeler from the bank several months ago, according to a person familiar with the matter. The latest one, though, was quickly disavowed. “Bank of America did not authorize any investment banker to approach any company over the last six weeks,” a Bank of America spokesman said.

Citigroup declined to comment.

A deal with Citigroup would have marked the culmination of Bank of America Chairman and CEO Kenneth D. Lewis’s quest to make his company the undisputed titan in American banking. The 60-year-old Mr. Lewis, who has spent his career at Bank of America, has long complained that the company doesn’t get the respect it deserves from Wall Street and New York banks. Bank of America recently surpassed New York-based Citigroup to become the biggest U.S. bank by market value, a longtime goal for Mr. Lewis.

To be sure, investment bankers and other representatives for companies often approach potential merger partners, and it is hard to ascertain how serious Mr. Lewis and his management would be about such a deal.

All the major banks would be particularly sensitive to these sorts of overtures, following the ouster of Merrill Lynch & Co. CEO Stan O’Neal earlier this month. Mr. O’Neal was forced out of Merrill in the wake of disastrous quarterly results, unexpected write-downs and an unauthorized approach to Wachovia Corp. about a potential merger.

A combined Citigroup and Bank of America would have had to shed most of Citigroup’s 1,000 U.S. branches and its $249.34 billion in consumer deposits, to stay under a regulatory cap that bars any U.S. bank from an acquisition that would give it more than 10% of the nation’s total bank deposits. Together Citigroup and Bank of America, with its $598.21 billion in deposits as of June 30, would have had nearly 13% of the U.S. total. Bank of America alone holds 9%.

One incentive for Citigroup to do a deal with Bank of America would be to fill its leadership void. Now that Mr. Prince has stepped down, the bank’s board is searching for a new CEO but there is a paucity of senior bank executives with the experience to deal with the current credit crisis. Mr. Lewis is well-regarded in the industry despite Bank of America’s recent stumbles in its effort to build an investment bank.

Citigroup’s board is continuing to review outside candidates for the bank’s top job. The leading internal candidate is Vikram Pandit, a former Morgan Stanley executive who joined Citigroup earlier this year. Mr. Pandit, who was recently named to oversee Citigroup’s investment banking and alternative-investments operations, has a strong ally in Robert Rubin, the longtime adviser who became chairman of the board when Mr. Prince stepped down earlier this month.

However, a person familiar with the matter says the Citigroup board would be unlikely to view a merger with Bank of America favorably. That’s because the events of the past few months have shown that Citigroup is already unwieldy and difficult to manage, and combining it with another giant would make it even more so.

Citigroup, in its pursuit of fresh capital, has opted to look overseas, where government investment arms, known as sovereign wealth funds, are bulging with cash. The transaction with the Abu Dhabi government was aimed at shoring up investor confidence and the massive bank’s capital levels, which had fallen below its targeted rate in the third quarter for the first time in years. In exchange for the capital infusion, Citigroup will pay a pricey 11% in interest annually to the Abu Dhabi Investment Authority.

The deal may have modestly assuaged Citigroup investors, who have seen the bank’s shares slump for months. Yesterday, the stock rose 57 cents, or 1.9%, to $30.32.

An influx of fresh capital can often be bad news for existing stockholders because such deals typically dilute earnings. Still, for Citigroup, investors are “most concerned about getting stability and allowing the company to run their business, and hopefully get beyond this mess,” says David Easthope, senior analyst at Celent, a Boston financial research and consulting firm.

The move by Citigroup came weeks after mortgage giants Fannie Mae and Freddie Mac announced plans to issue preferred shares to shore up their capital as a wave of mortgage defaults spread from subprime loans to the traditional loans that the two companies guarantee.

Between them, Fannie and Freddie own or guarantee a combined $4.8 trillion of U.S. home mortgages, or nearly half the total outstanding.

Earlier this month, Fannie Mae priced a $500 million preferred-stock issue, which followed another preferred-stock issue several weeks earlier.

Freddie Mac, which said yesterday it was selling preferred stock to raise up to $6 billion, said the sale will consist of “a larger offering of nonconvertible noncumulative perpetual preferred stock, and a substantially smaller offering of convertible noncumulative perpetual preferred stock.” Freddie Mac said it expects to price both offerings soon.

Three months ago, Countrywide Financial Corp., facing a funding crisis of its own, turned to Bank of America for help. The bank pumped $2 billion into the nation’s No. 1 mortgage lender in exchange for convertible preferred stock yielding 7.25% annually.

“What companies are doing is trying to find ways to get some money to harbor this short-term liquidity freeze,” says Eric Fitzwater, senior analyst at SNL Financial, a Charlottesville, Va., research firm that focuses on the financial-services industry.

Bond insurers, whose businesses, reputations and share prices have been hit hard in recent weeks by rising defaults on U.S. subprime mortgages and a flood of downgrades of collateralized debt obligations — securities backed by pools of mortgages or other assets — are also trying to raise fresh cash. The companies, which guarantee payment of interest and principal in the event of default by a bond issuer, are considering everything from debt offerings, to issuing hybrid securities, to buying reinsurance that could reduce risk and relieve the stress on their balance sheets.

Two of them, Ambac Financial Group and MBIA Inc., have lost more than half of their market value in recent months over concerns that potential losses in their portfolios of risky mortgage-related CDOs would erode their capital bases so much that they would lose their coveted triple-A credit ratings.

Last week, CIFG Holding Inc., a private bond insurer that rating agencies had recently named as the most imperiled of the triple-A-rated guarantors, announced it was getting a $1.5 billion capital injection from the controlling shareholders of its French parent in the form of a convertible bond, reinsurance and long-term debt. The new funding, which doubled CIFG’s capital, increased the pressure on its peers to shore up their own finances.

Financial Guaranty Insurance Co has been talking with its investors, including private-equity firms Blackstone Group Inc. and Cypress Group, about how much capital it could tap to support its triple-A rating, while MBIA has been fielding offers of capital from existing investors and hedge funds, according to people familiar with the matter.

–Valerie Bauerlein contributed to this article.

Write to Robin Sidel at robin.sidel@wsj.com, Karen Richardson at karen.richardson@wsj.com and David Enrich at david.enrich@dowjones.com

http://online.wsj.com/article/SB11962168

0974306166.html?mod=hps_us_whats_news

 

Global Economy May Not Have Touted ‘Shield’

Are Europe and Asia
Strong Enough to Offset
A Slowdown in U.S.?

By JUSTIN LAHART
November 28, 2007

 

http://online.wsj.com/article/SB119620937343805910.html?mod=hps_us_whats_news 

With worries over the fallout from the housing and credit markets deepening, the once-widespread view that Europe and Asia would pick up the slack and shield the global economy from the effects of a U.S. downturn is being put to the test.

Investors embraced the idea, shuttling money abroad and buying shares of companies with big overseas operations, like Wm. Wrigley Jr. Co. and 3M Co. — until disappointing results from both sent their shares down. Technology companies, which as a group have the largest overseas-sales exposure, were another popular destination. After weathering the initial stages of the stock-market selloff in October, they have fallen sharply this month.

Less than two months ago, the International Monetary Fund offered a remarkably upbeat view that global economic growth would slow down just a smidge to 4.8% next year from an estimated 5.2% this year. But that no longer seems certain.

“It’s quite clear that the downside risks to world growth have increased since we met about a month ago at the IMF,” the governor of the Canadian central bank, David Dodge, said recently.

House prices have continued to fall in the U.S. and elsewhere, banks in the U.S. and Europe have announced billions of dollars in mortgage-related losses, stocks around the world have fallen sharply and an unrelenting reluctance by banks to lend — even to one another — has prompted the Federal Reserve and European Central Bank to act.

The notion that the rest of the world has “decoupled” from the U.S. came into vogue earlier this year, as overseas economies — particularly emerging markets — continued to post robust growth and Europe and Japan appeared to be enjoying a long-delayed upturn.

Policy makers joined the decoupling parade. In the spring, the IMF included a chapter in its April World Economic Outlook called “Decoupling the Train.” The gist: The current weakness of the U.S. economy stems largely from housing woes — and housing is less global than, say, computers and other parts of the U.S. economy. That is good news for the rest of the world.

But the U.S. is now flirting with something more severe than a mere slowdown. That — along with rising oil prices and the specter of a global credit crunch — is changing the picture.

Europe is showing signs of faltering, while Japan may be at risk of sliding back into recession. While developing economies like China are still on a steady boil, recent drops in their stock markets suggest investors are beginning to doubt their immunity to a U.S.-led slowdown.

“We’re seeing a bond market in the U.S. which is pricing in a very high chance of a recession and yet is refusing to price in any significant chance of monetary easing in the euro area,” says Jacques Cailloux, chief euro-area economist with Royal Bank of Scotland.

“So I do think the market is betting, to some extent, on the decoupling,” he says. “But I think it’s the wrong bet.”

Recent data show the euro-zone economy has been resilient, so far, with gross domestic product rising 2.6% in the third quarter, compared with last year. German and French business confidence staged surprising rebounds this month, according to data released yesterday, with German exporters notably optimistic, despite the euro’s flirtation with $1.50.

The combination of a U.S. slowdown, the stronger euro and continuing credit-market turmoil is likely to damp growth in the fourth quarter and through next year. Once-hot housing markets in Spain and Ireland are slowing. Last week, the British Bankers’ Association said United Kingdom mortgage approvals fell sharply in October.

Canadian door maker Masonite International Corp. saw demand in the U.K. and France soften in the third quarter. “Although we do not expect a major downturn in Europe like we are experiencing in North America, these markets could be materially less robust in the last quarter of 2007 and into 2008,” Chief Executive Officer Fred Lynch told investors on a conference call earlier this month.

Weinig Group, a German machine-tool maker typical of the midsize export-oriented companies, says new orders from China have begun to slow sharply. “Many of our Chinese customers sell their products in North America, and they are growing more slowly or not at all. That hurts their appetite for investment,” says Rainer Hundsdörfer, Weinig’s CEO. Other Chinese customers, which make fittings for the domestic market, are still buying machines, he says. Weinig’s orders from Latin America have also begun to slow, for the same reason: Many manufacturers there rely on exports of finished goods to the U.S.

Demand from Europe, especially Eastern Europe, is helping to compensate. Demand in oil-producing countries also remains strong. “If the U.S. economy went into recession, Asia would be most affected, but the rest of the world could largely carry on,” Mr. Hundsdörfer predicts. But his company’s spectacular growth rates will come to an end. “We will return to more normal growth rates of 2%-3% a year, but I don’t expect a collapse in sales, except in the U.S,” he says.

“Europe is in more serious danger of a slowdown than many people think,” says Simon Johnson, chief IMF economist. “If the U.S. slows down and Europe slows down, that affects trade…and there are no amount of reserves an emerging market can have that protects against markets drying up.”

The global economy, he says, now faces the potential for a late-20th-century-style spike in oil prices, a 21st-century global financial shock — and an old-fashioned 19th-century-style slowdown in global trade.

That could put Japan, in particular, at risk. Despite an expansion that has lasted nearly six years, and despite policy makers’ efforts to boost domestic demand, the country remains overly dependent on exports, says Lehman Brothers global economist Paul Sheard. “For the first time in a while, you can look at the Japan and say ‘Gee, could the economy slip back into recession?’ ” he says.

While the risks to other Asian economies don’t seem as stark as in Japan, investors have been selling shares. The decline in the Seoul stock market, which has fallen 10% this month, is especially notable: Because South Korean companies are export-oriented and carry heavy debt loads, they are seen as particularly sensitive to changes in global growth and the global availability of credit.

–Joellen Perry in Frankfurt and Marcus Walker in Berlin contributed to this article.

Write to Justin Lahart at justin.lahart@wsj.com

Treasurys plunge as stocks stage rebound

Tue, Nov 27 2007, 22:59 GMT
http://www.afxnews.com

NEW YORK (AP) - Treasury prices plunged Tuesday after news of a capital infusion for ailing Citigroup Inc. emboldened investors to venture back into stocks and diminished the appeal of government bonds.

The news caused Treasurys to give back nearly all the gains they registered during a massive rally the day before.

The Abu Dhabi Investment Authority, one of the world’s largest sovereign wealth funds, will invest $7.5 billion in Citigroup Inc, which has suffered heavy losses and lost its top leader due to its exposure to the below prime mortgage market. The agreement kindled hopes that banks will be able to garner the resources to weather severe liquidity and confidence problems in the capital markets.

The announcement could not come at a better time for the badly beaten financial sector and the stock market. For a number of weeks, a steady procession of worrisome stories about the spreading impact of souring subprime home loans has sent stocks tumbling.

These stories also sent Treasury prices sharply higher and yields to multi-year lows, given that government-backed bonds were seen as the safest assets available. But on Tuesday, stocks rebounded, with the Dow Jones industrials up 215 points.

“This news has given equities a lift,” said Kim Rupert, fixed-income analyst at Action Economics. “We are seeing some shifts in asset allocation, with money going into stocks. And Treasurys are also under pressure after really surging yesterday.”

The benchmark 10-year Treasury closed down 26/32 at 102 15/32 with a yield of 3.95 percent, up from 3.84 percent late Monday. During Monday’s rally, the benchmark yield fell to its lowest level since June 2005. Prices and yields move in opposite directions.

The 30-year long bond fell 1 1/32 to 110 18/32 with a yield of 4.36 percent, up from 4.29 percent late Monday.

The 2-year note dropped 10/32 to 101 1/32 with a 3.06 percent yield, up from 2.89 percent late Monday.

After hours trade had no impact on the benchmark yield, which remained at 3.95 percent at 5:30 p.m. Eastern time. The yield on the 30-year long bond was unchanged at 4.36 percent, although additional selling pushed the 2-year note’s yield up to 3.08 percent at 5:30 p.m. from 3.06 percent at the 3 p.m. close.

The 3-month note yield rose to 3.19 percent from 3.10 percent Monday, while the discount rate advanced to 3.11 percent from 3.02 percent.

A new report showed consumer confidence this month was shaken by mounting worries about higher energy prices and lower values for stocks and homes. Consumers are being carefully watched now that the holiday shopping season is under way. There is uncertainty whether consumers currently facing multiple challenges can continue to drive the economy.

The Conference Board said its consumer confidence index fell to 87.3 in November from 95.2 in October. The reading was the lowest since Hurricane Katrina in 2005.

Copyright 2007 Associated Press. All rights reserved. This material may not be published, broadcast, rewritten, or redistributed.

Saudi minister says oil market well supplied - UPDATE

Wed, Nov 28 2007, 03:39 GMT
http://www.afxnews.com

http://www.fxstreet.com/futures/news/

article.aspx?StoryId=64c77f22-3a26-407a-a4e0-9dbdb3e593c6

SINGAPORE (Thomson Financial) - The world oil market is well supplied and fundamentals do not support high prices, Saudi Oil Minister Ali Al-Naimi said Wednesday ahead of a key OPEC meeting next week.

“There is no relationship between the fundamentals today and the price of oil. There is a mismatch,” he told reporters after delivering a speech at an energy forum in Singapore.

“Fundamentals do not support high petroleum prices. The world market is well supplied,” he said in his speech.

Asked whether Saudi Arabia, the world’s biggest oil exporter, will push for an increase in crude production at OPEC’s meeting next Wednesday, he said the cartel needed to see the data first.

“You are trying to get a premature answer. We need to meet first, we need to look at the data and then decide accordingly,” he said.

On global oil supplies, the minister said: “They are definitely comfortable and they are definitely within the five-year average, and no one can deny it. That is a fact.”

The Organization of Petroleum Exporting Countries had no control over prices being determined by the market, he said.

“You see the (price) volatility today because of different reasons,” he said.

In morning Asian trade, New York’s main contract, light sweet crude for January delivery, slumped 42 cents to 94.00 dollars a barrel from 94.42 dollars in late US trades Tuesday.

The benchmark contract has fallen around 5 dollars since climbing close to the 100 dollar mark last week, reaching a record high of 99.29 dollars.

Brent North Sea crude for January delivery tumbled 37 cents to 92.15 dollars.

The market had turned bearish on rumours that OPEC would increase production to help cool prices.

OPEC last decided to raise output in September when it agreed to provide an extra 500,000 barrels of crude a day to the market, effective November 1.

afp

ms/jg

COPYRIGHT

Copyright Thomson Financial News Limited 2007. All rights reserved.

http://www.fxstreet.com/futures/market-review/outside-the-box/2007-11-27.html

The Next Dominos: Junk Bond And Counterparty Risk

Tue, Nov 27 2007, 06:59 GMT
by John Mauldin

Millennium Wave Investments

The subprime problem, we were told, would not spread to other markets. It would be “contained.” And it has, according to Jim Grant. He quipped last week that it has been contained on planet Earth. The risks coming from rising defaults in the US (now above 600,000 and rising from just 200,000 a few years ago) are clearly spreading to markets far beyond the subprime world.

This week’s Outside the Box talks about the next two dominoes that could fall: junk bonds and counterparty risk in the various credit default swap markets. Ted Seides is the Director of Investments at Protégé Partners, LLC, a hybrid fund of funds that invests in and seeds small, specialized hedge funds. He writes this week’s piece in Peter Bernstein’s Economic and Portfolio Strategy, one of the most respected of market analysis letters. You can learn more about the letter at www.peterlbernsteininc.com.

This piece is a little longer than most letters, but it is one of the more important editions of Outside the Box this year. This is a must read. You absolutely need to understand the nature of the systemic risk we are facing, and Ted does a great job of explaining in very clear terms the nature of the risks that we have created din our modern markets. I have left the footnotes in, and they are at the end of the letter.

John Mauldin, Editor

Outside the Box

The Next Dominos: Junk Bond And Counterparty Risk

By Ted Seides, CFA[i]

Financial history doesn’t repeat itself, but it often rhymes. Earlier this year, losses from subprime mortgages revealed that the financial markets had taken to excess a good idea in the real economy. A perfect economic environment allowed the alchemists in structured finance to apply massive amounts of leverage on low quality, securitized mortgages.[ii] When the first signs of softening in real estate prices surfaced, we learned that investors had taken on far more risk than anyone realized, and losses could not be contained.

The severity of the subprime debacle may be only a prologue to the main act, a tragedy on the grand stage in the corporate credit markets. Over the past decade, the exponential growth of credit derivatives has created unprecedented amounts of financial leverage on corporate credit. Similar to the growth of subprime mortgages, the rapid rise of credit products required ideal economic conditions and disconnected the assessors of risk from those bearing it.

The amount of outstanding corporate credit and leverage applied to it dwarfs the market for subprime mortgages. As such, the consequences of a problem in this arena may be far more severe than what happened in subprime. If we are going to experience the downside of another economic cycle, we may be in for a painful ride.

The evils that lurk from our creations epitomize Peter Bernstein’s definition of risk - we don’t know what will happen. By thinking through the evolution of the credit derivatives market and the storm clouds on the horizon, I hope to heighten awareness while there is still time to act.

Credit Default Swaps: A Brief Introduction

Just a decade ago, the corporate credit market was comparatively simple. Companies seeking to fund their operations and expansion plans tapped commercial banks for loans and financial markets for bonds. Commercial banks carried these senior secured loans directly on their balance sheet. Subordinated lenders - primarily banks, mutual funds, and pension funds - evaluated the credit worthiness of the issuer and determined an appropriate compensation for the risk that the issuer might fail to meet its obligations. When the borrower offered sufficient compensation and legal protection, the company received financing. Since many bondholders owned assets to defray long-term liabilities, the corporate bond markets had relatively low turnover. Investment banks served primarily as intermediaries between corporations and capital providers to place new issues and refinance paper.

While these arrangements served most participants upon initial offer, bank loans did not exchange hands in secondary markets, and hedge fund shied away from shorting credit because of expensive borrowing costs.[iii] More cynically and perhaps more accurately, the absence of loan trading and “bond loan” departments left holes in the investment banks’ playbook that they could fill with a more fluid trading vehicle. In order to meet these needs, in the mid-1990s Wall Street gave birth to the credit default swap (”CDS”), the basic contract from which all credit derivatives emanated.

The CDS was an innovative financial technology that revolutionized the way credit changes hands. A CDS is a financial agreement between two parties to exchange the credit risk of a reference entity or issuer. The buyer of CDS pays a periodic premium for which it purchases credit protection on a specified, notional amount of exposure. In the event the reference entity faces a credit event - typically a bankruptcy, failure to pay, or restructuring - the owner of credit protection receives a windfall profit. In terms of exposure, a buyer of CDS is short the credit risk of the reference issuer. Conversely, the seller of protection assumes a risk comparable to owning the reference bond; the seller receives a premium for taking risk but suffers large losses in an event of default. Thus, the CDS market is a zero sum game between the buyers and sellers of protection.

While new to the credit markets a decade ago, CDS has roots in generations of related financial contracts. A CDS closely resembles an insurance contract in which the seller receives a premium and suffers losses of up to the notional amount in the event a low probability default occurs within the term of the agreement. If the market properly handicaps the probability of default, the premium on CDS should equal the yield spread of a corporate issue over Treasuries after taking into account funding costs.

CDS also share characteristics with put options. Buyers of put options pay a small premium and have the opportunity to make a large sum should the underlying stock fall precipitously. However, unlike options that trade on organized exchanges, CDS transact only between two counterparties, carrying an additional counterparty risk absent in listed options markets.

Credit Default Swaps in Practice

CDS loosened the reigns on the rigid credit markets and introduced a dizzying array of new applications to trade credit. For the first time, bank loans traded actively in the secondary market, and investors shorted debt across the credit spectrum for a modest cost.[iv] Investment banks created a host of indexes to replicate broad exposure to the loan and bond markets, further augmenting the menu of hedging alternatives. CDS are commonly used to reference single-name credits, indexes of credit baskets, and synthetic exposure in other financial technologies such as collateralized debt obligations (”CDOs”) and collateralized loan obligations (”CLOs”). Each of these broad categories comprises roughly one-third of the total notional amount of outstanding CDS.v]

The introduction of CDS coincided with a favorable economic climate for creditors and debtors. Since the nadir of the last credit cycle in 2002, creditors had a uniformly positive lending experience with virtually no defaults. The CDS market blossomed and the issuance of credit expanded, untethered by considerations of risk. From a modest infancy, the notional value of CDS today surpasses the amount of underlying cash bonds by an order of magnitude.[vi] CDS contracts now total $45.5 trillion of outstanding credit risk, growing an amazing nine-fold in the last three years alone. Putting such a large number in some perspective, $45 trillion is almost five times the U.S. national debt and more than three times U.S. GDP.

An Insurance Market with No Loss Reserves

One way of thinking about the CDS market is that of a huge, new insurance industry whose providers reserve nothing for future losses. Imagine what would happen if $45 trillion worth of insurance policies experienced an actuarial average of 5% losses and no one had $2.25 trillion sitting around to foot the bill![vii]

This woefully undercapitalized market may be a frightening reality. Sellers of credit protection post margin for marked-to-market moves, but CDS contracts are generally uncollateralized. Further, investment banks that hold one side of each CDS transaction claim to be hedged, but their financial statements show neither loss reserves nor bad debt reserves for potential counterparty failure. The absence of collateral and significance of counterparty risk have important implications discussed below.

For a number of years, credit spreads have tightened to historical lows. During this time, CDS took over cash bonds as the primary form of trading in credit markets. Is it too much of a stretch to consider that spreads have been abnormally tight in part because sellers failed to price in a reserve for future losses and thus systematically underpriced risk?

The Second Domino: “High”-Yield Bonds[viii]

The economic climate that enabled a transformation in the credit markets over the last five years simultaneously prevented the system from being tested. The machine hummed at ever increasing velocity as long as companies received cheap financing, borrowers repaid lenders, and expectations remained cheerful. A downturn in the real economy, or just expectations of pending credit problems, needed to arise before the imbedded leverage in the system could cause harm. As soon as either occurred, however, the machine would screech to a halt.

Given their subordination in the capital structure, junk bonds (or, euphemistically, high-yield bonds) are a logical place to look for the first signs of trouble. Statistics of high-yield issuance reveal relaxed lending standards in a marketplace determined to ignore risk. In each year since 2004, more than 40% of all new debt held ratings below investment grade. For perspective, the proportion of new paper of such poor quality issued in each of the last four years far exceeded the proportion of such issuances in any year since the late 1980s.

High-yield bonds are dubbed junk for good reason. Corporate mortality tables indicate that defaults of high-yield bonds within five years of issuance occur 28% of the time for those just below investment grade and 47% of the time for those with the lowest ratings. Past instances of high default rates lagged periods of strong junk issuance by 4 to 5 years, coinciding with recessionary periods in the economy.[ix] In good times, issuance is high, underwriting standards are low, and investors forget that risky credits may actually default. A few years later, the economic cycle turns and junk bonds reveal their flawed character.

A disproportional amount of low-grade paper hit the market in recent years, but that was not all. Investors also received meager compensation for taking risk. High-yield spreads over Treasury yields have hovered around historical lows for nearly four years, indicating that investors have paid little attention to the real possibility of loss.[x]

Making matters worse, approximately one-third of all outstanding, single-name CDS are derivatives of credits with ratings below investment grade.[xi] When investors have insatiable appetites for yield, the food stinks, compensation for it comes in small portions, and customers still can’t get enough.

Subprime Revisited in High-Yield: A System with Faulty Design

The anatomy of the high-yield bubble started with a virtuous cycle. When both the markets and the economy were strong, investors paid little attention to risk. The more investors assumed risk, the more they received rewards. Companies seized the opportunity to obtain inexpensive financing and issued paper to the market on attractive terms. As leverage increased, private equity buyers drove up asset values. Higher asset values enhanced collateral and allowed companies to borrow more or refinance their way out of trouble. Without defaults, creditors were willing to lend on ever more egregious terms. As the cycle grew stronger, buyers received less compensation for the risks they assumed.

Hidden leverage and conciliatory lending standards should be a sign of caution, and this particular cycle looks familiar. The recent history and current state of the high-yield market shares a close resemblance to the ascendance and positioning of the subprime mortgage market prior to the pricking of its bubble earlier this year.

First, subprime mortgages and high-yield bonds were successful financial innovations that served an unmet need, but both good ideas rode a wave to excess on the crest of strong economic conditions. Initially, subprime mortgages made housing available for those just beyond its reach. Later, the confluence of rising home prices, low interest rates, abundant liquidity, and creative structures fueled an unprecedented growth of mortgage issuance with deteriorating underwriting standards. Similarly, while investors once accepted the high risk-high reward proposition of junk bonds only on occasion, over the last five years low interest rates, a strong economy, and minimal market volatility combined to foster massive issuance of high-yield paper with poor promised returns and weak protections for lenders.

Second, investors bid for structured products at remarkably low yields, accompanied by paltry lending standards. In order to meet client demands, investment banks created CDOs to deliver investments that maximized yield for a given credit rating.[xii] Through the magic of financial engineering, CDOs turned low quality assets - many of which contained subprime mortgages, leveraged loans, and high-yield debt - into a blend of high- and low-rated paper. In contrast to the zero sum nature of CDS, CDOs became a positive sum game in which increasing securitization provided additional capital to companies while adding leverage in the system. In the process, banks, rating agencies, and CDO managers were agents with collective economic incentives to deliver quantity over quality.

Third, CDOs brought the unwelcome side-effect of segregating the risk-takers from the risk-assessors. Mortgage originators found every way possible to increase their production volume, and mortgage companies sold off the loans to investment banks. The banks securitized loans into mortgage-backed securities (”MBS”), which they then sold to investors. Banks also arranged for CDOs to pool a group of MBS into a portfolio that had sufficient statistical diversification to receive the imprimatur of the rating agencies. By the time investment banks sold the CDO to clients, the ultimate risk takers were three or four degrees of separation from an opaque pool of underlying assets. Employing the financial “innovation” of statistical default analysis, leveraged pools of credit with customized risk and reward profiles for each investor replaced good, old-fashioned credit analysis. In the high-yield market, the passing of the baton from issuer to investment bank to CDO to ultimate principal and the corresponding shift in credit risk from those with the best ability to analyze it to those with the least are identical to what transpired in the subprime sector.

Fourth, as long as the economic environment was robust, the complicit players in the game cooked up increasingly dubious ways to offer more risk without adequate compensation. The subprime mortgage market is now notorious for extending no documentation, “liar loans” and negative amortizing mortgages. In the last year, the high-yield market welcomed covenant light and PIK-toggle notes.[xiii] Both cases reached extremes of weakening protections and lowering interest payments. Investment banks even created a host of products with acronyms like CDO-squared, CPDO, and SIV that accompanied the CDO structure itself. Each new vehicle offered a greater degree of leverage, less transparency, and another degree of separation from the underlying credit risk.

Finally, when the real economy no longer cooperated, the music stopped in the markets for subprime mortgages, and financial institutions throughout the world were left holding the bag. As subprime mortgage pools created in 2006 and 2007 manifested high rates of early delinquent payers, the expectation of losses and subsequent rating agency downgrades triggered widespread sales. The resulting collapse in CDO valuations threatened to provoke a forced unwind of leveraged structures whose stability depended on a mortgage payment experience that resembled those of the past. The unraveling of leverage in CDO structures has yet to see its bottom in subprime, and financial observers cannot measure the depth of the abyss. As described by Orin Kramer, Chairman of the New Jersey State Investment Council, “We simply don’t know how the enormous growing role that credit derivative products play in the global financial architecture has altered the fundamental correlation assumptions upon which the entire edifice is built.”[xiv]

Should a recession expose weakness in credit fundamentals, high-yield bonds may suffer a similar fate. As much as the situation has been set in motion by the financial economy, the tipping point will be a fundamental deterioration in the real economy. With current default rates around 1% and the lowest since 1981, a consumer recession or business slowdown thus far are little more than the prognostications of bearish economists. When the cycle turns and defaults rise, however, falling prices of CDOs backed by high-yield collateral and forced sales of CDOs could mimic the catastrophic declines of subprime CDO prices. A large amount of high-yield paper at low rates with weak covenants is already out in the marketplace and worth a good deal less than the values at which it may be carried on investors’ books today. So the stage is set for the drama to unfold, as the positive sum game reverses and becomes a negative sum game for all participants.

The Third Domino: Counterparty Risk

As derivative markets replaced cash markets in the trading of debt, another novel form of risk entered the fray - counterparty risk. Each CDS is a swap between two counterparties, and a broker-dealer is on one side of every transaction. In the cash markets, the performance of the debtor is the creditor’s only concern. In the derivative markets, the lender must also be concerned with the performance of the counterparty.

Counterparty risk in the CDS market lies with the sellers of protection, or the insurers of risk. Banks are the primary sellers of CDS, totaling 40% of all written CDS and representing notional exposure of $18.2 trillion.[xv] Banks claim to run hedged books, effectively serving as a market-maker in the CDS market. As should be evident from the events in subprime, even the most sophisticated systems are often unable to fully hedge risks of this size and degree of complexity. If printed materials are any indication, banks may be asleep at the switch. The “Counterparty Considerations” section in the Credit Derivatives Primer of market share leader JP Morgan is a single paragraph on the last page of the volume, which proclaims “the likelihood of suffering (counterparty default) is remote.”[xvi] (italics added)

Hedge funds appear to be in over their heads as well. According to printed statistics and consistent with anecdotal evidence, hedge funds are sellers of 32% of all CDS, insuring exposure of $14.5 trillion.[xvii] Recent estimates indicate that the entire hedge fund market is approximately $2.5 trillion in net assets under management. Thus, hedge funds are bearing risk in excess of their ability to pay the piper if anything goes wrong.

Jeremy Grantham of GMO recently predicted that a major bank will fail in the next five years.[xviii] I would take his vision a step further and offer two ways that outcome might occur. First, a bank could simply collapse under the weight of its written CDS obligations. This event would not be the first time that massive high-yield issuance followed by a change in credit cycle induced bank failure - remember Drexel Burnham? Second, imagine what would happen in the unlikely event that banks have perfectly hedged CDS exposure on paper. In a wave of defaults, banks would be obliged to pay where they are long credit and may experience counterparty defaults from hedge funds or others sellers where they are short. Losses would shift to the bank’s balance sheet, and sufficient losses could wipe out their equity capital.

It seems logical that a market of this size with expected defaults should be housed on an exchange, obviating the need for counterparty involvement. The issuance of CDS today falls under standards set forth by the International Swap Derivative Association (ISDA), which is a big step forward from the early days when no two contracts looked alike. Nevertheless, the CDS market remains over-the-counter, so perhaps banks earn a pretty penny coming in between buyers and sellers and would rather maintain the revenue stream than be concerned with the risk of a fat tail event.

Counterparty risk management supposedly ensures that sellers of protection post adequate collateral and do not exceed safe limits. Even if we make the bold assumption that risk management is effective, the implementation of such techniques could cause a violent downward spiral. In a volatile market, the vast amounts of leverage created by CDS would be withdrawn from the market suddenly and simultaneously, leading to a market paralysis comparable to or worse than the crisis of last August.

Who’s Holding the Bag?

One of the uncertainties about risk in this complex system results from the unprecedented degree of financial leverage placed on real economy capital structures. Never before have we entered a downturn of an economic cycle with so much paper riding on the fortunes of companies known to have such poor credit quality. Those left holding the bag will be the sellers of CDS (the insurers), owners of CDOs, financial guarantors of CDOs, and may include another link in the food chain.[xix] Regardless, in the aftermath of the subprime mess, no one will fess up to holding politically toxic securities before they must. In short, the separation of risk production and risk taking makes any definitive assessment of risk in this market unattainable.

When subprime mortgage losses surfaced in February and again over the summer, the success of structured finance in dispersing risk was more than offset by the exceedingly high degree of risk taken across the globe. Not only did direct participants like subprime mortgage originators meet their demise, but also U.S. investment banks, European insurance companies, Chinese state-owned institutions, hedge funds promising a low risk profile, and even money market mutual funds suffered write-downs on their balance sheets.

Unfortunately for our financi al system, the magnitude of risk in corporate credit is a multiple of that in subprime mortgages. Each written CDS exchanges a risk that cannot be eradicated no matter how broadly aggregate risk is dispersed. Sinking valuations of CDOs and a commensurate leverage unwind could trigger a vicious cycle of financial losses. By implication, the problems that might ensue could make the subprime mortgage problem look like a walk in the park.

I cannot be sure these assertions are true, but I suspect that it would be just as difficult to provide evidence that they are not. I have listened to arguments against systemic risk, suggesting that the double counting of CDS, matched books of investment banks, and increasing sophistication of risk management techniques make the eye-popping numbers of notional risky debt larger than they seem. Nevertheless, I remain skeptical. We’ve seen similar movies before, and they don’t end well.

Only Time Will Tell

Earlier this summer, we saw the first tremors of change in the credit markets, as liquidity dried up, spreads widened, volatility returned, CDO issuance all but disappeared, and the private equity markets took a pause. The continued absence of liquidity in the commercial paper markets makes us wonder what might come around the next corner. Though Wall Street may have witnessed the beginning of the end of the good times, Main Street has yet to encounter problems. Sure enough, in the months following Chairman Bernanke’s intervention, spreads tightened as if everything was good again.

So long as we no longer have economic cycles and defaults do not occur, we can all shrug off the possibility of a calamity and go on our merry way. But the tide will go out - it’s not a question of if, but when. And when it does, we may experience the harrowing affects of real financial hardship.

Footnotes:

[i]Ted Seides is the Director of Investments at Protégé Partners, LLC, a hybrid fund of funds that invests in and seeds small, specialized hedge funds.

[ii] By alchemists I am referring to the financial engineers who, complicit with the rating agencies, turned over 85% of asset pools comprised of BBB-rated subprime mortgages into AAA-rated paper.

[iii] An investor with a short position in bonds must borrow the security and pay out the coupon to the lender. Since coupons are a significant component of bond returns, shorting the securities can be an expensive proposition.

[iv]Buyers of CDS pay out only the yield spread of the bond over Treasuries.

[v] British Bankers’ Association, “Credit Derivatives Report 2006,” pg 6.

[vi] JPMorgan Corporate Quantitative Research, “Credit Derivatives Handbook,” December 2006, pg 6.

[vii] Assuming recovery rates on defaulted debt of forty cents on the dollar, the tab to the insurers would still run $1.35 trillion, far surpassing the amount of capital available to pay.

[viii] I use the adjectives “high-yield” and “junk” interchangeably to describe less-than-investment-grade debt. It pains me to use “high” to describe bonds that offer single-digit yields to maturity. The nomenclature reminds me of my disappointment in seeing the size of London’s legendary clock tower for the first time, after which I referred to the monument as either “Medium Ben” or “Big Benji.”

[ix] Presentation by Dr. Edward I. Altman, “Current Conditions in Global Credit Markets,” October 2007.

[x] Ibid.

[xi] BBA Credit Derivatives Report 2006, pg 23.

[xii] CDOs are effectively financial service companies whose assets are debt issues and liabilities are parsed into a capital structure and sold to investors. Relying on historical correlation analysis of defaults, rating agencies mark senior paper with a rating of AAA, senior subordinated rated AA, and so forth down to below investment grade and equity. The ratings provided investors with paper with a range of ratings quality independent of the quality of the underlying assets held by the CDO.

[xiii] A “PIK-toggle” note gives a borrower an option to defer cash interest payments on bonds, toggling from a cash pay instrument to a pay-in-kind indenture. The fancy instrument was a recent example of clever structuring employed by private equity firms to finance leveraged buyouts.

[xiv] Orin Kramer, “Speech on Credit Derivatives,” April 23, 2007. The statement is another example of physicist Werner Heisenberg’s contention that you cannot measure something and observe its movements at the same time, because the act of measurement alters the character of the motion. See Peter L. Bernstein, “Can We Measure Risk with a Number?,” EPS, June 15, 2007.

[xv]BBA Credit Derivatives Report, pg 18.

[xvi] JPMorgan Credit Derivatives and Quantitative Research, “Credit Derivatives: A Primer,” January 2005, pg 25.

[xvii]BBA, pg 18.

[xviii]Jeremy Grantham, “The Blackstone Peak and the Turning of the Worms (The Slow Motion Train Wreck Continues),” GMO Quarterly Letter, July 2007.

[xix] For example, should sellers of CDS default, the buyers of CDS would find their alleged protection worth substantially less than was promised.

Your expecting more difficult credit markets analyst,

John F. Mauldin

johnmauldin@investorsinsight.com

 

Published on Tue, Nov 27 2007, 10:20 GMT

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Oil falls on talk of Opec increase

By Javier Blas in London

Published: November 27 2007 15:22 | Last updated: November 27 2007 22:49

Prices of commodities moved lower on Tuesday, with crude oil sharply down on expectations that Opec would agree to increase production at its ministerial meeting in Abu Dhabi on Wednesday.

Crude oil prices plunged more than $3 a barrel.

EDITOR’S CHOICE

Opec to discuss rise in output - Nov-27

The Short View: Commodity prices - Nov-26

European View: Kazakhstan plays deft hand in global oil game - Nov-26

Where next for commodities after price blip? - Nov-23

Apart from the hope of a production increase from the cartel, prices also came under pressure after Goldman Sachs downgraded its forecast for the US economy. Any US slowdown could lead to weaker demand for oil.

However, crude oil prices were still trading within the range of $90-$100 a barrel that has prevailed for most of the past five weeks.

Nymex January West Texas Intermediate fell $3.28 to settle at $94.42 a barrel ICE January Brent fell $2.80 to close at $92.52 a barrel.

WTI crude oil prices had hit a nominal all-time high of $99.29 a barrel last week.

The oil producers’ cartel, which controls more than 40 per cent of the world’s crude oil supply, will consider a further supply boost on top of the 500,000 barrels a day it approved in September, according to several Opec officials.

An industry official familiar with Opec policy said that several Gulf countries, including Saudi Arabia, were pushing for a production increase.

“They are going for an increase in Abu Dhabi,” the industry official said, noting that ministers were discussing a rise of at least 500,000b/d and as high as 1mb/d.

The official warned that Venezuela and other countries opposed the move. Another official confirmed the discussion and the production volumes.

Saudi Arabia, the group’s most influential member, has not disclosed its position yet, only noting that it was currently pumping about 9mb/d, in line with Opec’s September agreement.

The fall in oil prices and a firm US dollar helped to push gold prices lower. Spot gold in London fell to $807.9 an ounce from Monday’s high of $836.7 an ounce.

http://www.ft.com/cms/s/0/8dba6b84-9cfc-11dc-af03-0000779fd2ac.html 

Sovereign wealth funds

Published: November 26 2007 09:29 | Last updated: November 26 2007 19:36

With private equity sitting on the sidelines, it is reassuring to see sovereign wealth funds starting to flex their muscles around the world. Dubai International Capital on Monday indicated a hunger for Asian assets, kicking off its shopping trip with a small stake in Sony Corp.

Oil exporters, including Norway, Russia and the Middle East, held up to $3,800bn in foreign financial assets through sovereign wealth funds, central banks and wealthy individuals at the end of 2006, according to the McKinsey Global Institute. Asian central banks, part of whose foreign exchange reserves have been split off into more actively managed vehicles, held a total of $3,100bn.

EDITOR’S CHOICE

Sovereign wealth funds: Power magnifies as petrodollar gains ground - Nov-19

On Wall Street: Sovereign Wealth Funds to drive hard bargain - Nov-16

Insight: A passage to the west for sovereign wealth funds - Oct-30

Call for better accountability - Oct-17

That is more than double the total assets managed by hedge funds and roughly four times that held by global private equity. These numbers, measured at the end of last year, already look out of date. So far this year, Asian foreign exchange reserves are up 20 per cent to $3,700bn, and MGI calculates that if oil prices remain above $70 a barrel, nearly $2bn of new petrodollars will enter global financial markets every day.

If Asia is the beneficiary of the new investment dynamics, does it necessarily follow that the US suffers? At the end of June 2006, China held $700bn of US debt, according to US figures. A mass withdrawal is unlikely. China, with $1,400bn of mostly dollar-denominated foreign exchange reserves, has no incentive to drive down the greenback by flogging dollar-denominated assets. Second, the pace at which funds are growing means they can buy several asset classes simultaneously. Third, the political impact is being felt keenly by Asian wealth funds: witness Temasek, the Singapore state agency, which is switching to a lower-profile strategy and avoiding stakes in “iconic” companies overseas.

China is unlikely to risk negative publicity by launching all-out takeovers of Asian peers. Ultimately, the movement of capital flows will change significantly – but it will be a slow process.

Copyright The Financial Times Limited 2007

http://www.ft.com/cms/s/1/8b60adea-9c01-11dc-bcd8-0000779fd2ac.html

Payload: Taking Aim at Corporate Bribery

•   NELSON D. SCHWARTZ and LOWELL BERGMAN

Published: November 25, 2007

LATE last month, five jumbo jets from Riyadh touched down at Heathrow Airport in London. They brought with them 13 members of the Saudi royal family, including King Abdullah and his retainers — and controversy. Over the last four years, the British government has been dogged by criticism of its relationship with Saudi Arabia, which is Britain’s biggest trading partner in the Middle East.

Illustration by The New York Times

 

Multimedia

Graphic

The Overseas Reach of the BAE Investigation

Pool photo by Fiona Hanson

King Abdullah of Saudi Arabia and Prince Philip of Britain in October during the king’s state visit to London. It was the first state visit by a Saudi monarch in two decades.

Sebastian Meyer/Getty Images

People protesting the British government’s relationship with Saudi Arabia and BAE when King Abdullah visited London.

The state visit, the first by a Saudi monarch in 20 years, was no exception, with much of the storm centering on controversial financial ties linking the British military contracting giant, BAE Systems, to Downing Street and the desert kingdom. The leader of one major British political party boycotted King Abdullah’s visit while protesters turned out for his ceremonial carriage ride to Buckingham Palace.

Much of the debate turns on the fact that BAE made billions of dollars in clandestine and questionable payments to Saudi royals over the last 20 years as part of an $80 billion contract to supply the kingdom with advanced fighter jets and other military hardware. While the investigation of BAE’s business practices has followed a circuitous path in Britain, it has recently gained independent momentum in the United States, where the Justice Department is now investigating the company.

BAE generates nearly half its revenue in the United States, and it recently acquired a major supplier of armored Humvees used by American forces in Iraq. American officials who were granted anonymity because they were not authorized to speak publicly about the matter said the Justice Department is examining whether BAE violated domestic laws banning international bribery and money laundering. Accounts in Switzerland, the Caribbean and elsewhere are involved, and, like Britain, the United States has a strategic relationship with the Saudis that the investigation threatens.

Although the cast of players in the BAE story is unusually broad — it includes Saudi royals like Prince Bandar bin Sultan, the kingdom’s former ambassador to the United States, as well as Tony Blair, the former British prime minister — the investigation is but one in a bounty of cases that the Justice Department recently started under a once-obscure law called the Foreign Corrupt Practices Act (or F.C.P.A.).

BAE and the Saudis have openly acknowledged the payments at the center of the investigation, deny any wrongdoing and say that the payments were known to the British and Saudi governments. “We are aware of the U.S. D.O.J. investigation and we are fully cooperating,” a BAE spokeswoman said. “As it is an ongoing investigation, we cannot comment any further.”

While the BAE investigation apparently ran aground in Britain, it has gained enough interest in the United States to cause some of those in the middle of it to secure high-profile legal advisers. Prince Bandar, a confidant of the Bush family, recently retained the former Federal Bureau of Investigation director Louis J. Freeh, as well as one of the fathers of the F.C.P.A., the retired federal judge Stanley Sporkin, to represent him.

“There have been no charges filed,” Mr. Freeh said in an interview. “The prince denies any impropriety and violating any statutes in the United Kingdom or the United States.”

The revelation that British investigators had discovered that BAE deposited $2 billion in payments into Prince Bandar’s Washington bank accounts led the Justice Department to enter what analysts describe as the highest-profile F.C.P.A. case to date. Passed by Congress three decades ago in the wake of Watergate, it is only in the last five years that the F.C.P.A. has become a powerful tool for prosecuting domestic and overseas companies suspected of bribing foreign officials to secure business.

Justice Department officials estimate that there are about 60 such cases under investigation or prosecution in the United States, with a new, five-member F.B.I. team dedicated to examining possible violations of the act. According to the Organization for Economic Cooperation and Development, a group based in Paris that represents 30 industrialized countries, there are more than 150 prosecutions or investigations worldwide involving possible bribery of government officials for commercial gain.

While law enforcement officials and governments in disparate jurisdictions once hesitated to work together to combat corporate fraud, graft has come to be seen as such a severe impediment to global economic growth that cooperation is becoming more frequent.

Analysts say that this shift, along with the enactment of the Sarbanes-Oxley law tightening corporate oversight — and a greater willingness among companies themselves to tackle corruption — has also begun to change how many corporations operate in poorer, developing countries where graft has been most detrimental.

Lawyers, prosecutors and corporate executives in the United States and abroad say they are closely watching the BAE investigation because it offers a test of how aggressively anti-corruption initiatives will be pursued globally, particularly in countries like Britain and Japan that have resisted enforcing such efforts. “The BAE case is a watershed moment,” says Mark Pieth, who oversees anti-bribery efforts for the O.E.C.D. “Large multinationals in many countries have come to us and told us that.”

FOR BAE, the fact that billions in payments to Prince Bandar and his relatives might be considered bribes means more than just the potential imposition of heavy fines. It may also mean, analysts say, that BAE executives potentially could go to prison and the company might find itself barred from doing business with the United States government.

The taint of bribery scandals in emerging markets could also have bruising financial implications for BAE. In regions of the world where bribe-taking has long been baked into business transactions — East Asia, the former Soviet Union, Africa and Latin America, for example — legal investigations could make the company vulnerable as those areas become more desirable for military contractors looking for new clients.

For companies that have not adapted to the new legal landscape, the consequences are becoming more serious. This year, Baker Hughes, the oil services company, paid a record $44 million fine after admitting that it had bribed officials in Kazakhstan, Angola, Russia, Nigeria and elsewhere.

Halliburton, an oil services giant that was once headed by Vice President Dick Cheney, has disclosed that it is facing an F.C.P.A. investigation into its activities in Nigeria before, during and after Mr. Cheney’s tenure at the company. A spokeswoman for the vice president declined to comment. Halliburton did not respond to an interview request.

Aon, a major insurance broker, recently disclosed in corporate filings that it is the subject of an F.C.P.A. inquiry but declined to provide further details. Last month, the Willbros Group, an oil services company, said it would pay $32 million to settle an F.C.P.A. charge related to bribes paid in Nigeria and elsewhere — including $1 million handed over in a suitcase. A former Willbros executive who pleaded guilty to federal charges in the case faces a prison sentence of as much as five years. While executives involved in paying bribes can be jailed, foreign officials cannot be charged under the law.

“The F.C.P.A. has now surpassed Sarbanes-Oxley for being at the nerve endings of corporate general counsels and executives,” says Daniel E. Karson, executive managing director at Kroll Associates, a private investigative firm that conducts due diligence and background investigations for corporations and other clients.

Last week, Alice Fisher, assistant attorney general and head of the Justice Department’s criminal division, traveled to Rome for an anticorruption conference marking the 10th anniversary of the O.E.C.D.’s adoption of anti-bribery regulations, which parallel the Foreign Corrupt Practices Act.

Ms. Fisher, who declined to comment on the BAE case, said her F.C.P.A. caseload this year was running at twice last year’s pace, and she predicted that the upward trend would continue in 2008. She said she planned to press her overseas law enforcement counterparts in Rome for continued collaboration to combat corporate bribery.

“I don’t take many foreign trips, but this is important to the overall program,” she said. “There are a lot of countries that can do more.”

ONE of those countries, ironically, is Britain, usually among the closest of allies of the United States. Historically, according to documents in British government archives, Britain, long dependent on foreign trade, has resisted anticorruption efforts because it believes that they undermine the country’s business interests abroad.

After a series of articles in 2003 and 2004 in The Guardian, the British newspaper, about possible bribes and other improprieties involving BAE, the Serious Fraud Office of Britain started an official investigation. But after the Saudi government strongly objected to the investigation, Mr. Blair, then the prime minister, ordered it halted late last year on security grounds.

“The result would have been devastating for our relationship with an important country with whom we cooperate closely on terrorism, on security, on the Middle East peace process,” Mr. Blair said at a news conference. “That is leaving aside the thousands of jobs which would have been lost, which is not the consideration in this case, but I just point it out.”

The British High Court recently ordered a full judicial review of Mr. Blair’s decision not to pursue the BAE investigation. Meanwhile, the Justice Department’s BAE investigation has benefited from cooperation by law enforcement agencies elsewhere in Europe, according to people with direct knowledge of the inquiry. A decade ago, such cooperation would have been impossible because many European governments considered corporate bribery tolerable — and in the case of Germany, even made it tax-deductible, as “schmear gelt,” or “grease money.”

Since then, German authorities have become particularly aggressive in pursuing possible corruption violations, as illustrated through their continuing investigation of Siemens AG, the German industrial conglomerate. Although some American companies once actively lobbied to water down the F.C.P.A., arguing that it made it hard to compete overseas, many corporations here have now thrown their weight behind it in the belief that it can be used to prevent competitors from indulging in bribes. So anti-corruption efforts in the United States are now gathering legal steam.

“There has been a dramatic increase in the resources dedicated to enforcing the law by the Justice Department and the F.B.I., and even more important, a strong public commitment to compliance as well as enforcement,” says Peter B. Clark, who oversaw F.C.P.A. prosecutions at the Justice Department from the enactment of the law in 1977 until his retirement two years ago.

According to top Justice Department officials, strengthening F.C.P.A. enforcement isn’t only about getting American companies to clean up their act or punishing foreign enterprises for breaking domestic laws. It is also part of an attempt to deal with the long-term impact that bribery has on emerging markets.

“Corruption undercuts democracy, stifles economic growth and creates an uneven playing field for U.S. companies overseas,” Ms. Fisher says. “We are facing transnational crime all over the place.”

Any company with an American connection — a listing on the New York Stock Exchange, for example, or the use of an American bank account to transfer suspect payments — opens the door for prosecution under the F.C.P.A. For example, the Justice Department began investigating BAE’s payments to the Saudi royals, and Prince Bandar in particular, this year, after it learned that BAE deposited billions of dollars in such payments in American banks.

Among those institutions was Riggs Bank. Riggs, a subsidiary of the Riggs National Corporation, paid $41 million in federal penalties in 2004 and 2005 to settle a high-profile federal investigation of money-laundering violations before it was taken over by the PNC Financial Services Group. A PNC spokesman declined to comment directly on the BAE matter, but said that any possible transgressions occurred before the takeover and that Riggs was required to divest units catering to diplomats and foreign clients before the buyout.

ON a rainy morning this August, an unusual visitor arrived at the Justice Department’s headquarters in Washington. Although a British citizen, he had, for security reasons, taken a circuitous route via Paris to meet with senior Justice Department prosecutors, F.B.I. agents and members of the criminal division of the Internal Revenue Service.

During two days of questioning in a windowless conference room, that visitor, Peter Gardiner, detailed how he had helped BAE disburse millions to the Saudi royal family to pay for everything from luxury travel to female escorts, according to people with knowledge of the meeting who insisted on anonymity because they were not authorized to publicly discuss the case.

Much of the money Mr. Gardiner said he had disbursed went to cover expenses racked up by Prince Turki bin Nasser, head of the Saudi air force and a major BAE customer. Other funds were earmarked for the honeymoon of Prince Bandar’s daughter. Mr. Gardiner owned a travel agency that catered to the needs of BAE and its Saudi customers, and his information about their dealings has been known to British authorities for some time. It was also a primary basis for some of The Guardian’s articles about the matter.

But the meetings, on Aug. 20 and 21, signaled that the Justice Department had moved beyond asking London for assistance with the investigation to interviewing witnesses and collecting documents directly, based on the belief that BAE’s payments may have violated United States laws banning international bribery and money laundering.

When contacted for an interview about the meetings, Mr. Gardiner said that the Justice Department had asked him not to comment.

In September, about 10 months after Mr. Blair quashed the BAE investigation in Britain, the company won a new contract to supply Typhoon jets to Saudi Arabia; the deal could amount to $60 billion over the next 25 years, according to trade publications.

By the time Mr. Blair shut down the British investigation late last year, however, the Justice Department was already aware of BAE’s practices. As far back as July 2002, representatives from the State, Justice and Defense departments, as well as the C.I.A., sat down in Washington with senior British officials from the Ministry of Defense to complain about suspected bribery by BAE in Central Europe, the Persian Gulf and South Africa.

Sir Kevin Tebbit, then Britain’s permanent under secretary of the Ministry of Defense, rejected the suspicions as baseless. American officials who participated in the meeting later nicknamed him Sir Topham Hatt after a character in the Thomas the Tank Engine children’s series because of what they said was “his almost haughty disdain for the allegations of bribery involving BAE” and the manner in which he challenged them to detail evidence of wrongdoing.

Mr. Tebbit, now retired, declined to comment and referred questions about his interactions with American officials to his former employers in the Ministry of Defense. The ministry declined to comment.

The meeting with Mr. Tebbit came after the United States Defense Department, along with the military contractors Lockheed and Boeing, formally withdrew from a competition to sell fighter aircraft to the Czech Republic in 2001. A letter written by Lt. Gen. Tome H. Walters Jr., then head of overseas sales for the Pentagon, to the Czech foreign minister said that there was a “lack of transparency” in the negotiations. The letter also cited a conclusion by the United States government that competition for the contract was not above board. The contract was subsequently awarded to BAE and its Swedish partner, Saab.

In an interview, General Walters, now retired, said that the problems in the Czech Republic followed similar problems trying to sell American jets to the Hungarian government. BAE secured the Hungarian contract as well. American officials say they believe that the Hungarian and Czech governments were influenced by payments. They cite a C.I.A. briefing during which they were told that BAE paid millions of dollars to the major political parties in Hungary to win the contracts there.

BAE said it is unaware of any investigations of the company in Hungary. “BAE Systems has very strong policies and processes in place which it is clearly committed to communicating to its employees and advisers,” a spokesman said. “Any action which is unlawful, dishonest, harmful to others or otherwise against our policies, is unacceptable.”

Although Mr. Gardiner’s cooperation signaled a possible escalation in the American investigation, those with knowledge of the inquiry say British authorities are resisting requests from Washington for help. Representatives of the Home Office of Britain, which handles these requests, have told Parliament that they have yet to decide whether to cooperate.

Despite tensions between the United States and Britain over the matter, Swiss law enforcement authorities have decided to cooperate with the Justice Department investigation, according to a person with direct knowledge of the matter. The Swiss are likely to soon begin sharing records of financial transactions and bank accounts with American prosecutors. That will be crucial to charting what law enforcement officials describe as a flow of dollars from BAE to a network of company agents and public officials in Saudi Arabia, South Africa, Hungary and the Czech Republic.

So far, the American investigation hasn’t harmed BAE’s booming business with the Pentagon. This summer, Senator John Kerry, Democrat of Massachusetts, citing the inquiry, objected to BAE’s purchase of Armor Holdings, which makes armored Humvees and other military equipment, in letters to the Justice Department and the Treasury Department. But the Armor Holdings sale was completed in July for $4.5 billion.

DESPITE the new fondness for the F.C.P.A. in domestic law enforcement circles, the cases are notoriously complex to prosecute and are made even more so by the fact that many overseas jurisdictions are involved. Even in an era of increasing cooperation, internal politics in other countries can become roadblocks.

“The rhetoric has changed,” says Benjamin W. Heineman Jr., who was General Electric’s chief legal officer from 1987 to 2005. “Everybody says the right thing now, but what are they doing?”

Mr. Heineman praises the Justice Department’s efforts but says he is frustrated that the O.E.C.D. isn’t doing even more, especially in the BAE case. “They don’t powerfully name and shame the laggards,” he says.

The threat of an indictment under the F.C.P.A., more than financial penalties, is what worries most companies that may come under scrutiny as part of the Justice Department’s crackdown on bribery.

“No publicly traded company wants to be branded with the stigma of an indictment,” says David Zornow, who directs the white-collar criminal practice in New York for the law firm of Skadden, Arps, Slate, Meagher & Flom. “It’s potentially ruinous.”

Multinational companies competing in these countries are turning to law and accounting firms as well corporate investigators like Kroll to help them navigate through the F.C.P.A.’s regulations and to vet local partners in countries like China and Nigeria.

PricewaterhouseCoopers has doubled the size of its F.C.P.A. practice over the past five years. Deloitte & Touche has mobilized in a similar way. It says that when it scrutinizes companies for possible bribery problems, it looks for such red flags as tuition payments for the children of government administrators, property purchases or rentals from foreign officials or their relatives, and payments in exchange for information about competitor’s activities.

Lawyers with experience in F.C.P.A. cases say that gathering facts in such matters is never easy. Kevin T. Abikoff, a lawyer at Hughes, Hubbard & Reed who has represented several companies accused of running afoul of the F.C.P.A. in Nigeria, says that large companies typically cut employees loose once they are charged with a crime.

“It’s a rare person who says, ‘It was me; it’s my fault,’” he says. “There’s finger-pointing up, down and sideways.”

During the O.E.C.D. anti-corruption meeting in Rome last week, which celebrated the 10th anniversary of the organization’s treaty outlawing international bribery, its head, Angel Gurria, said that national security concerns — the reason Mr. Blair gave for terminating the BAE investigation in Britain — “should not be used” as a reason for quashing bribery investigations. He also voiced concern that anti-corruption efforts were in danger of weakening.

“Now I do not want to spoil the birthday party, but I do have to say that what we have achieved is still not good enough,” he added. “There will be big risks that countries will go back to doing ‘business as usual,’ including corruption. The only way to prevent this is to ensure that everyone plays by the same rules.”

Marlena Telvick contributed reporting.

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