The Problems in Dubai

The panic associated with the financial difficulties of Dubai’s government-controlled Dubai World is having ripple effects into commodities, developing countries, and other markets.  Such contagion seems to have become commonplace now, as the short-run interests of traders in worldwide markets are matched against the interests of long-run investors.  Predictably, the call is going out from Dubai for support from the United Arab Emirates.  Most likely that support will be supplied once the internal politics have been worked out.  Reputation risk, especially when solvency is at issue, is even more important when it comes to government sponsored firms than for subsidiaries and affiliates of private companies.

Will the spillover effects require action in the U.S. by the Federal Reserve?  The answer is, not likely.  US financial institutions are not exposed to Dubai to the significant extent that European institutions are.  Furthermore, discount-window and other borrowing facilities are already in place, should liquidity be needed.  Since the dollar is benefiting temporarily from this crisis, reversing its recent declines, there is no likelihood of or need for a currency intervention by US authorities.

Short-term, there is a movement away from the Middle East, but that is not likely to carry with it negative spillovers to Asian markets whose fundamentals haven’t changed.  Developing-market contagion is not the problem it was during the Asian crisis.  Markets now have a much better idea about the relative strengths and weaknesses of developing countries and don’t treat them as a group, as was the case in the past.  Given the extremely large credit exposures of UK and European banks to Dubai, their stocks are likely to take a hit until more progress is made on credit-risk transparency and loss recognition.  An interesting commodity-currency play suggests itself, since oil sales will likely be the source of funds to support credit losses in Middle East institutions, combined with an appreciation of the dollar relative to the euro.

Longer-term, US fundamentals haven’t changed, and the dollar is likely to continue to drift downward relative to other currencies.  Asian economies haven’t changed either.  The big effects will be on fund flows to investments in those Middle Eastern countries where excessive spending, combined with unfavorable demographics and government policies, imply a substantial increase in risk.

Asia trip, Dubai news, T-Day wish!

We’ve spent two weeks traveling almost 20,000 miles and visiting three cities: Tokyo, Hanoi & Singapore.  Meetings included quality time spent with central bankers, investors, pension fund managers, academics, commercial bankers, and others.  It has been a whirlwind and well worth the fatigue. 

We will summarize the observations with some key points.

Our trip confirms that the Asian emerging-market story is real and is likely to accelerate.  This is not just a China story, and folks who view it that way are making a mistake.  China is the largest player in the region, but the others need respect.  This conclusion is true for newly emerging economies and markets like Vietnam (devaluation of currency notwithstanding) and for seasoned and established ones like Singapore. 

At Cumberland, our global portfolio strategy maintains an overweighted position on non-Japan Asia.  Asian emerging markets are a terrific story.  This is true both for the fledgling ones and for the largest one, China.  There are many in the region and they need to be examined separately. We will be going back to Shanghai and Hong Kong in January for another look at the region and to examine how US policy is playing out there.  Or should I say, how US policy is failing miserably to play out there.  More on that below, but first let’s wrap up the Japan report.

We are still not ready to take the Japan weight to a bullishly overweighted position.  That may come after next summer’s Japanese elections, and if the new government is strong enough and determined enough to change policy.  Both the electoral outcome and the willingness to change policy are open questions.  It is the present policy that keeps the yen very strong and keeps deflationary forces at work in Japan.  Government officials know it but are not yet compelled to change.  Many there believe that a stable price level or a slightly falling price level is a better choice than an inflation-prone policy.  Many reject the Bernanke approach of massive monetization.  They heard his lecture many years ago and have taken a different view.  We shall see what unfolds now that those in Japan have the opportunity to watch Bernanke apply the policy that they rejected.  In sum, the final chapters of this book on Japan and deflation and on QE and inflation are not yet written.

Now to the regional takeaway from our trip

We believe that few trust the United States.  This is obvious in private conversation.  And it is clear to all that confidence in the dollar is low.  This is mostly mentioned only in private. 

In public there is quiet response when the Treasury Secretary of the United States utters words about a strong dollar.  Asians have heard that for years and with the many different accents of the various Treasury Secretaries.  Geithner would serve the country better by ceasing to mouth the same words that his predecessor Snow and others used.  He is not believed.  Frankly, in some circles he is actually seen as an incompetent political hack.  He is blamed by some for the insufficiency of the New York Fed under his presidency to supervise the primary dealers that failed — Countrywide, Bear Stearns, and Lehman.  And the ethics issues surrounding the NY Fed under his tenure are viewed as appalling; this continues to surface in private conversations.  Some folks are puzzled about why Obama maintains his support for Geithner.  Some just attribute it to the President’s inexperience as a leader. 

My takeaway is that our present Secretary of the Treasury is seriously and sustainably injuring the image of the United States.  He has lost credibility.  His actions are real and they impact markets.  My conversations with those who are attempting to market GSE securities to Asians and getting rebuffed are validation enough for me on this point.  When the Fed stops buying GSE mortgage backed securities, this reality will hit the markets in a re-pricing of that asset class.  Spreads are going to widen.

The American federal budget deficits are worrisome everywhere.  Policy promises from Washington to reduce them are greeted with great skepticism.  Often they are privately described as American arrogance.  Publicly, Asians are very polite and do not often subject their guests to embarrassing criticism.  Privately they are quite candid.  In my view they are correct: America is arrogant and seems to pretend that it is still the best and most trustworthy financial and capital market in the world.  There is no basis for the US to have such a view of itself.  We have squandered our reputational capital as a financial center leader.

This recent financial crisis is quite different from its predecessors.  In 1997-1998, the Asian currency crisis and Russian ruble collapse wasn’t viewed as America’s responsibility.  We didn’t cause it.  We didn’t cause the 1994 Mexican peso crisis either.  And while we contributed to the tech-stock bubble, we weren’t the only ones to do so.  But the last two years of Madoff scandal, federal agency failure, rating agency restatement, bond insurer demise, Fed primary dealer (Lehman) bankruptcy, and mortgage securitization deception (CDOs) are all Made in the USA.  We led the world into crisis.  We caused it.  And we haven’t fixed it. 

To Asian eyes it appears that this American-made tragedy continues to this day.  Proposals for reforms in America are greeted abroad with skepticism and doubt.  The political structure of America is seen as a weakness.  And confidence abroad is falling, just as it is at home.  

Some will view our conclusions as harsh.  Maybe so.  But the lists of American-made errors that have cost the world billions are factually correct.  Say what you want, but Madoff WAS regulated by the SEC, Fannie IS a federal agency, and AAA used to be a respected rating that that has turned out to mean nothing. 

This is not just a Democrat or Republican critique.  Both political parties have failed the country miserably and both are seen as contributing to the mess, from the Asian perspective.  Personally I agree.  Our Washington leadership under this president and under the last one has proven to be impoverished.  The money influence in politics seems to have overwhelmed any sense of centering ethics.

We come back from this trip more determined than ever that investors must protect themselves.  The starting point for that defense is an old principle: diversification of risk.  To do that they must take a global view.  And Americans need to be very critical of US policy and distrusting of their politicians. 

Cumberland’s recommendations include worldwide diversification of security risk and worldwide diversification of currency exposure.  Favor spread product in the fixed-income area and avoid US Treasury securities.  View all positions as subject to change in strategic ways.  Require independent verification of credit rating opinions and do not depend solely on rating agencies.  And be prepared to change course as events unfold.  Act prospectively and preemptively and not reactively. 

Lastly, separate the silos of investment approaches.  This may seem self-serving to say, but we believe that the separation of investment management, brokerage, and custody is needed to insure safety.  At Cumberland that has always been our view.  Not one of our managed client’s accounts had any money exposed to Madoff, Stanford, or any others of their ilk.  Separate silos prevent that risk and allow for audit trails. 

Cumberland does not take custody of client’s assets; they are held by investment firms or banks.  Cumberland believes that a separately managed bond account must be able to “trade away” from the firm where it is domiciled and in whose “wrap” program it is placed.  We will not manage an account where we cannot trade independently.  

We are finding this view acceptable worldwide.  As the globe grows, investors and financial professionals are becoming more and more skilled at their work and less and less trusting of governments and policies.  They have good reason, in our view.  This approach works for Asians and needs to be the foundation of investing for Americans.

We are often asked if we are optimistic about the future.  For the world as a whole the answer is yes.  Most of the world is seeking growth and peaceful economic outcomes that enhance the quality of life.  

We are less optimistic for the US.  Our longer-term trends are working against us.  We have squandered our political capital and are neglecting the education of our youth.  We practice polices of subsidy and deceit instead of self-determination and transparency. 

No, we are not about to abandon our country; we have deep respect for our entrenched American traditions of freedom.  But we are directing the harshest of criticism against our politicians of both parties.  They are equally accountable and responsible for the mess we have.  If only we could limit them – but the citizens are not yet angry enough to do that. 

When we Americans have had enough, the voters will throw many of the bums out and start over.  That will be a great day of celebration in America.  We expect that others in the world will join the celebration.  I hope that day arrives sooner, not later.  By the way, financial markets will anticipate this change and be moving higher before the votes are actually counted.  Markets measure change with sensitivity and find the pulse of that change before events are widely known.

Speaking of events, we built a little cash reserve in the US stock market accounts in the run-up to the Thanksgiving holiday.  The Dubai World debt crisis has contagion risk.  Insolvency cannot be permanently papered over by excess liquidity, not in the Middle East nor, for that matter, in America.  In our global portfolios we are underweight the UK and have zero ETF exposure to the Persian Gulf states.  Readers are directed to the Gartman letter.  Dennis Gartman identified this Dubai risk well in his Thanksgiving Day missive.  At Cumberland, we want to see the market make the adjustment for this risk before we resume a fully invested posture.  

In America we have much to be thankful for.  Our great freedoms are our strength.  Our ability to speak and write with openness and to articulate diverse views is a powerful force.  Our press is permitted to investigate and disclose.  Our courts are honest and our legal systems include entrenched respect for individual rights.  World travel confirms that for me every trip.  I worry for my country but I still love it.  

Happy Thanksgiving.  Stay safe.

Cumberland Advisors Announces Growth and Expansion with Florida Office

Vineland, NJ – Cumberland Advisors, based in Vineland, New Jersey, announced its expansion with the opening of an office in Sarasota, Florida.  Two years of record growth and the growing number of Florida clients prompted the office expansion.  “Our firm has had two years of record growth, is at an all-time high in employment and much of the growth occurs in Florida and other states. We will be in both the New Jersey location and the Florida location with staff and functions in each,” said David Kotok, Chairman and Chief Investment Officer. 

Beginning January 1, 2010, Cumberland Advisors will open the Florida office to better serve its Southeast U.S. and national clients.  Contrary to media reports, the firm will also continue to operate its Vineland, New Jersey office to serve its many New Jersey, Pennsylvania, and New York clients and to further grow its East Coast business. The firm has clients in 43 states and several countries. 

Cumberland Advisors has developed a national and international reputation for financial market expertise and independence.  The firm manages $1.3 billion in separate accounts for both fixed income and equity accounts (using only ETFs). In addition to individual portfolios, Cumberland Advisors also consults for institutional clients on portfolio specifics and macroeconomic and financial market strategies.  The firm’s largest institutional client is a $70 billion pension system and its largest single institutional portfolio is over $500 million.

For additional information, contact Michael McNiven at (856) 305-8576.

ABOUT CUMBERLAND ADVISORS – Cumberland Advisors is an independent, dedicated fee-for-service only asset manager.  With an office in Vineland, New Jersey and another in Sarasota, Florida beginning January 1, 2010, Cumberland manages over $1.3 billion in fixed income and equity portfolio assets for individuals, institutions, retirement plans, government entities, and cash management portfolios.  Since 1973, Cumberland has emphasized long-lasting relationships, individual accounts, and continuous personalized discussion among clients, their consultants, tax advisors, and the firm. Cumberland AdvisorsSM is registered with the SEC under the Investment Advisors Act of 1940.


Michael McNiven, VP & Investment Advisor Representative

Cumberland Advisors

Phone: (856) 305-8576

FAX: (856) 794-9113  


Is Contingent Capital the Answer to the Bank Capital Problem?

Lloyds Bank has announced the successful exchange of some outstanding subordinated debt for a new debt instrument that would be converted to common equity if its capital ratio declined below a critical value.  Specifically, in the Lloyds proposal, the security would convert when its Tier 1 capital ratio fell below 5%.  The instrument is called contingent capital and has recently become the latest fad among regulators both in the US and abroad.  It has even been incorporated into Senator Dodd’s recently introduced financial regulatory reform bill as a means to bolster bank capital positions.  Sounds like a good idea, right?  Especially if an institution can be recapitalized at no cost to the taxpayer.  The instrument is billed as providing an additional buffer should an institution fall on hard times.  But does it really and is it the panacea that regulators see?

First, we need to recognize that there are really only two types of bank liabilities: insured (or federally guaranteed liabilities) and uninsured liabilities that might have to absorb losses in the event of a failure, depending of course upon their priority in bankruptcy.  Prior to the current crisis, it was relatively easy to identify de jure those liabilities that were federally guaranteed.  Now it is not so easy, either for banks or for non-bank financial institutions, because many governments have stepped in and extended guarantees to all types of liabilities including transactions accounts, deposits , and virtually all debt – especially the debt of what are deemed to be systemically important institutions.  Now, rational holders of the debt instruments issued by large institutions – including uninsured deposits, subordinated debt, and non-subordinated debt – can be reasonably assured that in the event of a crisis they will be covered, even if those instruments weren’t covered de jure.  Unfortunately, what this does is to mute any incentives that uninsured creditors of large institutions might now have to exercise market discipline or to monitor the risk exposure of the institutions in which they have invested.  It means that an unfortunate legacy of the policies now in place is that only tangible common equity and certain categories of preferred stock unambiguously stand to lose should an institution fail.

For large institutions, regulators historically had counted qualifying subordinated debt instruments as a limited form of capital when it came to establishing capital adequacy requirements.  Debt, including subordinated debt, is a lower-cost way of getting additional loss protection into an institution, because of the tax deductibility of interest payments on that debt.  Subordinated debt, like uninsured deposits and other non-deposit liabilities, would stand to share losses in the event the bank failed and was closed, thereby providing some residual protection to the insurer.

Under the Basel Capital Accords, Tier 1 capital consists, among other things, of common equity, retained earnings, and certain non-redeemable, non-cumulative preferred stock.  The second level of capital, called Tier 2 capital, includes undisclosed reserves, revaluation reserves, provisions for loan losses, preferred stock not included in Tier 1 capital, and other hybrid instruments, as well as subordinated debt with a minimum maturity of five years.

Regulators, and economists, had hoped that expansion of subordinated debt might be one avenue for improving market discipline for large financial institutions.  In the U.S. that has now changed because of the short-term policy decisions made by FDIC, the Fed, and Treasury during the crisis to insulate virtually all large bank creditors from losses.  Enter contingent capital as the newest wrinkle.

In its current incarnation, contingent capital was developed by Professor Mark J. Flannery of the University of Florida.  The basic idea is that banks should be required to issue a debt security that would automatically convert to common equity when a pre-specified trigger is reached.  In his proposal, the conversion would be triggered when the market value of equity fell to a critical value, and the securities would convert to equity at a slight premium price to prevent short sellers from forcing conversion.  The instrument is designed to provide a way to delever and recapitalize a large banking organization, thereby avoiding the costly negative externalities to depositors, borrowers, and counterparties that a bankruptcy might entail.  At the same time the aim is to preserve market discipline and to internalize to shareholders the costs that might be associated with moral hazard and other risk-taking incentives.

Using a market-value trigger is especially important.  It avoids reliance upon GAAP measures, which historically have lagged changes in market values and provided a poor indication of an institution’s current financial health.  It also would limit the ability of management to engage in balance sheet manipulation.  Finally, it would prevent regulators from pursuing forbearance because it eliminats regulatory discretion in deciding when the trigger should be invoked.

Flannery considers in depth many other important design issues that won’t be discussed here, but they are also critically important, especially since more recent contingent capital proposals like the Lloyds issue contain serious and even dangerous design defects.  As is the case with most reform concepts, the devil is in the details, and the current contingent capital proposals are no exception.  For example, Lloyd’s contingent capital would be triggered by a decline in its Tier 1 capital ratio, which is a lagging indicator of financial strength, but also is subject to accounting manipulation and all the other flaws that have been noted by critics of the Basel capital standards more generally.  As the recent financial crisis has proved, institutions’ regulatory capital ratios can be positive even when they may be economically insolvent or have substantial unrecognized losses such that conversion might even wipe out the newly converted equity shares.  In fact, Flannery maintains that “Contingent capital driven by a book-valued trigger is virtually worthless.”

Another variant of the contingent capital proposal would incorporate a dual trigger feature — one that would not only rely upon an institution’s Tier 1 capital ratio but also would require a declaration by regulators that the financial system was experiencing a systemic crisis.  An instrument with such features would be a double disaster, by introducing regulatory discretion and politics into both triggers to the potential detriment of  equity holders, debt holders and taxpayers.

What needs to be recognized about contingent capital as it is currently being touted is that the conversion from debt to equity doesn’t bring new funds into an institution.  No new securities have been issued (Flannery would require, however, that any converted contingent capital be replaced).  Rather, all that happens is that holders of the contingent instruments are moved into a first-loss position along with current equity holders, whose interests have been diluted by the exchange.  We might better term the conversion contingent bankruptcy rather than contingent capital for this reason.  The conversion feature with the trigger is the way of orchestrating a reorganization of the capital structure of the firm without resorting to the traditional bankruptcy courts or standard resolution policies employed by banking regulators.  However, as typically structured, it does keep the existing management in place, although management replacement could be incorporated as a feature of the instrument.

Before such an instrument could or should become an additional element in the regulators’ tool kit, much deeper consideration of the design issues should be pursued.  For example, it is critical that the trigger not be a matter of regulatory discretion, and it should be market-based.  How the trigger should be structured is a matter warranting considerable study.  Neither of these features is incorporated in the Lloyds contingent capital securities.  Additionally, no one has addressed the issue of what kinds of institutions – financial or otherwise – would be required to issue contingent capital.  Then there is a matter of how a complex holding company would be treated.  The security doesn’t address the issues raised in the case of large cross-border organizational structures with multiple subsidiaries chartered in many different national jurisdictions.  Contingent capital in a parent company would not translate into capital in a separately chartered bank subsidiary, regardless of whether it was chartered in the US or another country.  Conversely, contingent capital securities issued by a wholly owned bank subsidiary would only dilute the parent company’s ownership interest, and might even result in a de facto spin off should the diluted ownership fall to minority status.  Since only legal entities and not the consolidated company can issue securities, where within the organization the contingent capital securities would be situated is important.   In short, we should beware of incomplete or fragmentary solutions to complex problems without careful vetting and discussion.

How would we view such a security from an investor’s perspective?  Again, it depends upon the price, instrument design, and where within the company’s structure the securities would be issued.  But at present, the instrument’s features, especially those that rely upon book-value measures and/or regulatory discretion, are likely to contain significant uncertainty, will probably be expensive and likely be miss-priced.

While we don’t have experience with a debt security that has a regulatory trigger, there is a close parallel in the form of the non-cumulative preferred stock that was issued by Freddie and Fannie.  As a specific example, Freddie Mac issued an 8.375% Non-cumulative Perpetual Preferred Stock, Series Z on Nov. 29th, 2007 at $25 per share.   These securities were issued long after the accounting troubles experienced by the GSEs and long after the mortgage market had gone into decline.  Trading was suspended on this issue when the government placed Freddie Mac into conservatorship.  Dividends were suspended and because the securities were non-cumulative, should dividends be resumed, investors can not recoup past missed dividends.  In effect, investors in that preferred stock issue have been de facto converted into quasi-equity holders and their shares are essentially worthless.  The securities closed on Friday November 20th, 2009 at about $0.97.  The losses in Freddie Mac keep rising, and the likelihood of it being able to restart paying dividends is close to zero.  These securities did not nor will they contribute to rebuilding the capital structure of Freddie Mac.

Markets aren’t dumb nor are they likely to forget the recent Freddie and Fannie experience should contingent capital certificates with government triggers come onto the market.  The securities are not likely to be liquid and, like the Lloyds’ issue, they contain significant regulatory and accounting risk.  Like other convertible preferred stock and trust preferred securities, they will certainly require a risk premium; and if these other securities are any guide, that premium will be on the order of a several hundred basis points.

I benefited from comments from Professor Mark Flannery and Larry Wall.

Mark J. Flannery, “No Pain, No Gain? Effecting Market Discipline via ‘Reverse Convertible Debentures’”, in Hal S. Scott (ed.), Risk Based Capital Adequacy, Oxford University Press, 2005.

Mark J Flannery, “Market-Valued Triggers Will Work for Contingent Capital Instruments,” Solicited Submission to U.S. Treasury Working Group on Bank Capital, University of Florida, November 6, 2009

In Fed We Trust by Robert A. Eisenbeis and Ellis Tallman

Ellis Tallman is the Danforth-Lewis Professor of Economics, Oberlin College, and was formerly Vice President, Federal Reserve Bank of Atlanta.

David Wessel’s book, In Fed We Trust: Ben Bernanke’s War on the Great Panic, is the definitive chronicle of the 2007-2009 financial crisis, but it is much more.  The book gives us an inside view of how policy making took place in response to the striking events. Wessel provides insights into the key players and decision makers, and conveys a very real sense of what they were thinking as those events unfolded.  In doing so, however, his account triggers serious questions about the Treasury/Federal Reserve decision-making process.  Here, we emphasize three serious flaws in the policy-making process that Wessel describes: the consistent lack of a plan and short-time horizon of the decisions, the insularity of the decision makers, and the apparent disregard for FOMC information-security rules governing meetings and associated documents.  We conclude by noting some oversights in Wessel’s account of the Great Depression and the Panic of 1907.

Lack of a Plan

The insider’s view of the policy making is the unabashed strength of this book, and Wessel provides an extensive chronology of how the crisis unfolded.  It is not a pretty picture.  His most telling observation is that the principals seem to have lurched from event to event without a plan, even after it should have been apparent that one was needed. 

The discussions among key participants – namely Chairman Bernanke, Secretary Paulson, then-president Geithner, and Governors Kohn and Warsh – seem rushed, from Wessel’s descriptions of them.  The policy discussions tended to focus on short-term problems, pushing off potential longer-run consequences of the policy responses as a matter of expediency.  The sense is that the participants expected each decision to be sufficient to return markets to normalcy; but of course, they were not.  The ad hoc, short-term nature of policy process, as described in the book, carried with it the risk that not all decisions would be good and would carry with them unintended consequences.  For example, the problems of exiting from many of the policies are now significant and have yet to be addressed. 

Wessel alleges that the policy makers continually underestimated the crisis and that there was no long-range planning undertaken from the time that the crisis initially erupted.  This should come as no surprise to anyone reading closely the financial press throughout the crisis, and yet it remains disappointing.  It is important to note that not all the decisions had the time constraints that surrounded the issue of the Lehman failure in the fall of 2008.  That event was preceded by almost a year of financial turmoil, serial reports of losses, failures or mortgage related institutions, and market disruptions that should have signaled to policy makers that something serious was at hand and that they weren’t simply facing a short-term liquidity problem. 

By now, it is apparent that the crisis was misdiagnosed as a liquidity problem when in fact it was a solvency crisis.  Funds didn’t suddenly dry up and markets did not stop functioning because there were no funds available.  Rather, because of the trail of losses and preceding events, financial markets finally became wary of the solvency of key counterparties, as the Bear Stearns episode clearly demonstrated.  This was long before the problems in Lehman Brothers emerged.  Market participants’ concerns, as subsequent events proved, were well-founded.  It took policy makers too long to recognize the capital deficiencies relative to the risk exposures of major primary dealers, which then left them with insufficient time to design resolution plans.  Most of the largest financial institutions – both domestic and international – proved to have inadequate capital.  Some failed, and many were bailed out by their respective governments. 

Wessel’s description of the decision-making process reminds one of a perpetual Chinese fire drill rather than a considered, analytic approach to the problems as they unfolded over time.  The latter implies a systematic plan, and the former implies a sequence of ad hoc responses to unrelated shocks. Even if an initial plan proved inadequate, the experience would have permitted corrections as events evolved.    And lacking a plan, it is harder to see if and when a decision was wrong.

Delegated and Concentrated Decision Making

The second issue that emerges from Wessel’s account is the insular and concentrated nature of the decision-making process, which excluded many members of the Board of Governors and FOMC.  Three governors and the president of the NY Fed apparently took on the decision-making responsibility for the central bank in the midst of the crisis. From the narrative, it seems as if this core group effectively froze out the remaining two members of the Board and FOMC members from both decision making and access to key real-time information. 

Why did it happen?  Under what authority did this happen?  One plausible answer is that the core group felt that the existing structure was too cumbersome to effectively coordinate policy among so many principals, and so they simply exploited a loophole in the law governing open and closed meetings of government agencies.  Let us explain.  Normally, there are seven members of the Board of Governors, so that a gathering of four would constitute a majority and could officially make decisions.  According to the 1976 Government in the Sunshine Act, which sets out the rules meetings of  federal governmental agencies, official Federal Reserve Board meetings in which policies are considered must be announced in advance and,  at a minimum, an agenda must be provided,.  For this reason, only three governors can get together in the same room without it constituting a “meeting”  and invoking the provisions of the Sunshine Act.   But during the entire crisis there have only been five governors on the Board, with two vacancies.  (David Kotok has written extensively on this issue in previous commentaries.)  Thus, the gathering of the three governors in the meetings that Wessel describes meant that while not technically meeting the legal requirement for a meeting, the three de facto constituted a majority of the sitting governors and could actually make decisions.  Coordinating policy with the entire FOMC would have been more cumbersome and likely would have also required that a written transcript be prepared.  It could be that the core principals felt that a smaller group would make decisions more quickly, and the sense of such a desire for quick decisions comes across in the narrative.  Nevertheless, one can’t help but feel that it might have been beneficial to have been able to tap the broader experience and expertise of the Federal Reserve Bank presidents, especially since so many of the key principals making the crucial decisions were relatively new to their jobs. 

The Sanctity of FOMC Meetings

From the perspective of former senior officials of the Federal Reserve System, the details that Wessel reports about specific material in confidential FOMC documents and discussions that took place during FOMC meetings are especially discomforting.  FOMC security is governed by the FOMC’s Program for Security of FOMC Materials, which is a classified program that defines the security levels and handling of FOMC-classified documents.  The Program also sets out rules for how many people can have access to such documents.  At one time, only 10 people at each reserve bank (with the exception of New York and the Board) could have access to the Bluebooks, which contain the policy options presented by the staff to the FOMC.  The Bluebooks receive the highest level of  security classification.  The procedures also require detailed record keeping and govern storage and delivery of both hard-copy and electronic documents. 

Most importantly, it is also clear in the Program to every attendee that what goes on in that board room at the Board of Governors stays in that room until the transcripts are made public five years later.  In the past there have been a few leaks.  When that happened, staff who attended the meetings, as well as bank presidents, and presumably Governors, were interviewed under oath by the FBI in one case and by a representative of the Board’s Inspector General in another case in an attempt to smoke out the source of the leaks.  The penalties for divulging classified information are extremely severe and might even include criminal charges.

Against that background, the kinds of candid conversations that Wessel had and divulged in his book are indeed surprising.  There are at least a dozen revelations of what went on at various FOMC meetings, who said what, and even what was substantively covered, that rise to a level of severity far above that which triggered investigations by the FBI and Inspector General during the Greenspan era.  One might deduce by simply examining historical Bluebook documents released on the Board’s website that the staff typically offers three policy options for FOMC consideration at each meeting.  So in describing that process Wessel is merely drawing on public information. However, Wessel indicates that in one meeting during the crisis there were actually four options presented, and he describes what some of those options were.  Either there have been significant revisions in the Program for Security of FOMC Materials in the past couple of years or there is now blatant disregard, for whatever reason, of the rules and sanctity of the meetings.  One could view this as another example of how the rules are now being bent at the Fed.  In the near term, these revelations may further damage the credibility of both the FOMC and the Federal Reserve.  It certainly weakens the Federal Reserve’s arguments against additional Congressional auditing of Federal Reserve activities.  After all, if FOMC participants can freely talk to the press in violation of their own security rules, surely Congress has a right to know what is going on as well.

Prior Financial Crises: 1907; The Great Depression vs. Depression 2.0 

Wessel devotes Chapter 2 to describing what he believes are parallels between financial crises of the past and present.  In the interest of historical accuracy, even if it appears that we are nitpicking,  it appropriate to point out a couple of factual oversights.  In the second chapter of the book Wessel mischaracterizes key events during the Panic of 1907.  Specifically, he notes that the suspension of Knickerbocker Trust on October 22, 1907, after several days of depositor withdrawals, was the catalyst for the onset of that crisis. Wessel refers to the Knickerbocker Trust as the “Bear Stearns” of its day, claiming that Knickerbocker had lent heavily to the copper speculators, who failed in an attempt to corner that market and brought that firm down, just as Bear Stearns’ mortgage activities brought it down.  But in fact, such allegations about Knickerbocker have never been substantiated, and Wessels may have drawn upon a flawed analogy.  Bear Sterns’ problems were of its own making and not due to the actions of its borrowers.  In discussing Knickerbocker’s failure, Wessels also suggests that Benjamin Strong, then a Morgan employee who was asked by Morgan to inspect the books of the trust company, said that Knickerbocker Trust was insolvent.  Rather, Strong said that he was unable to determine whether it was solvent or not, a subtle but important difference.  That uncertainty parallels the uncertainty that market participants apparently felt about counterparties during the current crisis.  Finally, in contrast to Bear Stearns, which was rescued, Knickerbocker Trust suspended operations but eventually reopened as a going concern in March of 1908.  Ironically, the corrected analogy is likely a closer parallel than the one Wessel draws.  It is precisely the lack of clarity about financial-market solvency in 1907 that parallels the opacity that existed in 2007-2008. 

Regardless of perspective, we do not really know how close the financial market came to collapse in 2008.  Whether letting Lehman Brothers fail was good policy or not, it is clear that timely resolution is critical when systemic issues are of concern.  If policy makers, present and future, draw their insights from past attempts to alleviate crises, they should distinguish the successes from the failures during those episodes.  Allowing Knickerbocker Trust to fail was likely a mistake, and one that arose from the lack of timely information about its solvency to the existing lender of last resort at the time (Morgan).

In another section, Wessel suggests that the Federal Reserve System’s creation was largely based on an earlier plan written by investment banker Paul Warburg.  The statement overlooks the overarching point that the Federal Reserve Act was not the work of one person, but was in fact the outcome of several years of careful research, discussion, and debate.  In particular, the National Monetary Commission and its proposal for banking reform, named the National Reserve Association, did incorporate many of Warburg’s ideas.  But Wicker (2005) emphasizes that the Federal Reserve Act bore a striking resemblance to the National Reserve Association legislation.  More importantly, the process was completed nearly five years after the Aldrich-Vreeland Act created the commission to study the reform of the monetary system.  The larger point about the time taken to appropriately reform the financial and monetary system is especially relevant today, as the Congress seems to be in a great rush to reform our financial regulatory system in response to the current crisis. 

Wessel’s treatment of the Great Depression era is essentially in accord with the standard views regarding that period.  There are two minor points of difference, however.  First, some of the Reserve Bank presidents (governors, as they were then called), most particularly Eugene Robert Black of Atlanta, were consistently supporting the extension of liquidity, rather than policies to enforce the gold standard.  It was this policy that Friedman and Schwartz document and that resulted in a one third contraction in the U.S. money supply, thereby exacerbating the depression.  

Bottom Lines

Wessel’s book confirms that the process of saving the financial system was, to no one’s surprise, ad hoc.  Further, the decisions were imperfectly informed by the principals’ perceptions of what was actually occurring.  Clearly, Chairman Bernanke understood the big risk of a financial meltdown and made bold moves to ensure that we didn’t experience another Great Depression.  President Geithner, now Treasury Secretary Geithner, is described as an interventionist whose main concern was the short run and who was willing to deal with the unintended consequences as they arose. Finally, Secretary Paulson seems to have been solely a markets person, long on the bravado associated with a deal maker and short on the analytics required to formulate good policy.  

Whether all the actions taken were necessary we will never know, because we can’t observe what might have been had other policies been followed.  But it is clear that the process of dealing with the crisis might have benefited from additional inputs and analysis by people who held responsible positions within the Federal Reserve, but who, for whatever reasons, were not actively involved in the policy-framing process.  Perhaps in the debate that surrounds regulatory reform of the financial markets, the basic management issues of decision-making process design and planning should become a priority.  If not, then we may in the words of Yogi Berra experience déjà vu all over again.

We would like to note that we benefited greatly from the comments of Kenneth Kuttner who is the Robert F. White Class of 1952 professor of Economics, Williams College.

Good Morning, Vietnam!

Robin Williams’ movie scenes are nothing like modern-day Vietnam. At 6 AM the streets are already teeming with people, scooters, buses and cars. Many Hanoi city folks gather to exercise in the early morning. Badminton games are everywhere and exercise groups of all types are ubiquitous, almost as ubiquitous as the cell phones.

By 8 AM the workday has commenced and the traffic is chaotic but not truly a “jam.” Somehow it works. There are 3 million scooters in this city of 6.5 million people. Many intersections have neither stop signs nor traffic lights. There is a remarkable order in the how the scooters and pedestrians and buses all seem to accommodate each other. Ask anyone who has been here and they will describe this cacophony to the reader who hasn’t yet put Vietnam on the top of the list of places to visit.

Vietnam is an emerging-market success story. Our GIC (Global Interdependence Center, delegation has visited the stock exchange, where 400 listed companies now trade with a combined market cap of 50% of GDP. We met privately with the chairman of the VN version of the Securities and Exchange Commission. They were formed in 2007 and are dealing with the growing pains of rapidly expanding private-sector markets in a newly emerging country. This looks like a mini-China of a few years ago. Under present plans there will be 1500 companies trading soon, as the government sheds its state-owned industries and privatizes the economy. There is one Vietnam ETF in the US. It was launched in September and bears watching closely. The issue is that half of its weight is in the financials, and therein one finds an ongoing global problem. It also has limited liquidity because of newness. Cumberland hasn’t bought it yet, but it is on the watch list for future positioning in our global portfolios.

Back to Hanoi. Segue to history.

Bill Stone of the Philly Fed is in our delegation. He served in South Vietnam in 1970. I was lucky enough to be assigned elsewhere by the US Army in the 1960s. Our group visited the “Hanoi Hilton” and shared some thoughts about the experience. By agreement, Bill will speak for himself; the following impressions are mine alone.

The visit to war history here is sobering. There is the photo of John McCain on his return visit and another of him lying on a stretcher while he was a prisoner. There are other powerful photos. And there is the story of the war told through the Vietnamese lens. They call it the American War; the obverse of what we call the Vietnam War. The Hanoi Hilton was originally built by the French to be a prison for Vietnamese dissidents. VN war history shows that VN treated their American prisoners better than the Vietnamese were treated by their French occupiers.

We also visited the war museum and saw the defeat of the French in the 1950s. In the next section, Dien Bien Phu history was followed by the memorial to the defeat of the Americans. Yes, we Americans were resoundingly defeated.

In my view and as a retrospective, we were misled by our politicians. There are so many questions unanswered. What if Eisenhower had responded positively to Ho Chi Minh? Would HCM have sought out the communist Russian alliance, or was that his last resort to escape what had been brutal French occupation and colonization?

Remember, this history here is told through the Vietnamese lens. It is clear that the internal story of Vietnam is one of repelling conquest by China or France or America or others. Vietnamese youth are taught that they have always resisted the invader and that they have never aspired to conquer others. That is the first message one hears here.

The second, and my personal one, is a feeling of good luck. I wasn’t sent here. I didn’t die here. Many Americans were not and are not as lucky. “There but for the grace of God, go I” has resonance to this writer as he stands and looks at the history with his own eyes.

Lastly, the sense of the futility of war is very powerful here. Why are politicians so engaged in these acts of madness? Was Kennedy convinced because the southern part of the country was dominated by a Roman Catholic minority in power, and they prevailed on his religiosity and that got us into the Vietnam War? Did the so-called Harvard brain trust really think they were making the world safe for democracy by expanding the Vietnam War, as we call it? Did anyone believe that bombing Hanoi would lead these people to capitulate, after they had resisted invaders for several thousand years? Did they take the time to understand history?

And lastly, the debate in our group centered on American policy as we presently know it. President Bush’s war is now becoming President Obama’s war. We discussed the parallels and differences between Vietnam then and Afghanistan now. Has anyone throughout history occupied and successfully pacified Afghanistan? Will that be Obama’s failure? Does the “domino theory hold with Pakistan?” It certainly didn’t hold in Southeast Asia.

Personally, I expect Vietnam to be a booming emerging market. These younger folks do not want war. They have moved from bicycle to scooter, from hand writing notes to cell phones. They do not want to lose what they have and they reject the violence of the past.

Can we find a way to introduce that notion of stakeholdership elsewhere in the world? In Afghanistan? In Iraq or in Iran? I am convinced that the task is enormously difficult and fraught with many obstacles. But it is the noble purpose of the GIC to try to avoid war by developing stakeholders who are invested in the peace. We do that in economic and financial terms. That is why we came to Vietnam.

The trip was well worth the effort. Come see for yourself.

We finish with meetings with the Finance Ministry here, and then off to Singapore for the public conference that GIC is holding in partnership with the University of Chicago. Readers may find me as guest host on CNBC’s Worldwide Exchange at 5 AM New York time on Wednesday morning. Safe journey to all. For now we wish you Tam Biet.

Is Restricting Pay the Silver Bullet?

Financial institution regulators around the world have coalesced around the idea that the way to control excessive risk taking is to restrict bankers’ pay. In part they are responding to taxpayer ire at their having put billions of dollars of rescue funds into financial institutions, only to see those institutions pay what are viewed as outlandish bonuses and incentives to senior executives, traders, and other key employees. That outrage is understandable. But the key question is whether high salaries and incentive pay encouraged increased risk taking that played a significant role in causing the current financial crisis, or is that compensation simply an example of a few talented executives capturing economic rents? The prime example of such economic rents is the salaries paid to professional athletes, which by most standards might be viewed as excessive. With few exceptions (Roger Staubach who became a real estate magnate and Roger Penske who became a successful Indy car owner and truck rental entrepreneur are two notable exceptions) professional athletes earn high salaries because of a unique skill, and many would be hard pressed to earn more than a small fraction of that in their next-best job alternative. It is unlikely that there is a unique skill to justify such rents in the financial services industry, so it is worthwhile to examine closely the role that the structure of compensation has played in the financial crisis.

A recent NBER working paper by Rene Stultz and Rudiger Fahlenbrach carefully investigated whether the extent to which bank and investment bank CEO compensation was aligned with shareholder interests played a role in the financial crisis. They find no support for the idea that CEOs took risks at the expense of shareholders. What they did find was that risk taking was somewhat greater the more that CEO and shareholder interests were aligned. They interpret this finding as evidence that perhaps institutions were taking risks at the expense of taxpayers and the FDIC. Other studies point out how CEO compensation is structured so that executives stand to gain more on the upside when good results are obtained than they stand to lose when bad results occur. (See for example Bebchuk, Lucian A. and Spamann, Holger, “Regulating Bankers’ Pay” (October 2009). Georgetown Law Journal, forthcoming; Harvard Law and Economics Discussion Paper No. 641. Available at SSRN: The studies also point out that even when bankers’ pay is aligned with shareholder interests, those interests may not be aligned with societal interests (read: moral hazard behavior may shift risks to taxpayers). But to date there is little clear evidence of the role that executive compensation actually played in the financial crisis itself. We do know that many key executives had substantial portions of their wealth invested in their firms, that they suffered huge financial losses when their firms failed or were forced into assisted mergers, and that most lost their jobs, status and positions (the executives of Merrill-Lynch, Bear Stearns, AIG, and Lehman Brothers are but a few examples).

Lack of evidence, however, is seemingly irrelevant when conventional wisdom is that executive pay was the problem and it is in the political interest of policy makers to “fix the problem.” The Administration’s pay czar has already cut the salaries of the CEOs of firms receiving TARP funds and has begun to dictate the form of compensation in terms of the permissible split between base salary and incentives. The Federal Reserve has also jumped on this bandwagon and has not only indicated it intends to play a role in the setting compensation for all banks, but also has aggressively begun to do so, even in advance of the publication of its guidelines on executive compensation. The intention of course is to limit the incentives for “excessive risk taking.”

Here is the rub. To limit “excessive risk taking” one first has to be able to identify it. But isn’t this exactly what banking supervision and regulation more generally is designed to do to identify and limit “excessive risk taking” and behavior that might lead to unsafe and unsound banking? Given the failure of banking supervisors to ensure that banks – and more specifically, large, complex banking organizations – had adequate capital to buffer the risks they were taking and were clearly caught flatfooted during the current crisis, how are we to have confidence that these same people will now suddenly be able not only to identify excessive risk taking and but also to understand how to set executive salaries to limit it? This problem is compounded by the fact that each executive has a different inclination to take risks and will respond to compensation incentives differently. We will need an army of psychologists to augment the bank examination staffs if the current proposals and policies go forward. Finally, are we now expecting regulators to impose their own risk preferences and tolerances on shareholders as well, as opposed to simply truncating a bank’s operations as it approaches failure? If they don’t, we would argue that shareholders will find ways to incent their executives to take the risks they (the shareholders) desire. Otherwise, the government will effectively be running the banks. In short, dictating the structure of individual executives’ pay is no silver bullet.

In another commentary,, we suggested an alternative approach to executive compensation. In more refined form here, the proposal is simply to eliminate the ability to expense bonuses and incentive pay and to require that such compensation can only be paid out of and up to the amount of positive consolidated-entity profits. The proposed pay limits would change the internal corporate pay policies that presently enable traders and other risk takers to earn huge bonuses irrespective of the losses that might accumulate in other parts of the organization. By adopting the proposed policy, those under incentive and bonus plans would not only have an incentive to care about subsidizing unprofitable parts of the business that would reduce the bonus pool but also they would share gains with shareholders, who would have the say on the split. Such a plan would eliminate the asymmetric nature of current compensation plans, would be easy to implement and monitor, and would not require micro-management by government.

The Fed and the Unemployment Rate cont’d

In response to the recent piece we wrote about the Fed and the unemployment rate, Bloomberg anchor Kathleen Hays emailed the following: [Richmond Fed president] “Jeff Lacker told me he could see the Fed tightening before unemployment comes down when I interviewed him last month on The Hays Advantage.”

Kathleen also sent a recent NY Fed staff report (number 397) entitled “Monetary Tightening Cycles and the Predictability of Economic Activity.” We thank her for this response and we have posted the NY Fed staff study on our website, Also there is our original October 31 commentary:

We have several items to raise for discussion.

First point.

The NY Fed study seems to examine a separate issue than the study we cited. The authors looked at the unemployment rate AFTER the Fed had stopped tightening. In our view that may be helpful from a policy-issue perspective but it does not help us to determine whether the Fed will start to raise rates BEFORE the unemployment rate peaks.

As portfolio managers we are concerned with the latter. Academics can use the former to debate the efficacy of Fed policy making. We do not have that luxury. We must spend our days managing clients’ money in real time, not debating policy outcomes after the fact. We have to deal with what the policy is doing or will do to the financial markets. When government gets it wrong, which they often do, it is our clients who will pay the price for their errors.

Second point.

Jeff Lacker’s comments are significant. He is an independent thinker on the Federal Open Market Committee (FOMC) and has expressed dissent from Fed Chairman Bernanke in the past. He is often characterized as one of the “hawks” among the presidents. Suffice it to say the hawks have been more vocal recently, although they are each speaking as individuals and not arguing with a collective voice.

Lacker is also the current chairman of the conference of 12 Fed regional bank presidents. This is an annual and rotating position among the twelve Fed regional banks. The conference of presidents meets regularly to discuss operational and administrative issues in the Fed. They reportedly avoid discussion of monetary policy in deference to the FOMC gathering. Their meetings do not receive high-profile attention, and the documents circulated are internal.

Since the Fed presidents only have five voting at any given FOMC meeting, they are not deemed to be under the sunshine rules when they meet. The FOMC is supposed to have a total of twelve voting; of course, this requires that there be seven sitting governors. We have written about how politics is holding up a full board of governors, which is why there are only five at this time.

We have no way to know what the regional bank presidents discuss when they assemble privately. They make individual speeches and comments but are not known to publicly express a collective presidents’ view that is independent of the Board of Governors. In our view this is a mistake. Maybe there would be a healthier policy debate if the presidents combined into a coalesced body and offered a policy view of their own. Maybe we would be much better off if we followed the British system, wherein every member of the market committee has to testify before Parliament and explain their votes on policy? In America we only see Chairman Bernanke speaking for the FOMC. And we occasionally see a governor in front of Congress. When is the last time you can remember a Fed president testifying and explaining his or her policy decision in front of Barney Frank’s or Christopher Dodd’s Congressional committee?

Anyway, we go back to the Fed and the unemployment rate.

We argue that the Fed is not likely to raise the policy-setting interest rate until after the unemployment rate has clearly peaked. Our backup is a study done by David Hale. In that paper, Hale identified nine post-World War II periods in which the Fed started a tightening cycle after the unemployment rate peaked.

The series starting months are: December 1954, August ’58, February ’62, April ’71, June ’75, September ’80, June ’83, February ’94, and June ’04. The average time from unemployment rate peak to first tightening was six months. Hale’s sources are the Bureau of Labor Statistics and the Fed’s public records. Hale found that sometimes the first hike came as soon as one month after the unemployment rate peaked. Other times it was as long as 20 months after. But in every case it was AFTER and not BEFORE the peak in unemployment.

Is Jeff Lacker calling for an exception to this long-standing Fed tendency? We do not know, but we doubt it. It is unlikely that he or any of his colleagues will initiate a tightening cycle as long as inflation indicators remain as low as they are today. It is hard to see the Fed acting while the employment situation is deteriorating.

More likely, the Fed will wait until it is confident that the economy has commenced on a sustainable recovery path. Then it will start a tightening cycle that may be different from what we last saw under the Greenspan Fed. When this occurs we expect the Fed Funds rate to be adjusted in a less predictable fashion than Greenspan’s regular and systematic 1/4-point rate hikes that we witnessed in the early part of this decade.

The FOMC statement just released affirmed this outlook. We expect the Fed to continue the targeted zero to 25-basis-point Fed Funds rate for an “extended period.” They just said that’s what they will do. We believe they mean it. Please note that the vote was unanimous and included Jeff Lacker.

By Monday we will be in our first meeting in Tokyo. There we will raise the issue of whether or not the new government in Japan will proactively expand the Bank of Japan balance sheet and alter the form of the policy that the old government applied for years without success. In Japan, two members of the government sit on the monetary policy committee. Now that is political intervention.

More BRICs Falling

Last week (October 26-30) was a roller-coaster ride for global equity markets. In the US, the S&P 500 finished the week down 4.1% from the Friday, October 23, close; and the international advanced-economy (ex-North America) benchmark, the MSCI EAFE Index, dropped 5.1%.  The emerging-market benchmark MSCI EEM Index lost 7.8%. A break in the run-up of prices in global equity markets, particularly those in emerging markets, was probably overdue. Equity valuations in emerging markets, while not expensive in relative terms, had become somewhat elevated.  It is revealing to drill down to the individual emerging markets to see how each fared when faced with last week’s global downdraft.

The four large emerging-market economies, referred to as the BRICs (Brazil, Russia, India, and China), have been favorites of international investors and strong performers this year.  However, two of the BRICs significantly underperformed last week. India, as measured by the main India market ETF, Wisdomtree India Earnings (EPI), dropped 9.8%, and the Market Vectors Russian ETF (RSX) lost 10.5%.  The decline in Brazil, as indicated by the iShares MSCI Brazil ETF (EWZ), was -7.4%, close to the emerging-market benchmark.  China, in contrast, outperformed the benchmark, declining by 6.3% as measured by the SPDR S&P China ETF (GXC).

The Chinese authorities moved earlier than those in other emerging markets to counter overheating in their equity and real estate markets. Their actions, which led to a market correction in the summer, appear to have been successful, and the Chinese economy continues to lead the global economy, advancing at an 8.9% pace in the third quarter. We are maintaining our overweight for the Chinese market.

We wrote about Brazil last week and why we decided to book our profits for that market. The decline for Brazil last week appears to be due to the global increase in risk aversion and not the tax increase on capital flows. We are remaining on the sidelines for the time being to see whether or not the Brazilian authorities will take any further actions to discourage equity portfolio inflows.

The Russian economy remains weak (growth this year is projected at -7.5%), while its inflation rate is high, around 10%.  The economy is severely underinvested; and what is more worrisome, capital expenditures are not increasing to rectify the situation. The Russian banking system remains inadequate to meet the credit needs of the economy. The energy sector is the strongest part of the Russian economy, but there are more reliable global energy plays available.  We continue to find the Russian market too volatile and unpredictable.

The Indian economy growth rate, projected at 7.2% for this year, is second only to China’s 8.7%. The Indian equity market outperformed the Chinese market before last week, up 91% YTD through October 23, as compared with 71% for China. Last week’s decline was likely amplified by the central bank’s move  to tighten credit to counter rising inflation.  Unlike Brazil, India did not add any restrictions on capital inflows. Despite liberalization steps in recent years, India still maintains an excessively complex structure of restrictions, including absolute limits on foreign investors’ ability to purchase bonds. This is just one of the uncompleted reforms needed if India is to sustain its recent strong economic performance over the long term. Until we see more decisive action by the government, we will maintain a slight underweight position for India in our portfolios.

Going forward, we see more attractive emerging-market prospects outside of the BRICs group in the second tier of emerging markets.  A number of these markets demonstrated their strength by outperforming the emerging-market benchmark during last week’s global retreat from risk. Four of these have been consistent favorites of Cumberland due to the high quality of their financial and economic policies: Chile the MSCI Chile ETF (ECH) declined 4.3%; Singapore – the MSCI Singapore ETF (EWS) declined 4.1%; Israel – the MSCI Israel ETF (EIS) declined 3.9%; and Hong Kong – the MSCI Hong Kong ETF (EWH) declined 2.9%.  Two other emerging markets that outperformed last week were Malaysia, where the MSCI Malaysia ETF (EWM) declined 3.7%, and Taiwan, with the MSCI Taiwan ETF (EWT) declining 5.0%.  On the other hand, some of the second-tier emerging markets underperformed last week, suggesting their vulnerability to any global retreat from risk. Two examples are South Africa – the MSCI South Africa ETF (EZA) declined 8.9% – and Turkey, where the MSCI Turkey ETF (EZA) declined 10.9%.

We maintain a positive view on the medium-term outlook for the emerging-market economies and their equity markets. In 2010 these economies are likely to again register the strongest growth rates in the global economy, and a number of their equity markets should outperform the advanced-economy markets. But in the near term, at least through the end of this year, these markets could be particularly volatile. It will be especially important to be selective when investing in this asset class.

The Coming Week: Fed, Employment Report, Asia

This is going to be a big week.  And it comes on the heels of another weekend bank-failure announcement, and as we absorb the Geithner testimony and the discussion draft hearing in front of Barney Franks’ House Financial Services Committee.  

Ours views of this Geithner-designed proposal are harsh and already known to readers. It has the makings of another PPIP-type fiasco; but in this case the damage could be lasting, since it involves a government super-regulator structure and not just a single program.  This is a mix of politics and money and power at its worst.

It seems as if criticism is mounting from all sides, labor and business, left and right, Democrat and Republican.  Geithner really hurt himself when he danced around the direct questions pertaining to “secret lists.”  Mr. Secretary: when you were asked if there were going to be secret lists, why didn’t you just say yes?  By not answering the questions directly you opened yourself up to an entire scrutiny of the flaws in the bill and lost your already damaged credibility.  As for secret lists, it is time for the federal government to stop.  Make rating scores public.  Stop mouthing the word transparency while practicing opacity.  That may restore the term moral hazard back into usage, in place of what we have witnessed.  Kevin Ferry aptly described the current condition as “moral swamp.”

The first question for this week is easy.  Will the Fed signal a policy change in the text of the release at the end of its meeting?  If yes, what will it be?  If no, will there be any revelation of the internal disagreements within the Fed?  All eyes will be focused on this event at 2:15 PM, Wednesday, November 4.

There is real and serious division within the Fed.  The regional Federal Reserve Bank presidents are being marginalized.  They know it and do not like it.  They are a lot closer to the real economy than the ivory-tower, Washington-based board.  The Geithner proposal draft only exacerbates this marginalizing of the FOMC members who are presidents and not governors. 

Among the Board of Governors a threesome of Chairman Bernanke, Vice-Chairman Kohn, and Governor Tarullo appear to be the new inner core.  Tarullo seems to have replaced Governor Warsh, who held this insider’s insider position last year while Tim Geithner was still at the Federal Reserve Bank of New York.  David Wessel’s book In Fed We Trust provides insight into this threesome and how it operates.

We wish Wessel had been less polite.  For example, he didn’t stress how the Fed has interpreted the requirements for “sunshine” in its deliberations.  Here is why it hasn’t: There are supposed to be seven governors.  We have written and spoken about that repeatedly.  Politics have held the number to five seated governors for over three years.  Obama has continued this policy of holding the Fed captive.  Senator Christopher Dodd was the point man on this in his capacity of chair of the Senate Banking Committee. 

When you have seven governors, a normal decision is made with four votes of the board.  And an emergency power invocation is made with five.  But when you have only five, the designed supermajority rule becomes a unanimity rule.  So we now have and have had a situation where any governor holds a veto.  Today, Obama appointee Tarullo holds a veto in his hand, as does every other governor.  If Tarullo disagrees with Bernanke, Kohn, Warsh, and Duke, he can stop them from any Fed emergency action.  Notice how the emergency actions have receded from prominence since Tarullo became a governor.

The key here is in the interpretation of the sunshine requirement.  The Fed is taking the position that when three governors are together, it does not constitute a “meeting,” because the sunshine meeting rule is set for seven governors, not five.  Therefore, Bernanke is acting as if four are required to convene a meeting.  Wessel has described the use of this stratagem during the crisis decision making.  Is this the same Fed that wants to sponsor transparency? 

When markets do not trust the central bank, they can be very punishing.  These market-driven actions occur at the margin.  They are not recorded in public pronouncements.  They appear in transactions.  That is one of the reasons the US dollar has been chronically weak.  The actors in world finance do not trust the United States.  Who can blame them after what we have delivered to the world during the last two years.

There are other reasons for dollar weakness, too.  Here is a short list: massive issuance of federal debt, dramatic and expansive federal spending programs, Obama policies that will hurt productivity, layers of government regulation on top of what is already in the pipeline, forthcoming tax increases that will ultimately take the top US personal-income bracket to somewhere between the rate in Denmark and that in Sweden.  Denmark and Sweden rank number one and two among the most highly taxed and socially managed people and economies in the world.  The US will be vying for the top position in 2011 if all the present offerings are enacted into law.

Back to the rest of this week. 

Friday’s unemployment report may reveal an unemployment rate at or even above 10%.  Whether the number is 9.9 or 10.1 is not the issue.  The key is that chronic and very high unemployment is going to be with us for a very long time.  The U-6, or underemployment rate, is likely to be 18%.  The rate for married men with spouses present will be around 8%.  Jason Benderly taught me about the importance of this one.  Other record unemployment rates will occur for teenagers, those with lower levels of education, and those with disabilities.  The last one will be extraordinarily high.  The unemployment rate for those with all types of disabilities will top 70%.  For those with cognitive disabilities, the unemployment rate will approach 90%.  Does anyone really expect the Fed to raise interest rates in the face of these numbers?  I don’t.

Remember, the Fed has never raised interest rates coming out of a recession before the unemployment rate peaked and clearly marked that peaking with at least five or six months of improvement.  Even if this coming report is going to mark the peak, history shows that the Fed would not make its first move until next summer.  We do not expect a rate increase, but let’s assume it for the point we wish to make.  We repeat: even if this report marks the peak, history shows that the Fed may be facing its first move next summer.  Does anyone believe that this politically influenced and politically threatened Fed will raise rates next summer, when the unemployment rate is still in the 9%-plus range and it is an election year?  We don’t.

So, the Fed is expected to hold the target short-term policy interest rate to ¼ of 1% for some additional and prolonged time.  We have written on how a very low shorter-term policy rate anchors all rates because of the use of forward rates in the managing of debt.  Experience shows that the top yield on the 10-year Treasury note is likely to be limited to about 3-¾% to 4% as long as the Fed is holding the short-term rate near zero.  We also know from Japan and elsewhere, including the US, that the bottom of the 10-year note yield range could be as low as 2%, or even lower if deflationary psychology creeps back into expectations. 

We conclude that a range of 3% to 4% defines the yield on the 10-year Treasury note for the foreseeable future.  For markets this means tax-free Munis are still a desirable asset class, since they contain a great deal of the “tax arbitrage" and since future tax rates are likely to be higher than present ones.  We also like the Build America Bonds, since they tier in an alignment with tax-free Muni rates.  BABs are taxable municipal securities that came into existence in 2009 under a special new Obama administration program.  We believe they are a terrific bargain for the investor who uses them properly in portfolio constructions. 

As for US stocks, we believe the American market will be higher by next spring.  We are targeting a range for the S&P 500 of 1200 to 1300 and believe that the index will fully close the “Lehman gap” created by the waterfall selling after Lehman Brothers failed.  We are nearly fully invested and expect to use any weakness in November to deploy any cash residual in accounts. 

In the international arena we have taken some of the stellar profits in emerging markets.  Some of these positions have nearly doubled.  Presently the international accounts are holding a cash reserve of nearly 13%.  We expect to deploy those funds in weakness as the long-awaited correction in these extended markets unfolds.  

At the end of this coming week we will leave for a three-country Asian trip.  Tokyo comes first, then Hanoi, and lastly Singapore.  An exciting GIC delegation trip is ahead.  Details on Hanoi and Singapore may be found at  Our meetings include central bankers, finance ministries, and stock exchanges, as well as various investors and banking and academic professionals.  Private roundtable discussions will round out the information gathering.  The GIC is honored to have Philly Fed President Charles Plosser join the delegation and speak in Singapore, and Philly Fed First VP Bill Stone with us in Vietnam. 

We will try to write impressions during the trip if time permits and if jet lag doesn’t suppress the flow of words.  Fortunately, email and phone work on our 3G BlackBerry in all three countries.    That has been my experience in the past in Singapore.  Last time in Narita Airport, I had to borrow a Japanese keyboard; that required lots of help from the Japan Airlines business center.  We expect to do better this time.