AIG-LEH-Federal Reserve and Asymmetric Information. Special thanks to John Silvia, Dennis Gartman, George Akerlof and (we hope) Janet Yellen

September 16, 2008-a critical FOMC meeting day

“How did we get into this big of a mess?” asked the journalist.   “Asymmetric information” we quickly answered.  

Huh?  What’s that?

My friend, John Silvia, is not only my fishing partner.  He also is one smart economist and an encyclopedia of research references.   “Look at George Akerlof’s “Lemons” for guidance” he said.

Noble Laureate Akerlof wrote about how the imbalance in information between the buyer and the seller (asymmetry) can result in lesser quality paper crowding out higher quality.  His theory explains some of the financial market dysfunction we see today.  

The theory says that a security seller may know the quality, credit risk, payment stream, collateral support, etc. better than the buyer.  Hence the seller will sell if the buyer is over paying in the seller’s eyes.  The seller can unload lesser quality stuff on the buyer at a price that reflects a higher quality level.  Over time, the lower quality stuff crowds out the higher quality stuff and, eventually, the market fails to clear in a normal way.  The information asymmetry is that the seller knows more information than the buyer (nothing new there).  The financial market impact hits when the buyer realizes his information is incomplete and his guarantee is uncertain.  Then, risk premia sky rocket.  That describes today.

John Silvia’s summation: “This may be what we have witnessed in the credit markets over the past year and may be seeing again this week.  The seller of an asset that may be impaired cannot find a buyer.  The seller knows the quality of the portfolio but the buyer does not.  Quality information is asymmetric and therefore the buyer is unwilling to take risk in the trade.”

Uncertainty is heightened when the central bank constantly changes the rules and when it fails to explain itself clearly.   The result is that market agents read into the actions and the uncertainty premium rises.  The market agents presume that the Fed knows more than they do.  Right or wrong that is how markets operate. 

Fed inconsistency and insufficient explanation therefore fail to calm markets and may exacerbate their volatility and enlarge the turmoil.  We see that today in the extremely wide credit spreads.  

The Fed has done that this year by saving Bears Stearns (BSC) in March and allowing Lehman (LEH) to fail in September.  In both cases the share price suffered immensely.  No market uncertainty there.   But in the BSC case the toxic portfolio portion was placed in a Delaware LLC called Maiden Lane and the Federal Reserve funded it with $29 billion.  It appears on the Fed’s balance sheet as the Fed slowly works off the position.  

This transaction allowed the rest of BSC to be merged into JP Morgan Chase and that meant the debt of BSC and the derivative contracts in which they were counter parties did not fail.  The Fed action with BSC calmed markets temporarily and narrowed risk premia.

The Fed then put in place new tools that were directed at the primary dealers.  These have been discussed many times (see but it is important to realize that the primary dealers are those who handle some of the transmission of the Fed’s policy into the credit markets and they are viewed by the rest of the world as a very private club.  LEH was among them. 

Previously the Fed and the federal authorities had assisted Countrywide to be merged with Bank of America.  Countrywide was a primary dealer.   Markets saw this policy of saving primary dealers repeated with BSC, another primary dealer.  Markets expected this to be repeated with LEH. 

LEH’s failure was and is a global shock.  One of two things can be surmised.  Either option we surmise is bad and raises uncertainty.  

Option one is that LEH may have been a larger mess than BSC or it may have been worse or both.  If that is so, it failed 6 months after the Fed’s new tools were in force and had been applied.  One would have expected the patient to be healing if the new medicine were effective.   So if the LEH was a bigger mess than expected, by allowing failure the Fed is sending a message to the markets that its new tools are insufficient or impotent. 

The other option is that the Fed has changed policy and that it will not act in the lender of last resort capacity.  That implies that the primary dealers are not safe and that the markets are on their own without a life support central bank function.

AIG is not a primary dealer.  But it is a huge global financial enterprise and it faces credit rating issues that impact its ability to clear the counter-party risk.  AIG knows the quality of its portfolio but the market does not.  Hence Akerlof’s principle is at work.  That is why the Fed must act.

The AIG problem comes on the heals of the LEH failure and immediately following the Fannie Freddie shock.  This has the appearance of a cascade or a contagion.  Failure of LEH has created contagion because of counter-party risk that was not contained by the Fed.   Failure of AIG will make this much worse.

Stemming a contagion is the job of the central bank.  To do so, it must diminish uncertainty and restore confidence with transparency and clarity.  And it must apply its lender of last resort function which Dennis Gartman explained so well in his recent market letter.  Gartman accurately summarized that “a central banks obligation is to be there at times of monetary duress, discounting reasonably liquid "paper" for the purpose of making certain that liquidity exists in the banking and trading system in order to avoid the periodic paroxysms that markets are prone to find themselves devolving into. Walter Bagehot, in his seminal "textbook" on the issue of central banking, Lombard Street, said that a central bank’s raison d’être is to supply liquidity when liquidity is needed…”

I add to Dennis’ quote that it is the primary dealers who do this for the central bank and with the support of the central bank.  That is why LEH failure is so important and why it is causing contagion. 

Within the Fed, there are those who understand this link between quality perception by the seller and imperfect quality knowledge of the buyer.  Janet Yellen, president of the San Francisco Fed, wife of George Akerlof and a co-author with him is fully cognizant of this principle.  She may raise a voice of reason here.   This writer hopes so.   

September 11th Reflection

There are two images that have not muted with time.   They are exactly 84 months old. 

After seven years, these closed eyes still see the jumpers as vividly as I did that morning.  I counted five in the few minutes between the time I first turned around to look at the smoldering North Tower and the time the second explosion rocked the South Tower.  The couple holding hands and flinging themselves out of an uppermost floor right below the “Windows” restaurant are framed on my inner eyelids. 

They seemed so young to me.  He had no jacket and tie.  She had long hair which was illuminated by the bright sun.  It was hard to see much more detail from that distance.   Even now, as I write this, they still seem so young.  Yes, too young, they were much too young.

I often speculate about what was in their minds.  They were knowingly jumping from 100 stories to certain death.  What was it like for them with heat and smoke and carnage to bring them to that action?  This was before the second explosion and before the buildings fell.  This was an act determined by them and only by them before we learned details of scheming Al Qaida monsters and their consummate evil.

Were they young lovers?   Were they a couple?  They jumped holding hands.  They fell clasped to each other for as long as they could.  They must have been plummeting a hundred miles an hour as their rate of fall accelerated.  Had they been at breakfast together on that clear, blue sky, bright sun, welcoming beautiful autumn day?  Did they hold hands while walking to work that morning?  The instant before Mohammed Atta struck, that “September morning” was as appealing, tranquil and inviting as one could imagine.  Was it that way for them?

The second explosion is the other image.  I was then standing on the knoll across West St. and near the entrance to the building where the escalator takes you up to a lobby and on to elevators that rise to the Wall St. Journal offices. 

Ancient army training instinctively had me measure the size of the fireball.  It was 20 stories tall and about the same width.  I counted the stories out of instinct.  I also counted the “flash-to-bang” time and determined that I was between 4000 and 5000 feet from it.   I could feel the heat briefly as the shock waves rolled out from the blast.  It made the loudest sound I had heard since the ‘60s when I crawled on my belly next to an artillery simulation pit at Fort Sam Houston, Texas.

My mind surfaced the 23rd Psalm that morning as I stood on that knoll.  Looking across West Street and down Liberty Street and beyond Broadway toward Wall St. one had a vista of two smoking buildings, panicked and running people, chaotic and sporadic emergency vehicle movements, injury and death.  Through all of this, the bright sun and cloudless sky allowed a sharply defined shadow to angle onto the buildings in the financial district.  There are places here where the sun never reaches the pavement, I thought.  The nickname “canyons of Wall St.” entered my consciousness.   I cannot recall who coined that phrase. 

From the metaphor of canyon and shadows the psalmist’s words leapt at me.   You are looking at the valley of the shadow of death, David.   At that moment we felt calm and not panic.  We pursued action not frozenness.   We moved decisively.  We escaped and are here to tell about it and to contemplate.

Why me?   Why those jumpers? 

Ancient texts yearly ask that we reflect and personally examine that question.  Millennium old teachings say that an annual accounting is done in a spiritual realm.   Who shall live and who shall die?  These things get sealed yearly according to those traditions.  

But good deeds of charity and kindness can annul the judgment.  That is also the message imparted by those ancient teachings.   

Maybe that is why I recite the 23rd psalm?  Why I keep it on my personal bulletin board in my kitchen?   Maybe that is why its final sentence is phrased so profoundly with the text that we know? 

Wishful Thinking

Markets breathed a sigh of relief on Monday following the government bailout of the debt holders of Freddie Mac and Fannie Mae. But one wonders if that sigh is like that of the murderer who received life in prison rather than the death penalty. Once the immediate threat was removed then the reality of the long run set in, and it isn’t pretty.

We have a nasty mess our hands, and it isn’t helped by the fact that few of the parties to the problem have faced up to what the true causes were. For example, consider the observations of Senator Shelby quoted in a Bloomberg article on Tuesday, September 9.

“Once they got someone looking closely at Fannie and Freddie’s books, they realized there just wasn’t adequate capital there,” US Senator Richard Shelby of Alabama, the ranking Republican on the Senate Banking Committee, said after a briefing by Treasury officials. “They found out they had a house of cards.”

Coming from someone who was in Congress during the accounting scandals of the Frank Raines era and the failure of Freddie and Fannie to produce audited financial statements for many years, such a statement is incredible. The regulators and accountants have been in those two institutions for several years, trying to unravel the creative regulatory capital accounting they employed. It is hard to believe that the whiz-kids from Morgan Stanley were able to divine in less than a couple of weeks accounting problems that outside accountants and regulators couldn’t discern in years.

The fact is that problems weren’t found because no one wanted to find them. And if they were found, the fallout from Congress, as the Wall Street Journal’s Tuesday editorial correctly points out, would likely have been to protect the institutions from regulatory sanctions.

The bailout of debt holders doesn’t solve either the problem of Fannie and Freddie nor the problems in the housing market. Until housing prices find their new equilibrium, the demand for new mortgages will be slow and delinquencies will run their course. The drop in mortgage rates from this new temporary subsidy program will only have a marginal effect, if any, and the current problems make any attempt on the part of the Federal Reserve to begin fighting inflation by raising rates a non-starter in the near term.

All the intervention and government support also now creates expectations that will constitute moral hazard of the worst kind, because it extends far beyond just financial institutions and their incentives to take excessive risk. The bailout also rewards the “lobbying” efforts by foreign central banks and governments, which was widely reported in Tuesday’s press, and will only encourage them to keep at it when the risk in their dollar-denominated investments threatens to be realized. Actions to protect borrowers will encourage others to take on debt and engage in the same excessive leverage activities that home buyers did. The end result will only be more leverage and risk taking.

Speaking of leverage, it is remarkable that so little attention has been given to what turns out to be the common denominator affecting borrowers, lenders, and financial markets and that was the root catalyst of the current turmoil. Homeowners were highly leveraged, with little or no equity down payments. Lending institutions were encouraged by low regulatory capital charges on mortgages to take on leverage. Derivative securities vehicles relied upon highly leveraged structures to make them profitable. None of this was even considered by Chairman Bernanke when he reviewed the problems in his Jackson Hole remarks.

Finally, there is the issue of the need for an exit strategy to get the government out of the housing finance business. It is not likely to happen any time soon. Treasury now has a huge mortgage portfolio, due to its acquisition of Freddie and Fannie, and that portfolio will grow because of the new lending and liquidity facilities that Secretary Paulson has created. These programs will have to be managed, and he has already indicated that it will be done by an outside asset manager. Would you care to guess where the asset managers are likely to come from? To think that the government can run a mortgage lending and finance business better than the private sector or that the new management can change the flawed business model of Freddie and Fannie is wishful thinking. These institutions will borrow in the market at subsidized rates and distort the pricing decisions that the market might otherwise make.

Trouble in the Eurozone

The 10th anniversary of the January 1, 1999 launching of the euro is approaching.  However, the celebrations are likely to be tempered by the sluggish performance of the 15 European economies that have adopted the euro as their common currency (Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovenia, and Spain) and other countries with currencies pegged to the euro.  The prospects for the Eurozone economies have clearly worsened following an unexpectedly strong first quarter.

The euro-skeptics that predicted that the largely political decision to launch the euro would founder in the absence of the economic conditions thought necessary for a common currency area have been proven wrong at least thus far.  On the other hand, it is not evident that the euro has made a significant contribution to the region’s growth or international competitive position. The Bank for International Settlements (BIS) reports that the euro’s role in the foreign exchange market is pretty close to just the sum of its parts (the former national currencies of the Eurozone members).  The same can be said of the euro’s share of official reserves.

Our focus in this note is on the region’s economic performance.  When a country adopts the euro as its currency, it must cede control over the nation’s monetary policy to the European Central Bank (ECB).  Thus the ECB calls the tune for all of the 15 Eurozone economies – from Germany to Malta – and it can not differentiate among these economies. One size of monetary policy must fit all, regardless of the situation in the national economy.  A further constraint on policy flexibility is the fact that the ECB has only one policy objective in its mandate – to maintain price stability, which they interpret to mean inflation rates below but close to 2% over the medium term.  This does not mean the ECB must ignore economic growth or employment conditions, but combating inflation must be its over-riding priority.

Earlier this year the Eurozone economies were registering healthy growth and economic policymakers were proclaiming that Europe would escape much of the crisis in credit markets and the slowdown underway in the US.  The ECB’s single-minded focus at that time on the inflationary threat from surging global prices for oil and other commodities looked appropriate. 

As the credit crisis spread to Europe and European banks encountered funding problems, the ECB moved promptly to provide extra liquidity but did not reduce their policy interest rates. Indeed, in July, following a quarter in which the German economy actually declined and many economic indicators were heading south, the ECB increased ECB interest rates by 25 basis points, citing risks to price stability.  In their latest, September 4, press statement, the ECB left rates unchanged.  They recognized the "weakening of real GDP growth" but still emphasized "continuing upside risks to price stability."  It appears that ECB interest rates will remain on hold at their current relatively high level for the next several quarters, despite the weak economy.

The ECB does have more reason to be concerned about persistent inflation than do the US monetary authorities.  The Eurozone’s markets – particularly the labor markets – are considerably less flexible than is the case in the US. This means that inflation, once it takes hold, is considerably more "sticky" than in the US.  While the global prices for oil and other commodities have backed off from their recent highs, underlying inflation in Europe continues to rise and is likely to remain well above the ECB’s "comfort level" for some time.  Higher wage inflation and slower productivity growth will combine to boost unit labor cost by some 3 percent this year.  The deteriorating inflation picture will prevent the ECB from moving to a more pro-growth policy stance unless a serious recession should appear to be likely.  A more likely outcome appears to be an extended period of essentially flat economic activity for the Eurozone.

The implications of this economic scenario for Eurozone stocks are not promising. In addition, investors have to consider the implications of the Russian invasion of Georgia and subsequent deterioration in Europe’s relations with its large neighbor to the east. These events have underlined the region’s dangerously high dependence on Russia for its energy needs. International and domestic investors have retreated from Eurozone equity markets and from the euro. The MSCI index for the Eurozone’s equities markets is down 27.3 % year-to-date (Aug. 8); and the MSCI indices for Germany and for France are down 27% and 24%, respectively.  In contrast, the MSCI index for the US stock markets is down only half as much, 13.5 %.  This is a reversal of Europe’s relative outperformance last year, when Eurozone’s equities rose by 18.7%, Germany’s by 32.5%, and France’s by 10.9%, while the US index rose by only 4.1%.

Despite the declines in Eurozone equity prices, we do not yet find European valuations attractive, relative to those in North America or Asia. The prospects for earnings in Europe’s sluggish economy with rising cost pressures are not bright. The weakening of the Euro, if sustained as we expect, will eventually help Europe’s exports, which have suffered under the recently high value for this currency. The immediate effect of a lower euro/US dollar rate, however, is to reduce earnings translated into US dollars, which is the relevant measure for US dollar-based investors.  We expect the latter effect will be dominant during most of the remainder of this year. In view of these prospects, we have scaled back the weight of Eurozone ETFs in our international and global portfolios.

Hank Punts on First Day of Pro Football Season

Treasury and the Federal Housing Finance Agency (FHFA) placed Freddie and Fannie into conservatorship, replaced existing management, suspended dividend payments on outstanding equity and preferred stock, and promised injections of new capital in the form of senior preferred stock with warrants.  The actions are designed to maintain the flow of funds to housing and to stabilize financial markets while providing protections to the taxpayer.  There are many good things about the structure of the deal.  For example, the arrangement does keep Freddie and Fannie in the business of supporting the mortgage origination business in the short run, by expanding slightly their ability to increase their mortgage-backed securities business.  It also calls for shrinkage in their portfolio investments by 10% per year, starting in 2010, until they decline from a max of approximately $850 billion to $250 billion.  They are to suspend all lobbying efforts, and presumably this will mean campaign contributions as well.  Finally, it is clear that existing preferred and common stockholders will experience significant, if not 100%, loss of their investments. 

But when one delves more deeply into the plan there are many problems and questions.  What Treasury clearly has done is punted the actual dirty details of handling these two hot potatoes to the next administration, with no clear exit strategy nor any practical solutions to the fundamentally flawed business model that Secretary Paulson referred to on several occasions during his press conference. 

What are some of the troubling aspects of the deal?  First, Treasury has agreed to provide a liquidity facility which will acquire newly originated mortgage-backed securities, presumably from Freddie and Fannie.  The facility will expire at the end of 2009, so what happens if it is still needed?  Mostly likely it will be extended by the next Congress, with no end in sight. 

Second, the creation of the facility means that Freddie and Fannie will be able to launder new mortgage debt to the Treasury, in addition to increasing their own portfolios in the short run, with no clear idea of when and how the program will be phased out. This will be at a favorable rate (only 50 basis points over LIBOR) and in addition to whatever opportunities exist to borrow from the already authorized Federal Reserve Discount Window.  The arbitrage possibilities here are significant. 

Third, the conditions under which the preferred stock injections will take place are unclear.  Secretary Paulson indicated that Treasury initially will receive $1 billion in preferred stock plus warrants, just for providing the facility.  It also means that funds would be provided on an as-needed basis to enable Freddie and Fannie to maintain positive net worth.  Assuming that losses exceed the value of common equity and perhaps even that of preferred stockholders, any positive net worth will be solely due to the government’s preferred stock interest, on which the institutions will have to pay a 10% dividend.  Earnings on a shrinking business will have to be positive for a long time before there is any value to existing equity holders or to the government through the warrants.

Fourth, the accounting here is critical in terms of when and how losses are recognized and as to the timing of any injections of public monies.  It is not even clear how the preferred stock will be valued.  Given the current state of Freddie and Fannie’s books and the negative implications that Morgan Stanley’s analysis has suggested with regard to the calculation of the value equity, one can’t have a lot of confidence that there will be much transparency when it comes to treatment of the capital injections or the sharing of losses. 

Fifth, while it appears that the intention is that Freddie and Fannie will emerge from this nationalization much smaller in size, this is not necessarily the case with respect to their guarantee programs.  Nor do we have any clues as to how their flawed business model will be repaired.

Sixth, a lot of people and institutions have purchased preferred stock and other debt on the basis of representations of management and others about the financial condition of these institutions.  Should lawsuits arise or possible fraud allegations be raised and sustained, then one wonders about the status of such claims relative to those of the government.

Left to be determined is what the final structure of these institutions will be, how these institutions will relate to private market sector alternatives, and when and how Treasury exits from its mortgage and mortgage-backed securities programs.  These are all issues that will conveniently take some time to identify and address and thus be punted to the next administration and to the Congress.  Regardless, it is safe to say that Freddie and Fannie are unlikely to be returned to the private sector any time soon, if ever.  This is especially the case given the politics that are likely to surround these institutions’ role in housing.  In the meanwhile, debt holders can breathe easier, as can mortgage originators.  The same can’t be said for preferred stock or equity holders.

In the end, this whole problem is likely to dwarf the thrift crisis of years ago in terms of the cost to the taxpayer, and it is totally a consequence of misguided housing polices.  It is not of Secretary Paulson’s creation.  It is a problem that has been incubating for a long time and one that was predicted by many observers.  Equally important, Congress, HUD, and Freddie and Fannie’s regulators are mainly responsible for the creation of these institutions, for their flawed business model, and for their unconstrained moral hazard behavior.  Congress and HUD mandated certain goals and objectives often formulated in terms of market shares of certain products of primary markets, just at the time that more and more bad loans were being made.  Congress, in particular, both allowed and refused to limit the lobbying efforts of Freddie and Fannie while gladly taking campaign contributions when offered.

GSE and Moral Hazard

GSE stands for Government Sponsored Enterprises and is now the common reference for the federal government’s housing mortgage lenders Fannie Mae and Freddie Mac (FF).  Other GSEs like the Federal Farm Credit Banks or the Federal Home Loan Banks are not public shareholder-owned and have not encountered the problems of FF.

“Moral hazard” is a term with several definitions.  It is frequently used to describe how the action of a governmental entity like the US Treasury or the Federal Reserve can encourage speculative risk taking.  When players in the financial marketplace believe that the government will bail them out and/or cushion their losses, those players change their risk-taking profiles from what they otherwise would do.  They begin to gamble, based on the belief that the government will make them whole if they lose and allow them to keep their winnings if they succeed.

As the weekend news unfolds we are witnessing the tug of war between the US government’s instruments of policy and the forces of moral hazard.  Here is the scorecard in the ongoing saga of FF.

The roller coaster ride in the common share price of FF reveals the ultimate play of a moral hazard.  If Treasury Secretary Paulson’s plan preserves any value for these shareholders, it will ratchet up the level of moral hazard to a new high for the United States.  That scenario would take a probably valueless security and use the government’s credit (read: taxpayer money) to make gambling stock market investors whole or cushion their losses.  Paulson knows this.  So does the other federal power broker, Fed Chairman Bernanke, which is why this outcome is unlikely.  Anyone who is playing in the stock of FF is purely gambling.

FF preferred stock is considered equity by most investors.  It is senior to the common but is not in the category of debt incurred to finance mortgages, derivative guarantees, or mortgage pool guarantees.  Some shares of preferred are held by US commercial banks and some are held by foreign institutions.  They purchased it knowing it had equity status.  In addition, many speculators have bought FF preferreds on the open market during the last year on the hope that the government would keep them whole.  They are an example of a financial market player who is acting out the moral hazard definition.

The Paulson plan for preferreds status is unknown as this is written.  An hour ago, Chris Whalen of Institutional Risk Analytics sent me a news reference quoting a “person briefed on the plan” that says the preferreds will be kept whole. 

If the Paulson plan makes the preferred whole it will provide a windfall profit in the billions to those who recently speculated on the government’s bailout structure.  If the plan collapses all the equity, the preferred will be nearly worthless, just like the common.  Saving the preferred is also an action within the moral hazard definition.  In this case, making the preferred whole will increase moral hazard by an order of magnitude.  It will include a form of equity in the federal bailout arsenal.

FF derivatives and counter-party contracts are an entirely different matter.  Here the financial system is threatened with unknown and possibly serious consequences, just like it was when Bear Stearns was forced into a merger with JPMorgan Chase.  The federal authorities cannot risk a systemic failure.  That is why the FF restructure will preserve the derivative contractual obligations of FF.  There may be some moral hazard issues, but they are overwhelmed by the factors of systemic risk.

FF mortgage pool guaranteed securities and debt obligations are likely to be honored in full.  Billions are held by state and local governments in the United States.  Similar large holdings are found among the central banks and foreign institutions of the world.  They purchased and held this paper based on the fact that the United States would honor the guarantee of the federal agency, even though the guarantee was not explicit.  These buyers had history on their side.  The US has not permitted any agency to default.  In the end and after all the political wrangling, it is not about to start now.  Does keeping the debt holder whole amount to some form of moral hazard issue?  The answer is yes.  Is it necessary?  The answer is also yes.

If the government wishes to stop this enlargement of moral hazard in the future it must get out of the implied guarantee business.  It must stop seeding and fertilizing moral hazard as it did when it permitted the federal housing finance agencies to become stock market plays and then allowed the management of those agencies to make fortunes with stock options on those shares.

Governmental explicit action is the best way to reduce moral hazard.  Transparent and consistent behavior works well.

Will the government end this FF saga in a way that ratchets down the moral hazard created by previous administrations?  That is the most fundamental of issues.  As of this writing the answer is unknown.

A decision to allow the common and preferred shareholders to lose and to nationalize FF and remove their publicly traded shareholder status will reduce moral hazard risk and promote better-functioning financial markets.  That will return risk to more symmetry with regard to the outcome of risk taking. 

Any plan by Secretary Paulson that preserves equity will raise moral hazard.  It will plant the seeds of the next crisis even as it attempts to cure this one. 

At Cumberland we have tried to avoid fixed-income instruments which are dependent on some form of moral hazard for their payments.  When we identify one after purchase, we are not afraid to sell it and take a loss.  We also understand that the market doesn’t always do the homework necessary to distinguish between good value in fixed income and appearances of value.  The unfolding saga in the municipal bonds insurers is a good example.  Here too, investors ignored the hazard that was developing as Muni insurers went outside their traditional business lines.

In the case of Muni bond insurers the government did not bail them out.  It is letting a $2.6 trillion dollar asset class work through its problems.  That is encouraging investors to do the work required in order to make good investment decisions.  This lack of action by government has lowered moral hazard exposure in Muni-land.  In the end that will serve the public well and facilitate the successful financing of state and local government for many years to come.

Treasury Secretary Paulson can look to this example in Munis when he advances his plans for FF.  He must remember that he represents the taxpayer and holds a seat of trust.  As trustee of the federal purse Paulson must remember that he is spending the money of those who make their mortgage payments on time, NOT those who gambled on moral hazard prevailing.  That is the ultimate trade-off in the FF restructuring plan.

One Small Step for a Beaten-Up Insurer and a Battered Muni Market

John Mousseau is a portfolio manager and heads the tax-free Muni section of Cumberland.  He is a member of the Management Committee of Cumberland Advisors.  His bio is found at  His email is

This past week, Financial Guaranty Insurance Corporation (FGIC) announced that Municipal Bond Insurance Corporation (MBIA) would reinsure $184 billion of FGIC’s municipal bond book of insured bonds. We think this is a positive development for FGIC and the bond market.

This means that MBIA – in return for insuring FGIC’s bonds – will receive, over time, $741 million in unearned premium income from the FGIC insured bonds.  In addition, FGIC has paid $200 million to a French bank, Calyon, to commute its exposure to Collateralized Debt Obligations (CDOs)

There are three results from this which should be positive for the beaten-up municipal bond market in general, MBIA overall and FGIC-backed bonds in particular.  First and foremost, this will free up capital for FGIC.  This is important for the ongoing business of FGIC – even if it is in a runoff position.

The second and more important development is that many FGIC bonds could see upgrades to MBIA’s ratings which are A2 by Moody’s and AA by Standard and Poor’s.  Though these ratings were the result of downgrades from AAA/AAA status earlier in the year, they are a far cry from FGIC’s current ratings which are B1 Moody’s (negative outlook) and BB (CreditWatch negative) by Standard and Poor’s.  It also is a positive for MBIA as this will mean additional income from reinsuring risks that are very small, in our opinion.  It is also a further statement of MBIA’s “raison d’être” in the world of municipal finance.

Most insured bonds have been trading to their underlying ratings with the rating cuts of the various bond insurers.  Prior to FGIC’s current problems, it was Cumberland Advisors’ opinion that FGIC insured municipal bonds to the most stringent credit standards of the AAA bond insurers.  The downgrade of FGIC has left a number of very good underlying credits trading very poorly because of the “FGIC-insured” sign on the front of the bonds.  This should be one step in reversing some of this fall-off.

The next step will be to see whether other, previously AAA insurers, such as XLCA or CIFG, can take similar steps towards freeing up capital.  In any event, we view last week’s developments as overall favorable for the battered Muni bond market.

Banks, Cash & Labor Day

Labor Day weekend started with another bank failure; this time in Georgia.  That is number 10 for the year.  Another few hundred million is lost by the Federal Deposit Insurance Corporation (FDIC) fund as a billion-dollar, five-branch bank disappears. 

The weekend also saw a few of us back at Leen’s Lodge in Maine, talking informally about how far this credit market crisis has to go before it hits bottom.  None of us are misled by the 2nd quarter GDP number, which had a “puff” because of inventories and which also reflected the federal stimulus package. 

We expect the rest of the year to be bleak.  The list of problem areas is well known.  We won’t dwell on housing or autos or the related consumer areas or energy costs (Gustav added).  Let’s get right to the banks.

Despite some earlier media reports that IndyMac was on the first-quarter FDIC problem bank list, we disagree with that conclusion.  The first-quarter list had 90 banks, according to the FDIC.  The asset size of the total 90 banks was $26.3 billion.  IndyMac was a $32 billion failure.  Therefore we conclude that it wasn’t on the list.

That means a $32 billion failure went from not making the list to an FDIC loss of billions in about 100 days.  Remember that the FDIC keeps the list confidential.  They fear giving out the names on the list would trigger runs on those banks.  They are probably correct.

At the end of the 2nd quarter the list was enlarged to 117 banks.  IndyMac’s actual failure happened in July, so it will end up reported as a 3rd-quarter event.  It was one of the 117 banks listed on June 30th.  The Office of Thrift Supervision (OTS) has disclosed that.

Some analysts speculate that the OTS didn’t put a $32 billion bank on the list because it would have triggered a market search for potential large bank failures.  OTS denies that.  They only say that they were not finished examining IndyMac, so they didn’t list it.  We believe the OTS but many do not.  Conspiracy theories are impossible to prove.  Even if they do alter timing of list placement, the OTS cannot admit they manipulate the timing of the list to avoid market-based runs on banks. 

Our conclusion is that the FDIC list is an indicator of trend but gives us little guidance about how big the bank failure problem will become.  Our second conclusion is that we are still in the early stages of bank failures.  We agree with our friend Chris Whalen, a skilled bank analyst who projects the trouble bank list will be in the hundreds and the asset size in the many hundred billions. 

To quote the great economist Yogi Berra: “It ain’t over till it’s over.”  Stock market complacency about the financials hitting a bottom in mid-July is about to be sorely tested as we enter autumn. 

September can be a particularly treacherous month.  History suggests a cash reserve is wise when Labor Day weekend concludes. At Cumberland we leave the Labor Day weekend behind with one in place in our ETF accounts.

Special thanks to David Ellis of CNN for FDIC data.

Vladimir Putin, Teddy Roosevelt, the GIC & me on a Baltic Non-vacation

We left the Baltic region Friday morning concerned for the security of the EU.  We suspect the Russians have a trifurcated strategy:

(1) They will use the energy card (electricity, oil and gas production, pipelines, and the power grid) to project their power on the EU and NATO member states.

(2) They will use their newly tested success in Georgia to undermine US alliances around the globe.

(3) They will opportunistically use their military might or the threat of same with non-NATO, non-EU states in their neighborhood.  How the EU handles this remains to be seen.

Some analysts found comfort in the Friday afternoon interview with the chief US diplomat in Moscow.  “US Ambassador John Beyrle, in his first interview to Russia’s media, spoke of the US-Russia’s relations after that war.  He emphasized that the US told Georgia the conflict couldn’t be resolved by force…..Moscow has gone too far, Mr Beyrle concluded.”  For the English language version of the Russian daily Kommersant see:

Opinions about Russia/Georgia now range widely.  At one extreme, America’s critics blame the Bush Administration’s arrogance.  One seems to defend Putin for wanting only to restore the Russian “sphere of influence.”  An editorial in the FT (August 20, 2008) by Singapore’s Kishore Mahbubani articulates the “let’s sympathetically understand this Putin action” view.  His op-ed doesn’t defend tanks, but he does place the Western alliance in a troubling perspective.

Mahbubani writes: “Indeed, most of the world is bemused by western moralizing on Georgia. America would not tolerate Russia intruding into its geopolitical sphere in Latin America. Hence Latin Americans see American double standards clearly. So do all the Muslim commentaries that note that the US invaded Iraq illegally, too. Neither India nor China is moved to protest against Russia. It shows how isolated is the western view on Georgia: that the world should support the underdog, Georgia, against Russia. In reality, most support Russia against the bullying west. The gap between the western narrative and the rest of the world could not be greater.”

The opposite extreme is best characterized as a US “neo-con” response which threatens to turn a developing 21st-century cold war into a 20th-century hot one.  In our view these hawkish threats are the 21st-century version of scolding the child when the parent says, “If you take another cookie from the jar I will punish you.”

Even more extreme is the harsh right-wing harrumphing of “shoot first and ask questions later.”  Armchair generals can easily say such things because they do not have to solve the problems of depleted troops or poor underlying economics or questionable reliance on allies and friends.  It is easy to say what others should do.  Much more difficult is the execution of policy in a practical sense when the policy originates from a political economy filled with Internet-informed, blogging voters.

We personally reject both of these extreme positions.  Georgia does not equal the 1939 invasion of Poland by the German army. That 20th-century action forced a treaty-based response.  Hitler wanted to bring all of Europe into a war of conquest.  Britain had a defense treaty with Poland.  Attacking Poland was a direct attack on Britain, and Hitler knew it.

We believe that Putin is way too smart to make that mistake.  Furthermore, he has no need to do it.  He seeks regional hegemony, not grandiose empire building.

The challenge to the US and the EU is to recognize that we are in the 21st century and we have 21st-century tools with which to avoid a repeat of 1939-1945 experience.  The key is to preserve and expand a now threatened global financial and economic integration which has raised the living standards of billions of people, including many Russians.  We admit that the task is easy to articulate, but the achievement of a successful outcome is difficult to obtain during periods of belligerency.

To understand how we got here, we must start with the premise that Russian has achieved its present power through its extraction industries.  As the world’s mature economies became dependent on oil, metals, and other commodities, it empowered those who provided them.  Western consumption profligacy and the growing global indebtedness of the United States made the Putins of the world stronger.

Thugs become statesmen when they have money.  Or at least they try.  Putin is not alone.  Look at Chavez for a proximate example.

In the 21st century, the key to successful US policy is to manage a change from debt dependency, imported oil dependency, and commodity dependency to a restoration of balance.  That may sound simple; it certainly is not easy in the US political system.

We must add a troubling caveat.  In our opinion both of the extreme views noted above are fraught with risk.  Why the higher risk?  There are two reasons.

First, we note that the present-day US is a political economy which is weary of war.  That means the arguments of paradigm shift made by America’s critics can have resonance.  War weariness is a constraint on any political leader, especially one newly elected in the US.

Secondly, an otherwise low probability of hawkishness is currently high because of 21st-century imaging.  Emotional buttons are easily pushed by professional media warriors.  That is what you get in this century of instant Internet and TV communication.  In the 20th century we learned of things from radio and then “Movietone News” in the WWII era.  We enhanced this with live video only after the Viet Nam-era images changed global politics.  In the 21st century, the Russians know how to embed journalists for their advantage, just as Americans do.

In this century, the Internet and the use of video imagery combine to make cyber warfare into a powerful weapon.  The US and the EU need to stress that in their preparedness.  The Russian incursion into Georgia was preceded by a cyber attack of several weeks.  Anyone who thinks that was a coincidence is delusional.  In the 20th century you bombed the beaches to degrade physical defenses, and you attempted to disrupt communication with paratroopers behind enemy lines.  This is all antiquated in the 21st century.  Much more damage can be done by disabling an electronic network.  Imagine if all the world’s Blackberries were simultaneously disabled.  Picture a 3G wireless communication disruption precisely at the onset of hostilities.  The thought is frightening.

Who is speaking softly and who is carrying a big stick?

In our view, soft-spoken Vladimir Putin has successfully tested the US, NATO, and the EU with a big stick.  All three organizations (much overlapped) failed because they were not prepared.  They had convinced themselves that Putin would not use an armored rifle division with coordinated close air support in such a heavy-handed yet efficiently executed way.  They did not believe the cyber attack was a warning sign.  Thus they were caught by surprise.  Russia’s Georgian exercise has skillfully executed the 21st-century equivalent of the mid-1930s Nazi invasion of the Sudetenland.

The West’s reactions now are a “ratcheting up” of tensions as we phase into the 21st-century version of the Cold War.  Each Western reaction begets a Russian counteraction.

The US-Poland missile deal is viewed by Russia as a response.  It is answered by a Russian negotiation of a Syria air defense deal.  Russia will also court Raul Castro to demonstrate its reach.  Putin has specifically said he plans on “restoring our position in Cuba.”  Military movement induces fear, and it works.  It appears that Kazakhstan is now accepting the prospect of pumping oil through Russia instead of via the Baku-Tbilisi-Ceyhan (BTC) pipeline, according to the Turkish daily Referans, August 21 (source: Stratfor).

Meanwhile the US faces an Iraqi government now asking us to leave.  We are failing in the quiet attempt to negotiate some settlement with Iran.  We see Taliban escalation in Afghanistan.  There is growing turmoil in nuclear-armed Pakistan.  I will stop listing here and leave the rest of the list for our readers to complete.

Washington will not admit that the policies of the last few years have weakened the United States.  We entered the 21st century as the most technologically advanced military power in the world, yet our “big stick” has been broken by our own leadership.  And we have not learned to “speak softly.

A Republican president, Teddy Roosevelt, launched the 20th century with “Speak softly and carry a big stick, and you will go far.”  He followed this prescription and won a Nobel Peace Prize for negotiating the end of the Russo-Japanese war.  He projected American economics with the advancement of the Panama Canal and achieved environmental milestones like our National Park system.  He initiated the Interstate Commerce Commission and the Pure Food and Drug and Meat Inspection Acts of 1906.  We have quite a legacy from this 20th-century Republican president, notwithstanding his “cowboy” image.  I will leave it to readers to compare this with the legacy of the 21st-century version.

We are also seriously wounded in the financial sector.

We will not dwell on this issue, since Cumberland has discussed it at great length in our commentaries.  See  Let me only note that Russia holds half a trillion dollars of reserves accumulated because of its oil producer status.  Also note that the Bush Administration leaves office and a new president takes office in the middle of a fiscal year when the cash deficit of the United States will approximate 600 billion dollars.  At the same time the US Congress has positioned the country with a two-thirds dependency on foreign-sourced oil.

The 27 EU countries face an economic slowdown and are starting to report their share of global financial losses.  Their structure is less cohesive than that of the united 50 states of the US.  Their domestic governments still think in nationalistic terms.  They still compute the current account deficits between countries.  Think for a moment about how 20th-century nationalism raises costs and adds to barriers.  Does anyone even know the trade deficit between New Jersey and Pennsylvania?

Can Europe coalesce and achieve a coordinated policy response to Russia?  This is where the risk is also high.

Our repeated travels to European countries leave us with skepticism.  The leadership in many of them understands the problem.  But they are dealing with a socialized form of political economy.  Their citizens look to government entitlements and worry not about the financial liabilities that are mounting.  And their finances are imbalanced.

The European Central Bank has more credibility than many EU governments.  It has preserved its independence because it was enshrined in a treaty.  But monetary policy has its limits.  A strong currency alone is not enough of a weapon against a large external threat like Russia.  Europeans are in for a tough, cold winter when Putin plays his energy cards.

A new American president can achieve a reversal of the imbalances.  To do so, he must avoid sanctions and eschew bellicosity.  Speaking softly will help.  Using the big stick of market-based choices and transparent financial policy is important.  The more we advance global financial integration, the more stakeholders take root in every country of the world.  Stakeholders do not want war.  They have something to lose, and hence they tend to seek options besides tanks.  New Russian entrepreneurs are included.

Global financial integration and commercial expansion is a distinctly American contribution.  These are among our best tools.

In our anger with the Russians we must not let the neo-cons prevail and construct barriers.  We must not apply sanctions.  Instead we should remove them.  The examples of failed barriers are everywhere.  I will mention just one.

The US embargo hasn’t toppled Castro.  Opening up may be more helpful.  Would we rather see Russia drilling for oil in Cuba’s Gulf of México waters, or do we want US companies doing that exploration?  Readers may want to read Rens Lee’s essay, entitled “In Havana, waiting for Obama or for Putin,” at

The other powerful American tool is our technological advantage.  We are still a global leader in IT.  We can still create distinctly American companies and products.  Google is a corporate example.  So is Intel.

Teddy Roosevelt’s 20th-century initiatives may provide guidance for our new president.  McCain and Obama would do well to read this history.

The investment implication is clear.

Finally, we believe the battleground is in IT.  That means more government spending in the tech area will pile on top of business spending.  We expect the increasing defense cost to raise deficits in nearly all the OECD countries.  Much of that money will be spent in the tech sector.  IT gives the fastest productivity payback for each dollar spent.  And cyber war is here to stay and has been proven effective in Georgia.  Cumberland’s portfolios are at maximum overweight in this broad sector.

Why we went to the Baltic region.

During the past week we have traveled from one end of the Baltic Sea to the other.  On August 21 there was a public conference dealing with energy and security.  Discussions included perspectives of Central European, Baltic, and Scandinavian countries.  In addition we heard about the broader approach of the European Union (EU).  There was much analysis focused on the Russian/Georgian experience.  Two Russian-language journalists were in attendance at the public portion.

The speakers presented multiple views and were very thought-provoking.  More than a dozen countries were represented in the panels and among the audience discussants.  The various presenters’ slides will be available publicly on the Estonian Central Bank website, (original website is no longer available).

For those in the GIC delegation ( a great additional value were the private conversations with central bankers, economists, private investors, diplomats, and government officials.  Achieving this dialogue without the public and press scrutiny is a key benefit of Global Interdependence Center conferences.

It was a personal privilege for me to chair of the GIC delegation.  That organization is trying to make the world a better and more peaceful place, a noble purpose in this very difficult world.  GIC’s goal is to sponsor dialogue.  It supports the use of economic, monetary, and trade openness and transparency and seeks to do so with integrity.  The GIC is a nonpartisan think tank; thus its members hold diverse views.  Those written here are our own and do not reflect the organization’s views.

Cumberland Advisors is a proud sponsor of the GIC.

Hans Christian Anderson and Vladimir Putin

Tivoli Gardens’ pleasantries are brightened by the warming sunshine in this western Baltic nation.  It finally stopped raining.  Three flavors of herring and a cold beer will mask geo-political and financial concerns if you allow it to happen. 

Five and a half million Danish citizens live on their four hundred island nation, enjoy the fruits of the European Union (EU), accept their social welfare state and demonstrate their tolerance of people and events.  One wonders if they should think about Hans Christian Andersen’s fairy tales as the parents for whom the poet wrote metaphorically and not just as they were read to children.

I recalled Andersen’s “The Red Shoes” which teaches children the solace and joy one can find in heaven.  The adult version and adaptation ends much differently and in tragedy.  Was Georgia’s leader, Saakashvili, wearing red shoes when he engaged Russia and provided Putin with the pretext for the Russian army to invade Georgia? 

Clearly, there were American advisors present in Georgia.  Did they counsel Saakashvili to act militarily?  If they did, the White House has opened another Pandora’s box.  If Saakashvili acted unilaterally and without the counsel and advice of his American supporters, one must question his motivation.  Concomitantly, one must ponder possible American ineptitude.  Neither option gives comfort.  Unlike some folks here in Denmark at the western end of the Baltic Sea, we believe Putin and company have prepared and staged a division size, armored military incursion which was preceded by a multi-week intensive cyber warfare attack.  We wrote about this several days ago and also commented on CNBC yesterday morning from Copenhagen.  The responses range from full agreement and compliments on a candid assessment to being called names and being threatened. 

I thank readers who emailed constructive criticism and commentary.  To those who reduced their messages to name calling in disagreement with our views, I would call their attention to another Danish personality. 

Kierkegaard’s existentialism would argue that each person has the capacity to create the essential meaning of his or her life and that this is beyond the power of the civil authorities or religious doctrine.  In response one has to ask how existentialist the villager in Georgia feels today when his house has been destroyed by a tank. 

Let’s move to finance.  The CNBC interview ( and, subsequent, Yahoo story created a second flurry of email.  Here are some embellishing bullets:

  1. Firms like Merrill or UBS or Wachovia who are taking back as much as $100 billion of illiquid auction rate securities (ARS) do not require $100 billion of new capital to do so.  They acquire these securities as earning assets just as they would acquire any other earning asset.  If they already have adequate capital, they could substitute these ARS for other assets by selling the other assets.  They may fund the ARS acquisition by using various alternatives.  Wachovia, for example, could borrow money through its holding company or issue preferred stock or use insured bank deposits or borrow from the Federal Reserve or some combination of these and other possibilities. 

  2. The ARS being acquired have very low yields which means the firm that uses a higher cost of funding will experience a carry loss during the period they hold the ARS.  The buy-back of the ARS and the way it is funded is an income statement item. 

  3. The capital requirement arises out of the overall position of each firm.  It requires a certain ratio of capital to assets.  The ratios are different depending on which “tier” governs the asset type.  ARS will be viewed as illiquid and low earning assets.  They will be either held for a long time or sold at losses.  Either way they will operate to detract either directly or indirectly from the firm’s capital ratio. 

  4. If all other things were neutral and equal, the buy-back of ARS would be manageable by most of these firms.  But the ARS buy-back is another item on top of an already very serious list which includes financial turmoil, growing loan loss reserves, persistent and continuing mortgage related asset deterioration, growing consumer debt and home equity loan defaults, questionable commercial real estate asset values and ongoing housing price decline.

We reiterate the message in our CNBC interview.  We think the housing finance related crisis is about half over.  The end point is not in view.  The economic slow down in the United States is likely to worsen and the slow down in Europe is very real.  Many financial firms will need to raise more capital before this is over.  The list of total global financial losses which currently approximate a half trillion dollars.  In our view, hundreds of billions more are still to be revealed. 

Large looming governmental deficits are restricting the ability of the U.S. and Europeans to expand fiscal policy.  That means traditional fiscal stimulus is missing at the very time the economic cycle needs it the most.  Think about it:  the new American president will inherit a $500 billion deficit in the fiscal year of his inauguration.  That also impairs the NATO/EU/US response to Russia. 

By tomorrow night we will be in Estonia and encounter the eastern Baltic view.  Unlike Denmark, those countries are much closer in proximity and experience to the Russian bear.  We doubt if there will be any fairy tales at our meetings in Tallinn