And Then There Were None

A little over a year ago I wrote a piece on the earnings and prospects of the brokerage industry. Little did I know that I’d be writing an obituary for the group at the end of 2008. The list of calamities and casualties is quite long. I will try to summarize them and give our thoughts on how the coming quarters will unfold as we navigate through this credit crisis.

Bear Stearns

Bear Stearns was the canary in the coal mine. It was Bear’s hedge funds that ran into trouble in the summer of 2007 with exposure to subprime mortgages and other illiquid, difficult-to-value assets. Over time, whispers and rumors caused clients and customers to take their business elsewhere. Fixed-income trading revenues declined and the mortgage inventory carried on its books quickly lost value. Marching the two hedge funds’ managers in handcuffs in front of television cameras did nothing to instill confidence in Bear as an ongoing concern. Most importantly, Bear Stearns was a one-trick pony. They were known for their trading acumen in esoteric fixed-income securities but did not have much of a presence in equity trading. There was an absence of international exposure either in trading or investment banking. Currency and commodity trading was also nonexistent. Fortunately for Bear, the Federal Reserve thought they were too big to fail and engineered a takeover by JPMorgan Chase. Most investors and economists thought that event was probably the end of Wall Street’s problems.  Little did anyone expect that the L.L.C. Model called “Maiden Lane” would be replicated many times by the Fed during the ensuring financial turmoil.

Lehman Brothers

No sooner did Bear Stearns wind up in JPMorgan Chase’s lap, than Lehman’s name was mentioned as having problems. Lehman had a better business model than Bear Stearns. Over the last several years they had invested heavily in expanding equity trading, investment banking, and asset management. It seemed to work. However, Lehman held large positions in illiquid Level 3 assets. Those are assets for which there is no reliable market price, and management is allowed to put a value on the securities (model-based, of course). The environment got steadily worse for Lehman as Fannie Mae and Freddie Mac unraveled and were effectively seized by the federal government. Events overwhelmed not only market participants but also regulators (the Secretary of the Treasury, Fed Chairman Bernanke, and others), and in the end there was no one willing to buy Lehman or bail them out, as they did with Bear Stearns. The flight to quality was in a full-fledged sprint.  Lehman’s failure took the firm specific period of this financial turmoil and made it systemic and global.

Merrill Lynch

The same weekend that Lehman ran out of options, Merrill Lynch realized it had one last chance at survival. It was apparent Merrill was in the same bind as Lehman. John Thain, recently hired to rescue Merrill and now rescued by Bank of America cut the deal for the sake of survival. Time was not on anyone’s side, and Thain realized it. Merrill had gone through a tumultuous period with Stanley O’Neal at the helm. Seasoned veterans and risk officers were dismissed or left. O’Neal left under a cloud, as he was able to walk away with approximately $180 million in deferred compensation. If anyone hit the Mega-Millions jackpot lottery, it was Stan. Shortly after his departure, a major capital raise was announced and toxic securities were sold at roughly 22 cents on the dollar. It still didn’t help. Merrill was another victim of the credit crunch and haphazard government programs.

Morgan Stanley & Goldman Sachs

I’ve lumped the two premier investment banks together, since they survived but in another form. For all intents and purposes, both institutions ceased to exist when they were forced to become bank holding companies. Goldman Sachs avoided much of the trouble that plagued Lehman, Bear, and Merrill. In fact, Goldman profited by shorting subprime mortgages and other exotic debt. However, it did not go unscathed and recently announced a $2 billion loss for the last quarter. It was forced to shore up its capital position by taking on Warren Buffett as an investor. Goldman’s shares are off almost 70 percent from its high of 2007.

Morgan Stanley was also infected by this ebola-like virus that hit the financial sector. Morgan had made some bad trading decisions but had acted quickly to stop the bleeding. Investment banking revenues offset the declines in trading profits. It received a capital infusion from a Japanese bank of several billion dollars and did all it could to assert its viability. The effects of Lehman’s failure on top of Fannie Mae, Freddie Mac, and AIG’s problems did not help the atmosphere. Several times there were rumors Morgan was going under.

Federal officials strongly urged Morgan and Goldman to change their charters to become banks. What this did is cause these two firms to become regulated entities and force them to reduce their risk profiles significantly. This has long-term implications for their profitability. They will be run much more conservatively and will not generate the profits they did over the last several years. The culture of these firms will never be the same.

2009 Outlook

We are currently experiencing an unprecedented rise in risk premiums. Today, investment-grade bonds trade at yields that high-yield bonds traded at only a short time ago. High-yield (junk) bonds trade at distressed debt levels, and distressed debt just doesn’t trade. There are some powerful deflationary forces at work in the economy. Ultimately, Cumberland Advisors expects the environment for the investment-grade corporate bonds and agency mortgage-backed securities to improve over the coming quarters. Our view is that corporate profits will rebound in 2010 after a bottoming and then tepid recovery start in 2009.  We believe that the facilities and programs put in place by the Treasury and Federal Reserve will alleviate many of the stresses in the credit markets. We continue to avoid housing related companies and underweight our bond exposure to many of the financial services firms. Portfolios still have a longer than benchmark duration to take advantage of the very high yields available to investors in the investment-grade area.

Statements from the Shadow Financial Regulatory Committee

The Shadow Financial Regulatory Committee is an independent, non-industry watchdog group whose membership consists of economists and lawyers drawn from academic institutions and private organizations who are recognized experts on the financial services industry.  Their common denominator is the belief that financial markets function most efficiently in allocating resources with a minimum degree of government regulation.  The Committee has been in existence since 1986 and meets quarterly to consider developments in the financial system.

At our most recent meeting this past weekend, we published four statements, three of which focus on key issues that have contributed to the current financial crisis. The fourth is an open letter to the new administration, laying out key short- and long-term issues that would need to be addressed in any attempt to resolve the crisis.  What follows is a brief summary of each statement.  It is difficult to do them justice in just a few short paragraphs, so interested readers are encouraged to use the attached link to access the statements themselves,  Particularly important is the Committee’s “Open Letter to President-Elect Obama” on the financial crisis and what his priority concerns should be.

In Statement No. 264, “An Open Letter to President-Elect Obama,” the Committee distinguished among three separate tasks that the new administration will take on:  

1) Managing the current crisis

2) Developing a program for unwinding many of the short-term, ad hoc programs that the current administration has put in place, and

3) Crafting a comprehensive strategy to help shape what the future financial system will look like. 

The Committee identified five priority areas requiring attention and re-evaluation and made suggestions for each, including:

 1) Government policies subsidizing affordable housing:

If housing is to be subsidized, the Committee suggests it  is better to do so through direct grants which are targeted and on budget rather than through indirect subsidies which lead to financial crises and instability.

2) Ways to limit extension of the federal safety–net:

In order to limit the extension of federal guarantees, policies must be developed to restore competition and that clearly define when and under what exigent situations particular markets and institutions will be subject to government interventions. 

3) Competitive policies and actions favoring financial industry consolidation:

A clear lesson from the crisis is that some institutions are now too big to manage, and current rescue policies have fostered further consolidation.

The Committee proposes that the disproportionate systemic risks posed by large complex institutions be recognized and an ex ante systemic risk premium surcharge be levied to internalize the costs that these institutions pose to the financial system.

4) Prudential supervision and regulation of financial institutions and markets:

The Committee also argues that a careful study of the causes of the crisis reveals that there was a significant breakdown in incentives to control risk taking, both within financial institutions and in the regulatory system.

The remedy is not more government regulation but rather policies that efficiently ensure that risks are transparent, recognized, and acted upon by supervisors in a prompt fashion. 

5) Rules ensuring adequate disclosure and transparency in financial transitions and positions: 

Finally, it is clear that policies must be developed that ensure that financial institutions make themselves more transparent to investors, creditors, and counterparties and that regulators can play an important role in this process by ensuring that the information needed by market participants is made available. 

Statement No. 265 focused on the “Regulation of Credit Rating Organizations” and specifically addressed the different approaches being taken by the SEC as compared with the European Commission. 

The Committee expressed concern that the EU approach to enforcing transparency on the Credit Rating Organizations risks Balkanization of world capital markets, because it would permit the establishment of different rating standards in different jurisdictions and impede cross-border comparison of credit worthiness. 

At the same time the Committee points out that the SEC had originally proposed some bold and potentially promising proposals to reform the role of Credit Rating Organizations, including enshrining their ratings in government regulation. 

But the SEC last week chose not to mandate disclosures that would enable outside parties to evaluate the ratings.  It also opted to deal with the potential conflict of interest between ratings and advising by prohibiting the rating of issues that the organization to which they provide advisory services. 

Given industry practice, the Committee questions whether such prohibitions will be practical or enforceable. 

The Committee argues that the best way to reform the process is to simply eliminate ratings from the regulatory process by removing references to ratings from its rules and regulations. 

Statement No. 266 takes another look at “Fair Value Accounting” because the recently enacted Emergency Economic Stabilization Act of 2008 mandates that the SEC investigate the role that mark-to-market accounting rules may have played in the financial crisis.

The Committee argues against suspension of the rules, since this would not in any way address the uncertainty that investors, creditors, or counterparties may have about the quality of the underlying assets on financial institution balance sheets. 

The Committee also notes that the criticism that marking assets to market is pro-cyclical misses the asymmetry that the preferred alternative, historical accounting rules mainly prohibit the writing up of asset values during expansions but, like mark-to-market rules, require assets to be valued at the lower of cost or market when they decline. 

The Committee points out that careful reading of the mark-to-market rules, especially for Level 3 assets for which there are no reliable prices or whose markets are distressed and require judgment, reveals that the existence of prices in distressed markets should be informative but not determinative in valuing assets. 

It recommends that there should be a concerted effort in the case of hard-to-value assets to ensure that there is adequate disclosure of the holdings of such assets, as well as the methods employed in their valuation. 

The Committee’s final Statement No. 267 addresses the fact that “Regulatory Responses to the Current Crisis Have Undermined the Integrity of Tier 1 Capital and Tier 1 Capital Requirements.”  It points out that during the financial crisis institutions that have been recipients of government funds in the form of perpetual preferred stock have been elevated to the level of Tier 1 capital; and a number of hybrid instruments, and even subordinated debt in the case of French institutions, have been authorized by regulators of various countries to be added to Tier 1, weakening the ability of Tier 1 capital to absorb losses.

In addition, recent accounting conventions have contributed to the problem.  For example, Freddie Mac was recently permitted to include $21 billion of fair-value losses on available-for-sale assets in its equity base, reducing its reported leverage from 76 to 1 to 26 to 1.

As a result of these and other problems, Tier 1 capital ratios increasingly have served as unreliable guides in assessing an institution’s capital adequacy, especially during the recent crisis.

It has become increasingly clear that market participants lack confidence in the reported capital ratios and especially risk-related capital ratios and this, in combination with recent research, suggests that increased reliance upon appropriately constructed leverage ratios may be more effective and less pro-cyclical than the current approach to regulating capital adequacy.

Anomalous behavior: negative T-bill yields

Trying to understand a trade that makes no apparent sense is one of the most critical ingredients in portfolio management.  Yesterday we had such a trade.  The 90-day US Treasury bill was reported to have traded in an auction at a negative yield.  That’s right.  You bought the instrument at the price indicated and, if you held it to maturity, you got back less money than you paid for it.  Diane Swonk summed it up well: “someone paid the government for the right to loan money to it.”

On the surface this makes no sense.

There are plenty of shorter-term interest-bearing pieces of paper that are available and that are backed by the full faith and credit of the United States.  So why buy one that is at a negative yield?  And, why invest in any fund that is investing in this near-zero-interest paper?

We cannot find a single investor or institution or organization that would volitionally buy this T-bill at zero interest, let alone a negative yield.  We have polled firms and agents and portfolio managers.  We’ve asked people who range from sophisticated, high-net-worth individuals to multi-billion-dollar institutions.  None would do it.  We have asked professionals and skilled and trained consultants.  All answer “not me.”  Foreign currency traders would not do this trade; they have other ways to hedge or structure without buying a negative yield.

Another possibility is market manipulation or a pricing error.  Not this time.  All evidence points to the negative yield as seeming to be a market-driven price.  This is a real puzzle on the surface.

The only explanation we can find is that there are some organizations that are forced to buy T-bills.  They function with rules that restrict them from doing anything else.  Many of them are foreign institutions. 

Others are forced to own T-bills in order to use them as collateral to secure some other transactions.  Only a “forced” buyer would pay a negative interest rate to own a 90-day bill.  Examples include structures where the T-bill is collateral for an overnight repurchase agreement.  For the major institutions that have access to the Fed, this is no longer an issue because they may use the Fed’s portfolio to secure their overnight repos.  But those who are not primary dealers and are executing overnight repos could be among the sources of the buying pressure. 

Some state funds or other institutional funds also have to be collateralized, and many of those agreements require that the collateral be T-bills.  We are familiar with those funds since we use them for some of our governmental clients. 

Okay, so we have an explanation, but it is quite limited and we still haven’t found a single firm or agent who will step forward and admit they actually bought a T-bill at a negative yield.  Maybe they are embarrassed at admitting it.  Maybe this is a real anomaly and there are actually very few intentionally priced trades which took place at this negative yield.  Instead maybe there were buyers who were willing to take the average price and then they suddenly found that they came up on the short end of the auction.

Anomalies are important because they are disturbing.  When they are not explained, they lead to lots of speculation and innuendo and rumor.  They fuel volatility and they add to uncertainty and, hence, increase the uncertainty premium, which is already very high these days.

Is there some role for government here?  The answer is yes.  The Fed’s research capability in the 12 regional Fed banks and at the Board of Governors could help.  They could publish research on why the market traded the 90-day T-bill at a negative yield or why it traded at zero.  They could analyze the credit spreads in the shorter-term end of the yield curve and explain why a 2-year Treasury note is trading at a yield of under 1% while an equivalent-maturity federally guaranteed note issued by one of the capital market firms is trading at a yield of 1.75% higher.

In technical terms, the Fed has the resources to dissect the “preferred habitats” that are dramatically impacting the markets and therefore adding to the uncertainty risk premia.  This research would be helpful and it could provide explanations for anomalous behavior.  If it were available, maybe risk premiums might shrink, and that means credit spreads might narrow.

At Cumberland, and for Cumberland’s clients, both individuals and institutions, we have advised that it is lunacy to buy a 90-day Treasury bill at a negative yield.  We don’t own them and would not buy them.  This is the time to buy spread product in the corporate sector or the tax-free municipal sector or in the mortgage sector.  Risk-averse investors who still think we are going to have the world come to an end, can obtain the federal guarantee without having to buy zero-interest US Treasury obligations.  There are plenty of options for you.

Cumberland has some of those investors, and we are managing accounts that carry government-level risk only.  We think that is way too conservative a position to take, but our job is to implement a client’s wishes and not impose our own view.  We give the client the options.  That is the job of a separate account manager

In sum, the negative yield is a true anomaly.  We would stay away from it.  But, we welcome any reader to offer us an example of an ACTUAL trade in which they or their institution purchased a T-bill at a negative yield and did so fully volitionally and purposefully. 

Dear readers: please do not email back speculations.  There are many.  Please do email back actual examples, if you have them.  We will protect the identity of anyone who wants to offer an example and remain anonymous.  But we ask that this be an actual trade they have personally confirmed and that it is at a negative yield.

‘None. Zilch. Zip.’

Steve Shorkey, Director for Debt Capital Markets at Wachovia Securities needed few words to describe the use of one of the Fed’s new tools.  

Don’t be confused.  In this case zero use is an indicator of total effectiveness.   The Fed has cured a sector of the credit markets without having to apply a single dollar.   The announcement and design of the program was sufficient to return this important credit market sector to functionality.

Shorkey wrote:

“The Money Market Investor Funding Facility (MMIFF) has been in operation for two full weeks, spanning two Federal Reserve reporting periods (November 26th and December 3rd). During that period of time, there has been no activity under the program. None. Zilch. Zip. That’s a pretty solid indication that the MMMFs (money market mutual funds) feel secure with their liquidity positions and see no need to sell any of the CDs, bank notes, or CP of the 50 obligors that they may hold and that are eligible to be sold to the Fed.”

Remember: it was not long ago that a MMMF faced losses and had to “break the buck.”  The fund had held a position of Lehman paper and the failure of Lehman triggered the loss and an immediate run on the MMMF.  The fear of loss in MMMFs spread like a wild fire and all MMMFs experienced withdrawals.  That, in turn, meant forced liquidation of assets.  The sale of those assets triggered interest rate spikes (high rates from lower prices).  Within days the entire commercial paper (CP) market froze.  That meant the firms which depend on CP had lost their financing mechanism.  This is exactly how a contagion works.  It starts in one place and spreads rapidly and intensifies.

The government’s response to this contagion commenced with a guarantee of the MMMF balances as of September 19.  It was followed by a series of initiatives designed to stop the hemorrhaging and restore the MMMF sector to functioning.  These initiatives worked. 

Shorkey’s research paper helps us summarize the position of a MMMF manager today.  Please note how this has benefitted those investors who followed events closely and were worried about safety.  They acted quickly and profitably.  Other investors frozen by panic lost out.

If you are managing a MMMF nowadays, let’s review your position according to Shorkey:

(1) Government’s insurance on investor’s deposits? Check (via the just extended government insurance program).

(2) Ability to sell any Asset Backed CP in your portfolio at par? Check (via the AMLF program).  Readers please note that the AMLF is the Fed’s Asset-Backed Commercial Paper MMMF Liquidity Facility run by the Boston Fed.  It will buy unlimited amounts of Asset Backed CP at par from MMMFs.

(3) Ability to sell most of the other assets held in your portfolio at par? Check (via the MMIFF).

(4) Basically, MMMF portfolio managers have no excuse for breaking the buck, at least through April 30, 2009.

The Fed’s programs aimed at CP are a total success so far. And the money market funds are returning to full functionality.  The spreads are narrowing.  Here is an excerpt from Shorkey’s December 5 report:

“Total MMMF assets rose for the 10th consecutive week, increasing by $29.1B to a record total of $3.743 trillion. Retail assets increased by $6.7B to $1.283B while institutional assets rose by $22.34B to $2.46B in the week ended Dec. 3rd.  The trend in flows between fund types in the MMMF are complex and are by no means in a straight line, but in general, Prime funds seem to be picking up balances as interest wanes among investors holding Treasury and Government MMMFs as the yields on those ultra-safe funds are near historic lows. A significant portion of the inflows are coming from stock and bond mutual funds.”

Readers should note how the CP markets are also returning to function at credit grades lower than the A-1/P-1 rating level.  “Total CP outstanding now stands at $1,652MM, having edged up $50B over the past month. ABCP comprises approximately $732B of that total, while financial issuers stand at $709B.  A-2/P-2 outstanding is now $81B, substantially above the first-half 2008 average of roughly $60B.

At Cumberland we have been arguing that massive and creative Federal Reserve policy used without limits will break loose the logjam in the credit markets.   The Fed has been at work on this intensely for only a matter of weeks and the Fed started to intensify this effort only after the failure of Lehman.  Doubters who have hoarded their money in government money market funds at near zero interest were motivated by pure fear.  They are not paying attention to the changes taking place.  Like scared rabbits, they will miss the opportunities staring them in the face.

Cumberland won’t.  We see terrific opportunities in the credit markets in many sectors.  They range from tax-free municipal bonds to money market type instruments.  We intend to seize them for our clients.

Many thanks to Steve Shorkey for his superb work on this sector and for granting us permission to share it with our readers.

A Shift in Direction, or Blowing in the Wind?

Both Treasury and the Fed, perhaps either sensing the preferences of President-elect Obama or simply having seen the light, have suddenly focused their financial triage efforts on attempting to directly stabilize housing prices and provide relief to homeowners facing mortgage foreclosure.  Reports are that Treasury has efforts under consideration to bring mortgage rates down to 4.5% in an effort to stimulate demand for housing and stem the decline in housing prices.  This would imply, assuming that servicing rights are worth about 50 basis points, that the wholesale rate would be about 4%, and this would have implications for rates needed to fund the holding of those mortgages.  Given that Freddie and Fannie would have the option to sell MBS to the Fed or to fund mortgages in the debt markets, it is not unreasonable to think of a cost of funds in the neighborhood of  2.5 percent to 3 percent would still make for a profitable activity.  We could be looking at market rates being low for a long time.

Equally interesting were several nuggets contained in two speeches this week by Chairman Bernanke.  He covered the current economic situation and efforts the Fed and Treasury have taken to deal with the financial crisis and floated suggestions to reduce the impact of mortgage foreclosures on homeowners and housing prices. 

The speeches give the distinct impression that policy is still in its triage (stop the hemorrhaging) stage.  Chairman Bernanke described the complex linkages between the housing crisis, the problems in financial institutions, and the subsequent negative feedback effects that the two were having on the real economy which still seemed to be slipping further into recession.  This latter observation was also supported by anecdotal information summarized in the most recent Beige Book released yesterday. 

What was noteworthy in the first of the two speeches was the suggestion that the efforts to date to deal with the macro environment, which have included substantial cuts in interest rates, injections of massive amounts of liquidity into financial markets, TARP injections of capital into banks, and interventions to prevent the collapse of what were believed to be systemically important institutions, were yet to have the desired results.  Spreads, he noted, had narrowed, but had not yet returned to any semblance of normalcy, and significant dislocations existed across a wide array of financial markets.  The picture painted was that it might be some while before markets stabilized.  In the meanwhile, the real economy may experience considerable stress and the outlook is subject to considerable uncertainty.  He hinted that further rate cuts were still possible; but more importantly, he clearly indicated the willingness to do whatever is necessary using the Fed’s balance sheet to purchase assets along the Treasury curve as well agency securities, and backstop other markets as well. 

The important aspect of the second speech was the tacit admission that while macro policies were important, a broader approach was needed, and it was time to turn to micro policies targeted to the mortgage market.  Specifically, the Chairman discussed several options to stem mortgage delinquencies to help mitigate the negative impacts that a flood of foreclosed properties back onto the market might have in further depressing housing prices.  To me, this seemed to be a significant departure from the current macro approaches taken by the Fed and Treasury and perhaps was also opening the door to the use of TARP funds to buy troubled assets. 

Regardless of your preferred solutions, what needs to be recognized is that the root policy issue centers on the fact that there are substantial housing-related losses yet to be realized; and what most of the discussions are about is how those losses will be distributed among lenders, mortgagees, taxpayers, and other claimants.  Whether one is talking about bailing out banks or funding various forms of mortgage foreclosure mitigation, in the end it is all about loss sharing.  One wonders how much those losses have escalated over the past 16 months and how much deeper the recession will be because we have pursued piecemeal solutions rather than tackling root problems.  As policy makers finally beginning to home in on the underlying problems, we should seek solutions that cut our losses and worry less about distributional issues.  For example, would it be cheaper to simply force mortgage rates lower, as the Treasury is considering, or would it be cheaper to have the government buy up the risky loans?  Which policy would have the greatest impact in terms of stabilizing housing prices?  These are the threshold questions. 

Reflections on Mumbai and What It Might Mean

Several years ago I had an occasion to go on a mission for the IMF to the Central Bank of India, headquartered in Mumbai.  It was the second week of December, so it was past the rainy season and the weather was warm, with temperatures in the high 80s and low 90s.  That India is the scene of so many incidents of unrest and violence should not be surprising.  The wide disparity of income plus the long history of the caste system and discrimination against various ethnic and religious groups is a hard legacy to shake.  Poverty hits you even as you land at the airport in Mumbai.  At the end of the runway were many acres of tents made out of black plastic garbage bags, which were homes to many.  It hits you again on the drive into the city from the airport.  A similar sight awaits you in downtown Mumbai from the Central Bank of India, which overlooked a similar several-acre tent city.

Because it was the dry season, work had begun on road repairs.  Instead of dump trucks, however, I saw on the way in from the airport many women dressed in colorful saris, each with a basket of dirt on her head, performing the dump trucks’ tasks.

We stayed at the huge Oberoi Hotel, which was one of the main sites of the recent terrorist attacks.  The hotel is located right across from a major street adjacent to a seaside harbor and beach area.  The problem with the beach, however, was the pollution, which plagues much of the water and permeates the air around Mumbai, since the ocean is the main repository for garbage and sewage. 

The main entrance to the Oberoi is on a small oval drive with very large men serving as gatekeepers, wearing turbans suggesting they are Sikhs.   The lobby itself is one floor up for security reasons and to separate patrons from common street people.  After a few days there, for example, it became clear that a woman who greeted our taxi as it entered and left the drive, asking for coins, lived with her small child next to one of the large flowerpots decorating the Oberoi’s driveway entrance.

The Oberoi’s main lobby is spacious, and the interior reminds you of a Hyatt because the entire inside is open to the top, with balcony rooms encircling the atrium.  I will always remember this atrium, for while we were there a 40-foot Christmas tree, resembling a Norfolk pine, was erected and decorated.  Christmas carols wafted through the entire area provided by a trio of Indian musicians on piano, violin, and cello.  It seemed incongruous at the time, especially given the warm weather, but must seem even more out of place now.

In the atrium lobby is a restaurant in which my friend and I ate nearly every meal.  At that time we were concerned about health and avoided going to places where water-quality or food risks were high.  This restaurant is where the first of the mass killings reportedly began.  Off to one side is the long entrance to a shopping wing, where there is an exclusive restaurant and high-end stores selling rugs, jewelry, and clothing.  This is where the terrorists next herded the hostages they had taken and began killing bystanders, including some in the restaurant.  The distance between the two areas is great enough that under normal circumstances police should have been notified and already responded to the first shots that had dispatched the doormen on the ground.  The terrorists then made their way up several floors.  Since there were no elevators in that area, they had to have used a stairway.  Again, more time must have passed, simply because of the distances involved before they began killing again, high up in the hotel.

We also ate one evening at the Taj – as it is usually referred to – because it was one of the other safe areas where my IMF friend felt comfortable dining.  The Taj was a cab ride away – not a short walking distance – and was substantially more imposing than the Oberoi.

That such an attack by only about 10 people could take place in so many places throughout the city is astounding. The area is crowded and the places where the attacks occurred are not close enough to permit easy walking from one to another.  Yet it is apparent that the terrorists hit one place and then moved to the next, but most likely only in groups of two.  Little has been said in press reports about how the terrorists got from one place to another, but given the distances they could not have walked without detection and possible apprehension.  Not only did they move about freely, it is also clear that they had selected their targets in advance.  In view of what even a casual visitor might glean from having visited the area, there is a high probability that the terrorists had inside help or that the areas had been meticulously scouted in advance.

What has all this to do with investments?  The vicious nature of the attacks and the political response to them would suggest that uncertainty has increased, but interestingly, Indian domestic markets hardly blinked.  The potential links to Pakistan are worrisome and will likely impact relationships between the two countries, whether the links prove out or not.  But again, it does not seem that investors, outside some who are directly involved in India, have been significantly affected. 

Perhaps the world’s financial markets have become inured to the ongoing string of terrorist attacks since 9/11.  This last event in Mumbai is only another in a sequence of terror events in London, Spain, Bali, and elsewhere.  Perhaps they are viewed as an ordinary element of 21st-century life that may be dramatic and riveting in the media but that has few financial and economic implications. 

Only time will tell if markets are becoming wrongly complacent about terrorism.  But while that time elapses it seems that the monetary and economic implications of the events in India are minimal.

How big? How low? How now brown cow?

“How low can things go?”   Or   “How bad can things get?”   We keep getting these questions from clients and consultants.  Let’s look at a few items.   

Interest Rates.   Our metaphor is World War 2.  During that period the Federal Reserve kept the 90-day T-bill rate at 3/8 of 1%.  The long term US Treasury bond yielded 2%.   The Fed actually placed unlimited bids and bought whatever was offered by the Treasury or the market at those yields.   This enabled the US government to finance the war.  So the answer to the question is that we could see these rates again if the Fed deems it necessary.

Cumberland’s outlook.    The short term Treasury rates are already at or near the bottom with yields between zero and 1%.  They cannot go much lower.  The longer term Treasury note and bond rates could be forced lower if the Fed buys them without any limitation.  The Fed can also facilitate this indirectly because it is engaged in global swaps from its balance sheet so that the actual buyers may be foreign official entities and the Fed would be transacting on their behalf.  All interest rates worldwide are headed down or will be flat. 

Cumberland’s strategy.  We are avoiding positions in Treasury bills, notes and bonds.  We are buying inflation indexed treasuries (TIPS).   Care must be used in this sector since there is a risk of a negative accrual if the Consumer Price Index declines for an extended period of time.  So far the CPI has shown negative response mostly due to falling gasoline.  That is a one time adjustment.   Watch Owners Equivalent Rent (OER) for clues revealing a prolonged declining trend.

Unemployment Rate.   We are in a stiff recession but will not get to a Great Depression level.  In the 1930s one out of four workers was unemployed at the bottom.  That is NOT the metaphor for today.

Cumberland’s outlook.    This coming Friday we will see the UR get close to 7%.  In Europe in the euro zone countries we expect it to be close to 8%.  In both of these large global economies the UR is likely to rise for the next year with an 8% peak in the US and a 9% peak in Europe.

Cumberland’s strategy.  UR is a lagging indicator.  It usually peaks after the recession has reached its bottom and during the beginning of the recovery.  We are underweighting the consumer discretionary sector that is impacted by a rising UR.  This also means the housing recovery will be tepid in the beginning.  We continue to underweight that sector as we have for the last several years.

Credit markets.  This has been the key element in triggering the serious degree of recession we face.  Credit spreads are wider than historical norms by a wide margin.  The deteriorating events occurred over the year and a half starting in summer of 2007.  In the first period we witnessed firm specific events like Countrywide, IndyMac, Bear Stearns or Fannie & Freddie.  In mid-September Lehman Brothers failed and that triggered the second and vicious leg down.  Post-Lehman spreads reached levels where entire sectors were frozen.  The Lehman-triggered contagion was a global catastrophic effect which lasted from Mid-September into November.  In six weeks the worldwide destruction of wealth was about 25% of total global stock market value.  Bond yields soared except for Treasury debt.  Marked-to-market losses for investment grade bonds were about 10% in only a few weeks. 

Cumberland outlook.  In the US the Fed is determined to break the freeze and force credit spreads to narrow.   The use of the Fed’s balance sheet has no historical metaphor.  See for our weekly graphic update and explanation.   As each sector in the bond market resumes functionality, the price changes are seen in a gapping way.  An example is in the tax-free municipal market where price changes from their worst to present are often as much as 10% in a matter of weeks.  There are few capital market firms supporting these markets.  That means trading ranges on bonds are exceptionally wide.  Pricing references by matrix-based services are highly suspect at this time.  These services offer a single point estimate of each bond’s market value.  In fact the actual trading range of that bond may often be several points higher or lower. 

Cumberland’s strategy.   We are now very aggressive and active in the managed bond accounts and are seizing the trading opportunities which abound.  This is the time to be a buyer of bonds.  Care must be exercised and research done on each bond to be sure of the credit quality and of the structural internals.   The days of complacency about bonds and reliance on bond insurers or credit rating agencies are long over.

Stock markets.  From its October 2007 peak to the October-November lows the stock markets of the world have lost half their market value.  This occurred in a highly correlated way after the demise of Lehman.  Only recently has the correlation of world market declines started to diminish from its peak and then only in part.  The market showed signs of a selling climax on October 10, 2008.  It has retested those lows and broken through them in the pre-Thanksgiving selloff.   The market rebound in the face of bad news suggests that the market bottom has occurred.  Of course, that will not be clear until many months from now.  US GDP is contracting now and the profit share of that GDP is falling.   This is a world wide phenomenon and not just in the US.   That means reported earnings of companies will be poor for the next few quarters.  Stock’s aggregate value is well below one year’s GDP.  This level is usually a strategic buying opportunity which is rare in history.

Cumberland’s outlook and strategy.   We believe the market has an upward bias through yearend.  Stocks are a discounting vehicle and they are looking for signs that there will be an economic recovery beginning in 2009 and accelerating in 2010.  So far those signs are not evident nor should they be expected to be visible now.  Stocks will lead them.   We believe that the amount of stimulus in the federal pipeline in both monetary and fiscal form will encourage the 2009 forecast to become reality.   With confidence rising rather than falling the 2010 recovery could be surprisingly robust.   That is our outlook.  We do not believe a protracted period of deflation over the next 3-5 years is in our future.  Stock market accounts using only exchange-traded funds (ETF) are moving to a fully invested position and most of that buying has already occurred.

Asset allocation.   Traditional efficient frontier, longer-term allocation models divide about 70% stocks and 30% bonds.  Cash reserves in longer term models are usually quite low.   These models failed during the last year and half as markets in both stocks and bonds punished investors.  In the post-Lehman contagion only cash and Treasury debt had a positive return.   Fear-induced panic prevailed.  The amount of cash available for investment and sitting on the sidelines today is variously estimated at between 40% and 50% of the total stock market value.   This is the highest level in history.

Cumberland’s strategy.  We have committed cash to markets and taken the level of cash to the lowest that a specific account requires.  Cash is now earning next to zero.   Our asset allocation is 50% stocks and 50% bonds.  Stocks are much lower than our normal range and bonds much higher.   The wide credit spreads are the reason.   In many jurisdictions the taxable equivalent yield of high grade tax-free municipal bonds is close to 10%.  And that is based on present tax rates and does not include any estimate for higher tax rates in the future.   Remember the higher the tax rates the greater the value of tax-free Munis.   Our taxable fixed income accounts are invested at very wide spreads to treasuries.  Our conclusion is that bonds are offering unusually high yields and have the potential for capital gains as well as the interest income as the credit markets unfreeze and the Fed’s determined stimulative policy approach succeeds.   We believe the Fed will succeed and credit spreads will narrow.

No Great depression.  Those who disagree with us argue that we will see a protracted period of deflation and that markets are headed much lower.  Some even predict a modern version repetition of the Great Depression era.  If they are right, the stock markets will be much lower and the only debt to own is treasury debt.   If they are correct, there will be massive dislocation and many bankruptcies.  If they are right, there are no safe assert classes other than direct obligations of the government.

We disagree with this Great Depression outlook for two reasons.   During the 1930s the world turned to protectionism and the amount of global business contracted immensely.  Today, governments and policy makers worldwide have committed themselves not to repeat that history.

Also, during the Depression the central bank contracted money and credit.  Bank failures resulted in huge losses to depositors.  Their money disappeared.   Our Federal Reserve and federal agencies like the FDIC are committed to liquidity and preservation of the system.  During the Depression the first large failure (Bank of the United States in December, 1930) intensified bad policy. 

Today the failure of Lehman and subsequent global contagion jolted the Federal Reserve and the federal agency response into proactive results.   In the Depression it took until 1933 and the election of Roosevelt to get a policy change.  In 2008, it took only a few weeks after Lehman for the federal authorities to radically alter course in favor of massive and unprecedented stimulus.

“Aren’t you worried about all this debt and future inflation?”  We are often asked this question.  The answer is not now.   For the immediate future the issue is narrowing credit spreads, offsetting the credit contraction, stimulating the economy and liquefying markets.  Inflation and debt loads will be an issue down the road.  Investors who focus on them now are acting too far in advance of their arrival. 

In sum, the economic outlook seems bleak and foreboding.  Stocks usually bottom when things appear to be only negative.  Credit spreads are usually at their widest when that occurs.  The sequence of restoration is usually credit markets first and then stocks.  We are seeing the first signs of the credit contraction being unwound.  Stocks will follow.  In the yearend 2008, year-start 2009 market recovery, we believe this sequence will happen much faster than in previous cycles just as the post-Lehman contagion occurred with rapidity.  Investors who are not in the markets may not have much opportunity to get in without chasing it higher.  We believe “gapping” may be the key word to describe what lies ahead.

Transparency or Opacity?

On the Tuesday before Thanksgiving, the US Treasury without even an accompanying press release published guidelines it will follow in determining eligibility for participation in the Systemically Significant Failing Institutions (SSFI) Program.  This is apparently one of the programs that Treasury has established under the Emergency Economic Stabilization Act, which also includes the Capital Purchase Plan, the as-yet-to be implemented Troubled Asset Relief Program, and the newly announced Consumer ABS program.  The lack of transparency on the part of Treasury and the other regulators involved in implementing these ad hoc recue programs should be of concern to all taxpayers.

It turns out that the SFFI is the program that was conceived and used to fund the injection of resources into AIG.  This set of guidelines is for that program and has only surfaced long after AIG bailout had been put in place and is essentially open-ended in terms of what financial institutions may apply.  Unlike the Capital Purchase Plan, which had a signup deadline, the SSFI Program will have no deadline and will deal with institutions judged to be failing and that are viewed as being systemically important. There has been no statement from Treasury as to how much of the TARP funds have been set aside for the program and so far that has been used only in that case. 

The program guidelines lay out the considerations Treasury will apply in determining eligibility including the extent to which failure would potentially bring down creditors and counterparties, the extent and number of similarly situated institutions that might be subject to contagion effects from that failure, whether the institution’s disorderly failure might cause major disruptions to credit markets, payments systems, asset prices or loss of investor confidence, and the extent to which the institution might be able to access private sector or other sources of funds.  While these considerations sound reasonable on the surface, they lack specificity and simply provide cover for ex post assertions about adverse consequences that would have happened had a bail out not been provided.  The program guidelines are silent on what kind of documentation will be provided to justify its decisions under the program, and we have as yet to see such documentation in conjunction with the AIG multiple commitment of funds. 

The lack of transparency seems to be getting worse rather than better.  For example, while funds were committed under the TARP to support Citigroup on Nov. 24th that support was not accompanied by any press releases on their respective websites from the Treasury, the Fed or the FDIC.  The only information is that contained in a Citigroup announcement and release of a term sheet which doesn’t even mention the programs under which the funds are being advanced. 

T’is the Season for Giving While Saving?

Carol Mulcahy is a Client Relationship Manager at Cumberland and a Chartered Retirement Plans Specialist SM designee. She was recently approved to be an arbitrator with FINRA.  She has over 23 years experience in the banking and investment industry both in retail and institutional sales and marketing.  Her bio can be found on Cumberland’s home page,  She can be reached at

You may be asking, during this busy season of hunting for the perfect gift to give, how can I possibly give that gift and at the same time save money? Well believe it or not, we can thank our politicians; yes, I said the politicians, the same ones giving away billions of dollars to help selected financially compromised companies, can now help you, too.

On October 3, 2008, President Bush signed into law the Emergency Economic Stabilization Act of 2008, better known as the “bailout package” of the US financial markets.  The section of this act I will touch on is the extension of the Charitable IRA Rollover, also known as the QCD (Qualified Charitable Distribution).  This was originally introduced to us in the Pension Protection Act of 2006, and subsequently expired on December 31, 2007.  Through the Emergency Economic Stabilization Act of 2008, this provision has been extended to cover distributions in tax years 2008 and 2009.

You may be asking yourself, what is this and why do I need it?

What is the Charitable IRA Rollover?

A Charitable IRA Rollover allows an individual to make distributions from their traditional or Roth IRA account directly to a public charity without first recognizing the distribution as income. This type of rollover will count towards satisfying the RMD (Required Minimum Distribution) required by law.

No charitable deduction is allowed on your tax return, since this provision allows you to exclude the distribution from income. 

What are the qualifications to use the Charitable IRA Rollover?

  1. Donor must be at least 70-1/2 at the time of the charitable distribution.
  2. Donor may distribute up to $100,000 per year for tax years 2008 & 2009.
  3. Donee must be a tax-exempt organization for which deductible contributions are allowed.
  4. Donor must direct the IRA custodian to transfer funds DIRECTLY to a qualifying donee
  5. Distribution must be an outright GIFT.

What will not qualify?

  1. This is an outright gift, so:  No qualifying distributions to a gift annuityNo qualifying distributions to a CRT (Charitable Remainder Trust)
  2. No distributions from employer-sponsored plans
  3. Donor cannot receive the proceeds from the distribution first and then donate
  4. This would make the donor have to include the distribution as taxable income, and then they could take a deduction on their taxes for the gift
  5. Cannot donate to: Donor-advised funds and Supporting organizations

    (Make sure to check with your charity first for their classification.)

Who may benefit from this type of distribution?

  1. Individuals who have accumulated IRA assets that may not be needed to support their retirement lifestyle, but are required to take the RMD
  2. Individuals who may make charitable gifts that exceed 50% of their AGI (the maximum amount of deduction allowed for cash gifts). Qualified charitable distributions are not subject to the 50% AGI limitation, because no deduction is permitted.
  3. Donors that have a large cost basis on securities
  4. Donors who do not itemize their deductions (may prefer to take standard deduction for simplified tax returns)
  5. Donors with high income who might lose other exemptions, credits, and itemized deductions if income is inflated by the withdrawal
  6. Donors who reside in a state where charitable deductions are not deductible on their state income tax returns

Interesting Facts

  1. Traditional retirement plan accounts are one of the most highly taxed assets that a person can give to their heirs at death (potential estate tax and income tax).
  2. Retirement plan assets are one of the most inefficient assets to pass to family members; however, they are one of the most tax-efficient assets to gift via a Charitable IRA Rollover.
  3. One advantage is, your heirs may potentially avoid excessive taxation on these assets at your death; another is you also have the tax advantage of distributing these assets in your lifetime and, maybe even more importantly, knowing the joy of giving to a charity you hold dear.

Please remember, Cumberland Advisors does not provide tax advice.  We strongly urge you to work with your financial advisor and tax accountant to see what works best for you.

Enjoy the Season of Giving … while saving!

Questions for Geithner

NY Fed president Timothy Geithner will face a Senate confirmation hearing about his nomination to succeed Hank Paulson as Secretary of the Treasury.  Here are a few questions for the Senators to consider.  Politics being what they are, we recognize that some of them may not be asked.

Q. As the NY Fed president, you held a unique position.  NY is the only one of the 12 regional Fed banks that is always a voting member of the Federal Open Market Committee (FOMC).  The other 11 banks rotate the voting slot, with only four of those 11 presidents voting at any one time.  Mr. Geithner: is this system obsolete?  Is there a need for 12 regional banks now that payments are largely electronic?  Isn’t the concentration of banks in the north and east (Boston, New York, Philadelphia, Cleveland, Richmond) a reflection of history and not the present distribution of economic and banking activity around the United States?  With your experience as the NY Fed president and now as the new Treasury Secretary, would you recommend any changes?  Should we have fewer regional Reserve banks?  Is there redundancy that can be eliminated and reduce cost?  Since Congress is empowered to make any changes in this structure, we are asking you, Mr. Geithner.

Q. As NY Fed president you were involved in the mergers of Countrywide, Merrill Lynch, and Bear Stearns.  They were all primary dealers with direct activity under your supervision.  They did not fail.  Lehman Brothers was also a primary dealer and did fail.  Why Lehman and not the other three?  For six months after Bear Stearns and during the time that the Fed governors changed the rules under their 1932-legislated emergency powers, your NY Fed was using the Fed’s portfolio to secure overnight repos with Lehman and the other primaries, and it was lending to Lehman.  During that time weren’t you able to question Lehman to see if they were developing a workable plan to avoid bankruptcy?  Was that the NY Fed’s responsibility?  If yes, did you fail?  If not, who was responsible?  Was there any culpability at Treasury for Lehman’s failure?

Q. Let me follow up on Lehman with another question, Mr. Geithner.  On that famous Lehman failure weekend you and your colleagues at the Fed and Treasury faced three firms in crisis: Merrill Lynch, Lehman, and AIG.  The Merrill outcome we know.  The AIG outcome we know.  Re: Lehman did you and your weekend colleagues consider the contagion that would follow if Lehman failed and triggered counterparty failure?  Did you see the global collapse coming because of Lehman’s failure?  Did you realize that risk premiums would spike in all financial sectors if a primary dealer failed?  If so, why did you permit it?  If not, what information were you lacking that could have avoided it?

Q. Last one on Lehman.  Barron’s (Nov. 24, pg. 32) and others have reported that the Fed has “created special lines for London offices of primary US government dealers after the Bank of England (BOE) cut off its short-term lending to them.”  BOE acted “because Lehman repatriated $8 billion to New York from London just before its bankruptcy filing.”  Mr. Geithner: what was the $8 billion and where did it go?  Did the New York Fed know about it?  What is your opinion of the fact that the primary dealers were cut off by another global central bank?

Q. Let’s move from Lehman to the whole notion of primary dealers.  Maybe this system is obsolete now?  They are now down to 16 firms.  More than half of them are owned by foreign institutions and the Fed is dealing with the US subsidiaries of them.  The ultimate headquarters of those firms is in London, Paris, and Tokyo.  Those firms’ primary supervision is not the Federal Reserve; it is the BOE, the Banque de France (and European Central Bank), and the Bank of Japan.  What changes do you recommend, if any?  What have you learned as NY Fed president that you can recommend to this Congress for alteration of the laws empowering the Federal Reserve?

Q. Perhaps you can help this Congress restore its approval rating from the lowest level in decades.  We have seen the results of Senator Stevens’ home improvement scandal.  The Banking Committee chair and his wife obtained two personal mortgages under the Countrywide VIP program.  Senator Dodd called it a “non-issue” when questioned about it.  Senator Dodd also held up the appointments of two vacancies on the Board of Governors for years.  He only allowed governor Duke to be confirmed after former governor Mishkin resigned and that left the Fed with only four Governors and no legal ability to use emergency powers.  It takes five votes to use those powers.  Did Congress politicize the Fed?  Did that widen risk premiums? What would you recommend to this Congress?  Mr Geithner, do you have the courage to do it, since we are the ones who vote on your confirmation?  And by the way, is there really any difference between Dodd’s behavior and the AIG folks having a party after they got their bailout money?

Mr. Geithner, we Senators also thank you for your answers on the policy issues of the day, as partially recited in the Wall St. Journal: TARP, Fannie and Freddie, foreclosures, financial regulation, international risk, China and other larger Treasury holders, the stimulus package, taxes, etc.  And now we will adjourn for lunch, having spent four hours in this carefully orchestrated production.

By the way, Mr. Geithner, please consider that the US stock market is now worth about 59% of the US GDP, about half of its year-ago former self and much below the 80% average from the roaring 20s to present. The yield on the 90-day T-bill is near zero.  The VIX (volatility index) is four times higher than a year ago.  The tax-free bond of a major state (example Ohio) yields 150% of the taxable bond of the US Treasury.  Corporate credit spreads are wide without precedent and have caused business to be unable to finance.  The federal deficit will exceed $1 trillion for this and the next fiscal year. Your old employer, the Fed, has tripled the size of its balance sheet in the last few weeks. 

Dear Mr. Treasury Secretary to be: are we correct in assuming that the combination of massively stimulative fiscal policy and massively stimulative monetary policy (unlike anything we have seen since World War II) can turn this serious recession and avoid a further deflationary meltdown like we had in the Great Depression?  Massive fiscal and massive monetary stimulus has the power to turn deflationary forces into a rebound, so we believe.  Are you prepared to increase them, if needed?  Would you recommend a deficit of $2 trillion monetized by the Fed, if needed?

We are investing based on this premise, Mr. Secretary to be.  We believe that Treasury and the Fed have this power to print money hugely.  Are you confident you can succeed?  If yes, specifically tell us why and how.  If not, we should sell everything and move into a cave with canned food and bottled water.

We wish our readers a happy and festive Thanksgiving holiday and hope that you travel in safety during this holiday week.  As we partake of our great bounty in this wonderful and free nation, where political aspirations previously never dreamed of may be reached, let us also remember those who are “food insecure.”  The US Department of Agriculture now estimates that number is up to 36 million Americans, 12% of our population.