Bribery in the U.S. Senate Sets a New Low Point

A quick market comment will follow this personal polemic on the abominable behavior we have witnessed this weekend in the United States Senate.  Political bribery has sunk to a new low. 

Senator Nelson of Nebraska sold his vote in return for special treatment for the Mutual of Omaha insurance company and for perpetual Medicaid funding for his state.  He has just set a record for pork.  I have not seen the present discounted value of an open-ended perpetual funding for Medicaid for all Nebraskans.  Believe me, the other 49 states would like to have it.  And if you are a taxpayer in the other 49 states you are going to pay for it. 

Now if the good Senator had bargained the abortion issue out of his pure conviction, I would not have agreed with him but I would have respected him for having the courage and honesty to practice politics because of policy.  He argued he was maintaining his position out of conviction for an ideal and a belief.   But the reality is, he sold his 60th vote for money.  He practiced political prostitution.

In my view and in the vernacular of the current generation: that just plain sucks.  Accordingly, so does Senator Nelson.  And we would add the same characterization to Senator Harry Reid and Senator Christopher Dodd and the others who voted with their feet to say that they would do anything to get to 60 votes. 

Did all the Senators know about this Medicaid provision?  I suspect not, but they do now.  Did the House leadership?  I suspect not, but they do now.  Did President Obama?  Maybe not, but he does now.  

Ok, is this the “change” we were promised last year?  Is this how we want the policy of the United States to be made by our Congress?  The phone numbers for your Congressman and Senator are public information.  Mine has already told me he will vote against this.

Now quickly to markets which are headed higher.  Stock prices are responding to ongoing large central bank-induced liquidity and to the prospects that the recovery will feature high productivity, and low labor-cost pressure.  Thus profit margins will be wide and earnings will reflect it.  Cumberland accounts remain fully invested.

Back to Senator Nelson and the new level of political bribery.  I worry for my children and for my granddaughter, who is three and a half and will inherit this mess.  My friend and fellow grandfather Vince Farrell shares this worry.  I will close with an excerpt from the morning missive he writes for Soleil Securities Corporation.

“Beat the Clock was a 1950s game show where couples tried to complete stunts within a certain time limit for prizes. It stayed on TV in one form or another until 1980 or so. It was a simple game and a classic of early American TV. I remember the host was Bud Collyer. But wait — it has not gone away. It only moved over to the US Senate where, if you know how, you can compete for far grander prizes than TV ever offered.

“Senator Ben Nelson of Nebraska has true conviction regarding his abortion views and was troubled by the language in the bill the Senate looked set to pass reforming health care in America. He was holding out. The bill would extend health benefits by, says the New York Times, ‘…expanding Medicaid and providing subsidies to help moderate income people buy private insurance. It would require nearly all Americans to obtain insurance or pay financial penalties for failing to do so.’ In place of the fiercely debated ‘public option’ the Senate bill would create at least two national insurance plans modeled after those offered federal workers (Senators included.) There is a long-term-care insurance program. It also bars insurance companies from denying coverage for pre-existing conditions and limits how much extra a company can charge due to age (I think I like that one.)

“All this will cost, says the nonpartisan Congressional Budget office, $871 billion over ten years. I love the exactitude of $871 billion. Not $870, or ‘about $900,’, but no, it’s $871 to the million. This will be paid for by new taxes and fees and reductions in government spending, especially Medicare. I heard on a Sunday talk show that the Medicare savings will be over $400 billion. (Why don’t I believe that will ever happen?) Senator Nelson got the language regarding abortion restrictions, but he also got an increase in federal grants to cover a Medicaid expansion in his state of Nebraska. Only Nebraska got this special extension. He also won an exemption from an insurance tax for Mutual of Omaha. He was not the only one, though. Senator Mary Landrieu of Louisiana obtained an extra $300 million in Medicaid funds for her state, for being open-minded enough to be convinced of the bill’s merits. Waiting to the 12th hour when the administration has its mind set on getting a bill passed this year is a good time to play Beat the Clock. I thought this was the ‘greatest deliberative body in history.’ Maybe it is. Politics is the art of the possible, but it does feel a bit disappointing to read the fine print.”

Sarasota and Fannie Mae

We are writing this from Sarasota on Saturday afternoon. It’s 77 degrees with a Gulf breeze; the rain and fog are gone. Setting up the new Sarasota office is underway. We expect it will be functional and integrated with the Vineland office in January.

Here in Sarasota, the local paper is full of mini-Madoff stories and a reference to the big one. There is an auction tomorrow of Madoff stuff at the Ritz Carlton. The home grown local versions of Bernie are measured in millions and not in billions. They contain names like Arthur Nadel, John & Marian Morgan and Beau Diamond. Sarasota has had its share of scam artists.

One type of Ponzi scheme didn’t make the front page of the local paper. That is because it isn’t criminal. It is a gift from the same Congress that just witnessed the House passing the financial reform bill. That gift is Fannie Mae and Freddie Mac.

In a superb piece of December 11 research, Barclays Capital has discussed the forthcoming expiration of certain components of the assistance that Fannie and Freddie are getting from the Treasury. Several components will be expiring or will need reauthorization by Congress.

The key area is in the enabling of the Treasury to support the equity stake in Fannie with use of the Preferred Stock Purchase Option. (PSPA). Barclays notes the following when it comes to their review of the $400 billion Treasury has committed:

“In retrospect, the PSPAs should never have been equally sized, in light of the fact that FNM’s credit book is more than 50% larger than FRE’s. In the spirit of providing investors with a comfort under a tail scenario that triggers GSE receivership, we believe that Treasury should increase the preferred backstop available to $300bn before year-end.” Note that after yearend no increases can be made without congressional approval.

Barclays also notes the requirements for the GSEs to start shrinking their portfolios in 2010 and that the GSEs have been slow to buy out existing delinquencies from pools. The combination of all the elements suggests that there are many billions of losses still to be revealed in the saga of the GSEs.

Many say, and we agree, that it is time to end this fiction of an implied guarantee and for the Treasury to take the GSE debt onto its balance sheet. Everyone assumes the US will not permit a default of a GSE on its debt even if it goes into a receivership. And most observers realize that the housing recovery now depends on federal mortgage credit flowing to home purchasers.

But there is another collision course under way in the Washington. The debate over the debt ceiling is already testy and that is before any authorization to formally take GSE debt on the balance sheet of the United States. Officials mostly say that the nationalization of the GSEs is likely to occur and that timing is the issue. Welcome to the world of politics.

So, we thank the House of Representatives for giving us a financial reform bill that was silent on the housing financing/GSE issues. Meanwhile, GSE debt seems to trade at a tight spread and the Fed purchase program continues until March. After that, nobody knows where GSE debt yields will go. Remember this: if they go higher and spreads widen, the marginal house buyer is put out of action. Housing recovery depends on house prices falling or stabilizing and on mortgage availability for the new buyer. The former is likely to continue for a while. The latter may be in jeopardy because of politics.

In Florida we see housing trading hands at half the price level of 4 and 5 years ago. Several Cumberland folks have purchased homes at prices they previously didn’t think possible. If mortgage financing remains available, this market will start to clear and gradually stabilize. The same will be true throughout the country where the price level of housing has fallen to levels that can be supported by the GSE limits. Higher priced houses with jumbo mortgages are another issue.

Stay tuned as we watch the GSE theatre unfold in 2010.

Growth Over Value

Cumberland’s stock market strategy continues to be nearly fully invested. The cash positions in individual accounts are purposefully low. We took advantage of the Dubai World shock to reposition and rebalance. Dubai’s sukuk turned into couscous.

We have overweighted large-cap and overweighted growth instead of value. We believe the long period of value outperforming growth is ending. We also believe the long period of small-cap outperformance is shifting in favor of larger-cap stocks. The coming outperformance of growth can be extensive in our view. ETF choices give us a number of ways to craft this portfolio.

While we were working on a written piece to describe why we have made this shift, a friend, Howard Simons of the Bianco Research firm, penned an excellent and succinct summary of the recent decade, where value outperformed growth. Howard also made the mean reversion case for growth to ascend to outperformance. We asked Howard for permission to share his work with our readers. You may find the piece posted on our website at, bianco120109.pdf

Growth has been outperforming value since the end of September. We see this by various measures in which we compare the relative performance of two baskets of stocks. The growth baskets are outperforming value in both up and down markets. We see the outperformance gap accelerating and expect it to extend for a period of years.

Cumberland’s US ETF portfolios now reflect this strategic change. The international portfolios are more difficult to position in this way, because there are fewer offerings that distinguish between growth and value. We are using those ETFs that meet our criteria for portfolio placement and have this growth characteristic as a bias within the ETF holdings.

Many thanks to Howard Simons for sharing his missive with our readers.

Bernanke Confirmation?

Strategas Research is reporting the latest (Rasmussen) poll numbers on Bernanke’s reappointment.  They show that in July 26% were in favor of the reappointment and 33% wanted a new Fed chairman.  Their December 5 missive says the latest November numbers are that 41% want a new chairman and only 21% favor Bernanke’s reappointment.  

Other polls show that the Federal Reserve is held in very low esteem by mainstream Americans.  Various measures of public sentiment are not supportive of the Fed.  This attitude among Americans has empowered the Fed’s detractors in Congress.  It has empowered Senators and Representatives to attack the Fed and to offer legislation which changes the Fed’s structure.  Some of those proposals will certainly intensify the amount of political influence that the executive branch will have over the central bank. 

In our view the Fed has handled this political attack miserably.  For a while the Fed’s leadership maintained a business as usual attitude.  Now they have realized that they are at risk and we see chairman Bernanke in a more public role than in earlier times.  His next message will be in his Washington speech on Monday. We also see this message of Fed independence coming from other sitting Fed governors and regional bank presidents and from former Fed governors like Krozner and Mishkin and Meyer.  

Is this counterattack enough to blunt the politics that will permanently change the Fed’s status?  We believe that the answer is no.  The Fed is offering too little and too late.  And it is relying on giving opinions instead of citing facts that are credible in the eyes of the public.

Former Feddies who are defending Fed independence have limited credibility.  Sorry, Randy, Rick, and Larry.  You are all bright and articulate and accomplished economists.  You are also viewed as insiders.  You are seen as having been there when the problems were created, and you are viewed as part of the problem.  Rick, you voted for some of these emergency actions, which are now highly questionable.  Randy you did, too.  Larry, you argued there was no proven direction of causality between margin requirement setting and stock price bubbles.  You argued that with me at a NABE meeting in Washington when the world was thirsting for a sign that the Fed would rein in an asset bubble. 

Therefore, spouting broad opinions now doesn’t help the Fed’s cause.  To argue well you need very pointed and concrete examples of why the Fed must act independently and with workable emergency powers.  Cite the work of the Fed in payments after the 9-11 attack and show how the Fed was able to continue the flow of funds in the country because of the redundant system in Atlanta when the New York system was under a pile of rubble.  And demonstrate how the Fed gave the system a massive liquidity boost on an emergent basis.  Show how the Y2K transition evolved without a shutdown and how you took the lead in global planning after the satellite failure in the late 1990s alerted you to the possibilities.  Show how Fed regional banks perform roles that assist the banking system.  Explain how the Board of Governors has no money and how the regional banks are the financing conduits for policy. 

And get the perspective on the New York Fed clearer. Newly installed NY Fed president Bill Dudley is trying his best.  Because of his position he cannot criticize the faults of his predecessor, whose record is tainted by behaviors that are now revealed.  But I can and so can you if you stop being polite.  Tell your story with facts.  Opinions do not help now when the general public no longer believes you.  

And stop trying to oppose an audit.  It is coming.  When 300 Congressmen sign onto a bill, you can rest assured it will be in the final conference version in some form.  And the country doesn’t believe it when you say an audit will hurt the Fed’s independence.  You have to show why and how.  The more a federal body opposes an audit of itself, the more the public and the Congress want it.  You are making yourself the scapegoat. Instead, explain why any audit has to be confidential.  Explain why disclosure of an institution’s condition can be misunderstood and trigger a run on a bank.  Point out how the Defense Department audits are done with confidentiality rules that protect military secrets.  Use your expertise to shape the audit so it doesn’t hurt the country.  The audit is coming.  What form it takes is still under debate and discussion.

Instead of an immediate confirmation vote there will be a delay on Bernanke‘s nomination. That will trigger a period of speculation as to whether he will make it.  We think he will, but the margin will be thinner and the vote may go to the wire.  The delay may impact markets, because it introduces a risk premium. 

Meanwhile the politics favoring changing the Fed’s structure will continue and intensify.  We do not know how the various pieces of legislation will coalesce and become law.  We do know that ALL OF THEM narrow or alter the Fed’s independence.  Our conclusion: whatever comes out of this Congress will limit the Fed’s powers and transfer some its ability to set an independent monetary policy.  That transfer will shift control to the executive branch.  That means more of the policy will be made by the President and a very few people around him, like the Treasury Secretary and his chief advisers. 

Welcome to the new 2010 structure in America.

Does a politicized central bank mean we are going to have high inflation?  No.  In Japan, two members of the cabinet sit in every central bank policy meeting.  They have powers to delay implementation of decisions.  Japan has double the debt-to-GDP ratio we do.  It has had over a decade of deflation and has very low interest rates.  Politics in central banking doesn’t always lead to Zimbabwe.  You can get ice as well as fire.  

What politics does is weaken the compromising center.  The strength of the US central bank is that it combines the views of the Board of Governors with those of the regional presidents.  The unique power of the NY Fed was an accident of history formed in the days when transactions were done with paper and handwritten ledgers.  The 12 regional banks found that they were trading through brokers and transacting with each other.  They centralized things in New York because of the need for “runners” and "physical delivery” of securities.  The whole structure that empowers NY and the Wall Street center acts to the disadvantage of the rest of America and is an antique.  It can be changed.  Talk about it. Debate it.  Do it.

How many Feddies are speaking about changing structure?  I haven’t heard this chorus.  And I haven’t heard anyone defend why we need to have this private club of a few primary dealers.  That club and the Fed’s oversight of it gave us Countrywide, Bear Stearns, Merrill, and Lehman. Shouldn’t the membership rules be changed?  These are the types of issues that Feddies should be addressing in public.  They get to the heart of why there has been a failure at the Fed in both communication and explanation.  

We see all this risk demonstrated in the currency markets.  The Fed produces only one thing: dollars.  They manufacture US dollars.  When the rest of the world wants to shift away from what the Fed manufactures and redirect wealth to something manufactured by another central bank or by a gold mining company, the world sells dollars and buys something else.  It is as simple as that.  

Cumberland’s global multi-asset class allocation has favored a majority of exposure outside the United States.  We believe that financial policy is changing to the detriment of America in a relative way.  We describe this in economic and financial terms.  We still have terrific imbedded personal freedoms in this country, including the ability of a writer like me to criticize the Treasury Secretary and the President and not get shot because I did it.  But our financial strength is under attack; and sadly, the harm has originated, in part, from within.


Interview of Eisenbeis and Kotok by Chris Whalen of Institutional Risk Analytics

Liquidity vs. Solvency: Interview with Bob Eisenbeis and David Kotok

Interview released on November 30, 2009, for the direct link use: the link is no longer available.

“Mr. Chairman, we have in this Country one of the most corrupt institutions the world has ever known. I refer to the Federal Reserve Board and the Federal Reserve Banks, hereinafter called the Fed. The Fed has cheated the Government of these United States and the people of the United States out of enough money to pay the Nation’s debt. The depredations and iniquities of the Fed has cost enough money to pay the National debt several times over… This evil institution has impoverished and ruined the people of these United States, has bankrupted itself, and has practically bankrupted our Government. It has done this through the defects of the law under which it operates, through the maladministration of that law by the Fed and through the corrupt practices of the moneyed vultures who control it.”

Rep. Louis T. McFadden (D-PA)

Chairman Committee on Banking Currency US House of Representatives

Congressional Record/Page 12595

First we must pause to note the passing of our friend Mark Pittman of Bloomberg News. He died last week of a heart attack. Mark was one of the great men of financial journalism. He led the fight to force the Fed to release details of its corrupt bailouts for AIG and other insolvent financial institutions. We shall carry on that fight in Mark’s memory.

We publish this issue of The IRA as the global financial markets seem to be teetering on the brink of a new period of instability. The final Q3 2009 data from the FDIC is loaded into The IRA Bank Monitor and, as we reported several weeks ago with our preliminary results, stress in the banking industry is up from Q2 2009 and by a significant margin.

The number of FDIC-insured bank units rated “F” rose from 2,256 at the end of June to 2,337 as of Q3 2009. Even with the heavily subsidized money center banks added back into the equation, the Stress Index results suggest that the US financial services sector is still sinking bow down under the weight of the highest loss rate experience in the post-WW II period. Whereas 2008 was about fear, 2009 has been about buying time. But now dwindling cash positions inside some of the largest financial institutions and investors seem to suggest that 2010 will be about resolution, whether we like it or not. This suggests that the economy will muddle along through next year and that the 2010 US mid-term elections could be problematic for all incumbents.

With the apparent default by the leading government-owned holding company in Dubai, investors have been reminded that solvency remains a core problem in the global economy despite ample official liquidity. While the Fed and other central banks have thrown a great deal of fiat paper money at the solvency problem, many obligors still have piles of liabilities that were predicated on price levels and volumes in many markets that no longer pertain. Ponder why the government of China might publicly state that its banks need more capital and the next leg of the proverbial systemic risk stool may come into sharper focus.

One of the initial solutions offered to deal with the problem of insolvency in financial institutions is mandatory convertible debt or “CoCo” bonds. This is a capital finance mechanism we have long advocated because it provides additional funding for large banks to absorb losses without liquidating the entire enterprise. The advocates of “Too Big To Fail” or TBTF are right to say that sudden liquidation of a global bank is unreasonable. CoCo bonds solve this issue by allowing a partial liquidation of a bank’s portfolio without a legal liquidation of the company.

To that precise point, Robert Eisenbeis of Cumberland Advisors of Vineland, NJ, wrote in a recent commentary:

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

The IRA spoke to Bob and David Kotok of Cumberland last week.

The IRA: So Bob, David, congratulations on announcing your new office in FL. We were on the radio last week with Dr. Karl Case, founder of the Case-Shiller Home Price Indices. He is not convinced that real estate in FL has bottomed yet. Indeed, between his comments and the Q3 2009 data from the FDIC, we are heading into year-end expecting a rough ride in 2010.

Kotok: Thank you. We are expanding with a new office in Sarasota. For us, it has been two great growth years and the firm is larger in assets, head count than ever before. Many of the new clients are in Florida. Our people are finding property at 40% and 50% of recent valuations and that makes it easy for us to move staff. Climate and friendly tax structure certainly help. We think the Florida property problem is old news; everyone will tell you about it. That seems like a sign of a bottoming process to me.

The IRA: Ah, take note that Kotok is optimistic about FL real estate. Bob, you wrote an interesting comment about contingent capital for banks this past week. You are pointing out some very obvious issues, chief among them is that given the way in which the G-20 nations have been subsidizing the bond holders of the largest banks, what is the point? Do you believe that we can restore market discipline to our financial community after such a reckless expansion of TBTF and the benevolent corporate state? It’s like having no-fault insurance for auto accidents for decades, but then returning to strict liability. Are these convertible CoCo bonds really workable? This represents a pretty big change from the current socialist policy.

Eisenbeis: I presume you are asking whether firms will actually find it attractive to issue CoCo bonds, but more importantly, will they work as a means to address the too-big-to-fail problem and will the regulators have the will to force conversion?

The IRA: Yes and to actually force conversion. We’ve been arguing for debt to equity conversion to fix the money centers for over a year. But debt conversion is a pretty big departure from the free ride that Tim Geithner and his colleagues at the Fed have given global bond holders under TBTF. The officials of the Fed wrote the bond holders of Bear Stearns, AIG, Wachovia and Merrill Lynch a check c/o the US taxpayer. Eventually the Fed will be calling for tax increases to pay for this generosity. Our mutual friend and fishing companion Josh Rosner, as well as other colleagues in Washington, fully expect a VAT to be proposed by President Obama to pay for the global financial fiasco.

Eisenbeis: The one thing that is now evident is that a lot of the regulators are at least talking about CoCos. Lloyds Bank has actually issued CoCos, but their case is a little different because investors have been given the option to exchange a piece of paper that is not worth anything, that is not paying dividends at this point, for another piece of paper. It is not likely that the UK government will let that institution go under, so sub-debt holders might as well convert. But I don’t think that the Lloyds example is a good parallel for what might happen more generally should regulators adopt the CoCo model. Everybody is looking for a way out of TBTF. Some are perceiving CoCos as a way to get some market discipline back into the process. Whether it will be credible or workable depends critically upon the trigger mechanism. If the trigger is some market value-based measure, then there is some chance that it could work. If the trigger is something like that in the Lloyds situation, which is dependent upon some book value /regulatory capital measure, then I don’t think it has a prayer of being effective because politics will come into play.

The IRA: You raise the age old question of separating economics from politics.

Eisenbeis: I think that is exactly right.

The IRA: David, what do bond holders think about CoCo bonds and the discussion of contingent capital more broadly? Are regulators and their political masters offering solutions or creating new problems?

Kotok: Bond holders find themselves in an uncomfortable place. They like the distinction between the equity side of the balance sheet, which is where the preferred classes reside, and the debt side of the balance sheet as long as that debt is paid. The subordinated debt holders of the GSEs went through a worry period but then a line was drawn so that they are on the protected side of the balance sheet. The preferred holders of the GSEs got killed and that included banks which owned those preferred as part of their capital structure. Now what bond holders say today is now how can I be so sure? Bond holders will start to look for compensation for what they see to be rising risk. This gets worse when you introduce this concept of the convertible bond or CoCo instrument. The market will price the convertible bond. It will assess a risk premium. The market now must add to the business risk of the issuer something I would describe as government policy risk or, if you are impolite, government policy run amok risk. What will that interest rate be? If that interest rate truly reflects the risk, will the cost to the issuer be so high as to make this type of debt unproductive?

The IRA: It seems to us that the discussion of CoCo bonds is really about repudiating the doctrine of TBTF and this means repudiating the implicit state guarantee to bond holders of large banks. So wasn’t bank debt always too cheap? Like Fannie Mae and Freddie Mac, were not investors always free riding on the public credit when they purchased the debt of complex universal banks?

Kotok: Well, we don’t know! The big issue for investors today is and for us at Cumberland is that when we look at the indices that Bloomberg collects on banking holding company debt and we look out on the yield curve past two or three years, what we find is that the interest rates have not declined very much. Those yield spreads on bank holding company debt are still extremely wide. The other day in our shop we did a secondary market trade in Wells Fargo paper, 8 1/2% yield, 17 years to maturity. Now 8 1/2% yield on 17 years for WFC is probably +300 bp to similarly rated corporates that are industrial companies.

The IRA: That is because the corporate sector is still solvent whereas the banks are not. One of the idiocies of recent Washington history was not repealing the Bank Holding Company Act when we did away with Glass Steagall. Today the banking industry is a government-protected monopoly with no capital – except from the government. Non-banks and private equity are locked out. Your description of the cost of debt for large bank holding companies also explains why they cannot raise new equity capital in meaningful amounts without government support.

Kotok: Going back to Bob’s point, today market based pricing is telling you that sure, for the next year or two we have this notion of TBTF. But after that, who knows. We have all of this application of the federal guarantee, FDIC-insured notes and so forth. But beyond that we don’t have a clue as to what is going to evolve here. Policy making has been so haphazard and uncertain and of questionable transparency, we have no basis to develop a projection. So long as WFC has to pay 8 1/2% for money, what does it have to get in the redeployment of that money in order to be profitable?

The IRA: Precisely. And we are not even talking about the WFC off-balance sheet exposures, although perhaps the bond market spreads do reflect the uncertainty in that regard.

Kotok: Well, the bottom line is that the policies that we see including this new instrument and the other, what I call “wiz kid” ideas like the $1 trillion PPIP which is a fizzle, they do not create confidence. These polices inspire distrust and undermine confidence number two. And thirdly they are not solving basic issues with banks and markets that Bob has been describing in our comments over the past many months, chiefly the difference between solvency and liquidity. Some people in the Treasury do not understand the difference or they do not want to.

The IRA: In most cases we’d guess that they do not want to. The political implications of ending America’s addiction to debt and inflation, an addiction that goes back to the Civil War and was only temporarily interrupted by WW I & II and the Cold War, are too horrifying for our cowardly political class. Or as Ed Kane likes to say, the convenience of regulators is a vastly under-appreciated factor behind TBTF.

Eisenbeis: Another dimension to the issue that David raises is transparency. There has been no discussion at all about how one unwinds the series of ad hoc guarantees and the debt guarantees…

The IRA: And the “temporary” repurchase agreements between the Fed and the large dealers.

Eisenbeis: Yes. There has been no discussion of an exit strategy from any of these government guarantees.

The IRA: Bob, in your comment you talk about the supposed CoCo bonds as a partial or contingent liquidation for a bank. Don’t you think that this is really the point; that we should stop talking about suddenly liquidating large banks and that instead we need to provide a transparent mechanism for funding them when they take large losses and need to de-lever in an orderly way?

Eisenbeis: There is this fundamental misunderstanding that just because a financial institution fails does not mean that it disappears. Airlines in bankruptcy have continued flying and not been liquidated time and again…

The IRA: What a flattering comparison…

Eisenbeis: If the concern is about risk, why do people seem so willing to travel on bankrupt airlines? People assume that the company will keep running. With the concept behind CoCo bonds is to enable a bank to de-lever and keep on going without a liquidation. That was one of Mark Flannery’s basic ideas in his paper, “No Pain No Gain,” which we wrote about last week. The idea is to be a phased de-levering, but that does not seem to be happening in the Lloyds case. Under Flannery’s concept, the de-levering of the enterprise was supposed to include write-downs of assets while the conversion of debt occurred, so that the bank would shrink significantly. The Lloyds model seems to be a means for the bank to continue on a levered basis without any realized losses. The idea of recapitalizing the institution seems to have gotten lost in the conversation.

The IRA: So what about this surprises you? There are few willing sellers of assets on Wall Street or in the City of London. Just watch how the creditors of Dubai will now clamor for a debt exchange to avoid realizing losses on this monument to excessive leverage.

Eisenbeis: The other point made by Flannery that is lost in the Lloyds case is the mechanism for conversion. Flannery envisioned a re-issuance of securities upon conversion to replace the securities. But what about the actual mechanics of conversion? How do you share the losses with different classes of security holders? Does everyone share equally or do we assess losses sequentially?

Kotok: You know, in a strange way the Dubai Islamic bonds may become a test case for this cockamamie CoCo proposal of distinguishing between debt and equity. Under English law the interest payment from Dubai World is due and it will be a item of default if they fail to pay. Under Islamic law these are equity interests so the technical form is a distribution of a profit which is not there; hence, no payment is required. The bond indenture says this debt instrument is under English law. But the adjudication of any dispute will be under Islamic law. The market is assuming that the Abu Dhabi Investment fund will bail out the bond. I am not so sure. If they do, they open up an Islamic version of a moral hazard expansion. That is why I think there is a possible contagion risk and that this problem potentially is much larger than a single payment on a $3.5 billion item. Markets are only looking a the outstanding Islamic bonds that have been issued. The amount of bank loans in this form is unknown and transparency will not be available until reporting bank have to disclose their exposure. I digressed a little from the US situation. Sorry.

The IRA: Digress away. That’s okay given the news. There is no transparency in the EU either when it comes to bank financial disclosure, so let’s not beat up on the Arabs overmuch. It’s not like people did not know that Dubai was making aggressive use of debt to fund its development. So, if we see CoCo bonds in the US, who takes the first loss? In the case of equity, would it not have to be pro-rata to meet the basic test of fairness in the US law? What about this David? Should regulators demand a set schedule for the assessment of loss against equity holders based on a first-in, first-out type arrangement? A living will?

Kotok: Sure, the more clarity you bring to the situation, the better. My issues as a bond buyer and money manager start with how clear are you as to the claim you have to secure you as a bond holder? What is the priority of these claims? What are the event risks that can undermine them? And can I then price the various options in these instruments? A bond indenture is an articulation of a bunch of options. That’s what it is in simple terms. If you have all of those elements and they are clear, then you make an assessment of risk and you come up with a price. Everyone else in the market does the same and you have a consensus about valuation. That is a mechanism we are used to. But when you add to this calculus the government event risk that comes from inconsistent policy making, you up the ante enormously.

The IRA: So you believe that the still wide spreads on financials beyond short-term yields reflects uncertainty about the Congress, the Fed and policy making in general?

Kotok: Yes, I believe so. And I believe that government event risk is an infectious element and that is why it is reflected going out the yield curve with a very large risk premium reflected in market prices for bank debt. The reason for this risk premium is that the markets are, in effect., saying that we have seen intervention established for a short period of time. We’ve defined it in the FDIC when it comes to bank deposit guarantees expiring in 2013. We’ve defined it in a new regime for guarantees for bank debt set by the FDIC that are so onerous than nobody wants to participate unless they are desperate for funds like GMAC.

The IRA: Careful David, some of our former colleagues from Bear, Stearns are building a bond arbitrage desk at GMAC. This is what the Obama Administration calls “green shoots.” Of interest, GMAC’s bank unit, now called Ally Bank, rates an “F” as of Q3 2009 from The IRA Bank Monitor.

Kotok: In the end, the market is saying that for the next two years we are not too worried about banks. Through the 2012 election, the majority in the Congress and the President will be the people who have brought us these programs to stabilize the banks. In 2013, this could all change. We have GSEs that are still operating in the markets on an implied guarantee from Treasury because Treasury will not take the GSE debt explicitly on its balance sheet. On the way back from Tokyo last week, I sat next to a guy who is running the agency desk at one of the largest primary dealers. He described to me the road show he was on to sell US agency paper to Asian financial institutions. We talked about this approach. He said very bluntly that the Asian banks are not buying it. He told me that “we have destroyed confidence and they do not trust us.” My response to this was “do you blame them?” We then talked about the failure of US policy to date and he confirmed my view, that I talk about in my upcoming book, which is that Washington has largely destroyed confidence in the United States of America among global investors. So when we introduce new cockamamie schemes like CoCo bonds to go along with the existing cockamamie schemes such as those we already have, we only make matters worse.

The IRA: Well, when we were on Bloomberg Radio with Josh Rosner on Tuesday, he leaned over to me during a break and predicted that the Obama Administration was preparing to impose a VAT on the US and will use the supposed pressure from our aggrieved allies and global investors as the pretext. We later spoke to our friends in the conservative movement and it turns out that Brookings Institution has been working night and day on a study that will be the road map for implementing a VAT. This is to be a nation-wide sales tax on the American people to pay for the bank bailout. Apparently Bob Rubin and Larry Summers are the proponents of the VAT and they are planning to use the apparent pressure from our foreign creditors as the justification for a large, permanent increase in taxes. And David, you just described the failure of an auction of agency debt that could provide the pretext for just such a move.

Kotok: Joe Mason and I have had this conversation. Bob and I have had this conversation. The failed auction has not happened yet. It may not happen. But it would not surprise any of us if it eventually does happen. I expect a VAT to be introduced. I expect it to be introduced during the lame duck session of Congress in 2012.

The IRA: You think we can hold it off for that long?

Kotok: Yes. To introduce it sooner is a huge political risk to the Democrats. Obama & Co has lost an enormous amount of support. If Obama introduces a VAT reluctantly, as a last ditch effort to repair American credibility on fiscal issues as part of this re-election campaign, then it can work.

The IRA: So despite the weakness in the polls and the economy and double-digit unemployment pretty much a given as far as the eye can see, you believe Obama can be re-elected? Is not America ready for Sarah Palin? Her book, Going Rogue, is generating some impressive traffic in the great media void.

Kotok: The Republicans are capable of establishing loss. They will do everything possible to avoid victory. They already have proven that time and again. If it is a Palin-Obama race, then Obama will be re-elected.

The IRA: With the economy likely to be still in the dolldroms by 2012, since we are unlike to grow at the 5-6% annual rates necessary to jobs for unemployed workers, that is a pretty stark indictment of the GOP. Bob?

Eisenbeis: To David’s point about the uncertainty reflected in bond prices, with the crazy schemes for regulatory reform now being tossed around Washington and no discussion or vision as to how the competitive landscape in financial services will look several years out, it is no wonder we see longer term bond prices behaving the way they are. Not only do we have uncertainty reflected in bond risk premiums, but also bond investors don’t have a clue about how the financial services industry will look. It’s like Christopher Columbus sailing off for the New World with no idea as to the destination. No wonder uncertainty and bond yields are so high.

Kotok: And to Bob’s point, nobody is even starting to talk about how we get back to a well-capitalized financial sector that can support risk or real economic growth. If you use the numbers from Jim Bianco’s tally of about $1.8 trillion in losses, we have had capital raised of $1.6 trillion, but almost $600 billion of that is government money. So the private sector has come up with $1 trillion, but we are still $1 trillion short if you think of meeting the losses and actually increasing capital. And let’s assume you could stop today and have no more losses, which is questionable since we all expect several hundred billion more in losses. Yet now we are imposing new regulatory structures, we manage compensation and we diminish the profitability of a business sector and add to its risk. And then we wonder why we do not get more private sector investment in financials.

The IRA: Well, as we have discussed many times, we are heading for a European model David. President Obama is an internationalist, he does not even begin to resemble an American socialist like Mark Pittman’s hero Woody Guthrie. He is definitely in the one-world, Euro-centric model, as evidenced by the White House’s open admiration for the Canadian and French banking systems.

Kotok: Correct. So what that says to me is that the wounded banking sector of the US is here for a very long time. You said it on the radio this week in terms of the 2,400 plus banks that are now rated “F” in your system, which is a quarter of the whole industry. You’ve said that something like half of the “F” banks will fail. So over the next five years or so, I see the US muddling along with more and more interventionist, cockamamie scheming power which, sadly in my view, is not just coming from the Treasury.

The IRA: It’s worse than that David. It is pretty clear from the leaks that populate book’s such as David Wessel’s fine tome, In Fed We Trust, that the decision process at the Fed is entirely short-term and reactive. We could take some comfort were the players at Treasury or the Fed or even the White House really purposeful, ideological socialists. But instead we have a group or politicians who collectively are almost entirely ignorant of American history or economics making structural decisions about the US economy based entirely on today’s crisis or expediency. Is that unfair?

Kotok: No, I would not argue with that.

Eisenbeis: There is no question that we are trapped in a short-term mindset. When you see all of these excuses from the Fed reflected in Wessel’s book how “they did not have time,” well yes they did. We still have time to look at these issues and make deliberate choices. When you are not playing with your own money, you don’t have incentives to plan for the future. It is interesting that Congress feels the need to rush to reform the financial system, but the Fed found it necessary to bow to congressional pressure to postpone dealing with internet gambling on the grounds that more time was needed to carefully consider the issues.

The IRA: Well, most of the money we are talking about is borrowed from our foreign creditors, so perhaps that is the answer. And yes we did notice Rep. Barney Frank (D-MA) taking a victory lap for derailing the new limits on Internet gambling. Maybe now we know who pulls Barney’s strings. Thank you gentlemen.

Questions? Comments?

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Dubai: A Stress Test for Global Markets

Last Wednesday, as Americans prepared for their Thanksgiving Day celebrations, Dubai’s flagship government-owned holding company, Dubai World, announced that Dubai will seek a standstill agreement on all of Dubai World’s debt until at least May 30, 2010. Dubai is one of seven emirates that make up the United Arab Emirates (UAE), which has a federal government and a central bank. The wealthiest emirate by far is Abu Dhabi, due to its oil revenues. Dubai lacks oil but has pursued an aggressive growth program to develop trade, tourism, and transport, a la Singapore. The program has been fueled by debt and characterized at times by flamboyant excesses. Note that Dubai’s GDP accounts for only 2% of the GDP of the UAE. Investors were not totally surprised that Dubai World would encounter problems, but felt assured that the UAE would stand behind Dubai. Such support was not immediately evident as events unfolded last week.

On Thursday, this bombshell roiled global markets outside the US (closed for the holiday) and continued to unsettle markets on Friday. The US stock market joined the global sell-off, with the Dow-Jones Industrial Average losing 154.48 points (-1.5%). Oil dropped to $76.05 a barrel and the yield on 10-year US Treasuries ended the week at 3.202%. These reactions were more moderate than some anticipated, following the more pronounced declines outside the US on Thursday, which saw a 3.2% decline in the pan-European FTSE Eurotop 300 and a similar decline in the FTSE 100 in London. Since UK banks were believed to be among the most active in Dubai, financial stocks dropped 5.3% in London, with Barclay’s shares declining 8%. Clearly markets were shocked by the news and uncertain about exposures and likely outcomes, in view of the lack of transparency about restructuring plans and the position of the UAE authorities.

By Friday the global sell-off was losing steam as global investors appeared to come to the view that the problem was containable. The amount of debt involved, $60 billion, is relatively small and it seemed rather likely that Abu Dhabi would extend help to Dubai in an effort to limit the damage done to the financial standing of the United Arab Emirates. Over the weekend the UAE central bank indicated that it would “stand behind” local banks by setting up an emergency liquidity facility for UAE banks, including local subsidiaries of foreign banks, in a move designed to shore up confidence in the banking system. The move was welcomed, but many questions remain as to what, if any, further moves the UAE and Abu Dhabi may decide to make. Of immediate concern is a sukuk, or Islamic bond, of Dubai World’s real estate unit, Nakheel World, on which a payment of $4 billion is due on December. It was announced on Monday, November 30, that “constructive” initial talks with banks on a restructuring of $26 billion of Dubai World’s debt (including the $6 billion of Islamic bonds sold by Nakheel World) have commenced.

While Dubai and Abu Dhabi shares tumbled Monday, their first trading day since the announcement last Wednesday, global markets appear to have moved on as the problem became viewed as more of a regional issue with only limited potential for contagion.

It is revealing to look at the way global markets have reacted. The initial sharp global reaction, despite the relatively small amount of debt involved, reflects a continuing sense of investor unease about the rapid run-up in risk assets this year, fueled by massive liquidity provision by the central banks and the continued presence of other substantial credit risks in the global economy. This event was a reminder that not all credit risks will be bailed out. The lack of transparency magnified the reaction.

On the other hand, the speed with which markets outside of the Gulf limited the contagion and turned their attention to other market developments is an encouraging indication of market resilience. The cyclical bull market in global risk assets still has legs but has entered a more difficult stage in which differentiation between assets will become particularly important. Debtor countries will likely face a more difficult time.

While the Dubai problem did not lead to a major correction in global markets, it served to remind investors of the growing risk of such a correction, which may be triggered by an event few have anticipated. One protection against such a risk is choosing investments wisely, avoiding weak credit risks. Another protection that we also recommend highly is a strategy of broad diversification across countries, industries, and asset classes. The current availability of almost 800 exchange-traded funds on the US market makes such diversification available at low cost. By the end of the third quarter of this year the availability of ETFs by type was US Equity: 334, International Equity: 157, Global Equity: 60, Fixed Income: 72, Commodity: 20, Currency: 20, and Leveraged/Inverse: 126, according to Morgan Stanley.

At Cumberland we have been using ETFs in our actively managed equity portfolios since 2000. In 2006 we launched our Global Multi-Asset Class portfolio, crafted exclusively of ETFs covering the asset classes of US and international equities, US and international fixed-income, commodities, currencies, and real estate. A new brochure explaining this investment style is now available on the Cumberland website at (the link is no longer available).

Questions for Bernanke

In an unusual communication on Sunday in the Washington Post, Fed Chairman Bernanke drove a stake in the ground to his inquisitors in advance of his confirmation hearing latter this week.  He wrote about the Fed’s role in stemming the financial crisis and the importance of not tampering with the structure of the Federal Reserve.  He makes a number of points. 

First, he argues that despite the public outcry at the costs, the bailout of financial institutions saved the country from financial and economic collapse.  Second, he admits to regulatory failures on the part of the Fed and its foreign counterparts, but argues that these have now been fixed.  Third, he argues that because of the Fed’s unique role in monetary policy it is also qualified to continue its role in supervising large, complex institutions. Fourth, he states that it is important to maintain the independence of the central bank, especially since not to do so would run counter to trends in other countries.  

Critical assessment of these arguments will obviously take place during Confirmation and Congressional hearings, but there is a risk that the key issues will soon be forgotten as the regulatory reform process unfolds. 

Let us consider the points raised above.  First, his assertion that Fed actions saved the US economy is not verifiable.  Such assertions aren’t evidence, nor are the claims for Bernanke’s special expertise.  What we do know is that the rescue efforts cost taxpayers more – several multiples more – than the thrift crisis of the 1980s.  In fact, the final taxpayer cost of saving AIG may probably exceed the entire cost of the thrift crisis.  No analysis has as yet been done of the true exposure to counterparties of AIG, Bear Stearns, or Lehman Brothers.  What we do know is that the unwinding of Lehman Brothers under current bankruptcy statues has proceeded in a more orderly way than most might have guessed. 

Second, he states that past regulatory defects have been remedied; but again, no evidence is provided as to what changes have been made or how those changes may have addressed the failure of regulators to enforce the early-intervention and prompt corrective-action requirements of the FDICIA Act of 1991.  In fact, he makes no reference to that law or what it requires of regulators in dealing with troubled institutions. 

Perhaps one of the most strained arguments Chairman Bernanke makes is that the Fed’s role in monetary policy qualifies it to supervise large institutions.  Historically, the Fed has argued just the opposite: that its role in supervising large institutions has helped it to be better informed in the making of monetary policy.  The obvious question this time around is what knowledge did the Fed glean from its supervisory role that was critical to its policy decisions?  It is a fact that Fed supervisory staff don’t participate in the FOMC meetings or briefings, nor do they provide official written input to the deliberations.  So it is fair to ask what critical information the Fed learned that made a difference in its policy discussions.

Putting aside what are essentially political and regulatory turf issues, another key issue raised concerns the Fed’s independence.  There has been an historical bias in the US against the concentration of financial power and undue influence by New York money-center banks, and this is why compromises led to the creation of a decentralized central bank.  Over time, power has become more and more concentrated at the Board of Governors in Washington and through the NY Federal Reserve Bank and its connections to Wall Street. 

We need to put aside the personal issues and first address the policy question of whether the US truly desires to have an independent central bank.  The legislative proposals coming out of both the House and Senate Banking Committees seemed to reflect the desire to have more Congressional influence over the Fed, through changes in its structure.

We are now faced with the classic problem of unscrambling the egg.  The perception is that government-supported institutions are now too big to fail and will be so in the future.  The claim is that revising the financial institution failure-resolution procedures will solve that problem, but no one has suggested how additional policies will change market perceptions.  Simply putting in place a resolution process in no way guarantees that it will be used or that it in any way deals with the too-big-to-fail problem. 

Chairman Bernanke also needs to address several dimensions of the policy-unwinding process.  For example, exactly how will he shrink the Fed’s balance sheet, and how likely will capital losses on asset sales be handled?  We need details on how the Fed plans to wean Freddie and Fannie from reliance upon Fed purchases of their mortgage-backed securities and who will step in as willing investors.  Simply slowing purchases doesn’t replace the needed supply of funds to the GSEs. 

Along with claiming that the supervisory process has been fixed, it would be important to explain what procedures have been put in place to ensure that Fed examiners carry out their responsibilities the next time.  In the recent crisis, the key supervisory problem proved to be an unwillingness to enforce existing standards, more than a failure to understand the risks that were being taken.  Adding economists and other experts to supervisory staffs in Washington won’t necessarily improve the quality of field examinations unless that expertise is widely disbursed, which it isn’t at present. 

Similarly, it isn’t clear how the Fed’s belated promulgation of tougher ethics standards would have prevented some of the problems that were experienced at the Federal Reserve Bank of NY.  The answers to these questions will go a long way to clarifying what kinds of financial and regulatory reforms are or are not needed. 

But the important questions remain unanswered.  Do we want, as a matter of public policy, an independent central bank?  Or do we want to further the accelerating evolution of increased political influence in the setting of monetary policy?  We have argued, in another commentaries, that the failure to fill vacancies on the Board of Governors – due to political interference and delay on the part of Senator Dodd – coupled with failures on the part of both the previous and current administrations to press to fill those vacancies, contributed to the politicization of policy.  The dominance of the Fed by the Treasury during the previous administration only added to perception that the Fed and its balance sheet were at the beck and call of the Treasury. 

Do we want, as a matter of public policy, an independent central bank?  If so, then what is the best way to ensure that outcome?

There are several rather easy steps that could be taken to ensure Fed independence.  Perhaps the most important are steps that would strengthen rather than weaken the role of the twelve reserve banks and their presidents in the policy-setting process.  First, all twelve bank presidents should be permitted to vote on policy, rather than just five.  Second, the position of vice-chairman of the FOMC could be rotated among the reserve banks rather than being the permanent responsibility of the president of the Federal Reserve Bank of NY.  Third, opening the bidding process of the daily System Open Market Account auctions to all member banks would reduce the FOMC’s dependence upon the primary dealers and powerful institutions in New York.  Finally, it would be a mistake to change the selection process for reserve bank presidents, to parallel the centralized political process for selecting members of the Federal Reserve Board by the president. 

One hopes, as Chairman Bernanke appears in his confirmation hearings that these bigger issues will be at the center of discussion.  Hard questions need to be asked and answered, and the fate of the Federal Reserve System as we have known it, and the health of the country, rest on the outcome of those discussions.  One wonders whether a Senator will ask Chairman Bernanke some of the following structural and operational questions:  Why should not all of the Federal Reserve Bank presidents have a vote at each FOMC meeting?  Why is it important that the NY Fed president have a permanent vote at the FOMC but also always be the vice-chairman of the Committee?  Why shouldn’t that position rotate or be elected by FOMC members?  Exactly what information did the FOMC glean from the Fed’s involvement in banking supervision that affected a specific decision on monetary policy during the crisis? Should the Fed broaden the access of member banks to the SOMA desk daily auction process?  Why can’t the Fed transact with 500 banks like the ECB instead of using 17 primary dealers who are especially privileged?  Why was it necessary to change the code of ethics for the boards of directors of Federal Reserve Banks?  At what point and by how much will the Fed reduce its balance sheet?  Will it return to the pre-crisis level?  How much inflation is tolerable for the U.S. economy and how much will inflation have to accelerate before the Fed acts?  If the Fed is truly committed to transparency, accountability and openness, then these are among the questions that should be answered.

The Problems in Dubai

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

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

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

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

Asia trip, Dubai news, T-Day wish!

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

We will summarize the observations with some key points.

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

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

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

Now to the regional takeaway from our trip

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Happy Thanksgiving.  Stay safe.

Cumberland Advisors Announces Growth and Expansion with Florida Office

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

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

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

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

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


Michael McNiven, VP & Investment Advisor Representative

Cumberland Advisors

Phone: (856) 305-8576

FAX: (856) 794-9113