Pondering Madoff as we enter 2009

"This is a major disaster for a lot of people.  You work all your life, you finally manage to save up something, and somebody who’s entrusted with it, it turns out suddenly he’s a crook. Lots of people are getting fully or partially wiped out." 

Lawrence Velvel, 69, Dean of the Massachusetts School of Law who said he and friends had lost millions among them.

“Those with the biggest financial gains generally had their money managed by Madoff. It was an honor having him handle your fortune. He didn’t take just anybody. He turned down all kinds of people, and that made you want to give the man even more of your money. When he took your fortune, he told you that he would tell you nothing about how he achieved his returns.” 

Laurence Leamer, a Palm Beach based journalist, writing in the New York Post, December 13.

First to the structural business issues.

Cumberland Advisors did not and does not have a single penny in any fund directly or indirectly positioned with, having custody with, or in any way associated with Madoff.  The Madoff structure violates all of our internal disciplines.  Madoff required that investment management, brokerage, and custody all be with him under the same roof.  At Cumberland we require that each of these three functions be separated by task, separately evaluated, and separately reported.

Cumberland will not invest in any conduits or vehicles where the sponsor refuses to disclose the contents of the investment.  Furthermore, we recommend that our clients avoid any investments they do not understand.  We also avoid any investment about which we cannot obtain a full and completely clear description, so that the investment’s merit may be independently evaluated.

Moreover, at Cumberland, all discretionary managed accounts separate asset custody from brokerage and from Cumberland as manager.  Our performance reports and asset lists are separate and independently compiled from those of the custodian broker or bank.  Managed accounts that are in custody at a broker have explicit permission for us to trade “street wide” when it benefits the client.  We will not accept a managed account where the brokerage transactions are captive to the broker custodian unless there is a specific pricing of transaction costs and the client knows what their broker will charge them.  Cumberland never acts as broker and never mixes commissions with fees.  We are a fee-for-service only manager.

We recommend this structure for all of our institutional consulting clients where we are not the discretionary manager but only consultants on the strategy.  We also recommend this for those whom we are advising on boards and as trustees.  In fact, we advise that those who place funds as a fiduciary in any other format should consult their legal counsel before doing so, in order to ascertain if they are in compliance with fiduciary standards.

The Madoff affair’s implications for lawyers, accountants, trustees, boards, etc…

How the dean of a law school (quoted above) or the trustees of the charities that were allegedly burned by Madoff acted based on a standard that concentrated all the exposure with Madoff is incomprehensible to us.  Placing investment management, custody, and brokerage in one institution and agreeing to opacity about the activity is viewed as the riskiest structure by skilled professionals. How their lawyers and accountants and advisers allegedly sanctioned that decision also triggers many questions.

A separate issue is the role of those conduit funds that were the alleged “feeders” to Madoff.  Some of them allegedly charged investors separate fees and then placed the money with Madoff; they allegedly did so without doing full diligence.  They failed to ascertain that the above separation structure was in place.  Alternatively, they determined it was not in place and took no action.  We expect many investors in “fund of funds” structures will assert claims against those funds for money lost by them.  One case describes how one of these funds allegedly placed 100% of the money under its supervision with Madoff while charging its clients incentive fees for doing so.

This raises many more questions about custody.  The FT reports that $1.4 billion of Madoff money was placed in a form where there were conflicting sets of instructions.  In one set, the client waived the bank custodian’s requirement to due diligence and to provide “safekeeping.”  The other document sets out the obligation of the bank to do so.  If not settled, that will make for an interesting court case.

Lawyers are going to have a field day as the alleged losses from the collapse of the Madoff scheme become the substance of claims against trustees and custodians and accountants and other professionals who had co-fiduciary responsibilities.  Daily we are seeing more and more revelations as the investigation unfolds.

Madoff and the aftermath will consume media attention for a whole year.  And while we naturally tend to feel compassion for victims because they were innocent and acted in good faith, we need to remember that our emotional response must be accompanied by the realization that no one was forced to invest with Madoff.

Madoff was allegedly involved in a criminal fraud.  He purportedly practiced skilled seduction and deception.  He used his communal and charitable relationships to expand his scheme.  His victims were all motivated to grow their money.  Some were driven solely by greed.  True: they were seduced and are now hurt.  But also true: they acted volitionally.  We argue that the true victims are the innocent millions of people throughout the world who are the beneficiaries of the charities that have now have lost their funding because of their board’s or trustee’s decision to place money with Madoff.

The Securities and Exchange Commission and other regulators.

We have already heard remarks from SEC Chairman Christopher Cox and former Chairmen Harvey Pitt and Arthur Levitt.  We see their admissions that the SEC had received information about Madoff for years and that it had been ignored.  We see their recommendations for transparency and their prediction that the new SEC under Chairwoman Designee Mary Schapiro will be proactive in changing the way the SEC acts to protect investors.  And we see them repeatedly state that a designed and intentional fraud is hard to detect.

But what about the depth of this embarrassment for the SEC?  We see evidence that the SEC used Madoff as an example of compliance achievement.  No SEC audit found any wrongdoing.  This is true even though the structure of combining investment management, custody, and brokerage is a “red flag” on the SEC checklist, according to many experts in the compliance field.

The SEC’s embarrassment is even greater when one considers that the SEC received warnings as long as a decade ago.  Furthermore, there is evidence that many prospective investors refused to place money with Madoff.  They suspected the returns Madoff represented were not possible, and they advised the SEC of their suspicions.

Why did the SEC and other regulators fail to find Madoff’s flaws?  And were there other regulators who had supervisory roles and also failed?  Questions must also be asked about what the regulators’ liabilities are when they fail.  If a state or municipal government fails to perform an assigned and legislated role, it can be sued for negligence and may have to pay damages to innocent victims for its governmental failure.  What is the obligation of the federal government?  Will that subject be tested here?  Can the United States avoid all liability for its failure?

The Madoff case certainly opens these issues to legal inquiry.  It also requires Congress to address them.  We expect both to occur in 2009.

In that spirit we worry about a regulatory backlash.  In an effort to redeem itself, the SEC may impose rules that have unintended consequences.  And they may add costs to the law-abiding practitioners.  History is replete with examples of regulators chasing the horse after it left the barn and wounding the well-meaning and honest instead.

Congress, Madoff and money.

We expect the new Congress to hold hearings on the Madoff affair.  And the new SEC chair will get the usual earful from Senators and Representatives.  This is our system and these are the folks we elect to represent us.  They are supposed to be acting in the interest of the citizens and to be concerned for the country’s welfare.  Their supervisory role and legislative role are supposed to be in that direction.

They fund the budgets of the enforcement agencies.  They write the laws that the regulators are empowered to enforce.  In the Madoff case, they determine the depth and strength of the SEC. There are 11,000 registered investment advisers and 8,000 hedge funds.  In addition there are the so-called self-regulatory organizations (SRO), of which Madoff was certainly a pre-eminent member.

So why is this Madoff story so filled with failure and why is the system so sick?  And why is the legislative oversight provided by the Congress so poor?  And why do Americans have such a low opinion of the Congress?

Here goes.

Madoff’s political contributions included several for $25,000 each to the Democratic Senatorial Campaign Committee.  Other contributions were made to individual campaigns of folks like former Senator Hillary Clinton and present Senator Charles Schumer, as well as Congressmen like Charles Rangel.  Madoff did nothing illegal in making those contributions.  At least that is how it looks from the cursory review we conducted on disclosure services.

The recipient politicians argue that these contributions were only individual in nature and are legal.  They do not discuss what motivated Madoff.  Maybe it was Madoff’s sense of citizenship and his patriotic concern for the ethics of the United States.  Ok, I admit sarcasm.  More likely these contributions were part of the collective enterprise of political fundraising from the very industry that lacked the transparency and regulatory supervision to prevent an alleged Madoff-type swindle to occur.  We see the political money everywhere and intertwined with the financial industry and its problems.  It plainly stinks.  We will leave it to others to dig into the amount of political influence Madoff had over the years.

How Ponzi schemes work and how they collapse.

So far, it appears that Madoff’s undoing was driven by European investors who withdrew money because of their fear of the US dollar weakening.  That triggered the large withdrawals that ran this alleged Ponzi scheme out of money.  History shows that the end of a swindle can be triggered many ways, but the result is nearly always the same.  The swindler runs out of cash and the house of cards collapses.

The end of the original Ponzi swindle ended the same way.  In 1920, Charles Ponzi established the fraud of using one investor’s money to pay another while advertising that the payment was the result of a little-known investment idea.  Ponzi’s undoing came because he promised a 50% return in less than two months’ time. Ponzi ran through millions of his suckers’ money.  When the scheme collapsed he had $61 left. 

Madoff was telling his investors the investment results were much lower (10% to 13%) and were derived from a “proprietary” method involving stock option structures.  His scheme was sold to victims who were looking for consistency.  Professionals who could not replicate the strategy warned the SEC as much as a decade ago.  Madoff persisted for years because he promised a lower return and, therefore, his need to raise new funds to pay off older investors was not as acute as the original Ponzi’s. As with all such schemes, he ultimately exhausted his cash and failed.

We do not yet know how many years of effort were applied by Madoff to this fraud.  We do know that it was a protracted period.  We know it grew and grew over time.  We know Madoff used subtle and social relationships to attract more investors.  We know he turned some away, and that only made him more desirable.  Oh, how the seduction works.  And in the very high-profile social circles of Palm Beach it developed its own momentum.  And it appears that Madoff played the crowd quite well.

Unanswered questions about Madoff and Ponzi.

In the business area there are many lawsuits ahead.  A bankruptcy judge will rule on who got paid out with a “preference.”  Those parties will be asked to return the money to the general fund for redistribution.  This is a lawyer’s field day.  So is the litigation to come against the funds of funds and the board trustees and other co-fiduciaries.  Accountants will be busy, too.  Many thousands of tax returns will have to be amended and refiled for multiple years.  For those who received payments from Madoff, these are “ill-gotten” gains.  Their tax treatment is different from what they reported to the IRS.  International arrangements and multiple national jurisdictions make this accounting/legal complexity extraordinary. That is the cleanup that lies ahead.

What history doesn’t tell us is how these things start.  What gets in the brain of a crook and when does it first get there?  Do swindlers really believe they can continue forever?  Does the scheme’s momentum create its own force and overwhelm the perpetrator?

Was Madoff a cheat and faker when he was born in 1938?  Was he a cheat in college?  Was he a crook when he started his firm in 1960?  When he brought his brother, Peter, into the business?  Or when his sons Andrew and Mark first reached young adulthood?  Or when they joined the firm with him?  Was he a thief when he used internet technology to move quotations from the “pink sheets” to what eventually became the NASDAQ that he chaired?

By the time the Madoff affair recedes into history, there will have been books and movies and TV specials about it.  Millions of words will have been written.  Many victims will be revealed.  Their stories are already being told in TV interviews.  One at a time, we see the journalists asking how the victims “feel” and inquiring about their sense of “trust” and “betrayal.”

Fewer interviewees were asked the question “why?”  Their choice of Madoff is not probed.  Why did they allow themselves to get “sucked in?”  Didn’t they realize that the results promised were not reasonable?  Weren’t they wondering how they could receive an investment return which was inconsistent with what they saw in the market?  Did they balance their desire for money with the risk they took when dealing without transparency and without separating the three functions that we outlined at the beginning of this commentary?

Going forward after Madoff.

The basic lesson remains, and the Madoff affair has affirmed it.  Separate custody from brokerage from investment management.  Have each reported differently and accounted for independently.  If you cannot understand the investment, beware of participation.  And remember, there are no free lunches.  Clichés become so because they are true.

This is the season of festivities in Western traditions.  Holidays affirm faith and ask those who are more fortunate to give to those who are less so.  We then pass the solstice, enter the New Year, and begin the process of renewal.

Madoff has dealt a huge blow to charity.  We’ve talked about the trustees and boards who failed to review his activity and who breached their fiduciary requirements.

But what about the beneficiaries of those charities?  They did nothing wrong.  They are sick or hungry or poor or isolated or weak. They are global, since Madoff’s tentacles reached afar.  And, in this year of global recession, they need assistance in great numbers and with earnest commitment from the donors.

Perhaps we can remember an ancient teaching as we thankfully close this year of 2008.

“For this reason, man [i.e. the first human being] was created alone to teach that whoever destroys a single life is as though he had destroyed an entire universe, and whoever saves a single life is as if he had saved an entire universe. Furthermore [the first man was created alone] for the sake of peace among men, so that no one could say to another, ‘My ancestor was greater than yours.’” 

Mishnah: Sanhedrin 4:5

For our clients, colleagues, readers, friends, and others, we wish peace, good health, and prosperity for 2009.  Travel in safety.


Give the Gift of Education

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, www.cumber.com.  She can be reached at carol.mulcahy@cumber.com.

It’s never too early to start saving for college. So when thinking of gift giving by year end, think of your grandbabies, your children, nieces or nephews, and give the gift of education.

History of the 529 Plan

As many other investment vehicles are named after the Internal Revenue Code in which they appear, this one is no different: IRC 529 was first introduced to us by Congress in the Small Business Job Protection Act of 1996.  It has had modifications over the years, including the Economic Growth & Tax Relief Reconciliations Act of 2001 (EGTRRA), which made it more attractive by allowing distributions for qualified higher-educational expenses to be federally tax exempt. Most recently, the Pension Protection Act of 2006 made this tax exemption permanent.  The federal tax exemption for the 529 Plan was due for a sunset provision in 2010, and many were skeptical of investing for the long term until the exemption was made permanent in 2006. 

What is the 529 Plan?

A 529 Plan is a tax-advantaged college savings plan. It allows the earnings derived from contributions made to an account from the account owner (participant) for a beneficiary to grow tax deferred and ultimately income tax-free, provided they are used for qualified higher education expenses at an eligible educational institution. It is a revocable gift (participant retains control of assets) and can be taken back if needed at a later date (certain rules apply to this, check with plan manager).  In most cases, the student’s choice of school is not impacted by the state in which the 529 Plan was established.  So in the case of a family moving from one state to another or a grandparent opening an account in their own state, as opposed to the beneficiary’s state, state residency should have no impact on the choice of school.

The 529 Plan can be used for accredited U.S. (and selected foreign) private and public colleges or universities, graduate schools, junior colleges, or vocational/technical schools. 

Qualified expenses usually include tuition, books, supplies, mandatory fees, equipment required for enrollment, room and board, and certain expenses for “special needs” students.

There are two types of 529 Plans

1) Savings

Contributions are made with your after-tax dollars (no securities transfer) to the 529 Plan of your choice. Many plans will include mutual funds that offer an age-based asset allocation. This is where the underlying investment will become more conservative as the beneficiary gets closer to the target date of starting college. The risk/performance is directly associated to the performance of the underlying investments. There is no guarantee that the necessary dollars to cover all college costs will be there once the beneficiary goes to college.

The Savings plan is offered for sale in two ways, either Broker/Advisor-Sold or Direct-Sold

Advisor or Broker-Sold Plans

This type of plan is sold through your financial professional.  It means you will get advice on the type of plan and investment options available, but you will also pay commissions and/or fees which may impact your portfolio’s performance.

Direct-Sold Plans

This type of plan is purchased directly from the plan manager. You will need to do your own research and make decisions on what is best for you; however, you would not be paying the commissions you would in the advisor/broker scenario.

2) Prepaid

A prepaid plan allows you to purchase tuition credits or units. You could potentially pay for all or at least part of future in-state public college costs at today’s prices.  Many of these plans can be converted for use for out-of-state schools or private schools. It best to check with the plan you have chosen to see the benefits that will convert over.

One other type of prepaid plan for participating private colleges is the Independent 529 Plan. See link below under “Helpful Sites.”


To avoid federal gift taxes you could invest, for 2008, $12,000 per beneficiary per donor. However, if you choose to take advantage of the special five-year election, you could, for 2008, contribute $60,000 ($120,000 per married couple) per beneficiary without federal gift taxes. This will increase to $65,000 ($130,000 per married couple) in 2009.  This works as long as you do not make any other annual exclusion gifts to the same beneficiary in the five-year election period.  Once the contribution has been made to a 529 Plan, the assets are generally considered removed from the account owners’ (participants’) estate.

For most plans there are no age or income restrictions on giving or being a beneficiary of a 529 Plan. The maximum dollar amount you can contribute may vary from state to state. Remember, we are dealing with sheltering assets and potentially avoiding some taxes; therefore there are some parameters around the maximum dollar amount allowed to be contributed.  It can be realistically based on what a college education is anticipated to cost. Some states will allow over $300k per beneficiary.


A beneficiary can be changed for a variety of reasons. Please check with your plan provider for a list of who qualifies as a “member of the family” to whom the 529 Plan can be changed, without the distribution being treated as taxable.

Distributions not used for qualified expenses are subject to a 10% penalty plus ordinary income tax at your tax rate on the earnings portion.  If you are in a state that allowed for a deduction of a portion of the principal you contributed, you may have to report that “recapture” income on your taxes.  

There are certain cases when the penalty would not apply:

* Death of the beneficiary

* Beneficiary becomes disabled

* Beneficiary receives scholarships, veteran’s or employer-provided educational assistance

Check with your provider for more in-depth details on these exclusions.

Financial Aid Impact

If a parent is the account owner, the 529 Plan is considered their asset and FAFSA (Free Application for Federal Student Aid) will take into consideration only 5.64% of the account value. If the student owns the plan, FAFSA will take 20% of the account value into consideration when calculating awards. If a grandparent is the account owner, this may exclude the plan from reporting on a financial aid application – check with your accountant.

Keep in mind, though, that a lot of financial aid is given in the form of loans, and you will need to pay these back eventually. Loans and loan interest are not qualified distributions under a 529 Plan.

Every case is unique, and each state offers its own form of the 529 Plan. Many have slightly different provisions and state tax implications that make it necessary for you to do research, either on your own or with a financial professional to see which state plan works best for you. We at Cumberland are not tax advisors, we recommend that you consult with your tax professional before investing.

Helpful Sites




At First Blush

Markets responded overwhelmingly positively to the Fed’s policy announcement yesterday.  At first blush, the Fed appeared to pull out all the big guns.  The Wall Street Journal characterized the move as Bernanke having gone all in, to draw upon a poker analogy. 

The FOMC cut its policy target rate to a new low and also expressed it as a range instead of a single rate.  The Committee stated that its new target for the Federal Funds Rate was a range of between 0 and 25 basis points. Furthermore, it indicated that it will employ “all available tools” to ensure a resumption of trend growth of the real economy.  These tools would include, but were not limited to, enlarging the Fed’s balance sheet by purchasing agency debt and mortgage-backed securities, and wide use of its Term Asset-Backed Securities Loan Facility to support the extension of consumer and small business credits, as well as possible purchase of long-term Treasury debt.  The Board of Governors, in addition to lowering the discount rate to 50 basis points, lowered the rate it would pay on reserves to 25 basis points. 

What has been overlooked in the market’s euphoric reaction is how little was actually new in the FOMC’s announced policies.  In reality, what the Fed actually did was to make public what it had been doing de facto for the past two weeks.  For example, the Federal Funds effective rate has not exceeded 20 basis points since December 4.  The asset purchase programs were previously announced or were minor extensions of existing programs to accept agency and mortgage-backed securities as eligible collateral for many of its new liquidity programs.  And the intention to provide direct funding to consumer loans and small business-related paper was a restatement of existing policy. 

What the FOMC’s actions really have done is make explicit that it had changed its policy implementation regime.  The Fed Funds Rate is no longer a target, but rather it will fluctuate within a range – which it has been doing for some time now, anyway.  Interestingly, the Fed has set the rate that it will pay on reserves at 25 basis points, setting up a risk-free arbitrage for those banks able to buy funds at the effective funds rate, to increase their reserve balances at the Fed.  The policy focus is now not on interest rates but on the size of the Fed’s balance sheet or, equivalently, the money supply.  And we can count on this for “some time.”  The rationale for this regime shift is to provide whatever funds are necessary to ensure well-functioning financial markets.  Call it quantitative easing, if you wish. 

However, there are some interesting side issues.  The first is how and by whom policy will be decided during this period.  The size of the Fed’s balance sheet is largely dependent upon the Board of Governors and its lending programs and is not the province of the FOMC.  Day-to-day decisions will be determined by the Open Market Desk and, presumably, Chairman Bernanke.  Will the guidance to the Open Market Desk be to keep the Fed’s balance sheet at a target level, or will that target change on a day-to-day basis?  From the current statement, all we know is that the balance sheet will remain at a “high level.”  If the balance sheet target changes daily, then those changes will affect the supply of reserves and impact rates, and consequently will affect the players in those markets in which the Fed operates. This looks an awful lot like the policy regime in the ’50s and ’60s, when then Fed Chairman William Machesney Martin, and the manager of the desk, set monetary policy daily, which they characterized as “responding to the tone and feel of the market.” 

This new regime also raises an important issue of transparency to the market, for several reasons. 

First, when Chairman Martin ran policy, markets were completely in the dark as to whether the Fed was pursuing tighter or easier policies and could only infer shifts in policy by carefully watching after-the-fact what had happened daily to interest rates.  Fed watching was a boon to economists who understood the tone and pulse of markets.  Since today’s Fed will be operating by increasing or decreasing the size of its balance sheet, information on changes in size and composition will be critical to market participants.  Right now the Fed only publishes a weekly balance sheet, ex post.  Will it announce a daily target for its balance sheet?  Will it publish a daily balance sheet, and if so, how detailed will it be?  The more transparent the Fed is as to what it is doing on a daily basis, the better market participants will be able to infer when policy has, de facto, been tightened or loosened. 

Second, we need to keep in mind that in the new regime, if the Fed relies upon the 17 primary dealers as sources of the non-traditional assets it will be purchasing, these institutions will have a real informational advantage relative to market participants without access to daily information on the Fed’s activities.  In addition, over half of these are foreign institutions or their affiliates. 

Third, because the Fed indicates that it will be operating in the markets for different types of assets, and perhaps not Treasuries initially, information on exactly what the Fed is doing on a daily basis will be critical to assessing changes in market rates in those markets.  Otherwise, by looking only at rate changes, one will not know whether they changed because of actions by the Fed to increase or decrease the supply of funds in those markets or because of changes in market perceptions of risk premiums.

Finally, there is the issue of what the role of the FOMC will be in policy formulation.  This new regime is not one in which the FOMC can meet and consult eight times a year, set the operating directions for the desk, and go home.  This is a regime that requires daily decisions.  It is neither feasible nor practical for the Reserve Bank Presidents to move to Washington and meet daily.  So it is likely that the FOMC will be de facto mothballed, until and if there is ever a return to “normalcy” in the policy formulation process

All of these issues seem to swamp the initial reaction to the Fed’s supposed rate reduction yesterday.

Today’s New York Times Editorial

As many of our readers know, my colleagues and I have written and spoken about the Lehman failure and the lack of forensics on the Fed’s Bear Stearns decision and the Fed’s Lehman non-decision.  We have articulated the risks to policy transparency that originate with  the US Senate Banking Committee under Senator Christopher Dodd’s chairmanship; he has kept the Fed’s Board with only 5 governors and therefore forced a unanimity rule instead of a super majority rule which was intended for Section 13 emergency power intervention.  Note that there are no records and no memorialized discussions other than when 5 votes were affirmatively cast.  

We have asked what happened during the 6 months between March when BSC was merged through the use of Maiden Lane, LLC and September when Lehman failed.  Those 6 months were the months when Lehman was using the Fed’s own treasuries to secure overnight repos and when primary dealers like Lehman were borrowing directly from the Fed and pledging collateral.   What was the Fed seeing in Lehman?  What was Lehman asked to produce besides collateral?  Was there any clue about Lehman’s growing insolvency?   Other questions still unanswered include if there were suitors among the primary dealers or elsewhere who would have taken Lehman?  Were they among the firms that have to answer to a foreign central bank or regulator; therefore they may have required the Fed to take a larger amount of Lehman’s toxicity onto the Fed’s balance sheet in the form of a Maiden Lane 2?

These and related questions remain unanswered.  Today some of them are being asked by the NYTIMES.   One might wonder where the Times was for the last 6 months as these events unfolded.   Where were the editorials calling for transparency between March and September?   Whatever the case, now the Times has awakened to the important role played by media.   We forward this editorial in case any of our readers missed it.  


New York Times

December 15, 2008


Questions for Mr. Geithner

Timothy Geithner, President-elect Barack Obama’s choice for Treasury secretary, has some explaining to do.

As president of the Federal Reserve Bank of New York, Mr. Geithner was a key decision maker last September when the government let Lehman Brothers fail and then, two days later, bailed out the insurer American International Group for $85 billion.

Those decisions proved cataclysmic. The markets and the economy have yet to recover from Lehman’s failure. The bailout of A.I.G. dealt a further blow to the Fed’s credibility — and, by extension, Mr. Geithner’s — because it was an abrupt reversal from the no-new-bailouts stance that had applied to Lehman and, initially, to A.I.G. Together, the decisions showed that several months into the financial crisis, officials lacked the information and the insight to correctly call the shots.

Making matters worse, the Fed and the Treasury have now changed their story about how the calamity unfolded. No one expects a perfect performance in the thick of a crisis. But an after-the-fact revision of what happened at best raises questions and worse, looks like an attempt to dodge accountability.

In testimony before Congress on Sept. 24, about a week after Lehman’s collapse, Federal Reserve Chairman Ben Bernanke gave an accounting consistent with comments and news coverage at the time. “The Federal Reserve and the Treasury declined to commit public funds to support the institution,” he said. He said that the failure of Lehman posed risks but that the firm’s troubles had been well known for some time and investors recognized that bankruptcy was a significant possibility. “Thus,” he said, “we judged that investors and counterparties had had time to take precautionary measures.”

Mr. Bernanke said Lehman’s default, “while perhaps manageable in itself,” combined with the “unexpectedly rapid collapse of A.I.G.” to create a global financial tempest. In other words, Mr. Bernanke, Mr. Geithner and Treasury Secretary Henry Paulson believed the system was stable enough to withstand Lehman’s downfall.

The story changed as they were proved wrong and as the government’s obligations to prop up the financial system rose precipitously. In a speech on Dec. 1, Mr. Bernanke said “legal constraints” had prevented the Fed from rescuing Lehman, making a bankruptcy “unavoidable.” Translation: Not our fault!

The law allows the Fed to make emergency loans when the financial system is in danger, provided that the lending is “indorsed or otherwise secured” to its satisfaction. The Fed has accepted all manner of dubious assets in exchange for its various loans as the crisis has deepened. In a speech on Oct. 15 and in his Dec. 1 speech, however, Mr. Bernanke said Lehman’s collateral was insufficient. Secretary Paulson also invoked a lack-of-legal-authority argument in a speech last month to explain Lehman’s demise. Why didn’t they say so at the time?

Mr. Geithner has made few public comments during the serial crises, but a spokesman for the New York Fed recently disputed this page’s characterization that the Fed “allowed” Lehman to fail, saying — you guessed it — that the Fed had no legal authority to intervene.

The lack-of-legal-authority line also surfaced in video interviews by Fortune magazine of executives at its recent Fortune 500 conference. Peter Peterson, the co-founder of the private equity firm Blackstone Group and a former chairman of Lehman Brothers, was asked about the prevailing view that Lehman’s collapse was “the straw that broke the camel’s back.”

Mr. Peterson said he had talked to Mr. Geithner about that and was told that the Fed did not have the authority to intervene. Mr. Peterson suggested that the media might want to explore the issue in more depth, “before there is too much criticism of what Mr. Geithner’s role was.” He added: “You can probably see I’m a little defensive about Geithner. I was involved in picking him” to lead the New York Fed.

The burden is on Mr. Geithner to clear up the matter. If legal constraints precluded a Fed intervention in Lehman, why weren’t they mentioned at the time? Did Fed officials consider asking Congress for the necessary authority? There was plenty of time to do so because, as Mr. Bernanke noted last September, the collapse of Lehman was a long time coming.

In the absence of an explanation, the changing Lehman story seems like an attempt to deflect public attention from what could go down in history as an epic blunder. It also reinforces the impression of bias created by the disparate treatment of Lehman and A.I.G. Lehman was left to die, while A.I.G.’s counterparties were saved.

The revised version of the story (in which there is no disparate treatment, only officials following the letter of the law in each case) sidesteps questions about whether the bailout of A.I.G. — arranged by Mr. Geithner — was influenced by the specific needs of some of the insurer’s counterparties, like Goldman Sachs.

The Times’s Gretchen Morgenson reported that Lloyd Blankfein, the chief executive of Goldman, was the only Wall Street executive at a meeting at the New York Federal Reserve on Sept. 15 to discuss the A.I.G. bailout. A Goldman spokesman said Mr. Blankfein was not there to represent his firm’s interests, but rather that Goldman “engaged” the issue because of the implications to the entire system.

Adding to the opacity, the Fed recently decided to keep confidential one of two reports that it made to Congress on the A.I.G. bailout. If the Fed had not insisted on confidentiality, that report would have been made public.

Mr. Geithner should be asked at his confirmation hearing to explain which firms were threatened by an A.I.G. collapse, in what amounts and how those entanglements justify an ongoing bailout. Mr. Geithner must also explain how such entanglements came to be the norm on his watch. His answers will help shed light on whether he is sufficiently distant from Wall Street to reform a system that has proved catastrophically unstable.

2009 Outlook – Markets Measure; They Don’t Forecast

We are starting this commentary with two quotes that superbly summarize the state of the wealth effect, economy, and the outlook for applied stimulus. Cumberland’s strategy and rationale follow the quotes. We specifically acknowledge the effort of Howard Simons of Bianco Research for his repeated seminal work on how markets measure well and forecast much less well.

“The Federal Reserve Flow of Funds report showed a marked deterioration in the state of household balance sheets in Q3. Household net worth fell 4.7% q/q in Q3, translating to a $2.8 trillion loss in household wealth and marking the biggest y/y decline in the history of the series. Household real estate wealth fell 2.8%, reflecting the sharp decline in home prices… The decline in household wealth was accompanied by a decline in mortgage debt, which fell 0.5% q/q, the first decline since 1983. Homeowner equity fell to 44.7% of household real estate, marking a new record low. Household balance sheets also suffered from a 4.5% q/q decline in financial assets, driven by a sharp drop in the market value of corporate equities and mutual fund shares.”

– December 12, Julia Coronado and Michelle Meyer, Barclays Capital

“The economy’s recovery depends critically on an energetic fiscal policy by the new Administration and Congress…President-elect Obama…will quickly enact significant stimulus for the economy. This is sure to include major new tax reductions…Also to be included is sizable additional spending on infrastructure, broadly defined to include support to state and local governments for a wide range of outlays.…On the monetary side, the Fed will soon be lowering its official rates close to the vanishing point…Yield penalties on investment-grade securities relative to Treasuries are likely to narrow once the extraordinary pressures created by year-end portfolio “window-dressing” pass, but if they do not, the Fed will broaden further the types of securities it buys…With such vigorous support, retail sales, housing starts, and business inventories may stop declining by mid-2009… even in such an environment of near-zero GDP growth, aggregate profits of non-financial firms (except those related to construction, autos, and, perhaps, oil), may actually hold steady or rise, cushioning the decline in capital spending. Net revenue will be well maintained as labor and import costs tend to decline…”

– December 12, Dr. Albert Wojnilower, Craig Drill Capital

Cumberland Advisors’ portfolio management strategy starts with a few assumptions. In the United States both financial policy engines are at full throttle: they are the fiscal engine (deficit spending of $1.5 trillion or more) and the monetary engine (see: www.cumber.com for the weekly updated description of the Federal Reserve’s balance sheet and programs). As Dr. Wojnilower notes, and we agree, this “vigorous support” is expected to arrest the economy’s decline by the 2nd half of 2009. The Fed’s own forecasts are reasonably consistent with this conclusion; they argue that it is the target of Fed policy to bring this result to reality.

This massive stimulus is applied because there is (1) an extreme negative wealth effect (see the Barclays quote above) and (2) a decline in employment and (3) pressure on incomes. Note how this may not play out into a profits debacle (outside of the financial, housing, and consumer discretionary sectors).

Also note how the appearance of no positive outcome prevalent in many forecasts is dependent on the failure of the two-engine stimulus.

We are on the other side. Instead of saying that stimulus fails and the economy just sinks and sinks and sinks, we are saying that stimulus in this massive amount succeeds and that the economy will stop sinking and plateau. Subsequently it will start to expand as all the pent-up demand begins to convert to spending and economic activity.

We are saying that markets change their pricing because they are forward looking. They usually bottom in the midst of the bleakest outlook and they often bottom BEFORE the economics appear to turn. History shows that over time, financial markets are able to change prices to reflect forthcoming changes in economic data. That is why markets are viewed as leading indicators. They are not forecasting the change; they are measuring the behaviors and sentiment of the investors who are forecasting the change. Markets move as a result of actions by those who are seeing a change earlier than economists can compile the data to demonstrate that the change is at hand.

Financial Markets do NOT forecast well in a strategic sense. If they did the oil futures curve would have warned of $140 oil when the price was $40 and it would have warned us of 40 dollar oil when the price was $140. Markets did neither accurately.

Financial markets measure the present consensus sentiment. They price it every day as folks make their real money commitments. The price tells you what the existing psychology is; it doesn’t tell you what it will be and it doesn’t tell you when it will change. Markets measure; they don’t forecast.

Here are some samples of current measurements that are not forecasts. Readers may judge for themselves if these are market forecasts of doom or if they are measurements of market dysfunction and extremes of psychological damage. Then each reader may decide and act according to his/her own view. In doing so he/she will become one of the many agents that make up the very markets we are measuring. Readers and their actions will be measured along with all the others.

Here is the evidence. You decide.

When the 90-day T-bill trades at zero interest it is measuring something. It does that on the same day that the two commercial banks used by Cumberland Advisors for our firm’s own deposits are paying us over 3% on our cash. Both of those yields are backed by the United States of America. The risk of loss is equally nonexistent. So why are they so different? Because they are measuring two different things: zero interest on US government Treasury obligations is driven by one set of investors; 3% interest is driven by a different set. Each is measuring a unique subset of cash and cash equivalent yields. Market measure; they do not forecast.

You can loan your money to the United States of America for 30 years at 3% and that is a taxable instrument. You can loan your money to a high-grade state credit and get 6% (in some jurisdictions we are getting clients as much as 7%). The tax-free yield on long duration in the United States is double the taxable Treasury yield. Markets are measuring the psychology of fear. They are not forecasting that all states and local governments are going to default.

Those who do not accept this principle that markets measure are doomed to lose sleep trying to understand behavioral malfunction in the realm of sentiment. In dysfunctional market periods like the present one it is critically important to sort through this issue. Each investor has to determine what they are missing when they see an anomaly. Understanding what the market is measuring helps clear up the puzzle. Remembering that markets are measuring and not forecasting maintains the balance while the puzzle is being solved. Here are more examples.

The credit default swap on the State of California is priced higher than the credit default swap on the country of Turkey. Does anyone really believe that the US is more likely to default than Turkey? No disrespect for the Turks is intended. Maybe if California Governor Schwarzenegger had the Turkish parliament instead of his legislature, he would have a budget passed and his credit default swap would be priced differently.

The credit default swap price for the United States is higher than the credit default swap price for Campbell Soup. No disrespect to Campbell Soup. I like it on a cold winter day. But I think the US has a better chance of paying its debt than the soup maker. And both of them use the US dollar to make the payments. Campbell makes soup; I own some cans of it and bought it with my dollars. The US government makes those dollars and has unlimited dollar productive capacity and negligible cost of production or materials.

Markets measure; they don’t forecast. If they were forecasting, they would be saying that Turkey soup is more likely to pay the dollars it owes than is US Treasury and the US’ largest state.

Ok. Let’s sum this up as we approach 2009. We believe the economy will bottom in 2009 and the bottoming will be in the data during the second half of the year. We believe that the stimulus combination of massive fiscal and massive monetary will work. And we are applying that assumption in our portfolio management.

Clients who do not agree with us have asked us to take a more cautious view, and we do so for them. We are a manager of separate accounts. We are not a common fund. Our job is to meet the client’s objectives and not impose our will on the client. If the client asks, we offer what we think is our best guess of the future. If the client wants to be riskless and in US government credit only, we do it.

That said, we are recommending to our clients that they use an asset allocation of 50% stocks and 50% bonds. Cash is at zero. Remember that the classic efficient frontier is 70% stocks and 30% bonds. So we are 20 points under on the stocks side and 20 points over on the bond side. The reason is that bonds are soooooo cheap that they warrant overweight.

Both sides in this 50-50 stock-bond mix are fully invested. On the stock side we only use exchange-traded funds (ETF). We do this domestically in the US, and we do this abroad. And we do this in other asset classes like currencies and commodities and precious metals.

On the bond side we are emphasizing high-grade credits. The junk bond market is very cheap, but it requires a special set of skills and we do not apply them at Cumberland. Clients who use junk bond allocations are using other managers. We are in investment-grade bonds only, whether taxable or tax-free. On that note, our clients are also fully invested and favor longer duration.

As this financial turmoil period enters its third year in 2009, we expect the various sectors to heal and the spreads to narrow. This will occur piecemeal. We already see it in some areas. The results of the application of stimulus by the Fed will be seen sector by sector and will have its own accelerator. Investors who wait until the air has cleared are taking no risk, but they are also not going to get a reward.

Right now markets are measuring extremes in risk aversion by investors. That explains high cash balances and zero-interest T-bills. As each market clears it will gap to another level. It will not trade there calmly and slowly. The lesson to be learned from high-volatility measures like the VIX is that markets can gap. When they do so, an investor sitting on the sidelines has very little chance of getting in. The most money is made in markets when measures of risk aversion are extremely high and then markets turn.

Remember, when you see a parabolic curve you have no way to know when it will stop and turn. You can only learn that after the fact. Most markets today are showing us this parabolic formation. They are measuring extremes at several standard deviations from mean and at record levels, levels that have never been seen before.

I know this statement is redundant; I repeat it for good reason: Market spreads and risk indicators are at levels never seen before. They are measuring, not forecasting.

2009 may just work out to be a good year. 2010 may be even more robust. At Cumberland we want to be in it, not out. Stay tuned.

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, http://www.aei.org/research/shadow/projectID.15/default.asp.  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.