Hans Christian Anderson and Vladimir Putin

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

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

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

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

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

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

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

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

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

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

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

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

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

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




Primary Dealers and Their Loss Experience

Bianco Research periodically has published a compilation of the losses that have accumulated in major banks and investment banks as a result of the so-called subprime crisis.

(1) When Chairman Bernanke hinted in his July 12, 2007 Congressional testimony that losses might reach $100 billion, this seemed alarmingly large.  But the Bianco data now show that this was a very conservative estimate indeed.

Losses recognized to date now amount to nearly $500 billion and clearly are likely to grow larger as foreign institutions begin to release their second-quarter financial statements.  To their credit, the institutions reporting have successfully raised more than $350 billion to replenish capital depleted due to loss recognition.  But a large hole still remains, and there is now reason to suggest that those institutions that have experienced the largest losses – namely Citigroup, UBS, Wachovia, Morgan Stanley, and the others – will need to raise substantial additional capital as a result of having to take nearly $50 billion of auction rate securities back onto their balance sheets as part of the settlements with the attorneys general of New York and other states.  Clearly, there are more securities to bring back on balance sheet and Cumberland’s estimates are that they could go as high as $100 billion.

While the financial turmoil has received wide attention, the extent to which the losses and impacts have been experienced by a relatively few institutions has drawn little notice.   It is noteworthy that most of these institutions are also among the subset of large, complex financial intermediaries that function as primary dealers.  These are the so-called elite institutions qualified, because of their supposed sophistication and financial strength, to deal directly with the Federal Reserve as it conducts its daily open market operations.  Their role in the monetary policy transmission process also explains the special treatment they have received by being granted access to the Primary Dealer Credit Facility (PDCF).

To illustrate the loss concentration, the Bianco data in the table attached, (the document is no longer available at the original site) were first sorted by primary dealer status (the firms listed in bold type) and then by the sizes of the losses institutions have recognized to date.  Four facts are important to note about this list.  First, the 16 primary dealers are among the nearly 60 firms listed but they dominate the universe having experienced $280 billion or (56%) of the total losses reported to date.  Second, these primary dealers have raised about $184 billion in new capital, but they are still are nearly $100 billion short of covering even their reported losses, which is seriously impacting their ability to deleverage as financial markets are now demanding.  Third, only two of the primary dealers have actually successfully replenished their capital, while the remainder has suffered in some cases significant capital impairment.  Finally, Bianco notes that losses aren’t concentrated solely in US firms.  Combined European and Asian losses are virtually equal to those of US institutions, with most ($ 222 billion) being in European headquartered institutions.

This loss experience of the primary dealers raises both short- and longer-term issues.  For example, given that the primary dealers have access to the discount window now, should they now be allowed both to fund and to liquefy the auction rate notes that many are now having to bring back on their balance sheets in significant amounts, by using these securities as collateral for discount window borrowings and participation in the securities lending programs? These instruments are clearly of high quality in most cases and would likely qualify as eligible collateral.  But if they do, then the subsidies granted would more than offset the costs to the institutions of bringing the securities back on their balance sheets.  For example, if the holdings of auction rate securities are funded through the Fed, the cost would be 2 ¼% (the discount rate) whereas current market rates suggest that funding them by issuing only preferred stock would cost about 9%; regardless, additional capital would have to be raised to support the growth in assets.  Clearly, it seems inappropriate to reward what was likely questionable behavior in the auction securities markets by these institutions by cushioning their exit from the market. There is ample evidence, again provided in recent data from Bianco Research, L.L.C. that these dealers are already relying substantially upon the Federal Reserve’s new special lending and other new facilities to finance their assets and have not made significant progress in shrinking their balance sheets.  Keep in mind that these are the elite institutions that have been deemed critical to the functioning of our financial markets.

Over the longer run, the current difficulties raise serious questions about the structure of Federal Reserve daily open market operations and the wisdom of only dealing with a few institutions heavily concentrated in New York.  We learned from 9/11 that serious things can happen and jeopardize the smooth functioning of our money markets and payments systems.  Is there justification for permitting investment banks, that have been among the biggest losers in the subprime debacle, to be primary dealers, given that they aren’t subject to supervision and prudential regulation?  Current daily operating procedures which rely upon only a few select institutions are a legacy of a pre-computer world.  There clearly is no reason today that bids can’t be accepted electronically from any sound member bank.  Bids are processed and allocated electronically, so there are currently no technical limitations to the ability to accept and process bids from institutions across the country.

What these issues mean for investors and market participants is that the concentration of financial difficulties in a relatively few, very large institutions makes the swift return to smooth functioning financial markets more problematic and implies that it will be extremely difficult to quickly withdraw the emergency lending and support facilities that have been put in place for these major financial institutions.  These firms will be faced with continued pressures to de-lever and to raise more equity, and until they do and the full extent of their losses are revealed their stock prices are likely to languish.  It is important to remember, as Peter Fisher of Blackrock pointed out in a recent Bloomberg radio interview, banks can’t de-lever by maintaining their borrowing from either the market or the Federal Reserve.  Finally, the bringing back of auction rate securities to institution balance sheets may help customers, but it will certainly not remedy the problems that have plagued the auction rate markets for some time now.

(1)See Bianco Research L.L.C., “The Latest On the Credit Crisis,” August 12, 2008.




Joseph Stalin plus 75 (years) = Vladimir Putin

Seventy-five years ago another Soviet thug by the name of Stalin chased a food supply and starved the Ukraine. He killed between 7 and 10 million people and thought nothing of it. In an ironic quirk of history, Stalin was born in Gori, Georgia.

We now say “Ukraine” and not “the” Ukraine because Ukraine is supposedly an independent country. The Orange Revolution was supposed to have peacefully freed it from the Soviet sphere. So much for wishful thinking.

Georgia’s experiment with western-style freedom has ended. The modern-day Stalin looked in George Bush’s eyes and seized the moment. Now Putin is ready to take Ukraine. Anyone who thinks the Georgia events were a one-off and isolated incident is overindulging on vodka.

Ukrainian president Yushchenko’s attempt to limit Russian troop movements and obtain notice of them will fail. Putin will use this as the next pretext. We can learn from Georgia how brutal the Russian “ursus horribilus” can be when it chooses to send a message.

It will get harder for Mr. Putin when he starts to mess with Poland, Estonia, Latvia, and Lithuania. These are now member states of the European Union. So are others like Slovakia, Slovenia, and Czech Republic. The Russians may draw a line between the EU members and the EU nonmembers. They will use economic warfare against the former and military intervention against the latter.

All this leads to more trouble. The EU now faces a real solidarity test and it faces the need to think about defense expenditures.

The US faces so many issues now and has demonstrated a complete lack of power or even suasion or influence. American weakness is now at an extreme and invites more trouble. Putin leaned over to Bush and made nice at the Olympics opening ceremonies while knowing full well that he was presiding over an invasion about to commence. One has to be delusional to think the Russians could spontaneously stage a movement about the size of a full division, with complete air and naval support, without preparation and staging.

Other clues about their intention came from the cyber attack launched against Georgia during the three weeks prior to the invasion. In the old days an antagonist degraded infrastructure with bombing and long-range artillery before an attack. He introduced subversives and paratroopers to cut communication lines. Degrade communications and defense, and the attacker will improve his chances when the fighting gets intense.

In the present day the rules are different. Militarily, you must seize complete air control. Tanks are wonderful instruments of combat after you have achieved total air superiority. Without air support tanks are very vulnerable. When it comes to communications, we live in the cyber world. So bombard your enemy and undermine his websites and Internet backbone. That occurred in Georgia from the middle of July.

We saw other evidence of that approach in Estonia in the recent past. In Georgia’s case most of the Internet backbone connects through Turkey.  That makes it harder for Russian-based Internet service providers to disable or derail Georgia. They were only partially successful.

In Ukraine there will be a different story if Putin prepares to move. Watch the Internet traffic in Ukraine for clues about a forthcoming Soviet intervention.

For investment strategy, we have totally exited the Russian connection in ETFs, and that includes the Central European emerging sector. Anything tied to Russia is now a very high-risk proposition. Also, we will underweight activity tied to foreign direct investment in former Soviet-sphere countries. Who would spend foreign direct investment money in Georgia now?

We also have taken the tech sector to a major overweight. The lesson from Georgia is in the cyber warfare arena. Worldwide upgrade in tech and defense from tech attack will lead to huge incremental spending. This will come on top of deployment of capital for business upgrades as the economy forces this spending on the fastest payback sector. Companies raise IT budgets first when coming out of recession or slowdown.

Tomorrow we are off to the Baltic on a Saturday night flight. Helsinki, Copenhagen, and Tallinn loom ahead. A CNBC interview on Worldwide Exchange is scheduled for Monday morning at 5:20 AM NY time.

In Tallinn, Estonia, the subject of the conference is energy and Central Europe and the Baltic and the dependency on Russia for energy. The festivities start next Wednesday night and end Friday morning.

For more details see: www.interdependence.org. There are a few last-minute seats in the GIC delegation for anyone interested in attending.

What a time to go to Estonia for this meeting which was planned about 10 months ago. Who’d a thunk it?




Russia Enters Georgia – Cumberland Exits Russian Stocks

The Russian economy, fueled by energy and commodity exports, registered impressive growth of 8.1% in 2007 and is on its way to over 7% this year and probably in 2009 as well.  The Russian stock market as measured by the DAX Global Russia Index (DXRPUS) advanced by 40% in 2007, and as recently as June it looked set to outperform global markets again this year. We were reluctant to invest in a country under an autocratic and unpredictable government and a market with continued evident shortcomings in corporate governance and in the equitable application of laws and regulations. Yet with Russia accounting for some 11% of the emerging markets, staying out of this booming market was becoming a drag on portfolio performance relative to the emerging market benchmark, the MSCI Emerging Market Index. And, the “election” of Dmitry Medvedev as president and the move of Vladimir Putin to prime minister early this year held promise for political stability and continued improvements in economic prosperity.

Finally, in February we decided – while holding our nose – to include a position in Russia in our international and global ETF portfolios, using the Van Eck Global ETF Market Vectors Russia ETF, symbol RSX, which seeks to track the DXRPUS Index. The sector distribution of the holdings of this ETF is dominated by a 39.1% position in oil and gas companies (Lukoil, Rosneft, and Gazprom) and a 24.45% in iron and steel companies.

As global energy and materials prices surged in April and May, the Russian stock market also performed strongly. In June the first headwinds hit that market in the form of the shareholder fight at TNK-BP, coupled with administrative pressure (visa and work permit problems, regulatory investigations) and  then in late July a verbal attack by Putin on steelmaker Mechel – both developments raising the political risk premium for Russian equities in the eyes of foreign investors. A reversal in prices in the international oil and materials markets in July added downward pressure on Russian equities. While we were not sure how long-lived the decline in oil prices would be, we were seriously considering reducing our Russian exposure.

Then came the entry of Russian armored and motorized infantry forces into the Republic of Georgia (a vocal US ally), along with air power, the morning of August 8th, which marked an important turning point in the geopolitics of Euroasia.  While Georgia’s president, Mikheil Saakasvili, seriously miscalculated when he moved Georgian forces into South Ossetia, a secessionist region of Georgia, the night of August 7th, the military response of Russia on the 8th and in subsequent days was greatly disproportionate. The indiscriminate pounding of civilian as well as military targets well within Georgia sent a chilling message across Europe about both the nature and the relative power of the present Russian state. The US, with its military assets (and interests) tied up in the Middle East, and the Europeans were shown to be unable and/or unwilling to react other than with words. All the new democracies along the periphery of Russia have been sent a message – as have foreign investors.

For Cumberland, this event raised the political risk premium of the Russian market far above an acceptable level. We rapidly sold our positions in the Russian ETF, RSX, even though this meant booking some losses on those investments. Because our positions were in an ETF traded on the US market, we were able to accomplish this in minutes while the market was open on August 8th. Had our position been a diversified portfolio of stocks in individual Russian companies, the process would have taken far longer. Or if it had been in a mutual fund, the transactions would have had to take place at the closing prices on Friday. This was a good example of the relative flexibility and efficiency of ETFs.

While at the time of writing the Russian market has recovered somewhat, as an end to the six-day battle appears to have been successfully brokered by French President Sarkozy, we are not about to return to this market in the foreseeable future. While Russia’s wealth of natural resources will continue to underpin the economy, Russia’s relations with Europe, its most important trading partner, have been dealt a serious blow, the effects of which have yet to be seen. The US has cancelled planned joint military exercises with Russia and secretary of state, Condoleezza Rice, has stated”… what role Russia can play in the international community is very much at stake here.”

In Europe, the Baltic States have called on the European Union to suspend its efforts to strengthen relations with Russia; and the Presidents of Latvia, Lithuania, and Estonia, together with Poland, issued a statement warning that the Georgian conflict was a “litmus test” for NATO and the EU. The Baltic States, indeed most countries of Europe, are heavily dependent on Russia for energy supplies. In response, the Russian ambassador to Latvia warned that the stance of these countries will “have to be paid for a long time afterwards.” The already great unease of many Europeans about this vulnerability of their energy supplies surely has increased.  This will affect future investment decisions. My colleague David Kotok will have a good opportunity to explore the situation in the Baltics first-hand when he participates in Tallinn, Estonia, next week at a Global Interdependence Conference on Nordic-Baltic Energy Issues. Look for his Commentaries from Tallinn.




Auction Rate Securities (ARS) and a new Fed ‘Maiden Lane 2’. Also, Cleveland: ‘hold your water.’ And more on fishing weekend in Maine

The Auction Rate Securities (ARS) market saw big news this week as Merrill Lynch, UBS, and Citigroup settled about $30 billion in claims and agreed to pay investors by buying back their frozen paper over the next several months.  Each settlement has its own time period and terms.

The theme is nearly the same in all of them.  The brokerage firms neither admit nor deny any criminal activities.  The investor gets cash instead of being locked up in these securities that were originally purchased as a cash equivalent.  The problem now transfers to the brokerage firm, which has to dispose of or hold the ARS.  Some firms are forming trusts or other vehicles to hold ARS until they eventually mature.  Others plan to remarket the paper, although there is not a lot of disclosure of the amount of losses that the brokerage firms will take.  Citi estimates a $500 million loss.  So far, Merrill is silent.

Other firms are also silent on their plans.  No matter what, the firms are partially relieved of some potential liability and can begin to get on about their business without this ARS cloud hanging over their heads. 

The ARS investors will face options because the cash will be unfrozen.  Will they put this money into the securities markets?  Will they take out their cash and run elsewhere.  If so, where will they go?  No one knows, and we’ll probably see some of each occur in the future.  The short-term impact is likely to be slightly bullish for other securities like stocks or bonds, since a chunk of the money that was illiquid is now going to be freely available. 

What about the brokerage firms.  First they will recognize the losses, and that will depend on the process they elect to use in absorption of these ARS.  They still face a similar issue with their sophisticated and institutional clients.  They still face some claims and litigation settlements, because it took months to get to this point and some of their customers suffered losses due to the waiting period.  And they still need to raise the cash to pay back the ARS holders.

Some folks speculate that they will look to the Federal Reserve.  This is especially the case for those brokers who are also primary dealers.  That is possible in either a direct way or an indirect way.

Think of it this way.  If a brokerage firm like Merrill uses its access to the Fed, the interest rate attached to the cost of funding the ARS buyback is currently estimated at 2.25%.  Some of this ARS paper might even qualify as collateral, because it is AAA credit quality as to default risk.  It is the illiquidity issue that taints many of these securities, not their credit risk.

Who knows, the Fed might even arrange a Maiden Lane 2 structure for these firms, just like it organized Maiden Lane 1 for the Bear Stearns (BSC) portfolio.  One could argue that the ARS paper is of much higher credit quality than the paper placed in the current Maiden Lane LLC that was specifically formed to hold the BSC paper after the JPMorgan Chase-Bear Stearns deal was forced by the Fed in one of the weekend shootouts.

If the brokerage firms do not use the Fed, the cost will be about 4 times the Fed’s lending rate, and there may be some dilution of existing shareholders if more capital needs to be raised.  We base this estimate on the recent capital raises and the pricing needed by these brokerage firms to attract investors.  More will be revealed as this process unfolds and as Wachovia and Bank of America and others make their settlements.

Meanwhile, there is continued terrific opportunity for investors as long as the detailed homework is done on each security.  A good example is the auction freeze of the Cleveland Ohio water utility.  The original bonds were issued as an AAA insured floater with FGIC insurance.  The liquidity provider has terminated its contract because the rating on FGIC has fallen below investment grade.  At this moment there is no liquidity provider for the auctions and the bonds are in a frozen state.  They are paying an 8% interest rate and that rate is frozen until the situation is fixed or until the bonds mature on January 1, 2033.

Disclosure:  Cumberland Advisors purposefully holds about $8.5 million of these bonds in clients’ accounts.  We are in no hurry to see Cleveland Water fix the problem, although we expect they are busily working on it.  T hese bonds are a natural AA credit.  The water utility is well run.  Cleveland originally got into the floater structure because they believed it would save them money in financing this $90 million.  It did until the financial turmoil derailed the entire Muni market.  Now the water utility is paying 8% while it works out its problem.

8% tax-free on a natural AA credit quality is a gift to a Muni buyer.  It probably won’t last, but it is likely to be there for a period of time until the issue gets resolved.  Just like the recent 9% San Francisco Bay Area Transportation Authority (BATA) bonds, this water utility will have market access and will be able to “bond out” and pay these 8% floaters in full when they do.  Alternatively, they may be able to replace the liquidity provider and restore the auction function; if that happens, the interest rate will probably plummet.  Meanwhile, investors who are opportunistic are taking advantage of this gift that “Mr. Market” has presented to them.  For Cumberland comments on this asset class and on BATA bonds see: www.cumber.com.

We recommend interested readers also take a few minutes and review Jacqueline Doherty’s excellent article in this week’s Barron’s (page 32) entitled Unlocking the Auction-Rate Mess.”  While in Barron’s, see Jim McTague’s report on the annual fishing retreat weekend, which was featured on CNBC.  For interviews see www.CNBC.com.  We have added that Barron’s article below. 

In Deep Dark Woods, Bears on the Prowl

By JIM MCTAGUE, Barron’s, August 11, 2008 issue, page 33

Bears invade money mavens’ annual fishing outing.

I SHOULD HAVE PACKED A CAN OF PEPPER SPRAY ALONG with my fishing poles this year, because the lodge at Grand Lake Stream, Maine, population 120, was overrun by a herd of frightful bears — more than 30 of them. They left me badly shaken.

For you woodsmen who are grumbling that I am full of blarney because bears by nature are solitary creatures, let me point out that these particular animals wereUrsus wallstreetus horribilis. The sociable predators migrated, as they do annually, from as far west as Victoria, British Columbia, and as far east as London to congregate at remote and lovely Leen’s Lodge to fatten up on smallmouth bass, fine wine, superb Scotch whisky, fat cigars and stimulating conversation in advance of a long, hard winter.

They included big-bank economists, bond traders, money managers and financial consultants who have been brought together in this enchanted world of pristine lakes for almost 10 years by David Kotok, an expert fly fisherman and the chairman and chief investment officer of Cumberland Advisors, a money-management firm in Vineland, N.J. — a short commute to the Atlantic Ocean.

Sure, it was overcast and rainy the entire four days of the gathering. And sure, the fishing wasn’t as spectacular as in the past (I managed just 15 to 20 bass a day, as opposed to 40 or more on other occasions). But that’s not why the crowd was so miserably bearish. There isn’t a mood lamp on earth that would lift spirits laid so low by the seemingly bottomless credit crisis that is now beginning to spread from the housing and financial sectors into other corners of the economy.

Kotok’s diagnosis of the cause of the gloom that permeated the crowd was this: Most of them see more economic downside than upside; we don’t have functioning credit markets; banks and big Wall Street credit intermediaries are either dead, wounded or on life-support; housing is a wreck; and the auto industry "is done."

Once the economy stabilizes, it will take many years to fully recover, he said, because no strong growth engines are evident. "That’s why people are so gloomy! They see no upside!" He personally is investing client money in agricultural plays because, he says, the long-term price of food is trending up. He likes bio-companies whose products are geared to an aging population. And he likes Asia as an investment destination…and he doesn’t like much else.

I conducted in-depth interviews with a dozen of the participants. They all perceive the economy in the early stages of a multiyear recession that will be the most painful downturn since the 1970s. The housing market, which experts once predicted would recover in 2008, may not recover even in 2009. Credit woes on Wall Street will begin to inflict real pain on Main Street.

"The silver lining is that inflation likely peaked in the second quarter and now we will see a deflationary cycle," said Barry Ritholtz, director of equity research for Fusion IQ, a quant shop. Ritholtz says that investors should focus on export-based companies or anything else that will profit from a weaker dollar.

The predictions of the fishing-economics group averaged 2.1% for the federal-funds rate by year end 2008 and 2.5% at midyear 2009; a 10-year Treasury rate of 4.2% at year end ’08 and 4.6% at midyear ’09; the dollar trading at 110 yen at year end ’08 and ¥108.5 at midyear ’09, versus ¥109 now; and the euro trading at $1.48 at year end ’08 and $1.47 at midyear ’09, versus $153.41 now.

Scott Frew, manager of Rockingham Capital Partners, a hedge fund in Connecticut, says that job losses eventually will reach 7% or 8%. He was most bearish because the group, on average, predicted an unemployment rate of 6% for 2008 and 6.1% for 2009. John Silvia, Wachovia’s chief economist, says that unemployment is "widening out" and affecting skilled and highly educated workers. Data show that less than half of all firms intend to add jobs, he says, a sign of slower growth ahead.

AS FOR THE MARKETS, technical analyst Stuart Taylor, a senior fixed-income trader at Eaton Vance, believes that although we have reached a short-term bottom, the overall trend remains down. Maine asset manager J. Dwight sees some attractive prices in the down market, but he’s only nibbling, because he knows they can go down further.

Even the contrarians were depressing.

"I’m certainly not in the world-is-ending camp," said Scotsman Martin Barnes, managing editor of the Bank Credit Analyst. "If you have a nervous disposition, then you can work yourself into a lather about banking problems and various issues." Barnes, who works from his home in Victoria, said that the corporate sector appears to be in decent financial shape, and he thinks that the auto makers are being reasonably aggressive in attacking their problems. Even so, the next few years will be "quite a bit of a slog."

And he adds: "I think we face a mediocre, tough environment — the other side of having this enormous credit boom. And if you believe in symmetry, then the bigger the boom, the bigger the bust!"

I really should have packed some pepper spray.

We thank Barry Ritholtz for forwarding this in a form we can send to our readers.  Barry is quoted along with others from the weekend retreat. 




Fishing and Forecasting

Intermittent rain didn’t dampen the spirits of the attendees at the annual fishing, economic, and financial retreat.  This year’s was the largest gathering ever.

CNBC’s Steve Liesman added to the enthusiasm with the live coverage that started on Squawk Box Friday morning and carried on to other shows during the day.  Steve and his producer, Matt Greco, are both accomplished fishermen, and that quickly bound them to the camaraderie of the gathering.  They were also robust participants in the weekend discussions. 

Readers who wish to see and hear some of the interviews may find them on www.CNBC.com .  Search under “Kotok” to get started and you will speedily obtain several segments from the group.  Special thanks to Becky Quick for the eponymous imprimatur of “Camp Kotok.”

No one in the group expected the Fed to change interest rates at yesterday’s meeting.  The two Fed folks attending the retreat maintained silence on this issue.

Nearly all of the retreat participants hold serious concerns about the credit market turmoil and the prolonged period of economic weakness.  As one might expect, the group is divided about how long the slow period will last and about how severe any downturn will be. 

The big issues are the continuing deterioration in housing values, trouble for automobiles, the developing list of bank failures, specific concerns about home equity loan losses still to be taken by banks, the federal budget, energy prices and, lastly, the prospect of an unemployment rate that may go well above 6% and even approach 7% before this cycle ends.  I’m in the high 6% camp and had plenty of company.

There will be a number of articles covering the retreat and reporting on the survey results.  Barron’s will carry one by Jim McTague.  Therefore we will only add a brief perspective to what has been reported on TV and what will be in the press. 

First, the group thought a robust recovery scenario was unlikely.  While we divided on whether or not there will be a serious recession, we are nearly unanimous in the view that any recovery will be tepid.  I think it is the lack of a vigorous rebound that causes the gloom in the group.  When we outlined and brainstormed scenarios that could lead to a V-shaped cycle, we all concluded that they are highly unlikely and can be dismissed.

The second item is another nearly unanimous view that this credit market cycle is non-normal and that we are witnessing a very unusual period with major and strategic changes underway.  Most participants would agree with Alan Greenspan’s characterization that this is “a once or twice a century event.”

We discussed and dissected the details, like the alteration of the Federal Reserve’s balance sheet, the de facto nationalization of the federal agencies, and the rising risk to uninsured bank depositors in the United States.  Nearly all participants agreed that the national leadership of the country is impoverished and that the Congress is particularly distressing.  The sense of that is exacerbated by the indictment of Senator Stevens, the personal use of Countrywide’s VIP program home mortgages by Senator Dodd, the indiscreet and now famous “IndyMac” letter from Senator Schumer.  Furthermore, the outlook for any improvement in the Congressional arena was considered bleak.

When we were done, the list of issues was extraordinary and touched nearly every sector and component of the US economic pie.  It impacts the entire globalization theme.  I guess it is this vastness of issues which all carry high uncertainty that is the second major theme we take away from the weekend.

All enjoyed the informality that fostered these discussions.  We agreed to respect the Chatham House Rule and quote only those who agreed to be public in their views.  There was unanimity on the fishing and the enjoyment of the pristine water and surrounding wilderness and wildlife.  A mama moose and calf and several bald eagles added to the entertainment as did the Steve Liesman and Randy Spencer guitar duet.

Now back to markets and to issues.  We are about 90% invested in this US stock market at the moment.  A cash reserve still seems prudent to us.  We do not believe that the turmoil is over.  Our bond accounts still have longer to intermediate duration in Munis and spread-related positioning in taxable fixed income.  We are still using alternative techniques to help clients avoid the risk of uninsured deposit status in their banks.

PS.  A few of us are heading back to Leen’s Lodge for a relaxing Labor Day.  Early fall colors (bright reds) are usually teasing visitors at that time of year.   So are the northern lights if the evening sky is moonless.




Sliced Bread or Double Dipping? More on Covered Bonds

In what is now proving to be an unrelenting series of initiatives on the part of both Treasury and Congress to channel more funds into housing, no matter what the costs or risks to taxpayers, Treasury has put out a “Best Practices” guide with the aim of stimulating the market for covered bonds.1  A previous Cumberland commentary about covered bonds (www.cumber.com) generated some comments from Europe.  In particular, they suggested that I had been less than sympathetic to the attractiveness and utility of covered bonds.   Covered bonds have been a successful vehicle in Europe, and this is due in part to the fact that when bank-issuers fail, they typically are nationalized, protecting all creditors. 

The situation is different in the United States.  A few points of clarification are in order, together with some additional observations. 

First, given how the covered bonds would be structured, they clearly would be attractive to investors, perhaps as good as, or maybe even stronger than, insured deposits but not subject to the $100k deposit insurance coverage limit.  The bonds would be dynamically collateralized; in fact, they would be over-collateralized by 5% with some of the highest-quality mortgages.  Treasury “Best Practices,” for example, call for loan-to-value ratios of not more than 80%.  The dynamic collateralization comes from the fact that the collateral pool would be actively managed, and any loan that violated the loan-to-value ceiling or was more than 60 days non-performing or delinquent would have to be replaced.  Thus, the bond holders would essentially have both a put and a call: a put on the bad assets in the collateral pool back to the issuing bank and a call on the bank’s good assets for replacements that might be other mortgages, cash, Treasuries, or agency securities.   While the puts and calls are likely to be out-of-the-money initially, they both become valuable during times of general financial distress – like now- or when an issuer experiences financial difficulty.  In that respect, they transfer value (and reduce risk) to covered bond holders from other uninsured creditors, exacerbating any tendency they might have to flee.

Second, the covered bond would also have a priority claim on the bank’s entire revenue stream, and not just the cash flows from the collateral, when it comes to meeting the required payments on the bonds.  Any remaining revenue after paying covered bond holders would then be available to pay interest on deposits or other debt or to make payments to preferred stock and equity holders.  This added priority serves to reduce the risks to covered bond holders relative to their promised returns but increases risks to other claimants and uninsured depositors.  Overall, the scheme should serve to lower the relative costs of covered bonds, but this should be offset by the added costs of the additional risks that would now be visited on other types of claims and uninsured deposits.  These risks become especially evident in the event of insolvency.  Covered bond holders would not only have their collateral, but also would have a residual claim, just like any uninsured depositor or other creditors, on the assets of the bank.  This is a form of double dipping, at the expense of uninsured depositors. 

As an aside, the FDIC statement on how covered bonds would be treated in the event of insolvency provides added assurance of the priority protections covered bonds’ claims would be treated relative to other creditors.

Third, promotion of covered bonds also will impose greater risks on the FDIC and, ceteris paribus, increase deposit insurance costs to banks and ultimately taxpayers.  Just like collateral arrangements associated with asset pledging to secure municipal deposits, Home Loan Bank advances, or discount window borrowings, high-valued assets would be unavailable to the FDIC as receiver or conservator to liquidate to cover either its own costs or the claims of other uninsured creditors or depositors.   Moreover, since covered bonds will initially be put in place after other creditors have already purchased debt or deposit claims, the interest rates they receive will not fully reflect the risks to which the non-covered bond creditors and uninsured depositors are subsequently exposed by the addition of covered bonds to the bank’s funding pool. 

Regulators, of course, have their CAMEL risk rankings and are in position to potentially understand and monitor those risks.  But these risk assessments are confidential, and they are not available to depositors who are less informed and must instead rely upon private risk-rating services to assess their risk exposure.

The higher insurance costs and increased risks are just another of the unintended costs of a piecemeal approach to the current problem and of policies indirectly to subsidize housing.   Overall, the constraints imposed by the covered bond contract should, in the aggregate, increase rather than lower bank funding costs, because some of the benefits of diversification would be taxed away by the covered bond holders.

The bottom line is that from the investor’s perspective, covered bonds might be as good as sliced bread, but that is only part of the story.  The payments and constraints they impose also come at a cost, and those costs will be born by other creditors, the FDIC, and taxpayers.  Such instruments put an even higher premium on well-functioning, prompt corrective action and early intervention by banking regulators.  Unfortunately, the poor performance of OTS in the case of IndyMac and other regulators in the case of the failure of First National Bank Corporation don’t give one confidence that the system will work as intended.

1 U.S. Treasury, “Best Practices for Residential Covered Bonds,” July 28, 2008.




Celebrating the Anniversary of the Credit Crunch in Maine

We have officially started year 2 of the credit crunch.  Some could argue that the actual start was in late May or June of 2007 when the first signs of widening credit spreads were observed.  In real time that was a difficult conclusion to reach since those early warning signs then were within the normal trading ranges and seemed to be nothing more than ordinary volatility.

We believe the first apparent sign was the Bear Stearns (BSC) announcement in July 2007.  BSC admitted problems with their hedge fund construction and indicated they would have to add funds and recognize losses.  At that time no one believed that this first chapter in the Bear Stearns saga would end eight months later, with the final chapter in March 2008.  BSC disappeared in a remarkable application of the Federal Reserve’s power and emergency funding tools.

So where are we now?

We are watching a massive adjustment in finance.  The next generation of textbooks will have chapters devoted to Bear Stearns, JPMorgan Chase, and the Fed-financed weekend shotgun merger.  There will be whole sections on the Federal Reserve and how it has hugely altered its balance sheet and is reconstructing its role.

Fannie and Freddie will require a treatise on the largest de facto nationalization in American history.  Bank failures will be examined to determine how and why they happened.  IndyMac is also a chapter in this new book.  How is it that a $32 billion failure is deemed adequately capitalized in March and fails 100 days later?  I will stop this listing of what we know, so we can articulate what we don’t know.

We don’t know if the stock market correction is finished or if there is another serious decline ahead.  We don’t know if the Treasury bond market faces a sustained upward movement in yields or will rally to lower yields.  We don’t know if we are going to see the deflationary forces of falling housing, collapsing autos, and distressed consumers prevail over the inflationary forces of commodities and a weaker currency. 

We don’t know if the 2009 fiscal condition of the US and its 50 states and local governments will break the limit on deficits.  It is starting to appear that the public sector total borrowing requirement in the United States will exceed $600 billion in fiscal 2009.  And please remember that is the cash borrowing portion, not the accrual.  With the accrual it is likely to exceed $1 trillion.  If the US reported its liabilities the way it requires every private company to report, we would be routinely seeing this trillion appendage to the national numbers.

In the corrective actions taken by the Congress and the Treasury Secretary and the Federal Reserve Chairman, we are witnessing a massive expansion of leverage.  And we witness a growing intervention of the government into finance, economics, and markets.  Some argue this is for the better.  Maybe so?  Others argue for the laissez faire ways of yesteryear.  They are in the distinct minority, and their arguments are not persuasive to the majority.  Like it or not, the outcome of the credit crunch is more and bigger government intervention into the economy and the financial structure of the country.

That means the seeds of the next crises are being sown right now, as these fixes of the past problems are enacted.  The very same folks who planted the soil in the breeding ground of housing finance or leverage loans are now fertilizing the successor crisis during this rocky period.

Where will we look for the unintended consequences?  Is the entire federal bank deposit insurance structure being realigned so that risk is shifted to the uninsured depositor in an unprecedented way?  We think so.  Who is the uninsured depositor?  Mostly independent businesses and smaller institutions are taking on this risk.  Many of them do not even understand it. 

Have we marked up the retirement system unfunded liabilities and therefore added to the risk of the federal government’s guarantee of insured pensions?  Will Pension Benefit Guarantee Corporation be the next crisis?  Or will the crisis erupt from a run on securities firms because of suspicions about SIPC insurance protection?

We do not know where the next explosion will occur.  We do know it is coming.  In the global market, the credit default swap (CDS) on the United States has doubled in price since the Fannie-Freddie nationalization (10-yr CDS from 8 basis points to 16).  This security trades in euro because dollar pricing makes no sense when measuring credit risk on the primary issuer of dollar denominated debt.  Likewise the credit default swap on Germany trades in dollars because the German home currency is the euro.  The US is now priced at double the credit risk of Germany.  Both are still low compared to other countries.  Most importantly, the US trend is clearly negative.  At Cumberland, we view credit default swap pricing as one of the single most important market based indicators of risk.  Watching the credit default swap price on the United States widen is a warning signal of higher interest rates to come, if it persists.   We must give commendation to Howard Simons of Bianco Research for excellent comments on this technical subject.

At Cumberland we will continue to use scenario strategies and attempt to manage clients’ funds around these risks.  Sometimes that means selling something at an early stage and before the risk materializes.  Often that early move is anticipatory and the event does not happen.  There are many times when a cure is put in place before the loss occurs.

Is it better to run early and then miss a move because the loss didn’t happen?  We think so.  The alternative is to wait until it does happen, and that is often too late.  On our website, www.cumber.com,  in the right corner, are three commentaries from the past.  In them we discussed the growing risk in Fannie and Freddie and in the mortgage sector.  One of them (December 17, 2004) suggested that investors in Fannie Mae were heading for trouble.  We wrote: “…the stock is still near 70 bucks. Oh, well. These folks once bought Cisco and Microsoft at $100 a share. They are each a more responsible reporting company than FNMA.”  We were ridiculed when we published it three and a half years ago. 

This weekend we are off to the annual economic-finance retreat at a fishing camp in Maine.

Each year we organize this event by invitation only.  Finance and market professionals and economists gather privately at Leen’s Lodge in the village of Grand Lake Stream, Maine.  Some of the discussions are private.  Other comments become public as attendees write about them.  Quotation is allowed but only with the permission of the speaker. 

This year CNBC is sending a live truck to the fishing camp.  My interview is scheduled for 6:30 AM on Friday, August 1.  There will be other interviews of attendees, and the panel discussion of the 8:30 AM employment report release will be conducted from the location in Maine.

When we gathered last year, the first chapter of the Bear Stearns saga was very fresh.  The Fed Funds rate was 5-1⁄4%.  There were few concerns about bank failures or bear stock markets or $140 oil.  There were numerous AAA rated municipal bond insurers a year ago and student loan paper was viewed as a cash equivalent.  I expect this year’s discussions will be quite robust.




How Safe is Your Bank?

In 1790, Edmund Burke, the founder of Anglo-American conservatism, waxed eloquently about the power and responsibilities of a government’s agencies in a democracy.  He said: “To execute laws is a royal office; to execute orders is not to be king.  A political magistracy, though merely such, is a great trust.”  This warning came before there were central banks like the Federal Reserve, before there were bank regulators & supervisors, and before there were bank deposit insurers like the FDIC.  Was Burke prescient and thinking about them?

Treasury Secretary Paulson didn’t quote Burke in his speech at the NY Public Library.  Paulson wanted to assure Americans that their banks and banking deposits are safe.  He used his position of “political magistracy” to announce what Burke referred to as the “great trust.”

How do we greet the Treasury Secretary’s remarks, in the face of IndyMac’s failure and the FDIC announcement that uninsured IndyMac depositors may only get 50% of their money?  How do we respond when the Wall Street Journal reports the Federal Deposit Insurance Corporation (FDIC) stayed in the subprime mortgage business after they seized failing Superior Bank FSB?  (See WSJ front-page story entitled “FDIC Faces Mortgage Mess,” July 21, 2008.)

Two hundred and eighteen years after Burke’s admonition, we can ask: Is your money safe in the bank?

We have received that question from clients and journalists on a continuing basis since the IndyMac events unfolded.  IndyMac is a very large bank failure.  On TV it became the American counter-image to the British bank run at Northern Rock.  For an IndyMac analysis, see Bob Eisenbeis’ commentary at www.cumber.com.  Bob notes that in IndyMac’s case the actual run came after the bank failed and was taken over unlike the Northern Rock run which preceded the failure.  We do not know if these folks wanted their insured deposits or their uninsured deposits.

Here is what we know about banks and your bank deposits.  And there is a lot we don’t know, as you will see.

A)    We are told that there are 90 banks on the “watch list” of the FDIC.  This is double the number that were on this list in 2006, the year before the financial crisis began.  Note that IndyMac was NOT on this list at the end of the first quarter of 2008.  It was then called “well-capitalized.”

B)    We are not told who these 90 institutions are.  The federal authorities know that making a name public will trigger withdrawals from that bank, so they keep the list confidential.  That means you, as an uninsured depositor, do not get advance warning from the FDIC that you may be at risk.  Uninsured depositors are supposed to worry about the safety of their own funds.  The system is designed that way.  Whether the federal authorities are doing enough to strengthen the system is a policy question currently open to debate.

C)    We are not told when banks borrow from the Federal Reserve’s Discount Window.  We only see the total borrowings.  They are broken down only as coming out of one of the twelve regional Federal Reserve Banks.  Thus the Fed is of no help in letting you assess the safety of your bank deposits.  We are not told the banks that borrow from the Fed’s Term Auction Facility (TAF).  They are also aggregated, just as with the Discount Window.  We need to use private services for these assessments not the Federal Reserve.

D)   Some riskier institutions are resorting to complex ways to obtain funds.  When they do they often collateralize them and that means less protection for the uninsured depositors.  Covered bonds are an example.  Many are not familiar with the “covered bond” concept.  See www.cumber.com for that recent analysis.  We know that Washington Mutual used covered bonds and denominated them in euros.  One has to wonder how much that contributed to their currently viewed weakened condition.  WAMU was seeking ways to gain funds other than using Federal Home Loan Bank advances.  Note that the covered bonds are collateralized.  That means they have a claim that is ahead of uninsured depositors if the bank fails.

E)    Your bank publishes public reports, and they must make them available to you.  In them you can see some details about your bank’s financial characteristics.  That will tell you part of the story, but only part.  You are able to find out about your bank’s Federal Home Loan Bank (FHLB) advances.  You may be able to find out more details in the footnotes of the bank’s reports.  The rules about what the bank has to tell you and what they don’t tell you are pretty clear.

F)   There is a federal ranking system for banks but a depositor cannot obtain it. The federal regulators rate all banks for safety and soundness.  Those ratings are scored, and the characteristics are known by the acronym CAMELS.  The score is kept confidential; the range is 1 for the best and 5 for the worst.  You do not have legal access to your bank’s score as a depositor.  We can infer that IndyMac had a CAMELS score of 1, 2, or 3 on March 31.  Were it to have been a 4 or 5, it would likely to have been on the FDIC watch list.

OK, so you can only get partial information to assess your risk exposure but is it enough?  And what if you are a lay person and do not have the financial analytical skills to dissect the technical side?

First, one must become familiar with the FDIC insurance rules.  Follow them carefully.  Insured deposits will be paid if a bank fails.  The US government has committed itself to this liability.  It makes no difference if the insurance fund is sufficient.  If it is not, we fully expect and the public will demand that the Congress fund any deficiency.  Current law gives the FDIC a claim on the entire equity of the banking system.  If that isn’t enough, the FDIC can draw on the Treasury.  Most analysts believe other steps would be taken long before that extreme action is required.  At Cumberland, we consider an insured CD or insured bank deposit to be just as safe as a US Treasury bill or note.  Note that the $100,000 limit is a cap but there are ways to obtain $200,000 through strategic use of joint accounts.  Remember the limits are per bank so use of multiple banks raises the total insurance coverage.  Many folks use CDs of $98000 or $95000 so that the accrued interest is also insured.  Some details about the FDIC insurance rules are at the bottom of this commentary.

As presently structured under 1991 law, the FDIC is actually first and foremost a mutual insurance company.  It must fund any deficits by levying premiums on the remaining insured banks.  The FDIC has indicated that those premiums are going to rise.  Only after equity in the banking system is exhausted can the FDIC turn to the federal government.  This is not widely understood, and it also means that the FDIC is not an agent for the Congress but for the banks to which it must turn if there are losses.

While this is a serious issue for the remaining banks because it increases their costs, this doesn’t jeopardize the insured depositor.   In the end you are backstopped by the pledge of the federal government to pay you when all other administrative systems fail.

Let’s go to the uninsured depositor.

“What if I have a deposit in my bank and it is above the insurance limits?”  This is really quite a common question.  Many operating businesses face this issue, since they need to keep larger amounts on deposit for operational purposes. These may be uninsured, and thus the depositor faces a risk of loss if the bank is seized.  That is what may happen with IndyMac.  The first $100,000 is insured.  For the IndyMac customers, the problems started with the $1 billion plus uninsured money.

It is important to understand the pecking order of claims when a bank is seized.  If the bank had collateralized loans, those bank assets which were used for that collateral come ahead of you as an uninsured depositor.  An example is a Federal Reserve Discount Window loan.  The Fed is secured by a claim on the bank’s pledged collateral.  The Fed gets paid before any of the depositors.  The same is true for the FHLB.  It is also true for numerous state and local government funds.  For example, in NJ there is the New Jersey Governmental Unit Deposit Protection Act (GUDPA).  New Jersey banks have pledged certain securities to collateralize governmental deposits.  That claim comes ahead of the other depositors who do not have collateral security.  In effect, the collateral turns an otherwise uninsured depositor into a 100% secured one.

Once all these claims are met, the FDIC then looks to the remaining bank assets of the seized bank in order to pay the uninsured depositors.  The FDIC pays the insured depositors and then stands in their place.  The FDIC then get itself repaid from the assets before any money is made available to pay the uninsured deposits.  The uninsured depositors are at the end of the list.  They will get paid before anything gets to any bank holding company bondholder or shareholder, but they are behind all the other competing claims on the specific bank that was seized.

Clients ask us if this is a serious problem.  Facts: there are 8500 banks in the US.  There are 90 banks on the FDIC “watch list.”  We do not know if they are large banks or small banks.  We do not know who they are.  We do know that this is about double the number that were on the list before all the housing finance and financial market turmoil started.  The FDIC estimates that 13% of the banks on the watch list will fail.  I guess that means the FDIC thinks the odds of an uninsured depositor being hurt are small.   But we must remember that IndyMac wasn’t on this list on March 31, 2008.

The trend in bank failures does not give any comfort.  IndyMac is the fifth failure in 2008 and it is big.  The other four are much smaller.  They are First Integrity Bank, ANB Financial, Hume Bank, and Douglas National Bank.  In all of 2007 there were three failures; none in 2006 or 2005. 

But there are only 90 banks on the watch list, and so we have been asked, “What’s the big problem?”  We put this question to Chris Whalen, whose service we will describe in the next paragraph.  Chris answered, "You need to remind your clients that the FHLB and Fed are likely to be supporting troubled banks and getting paid at PAR in the event of a closure, the assets available to repay uninsured depositors are less and less.  In the case of IndyMac, we estimate that uninsured depositors could take a 50% haircut if losses go as high as 25% of total assets.  This is an institution that was considered well-capitalized at year-end 2007.  While the FDIC had 90 institutions on its problem list as of Q1, we identified 8% of all banks, or around 700 institutions as troubled."

A way to protect yourself is to obtain good information about your bank from an independent research source.  At Cumberland, we have utilized the services of Chris Whalen’s firm, a custom analytics provider: Institutional Risk Analytics (www.institutionalriskanalytics.com) .  Their services range from an automated report showing the bank’s financial and credit performance ($50) to a detailed profile of an institution prepared by one of their analysts.  That costs $1,000.  For additional information, contact Christopher Whalen (914) 827-9272 or cwhalen@institutionalriskanalytics.com .

Our advice is that depositors should try to lower that risk as much as possible.  Here is one idea.

After you have spread your insured deposits around and IF you still have uninsured deposits that need some liquidity placement, consider placement of the funds in a state or local governmental weekly reset variable-rate demand note (VRDN).  For an example see www.cumber.com.

The rationale is that you can get the same claim on a bank liquidity provider for a VRDN as you get from being an uninsured depositor in that bank.   But you also get the obligation of the municipal issuer.  If the bank fails, the Muni issuer will be replacing it with another bank.  Meanwhile the Muni issuer is the primary obligor.  If the bank doesn’t fail, you still have the bank credit as backup for liquidity.

Lastly, we must remember that the financial landscape in the US is rapidly changing.  Many of Treasury Secretary Paulson’s proposals are altering the risk profile that we were previously accustomed to.  And there are issues of systemic risk that must not be forgotten.  The array of changes seems to be transferring more and more risk to the uninsured depositor.

The great sage Will Rogers gave some sound economic advice.  He said: “It’s not the return on the money; it’s the return of the money that counts.”  Had they met, Will Rogers and Edmund Burke may have liked each other.

The following is excerpted from the FDIC rules:

How much insurance coverage does the FDIC provide?

The basic insurance amount is $100,000 per depositor, per insured bank.

The $100,000 amount applies to all depositors of an insured bank except for owners of certain retirement accounts, which are insured up to $250,000 per owner, per insured bank.

Deposits in separate branches of an insured bank are not separately insured. Deposits in one insured bank are insured separately from deposits in another insured bank.

Deposits maintained in different categories of legal ownership at the same bank can be separately insured. Therefore, it is possible to have deposits of more than $100,000 at one insured bank and still be fully insured.

The following sections describe the eight ownership categories recognized by FDIC regulations and the requirements that must be met to have coverage beyond the basic $100,000 insurance amount.

Single accounts: A single account is a deposit owned by one person. The following deposit account types are included in this ownership category:

      Accounts held in one person’s name alone

      Accounts established for one person by an agent, nominee, guardian, custodian, or conservator, including Uniform Transfers to Minors Act accounts, escrow accounts, and brokered deposit accounts

      Accounts held in the name of a business that is a sole proprietorship (for example, a "DBA account")

      Accounts established for a decedent’s estate, and

      Any account that fails to qualify for coverage under another ownership category.

All single accounts owned by the same person at the same insured bank are added together, and the total is insured up to $100,000.

If an individual has a deposit account titled in his or her name alone but gives another person the right to withdraw deposits from the account, the account will be insured as a single account only if the insured bank’s deposit account records indicate that:

      The other signer is authorized to make withdrawals pursuant to a power of attorney, or

      The account is owned by one person, and the other person is authorized to withdraw deposits on the owner’s behalf (for example, a convenience account).

If the insured bank’s account records do not indicate that such a relationship exists, the deposit would be insured as a joint account.

Single Account Example

Account Title Deposit Type Account Balance ($)
Marci Jones NOW

5,000

Marci Jones Savings
20,000
Marci Jones CD
100,000
Marci’s Memories (a sole proprietorship) Checking
25,000
Total Deposits  
150,000
Amount Insured  
100,000
Amount UNinsured  
50,000

Explanation:

Marci Jones has four single accounts at the same insured bank: three accounts held in her name alone and one account held by her business, which is a sole proprietorship. Deposits owned by a sole proprietorship are insured as the single ownership deposits of the person who owns the business. Thus, the deposits in all of these accounts are added together, and the total balance, $150,000, is insured for $100,000, leaving $50,000 uninsured.

A final item: as we were about to release this tonight a Wall Street Journal news alert arrived.  It said: “Federal regulators shut down two national banks, First National Bank of Nevada, based in Reno, Nev., and First Heritage Bank of Newport Beach, Calif., in the latest chapter of the credit crisis. Both banks were units of First National Bank Holding Co. The Federal Deposit Insurance Corp. successfully protected all depositors by selling the accounts to Mutual of Omaha Bank.”

This means seven banks have now failed this year.  Three of them had more than $1 billion of assets.




Are Covered Bonds the Answer?

In yet another effort to resuscitate the mortgage market (remember the Super SIV?), Secretary Paulson is now urging that a market be created for covered bonds.  What are covered bonds?  They are a German creation dating back to the late 1700s. 

A bank-issued, covered bond is an obligation backed by an interest in a pool of assets, usually mortgages.  They are similar to mortgage-backed securities in that the bonds are backed by the cash flows from the underlying assets.  In addition, they are usually, but not required to be, issued by a special-purpose vehicle.  However, the underlying assets remain on the bank’s balance sheet and the bond is an uninsured debt security of the bank.  The bank can alter the composition of the asset pool to maintain its quality and also alter the terms of the mortgages, should that prove necessary.  This latter feature gets around a current problem with mortgage-backed securities over who has the right to alter the terms of the underlying mortgages should the borrower get in trouble.  In Europe, the bonds are typically rated by rating agencies and presumably would be here in the US as well.

Five key issues exist with trying to jump start this market in the US.  First, covered bonds are not familiar investments at this point, and in particular, they look a lot like mortgage-backed securities, which have lost their luster.

Second, the status of covered bonds in the event of a default by the issuing institution has been uncertain.  Only recently (July 15) did the FDIC issue a policy statement on how covered bonds would be treated in the event of a default by an insured depository institution.1  The FDIC also indicated that the outstanding amount of covered bonds by banks would be limited to 4% of an institution’s total assets.  Thus, the supply of bank-issued covered bonds would initially be very limited when compared, for example, to mortgage-backed securities.

Third, demand is also likely to be very cautious and limited.  Despite the claim that these instruments are rated and are of high quality, memory is long right now about the quality of credit ratings and the quality of mortgages that were supposedly highly rated. 

Fourth, there is the issue of the accounting treatment of such instruments, as well as how they would be treated from a capital adequacy perspective by regulators.  It is suggested that covered bonds would be a source of liquidity, but given that these instruments are likely to be very long-term securities, it is possible to see how they might be a source of funding but certainly not liquidity.   Without a broad, active market, the claim that such instruments would be a source of liquidly is only a hope.

Finally, and perhaps most importantly, in the event of a failure, covered bonds, like Home Loan Bank advances and Federal Reserve discount window loans, would represent senior claims that would stand ahead of uninsured depositors and other creditors, including the FDIC.  Thus, promoting covered bonds is really a way to compartmentalize and shift risk to the FDIC and uninsured depositors.  This would effectively make uninsured deposits even less attractive to bank customers because of the reduced protections that capital might otherwise afford them. 

In short, covered bonds aren’t necessarily the attractive instrument for investors that they are touted as being, particularly when considered from the broader interests of bank creditors.  Attempting to shore up the housing market without considering the potential unintended consequences is short-term policy making that may provoke taxpayer indigestion down the road.  The FDIC recognized this potential risk in its policy statement, but right now it appears that in Washington any risk that might remotely help housing is worth taking.

The bottom line is that from the perspective of an investor who is concerned about safety and has more than $100K to place, other alternatives, like Variable Rate Demand Notes, clearly look like an attractive option.  When properly backed by a liquidity provider, they certainly offer protection and the market is better developed.

Covered Bond Policy Statement, FDIC, July 15, 2008.  According to the current structure of such instruments, should a failure occur, the special-purpose vehicle would take possession of the underlying mortgages and continue payment on the bonds.  However, since the bonds are an uninsured debt of the bank, the FDIC as either conservator or receiver would have the discretion to honor the obligation or not.  Under the Federal Deposit Insurance Act (FDIA), there is either a 45-day (in the case of a conservatorship) or 90-day (in the case of a receivership) waiting period, during which holder of the debt cannot terminate the agreement because of the insolvency and the FDIC must honor the terms of the debt obligation.  While the FDIC can, after the waiting period, repudiate the debt and either pay off the debt or liquidate the underlying collateral and debt, the FDIA does provide protections up to the value of the underlying pledged assets to valid debt contracts.