The Global Bear Market in Equities

Before last week’s rebound, with few exceptions, equity markets around the globe had registered declines in excess of 20%, the magnitude commonly considered to indicate a “bear market.”  The convergence in market performance is striking. Over the period between the markets’ peak reached on October 12, 2007, and the low point of July 15 last week, global markets as measured by the MSCI World Index declined by 21.0%.  Over the same period, the MSCI EAFE Index, widely used as the benchmark for the advanced markets, ex-North America, lost 21.6%.  And the MSCI EEM Index for Emerging markets dropped 21.3%.  In the latter trading days of last week, equity markets reversed course. Does this signal that the bear market has reached a definitive bottom, or will the recent lows be revisited and possibly be surpassed?

The global bear market has resulted from a number of negative factors coming together and interacting. To summarize these very briefly, the collapse of the US housing market led to the subprime crisis, which later morphed into much broader problems for financial institutions, with a sharp drop in confidence affecting counterparty funding relationships.  Financial institutions in Europe were affected directly through their relationships with the US.  These negative developments are being compounded by developing serous problems in a number of European housing markets, particularly in Ireland, Spain, the UK, and France.  The second factor has been the dramatic rise in the price of oil and surging prices for other commodities, particularly for agriculture.  These have had growing negative effects on consumer attitudes and the business climate and have contributed to rising inflation and inflation expectations. The direct impact of these higher prices has been greatest in emerging markets, where energy and food constitute a large proportion of the budgets of most citizens. Of course, the high energy and commodity prices have been a boon to those countries that are net exporters of these products, such as Brazil, Russia, Australia, Canada, Norway, and the Middle East oil exporters.

To what extent have these factors, or their expected future course, changed recently?  We have yet to see the US housing market carve out a clear bottom.  Mortgage delinquency curves have not flattened out.   The process of deleveraging by banks certainly does not appear to have been completed, and many banks still need to raise additional capital. While we may well have heard most of the bad news to come from the largest financial institutions, there is probably more to come from smaller banks.  And we have yet to see the impact of tightened lending standards on business investment.

On the energy front, the sharp drop in the oil price last week was certainly welcome, but a further sustained drop is needed to have a lasting impact.  The increase in output from Saudi Arabia’s oil fields is a positive development.  Efforts to tap the oil reserves of the US Continental Shelf, if carried forward, will not affect oil supplies for a number of years.  We continue to be concerned about the effect on consumers of what appear likely to be very high home heating costs for the coming winter. It is evident that oil prices at the current levels are finally having the positive effect of destroying demand for gasoline and for many other elements of energy demand. But it is difficult for families to economize on heating requirements.

Other commodity and materials prices have come off their highs, reflecting both slower global growth and growth expectations, along with some positive supply responses.  This is a plus for oil- and commodity-importing countries and for the outlook for global inflation.  Taiwan’s prospects, for example, should improve, both due to these factors and because of improved commercial relations with China.  But we doubt that the long-term boom in commodities has come to an end.  China’s economy, while it has also slowed somewhat, is still the most rapidly growing large economy in the world.  It is likely to continue to register growth in the 9-10% range for the foreseeable future and be a major consumer of raw materials and commodities.  India, while confronting greater near-term problems than China, is still advancing at a 7% pace, as also is Russia.

The future course of inflation is a critical and uncertain factor for the US economic outlook.  If energy and commodity prices do ease in a convincing way and the pace of economic activity remains modest, the Federal Reserve Board’s concerns about inflation and inflationary expectations will moderate.  Under those conditions, the Fed would be expected to hold off any interest rate increases for some time. On the other hand, should inflation start to ramp up further, the Fed would be forced to step in with higher interest rates, despite the risk of tipping a slow economy into a significant recession.

Among the advanced markets, despite the negative factors listed earlier, the US economy has proved to be surprisingly resilient in the first half of this year, avoiding any quarterly decline in GDP.  In fact, the lowest growth rate was registered in the final quarter of 2007, +0.6% at an annual rate. First quarter 2008 growth was +1.0% and it looks like the second quarter’s growth was in excess of 2%.  The latter was beefed up by Congress’s fiscal stimulus package and very strong exports, thanks to the weak US dollar. These two factors should help the current third quarter as well, but we are less confident about the closing months of this year and early 2009, which could be rather weak.

Economies in Europe were surprisingly strong early in 2008, but more recently there are growing and widespread indications of deceleration. The continued very expensive euro, high energy prices and high interest rates, along with rising inflation are biting into economic performance in Euro land.  Even Germany, the strongest performer among the major European economies, is signaling that its economy slowed sharply in the second quarter. In France, real wage growth has turned negative despite French President Sarkozy’s pledge to strengthen the purchasing power of consumers.  The UK economy, while not tied to the euro, is looking particularly weak.  The Bank of England’s leeway to stimulate the economy is severely limited by the fact that the UK’s inflation rate is the highest it has been for 16 years. We expect that European equity markets will underperform in comparison to the US equity market in the coming months.

In Asia, Japan appears to be experiencing a mild recession, but its equity market has outperformed the Euro land markets this year. Japan has largely avoided the banking  crisis that hit Europe along with the US, Japan’s inflation remains subdued (indeed, there is still a risk of slipping back into deflation), and the Bank of Japan is not expected to raise Japan’s very low interest rates for the foreseeable future.

Putting these and other pieces of a complex and uncertain outlook for global equity markets together suggests to us that, while there are some promising developments, the downside risks going forward remain significant.  In order to preserve investors’ capital and to be ready to take advantage of a more convincing upswing in markets, Cumberland has been raising cash levels in our Exchange-Traded Fund (ETF) accounts.  In doing this, it is important to seek to identify those markets that are most likely to underperform going forward and to target the most likely outperformers for the time when the cash that has been raised is to be put to work.

Finally we should note the value of a diversified, multi-asset class investment strategy in such markets. Diversification across equity markets, sectors, industries, and countries is likely to reduce the overall risk in a portfolio.  Adding other asset classes that are not closely correlated with equities, such as commodities, currencies, fixed income, and real estate, can significantly add to the diversification of a portfolio, and the benefits that come from diversification. (Correlation is a statistical term that defines the strength of a linear relationship between two markets.) This approach has been followed by major institutional investors, particularly university endowment funds and pension funds.  The development of an ever-growing number of ETFs covering all of these asset classes provides an efficient, low-cost way to create such a portfolio.  

At Cumberland Advisors, we now have accumulated two and a half years of experience with such an all-ETF investment style, our Global Multi-Asset Class Portfolio.  This portfolio style uses ETFs that represent major markets in multiple asset classes. These markets may have varying degrees of correlation with each other.  It is the goal of this portfolio style to take advantage of low or negative correlations between asset classes, represented by the ETFs. This way, when some markets are down, others should be steady or up, if they conform to historical patterns of behavior.

Kotok comment: readers must note that this approach only has 2 ½ years of live account experience.  These instruments (ETFs) did not exist a few years ago.  We can provide details on the composition and structure to those who email a request.

‘IndyMac: Who’s to Blame for What?’

Last Monday witnessed the reopening of IndyMac under the management and receivership authority of the Federal Deposit Insurance Corporation (FDIC). Photos of lines formed by anxious depositors appeared in numerous news accounts and triggered widespread concern about the safety of depositor funds.

(1) IndyMac’s regulator, the Office of Thrift Supervision (OTS), closed the institution on Friday, July 11 and turned it over, as the law requires, to the FDIC to act as receiver and insurer of deposits. The FDIC’s preliminary estimates are that the failure will cost it somewhere between $4 and $8 billion. This is despite the requirements in the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) that regulators intervene and attempt to minimize losses to the insurance fund.

(2) In fact, the theory behind FDICIA intends that an instuition should be closed before its net worth goes to zero, so that creditors can be repaid without loss to the FDIC or taxpayers.

The statement that the OTS released announcing the failure indicated that it had been concerned about IndyMac’s “precarious financial condition” as early as November of 2007.

(3) The institution had modified its business plan and sought to raise additional capital. Furthermore, additional steps had been taken following OTS examination of the institution in January of 2008, to return it to financial health.

The press release intimates that these plans and efforts were frustrated by the leaking of a letter from Senator Schumer to the OTS, questioning IndyMac’s financial viability, which triggered a deposit run and caused the demise of the institution. Clearly, Senator Schumer’s actions seem reckless. Had his remarks been uttered by a private citizen and not protected by the legal immunity accorded to our federal legislators, that person might have been subject to prosecution, if the claims proved to be false. That said, it seems the OTS’s responses were equally reprehensible and self-serving.

As in most highly charged events, the facts have mostly gotten left behind, so it would pay to restate them and to delve into why the losses are likely to be so large.

IndyMac was a hybrid savings institution spun off from the now defunct Countrywide, that specialized in the origination, servicing, and securitization of Alt-A (low-documentation) mortgage loans. It grew very rapidly, doubling in size between March 2005 and December 2007 from $16.8 billion to $32.5 billion.

(4) Its funding, in rough order of importance, consisted primarily of Federal Home Loan Bank (FHLB) advances and insured and uninsured deposits. The advances were a particularly important source of funding, accounting for between 32% to 45% of its total liabilities.

(5) IndyMac’s reported capital declined over the period from its peak of $2.7 billion in June of 2007 to $1.8 billion at the end of March 2008. Uninsured deposits began to run off in mid-2007, long before Senator Schumer’s letter. In fact, the bank actively replaced slight declines in FHLB advances and a drop in uninsured deposits with insured deposits, and particularly with fully insured brokered deposits under $100K. At about the same time, the bank’s stock price began to plummet, dropping from a high of about $35 per share in June to about $3 just prior to the Schumer letter. Additionally, earnings also turned negative in the fall of 2007. These factors all pointed to a very troubled institution whose situation was continuing to worsen.

Despite the OTS examination in January and subsequent actions by the institution to change its strategy, its capital position continued to decline and earnings deteriorated. In the face of this, OTS director Reich maintained that IndyMac was adequately capitalized and the institution touted that fact in its SEC filing. In fact, in the bank’s March 31, 2008 10Q it stated that tangible and Tier 1 core capital stood at 5.74%, well above the regulatory requirements for the bank to be classified as well-capitalized. Risk-Based Tier 1 capital was 9% and Total Risk-Based capital was at 10.26%. Given that it was supposedly adequately capitalized and was done in by a liquidity problem as some $1.3 billion of deposits ran off, it stretches credibility that the bank’s failure would lead the FDIC to estimate that it could stand to lose between $4 and $8 billion.

(6) How could losses of this magnitude accumulate in just a matter of a few days due to a supposed run of $1.3 billion? The answer, of course, is that they didn’t.

The bank was likely to have been deeply economically insolvent, which was masked by faulty accounting according to current rules and regulatory standards. Clearly, the bank’s active bidding for brokered deposits and reliance upon funding from the FHLB amounted to a big gamble – financed by other government entities – that it might weather the storm. Keep in mind that IndyMac had, at closing, about $10.1 billion in FHLB advances and perhaps even Federal Reserve discount window borrowings as well. Any such borrowings would be over-collateralized with high-quality assets – in this case the collateral was largely mortgage-backed securities. Such claims stand ahead of insured deposits or the FDIC in the liquidation. This means that much of the best collateral that could have been used to backstop the FDIC or shared to reduce losses to uninsured claimants was instead siphoned off by other agencies. Indeed, the FDIC initial estimates are that uninsured depositors may receive fifty cents on the dollar of uninsured deposits.

What emerges from even a partially informed and quick analysis of the available evidence and data is the suggestion that
(a) the institution was in deep trouble long before it was closed;
(b) the OTS appeared to be late to the party, despite market signals;
(c) OTS actions were ineffective when measured against the intent of FDICIA;
(d) the institution engaged in moral hazard behavior by pumping up its brokered deposits that were 100% insured and borrowing from the FHLB, and possibly the Federal Reserve.

The bottom line is that the FDIC is left to clean up the mess and the costs associated with regulatory ineptitude, and the moral hazard behavior will be paid for collectively by the banking system through higher FDIC premiums on the surviving banks.

(1) As of this writing, it is unclear whether those photos pre- or post-dated the opening of the bank under FDIC receivership.

(2)“FDIC Establishes IndyMac Federal Bank, FSB as Successor to IndyMac Bank, FSB, Pasadena, California,” FDIC press release, July 11, 2008.

(3)“OTS Closes IndyMac Bank and Transfers Operations to FDIC,” Office of Thrift Supervision press release, July 11, 2008.

(4) Data from FDIC Quarterly Reports of Condition and Income.

(5) Data from FDIC Quarterly Reports of Condition and Income.

(6) It is likely, given estimates of the amount of deposits in the institution in excess of $100K, that most of this runoff was uninsured deposits.

Tax-free Bond Opportunity: A VRDN Case Study

Since early in 2008 there has been much congestion and volatility in the short-term tax-exempt bond market.  This has been due to the failure of the short-term auction-rate market, specifically the backup in yields in the variable-rate demand-note (VRDN) market caused by market aversion to downgraded insurers, the abject failure of auction markets of student loans and closed-end preferred shares’ failure to clear.

Clearly the high rates on floaters and auctions have put financial pressure on municipal issuers who have done nothing wrong on their own except be hurt by the fallout from the downgrading of the bond insurers.

Let’s take a look at one bond which we have recently owned in Cumberland accounts.

The Bay Area Toll Authority (BATA) in California is eleven years old and was created in 1997 by the California state legislature to fund and administer the seven state-owned toll bridges in the San Francisco Bay Area.  BATA is rated AA3 by Moody’s and AA by Standard and Poor’s and has an entire portfolio of $2.4 billion in variable-rate debt, both auctions and floaters.

Last fall they issued VRDNs.  The issue we reference was a $500mm issue, and this particular nominal maturity was $50mm.  The bonds came with AMBAC insurance – then AAA rated by both Moody’s and Standard & Poor’s.  The bonds have a nominal maturity of 2047 but were issued as weekly floaters.  The weekly “put” feature was secured by a Standby Purchase Agreement from Dexia (a Belgian-based European bank specializing in public finance internationally), which gave the bonds a VMIG1 short-term rating (Moody’s highest short-term rating).

The reason that BATA, like many large infrastructure issuers, issued variable-rate debt is that it allowed them to offer long-term maturities but also enjoy the benefits of the traditionally steep tax-exempt municipal yield curve, where short-term rates are usually much lower than long-term rates.

The initial weekly rate was 3.23% last October and stayed roughly between 3.5% and 3.0% until year end.  To compare this: if BATA had issued long-term bonds instead, the interest cost to BATA would have been a yield of roughly 4.50%-4.80% for long, high-quality California debt.

The rates stayed low in the beginning of 2008, dropping to nearly 2% in late January.  This certainly correlates with the rest of the short-term market, where rates were falling in concert with the Federal Reserve moves of lowering all short-term interest rates to battle the freeze-up in liquidity which had gripped all financial markets.

February, 2008 saw most money market funds (where VRDNs are a staple item) “put” almost all floaters – FGIC, CIFG & XLCA-insured because of downgrades;  AMBAC & MBIA-insured bonds because of the threat of downgrades.  These funds did not want to take a chance of having downgrades appear in their portfolios for legal as well as marketing reasons.  Thus, the interest rates on all floaters shot up in February as the dealers’ only recourse (since the bonds trade at par) was to offer higher and higher rates. 

On Feb 28 the weekly reset rates on BATA floaters shot up to 6% from 2.75%.  Because of the great demand for California paper in general, and short-term California paper in  particular, these rates soon started to work their way back down.  At that time AMBAC & MBIA, unlike some of the other insurers, were not yet downgraded.

It was Cumberland’s opinion that these instruments offered outstanding value, not only because of the high tax-exempt rate (compare 6% to the 1.5-2% offered by short US Treasury bills) but also because most (not all) floaters offered provisions to buyers which allowed a grace period to put the bonds back to the liquidity provider in case of downgrades below a certain level.  That level is important since it is the point at which the liquidity provider is able to terminate its liquidity agreement.

In states other than California, AMBAC and MBIA VRDN rates stayed high but started to subsequently decline as large numbers of nontraditional buyers found their way to this market.  New buyers included foreign buyers and US state and local governments that did not need the tax exemption.  They found the nominal level of rates very compelling; so did some charitable and nonprofit accounts as well.

In early June, both MBIA and AMBAC saw themselves downgraded by Moody’s and Standard & Poor’s.  AMBAC was downgraded to AA3 by Moody’s and to AA by S&P.  The rates on BATA’s floaters shot up from 2.9% to 6%.  The weekly resets since have yielded 9%, 7%, 8%, 8%.  Cumberland’s clients were invested at the 9% level and continue to hold them.

In the case of this BATA credit, we know that a downgrade by TWO rating agencies to below an AA3 (Moody’s), AA- (S&P), or AA- (Fitch) for 90 consecutive days will allow Dexia to issue a 30-day notice of termination.  Upon receipt of the notice a mandatory redemption will be made.  This means that there is a grace period AND, in this case, the bonds would be called because of the downgrade.  So far, the downgrade has not   been below the specified level.   

It should also be noted that all floaters DIFFER in terms of liquidity and termination provisions.  It is this complexity and confusion which has additionally caused these rates to stay high on what we consider extremely high-grade credits.

Of course, from the issuers’ standpoint these high rates are hitting them at the worst possible time: during an economic slowdown.  Issuers had planned for rates to approximate short-term Muni rates and that clearly is not what happened here.  The hole that is being driven into municipal budgets by these high short-term rates is having what we call a “common sense” effect.  Issuers are taking action to redeem these securities.

In the case of BATA, we now know the endgame.  BATA announced this week that it will convert a total of $1.9 billion in various insured variable-rate demand obligations to uninsured obligations with new liquidity facilities.  It will also be refunding $510 million in auction-rate bonds which have also been at much higher than normal rates.

Cumberland’s course of action will be to look for other short-term VRDNs once these have been redeemed.  We would expect other issuers to continue this practice (which has been ongoing the last 4 months) as they seek to replace the higher-yielding VRDN and auction product with either a new short-term product or with bond issues into the longer-maturity end of the market at a fixed rate. While that longer-term bonding out is done, this new issue volume will keep pressure on the long-maturity spectrum of the Muni market.

Meanwhile, we recognize that the ability to average 7%-8% tax-free (10.75% to 12.3% (taxable equivalent yields BEFORE taking into account any state tax exemption benefits) is as compelling a short-term opportunity as we have seen in a generation.  We will continue to take advantage of them.

David Kotok added note and disclosure: Cumberland has numerous separate accounts using this VRDN investment style; the clients are of all types; the largest institutional portfolio currently is $300 million.   These VRDN securities are often smaller sized issues and often need to be allocated among clients because there are not enough to fill all open positions.  Individual research on each issue is necessary in order to be sure that Cumberland’s internal specifications and requirements are met.  There is a special Cumberland staff segment dedicated to that purpose.  Retail and individual investors who try to do this on their owned are warned to take time and exercise great care so that they fully understand the terms and conditions of each offering prior to investing.

What Next for Freddic Mac and Fannie Mae?

The Treasury has proposed to Congress that it be granted “temporary” authority to extend virtually an unlimited line of credit to Freddie Mac and Fannie Mae and to also purchase their equity.  Additionally, the Federal Reserve Board has also granted authority to the Federal Reserve Bank of New York to provide them access to the discount window at the primary credit rate. 

These actions, while intended to be temporary and to enable these institutions to continue rolling over their outstanding debt and maintain their active role in mortgage markets, effectively amount to de facto nationalization of these two entities.  Far from being temporary, these actions change forever the links between Freddie and Fannie and the government.  This conclusion holds in spite of the fact that no loans have yet been extended, nor has equity been acquired. 

The very fact that Treasury and the Fed have put in place mechanisms to ensure that these two institutions will survive has already enabled them to raise funds and has resulted in stockholders’ shares remaining at positive values.  This result reflects the value of converting an implicit government guarantee into an explicit taxpayer guarantee, with all the problems and risks to the taxpayer that it entails. 

Secretary Paulson has indicated that the terms surrounding any injection of funds would be designed to protect the US taxpayer.  How this would be done seems to have been left purposely vague; but simply purchasing equity or preferred stock without additional rights, preferences, and warrants won’t cut it.  Furthermore, it is now clear that the taxpayers are already explicitly at risk and will have to absorb losses should these entities fail.

Thus, taxpayers need to have those protections put in place immediately, even if equity is not purchased by the Treasury.

The key question is, what kinds of protections should be instituted?  The Financial Economists Roundtable, a group of well-known senior finance experts, addressed this issue explicitly in a statement following their annual meeting in Glen Cove, NY earlier this week.  They articulated the principle that the government should be “fully compensated for the full economic value of its support…” and this should include, in the case of equity injections, the granting of stock warrants “… for converting its implicit guarantee of their liabilities into an explicit guarantee.” 

But I argue that further short-run protections are also needed, regardless of whether equity is provided, because existing stockholders stand to gain any upside should Freddie and Fannie recover, even without the injection of taxpayer funds.  What is needed now is a host of reforms, many of which are different from those being proposed by Treasury. 

First, the government’s commitment should be explicitly recognized through the granting of warrants or rights so that the taxpayer can participate in any upside that may now result. 

Second, the regulatory structure and oversight needs to be improved, including the granting of receivership authority to the responsible regulator. 

Third, capital adequacy standards need to be tightened, a system of mandatory trip wires should be put in place to trigger mandatory regulatory interventions should capital ratios fall below critical values, and accounting standards need to be based upon market and not book or regulatory values. 

Fourth, simply giving authority or new powers to a different regulator without also changing the underlying behavioral incentives and methods for ensuring accountability, means that reforms will be ineffective.  Particularly important will be mandatory outside reviews and strict accountability and reporting on the financial condition of these institutions and any losses that may have to be absorbed by taxpayers. 

Fifth, to deal with troubled financial institutions more generally, a crisis-resolution policy should be put in place for financial institutions, including Freddie and Fannie, that pose potential systemic risks to the financial system and economy. It should include bank-like receivership and resolution procedures expressly designed to minimize costs to the taxpayer.  This would include the authority to create a bridge bank-like institution to acquire and run the entity should it be placed in receivership.  

Sixth, serious consideration should be given to scaling back Freddie and Fannie’s activities to the mortgage guarantee business, since government financing of private mortgage debt will only drive out private sector lending activities. 

Finally, since Freddie and Fannie primarily exist today because their GSE status enabled them to borrow at an advantage that could not be matched by private sector firms, efforts need to be made to reprivatize them.  Since this didn’t work the last time it was done, and since the processes and markets for mortgage-backed instruments are sufficiently developed now, consideration should be given to breaking the two GSEs up and selling the activities off to private investors in ways that clearly and unambiguously sever the link between them and the federal government. 

These suggestions, of course, ignore the political fight that would surely ensue, especially if Freddie and Fannie were to be broken up, because what will be perceived to be at stake here is the sacred cow of housing.  All that notwithstanding, it remains the responsibility of Congress to ensure that, whatever Treasury does, adequate protections are in place to make good on the goal of protecting the taxpayer.

About Paulson’s Statement

Excerpts from Treasury Secretary Paulson’s Statement (Published: July 13 2008, 6 PM) About Fannie and Freddie with inserts of Cumberland’s Observations.

Treasury Secretary Paulson.  “In recent days, I have consulted with the Federal Reserve, OFHEO, the SEC, Congressional leaders of both parties and with the two companies to develop a three-part plan for immediate action. The President has asked me to work with Congress to act on this plan immediately.”

Cumberland comment:   Everybody has bought into this plan (politically) whether they want to or not.   This is no longer about “if” but about “how soon” and “how much.”

Paulson:  “First, as a liquidity backstop, the plan includes a temporary increase in the line of credit the GSEs have with Treasury. Treasury would determine the terms and conditions for accessing the line of credit and the amount to be drawn.”

Cumberland comment:  Paulson wants a full discretion as to “how much.”  He must have Congressional approval to increase this line of credit.  He may get it but he may also get a limit as to the amount and as to the timing.   Congress would be more protective of the federal taxpayer if it puts a cap on this line of credit rather than vest discretion without limits.   And Congress would better protect the taxpayer by oversight.  Remember that it was the Congress and the government agencies that got us deeply into this mess.  What makes anyone believe they can be trusted with full discretion and without any limitations?

Paulson:  “Second, to ensure the GSEs have access to sufficient capital to continue to serve their mission, the plan includes temporary authority for Treasury to purchase equity in either of the two GSEs if needed.”

Cumberland:  Okay, taxpayer, you are about to become a shareholder in F&F with your voting rights in the hands of the Bush Administration.  Are you ready for that one?  There are many ways the government can honor the “implied” guarantee of the federal government on F&F debt.  No where is the shareholder granted an implied bailout.   Treasury does not need to buy equity.  It does not need to dilute existing shareholders.  Under current market conditions, if it does not dilute them, it gives the existing shareholders a subsidy from the rest of the taxpayers who will have to pay it.  An alternative is for Treasury to buy subordinated debt or preferred stock (convertible or non-convertible).  Congress can modify this one quickly and place the taxpayer in a more senior position to the existing shareholders.  We expect a policy fight over this one. 

Paulson: “Use of either the line of credit or the equity investment would carry terms and conditions necessary to protect the taxpayer. “

Cumberland:  The line of credit expansion is a partial fulfillment of the implied federal guarantee.  It reassures markets and improves the liquidity necessary for the functioning of markets in F&F mortgage related debt.  It requires Congressional Authorization which is why the Federal Reserve has agreed to “backstop” F&F after the existing $2.25 billion credit line is exhausted.  F&F now have Discount Window access to all the liquidity they need to operate.  F&F debt markets will like these provisions.  A rally in their prices and decline in their yields is expected. 

Paulson:  “Third, to protect the financial system from systemic risk going forward, the plan strengthens the GSE regulatory reform legislation currently moving through Congress by giving the Federal Reserve a consultative role in the new GSE regulator’s process for setting capital requirements and other prudential standards.”

Cumberland:  It is the proper role of the Federal Reserve to deal with systemic risk.  In fact the Fed cannot apply monetary policy without a functioning system.  But here we see a vast expansion of the role of the central bank.  This is worrisome.  The last year of turmoil has dramatically changed the role of the central bank.  And it has caused the Fed to alter its balance sheet in ways never previously seen.  See Cumberland’s website,, for the tracking of the Fed’s balance sheet changes. 

All of this has been done without thoughtful deliberation and has occurred in response to crisis.  We do not know what seeds of future turmoil are being planted now by this policy making apparatus.  We are not sure of any of the measures of outcome.  Congress will give this power to the Fed because it does not want to take on any responsibility itself.  The Fed has been a credible institution and thus is available for this role.  But readers must remember that the Fed is a creature created by the Congress and that this Congress has held Fed Governor appointees hostage.  

We are proceeding into dangerous and uncharted waters.   We can only hope that the radar is turned on and the lookout is peering into the murky water for mines and rocks.   But financial markets cannot operate on hope.  We expect this proposal to cause more questioning of American resolve after it is examined by foreigners.

We believe that Congress is going to pass this legislation rapidly.  It will probably be law before the August recess. 

Stock markets may have a positive initial reaction from a deeply oversold position.  F&F debt will rally and the entire spectrum of financial asset classes will be relieved because they will see the federal government extending its commitment to the implied federal guarantee with deeds and not just words.  Once this rally is over, the markets will have to confront the economic realties of our housing/energy/food/election-uncertainty/economic slowdown/pressured-consumer/large deficit/weak dollar situation.

Fannie and Freddie

Let’s try to sculpt some of the fog swirling around the Fannie Mae and Freddie Mac (F&F) issues.  First some facts:

1. Under present rules the Fed is already specifically authorized to purchase F&F debt for its own account. view history No change in rule or law is needed.  As of the most recent Fed Reserve report (Thursday, July 10) the Fed’s holdings were zero.

2. The Fed already accepts F&F as collateral for Discount Window lending and TAF lending.  The same is true for all the debt of any of the Government Sponsored Enterprises (GSE).

3. The Fed does not lend directly to F&F at the present time.  F&F are not primary dealers.  For a list of the primary dealers, look at the NY Fed website.  You will not see F&F.

4. The Fed could make F&F a primary dealer at any time.  It can invoke the same emergency power that it used in the Bear Stearns transaction and in the subsequent authorization of direct lending to the remaining primary dealers.  At the moment the Fed has no reason to do this.  F&F are not important agents for the Fed when it engages in open-market operations.

Now we offer some opinions:

F&F will not be allowed to default on their direct outstanding debt.  The systemic destruction would be global and enormous.  F&F paper is held by institutions worldwide.  And it is a legal investment and holding for nearly all state and local governments in the United States.

Equally true is the status of the debt that F&F has guaranteed.  The government will not permit default on the mortgage-related securities pooled and then resold with an F&F guarantee.  Furthermore, there is no imminent threat of default.  The payment stream from the more than $5 trillion of mortgages is mostly current and has a reasonably good performance history.  In addition, F&F are functioning agencies.  They have liquidity and market access.  Default by F&F is very unlikely.  Those who compare F&F to IndyMac’s seizure are mistaken.

Solvency and the need for capital is another issue.  If one puts the guaranteed mortgages on the balance sheets of F&F, they will have absolute and certain capital inadequacy.  The estimates vary but seem to center at about $50 billion.  F&F face an impossible task if they have to raise that amount by conventional means in this market climate and with the intensely negative sentiment circulating about them.  Their capital is thin to start with although it is conforming in accordance with the rules of their federal regulator.  The now infamous accounting rule change would render them technically insolvent, as former St. Louis Fed President Bill Poole correctly contends.

In sum, we are not worried about a default in F&F debt.  We hold positions in mortgages guaranteed by F&F and some small positions in their debentures and notes.  The widening of credit spreads on all GSEs has made them attractive for certain portfolios.

Common shares of F&F are another matter.  We value them at near zero.  In the Bear Stearns event we saw affirmation that the federal government had no sympathy for equity investors even as it preserved the rights of debt holders and counterparties.  We believe the same is true for F&F.  The stock market thinks so, too.  That is why the equity value of F&F has been decimated.  We have avoided F&F shares and have been selective in the use of broad ETFs where they are part of a large assemblage of stocks

The preferred shares are a tougher issue for investors.  They are trading at about 70 cents on the dollar in a thin market.  We believe they are at risk if some restructuring of F&F is undertaken by the federal authorities.  The balance sheet construction and the concept of a preferred are clear, and investors should not be deluded into thinking otherwise. 

A restructuring of F&F could take many forms.  Some of the possibilities would eliminate the claim of to the preferred shareholder. Other forms of reorganization would preserve it.  This outcome is unpredictable. There is risk in this preferred security.

The Fed is not the likely operational vehicle for a restructuring of F&F.  The Fed’s task is to deal with liquidity, not solvency.  The Fed can reliquefy dysfunctional financial markets and is doing so.  It can use its balance sheet to achieve a clearing market in F&F debt if markets seize and cease to function.

F&F are not banks.  They do not experience “runs.”  They should not be compared to Countrywide or Indymac.  Their status of congressionally sponsored federal agencies places them in a unique position and parallel with all other federal agencies.  There is no history of the federal government reneging on its implied promise to pay the debt obligations of a federal agency.  Yesteryear’s S&L crisis and federal deposit insurance issues affirmed this federal obligatory concept. 

Readers may wish to note the list of US federal agencies and other organizations for which the Fed is the paying agent.  They are articulated in a Fed press release: “By law, Reserve Banks act as fiscal agents for these government-sponsored enterprises and international organizations: the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, entities of the Federal Home Loan Bank System, the Farm Credit System, the Federal Agricultural Mortgage Corporation, the Student Loan Marketing Association, the International Bank for Reconstruction and Development (World Bank), the Inter-American Development Bank, the Asian Development Bank, and the African Development Bank.” 

Readers may also note that, until July 2006, the Fed allowed these agencies to obtain daylight overdrafts without cost.  Since July 2006, the Fed has required these agencies to hold balances sufficient to cover those payments.  The Fed affirmed in that 2006 rule change that these agencies do NOT have regular access to the Discount Window.  The Fed operated by its own rulemaking ability and could reverse this decision at any time.

The Fed is not normally in the business of fixing insolvencies, especially those which are created by changes in accounting rules.  These are issues for F&F regulators and for the Congress. 

Readers, please note that I may end up being totally wrong in this statement.  The Fed is now engaged in the extraordinary Maiden Lane, LLC portfolio liquidation project which is the result of the Bear Stearns debacle.  In that case the Fed may (underline the word may) actually face loss of taxpayer funds when that portfolio issue is finally resolved.  Alternatively, the Fed could end up with a profit.  We have no way to know if Maiden Lane becomes the new model of Fed assisted financial engineering in cases like Bear Stearns and others.  We do know that applying that model to F&F would be a monstrous task and one that the Fed certainly would prefer to avoid.

Longtime readers know we have a dim view of Congress.  It is exacerbated by the scandalous and arrogant behavior of the present chairman of the Senate Banking Committee, Christopher Dodd, who still hasn’t admitted his personal failure in taking a VIP mortgage from Countrywide.  That said we believe Dodd and his House counterpart Barney Frank will support Congressional changes that add financial strength to the GSEs.  They are pro-GSE in their politics.

The US Treasury cannot do much other than jawbone regarding F&F.  It takes changes in law to expand the powers for a Treasury intervention.  There is a small credit line with the Treasury that has never been used by the GSEs.  We do not expect it to be used now.  It was originally legislated in order to insure liquidity.  The Fed can and will handle that part.  If a GSE were to draw on a Treasury line now, the action would create a panic far worse than we have seen this week.  Markets would infer that things are even worse than presently believed.  We do not expect F&F to borrow from Treasury.

Finally, the Congress could easily fix this mess and improve the state of housing finance.  The credit spreads between GSE debt and Treasury debt are wide because of the uncertainty.  The government backing of F&F is “implied” and not explicit.  A Congressional guarantee would change that.  Studies of the cost of this Congressional failure suggest that the annual cost of this uncertainty created by the Congress is in the multi-hundred billions.

Furthermore, the guarantee could be limited to existing debt and explicitly avoid guaranteeing any new debt if Congress wanted to phase out F&F as a federal agency.  That would create a two-tiered market; call it old F&F and new F&F.  Alternatively, Congress could extend the guarantee with limits and rules if it wanted to clarify and strengthen F&F.  Either way, Congress could remove the uncertainty premium and that would cause mortgage interest rates to fall and housing finance to become marginally more affordable.  Under these “permanent fix” scenarios, the shareholders of F&F cease to exist and the true federal agency status, without public stockholders, would be restored.  In our view that would be a best outcome for the country.  Federal agencies were not originally intended to enrich private investors and grant stock options to F&F management.  The GNMA program and the veteran’s post WW2 home mortgage lending operations seem to work well in the United States and without all the turmoil created by F&F. 

Detractors of these ideas have argued that the credit rating of the United States would fall below AAA if Congress were to extend this guarantee.  We disagree.  Nearly all of the $5 trillion in mortgages will pay.  And there is large recovery on those mortgages that don’t pay.  Remember, these are not subprime loans.  For the most part they are fully conforming and of fairly high quality. 

But this decisive solution requires political will and political leadership.  Sadly for the financial markets and the country, neither seems visible in July, 2008.

TAF, Fallacy of Composition, Report from Singapore

Our July 2 commentary about the Fed’s Term Auction Facility (TAF) and banks (see: ) triggered a banker’s response.  He argued that the 9-basis-point premium that banks paid in the latest TAF auction is justified because of the desire of each bank not to be known as one that borrows at the Discount Window.  The banker was confirming the “stigma” that the market attaches to the use of the Window.

Specifically, he wrote:

“Even a bank on the ropes steered clear of the Window.  The potential reputational cost of using the Discount Window far outweighs the financial savings.  Look at the example above.  9 basis points on $75 billion for 28 days is $630,000.  The most one bank can be is 10% of any TAF, so the cost savings of using the Discount Window over TAF for any one bank was a whopping $63,000 (before taxes).  I’ll pass.

“I don’t get the relationship between the current mess and Discount Window stigma.  The stigma has been there through good times and bad.  If banks collectively as a group decide to override the stigma and use the Discount Window, how does that imply we as a group are not wounded and therefore functional?”

The direct answer to the rhetorical question is “It doesn’t.”  Systemic dysfunction is operating in the US regardless of the use of the TAF or the stigmatized Discount Window.  In fact, the banker reinforces my point and leads the conversation to the Fed’s dilemma.

The Fed is trying to overcome what we call the “fallacy of composition.”  That is the term we use to describe a situation where each agent thinks he is acting in his own rational self interest while the collective actions are counterproductive.  A simple metaphor is a fire in a theater.  Each person wants to get out quickly.  If they collectively do so in an orderly way they can all exit safely.  But if they ignore the orderly process, they create a stampede and some of them get hurt.

The Discount Window was designed to be an orderly process where banks could borrow from the Fed when reserves were needed during dysfunctional times.  That characteristic created the stigma.  To try and remove this sign of failure, the Fed actually came out and stated there was no stigma.  Clearly no one believed it. 

The Fed then tried to demonstrate this with a request that certain banks use the Window to show there was no stigma.  Four large banks did use the Window for a short time.  They then withdrew.  So much for the Fed’s request!  That approach failed, too. 

During the recent financial turmoil the Fed has lowered the Discount Window borrowing rate by a greater amount than it lowered the Federal Funds Rate.  And the Fed has liberalized the collateral it will accept.

The collateral for the TAF is the same as that for the Discount Window.  Because of the Window’s stigma, banks still elect not to use it.  Instead they pay a higher rate at the very time the Fed is trying to lower rates in the whole system.

The banker who commented calculated what appears to be a very small cost attached to this fallacy of composition.  In doing so, he fails to see the whole systemic picture.  Interest rates are tiered.  When one key rate (Window) suffers from a “stigma” premium over the Window, the premium is applied as a widening of the tiers in a global system.  The cost of 9 basis points must be calculated on the entire $150 trillion in US dollar debt and derivatives that trade in our global system. This is a huge price ($135 billion annualized) to pay for a stigma that the Fed can easily remove.

The Fed can fix this problem by altering the form of the TAF.  It can lift the 10% restriction at each TAF auction.  And it can make the auction size unlimited.  Essentially the Fed can say that it will loan each member bank all a bank wishes to borrow as long as the bank posts acceptable collateral.  The key is that the Fed maintains the high-quality collateral requirement so that the Fed does not end up with “junk.”

The Fed wants the system to function with sufficient liquidity to clear markets.  And it wants to apply monetary policy, which it can only do when the system is functioning.  An unlimited TAF at the Discount Rate would mean the penalty for borrowing was still 25 basis points over the Federal Funds Rate.  Banks could use the FF market if they so chose.

This way the Fed would be able to better judge if the policy-setting Federal Funds target rate was consistent with the Fed’s outlook for inflation and growth.  The sooner the Fed overcomes the fallacy of composition, the faster it can get back into the business of formulating monetary policy.

At Cumberland we continue to view the financial markets as dysfunctional.  Credit spreads are wider than normal and that is creating both opportunity and risk.  Certain sectors like adjustable-rate preferreds are still nonfunctional.  Banks continue to be plagued with falling housing collateral values and rising delinquencies on home equity loans and other credits.  Commercial credit problems are intensifying.

For fixed income investors that means carefully understanding the structure of bonds and not taking credit quality for granted.  For stock portfolios (ETFs) some cash reserves are warranted, as there may be future buying opportunities available in these struggling markets.

And for the Fed, it means more and longer term application of the important new tools the Fed has deployed to restore liquidity and functionality to these very troubled markets.

A personal note: we write this from Singapore after a whirlwind series of meetings with bankers, foreign exchange traders, investors, money and wealth managers and institutional policy makers.  It is apparent to this writer that the view of the US from this regional financial center is highly skeptical.  The US dollar is not trusted and the US government’s policy apparatus is seen as damaged if not broken.  There is an underlying theme of conversation about diversification out of the dollar.  And there are many questions posed about the economic outlook in the US.  I will have more observations to share as time permits.  Readers may see some of the clips from our CNBC Squawk Box Asia guest hosting by searching under “Kotok” at  We are scheduled for another interview on Worldwide Exchange at 5:30 AM New York time on Wednesday morning, July 9.

TAF Results and Banks

If you look at the most recent reports of the Federal Reserve, you will see that loans and investments in the US banking system are contracting.  Northern Trust’s Paul Kasriel notes that this is the “sharpest 13-week contraction” in the history of this data series.  The Fed’s measure started in 1973.  Contracting credit is an indicator of the deleveraging of the US banking system.

Contracting credit is also a force for deflation, not inflation.  Money expands through the use of credit.  Monetary policy works because of this credit multiplier, which is why a rise in the price level (the true definition of inflation) is achieved through credit expansion.  The reverse is true when credit is contracting.

In the most recent Term Auction Facility (TAF) auction, the Federal Reserve rolled $75 billion in direct-reserve 28-day lending to US banks at an interest rate of 2.34%.  That rate is higher than the Discount Window borrowing rate by 9 basis points (bps).  It is also 33 bps higher than the expected Fed Funds rate over the same period (overnight indexed swap rate, OIX). 

Why did 77 American banks participate in an auction and pay 33 bps above the rate they could pay by borrowing from each other?  Or why did they pay 9 bps above the rate they would pay if they borrowed from the Discount Window (which uses the same collateral as the TAF)?  Answer: the “stigma” of borrowing is still infecting the banking system.

One must conclude that the US banking system is still wounded and the US credit markets are still dysfunctional. They may be less dysfunctional than in previous months when the bid-to-cover ratio of the TAF was higher but they are still not functioning rationally.  What about this relative measure of dysfunction over the last few weeks?  Here the news is not good.  In May there was a TAF auction below the Discount rate.    Now it is above the Discount rate. 

For us to conclude that the US banking system is really mending, we must see repeated auctions of the TAF below the Discount rate.   We are not yet there.

In Europe things appear to be worse when we examine the US dollar-denominated credit sector.   We conclude this by comparing the bidding for the TAF conducted through the European Central Bank (ECB).   Remember, this is a parallel process to our American TAF auctions.

In the US there were 77 banks bidding, submitting $91 billion in bids for $75 billion of available TAF funding.  In Europe the ECB country member banks collectively submitted bids for $85 billion even though that TAF-type facility had only $25 billion of available funding.  Remember that in Europe the banks post collateral with their local national banks.  That collateral is denominated in euros even though the money is actually loaned to them in dollars which are sourced in our Fed.

In other words the demand for TAF-type dollar liquidity in Europe (outside the US jurisdiction) was about the same as the demand inside the US.  We infer that the banking problems in Europe are worsening in terms of US dollar lending and investing.  The ECB bidding was a new record high.  This may also explain why the London Interbank Rate (LIBOR) has been stubbornly above the normal spreads that existed before the credit crisis of the last year commenced.

More support for these inferences is seen in the substantial deterioration in the market prices of banks stocks in the US and in Europe.  In the US we now see the collective market value of the banks in the bank stock index trading below the collective book value.  This is a rare occurrence and usually coincides with a very attractive entry point in the banking sector.  In the present case it seems that the market does not believe the book value and suspects that there are billions of additional losses to unfold in the banking sector.

At Cumberland, we believe that caution is warranted toward banks at this time.  We think this is true of the financial sector generally.  Our portfolios are now below market weight for this sector, even as the market weight is dramatically lower than when the credit crisis began.  We have avoided the capital market sector specialty ETFs and exited the insurance sector ETF.  We stopped scaling into the banking sector ETFs.  Our original start of scaling was too early.

We want to see the second-quarter reports of banks, and we want to see more information about the deterioration of the home equity lending balances on banks’ books before we resume positioning in this sector.  We also believe that the capital markets and brokerage firms face additional difficulties.  And we expect more revelations about liabilities of those firms involved with Auction Rate Securities (ARS) and other sectors of the financial markets which are nonfunctional.

We look for the Fed to extend the various special tools they have introduced as temporary measures before their September expiration.  The sooner the Fed announces that extension, the better the markets will be able to rely on the Fed, and that will serve to lessen an uncertainty risk premium that currently is priced into credit.  We also expect the Fed to move to liberalize the ownership rules for banks so that additional capital can be attracted into the system.

Not all banking in all places is impaired.  There are several regions and countries where the toxic poison paper is diminished.  Singapore is one of them.  The Singapore index ETF is about 50% financials.  The city state is a regional banking and financial center.  The currency is strong and corporate governance is seen to be of a high standard.  We are maintaining our over-weight position in Singapore in our international ETF portfolios.

We will celebrate the 4th of July on a plane to Singapore.  Three days of meetings next week include bankers and investors in Singapore.  This is my first visit; colleagues Bill Witherell and Bob Eisenbeis have been there several times.  For those with access, CNBC Squawk Box Asia has scheduled me to guest host from 7 to 9 A.M. Singapore time on Tuesday, July 8th.

Readers are wished a festive celebratory birthday of America.  

We close with a special thanks to Barclays Capital’s Julian Callow and Julia Coronado for the auction details on the ECB’s TAF-type liquidity facility auction.

Financial Turmoil moves G7 to Decisive Action

The Finance Ministers and Central Bank Governors of the Group of Seven industrialized countries met Friday, April 11, in Washington D.C. as is the established practice before the annual meetings of the IMF. Very often the public statements released at the conclusion of such G-7 meetings are highly predictable, containing support for established policies, papering over issues where positions are known to differ and rather little that is particularly newsworthy. Friday’s G-7 Statement was an exception. The reason was evident in their frank admission that “The turmoil in global financial markets remains challenging and more protracted than we had anticipated.”

Faced with this situation, the G-7 decided on a very ambitious action program, endorsing all the recommendations in a report the G-7 tasked the Financial Stability Forum to produce, identifying the underlying causes and weaknesses in the international financial system that contributed to the current financial problems. The Financial Stability Forum (FSF) was established in 1999 to “promote international financial stability” by bringing together on a regular basis senior representatives of national authorities responsible for financial stability in major international financial centers (e.g., the Treasury Department, the Federal Reserve and the SEC in the case of the US), international financial institutions, and international groupings of financial sector regulators and supervisors. The FSF Report recommends 65 actions in five areas:

  • · Strengthened prudential oversight capital, liquidity and risk management
  • · Enhancing transparency and valuation
  • · Changes in the role and uses of credit ratings
  • · Strengthening the authorities’ responsiveness to risks
  • · More robust arrangements for dealing with stress in the financial system

The G-7 Finance Ministers and Central Bank Governors not only were able to reach consensus on strongly endorsing the report and committing to implement its many recommendations. They uncharacteristically went further to set priorities and a very ambitious time-table, identifying some actions for implementation within the next 100 days and other for implementation by the end of the year. We will point out just several important examples here. [The full report of the Financial Stability Forum is not longer available at the original site.]

The G-7 called for financial institutions in their upcoming mid-year 2008 reporting to “fully and promptly disclose their risk exposures, write-downs and fair value estimates for complex and illiquid instruments…consistent with leading disclosure practices”. Also within the next 100 days, the International Accounting Standards Board and other standard setters are asked to “initiate urgent action to improve the accounting and disclosure standards for off-balance sheet entities and enhance its guidance on fair value accounting, particularly on valuing financial instruments in periods of stress.” Despite the validity of this request, rapid progress in this area will be very difficult to achieve.

An important and controversial call by the G-7 is the request that by end-2008 the Basel Committee (a grouping of Central Banks) should raise bank capital requirements for complex structured credit instruments and off-balance sheet vehicles. This would reduce the attractiveness to banks of these assets, which recent events have shown to be more risky than previously thought. Earlier in the week the Institute of International Finance, an organization of the world’s largest banks, warned that increasing regulatory capital requirements would add too much “conservatism” to banking practices and proposed instead a voluntary code. Evidently, the financial officials believe self-regulation would not be an adequate response.

Another noteworthy action is the call for the International Organization of Securities Commissions (IOSCO) to revise its Code of Conduct Fundamentals for Credit Rating Agencies and for these agencies to improve the quality of the rating process and manage conflicts of interest in rating structured products. The FSF Report concluded that poor credit assessments by credit rating agencies contributed both to the build-up and to the unfolding of recent events.” One specific recommendation is that ratings of structured risk products should be differentiated from traditional corporate bond ratings. There is also a call for investors to improve their due diligence in the use of ratings.

In addition to the action program for strengthening the global financial system, the G-7 set a new tone in its brief reference to exchange rates. They said “Since our last meeting, there have been at times sharp fluctuations in major currencies, and we are concerned about their possible implications for economic and financial stability.” This modest statement marks a first time in recent years that the G-7 has agreed to express such a concern, although some individual G-7 participants have made such statements, fear the effects of a possible further slide in the US dollar. The IMF’s sharply lower forecasts for the US economy likely have strengthened such fear. This expression of concern by the G-7 could possibly signal future policy changes to draw a line under the dollar, but none have been announced.

A resumption of growth in the US in the second half of this year would be the best counter to these concerns about a destabilizing further fall of the dollar. Unlike the IMF, we are projecting such a pick-up in economic activity (albeit a modest one) with the US leading the Euro-zone in this change in direction. For this reason, we believe the US dollar is probably at or close to a bottom with respect to the euro and a number of other currencies, the main exception being some of the Asian emerging market currencies, where strong economic growth is continuing and stronger currencies are being used to counter inflationary pressures. Cumberland’s US, International and Global equity ETF portfolios are fully invested.

Investing in Emerging Markets- Will the Boom Continue in 2008?

2007 was the fifth consecutive year that emerging market stocks registered a double–digit advance. They significantly outperformed US and other advanced markets. The broad MSCI (Morgan Stanley Capital International) Emerging Markets Index increased by 36.5%. This compares with an advance of 10.6% for the MSCI Europe Index and is almost 9 times the 4.1% advance in the MSCI US Index. (The MSCI Canada Index, however, was up by a strong 27.6% at year end).

Like last year, the same basic question applies, looking forward to 2008: “Will the boom continue?” Our response is conditionally “Yes”. The reason is that, as a group, emerging markets have become more mature. So far, they have demonstrated an impressive ability to weather the storms caused by the same credit crunch that adversely affected most advanced country’s markets in recent months. However, market volatility has increased, and country allocation within the emerging market universe is likely to be critical for portfolio performance.

The increased liquidity that major central banks are injecting into the global economy should help ensure that the current slowdown in the advanced economies is relatively short-lived. Cumberland does not believe it will deteriorate into a serious or global recession. Domestic liquidity conditions in most emerging market economies are healthy. Many emerging market countries are net creditors in the global markets. For them, domestic demand factors should underpin another year of solid economic growth.

While the large price advances in many of the major emerging markets in the first ten months of this year had reduced the relative attractiveness of their valuations, the market drawbacks in the last few months have tempered their overheated nature. China and Hong Kong are examples.

China and Hong Kong

The Chinese economy continued to grow at a very rapid pace in 2007, 11% according to some preliminary estimates. Domestic Chinese investors piled into the stocks of Chinese firms. Prices in the Shanghai and Shenzhen markets rose to speculative bubble levels by mid-year (Shanghai was up by 85%), followed by a retrenchment of almost 20% in the second half.

The domestic Mainland Chinese markets are largely closed to foreign investors. However, many of the major Chinese firms are listed on the Hong Kong market (via Chinese H shares) and/or the US market. These firms are required meet the higher reporting standards of these exchanges. There are several Exchange-Traded Funds trading in the US market that invest in these shares. The most popular of these, the iShares FTSE/Xinhua China Index Fund (ticker FXI), which tracks the corresponding index, advanced by 58.7% last year.

The pace of economic activity in China, while decelerating, is still likely to be again in excess of 10% in 2008. Domestic Chinese investors, with growing incomes, are still largely a captive audience. They will persist in flocking to China’s equity markets.

That said, Chinese equities may encounter some headwinds in 2008. A more rapid appreciation of the Chinese currency, the Yuan, perhaps as much as 10% over the year, is likely as the authorities seek to reduce inflationary pressures. This will hurt the earnings of Chinese exporters as well as the translation of equity returns into US dollars for US dollar-based investors. Another important risk facing Chinese exporters is the US Presidential elections and the effect that will have on US-China trade relations. Also the plans of Chinese companies to raise another $100 billion on domestic and international equity markets next year could weigh on those markets.

On the positive side of the ledger, the Chinese authorities will likely take further measured steps in the coming months to lower the present regulatory barriers preventing most domestic Chinese citizens from investing in the Hong Kong and US markets. The Hong-Kong and US-listed shares of Chinese companies are now priced at a discount of 60% or more relative to the prices of the shares of the same companies in the China Mainland markets. The expected process of arbitrage between the markets as the so-called “through train to Hong Kong” gets underway in earnest should give a significant boost to these shares over the course of the year.

Increasing the ability of Mainland Chinese investors to invest in the Hong Kong market should also attract substantial new funds into the securities of domestic Hong Kong companies. Anticipation of this development already added to the Hong Kong market’s performance in 2007. This factor and the close relationship between the Hong Kong and Chinese economies helped Hong Kong stocks, as measured by the MSCI Hong Kong Index, advance by 34% this past year. The leading domestic Hong Kong companies are in the real estate and financial sectors. Both of these sectors are helped by the prevailing low interest rates, an ample supply of liquidity, and strong fundamentals for the economy.


Korea has a new, more pro-business President, Lee Myung-bak., who ran on a pro-growth platform of cutting both taxes and regulations. However, there are a number of economic concerns that are affecting investor sentiment. Domestic demand growth in Korea looks likely to be weaker than in other emerging market economies. Korean banks have experienced serious funding problems and interest rates have risen sharply. These high rates will hurt the heavily indebted Korean households. This does not bode well for Korean equities in the coming months. Later in the year the fiscal stimulus and market-friendly reforms planned by the new government should be important positive factors for equities. The Korean stock market as measured by the MSCI Korea Index registered a strong increase of 30% in 2007 but has underperformed in recent months.


Outside of Asia, Brazil is the other major center of growth among the emerging markets. Indeed, in 2007 Brazil’s equity market registered the strongest performance among the major emerging markets. The MSCI Brazil Index rose by 75.4% last year. India came in second with a 71.2% increase. It is noteworthy that this outperformance by Brazil continued through the recent adjustment in global markets.

Brazil’s economic prospects continue to look benign, with growth in excess of 4% expected in 2008. While Brazil is affected by developments in the global economy, it is not as directly tied to the US economy as are other Latin American countries, for example, Mexico. This currently is a plus as the US economy passes through a slow growth period. Another significant plus is the growing importance of Brazil’s energy sector. Despite the fact that Brazilian equity valuations are no longer cheap, this market is expected to perform strongly again in 2008.


In contrast to Brazil, Mexico has limited ability to insulate itself from developments in the US. The housing slump and the credit crunch in the US have had a depressing effect on Mexican equities, which declined during the latter half of 2007. As a result, the MSCI Mexico Index advanced by only 9.3% in 2007, in sharp contrast to the Brazilian market. Mexico’s interest rates remain very high, and its equity valuations are not particularly attractive. This situation may turn around later in 2008 when monetary policy is expected to ease and it becomes evident that the US has avoided a serious recession


in recent days, there have been violent riots in Pakistan, following the tragic assassination of Benazir Bhutto. The global struggle against terrorism has become more difficult with this testing of Pakistan’s political stability. While there has been little effect on global equity markets or on spreads on Asian emerging market sovereign bonds, this event was a reminder to investors that we live in an uncertain world. Investing in emerging markets, despite the many advances that have been achieved, still involves a higher element of risk than is the case for the advanced market economies with their deeper, more liquid markets, stronger regulatory and legal systems, better corporate governance and more stable political structures.

Their generally higher risk does not mean that emerging market equities should be avoided. Rather, it underlines the importance of diversification of risks as an essential element of prudent portfolio management. A distinguishing feature of risk management at Cumberland Advisors is our exclusive use of Exchange Traded Funds in our managed equity portfolios. These securities, which are traded like single stocks, provide broadly diversified investments at relatively low cost in entire country markets, regions, sectors and/or investment styles. For example, the iShares Korean ETF (ticker EWY) holds the shares of some 100 Korean companies. One of our core ETF holdings, the broad BLDRS Emerging Markets 50 ADR Index Fund (ticker ADRE) invests in 50 companies in eleven major emerging markets. A high level of diversification can be achieved through building portfolios with such funds.

The index returns in this article are US dollar returns and therefore are heavily affected by the depreciation of this currency in 2007. For example, The Canadian dollar MSCI Canada Index return for 2007 was only 8.2%