A Shift in Direction, or Blowing in the Wind?

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

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

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

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

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

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




Reflections on Mumbai and What It Might Mean

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

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

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

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

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

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

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

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

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

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

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




How big? How low? How now brown cow?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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




Transparency or Opacity?

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

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

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

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




T’is the Season for Giving While Saving?

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

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

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

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

What is the Charitable IRA Rollover?

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

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

What are the qualifications to use the Charitable IRA Rollover?

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

What will not qualify?

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

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

Who may benefit from this type of distribution?

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

Interesting Facts

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

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

Enjoy the Season of Giving … while saving!




Questions for Geithner

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

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

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

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

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

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

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

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

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

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

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

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




G20 Summit Outcome Surpasses Expectations

Following a six hour summit meeting in Washington, DC, on Saturday (November 15th) the leaders of the major economies represented in the Group of 20 issued a lengthy Declaration. The results of this first in what promises to be a series of such gatherings were as successful as one could have reasonably hoped from such a meeting at this time. The serious state of the global economy has concentrated minds and made possible a rare degree of international consensus on difficult issues.

While the level of detail in the Declaration may appear remarkable as a result of a single half day meeting of political leaders, one should recognize that there has been considerable preparation at the senior official level at recent meetings of the Financial Stability Forum, the IMF, and notably at the G-20 Meeting of Finance Ministers and Central Bank Governors in Sao-Paulo Brazil the previous week-end. The Communiqué from the Sao Paulo meeting includes much of what is now found in the Declaration. The ideas now have political endorsement at the highest level.  There are numerous commitments for action and some elements of a time-table, including steps to be taken by various parties at the national and international level by March 31st 2009 and the scheduling of the next G20 meeting at the summit level by April 30, 2009.

The economies represented by these leaders (19 individual countries: Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Turkey, the United Kingdom and the United States of America, and The European Union) account for more than 85% of the world’s GDP.  Therefore, the commitment in the Declaration of these governments to restore economic growth through “monetary policy support” and the use of fiscal measures “to stimulate domestic demand to rapid effect” should help restore investors confidence in the future course of the global economy. The commitment to help emerging and developing economies to gain access to needed finance through liquidity facilities and program support adds to this positive picture for the global economy going forward. A global recession can not be avoided – we are already in one. However the economic stimulus that has already been provided by the US government and the Federal Reserve and a number of other governments and central banks, together with the further stimulus moves indicated in this Declaration, should put an effective floor under the current slowdown and limit its duration.

Contrary to some earlier fears, the Declaration underlines a continued commitment to ensure that financial market reforms are in line with free market principles. The regulatory and supervisory reforms that the leaders endorsed are largely those in a Plan developed earlier this year by the Financial Stability Forum, which I summarized in my November 14 Commentary “Reforming the Global Financial System”.  These reforms seek to strike a balance between national sovereignty considerations (for example, governments do not wish to create international regulatory authorities) and the now globalised nature of the financial system and financial institutions and the need to close regulatory loop-holes and gaps in supervision. The reforms also seek to catch up with the complex nature of many financial operations and instruments, achieve much needed increased transparency, improve the identification and management of risks and align incentives to avoid excessive risk-taking and leverage.

The Declaration’s statements on Trade are stronger than many, including this writer, expected.  There is a firm rejection of protectionism that is reinforced by a commitment during the next 12 months to “… refrain from raising new barriers to investment or to trade in goods and services, imposing new export restrictions, or implementing World Trade Organization (WTO) inconsistent measures to stimulate exports.”   There is also a commitment to “strive to reach agreement this year on modalities that leads to the successful conclusion to the WTO’s Doha Development Agenda with an ambitious and balanced outcome.”  Implementing this commitment to move forward the stalled trade negotiations will be one of the most difficult tasks the leaders have taken on in this Declaration. The course President-elect Obama takes in this area will be critical.

As usual, the devil will be in the details and in the follow-up to the many actions endorsed by the leaders at this summit. Some of the reforms will require great effort and an extended period of time to achieve.  Nevertheless, the results of this summit meeting constitute a commendable first step that should be warmly welcomed by the markets.  This outcome reinforces the view underlying our current investment strategies at Cumberland that the recovery in global equity markets may come sooner and be more pronounced than many are predicting. We have been moving our equity ETF portfolios, both domestic U.S. and international, to fully invested positions, taking advantage of what appears to us to be very attractive valuations.




See The USA In Your Chevrolet

The Dinah Shore Chevy Show (1956-1963) promoted the most popular car in America.  I remember my first Chevy (a used 1951) and my hottest, a 1957 “nosed and decked” all-black street monster with a soft growling sound emitted through dual exhausts.  The sound to a seasoned ear said a beastly 283 with a big 4 barrel carburetor was lurking under the hood.  I used the street Chevy to tow the 1938 Chevy coupe with a 1956 Chevy engine and three carburetors to the drag strip and win trophies in the “E” gas class. 

In those days America was Chevy country, with Ford aficionados ankle biting for recognition.  Not any more.  America’s automobile industry seems to be mortally wounded.  In 2008 that means corporate begging is at hand.  Like it or not, we are about to witness the automobile industry’s version of the federal bailout directed so far for housing, banks and insurance companies.

New York University’s David Yermack used the Wall St. Journal to argue eloquently against federal money.  For a must-read column see WSJ Weekend edition, page W1, November 15. Yermack reminds us how GM and F squandered $110 billion in the decade of the 1980s.  He notes that “given the abysmal performance by Detroit’s Big Three, it would be better to send each employee a check than to waste it on a bailout.”  Other companies will substitute the jobs and the production facilities, according to Professor Yermack.

Annual replacement of our country’s auto stock alone, with no growth in total auto stock, is 14.7 million cars (David Hale).  That means a big pent-up demand is forming since current sales rates are far below replacement demand.  Hale notes that it will take a thawing of the credit crunch to get the auto business moving.  We agree.  In 2007, 12% of auto purchases were financed with home equity loans.  Tighter credit tests and higher FICO score thresholds are excluding as many as half of the usual car buyers.  The Fed is busily applying monetary policy to break that credit freeze loose.

We believe that the Fed will succeed in time; they have the tools to do so.  The question is what company will assemble and sell the cars when financing returns to broader availability.  Will they be the “not so big three” with their embedded legacy costs and UAW labor union domination?  Or will they be the foreign-owned US subsidiary competitors that build and sell cars in the US at lower cost and without the burden of the UAW legacy?

Economics will not decide this issue.  We now live in a political economy with an evolving US form of socialization and nationalization of business.  That Pandora’s Box is already open and propagating.  Autos are just the next chapter in a string of industries that will get federal money.  The auto bailout bill coming from Congress will run at least $25 billion and may grow much larger.  Remember, the TARP started as $700 billion and ended up at $850 billion.  And that took only a week and wasn’t in a lame duck session.  The lame duck $25 billion is only the down payment.

But can Detroit make it until President-elect Obama takes office?  GM has a cash burn rate so high that this question has become a legitimate one and not just rhetoric used to terrify Congress into voting for lousy legislation.  Congress proved they were capable of succumbing to fear with the TARP, when they authorized the Treasury Secretary a virtually unlimited power of finance.  Expect more of the same with the Senator Reid-House Speaker Pelosi effort that will be rolled out this week.  UAW and GM lobbyists know that this is the moment to strike a hot iron.  A lame duck session is their window. 

Investors have already paid the price of owning GM and F stock.  Not much left there.  Big auto fixed-income securities are already trading like a rejected form of junk.  Investors remember what happened with Fannie and Freddie preferred.  They are not about to risk getting burned again.  So there is a clear path for the federal government to take a very senior equity stake in GM and F while massively diluting the existing equity.

But investors who hold auto company bonds cannot breathe easy.  This time the form may change to some super-senior direct government lending.  Those loans may jump ahead of the existing debt holders if the contractual form can be found.  GM and F are not federal agencies like Fannie or Freddie or the Federal Home Loan Bank.  Anyone who bought auto company debt instruments did so without any implied federal guarantee.  This is not like a bank capital raising issuance.  And the holders of that auto debt have already taken the “hit” in a mark to market.

In sum, we would not be sanguine about GM or F debt. 

One final thought about this process of the socialization of American finance.  As the numbers get larger they permit even larger bailouts.  When the deficit was $100 billion, another $5 or $10 billion was a lot.  When the deficit is a trillion dollars, another $100 or $200 billion can easily be piled on by the politicians.  Be assured that more bailouts are coming; the deficit will grow beyond present estimates.  And any industry with political clout has become eligible for federal money.

Cumberland has not held GM or F debt for years.  We have avoided autos and the auto-related industry in our ETF accounts as much as possible.  Broad-based ETFs contain auto sector exposure and therefore some is in the portfolios.  We consider it to be at a minimum.

We expect the auto bailout to pass and we expect the fiscal policy of the United States to reach stimulus levels that have not been seen since World War II.  This is coupled with the most stimulative monetary policy seen since then, as the Federal Reserve expands its balance sheet threefold in a matter of weeks. 

For investors this stimulus combination is setting the stage for a substantial upward movement in financial asset pricing.  Stocks and bonds will eventually gap higher as the fiscal and monetary stimulus works its way into the system.  There will be a price to play in the future with the inflationary impact, but that is then and this is now.  For now, inflation is not an issue to worry about.




Reforming the Global Financial System

The Group of 20 (G20) summit meeting on the global financial crisis is being held this weekend in Washington, starting this evening (Nov. 14).  While some have called it a second Bretton Woods conference, aiming to reform the global financial system, the outcome is likely to be somewhat more modest yet nevertheless important for helping to chart the way towards needed reforms. Yesterday President Bush gave a speech strongly defending the free market system and supporting efforts to bring greater stability and transparency to the financial system, but warning against excessive regulation. US authorities clearly wish to push back against the expected moves by some European leaders for heavy-handed financial regulation.

Yesterday in the Financial Times, the chairman of the Financial Stability Forum (FSF), Mario Draghi, summarized the plan for making the global financial system more resilient that the FSF set out last April.[1]  The FSF brings together finance ministries, central banks, supervisors and regulators, the major international institutions, and standard-setting bodies. Draghi indicates that the guiding principles of the FSF plan are “to create a financial system that operates with less leverage, is immune to the misguided incentives that have been at the root of this crisis, has stronger oversight and is more transparent so that risk can be better identified and managed.”  The specifics of the plan go into regulatory and supervisory issues in greater depth than leaders at a summit are likely to discuss, but it is to be hoped that this summit’s broad conclusions will be consistent with this well-developed road map.

The FSF plan includes the following needed steps:

  1. Prudential oversight on bank capital and liquidity needs to be strengthened and loopholes should be closed.
  2. Transparency and valuation standards and practices need to be enhanced, in particular standards for bank risk management and valuation guidance for illiquid markets and for complex products.
  3. Credit-rating agencies should be subject to strong requirements on how they manage conflicts of interest and should differentiate information on structured products. Also in the credit area, the already well-advanced moves to establish central counterparty clearing in the credit default swaps market will meet an important need.
  4. A difficult issue is how to dampen the forces inherent in the financial system that amplify cyclical booms and busts. The task is to make sure that regulations (such as those relating to capital adequacy and accounting standards) do not reinforce the inevitable cyclical tendencies.
  5. Ensure that all financial activities that pose material risks are subject to adequate transparency standards and safeguards.

Aside from financial system reform, the G20 Summit will address a number of other important issues, including the future role and resourcing of the IMF, the need for increased fiscal stimulus to the global economy “where appropriate,” a commitment to avoid beggar thy neighbor policies, and reaffirmation of the commitment to trade liberalization.  The outcomes in these areas are likely to be rather generally worded and be coupled with a commitment to holding further G20 summits to carry on the deliberations. In sum, we expect this meeting to have a welcome but moderate uplifting effect on global market sentiment at a time when positive signals are very scarce.

[1] This plan and subsequent reports on its implementation can be found on the FSF web site; www.fsforum.org.




Was It or Wasn’t It?

It sure looked like a classic intraday reversal.  We were trading down over 300 Dow points.  We closed up over 550 Dow points.  The buying pressure was expanding right through the closing moments. 

In the intraday trading the stock market tested the October 10 lows.  The Standard & Poor’s 500 Index actually broke slightly below the 840 bottom set in early October.  The Dow Jones 30 stock average came very close to its October 10 low. 

This type of activity is typical of retesting during a bottoming process.  We expected it and were pleased to see the test was made successfully.  This activity supports the idea that the US stock market has an upward bias for the rest of this year.

At this time Cumberland’s stock accounts are fully invested.  We only use exchange-traded funds.  We are holding minimal cash reserves in our separately managed accounts and have fully committed monies allocated to stocks. 

In our bond accounts we have exited our US Treasury positions and purchased bonds in the corporate sector.  They are very cheap and offer equity-like returns. 

In the tax-free municipal bond arena the risk-adjusted returns available to a high-tax-bracket American investor are stellar in our view.  Today a high-grade New Jersey tax-free Muni was offered at a 6% yield for the longer-term maturity.  6% tax-free in New Jersey is equivalent to over 10% for a top-bracket NJ resident.  New Jersey’s top income tax rate is about 9%.  In many cases the extremely high taxes in New Jersey trigger Alternative Minimum Taxes (AMT) for the state’s residents.  This particular bond was exempt from AMT as well as regular tax.

Absurdities in the market are common and demonstrate how this market is in disarray and, hence, how one can be very opportunistic.  Altria (The old Phillip Morris) corporate bonds traded at about a 10% yield.  The Tobacco settlement tax-free bonds traded above a 9% yield.  Both are investment grade and both depend on cigarette sales for revenue.  One is a taxable item and the other tax-free; their credit is sourced in the same revenue; the market is ignoring the income tax code in setting their pricing.

The Federal Reserve and the US Treasury have engaged in a massive stimulus initiative.  It is designed to bring down interest rates and break loose the frozen credit markets. Treasury has added capital to the banking system and extended the federal guarantee to all sorts of items that were not previously contemplated.  The Fed has expanded its lending and nearly tripled the size of its balance sheet in a matter of weeks.  See www.cumber.com for a graphic depiction.  

The stimulus process was a response to fear that intensified after the failure of Lehman Brothers.  Investors sold for emotional reasons and have amassed huge amounts of uninvested cash.  Financial intermediaries ceased to function; the markets were frozen.

The rest of the world has joined the United States and other major mature economies in this massive program of expanding stimulus.  Global liquidity is being created at mammoth rates.  This happens as the rest of the world also suffers in the meltdown.  Fear is and was global.  Panic is and was global.  Liquidity creation is now global.  Fiscal expansionism is now global.

All this is bullish for financial assets.  Risk taking is now being rewarded and the amount of uninvested money sitting on the sidelines is without modern precedent.  That risk averse cash is earning next to nothing.

All this means the stock markets in the US and many places in the world can go surprisingly higher.  We expect that they will do so.  Remember that stock markets usually bottom when the economics look horrible and they certainly look ugly right now. That is why our accounts are now fully invested in both stocks and bonds.  Our model asset allocation is now 50% stocks, 50% bonds and zero cash.  Bonds offer very compelling returns which is why the stock side is lower than usual and the bond side is higher.