Personal Savings Rate to Rise. Also, Ask Bob Parker

The current and projected massive annual federal deficits trigger questions.  A big one is: how will the US finance this onslaught of debt and also find the necessary savings to invest in the economy so that growth can resume?  

Don Rissmiller of Strategas argues that “Even if corporate profits rebound, it’s tough to see more than $400 billion in undistributed profits.”  He notes that a personal savings rate (PSR) of 6% (April was 5.7%) would add an additional $600 billion.  Don concludes that the US is still $800 billion short, and that sum will have to be funded by “foreign capital.” 

But what if the Personal Savings Rate (PSR) is higher?  That means the pressure to attract foreign capital flows is not as severe as markets currently assume.

Dean Maki of Barclays Capital compared the PSR estimate from the Flow of Funds (FOF) report with the computation of the PSR that Don is using.  Maki suggests that the PSR estimate will be revised by the Bureau of Economic Analysis (BEA) in July.  He expects it to go higher.  Maki’s work shows an extraordinary gap between FOF data and current savings rate estimates.  Assuming FOF data is a leading indicator of the forthcoming BEA revised estimate, we can look at four decades of history and surmise that the current PSR is much higher than the reported 5.7%.  Our best guess is that it is somewhere between 7% and 9%. 

If we are correct, that would explain why the US deficit is being financed without as much pressure on interest rates as many believe we should be seeing.  Each percentage point shift in the PSR amounts to about $100 billion in cash that is being transferred from spending streams by American consumers into savings vehicles of some type. 

To help us sort through this puzzle we asked a series of questions to Robert Parker.  Bob is a colleague in several organizations, including NBEIC* and NABE*, a trusted friend of many years, a good musician (although he is shy about it) and, more importantly for this commentary, Bob is an expert in federal statistics.  He is the former BEA Chief Statistician and Director of National Accounts.

Our Q & A with Bob Parker follows. 

DRK:  “Bob, what are these forthcoming revisions, so we may inform our readers?”

BP: “At the end of July, the Commerce Department’s Bureau of Economic Analysis will release its first (“advance”) estimate of second-quarter GDP. In addition to this first take at second-quarter economic activity, BEA also will release revised estimates of the complete set of GDP accounts — back to 1929 annually, 1947 quarterly, and 1959 monthly. It makes these massive revisions every five years or so in what it calls a ‘comprehensive revision.’ (Normally they would revise only the past three years.)  Such major revisions are critical to maintaining the reliability of the accounts, because they allow BEA to incorporate the results of the most recent quinquennial economic censuses – this time for 2002.”

DRK: “Are these usually administrative, or can they be substantive?”

BP:  “Such major revisions have occasionally rewritten economic history by showing that GDP fell earlier or later than previously estimated or that personal saving was stronger in the revised estimates. Consequently, most economists are wondering whether any such important revisions are likely this July.”

DRK: “Are there any methods that can estimate the size of the revisions in advance?”

BP:  “Speculating on such revisions is hard to do. On the one hand, BEA has provided lots of detailed information on its Web site ( on how the accounts will be changed, including a few new definitions, a new classification system for consumer spending, and the re-basing of the chained-dollar estimates from 2000 to 2005. In contrast, BEA has released only sketchy information on the size and direction of the revisions: that GDP for 2002 will be revised up $202 billion, or 1.9 percent, with about $150 billion of the revision to consumer spending. We also know from BEA’s published methodology that these revisions will be extrapolated back to 1998 (the last economic censuses were in 1997) and then extrapolated forward to 2005 using essentially the published estimates, and then to 2008 using the published estimates plus whatever new annual surveys have been published since July 2008.”

DRK: “Can you speculate on some changes that may be forthcoming?  We are certainly interested in the personal savings rate.”

BP: “So if we want to speculate about revisions to the personal savings rate – such revisions could give economists a different picture about the recent health of the consumer – we need to speculate about personal outlays and incomes. We can get a reasonably good take on outlays, most of which come from consumer spending, extrapolating the revised 2002 estimate by the currently published data. We extrapolate the revised 2002 estimate by the published consumer spending estimates for 2002-2008 and get an expected upward revision to 2008 consumer spending of some $200 billion. That amount is slightly above the currently published estimate of savings and so savings would be higher.”

DRK: “What about the income side?”

BP:  “Of course, this upward revision to outlays could be more than offset by an upward revision to incomes. As for data on the revisions to incomes, BEA will be using new data for 2007-08, except for wages and salaries, and the new method for handling disasters, like Hurricane Ike that hit in 2008. We also know that BEA will using a new source for estimating income misreported to the IRS, but I have no idea whether it will be more or less. The bottom line is that we know very little, although some followers of these revisions have observed that upward revisions to personal savings are common, so why not again.”

DRK: “Got any sense of the size of the number?”  

BP: “Although not out of the question, given the upward revision to spending, a lot more income would be needed first to offset the upward revision to consumer spending – about $200 billion for 2008 — and then to actually increase savings and the savings rate.”

We thank Bob Parker for his help. And we also thank Don Rissmiller and Dean Maki for their inputs. 

We think the Personal Savings Rate is going to be a surprise when released; Dean Maki has found a clue in the Flow of Funds reports.  Furthermore, a higher savings rate than currently estimated explains some of the other data we are seeing and also helps explain how the large Treasury auctions are able to be absorbed.  It looks like it is not just Chinese and other foreign buyers.  It also looks like the consumer retrenchment is deeper than markets suspect. We will know in a month. 

*NBEIC is the National Business Economics Issues Council; NABE is the National Association for Business Economics.

Florida, Florida, Florida & Clock Restaurant

Besides the oppressive heat and humidity, the most striking thing on my five-city, six-night Florida swing was the lack of traffic on the roads.  North-south interstates on both coasts (I-95 and I-75) flowed easily.  So did Alligator Alley when I drove across the state. 

Florida went into recession nearly a year before the national economy.  It fights the frontline economic battle in the correction of “overbuilding” commercial space and residential housing.  One doesn’t need data to see how Florida’s economics are suffering.  The vacant highway commercial buildings tell part of the story.  The empty condos and “for-sale signs that scream “short sale” tell the rest.

In a reversal of the boom times, rapidly falling house prices are now the Floridian’s widely accepted norm.  Pressured sellers realize that to move a property they must “leapfrog” the selling price downward in order to get “ahead” of the pack of sellers.  In some condo buildings the disparity of pricing can be as much as 40-50%.  That gap demonstrates the impact of short sales.  A “short sale” is when the seller’s listing price is below the face amount of the mortgage. 

Housing prices are normally sticky; they do not change easily.  After decades of a rising price trend, sellers have been reluctant to cut prices at the beginning of a downturn.  That was the case in Florida for 2006 and 2007.  Foreclosures and short sales are now forcing prices lower.  Psychology has changed.  In Florida, no one expects housing prices to rise for years.  At best, they hope for a leveling off. 

Florida’s employment statistics validate this continuing recession outlook.  The unemployment rate is likely to top 11%.  Wachovia economists Mark Vitner and Yasmine Kamaruddin note (June 11) that the rate would be higher “if not for the out-migration of prime working-age adults.”  We have received permission to share their excellent, in-depth report with readers.  You may find it on the Special Section of Cumberland’s website: this document is no longer available.  The report includes ten sections with local area specifics and may interest readers from Jacksonville to Ft. Lauderdale, Tampa to Naples, or Pensacola to Orlando.  Pour yourself a stiff drink and then spend a few minutes on the city of your choice.

Unemployment doesn’t tell the whole story in the Florida labor market.  In this state, as in others, there is a component of underemployment.  There are many folks who still hold jobs but their income is lower now.  They are struggling.  In 2008, personal income gains for the state were the smallest since 1946.  They came from transfer payments, not labor income.  The negative wealth effect in Florida last year was over $1 trillion.

Segue to an anecdote.

Clock Restaurant, 670 Tamiami Trail North (Highway 41), Naples, Florida is the only 24-hour eatery in town.  I had breakfast there at 5:15 AM.  Three policemen were standing outside when I pulled up.  These members of Naples’ finest were finishing a smoke and coffee and heading back to their patrol cars.  “Good morning” I greeted.  “How’s it going?”  It had been a “quiet night” they said.

Inside there were two night owls staring at mugs of coffee.  One sat at the counter; the other one was parked in a booth.  His profile was low and clearly the booth’s seat sagged in the middle from years of use.  I decided not to engage. 

But the waiter was talkative.  He soon would finish his night shift.  I surmised it had been boring.  He’d been at Clock for seven months and had worked as a waiter in Naples for “about” ten years.  He lost his previous job when the “Manatee mall” closed 16 of their 50 stores and their restaurant shut its doors.  I sat through a lecture about retail stores and how the company headquarters decides it is cheaper to close the store and just pay the rent than to keep it open.  This is “ordered” by the “big guys” in New York, he authoritatively opined. 

I sat there, unshaven, in my fishing shirt and pants, with coffee, two eggs over medium, and rye toast, lightly buttered by me from the small rectangular container whose damn aluminum cover I had to peel back with my stiff arthritic fingers at 5 in the morning.  Some day, I am going to meet the guy who invented that monster and tell him how I really feel.  The waiter talked.  I just listened.

His replacement came at quarter to six.  Thank and bless the deity!

She had been a waitress at Clock for 17 years.  This downturn is the “worst” she remembers.  Tips are down; business is down; the winter was slow; her hours have been cut.  “Even the Germans aren’t coming this year” she said.  Naples’ warmth and golf are a tourist attraction for Europeans.  “At least I still have my job,” she said.  “But I may have trouble with the mortgage payment.”  She concluded, “This is really tough. I haven’t ever seen it like this.” 

Later that morning the fishing guide pointed me at a snook that had disdain for the fly at the end of my line.  Even a spinning rod and live bait didn’t work.  I thought, when the recession hits the Florida fishing territory, things must really be bad.  The fishing guide’s business is off a little. “I’m still booked most days,” he said as we worked our way through the mangroves in the Everglades.  Not true for the storekeeper at the marina.  Those sales are “off noticeably.”

Anecdotes and broad statistics tell the same story about Florida.  This state’s recovery doesn’t start for another two or three years.  Details on housing, manufacturing, agriculture, wealth, and income are in the Wachovia report, so I won’t repeat them.  With my own eyes, I have seen them. 

We thank Mark and Yasmine of Wachovia for their excellent report and must also thank John Silvia, my regular fishing partner and W’s chief economist, for obtaining permission to share it with our readers.

Obama’s Financial Regulatory Restructuring is an ‘Industrial Policy’

President Obama’s plan to restructure regulation of America’s financial system has some desirable elements.  It also has great danger.

Eliminating certain banks that were exempted from supervision is appropriate.  So is the elimination of the Office of Thrift Supervision (OTS) one of the regulators of AIG.  Is there really a difference between a thrift charter and a commercial bank in the modern system?  The answer is no. 

The grave risk in the plan is that it politicizes the Federal Reserve and, in certain instances, gives the Treasury a veto over Fed activity.  This is particularly true for the implementing of the emergency powers that the Fed has used during the crisis.  The Fed will have to obtain the Treasury Secretary’s written permission before an emergency action occurs.  Do we really want to have an appointed cabinet officer in our government wield that power over our so-called independent central bank? 

Remember, it is the central bank that is charged with policy making to encourage low inflation and economic growth.  The more politics gets into central banking, the greater the inflation risk.  Politicians do not want to apply restraint.  They tend to discourage higher interest rates as a tool to fight inflation.  History is replete with examples of central bank policy failures while under political influence.

Power over the “review” of the Fed’s structure is also given to Treasury, even as the Fed is charged with drafting a report.  Many Fed watchers expect this to be the basis for an attack on the regional Fed bank system.  The suspected target is to shrink the number of regional banks and also reconstitute the structure of the Fed’s decision making. 

Right now the Federal Open Market Committee sets monetary policy.  It is composed of seven governors (when all seats are filled) and the presidents of the twelve regional Fed banks.  We expect the Congress to change that and, perhaps, reduce the number of regional banks to five.  The survivor banks may have changed roles and even house some of the supervisors under the Fed’s expanded role.  

Once this Obama proposal becomes an introduced, proposed law, the Federal Reserve Act will be reopened for amendment and anything can happen.  That is when the lid on Pandora’s Box will have been lifted.

In the House, the Obama administration has the certain votes to pass a comprehensive revised Federal Reserve Act.  Several key committees will be involved, with Barney Frank’s Financial Services in the forefront.  If the pattern of other legislation is followed, the Pelosi-led House will send the final law to its rules committee, which will vote out a limited-debate, no-amendments structure.  Republicans are emasculated in the House, so the most they can do is bluster for the TV cameras.  House passage is nearly a certainty.

In the Senate there is still room for material change to this proposal, and the debate there is destined to be fierce.  We expect that the Senate version will be markedly different from the House’s.  The rules will require that the differences be hashed out by a House-Senate conference committee.  Then that final proposed law will head back to the House and Senate for straight up or down votes, with no amendments permitted in either chamber.  It will pass.

This Obama proposal is on a fast track.  There will be public hearings, of course, but the decisions are being made in the smoke-filled rooms.  The lobbying is already intense.  We believe that the end result is coming and it is already known.  The United States is extending a social-democratic form of government to the bulk of the US economy.  We are applying an “industrial policy” to finance and banking, just as we are doing to health care and autos. 

We have already done this for years with the agriculture sector.  The result is that we pay farmers not to farm and we get ethanol policies that starve millions of people, and we promote protectionism in sectors like sugar.  That’s how industrial policies end up in social democracies.  We are going to get one in banking and lending and the monetary business.  The outlook is not sanguine.

We will have more to say about the concept of industrial policy as a form of economic policy.  For now we are going to get some rest, having read through this 89-page white paper twice.  Many of its highlights will be seen in newsprint and on TV and heard on radio.  We see no need to be redundant. 

As for the phrase “industrial policy,” we will leave readers to contemplate its meaning, because it will affect every one of us.  One of several definitions from a Google search of economic references is: “An industrial policy is a set of actions executed by interventionist or mixed-economy countries in order to affect the way in which factors of production are being distributed across national industries.  By this definition, it’s logical that industrial policies contain common elements with other types of interventionist practices, such as trade policy and fiscal policy.” 

Welcome to the new America.  Add up finance and banking, agriculture, autos, housing, and health care: you get nearly half the nation’s GDP under an industrial policy.  Larry Kudlow, take note: “free-market capitalism” is dead.

Interest Rates and the Policy Squeeze

As Treasury and mortgage rates have risen, the question arises whether the Federal Reserve will accelerate its purchases of government debt and mortgage-related securities to force interest rates down closer to the 4.5% target that had been announced for mortgage rates some while ago.  But the prospect of purchasing more Treasuries is now exposing significant tensions within the Federal Reserve, for several reasons. 

First, as the Fed’s balance sheet has expanded, the market and others have begun to worry and focus on the Fed’s exit strategy and how it will be executed.  Indeed, Chairman Bernanke has made repeated references to the fact that consideration is being given to various exit strategies, but to date few specifics have been forthcoming, aside from simply listing some of the options available to the Fed.  It is clear, however, that because of the lag effects of monetary policy, the Fed will have to change policy well in advance of clear evidence of actual inflation having taken hold if it is to be successful in containing inflation.  Furthermore, policy action will require a rapid and preemptive sale of assets to mop up the liquidity the Fed has injected into the system in the form of high-powered money.

A Fed policy reversal will have to take place in the presence of higher-than-desired unemployment, and probably a barely recovering housing market and only the glimmer of a resurgence of real economic growth.  Politically, changing policy in that environment will be a difficult sell to both the public and the Congress, and will have to be done well in advance of the actual policy move.  These two key constituents who have to be convinced of the merits of the policy change have demonstrated repeatedly their willingness to tolerate higher inflation in the short run, if it means more jobs.  Unfortunately, the lessons of the 1970s and 1980s are easily forgotten.

Second, as FOMC members talk about the recent rise in Treasury rates in speeches, they don’t point out that most, if not all, of the increase in nominal interest rates has been due to an increase in inflation expectations as inferred from TIPS, and not due to increases in real rates that might signal a recovery in growth prospects.1  This means that we may already be observing the beginnings of the unhinging of inflation expectations.  Therefore, the window for policy action may be closing quickly.

Third, as the Fed’s holdings of Treasuries increases as a proportion of the outstanding supply, some policy makers are concerned about causing volatility in rates and prices should the Fed have to engage in large sales.  This is what the System Open Market Desk seeks to avoid on a day-to-day basis.  In the past the SOMA desk has attempted to spread its holdings of Treasuries out across different issues so as to avoid dominating a large portion of any issue.  This will be more difficult if the Fed continues lengthening the maturities of its holdings, because issue size is smaller at the long end of the maturity spectrum.  Selling into thinner markets means the price effects and increases in interest rates are likely to be larger and the likelihood of capital losses to the Fed will increase.  At some point the perception of the impacts of the potential losses on the Fed’s reported capital structure will become an issue.  Keep in mind that the Fed is not marking its balance sheet to market.

Fourth, market size is a two-edged sword.  If confining Fed purchases to Treasuries is most desirable when the objective is to minimize price effects and volatility of Fed portfolio moves, then this also means that efforts to drive down long-term rates through additional purchases will require huge purchases of securities.  So far, purchases of Treasuries have not resulted in lower rates, and it may be likely that the volume of purchases to accomplish that aim would be sufficiently large that the Fed’s balance sheet might have to increase significantly.  Those securities would then have to be returned to the market at some time in the future.  The Fed’s security purchases will also generate even more high-powered money, further exacerbating both the inflation risks and the exit strategy problem. 

Finally, it is hard to believe that letting existing securities holdings simply run off, selling non-Treasury assets or paying interest on reserves are considered as serious or viable policy alternatives to preemptive sales of Treasuries.  Studies conducted back when the Fed was worried about the disappearance of Treasuries suggested that there were no alternative markets deep enough to substitute effectively for the Treasury market, as far as the Fed was concerned for day-to-day implementation of monetary policy, without its actions having strong effects on asset prices.  This problem has surely become more severe during the current financial crisis.  Hence, one can’t easily rely upon the sale of significant quantities of non-Treasury assets, as Chairman Bernanke has suggested, without seriously disrupting those markets.  As a result, exit strategies that attempt to rely upon either sales of Treasuries or simply passively waiting until the other assets mature will pose a serious threat to the Fed’s ability to pursue as aggressive or anticipatory an exit as it may desire. 

Similarly, the argument that the payment of interest on reserves can be used as an effective tool seems weak.  At present, the rate paid on reserves is ¼ percent on both required and excess reserves, while the Fed Funds Target rate is a range of between 0 and ¼ percent and the discount rate is ½ percent.  Conceptually, the rate paid on reserves should set a floor on the effective Fed Funds rate, since any institution could borrow in the Fed Funds market at between 0 and ¼ percent and set up a riskless arbitrage by keeping those funds at the Fed earning ¼ percent.  However, as the Fed begins to move its funds rate target up to cut off the threat of inflation, it will also have to move both the discount rate and the rate it pays on reserves up in parallel.  But this doesn’t sterilize reserves.  The only way to do that would be to keep pushing up the rate paid on reserves until it met or even exceeded the discount rate, but this would then create an arbitrage incentive for institutions eligible to borrow at the discount window.  For a long time, the discount rate was set above the funds rate target; and to prevent the obvious arbitrage, institutions were discouraged from using the discount window except in dire need, hence the stigma that has been long associated with discount window borrowing.  Pushing the rate paid on reserves above the discount rate would require abandoning the current discount window borrowing environment, which the Fed has been attempting to encourage as a buffer to deal with short-term liquidity needs. 

What does this mean from an investor perspective?  Put it all together and I think we are looking at the sudden realization that the reliance upon anchored inflation expectations is a weak and fleeting reed to rely upon.  Markets aren’t stupid, and attention has already turned to inflation risks and the market has begun to price those risks.  Add to this dilemma the prospects for the flood of Treasuries on the market that will be necessary to fund the huge federal deficits associated with implementation of the stimulus program, and the implications for interest rates seem obvious.  If the market front runs the potential supply of Treasuries, as is likely, then interest-rate increases will accelerate even without the Fed executing its exit strategy, making the withdrawal of liquidity it had injected even more problematic.  If the Fed monetizes the debt in an attempt to keep interest rates low, then they are bound to fail on two fronts – both inflation and interest rates will increase.  The increase in rates and flood of Treasuries will also crowd out private-sector debt.  All in all, it looks like we are in for a period of rising rates, inflation, and slower growth than would have been the case without the heroic rescue.  The only question is when it will start.

1 It is recognized that TIPS are an imperfect indicator of inflation expectations, but the recent trend seems to be clear.

Notes from the Corporate Governance Front Lines

Last week the Millstein Center for Corporate Governance and Performance at the Yale School of Management held its annual Governance Forum, drawing to the Yale campus in New Haven over one hundred of the leading figures in the corporate governance field. My invite was due to my previous position as Director of the OECD team that developed the OECD Principles of Corporate Governance, which are recognized by the World Bank, the IMF, and the Financial Stability Board as the global standard in this field. The objectives of this year’s Forum were to explore what is required to restore trust in the financial system and what changes are needed going forward to avoid future crises. As has been underlined by the global financial crisis, trust is essential for the easy flow of capital.

A central issue relating to restoring trust in the market system is the marked increase in the role of government in the United States as lender to and shareholder in public corporations, together with its expected strengthened role as market regulator. Will investors be willing to invest in situations where government is a major shareholder of the firm or of competitors, where government is seen as forcing mergers not in the interest of shareholders, where government may cap profits, where government may alter the priority among creditors, etc.?  Participants appeared generally to accept the reasons why the government decided to take exceptional actions in confronting the crisis. Also, it is evident that the US Treasury really does want to get out of its ownership role as rapidly as possible, and the Fed and the economic advisors in the White House share this view.  However, the part of government that is a concern is on Capitol Hill, where there appears to be less interest in getting out soon. Legislators, rather, are concerned about their constituents and the effects on them due to such developments as the closing of plants or dealerships.

Many difficult questions are raised by the government becoming an engaged shareholder in a public company, particularly where it also has a strong regulatory role. Should government directors have special obligations or limitations? Can you sue the government for insider trading? The advice from the Forum is that the government should seek to put the best people it can on the boards and give them the objectives of looking after the interests of all shareholders and moving the firms forward rapidly to a situation in which the government can exit.

Turning to regulatory reform, the Millstein Center issued a June 11 press release containing a proposal entitled “Roadmap to Restoring Capital Market Integrity,” which was sent to President Obama and others in Washington. The proposal was featured in an editorial in the Saturday, June 13 edition of the New York Times.  Among the signatories were Roger Altman, James Wolfensohn, William Donaldson, Harvey Goldschmid, Arthur Levitt, and Ira Millstein. The proposal advocates a “phased roadmap to reform the capital markets,” moving first on “shovel-ready” improvements that can be implemented immediately (such as improved oversight of key derivative products and merging the Commodities Futures Trading Commission into the SEC) and then developing a “blueprint for built-to-last regulation reform.” One speaker referred to the approach as moving fast to plug visible holes in the dike but taking the time necessary to carefully study the dike before making major changes in its fundamental structure. The full text of the proposal can be found at

The “Roadmap” supports several long sought-after steps to strengthen the role of shareholders in the governance of firms, mandating that all public companies offer annual advisory shareholder votes on compensation policies (“say-on-pay”) and ensuring that SEC “access” rules are protected under federal law so that investors can more easily nominate candidates to boards. It appears increasingly likely that such changes will be forthcoming. Indeed, Treasury Secretary Geithner announced last week an administration that would require companies to give shareholders a nonbinding vote on pay, without setting limits. Directors who determine the pay and consultants that advise companies would have to be more independent from management. This increased focus on empowering shareholders rather than adding new rules that eventually would be gamed, should be welcomed.

There are limits, however, to this approach. After being in effect for six years, say-on-pay in the UK is experiencing problems of micromanagement.  Shareholder groups seeking a role in nominating directors will have to develop the means to identify qualified candidates. They risk being in the position of a dog chasing a car and finally catching it. What does he do with it?

And if engaged shareholders are to be expected to play an increased governance role in order to restore trust and avoid excessive regulation, institutional investors will be pressed to carry out their shareholder responsibilities.  While some large public-sector and trade-union pension funds and some hedge funds have been very active, most of the large mutual funds have remained on the sidelines, calculating that the costs of engagement exceed likely benefits. This is particularly clear for index funds that have no interest in the behavior of the management of the companies they own. There is also the problem of hedge funds that are short-term owners. Their interests can diverge sharply from those of the long-term investor.  It was noted that one form of institutional investor is now being looked upon much more favorably these days: the sovereign wealth funds.

The final session of the Forum looked at global trends in corporate governance. This will be subject of a separate Commentary. It is worth noting here that there is considerable evidence that corporate governance is improving in many markets. At Cumberland, the prevailing quality of governance is an important consideration in our international investment strategies.

The Fed Subpoena and BofA Testimony

Yesterday, the House Oversight and Government Reform Committee subpoenaed Federal Reserve internal documents, notes, and emails in advance of the testimony by Bank of America’s Ken Lewis on Thursday.  The hearing is on the alleged pressure applied by Secretary Paulson and Chairman Bernanke to go through with BofA’s acquisition of Merrill Lynch.  Accounts of this pressure first surfaced in a letter to Congress and testimony released by New York State attorney general Andrew Cuomo.  This subpoena may not seem like a big deal, especially since the Fed has indicated that it would supply the requested information, but it is for many reasons.  But first, what is at issue?

Briefly, we can glean much from Attorney General Cuomo’s letter to the Congress, the SEC, and Congressional Oversight Panel.  This much seems reasonably clear:

  1. A few days after the BofA shareholder vote on Dec. 5, 2008, approving the acquisition of Merrill Lynch, the latter’s projected losses for the 4th quarter jumped by $3 billion and ultimately proved to be $6 billion.
  2. The declining financial condition of Merrill was such that Mr. Lewis had essentially all but concluded that BofA should exercise what is called a “material adverse change” (MAC) clause in the merger agreement, allowing BofA to either abandon or possibly renegotiate the terms of the deal.
  3. Mr. Lewis informed Secretary Paulson of his concerns, and between Dec. 17 and Dec. 22 a series of discussions took place between Mr. Lewis, Mr. Paulson, Chairman Bernanke, and other regulators.  Policy makers made it clear that they were concerned about the systemic risk to the financial system and to BofA if the merger not go through, and apparently they strongly pressured Mr. Lewis not to invoke the MAC clause.
  4. On Dec. 21 Secretary Paulson reportedly threatened that if BofA abandon the merger then its management and board might or could be replaced.  According to the Cuomo letter, Mr. Paulson indicated that this communication was at the request of Chairman Bernanke.
  5. On Dec. 22, at the bank’s board meeting, the views of the regulators were presented concerning systemic risk, the existence of the threat, and the willingness of the government to provide financial assistance to ensure that the transaction was completed.  It was also indicated that the financial assistance could not be confirmed in writing.  Other testimony indicated that if the commitment was put in writing, then the Treasury would have to disclose it, which the regulators did not want.  In that meeting, the board also included a statement in its minutes that the existence of the threat did not influence its desire to proceed with the acquisition. (It is not unreasonable to think that this statement was a way for the board to provide itself some cover from liability).
  6. On Dec. 30, at another BofA board meeting, further discussions with regulators about the commitment of financial support were considered, and Mr. Lewis made clear his view that were it not for the systemic risk issues, the MAC clause should be invoked.  However, the commitment of government support to make BofA whole seemed, by inference from the board minutes, to be sufficient to put that problem aside.

This brief summary doesn’t do justice to the nature of the discussions already in the public domain among the regulators, the bank’s management, and its board.  But it does suggest several issues that should be explored in the hearings in the interest of transparency, since taxpayer money was being used to encourage a merger that management was otherwise reluctant to pursue.

First, it is clear that policy makers’ actions and concerns meant that they were functioning as a de facto systemic-risk regulator, even though there was no explicit authority to do so.  Second, in that capacity they knowingly committed taxpayer funds to make sure the merger went through, while not wishing to make that commitment known to either the general public or to BofA’s shareholders.  That is, as the de facto systemic-risk regulator they were exercising regulatory discretion to downgrade the interests of BofA’s shareholders in favor of what they perceived to be the undefined, but potentially negative, consequences of “systemic risk.”   In the process, the agency in charge of protecting shareholder interests – the SEC – was apparently not involved or informed in any way.  Third, while both Secretary Paulson and Chairman Bernanke have steadfastly asserted that they did not specifically advise Mr. Lewis on what his responsibilities were regarding disclosures to shareholders, this seems based on the available information to be a distinction without a difference.  It may be relevant from a legal perspective but not substantive as far as what was intended.  The testimony by Mr. Lewis suggests there was a threat, a commitment of funds to ensure that the transaction took place, an expression of concern about public disclosure, and the granting of regulatory forbearance, which together raise significant questions about intent. 

All of these issues will be explored tomorrow in greater depth, we hope.  More important, however, is the lessons that will be drawn by Congress at it considers regulatory and agency reform and what powers and authorities to grant to the responsible agencies in a financial crisis.  This case makes it clear that a crisis – and even non-crisis situation – can sometimes create conflicts among the interests of various affected parties or stakeholders, in this case the interests of the taxpayer, the financial system and real economy, and shareholders.  In a paper with a former colleague at the Atlanta Fed, Larry Wall, we pointed out that when a regulatory agency is charged with multiple regulatory goals (such as monetary policy, banking supervision, and consumer protection) any conflicts that arise will be resolved internally to the agency, with the most weight given to the objective which it deems most important.1  This means that agencies with overlapping regulatory responsibilities – as in the case of banking regulation and supervision – will oftentimes resolve those goal conflicts differently.  Hence, careful consideration should be given to deciding when the public interest is best served by having those conflicts externalized and when they can be resolved internally. 

That is what is at root in the current discussion about the Merrill Lynch acquisition.  Mr. Lewis and the BofA board were caught in the middle of a problem for which they potentially faced legal liabilities to shareholders for their actions and at the same time they must deal with the Fed and Treasury, who had other concerns.

Now, about the subpoena and the issues it raises.  First, it says something about both the continuing Congressional complaints of lack of transparency on the part of the Fed when it comes to the recent responses it has taken to the financial crisis, and the erosion of the Fed’s reputation and credibility with Congress.  That it should be forced, rather than acting voluntarily, to release information requested by Congress when there are less than compelling reasons for not releasing that information, sure looks like a power play between the Fed and Congress. 

Second, such subpoenas are extremely rare, indeed.  The last Congressional subpoena of the Fed was in 1990 when Congress subpoenaed the Fed to release examination reports on a foreign bank operating in the US, accused of channeling funds to Saddam Hussein.  In that case, the documents in question were actually the property of several state bank regulators and not the Federal Reserve.  The Fed was willing to release the documents, but state authorities used the courts to fight Congress’ right to obtain the documents from a secondary source.  The subpoena did not involve a substantive issue concerning the Fed itself.

Third, in this case, most of the documents requested relate to communications between the Fed, Mr. Lewis, and the Treasury, pertaining to the Merrill acquisition and not examination reports.  The Fed initially let the committee staff review the requested information on the Fed’s premises for several days.  The reason for this restriction on distribution of the documents was that the documents supposedly included information that had been collected under conditions of confidentiality.  Now, the committee has determined that it wants its members to have access to the documents.  What substance is in those documents that require direct inspection by each Congressman and that could not be conveyed by their staff remains a mystery.  It will hopefully be revealed tomorrow.  Also unclear at this time is whether the treatment of such documents would or would not be subject to the same confidentiality agreements negotiated between Chairman Greenspan and Congressman Gonzalez in 1991, pursuant to its request of the Saddam Hussein financial records.  Again, this looks like a power play between the Congress and the Fed rather than a substantive issue concerning regulatory reform, as discussed earlier.  As such it is simply another indication of the willingness of Congress to press the Federal Reserve on its independence – issues that arise because of the Fed’s multiple regulatory roles.


PAYGO, Deficits and the Fed

Markets are starting to worry about the large and continuing issuance of federal debt.  President Obama’s PAYGO proposal notwithstanding they have good reason to be concerned. 

Fed Chairman Bernanke has picked up this baton.  In his recent House testimony he validated the Obama administration forecast that the ratio of US government debt to GDP will rise to about 70% by 2011.  After that the two major forecasts from the US government diverge. 

The Obama administration forecast is the rosier one.  It suggests that the debt-to-GDP ratio will start to decline in 2012.  Nothing new here.  History shows that nearly every administration, Republican or Democrat, had rosy forecasts in the “out years” that ranged beyond the expiration of their term of office. 

A more fearful forecast comes from the Congressional Budget Office (CBO).  They are charged with the task of forecasting from a more neutral political view.  According to CBO, the present trajectory leads only higher over the next ten years.  2019 is the limit of their outlook, since CBO is in the business of rolling, decade-long projections.

Worry about compounding deficits is not new in American history.  We have traveled this path numerous times.  The issue for the country is that the current huge Obama deficits have no size precedent since World War II.  And their trajectory seems likely to be revised higher. 

This US dollar-based Treasury debt explosion happens at the same time other governments of the world are on a similar track.  Within only a few years, BCA Research notes, the interest cost of financing the US federal debt is projected to rise to about 4% of GDP, if interest rates stay at present levels.  But if they rise, the cost of refinancing that debt will rise, and the annual interest bill will approach 5% of GDP.  Similar tracks are forecast for the UK and, to a lesser extent, the euro zone.  Japan is the fourth largest global debt issuer, and it is projected to have a slowly rising annual interest bill.

The fear in markets is real.  Annual interest on the federal budget must be paid before anything else.  Otherwise there is a default.  So the compounding effect of continuous and rising issuance of debt relative to the income of a country has a longer-term deleterious impact.  Using the CBO projections instead of the rosier Obama administration estimates, we see this problem exacerbating quickly. 

Markets see it too, which is why the interest rate on the benchmark 10-year US Treasury note has risen from its nearly 2% low to about 3.9% in only a few months.  Treasury bond investors are nervous. Remember, many of them are foreign governments who are parking their reserves in US dollars and with special US Treasury obligations.  As Treasury interest rates rise, they are watching the market value of their reserves decline.  China has become quite vocal on this issue, and Secretary Geithner’s recent assurances to a Chinese audience were greeted with laughter in Beijing. 

At Cumberland we exited our Treasury positions some months ago.  We have emphasized the deployment of bond monies into higher-grade, tax-free municipals and into certain corporate and taxable municipal bonds.  The new issuance of Build America taxable bonds has offered our clients opportunities and we have seized them.  This process is defined as the “spread side” of the bond market.  It offers the best value (higher yields), while the Treasuries side is overpriced (lower yields). 

While spreads are still attractive, the process is more than half over.  Narrowing spreads mean the tailwind for the bond buyer is dissipating.  Total-return bond management is more exacting now.  Markets are more volatile and new issuance is becoming more complex.  Meanwhile the capital market firms that facilitate this bond issuance are still dysfunctional as a result of the credit crisis. 

It is too soon to shorten duration and go to a full defensive posture.  Bonds in the spread sector are still cheap.  But the time for shortening duration is closer than it was a few months ago.  A lot now depends on the credibility of the US government. 

Sadly the outlook here is mixed at best.  Geithner has lost the respect of many in the global financial arena.  The Federal Reserve is moving to distance itself from the Treasury, because it was appearing to be too politically involved.  Both Bernanke and Kohn have mentioned the need for central bank independence.  In a rare occurrence, Fed Chairman Bernanke openly disagreed with the comment attributed to the German chancellor when she criticized central banks.  Vice Chairman Kohn used his Princeton speech to echo this posture. 

Sadly, this protestation in Fed Speak is also not fully believed by the markets.  Markets look at the Congress. And they see the politicians gearing up for an attack on the central bank and a possible reopening of the Federal Reserve Act after the mid-term congressional elections next year.  They see vacancies continuing on the Board of Governors and they speculate about political influences on the Fed.

For three years now and during this entire financial crisis, the Fed board has been forced to make emergency decisions (like Bear Stearns) that required five affirmative votes.  Since there were and still are two vacancies, the intended super-majority rule has been replaced with a unanimity rule. Thus, each Fed governor has a veto.  And the Fed operates with opacity in these decisions.  We only know about them when there are five affirmative votes and an emergency-action provision is invoked.  We never hear about any disagreement among the five governors.  We have no minutes or records to yield forensic evidence about decisions.  We the public and the markets operate in the dark when it comes to the most critical of the Fed’s decisions.

Markets worry about politics and the central bank.  They should.  Massive new federal borrowing of US dollars is originating in this environment of subtle threat to the independence of the central bank.  That is why US Treasury note and bond yields are higher and why their longer trend is up.

Two Pacific Rim Gems

As we anticipated, the Asian and Latin American markets have led the recovery in global equity markets thus far this year. The MSCI Asia Emerging Market Index is up 38.4% year-to-date (June 5), while the MSCI Latin American Emerging Market Index is up 47.8%. The large economies of China (up 36.2%) and India (up 66.5%) in the case of Asia, and Brazil (up 62.7%) in Latin America are the locomotives behind these advances. There are several smaller markets in these two regions that have also provided good opportunities to add value to portfolios. In this note we look at two of our favorites that offer sound prospects for both the near and longer term, Chile and Singapore.

The Chilean economy is poised for a period of outperformance, with high productivity growth due to strong investment, together with healthy growth in a relatively well-educated labor force. Unlike just about all other emerging markets, Chile has a deep and liquid domestic bond market that operates in a sound financial regulatory system. This has helped offset the negative effects of the global financial crisis that hit Chile’s banking system, in which foreign-controlled banks account for almost half of domestic credit.

We are particularly impressed with Chile’s record of sound financial and economic policies. After building up substantial savings in the prior period of surging copper prices (Chile is the world’s largest producer of copper), paying down its foreign debt and becoming a net creditor, Chile has been able to mount a stimulus package that is massive relative to the size of its economy.  Chile’s central bank, arguably the best in the region, has also moved aggressively, cutting interest rates from 8.25% to 1.25% over the last six months. These policy moves should help the Chilean economy recover more rapidly than others in the region.

A sharp recovery in the world market for copper is another positive factor for the Chilean economy. Since early March copper prices have risen some 46%, driven by the economic recovery and stock-building in China and an improving outlook for the global economy. In the iShares MSCI Chile Investible Market Index ETF, ECH, materials have a weight of 19.5%, second only to utilities (31.1%).  The MSCI Chile Index, tracked by ECH, is up by 47.1% year-to-date.

The small island state of Singapore, on the other side of the Pacific, is not a commodity exporter.  It does, however, share an important characteristic (other than small size) with Chile, that is, a solid record of sound economic and financial policies. This year Singapore’s policy makers are being put to the test, as its economy, heavily dependent on exports, has been one of the hardest hit by the credit crisis. It is experiencing its deepest recession since 1965. In the first quarter of this year, the economy shrank by 10.1% from a year ago, which was a little better than the 11.5% drop Singapore officials forecast in April.

Thanks to ample reserves, the government has been able to mount a substantial US$13.7 billion “resilience package” that includes measures to enhance business cash flow and further improve Singapore’s already high competitiveness.  The corporate tax rate has been reduced to 17% (from 18%), to take effect in the 2010 assessment year. The top personal tax rate is only 20%. The Monetary Authority of Singapore in April adjusted the trading band of the Singapore dollar to the prevailing nominal effective exchange rate, allowing for a weakening of that currency.

There are signs that the worst may be over for the Singapore economy. Industrial production fell only 0.5% in April following a 32.8% plunge in March. Singapore’s purchasing managers index (PMI) for May showed manufacturing increasing for the first time in eight months. The index has climbed steadily, from 47.1 in March to 49.2% in April and then to 51.2% in May. There was an expansion in May of overall new orders and of new export orders.

Singapore’s economy is set to benefit strongly from the economic recovery elsewhere in Asia. Its top three export markets are Malaysia, Hong Kong, and China, with the United States only in fourth place, accounting for 7% of Singapore’s exports in 2008. While the GDP growth figure for the year will likely show a decline of 4%, this masks an expected solid rebound in the second half. Growth in 2010 is projected at a healthy +4%.

The iShares MSCI Singapore Index ETF, EWS, is heavily weighted towards the financial sector (47.3%), with industrials in second place at 23.7%. The top four holdings are Singapore Telecommunications, DBS Group Holdings (originally the Development Bank of Singapore), United Overseas Bank LTD, and Overseas-Chinese Banking Corp.  The MSCI Singapore Index, which is tracked by EWS, is up 34.9% year-to-date., which is pretty impressive in view of the depth of the recession in the first quarter.

There are many factors that affect the relative performance of national equity markets, and they can change frequently.  The sustained sound, market-friendly economic and financial policies and regulations, together with political stability and good governance, that are found in both Chile and Singapore are considerations we weigh heavily in our investment strategies for our International, Emerging Market, and Global Multi-Asset Class Portfolios.

Canada: Looking North to Add Value

When considering investing in markets outside the US, individual investors often ignore neighboring Canada and look to more “foreign” markets in Europe, Asia, and Latin America. Institutional investors, on the other hand, have been increasing their investments in Canada. State Street Global Markets reported on May 25 that the latest 5-day cross-border equity flows to Canada were at the highest level since October 2004. These flows are reflected in the performance of the Canadian market. The MSCI Canadian equity market index is up 35.9% year-to-date (June 1), far stronger than the international benchmark index, MSCI EAFE, up 8.97%. This Commentary summarizes why we also are attracted to Canada at this time.

The Canadian economy, eleventh largest in the world, was, of course, struck by the global financial crisis and sharp slowdown in global demand. It is reported to have declined 5.4% in the first quarter, very close to the 5.7% drop in the US. However, there have been increasing signs that the Canadian economy is stabilizing: an April bounce in payrolls, a rebound in existing home sales, and a jump in the Ivey PMI (Purchasing Managers Index). A recovery of the Canadian economy in the second half of this year is looking increasingly likely.

The Canadian economy is highly integrated with the US economy, which accounts for some 78% of Canada’s goods exports and provides 52% of Canada’s imports. The Canadian equity market is strongly affected by developments in the US equity markets. Indeed, the one-year correlation between equity prices in the two markets is close to 1.0. However, short- and medium-term variations in the two markets can differ significantly. The 6-month correlation between the iShares Canadian market ETF, ewc, which tracks the above-mentioned MSCI Canadian market index, and the SPDR ETF that tracks the S&P 500, spy, is 0.74.

Along with differences in economic policies and other macro influences, there are important differences in the sector composition of the two economies. Energy and raw materials sectors together account for 50.8% of the sector weights of the MSCI index for Canada; financials account for 30.2%. In comparison, energy and raw materials account for just 16.3% of the S&P 500 and financials are only 10% (3/31/2009 weights).

The above differences help explain the outperformance of Canada thus far this year. The long-term global boom in commodity markets has returned, with the pickup of demand in China being a major factor. For example, the commodity ETF, dbc, which tracks the Deutsche Bank Liquid Commodity index, is up some 31.5% from its March 2 low. Similarly, energy markets are recovering from their steep fall. The Powershares Deutsche Bank Oil ETF, dbo, is up 57% from its mid-February low. With respect to the financial sector, Canadian banks are in better condition than their US counterparts, thanks to their more conservative approach to lending, particularly with respect to the housing sector.

The Canadian market ETF, ewc, that we use in our international accounts, has diversified holdings of the equities of 100 firms. The top ten firms are the Royal Bank of Canada, ENCANA, Barrick Gold, Toronto-Dominion Bank, Goldcorp, Potash Corp of Saskatchewan, Bank of Nova Soctia, Research in Motion, Canadian Natural Resources, and Suncor Energy. To focus in more on the energy sector in Canada we also use the Claymore/SWM Canadian Energy Income Index ETF, eny, which tracks the Sustainable Canadian Energy Income Index. Its main holdings are Toronto Stock Exchange-listed Canadian royalty trusts and oil sands resource producers.

Finally, we have recently added a long position in the Canadian dollar (the “loonie”) to our Global Multi-Asset Class Portfolios, using the Currencyshares Canadian dollar ETF, fxc. The currency markets have taken note of the emerging strength of the Canadian economy and equity market. In May the Canadian dollar registered the largest monthly advance since the Korean War (October 1950). The loonie’s 19% advance since its four-year low, reached on March 9, has added significantly to the returns received by US dollar-based investors in the Canadian market. The currency’s strengthening versus the US dollar accounted for almost half of the 35.9% year-to-date market gain cited in the first paragraph. The loonie’s advance appears still to have legs, but in view of the extent of the gains thus far, a pull-back later in the year is quite probable if the nascent recovery in the US economy gathers momentum


“Tiger fishing is best during a waxing gibbous moon,” said George Bell. We put the rods and water cooler in the boat and headed toward the middle of the river. The results of this fishing expedition may be accessed toward the end of this commentary.

The "deepest channel" of the Lower Zambezi River is the "official" border between Zambia and Zimbabwe (Zim).  George is originally from Zim and closely follows events there.  We talked as we motored downriver to one of his favorite places.  Zim was on the right (south), Zambia on the left (north).

The hippos and crocs were ubiquitous and ignored national boundaries. They could do so safely.  We chose not to cross the border.

Zimbabwe has withdrawn the latest round of its currency from circulation.  The largest denomination in use was the 100-trillion Zim-dollar bill.  Tourists can now buy them for a single US dollar at gift shops near Victoria Falls.  The Zim currency had become so hyperinflated that it reached full worthlessness.  In Zim today the US dollar, South African rand, and euro are in circulation.  The government pays its agents in US dollars that come in from foreign exchange transactions.  In Zim the maximum pay level is now 100 US dollars per month.  Note that in neighboring Zambia the minimum wage is about the equivalent of 100 US dollars.  That is an indication of how far these two economies have diverged.

At dinner we discussed how regimes alter policy and how Zim is the extreme example of a sequence that was summarized by LSU professor Joe Mason as political change leading to socialization and industrial policy followed by inflation, as the government dominates or controls the financial engine.  In Zim’s case, Joe noted that the politics were those of “a "ruthless dictatorship.”  The target of the industrial policy in Zim is agriculture, and property seizure, corrupted courts, and painfully inflicted police power have also been characteristics of this regime change.

That led us to a discussion of the present evolution underway in the United States.  We do see major political change in the massive repudiation of the Bush Administration and with the now overwhelming majority in the House and the Senate of a single party that also includes the president.  Add only one or two Democrat senators, and the US will be operating under a full one-party rule.

There is a trend toward growing socialization, which will accelerate when the proposed Obama tax structure becomes law.  By then, less than half the wage earners in America will be paying income taxes; hence, the funding of government will fall on the minority.

We already see an industrial policy in banking.  And we have one in housing finance now that most residential mortgage lending is done by government agencies. We are also evolving an industrial policy with autos.  We’ve had one in agriculture for years; federally subsidized ethanol policy was one of the worst results.

Will this lead to inflation?  Our central bank claims vigilance while expanding its balance sheet in ways without precedent.  Clearly markets see an inflation risk and are raising interest rates.  Foreigners worry about the US dollar and evidence their views in the foreign-exchange market.  The jury is still out on an eventual large inflation while the US economy remains in recession, but one must certainly admit that the inflation risk is high.  The political influence on the central bank by our Congress doesn’t lessen this longer-term inflation fear.

Dinner conversation ended with more questions than answers.  To sum it up: can the US borrow trillions, run expansive monetary policy, raise the amount of government control of private enterprise, and still keep its head above water?

Speaking of water, George successfully reached the place where tiger fish were supposed to be.  Off went the motor.  At first some casting was needed.  Trial and error with flies and lures ultimately led to success.  George’s choices brought about results, as readers can see at

We are leaving Kulefu tomorrow and will be back at our desk on Monday.  Kulefu is a word in the language of the Shona tribe that is indigenous to this region. It means “far away place.” It certainly is that, yet in this modern, wonderful world I can catch a tiger fish and email George’s digital photo for any interested reader to see.

Steve Liesman, you would like it here. The new Orvis Helios 8 wt. performed well.

So did George and the whole staff at Zambezi Kulefu Camp and at Puku Ridge. We hope to return soon. See