Cry for Argentina, Maybe for Mexico; Dry Eyes for Brazil and Chile

With the return of David Kotok from a week of matching his wits against the wily trout of Patagonia, it is a good time to look at how Argentina is handling the challenges of the global recession.  We will also discuss the three major Latin American economies in which we can invest using country-specific ETFs: Mexico, Brazil, and Chile. It will become clear that selectivity will be very important for investing in the Latin American region this year.


Riding on the global boom in commodities, Argentina experienced a strong economic rebound from the deep recession of 2001-02, with annual GDP growth averaging 8.8% in the 2003-07 period.  Since then, however, Argentina’s increasingly discretionary and interventionist growth-at-any-price policies, including ignoring the IMF, abandoning price stability objectives, breaking contracts with foreign investors, and shafting bondholders, are finally slowing the economy sharply. This comes at a time when the external environment has become decidedly negative, with export volumes tanking. The Kirchner government (Peronist Party) is rapidly declining in popularity. Rising tensions with farmers are threatening a repetition of the costly March 2008 farmers’ strike.

Investors’ confidence has deteriorated sharply. Credit default swaps soared to 4300 in early January and are now at 3120. That means one must pay $3,120,000 per year to protect $10 million of Argentine debt against default.  Investors have not forgotten that in 2001 Argentina was responsible for the largest sovereign debt default in history.  The government’s nationalization of pension funds in November, a transparent grab of assets to fill a growing gap in debt-service finance in 2009, dealt a serious blow to business confidence and eliminated a significant portion of the domestic capital market. 

Argentina’s equity market is moribund except for the Buenos Aires-listed Brazilian company Petrobras and the Luxembourg firm Tenaris.  The situation can be summed up by last week’s action by MSCI Barra, which is downgrading the Argentine market to “frontier-market” status from “emerging-market” status in its indexes.  Others sharing that status are Sri Lanka, Lebanon, and Kazakhstan. This is a sorry situation for a country, blessed with ample natural resources, that once had one of the strongest economies in the world. The blame rests solely on the shoulders of those who have been guiding economic policy.


The very close interrelationship with the US economy, which in boom times is a great benefit to the Mexican economy, is bringing the latter sharply to a halt.  Merchandise exports (non-oil) to the US (24% of GDP) have been hit particularly hard. The negative effects on government finances of the global downturn in the oil market have been offset significantly for 2009 by a successful hedging program. The full brunt of lower oil prices will hit in 2010.  Remittance flows from the US are contracting. 

Economic policy responses have been behind the curve and too timid. In particular, monetary policy has not eased sufficiently to keep credit flowing.  The banking system is largely foreign-owned, and US and Spanish parent banks, under great pressure in their home markets, have significantly reduced their lending while increasing credit costs.

Along with these substantial economic headwinds, Mexico is experiencing a sharp increase in violence on three fronts: between the authorities and the drug cartels, among the drug cartels, and between the general public and a wide range of criminal elements. Increasingly, this violence involves the use of military weapons.  Mexico has become a dangerous place for businesses to operate. Heightened security risks together with a likely increase in social tensions due to economic problems will weigh heavily on investor and consumer attitudes.


As signaled by recent credit default swap trends, investors have a more favorable view of Brazil than they do of Mexico.  Nevertheless, Brazil’s growth has also collapsed, hit by the global confidence crisis and the plunge in Brazil’s global markets, particularly China. In December Brazil’s industrial production was down 14.5% year-over-year, the worst decline ever recorded. In part, this appears to reflect a sharp inventory correction.  While the slowdown no doubt will continue in the first half of 2009, there are reasons to expect that a recovery will become evident by the summer.

First, the Brazilian economy is not suffering from a crisis in the housing sector, nor is the Brazilian consumer overextended.  Second, the government has moved rapidly to adopt important policy stimulus measures. The central bank, drawing upon the country’s ample foreign reserves, stepped in to provide funds to companies with important foreign liabilities.  It has also encouraged large banks to buy the loan portfolios of relatively weak smaller banks. Third, Brazil’s economy is becoming increasingly linked to China and the rest of Asia, while links to the US economy are weakening. The relatively positive outlook for the Chinese economy and non-Japan Asia is bullish for the Brazilian economy and for its equity market.


Economic and central bank policies in Chile have for a long time stood head and shoulders above those of other Latin American countries, and the Chilean economy and markets are now realizing the benefits.  Of course, Chile, a small open economy, has not been able to avoid the downdraft from the global recession and financial market problems. The price of its major export, copper, has plummeted. Economic growth for the year may be on the order of 2%, compared with 3.5% in 2008.

Nevertheless, relative to other countries in the region, Chile has outperformed. Indeed, its equity market has been one of the few bright spots in a global sea of red. Over the past three months the Chilean equity market increased by 10.7%. This compares with a 2.6% increase in the Brazilian market and declines of -19.8% in Mexico and -18% in Argentina, according to the MSCI indices for these countries.

Because of past rigorous fiscal policies (a cumulative fiscal surplus of 21.7% of GDP over the 2006-08 period), the government was in a good position last month to announce a $4 billion fiscal stimulus package. The proactive central bank followed up on February 12 with a swinging 250-basis-point reduction in the policy interest rate.  While this cut might have been expected to lead to a weakening of the currency, the Chilean peso strengthened by more than 2% after the announcement, a striking market endorsement of Chile’s economic fundamentals and policies.  Lower interest rates are likely to be more effective in Chile than elsewhere in the region.  Years of sound regulation have resulted in a capital market that is far deeper than those of Brazil and Mexico (measured by credit as a % of GDP).

Investment Implications

All Latin American economies have been hit by the global recession and will continue to be affected by swings in global risk aversion. However, the prospects for the national equity markets of the four countries under discussion differ markedly.  Only one of the four, Argentina, is suffering from the self-inflicted wounds of seriously unsound economic policies.  One other, Mexico, is confronting domestic security concerns on an unprecedented level as well as the (temporary) disadvantage of very close linkages to the declining US manufacturing sector.  The economies of the remaining two countries should outperform during the coming months and the eventual global recovery. At Cumberland, we have positioned our ETF portfolios accordingly, overweighting Chile and Brazil and significantly underweighting Mexico.


Housing Affordability Plan

The Obama Administration has announced its Homeowner Affordability and Stability Plan (HASP).  What problems are these efforts attempting to address?  And how significant are they likely to be in addressing the current problems in the housing market?

HASP is a very limited plan with a large price tag. It is directed primarily towards helping two groups of homeowners with conforming mortgages (meaning that the loans met Freddie and Fannie’s requirements in their terms and conditions and were eligible to be purchased by these two GSEs).  The first group consists of 4-5 million homeowners who are presently current on what had been conforming mortgages but who can’t refinance because the decline in house prices put their loans underwater.  The second group consists of about 6 million homeowners with conforming mortgages who are in imminent danger of going into default.  The plan would provide financial incentives for lenders to renegotiate loans not only on conforming loans but on other loans as well.  The government would also inject more capital into Freddie and Fannie and permit them to expand their holdings of mortgages in their own portfolios in an attempt to lower mortgage rates, and in a parallel effort the Federal Reserve would expand its purchase of mortgage-related assets.  Finally, the program proposes additional reforms to help families stay in homes that would otherwise be foreclosed upon by permitting judges to modify loan terms and conditions (so-called “cram-downs”).  All together, the plan has an estimated price tag of $275 billion.

What problems are these programs designed to solve?  The answer is that they are largely directed towards prospective problems and not the existing problems in the mortgage market.  For example, just because a loan is underwater doesn’t mean that mortgage payments can’t be made or that the loan can’t be refinanced.  At this time, helping that first group of homeowners seems like a second- or third-order problem. Likewise, while mortgage renegotiation may be beneficial to homeowners and to lenders to avoid the costs of foreclosure, this is a preventative step to keep the potential supply of foreclosed homes from growing.  Perhaps an analogy that could be used to characterize this effort is that it is like a group of emergency-room doctors, surrounded by sick and injured patients, focusing their efforts on administering flu shots to the healthy people in the room who were exposed to the flu.

During the 2000-2006 period there was a huge surge in overbuilding, which resulted in an excess supply of housing.  Prices began to decline in 2006, and then the lowest-quality loans namely, subprime loans with high leverage and poor payment prospects – triggered the financial crisis.  In particular, it was the nonconforming segments of the mortgage loan market, specifically subprime, Alt-A, and jumbo loans, in the most heavily overbuilt areas like Southern California, Arizona, Nevada, and South Florida where the big problems emerged.  Default rates on subprime loans were the first to take off and are now at 20%, as of the end of Q3 2008 (the latest available data).  Moreover, the performance in terms of delinquencies for loans originated in 2006 and 2007 is substantially worse than for similar loans made in earlier years – a reflection of the serial relaxation of lending standards during the period. As a proportion of the total mortgage loans outstanding, subprime loans amount to about $1 trillion or some 9% of the outstanding $11.1 trillion of mortgage loans.  In contrast, default rates on prime mortgages (which include so-called Alt-A loans) have nearly doubled, but remain at about 3%.

The first step in addressing a crisis should be triage with the most critical problems being tackled first.  These are the problems of excess supply of houses on the market; the decline in housing prices, especially in certain areas of the country like California and Florida; and the effects that already delinquent subprime and Alt-A and defaulted mortgages are having on both the housing market and financial institution balance sheets.  The supply of existing homes on the market has come down significantly but has a long way to go and, unfortunately, this will take some time to be resolved.  Taking the excess supply off the market will require growth in population and family formations and increases in the home ownership rate (but putting unqualified borrowers into loans they can’t afford isn’t a viable solution).  It will also require policy makers to hold their noses and address the problems the subprime market has caused, which may require bailing out some borrowers and lenders who abused the system. 

Increasing the supply of mortgages on the market and/or lowering mortgage rates even further will accelerate refinancing efforts, which is part of the Obama plan, and will induce existing homeowners to move, but will not reduce the oversupply of homes on the market.  Unfortunately, the current relief efforts are not directed primarily toward the key problems; and interestingly, they will have minimal effect on the housing situation in California or South Florida.  In the meantime, taxpayer dollars are being diverted from addressing existing problems in an attempt to prevent the development of new problems.  This is not triage.

The next chapter in Citigroup’s saga is unfolding as the Oscar winners are revealed

At a time when the price of an ounce of gold is about equal to the value of 500 shares of Citigroup, we are about to witness the next chapter in the evolution of the federal government’s role in shoring up the banking system. Under discussion now is the conversion of the preferred stock owned by the government into common equity. We expect this process to continue, and end with the federal government owning large shareholding positions in numerous banks.

Will this be voluntary, as the recently disclosed talks with Citigroup and various government regulators make it appear to be? Or will this become a mandated method of adding to the assistance to banks by forcing banks to accept these terms? Is this a dimension of Geithner’s stress test? It is too soon to tell.

The first round of Treasury Secretary Geithner’s new bank salvage plan was met with disdain by the markets. Geithner created more uncertainty because his plan lacked details. Others piled on with references to nationalization of banks by former Fed Chairman Alan Greenspan and by Banking Committee Chairman, Senator Christopher Dodd.

The insiders in the Obama Administration have avoided the “nationalization” word. They must. If anyone holding a position within the administration mentions this possibility, the markets will immediately respond with intense volatility. President Obama, Secretary Geithner, and adviser Summers know that this time they must be clear and specific.

This leads us to believe that the story circulating about Citigroup is a way for the idea of nationalization to get vetted. Once markets realize that conversion means that the preferred shares become tangible common equity, the debt markets will see this as a positive force and may narrow credit spreads. Equity market prices in the shares of the banks that are the subject of these stories (like Citigroup) will not like it, because of the possible dilution of the existing shares. But overall reaction in stock markets may be better than most expect.

The reason is, simply, that markets have been on edge due to uncertainty. Clarity in the plan and action which is measurable will calm markets. With clarity, agents in markets will be able to make their own estimates of value. Right now they have great difficulty doing so. And they feel the rules are constantly changing, so they wait.

Like it or not, the nationalization of our banks and financial system is already at hand. It is here in substance due to the massive use of federal guarantees. It is the form which has not yet clearly been resolved. That will soon change.

My colleague Bob Eisenbeis has used a metaphor from medicine to describe the process to date. Treasury Secretaries and others are like doctors in the emergency room. The patient was having a heart attack and they were busy giving him a flu shot. That too is about to change. Surgery is coming whether we like it or not.

We expect this move to common equity to come fast. With the price of a stock like Citi at $2 a share, the market is already valuing the expectation of large dilution. Two bucks represents a call option on the franchise. You get the rest of the bank for zero. Add the conversion of the preferred into common, and the franchise value gets stronger because the likelihood of survival improves.

One final note. All these new forms of federal bailouts of banks are a direct result of the failure of Lehman. Federal authorities watched the Lehman failure cause systemic risk to rise to unprecedented levels. They are terrified of another failure. They are doing everything possible to avoid it.

Whether this is the correct policy is certainly a fair subject for debate. But that is not the issue. In the US we now have this policy whether we like it or not. The idea now is to figure out how markets will react to these details and then take measured positions subject to each investor’s risk tolerance. In today’s markets that means very small increments, because risk tolerance has been worn thin.

Primary Dealers

The Federal Reserve is reportedly in negotiations to expand its shrunken list of Primary Dealers.  Who are these firms?  What do they do?  Why are they important?

Each day the Federal Reserve enters financial markets to adjust the amount of Federal Funds (deposit balances of banks with the Federal Reserve) outstanding to keep the rate on overnight Federal Funds close to the target rate set by the Federal Open Market Committee.  It does so by either buying or selling short-term US Treasury bills or by engaging in repurchase agreements or reverse repurchase agreements in which the Fed agrees to sell and then buy back, or buy and then sell back, Treasury securities to counterparties at a specified time in the future (eg. overnight, three days, twenty eight days, etc.). 

These transactions are conducted by the Open Market Desk, which executes transactions on behalf of the FOMC through the SOMA or System Open Market Account.  The Desk and SOMA are housed at the Federal Reserve Bank of New York, although technically they are not part of the bank.  In fact, two of the past three presidents of the NY Fed were managers of the Open Market Desk – Bill McDunough and Bill Dudley (though you don’t have to be named Bill to hold that position). 

Every business day morning, the Desk staff first prepares an estimate of the amount of reserves the banking system will need that day, in conjunction and in consultation with the Treasury and Federal Reserve Board staff in Washington, DC.  That proposed program is shared on a phone call at about 9:10 AM with the Board staff, the Desk staff, and one of the voting Federal Reserve Bank presidents on the FOMC.  A number of factors affect the size of the program for the day.  This includes (a) estimates of float for the day (checks and electronic payments in process of collection but not yet cleared through the system), (b) Treasury disbursements of funds for the day, (c) transfers out of Treasury Tax and Loan Accounts (which are accounts at commercial banks into which tax receipts are aggregated), (d) the need to replace maturing transactions from previous days, and (f) additions or reductions in the SOMA to accommodate increased demands for currency.  As it turns out, weather, especially in the winter, can cause significant unanticipated fluctuations in float, because planes carrying checks can be delayed.  Once the needs have been determined, the Desk sends out a notice to the Primary Dealers and calls for bids to participate in that day’s program.  This is where the so-called Primary Dealers come into the picture: they stand ready to buy or sell according to that day’s program.

The Primary Dealers are specially designated banks and investment banks who agree to submit bids and participate in the daily auctions that constitute the SOMA’s program.  These are supposed to be large, well-capitalized, sound institutions.  There are presently 16 such institutions, but that number has been much larger in the past.  Who are these firms?  The NY Fed provides the list, and it is attached at the end of this commentary.  Interestingly, over half are either foreign institutions or US-chartered subsidiaries or affiliates of foreign parents.  For example, Merrill-Lynch and Bear Stearns were Primary Dealers, as were Lehman Brothers and Countrywide, all of whom have disappeared.

Why would a firm want to become a Primary Dealer?  Treasury securities can be bought and sold and used as collateral for interbank borrowings and for investments by both foreign and US citizens and companies.  These securities trade at bid-ask spreads, and participants can engage in transactions with the Fed that are free of credit risk and make the bid-ask spread by redistributing securities and funds to other counterparties throughout the banking system.  Put simply, the Primary Dealers are directly involved on a day-to-day basis with the major determinant of interest rates in the Federal Funds market and therefore have inside knowledge of trade volumes, etc.  This access was especially important when the Fed didn’t publicly announce changes in monetary policy, and bid-ask spreads were wider.  It is likely becoming more important again today because of the widening bid-ask spreads, the increase in outstanding Treasury borrowings due to the stimulus programs, and the Fed engaging in quantitative easing, with the Federal Funds rate allowed to float between 0 and 25 basis points. 

Why only 16 firms?  First, the current system structure is really an anachronism.  It is rooted in the days before electronics, when bids were submitted on paper by runners and US government securities were all paper instruments that had to be shuffled between buyer and seller.  That meant that bidders had to be in close proximity to the NY Fed, and this implied that they had to be major banks or investment banks.  Keep in mind that in the early history of the NY money market, investment banks were major traders and distributors of US government obligations.  Now, of course, bids are submitted electronically.

The NY Fed is now seeking to expand the number of primary dealers, for two principal reasons.  The first is to make up for the shrinkage in the number of dealers, and the second is to increase liquidity in the market in anticipation of the flood of new Treasury obligations that will be coming onto the market.

Why so few?  Interestingly, the ECB uses a different system and deals with over 500 counterparties located throughout Europe.  It is possible that the strong linkage between the Primary Dealers and the Fed and the extreme financial difficulties that many of these key institutions experienced this past year and a half explain the special efforts made by both the Fed and Treasury to ensure the dealers’ continued existence, irrespective of the costs.

This is one area where the Fed should consider being more innovative. 

There is no reason, for example, that any healthy Federal Reserve member bank in the US shouldn’t be able to participate in the auctions if it chose to do so.  The bids are accepted electronically, and the securities are electronic book entries (not paper) and can be transferred daily over the Federal Reserve’s wire system.  There is no need for those institutions to deal though a Prime Dealer intermediary and pay the bid-ask spread.  Broadening the participation would likely make the market more liquid and deeper.  Increasing the number of counterparties would also lessen the Desk’s dependence upon the Primary Dealers, most of whom now aren’t the pillars of strength they once were.  Finally, it would diversify operational risk both in terms of numbers and geographically, by lessening the dependence on NY-based institutions; a risk that the 9/11 experience suggests is very real. 

Primary Dealers

BNP Paribas Securities Corp.

Banc of America Securities LLC

Barclays Capital Inc.

Cantor Fitzgerald & Co.

Citigroup Global Markets Inc.

Credit Suisse Securities (USA) LLC

Daiwa Securities America Inc.

Deutsche Bank Securities Inc.

Dresdner Kleinwort Securities LLC

Goldman, Sachs & Co.

Greenwich Capital Markets, Inc.

HSBC Securities (USA) Inc.

J. P. Morgan Securities Inc.

Mizuho Securities USA Inc.

Morgan Stanley & Co. Incorporated

UBS Securities LLC

The G7 and the Global Recession

The finance ministers and central bank governors of the G7 countries (Japan, Germany, Britain, France, Italy, Canada, and the US) met in Rome Saturday to discuss how best to tackle the global economic crisis, the worst that has been experienced in decades. This was the first G7 meeting for Tim Geithner since he became Treasury Secretary (he is well known to his counterparts from his previous positions). The carefully drafted and negotiated communiqués from such meetings are often full of platitudes and generalities.  Yet they do convey some useful indications of the views of the top financial policy officials of these important economies.  The full text of this Saturday’s G7 communiqué can be found at .

Clearly, financial officials were in a very somber mood at this meeting, terming the current situation as one of “severe global economic downturn and financial turmoil” with “extremely volatile financial markets.”  The downturn is projected to “persist through most of 2009.”  This evaluation reflects the latest economic data.

Preliminary data for 2008 Q4 GDP for the US on an annualized basis registered a 3.8% decline (this number is expected to be revised down to -4%). On the same basis, data for European Union countries indicate that the French economy declined by 4.8%, the Italian economy by 7.2%, and the German economy by 8.4%. (The German result dramatically refutes comments coming out of that country in the autumn that the recession was mainly a US problem.) The OECD’s Secretary-General Gurria announced that it is reducing its forecast for the eurozone economy for 2009 to “slightly below the IMF forecast of -2.0%.”  On the other side of the globe, data released today show that the Japanese economy dropped by a whopping 12.7% annualized rate in 2008 Q4, the worst drop since 1974.

Confronted with this grim actuality, finance ministers and central bank governors reaffirmed their “commitment to act together using the full range of policy tools to support growth and employment and strengthen the financial sector.” No new collective action initiatives are mentioned, however. General principles and objectives for individual actions by each country are given. Each country does have to design its policy response to fit the country’s situation.  For example, not all countries face a crisis in the residential housing market similar to that at the center of the US credit crunch. The fact that all G7 governments have finally come to recognize the urgent need for prompt and very substantial action is a positive development.  But it is prompt and effective action that counts here words come easily.

Geithner, in his prepared statement to the G7, praised the Obama administration’s massive American Recovery and Reinvestment Plan, passed by Congress “with unprecedented speed” last week, and also cited his forthcoming plan for financial market recovery and stability, a plan to address the housing crisis which will be unveiled “in the coming days,” and beginning steps for “comprehensive reform of our financial system and the international financial system.” His counterparts no doubt praised their own respective efforts and plans.

After the meeting European participants reportedly encouraged the US to proceed rapidly with implementation. This may reflect some frustration with the continued absence of specifics from the US Treasury on the financial-market plan. According to the Financial Times, Mario Draghi, governor of the Bank of Italy, said, “Of course, the United States is one of those furthest behind in adopting these plans.” Apparently there was considerable discussion at the meeting about how to identify and deal with losses and bad assets in the financial institutions. Geithner said after the meeting that all recognized the need for more capital in the G7 members’ financial systems and for temporary financing to help restart credit markets.

One very welcome and timely reaffirmation was the G7 pledge to avoid protectionism. “The G7 remains committed to avoiding protectionist measures, which would only exacerbate the downturn, to refrain from raising new barriers and to working towards an ambitious conclusion of the Doha round [of trade negotiations].” Geithner repeated after the meeting that “All countries need to sustain a commitment to open trade and investment policies which are essential to economic growth and prosperity.” Finance ministers clearly wished to attempt to draw a line in the sand against rising protectionist pressures in their countries, such as France’s car rescue package or the Buy America provisions in the stimulus package.

The G7’s statements on currency repeated warnings against “excess volatility and disorderly movements in exchange rates” but made no mention of the Japanese yen or British pound and, more generally, contained no hint of possible coordinated intervention. What was new here was a softened statement on China.  In contrast to Geithner’s earlier “faux pas” in written Congressional testimony, criticizing China for manipulating its currency, the G7 welcomed “China’s fiscal measures and continued commitment to move to a more flexible exchange rate.” Clearly the G7, including the US, are now giving priority to the important role they wish China to play in stabilizing the international financial system.

Finally, the G7 called for development of “an agreed set of common principles and standards on propriety, integrity and transparency of international economic and financial activity.”  On the face of it, this looks like a particularly ambitious undertaking, motivated, no doubt, by the recent evidence of serious shortcomings in these areas.  This initiative was based on a proposal by Italian Economy and Finance Minister Tremonti. He cited as the initial building blocks for the core principles the instruments developed by the OECD (incidentally by the OECD Directorate, which I headed from 1987-2005) and signed by all 30 OECD members and a number of non-member countries, covering corporate governance, bribery, responsible business conduct, money laundering, and taxes.

In sum, The G7 finance ministers and central bank governors appear to fully recognize the gravity of the current situation, and they have said the right things about the actions that need to be taken.  We must close, however, by repeating that the good words need to be matched by deeds, by prompt and effective action. On this, the jury is still out for the G7 governments and central banks. 


Washington Seems in Disarray and More on Intel and President Obama

(The following two commentaries were released in the morning on Feb. 13)

Washington seems in disarray

February 13, 2009 (8:50 am)

Imagine! There is a Congressman who actually wants to delay the vote on the stimulus bill so he can read it and make sure it says what he was told it says. Kudos for him. There is still hope for our country.

This 575 page piece of legislation is being rammed through Congress without any hearings, without any detailed examination, without any vetting. It is loaded with pieces of spending that are not going to trigger job creating activity for months or even years or maybe never. It is larger than all the money spent on the Iraq war. Its size rivals the Defense Department appropriations. It will be funded through federal borrowing. And there has not been any comprehensive vetting of the component parts.

Now we are continually told that there will be a “catastrophe” or a “disaster” if this 789 billion dollar package is not passed at once. Note that there is a continuing reference that ONLY government can fix the economic problems in the United States.

Not once did anyone mention that Cisco financed a 4 billion dollar bond issue without any TARP funds and without any government guarantees. Note that Intel announced an investment of billions into an entire new facility that will be located in the United States (Arizona) and will be privately funded. Intel didn’t need TARP funds. Intel didn’t need the stimulus package. Not one official in the Obama administration has even acknowledged the Intel commitment.

All we hear is that government can fix what will otherwise be a complete disaster. And all we hear is that banks are not lending and that there is no credit available.

Yesterday our chief monetary economist, Bob Eisenbeis, cited bank lending figures compiled by the federal authorities which show that bank lending is not at a dead stop. Sure credit is tightening. But creditworthy borrowers are getting loans. We see that among the clients in our firm.

In the United States our government is meeting behind closed doors and working up an $800 billion spending package and then giving the country no time to examine it. Even the Members of Congress who have to vote on it haven’t had time for their staffs to examine it. Campaigner Obama promised transparency. President Obama seems to have forgotten his message.

And for those of us in the business of managing the wealth of clients, we must deal with the conflict of emotions when we see the policy prescription in Washington on a collision course with the investment needs of our clients. Our job is to protect the wealth of our clients as best we can. Our job is to try to allocate among the component choices available to them. And our job is to tell our clients, their consultants and those readers who listen to us what we see and how it impacts them.

We see a Washington in disarray. We see repeated failure in assembling a cabinet. We see nominees having to withdraw their names because of their failure to comply with our tax laws. The first scofflaw was confirmed and he used up a lot of the new president’s political capital. The series that followed have had to withdraw.

Senator Gregg apparently withdrew when he realized that the Census Bureau was going to be moved from the Commerce Department to the White House. And he realized that this formerly neutral agency would be at risk of political influence. At least his withdrawal was not for failure to pay his taxes.

In Washington we see harsh and shrill rhetoric attempting to force immediate passage of legislation without vetting. And we see apologetic admission of “screwing up.” What we don’t see is a stimulus bill that will put people back to work promptly.

We do not believe the United States will fail immediately if something is not done at once. We think the 135 million Americans who still go to work every day and pay taxes and try to save and invest are the backbone of the country. And we think that government is NOT the only answer.

Today we fly to South America. In Argentina we will visit a country that squandered its great natural resources and ran up its debt and has defaulted several times. Argentina can claim the award for the largest US dollar denominated default in history. It, too, had a banking crisis. I remember visiting when “no al corralito” was chanted in the streets by citizens who could not get their money from the banks. We will also visit Chile, a country where dictatorship has been replaced with democracy and market based systems that seem to work. Chile is a success story. Argentina is an example of how populism and socialism destroyed what was once the fifth largest economy in the world.

This is our tenth trip to that region and to Patagonia. The people are friendly and welcoming. They do not trust their government. They have good reasons.

We will travel as best we can in South America. In these times we will carry a satellite phone when in remote areas where black berry has not penetrated. While away on our trip our Cumberland colleagues made up of tax paying employed private sector employees are available to serve our clients.

Our asset allocation remains unchanged. We are invested 50% in Stocks and 50% in bonds and zero in cash equivalents. Cash earning zero is a bad deal in our view. Our normal allocation is 70% stocks and 30% bonds. So we are under on the stock side and over on the bond side. In the bond accounts we are favoring tax-free municipal bonds and in the taxable accounts we favor higher grade taxable spread issues and we are avoiding treasury issues. In stock accounts we are using only exchange traded funds and we are broadly diversifying risk.

The enduring quality of these great United States is that our institutions survive our politicians and endure in spite of them. The real fabric in America is the willingness of its citizens to participate in the government. And it is in the ability of our society to voice criticism and to debate ideas without fear of retribution by the government. Those wonderful characteristics are still alive.

I would still rather be a citizen of our country than anywhere else. But I am very concerned about the start of the new Obama Administration. I supported him and I voted for him I want him to succeed. I repudiated what seemed to be a failed policy of the last few years; that was my personal choice. But I am now very insecure in the way the government is being run by the new folks. I find the thought of a Pelosi dominated policy repugnant. And it seems to me that the House of Representatives is now a one party system without any respect for the tradition of debate on the issues.

2009 is certainly an interesting year. Happy Valentine’s Day and Happy Presidents Day.

More on Intel and President Obama

February 13, 2009 (9:49 am)

We would like to add to the information sent out in this morning’s missive. We have learned that president Obama called the CEO of Intel after the announcement that Intel would make a multi billion dollar investment in the United States. We are told that Obama praised the company’s decision. This is a positive sign from the Obama Administration and is applauded by this writer.

We ask readers within the administration to consider that the Intel decision shows that government is not the ONLY answer to the present economic malaise. The point we want to drive home is that the country is ill served by our leaders continually telling us how bad things are and how things will ONLY get worse and that the politiicans, in Washington, are the ONLY ones who know what to do. It just is not true. Intel demonstrates the opposite. The company is visionary and “puts its money where its mouth is.”

We thank those readers who brought this information about President Obama’s call to our attention.

Again we wish readers happy holidays, restful vacations and safe travels.

Does Fair Value Accounting + Credit Default Swaps = Global Deflation?

This article will appear in the upcoming issue of HousingWire Magazine (

The US housing market continues to reel under the double weight of asset price deflation on the supply side, which is making banks reluctant to lend, and shrinkage of consumer demand for financing.  The good news is that the decline in existing home prices is going to fix the issue of affordability and demand over time.  It is on the supply side, though, in terms of credit available financing for buyers and builders of homes, that the market outlook remains uncertain.

Consider the drivers behind the falling supply of financing for all aspects of housing.  First, the collapse of the market for private label securitization, a once multi-trillion dollar source of gray market financing which has disappeared.  Second, the deleveraging of the banking system globally, which has consumed more than a trillion dollars in capital via mark-to-market (“M2M”) and realized losses over the past 18 months and looks to be set to consume another trillion in the next year. 

The fact of the market excesses behind these grim figures is undisputed.  But the one thing that arguably has accelerated the process of deflation, the one change in public policy put in place by the SEC and the Financial Accounting Standards Board at the start of 2008, is fair value accounting or “FVA.”  For housing professionals in all aspects of the financial chain, this obscure accounting rule should be “Target A” when you interact with elected officials at the state and local level.

FVA is the last remnant of bubble-think, a well-intended effort to restore market transparency that is instead driving us into the proverbial Thresher (SSN-593) scenario, straight down into the deepest trench of an economic correction that is well-beyond crush depth.  Think of FVA as a reasonable effort by academic experts from the audit world to deal with the increased opacity of the OTC markets, but one that has gone badly astray.

Over the past several months, my colleagues and I have come to the conclusion that we must make a correction in the FVA rule. We see two issues:

First, FVA relies on efficient market theory, namely that short term price = value and that consequently income, assets and liabilities should be adjusted in real time to reflect same. We think that the collapse of all of the other market efficiency based constructs, from structured assets to hedge funds, ends the discussion of derivative notions such as FVA, but readers of HW should recognize that the price=value assumption, which goes back to the Chicago School of Economics, is a huge intellectual driver behind the deflation we see in many markets today.

Second, FVA fails to recognize the historical role of banks, depositories, pensions and insurance companies as repositories for long-term value and consequently as havens from swings in short-term market pricing and economic trends. The whole point of capital adequacy regulation, with the notable exception of liquidity tests for broker dealers, is to give such institutions the freedom to take the long view. FVA makes the long view impossible and basically turns what are supposed to be low-beta, low risk, highly solvent hold-to-maturity vehicles into mark-to-market liquidations every day via the derivatives markets.

Just as you cannot buy bad assets from an insolvent bank at "fair value" without worsening the insolvency, likewise when you mark down assets you are reducing the ability of the entire financial system to support leverage. When you combine the zero effective collateral and margin operating in the derivative markets for instruments such as credit default swaps or CDS with the quarterly idiocy of marking down performing securities and loans to satisfy the advocates of FVA, it would be difficult to imagine the enemies of the United States constructing a more perfect weapon to bring about our collective demise.  Or to put it another way, what bank is going to be willing to buy residential mortgage collateral and hold same for sale in an FVA world?   Ask your MCs and Senators what they are doing to help repair the private secondary market for home mortgages. 

That said, I am not against disclosing the short-term fair value of assets. In fact, my colleagues and I at IRA want to see expanded disclosure of swings in FVA for all public companies, financials and otherwise. And as we have written in The Institutional Risk Analyst, the bank regulatory community is moving, painfully, slowly, to expand disclosure for banks and BHCs via efforts such as the expansion of the Shared National Credits reporting matrix, Basel II and a monthly reporting series on credit cards, a vast task that could require the collection of half a trillion records containing your personal credit and financial information, some 100 data elements per discreet record.

IRA is actively competing as a subject matter expert and system design architects for some of these new data collection tasks before the OCC, SEC, FDIC, etc, and we shall keep you in the loop to the extent we are allowed under the very tight confidentiality that is required. But suffice to say that we believe that there will be vast amounts of new data available on assets and liabilities as the restoration of prudential limits on finance proceeds apace.  The question for financial professionals is what to do – or not do – with this data.

We agree with those who believe that a compromise must be struck between the utopian goals of complete and total market efficiency and transparency and the real world of human action and inefficiency. The fact is, normal people are simply not able to react to and understand the torrent of short-term swings in assets prices, thus the net effect of FVA is not greater understanding, but instead fear, panic and systemic instability.

Believe us when we say that we have seen the wild eyed, "don’t you get it" look from the proponents of FVA in our colleagues in the XBRL community. We love their idealism and their vision, and we share same. But we at IRA also live in the real world of operating and delivering decision support systems for investors and fiduciaries. These systems must operate in the objective and very arbitrary rules of scientific method, because as Graham and Dodd taught us 80 years ago, the more speculative, the more unstable the data inputs, the less the analysis matters.

The subjective, speculative perspective that is the essence of FVA, when applied to illiquid assets has, we believe, the net effect of increasing the instability in the global economy. We’d like to ask the reader of HW to answer the following question: Is FVA accelerating the slowdown in the economy?  Because if the answer is yes, than nothing the Fed or Treasury try to do in nominal terms will be effective in stabilizing the banks, consumer prices or GDP because FVA, imposed just as the great real estate bubble was imploding, is now driving the global economy to a fire sale liquidation.

Disclose swings in market value of assets, you can even put aside reserves against the weaker credits, but so long as the asset is money good, it should not be charged against reserves. We might even construct some type of averaging rule for FVA swings in assets, affecting income and even reserves once the swing in value if confirmed over time, but the notion of instantaneous and immediate price discovery, disclosure and financial adjustment is a childishly idealized notion that must be gently restrained.  If we want to first fix the banks and then the secondary market for necessary things like mortgage finance, then I believe that the SEC and FASB must make an adjustment in the FVA rule.

Christopher Whalen is the co-founder of Institutional Risk Analytics, the Los Angeles based publisher of bank risk ratings and provider of risk management tools and consulting services for auditors, regulators and financial professionals.  He edits The Institutional Risk Analyst, a news report and commentary on developments in and around the global financial markets.

We thank Chris Whalen for sharing this commentary with our readers.

Tim Geithner’s Speech and Plan

Markets do not initially like Geithner’s comments.   There are good reasons.    He gave only sketchy details that would help clarify the program.  His speech was purposefully vague.   Markets and the country want clarity, transparency and reliability.   Instead. they got promises it would be forthcoming but they did not get facts and details that would substantiate it.

He alluded to “public-private” partnerships.  This is a concept that has often failed.   He offered a new “stress test.”  We do not know what this is or how it will be implemented or what the penalties will be if one fails that test.  And what will the reward be if one passes?

We also heard that there would be a large expansion of the Federal Reserve’s balance sheet as part of the program.   This is not surprising.   The Fed is the one agency of the federal government that is implementing policy to unfreeze the credit markets.   The Fed is succeeding in part.  We see that in the narrowing of the TED spreads and in the restoration of some working functionality in the commercial paper market.   What the outcome of this monetary expansion will be out in the future remains to be seen.  That comes after the economy starts to recover and then we can gauge the inflation risk.

Geithner did not address the problem of pricing of toxic assets presently held by financial institutions.  He also avoided the issue of recognition of losses by those institutions.  He only admitted in the post speech interview that his was being worked on.

He never mentioned the damage that has been done to the US financial system because the Financial Accounting Standards Board (FASB) has rigidly stayed with its rulemaking that caused 30 year assets to be marked to an estimated price with the variance charged against current earnings or added to current profits.   Mark-to-market works when markets are functioning, have transparency and ample liquidity for transactions.   Marking-to-market when the market is broken is impossible and results in the mess we now see.

His speech did not mention his earlier trial proposal of the aggregator bank.  He did not repudiate other ideas that had been surfaced and subsequently rejected.  And he seemed to imply that he was consistent with President Obama’s framework for government as the ONLY institution that can stimulate the economy.

The speech release was accompanied by a “fact sheet.”  How factual it seems we will leave to our readers to determine.  The fact sheet follows:



The Financial Stability Plan: Deploying our Full Arsenal to Attack the Credit Crisis on All Fronts. Today, our nation faces the most severe financial crisis since the Great Depression. It is a crisis of confidence, of capital, of credit, and of consumer and business demand. Rather than providing the credit that allows new ideas to flourish into new jobs, or families to afford homes and autos, we have seen banks and other sources of credit freeze up – contributing to and potentially accelerating what already threatens to be a serious recession.  Restarting our economy and job creation requires both jumpstarting economic demand for goods and services through our American Recovery and Reinvestment Act and simultaneously ensuring through our new Financial Stability Plan that businesses with good ideas have the credit to grow and expand, and working families can get the affordable loans they need to meet their economic needs and power an economic recovery.

To address the financial crisis, the Financial Stability Plan is designed to attack our credit crisis on all fronts with our full arsenal of financial tools and the resources commensurate to the depth of the problem.  To be successful, we must address the uncertainty, troubled assets and capital constraints of our financial institutions as well as the frozen secondary markets that have been the source of around half of our lending for everything from small business loans to auto loans.

To protect taxpayers and ensure that every dollar is directed toward lending and economic revitalization, the Financial Stability Plan will institute a new era of accountability, transparency and conditions on the financial institutions receiving funds. To ensure that we are responding to this crisis as one government, Secretary Timothy Geithner — working in collaboration and joined by Federal Reserve Chairman Ben Bernanke, FDIC Chair Sheila Bair, Office of Thrift Supervision Director John Reich and Comptroller of the Currency John Dugan – is bringing the full force and full range of financial tools available to cleaning up lingering problems in our banking system, opening up credit and beginning the process of financial recovery.

Financial Stability Plan

1.      Financial Stability Trust

·       A Comprehensive Stress Test for Major Banks

·       Increased Balance Sheet Transparency and Disclosure

·       Capital Assistance Program

2.      Public-Private Investment Fund  ($500 Billion – $1 Trillion)

3.      Consumer and Business Lending Initiative (Up to $1 trillion)

4.      Transparency and Accountability Agenda – Including Dividend   Limitation

5.      Affordable Housing Support and Foreclosure Prevention Plan

6.      A Small Business and Community Lending Initiative


1.      Financial Stability Trust:  A key aspect of the Financial Stability Plan is an effort to strengthen our financial institutions so that they have the ability to support recovery. This Financial Stability Trust  includes:

a.      A Comprehensive Stress Test: A Forward Looking Assessment of What Banks Need to Keep Lending Even Through a Severe Economic Downturn:  Today, uncertainty about the real value of distressed assets and the ability of borrowers to repay loans as well as uncertainty as to whether some financial institutions have the capital required to weather a continued decline in the economy have caused both a dramatic slowdown  in lending and a decline in the confidence required for the private sector to make much needed equity investments in our major financial institutions. The Financial Stability Plan will seek to respond to these challenges with:

·  Increased Transparency and Disclosure: Increased transparency will facilitate a more effective use of market discipline in financial markets.  The Treasury Department will work with bank supervisors and the Securities and Exchange Commission and accounting standard setters in their efforts to improve public disclosure by banks.  This effort will include measures to improve the disclosure of the exposures on bank balance sheets.  In conducting these exercises, supervisors recognize the need not to adopt an overly conservative posture or take steps that could inappropriately constrain lending.

·       Coordinated, Accurate, and Realistic Assessment:  All relevant financial regulators —  the Federal Reserve, FDIC, OCC,  and OTS —  will work together in a coordinated way to bring more consistent, realistic and forward looking assessment of exposures on the balance sheet of financial institutions..

·       Forward Looking Assessment – Stress Test: A key component of the Capital Assistance Program is a forward looking comprehensive “stress test” that  requires an assessment of whether major financial institutions have the capital necessary to continue lending and to absorb the potential losses that could result from a more severe decline in the economy than projected.

·       Requirement for $100 Billion-Plus Banks: All banking institutions with assets in excess of $100 billion will be required to participate in the coordinated supervisory review process and comprehensive stress test.

b.      Capital Assistance Program: While banks will be encouraged to access private markets to raise any additional capital needed to establish this buffer, a financial institution that has undergone a comprehensive “stress test” will have access to a Treasury provided “capital buffer” to help absorb losses and  serve as a bridge to receiving increased private capital. While most banks have strong capital positions, the Financial Stability Trust will provide a capital buffer that will: Operate as a form of “contingent equity” to ensure firms the capital strength to preserve or increase lending in a worse than expected economic downturn.   Firms will receive a preferred security investment from Treasury in convertible securities that they can convert into common equity if needed to preserve lending in a worse-than-expected economic environment. This convertible preferred security will carry a dividend to be specified later and a conversion price set at a modest discount from the prevailing level of the institution’s stock price as of February 9, 2009. Banking institutions with consolidated assets below $100 billion will also be eligible to obtain capital from the CAP after a supervisory review.

c.      Financial Stability Trust:  Any capital investments made by Treasury under the CAP will be placed in a separate entity – the Financial Stability Trust – set up to manage the government’s investments in US financial institutions.

2.      Public-Private Investment Fund:  One aspect of a full arsenal approach is the need to provide greater means for financial institutions to cleanse their balance sheets of what are often referred to as “legacy” assets.  Many proposals designed to achieve this are complicated both by their sole reliance on public purchasing and the difficulties in pricing assets.  Working together in partnership with the FDIC and the Federal Reserve, the Treasury Department will initiate a Public-Private Investment Fund that takes a new approach.

·       Public-Private Capital: This new program will be designed with a public-private financing component, which could involve putting public or private capital side-by-side and using public financing to leverage private capital on an initial scale of up to $500 billion, with the potential to expand up to $1 trillion.

·       Private Sector Pricing of Assets: Because the new program is designed to bring private sector equity contributions to make large-scale asset purchases, it not only minimizes public capital and maximizes private capital: it allows private sector buyers to determine the price for current troubled and previously illiquid assets

3.      Consumer & Business Lending Initiative – Up to $1 Trillion:  Addressing our credit crisis on all fronts means going beyond simply dealing with banks.  While the intricacies of secondary markets and securitization – the bundling together and selling of loans – may be complex, they account for almost half of the credit going to Main Street as well as Wall Street.  When banks making loans for small businesses, commercial real estate or autos are able to bundle and sell those loans into a vibrant and liquid secondary market, it instantly recycles money back to financial institutions to make additional loans to other worthy borrowers.  When those markets freeze up, the impact on lending for consumers and businesses – small and large – can be devastating.  Unable to sell loans into secondary markets, lenders freeze up, leading those seeking credit like car loans to face exorbitant rates.  Between 2006 and 2008, there was a net $1.2 trillion decline in securitized lending (outside of the GSEs) in these markets. That is why a core component of the Financial Stability Plan is:

·       A Bold Expansion Up to $1 Trillion: This joint initiative with the Federal Reserve builds off, broadens and expands the resources of the previously announced but not yet implemented Term Asset-Backed Securities Loan Facility (TALF). The Consumer & Business Lending Initiative will support the purchase of loans by providing the financing to private investors to help unfreeze and lower interest rates for auto, small business, credit card and other consumer and business credit.  Previously, Treasury was to use $20 billion to leverage $200 billion of lending from the Federal Reserve.  The Financial Stability Plan will dramatically increase the size by using $100 billion to leverage up to $1 trillion and kick start lending by focusing on new loans.

·       Protecting Taxpayer Resources by Limiting Purchases to Newly Packaged AAA Loans: Because these are the highest quality portion of any security — the first ones to be paid — we will be able to best protect against taxpayer losses and efficiently leverage taxpayer money to support a large flow of credit to these sectors.

·       Expand Reach – Including Commercial Real Estate: The Consumer & Business Lending Initiative will expand the initial reach of the Term Asset-Backed Securities Loan Facility to now include commercial mortgage-backed securities (CMBS). In addition, the Treasury will continue to consult with the Federal Reserve regarding possible further expansion of the TALF program to include other asset classes, such as non-Agency residential mortgage-backed securities (RMBS) and assets collateralized by corporate debt.

4.      New Era of Transparency, Accountability, Monitoring and Conditions:  A major and legitimate source of public frustration and even anger with the initial deployment of the first $350 billion of EESA funds was a lack of accountability or transparency as to whether assistance was being provided solely for the public interest and a stronger economy, rather than the private gain of shareholders, bondholders or executives.  Going forward, the Financial Stability Plan will call for greater transparency, accountability and conditionality with tougher standards for firms receiving exceptional assistance. These will be the new standards going forward and are not retroactive. These stronger monitoring conditions were informed by recommendations made by formal oversight groups – the Congressional Oversight Panel, the Special Inspector General, and the Government Accountability Office — as well as Congressional committees charged with oversight of the banking system.

a.      Requiring Firms to Show How Assistance from Financial Stability Plan Will Expand Lending: The core of the new monitoring requirement is to require recipients of exceptional assistance or capital buffer assistance to show how every dollar of capital they receive is enabling them to preserve or generate  new lending compared to what would have been possible without government capital assistance.

·       Intended Use of Government Funds:  All recipients of assistance must submit a plan for how they intend to use that capital to preserve and strengthen their lending capacity.  This plan will be submitted during the application process, and the Treasury Department will make these reports public upon completion of the capital investment in the firm.

·       The Impact on Lending Requirement: Firms must detail in monthly reports submitted to the Treasury Department their lending broken out by category, showing how many new loans they provided to businesses and consumers and how many asset-backed and mortgage-backed securities they purchased, accompanied by a description of the lending environment in the communities and markets they serve.  This report will also include a comparison to their most rigorous estimate of what their lending would have been in the absence of government support.  For public companies, similar reports will be filed on an 8K simultaneous with the filing of their 10-Q or 10-K reports.  Additionally, the Treasury Department will – in collaboration with banking agencies – publish and regularly update key metrics showing the impact of the Financial Stability Plan on credit markets. These reports will be put on the Treasury website so that they can be subject to scrutiny by outside and independent experts.

·       Taxpayers’ Right to Know: All information disclosed or reported to Treasury by recipients of capital assistance will be posted on because taxpayers have the right to know whether these programs are succeeding in creating and preserving lending and financial stability.

b.      Committing Recipients to Mortgage Foreclosure Mitigation:  All recipients of capital investments under the new initiatives announced today will be required to commit to participate in mortgage foreclosure mitigation programs consistent with guidelines Treasury will release on industry standard best practices.

c.      Restricting Dividends, Stock Repurchases and Acquisitions: Limiting common dividends, stock repurchases and acquisitions provides assurance to taxpayers that all of the capital invested by the government under the Financial Stability Trust will go to improving banks’ capital bases and promoting lending.  All banks that receive new capital assistance will be:

·       Restricted from Paying Quarterly Common Dividend Payments in Excess Of $0.01 Until the Government Investment Is Repaid:  Banks that receive exceptional assistance can only pay $0.01 quarterly.  That presumption will be the same for firms that receive generally available capital unless the Treasury Department and their primary regulator approve more based on their assessment that it is consistent with reaching their capital planning objectives.

·       Restricted from Repurchasing Shares: All banks that receive funding from the new Capital Assistance Program are restricted from repurchasing any privately-held shares, subject to approval by the Treasury Department and their primary regulator, until the government’s investment is repaid.

·       Restricted from Pursuing Acquisitions:  All banks that receive capital assistance are restricted from pursuing cash acquisitions of healthy firms until the government investment is repaid.  Exceptions will be made for explicit supervisor-approved restructuring plans.

d.      Limiting Executive Compensation:  Firms will be required to comply with the senior executive compensation restrictions announced February 4th, including those pertaining to a $500,000 in total annual compensation  cap plus restricted stock payable when the government is getting paid back,  “say on pay” shareholder votes, and new disclosure and accountability requirements  applicable to luxury purchases.

e.      Prohibiting Political Interference in Investment Decisions: The Treasury Department has announced measures to ensure that lobbyists do not influence applications for, or disbursements of, Financial Stability Plan funds, and will certify that each investment decision is based only on investment criteria and the facts of the case.

f.      Posting Contracts and Investment Information on the Web: The Treasury Department will post all contracts under the Financial Stability Plan on within five to 10 business days of their completion. Whenever Treasury makes a capital investment under these new initiatives, it will make public the value of the investment, the quantity and strike price of warrants received, the schedule of required payments to the government and when government is being paid back.  The terms of pricing of these investments will be compared to terms and pricing of recent market transactions during the period the investment was made, if available.

5.      Housing Support and Foreclosure Prevention:  There is bipartisan agreement today that stemming foreclosures and restructuring troubled mortgages will help slow the downward spiral harming financial institutions and the real American economy.  Many Congressional leaders, housing advocates, and ordinary citizens have been disappointed that the Troubled Asset Relief Program was not aimed at ending the foreclosure crisis.  We will soon be announcing a comprehensive plan that builds on the work of Congressional leaders and the FDIC. Among other things, our plan will:

·       Drive Down Overall Mortgage Rates: The Treasury Department and the Federal Reserve remain committed to expand as necessary the current effort by the Federal Reserve to help drive down mortgage rates – freeing up funds for working families – through continuation of its efforts to spend as much as $600 billion for purchasing of GSE mortgage-backed securities and GSE  debt.

·       Commit $50 Billion to Prevent Avoidable Foreclosures of owner-occupied middle class homes by helping to reduce monthly payments in line with prudent underwriting and long-term loan performance.

·       Help Bring Order and Consistency to the various efforts to address the foreclosure crisis by establishing loan modification guidelines and standards for government and private programs.

·       Require All Financial Stability Plan Recipients to Participate in Foreclosure Mitigation Plans consistent with Treasury guidance.

·       Build Flexibility into Hope for Homeowners and the FHA to enable loan modifications for a greater number of distressed borrowers.

6.      Small Business and Community Lending Initiative:  Few aspects of our current financial crisis have created more justifiable resentment than the specter of hard-working entrepreneurs and small business owners seeing their companies hurt and even bankrupt because of a squeeze on credit they played no role in creating.  Currently, the increased capital constraints of banks, the inability to sell SBA loans on the secondary market and a weakening economy have combined to dramatically reduce SBA lending at the very time our economy cannot afford to deny credit to any entrepreneur with the potential to create jobs and expand markets.  Further adding to this frustration is the sense that community banks – which still engage in relationship lending that serves their local communities —  have been overlooked not just during this crisis, but over the last several years.

Over the next several days, President Obama, the Treasury Department and the SBA will announce the launch of a Small Business and Community Bank Lending Initiative: This effort will seek to arrest the precipitous decline in SBA lending – down 57 percent last quarter from the same quarter a year earlier for the flagship 7(a) loans through:

·       Use of the Consumer &Business Lending Initiative to finance the purchase of AAA-rated SBA loans to unfreeze secondary markets for small business loans.

·       Increasing the Guarantee for SBA Loans to 90%: The Administration is seeking to pass in the American Recovery and Reinvestment Act an increase in the guarantee of SBA loans from as low as 75% to as high as 90%.

·       Reducing Fees for SBA 7(a) and 504 Lending and Provide Funds for Both Oversight and Speedier and Less Burdensome Processing of Loan Applications.

The EMU versus the Global Recession

The European Economic and Monetary Union (EMU) and its common currency, the euro, and single central bank, the European Central Bank (ECB), were created with the primary objective of achieving economic stability in Europe. January 1, 2009 marked the 10th anniversary of the introduction of the euro. Broadly speaking, a high degree of macroeconomic stability has been achieved, with a welcome end to exchange-rate turbulence.

However, this anniversary year happens to coincide with the most severe test of the EMU and the euro to date, due to the deep recession that is rocking Europe and the global economy. The declines in industrial production in the eurozone in the 4th quarter of 2008 were extremely severe. This week ECB President Trichet said available data point to “very negative quarter-to-quarter real GDP growth in the last quarter of 2008.” Questions are being raised as to whether the Union can survive this test.  We believe the EMU will muddle through this difficult period, but important weaknesses in its architecture have been revealed and need to be addressed.

It was hoped that the EMU would lead to a convergence of economic performance among the separate member economies, a development which would greatly strengthen the efficacy of a single monetary policy.  The progress towards convergence has been limited in important respects, and serious divergences have become apparent in recent months.  The elimination of restrictions on financial flows within the EMU and the mandatory use of a common currency, the euro, resulted in a high degree of integration of the euro area money market (the short-term interbank market), essentially from 1999.  Short-term lending rates varied little within the EMU until the period of credit market turbulence and greatly increased volatility began in mid-2007. Over the past year and a half there have been greater concerns about national differences in credit risk and increased preference for national counterparties.

Convergence in the European securities markets has been far more limited due to differences in market standards and practices, liquidity, and the availability of developed derivative markets. Another factor which has increased in importance due to the current economic strains is perceived country differences in credit risk sovereign risk in the case of government securities.

The ECB calculates “harmonized long-term interest rates” to assess the progress towards market convergence.  As recently as December 2007, while spreads over the benchmark German 10-year bond rate had started to widen, they were only 14 basis points for France and 33 basis points for Italy. By December of 2008, these spreads had widened sharply to 49 basis points for France and 142 basis points for Italy. Very large spreads developed for other EMU members, including Spain (81 basis points), Ireland (152 basis points), and Greece (203 basis points).  This serious divergence reflects significant differences among the EMU member economies with respect to their competitiveness and perceived ability to recover from the recession while maintaining price stability and avoiding an erosion of confidence in their solvency.

Budget deficits have worsened due to the recession, with economies in which housing growth has been particularly strong being hit the hardest (Spain, Ireland). Also, increasing government guarantees to loans, capital injections, and purchases of toxic assets have been a factor.  Ireland is notable in this respect; guarantees offered to Irish banks amount to 221% of GDP.  In addition, the current account positions of some members (Greece, Spain, Portugal, and Ireland) have deteriorated sharply. They do not have the option of depreciating their currencies or cutting short-term interest rates.

Underlining these differing situations, Standard & Poors has downgraded the sovereign debt of Spain, Greece, and Portugal in recent weeks and Moody’s has issued a warning that it may downgrade Ireland.

The ECB is quite limited in its ability to assist individual member countries whose economies are suffering the most from the recession. It has to apply the same monetary policy across the EMU. It is not permitted to buy sovereign bonds in the primary markets (a restriction designed to protect the independence of the ECB from the kind of political pressures to which European national central banks were subject prior to 1999). The ECB could buy debt in the secondary market, but this would require agreement across the EMU as to what debt to buy, how much, on what terms, etc.  There is no provision permitting the EU to support a country should it default.

On the other hand, countries for which spreads and hence borrowing costs have widened substantially are unlikely to be driven to leave the Euro area and reintroduce and devalue a national currency.  The costs for doing so would be high and their already high sovereign spreads would very likely widen significantly more. The country would find itself under even greater pressure to undertake needed economic reforms.

Aside from these problems, the ECB, with its mandatory single policy objective of price stability, maintained a restrictive monetary policy for too long last year. It continues to be somewhat behind the curve in responding to the global recession, apparently reluctant to lower interest rates as aggressively as the US Federal Reserve and the Bank of England. 

National governments within the EMU have announced substantial fiscal stimulus programs and in various ways have stepped in to shore up their financial institutions and unfreeze credit markets. However, economic recovery will be hampered by continuing rigidities in labor and other markets.  Economic hardships create strong headwinds for needed economic reforms, as was demonstrated by the massive national protests in France in recent days against economic reforms and layoffs in that country.

The eurozone economies as a group are expected to decline by 2% this year, following an estimated 1% advance in 2008 (this latter number may well be revised downward). The projected decline this year is similar to that expected  for the US, but the time path will be different, with recovery in the US becoming apparent in the second half of this year, leading to a near potential growth rate of 2.5 – 3% in 2010.  Recovery in the Eurozone will likely be slower for the reasons cited above, with 2010 growth around 1.5%.

At Cumberland we are continuing to under-weight the eurozone as a region in our International and Global Multi-Asset Class portfolios.  We are monitoring the individual eurozone countries closely, for some are likely to do better than others in the coming months. We also expect the US dollar to strengthen further in 2009, in particular, versus the euro.

It Isn’t That Hard

The FDIC on January 27 proposed a change in the restrictions on interest rates that institutions that are “less than well capitalized” may pay on deposits to prevent moral hazard behavior by zombie institutions.  The notice of the proposed change goes on to note that “(T)he proposed rule applies only to the small minority of banks that are less than well capitalized.  As of third quarter 2008, there were 154 banks that reported being less than well capitalized, out of more than 8,300 banks nationwide.” 

Something isn’t right here.  If there are only a handful of institutions that are inadequately capitalized, then why are we talking about buying bad assets from banks, or establishing a “bad” bank to house those assets and potentially commit another several hundred billion (maybe as high as two trillion) dollars of taxpayer money to support banks? This disconnect has plagued the handling of the financial crisis in financial institutions from the outset and continues to be a problem that has to stop. 

It isn’t that hard to put the system on a sound footing, and it has been done before by others.  The Scandinavian countries experienced a financial crisis that resulted in nationalization of most of the banks; and the episode, its successes and failures, have been aptly described in a book by Thorvald Moe, Jon Solheim, and Bent Vale, entitled The Norwegian Banking Crisis, published by the Norges Bank in 2004.  The parallels between their crisis and ours and the problems with how it was handled are sobering, and it appears that we have learned nothing from their experience.

What needs to be done can be summed up quite succinctly in three simple steps.  Some might object that these proposals may be too costly, but it seems we have already crossed that bridge and now it is time to get some bang for our spending.

Step 1.  Losses Must Be Identified. 

Loss identification should be the job of management.  After all, they granted the loans and/or purchased the assets and are closest to the source.  If management won’t or can’t do it, then it is the responsibility of the regulators as part of their supervisory activities.  Unfortunately, management hasn’t done its job and neither have the supervisors. 

Step 2.  Losses must be written off against common equity.

Carrying unrecognized losses creates uncertainty about institutional solvency and is at the heart of the breakdown of the interbank market and the decline in bank stock values.  Furthermore, avoidance of loss recognition by relying upon government guarantees only creates moral hazard incentives and behaviors and encourages increased risk taking.  Again, it is the responsibility of management and bank supervisors to see that not only are losses identified, but also written off.  So far all we have seen is serial loss identification and recognition, with no end in sight.  No wonder institutions are having trouble funding themselves.

Step 3.  Insolvent institutions must be closed, reorganized, recapitalized, and reprivatized. 

Policy makers and regulators have been paralyzed by the fear of so-called systemic risk and by concerns that some institutions are “too –big –to fail.”  Note that I didn’t suggest that institutions should be liquidated.  What the Nordic countries did was to inject government capital into their major institutions, but only after losses had been identified and taken by shareholders.  Management was replaced and a plan was put in place to reprivatize the institutions.  Those institutions left standing were soundly capitalized for which there was no uncertainty about their financial condition.  Only after losses have been recognized will the public and financial markets be assured that the existing institutions are healthy, regardless of whether they are privately owned or temporarily government owned. Confidence can be restored only by such actions.  Unfortunately, this is not the path we have taken, and it now looks like we are bent on throwing good money after bad, under current proposals.

A Bad Bank as Proposed Is a Bad Idea

Current proposals to establish a “bad bank” that would buy, hold, and liquidate bad assets, perhaps in combination with additional guarantees of losses on retained assets, are likely to be expensive and not solve the fundamental problems.  As it stands, the bad bank idea is nothing but reconstitution of the original idea in the TARP, with all its associated problems.  The sticking point before was how to price the assets that are acquired, which boils down to loss sharing between the taxpayers and the institution’s debt and equity holders.  Pay the current market value (or some very low price), and equity has to be written down, which risks forcing the institution into insolvency.  Pay too much, and the taxpayer gets the loss.  Then there is the problem of monitoring the asset maintenance and/or liquidation process, especially if some of the assets remain on bank balance sheets subject to loss guarantees.  Granting loss guarantees is equivalent to letting people with no equity stake in their homes to continue to live there free.  We know what that does to incentives to maintain the property. 

One proposal being floated by the administration is to have the “bad bank” buy only assets that have written down.  But someone isn’t thinking.  If the assets have already been written down, then they are no longer bad assets, unless they haven’t been written down enough.  This would leave the selling bank with only the remaining questionable assets in which all the risks reside.  This will do nothing to assuage market uncertainty about the viability or soundness of the institution, and hence will not restore the smooth functioning of the interbank market or lower risk spreads.  Coupling the purchase of bad assets with a government guarantee would only create uncertainty about the quality of remaining assets on the books and the ability of the institution to go it on its own without continued government support.  This is a band-aid covering up the wound.  Guarantees also have the added problem that they imply there is no exit policy in place for removal of government support. 

A “bad bank” only makes sense to hold assets after reorganization and recapitalization has already taken place.  Existing shareholders would be wiped out, and questionable assets would be taken over and managed by the FDIC or some other entity, where true costs to the taxpayer can be scored and their performance monitored and assessed.  Dividing a bank into a “good” bank and “bad” bank also avoids the accounting nuances that have served as a deterrent to loss recognition.  Management and shareholders are then left with the sole responsibility for running the good bank, and presumably, taxpayers would be granted warrants and/or equity to participate in the upside as recovery occurs.  It just isn’t that hard!