Maiden Lane Losses

As we contemplate the prospects for more government support for financial institutions, it is useful to reflect on what lessons we can now glean from the performance of the portfolio the Federal Reserve acquired in assisting the acquisition of Bear Stearns by JPMorgan Chase through its sponsored LLC, Maiden Lane.  At the hearings following the rescue before the Senate Banking Committee in April of 2008, Chairman Bernanke suggested that not only was the support of Bear Stearns’s acquisition by JPMorgan Chase necessary to avoid a potential crippling disruption to financial markets, but the Fed might even make money on the deal.

Now, one might ask, what were the Fed’s alternatives?  Might it have struck a better deal?  How much of the performance was the unforeseen consequence of the further decline in markets following the Lehman Brothers failure?

We can’t really answer most of these questions, because of the lack of transparency going into the deal, how Bear was initially valued, how over-collateralized the transaction was, or how much was actually known about Bear’s true condition.  All we know about the portfolio is contained in Appendix II of then-NY Fed president Timothy Geithner’s prepared remarks before the Senate Banking Committee on April 3, 2008.  On the surface, it appeared to be of reasonable quality:

“The portfolio supporting the credit extensions consists largely of mortgage related assets.  In particular, it includes cash assets as well as related hedges.

The cash assets consist of investment grade securities (i.e. securities rated BBB- or higher by at least one of the three principal credit rating agencies and no lower than that by the others) and residential or commercial mortgage loans classified as “performing”. All of the assets are current as to principal and interest (as of March 14, 2008). All securities are domiciled and issued in the U.S. and denominated in U.S. dollars.

The portfolio consists of collateralized mortgage obligations (CMOs), the majority of which are obligations of government-sponsored entities (GSEs), such as the Federal Home Loan Mortgage Corporation (“Freddie Mac”), as well as asset-backed securities, adjustable-rate mortgages, commercial mortgage-backed securities, non-GSE CMOs, collateralized bond obligations, and various other loan obligations.”

The question we can address is, how has Maiden Lane done so far?  The Fed reports on the net portfolio holdings and accrued interest and expenses for Maiden Lane each week in its H.4.1. release, “Factors Affecting Reserve Balances.”  The Fed discloses the net portfolio value based on quarterly revaluations of the assets in the portfolio, estimated as if they were sold on the valuation date in an orderly market, presumably done by the asset manager, BlackRock Financial Management.  We don’t know the specifics, though, of how the estimates were compiled.  There have been three portfolio revaluations since the initial portfolio was set up, and these were as of June 30, 2008; September 30, 2008; and December 30, 2008.

So far the results aren’t good, and there is no prospect for a profit on the assets.  In fact, the portfolio has lost over 10% of its value, and losses are mounting.  The attached chart details the reported performance of the portfolio from its inception.  Included in the calculations are not only the value of the portfolio but also the accrued interest owed to both the Federal Reserve Bank of New York and JPMorgan Chase.  Not included are the fees paid to the asset management company.

As part of the terms of the assistance provided, JPMorgan agreed to absorb the first $1 billion of losses.  The chart shows that JPMorgan was in the hole for almost all of the $1 billion from the outset.  The loss appeared to begin to shrink, based on the June 30 asset valuations.  But the shocker occurred in October when the portfolio was revalued using September 30 valuations.  Not only did JPMorgan lose all of the funds it had committed, but suddenly the taxpayer appeared to also be thrown into a substantial loss position of nearly $2.5 billion.  Again, over the ensuing months, the loss situation seemed to moderate; but then the portfolio was finally revalued in the most recent H.4.1 release, and losses skyrocketed again.  At present, losses now exceed $4.5 billion and the taxpayers’ share is now $3.5 billion.

The declines in the net portfolio value probably reflect not only the deteriorating condition of the housing market, since most of the assets are housing related, but also reflects the likely optimistic valuation of the portfolio at the outset.  The chart also suggests that most of the monthly reports on the performance of Maiden Lane are worthless, since changes in the market value of the portfolio are key to assessing where the entire transaction stands and what the taxpayer losses are.

Three conclusions suggest themselves from this analysis, that have implications for the kinds of transparency Congress should demand from policy makers in future bailout situations.  First, without more detailed disclosure of the initial assets that were included in the deal, it was hard to even guess what the likely risks would be to the taxpayer under alternative economic scenarios.  Second, meaningful reporting transparency requires more frequent valuation of the portfolio than quarterly, when markets are volatile and disrupted.  Third, it clearly was the case that the transaction was not structured with adequate over-collateralization to protect the taxpayer from losses, given the downside economic risks that were perceived for housing-related assets at the time and that were also reflected in the Federal Reserve’s own forecasts for the economy as a whole.

Managing Inflation Expectations and Motivating Economic Growth by Joseph R. Mason

The term “liquidity trap” originated with John Maynard Keynes in 1936 with the publication of his seminal work: “The General Theory of Employment, Interest, and Money.”   Essentially a liquidity trap occurs when expansive monetary policy fails to stimulate the economy. Keynes wrote about when bond interest rates were so low that fear of an impending rise in rates motivated people to avoid holding bonds.  In our modern times “liquidity trap” is used to describe the situation where the nominal interest rate is near zero.  Implied is that monetary policy becomes impotent.  Also, implied is that fiscal policy is needed in great quantity to derive stimulus because of the ineffectiveness of monetary policy.  Joe Mason has honed skills in this area and has given us permission to offer our readers his recent commentary about the present US liquidity trap.

Joe Mason wrote:

A Rising Tide Lifts All Boats (that can Float)

Economists are still vexed by liquidity traps. The reason is that it is easy to see frictions in resolving bad assets, but difficult to see a way out. Right now, banks can’t afford to write off their full exposures to bad assets without additional capital, but banks also can’t afford to keep the assets on the balance sheet without even more capital because, without explicit recognition they are unable to credibly commit their exposure to the bad assets. Hence, banks don’t lend and economic growth stagnates.

The problem, however, is not just the banks but also what can be called the “unwitting” investors in the bad assets. In the Great Depression, regular bank depositors turned into unwitting long-term creditors overnight when banks failed without deposit insurance. Today, myriad banks and funds are prohibiting withdrawals (even against contractual terms) or paying out only “in-kind” in order to stem debilitating losses in a manner similar to the Great Depression. Even bank shareholders who thought they had blue-chip investments are finding out they held junk.

To wake up one day and find you had intended to invest in blue-chips but had really invested in junk is systemically problematic when you can’t withdraw your funds. When redemptions or sales are impossible because the market is flooded with junk, investors are stuck with maturities and risk grades they did not desire and are unable to reallocate their portfolios to their preferred characteristics, particularly investments issued by value-producing firms.

Government funds to take the assets off investors’ hands don’t help, either, only replacing the personal tax with an equivalent public fiscal burden. No matter how we distribute the loss, the aggregate amount of loss to the economy remains the same: the resulting liquidity trap substantially drags down economic growth.

The trap, however, is endemic in the “wait until tomorrow” approach that is so attractive in crises. Values slid from historic highs to today’s levels. The central bank has stepped in with accommodative measures, bringing rates to historic lows. Economic growth is right around the corner. So investors wait… and wait… and wait. But growth never comes. Why?

The answer proposed in my own research1 is that the cost of waiting has been reduced by the central bank to almost zero. Without a traditional market cost of waiting, investors’ money remains tied up in bad assets. With zero interest rates and no economic growth, deflationary expectations arise and begin to be priced into financial contracts. The liquidity trap does not respond to traditional interest rate cuts because investors’ behavior is working for them. Hence, exit from the liquidity trap requires changing investors’ incentives.

The goal should be to put bad assets to investors willing and able to make use of them, particularly deep pockets investors (with a lot of long-term cash) that know how to extract value out of the assets. The sentiment is similar to that espoused by Ben Bernanke in his famous “Non-monetary Effects…” paper: Bernanke (1983, p. 272) surmised that as “…a matter of theory, the duration of the credit effects … depends on the amount of time it takes to (1) establish new or revive old channels of credit flow after a major disruption and (2) rehabilitate insolvent debtors.” In practice, Bernanke seems to be attempting to “establish new channels,” but the only attempt at “rehabilitation” seems to be mortgage modification. In my opinion, “establishing new and reviving old credit channels,” will follow “rehabilitation” if “rehabilitation” is carried out completely and targeted at the right group of debtors.

So how do we get the assets from the current “unwitting” investors to the vulture investors who know how to remediate credit and rehabilitate borrowers? The government could buy the assets and subsidize the reallocation but that is bound to be horribly inefficient. Furthermore, if investors thought they could get a better price later – from the government or the market –they still face the zero cost of waiting.

Perhaps it is better to raise the cost of waiting by reflating interest rates. That means credibly committing to an inflationary bias in order to get investments out of the hands of “unwitting” investors and into the hands of vulture specialists that have the means and capability of managing bad assets. With the cash received, previously “unwitting” investors can reallocate their portfolios to value-producing firms rather than facing the potential for further value-destruction in their present portfolios. When value-destroying firms lock up markets, they drag the economy down with them. When value-producing firms raise funds, they exert a powerful force for economic growth.2

The new administration has a unique opportunity support value-producing firms by promoting reflation now. Timothy Geithner, having spent considerable time inside the Federal Reserve System and having worked directly with Bernanke already, may have the ability to creatively pursue coordinated Treasury and Federal Reserve actions not seen since the Fed-Treasury Accord of 1951, which affirmed the Fed’s staunch independence from Treasury.3  While I would not normally suggest the breakdown of central bank independence and the strategy carries with it risks of whether the Fed can effectively de-politicize itself on the other side of the crisis, the strategy allows the Fed to maintain short-term rates at their current low levels while the Treasury swaps out or repurchases TIPs and assembles its financing for the higher inflation to follow. By generating inflationary expectations in such a manner, the Fed avoids further embedding the zero-rate liquidity trap problem in longer-term markets through the proposed purchase of longer maturity paper and can stop overextending their balance sheet to fund troubled asset liquidity programs that, themselves, threaten not just the central bank’s independence, but continued viability.

In summary dealing effectively with liquidity traps vexes even the best economists. Agencies like Treasury do not maintain significant staffs of economists devoted to understanding and dealing with today’s crisis, but they do possess policy tools that can be used to fight the crisis. The Federal Reserve, on the other hand, possesses vast economic knowledge and creative thought about the crisis, but its tools for dealing with financial exigencies such as this are limited. Coordination between Treasury and the Federal Reserve can therefore augment the Federal Reserve’s very limited toolbox for affecting inflation expectations. We need to incentivize the shift of bad assets from general investors to specialists by increasing inflation expectations. Treasury policies like a TIPs buyback or swap could be a powerful means of shaping expectations in the near term, incentivizing Bernanke’s resuscitation of “…channels of credit flow after a major disruption and …rehabilitat[ion of] insolvent debtors.”

Joseph R. Mason – Hermann Moyse, Jr./Louisiana Bankers Association Professor of Finance, Louisiana State University, Senior Fellow at the Wharton School, and Macroeconomic and Financial Industry Consultant, Empiris Economics, LLC. Contact information:; (202) 683-8909 office. Copyright Joseph R. Mason, 2008. All rights reserved. Past commentaries and testimony are blogged on  

1 “A Real Options Approach to Bankruptcy Costs: Evidence from Failed Commercial Banks during the 1990s.” Journal of Business, July 2005 (79:3), pp. 1523-53. “Bank Asset Liquidation and the Propagation of the Great Depression,” (with Ali Anari and James Kolari). Journal of Money, Credit, and Banking, August 2005 (37:4), pp. 753-773.

2 Indeed, Japan’s economic growth only began to take off when it pursued a reflation program, albeit nearly a decade after their crisis began.

3 Prior to that time, the Fed agreed with Treasury that the primary emphasis, for funding WWI, the Great Depression programs, and WWII, was to keep Treasury borrowing rates low.

Pondering Madoff as you Choose Auditors by

Friehling & Horowitz was the accounting firm that supposedly performed the audits of Bernie Madoff’s alleged Ponzi apparatus. The report of due diligence done by an investigator from Aksia helped steer that company clear of doing business with Madoff. Their recommendation was based, in part, on the findings about the Madoff’s auditor. As part of our research we asked a longtime friend, Jack Blumenthal, about the standards of audits and if adherence to those standards would have kept someone from using Madoff. Jack was kind enough to write this contribution which we offer to our readers.

Jack Blumenthal wrote:

As we now know, Madoff is a firm that was audited by a three person C.P.A. firm which performed no other audits than Madoff’s. Would a competent auditor have uncovered the fraud? An audit of financial statements does not guarantee that fraud will be uncovered, but using a competent audit firm increases the probability of uncovering fraud if it does exist.

First the Structural Issues.

Independent Peer Reviews:

44 of the 50 states have regulations which require that in order to perform audits a C.P.A. firm must have a peer review of its audit practice by an independent C.P.A. firm. Unfortunately, New York State, at the time, did not require this.

Peer reviews of audit practices have been administered under the auspices of the American Institute of CPA’s for more than twenty years. A peer review consists of outside auditors from other firms, approved by the AICPA, paid for by the subject firm, inspecting the quality control over audit processes, procedures and a sample of actual engagement files together with evaluating the governance of the firm. The resulting peer review formal report is a public document which can be obtained from the AICPA or from the reviewed audit firm. Peer reviews are conducted every three years and although mandatory in 44 states, it is done voluntarily by firms in the six states that do not currently require them.

Public Company Accounting Oversight Board (PCAOB) Inspections:

As an outgrowth of Enron, the SEC established the PCAOB to oversee the quality of audit firms which audit public companies. As part of this process, the PCAOB conducts quality audits of C.P.A. firms which audit publicly held companies. Although considered, the PCAOB does not currently require PCAOB inspection of C.P.A. firms which audit brokerage or other regulated financial firms, unless they are publically owned.

These inspections are conducted by former audit partners or managers who work full time for and are paid by the PCAOB. These inspections, while they focus on audits of publically held clients, also cover the quality control and governance of these firms, including independent, professional staff training and performance procedures, adherence imposed by the PCAOB, as well as an audit of a sample of audit engagements.

Like peer review reports, the reports on each PCAOB inspections are also public information.

How Do These Inspections Impact a C.P.A. Firm’s Professional Behavior?

Given the competitive business pressures on C.P.A. firms, no firm which is thus regulated can afford to have an adverse opinion and stay in the audit business or continue to provide audits to publically held companies. Firms which have unqualified inspections, communicate this to their clients, prospective clients, and users of their audit opinion. The results also impact recruiting and retention of quality professionals who view this as an important factor in developing their professional careers.

With respect to our firm, the importance of having clean peer reviewed PCAOB reports incents us to establish, enhance, and adhere to every aspect of our quality control, governance and engagement conduct. It encourages every principal to dot every “i” and cross every “t”, knowing that every engagement and all processes are subject to an independent set of eyes scrutinizing and reporting on everything we do.

So What to Do?

Before investing in a private and unregistered investment entity, ask whether the vehicle is audited and whether the auditor is a PCAOB audit firm. Any security that is registered with the Securities and Exchange Commission (SEC) is likely to meet this test. Had you followed this procedure, you would not have placed any money with Madoff. To obtain the PCAOB report on a CPA firm go to, click on inspections, and click on the firm name.

About the author:

Jack Blumenthal is a Principal at Causey Demgen & Moore Inc., a PCAOB member firm. Mr. Blumenthal leads the firm’s financial services industry practice which serves clients throughout the U.S. He can be reached at or at (303) 672-9890.

We thank Jack Blumenthal for his guest contribution to our website. We note that Cumberland Advisors follows the advice outlined here. Our own auditor handles public companies and falls under these rules. And we only use listed securities for our clients and thus have the publicly owned standard applying to them.

2008 Muni Madness: The Movie

“Education is what’s left after everything learned at school has been forgotten.” – Albert Einstein

It was that type of year in tax-free municipal bonds, as most of the assumptions that investors and portfolio managers have made for years were thrown up in the air.  We are completing a year which has seen high-grade municipal bonds yielding 200% of US Treasury yields, two episodes of massive municipal bond hedge fund blowups, most municipal bond insurers’ ratings downgraded, insurers ceasing to be a force in the market, a total collapse of Wall Street Liquidity supporting the market and, recently, massive supply.  All of this amidst the stock market meltdown and various federal bailouts.  We will review these forces at work in a market that Cumberland Advisors still feels represents a terrific opportunity in tax-free bonds. 

Wall Street liquidity

We first noticed the drop in Wall Street liquidity in relation to the municipal bond market in the fall of 2007, as concerns about balance sheets and subprime exposure began.  This was the first instance of tax-free bond yields rising above longer US Treasury yields.  Clearly this liquidity situation became dramatically worse with Bear Stearns being taken over by JPMorgan, Merrill Lynch being absorbed by Bank of America, Lehman Brothers declaring bankruptcy, UBS closing their public finance department, and Wachovia awaiting absorption by Wells Fargo.  Smaller dealers have not been immune to this drop in liquidity, either.  The result has been, with few exceptions, a market which has had to rely on the bid from retail investors – which can often be very strong but which is overwhelmed in the face of hedge fund liquidations or huge supply.  Some of this drop-off in street liquidity is being replaced by some nontraditional sources:  pension funds, state and local governments, foreign buyers, and charitable foundations. None of these groups benefit from the tax-exempt nature of municipal bonds.  But the absolute cheapness of the market is attracting these buyers on a long-term total-return basis – especially when the credit quality of municipals is compared to that of corporate securities.



as of January 17, 2008

as of January 5, 2009














Assured Guaranty
























































Berkshire Hathaway




The chart above shows the ratings of the various insurers at the end of 2007 and where they are now.  The drop is dramatic and reflects two main themes: (1) The rating agencies’ request that insurers raise more capital in the face of the drop-off in the market value of mortgage-backed securities that they insured and (2) the rating agencies’ opinion of a bleak outlook for municipal bond insurance in general. 

The drop in market value of the mortgage-backed securities that the insurers backed has been dramatic, reflecting the liquidity of this class and, to a lesser degree, the outright default rate to date of these securities.  Many of the insurers did in fact raise capital, but not to the satisfaction of the rating agencies.  The downgrades of the insurers have also triggered covenants in certain swap agreements, requiring the insurers to post more collateral.  This has exacerbated an already troubled situation.  As for the downgrading related to prospects for the industry (cited often as a reason for recent downgrades), we feel this is in part a self-fulfilling prophecy on the part of the rating agencies.  This year has also seen Berkshire Hathaway and the Macquarie Group of Australia announce the new entry into the municipal market of a new insurer of AAA-rated bonds.  Thus these groups clearly see an opportunity (caused in no small part by the rating agencies’ downgrades of other insurers).  In any case, insurance coverage by all insurers with the exception of Berkshire, and to a lesser extent the combined Assured/FSA, has been rendered moot by the market.  Insurance is still in force, of course, but the bond market treats bonds with insurance on all but the aforementioned as if they had none and are instead pricing bonds off the underlying ratings. This process has been exacerbated since MBIA and AMBAC were downgraded by Moody’s to BAA1 early in November. 

This has really created a municipal bond universe of haves and have nots.  Bonds with denigrated insurers and weaker underlying ratings have seen their market values lowered and have not participated in what has been a rally in municipals in January.  Bonds insured by Assured Guaranty, FSA, or Berkshire Hathaway have participated in this rally, but clearly high-grade bonds with AA or higher ratings on their own have performed the best.  We are now witnessing the market phenomenon of seeing issues with no insurance out-trade the VERY SAME bond issues which have insurance – though downgraded.  Thus the market is treating the existence of one of the denigrated insurers as a net NEGATIVE impact on the pricing of bonds.  This is an unusual development indeed, and we feel it represents some value.

Overall Muni Cheapness

Source: Bloomberg

We have published the above graph a number of times this year.  It shows the difference in yields between the thirty-year US Treasury bond and the Bond Buyer 40, a long-maturity index of mostly AA and higher-rated tax-free bonds.  Normally, the yield on tax-free bonds has been below that of Treasuries, for the main reason of Federal tax exemption of income.  This year has seen a dramatic about-face: blowups of municipal bond hedge funds in February, and then later in October, were precipitated by municipal insurer downgrades in February and the Lehman Brothers bankruptcy in October.  We thought the point of absurdity had been reached in mid-October, in the midst of hedge fund selling, when the yield gap between the thirty-year US Treasury and the Bond Buyer 40 reached 250 basis points.  That was eclipsed in December with the gap climbing to over 350 basis points.  The further gapping between these two markets was due to a drop in long Treasury yields caused by what we think is outright buying of US Treasuries by the Federal Reserve in an effort to lower long-term interest rates and hence mortgage rates.  At the same time, long tax-free rates headed higher through a combination of events. High-yield bond funds saw a lot of redemptions and were selling many A-rated and BBB bonds, pushing yields on those instruments much higher and dragging better-quality bond yields higher as well.  Since then there has been a dramatic about-face in the municipal market, with a vigorous price rally and drop in muni yields similar to that in October.  This has been due to a number of factors: a market realization that yields had become distended, renewed institutional buying as year-end rollover of coupons and maturing bonds combined with flows into municipal bond funds to form a wedge of demand, and the overall collapse of short-term interest rates, forcing investors in to longer-dated paper.  In addition, there was recognition that the new administration will a have a stimulus program that includes state and local governments, thus lowering some of the default concerns which had been present last December in the muni market.  Bottom line: munis, though less cheap than in December, are still a bargain, with plenty of room for price appreciation. 

Looking Ahead in 2009

Source: Bloomberg

Supply has picked up recently as issuers who had the flexibility and avoided coming to market in mid to late December are lining up now that yields are less distended.  Bulges of supply should be looked upon as opportunities.  Overall supply is clearly at a higher sustained level than two years ago – and issuers are seeking access to the capital markets now that rates have dropped.

Creditworthiness will continue to be important.  General-obligation and essential-service revenue bonds will continue to garner most of the interest, and we expect it will take a while for the high-yield municipal bond market to recover.  That is more of a story for 2010.

Higher-coupon bonds (5.5% or higher) that were issued in 2008 at various times are excellent candidates to be prerefunded by their issuers when overall interest rates in tax-exempt bonds move down.  Bonds that get prerefunded to call dates in 2017-19 will have terrific upsides in price appreciation, both from the steepness of the yield curve as bonds move to being priced to their call dates, as well as the inexorable pick-up in credit quality from the defeasance in US Treasuries.  Thus, “cushion bonds” are excellent municipal investments, especially as the relative values of municipals and Treasuries move back to a more normal environment.

State and local Governments will benefit from the House stimulus package.  This includes direct aid, infrastructure programs, aid for schools, unemployment insurance payments, and an increase in Medicaid matching grants.  There is no question that state and local governments will be under pressure in 2009.  However, as Cumberland Advisors has stated before, we DO NOT believe that we are having a repeat of the 1930s depression: both monetary and fiscal stimulus are much higher and at faster response levels than in the ’30s.

Bottom line: the turmoil of 2008 has created the opportunity of 2009.

Today’s Fed Statement

Excerpt from today’s Fed statement:

“The focus of the Committee’s policy is to support the functioning of financial markets and stimulate the economy through open market operations and other measures that are likely to keep the size of the Federal Reserve’s balance sheet at a high level. The Federal Reserve continues to purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand the quantity of such purchases and the duration of the purchase program as conditions warrant. The Committee also is prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets.”

Translation of key words follows.

“Open market operations” means the Fed will print money (expand the liability side of our balance sheet) and buy these securities through the primary dealers.  We will do so for our own System Open Market Account (SOMA).  We are prepared to hold them.  This is the traditional form of monetary policy and has usually been focused on short-term treasuries.

The “size” of the Fed’s balance sheet has tripled in a matter of weeks (see  The Fed has been targeting the asset side with its special facilities.  The liability side of the balance sheet is the electronic equivalent of the printing of money to buy the assets.

“Purchase large quantities of agency debt and mortgage-backed securities” means, the Fed will go into the mortgage finance market and do whatever it takes to drive the mortgage interest rate lower.  The Fed is in partners with the Treasury and Fannie and Freddie in trying to implement a 4.5% conforming mortgage interest rate.  The Fed has unlimited power to direct newly created money to this sector.  We believe they will succeed.

“Purchase longer-term Treasury securities” means the Fed is broadcasting that it is willing to buy and hold longer-term Treasury notes and bonds.  This means the Fed is targeting two points on the yield curve.    They are targeting the short-term rate (Fed Funds) and a longer-term rate (Treasury notes).  Once it is established that the Fed is targeting two points on the yield curve, one can quickly determine all the other points on the yield curve. 

This last item is very important.  It says that the Fed will do what it needs to do to keep any inflation expectation from creeping into the pricing of longer-term Treasury notes and bonds.  The Fed is now transparent about this policy and wants to remove any market-driven guesswork.  We can expect Treasury bill rates in the US to remain between zero and something above zero, but under 1%, in the shorter-term sector for a while.  We define “a while” as most, if not all, of 2009, and maybe into 2010.  We can also now expect the longer-term Treasury notes (10-year for reference) to trade at yields somewhere between 2% on the low side and 3% on the high side, with 2.5% a good estimate of the average.  The Fed is trying to tell the market that this rate, too, will be maintained for a while.

Now that the Fed is defining the range of the yield curve, financial agents can quickly determine where they want to take risk and how to price it.  Cumberland’s strategy is to place bond positions in the longer end of the term structure and to focus on spread product.  We are buying longer-term tax-free municipal bonds and taxable bonds of investment-grade quality.  We believe that these spreads will narrow to treasuries over time, as the Fed continues to hold this policy in place. 

The Fed is inviting investors to take risk.  They are encouraging agents to move their money from the zero interest rate on cash to something else.  At Cumberland we are doing just that for our clients.

Why Secretary Geithner’s China Comments Matter

Treasury Secretary Geithner’s comments at his confirmation hearing and subsequent responses to written questions from Senators have provoked surprise and consternation here, in China, and around the world.  His comments went far beyond his own personal views when he stated that the Obama administration believes that the Chinese government has engaged in currency manipulation.  Why would the administration deliberately pick that moment to intentionally slight the Chinese government?  It is clear that this slight was not, like forgetting to pay taxes, an “innocent mistake.”

What has gotten somewhat lost in the turmoil over these remarks is that this was not a “slip” by an inexperienced person.  Regardless of what one thinks about the economic credentials that Secretary Geithner brings to the job, he does have credentials when it comes to international relations, and especially China and the Far East.  He served as Undersecretary of the Treasury for International Affairs and was director of the Policy Development and Review Department at the International Monetary Fund.  In terms of degrees, his bachelor’s degree is in government and Asian studies, and his master’s degree is from Johns Hopkins School of Advanced International Studies, in international economics and East Asian studies. In addition, he has studied both Japanese and Chinese and has lived in East Africa, India, Thailand, China, and Japan. 

This is not the background of someone who would fail to understand the import of his remarks.  He, above all, should have realized that the carefully worded statement would send a strong message.  This means that either he actually believes that the slight was worth the potential costs, or else he may have warned against how the response would be received, but was ignored.  Either way, we should be concerned.

Consultation versus Confrontation with China

The first move by the Obama economic team in the delicate area of international economic and financial relations is a serious misstep, in our view.  The counterparts in China to Treasury Secretary designee Tim Geithner and the head of the National Economic Council, Larry Summers, were confronted at the end of last week with the following statement (repeated twice) in a written submission by Geithner to the US Senate Finance Committee:

“President Obama – backed by the conclusions of a broad range of economists – believes that China is manipulating its currency. President Obama has pledged as President to use aggressively all the diplomatic avenues open to him to seek change in China’s currency practices.”

This statement takes an issue central to the US – Chinese commercial and financial relations, which have been handled with considerable finesse by former Treasury Secretary Paulson – and moves it from thoughtful consultations to “aggressive diplomacy”, in other words, confrontation.

The Chinese are familiar, from the Clinton era, with the blunt, undiplomatic style of Larry Summers but probably still were surprised to receive this shot across their bow in the opening days of the Obama Presidency.  While this may play well among the more protectionist-leaning politicians in the US, it risks seriously undermining our relations with a major trading and investment partner at a critical time for our economy.  It is ironic, as well as disturbing, that an administration that has the stated intention to move the US from a confrontational approach to more effective diplomacy in the foreign policy arena should veer off in the opposite direction in international economic relations.

There is no debating the fact that China has a managed exchange rate.  China’s fears about moving all the way to a freely floating currency are not without some merit. The Chinese financial and regulatory system still is not up to advanced-economy standards.  The consultations between China and the US on this issue have focused, rather, on the (managed) speed of appreciation of the Chinese currency, with the US urging faster appreciation in view of the apparent undervaluation of the Yuan. These consultations have been part of the “US-China Strategic Economic Dialogue,” recognized on both sides of the Pacific as a successful framework for US-China discussions.  We hope the Obama team will continue this dialogue. There is little evidence in history of belligerency and confrontation yielding positive results. Rather, in this case, they risk affecting the willingness of China to continue to accumulate US securities, essential for the financing of our huge and growing debt, while stoking dangerous protectionist sentiments in the US.  Following the example of the Smoot-Hawley Act of 1930 would be the surest way to turn the current serious recession into a depression.

Finally, we would note that a stronger Chinese currency would not necessarily mean a dramatic improvement in the US- China balance of trade.  Many Chinese firms are likely to have considerable scope to absorb the impact of a stronger currency. They weathered an overnight 30% revaluation during the Asian crisis and emerged in good shape.  Moreover, their costs of imported raw materials would be lowered by currency revaluation.  Industries where margins are tight in China are being phased out, in any event, and are moving to lower-cost countries such as Viet Nam. 

While the Obama team should continue the currency consultations and encourage the Chinese to move in a direction that would be in the long-term interests of China as well as the global economy, the Strategic Economic Dialogue should give at least equal emphasis to encouraging efforts to promote domestic consumption and to pressing for further opening of Chinese markets.  These efforts should be backed up by effective use of the World Trade Organization to hold the Chinese to their WTO commitments..


Geithner, Obama and China

Following Treasury Secretary designee Tim Geithner’s public confirmation hearing, an extensive Q & A occurred in writing. We have posted a copy of the US Senate Finance Committee’s 100-page text on our website. See: (Link is no longer available). This is a must read for any serious investor, economist, strategist, analyst, or observer. In this text you will find what is on the minds of the Senators, and you will gain insight into the policies that will be forthcoming from the Obama administration.

One telling example is found in the following quote that has already created international consternation. Geithner twice answered questions about currency and China. In so doing he has placed the Obama administration squarely in the middle of the tension between the United States and the largest international buyer and holder of US debt: China. This happened as the same Obama administration is unveiling a package that will add to the TARP financing needs and the cyclical deficit financing needs and cause the United States to borrow about $2 trillion this year. Two trillion dollars of newly issued Treasury debt – (Link is no longer available) and this is how the question was answered. Not once but twice.

Geithner (on page 81 and again on page 95) answered: “President Obama – backed by the conclusions of a broad range of economists – believes that China is manipulating its currency. President Obama has pledged as President to use aggressively all the diplomatic avenues open to him to seek change in China’s currency practices.”

“Manipulation?” “Aggressively? This is strong language. Geithner did not do this on his own authority. These are prepared answers. He is citing the new President, not once but twice.

China’s response was fast and direct. China’s commerce ministry said in Beijing that China “has never used so-called currency manipulation to gain benefits in its international trade. Directing unsubstantiated criticism at China on the exchange-rate issue will only help US protectionism and will not help towards a real solution to the issue.”

Are we seeing the world’s largest and third largest economies calling each other names in the middle of a global economic and financial meltdown?

The world is in recession. The economic growth rates in the major and mature economies are now negative numbers. In China the growth rate is at least 4 and maybe as much as 8 points below last year. All the governments of the world that are running deficits are enlarging them in order to finance stimulus packages. Their central banks are bringing the policy interest rates toward zero. Trillions will need to be borrowed by those governments. Either they will be financed by the outright massive printing of money through the central bank mechanism, or they will be financed by those in the world who have savings. China is the largest single holder of financial savings in the world. Japan is next.

Why are we picking a fight with China? The implied question is why are we alluding to one with Japan, whose currency is currently the strongest of the G4 majors? In a world where global finance is mostly in US dollars, British pounds, euros, and yen, this is engaging in a dangerous sport.

The pound has lost one third of its value against the dollar since the crisis began. It is destined to weaken more. The euro struggles because of the structural issue of having to conduct monetary policy in the sovereign debt of the various euro zone member countries. The gap between those sovereign interest rates has reached nearly 3% between the weakest and strongest. This is an extremely difficult task for the European Central Bank to manage.

And Japan is getting killed by the flight to the strong yen. Japan will intervene soon to weaken the yen; they have as much as said so. The yen is strengthening against the Chinese Yuan; that is Japan’s largest trading partner. The yen is 1.5 standard deviations above the JPY/USD exchange rate. It is nearly 3 standard deviations above the JPY/EUR cross rate that has been established during the ten years the euro existed. And it is over 3 standard deviations above the JPY/GBP cross rate.

So that leaves the dollar likely to get stronger. Right now it is the default choice of the world. We have currency strength not because we are so desirable but because we are currently better than the others. All bad; we’re not as bad as they are. Or all bad and the others are even worse.

So what do we do within 72 hours of launching the Obama administration that says it is seeking “change?” We fire the first public salvo in what could easily become a trade war or a threat to global financial integration.

What makes us so credible? Is it our proven record of regulatory oversight of our financial markets, as demonstrated by the Madoff scandal and the SEC? Is it the way our rating agencies work so diligently to place a coveted “AAA” on paper that was peddled to the rest of the world and was found out to be highly toxic? Is it the way we honor the promises of federal agencies by having tier-one-eligible Fannie and Freddie preferred held in the US and abroad by institutions, and then essentially cause a structural default on that preferred (actually, dividend suspension)? Or is it the way the actions of Treasury and the Federal Reserve allowed a primary dealer (Lehman) to fail, thus triggering a global contagion?

C’mon? Where is the plan to restore confidence and credibility and transparency and consistent policy for the United States? And how does the Obama administration believe that launching a fight with China is beneficial?

In the 1930s the severe recession of 1929-1931 was turned into the depression of 1931-1933 because of protectionism. Every historian knows that. Every economist learns it in school. This is well-known by Geithner and even better-known by Larry Summers and Paul Volcker. They are the three members of the Obama economic troika.

The statement Geithner repeated twice was certainly known to them in advance. Why did they not temper it? What is the plan? Do they want to threaten and see if China backs down? This, too, is dangerous. Do they intend to pursue the Schumer tariff scheme? There are more questions than answers.

Lastly, Larry Summers was going to attend the World Economic Forum in Davos, Switzerland. He has cancelled. Why? Was it because he did not want to have to face the private conversations that would follow such statements as have been made by Geithner in the name of the President?

Watch Davos closely. And remember that the absence of statements is as revealing, if not more so, than the presence of them. Not one mention of trade openness appears in our reading of the 100 pages of answers to the Senate. Maybe someone else can find an affirmation of free and open trade. I cannot.

We fear protectionism. It starts with rhetoric. We now have that threat. If it is pursued, it ends badly for everyone. No one wins.

Geithner’s answers are sobering. We are now in the realm of fiscal policy and national policy. This is not in the realm of the central bank; the Federal Reserve is not the player here. The Fed is doing all it can to unfreeze the financial system and restore it to functionality. If permitted to complete its task, that policy will work. If stymied or corrupted by conflicting policy in trade or federal finance, the recession will worsen and the pain will become more severe.

We are maintaining our 50-50 allocation between bonds and stocks in balanced accounts. Our normal baseline is 70% stocks and 30% bonds. Thus we are 20 points below baseline in stocks and 20 points above in bonds. We were planning to raise the stock portion as the credit markets improved. That change is now on hold. We continue to favor tax-free municipal bonds and taxable high-grade instruments and continue to avoid Treasury notes.

We believe cash at near zero percent interest is not desirable. We find that the amount of cash on the uninvested sidelines now approaches nearly half the value of the security markets. It has no precedent at that size. It represents future purchases of securities when and if this mess finally starts to clear.

Bianco: The Dow Is Distorted

Comment – The Dow Jones Industrial Average (DJIA) is a price weighted index. The divisor for the DJIA is 7.964782. That means that every $1 a DJIA stock loses, the index loses 7.96 points, regardless of the company’s market capitalization.

Dow Jones, the keeper of the DJIA, has an unwritten rule that any DJIA stock that gets below $10 gets tossed out. As of last night’s close (January 20), The DJIA had the following stocks less than $10…

Citi (C) = $2.80

GM (GM) = $3.50

B of A (BAC) = $5.10

Alcoa (AA) = $8.35

If all four of these stocks went to zero on today’s open, the DJIA would lose only 157.3 points.

The financials in the DJIA are…

Citi (C) = $2.80

B of A (BAC) = $5.10

Amex (AXP) = 15.60

JP Morgan (JPM) = $18.09

If every financial stock in the DJIA went to zero on today’s open, it would only lose 331.25 points, less than it lost yesterday (332.13 points).

If you want to add GE into the financial sector, a debatable proposition, then:

GE (GE) = $12.93

If the four financial stocks above and GE opened at zero today, the DJIA would only lose 434.24 points.

The reason the DJIA is outperforming on the downside is the index committee is not doing it job and replacing sub-$10 stocks and the financials are so beaten up that they cannot push the index much lower.

So what is driving the index? The highest priced stocks:

IBM (IBM) = $81.98

Exxon (XOM) = $76.29

Chevron (CHV) = $68.31

P&G (PG) = $57.34

McDonalds (MCD) = $57.07

J&J (JNJ) = $56.75

3M (MMM) = $53.92

Wal-Mart (WMT) = $50.56

For instance if all the sub-$10 stocks listed above, all the financials listed above and GE opened at zero, the DJIA loses 528.63 points. To repeat if C, BAC, GM, AA, JPM, AXP and GE all open at zero, the DJIA loses 528.63 points.

If IBM opens at zero, it loses 652.95 points. So, the DJIA says that IBM has more influence on the index than all the financials, autos, GE and Alcoa combined.

The DJIA is not normal as the Index committee is not doing their job during this crisis, possibly because of the political fallout of kicking out a Citi or GM.  As a result, this index is now severely distorted as it has a tiny weighting in financials and autos.

We thank Jim Bianco for giving us permission to share his firm’s research with our readers.

Geithner and the NY Fed Code of Conduct

We will start with two quotes.

“It is indispensable to the proper functioning of, and the maintenance of public confidence in, the Federal Reserve Bank of New York ("Bank") and the Federal Reserve System ("System") that every employee perform his or her duties with honesty, integrity and impartiality, and without improper preferential treatment of any person. Each employee has a responsibility to the Bank and to the System to avoid conduct which places private gain above his or her duties to the Bank, which gives rise to an actual or apparent conflict of interest, or which might result in a question being raised regarding the independence of the employee’s judgment or the employee’s ability to perform the duties of his or her position satisfactorily. Each employee should conduct his or her financial affairs with integrity and honesty. To ensure the foregoing, each employee, including all Bank officers, shall respect and comply with the principles and standards of conduct contained in this Code. An employee who needs assistance in interpreting the provisions of the Code or who desires additional information should contact the Bank’s Ethics Officer.”

Source: Code of Conduct, Federal Reserve Bank of New York.

“There will be false starts and setbacks, frustrations and disappointments.  I will make some mistakes, and we will be called to show patience even as we act with fierce urgency.”

President-elect Obama, in Philadelphia, before he commenced his historic rail trip to Washington.

We thank our readers for the many emails regarding the nomination of Tim Geithner for Treasury Secretary.  His hearing is scheduled for January 21, one day after our newly elected President Obama officially takes office.  Remember that this is the new US Senate at work, too.  Many eyes around the world are watching to see how they handle this hearing, now that the facts around the Geithner tax scofflaw behavior have been disclosed.

Our email and conversations have revealed several things.  The email critical of Geithner and suggesting that his name should be withdrawn is consistent and in high volume.  He has no defenders.  Only two emailers responded that this is not a “big deal” and “what difference does it make,” since all the politicians are like that. 

Most emailers did not extend the error to Obama.  They noted that Obama’s staff people and vetting process were at fault for letting the nomination proceed, but they were not ready to extend Geithner’s apparent judgment error to the new President.  Obama enjoys the “honeymoon” status that most observers affirm.

One member of Congress I spoke with noted how appalling this Geithner revelation is and that “it is no wonder” the public holds “such a low opinion of politicians.”  Several political staffers said the same.  All of this was “off the record.”  After all, no one in Washington wants to publicly alienate the future Treasury Secretary in case Geithner gets confirmed.  

A former IMF employee noted how they were advised about these taxes repeatedly and in writing and that the IMF was very proactive in getting tax compliance from its staff.  They saw Geithner’s excuse as lame and they found his claim of innocence “inconceivable.”  The IMF has confirmed the story about the written documentation that they gave out.

Federal Reserve officials are silent on this matter, as they must be.  And the board of the New York Fed is silent as well, even as they conduct a search for Geithner’s replacement.  There are six names in play for the NY Fed presidency; they include prominent NY Fed senior officers.  The Fed’s Washington-based Board of Governors has its input into this replacement choice and is also publicly silent. 

The Geithner affair has become an embarrassment to the Federal Reserve.  We can expect the vetting process for new Fed presidents and governors to become more intense as a result.  In a way this is a good thing.  Obama will be appointing several more Fed governors and has the option to replace Bernanke as chairman within a year.  We will not see any more tax scofflaws holding Fed positions.

Several readers commented on the double standard that would prevail if Geithner is confirmed.  They recalled the facts around the “pulled” judicial appointments of Kimba Wood and Zoe Baird for the attorney general vacancies at that time.  In the case of Wood, she paid her taxes legally and on time and she violated no law.  She did employ a “nanny” who was an undocumented person (illegal alien status).  Perception alone was enough to end her consideration for the nation’s highest court.

The Geithner affair is now in the hands of the US Senate.  They have heard from the press (lots of critical editorials and letters to editors).  They are aware of the facts.  And they know that the world is seeking a new and trustworthy level of integrity and transparency in the post-Lehman, post-Madoff environment.  Senators know that the qualities of good character and sound judgment are needed by the Treasury Secretary.   Senators also know from the behaviors within their own ranks that the tests of character and judgment are most profound when they are determined by behavior that occurs when no one is watching.

The only open item is whether the Senate has heard from you.  Email is nice and easy but a phone call with a message to a Senator’s office carries a lot more weight.  Politicians know that emails are easily sent.  They have greater respect for constituents who pick up the phone.  The US Capitol switchboard number is (202) 224-3121.  If you do not know the name of your Senator, ask the operators; they will help you.  The same is true for your Congressman.  They can connect you to an office so that you may leave a message.

We close by remembering an interpretation of an ancient text. 

God was talking with Adam in the Garden of Eden.  He was describing all the trees that would be in the world since they were all there for Adam to see in that special garden.  The trees were the metaphor for all the decisions that men and women would be making in the future.  Adam asked God what he was going to do with the trees.  God replied, “I am going to give them to you.  What you do with them will be your decision.”

On January 21 a piece of a tree will gavel a Senate hearing to order.  Tim Geithner’s confirmation or rejection will be determined. And then newly inaugurated President Obama will see if his Philadelphia quote was prescient.

Readers who wish may find the full 15 page Code of Conduct of the NY Fed on the New York Fed website by searching under the words “code of conduct.”