At a Federal Reserve meeting I attended shortly after he took office, Chairman Bernanke remarked that the plural of anecdote was data.  In that spirit, a working paper last month by economists affiliated with the Federal Reserve Bank of Minneapolis sought to shed some empirical evidence on what they characterized as four myths about the current financial crisis.(1)  This paper was quickly followed by a working paper from the Federal Reserve Bank of Boston, which argued that, if one looked behind the data, the so-called myths weren’t myths at all.(2)  Such a difference of opinion and open debate between researchers at Federal Reserve banks is both unusual and interesting, and it is testimony to the difficult times in which we find ourselves.  Which of these works is more likely to be correct, and what did the authors do?  In what follows, I attempt both to summarize the findings of the two camps and, in the spirit of improving the quality of the debate, to provide a disinterested third-party view of the issues.

The Four Myths

The FRB Minneapolis economists, hereafter referred to as CCK, argued there were four myths about the current crisis, which were that:

  1. Lending to nonfinancial corporations and individuals has declined sharply
  2. Interbank lending is essentially nonexistent
  3. Commercial paper issuance by nonfinancial corporations has declined sharply and
  4. Banks play a large role in channeling funds from savers to borrowers.

They employed the most current, publicly available data from the Federal Reserve and Bloomberg and showed that there was little support in the aggregate data that bank lending in total had declined; and in fact lending to both businesses and consumers actually appeared to increase, especially during the crisis period.(3)  Similarly, the authors also found that, while volatile, interbank lending was substantially above what it was in mid-2005-2006.  (In fact, further examination shows that it was up by nearly $150 billion or 50% greater).  CCK also argue that the data also fail to support the idea that commercial paper issuance by nonfinancial corporations has declined or that this market has been closed to qualified issuers (such as some of those being accommodated under the Federal Reserve’s new facility); and this remains true even into November, where the data released subsequent to the study show that outstanding nonfinancial paper is above year-end 2007 levels and has not exhibited sharp declines.  Even in the case of financial commercial paper, monthly aggregate outstanding volumes exceeded year-end levels for both 2006 or 2007 until September and October.  And even here most of the drop in outstandings was to foreign financial issuers.  The picture for either nonfinancial or financial issuers can’t compare with the declines in asset-backed commercial paper issuance, most of which was related to mortgage-backed paper.  Finally, using data from the Federal Reserve’s Flow of Funds, CCK argue that nearly 80% of the sources of funding for businesses are outside the banking system, so concerns that bank troubles would destroy the ability of business to obtain funding were largely unfounded. 

CCK’s attention then turns to credit spreads, which have typically played an important role in discussions of the supposed freezing up of credit markets.  They argue that the focus on spreads may be appropriate in normal times, but in the current crisis, while spreads have widened, the level of rates remains low, as does the real cost of borrowing. 

What About the Myth-Busters Busters Case?

The Boston Fed authors, hereafter referred to as BF, attack the cases for the four myths.  First, while they concede that the aggregate data don’t show a decline in lending to consumers or nonfinancial businesses, but they argue that going behind the data to look at the detail shows a sharp weakening of credit conditions.  Here their evidence and its relevance isn’t clear at all.  For example, BF provide data on the decline of the issuance of asset-backed commercial paper.  Most of this commercial paper, however, was related to mortgages, which would be expected to decline, given what has happened in the mortgage market and was primarily issued by financial firms.  Thus, focusing on asset-backed paper is largely irrelevant to the issue of what has happened to lending to consumers and businesses.  BF then go on to argue, by presenting data on the volume of unused loan commitments and commitments relative to loans, that this somehow sheds light on lending conditions.  Unused commitments aren’t loans, they are simply commitments.  That the ratio of commitments to loans has declined could be due to substitution of bank loans for other sources of credit, hence the reason that loan volumes haven’t shrunk.  Or it might be simply due to a reduction in demand.  The data provided by BF don’t enable one to examine these hypotheses and, again, are largely irrelevant to the issues.  It is interesting, however, that recent reports from the National Federation of Independent Business suggest that shrinkage in loan demand may be part of the explanation and that, while credit conditions have become tighter, they are consistent with what one would see at the end of an expansion and haven’t risen to credit-crunch levels.

As for the second myth – that interbank lending has essentially dried up – the BF authors offer four arguments.  The first is that by looking at the interbank market CCK ignore lending to and by brokers and dealers which, they assert, without empirical support, is the same size as the interbank market and has declined.  Their second point is that anecdotal evidence suggests that a large portion of the interbank market has become of overnight maturity and isn’t working as usual.  But again, anecdotes aren’t data and no data are provided.  The third piece of evidence is data on the comparative cash holdings of large versus small banks.  Cash holdings of large banks have ballooned, whereas there is no discernable increase in the cash holdings of small banks.  BF interpret this to suggest that if interbank lending markets were functioning normally, then banks would not have to carry such large cash holdings because of the significant opportunity cost of holding cash.  Finally, the authors argue that because interbank demands for funds are highly inelastic, rates, spreads provide a better indication of the health of the market than do volume statistics.

Of the four pieces of evidence offered by BF, only with respect to cash holdings is there hard data, while the other evidence is either anecdotal or in the form of assertions without empirical support.  Interestingly, the data on cash holdings suggest that the so-called liquidity problem is really a large-bank problem, which is consistent with the difficulties experienced by the primary dealers.  In other words, the interbank market problems, to the extent they exist, result from large banks being unwilling to transact with each other, rather than a feature of the entire banking system.  Interestingly, virtually all of the Federal Reserve lending programs have been targeted to this problem and are directed toward the primary dealers.  These include the Primary Dealer Credit Facility, Transitional Credit Extensions, Securities Lending Program, Term Securities Lending Facility, and Term Securities Lending Facility Options Program.

BF’s discussion of the third myth – that commercial paper issuance by nonfinancial companies has dried up – again suggests the need to disaggregate the commercial paper issuance data by rating classes.  They assert that CCK’s conclusion rests primarily upon data on outstanding aggregate non financial paper and on rates for AA –90-day nonfinancial commercial paper.  However, BF argue that disaggregation by ratings shows that not only has the issuance of A2P2 paper declined but that rates for this lower-quality paper have increased.  As a result, they conclude that the third myth is false.  Data on issuance of A2P2 nonfinancial paper show it has clearly slacked off.  However, it is also the case that the monthly average volume, except for the partial data for November, of this lower quality paper for 2008 exceeded the annual average for 2006 (which predates the crisis period) and except for October and the partial month of November issuance also exceeded the annual average issuance for 2007.   Clearly, there was a decline in the ability of lower-quality issuers to tap the market, and it is also clear that spreads for this segment increased.  But most of this decline post dates the period when the claim was that the commercial paper market had frozen up for nonfinancial issuers.  Even for those issuers unable to place paper, it is still possible that they were able to take down other credit lines.  It is also the case that the level of rates to A2P2 borrowers declined and in absolute terms were below those that prevailed in early 2008 and throughout 2007.  In this respect, then, pinning a conclusion on spreads may not reflect the real cost of borrowing, a point of emphasis by CCK.

Finally, with respect to CCK’s evidence that banks play only about a 20% role in channeling funds from households to businesses, the only counterarguments advanced by BF are that (1) we don’t know if the relationship is stable and (2) data show that outstanding consumer credit in the month of August declined.  Neither of these are particularly persuasive, especially since we don’t know whether this decline represents a reduction in supply or a reduced quantity of outstanding credit because of reduced demand. 

Are the Myths Busted?

This short tour of the issues and evidence suggests several conclusions.  First, none of the evidence provided by BF appears to be fatally damaging to CCK’s case, as they would like to suggest, and in this sense the myths remain busted.  The aggregate data provided by CCK don’t support the dire descriptions of the financial disruptions that have characterized many of the statements of government officials and the press.  However, the analysis provided by CCK is also incomplete, since it should have considered evidence on both outstanding stocks and fund flows.  In addition, a complete understanding of why quantities might have increased or decreased requires a decomposition into demand as well as supply effects. (4)  

What we do know is there are clearly problems being experienced by large financial institutions – both banks and investment banks.  Many have reported losses, some for the very first time.  Second, those that relied upon short-term funding in the commercial paper market to support an originate-and-distribute business model have either failed or have been merged out of existence.  Third, many of these institutions were primary dealers and had been relied upon as a major channel as the Federal Reserve attempted to conduct ordinary monetary policy activities.  That conduit appears to have broken down and is need of restructuring and repair.  The special treatment these institutions have been afforded hasn’t worked.  Fourth, the FDIC maintains that the vast majority of banks are sound and well-capitalized.  They will be even more so as they avail themselves of the government subsidies inherent in the TARP preferred-capital injection program.  Finally, this is a debate and discussion that is worth continuing, so as to better understand the problem and to design appropriate remedies. 

(1)  See “Facts and Myths about the Financial Crisis of 2008,” by Chari, Christiano and Kehoe, WP 666, Federal Reserve Bank of Minneapolis, October 2008.

(2)  “Looking Behind the Aggregates: A Reply to ‘Facts and Myths about the Financial Crisis of 2008,’” by Cohen-Cole, Duygan-Bump, Fillat and Montoriol-Garriga, Federal Reserve Bank of Boston Working Paper No. QAU08-5. November 3, 2008.

(3)  Subsequent extensive documentation of the data sources were released in “Technical Notes on Facts and Myths about the Financial Crisis of 2008,” by Maxim Troshkin,  WP 667, Federal Reserve Bank of Minneapolis, October 2008.

(4) To their credit BF do recognize the need to consider both supply and demand effects.

A Program With an Exit Strategy

On October 27th the Federal Reserve began purchasing commercial paper through a special purpose vehicle (SPV) directly from registered insurers under its new Commercial Paper Funding Facility (CPFF). It did so pursuant to Section 13(3) of the Federal Reserve Act in order to provide additional liquidity to that market. The program is limited in the sense that it provides funding for dollar-denominated 3-month paper through the primary dealers to high-quality US issuers, which does, however, include US domestic entities with a foreign parent.

The evidence is that the program is having the desired effect. The daily discount rate on unsecured commercial paper declined steadily from a high of 1.89% on October 28th to 1.54% as of Nov. 7th, a drop of 35 basis points. A similar decline occurred for asset-backed paper, whose discount rate fell from a high of 3.89% on October 28th to 3.54% on Nov. 7th.

Combined outstanding volumes of unsecured and asset-backed paper also declined slightly from an average of $99.9 billion the first week to an average of $91.7 billion (on the last day of the reporting period, outstanding volume was down to $85.1 billion).

The interesting aspect of the program, however, is the fact that it also incorporated a rate structure that was clearly intended to self-obsolete the facility should commercial paper rate spreads decline to more “normal” levels. Fees and rates for the facility were set as follows. Unsecured paper was priced at 100 basis points over the 3-month overnight index swap rate, with an additional up-front 100-basis-point annual fee on each sale to the SPV. Asset-backed paper was priced at 300 basis points over the 3-month overnight index swap rate, but with no surcharge.

A chart (no longer available from original site) prepared by the staff of the Federal Reserve Bank of Atlanta provides some interesting history of actual commercial paper rates on AA-rated asset-backed commercial paper, as well as financial and nonfinancial commercial paper rates, compared with what the CPFF rates would have been had the facility been in place since January 2008. The chart prompts three interesting observations. First, it shows that up until October there were virtually no instances where the CPFF rates would have been competitive with the rates actually prevailing in the market, suggesting that it would be uneconomic for any issuer to sell paper directly to the Fed. Second, during October, when commercial paper rates spiked, the facility would have been very attractive to issuers of asset-backed and financial 3-month paper and marginally attractive to issuers of nonfinancial paper. Finally, once the facility was in place, market rates declined significantly and by November participation in the program remained primarily attractive to financial issuers and became marginally attractive to nonfinancial issuers.

The bottom line is that this program appears to have been soundly constructed and relies upon penalty rates as a disincentive for continued issuer reliance on the program. The subsidies to participants in the program appear to be relatively modest, likely to be short-lived and self-eliminating as markets calm. This is exactly the way that such programs should be designed.

Tinker to Evers to Chance

These are the saddest of possible words:

Tinker to Evers to Chance.

Trio of bear cubs, and fleeter than birds,

Tinker and Evers and Chance.

Ruthlessly pricking our gonfalon bubble,

Making a Giant hit into a double —

Words that are heavy with nothing but trouble:
"Tinker to Evers to Chance."

A 1910 baseball poem entitled “Baseball’s Sad Lexicon,” by Franklin Pierce Adams

Was October 10 the bear market low?  Can baseball guide us in deciding how to proceed?

As this is written the Dow Jones 30 stock average is around the 9200 level.  Its October 10 intraday low was about 7900.  The Standard & Poor’s 500 Index is about 955.  Its October 10 intraday low was around 840.  Volatile trading has retested these lows several times since October 10.  So far the lows have held, but it is too soon to be complacent about them.  Note that the S&P and Dow tend to peak and trough together (not always but often).  The NASDAQ tends to lag a few months behind them (not always but often).

History shows that stocks tend to follow bonds when coming out of a bear market.  At the end of the 1966-1982 period the bond rally preceded the stock market rally by about 9 months.  History also shows that bonds tend to follow short-term credit spreads when coming out of their (bond) bear markets.  And credit spreads tend to reach their widest at the height of a credit crunch and at the point when the central banks launch their most intense countermeasures. 

Like the famous Chicago Cubs’ infield team.  There is a sequence and it is usually followed: credit crunch easing to spreads narrowing to bonds rallying to stocks rising.

Baseball Note: shortstop Joe Tinker, second baseman Johnny Evers, and first baseman Frank Chance were a feared double-play team.  They helped the Cubs win the World Series in 1907 and 1908.  The catchy and popular phrase a century ago was “Tinker to Evers to Chance.”  Oh how Tampa would have loved to have such a force in its infield.

The peak moment of the credit crunch can be marked with the failure of Lehman.  That triggered worldwide contagion, the staggering bear market collapse of global stocks, the extraordinary freezing of finance, and the flight to cash which ultimately drove the 90-day Treasury bill to a zero yield.  Lehman and its five-week aftermath will be the subject of textbooks and histories for the next generation of writers and academics.

Lehman triggered the widening of credit spreads and caused markets to seize.  Central banks and governments have reacted and continue to intervene massively.  Credit spreads are narrowing from their exceptional widening.  Bonds are starting to rally; bond yields are falling and bond prices are rising.  And global stock markets have risen.

All this happened with the speed of a highly skilled infield making a double play.  In this case the metaphorical batter that hit into the double play appears to be the global bear.

So the reader asks: “Did we see the bottom on October 10?”

The Tinker-Evers-Chance sequence outlined above seems underway.  For October 10 to be the bottom it is necessary for the sequence to continue.  We believe that it will but to raise confidence we need to witness the proof of more credit spreads tightening and bonds rallying. So the best answer we can give today is, it’s likely October 10 was a bottom but it is also too soon to say decisively yes.  We will position accounts as if it is the bottom and we will be vigilant and reverse those positions if we see a reason to do so.

The Ned Davis database offers some help.  They measure 42 global stock markets; all made new lows in recent days before their rallies.  All declines qualify as “bear” markets.  11 of their 12 bottoming indicators have reached extremes that suggest October 10 was the bottom.  Retests of those lows have been on declining volume; that is a good sign.  Breadth indicators suggest it was a bottom.  There are many more pieces of evidence in favor of the October 10 bottom conclusion.  I will stop listing here.

If it is the bottom, two other issues become important.  Wide credit spreads and a bottom suggest that small caps will be outperforming.  Valuation suggests that emerging markets will be outperforming.  Both groups have suffered during the post-Lehman slaughter.  We agree with this Ned Davis analysis.

At Cumberland we have taken most accounts to the fully invested position.  We have also been lengthening bond maturity as we imbed equity-like returns on investment-grade bonds.  We are taking similar action in the tax-free municipal bond market.  Bonds are rallying and have a lot of room for capital gain in addition to paying handsome rates of interest.  Our balanced accounts are divided about 50-50 between bonds and stocks.  We have taken cash to minimum levels.

Dammit! This is NOT the Great Depression

Bear markets fall into three categories: (A) the most common is the cyclical bear; they average about 20% to 25% down from peak to trough.  (B) Occasionally we experience a secular bear; they typically decline about 45% to 50% from peak to trough.  (C) Lastly and most rare is the devastating bear; these declines are 75% to 90% calamities like the Japanese collapse in the 1990s or the current selloff in Chinese "A" shares.  America’s most devastating bear was in the Great Depression era.  Stocks lost 90% of market value from peak to trough in 1929-1933.

This current 2007-2008 bear market is in the middle category; it is a secular, "45% bear."  Evidence suggests that it is nearly over.  The Dow peaked at 14165 on October 9, 2007 and the S&P peaked at 1565 on the same day.  At the moment it looks like the US stock market probably bottomed one year later on October 10, 2008 at 7883 intraday on the Dow Jones Industrial Average and 839.80 intraday on the S&P 500.  Both indexes’ peak-to-trough declines are about 45%.

The post-World War II history of bear market bottoms suggests that these bottoming levels will be retested and may be temporarily breached.  That is not unusual at the end of a secular bear market.  Sometimes the test sets a new low but it usually does not last very long.  Sometimes secular bears end in a sharply defined climax.  Other times they just peter out.  The 45% decline in the 1973-4 bear is a good example of a final December low being set without a climax.

Cyclical bears happen during protracted economic growth cycles.  They tend to complete their time quickly, then the primary growth trend resumes.  Cyclical bears are much too mild a reaction when there is a full-blown recession as we have today. 

Secular bears occur when there is some major economic inflection point in the longer-term trend; they often have easily identified speculative features.  If you use the S&P 500 index to measure it, the current secular bear market arguably peaked in 2000 with the tech stock bubble.  If you use the Dow, the demise of the financial sector marks a second bubble bursting within this secular bear market timeframe.  The run-up of oil to $147 a barrel and its subsequent collapse is another feature of the present secular bear.  And lastly, there is the widely spread impact of the housing market collapse.

Devastating bears are extended versions of secular bears.  Americans need to examine the Great Depression era to see our last one.  A devastating bear requires a government policy failure to occur.  Devastating bears happen when there is an absence of credible governmental attempts to counter them with stimulus.  The sequence is that first the government policy fails and then the secular bear morphs into a devastating bear. 

In a devastating bear, the government acts with too little and does it too late to stop the carnage.  We are seeing that now in China with the "A" shares.  Only after a 65% decline has the Chinese government started to seriously intervene.  We saw it in Japan.  We may be seeing it in Russia if Putin’s policies continue to dismember his fledgling market system. 

We saw it in the US in the Great Depression era when the Federal Reserve remained tight in the face of deflation.  It was the Fed tightness in 1928-1929 that triggered the stock market crash.  Stocks had become the speculative sector.  The Fed continued to drain liquidity in 1930, and that triggered bank failures.  In those days there was no federal deposit insurance.  Banks failed and people lost their money. 

A seminal event usually marks the end of a secular bear and/or the start of a devastating bear.  In the Great Depression era the event was the failure of the Bank of the United States.  On December 11, 1930, the NY banking superintendent closed this bank and left 500,000 depositors stranded.  Prior to that date, bank failures in the US were mostly limited to smaller rural institutions.  The Bank of the US failure resulted from the inability of the banking regulators to achieve a merger with two other NY banks. 

The secular bear of 1929-1930 became a devastating bear in 1931.  Then the federal government and a young Federal Reserve failed to be the lender of last resort. The aftermath of the Bank of the US failure exacerbated the 1929-1930 US recession into the 1931-1933 Great Depression.  That failure also triggered the financial and economic turmoil spreading into a global contagion. 

The rest of the Great Depression-era history is well known.  Federal stimulus wasn’t applied until 1933.  Depression-era money and credit contracted and collapsed.  There was 25% shrinkage.  One out of four American workers was unemployed.  Deflation ruined the economy.  Elsewhere in the world, economic and financial turmoil led to political regime changes.  In Europe the Nazi party achieved power in Germany in 1933.

The failure of Lehman Brothers is the modern-day equivalent of the Depression-era failure of the Bank of the United States.  In 2008, the Lehman failure induced global contagion.  What is different now is that the government’s policy reaction has been precisely the opposite of that during the Depression period. 

The Federal Reserve’s cash infusion is massive and clearly contrasts with the Depression era.  Liquidity is created and not withdrawn.  With the start of the commercial paper facility, the Fed’s balance sheet will have tripled its size in only a few weeks time.  In the Depression era it contracted. 

The fiscal stimulus coming from the federal government is also huge.  We expect the cash deficit of the US to exceed a trillion dollars a year for the next two years and then only slowly decline.  Other central banks and governments around the world are responding in a similar way. 

The turmoil of 2007-2008 and the present recession will not become another Great Depression.  The characteristics of global governments’ responses after Lehman are enough evidence to reach that conclusion.

We can forecast markets now that the unwinding of Lehman Brothers’ failure and its aftermath is coming to an end.  For stocks the post-secular bear market recoveries have been very robust.  They can double from the low and achieve 50% of that move in the first year of the new bull market.

This autumn, stocks were hammered along with bonds as the hedge fund unwinding trade took place during the weeks after Lehman’s failure.  Hedge funds were long stocks and bonds and hedged with credit default swaps and other derivatives.  Lehman’s failure introduced a counterparty risk premium, and that "blew up" the hedges.  The vicious sell-off ensued. 

We believe it is nearly over.  Friday morning’s limit down in futures is an indicator of climax activity at work.  We saw similar stock futures trading activity at the 1987 stock market bottom.  The actual trading after limit down was not a continuation of the plunge.  It appears that the rate of change in the sell-off has turned from its extreme.  It may still be negative, but it is less negative than at the stock market bottom.

Credit spreads are finally narrowing from their extreme and unprecedented peaks.  There are many measures of this financial market stress and all of them are narrowing.  Some more than others, but all have ceased widening. 

In the United States we are witnessing the largest fiscal stimulus combined with the largest monetary stimulus since the World War II era.  In WWII the US maintained interest rates at 3/8 of 1% on short-term T bills, and the deficit ran above 10% of GDP.  The government’s debt-to-GDP ratio exceeded 100% at the end of the war.  Current government policy will take the deficit over $1 trillion, and US Treasury bill interest rates have already seen their lows at levels similar to WWII.  When this turmoil has run its course, the federal debt-to-GDP ratio will again exceed 100%.

This entire government stimulus will work positively on the nominal prices of stocks and on unfreezing the credit structure.  Furthermore, the housing market will be a direct recipient of this stimulus and is now likely to bottom in 2009.  The extent of housing deterioration has already reached extreme levels not seen in the last half century. 

We think it is time to get focused on the recovery period.  It is time to move from cash to stocks and bonds.  Not Treasury bonds but other bonds.  High-grade tax-free municipal bonds were yielding 6 ½% in many jurisdictions.  That sector has started to thaw and the prices of bonds have gapped higher (yields lower).  We are buying them for our clients as we watch yields drop from the "6-handle" to the "5-handle".  We are selecting structure so that we can achieve potential capital gains in addition to the coupon.  We expect to see this market rally to a "4-handle."  Detailed inquiry into the composition of each bond is now more critical than ever.  

Stocks are now so cheap as to compare with levels seen at the 1987 and 1974 bottoms.  The S&P 500 is now 10 times its trailing 2007 earnings and the lowest price-to-book in decades.  The Treasury bond yield / S&P 500 dividend ratio is the lowest since 1979.  Sentiment measures and volatility indicators are at extremes rarely seen. 

All these measures say it is time to own stocks for longer-term investors.  And other measures suggest that the demand for stocks will be huge once the malaise gives way to a better outlook.  The ratio of uninvested and potential cash to the aggregate value of the stock market is estimated to be above 40%.  That is the highest percentage of uninvested cash in history.

At Cumberland, positions in US Treasury bonds have been sold with the exception of TIPS.  TIPS are trading at nearly a 3% real yield, and that is a good entry point. 

In sum, the eye of the hurricane has passed.  We still have high volatility and high risk and a recession in progress.  We are now focused on the economics of the aftershocks as the hurricane center moves away.  The maximum storm surge was felt in the aftermath of the failure of Lehman.  Now the water has receded and we are assessing the damage.  Like Katrina, this too shall pass.  And the rebuilding will add to GDP and enhance tangible and financial assets.

Longer-term targets are now estimable.  We believe a multi-year economic recovery will commence by yearend 2009.  The US GDP will be about $17 to $18 trillion in five years.  The stock market at that time will likely equal or exceed the GDP in aggregate value and reflect earnings commensurate with that change.  We expect the S&P 500 to achieve a level between 1700 and 2000 at some point in the next five years.

It is time to buy the dips and get positioned if you haven’t already done so.  We have been scaling into stocks and bonds and have picked up the pace in the aftermath of Lehman’s failure.  Cumberland’s stock accounts are nearly fully invested using exchange-traded funds.  Our bond accounts in taxable and tax-free bonds are positioning to imbed these extraordinary high yields.  Cash reserves are being reduced to minimum levels.

This period is NOT going to be a repeat of the Great Depression!

The Muni Hedge

The rapid deterioration of the municipal bond market in the past month has its roots in the sell-off of all markets in the aftermath of the Lehman Brothers collapse.  From an already cheap level versus US Treasuries, the Bond Buyer 40 (a long-maturity index of investment-grade tax-free bonds) soared to yields much higher than 6%, versus long-maturity US Treasuries at 4.25% or less.  This is unprecedented.  Recently, several forces have pushed muni yields higher:

  • The selling of all asset classes by individuals stocks, bonds, equity mutual funds, municipal bond funds, etc. – following the Lehman bankruptcy.  Municipal bond funds are included here and have been selling to meet a high level of redemptions.  This has sent longer municipal bond yields from 5% to 5.5%.
  • Aggravated selling by municipal bond hedge funds.  These funds make money on the difference between short-term municipal bond rates and longer-maturity bond rates.  With short-term rates heading higher (selling in money market funds) and the high degree of leverage (25:1 to 40:1 or higher), this liquidation has been much more damaging than that of individuals and has sent municipal bond yields even higher – from 5.5% to well over 6%.
  • There is much less liquidity in the markets than even last year.  Bear Stearns: gone.  Lehman Brothers: gone.  Merrill: to be merged into Bank of America.  UBS: cut public finance.  Retail desks have been busy but can’t keep up with the deluge of supply from the hedge fund selling.  This has caused yields to spike up dramatically.

Cumberland is looking to take advantage of this anomaly by starting a program which emphasizes long high-quality tax-free bonds in combination with two ETFs (exchange-traded funds) that provide two times the inverse performance of long-term Treasuries.  We are doing this on both the ten-year range (cheap) and the longer-term munis (really cheap).  The idea is that 2/3 munis, 1/3 inverse Treasury ETFs should provide very positive returns when the tax-free bond market returns to a more normal relationship with US Treasuries – that is, with tax-free bonds yielding LESS than US Treasuries.  Clearly there are times when this relationship moves adversely –  the last two months have been a perfect example, as investors have sought the safety of Treasuries at very low yields (in the case of short-term T-bills, effectively zero).  As the credit markets slowly unfreeze – given the level of interaction on the parts of the Federal Reserve and the US Treasury – we should see tax-free yields move down and Treasury yields move higher.  This would be an environment where this muni/Treasury strategy will provide ample total return.

Investing in a Global Bear Market

By the end of the third quarter of 2008, equity markets around the globe had registered declines well in excess of 20%, the magnitude commonly considered to indicate a “bear market.” The convergence in market performance is striking. Over the first three quarters of this year, global markets as measured by the MSCI World Index declined by 25.5% (total return basis). Over the same period, the MSCI EAFE Index, widely used as the benchmark for the advanced markets, ex-North America, lost 28.9%. And the MSCI EEM Index for Emerging markets dropped 35.4. Few are talking about a “decoupling” of emerging markets from the advanced economies. In the following 20 days as credit markets seized up and the reality of a global recession set in, investors fled to safety and equity markets swooned another 10-12% or more.

This global bear market has resulted from several negative factors coming together and interacting. To summarize these very briefly, one factor was the dramatic rise in the price of oil and surging prices for other commodities, particularly for agriculture, earlier in the year. These had substantial negative effects on consumer attitudes and the business climate and contributed to rising inflation and inflation expectations. Central banks became concerned; and a number of them, the U.S. being an exception, adopted tighter monetary policies despite indications that economic momentum was declining. The direct impact of these higher prices was the greatest in emerging markets, where energy and food constitute a large proportion of the budgets of most citizens. Of course, the high energy and commodity prices were a boon to those countries that are net exporters of these products, such as Brazil, Russia, Australia, Canada, Norway, and the Middle East oil exporters. This factor has now reversed, as is discussed below.

The more serious developments occurred in the financial markets. A collapse of the US housing market led to the sub-prime mortgage market crisis, which later morphed into much broader problems for financial institutions. As reported losses mounted, confidence affecting counterparty funding relationships dropped sharply. When several of the largest financial institutions were forced to close or be bought, culminating with the bankruptcy of Lehman Brothers, credit markets around the globe became essentially frozen. . Financial institutions in Europe were affected directly through their relationships with the US. and their requirements for dollar funding.

With the worst financial crisis since the Depression at hand and economies veering into a recession of unknown depth and duration, it became unavoidable that monetary and financial policy officials come to the rescue. The cavalry finally did arrive with an impressive array of policy measures. On October 10th the Finance Ministers and Central Bank Governors of the G-7 countries met in Washington, D.C., and released a statement outlining an “urgent and exceptional” plan for coordinated action to support liquidity, bank recapitalization, deposit guarantees and re-starting the credit markets. Together with the internationally coordinated policy interest rate cuts earlier in that week, the plan demonstrated a remarkable degree of common assessment of the problem and of commitment to take effective and internationally coherent action.

Major moves to provide additional liquidity to the global financial system have been taken. The most pressing problem, however, was not a shortage of liquidity in the global system. Rather, it was the fact that many of the leading financial institutions had experienced steep declines in value of significant portions of the assets on their balance sheets. Recapitalization of the financial systems in the US and Europe was needed to re-establish the confidence necessary for banks to resume lending to firms, households and each other. Massive government steps to fill this need have since been announced.

Other important parts of the G-7 rescue plan involve greatly expanded government guarantees for bank deposits and other liabilities, including importantly, inter-bank loans. This major step was expected to help unfreeze the crucial inter-bank lending markets. The Federal Reserve is also back-stopping the commercial paper market. In effect, governments are inserting themselves as the counter-party in a broad range of financial transactions, which should offset the great concerns about counter-party risk that have shut down credit markets.

It appears that these efforts are beginning to have the desired effects on financial markets but the process of restoring confidence is likely to be slow. With counterparty risks and credit availability becoming less of a concern, equity investors are turning their attention to the state of the economy; and they are not happy with what they see. While economies in the first half of the year, particularly the U.S. economy, proved to be surprisingly resilient in the face of gathering economic head winds, economic growth appears to have slowed markedly in the second half. Indeed, most advanced economies may register declines in the current quarter. Growth in emerging markets has also slowed, although it remains considerably faster than in the advanced economies. Reported earnings have fallen substantially below earlier expectations and earnings forecasts are being revised downward.

Looking forward, we believe prospects may be somewhat brighter than is currently priced into the markets. Oil prices are currently more than 50% below their highs earlier in the year, which is equivalent to a substantial reduction in taxes. The drop in the prices of other commodities has a similar effect. The actions to rescue the financial system have involved major additions to global liquidity. And further economic stimulus actions seem increasingly likely in the U.S., China, Japan and some other economies. We, therefore, question projections of a severe and sustained recession in the U.S. More likely, in our view, is a relatively mild recession, with a gradual recovery beginning by late spring of 2009. A similar pattern is expected for the Euro-zone, with an even more gradual recovery. A sharper recession is underway in the U.K. The Japanese economy is one of the few economies projected to register stronger growth next year than in the current year. Another is Canada.

With the equity markets in a highly volatile mode as this is written, it is particularly difficult to judge whether a bottom has now been reached. But looking at all the indicators that in the past have signaled bear market bottoms, the case for a bottom having been reached, or being very near, is strong. For example, we have been seeing the kind of panic selling in which fear feeds on itself. Valuations have become very attractive. At Cumberland Advisors we have begun to invest the cash we had built up in our equity accounts. Going forward, we expect the U.S. market to outperform those in Europe where the economies are less flexible and interest rates have been held too high for too long. Among the advanced economies we also favor Japan and Canada.

The emerging markets as a group are expected to return to outperforming the markets of the advanced economies. While they have been affected by the slowdown in the advanced economies, domestic demand – both consumption and infrastructure – and trade between emerging market economies have become important drivers of growth. Relatively low sovereign debt burdens and improved government fiscal burdens are other significant positives for many of these economies. Equity markets in Asia ex-Japan (China, Hong Kong, Singapore, Malaysia, and Taiwan, in particular) are expected to be stronger than those in Latin America. The Chinese economy is slowing from 10-11% growth rates to perhaps 8-9% rates, which would still be well ahead of other economies and remain an important factor for the region. The situation of Central and Eastern Europe economies is less bright, with external financial strains becoming severe. Russia, despite the inherent strength of its natural resource-based economy, has lost the confidence of international investors in its markets and currency. The South African market also is likely to experience a bumpy road ahead until its new government gets inflation under better control. On the other hand, the Israel market is expected to continue to outperform.

All this being said, the global out look is particularly uncertain and downside risks going forward remain significant. A well-diversified, multi-asset class investment strategy should show its value in such markets. Diversification across equity markets, sectors, industries, and countries is likely to reduce the overall risk in a portfolio. Adding other asset classes that are not closely correlated with equities, such as commodities, currencies, fixed income, and real estate, can significantly add to the diversification of a portfolio, and the benefits that come from diversification. (Correlation is a statistical term that defines the strength of a linear relationship between two markets.) This approach has been followed by major institutional investors, particularly university endowment funds and pension funds. At Cumberland Advisors, we have found that the arrival of an ever-growing number of Exchange –Traded Funds (ETFs) covering all of these asset classes provides an efficient, low-cost way to create such a portfolio. It is the goal of this portfolio style to take advantage of low or negative correlations between asset classes, represented by the ETFs. This way, when some markets are down, others should be steady or up, if they conform to historical patterns of behavior.

An Offer They Couldn’t Refuse

As the first step in promoting the government’s new voluntary bank capital injection plan, Secretary Paulson summoned the CEOs of the nation’s largest banks to Washington and “made them an offer they couldn’t refuse.”  He told them that as part of the government’s “voluntary” capital program, he was going to “invest” $125 billion of the government’s money in preferred stock that they would issue.  In return for this capital injection, these institutions would also grant the government warrants, and executives would at least nominally subject themselves to limits on executive compensation.  It was also “suggested” that they deploy the capital to make new loans, even though many would improve their financial position measurably by redeeming other higher-cost debt, including preferred stock previously issued.  Finally, although the preferred stock was to be nonvoting, as would any common equity that the government might acquire through warrants, the “terms of the injection and suggestions” sure had the smell of exercising a controlling influence.

In a TV interview Secretary Paulson insisted that all these institutions were “healthy” and the intent in including all of them in the program was to avoid any possibility that if only some participated they would be stigmatized by the suggestion that they might be less sound than those that didn’t participate.  Furthermore, it was argued that it would encourage other smaller institutions to participate as well.

This program is curious indeed.  If the institutions were “healthy,” then by definition they didn’t need additional capital and presumably were in position to continue normal business operations.  The government’s intervention in those institutions amounts to confiscation of shareholder wealth, and the prospects are that even more wealth would disappear if warrants were exercised.  Why other “healthy” institutions would conclude, on the basis of the forced participation of the nation’s largest banks, that they too should sign up is curious logic.  If, on the other hand, some banks were healthy and others were in a more precarious position, then forcing capital on those that didn’t need it as well as those that did is not only inefficient but also would perpetuate the information problem that has already clogged the interbank market.  Banks are refusing to lend to each other because they aren’t certain about the health and quality of their counterparties.  Relying on government implicit guarantees and capital to paper over asset quality problems is but another way to provide forbearance to unhealthy institutions and does little to remedy the underlying problems of unrecognized losses and excessive leverage.  It would be much better to have required any recipient of government support to first write down all pending and likely losses against common equity before government capital was provided.  Furthermore, that capital support should have been made temporary, with a mandatory expiration date.  As it stands, the capital participation is permanent, with the only economic incentive to pay it down provided by an increase in the mandatory dividend after three years from 5% (which is currently much less than market) to 9%, which is less than the initial rate that Warren Buffett got for injecting funds into Goldman Sachs, supposedly one of the most healthy and best-run banks in the country. 

Sheila Bair, Chairman of the FDIC, repeatedly states that the majority of banks in the US are sound.  This is undoubtedly true, even though it is likely that more banks should be on the FDIC’s watch list.  These institutions – contrary to the picture Secretary Paulson paints, of a credit crunch in which all banks are participating – are still lending to qualified borrowers and small businesses on Main Street.  The most recent survey by the National Federation of Independent Businesses, which covers approximately 85 percent of the nation’s businesses and half of GDP, fails to confirm the existence of a credit crunch.  To be sure, credit standards are tightening, consistent with what one traditionally sees at the end of an expansion; but it is far from the kind of seizing up that Secretary Paulson claims.  The credit crunch is mainly a Wall Street problem, and virtually all the programs put in place by Treasury and the Federal Reserve have been directed towards that problem.  Perhaps it is time to cut bait and force those institutions to recognize losses, deleverage, and raise capital in the market place.  Those that can’t – and we’ve already seen the market cull out the Bear Stearns, Lehman Brothers, Wamu and the like – should suffer the same fate so we can get on with real business. 

Shhh! Don’t tell anybody about the 4.2 basis points

On July 30, 2008, the President signed into law the Housing and Economic Recovery Act of 2008 (“The Act”). The Act is segmented into three smaller acts, two of which have been highly publicized by the press; these are the Federal Housing Finance Regulatory Reform Act of 2008 and the Foreclosure Prevention Act of 2008.

To summarize, the following provisions have received a lot of press attention:

1.      Establishment of the Federal Housing Finance Agency to replace the Office of Housing Enterprise Oversight (OFHEO) and the Federal Housing Finance Board (FHFB), expanding government oversight over the GSEs.

2.      An increase in conforming loan limits (loans eligible for purchase by Fannie Mae and Freddie Mac) in areas where median home prices are greater than pre-existing conforming loan limits. This will give lenders more capital by allowing them to sell illiquid, jumbo loans to Fannie Mae and Freddie Mac, who in turn will resell them into the secondary market – creating a liquid secondary market for jumbo mortgages.

3.      Establishment of the GSE Credit Facility (GSECF), whereby the Treasury will extend short-term loans to the GSEs at L+50 in exchange for MBS collateral.

4.      Establishment of HOPE for Homeowners, a program that allows borrowers to refinance out of high-LTV, predatory loans into lower-principal, FHA-insured, 30-year fixed-rate mortgages.

This commentary will discuss legislation in the Housing and Economic Recovery Act not related to the current economic state of affairs. Specifically, the legislation does not cleanly seek to restore the housing market but contains extraneous provisions that result from having a Democrat-controlled Senate and House of Representatives. The most egregious of these is the 4.2 basis points tax on Fannie Mae and Freddie Mac that will be allocated to a new “Affordable Housing Trust Fund.”

Section 1338 of the Housing and Economic Recovery Act establishes an “Affordable Housing Trust Fund” to construct affordable rental housing for “extremely” low-income households. Specifically, the bill language states the purpose as follows:

A.      To increase and preserve the supply of rental housing for extremely low and very low-income families, including homeless families.

B.      To increase homeownership for extremely low and very low-income families.

Allocation of Moneys into the Fund

The Act establishes a formula to determine the amounts to be allocated to the fund. The formula changes on a yearly basis until FY2012 and remains constant each year thereafter.

Starting in 2009, Freddie Mac and Fannie Mae will be required to set aside 4.2 basis points of each dollar of new loans purchased during each fiscal year. Twenty-five percent will be transferred to the Treasury to offset lower tax payments as a result of the GSEs’ lower taxable income.

In FY09, the remaining 75% of moneys will be allocated to the aforementioned FHA insurance program, HOPE for Homeowners.

In FY10, 50% of the remaining moneys (after Treasury’s 25% tax reimbursement) will be applied to HOPE for Homeowners, while 32.5% of the balance will be applied to the Housing Trust Fund and 17.5% will be applied to the Magnet Capital Fund. The Magnet Capital Fund will provide capital on a contracting basis to private enterprise to help “develop, preserve and rehabilitate” low-income housing.

In FY11, 25% of the remaining moneys will be allocated toward HOPE for Homeowners. Of the remaining 75%, 48.75% will be allocated to the Housing Trust Fund and 26.25% will be allocated to the Magnet Capital Fund.

In FY12 and beyond, 100% of all moneys received will be allocated to the Housing Trust Fund and Magnet Capital Fund, 65% and 35% to each, respectively.

The amount to be allocated to the Housing Trust Fund, assuming no diversions to the HOPE Program Fund in 2007, would have been $557 million, based on $1.32 trillion of new mortgages acquired by Fannie Mae and Freddie Mac. 

Where’s the Money Going?

Moneys deposited into the funds are to be allocated to states to construct rental housing, based on a formula to be determined by the secretary of the Department of Housing and Urban Development, within 12 months of passage of the Act. The act gives the general formula for each state as follows:

      The summation of the ratios listed below x (average construction costs for the state / average national construction costs)


1.      Shortage of standard rental units affordable and available to extremely low-income renter households in a state divided by the shortage of standard rental units affordable and available to extremely low-income renter households in the United States.

2.      Shortage of standard rental units affordable and available to very low-income renter households in a state divided by the shortage of standard rental units affordable and available to very low-income renter households in the United States.

3.      The ratio of extremely low-income renter households in the state living with either (I) incomplete kitchen or plumbing facilities, (II) more than 1 person per room, (III) paying more than 50% of income for housing costs, to the aggregate number of extremely low-income renter housings living with either, (I), (II), or (III) in the United States.

4.      The ratio of very low-income renter households in the state living with either (I) incomplete kitchen or plumbing facilities, (II) more than 1 person per room, or (III) paying more than 50% of income for housing costs, to the aggregate number of very  low-income renter housings living with either, (I), (II), or (III) in the United States.

*Note, priority is to be given to #1 in this list of ratios.

Whether or not the US needs another affordable housing program of this magnitude is a matter of debate.  Consider the following:

1.      The legislation was first proposed on October 10, 2007, in a macroeconomic environment much different from that of July 30, 2008 when it was passed.

a.      For starters, Fannie and Freddie’s combined market capitalization was $106 billion at that point in time. It was $20 billion on the date of the bill’s passage. It is currently $2.1 billion.

b.      The fund seeks to extract $9 billion from Fannie and Freddie over a ten-year period. This comes after a $2 billion preferred stock sale to the federal government, with options to purchase up to 79.9% of outstanding common shares – effective nationalization of the two companies.

c.      The 4.2 basis point tax on new business purchases undermines the intent of the original legislation by increasing borrowing costs. Both companies are insolvent and will be forced to pass on the tax to lenders in the form of higher guaranty fees on mortgages, which in turn will be passed on to borrowers seeking to buy homes.

All things considered, the legislation contains much-needed provisions that seek to strengthen oversight of the GSEs, such as giving the director of the FHFA the ability to set capital requirements and restrict portfolio asset growth. It also attempts to put an end to processes in the mortgage origination process that started the sub-prime mortgage crisis.

Unfortunately, the legislation contains costly programs unrelated to issues at hand as well, such as the National Affordable Housing Trust Fund.

Guardians of Global Financial Stability

Last weekend, as global markets experienced the worst financial crisis since the Depression and economies veer into a recession of unknown depth and duration, Finance Ministers and Central Bank Governors gathered in Washington, D.C., for the Annual Meetings of the IMF and World Bank, and the related, and on this occasion, more critical meetings of the G-7 and G-20 groupings(1). On Friday the G-7 met and released a statement outlining an “urgent and exceptional” plan for coordinated action to support liquidity, bank recapitalization, deposit guarantees and re-starting the credit markets. They understandably did not provide details as each country has to determine the specifics depending on their national financial and legal system and the conditions in their national markets. But, together with the coordinated policy interest rate cuts earlier in the week, the plan did demonstrate a remarkable degree of common assessment of the problem and of commitment to take effective and internationally coherent action. We now are learning the detailed plans of governments pursuant to this action plan.

Major moves to provide additional liquidity to the global financial system are already well advanced. The latest step by the US Federal Reserve is the provision of “unlimited” dollar funding under its swap facilities with the European Central Bank, the Bank of England, and the Swiss National Bank. The three major European central banks indicated the objective is “to accommodate whatever quantity of US dollar funding is required.”

The most pressing problem however is not a shortage of liquidity in the global system. Rather, it is the urgent need to recapitalize many of the leading financial institutions that have experienced steep declines in value of significant portions of the assets on their balance sheets. These declines were a result of the various phases of the cascading financial crisis that began in the sub-prime mortgage market. The bankruptcy of Lehman Brothers aggravated this problem in the US since so many financial institutions had significant investments in securities backed by Lehman. To varying extents financial institutions in Europe and other financial centers have experienced similar problems. Indeed, in Europe many banks are believed to be considerably more highly leveraged which is the case in the US. Recapitalization of the financial systems in the US and Europe is needed to re-establish the confidence necessary for banks to resume lending to firms, households and each other.

Major European government moves to recapitalize banks were announced on Monday. The U.K. government is injecting 37 billion pounds into three of the country’s biggest banks, a move the Financial Times calls “partial nationalization.” Germany announced a 500 billion euro rescue plan that includes 70 billion euros to help rebuild banks’ balance sheets. These two moves were part of $340 billion in bank recapitalization pledges by seven European countries (Britain, Germany, France, the Netherlands, Spain, Portugal and Austria) on Monday.

Yesterday (October 14, 2008) President Bush, followed by Paulson, Bernanke, et al., announced plans to take approximately $250 billion in equity stakes in a “wide number of US banks and thrifts,” a move which will include substantial preferred equity stakes in nine top financial institutions. The US authorities made clear their intention that once these banks are able to raise sufficient private capital, they should seek to buy back the shares held by the government. Both the US and European capital injection moves include some strict conditions including restrictions on dividends and executive compensation.

Other important parts of the G-7 rescue plan involve greatly expanded government guarantees for bank deposits and other liabilities, including importantly, inter-bank loans. This major step should help unfreeze the crucial inter-bank lending markets. The Federal Reserve is also back-stopping the commercial paper market. In effect, governments are inserting themselves as the counter-party in a broad range of financial transactions, which should offset the great concerns about counter-party risk that have shut down credit markets.

The early market reactions to these moves have been positive but only time will tell if they have been sufficient to restore market confidence in a sustainable manner. This is by no means assured in view of the ongoing global recession and the absence to date of a clear bottoming of the decline in housing prices and residential construction. There are numerous further chapters to be written about this crisis and the response of those institutions and public officials that are charged with assuring the stability of national and the global financial institutions. In the coming months we will see intensive deliberations on regulatory and supervisory reforms. There will also be debates on the longer term implications of this unprecedented involvement of governments in the financial system.

It is not too early to ask, however, if our “guardians of financial stability” saw this train wreck coming. Did they issue warnings and seek to take preventative action, or were they caught unaware – blind-sided? While the meetings and deliberations of top financial and regulatory officials are highly confidential – and for good reasons – we can examine the public record of statements to the press and publically-issued reports to look for signs whether these officials were aware of the growing dangers developing in our markets.

Let us consider, in particular, the Financial Stability Forum (FSF) which is the international institution that was established in 1999 by the G-7 finance ministers to “promote international financial stability through enhanced information exchange and international cooperation in financial market supervision and surveillance.” It has been the practice of the FSF to issue a press release following its meetings and periodically to present reports on its work to meetings of the International Monetary and Financial Committee of the IMF(2).

While these statements do not reveal the details of the discussions in the meetings, they do give a sense of the principle issues and concerns that were raised in the meeting.

Going back to the press release of the FSF meeting of March 2003, there is a reference to the sensitivity of household sector balance sheets to changes in interest rates. The FSF refers also to work on credit risk transfer instruments (credit derivatives) where the concerns were 1) do the instruments accomplish a clean transfer of risk, 2) do market participants understand the risks involved in these instruments, and 3) are credit risk transfer instruments resulting in undue concentrations of risk inside or outside the regulated financial sector? These clearly were the right questions to be asking. The FSF asked for greater disclosure and better aggregate data on CRTs. The FSF also expressed a need for enhanced transparency and disclosure in the reinsurance industry and for an assessment of the resiliency and soundness of the reinsurance industry and its risk taking. Finally, the FSF indicated its support for efforts to address possible conflicts of interest and other reforms relating to credit rating agencies

These same themes are found in the press releases from the September 23, 2003 and March 30, 2004 meetings, with the latter including a stronger concern about the high level of household indebtedness in many countries. The September 2004 press release indicated that credit risk transfer transactions have a good record of accomplishing a clean transfer of risk, that market participants appear to be “largely aware of the risks involved” and there do not appear to be undue concentrations of risk. The FSF stressed the importance of “robust and up-to-date risk management practices, disclosure and supervisory approaches.” The FSF announced it was looking at the impact of “rising inflows to hedge funds on market functioning and the risk profile of financial institutions.”

The March 2005 FSF press release suggested a higher degree of concern, citing the high level of global funding and market liquidity and associated low levels of risk premia. The FSF notes the views of “some members” that market participants may be underpricing risk. They called for “stress testing of exposures to more adverse scenarios.” They also went into more detail about their concerns about household finances, indicating that “major changes in financial tools and risk exposures are underway on both the asset and liability sides of household balance sheets.”

The September 2005 press release repeats these themes and gives emphasis to the growing complexity of financial instruments, the entry of new players, and the need to study the loss absorption capacity of financial institutions. The March 2006 adds to this list of concerns counterparty risk management, operational risks and valuation practices for complex financial instruments. The FSF still judged market and macroeconomic conditions as “benign” and that “balance sheets and capital levels of financial institutions remain strong.” In September 2006, the FSF made its first statement of concern about “possible adjustments in housing markets,” and calls on financial market participants the “full implications of a possible reversal of the current benign conditions, including less liquid markets.”

By March 2007, the concern level expressed in the FSF meeting press release had clearly risen. Concerns were expressed as to how credit risk transfer instruments might behave during a period of stress. The FSF also returned to the issue of hedge funds and their significantly expanded involvement in credit markets “where complex products can pose substantial risk management and valuation challenges.” The Chairman of the FSF, Mario Draghi, in his subsequent report to the IMF’s International Monetary and Financial Committee, observed that the then apparent problems in the US sub-prime mortgage market “offer some insight into how sectoral credit problems could play out more generally in the new ‘originate-and-distribute model’ of credit intermediation.”

By the September 2007 meeting, the FSF decided to set up a working group to study the then ongoing financial turmoil and suggest an appropriate international response. The group’s Interim Report issued in February 2008 and the final report issue in April 2008 included a wide range of actions that, if implemented, should make the global financial system more robust. These will have to be revisited in light of the major developments since that time.

This review indicates that numerous warning signs were observed by financial officials and some steps to strengthen the system were taken. The “guardians” were not asleep at the switch. But it does seem apparent that the extent of the crisis that has unfolded was not expected by either financial officials or by most market participants. Clearly not enough was done in response to the warnings that were issued. Efforts to increase transparency, strengthen market oversight, and encourage/require more prudent financial practices always encounter significant push-back in the absence of an evident crisis. Now we will see action on both sides of the Atlantic. We can only hope that the steps taken will prove to be the right ones.

(1) The G-7, or Group of Seven, members countries are Canada, France, Germany, Italy, Japan the United Kingdom and the United States. The G-20 members include 19 countries: Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Turkey, the United Kingdom and the United States of America. The European Union is also a member, represented by the rotating Council presidency and the European Central Bank.

(2) These can be found on the web site of the FSF: (website is no longer active)

The Next New Paulson Plan

When George Allen was recruited by Washington Redskins owner Edward Bennett Williams to come to DC and rebuild the team, Williams said, “George was given an unlimited budget and he quickly exceeded it.”  It now appears that Hank Paulson has done the same.  Instead of using the money in the multi-billion bailout bill to buy troubled mortgages, he has now shifted that task to Freddie and Fannie, who have been instructed to each buy $20 billion of troubled mortgages every month.  And the bailout package plan has now focused, finally, upon ways to make capital injections into troubled banks.  As I have written previously, the problem never was one of liquidity – and it certainly isn’t now that massive amounts have been injected not only by the Federal Reserve but also by central banks around the world.  Instead, the problem was threefold: lack of capital, which raised questions of solvency; excessive leverage by borrowers, institutions, and in derivative securities; and continuing declines in housing prices.  At last, after more than a year of turmoil, the Treasury has begun to focus on the need for additional capital in financial institutions. 

Before commenting on the issues surrounding capital injections, it is important to remark briefly on what Fannie and Freddie have been ordered to do.  These institutions are to begin buying troubled subprime and Alt-A mortgages in a warehousing action that promises to be very risky and costly to the taxpayer.  These two institutions are now arms of the US government and can sell debt in the marketplace at near-Treasury rates (interestingly, their debt is still selling for a spread over Treasuries of comparable maturity, for some unexplained reason).  We are not told at what prices these troubled assets will be purchased, but it is likely not to be ones that will reflect their true likelihood of default.  This means that losses will be buried in Freddie and Fannie balance sheets and won’t come to light for many years.  Because there are no effective limits to how much Freddie and Fannie can grow, this frees the billions in the rescue plan to be used for other purposes, effectively giving Secretary Paulson an unlimited budget.  We should be breathlessly awaiting news of the protections that this will provide to the taxpayer that Paulson so often cites as a top priority.

As for injecting capital into banks, it is clear they need it.  But how it is done, by whom, and for how long, is another matter.  Right now financial institutions have two critical problems.  They still have embedded losses, which need to be identified and excised.  This means that capital write-downs will be required and capital will disappear.  It must be replaced before financial health can be restored

Additionally, troubled financial institutions are overleveraged and need to shrink.  Shrinking entails shedding assets, which essentially means less lending.  There is much handwringing over the prospects of less lending, but this loses sight of the fact that the key question is “Less lending to whom?”  If it means less lending to support the funding of derivative assets and other nonproductive purposes, then there is a small likelihood that this will have implications for the real economy.  Also, keep in mind that the institutions which have the largest portfolios of troubled assets aren’t the ones who are the main sources of credit to middle America.  Again, their shrinkage and implications for the macro economy are over-exaggerated. 

What about shrinkage in the inter-bank market – the market that there is so much concern about on Wall Street and so many efforts to jump start?  We must realize that one of the first things you are taught in Econ 101 is that while an individual bank can obtain funding in such a market, the entire banking system can’t. 

What this market does is temporarily reallocate funds among institutions, and the process enables the transmission of interest-rate changes, including those associated with the efficient implementation of monetary policy.  However, this channel has broken down, because institutions are now uncertain about the risks they face, even in lending overnight.  This has been billed as a problem of market psychology and lack of confidence.  But what it really reflects is concern about the quality and solvency of counterparties and uncertainty about what would happen should one of those counterparties suddenly fail.  Such concerns are rational and real, when a troubled Bear Stearns is rescued but Lehman Brothers is put into bankruptcy.  In actions today by central banks around the world to provide unlimited dollars through their respective Term Auction Facilities, central banks have effectively become counterparty intermediaries.  Large banks only have to borrow or lend from their respective central banks and need not worry about trading with each other any more.

The important issues concerning capital injections are (1) how will they be done?  (2) what will happen to recognition of losses on the balance sheets of those receiving the injections?  (3) what will happen to institution leverage?  and (4) how many institutions will de facto be forced into bankruptcy?  Right now, it appears that the main consideration is being given to injection of non-voting preferred stock.  We don’t know how this will be priced and valued, but it will certainly increase the capital in financial institutions.  Injection of preferred stock is likely being favored because it suggests there will be no government control or direct ownership, but of course it won’t take the market long to realize that such injections are as much a tangible evidence of government backing as the implicit guarantees that Freddie and Fannie exploited for years.  This smoke and mirrors attempt should be understood for what it is: government ownership of banks, which has continually resulted in credit allocation and resource misallocation in the long run in those economies that resort to it.  If government capital injections are provided, in even emergency situations, it should come with many strings attached, including protections for taxpayers, strict limits on risk taking, no dividends to common stockholders, warrants to give the taxpayer a stake in any gains that may result, and an explicit timetable for exit.  The experience of other countries, such as those in Scandinavia, is that the deeper government is involved in the banking sector, the more difficult and costly it is to end it.

Capital injections should also be accompanied by requirements to root out losses and write down common equity.  In this way, losses are imposed on stockholders and the government’s capital injections aren’t simply used as a form of forbearance, enabling troubled institutions to engage in more risk taking and morally hazardous behavior that becomes even more possible with the extension of government ownership.  Additionally, without recognition of losses, new lending is even less likely to take place.

What happens to leverage?  We must recognize that writing down losses reduces both sides of the balance sheet and de facto increases measured leverage.  Institutions must be required to reduce their leverage, which can be brought down by requirements that assets other than C&I and consumer loans be shed from the balance sheets of institutions that accept government capital.  These requirements, together with the proceeds of the sale of troubled loans to Freddie and Fannie and to any other governmental resources, will force institutions to reduce leverage and also potentially continue lending to middle America.

Finally, it should be recognized that any plan for government support (be it injection of capital or insurance of debt) will effectively sort financial institutions into four groups.  First, there will be those institutions that are healthy and don’t need government support.  These are likely to be the bulk of the country’s community banks and many regional institutions.  Second, there will be those for whom the combination of capital write-downs and the cost of warrants will reveal that even with the support they can’t be viable.  The owners of these institutions will effectively have to put their institutions into government hands.  We must recognize the important role that the structure of the support has in defining how many institutions will be put into bankruptcy. 

There are two other types of institutions that the capital injection program will reveal.  Some will find the combination of support, given the costs, as attractive and have a reasonable prospect of putting their institutions back on a healthy path.  Lastly, there will be some for which the program cost, given the risk/return tradeoff it offers, will encourage them to bet the ranch.  As a result, any government program should also be accompanied by a plan to strictly enforce the Prompt Corrective Action provisions of FDICIA to protect the taxpayer.

These are the types of program details that Treasury must announce when it trumpets its capital injection plan, rather than putting out vague statements of intent which quickly reveal they haven’t been thought through.