What Next for Freddic Mac and Fannie Mae?

The Treasury has proposed to Congress that it be granted “temporary” authority to extend virtually an unlimited line of credit to Freddie Mac and Fannie Mae and to also purchase their equity.  Additionally, the Federal Reserve Board has also granted authority to the Federal Reserve Bank of New York to provide them access to the discount window at the primary credit rate. 

These actions, while intended to be temporary and to enable these institutions to continue rolling over their outstanding debt and maintain their active role in mortgage markets, effectively amount to de facto nationalization of these two entities.  Far from being temporary, these actions change forever the links between Freddie and Fannie and the government.  This conclusion holds in spite of the fact that no loans have yet been extended, nor has equity been acquired. 

The very fact that Treasury and the Fed have put in place mechanisms to ensure that these two institutions will survive has already enabled them to raise funds and has resulted in stockholders’ shares remaining at positive values.  This result reflects the value of converting an implicit government guarantee into an explicit taxpayer guarantee, with all the problems and risks to the taxpayer that it entails. 

Secretary Paulson has indicated that the terms surrounding any injection of funds would be designed to protect the US taxpayer.  How this would be done seems to have been left purposely vague; but simply purchasing equity or preferred stock without additional rights, preferences, and warrants won’t cut it.  Furthermore, it is now clear that the taxpayers are already explicitly at risk and will have to absorb losses should these entities fail.

Thus, taxpayers need to have those protections put in place immediately, even if equity is not purchased by the Treasury.

The key question is, what kinds of protections should be instituted?  The Financial Economists Roundtable, a group of well-known senior finance experts, addressed this issue explicitly in a statement following their annual meeting in Glen Cove, NY earlier this week.  They articulated the principle that the government should be “fully compensated for the full economic value of its support…” and this should include, in the case of equity injections, the granting of stock warrants “… for converting its implicit guarantee of their liabilities into an explicit guarantee.” 

But I argue that further short-run protections are also needed, regardless of whether equity is provided, because existing stockholders stand to gain any upside should Freddie and Fannie recover, even without the injection of taxpayer funds.  What is needed now is a host of reforms, many of which are different from those being proposed by Treasury. 

First, the government’s commitment should be explicitly recognized through the granting of warrants or rights so that the taxpayer can participate in any upside that may now result. 

Second, the regulatory structure and oversight needs to be improved, including the granting of receivership authority to the responsible regulator. 

Third, capital adequacy standards need to be tightened, a system of mandatory trip wires should be put in place to trigger mandatory regulatory interventions should capital ratios fall below critical values, and accounting standards need to be based upon market and not book or regulatory values. 

Fourth, simply giving authority or new powers to a different regulator without also changing the underlying behavioral incentives and methods for ensuring accountability, means that reforms will be ineffective.  Particularly important will be mandatory outside reviews and strict accountability and reporting on the financial condition of these institutions and any losses that may have to be absorbed by taxpayers. 

Fifth, to deal with troubled financial institutions more generally, a crisis-resolution policy should be put in place for financial institutions, including Freddie and Fannie, that pose potential systemic risks to the financial system and economy. It should include bank-like receivership and resolution procedures expressly designed to minimize costs to the taxpayer.  This would include the authority to create a bridge bank-like institution to acquire and run the entity should it be placed in receivership.  

Sixth, serious consideration should be given to scaling back Freddie and Fannie’s activities to the mortgage guarantee business, since government financing of private mortgage debt will only drive out private sector lending activities. 

Finally, since Freddie and Fannie primarily exist today because their GSE status enabled them to borrow at an advantage that could not be matched by private sector firms, efforts need to be made to reprivatize them.  Since this didn’t work the last time it was done, and since the processes and markets for mortgage-backed instruments are sufficiently developed now, consideration should be given to breaking the two GSEs up and selling the activities off to private investors in ways that clearly and unambiguously sever the link between them and the federal government. 

These suggestions, of course, ignore the political fight that would surely ensue, especially if Freddie and Fannie were to be broken up, because what will be perceived to be at stake here is the sacred cow of housing.  All that notwithstanding, it remains the responsibility of Congress to ensure that, whatever Treasury does, adequate protections are in place to make good on the goal of protecting the taxpayer.




About Paulson’s Statement

Excerpts from Treasury Secretary Paulson’s Statement (Published: July 13 2008, 6 PM) About Fannie and Freddie with inserts of Cumberland’s Observations.

Treasury Secretary Paulson.  “In recent days, I have consulted with the Federal Reserve, OFHEO, the SEC, Congressional leaders of both parties and with the two companies to develop a three-part plan for immediate action. The President has asked me to work with Congress to act on this plan immediately.”

Cumberland comment:   Everybody has bought into this plan (politically) whether they want to or not.   This is no longer about “if” but about “how soon” and “how much.”

Paulson:  “First, as a liquidity backstop, the plan includes a temporary increase in the line of credit the GSEs have with Treasury. Treasury would determine the terms and conditions for accessing the line of credit and the amount to be drawn.”

Cumberland comment:  Paulson wants a full discretion as to “how much.”  He must have Congressional approval to increase this line of credit.  He may get it but he may also get a limit as to the amount and as to the timing.   Congress would be more protective of the federal taxpayer if it puts a cap on this line of credit rather than vest discretion without limits.   And Congress would better protect the taxpayer by oversight.  Remember that it was the Congress and the government agencies that got us deeply into this mess.  What makes anyone believe they can be trusted with full discretion and without any limitations?

Paulson:  “Second, to ensure the GSEs have access to sufficient capital to continue to serve their mission, the plan includes temporary authority for Treasury to purchase equity in either of the two GSEs if needed.”

Cumberland:  Okay, taxpayer, you are about to become a shareholder in F&F with your voting rights in the hands of the Bush Administration.  Are you ready for that one?  There are many ways the government can honor the “implied” guarantee of the federal government on F&F debt.  No where is the shareholder granted an implied bailout.   Treasury does not need to buy equity.  It does not need to dilute existing shareholders.  Under current market conditions, if it does not dilute them, it gives the existing shareholders a subsidy from the rest of the taxpayers who will have to pay it.  An alternative is for Treasury to buy subordinated debt or preferred stock (convertible or non-convertible).  Congress can modify this one quickly and place the taxpayer in a more senior position to the existing shareholders.  We expect a policy fight over this one. 

Paulson: “Use of either the line of credit or the equity investment would carry terms and conditions necessary to protect the taxpayer. “

Cumberland:  The line of credit expansion is a partial fulfillment of the implied federal guarantee.  It reassures markets and improves the liquidity necessary for the functioning of markets in F&F mortgage related debt.  It requires Congressional Authorization which is why the Federal Reserve has agreed to “backstop” F&F after the existing $2.25 billion credit line is exhausted.  F&F now have Discount Window access to all the liquidity they need to operate.  F&F debt markets will like these provisions.  A rally in their prices and decline in their yields is expected. 

Paulson:  “Third, to protect the financial system from systemic risk going forward, the plan strengthens the GSE regulatory reform legislation currently moving through Congress by giving the Federal Reserve a consultative role in the new GSE regulator’s process for setting capital requirements and other prudential standards.”

Cumberland:  It is the proper role of the Federal Reserve to deal with systemic risk.  In fact the Fed cannot apply monetary policy without a functioning system.  But here we see a vast expansion of the role of the central bank.  This is worrisome.  The last year of turmoil has dramatically changed the role of the central bank.  And it has caused the Fed to alter its balance sheet in ways never previously seen.  See Cumberland’s website, www.cumber.com, for the tracking of the Fed’s balance sheet changes. 

All of this has been done without thoughtful deliberation and has occurred in response to crisis.  We do not know what seeds of future turmoil are being planted now by this policy making apparatus.  We are not sure of any of the measures of outcome.  Congress will give this power to the Fed because it does not want to take on any responsibility itself.  The Fed has been a credible institution and thus is available for this role.  But readers must remember that the Fed is a creature created by the Congress and that this Congress has held Fed Governor appointees hostage.  

We are proceeding into dangerous and uncharted waters.   We can only hope that the radar is turned on and the lookout is peering into the murky water for mines and rocks.   But financial markets cannot operate on hope.  We expect this proposal to cause more questioning of American resolve after it is examined by foreigners.

We believe that Congress is going to pass this legislation rapidly.  It will probably be law before the August recess. 

Stock markets may have a positive initial reaction from a deeply oversold position.  F&F debt will rally and the entire spectrum of financial asset classes will be relieved because they will see the federal government extending its commitment to the implied federal guarantee with deeds and not just words.  Once this rally is over, the markets will have to confront the economic realties of our housing/energy/food/election-uncertainty/economic slowdown/pressured-consumer/large deficit/weak dollar situation.




Fannie and Freddie

Let’s try to sculpt some of the fog swirling around the Fannie Mae and Freddie Mac (F&F) issues.  First some facts:

1. Under present rules the Fed is already specifically authorized to purchase F&F debt for its own account. view history No change in rule or law is needed.  As of the most recent Fed Reserve report (Thursday, July 10) the Fed’s holdings were zero.

2. The Fed already accepts F&F as collateral for Discount Window lending and TAF lending.  The same is true for all the debt of any of the Government Sponsored Enterprises (GSE).

3. The Fed does not lend directly to F&F at the present time.  F&F are not primary dealers.  For a list of the primary dealers, look at the NY Fed website.  You will not see F&F.

4. The Fed could make F&F a primary dealer at any time.  It can invoke the same emergency power that it used in the Bear Stearns transaction and in the subsequent authorization of direct lending to the remaining primary dealers.  At the moment the Fed has no reason to do this.  F&F are not important agents for the Fed when it engages in open-market operations.

Now we offer some opinions:

F&F will not be allowed to default on their direct outstanding debt.  The systemic destruction would be global and enormous.  F&F paper is held by institutions worldwide.  And it is a legal investment and holding for nearly all state and local governments in the United States.

Equally true is the status of the debt that F&F has guaranteed.  The government will not permit default on the mortgage-related securities pooled and then resold with an F&F guarantee.  Furthermore, there is no imminent threat of default.  The payment stream from the more than $5 trillion of mortgages is mostly current and has a reasonably good performance history.  In addition, F&F are functioning agencies.  They have liquidity and market access.  Default by F&F is very unlikely.  Those who compare F&F to IndyMac’s seizure are mistaken.

Solvency and the need for capital is another issue.  If one puts the guaranteed mortgages on the balance sheets of F&F, they will have absolute and certain capital inadequacy.  The estimates vary but seem to center at about $50 billion.  F&F face an impossible task if they have to raise that amount by conventional means in this market climate and with the intensely negative sentiment circulating about them.  Their capital is thin to start with although it is conforming in accordance with the rules of their federal regulator.  The now infamous accounting rule change would render them technically insolvent, as former St. Louis Fed President Bill Poole correctly contends.

In sum, we are not worried about a default in F&F debt.  We hold positions in mortgages guaranteed by F&F and some small positions in their debentures and notes.  The widening of credit spreads on all GSEs has made them attractive for certain portfolios.

Common shares of F&F are another matter.  We value them at near zero.  In the Bear Stearns event we saw affirmation that the federal government had no sympathy for equity investors even as it preserved the rights of debt holders and counterparties.  We believe the same is true for F&F.  The stock market thinks so, too.  That is why the equity value of F&F has been decimated.  We have avoided F&F shares and have been selective in the use of broad ETFs where they are part of a large assemblage of stocks

The preferred shares are a tougher issue for investors.  They are trading at about 70 cents on the dollar in a thin market.  We believe they are at risk if some restructuring of F&F is undertaken by the federal authorities.  The balance sheet construction and the concept of a preferred are clear, and investors should not be deluded into thinking otherwise. 

A restructuring of F&F could take many forms.  Some of the possibilities would eliminate the claim of to the preferred shareholder. Other forms of reorganization would preserve it.  This outcome is unpredictable. There is risk in this preferred security.

The Fed is not the likely operational vehicle for a restructuring of F&F.  The Fed’s task is to deal with liquidity, not solvency.  The Fed can reliquefy dysfunctional financial markets and is doing so.  It can use its balance sheet to achieve a clearing market in F&F debt if markets seize and cease to function.

F&F are not banks.  They do not experience “runs.”  They should not be compared to Countrywide or Indymac.  Their status of congressionally sponsored federal agencies places them in a unique position and parallel with all other federal agencies.  There is no history of the federal government reneging on its implied promise to pay the debt obligations of a federal agency.  Yesteryear’s S&L crisis and federal deposit insurance issues affirmed this federal obligatory concept. 

Readers may wish to note the list of US federal agencies and other organizations for which the Fed is the paying agent.  They are articulated in a Fed press release: “By law, Reserve Banks act as fiscal agents for these government-sponsored enterprises and international organizations: the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, entities of the Federal Home Loan Bank System, the Farm Credit System, the Federal Agricultural Mortgage Corporation, the Student Loan Marketing Association, the International Bank for Reconstruction and Development (World Bank), the Inter-American Development Bank, the Asian Development Bank, and the African Development Bank.” 

Readers may also note that, until July 2006, the Fed allowed these agencies to obtain daylight overdrafts without cost.  Since July 2006, the Fed has required these agencies to hold balances sufficient to cover those payments.  The Fed affirmed in that 2006 rule change that these agencies do NOT have regular access to the Discount Window.  The Fed operated by its own rulemaking ability and could reverse this decision at any time.

The Fed is not normally in the business of fixing insolvencies, especially those which are created by changes in accounting rules.  These are issues for F&F regulators and for the Congress. 

Readers, please note that I may end up being totally wrong in this statement.  The Fed is now engaged in the extraordinary Maiden Lane, LLC portfolio liquidation project which is the result of the Bear Stearns debacle.  In that case the Fed may (underline the word may) actually face loss of taxpayer funds when that portfolio issue is finally resolved.  Alternatively, the Fed could end up with a profit.  We have no way to know if Maiden Lane becomes the new model of Fed assisted financial engineering in cases like Bear Stearns and others.  We do know that applying that model to F&F would be a monstrous task and one that the Fed certainly would prefer to avoid.

Longtime readers know we have a dim view of Congress.  It is exacerbated by the scandalous and arrogant behavior of the present chairman of the Senate Banking Committee, Christopher Dodd, who still hasn’t admitted his personal failure in taking a VIP mortgage from Countrywide.  That said we believe Dodd and his House counterpart Barney Frank will support Congressional changes that add financial strength to the GSEs.  They are pro-GSE in their politics.

The US Treasury cannot do much other than jawbone regarding F&F.  It takes changes in law to expand the powers for a Treasury intervention.  There is a small credit line with the Treasury that has never been used by the GSEs.  We do not expect it to be used now.  It was originally legislated in order to insure liquidity.  The Fed can and will handle that part.  If a GSE were to draw on a Treasury line now, the action would create a panic far worse than we have seen this week.  Markets would infer that things are even worse than presently believed.  We do not expect F&F to borrow from Treasury.

Finally, the Congress could easily fix this mess and improve the state of housing finance.  The credit spreads between GSE debt and Treasury debt are wide because of the uncertainty.  The government backing of F&F is “implied” and not explicit.  A Congressional guarantee would change that.  Studies of the cost of this Congressional failure suggest that the annual cost of this uncertainty created by the Congress is in the multi-hundred billions.

Furthermore, the guarantee could be limited to existing debt and explicitly avoid guaranteeing any new debt if Congress wanted to phase out F&F as a federal agency.  That would create a two-tiered market; call it old F&F and new F&F.  Alternatively, Congress could extend the guarantee with limits and rules if it wanted to clarify and strengthen F&F.  Either way, Congress could remove the uncertainty premium and that would cause mortgage interest rates to fall and housing finance to become marginally more affordable.  Under these “permanent fix” scenarios, the shareholders of F&F cease to exist and the true federal agency status, without public stockholders, would be restored.  In our view that would be a best outcome for the country.  Federal agencies were not originally intended to enrich private investors and grant stock options to F&F management.  The GNMA program and the veteran’s post WW2 home mortgage lending operations seem to work well in the United States and without all the turmoil created by F&F. 

Detractors of these ideas have argued that the credit rating of the United States would fall below AAA if Congress were to extend this guarantee.  We disagree.  Nearly all of the $5 trillion in mortgages will pay.  And there is large recovery on those mortgages that don’t pay.  Remember, these are not subprime loans.  For the most part they are fully conforming and of fairly high quality. 

But this decisive solution requires political will and political leadership.  Sadly for the financial markets and the country, neither seems visible in July, 2008.




TAF, Fallacy of Composition, Report from Singapore

Our July 2 commentary about the Fed’s Term Auction Facility (TAF) and banks (see: www.cumber.com ) triggered a banker’s response.  He argued that the 9-basis-point premium that banks paid in the latest TAF auction is justified because of the desire of each bank not to be known as one that borrows at the Discount Window.  The banker was confirming the “stigma” that the market attaches to the use of the Window.

Specifically, he wrote:

“Even a bank on the ropes steered clear of the Window.  The potential reputational cost of using the Discount Window far outweighs the financial savings.  Look at the example above.  9 basis points on $75 billion for 28 days is $630,000.  The most one bank can be is 10% of any TAF, so the cost savings of using the Discount Window over TAF for any one bank was a whopping $63,000 (before taxes).  I’ll pass.

“I don’t get the relationship between the current mess and Discount Window stigma.  The stigma has been there through good times and bad.  If banks collectively as a group decide to override the stigma and use the Discount Window, how does that imply we as a group are not wounded and therefore functional?”

The direct answer to the rhetorical question is “It doesn’t.”  Systemic dysfunction is operating in the US regardless of the use of the TAF or the stigmatized Discount Window.  In fact, the banker reinforces my point and leads the conversation to the Fed’s dilemma.

The Fed is trying to overcome what we call the “fallacy of composition.”  That is the term we use to describe a situation where each agent thinks he is acting in his own rational self interest while the collective actions are counterproductive.  A simple metaphor is a fire in a theater.  Each person wants to get out quickly.  If they collectively do so in an orderly way they can all exit safely.  But if they ignore the orderly process, they create a stampede and some of them get hurt.

The Discount Window was designed to be an orderly process where banks could borrow from the Fed when reserves were needed during dysfunctional times.  That characteristic created the stigma.  To try and remove this sign of failure, the Fed actually came out and stated there was no stigma.  Clearly no one believed it. 

The Fed then tried to demonstrate this with a request that certain banks use the Window to show there was no stigma.  Four large banks did use the Window for a short time.  They then withdrew.  So much for the Fed’s request!  That approach failed, too. 

During the recent financial turmoil the Fed has lowered the Discount Window borrowing rate by a greater amount than it lowered the Federal Funds Rate.  And the Fed has liberalized the collateral it will accept.

The collateral for the TAF is the same as that for the Discount Window.  Because of the Window’s stigma, banks still elect not to use it.  Instead they pay a higher rate at the very time the Fed is trying to lower rates in the whole system.

The banker who commented calculated what appears to be a very small cost attached to this fallacy of composition.  In doing so, he fails to see the whole systemic picture.  Interest rates are tiered.  When one key rate (Window) suffers from a “stigma” premium over the Window, the premium is applied as a widening of the tiers in a global system.  The cost of 9 basis points must be calculated on the entire $150 trillion in US dollar debt and derivatives that trade in our global system. This is a huge price ($135 billion annualized) to pay for a stigma that the Fed can easily remove.

The Fed can fix this problem by altering the form of the TAF.  It can lift the 10% restriction at each TAF auction.  And it can make the auction size unlimited.  Essentially the Fed can say that it will loan each member bank all a bank wishes to borrow as long as the bank posts acceptable collateral.  The key is that the Fed maintains the high-quality collateral requirement so that the Fed does not end up with “junk.”

The Fed wants the system to function with sufficient liquidity to clear markets.  And it wants to apply monetary policy, which it can only do when the system is functioning.  An unlimited TAF at the Discount Rate would mean the penalty for borrowing was still 25 basis points over the Federal Funds Rate.  Banks could use the FF market if they so chose.

This way the Fed would be able to better judge if the policy-setting Federal Funds target rate was consistent with the Fed’s outlook for inflation and growth.  The sooner the Fed overcomes the fallacy of composition, the faster it can get back into the business of formulating monetary policy.

At Cumberland we continue to view the financial markets as dysfunctional.  Credit spreads are wider than normal and that is creating both opportunity and risk.  Certain sectors like adjustable-rate preferreds are still nonfunctional.  Banks continue to be plagued with falling housing collateral values and rising delinquencies on home equity loans and other credits.  Commercial credit problems are intensifying.

For fixed income investors that means carefully understanding the structure of bonds and not taking credit quality for granted.  For stock portfolios (ETFs) some cash reserves are warranted, as there may be future buying opportunities available in these struggling markets.

And for the Fed, it means more and longer term application of the important new tools the Fed has deployed to restore liquidity and functionality to these very troubled markets.

A personal note: we write this from Singapore after a whirlwind series of meetings with bankers, foreign exchange traders, investors, money and wealth managers and institutional policy makers.  It is apparent to this writer that the view of the US from this regional financial center is highly skeptical.  The US dollar is not trusted and the US government’s policy apparatus is seen as damaged if not broken.  There is an underlying theme of conversation about diversification out of the dollar.  And there are many questions posed about the economic outlook in the US.  I will have more observations to share as time permits.  Readers may see some of the clips from our CNBC Squawk Box Asia guest hosting by searching under “Kotok” at CNBC.com.  We are scheduled for another interview on Worldwide Exchange at 5:30 AM New York time on Wednesday morning, July 9.




TAF Results and Banks

If you look at the most recent reports of the Federal Reserve, you will see that loans and investments in the US banking system are contracting.  Northern Trust’s Paul Kasriel notes that this is the “sharpest 13-week contraction” in the history of this data series.  The Fed’s measure started in 1973.  Contracting credit is an indicator of the deleveraging of the US banking system.

Contracting credit is also a force for deflation, not inflation.  Money expands through the use of credit.  Monetary policy works because of this credit multiplier, which is why a rise in the price level (the true definition of inflation) is achieved through credit expansion.  The reverse is true when credit is contracting.

In the most recent Term Auction Facility (TAF) auction, the Federal Reserve rolled $75 billion in direct-reserve 28-day lending to US banks at an interest rate of 2.34%.  That rate is higher than the Discount Window borrowing rate by 9 basis points (bps).  It is also 33 bps higher than the expected Fed Funds rate over the same period (overnight indexed swap rate, OIX). 

Why did 77 American banks participate in an auction and pay 33 bps above the rate they could pay by borrowing from each other?  Or why did they pay 9 bps above the rate they would pay if they borrowed from the Discount Window (which uses the same collateral as the TAF)?  Answer: the “stigma” of borrowing is still infecting the banking system.

One must conclude that the US banking system is still wounded and the US credit markets are still dysfunctional. They may be less dysfunctional than in previous months when the bid-to-cover ratio of the TAF was higher but they are still not functioning rationally.  What about this relative measure of dysfunction over the last few weeks?  Here the news is not good.  In May there was a TAF auction below the Discount rate.    Now it is above the Discount rate. 

For us to conclude that the US banking system is really mending, we must see repeated auctions of the TAF below the Discount rate.   We are not yet there.

In Europe things appear to be worse when we examine the US dollar-denominated credit sector.   We conclude this by comparing the bidding for the TAF conducted through the European Central Bank (ECB).   Remember, this is a parallel process to our American TAF auctions.

In the US there were 77 banks bidding, submitting $91 billion in bids for $75 billion of available TAF funding.  In Europe the ECB country member banks collectively submitted bids for $85 billion even though that TAF-type facility had only $25 billion of available funding.  Remember that in Europe the banks post collateral with their local national banks.  That collateral is denominated in euros even though the money is actually loaned to them in dollars which are sourced in our Fed.

In other words the demand for TAF-type dollar liquidity in Europe (outside the US jurisdiction) was about the same as the demand inside the US.  We infer that the banking problems in Europe are worsening in terms of US dollar lending and investing.  The ECB bidding was a new record high.  This may also explain why the London Interbank Rate (LIBOR) has been stubbornly above the normal spreads that existed before the credit crisis of the last year commenced.

More support for these inferences is seen in the substantial deterioration in the market prices of banks stocks in the US and in Europe.  In the US we now see the collective market value of the banks in the bank stock index trading below the collective book value.  This is a rare occurrence and usually coincides with a very attractive entry point in the banking sector.  In the present case it seems that the market does not believe the book value and suspects that there are billions of additional losses to unfold in the banking sector.

At Cumberland, we believe that caution is warranted toward banks at this time.  We think this is true of the financial sector generally.  Our portfolios are now below market weight for this sector, even as the market weight is dramatically lower than when the credit crisis began.  We have avoided the capital market sector specialty ETFs and exited the insurance sector ETF.  We stopped scaling into the banking sector ETFs.  Our original start of scaling was too early.

We want to see the second-quarter reports of banks, and we want to see more information about the deterioration of the home equity lending balances on banks’ books before we resume positioning in this sector.  We also believe that the capital markets and brokerage firms face additional difficulties.  And we expect more revelations about liabilities of those firms involved with Auction Rate Securities (ARS) and other sectors of the financial markets which are nonfunctional.

We look for the Fed to extend the various special tools they have introduced as temporary measures before their September expiration.  The sooner the Fed announces that extension, the better the markets will be able to rely on the Fed, and that will serve to lessen an uncertainty risk premium that currently is priced into credit.  We also expect the Fed to move to liberalize the ownership rules for banks so that additional capital can be attracted into the system.

Not all banking in all places is impaired.  There are several regions and countries where the toxic poison paper is diminished.  Singapore is one of them.  The Singapore index ETF is about 50% financials.  The city state is a regional banking and financial center.  The currency is strong and corporate governance is seen to be of a high standard.  We are maintaining our over-weight position in Singapore in our international ETF portfolios.

We will celebrate the 4th of July on a plane to Singapore.  Three days of meetings next week include bankers and investors in Singapore.  This is my first visit; colleagues Bill Witherell and Bob Eisenbeis have been there several times.  For those with access, CNBC Squawk Box Asia has scheduled me to guest host from 7 to 9 A.M. Singapore time on Tuesday, July 8th.

Readers are wished a festive celebratory birthday of America.  

We close with a special thanks to Barclays Capital’s Julian Callow and Julia Coronado for the auction details on the ECB’s TAF-type liquidity facility auction.




Financial Turmoil moves G7 to Decisive Action

The Finance Ministers and Central Bank Governors of the Group of Seven industrialized countries met Friday, April 11, in Washington D.C. as is the established practice before the annual meetings of the IMF. Very often the public statements released at the conclusion of such G-7 meetings are highly predictable, containing support for established policies, papering over issues where positions are known to differ and rather little that is particularly newsworthy. Friday’s G-7 Statement was an exception. The reason was evident in their frank admission that “The turmoil in global financial markets remains challenging and more protracted than we had anticipated.”

Faced with this situation, the G-7 decided on a very ambitious action program, endorsing all the recommendations in a report the G-7 tasked the Financial Stability Forum to produce, identifying the underlying causes and weaknesses in the international financial system that contributed to the current financial problems. The Financial Stability Forum (FSF) was established in 1999 to “promote international financial stability” by bringing together on a regular basis senior representatives of national authorities responsible for financial stability in major international financial centers (e.g., the Treasury Department, the Federal Reserve and the SEC in the case of the US), international financial institutions, and international groupings of financial sector regulators and supervisors. The FSF Report recommends 65 actions in five areas:

  • · Strengthened prudential oversight capital, liquidity and risk management
  • · Enhancing transparency and valuation
  • · Changes in the role and uses of credit ratings
  • · Strengthening the authorities’ responsiveness to risks
  • · More robust arrangements for dealing with stress in the financial system

The G-7 Finance Ministers and Central Bank Governors not only were able to reach consensus on strongly endorsing the report and committing to implement its many recommendations. They uncharacteristically went further to set priorities and a very ambitious time-table, identifying some actions for implementation within the next 100 days and other for implementation by the end of the year. We will point out just several important examples here. [The full report of the Financial Stability Forum is not longer available at the original site.]

The G-7 called for financial institutions in their upcoming mid-year 2008 reporting to “fully and promptly disclose their risk exposures, write-downs and fair value estimates for complex and illiquid instruments…consistent with leading disclosure practices”. Also within the next 100 days, the International Accounting Standards Board and other standard setters are asked to “initiate urgent action to improve the accounting and disclosure standards for off-balance sheet entities and enhance its guidance on fair value accounting, particularly on valuing financial instruments in periods of stress.” Despite the validity of this request, rapid progress in this area will be very difficult to achieve.

An important and controversial call by the G-7 is the request that by end-2008 the Basel Committee (a grouping of Central Banks) should raise bank capital requirements for complex structured credit instruments and off-balance sheet vehicles. This would reduce the attractiveness to banks of these assets, which recent events have shown to be more risky than previously thought. Earlier in the week the Institute of International Finance, an organization of the world’s largest banks, warned that increasing regulatory capital requirements would add too much “conservatism” to banking practices and proposed instead a voluntary code. Evidently, the financial officials believe self-regulation would not be an adequate response.

Another noteworthy action is the call for the International Organization of Securities Commissions (IOSCO) to revise its Code of Conduct Fundamentals for Credit Rating Agencies and for these agencies to improve the quality of the rating process and manage conflicts of interest in rating structured products. The FSF Report concluded that poor credit assessments by credit rating agencies contributed both to the build-up and to the unfolding of recent events.” One specific recommendation is that ratings of structured risk products should be differentiated from traditional corporate bond ratings. There is also a call for investors to improve their due diligence in the use of ratings.

In addition to the action program for strengthening the global financial system, the G-7 set a new tone in its brief reference to exchange rates. They said “Since our last meeting, there have been at times sharp fluctuations in major currencies, and we are concerned about their possible implications for economic and financial stability.” This modest statement marks a first time in recent years that the G-7 has agreed to express such a concern, although some individual G-7 participants have made such statements, fear the effects of a possible further slide in the US dollar. The IMF’s sharply lower forecasts for the US economy likely have strengthened such fear. This expression of concern by the G-7 could possibly signal future policy changes to draw a line under the dollar, but none have been announced.

A resumption of growth in the US in the second half of this year would be the best counter to these concerns about a destabilizing further fall of the dollar. Unlike the IMF, we are projecting such a pick-up in economic activity (albeit a modest one) with the US leading the Euro-zone in this change in direction. For this reason, we believe the US dollar is probably at or close to a bottom with respect to the euro and a number of other currencies, the main exception being some of the Asian emerging market currencies, where strong economic growth is continuing and stronger currencies are being used to counter inflationary pressures. Cumberland’s US, International and Global equity ETF portfolios are fully invested.




Investing in Emerging Markets- Will the Boom Continue in 2008?

2007 was the fifth consecutive year that emerging market stocks registered a double–digit advance. They significantly outperformed US and other advanced markets. The broad MSCI (Morgan Stanley Capital International) Emerging Markets Index increased by 36.5%. This compares with an advance of 10.6% for the MSCI Europe Index and is almost 9 times the 4.1% advance in the MSCI US Index. (The MSCI Canada Index, however, was up by a strong 27.6% at year end).

Like last year, the same basic question applies, looking forward to 2008: “Will the boom continue?” Our response is conditionally “Yes”. The reason is that, as a group, emerging markets have become more mature. So far, they have demonstrated an impressive ability to weather the storms caused by the same credit crunch that adversely affected most advanced country’s markets in recent months. However, market volatility has increased, and country allocation within the emerging market universe is likely to be critical for portfolio performance.

The increased liquidity that major central banks are injecting into the global economy should help ensure that the current slowdown in the advanced economies is relatively short-lived. Cumberland does not believe it will deteriorate into a serious or global recession. Domestic liquidity conditions in most emerging market economies are healthy. Many emerging market countries are net creditors in the global markets. For them, domestic demand factors should underpin another year of solid economic growth.

While the large price advances in many of the major emerging markets in the first ten months of this year had reduced the relative attractiveness of their valuations, the market drawbacks in the last few months have tempered their overheated nature. China and Hong Kong are examples.

China and Hong Kong

The Chinese economy continued to grow at a very rapid pace in 2007, 11% according to some preliminary estimates. Domestic Chinese investors piled into the stocks of Chinese firms. Prices in the Shanghai and Shenzhen markets rose to speculative bubble levels by mid-year (Shanghai was up by 85%), followed by a retrenchment of almost 20% in the second half.

The domestic Mainland Chinese markets are largely closed to foreign investors. However, many of the major Chinese firms are listed on the Hong Kong market (via Chinese H shares) and/or the US market. These firms are required meet the higher reporting standards of these exchanges. There are several Exchange-Traded Funds trading in the US market that invest in these shares. The most popular of these, the iShares FTSE/Xinhua China Index Fund (ticker FXI), which tracks the corresponding index, advanced by 58.7% last year.

The pace of economic activity in China, while decelerating, is still likely to be again in excess of 10% in 2008. Domestic Chinese investors, with growing incomes, are still largely a captive audience. They will persist in flocking to China’s equity markets.

That said, Chinese equities may encounter some headwinds in 2008. A more rapid appreciation of the Chinese currency, the Yuan, perhaps as much as 10% over the year, is likely as the authorities seek to reduce inflationary pressures. This will hurt the earnings of Chinese exporters as well as the translation of equity returns into US dollars for US dollar-based investors. Another important risk facing Chinese exporters is the US Presidential elections and the effect that will have on US-China trade relations. Also the plans of Chinese companies to raise another $100 billion on domestic and international equity markets next year could weigh on those markets.

On the positive side of the ledger, the Chinese authorities will likely take further measured steps in the coming months to lower the present regulatory barriers preventing most domestic Chinese citizens from investing in the Hong Kong and US markets. The Hong-Kong and US-listed shares of Chinese companies are now priced at a discount of 60% or more relative to the prices of the shares of the same companies in the China Mainland markets. The expected process of arbitrage between the markets as the so-called “through train to Hong Kong” gets underway in earnest should give a significant boost to these shares over the course of the year.

Increasing the ability of Mainland Chinese investors to invest in the Hong Kong market should also attract substantial new funds into the securities of domestic Hong Kong companies. Anticipation of this development already added to the Hong Kong market’s performance in 2007. This factor and the close relationship between the Hong Kong and Chinese economies helped Hong Kong stocks, as measured by the MSCI Hong Kong Index, advance by 34% this past year. The leading domestic Hong Kong companies are in the real estate and financial sectors. Both of these sectors are helped by the prevailing low interest rates, an ample supply of liquidity, and strong fundamentals for the economy.

Korea

Korea has a new, more pro-business President, Lee Myung-bak., who ran on a pro-growth platform of cutting both taxes and regulations. However, there are a number of economic concerns that are affecting investor sentiment. Domestic demand growth in Korea looks likely to be weaker than in other emerging market economies. Korean banks have experienced serious funding problems and interest rates have risen sharply. These high rates will hurt the heavily indebted Korean households. This does not bode well for Korean equities in the coming months. Later in the year the fiscal stimulus and market-friendly reforms planned by the new government should be important positive factors for equities. The Korean stock market as measured by the MSCI Korea Index registered a strong increase of 30% in 2007 but has underperformed in recent months.

Brazil

Outside of Asia, Brazil is the other major center of growth among the emerging markets. Indeed, in 2007 Brazil’s equity market registered the strongest performance among the major emerging markets. The MSCI Brazil Index rose by 75.4% last year. India came in second with a 71.2% increase. It is noteworthy that this outperformance by Brazil continued through the recent adjustment in global markets.

Brazil’s economic prospects continue to look benign, with growth in excess of 4% expected in 2008. While Brazil is affected by developments in the global economy, it is not as directly tied to the US economy as are other Latin American countries, for example, Mexico. This currently is a plus as the US economy passes through a slow growth period. Another significant plus is the growing importance of Brazil’s energy sector. Despite the fact that Brazilian equity valuations are no longer cheap, this market is expected to perform strongly again in 2008.

Mexico

In contrast to Brazil, Mexico has limited ability to insulate itself from developments in the US. The housing slump and the credit crunch in the US have had a depressing effect on Mexican equities, which declined during the latter half of 2007. As a result, the MSCI Mexico Index advanced by only 9.3% in 2007, in sharp contrast to the Brazilian market. Mexico’s interest rates remain very high, and its equity valuations are not particularly attractive. This situation may turn around later in 2008 when monetary policy is expected to ease and it becomes evident that the US has avoided a serious recession

Postscript

in recent days, there have been violent riots in Pakistan, following the tragic assassination of Benazir Bhutto. The global struggle against terrorism has become more difficult with this testing of Pakistan’s political stability. While there has been little effect on global equity markets or on spreads on Asian emerging market sovereign bonds, this event was a reminder to investors that we live in an uncertain world. Investing in emerging markets, despite the many advances that have been achieved, still involves a higher element of risk than is the case for the advanced market economies with their deeper, more liquid markets, stronger regulatory and legal systems, better corporate governance and more stable political structures.

Their generally higher risk does not mean that emerging market equities should be avoided. Rather, it underlines the importance of diversification of risks as an essential element of prudent portfolio management. A distinguishing feature of risk management at Cumberland Advisors is our exclusive use of Exchange Traded Funds in our managed equity portfolios. These securities, which are traded like single stocks, provide broadly diversified investments at relatively low cost in entire country markets, regions, sectors and/or investment styles. For example, the iShares Korean ETF (ticker EWY) holds the shares of some 100 Korean companies. One of our core ETF holdings, the broad BLDRS Emerging Markets 50 ADR Index Fund (ticker ADRE) invests in 50 companies in eleven major emerging markets. A high level of diversification can be achieved through building portfolios with such funds.

The index returns in this article are US dollar returns and therefore are heavily affected by the depreciation of this currency in 2007. For example, The Canadian dollar MSCI Canada Index return for 2007 was only 8.2%




Cumberland’s 2008 Emerging Markets Strategy

2007 was the fifth consecutive year that emerging market stocks registered a double–digit advance. They significantly outperformed US and other advanced markets. The benchmark we use is the broad MSCI (Morgan Stanley Capital International) Emerging Markets Index; it increased by 39.4% in 2007.

Like last year, the same basic question applies: “Will the Boom Continue?” Our response is conditionally “yes”. The reason is that, as a group, emerging markets have become more mature. So far, they have demonstrated an impressive ability to weather the storms caused by the same credit crunch that adversely affected most advanced country’s markets. Market volatility has increased and country allocation among the emerging market universe is critical for portfolio performance.

The increased liquidity that major central banks are injecting into the global economy should help ensure that the current slowdown in the advanced economies is relatively short-lived. Cumberland does not believe it will deteriorate into a serious or global recession. Domestic liquidity conditions in most emerging market economies are healthy. Many emerging market countries are net creditors in the global markets. For them, domestic demand factors should underpin another year of solid economic growth.

While the large price advances in many of the major emerging markets this year had reduced their relative attractiveness, the market drawbacks in the last few months tempered their overheated nature. China and Hong Kong are examples.

China and Hong Kong

The Chinese economy continued to grow at a very rapid pace in 2007, 11% according to some preliminary estimates. Domestic Chinese investors piled into the stocks of Chinese firms. Prices in the Shanghai and Shenzhen markets rose to speculative bubble levels by mid-year (Shanghai was up by 85%), followed by a retrenchment of almost 20% in the second half.

Cumberland takes a conservative approach to participating in Chinese economic growth. We use up to eight ETFs to craft our China exposure. We will mention just two.

These two ETFs that track the shares of major Chinese firms that are listed on the Hong Kong market and/or the US market and hence meet the higher standards of these exchanges. The iShares FTSE/Xinhua China Index Fund (ticker FXI), tracks the corresponding index. It increased by 58.7% last year. The second of these ETFs, the Powershares Golden Dragon Halter USX China Fund (ticker PGJ) is comprised of the U.S. listed securities of companies that derive the majority of their revenue from the People’s Republic of China. This ETF rose by 59% last year.

The pace of economic activity in China, while decelerating, is still likely to be again in excess of 10% in 2008. Domestic Chinese investors, with growing incomes, are still largely a captive audience. They persist in flocking to China’s equity markets.

That said, Chinese equities may encounter some headwinds in 2008. A more rapid appreciation of the Chinese currency, the Yuan, perhaps as much as 10% over the year, is likely as the authorities seek to reduce inflationary pressures. This will hurt the earnings of Chinese exporters as well as the translation of equity returns into US dollars for dollar-based investors. Another importance risk facing Chinese exporters is the US presidential elections and the effect that will have on US-China trade relations. Also the plans of Chinese companies to raise another $100 billion on domestic and international equity markets next year could weigh on those markets.

On the positive side of the ledger, the Chinese authorities will likely take further measured steps in the coming months to lower the present regulatory barriers preventing most domestic Chinese citizens from investing in the Hong Kong and US markets. The Hong-Kong and US-listed shares of Chinese companies tracked by the two China ETFs mentioned above are now priced at a discount of 60% or more relative to the prices of the shares of the same companies in the China Mainland markets. The expected process of arbitrage between the markets as the so-called “through train to Hong Kong” gets underway in earnest should give a significant boost to these ETFs over the course of the year. Expecting further gains in 2008, we are maintaining an overweight position in China and Hong Kong.

The heightened risks mean that it will be important to monitor developments carefully. For some recent observations and personal travel notes on China by David Kotok, see http://www.cumber.com/four-commentaries-from-trip-to-china/ .

Increasing the ability of Mainland Chinese investors to invest in the Hong Kong market should also attract substantial new funds into the securities of domestic Hong Kong companies. Anticipation of this development already added to the Hong Kong markets performance in 2007. This factor and the close relationship between the Hong Kong and Chinese economies helped the iShares Hong Kong ETF (ticker EWH) advance by 40.5% this past year. The leading Hong Kong companies in this ETF are in the real estate and financial sectors. Both of these sectors are helped by the prevailing low interest rates, an ample supply of liquidity, and strong fundamentals for the economy.

Singapore

Singapore’s economy and market are the most advanced of the markets Cumberland includes in our Emerging Market Portfolio. Singapore has a history of sound market-based economic policies and political stability. With few natural resources other than its people and its strategic location, the Singapore economy has demonstrated consistent strong performance, responding flexibly to changes in global markets. For example, it is now the world’s second largest inter-modal port. The iShares Singapore ETF (ticker EWS) increased by 27.8% last year, just a little less than its average annual increase of 29.9% over the past five years.

The Singapore market tends to outperform in periods of increased volatility in global markets as investors seek more stable investment opportunities. High volatility promises to be a characteristic of the emerging markets in the coming year.

Malaysia

The Malaysian economy is blessed with natural resources (particularly energy) a relatively stable government and currently a stimulative monetary policy. This year’s healthy economic growth of 6% should be followed by a similar advance in 2008. Like other emerging Asian economies, a modest weakening in the demand for Malaysia’s exports in 2008 is expected to be offset by stronger domestic demand. The iShares Malaysian ETF (ticker EWM) rose by 45.5% in 2007. Despite this advance, valuations are still attractive and the market appears poised for another good year in 2008.

Korea

Korea has a new, more pro-business President. However, there are a number of economic concerns that caution us from adding to our Korean position at this time. Domestic demand growth in Korea looks likely to be weaker than in other emerging market economies. Korean banks have experienced serious funding problems and interest rates have risen sharply. These high rates will hurt the heavily indebted Korean households. This does not bode well for Korean equities in the coming months. Later in the year the fiscal stimulus and market-friendly reforms planned by the new government should be important positive factors for equities. The iShares Korean ETF (ticker EWY) registered a strong increase of 32.1% last year but has underperformed in recent months.

Taiwan

The performance of Taiwanese stocks was considerably weaker than expected in 2007. The iShare Taiwan ETF (ticker EWT) increased by only 7.6% over the past 12 months. The big problem seems to be the negative sentiment of domestic Taiwanese investors towards their market. Perhaps this is due to uncertainties on the political front.

The positive factors which have encouraged us to retain our overweight for this market are the attractive valuations of Taiwanese companies and our global strategy of overweighting the technology sector which constitutes the major share of EWT. We also favor the increasingly close economic inter-relationships between Taiwan and China. Also, the upcoming elections in March may encourage Taiwanese investors to return to their domestic market.

Brazil

Outside of Asia, Brazil is the other major center of growth among the emerging markets. Indeed, in 2007 Brazil registered the strongest performance among the markets in Cumberland’s equity market universe. The iShares Brazil ETF (ticker EWZ) rose by 76.6% last year. This outperformance continued through the recent market adjustment.

Brazil’s economic prospects continue to look benign with growth in excess of 4% expected in 2008. While Brazil is affected by developments in the global economy, it is not as directly tied to the US economy as are other Latin American countries, for example, Mexico. This currently is a plus as the US economy passes through a slow growth period. Another significant plus is the growing importance of Brazil’s energy sector. Despite the fact that Brazilian equity valuations are no longer cheap, we expect this market will maintain strong performance in 2008.

Mexico

In contrast to Brazil, Mexico has limited ability to insulate itself from developments in the US. The housing slump and the credit crunch in the US have had a depressing effect on Mexican equities, which have declined during the latter half of 2007. As a result, the iShares Mexico ETF (ticker EWW) was up by only 12.3% for the year, in sharp contrast to Brazil’s 78% increase. Mexico’s interest rates remain among the highest in our Emerging Markets Portfolio, and its equity risk premium is negative. This situation may turn around later in 2008 when monetary policy is expected to ease and it becomes evident that the US has avoided a serious recession. For the time being, we are maintaining our underweight position.

South Africa

South Africa faces rising inflationary pressures and an external deficit that equals almost 7% of its GDP. These conditions are forcing interest rate hikes by the South African Reserve Bank despite the growing evidence that domestic demand is faltering. We expect growth in South Africa’s economy to drop below this year’s 5% pace. An inflated housing market is at considerable risk. Adding to investors concerns is the election of Jacob Zuma as the leader of the ruling ANC party. Of greater concern than the populist economic policies he may wish to employ are the press reports that Zuma is being charged with racketeering, tax evasion, and corruption. A period of domestic political turmoil could prompt an exodus of foreign investors in the coming months. The iShares South African ETF (ticker EZA) advanced by 17.3% in 2007. We anticipate underperformance for this market in the coming year.

Postscript

As I write this year-end review, there are violent riots in Pakistan, following the tragic assassination of Benazir Bhutto. So far there has been little effect on global equity markets or on spreads on Asian emerging market sovereign bonds. But the global struggle against terrorism has become more difficult with this testing of Pakistan’s political stability. This event is a reminder that we live in an uncertain world. Investing in emerging markets, despite the many advances that have been achieved, still involves a higher element of risk than is the case for the advanced market economies with their deeper, more liquid markets, stronger regulatory and legal systems, better corporate governance and more stable political structures.

At Cumberland in our active management of portfolios we seek to identify developing risks and rebalance portfolios accordingly. However, as not all developments can be foreseen, diversification of risks is an essential element of prudent portfolio management. A distinguishing feature of Cumberland’s risk management is our exclusive use of Exchange Traded Funds in our equity portfolios. These securities, which are traded like single stocks, provide broadly diversified investments in entire country markets, regions, sectors and/or styles. For example, the Korean ETF, ticker EWY, holds the shares of 100 Korean companies. One of our core holdings, the broad BLDRS Emerging Markets 50 ADR Index Fund (ticker ADRE), invests in 50 companies in eleven major emerging markets. The resulting diversification of risks together with a top-down approach to active portfolio management sums up our approach to investing in these markets.




Fannie and Freddie in dysfunctional credit markets

We expected the foreclosure, subprime mess to become the central focal point of US politics; it has now done so.

The reason is simple. A single foreclosure on a street impacts the entire population of the street not just the household that lost their home. All nearby property values are hurt. Foreclosures are an indicator of a much larger cohort of trouble.

Half the foreclosures we see are in three states: Florida, Texas and California. You cannot become president of the United States without winning at least two of these three states. Thus we see the presidential race moving to this topic as the premier issue.

Since the peak of adjustable rate mortgage resets is in May 2008, we expect the politics to intensify. Every pol will offer his or her solution as the best. They will blame others for the problem.

They are all shameful. They are reactive and have not been proactive. Now the dysfunctional American political system is trying to play catch up to the dysfunctional credit markets. Such coincidences of timing have ended badly in the past. This is how we get misguided legislative and permanent tax code changes which are launched as temporary solutions. The whole thing is a sad commentary on our system.

And, as we have written twice, the Federal Reserve is held political hostage during this period by the US Senate which will not confirm nor even hold hearings on two nominees for Fed Governor spots let alone a confirmation on a third sitting Governor who is up for reappointment.

Why am I harping on the politics and the threat to the Fed?

There is a fundamental reason. The United States has two nationally franchised mortgage agencies. Fannie Mae and Freddie Mac. They have had their share of troubles as we know. They have cut their dividends and are raising capital through preferred stock issuance into order to strengthen their weakened balance sheets. They are emasculated by the Congressional system that is also one of the main sources of this credit problem. They have a regulator who has no experience in dealing with an asset class that is falling in price. OFHEO price declines are just surfacing in the OFHEO data. What planet are they on?

Note that GSE debt and specifically Fannie and Freddie is held around the world. About $1 trillion is in foreign institutional hands. Those folks are watching our political system fail and they are insecure. The spreads of GSE debt to corresponding treasury debt by maturity have doubled.

The Greenspan Fed was highly critical of the implied guarantee of the federal government when it came to GSE debt. Yet the GSE debt is still held by many institutions and the status of the implied guarantee is unchanged. The GSEs never directly affirm they have it. The documents they issue deny it. The market has believed the guarantee is valid. Why else would Fannie have a credit line with the US Treasury? Fannie hasn’t used it. BUT it is still there.

This is the time to clarify that situation once and for all. Doing so would clear the markets and put the national housing agencies back into the business they were created to handle. Will that happen? Probably not because it requires forward looking proactive political activity. An oxymoron by definition in the United States where the morons get elected to office.

This overhang of implied guarantee vs. credit risk and credit worthiness of GSE debt is a huge issue and is symptomatic of dysfunctional markets

At Cumberland we believe that the Congress will not permit the GSE debt to default. There is no rescue coming for GSE shareholders nor for the employees of the GSEs when it comes to their stock options. But debt holders are not likely to suffer default.

We also believe that the Congress will not clarify this status even though they would serve the credit markets of the world by doing so.

We are willing to hold GSE debt because we believe we will get paid. We add that many state and local jurisdictions also hold GSE debt and use it as legally authorized cash management and portfolio tools. At current spreads, some GSE debt is becoming cheap. Clients of Cumberland will find it in their taxable fixed income accounts. We are selective about the issues and the structure of each security. That detail is very important in making a debt instrument selection.

Were the Fed not political hostage it would be able to speak clearly and with a single voice about the GSE debt status. Furthermore, it could advise on how it views this debt and how institutions can use it as collateral during this financial turmoil period. We do not expect Fed Governors or presidents to compromise their role as public servants. They are people of character and understand the seriousness of their task.

It is the Congress that could make this issue clear for the markets. If GSE is federally guaranteed, say so. If the guarantee is to be phased out, say so. Uncertainty doesn’t help in periods like this.




Northern Rock has a branch in Tallahassee

Runs on financial institutions are not always seen as lines forming in front of banks. The State of Florida has suspended withdrawals from a state operated pooled investment fund. The fund was designed to benefit Florida’s counties, cities and school districts by pooling and investing their short term funds for them. The suspension occurred just days after Florida officials said that their Local Government Investment Poll was safe.

State sponsored pooled funds are commonly used around the country. They are supervised by the states; their governing rules are usually made by the legislatures. They usually do NOT have federal government support or access to the Federal Reserve. In normal times, they provide economies of scale and convenience for municipal entities and allow for short term fund investments until they are needed for payments, payrolls, debt service, etc.

Florida’s fund has been hurt by some commercial paper of financial companies that had invested in subprime mortgages and subsequently been downgraded to default status. Thus, being one step removed did not prevent a “run” on the pooled fund. The pool had $10 billion in withdrawals in just two weeks. It is down to about $15 billion in size. This has shocked all the municipal subdivisions that invested in the fund. It is impacting payrolls in certain school districts. Many municipal entities were pulling their money out of the fund until Florida halted withdrawals. The fund was once as large as $42 billion. It appears there will be losses taken on some of the fund’s remaining investments.

In Montana, there was similar news as school districts, cities, and counties pulled out $247 million from the state’s $2.4 billion investment pool. The trigger was a revelation that one of the pool’s holdings was lowered to default status. So far we have not heard that Montana has halted withdrawals.

At Cumberland, we expect that every state and municipal pooled vehicle will now be scrutinized by the respective state officials. Furthermore, many municipal entities will simply seek immediate safety by pulling their money out of pools and return to collateralized bank deposits. We see that among our municipal consulting clients.

Some readers may not know that Cumberland has a division which consults for state and local government entities. We advise them on their $millions of investments vehicles. In that division we constantly are reviewing our client’s investments. Part of that process is the examination of the content and structure of these pools. If the pool is not fully transparent, we avoid it.

When this Florida and Montana news broke it brought to mind the debacle of Orange County, California in 1994. In that episode, Orange County, one of the wealthiest counties in the country, ended up filing for bankruptcy. It quickly lost its AA- rating. Orange County had pursued a risky strategy of investing in inverse floaters. That involved putting up bonds the county owned as collateral to buy more bonds. The county fund essentially leveraged itself by betting that the bonds they were buying would yield more than their borrowing costs. That strategy blew up in 1994 when the Fed raised short term rates and long term rates followed upward. Schools and cities in Orange County had used the fund for short term investments much like municipalities do/did in Florida. The State of California eventually restructured the fund and liabilities were eventually paid but the period was tortuous for the bond markets as well as the municipalities.

Three things become evident here.

1. Poor supervision of some state and local investment managers continues in the US. In this case it is Florida and Montana. More may be revealed. At this time, it is also unclear whether the counties and other municipalities who invested in the fund knew what the fund owned. Lawyers are going to have a field day with this one.

2. Diversification has its benefits and should be stressed in all portfolios. Florida is reported to have had 20% of its investments in this type of asset-backed commercial paper.

3. Notwithstanding all the talk of problems within municipal bond insurers, the benefits of secondary credit enhancement cannot be clearer. These are another set of eyes examining the risks in the $2 ½ trillion tax-free municipal bond market.

At Cumberland, we continue to look under the hood at bond financed projects whether they have underlying credit ratings or not. And we evaluate the credit of each bond insurer. We do NOT just rely on the rating of an agency. This doesn’t mean that one can totally avoid liquidity risk; the events of last August are indicative of that market based result. Even the highest quality bonds can experience a sloppy market. It does mean being prudent is about diversification among issuers, insurers, sectors, parts of the yield curve, and, where tax efficient, geographically.

Florida’s government and professionals are spending this weekend searching for solutions to this problem. A restructuring and some extensions of maturities can help to resolve this mess. We expect the State of Florida will have to pay the losses and make the constituent municipal entities whole.

Cumberland Advisors manages about a $½ billion of tax-free, total return, municipal bond portfolios for individual clients who reside in more than 30 states. Our internal credit standards are higher than those found in the benchmark indices. We have been doing this for nearly 35 years. In the municipal bond investing world, you do not get paid well for taking default risk. Our strategy of avoidance of payment failure has protected our clients since the days of Washington Public Power (we avoided it) and Orange County, California (we avoided it). We do not expect that any of our Florida clients will experience losses because of the Florida state pool failure.

A final irony: Orange County (FL) was an investor in the Florida pooled investment fund.