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)

Ratios:

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.

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)

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. 

Actions speak louder than words.

Yesterday I sat at the Washington luncheon speech of Ben Bernanke.  We watched the stock market meltdown start about three quarters of the way through his speech.  The rest of yesterday you know.  Last night, the meltdown continued worldwide.

This morning we saw coordinated central bank actions aimed at massive stimulus in order to encourage growth and abate the credit crunch.  The tools being applied in the monetary realm are enormous and without precedent.  These tools will succeed.  They are now global and will address the freeze that has infected global financial integration.

We will update our now famous chart late Thursday afternoon.   On Friday morning see www.cumber.com  for the graphic depiction of the Fed’s new balance sheet.  We are updating it as fast as we can.

Bernanke broadcast his intentions with words.  He used academic language.  He wore his Princeton Professor’s hat.  I sat there and understood his words and nuances.  I also realized that those who are not skilled in the language of monetary economics would have difficulty comprehending his meaning.

My colleagues and I who were sitting at the table discussed the Fed’s mechanics and how the interest rate “corridor” Bernanke described is now established.  We talked about the lower bound that Bernanke mentioned and the how the upper bound would be established.  We speculated about how much time it would take to narrow the LIBOR-OIS spread.  We talked about how the change in interest payments on bank reserves would allow the Fed to dramatically expand its balance sheet.  We delved into how monetary policy can blunt a shrinking credit multiplier.

The problem for the financial markets is that Bernanke didn’t say it in plain English.  He used classic academic Fed speak.

In the last two weeks I have personally had conversations with numerous officials at central banks.  Many of those were with officials in the Federal Reserve or the European Central Bank.  Believe me; they “get it.” 

The communication problem is that they have difficulty expressing “it” in plain language.  Yes, Virginia, there is a communication problem.  We have been writing about that for several years. 

But a communication problem is not a policy problem.  When it comes to policy, the central banks are acting.  We see it today with coordinated rate cuts.  We saw it with Fed’s new commercial paper facility.  We saw it with doubling of the TAF auction.  Think about it: the TAF expansion and the commercial paper facility are likely to be 5 times the initial $250 billion in Paulson‘s TARP.  And they will be immediate.  We also saw this policy coming from the technical jargon used in foreign central bankers’ speeches.  We saw it in the rate cuts broadcast from Hong Kong and Australia as those central banks cut rates by surprising amounts.  They were the early forerunners of today’s announcements.

All of this is very positive for economies and for markets. 

It means maximum monetary effort will be applied to (1) mitigate the damage from the global housing and commercial real estate crises and the deepening recession and (2) abort the credit spread contagion.  We believe that credit spreads are now at their widest and that the unsustainable levels are about to start a process of reversal. 

Cumberland has been and continues to be a buyer of high-grade tax-free municipal bonds.  Yesterday, a bond issued by the government of the state of Ohio traded below a 5.5% yield.  That is a 5.5% interest rate after federal taxes and after state taxes by Ohio.  At the same time the short-term Treasury bill yielded near zero. 

What does this mean?  It means panicked investors were forcing the liquidation of their mutual funds and fleeing into zero-interest government securities.  All asset classes were being sold.  The indiscriminate and emotional selling was overpowering all rational, analytical thinking.  It is also the mark of a selling climax and a bottoming process. 

A bottoming process is not a single point bottom.  All global markets do not bottom simultaneously.  All indexes do not make their lows concurrently.  But they do bottom in a correlated fashion.  The reason is that they were abandoned in a correlated fashion as investors decided to sell everything and run into cash.

At Cumberland, we believe the time to be opportunistic is when emotional sellers are offering bargain goods at prices which bear no reference to their underlying value.  Ohio State General Obligation tax-free municipal bonds are one example.  There are many others in the bond and stock markets and in the global asset classes. 

It is time to scale towards a fully invested position.  This morning the US stock market was down over 350 Dow points when measured by the futures market.  That pricing marked a 5000-point decline in one year if we measure from the market top in October 2007. 

The time to be a seller was last year.  We raised some cash.  In retrospect, it was not enough although we were criticized at the time for being too cautious.

Now is not the time to throw caution to the winds.  But it is time to focus on the bottoming process with an eye toward buying.  The perfect time to be a buyer is when the last fighter “throws the towel in the ring.”  You then have to be standing there to catch it.  At Cumberland, we are standing in the ring and catching these sweaty, stinking towels.  They are being thrown to us by sleepless and terrified investors who are running to place 100% of their money in zero-interest-rate cash.

We expect that many global markets will be higher than present levels by the end of this year.  Credit spreads will be narrower.  That is how it looks to us.

First we are told that financial chaos will break out if the House of Representatives didn’t pass the ill-conceived bailout bill that Secretary Paulson and Congressional leaders put together. When the bill didn’t pass, surprising everyone, the market fell over 700 points; but it rallied the following day, gaining back about 400 of the lost points. Clearly, financial Armageddon didn’t happen. But then we were told that it was just a day away if “something wasn’t done.” So what happened?

With some slight of hand centered on use of an appropriations bill that had already passed the House (all spending bills must originate in the House), Congressional leaders cobbled together a revised bill with additional provisions designed to buy support. Its three principle features were some additional tax cuts for some individuals surrounding the AMT, relief for small banks who got stuck with Freddie and Fannie preferred stock, and an increase in the size of deposits insured by the FDIC from $100K to $250K. These three features were unrelated and irrelevant to any of the key aspects of the current set of financial market problems. This time the bill was sent to the Senate in an end run around the House. Again we were told by people here in the U.S. and by uninformed leaders of other countries that if the bailout wasn’t passed we were in for financial chaos. The Senate passed the bill, which it spun as being necessary to improve market psychology, and what happened? The market went down and gave back most of the gains it had made.

Two days later, the House also caved and passed the revised bill, and the market went down another 150 points. It now looks as if the fear mongering resulted in an expensive trip to the psychiatrist for market participants, funded by the US taxpayer. Main Street, and especially most taxpayers, aren’t the ones who stopped lending in the interbank market or stopped buying mega-blocks of stock. Warren Buffett did step in, however, so apparently it may cost the taxpayer as much as $800 billion to make Warren Buffett feel good.

Commentators rationalized the market’s decline after the House vote by suggesting that the market was concerned that the allocated amount – now over $800 billion to bail out financial institutions with junk on their books – was likely not sufficient. So much for psychology or those who claimed to understand what markets wanted or needed. The alternative explanation I prefer is that the market perceived that the remedy passed is likely deficient because it didn’t address the underlying problems and was going to be very costly to boot.

Where does that leave us, since we are now stuck with what has been done and need to think instead what it may mean for markets and investment strategy? Here are some bullet thoughts in no order of importance.

We are left with a bad piece of legislation that in no way addresses the three key problems facing the economy and financial system. These problems are: insufficient capital, too much leverage in the system (and this includes borrowers, financial institutions, and complex instruments) and an oversupply of housing.

There are those who believe that we have now hit a market bottom and that the turnaround is just around the corner. But that’s an assessment more of how forward-looking financial markets are and of market psychology. It does not necessarily reflect what is happening in the real economy. It does appear from the employment numbers and anecdotal information that the real economy is slowing now, much more so than may have been apparent even a few weeks ago. What does this mean going forward? The answer hinges on what the Fed does in terms of interest rates; and the best guess is that the Fed will have to cut rates fairly significantly, perhaps even close to where we were coming out of the 2000 recession. It was done before and can be done again.

Trying to pick the exact bottom before a market reversal is probably one of the most difficult and risky activities an investor can engage in. History suggests that over the last 50 years or so, if you were not in the market on at least two dozen critical days, then you missed out on the gains. Warren Buffett knows this quite well and has made strategic bets in firms that have sound fundamentals and good prospects. Such moves have high potential payoffs with little downside risk.

There are more losses to hit the financial system, but they are likely to be centered on the handful of foreign banks who were big players in mortgage markets in the US, UK, and Europe. Unlike US banks and investment banks, European banks have been slower to recognize losses. This is due in part to a less strict regulatory environment, especially with respect to leverage that institutions pursued in dealing in the mortgage derivatives markets.

With both the US and global economies slowing, not only will this put a damper on US exports, it will also tend to favor the US over other economies because of the flexibility and adaptability of our industries.

In terms of implementing the rescue bill, Treasury is like the dog that chased and caught the car and now has to figure out what to do with it. Think about it. It took nearly 6 months to get the first stimulus checks into the hands of the public, and all that had to be done was to run a computer program and print some checks. Now Treasury has to hire a host of people to price assets and to run a program that is intended to be largely outsourced. The firms being named as potential outsource candidates aren’t ones experienced in pricing or managing individual mortgage loans, but rather are major players in derivatives, mortgage-backed securities, and the portfolio side of the mortgage market. There is no one who is currently adept at engaging in loan mediation and knowledgeable about what it will take to keep homeowners in their houses. Time is not on the Treasury’s side. The record keeping, disclosure requirements in the bill, and need to create the required monitoring systems to keep the program, including the outsourced contractors, in line and honest will all take a long time. And this must be in place before the first dollar gets spent. I predict that we will be faced with long delays before funds actually begin to flow to troubled institutions, and for many it will be too late. In the short run, this realization will likely put downward pressure on financial markets, will heighten the pressure on the Fed to cut rates, and will ultimately up the costs of the bailout to the taxpayer.

The bottom line is that investment risks are likely to be high, and we will be in for a protracted period of slow growth that will likely be followed by a quick turnaround in advance of the rest of the world. The key determinant of that turnaround point will be when the US housing market finally stabilizes and has worked off the excess supply. All of this will happen long after the current administration and the architects of the rescue package are gone, and Congress will be faced with a large bill and no one but themselves to hold accountable.

Look at a US $100 bill. Ben Franklin stares at you from one side; Philadelphia’s Independence Hall decorates the other side. British 10-pound notes depict the Queen on one side and Charles Darwin on the other. Twenty-euro notes have no pictures of people, only a map of Europe. Ten thousand Chilean peso notes feature Captain de Fragata Don Arturo Prat Chacon and his hacienda. Zimbabwe’s 25,000,000,000 dollar bill has two giraffes on each side and an expiration date of December 31, 2008.

These and many like them from around the world have two things in common. They are pieces of paper printed by central banks and offered by their respective governments. And they are non-interest-bearing liabilities of those governments. They only promise to replace the one you have with another one just like it. Their value or lack of same is determined by (1) what they will buy in the local region, (2) what each form of money can be exchanged for if one travels and wants to convert the currency into someone else’s currency, and (3) what interest rate you can obtain if you loan your piece of paper to someone else.

In Zimbabwe, the world’s current monetary basket case, a stack of these multi-billion bills may buy a loaf of bread. No one will loan anything to anyone. There is no interest rate which can clear the market. Paper money has been rendered essentially worthless by hyperinflation. It cannot be exchanged for any other currencies accept as a collector’s item.

In the United States, there has been a panicked flight to safety in the credit markets but not in the cash form of money. Massive demand for the interest-bearing monetary form (90-day Treasury bills) has driven that interest rate to near zero. Thus the interest rate paid on the interest-bearing form of money and the zero interest on cash money is about the same. Cash and US Treasury credit are priced at zero interest.

In America, people have cash and use it every day to transact business. Most also can use credit cards and electronic payments, so they do not have to carry huge numbers of “Franklins.” Our inflation rate is low and the buying power of our currency is trusted in daily life. We reaffirm that every day when we pay for food or fill our gasoline tank.

In America, the problem surfaces in the credit arena, not in the cash transaction arena. America is not Zimbabwe.

In America, people now are afraid to lend because they do not believe they will get repaid. In America, they are acting out of fear of default. Banks are afraid to lend to other banks. Pension funds and institutions are afraid to lend to corporations. Individuals are afraid to lend to their state and local governments. This is what a credit crunch looks like in America.

In America, the crunch has reached the extreme point where the credit mechanism is frozen. Once frozen it makes no difference how cold the ice becomes. Frozen is frozen. To get things moving again it takes a thaw. The measurement of how frozen things are is found in credit spreads. These are the numerical differences between the interest rate on one item and the interest rate on a corresponding maturity of another item of different credit quality.

In America these spreads have reached the point of absurdity. An example was recently discussed by my colleague John Mousseau. John showed how the interest rate on a TAX-FREE state or local government bond is now as much as 140% of the interest rate on a TAXABLE Treasury note. Normally the note yields more than the bond. Today the note yields less than the Muni bond. This makes no sense. We see this anomaly because of fear and panic in the markets.

Fear changes behavior, just like greed.

Nine years ago American investors were selling perfectly good-quality 6% tax-free municipal bonds and using the money to buy Cisco and Microsoft at 100 times earnings. These behaviors were motivated by greed.

A decade later the same Americans are avoiding 6% good-quality state or local tax-free municipal bonds in order to put their money in Treasury bills yielding near zero. They are now motivated by fear.

Both fear and greed lead to the same result. Investors make terrible judgments and do so at the wrong time in the cycle. In many ways that is the status of things today. That is why we have ice. That is why credit mechanisms are frozen. That is why it is time to focus on the thawing and not the freezing.

The thaw itself happens after the last investor or lender has become frozen; then the credit mechanism grinds to a full stop. We have reached that point in the last two weeks. Remember: once you have ice, it is a solid no matter how cold the temperature gets. You need to thaw to start the reversal and the healing process. So let’s get to how and when we will experience the thaw.

Thaw occurs when one investor or lender at a time gains enough liquidity to obtain some comfort instead of fear and then starts to use the zero-interest-rate cash to acquire some earning asset. The asset has to appear attractive and the investor has to have enough cash (zero-interest-rate money) to be willing to commit some of it to risk taking. We recently saw Warren Buffett do that with GE and Goldman Sachs. We see it again with Wells Fargo topping the Citi bid for Wachovia and doing so without federal assistance.

It takes three pieces of government policy to assist a thaw.

First we need infusion of a very large sum of cash. The Congress has just authorized that. We criticized the form of the package and believe it is seriously flawed. That said, it is now in the law and the amount of federal credit is huge.

More importantly, the Federal Reserve has nearly doubled the size of its balance sheet in a matter of weeks. This global infusion of cash is larger than the Congressionally authorized $700 billion plan. See www.cumber.com for a graphic depiction of this remarkable change.

The Fed will now reduce the policy-setting interest rate from 2% to 1.5% or even 1%. That will reinforce the very-low-interest yield on interest-bearing forms of cash.

So piece number one is in place and expanding. We are getting and will get a lot of money into the system.

Piece number two is transparency. We need to see the assets clearly and obtain market-based pricing discovery of their value. That process, too, is now underway. It is a long time in coming. We will see it in some of the government’s auctions. We will see it in the valuation of collateral used by the central banks as they attempt to liquefy the system. And we will see it in the disclosures that surround the forced mergers of firms like Bear Stearns and the liquidation of firms like Lehman. Transparency is coming because the market needs it to thaw, and therefore the market will get it because opacity is no longer a viable choice if you want to survive.

The third piece is a clearly understandable process of resolution. Here we are still in an opaque world. Perhaps the US Treasury will clarify this one when it starts the implementation process. It now has to disclose and report. It still has enormous power, and Congress did not put in an oversight and veto authority. The Federal Reserve’s role is consultative, and the Congressional directive is to report after the fact. Shame on the Congress: shame, shame, shame. As our national legislative body, they have affirmed their lack of willingness to accept responsibility for anything except getting re-elected to office.

The Treasury Secretary now has the greatest concentration of power in a cabinet officer in the financial history of the United States. All eyes that can do so must watch this cash register. And voters must hold this Congress responsible for the outcome, since they are the ones who empowered the Treasury Secretary.

When the market thaws we will immediately see it in the narrowing of credit spreads. That will remove some of the nonfunctioning elements in the financial markets. As this occurs it will pick up its own momentum, just as the freezing side led to an accelerating contagion. Thawing has an accelerator too.

In our view the US financial markets are in the process of marking a strategic turning point. They will not do it all at once, and the volatility at this turning point is enormous. But turning points also represent strategic entry opportunities. Only history will show you when an actual turning point occurred. It is visible only in retrospect.

I believe that two or three years from now we will be looking back and saying that the end of 2008 was one of them. I hope I’m right.

The municipal bond market has witnessed one of its most dramatic sell-offs in the past three weeks – most of this in the wake of the Lehman Brothers bankruptcy.  This has happened as all NON-TREASURY markets have seized up.  The capital markets are awaiting the potential bailout plan from Congress, but the municipal (as well as other markets) have backpedaled at breathtaking speed, with yields higher by 75-80 basis points in the past two weeks alone, which translates into price declines of 8-10% this month.  Many AA or better rated bonds are trading at 5.75% to 5.85% yields.  This is almost 140% of the US Treasury yield, unprecedented in the market, and in the long run unsustainable, in our view.  To put the backoff this month in perspective, the Lehman Brothers Long Bond Municipal Index is down 9.9% year-to-date; 8% of this was in the month of September.

The dramatic fall-off can be seen in the attached chart. This shows the difference in yields between the Bond Buyer 40, an index of longer, higher-rated, investment-grade, tax-free bonds, published by The Bond Buyer newspaper, and yields on the 30-year US Treasury bond, over the past three years.  The normal state of affairs is for tax-free bonds to yield less than Treasury bonds (red area) because of their tax-free nature.  That has been turned on its head in a historical proportion.  The green area on the graph – with munis yielding more than Treasuries –shows how aggravated this has become this year, and in the last month particularly.

There are a number of reasons for this:

–       A LACK OF LIQUIDITY ON WALL STREET.  The Lehman bankruptcy sent shock waves through an already fragile credit market, creating much higher short-term yields as well as intermediate to long-term yields.  This year has seen the closing of bond departments at Bear Stearns, UBS, and Lehman Brothers (returning as an arm of Barclays), with further reductions by virtue of the merger of Merrill Lynch with Bank of America and Wachovia with Citicorp.  This has left retail as the major buyer (though they have started buying).

–       HEDGE FUND SELLING. We witnessed this in February, when hedge funds (who buy tax-free bonds with funding based on short-term muni rates) sold non-stop for five days on the heels of the freeze-up in the auction-rate market.  We have seen much more of this in the wake of the Lehman bankruptcy as short-term rates have skyrocketed.  Thus bonds have been sold into a market with no bid.

–       THE DOWNGRADES OF MOST OF THE BOND INSURERS. This has been by Moody’s and Standard and Poor’s in response to the insurers’ insuring of mortgage-backed pools that have fallen in value.  Because there have been some defaults in these pools, many of the insurers have not put up the capital that Moody’s and S&P have requested; some of the insurers, FGIC and CIFG, were downgraded to below investment-grade; and AMBAC and MBIA, the stalwarts of municipal bond insurance, were downgraded in June, losing their AAA status and being put on watch for further downgrades. This has made the market look at only underlying ratings.

–     THE BANKS ARE NOT HOLDERS OF MUNIS BECAUSE OF THE TAX CODE.   The tax economics keep them from buying anything that isn’t bank qualified, so they don’t have inventories of munis to use as collateral pledges with the Fed.  Hence the muni market is a degree removed from other debt markets when it comes to the Fed’s liquidity provision.  Therefore it is not getting any help from the Fed’s policies

We believe the tax-free bond market is at the cheapest level it has been since early 2000.  On a relative basis it is the cheapest it has ever been.  Intermediate and longer tax-free bond yields have moved above their averages for the past 20 years. We feel it is the most OVERSOLD it has been in a generation and represents incredible value.

What are some of the factors that will bring the main market into a degree of normalcy over time?

–     DIRECT RETAIL BUYING.  This has been picking up speed, and we expect it to continue to accelerate.

–     CROSSOVER BUYING.  This is purchasing by nontraditional municipal bond buyers such as pension plans, charitable foundations, and state and local governments.  They realize that muni safety is second only to Treasuries and that in short-term paper there are yields HIGHER than they can buy in the taxable markets, while in the longer end the tremendous RELATIVE value offered by tax-free bonds will show good performance as the two markets eventually return to a normal relationship..

–     FUTURE INCOME TAX INCREASES.  With the financing of the bailout plan and a lowering revenue stream to the US Government, whoever is elected President is most likely faced with raising the marginal Federal income tax rate.  Right now, with many longer yields above 5.5%, this translates into roughly 8.5% on a taxable equivalent basis.  And in higher-tax states this taxable equivalent approaches 9% when state taxes are taken into effect.  This certainly approaches long-term equity returns

–     CASH HITTING the MARKET.  Many firms are settling with clients who have had funds invested in short-term, closed-end, preferred auction-rate securities, which froze up last February.  This amount could be in the $30-40 billion dollar range and will be available over the next month or two. With interest rates presumably higher by 75 to 85 basis points in only a few weeks, this will attract investment.

At Cumberland we are using this extraordinary opportunity to improve call protection on portfolios, achieve some tax-loss swapping now, and lock up yields which we have not seen in many years. 

Well, the deed is done.  It now makes no difference if we like this new law or not. 

Some Bullets.

The Senate has passed the new version with a filibuster proof margin of over 60 votes.  It now goes to the House.

The House first sends it to the Rules Committee; they decide the terms of debate in the House.  Since they are controlled by the majority party, the Rules Committee will decide in accordance with the decisions of the Pelosi leadership.  Rules Comm. will limit debate to a few hours.  We are told it is likely to be just three hours.  Rules will not permit any amendments.  Rules will not permit any substitutes.  Rules will restrict the debate and vote to the version which has just been passed by the Senate.

The changes now in the Senate version appear to be enough to turn some of the previous House votes from “no” to “yes.”  We expect that they will be in a sufficient number to achieve 218 “yes” votes in the House.  That is all it takes for passage.

We expect the president will sign this final bill quickly.

The politics have put members of the Congress in the middle.  If House members vote no, they will face a political attack for not voting to increase FDIC limits or extend Alternative Minimum Tax relief or provide other economic benefits.  Those benefits would have passed the Senate in a separate bill; many of them had already passed the House.  It is the Senate which has now tied the whole thing into one up or down vote.

If House members vote yes, they are open to attack for supporting the bailout plan.  Either way they are subject to intense fire as they go into the election.

The final bill has a partial blank check to the Treasury Secretary.  He is able to use taxpayer money to acquire “troubled assets.”  The paragraph below is in the legislation.  

“TROUBLED ASSETS — The term ‘‘troubled assets’’ means — (A) residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages, that in each case was originated or issued on or before March 14, 2008, the purchase of which the Secretary determines promotes financial market stability; and (B) any other financial instrument that the Secretary, after consultation with the Chairman of the Board of Governors of the Federal Reserve System, determines the purchase of which is necessary to promote financial market stability, but only upon transmittal of such determination, in writing, to the appropriate committees of Congress.”

Reader Don Greenup emailed this observation:  “Notice that conspicuously missing from the definition is the requirement that the asset’s underlying thing (that is, the property that was mortgaged, etc) lies within the United States.  Also note that Treasury must tell Congress if they add ‘new types’ of debt, but that Congress has no right of review or censure.”

He also noted that it is “perfectly legitimate under the bill for a foreign bank to sell or swap … a holding (irrespective of how or where it originated, so long as a mortgage is the basis for it somewhere) with a bank domiciled in the United States, and said bank may then "PUT" it into the TARP.”  I wonder how many citizens know that the US Treasury can pay for these assets which are foreign owned and swapped.

There are a lot of other distasteful things in this version.  And remember there has not been one single minute of hearings that allowed commentary from citizens.  My friend and fellow grand pop, Vince Farrell, sent this item:

“Our elected representatives said they needed more time to consider such sweeping and important legislation. What they wanted was time to dress the bill up with bells and whistles that make McCain’s tirade against earmarks sensible. Two Oregon Senators, one a Democrat and one a Republican, put in an earmark for the Rose City Archery Co. It’s an Oregon based company that makes arrows used by children. A provision repeals a $.39 excise tax on wooden and fiberglass arrows. It will save the Rose City Archery Company some money. Thank God for our diligent legislators! This is one of dozens of tax breaks that cover Hollywood producers, stock car racers and Virgin Island rum-makers. At least the rum is important.”

Ok.  We have written enough about the things wrong with his bill.  That debate is about to end with passage by the House on Friday. 

We now have clarity about this legislation.  Markets like clarity.  They can handle bad news better than no news.  It remains to be seen if this bill will work.   What’s clear is there is now a structure and funding in place.

Now that it is law, we expect the Federal Reserve can move to lower the targeted Federal Funds Rate.  A half point cut or more could come at any time.  The Fed will also immediately begin to pay interest on reserve deposits.  These were previously non-interest-bearing.  That is acceleration from a planned change 2011.

We expect credit spreads to narrow slowly and we expect stock markets in the world to have an upward bias through yearend.  The economic statistics will be bleak.  We are in a full-blown global recession.  Markets are forward-looking.  They will rise if they see the recession ending by the second half of 2009.

What a mess!   And it is about to get worse.

Americans have repudiated both their 2-term Republican Administration’s leaders (Bush & Co.) and the Democrat Congressional leaders (Pelosi, Frank, and Dodd).  We have done so for good reason.  These politicians are neither trusted nor respected.  This is the result of their behaviors over the last few years.  The Congress has an approval rating so low that it is in competition with cockroaches and palmetto bugs.

Terrified House members voted “no” and broke with their party leaders.  Democrat Pelosi faced an out right leadership defeat so she gave “permission” to her party members to vote against her.  They were going to anyway.  Republican Boehner allowed his members to ”vote their conscious” and oppose him.  They were going to do it anyway. 

Query: shouldn’t Congressmen and woman always vote their conscience?  Should they have to ask for “permission?”

Because the voter, independent business man, retiree, and bank depositor is afraid, the rank and file American citizen has finally emerged from a cocoon and besieged Congress with an avalanche of “no”.   Members who face election only weeks away responded. And a lousy piece of legislation failed in the House.  Yes, it was a bad bill.  Yes, it had been improved from an even worse initial draft offered as the Dodd-Frank proposal.   Yes, it took away some of the blank check handed to the Secretary of the Treasury.  No, it did not go far enough.

Today the Senate will take the same lousy bill and add an increase in FDIC limits and some other Alternative Minimum Tax fixes and pass it with a wide majority.  Senators believe they are “safer” than Members of the House.  Only one-third of them stand for re-election at a time.   This Senate version is still a lousy bill.

Here’s why.  It takes cash and buys bad assets from the institutions who decide to participate.  Any institution that can avoid the constraints in this bill will try to do so.  Thus only the weakest will opt in as an act of desperation.  The others will languish and deteriorate until they, too, become so weak as to leave them without any choice.  This bill’s structure only prolongs and exacerbates the problems.   

The transfer of assets does not get banks additional capital.   It gets a liquidity substitution and that will help but it is capital that the banking system lacks and this plan doesn’t provide it.  Alternate plans offered in the House are addressing this serious deficiency. 

Meanwhile the banking industry is consolidating rapidly on its own.  The Federal Reserve is now aggressively adding liquidity at unprecedented levels in ways that were never previously contemplated.   Bernanke and Co. realize they must avoid a Depression.  They will succeed on the liquidity side. 

The solvency issue is different.  It takes new additions of capital.  And it takes recognition of loss.  The current plan that will be passed by the Senate gives some consideration of the later but it doesn’t solve the former.   That is the flaw. 

Raising the FDIC limits will help slow the “runs” that are occurring on banks.   But the limit of $250,000 is not a sufficient increase to protect an independent businessman who operates with a bank account balance that is in the uninsured zone.   That business is afraid of losing its money in a bank failure.   Hence the businessman is spending his efforts managing his bank deposits for safety rather than running his business.  He is just as human as the retired CD buyer who is now using a dozen different banks to stay federally insured.  Think about all the wasted effort being consumed to protect one’s cash instead of growing the economy.

The FDIC is now acting relatively quickly and competently in ways that lessen the losses to depositors.  FDIC folks know that every uninsured depositor loss now will have a heavy multiplier and create more havoc in a weakened banking system.  There is now visible and responsible action by this federal agency and they are to be supported.

The problem is that banking is consolidating very rapidly.  The big three banks now have one-third of all the deposits in the country.   There will be a lot more consolidation before this turmoil period is over.  That means the smaller regional and local banks must fill a local service provision needed by their local customers.  This is a business opportunity for those banks but they must seize it with adequate capital.   

Congress is already way behind.  They’re acting reactively and not proactively.  They have shirked responsibility for years and the voters are truly angry.  

Alternate proposals are circulating in the House.   They need daylight and it must be done quickly.   The House leaders need to see that they must pass a “people’s version” of a proposal.  It needs to reflect the interests of the nation’s depositors and independent businesses.  It needs to protect 140 million Americans who are still employed and who earn their daily bread in a gainful enterprise.  And it needs to be clearly understood.  It must not hand a government official a blank $700 billion check. 

If we get that form of a bill we can meet the three tests needed to blunt the systemic risk that has developed following the failure of Lehman and the onset of accelerating contagion.  The three tests are: (1) a lot of money (2) transparency about valuation of assets (3) clarity of the process of resolution.  The House voted “No” on a bill that had only the first of these three elements and not the second and third.  The Senate is about to pass a bill that still only has the first element.  It is now going to be up to the House to add numbers 2 and 3. 

On September 12, we discussed the possibility of a Dow 1000 point drop if Lehman failed.  That interview is still up on cnbc.com.  Insert my last name into the search and it will be on the list.  In it we referred to the issue of systemic risk.  Now we have it.  In fact we are more than half way through the result already.  While our Washington emperors have fiddled, Rome has already burned.  The House has a way to put out this fire.  To do so, it must offer an alternative to the Senate version.  Otherwise we are only prolonging and intensifying the agony.

All that said, we expect stock markets are nearing levels of a bottom.  There are many signs that a bottoming process is now underway.   And credit spreads have already widened.  They are at levels where markets are seized.  Witness the LIBOR-OIS or the General Electric credit default swap pricing this morning.  We have reached the point of reversal because it is the only remaining option. 

Reversal in the credit markets will come with certainty of outcome.  I believe spreads narrow whether or not Congress acts.  Either failure or passage will remove the political uncertainty.  An election will lift the other uncertainty.  Markets will respond positively regardless of the political outcome.  Markets greatest fear is uncertainty.  Credit spreads hold the key and they are now so wide as to suggest they can only narrow.  The country cannot function unless they do. 

In sum, we are witnessing extraordinary American financial history.  The amount of fear in the land is immense.  That is usually symptomatic of a buying opportunity and that is how we are seeing it.   We are actually leaning toward becoming strategically bullish.  In the 800 point drop we did a little buying.  We expect that we will be doing some more.  In the bond market the tax-free municipal bond is now priced as a true gift and not just a bargain. 

We offer a final thought in the spirit of the calendar.  The Old Testament has many commandments and instructions.  The most frequently mentioned is not “do charity” or “respect thy neighbor”.  122 times the deity instructs us not to be afraid.   Fear is the worst enemy.  Panic is the outcome of intense fear.  Biblical scholars have examined this question for a long time.  There are reasons why fear is the number one issue addressed in the bible.  Those reasons are valid in the financial world today. 

A banker friend told me about the elderly woman who took her $250,000 out of his bank and put the cash in a shoe box.  He stopped her long enough to get her to sit down so he could ask her what she would do if she slipped in the parking lot and the wind blew the lid off the box and her life’s savings blew away.  In the end he was able to calm her and to convince her to put $100,000 in each of 2 banks and the other $50,000 in a third bank.  He helped her do it. 

That banker did a “good deed.”   He addressed her fear. 

The leaders of both Houses of Congress and our very unpopular president and our Treasury Secretary have not lessened American’s fear.  They have made it worse.  They now own it and voters will be able to express themselves in only a few weeks when memories are still fresh. 

It is now time for our national leaders to confront this fear and not fan its flames.  Riots must be quelled not fueled.  And we, the voters, have a duty to throw out any elected politician who chooses partisan scapegoating over national interest. 

We voters, too, must set aside our partisan differences and make selection only based on the candidate’s character.  That goes for Democrats and Republicans.  Partisan bickering is now painted with the same brush regardless of political party.  Partisan bickering is the enemy and those who engage in it must be thrown out. 

The Senate votes today.  Then all eyes turn to the People’s House.  There is where we will find the true test of leadership.  So far, its leaders have failed. 

Here we are with another intense weekend to add to the pile of 7-day work weeks. 

Washington Emperor Barney Frank says “Follow me.”  He looks around and no one is there.  Result: blame someone else.  So he points fingers and seeks scapegoats.

Did he mention he added 4.2 basis points to the Fannie-Freddie bailout for his pet projects?  Did he say he controlled the bill in his committee so that his projects would be paid regardless of profit or loss in the revitalized FF?  Did he mention that he and Chris Dodd also have the profits from this $700-billion plan headed for his special project funds and not to the US Treasury or the taxpayers?  No.

The Emperor would not remove his clothes to show us these warts.

CNN (last night) removed some outer garments when it reported the amount of campaign contributions Frank has received from the financial related industries is $2.5 million.  His Senate Counterpart, Chris Dodd, was listed at $13 million.  These Emperors have some very fine clothes.  You and I are the ones who will ultimately pay for them.

This is Washington, where Emperors fiddle while the rest of us burn.  When the music stops briefly they engage in Pontificatus Interruptus and then resume the closed-door negotiations. 

Transparency?  Fuhgedaboudit!  We don’t have any.  Markets know it.  That is why in London on Friday the British pound denominated credit default swap on the United States traded higher than the one on McDonalds.  That is why some money market funds on Friday would not tell their customers if they were going to “break the buck” or not.

Credit markets are seized and they are waiting.  That is why we are going to get a $700-billion deal. 

It will function as a way to replace or infuse capital into the banking system.  The system is $200 billion short right now if you take losses to date and subtract capital raised to date.  So the $700 makes up for the $200 billion shortage and adds another $500 billion, which is sorely needed.  It will be consumed by more recognition of losses.  That may seem circular.  It is, but that is what we are going to get as a policy.  $700 billion may not be enough in the end, but we are now getting closer to the correct number if we add it to the rest of the federal initiatives.  We are well over $2 trillion now.

Yes, indeed, there will be a $700-billion deal.  It will have lots of things wrong with it but it will become law.  Perhaps it will have a 9/11 type commission of independent and bi-partisan folks who will drill into the forensics on Bear Stearns and Lehman.  Some Congressmen are trying to get that into the law right now while the iron is hot.

Meanwhile the Fed is engaged in a massive, startling, and extraordinary use of its powers and redeployment of its balance sheet.  Several hundred billion of high-powered money has been injected worldwide this week in an attempt to blunt the contraction of the credit multiplier.  This is a partial amount of the price we all will pay for the failure of Lehman, a primary dealer.  That is the most tragic and awful policy mistake made so far in this two-year period of turmoil.

We track the Fed closely at Cumberland and try to make all this easily understood for our readers.  See www.cumber.com  for the latest graphic.  We must caution that changes are coming so fast now that we are in a constant struggle to keep things current for our readers.  We think we have most of it current after the Thursday afternoon reserve report.  We are trying.  Readers are invited to email me if they see an error.

Adding several hundred billion in raw cash by the central bank is normally an inflationary event.  But when the credit multiplier is shrinking faster than the money is added, the result is not inflationary.  In fact, if the Fed didn’t do this the result would be deflationary in the style that we saw for a decade in Japan.  Bernanke will use all the power of the central bank to avoid a Japan experience.  Of that we can be assured.

The problem will come in the future, when it is time to start extracting policy from this stimulus.  That is not for 2008 and may start in 2009 if the economic indicators begin to stabilize.  We will deal with that later. 

As Bill Dudley, the NY-based Fed officer who supervises the System Open Market Account described it, “we are in interesting times.”