Treasury rolls out the TARP

Change at the speed of Paulson

 

The banking landscape is changing and one thing is certain…we’re all going to have to move fast to keep up.  The Treasury department is rolling out the TARP (not a red carpet but hey…this is the government and a TARP will have to do). 

 

The TARP program is designed for the express purpose of injecting capital into the banking system to stabilize it and promote confidence therein.  This is no small program…starting with the initial $250 Billion it will literally change the look of the banking landscape. 

 

The first round of this program saw $125 Billion in capital distributed to the big nine: JP Morgan, Bank of America/Merrill Lynch, Citigroup, Wells Fargo (includes Wachovia), Goldman Sachs, Morgan Stanley, Bank of New York, and State Street Bank. 

 

The Treasury is very aware of the fact that some stigma might be attached to anyone that approached them for capital, so they forced these nine banks to take the money whether they needed it or not.  The goal here is to establish confidence and if everyone is doing it nobody can be singled out as weak for participating.  The remaining $125 Billion will be distributed to “qualifying US Banks”…this is where you come in. 

 

You may remember from our Nordic Banking Crisis review a few weeks ago that capital injections are part of the model that the government will use to get us out of this financial crisis.  All in all it’s a pretty good plan…as we’ll see it’s really good if you’re a community bank looking to boost earnings.

 

There are a lot of details to cover, but to get the ball rolling we’ll look at the big picture first.  We are dealing with a VERY compressed time frame for making decisions on this matter.  The deadline to apply is November 14^th.  That means you have to know all there is to know, educate the board, reach a consensus, fill out the application, and have it submitted in about 2.5 weeks.  That doesn’t leave a lot of time for scheduling committee meetings.  To help out in this regard we have scheduled two webinars that you can use to educate all key personnel on the details of the program and we’ve created all the analytics you need to illustrate how the program would apply to your bank.

 

So given that quick introduction lets dig in…the clock is ticking.

 

What’s a bank to do?

 

Every bank should consider participating in the US Treasury Department’s TARP Capital Purchase Program Senior Preferred Stock and Warrants (“TARP Preferred”) and here is why.

 

• The Treasury TARP Preferred is the cheapest source of capital - by a long shot.  Warren Buffet got a 10% interest rate and warrants equal to the amount invested in his deal with Goldman Sachs.  The TARP Preferred will cost you 5% with warrants equal to 15% of the amount invested.  There is no private capital available at these levels.

• The capital can be used to offset loan and security losses, merger and acquisition considerations or for balance sheet growth using securities in the short-term and loans longer term.
• The break-even point for leveraging the TARP Preferred is approximately 4 times at a spread of 150 basis points. The TARP Preferred is typically non dilutive to current shareholders at this level of levered asset growth.

• You do not have to be a troubled institution or have troubled assets to apply for the TARP Preferred.
• You can apply first while you review the terms of the program.
• The deadline to apply is November 14TH.
• The Treasury will not report applicants, only approved institutions.
• You can withdraw your application if you find the terms unacceptable. 

• Non Public Banks are eligible - Private and Sub S terms from the Treasury department are expected any day now.

 

The TARP preferred is a cheap source of capital, not a cheap funding source. To overcome the cost of the TARP Preferred, leverage will be necessary to blend the cost of the TARP Preferred with lower cost wholesale funding from the FHLB.

 

Attached is an analysis of the US Treasury Department’s TARP Capital Purchase Program Senior Preferred Stock and Warrants (“TARP Preferred”) on your institution using call report information. This model is flexible and can customized to show many variations.  In its current form it provides a very useful “big picture” look to use as a starting point for analyzing how your bank can maximize the potential of the TARP Preferred program. 

 

For a typical bank if TARP Preferred Stock equal to 3% of risk-weighted assets were issued the treasury would have a minimal effective ownership interest. The Treasury effective ownership interest for your institution can be found in the attached analysis.

 

The break-even point for leveraging the TARP Preferred is approximately 4 times at a spread of 150 basis points. In other words, the model suggests that the TARP Preferred should not be dilutive when asset growth of four times the amount of the TARP preferred is achieved. This can be done short term via security purchases with the cash flow from the securities used to fund loans. 

 

We believe the 150 basis point asset growth spread can be achieved. As an example 15-year MBS are trading at historically wide spreads, and offer an excellent opportunity to lever the TARP Preferred capital. Over time as an institution has the opportunity to fund loans, the cash flows from the MBS can fund the loan demand. We believe that to maximize the benefit it is important to purchase securities to lever the TARP Preferred before MBS spreads tighten to historical levels.  The Treasury Department will issue a total of $250 billion of TARP Preferred. If this $250 billion is levered at 10 to 1 it represents purchasing power to buy $2.5 Trillion worth of GSE debt.  The total MBS debt guaranteed by FNMA and FHLMC is roughly $5 Trillion, so the potential for bank purchases fueled by the TARP Preferred could tighten spreads dramatically. Currently MBS Spreads on 15yr paper are historically wide, at approximately 298 basis points over the 5-year treasury compared to a weekly average spread of 117 basis points over a 5-year period. If spreads tighten just 100 basis points the approximate gain is 4% on discounted seasoned 15 year MBS.

 

The attached model assumes that asset growth via loan funding and securities earns a yield of 5% against blended FHLB advances costing approximately 3.5% producing a spread of 150 basis points.  Given the volatility of the markets the spread will change from day to day and can be modeled for you given your asset liability and risk return profile.  We can model the asset growth using the mix of loan funding and asset purchases you deem appropriate for your institution.

 

We strongly suggest you consider applying for TARP Preferred capital.  This is one of those times in history where time is of the essence.  Banks have roughly 2.5 weeks to get the board and management educated on this program before the window shuts.  The big banks were told that if they didn’t participate in the program at the start then they would be locked out in the future…there would be only one chance to take the money.  It is imperative that at the very least you take a studied approach to this topic.  The deadline to apply is November 14, 2008.

 

Because this is such a timely and important topic we are hosting a webinar October 30 at 12:00 noon Central and again Friday October 31 at 12:00 noon central time.  This is the perfect time to get your board and senior management up to speed on this issue.  They can dial in from where ever they happen to be and get all the information they need to make informed decisions.   We are available on an ongoing basis to address analytical needs in support of this process. 

 

 

Market Update 10 21 08

 

Yesterday was notable for two things:  a massive rally in MBS product, and a big drop in Libor funding rates.  It appears that the globally crafted plans to restore confidence in the financial markets are beginning to get some traction.  Treasury prices are up this morning pushing yields a bit lower along the length of the curve, interbank lending rates are easing, and spreads are tightening on investment product.

 

 

 

The graph below shows the spread between 3 month Libor and 1 year Treasury.  As you can see, Interbank lending rates as indicated by Libor have dropped significantly.  Libor rates affect not only banks in England that need dollar denominated loans, they affect anyone who owns an adjustable rate security that resets over this curve, they affect the GSE’s that fund off the Libor curve, this rate has far reaching affects in the global economy.

 

 

 

 

Yesterday afternoon we saw a massive tightening in MBS spreads.  The graph below shows the recent history of MBS spreads but a more concrete example is available.  Yesterday morning I shot out a 10 year MBS that was available at 99-16 to provide a 5.10% yield.  By early afternoon that bond had run up to 100-19 to yield a 4.77%.  The bond dropped over 30 basis points in yield over a very short period of time in the early afternoon.

 

You’ve likely seen some of the ridiculous levels in corporate paper as well recently.  Two weeks ago we saw AAA rated, 3 month GE paper yielding 6.43%.  Yesterday 1-YEAR paper from GE was down to 5.11%.  Spreads are still wide in some sectors but they are getting more efficiently priced each week as we move through this crisis.

 

 

 

 

Fed Funds futures are pricing in a 100% chance of a cut at the 10/29/08 FOMC meeting.  58% of the probability is being placed on a 1.00% Fed Funds level.

 

 

 

 

If you have any questions on this material or if you need anything from me just let me know.

 

Steve Scaramastro

800-311-0707

 

 

 

 

 

Market update: 10 17 08

As we’ve been saying for a month or so…the financial crisis is taking front page but eventually people will begin looking at the real economy again and when they do they will see numbers that paint a very weak picture. Yesterday the Philadelphia Fed Index (an index that tracks manufacturing in the Philadelphia Federal Reserve district) posted its biggest drop in over 18 years. The survey expected a -10 reading and the index actually posted a -37.

This morning’s numbers on Housing Starts and Building Permits were the latest in a long line of economic releases that were worse than expected. Based on the prospect of a global economic slowdown oil is trading at $70 a barrel. That is down an astounding 52% from the high it posted over the summer.

Equity Index futures are pointing to a lower open for stocks.

The big news of the day is that Libor rates are beginning to decline. All it took was a massive and coordinated global effort which saw unlimited dollar loans to European banks and blanket guarantees of bank debt…piece of cake right? Un-freezing the inter-bank lending market is a primary goal of this effort. 3-month Libor is off about 9% from its high. That is a welcome sight as it indicates that some of the counter-party fear that has gripped the inter-bank market is beginning to wane.

Commodities are mirroring the drop in crude oil prices as the global economy slows. The Goldman Sachs Commodity Index has cratered from its high. It is down 52% over the last few months.

Fed Funds futures are trading with a 100% chance of a cut at the 10/29/08 meeting. 58% of the probability is assigned to a 1.00% level for the overnight rate after the next meeting. We’re in a spot now where the chatter is about the Fed needing to lower rates but running out of room to do so.

There has been a lot of friction in the markets over the last two months. Generally that friction has been very positive for buyers and not great for those needing to sell. I would expect this friction to continue for some time. There are some signs that the financial markets are moving toward a more normal operating state. Libor funding costs are a positive sign, when banks are willing to lend to each other the system gets lubricated with cash. Interbank lending is a necessary function. It will take some time before all is calm and trading desks begin stepping back into the market…in the interim we continue to find some very inefficiently priced securities that are making buyers happy.

If you have any questions on this material or if there is anything you need just let me know.

Market Update: 10 16 08 _The Fed, the Financial Crisis and what you need to know about Norway

What you need to know about the Nordic Banking Crisis

Earlier this week St. Louis Federal Reserve President James Bullard went to great lengths to point out that in the Feds view the best comparison for our financial systems current plight, and the government’s plan to respond to this plight, is the Nordic Banking Crisis of the late 80’s and early 90’s.  This statement was clearly a sign for anyone listening or reporting on the speech that the Feds actions going forward will be modeled on the actions that the Nordic countries used to tackle their problems.  As you see the Treasury and the Fed apply fixes to this problem and you wonder what on earth they are thinking, you should break out this guide to the Nordic Banking Crisis and use it as a beginning point of reference.

Before we look at the solutions I’ll summarize as best I can (and this will be a very brief synopsis) the conditions that set the stage for the Nordic crisis as it unfolded in Norway.  Sweden and Finland faced the same problems and dealt with them in similar but not identical fashion.

What caused it?

The Norwegian banking system was deregulated between 1984 and 1985.  Upon this newly deregulated landscape, banks competed for market share, free from their old restraints.   In many cases bank management teams were not sophisticated enough to even grasp the risks posed by the new environment, much less able to manage those risks.

A low interest rate environment combined with a newly deregulated banking system and a general sense of optimism fueled a huge boom in loans.  Lack of expertise in competitive credit markets on the part of bank management and regulators along with poor loan valuation techniques and a lack of internal controls ultimately would prove fatal in a down economy.

Recession hit the Nordic countries in the late 80’s and at that point the fundamental shortcomings mentioned above were brought into stark focus as the bad loans began piling up.  Bank losses ballooned to roughly 2.8% of Norway’s GDP at the height of the crisis.  US GDP for 2007 in current dollars is roughly $13.8 Trillion.  By comparison 2.80% of our 2007 GDP would equate to losses of $386 Billion.  Earlier this year we passed the $500 Billion mark in worldwide bank losses associated with problem loans and investments.  Many estimates put the final tally between $1 Trillion to $2 Trillion before the bleeding stops.  A $1 Trillion figure would equate to 7.24% of total US GDP…a shocking figure.   Not all losses will be absorbed by US firms but framing the losses in percentage of US GDP I think helps gain perspective.

Small and mid-sized Nordic banks went down first, then the problems began overtaking the big banks.  After the loan problems burned through the industry generated insurance funds the government had to step in to help recapitalize the banks.  Not all banks were deemed salvageable and any banks that sought government help had restrictions attached…here is where things should begin to sound familiar.

A summary of the more important restrictions set forth by Nordic regulators are below:

·         the management and board of directors of the bank were replaced

·         the existing share capital was written down to cover losses to the fullest extent possible

·         the bank's operating costs were reduced and some of its activities downsized

·         measures were taken to restrain growth in the bank's total assets.

(this list provided by Mr. Jarle Bergo’s paper “Crisis Resolution and Financial Stability in Norway”)

At the height of the crisis the Norwegian government owned roughly 60% of the banking sector…a startling figure.  Ultimately the government realized a “reasonable” return on the money lent to those problem banks.   What Norway considers a “reasonable return” in exchange for taking over 60% of the banking industry isn’t mentioned.   

So that is the short story of what caused the crisis.  Next we need to look at how they got out of it since theirs is the model that will guide our efforts.

How did they fix it?

“The most important characteristics of the resolution of the Norwegian crisis can be summarized as follows:

·         The banks' own collective guarantee funds handled the problems in the banking sector before the crisis became systemic.

 

·         No blanket guarantee for the banks' debts was provided by the government.

 

·         No regulatory forbearance.

 

·         No liquidity support to banks whose solvency was in doubt.

 

·         A clear and transparent division of responsibility between the political authorities, the supervisory authority and the central bank was established early on.

 

·         Government support was contingent on strict requirements being met, e.g. existing shareholders accepting a write-down to cover losses to the extent possible.

 

·         No micro-management of the banks.

 

·         Measures taken to prevent supported banks exploiting the situation vis-à-vis non-supported banks.

 

·         No asset management companies or "bad banks". “

 

(The list above was copied in its entirety from “Crisis Resolution and Financial Stability in Norway” by Mr. Jarle Bergo.)

So in summary the government set up a way for banks to draw on taxpayer funds to recapitalize, if it was demonstrated that the bank could remain solvent, and there were significant penalties involved with the government funding in order to provide incentive for the banks to exhaust all other alternatives before approaching the government for a handout.

Finland appears to have had the worst road as they had massive bank failures/mergers as GDP plummeted from positive 5.4% to negative 6.5%.  After Finlands crisis had run its course approximately 60% of their banks were owned by foreigners.  St. Louis Fed President Bullard specifically mentions Seppo Honkapohja’s paper as a reference point for their plan.  I’ve attached Mr. Honkapohja’s paper “The 1990’s Financial Crisis in Nordic Countries” for reference, along with a checklist of causes of the Nordic banking crisis as listed in the attached IMF paper on the subject, and a widely studied paper on the crisis by the Bank of Norway.

I hope you find this roadmap useful as we chart our own course.  Based on St. Louis Fed President Bullard’s comments it appears the Fed is telling us that this is the model they are using for reference.  With this in mind we should all be able to better track the method behind the madness. 

In the near future we’ll take a look at Japans Lost Decade as the Fed is beginning to mention avoiding our own Lost Decade as a primary motivator behind this effort to fix the financial mess.  That will have to wait a bit…right now I need to go sell some bonds.

If you have any questions or if there is anything I can be doing for you please let me know.

 

GSE Debt is now EXPLICITLY Guaranteed

Last night I made a huge sacrifice for everyone…I sat through a dinner/speech on monetary policy given by St. Louis Fed President James Bullard. Mr. Bullard is a great guy with a pretty good sense of humor for an economist. Most of the night was pretty standard fare, a review of the history that got us here, a description of the Feds mandate, yada-yada-yada. The real gem of the night came in his prepared remarks when he said…and I quote:

“The GSE’s were previously implicitly backed by the US Government, and the recent action (conservatorship) makes that backing completely explicit.”

Take a moment and read that again…I’ll wait right here…

The fact that GSE debt is now explicitly guaranteed means that those instruments should be trading much closer, if not on top of, comparable Full Faith and Credit paper. The only difference between Treasury debt and GSE debt at this time is that eventually the GSE debt will come out of conservatorship in one form or another. This will only happen when the GSE’s are in sound financial condition. In the interim, based on President Bullards comments the GSE’s provide the same level of safety as US Treasury bonds.

We believe spreads on GSE debt should eventually begin to reflect this Full Faith and Credit Guarantee. The Treasury and the Fed understand this very well. They are trying to restore confidence in the financial markets…and what better way to do that than to remove any question about the backing of the GSE’s?

As this market calms down, and as we begin to see the inter-bank lending market unfreeze, and as we see the trading activities of institutional desks return to normal after the threat of pulled lines of credit begins to wane, we will see GSE yields begin to converge on Treasury yields. I don’t anticipate they will ever trade exactly on top of them due to the eventual change in the GSE’s status some years down the road, but in the mean time they are full faith and credit and spreads should tighten.

What does this mean for investors? It means you buy GSE debt with the same level of confidence that you would buy a US Treasury with…except you’ll feel better about it because you get a much better yield than you would on a Treasury bond. If you have any board members that have been losing sleep about the GSE’s you need to send them this e-mail and take away their Nyquil. They have zero cause for concern over any GSE debt.

I’ve attached the full text of Fed President Bullards speech. If you have any questions on this material please let me know.

Market Update: 10 13 08_On Columbus day we set sail for a New World in Global finance

Well the economy has finally gotten everyone’s attention. It has the attention of consumers, regulators, investment banks, and government officials in industrial, emerging, and developing countries. You can’t go ANYWHERE and not hear people discussing it. I find it tragically ironic that people don’t even BEGIN to care about investments, economics and banking until we’re sliding straight down the chute into a recession. It seems like there are more opportune times to get educated on this stuff…at any rate…let’s review where we are right now. I’ll start off with an apology today…this update got to be a lot bigger than I expected (especially for a long weekend) but I wanted to provide as much color as I could as we are entering a new phase in the business cycle, and quite possibly a new era in global finance.

A brief history of the last year

Last summer (2007) we saw the beginning of the problems with two Bear Stearns hedge funds hitting the skids. Bear halted redemptions in order to buy time for an orderly liquidation. If memory serves me this was the first in this cycle that we heard the terms “need to buy time” and “orderly liquidation” in the same sentence.

This is about the time everyone began questioning the “mark to model” methodology of pricing complex structured investment vehicles that were based on suspect loans, sliced up, re-packaged, branded with a AAA rating, and then sold to/bought by, investors that didn’t understand any of it. The problem is that by the time anyone stopped to question it the horse was out of the barn. And in this case the horse must have been related to Sea Biscuit because it was off to the races and couldn’t be stopped.

If there is no market to mark against, firms can use a model to evaluate their assets. The first problem was the very nature of the products. These are very complex structured products that contain a wide range of risks. Under the best of circumstances they are difficult to model and require significant assumptions be made. Well now that some firms are having to actually sell assets…there IS a market against which you can mark. So we now have actual trades getting done and prices being pushed lower. All of the firms that carried these instruments on their books at highly optimistic prices are now having to book some major league write-downs.

Beginning in late 2007 we saw wave after wave of giant write-downs which as of August 2008 had passed the $500 Billion mark (most estimates put the ultimate total between $1 and $2 Trillion). These losses forced firms to raise capital to the tune of $352 Billion over the same time period. These firms are destroying capital faster than an industrial sized paper shredder chews through junk mail. I’ve attached a list that Bloomberg compiled through August of 2008. The top 5 companies by size of write-down are listed below to give you a feel for what’s on the list:

(I APOLOGIZE FOR THE FORMAT OF THIS CHART! This blog site seems to have zero compatibility with either Microsoft Word or Excel)

Write-down & loss Capital Raised

Citigroup 55.1 49.1

Merrill Lynch 51.8 29.9

UBS 44.2 28.3

HSBC 27.4 3.9

Wachovia 22.5 11

One immediately has to ask how the smartest guys in the room get themselves into such a mess. The answer appears to be as simple as good ol’ fashioned greed. Richard Bookstaber wrote about this phenomenon in his book “A Demon of Our Own Design”. I’ll paraphrase and hope to do him justice. Essentially the trading desk at these big street firms is the profit center. It’s where all of the money is made. Risk Management is a great title and people pay lip service to it but risk management generally means doing less of the things that make money. When risk managers at these firms point out activities that might lead to adverse consequences they are shouted down by the trading desk. It’s essentially a “we MAKE money and you don’t” type argument and the firm ultimately goes with the folks that make the money. Risk managers at these firms are analogous to a kicker on a football team…you have to have one on the payroll but nobody wants him in the game.

The fact that some of these institutions took their first ever quarterly loss only to be completely wiped off the map of Wall Street shortly thereafter will serve as a lasting testimony to the type of risk management programs these firms were employing. If the first loss you ever take balloons into the loss that kills you, then you were clearly taking far too much risk for far too little reward. The fact that everybody was doing it will be of little comfort to the shareholders that you drove into the dirt.

The situation we face today

So that set the stage for what we’re seeing now. The write-downs led to failures which led to heightened awareness of counter-party exposure, which led to a lack of lending, which began the liquidity crunch. After JP Morgan was given a loan from the government to execute an orderly takeover of Bear Stearns many people cried foul. After the government provided funding to rescue AIG people began screaming that this is “the end of capitalism” and that the feds won’t allow anyone to fail. When Lehman got in trouble the government did allow them to fail…and that failure sparked a global wildfire. Money Market funds holding short Lehman paper now had losses that prevented them from repaying depositors. When the first money market fund broke the buck it shook the entire foundation upon which our financial system is built. A massive wave of redemption orders from money market funds forced the Treasury Department and the Fed to begin taking drastic measures to keep the engine of our economy from seizing up.

If you picture the flow of capital through our financial system as the oil in our economic engine you’ll get a pretty good idea of what will happen if the $4 Trillion money market system dries up. When nobody has faith in anyone else people hoard cash. Banks hoard it and won’t lend to each other, consumers hoard it and pull it out of the bank, and it all goes downhill from there.

So now we’ve seen all of the theatrics that are modern politics with the Treasury Secretary and the Chairman of the Federal Reserve appearing before Congress, the G7 countries meeting at the White House, etc. We’ve heard all of the questions and complaints, and the one unanswered question that frustrates the politicians so greatly is “what if the plan doesn’t work?”

I can’t tell you how many times I’ve heard a politician ask this question in one form or another. I don’t think I’ve heard anyone associated with the plan provide an answer to the question, although I’m confident they have some ideas of what failure would mean. Failing to restore confidence in the financial system will at the least mean a deep recession, and clearly concerns are mounting about a global depression. With a potential depression looming what do you do? If you are a central banker do you sit idle and watch the train-wreck? Do you attempt to intervene? Will intervention help, or will intervention just prolong the agony or push it further out to a future date?

I continue to hear the comment that the government should do nothing. This stems from concern about Main Street vs. Wall Street. It is important to understand that if the money markets freeze up there won’t be much of a Main Street anymore. If a $4 Trillion market of short term deposits just walks away, business financing in this country will come to a sudden and screeching halt.

For instance, the average American today pays his bills, buys a house he can afford, goes to work and pays his taxes. Likewise his employer can be financially sound, running an honest set of books, and providing stable employment for dozens or hundreds of citizens in his community. But…due to things far outside of his control his company might not be able to fund inventory purchases due to a seizure in the money markets. If they can’t fund inventory they have nothing to sell, if they have nothing to sell they can’t pay the bills and they go under. Now our hard working Main Street American is out of a job, and likely out of a home due to events he had nothing to do with. Now multiply this scenario across every city in the country and you begin to get an idea of how important that $4 Trillion money market is to the economy as a whole…not just to Wall Street fat cats with golden parachutes.

What happens if the plan doesn’t work?

With all of these questions being currently pondered by everyone in America I thought it would be useful to review some depression era economics.

We are at the point where central banks around the world are clearly trying to avoid not a shallow recession…but a global depression.

Irving Fisher lived through the Great Depression and wrote some very influential material on the subject. Here is a very brief summary of Irving Fishers theory of the Debt Deflation Spiral that causes depressions. You can be quite certain that Bernanke and Paulson are familiar with the work of Irving Fisher…you can actually get a copy of Fishers work on the Debt Deflation Spiral from the St. Louis Fed’s website.

Fisher’s words, written in 1933 have an eerily familiar ring to them today. Below is a summary of Fishers work on the Debt Deflation Spiral written by Giovanni Pavanneli:

The explosive dynamic process typical of “great depressions” had its origins, rather, in the fact that the initial over-indebtedness was progressively aggravated by deflation. In brief, the model considered firstly a system burdened with debt, but otherwise in equilibrium, albeit an unstable one; in this situation, a minor shock (“bad news” or a fall in share prices) was enough to undermine the confidence of “either debtors, creditors or both” and to lead to a first wave of liquidation of debts.

The rush to “liquidate” led to “distress selling” and the consequent sharp fall in share prices and a contraction of bank deposits. This triggered deflation, which in turn increased the stock of debt in real terms.

In essence, the attempt by individuals and banks to reduce their debt touched off a perverse dynamic process that worsened their situation in real terms, dragging them towards financial collapse. The immediate consequence was a wave of bankruptcies that drove prices still further down.

The generalised reduction in prices also damaged the entrepreneurs who were not in debt: their sales prices fell faster than costs, squeezing profits. Now, in a capitalistic system, Fisher writes, “it is the profit taker who usually makes the decision as to the rate at which his enterprise is to be run”.

A fall in profits was thus bound to bring a general reduction in output and employment. Taken together, these factors produced a lack of confidence and pessimism that translated into a general rush towards money: phenomena of hoarding thus multiplied, further reducing the velocity of circulation of money and lowering price levels; consumption contracted even further.

Again in this case, therefore, the effort by each agent to improve his own position led to a worsening of the overall situation: “Every man who hoards does it for his own protection; yet by hoarding he aggravates the very condition that started his fear”..

In essence, if not adequately countered by the monetary authorities, the deflationary process will set in motion a perverse, self-fueling spiral bound to cause “almost universal bankruptcy”.

I find that this picture painted by Fisher helps to provide some context to what central banks are doing right now. Monetary authorities are trying their level best to avoid a depression and they are absolutely committed to not allowing a depression to run its natural course. I’ve read some scary things in my life but Fishers ultimate conclusion of “universal bankruptcy” is difficult to come to terms with. Clearly it scares world financial leaders as well.

Fisher’s insight on doing nothing in the face of depression is summed up below:

“Unless some counteracting cause comes along to prevent the fall in the price level, such a depression as that of 1929-1933 (namely when the more the debtors pay the more they owe) tends to continue, going deeper, in a vicious spiral, for many years. There is then no tendency of the boat to stop tipping until it has capsized. Ultimately, of course, but only after almost universal bankruptcy, the indebtedness must cease to grow greater and begin to grow less. Then comes recovery and a tendency for a new boom-depression sequence. This is the so called “natural” way out of a depression, via needless and cruel bankruptcy, unemployment, and starvation”

You couldn’t hire Stephen King to write something that scary…that’s worse than Cujo and Carrie combined!

Interestingly the IMF currently reports that the Global Financial Crisis could lead to famine in developing countries in Africa and Central America (that forecast follows Fishers roadmap on depression). The IMF also forecasts Global growth at only 3% in 2009 with growth in the G7 countries (US, France, Canada, Germany , Japan, Italy, and the UK) barely scraping by with just over 0% growth for the year.

JP Morgan just revised its forecasts for US growth to include recession, and most major firms have included downward revisions.

Views from around the world of finance:

The quotes below are taken from the attached Bloomberg article:

``It's certainly going to be the worst since the 1980s,'' says Bradford DeLong, an economics professor at the University of California at Berkeley who worked at the U.S. Treasury Department from 1993 to 1995. ``The hope is that it won't become the worst unemployment business cycle since the Great Depression.''

``This is the worst crisis I've seen in my 50-year career,'' William Rhodes, senior vice chairman of Citigroup Inc. in New York, told fellow bankers in Washington yesterday. ``We still have to deal with the effects on the real economy here and elsewhere.''

``We're heading into a global recession,'' Simon Johnson, also a former IMF chief economist and now a senior fellow at the Peterson Institute for International Economics in Washington, said last month.

``It's hard to imagine it not being the worst recession in at least 25 years,'' says Kenneth Rogoff, who is now a professor at Harvard University in Cambridge, Massachusetts. ``You can take most of the official forecasts for 2009 and knock two'' percentage points off of them, he adds. That would make it the worst slump since 1982, when the world economy grew 0.9 percent.

``Time is of crucial importance,'' JPMorgan Chase's Kasman says. ``The longer we wait to implement the strategies, the more damage we can do to the world economy.''

Looking forward

So where do we go from here? It’s tempting to throw our hands up in the air and say “who knows?” but prudence demands a more thoughtful analysis.

he first step is to unlock the credit markets. We’ve seen the disruption in this market impact things ranging from a lack of financing for company inventories, to securities dealers shutting off their purchase activities and leaving institutional buyers from Wall Street firms to community banks being unable to generate liquidity through selling investments.

Getting Libor in line with central bank rates is a first step. This has been a very difficult task to date, but the hope is that with coordinated policy action from central banks around the world it can be done.

There are measures being put forth to guarantee that solvent banks survive. Such guarantees will clearly help reduce perceived counter-party risk. Such guarantees may not even have to be funded. A rational investor will loan you money at a market rate if they know for certain that you won’t go bankrupt before the term of the loan is up. Since the banks being guaranteed are solvent banks to begin with the likelihood of actually having to step in with money is remote. The guarantee itself should be enough to restore confidence and efficiency.

Once banks begin lending to each other again we’ll see the return of credit lines. In the world of securities dealers your credit line is your life line. If that line gets cut you are living on borrowed time. One doesn’t have to look far back in history to get an example. A few days before Merrill Lynch sought out Bank of America to buy them they had their credit line cut…by Bank of America. I have no idea if that was B-of-A playing hardball and forcing Merrill to their knees in a period of known weakness, or if B-of-A simply did an impartial review of a counter-party’s creditworthiness and acted objectively. Either way it points out the vulnerability of financial firms to having credit lines cut. Within three days Merrill was history. Once the interbank lending market un-freezes we should see a more regular flow of credit here as well.

Once that credit flow returns to normal we should begin to see trading desks re-enter the market as buyers. Institutional trading desks are the main engine of efficiency in these markets. They know how to price securities and they put their own capital at risk to maintain efficient markets. If something is mispriced they immediately pounce on the opportunity, capturing the excess return offered by the inefficiently priced security and pushing that securities market price back in line at the same time. I would imagine that the return of efficiency here will be gradual rather than instantaneously. It’s a bit like stepping back into the batter’s box after being drilled with a fastball on your last at bat. You’re going to get back in there but you’ll be hesitant in your approach.

Depositors need to be assured that their money is safe. Despite decades of protection by the FDIC, fear still causes depositors to do stupid things. Like taking all of their savings out of an FDIC insured bank account and keeping it at home. I have a friend that sells safes for a living…he says business is booming. He also tells me that he has seen hundreds of thousands of dollars in people’s homes locked up in safes that would take him 15 minutes with a screwdriver to compromise. When depositors are assured of their safety the threat of bank runs will diminish.

These first steps of restoring calm to the money markets, unlocking the interbank lending market, and calming depositors’ fears should go a long way toward the end goal of steadying the markets.

Once that is done we can begin digesting the economic data that is being released. Will there be a recession? How long will it be? How deep? How will the employment situation develop? These are all questions that time will shed light on soon enough. I’ll keep you posted as things develop.

If you have any questions on this material please let me know.

Market update: 10 10 08

 

With the volatility we have this week anything I write will be out of date by the time I hit send so I’ll just hit the high points.  All eyes are on the stock market this morning.  Dow futures were indicating a big move lower on the open and that is what we got.  After 5 minutes of trading we’re down over 500 points.  Oil traded under 80 this morning on expectations of slower global growth.  3 month Libor remains elevated despite everyone’s best efforts to drive it lower.

 

 

 

 

 

 

One of the big stories of the day is that there is a proposal that will allow the government to insure ALL bank deposits.  The Wall Street Journal is printing a story on it this morning, I’ve attached an excerpt from the article. 

 

Here is the definition of volatility:  in the 5 minutes it took me to write this e-mail the Dow has come back from down 700 to only down 120.  Keep your seat belts fastened people…this is going to be a bumpy ride.

 

I’ll update as things develop.

 

 

From Today's Online Wall Street Journal

 

U.S. Weighs Backing Bank Debt - Removing Deposit Insurance Limits Also on the Table

WASHINGTON -- The U.S. is weighing two dramatic steps to repair ailing financial markets:

• guaranteeing billions of dollars in bank debt and
• temporarily insuring all U.S. bank deposits.

If the two moves come to fruition they would mark the government's most extensive intervention yet in the financial system, as officials ponder increasingly far-reaching measures to stem the sprawling crisis.

....

It's not clear that either idea will become reality, and U.S. officials downplayed expectations of any announcement this weekend. But as the crisis deepens and stocks continue to tumble, pressure is building on the Bush administration to find a solution that goes beyond the $700 billion financial rescue plan recently signed into law. Having the government back bank lending would effectively entail the U.S. being the backstop for the country's financial system.

 

 

 

 

Market Update 10 08 08: Emergency 50 basis point cut

Central banks around the world last night executed a coordinated assault on the liquidity crises.  The Fed, the ECB, The Bank of England, The Bank of Canada, Sweden’s Risk Bank, China’s central bank, and Switzerland took part.  Japan liked the idea but couldn’t play because their rates are already so low.  The Federal Reserve cut the Fed Funds Target rate by 50 basis points to put us at 1.50%. 

 

This move is unprecedented because of the coordination involved.  Facing slowing consumer spending and rising borrowing costs this feels like a last ditch effort to keep global economies from falling into recession.  A military analogy applies here.  When in a defensive position things may become so tenuous that in order to keep from being over-run you order a Final Protective Fire.  Final Protective Fire (FPF) involves every man on the line dumping everything he has into the wire as fast as he can, and every supporting fire available is called to bear on your line…dangerously close to friendly forces.   It is a last ditch effort to keep from being wiped out.  This feels like someone just called for FPF. 

 

As soon as I printed the screen shot below it was outdated.  The 10-year is now actually trading up almost ¾’s of a point to trade at 3.42%.  World Equity Index futures are indicating that the Dow will open down 200 or more.  Libor actually increased overnight with the one week spot trading at a 4.51%...that’s up from around a 4.19% most of this week.  The Fed Funds effective rate is running at 4.50% this morning although this usually eases down lower in the day as the Feds liquidity operations get traction.

 

 

 

The Fed Funds futures market is now pricing in a 94% chance of a 1.25% Fed Funds level at the 10/29/08 FOMC meeting.  Futures are pricing in a 43% chance of a 1.00% level by December.

 

 

 

This will be a very interesting day.  Look for more news as the day develops.  If you have any questions or if there is anything you need just let me know.

 

 

 

 

 

 

 

 

 

 

Market Update 10 07 08: Everything's fine...the Dow is only down 200

Today’s big news:

- The Fed becomes a buyer in the commercial paper market

- Fed talks of lowering rates

- FDIC talks of doubling deposit insurance premiums

- Regulators put forth proposal to reduce risk weight to 10% for Fannie and Freddie

- Consumer borrowing drops for first time in decade

- Lehman CEO gets knocked out by disgruntled employee

Fed buys CP

The market has been so volatile that seeing the Dow Jones average down 200 points almost doesn’t register as out of the ordinary. Someone asked me this morning how things were going and my response was that everything seemed good to go…the Dow was only down 200 and the 10-year was trading at a 3.43%. As soon as the words escaped my mouth it hit me that times are changing when that seems normal.

Today is another news filled day in a long string of such days. Today we have some items of substance to chew on. The day began with Bernanke telling us that the Federal Reserve will now be a buyer of commercial paper. In a move sure to entertain the acronyms anonymous meetings around the world we have yet another government program to add to the list. This one is called the CPFF, or Commercial Paper Funding Facility. You KNOW the government is getting bigger when they are cranking out 5 new acronyms a month. I’ve never calculated the number but it wouldn’t surprise me if the average were 150 new government employees for each letter in each new acronym.

So back to the CPFF. Here is the definition provided by the Feds website:

http://www.federalreserve.gov/newsevents/press/monetary/20081007c.htm

“The CPFF will provide a liquidity backstop to U.S. issuers of commercial paper through a special purpose vehicle (SPV) that will purchase three-month unsecured and asset-backed commercial paper directly from eligible issuers. The Federal Reserve will provide financing to the SPV under the CPFF and will be secured by all of the assets of the SPV and, in the case of commercial paper that is not asset-backed commercial paper, by the retention of up-front fees paid by the issuers or by other forms of security acceptable to the Federal Reserve in consultation with market participants.”

The commercial paper market has been under a tremendous amount of pressure over the last month. Many of the money market funds that live in the commercial paper markets abandoned ship and jumped into Treasuries when they experienced runs on their funds in the wake of Lehman’s collapse. This group led the charge to the short end of the Treasury curve and continues to keep yields depressed. The 4 month bill is currently trading at 30 basis points.

Fed hints at rate reduction

“`In light of these developments, the Federal Reserve will need to consider whether the current stance of policy remains appropriate,'' Bernanke said in a speech in Washington.

The Fed is currently pushing more than $1 Trillion into the markets via overnight loans to provide liquidity and here I sit looking at a Bloomberg that is telling me Fed funds are at 5% and Libor is still well above 4.00%. The trend with the Feds repo’s has been that the Fed Funds effective rate is elevated early in the trading day but over the course of the morning it drops below the target rate or lower. Today it hasn’t dropped.

Despite the Fed doubling its international operations and pumping $620 billion into that market…Libor remains elevated. Banks are hoarding cash…and who could blame them. This entire problem was kick started by sub-prime lending…or lending to people that probably won’t be able to pay you back. I think it’s a bit naïve to ask banks to continue playing that game on a grander scale and make unsecured overnight loans to each other when titans of finance are dropping like flies. Who knows if your counterparty will be around tomorrow? If you can’t answer that question then why would you lend to them?

The Fed Funds futures market is pricing in a 100% chance of a 50 basis point cut at the October 29 FOMC meeting. You’ll see that there is a 100% cut with 70% probability place on AT LEAST a 50 bps cut, the remaining 30% probability is placed on a 75 bps cut.

The chart below shows how the market is pricing the odds of rate changes over the next three meetings.

FDIC action

The bullet points below are from the FDIC’s proposal to raise deposit insurance premiums. The FDIC expects the increased insurance premiums to add $10 Billion annually to its fund.

· The FDIC projects that bank failures from 2008 to 2013 will cost the deposit insurance fund $40 billion, a number that includes the estimated $11 billion incurred so far this year. For the $40 billion, the FDIC says “there is a considerable degree of uncertainty surrounding these projections.”

· The FDIC projects total losses to the deposit insurance fund to be roughly $12.8 billion for 2008, which suggests the FDIC expects its fund to lose another $1.7 billion this year.

· The FDIC projects that its insurance fund, which was 1.01% of all insured deposits at the end of the second quarter, could fall as low as 0.65% early next year. The FDIC’s goal is to build the fund back up to 1.26% of insured deposits by 2013.

· There are 14 banks in the FDIC’s highest risk category, category 4, but the FDIC wouldn’t name them. These banks hold a combined $29.1 billion in domestic deposits.

· There are 723 banks and thrifts, a little less than 10% of the industry, in risk weight categories 2, 3 or 4. These banks hold roughly 13% of the nation’s deposits.

· The proposed premiums would result in pre-tax income for next year falling 5.6% for the banking industry.

Lower the Risk Weight

Regulators have put forth proposals that would lower the risk weighting of Fannie and Freddie issues to 10% from 20%.

From my Strategies group:

In a Notice of Proposed Rulemaking approved by the FDIC Board today and to be published in the Federal Register soon, the banking regulators have proposed changing the risk weighting on senior debt, subordinated debt, and mortgage guarantees of Fannie Mae and Freddie Mac. The rule, if approved in final form, would not take effect until the 12/31/08 reporting date. The risk weight would remain in effect as long as the treasury’s Senior Preferred Stock Purchase Agreements remain in place.

We will have a Strategic Insight bulletin on this later today.

Consumer borrowing drops

The amount of money borrowed by US consumers has been tracked by economic data series since 1943. August saw the first drop in this series in over a decade. Consumer spending is roughly 2/3’s of GDP and it is beginning to throttle back as loans are becoming harder to come by.

Lehman CEO gets KO’d

Today’s lesson in corporate etiquette comes to us from Lehman CEO Richard Fuld. It’s important for the aspiring Wall Street CEO’s out there to remember that if you run your company into the ground and in the process force thousands of your hard working and loyal employees into the unemployment line, destroy significant sums of their personal wealth, and ruin their dreams of retirement then you probably shouldn’t continue working out in the company gym.

A week after the company announced bankruptcy CEO Richard Fuld was walking on a treadmill in the company gym and a fellow employee walked up, punched him square in the face and knocked him out cold. No standing eight count…out cold.

Those are the big stories from today. If you have any questions or if there is anything I can be doing for you just let me know.

Market Update: Treasuries mixed on poor economic data

 

Bonds are mixed this morning on a morning packed with news.  Right off the bat we see Wells Fargo step in front of Citigroup and pay more for Wachovia and do it with no government help.  The FDIC had forced Wachovia to find a partner last week and Citigroup was getting an FDIC backstop on losses above $42 Billion.

Wells is paying more and doing the deal alone. 

 

Stories are coming out that California is giving the Treasury a heads up that the state might need an emergency loan to the tune of $7 billion as the credit crisis dries up funds that they normally use to fund operations.

 

Fed Funds are trading at ½% this morning.  Oil is trading at $94 a barrel.  Treasury prices are actually falling a bit this morning.  There has been a lot of pressure on Treasuries in the flight to safety that we’ve seen over the last few weeks so we may see some noise in Treasury prices as the economic data gets released.

 

Yesterday the Fed hit a single day record for the amount of money lent to financial institutions.  Commercial banks and brokerages borrowed a combined $342 billion from the Fed yesterday…that’s up 60% from a week ago.

 

 

 

 

 

There has been so much focus on the bailout bill that it’s been easy to ignore the economic data.  The economic data is the drumbeat that moves the fixed income world and it’s getting ugly.  This morning’s numbers are listed in WHITE font in the chart below.  I included all data released since October 1^st for reference.

 

When the change in non-farm payrolls number was released I could actually hear a gasp come from my trading desk over the speaker system we use to communicate with each other throughout the day.  The survey expected a loss of 105 thousand jobs, but we actually posted a loss of 159 thousand jobs.  The unemployment rate was unchanged, but it was unchanged at a level that is elevated to begin with.  As you look through the numbers that were released this week you’ll see a lot of data that is not positive.  Once we get past this bailout bill we will begin to see people get back to looking at the fundamentals.  At the moment those fundamentals do not paint a picture of a strong economy.

 

 

 

 

 

The Fed Funds futures market is pricing in more aggressive cuts by the Fed.  That market is currently pricing in a 100% chance of a cut at the October 29 FOMC meeting with 88% probability placed on a 1.50% level and 12% probability placed on a 1.25% level.  The December contracts place the odds of a 1.25% level at 47%.

 

Now what good would it do to cut the overnight rate when Fed Funds is trading at one-half of one percent?  The only outcome I can see is that it would lower the Prime Rate.  The Fed is desperately trying to keep enough liquidity in the system to keep borrowing rates between banks low, to keep liquidity lines between firms from drying up so they can fund their inventories…they don’t need the Prime Rate to drop.  They need to flood the market with cash, and that is why we’ve see them use all of their various new lending facilities to such a great extent.  This is also why we saw them stay put on rates at the last meeting despite what the futures market expected.  In the words of the St. Louis Fed President Bullard lowering the target rate to fight this problem is like using a blunt instrument where a scalpel is called for.

 

We’ve got a month until the meeting.  Some think that the Fed will lower to help the psychology of the market.  Sentiment in the futures market has seen a seismic shift toward the negative based on the economic data.  The Fed seems to be committed to using alternative means to fight these problems, and may want to keep it’s powder dry on cutting rates…they may need those rate cuts for more than psychological reasons next year. 

 

 

 

 

 

What does it look like when banks hoard cash?  The graph below is a perfect example.  The Fed has been pumping $620 Billion into the international markets, flooding them with cash to try to drive down Libor.  The GSE’s fund off the Libor curve and since this curve spiked up recently they’ve been experiencing higher borrowing costs…you can see that in the form of the 3 month bullets at 3.25% they’ve been issuing.   Libor is the London-Interbank-Offered-Rate.   It is the rate at which foreign banks will lend US dollars to each other, it is essentially a dollar denominated swap curve.  These are loans between banks so there is credit risk on this curve.  In a market like this you can see how banks might become hesitant to lend to each other…nobody knows who has exposure to what.