Stephen’s Posterous

Christopher Dodd, chairman of the Senate banking committee, has proposed a overhaul of the country’s regulatory architecture that would strip the powers from the Federal Reserve and create a single banking regulator.

The proposal to consolidate regulators faces strident opposition from the Fed, the Federal Deposit Insurance Corporation and smaller regulators.

Mr. Dodd said most institutions would benefit from a regulator that would provide "clarity, cut red tape and make it easier to compete," and banks would "no longer be able to shop for the weakest regulator."

The Senate draft legislation also creates an agency to oversee systemic risk, which could call for banks to be broken up if they threatened the entire financial system and impose tougher capital requirements.

Republicans declined to support the proposed legislation, with a proposed Consumer Financial Protection Agency, which Mr. Dodd said was vital to crack down on abusive selling of mortgages and credit cards.

Source.

Seeking Out Recession-Proof Stocks by Teresa Rivas, Barrons.com

The recent rally has bought comfort to many investors, but Walter Gerasimowicz isn't ready to celebrate just yet. Gerasimowicz warns that the market remains volatile, but that uncertainty also creates opportunities.

Many stocks are currently undervalued, he argues, making today's market a buffet for value investors. However, with the recession still very real, investors must also focus their picks on earnings growth in recession-resistant areas, and be willing to move quickly to adapt to changing conditions.

Gerasimowicz has a history to back up his theories. He formerly headed international portfolio advisory groups at JPMorgan and Lehman Brothers, before founding Meditron Asset Management in 2003. As chairman and CEO, he overseas the firm's wealth-management and private-equity businesses, and its hedge fund.

Since Meditron Fundamental Value/Growth Fund's 2003 launch, the hedge fund is up a cumulative 36.1%, compared to the S&P's negative return over that period.

Below are some excerpts from his conversation with Barrons.com.

The stock market has seen a remarkable rally recently. How do you view the market recovery and the possibility of the end of the recession?

With respect to the current market, we are in a rather volatile situation. Not only from the equity markets, but from the economy. We still have a host of economic data suggesting that we are in a market decline, although of late the contraction itself appears to be moderating.

I feel that not only the U.S., but the entire world is still facing these one-step-forward, two-steps-backward type of announcements that seem to come every other day. And one could ask, are we now, through the bottom of the bear market?

I say by their very nature, bear markets are very difficult to fathom and understand, and I'm not certain that we are not going to retrace over the summer. We will have pullbacks. If you take a look at where it all began with the U.S. housing market, the consumer, the banking system, they are intact in the U.S.; however, we still are only beginning to see very small positive momentum in those area.

The housing market appears to be recovering, but much of that is still due to the purchase of real estate that is for sale at fire-sale or foreclosure prices, and consumers continue to be cautious. Bank balance sheets remain somewhat questionable, although the Federal Reserve, the Treasury and Congress are all attempting to stabilize bank balance sheets, so we are seeing some improvement.

Globally speaking, the treasuries of various countries and the leaders therein are actually being forced to increase the size of their budgets to further stimulate their own economies with injections of money. There's also quantitative easing that is ongoing, a terse economic term for printing money, which the U.S. and British authorities have been doing.

On the other side of it, you have deflation, beginning to rear its ugly head, and we could begin to see greater acceptance of monetary stimulus, quantitative easing, as there is no further room to cut interests rates. Just as the U.S. was the first economy to go into a decline, based on the fact that we have acted quickly, we will be the first to begin to come out of this.

Perhaps China will beat us out of the recession, because they have the ability to react much more quickly. We need to see freer credit, not only for the consumer but for business, and as we begin to see the credit markets free up, so then we will begin to see an expansion. I feel comfortable indicating that toward the last quarter of 2009 and into 2010 we will see a positive but barely gross domestic product number, perhaps at the 1% or 1.5% level.

How can investors navigate this kind of market?

You cannot be just an asset allocator or a buy-and-hold investor in this market. You have to do the fundamental analysis and deal with capital preservation instead of chasing returns. The fact is that just because a security is cheap, doesn't mean it is of good value.

You still have to examine balance sheets of companies, earnings growth, and ask: Are they well diversified? Do they have low debt? Are they in sectors that are recession-proof or those that will lead us out of a recession? And then, should the company decline, you have get out.

You have to not only deal with the discipline of a stop-loss mechanism, but at the same time make certain you execute. That is where most investors fall down, they don't want to sell in a disciplined way. And then when they finally do, the stock has gone so far away, they're selling at a bottom.

Can you name a company you like now, that fits these criteria?

Gilead Sciences (ticker: GILD) is a biotechnology company that deals with three areas: cardiovascular, respiratory, and the treatment of HIV/AIDS. Unfortunately, it appears that even in the U.S. HIV infection is rising again. We have about a million HIV-positive people in this country and 30 million worldwide.

About 55%-60% are being treated with HIV drugs, and if they aren't treated, then it progresses to become AIDS. With proper drugs you can live for a number of decades, and the earlier the treatment, the better. The number of patients on HIV-related drugs continues to grow. Gilead is the primary player in this field.

Four out of every five patients with HIV take one of Gilead's drugs. Their sales come mainly from the U.S., Europe and Japan. In Africa Gilead licenses their drugs to third parties, which sell at a lower price. Their profits for the first quarter jumped 21%, with a 22% increase in revenues.

They beat all estimates and reiterated 2009 forecasts. They have an excellent pipeline for hepatitis, hypertension and new classes of HIV drugs, and a solid balance sheet. Their shares should trend sharply higher.

Ralcorp Holdings (RAH) is another one of your picks.

Ralcorp is a leading food company that offers nearly everything: cereal products, salad dressings, jelly, corn chips. They also now own Post and they sell their products in virtually every retail outlet as well.

One of the things about the company is they are heavily involved in the private-label business, so if you go into a supermarket or a Wal-Mart that has a lot of its own store brands, most of them are produced by Ralcorp through private-labeling agreements. And those private-label sales should only increase.

Their earnings growth has been phenomenal, along the order of 40%, a lot of that is the Post integration. They continue to grow through acquisitions, they bought over 20 companies in recent years, and we believe their margins will continue to increase. Currently their price to earnings is only about 11 times, which is wonderful. Even during times like this, people love to eat. We think the company will advance in terms of earnings, and remain recession proof.

Q: Thanks for your time.

Source.

Barnet Frank on the Financial Road Ahead by Avi Salzman, Barrons.com

Rep. Barney Frank (D., Mass.), the chairman of the House Financial Services Committee, has been one of the busiest men in Washington in recent months. So busy, in fact, that when a Barrons.com reporter started a telephone interview with him recently, he dispensed quickly with the formalities.

"Let's go," he said, in an accent that betrays his northern New Jersey roots, before embarking on a wide-ranging interview on whether to nationalize banks, how to rate debt, and how long mark-to-market accounting rules will remain relaxed.

You have talked a lot about the federal government having a systemic risk agency, with the Federal Reserve overseeing it. How would it work?

The Fed took a bit of a roughing up over the AIG bonuses, so it is now unlikely that it would be the Fed alone, though the Fed will have to play a major role. At this point there is more agreement on what than who. It has to have a systemic risk capacity to keep in particular nonbanks from getting overly leveraged.

Are you interested in limiting the size of banks?
 
No. There are always the antitrust laws, but if you look at a typical antitrust law, that doesn't work because no bank is big enough to be that kind of monopoly. By the way the problem seems to be less banks than nonbanks.

I think the problems were with Lehman and AIG and Bear Stearns. What I want to do is to have a systemic risk regulator that keeps any entity from getting so heavily indebted beyond its capacity to pay that it becomes too interconnected to fail.

And who will determine what overleverage is? How much leverage is too much?

A systemic risk regulator [will determine it]. It's in two ways; it's an individual situation and it could also be if too many people get in the same side of the boat it starts to tip over.

Paul Krugman, the liberal economist who just won the Nobel Prize, has talked about banks having to be nationalized to save the system. Is that something that you feel the Obama administration should do?

The president addressed that pretty well. As far as banks being nationalized, which banks? How many? All banks? Ten banks? Three banks? One bank? I mean, of course, I would not rule out a bank being nationalized. It is a tool that might be necessary, but it ought to be a much later resort than now. I don't see any need to do it now.

Some concern has been raised about pension funds investing in hedge funds. Should the government regulate pension investments in hedge funds?

I have limited jurisdiction over that because the pension funds are under Erisa [Employee Retirement Income Security Act], which is in the Education and Labor Committee. They are talking about some kind of safeguards.

I do believe that the hedge funds should be among those entities that are not allowed to get too leveraged, and I believe that they should be required to register with the Securities and Exchange Commission.

And give data on how much leverage they are using?

Well the SEC wouldn't be primarily [overseeing] the leverage thing -- they would be an investor and consumer protection entity. The systemic risk regulator would be looking at leverage with them as with any other entity.

So a systemic risk regulator would have access to the amount of leverage that hedge funds are using.

Any financial entity, yes.

How is the government going to make investors comfortable investing in financial markets? Some investors say that the rules have changed a lot. What's the timetable [on the rule changes]?
 
By the end of the year. I hope by the time Congress adjourns for the year, which may be very late this year. Yes, there is uncertainty now. I do think it's important to provide that kind of stability, and this is a case where regulation is very pro-market because it should give people that assurance.

What reforms do you mean specifically?

The systemic risk regulator, a way to resolve nonbank institutions, a buffing-up of the investor-consumer protection functions at the regular regulators. A change in compensation rules so that people cannot give one-way bonuses and then incentivize excessive risk, and rules that say you can't securitize 100% [of a loan].

You have to retain say 5%, but it still has to be worked out. A fundamental part of the problem was that 100% securitization led to a significant drop in people's focusing on the quality of the loans they made.

Are the credit-rating agencies fundamentally flawed? Does the government need to step in and in what capacity?
 
First of all, the thing to do about rating agencies is to make them less important. If there are enough flaws [with the debt] in the beginning, there is nothing they can do about it. The payment model clearly ought to be changed.

There were biases that grew from the fact that the [corporations] being rated were paying them. I have not myself [figured out] what the best way to do it is -- whether you have investor-paid models or whether there is a government model. Clearly the current system needs to be replaced.

Do you feel that Goldman Sach's (ticker: GS) move [to try to pay back TARP money] is problematic because it could expose other banks in the eyes of investors and the public?
 
No, I am all for it. It is a very good idea. In the first place the notion that 'Oh, if Goldman pays the money back people will know that some institutions are stronger than others' is ridiculous. People already know that. There are all kinds of metrics for deciding which financial institution is strong and which one is weak.

Now do you think that TARP and the PPIP [the government's Public-Private Investment Program to buy up bad assets] will be enough money to get us out of this or are you going to need to have more money?

They are going to have to do the best they can right now. Of course with the PPIP they have gotten the FDIC [Federal Deposit Insurance Corp.] involved as a way to get that going. I do not think there is any prospect of Congress voting more money until and unless people start to see some results.

That is why I am in favor of the TARP money being paid back -- to the extent that you get some substantial repayments of TARP money if you do need more money for some other purpose later on.

As far as mark-to-market accounting reforms, do you think the rules should continue to be relaxed?

Yes. It's indefinite. What is temporary is the discretion that the regulator should show. There are two aspects to mark-to-market. One is the actual valuation, and two is how the regulators react. I do think that at a time like this there is a reason for some administrative and regulatory discretion and that would be temporary.

If things get better then you don't have that same kind of forbearance. As to the mark-to-market rules themselves, they were a little bit too rigid. They didn't differentiate sufficiently it seemed to me between assets held for trading and assets (that were paying assets) that were to be held to maturity. And [the reforms to that are] not going to change.

Are we papering over some of the larger systemic problems in the system by changing or relaxing mark-to-market right now?

I think that's nonsense. It's a straw man. It's not what we are doing in mark-to-market. If you are holding an asset and you plan to hold it until maturity and it is paying as it was supposed to, I don't think you should have to mark it down substantially. The federal home loan banks in a couple of areas were forced to do excessive markdowns. It's not either or -- it's how well you do it.

Do you think that Obama has the right people in charge right now of economic and financial matters?
 
Yes.

Some of the concern is that maybe these guys are too close to some of the people they are regulating. I'm talking about Tim Geithner and Lawrence Summers for instance?
 
I don't think that's true. Who did you think I meant? Frick and Frack?

Source.

From Mohamed El-Erian, Chief Executive of Pimco

With the banking system still under stress, financial markets are waiting with great anticipation for the release by Washington of the results of stress tests for major US banks. Some believe the tests, scheduled to be released in early May, are excessively hyped. They are wrong.

The stress tests will accelerate the redefinition of the financial landscape, with a meaningful impact on future economic growth and welfare. However, whether the impact is for good or ill depends on how the results of the tests, and policies that flow from them, are pursued.

Rightly or wrongly, the February stress-test announcement was interpreted by markets as signalling a comprehensive process through which the government would evaluate the soundness of banks and decide on sustainable solutions for the sector – a sector critical to the economy’s prospects.

In particular, the tests suggested a concrete way to differentiate between the solid institutions that can raise private capital, and those that will (and must) feel a heavy government hand. They could also lead to a way to reconcile the multiple initiatives designed to stabilise a highly disrupted sector that is contaminating many sources of job creation, nationally and internationally.

The US government now has to deliver on those expectations; and it will not be easy. The outcome will be decided by more than the design and execution of the stress tests for the 19 selected institutions. It also depends critically on the announcement, context and follow-up.

To maximise the prospects for a good outcome, or at least minimise the risk of damage, it would be prudent for US policymakers to take seriously the following five factors:

First, transparency is key. Whether the government likes it or not, hundreds of analysts around the world will reverse engineer the stress tests. The government would be well advised to assist the process through clarity. Obfuscation would result in damaging market noise and further derail the real economy. At the minimum, policymakers need to provide credible details on the methodology, the underlying assumptions and scenario analyses.

Second, the results of the stress tests must be part of a comprehensive, forward-looking package to resolve problems at banks. Out-performing banks should be provided with exit mechanisms from the exceptional government support that they have been receiving and, presumably, no longer need. At the other end, there must be clarity as to how capital-deficient banks that no longer have access to private capital will be handled.

Third, the banks’ recovery and rehabilitation efforts must be co-ordinated closely with other efforts to put the banking system back on a viable road. In particular, they need to work together with the implementation of initiatives aimed at lowering funding costs (such as federally-guaranteed borrowings and Federal Reserve facilities), and facilitating the removal of the overhang of toxic assets. This will require a level of co-operation among US agencies that, historically, has not come easily or effectively.

Fourth, the government should arrest and counter the recent erosion in key parameters of the market system. Specifically, it must work hard to resist the temptation to override contracts, to undermine the sanctity of the capital structure and to treat differently stakeholders with similar legal rights. Indeed, seemingly attractive and politically expedient financial engineering, such as that used in the third Citigroup bail-out, risks undermining long-standing principles that have served the US well for years.

Finally, the US must never lose sight of the international dimensions of its policies. Its response must be consistent with efforts to upgrade a deeply challenged infrastructure for cross-border harmonisation of regulation and bank capital. The aim is to ensure a degree of global consistency that clarifies accountability and responsibility.

These are stringent requirements. Yet there is really no alternative. The US is already embarked on a journey to a “new normal” that includes reduced private credit intermediation and lower capacity for sustained, non-inflationary growth. Adherence to these five principles would help to ensure that the damage caused by past market failures is not compounded further by stress-test policy failures.

The writer is the author of ‘When Markets Collide: Investment Strategies for the Age of Global Economic Change’, winner of the 2008 FT/Goldman Sachs Business Book of the Year

Source.

The currency markets have been in a strange place recently. For the last few months the dollar maintained its strength even in the anticipation of more government debt and Federal Reserve policies that would seem to encourage dollar weakness.

With the most recent announcement of the newest plan to nuke the festering assets on the balance sheets of U.S. banks, the dollar is stronger, rallying even when the equity market is rising.

There are numerous expectations about what could transpire for the dollar in coming months. Some believe the greenback will, or should, weaken due to anticipation of a bloated federal budget and current-account deficit that concerns foreign investors about the U.S. system’s stability. Others suggest that if markets do recover, it would undermine the case for the dollar, as investors would be more persuaded to buy riskier assets denominated in other currencies.

“It’s really a struggle today, and a tug of war between improvement in risk appetite, which should be driving the dollar lower and foreign demand for dollars, and the assurance for foreign investors that there is basically a floor the U.S. government wants to create for these toxic assets,” says Kathy Lien, director of currency research at GFT. “The risk for the banks are diminishing by the day and that’s why banking stocks are rallying.”

Others arrive at a divergent view of the plan’s impact on the dollar. Chris Gaffney, vice president at EverBank World Markets Group, believes the dollar rally on Monday, March 23, 2009, is the result of traders reversing earlier gains after the dollar sold off sharply late last week.

While he believes the plan increases the risk to the U.S. currency, he noted that traditional safe-haven assets such as U.S. Treasurys and gold have not rallied along with the dollar. The lack of a positive move in those assets could also be a profit-covering move, but this interpretation has its own complications, because it undermines the case for safe-haven positioning by investors.

It may be that investors are reacting positively to a plan that increases investor appetite for risk, but are also heartened by the swiftness of the U.S. government’s moves, when compared with others.

“It’s fair to say there is an element of this that [the market] was oversold,” says Chris Furness, head of currency strategy at 4Cast Ltd. “Everyone and his brother were short at the time. There’s also a slight feeling in the background that maybe the U.S. administration is getting to grips with things, or rather more quickly than most of the rest of the world.”

Source.

The US Federal Reserve is increasing its balance sheet by another $1 trillion, including $300bn of Treasury bonds, the Federal Open Market Committee said on Wednesday, March 18, 2009. Yet the pace of US economic decline seems to be slowing, while deflation is nowhere visible. Fed policy is now high-risk, and resurgent inflation may strike sooner than expected.

The FOMC said it expects inflation to remain subdued with some risk it could "persist for a time below rates that best foster economic growth”. Notably, the Fed is not now forecasting actual deflation. That’s not surprising, since February’s top-line consumer price index rose 0.4%, equivalent to 4.8% annually, while core consumer prices also rose, by 0.2%.

The Cleveland Fed’s median CPI was 2.8% above the previous year. February’s producer price inflation was marginally lower, with the headline index rising at 1.2% annually and the core measure at 2.4%.

Meanwhile, last week’s unexpectedly strong February retail sales and Institute for Supply Management index readings suggest that economic decline is slowing.

The experience of the 1970s in both the United States and Britain demonstrates that the Fed’s theory that inflation won't co-exist with economic slack is wrong. Thus an over-inflationary monetary or fiscal policy could quickly produce accelerating inflation even while recession persists.

The Fed’s proposed purchase of $300bn of long-term Treasury bonds, when combined with the Obama administration’s record budget deficits, is particularly risky. Running large budget deficits and monetising them through central bank purchases of debt is a highly inflationary policy that has got plenty of emerging markets into trouble.

Broad money growth, whether by the M2 metric or by the St. Louis Fed’s MZM figure, has been running at over 15% annually since last September. The $1tr further expansion of the Fed’s balance sheet is very likely to accelerate this. The effect may not be obvious in the short term. But at some point, it is almost inevitable inflation will return, probably with force.

The Fed will then need to reverse policy with the speed and verve of a racing driver. Unfortunately, the odds are against it doing so before inflation has taken hold.

Source.

From Henry Paulson, former Secretary of the US Treasury and currently distinguished visiting scholar at SAIS.

In the midst of the market turmoil, the pressing priority for US and global policymakers is to repair the financial system and restore the economy. Just as important, however, will be addressing the serious flaws exposed by this crisis.

This process of reflection and reform will be critical to restoring confidence and enabling market-based capitalism to rebuild our economies.

We must recognise the real possibility that because the crisis is not behind us, there may be lessons to learn and problems to address that are not now obvious. Yet many lessons are obvious and I take confidence from the commitment of world leaders – in the US, Europe, China and elsewhere – to pursue comprehensive regulatory reform and co-ordinate internationally.

First, this will be a big, multi-year undertaking. The crisis has exposed serious flaws in many aspects of our financial system. There will be proposals for more effective regulations in areas ranging from over-the-counter derivatives and short selling, to the practices of financial institutions, investors, mortgage originators and credit rating agencies.

We will need to reflect on the long-held premise that sophisticated investors have the wherewithal to look out for themselves and require minimal, if any, supervision. In these areas and others, regulations must be crafted to foster market stability while maintaining the fundamental tenet of capitalism: if investors are to reap the rewards of taking risks they must also bear the negative results of their risk-taking.

Yet updating our regulations and market practices will not be enough. We must also fundamentally reform and modernise our regulatory architecture and authorities.

While regulators have co-operated in addressing this turmoil, it is clear that their overlapping jurisdictions, gaps in jurisdictions and authorities, uneven capabilities and competition among themselves created the environment in which excesses throughout the markets could thrive.

Consequently, to focus only on new regulation would fall short: we must also modernise the regulatory system and authorities in the US.

This is not a new issue, but it is a difficult one. If we search for something positive in the carnage created by this financial crisis, it may be that it will provide the impetus for doing what many, including myself, have repeatedly called for: real reform of our regulatory architecture.

In the US we have a patchwork of financial regulatory agencies. Our agencies reside at both federal and state level. A company’s regulator is determined largely by its business form. Thus two financial firms providing virtually identical products with similar economic attributes may be regulated quite differently.

No one would ever design a system like this. It has evolved in an accretive way, without any real thought to long-term goals or objectives. It allows and promotes regulatory arbitrage.

This system allowed unregulated state organisations and non-bank affiliates of banks and thrifts to originate thousands of risky mortgages and it allowed AIG to build a huge and essentially unregulated hedge fund on top of tightly regulated insurance companies.

Business models, financial products and markets will continually evolve. That is the nature of a dynamic market. We must have a regulatory structure that recognises that dynamism and adjusts to it. Fortunately, we are not starting this process of reflection and reform in the midst of crisis.

In March 2008, after conducting a year-long process of study, I put forward a series of comprehensive recommendations to modernise our regulatory architecture in the Treasury’s Blueprint for a Modern Financial Regulatory Framework. The blueprint identified an optimal structure that was not designed to be accomplished overnight.

The ideal regulatory structure would reflect the reasons we regulate and would recognise that the financial system has changed dramatically since our regulatory architecture was designed.

Last March the Treasury proposed a system of three primary federal regulators: one charged with maintaining market stability across the entire financial sector, one for supervising the soundness of those institutions with explicit government support and one responsible for protecting consumers and investors.

Our proposed structure recognised that there would sometimes be a need for the Federal Reserve to provide liquidity support to institutions that it did not regulate historically. This would be a drastic realignment and simplification of regulatory agencies – in order to clarify responsibilities, provide powers commensurate with those responsibilities and improve accountability.

A regulatory structure organised by objective is far more likely to withstand the test of time. In an objectives-based model no business can change regulator simply by changing its form.

The dedicated business conduct regulator would be responsible for vigorously protecting consumers and investors, through its regulation of disclosures, business practices, chartering and licensing of certain types of financial institutions and rigorous enforcement programmes.

Consumers and investors would benefit from greater consistency across product lines and centralised accountability so that no product or service fell through the cracks. Mortgages are an example of a consumer financial product that has suffered from uneven and inadequate treatment in our current regulatory and enforcement regime.

A single safety and soundness regulator would supervise all institutions that are ultimately backed by taxpayer-funded guarantees and other forms of government support. It would end the division of such regulation among several regulators, which promotes ­“charter-shopping” and a race to the bottom. It would mean that businesses would compete on an economic basis, not on the basis of their regulators.

Finally, the crisis has made abundantly clear that our financial system would benefit from a regulator whose focus is on risks across the financial system. While the Fed is assumed to have this role, it does not have the mandate or powers to carry it out effectively. There is already growing support for the blueprint’s recommendation that Congress explicitly give this responsibility to the Fed, and provide it with the tools to meet that mandate.

It would require the Fed to have access to information from a broader set of financial organisations, including hedge funds and systemically important payment systems. This authority should also have the power to intervene if it concluded that the financial system was at risk. Because the breadth of authority provided must be great, the standard for using such authority, to protect the system as a whole, should be high.

Dissemination of information by this regulator should also help maintain market discipline, a concept that is still important. While it is true that both our regulators and market discipline failed in curtailing the run-up to this crisis, we are witnessing a strong dosage of market discipline today as investors require financial firms to deliver.

Another important reason to charter a market stability regulator is to provide an authority with the responsibility to examine and attempt to mitigate the too-big or too-interconnected-to-fail problem that we face.

Congress should create regulatory authorities capable of ensuring that any institution, no matter its size, can fail with minimal systemic impact. That requires authorities that balance market stability with private capitalism by imposing an orderly wind-down of the failing institution.

We have a process in place that gives the Federal Deposit Insurance Corporation ample and flexible authority to deal with a failing bank. After Bear Stearns’ collapse in March of last year, the Treasury and the Fed expressed concern that the government lacked this type of wind-down authority for a failing non-bank.

That concern became a reality when Lehman collapsed in September, and there was no authority at the Treasury or the Fed to save the institution, and no authority to manage the wind-down outside bankruptcy. A regulatory system that treats systemically important institutions differently solely because of their charter does not make sense in today’s globally interconnected markets.

Any rewrite of financial regulatory authorities must include the explicit federal authority to intervene and wind down a failing non-bank in an orderly manner.

Defining the proper wind-down authorities and their scope will require thoughtful analysis. Necessary authorities include the power in exigent circumstances, to guarantee liabilities, provide loans and take other stabilising measures. But the circumstances that would trigger these authorities must be narrowly defined, to minimise moral hazard and preserve incentives for proper risk management.

Creating a fundamentally different regulatory system is complex and will take months, if not years. But policymakers can achieve significant near-term regulatory reforms that represent progress towards the ideal.

These include giving the Fed expanded powers to regulate market stability, combining the Office of Thrift Supervision and the Office of the Comptroller of the Currency to strengthen regulation by reducing duplication, centralising the scrutiny of mortgage origination, creating an optional federal insurance charter, beginning the process of integrating the Securities and Exchange Commission and Commodity Futures Trading Commission and continuing to improve arrangements for clearing and settling over-the-counter derivatives, including development of well regulated and prudently managed central clearing counterparties for OTC trades.

Wrenching as this period is, the cost to our nation will be even larger if we do not learn lessons from it and overhaul our regulatory system so federal regulators have clear missions, powers to execute them and accountability for carrying them out.

A new regulatory architecture accountable to investors, with flexibility to adapt to changing markets and clarity of responsibility to interact with international counterparts to forge a seamless global market infrastructure, would inspire the confidence for the financial system to create prosperity in all sectors once again.

Source.

When a group of men who got rich by buying low and selling high want to make you their partner, hang on to your wallet. That bit of financial wisdom was amply demonstrated by the 97 per cent peak-to-trough drop in the common stock of Fortress Investment Group on its second anniversary as a public company last month.

Leverage cuts both ways, and its impact has been almost entirely bad for the alternative asset manager with the low point being a temporary halt to redemptions at its Drawbridge hedge fund late last year.

But investors looking over the detritus left by the financial crisis seem suddenly to realise that, having survived so far, Fortress is ideally suited to reap a future bonanza. They looked past a hefty net loss for the fourth quarter and bid Fortress’ shares up as much as 40 per cent on Monday upon hearing its optimism about participating in the first round of the term asset-backed securities loan facility,TALF.

Fortress is one of a handful of groups that retain the size and credibility to play a role in what may prove to be a high reward and relatively low-risk exercise. Fortress executives dub the coming period “the great liquidation”.

Meanwhile, much of the bleeding has stopped in Fortress’ existing business. About 82 per cent of its capital is long-term in nature with an average remaining life of 9.2 years, leaving plenty of time for mark-to-market losses to be reversed. With important debt renegotiations and redemptions mostly behind it, nasty surprises are unlikely.

Management’s optimism about the future of their hedge fund business may sound like bluster after huge outflows and no inflows recently, but it is not so implausible. If it can build new funds while using the taxpayer as a low-cost prime broker, new investors should be willing to let bygones be bygones.

Source.

AIG Counter Parties List

From Alan Greenspan, former chairman of the Federal Reserve and president of Greenspan Associates LLC.

We are in the midst of a global crisis that will unquestionably rank as the most virulent since the 1930s. It will eventually subside and pass into history. But how the interacting and reinforcing causes and effects of this severe contraction are interpreted will shape the reconfiguration of our currently disabled global financial system.

There are at least two broad and competing explanations of the origins of this crisis. The first is that the "easy money" policies of the Federal Reserve produced the U.S. housing bubble that is at the core of today's financial mess.

The second, and far more credible, explanation agrees that it was indeed lower interest rates that spawned the speculative euphoria. However, the interest rate that mattered was not the federal-funds rate, but the rate on long-term, fixed-rate mortgages. Between 2002 and 2005, home mortgage rates led U.S. home price change by 11 months. This correlation between home prices and mortgage rates was highly significant, and a far better indicator of rising home prices than the fed-funds rate.

This should not come as a surprise. After all, the prices of long-lived assets have always been determined by discounting the flow of income (or imputed services) by interest rates of the same maturities as the life of the asset. No one, to my knowledge, employs overnight interest rates, such as the fed-funds rate, to determine the capitalization rate of real estate, whether it be an office building or a single-family residence.

The Federal Reserve became acutely aware of the disconnect between monetary policy and mortgage rates when the latter failed to respond as expected to the Fed tightening in mid-2004. Moreover, the data show that home mortgage rates had become gradually decoupled from monetary policy even earlier, in the wake of the emergence, beginning around the turn of this century, of a well arbitraged global market for long-term debt instruments.

U.S. mortgage rates' linkage to short-term U.S. rates had been close for decades. Between 1971 and 2002, the fed-funds rate and the mortgage rate moved in lockstep. The correlation between them was a tight 0.85. Between 2002 and 2005, however, the correlation diminished to insignificance.

As I noted on this page [Opinion, Wall Street Journal] in December 2007, the presumptive cause of the world-wide decline in long-term rates was the tectonic shift in the early 1990s by much of the developing world from heavy emphasis on central planning to increasingly dynamic, export-led market competition.

The result was a surge in growth in China and a large number of other emerging market economies that led to an excess of global intended savings relative to intended capital investment. That ex ante excess of savings propelled global long-term interest rates progressively lower between early 2000 and 2005.

That decline in long-term interest rates across a wide spectrum of countries statistically explains, and is the most likely major cause of, real-estate capitalization rates that declined and converged across the globe, resulting in the global housing price bubble.

The U.S. price bubble was at, or below, the median according to the International Monetary Fund. By 2006, long-term interest rates and the home mortgage rates driven by them, for all developed and the main developing economies, had declined to single digits, I believe for the first time ever. I would have thought that the weight of such evidence would lead to wide support for this as a global explanation of the current crisis.

However, starting in mid-2007, history began to be rewritten, in large part by my good friend and former colleague, Stanford University Professor John Taylor, with whom I have rarely disagreed. Yet writing in these pages last month, Mr. Taylor unequivocally claimed that had the Federal Reserve from 2003-2005 kept short-term interest rates at the levels implied by his "Taylor Rule," "it would have prevented this housing boom and bust. " This notion has been cited and repeated so often that it has taken on the aura of conventional wisdom.

Aside from the inappropriate use of short-term rates to explain the value of long-term assets, his statistical indictment of Federal Reserve policy in the period 2003-2005 fails to address the aforementioned extraordinary structural developments in the global economy. His statistical analysis carries empirical relationships of earlier decades into the most recent period where they no longer apply.

Moreover, while I believe the "Taylor Rule" is a useful first approximation to the path of monetary policy, its parameters and predictions derive from model structures that have been consistently unable to anticipate the onset of recessions or financial crises. Counterfactuals from such flawed structures cannot form the sole basis for successful policy analysis or advice, with or without the benefit of hindsight.

Given the decoupling of monetary policy from long-term mortgage rates, accelerating the path of monetary tightening that the Fed pursued in 2004-2005 could not have prevented the housing bubble. All things considered, I personally prefer Milton Friedman's performance appraisal of the Federal Reserve.

In evaluating the period of 1987 to 2005, he wrote on this page [Opinion, Wall Street Journal] in early 2006: "There is no other period of comparable length in which the Federal Reserve System has performed so well. It is more than a difference of degree; it approaches a difference of kind."

How much does it matter whether the bubble was caused by inappropriate monetary policy, over which policy makers have control, or broader global forces over which their control is limited? A great deal. If it is monetary policy that is at fault, then that can be corrected in the future, at least in principle. If, however, we are dealing with global forces beyond the control of domestic monetary policy makers, as I strongly suspect is the case, then we are facing a broader issue.

Global market competition and integration in goods, services and finance have brought unprecedented gains in material well being. But the growth path of highly competitive markets is cyclical. And on rare occasions it can break down, with consequences such as those we are currently experiencing.

It is now very clear that the levels of complexity to which market practitioners at the height of their euphoria tried to push risk-management techniques and products were too much for even the most sophisticated market players to handle properly and prudently.

However, the appropriate policy response is not to bridle financial intermediation with heavy regulation. That would stifle important advances in finance that enhance standards of living. Remember, prior to the crisis, the U.S. economy exhibited an impressive degree of productivity advance. To achieve that with a modest level of combined domestic and borrowed foreign savings, our current account deficit, was a measure of our financial system's precrisis success.

The solutions for the financial-market failures revealed by the crisis are higher capital requirements and a wider prosecution of fraud, not increased micromanagement by government entities.

Any new regulations should improve the ability of financial institutions to effectively direct a nation's savings into the most productive capital investments. Much regulation fails that test, and is often costly and counterproductive. Adequate capital and collateral requirements can address the weaknesses that the crisis has unearthed. Such requirements will not be overly intrusive, and thus will not interfere unduly in private-sector business decisions.

If we are to retain a dynamic world economy capable of producing prosperity and future sustainable growth, we cannot rely on governments to intermediate saving and investment flows.

Our challenge in the months ahead will be to install a regulatory regime that will ensure responsible risk management on the part of financial institutions, while encouraging them to continue taking the risks necessary and inherent in any successful market economy.

Mr. Greenspan is the author of The Age of Turbulence: Adventures in a New World.

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