Stephen’s Posterous

Finance ministers and central bank governors are gathering in Washington for their annual spring meetings. The outlook is challenging, but we have not been idle.

The global economy is projected to shrink this year for the first time in more than six decades. The collapse of world trade is expected to be the largest since the end of the second world war. A global process of deleveraging is adversely affecting the availability of financing domestically and internationally. Job losses in the US have topped 5m since our recession began.

Earlier this month in London, leaders of the Group of 20 nations adopted a common strategy to restart global growth and secure international financial stability for the future. Our task in Washington is to keep at this process of repair and reform.

First, the G20 nations must follow through on their commitment to deliver the fiscal, monetary and financial policies necessary to restore growth. In the US we have passed our largest recovery programme in the postwar period. We are moving aggressively to stabilise and repair our financial system and to restore credit flows on which businesses and consumers depend. Most other countries have initiated similar forceful measures.

The collective fiscal response by the G20 for 2008-2010 is estimated by the International Monetary Fund at $5,000bn . We are acting to limit the effects of dislocations in financial markets on the financing of global trade in goods and services. Our task now is to ensure the effective implementation of these programmes and to narrow the growth shortfall. The IMF must be proactive in holding our feet to the fire of our good intentions.

Second, a strengthened and more responsive IMF is at the core of our agreed strategy for promoting recovery. The objective is not only to mitigate the effects of the global recession and the drying up of international capital flows but also to support sustained growth. This weekend we will make progress on the major IMF-related components of the London package.

Putting in place $250bn in immediate, additional, temporary financial resources to support IMF lending is substantially completed. We are also making good progress in reshaping the New Arrangements to Borrow (NAB) and facilitating its expansion by up to $500bn, incorporating into the NAB the $250bn in immediate financing.

The actual and potential availability of IMF resources on this scale has encouraged Mexico, Poland and Colombia to apply for almost $80bn in precautionary financial assistance from the IMF’s new Flexible Credit Line facility. This will boost confidence within these countries and is also an insurance policy against further global weakness.

The IMF has also taken the first steps towards implementing the London agreement to support the general allocation of $250bn in Special Drawing Rights. Emerging and developing economies would receive $100bn of this liquidity to help meet their foreign exchange obligations as necessary.

President Barack Obama wrote last week to Congressional leaders to request their endorsement of speedy US action on these measures. He stressed their critical importance to restoring the health of the global economy and therefore our own.

Third, the G20 meeting in London transformed the framework of global economic and financial co-operation. In addition to measures to boost the global economy and support the international financial institutions, leaders agreed that the Financial Stability Forum, renamed the Financial Stability Board (FSB) and expanded to include all of the G20 nations, should be given greater responsibility for the stability of the international financial system.

The US is initiating a comprehensive reform of our own system of financial regulation as part of our determined effort to lead a race to the top in regulatory and supervisory standards. That effort will not be wholly successful, however, without parallel action in other national financial systems. The FSB will play a critical role in this international co-operation.

In recent weeks, there have been some encouraging signs that the global economic downturn may be slackening. Conditions in some financial markets have improved and the decline in world trade may be abating.

However, real progress requires time, and significant risks and challenges remain. Thus, it is critical that we continue to act together to strengthen the basis for global recovery. We have an agreed strategy and a common imperative to implement our strategy with energy and dedication to our shared objectives.

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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

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Just when venture capitalists think they’ve safely avoided the crosshairs of regulators, they find themselves lumped together again with hedge funds and the scrutiny that comes with it.

In his testimony today about regulating risk (read the transcript here), U.S. Treasury Secretary Timothy Geithner proposed that hedge funds, private equity firms and venture capital firms should be required to register with the Securities and Exchange Commission.

No further details were provided, but it’s implied that Geithner is aiming to follow the proposals outlined in a recent bill titled, The Hedge Fund Transparency Act, which calls for these investment firms to file with the SEC and publicly divulge the value of their funds and the names of their investors.

This blanket-like proposal infuriates the venture industry, which has largely escaped the regulatory clutches of the SEC and Treasury Department. The National Venture Capital Association, which represents the venture capital industry, has lobbied hard to drive a wedge between it and hedge funds, characterizing venture firms as job generators and innovators, not wealth creators. Venture capital is a long-term business and an engine of the nation’s economy, it argues.

But with legislators pressured to heal a sickly economy and prevent another financial catastrophe, nearly every private pool of capital faces regulatory oversight. It’s why the Obama administration, which has generally befriended the venture capital industry, didn’t exclude VC firms from its plan to tax carried interest at the higher ordinary income rate.

We chatted today with Mark Heesen, the president of the NVCA, to talk about Geithner’s latest proposal. Here’s an edited excerpt of the Q&A:

Q. What is your reaction to Geithner’s testimony?

There are a couple of things that jump out to me in his discussion about “hedge funds and other private pools of capital.” No. 1, he says they’re looking at those types of funds that “individually or collectively pose a threat to financial stability.” As much as we want to talk about how the world revolves around venture capital, the fact is that it’s a very small asset class, relatively speaking.

We’re talking about $30 billion being invested per year. If suddenly you were to lose it all, would that pose a threat to financial stability? No. When you’re seeing buyout funds or hedge funds that raise one fund that is almost the entire amount raised by the entire venture industry, you have to realize these are very different asset classes.

The other thing that jumped out, he says, “…in the wake of the Madoff episode it is clear that, in order to protect investors, we must close gaps and weaknesses in regulation of investment advisors and the funds they manage.”

Well, our investors, those that invest on behalf of college endowments and pension funds, are not only highly sophisticated within the bounds of law, there even more sophisticated than the law requires them to be. They aren’t your individual, everyday investors in venture capital. These people aren’t going to get ripped like Madoff’s investors did.

Q. Is this your worst nightmare as the head of a venture capital trade group that venture firms are being wrapped in with hedge funds with regards to regulation?

Absolutely. This is déjà vu. After 9/11, when the Patriot Act came out, the Treasury was going to register a lot of different financial institutions because of the threat that they might be used by foreign entities for illicit purposes, like laundering money.

We were swept into that. So we sat down with the Treasury and Department of Homeland Security, and asked them, “Do you really think a terrorist group would put $5 million into a venture capital fund and sit there for 10 years until they got a return?” They of course said, “That’s not going to happen.” This is kind of the same idea.

Q. Do you think that Congress has enough of an understanding about venture capital to exclude these firms from regulation?

We’re at a point where policy makers have too much on their plate. They are not by and large educated in distinguishing between hedge fund and buyouts and venture. They’re expected to know everything, but they can’t know everything. So a simple solution is to use a broad brush. We have to be there to continue to educate.

History repeats itself, it’s kind of like Sarbanes-Oxley. There was a rush to regulate and then take care of problems that arise from it afterward. You’re seeing that now with a group of policy makers that “want to get something done.”

They have real pressure from their constituents who have lost their jobs or their mortgages. So they’re trying to get something done quickly. This is very much a Washington issue: We’ll deal with it now and clean it up later.

Q. Do you think it’s practical for the SEC to suddenly oversee hundreds of more firms?

I think you need to balance oversight and regulation with the practicality of government bureaucracy. The government can only do so much with the amount of people and money they have. They need to pinpoint the major concerns and work on those as opposed to trying to cover the ocean and do every job simultaneously.

The SEC goes to the hill every year and requests more people and more money. I don’t begrudge them for that. But should they spend time reviewing hundreds of venture capital registrations each year, or more financially questionable issues from other entities out there?

Q: So what happens from here for the NVCA?

We’ll talk to the treasury folks, but Obama has appointed very few people to key positions. You have your career bureaucrats, but they don’t make these policy decisions.

So getting into the Treasury to talk to those who make policy decisions as opposed to technical ones is hard. It’s only going to get more problematic going forward, Geithner can’t keep working for 23 hours a day. He needs help.

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Wall Street stands to get richer off the latest installment of the financial system rescue. But this time, some individual investors might be offered a piece of the action.

Two of the country's biggest money managers, Newport Beach-based Pacific Investment Management Co., known as Pimco, and New York-based BlackRock Inc., say they may launch funds that would allow individuals to have a stake in some of the bad assets to be purchased from banks.

Under one of two programs announced Monday by Treasury Secretary Timothy F. Geithner, the government will invite money managers and other investors to buy residential and commercial mortgage-backed bonds from banks using a combination of the investors' capital and government capital.

The idea is for the money managers to buy the bonds at prices that won't destroy the banks but that still leave a good chance for the investors and taxpayers to profit as the underlying loans are collected or sold over time. Bill Gross, co-chief investment officer at Pimco, said his firm was looking into the idea of creating mutual funds that would tap into the program. BlackRock is doing the same, said Curtis Arledge, co-head of fixed income at the firm.

"I think it's a very good opportunity for investors," Arledge said.

But the format of such funds for individuals probably would be a "closed-end" portfolio rather than the more common "open-end" portfolio, Arledge and Gross said. A closed-end fund raises a specific amount of capital from investors and then invests the proceeds in a pool of securities. The funds' shares typically trade on a securities exchange, such as the New York Stock Exchange.

With an open-end fund, by contrast, investors can buy new shares in the fund at any time and sell them back at any time. Closed-end funds are ideal for illiquid assets that may take years to pay off. By contrast, open-end funds must set a value on their holdings daily.

BlackRock recently launched a closed-end fund called BlackRock Fixed Income Value Opportunities to invest in "distressed" mortgage and corporate bonds, Arledge said. But the fund's shares don't trade on an exchange; the company told investors that the fund, while expected to generate regular income for shareholders, would exclusively be a buy-and-hold investment for the next few years.

The fund also had a $25,000 minimum investment and was limited to high-net-worth investors. The Fixed Income Value Opportunities fund could be a template for closed-end funds under the Treasury's new programs, Arledge said.

That wouldn't allow average-Joe investors to get aboard, but it would be less exclusive than limiting the investor pool to pension funds, hedge funds and other institutions.

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Does Barack Obama have the same problem in Tim Geithner that George W. Bush had with his first disastrous Treasury Secretary, Paul O'Neill?

That's the question on the minds of many Republicans and Democrats in Washington in recent days. The not-so funny joke around town is that every time Mr. Geithner opens his mouth, the Dow falls by another 200 points. Democrats are somberly whispering that Mr. Geithner may not be up to the job and they're not so convinced that President Obama had it right when he told them that the Boy Wonder was desperately needed to reverse the financial meltdown.

Mr. Geithner still hasn't recovered from his first miserable performance in prime time, when he went to Capitol Hill, laid out his bank rescue plan, and the market tanked, falling 500 points.

Then his performance in front of the Budget Committee last week was widely panned by investors and politicians. Senator Max Baucus, the Democrat from Montana, was quoted as saying that he was underwhelmed by Mr. Geithner's comments on the budget and the economy.

Republicans were infuriated by the Treasury Secretary's sermon that Congress has a "moral imperative" to raise taxes on the rich. House Republicans I talked to last week fumed: "Geithner has zero credibility in telling us about moral obligations to pay taxes." They, of course, are referring to Mr. Geithner's $30,000 of unpaid taxes. Staffers on the committee tell me members routinely ridicule Mr. Geithner's "non-plan to save the banks and solve the banking crisis."

David Malpass of Encima, a Wall Street economics firm, notes that after listening to Mr. Geithner's inane comments about the virtues of raising taxes, some investors are starting to wonder whether income redistribution is a higher priority for the Obama economics team than growth and recovery.

As Mr. Malpass puts it: "The equity sell-off is rapidly narrowing the wealth gap between rich and poor and the geographic wealth gap between New York and Washington." He faults Mr. Geithner for inaction on reining in naked short selling, not fixing the mark-to-market issue, not changing the uptick rule, and other regulatory fixes that could raise equity values.

What's indisputable is that Tim Geithner is no longer regarded as the indispensable man to lead America back to prosperity. As one Republican on the Ways and Means Committee told me, "When he comes up here, it's like children's hour." The speculation now is that if the markets don't reverse course soon, Mr. Geithner may be out, and his former boss Larry Summers may be back in at Treasury.

From Stephen Moore, WSJ's Political Diary.

Private equity company Blackstone Group CEO Stephen Schwarzman said on Tuesday, March 10, 2009, that up to 45 percent of the world's wealth has been destroyed by the global credit crisis.

"Between 40 and 45 percent of the world's wealth has been destroyed in little less than a year and a half," Schwarzman told an audience at the Japan Society. "This is absolutely unprecedented in our lifetime."

But the U.S. government is committed to the preservation of financial institutions, he said, and will do whatever it takes to restart the economy. U.S. Treasury Secretary Timothy Geithner plans to unfreeze credit markets through a new program that will combine public and private capital in a fund that would buy bank toxic assets of up to $1 trillion.

"In all likelihood, that will have the private sector buy troubled assets to clean the banks out in terms of providing leverage ... so that we can get more money back into the banking system," Schwarzman said.He expects the private sector to end up making "some good money doing that," but added there were complex issues on how to price toxic assets.

Mr. Schwarzman put part of the blame for the financial crisis to credit rating agencies.

"What's pretty clear is that, if you were looking for one culprit out of the many, many, many culprits, you have to point your finger at the rating agencies," he said. Rating companies have been the focus of intense criticism for their role in granting top "AAA" ratings for complex bonds that later plummeted in value, resulting in subsequent rating cuts, in many cases to junk status.

"Once you bought into ... the Triple A paper and it turned out to be paper that was in many situations going to end up defaulting, then you really had the makings of a global problem," he said. Mr. Schwarzman said problems were then exacerbated by mark-to- market accounting rules. Those rules ask banks and other financial institutions to price assets at a value related to how they would be sold in the open market.

Blackstone reported a quarterly loss in February 2009 after writing down the value of its portfolio and eliminated its fourth-quarter dividend. Asked where was a good place to invest, Schwarzman said it made sense to buy cyclical names, which are less exposed to the economic cycles.

Mr. Schwarzman said investors also may find value in debt products, including "senior layers of certain securitizations," where investors can see 15 percent to 20 percent returns, he said. Geographically, he said there were "pockets of strength" in China, which is committed to getting to an 8 percent growth level, and in India, where the economy is slowing but banks are in good shape.

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Based on the costs of fiscal stimulus and the bank bailout, the US’ federal government debt to GDP ratio is heading much higher. While other factors are important, that suggests the credit quality of currently top-rated US Treasury debt may trend down. That’s not a complete disaster, but it means Treasuries won’t really be a safe-haven investment either.

Assuming deficit projections by the Congressional Budget Office for the 2009 and 2010 fiscal years are right, and adding in the cost of the stimulus plan, the bank rescue plan and borrowing costs, US public debt would rise from 41% of GDP in September 2008 to about 70% of GDP in September 2011.

After 2011, the US debt-to-GDP ratio is expected to decline again. The CBO projects deficits of less than 2% of GDP after 2012, and the capital injected into the banking system under the government’s bailout plans should start to produce some returns for taxpayers around that time.

There are considerable downside risks. The CBO projections are based on optimistic assumptions: that growth averages 4% annually between 2011-14, that the Bush tax cuts and Alternative Minimum Tax relief all expire in December 2010 and that discretionary spending only increases in line with inflation after 2010.

The falling debt scenario also assumes that none of the expenditures under the stimulus plan migrate into annual spending after 2010. Should the recession deepen, or persist beyond the end of 2010, higher budget deficits could become entrenched. Finally, the projection assumes US interest rates remain low. With Treasury bond maturities now averaging only 48 months, higher interest rates would rapidly feed into higher borrowing costs and budget deficits.

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Financial markets are supposedly driven by two competing forces: fear and greed. Fear just made another grab for the steering wheel.

Disappointment with the U.S. government's planned credit-market bailout and concerns that the $787 billion stimulus plan won't jolt the economy fast enough snuffed out the budding U.S. stock-market rally. Now investors are worried that stocks could fall back to their November lows-and possibly even further.

The Dow Jones Industrial Average finished last week at 7850.41, down 5.1% in the four days since the Obama administration unveiled its latest efforts to aid the credit markets and just 4% above the November low of 7552.29. A drop below that level would send the benchmark toward the 7286.27 low of the previous bear market, hit in October 2002. The market was closed Monday for the Presidents Day holiday.

"The hope balloon is losing air," says Henry Herrmann, chief executive at Waddell & Reed Financial Inc. in Overland Park, Kan. "It points to how on-edge everybody is and how much emotionalism is still involved."

In late 2008 and earlier this year, Mr. Herrmann's firm was betting on a revival. It had cut its cash holdings to around 11% on average from about 17%, increasing exposure to stocks. His money managers now have boosted cash back to around 14%. They are a lot more comfortable with safe Treasury bonds than higher-yielding junk bonds.

Many money managers, including Mr. Herrmann, still live in hope that any declines from here will be modest, but they also worry that a heavier drop to new lows can't be ruled out. With the road ahead looking rocky at best, many are turning more defensive.

Analysts have been disappointed that market upturns in 2009 have been wimpy, short-lived affairs. The upturns haven't had the strong trading volume and duration that would signal the investor confidence normally seen at the start of a lasting stock recovery. Instead of ratcheting higher, the Dow keeps slipping downward. That has reinforced the fears of new lows.

All of this has thrown a cloud over the optimism at the start of February, when some were betting that stimulus plans would move the global economy toward recovery.

Investors got a reminder of reality during Treasury Secretary Timothy Geithner's widely criticized speech last Tuesday. Details of his plan to get lending markets working normally again were unconvincing, and Mr. Geithner stressed in testimony to Congress that there would be no easy solutions. Some investors and analysts also worried that President Barack Obama's separate stimulus plan mightn't be able to spend enough money fast enough.

"Things are going to take longer, and that means the economy is going to be softer longer. It is hard to make a cheery story out of that," Mr. Herrmann says.

Such doubts were reflected in last week's market moves. Industrial commodities and junk bonds, which some investors had been buying in hopes of an economic upswing, dropped. Gold and Treasury bonds, widely perceived as havens for scared money, rose.

Gold futures rose 5.5% over those four unhappy days, finishing Friday at $941.50, just 6% below the New York record finish of $1,003.20 hit last year. The yield of the 10-year Treasury note, which declines as the note's price rises, slipped to 2.900% from 3.028% late Monday.

Copper futures, which had been recovering so far this year, fell 4.5% from Tuesday to Friday. New York oil futures fell 5.2%, wilting beneath the economic worries. And Brazil's stock market, which had been on the rise because of that country's clout as a raw-materials exporter, began falling again.

"There is a general feeling that we are a ways from the bottom of this recession. In fact, the bottom isn't in sight," says Edgar Peters, co-director at investment-management firm First Quadrant LP in Pasadena, Calif. That leaves few people feeling they can see far enough into the future to invest confidently. "There are very few long-term investors now. Everybody is a short-term investor," Mr. Peters says.

Stocks appeared to stabilize on Thursday, as some investors once again began betting that the government's recovery efforts, notably to slow foreclosures, would keep indexes above their November lows, at least for now. Still, setbacks like last week's are making it harder for optimistic money managers to convince weary investors that stocks will rally in the second half of the year and that they should increase their stock holdings in preparation.

"I feel a little like Charlie Brown. They keep taking the football away," says Jim Dunigan, chief investment officer at PNC Wealth Management in Philadelphia, a unit of PNC Financial Services Group Inc. While he has been urging clients to gradually return to stocks in anticipation of better days, he acknowledges that it hasn't hurt anyone to steer clear of stocks so far.

"There still are some clients who are very fearful about the prospect that the recession will get worse or continue," Mr. Dunigan says. "As long as we keep looking to Washington for something that will move the market, history would tell us we will get disappointed by that."

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Private Equity firms are agitating for a voice in how the public-private partnerships being set up by the government to get investment flowing to banks are going to work. So far, the PE community seems to feel it’s been left out of the process.

But a Treasury Department official we spoke to today said the department will be reaching out to “a broad spectrum” of private investors to seek their input in the next few weeks. The official said the government funding likely will come primarily in the form of lines of credit, to protect taxpayers.

The official did not address how the Treasury will deal with the sensitive topic of how public and private investors will share gains and losses, saying details like that will be ironed out in the near future. This is likely to be a serious sticking point, and may explain why the government has been slow to include private investors in its discussions, as it would not want to convey the perception that it is being overly influenced by them.

Bringing private investors into the process of fixing the financial system has benefits. Besides helping the government pay to resolve a very expensive problem, private equity firms and other private investors can bring management expertise and valuation skills that the government does not have.

But there are drawbacks, too. As the deal for Indymac Bank shows, the government is likely going to have to backstop potential losses to get private investors on board. In doing so, it runs the risk of leaving the public with the impression that they are being stuck with the losses while the fat cats get fatter. It is no accident that Treasury Secretary Timothy Geithner emphasized earlier this week that “we believe that access to public support is a privilege, not a right.”

Eric Zinterhofer, a senior partner with Apollo Management, said this week that the issue is thorny, pointing to the example of Shinsei Bank in Japan. Ripplewood Holdings and J.C. Flowers & Co. made a killing on that investment, which the Japanese government backstopped. But the government has been heavily criticized for the deal, and the bank still owes the government money.

Steven Kaplan, a professor at the University of Chicago Graduate School of Business, said the Shinsei transaction shows the need for transparency - something Geithner has repeatedly promised will be present as the U.S. cleans up banks’ balance sheets.

“You want to make sure when you sell assets, there is as much transparency and as much of an auction as possible,” said Kaplan. For his part, Zinterhofer said any good solution should begin with “more communication and trust” between government and private equity. Private equity coming in and making money “shouldn’t be a bad thing…investment is not a dirty word,” he said.

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