The Big Picture - Macro Perspective on the Capital Markets, Economy, Technology, and Digital Media

David R. Kotok co-founded Cumberland Advisors in 1973 and has been its Chief Investment Officer since inception. He holds a B.S. in Economics from The Wharton School of the University of Pennsylvania, an M.S. in Organizational Dynamics from The School of Arts and Sciences at the University of Pennsylvania, and a Masters in Philosophy from the University of Pennsylvania. Mr. Kotok’s articles and financial market commentary have appeared in The New York Times, The Wall Street Journal, Barron’s, and other publications. He is a frequent contributor to CNBC programs. Mr. Kotok is also a member of the National Business Economics Issues Council (NBEIC), the National Association for Business Economics (NABE), the Philadelphia Council for Business Economics (PCBE), and the Philadelphia Financial Economists Group (PFEG).

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President Obama’s plan to restructure regulation of America’s financial system has some desirable elements. It also has great danger.

Eliminating certain banks that were exempted from supervision is appropriate. So is the elimination of the Office of Thrift Supervision (OTS) one of the regulators of AIG. Is there really a difference between a thrift charter and a commercial bank in the modern system? The answer is no.

The grave risk in the plan is that it politicizes the Federal Reserve and, in certain instances, gives the Treasury a veto over Fed activity. This is particularly true for the implementing of the emergency powers that the Fed has used during the crisis. The Fed will have to obtain the Treasury Secretary’s written permission before an emergency action occurs. Do we really want to have an appointed cabinet officer in our government wield that power over our so-called independent central bank?

Remember, it is the central bank that is charged with policy making to encourage low inflation and economic growth. The more politics gets into central banking, the greater the inflation risk. Politicians do not want to apply restraint. They tend to discourage higher interest rates as a tool to fight inflation. History is replete with examples of central bank policy failures while under political influence.

Power over the “review” of the Fed’s structure is also given to Treasury, even as the Fed is charged with drafting a report. Many Fed watchers expect this to be the basis for an attack on the regional Fed bank system. The suspected target is to shrink the number of regional banks and also reconstitute the structure of the Fed’s decision making.

Right now the Federal Open Market Committee sets monetary policy. It is composed of seven governors (when all seats are filled) and the presidents of the twelve regional Fed banks. We expect the Congress to change that and, perhaps, reduce the number of regional banks to five. The survivor banks may have changed roles and even house some of the supervisors under the Fed’s expanded role.

Once this Obama proposal becomes an introduced, proposed law, the Federal Reserve Act will be reopened for amendment and anything can happen. That is when the lid on Pandora’s Box will have been lifted.

In the House, the Obama administration has the certain votes to pass a comprehensive revised Federal Reserve Act. Several key committees will be involved, with Barney Frank’s Financial Services in the forefront. If the pattern of other legislation is followed, the Pelosi-led House will send the final law to its rules committee, which will vote out a limited-debate, no-amendments structure. Republicans are emasculated in the House, so the most they can do is bluster for the TV cameras. House passage is nearly a certainty.

In the Senate there is still room for material change to this proposal, and the debate there is destined to be fierce. We expect that the Senate version will be markedly different from the House’s. The rules will require that the differences be hashed out by a House-Senate conference committee. Then that final proposed law will head back to the House and Senate for straight up or down votes, with no amendments permitted in either chamber. It will pass.

This Obama proposal is on a fast track. There will be public hearings, of course, but the decisions are being made in the smoke-filled rooms. The lobbying is already intense. We believe that the end result is coming and it is already known. The United States is extending a social-democratic form of government to the bulk of the US economy. We are applying an “industrial policy” to finance and banking, just as we are doing to health care and autos.

We have already done this for years with the agriculture sector. The result is that we pay farmers not to farm and we get ethanol policies that starve millions of people, and we promote protectionism in sectors like sugar. That’s how industrial policies end up in social democracies. We are going to get one in banking and lending and the monetary business. The outlook is not sanguine.

We will have more to say about the concept of industrial policy as a form of economic policy. For now we are going to get some rest, having read through this 89-page white paper twice. Many of its highlights will be seen in newsprint and on TV and heard on radio. We see no need to be redundant.

As for the phrase “industrial policy,” we will leave readers to contemplate its meaning, because it will affect every one of us. One of several definitions from a Google search of economic references is: “An industrial policy is a set of actions executed by interventionist or mixed-economy countries in order to affect the way in which factors of production are being distributed across national industries. By this definition, it’s logical that industrial policies contain common elements with other types of interventionist practices, such as trade policy and fiscal policy.”

Welcome to the new America. Add up finance and banking, agriculture, autos, housing, and health care: you get nearly half the nation’s GDP under an industrial policy. Larry Kudlow, take note: “free-market capitalism” is dead.

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David R. Kotok, Chairman and Chief Investment Officer, email: david.kotok@cumber.com
800-257-7013
June 18, 2009

http://www.cumber.com

Watch amateur video clips of post-election protests in Iran uploaded to YouTube by users

Good Evening: U.S. stocks finished mixed Wednesday after a morning dip and afternoon rally both failed. Some less than cheery news from FedEx and some bank downgrades set the tone for the early weakness, while a successful test of the 200 day moving average by the S&P 500 helped prices rebound in the afternoon. And it is also quite possible that stocks were ready to bounce a bit after a few down days, but I’ll focus more on market direction tomorrow. Instead I will review President Obama’s proposal for changing the regulatory landscape of the financial industry. The issues that brought us the financial crisis are not small, but I wonder if some of the President’s many, many ideas on the subject are correctly sized in relation to the problem. More is not always better, especially when it comes to a complex industry like modern finance.

Stocks overseas were on the weak side overnight, extending a trend that began late last week. U.S. stock index futures were also a bit lower, though the news out of FedEx may have been a contributing factor (see below). FDX announced an earnings beat, but then went on to say the economy deteriorated during the most recent quarter and put an exclamation point on this observation by halving its earnings guidance for the current quarter. Since what is shipped by FDX is the very stuff that makes our economy go, hearing its management say — whether from 30,000 feet or on the ground — that the green shoots are not visibly sprouting gave many investors pause in the early going.

The economic data was not much of a factor, since the tame CPI figures reported today tell us little about the inflation risks down the road. So, too, with the current account deficit; it narrowed in Q1 due to factors that have already started to reverse (see below). The banks, however, were a story with a little more teeth this morning. In the final story you will find below, S&P downgraded 18 banks — despite all the stress test results and capital raises in recent weeks. It would have been an even bigger story had the ratings agencies not trashed their reputations in the 2003-2007 time frame.

Given this news flow, stocks could have been forgiven for opening 1% lower, but they instead opened nearly unchanged before declining by the aforementioned amount 90 minutes into the trading day. The S&P 500 even managed to penetrate its 200 day moving average for a brief spell before that index followed NASDAQ higher. After rallying until they were up approximately 1%, the major averages settled back to close mixed. Bonds were firm in the morning, but they also reversed to finish mixed. Yields on the short end fell a couple of bps, while those on the long end rose in equal measure. At least the dollar and commodities were fairly consistent, though. The former fell and stayed down, while the latter followed oil and precious metals higher for most of the session. The CRB index closed 0.4% higher.

I’ve written quite a bit about how the U.S. can more intelligently regulate our financial system. Back in May, I cited Barry Ritholtz’s suggestions for financial reform, which he posted in this article on his site, The Big Picture . In addition to Barry’s list, I proposed the following suggestions in a commentary posted later the same day (comment) . I then added these ideas to this growing laundry list on June 9 in this piece. The philosophy behind these proposals is to create a regulatory boundary fence inside which financial firms can then more or less freely operate. Detail-loving micromanagers need not apply for a position in this framework-oriented approach.

In response to all of the free advice available above and elsewhere, the Obama administration put forth in the Monday edition of the Washington Post the following preview of the President’s proposal. This early glimpse was heartening to the extent that it addressed many of the issues that Barry and I have written about. But, as always, the mischief of regulatory reform is in the details. President Obama’s actual proposal broadly follows the outline laid out by Mr. Geithner and Mr. Summers, but it goes quite a bit further — and, perhaps, too far (Obama’s Draft Proposal). Let me clearly state that I have yet to read every one of the 85 pages, but the pages I have read seem to indicate that when choosing between “smarter” regulation and simply “more” regulation, the President’s draft proposal seems to favor a “more regulation is better” approach.

The first piece of evidence I offer in support of my assertion of an unwelcome drift toward “more” as opposed to “smarter” regulation is the size of the proposal itself. “Change” mean many things, but 85 pages are more indicative of too much micromanagement rather than a statement of principals and intents to be debated during the legislative process. The blueprints for the type of “boundary fence” regulation I’ve often proposed would require a few pages; regulating the behavior of financial institutions while inside the boundaries is what takes so much explaining.

Another indication that the “more is better” philosophy of regulation might be transcendent in the President’s draft is an entire section (# 3) has as its goal to “protect consumers and investors from financial abuse”. Like 99% of the American population, I’m against financial abuse in all its forms, but it’s a fool’s errand to try to set up a vast infrastructure of rules to deal with it. The smarter approach would tell all investors and consumers to take responsibility themselves for any dealings to which they are a party. “Caveat emptor” would be my first, if inelegant, suggestion.

To those two simple words I would also offer ways for consumers and investors have easy access (800#, website, etc.) to both FINRA and the enforcement division of the SEC. FINRA could handle most of the brokerage-related complaints (think: my advisor did unauthorized trades in my account), and the SEC could handle the larger problems surrounding organizational practices (think: Stanford or Madoff). Both FINRA and the SEC already have the power to police, fine and/or prosecute perpetrators of financial misdeeds, so let’s just make it easy for folks to find help at these two regulatory bodies and then just ask the agencies to do their jobs.

See? My version of section # 3 alone would take only two paragraphs to explain, will cost next to nothing to implement, and will likely be more effective than any attempt to legislate even more “do’s” and “don’ts” than already exist. Sarbanes-Oxley is only one example of a confusing tangle of regs that has utterly failed to address the abuses it was intended to prevent. Conscientious objectors of the potentially higher staffing costs my idea might bring needn’t worry too much, since the extra funding the SEC might need could be found in eliminating certain departments (e.g. “Economic Analysis”).

Before anyone takes umbrage at what they may think is a political attack on the administration, let me say there is plenty to like about Mr. Obama’s proposal. I support 1) the overall approach to taking systemic risk into consideration instead of focusing only on individual institutions, 2) the imposition of leverage caps on these firms, 3) the move toward more transparency, 4) the desire to better coordinate the various regulatory bodies and their roles, 5) the attempt to finally rein in OTC derivatives, and 5) the goal of working toward international standards on all of the above. Done well, these changes will be quite welcome in that they will help lower the systemic risk embedded in our current system.

I’m less than enthralled, however, about 1) giving the Fed more power, 2) attempting to detail the ways we can now “protect” consumers and investors, 3) requiring hedge funds and “other pools of capital” to register with the SEC, and 4) skating past the moral hazard issues created by all the 2007-2009 bailouts. In short, Mr. Obama’s proposal is a start — one which I hope will emphasize intelligent attempts at regulation, but one I fear will end up just being more governmental ways to micromanage. This draft obviously will be subjected to considerable tinkering during the legislative process. Financial firms are huge campaign donors, especially in the Senate, so I’m guessing whatever our President eventually signs into law could be quite different than what he laid out today. Let’s hope Mr. Obama’s 85 pages of what looks like “more” get whittled down until we can proudly call them “smart”.

– Jack McHugh

FedEx Falls as Forecast Trails Estimates on Economy
U.S. Economy: Consumer Costs Fall Most in Six Decades
S&P Cuts U.S. Banks, Citing Regulation, Volatility

In Breaking the Bank, FRONTLINE producer Michael Kirk (Inside the Meltdown, Bush’s War) draws on a rare combination of high-profile interviews with key players Ken Lewis and former Merrill Lynch CEO John Thain to reveal the story of two banks at the heart of the financial crisis, the rocky merger, and the government’s new role in taking over — some call it “nationalizing” — the American banking system.

If you doubt for a moment that the TARP was a ruse to cover up for Citigroup be sure to watch at the 30 minute mark about how Paulson got the 9 banks to accept the TARP money.

(wait a moment for video to load)

Hat tip Joe of The Millennial Project

What the heck!

3 down days in a row (not Nasdaq tho)

Its Wednesday, and I have a few fun things in the queue for tomorrow — what is on the collective hive mind?

What is getting you excited frustrated nervous annoyed?

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What say ye?

Vincent Farrell, Jr. is Chief Investment Officer of Soleil Securities, a New York based investment management company. Over his long career on Wall Street, he has worked for numerous distinguished firms. Mr. Farrell graduated from Princeton University in 1969 and received his M.B.A. from the Iona College Graduate School of Business in 1972.

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Household debt is “down” to 130% of disposable income. “Down” is a relative term. It was 134% recently. But it was half the current level as recently as the mid-1980′s. Total debt in the U.S. (all debt including the government) stands at about 360% of Gross Domestic Product. It was 155% in 1980. Another way to slice the debt overview is to look at non-financial debt (take the banks’ debt, etc. out) and that is 240% of GDP. The Euro zone is also at about that level and Japan is at something like 450% of GDP. But that economy has been down for a long time, so I take no comfort we are better off than that.

Let’s look at household debt for a moment. Disposable personal income is close enough to $11 trillion that we can use that as a number. If household debt were to retreat to, say, 100% of income, it would be a retrenchment of a good bit over $3 trillion. That would be one big bite out of consumer expenditures. I have no idea where this debt to income will or should go. Things tend to revert to the norm over time, and if we were in the 70% range in the 1980′s, I don’t think returning to 100% is a crazy view. If the savings rate were to return to its 70-year average of 9%, that would chip in almost $1 trillion a year. Savings might not go to pay off debt, but, from a total balance sheet overview, we could balance one against the other. If all else stayed equal (which of course it won’t), it would take several years to get back to 100%. Not a joyful prospect for a booming economy led by the consumer, but I don’t think any of us believe the consumer is going to be a driving force in any recovery.

What might be a driving force would be inventory restocking. I mentioned yesterday that Industrial Production was down again, which means there is no inventory build at all, and inventory liquidation instead. If final demand started to pick up, there would be a need to increase production quickly.

New York City has balanced its budget with the aid of Federal stimulus dollars. But the smoke and mirrors employed also revealed a rise in the sales tax and a reduction in the work force. How does the use of stimulus dollars in this sense stimulate? Taxes are up and employment down. I don’t get it. Only about $50 billion or so of the total stimulus package of $787 billion has been spent, and there is a lot of enthusiasm that, when the rest gets spent, the economy will prosper. But if it non-stimulates like this, we are in for a reassessment.

Read the rest of this entry »

Jack Bogle is having an author event at the Barnes & Noble on Fifth Avenue (555 5th/between 45 & 46), at 6:30PM June 17. He recently published a book called “Enough.”

Not sure how people feel about Jack. I like his criticism of Wall Street in general, but given what giant shareholders Vanguard is, I wish they took the issue of corporate governance more seriously.

Front page story in the WSJ on the nascent revival of nuclear power in the USA.

“Four power companies are expected to split $18.5 billion in federal financing to build the next generation of nuclear reactors — the biggest step in three decades to revive the U.S. nuclear industry and one that could vault the utilities ahead of some of the sector’s strongest players.

UniStar Nuclear Energy, NRG Energy Inc., Scana Corp and Southern Co. are expected to share a set of loan guarantees to be awarded by the Energy Department. The guarantees would enable the companies to start building the reactors as early as 2011, with the plants likely to come online by 2015 or 2016 . . .

Seventeen companies applied for $122 billion of federal loan guarantees for 21 proposed reactors . . .

Expanding the use of nuclear power has the potential to make a significant dent in emissions of carbon dioxide, the most commonly produced greenhouse gas. And Energy Secretary Stephen Chu has made nuclear power an agency priority.”

Fascinating development . . .

Source:
U.S. Chooses Four Utilities to Revive Nuclear Industry
REBECCA SMITH
WSJ, JUNE 17, 2009

http://online.wsj.com/article/SB124519618224221033.html

A recent draft of the plan to reshape financial regulation sent to members of Congress (via NYT)

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click for PDF

via NYT

The giveback of the June gains over the past few days in the S&P’s has been matched by the corporate credit markets where the CDS on the HY and IG index are back to the levels of late May. The action in the bank sector specifically is most interesting. On May 7th the results of the Treasury ‘stress test’ was revealed and some banks were told to raise money as a result and fortunately those chosen did, more than $65b in total with BAC alone raising more than $30b. The capital raising plugged holes based on a set of scenarios laid out by the Treasury. While its only a few days action, the CDS market is wondering whether it was enough. BAC 5 yr CDS is at 263 bps, the highest since May 5th and up from 230 yesterday and 135 on June 1. Citi is at 497 bps up 50 bps on the day at the highest also since May 5th and up from 320 bps on 6/1. WFC is at 157 bps, the highest since May 7th, up 12 bps and up from 115 bps on 6/1.