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

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Governor Daniel K. Tarullo

At the Symposium on Building the Financial System of the 21st Century, Armonk, New York
March 18, 2010

Two years ago this week, Bear Stearns succumbed to severe liquidity stress. It was rescued, and eventually absorbed by JPMorgan Chase, with financing assistance provided by the Federal Reserve. Although it would take another six months before the accumulating stress and uncertainty posed an immediate threat to nearly all of our major financial institutions, it is clear in retrospect that this arranged marriage, and its accompanying dowry of government financing, set off an expansion of the universe of firms perceived as too big to fail.

During the financial crisis, government authorities in the United States and elsewhere believed they had only two realistic options in the face of serious distress at a large financial firm. First, they could try to contain systemic risk by stabilizing the firm through capital injections, extraordinary liquidity assistance, a subsidized acquisition by a less vulnerable firm, or some combination of these supports. Second, they could allow the firm to fail and enter generally applicable bankruptcy processes, risking in those times of fear and uncertainty a run on similarly situated firms.

The Bear Stearns deal was an example of the first policy option. Lehman Brothers was an example of the second. When its bankruptcy set off a firestorm in the exceedingly dry tinder of financial markets in the fall of 2008, the U.S. government decided that further failures of large, interconnected financial institutions risked bringing down the entire financial system. It responded to the situation with the Troubled Asset Relief Program to provide capital, and the Temporary Liquidity Guarantee Program to extend debt guarantees, to large financial firms.

Indeed, faced with the possibility of a cascading financial crisis, most governments around the world selected the bailout option in most cases. But if the costs of this approach are less dramatic during a crisis, they are no less significant afterward. Entrenching too-big-to-fail status obviously risks imposing significant costs on the taxpayer. It undermines market discipline, competitive equality among financial institutions of different sizes, and normal regulatory and supervisory expectations.

The desirability of a third alternative to the Hobson’s choice of bailout or disorderly bankruptcy is obvious–hence the prominence during the regulatory reform debate of proposals for a special resolution process that would allow the government to wind down a systemically important firm in an orderly way while still imposing losses on shareholders and creditors. The crisis has also focused attention on the special problems created by the failure of a large, internationally active financial firm. In my remarks I will elaborate on the relationship between resolution regimes and an effective overall system of financial regulation and supervision, both in the international and domestic spheres. ¹

At the risk of some oversimplification, I would state that relationship as follows: First, an effective domestic resolution process is a necessary complement to supervision that would bring more market discipline into the decisionmaking of large financial firms, their counterparties, and investors. At the same time, even a well-designed resolution mechanism is no substitute for reformed regulatory rules and strengthened supervisory oversight.

Second, the high legal and political hurdles to harmonized cross-border resolution processes suggest that, for the foreseeable future, the effectiveness of those processes will largely depend on supervisory requirements and cooperation undertaken before distress appears on the horizon. I would further suggest that the importance of proposed requirements that each large financial firm produce a so-called living will is that this device could better tie the supervisory and resolution processes together.

A Resolution Regime for Large, Interconnected Firms
As compelling as the case for such a process is, the debate around resolution proposals has highlighted the challenge of crafting a workable resolution regime for large, interconnected firms. The basic design problem is that such a regime must advance the goals of both financial stability and market discipline. While these goals are usually complementary, they can at times be competing–especially in periods of high financial stress, when time consistency problems can loom large. In the midst of a crisis, governments fearful of financial upheaval can be tempted to provide assistance to supposedly uninsured creditors, even at the cost of increasing moral hazard in the post-crisis period. Despite the consequent design difficulties, I think there are certain essential features of any special resolution process.

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According to the CFTC weekly data for the week ended Tuesday, net shorts in the euro fell by 38% from last week’s record high and are now at a 6 week low. Net shorts in the pound moved up a touch to just shy of its record high. Net longs in the Australian$ rose to the most since May ’08 and net longs in the Canadian$ rose to the highest since Nov ’07. Gold new longs fell to a 4 week low. Net longs in crude rose 14% and are just 12k contracts from a record high dating back to 1983. Net shorts in natural gas reached a record high dating back to 1993. Coincident with the rise in 2 yr yields (and flattening of the yield curve), net longs in the 2 yr note fell to the lowest since July ’09 and net shorts in the 10 yr fell to the lowest since Dec ’09.

Some links for today:

• Rival Merrill warned regulators over Lehman (FT)
• Federal Reserve Must Disclose Bank Bailout Records (Bloomberg)
• Rosier Views + Easier Comps = Profit Growth (WSJ)
• Martin Wolf: China and Germany unite to impose global deflation (FT)
• S&P 500 in ‘Air Pocket,’ Could Reach 1,225: Technical Analysis (Bloomberg)
• It wasn’t us! Alan Greenspan and Ben Bernanke still do not believe monetary policy bears any blame for the crisis (The Economist)
• Philip K. Dick after seeing a glimpse of Blade Runner (PKD)
• New College Graduates To Be Cryogenically Frozen Until Job Market Improves (The Onion)
• The best video you will have watched this year: Benjamin Zander on Music and Passion (TED)

What are you browsing ?

Benjamin Zander has two infectious passions: classical music, and helping us all realize our untapped love for it — and by extension, our untapped love for all new possibilities, new experiences, new connections.

Stephen Roach, chairman of Morgan Stanley Asia Ltd., talks with Bloomberg’s Susan Li and Paul Gordon from Beijing about the U.S. calls for a stronger yuan. China is conducting stress tests to gauge the effect of yuan appreciation on companies, a sign the government may be preparing for policy change even as it rebuffs foreign criticism of its 20-month dollar peg

~~~

Morgan Stanley Asia Ltd. Chairman Stephen Roach says Paul Krugmans call to push China to allow a stronger yuan is “very bad” advice and that increased Chinese spending is a better way of reducing trade imbalances.

(Source: Bloomberg)

After trillions of dollars in taxpayer funds, cheap loans and other forms of support, the biggest banks are bigger and more complex than ever.

Source:
BIGGER BANKS, RISKIER BANKS (PDF)
By James Lardner Nomi Prins
January 28, 2010
http://www.demos.org/publication.cfm?currentpublicationID=338E9E95-3FF4-6C82-5F6675465EEDD0F2

Bob Lefsetz is a music industry observer, and publisher of the Lefsetz letter

~~~

I read a story on the airplane…

Not only am I not sure what time it is, I wouldn’t even bet on what DAY it is!

I got off the airplane and my BlackBerry said 3:22 AM. How could that be? My watch said an hour earlier. Took me about twenty minutes to factor in Daylight Savings Time. Fucking BlackBerry can’t figure out what time zone I’m in, but it can adjust for Daylight Savings Time?

Much earlier, as it rained outside, I had lunch on the twelfth floor of the Royal York with Roger Faxon, Chairman and CEO of EMI Music Publishing. They say these guys are clueless? Can’t agree with you when it comes to Mr. Faxon. His views were practical, he had a handle on the landscape and informed me that EMI’s record company and publishing company were two separate entities under the same umbrella, they were already divided, it had been a condition of Terra Firma’s purchase. So when the whip comes down…

Which it inevitably will.

Then I journeyed with Jake to the airport, which was a clusterfuck nonpareil. The “Wall Street Journal” said to arrive two and a half hours in advance, ever since that terrorist incident at the end of last year travel from Canada to the States has been…well, let’s just say they’ve gotten a lot stricter at immigration.

Not that it made any difference. My plane ended up being delayed by two and a half hours.

You see there was weather. Wind shear in T.O., our plane had to stop in Chi-town for more fuel after turning back, afraid of the waiting disaster at Pearson. As for NYC… Something was blowing really hard there too, flights were fucked up all day. Seymour told me he’d considered taking the bus. He had friends in for the Rock & Roll Hall of Fame, he needed to get home.

THE BUS?

I couldn’t quite envision it, Seymour Stein journeying like Joe Buck from T.O. to NYC. Only eight hours he said. THE BUS? I remember my parents making me take it from Connecticut back to college in Vermont. This was before every kid in America got a car when he turned 16, so his parents didn’t have to schlep him around. I was scarred for life! Shit, if you want someone to strive for economic greatness, just make them take the bus. It’s a window into a low class world that you’re dying to escape. Shit, did they even HAVE buses anymore? I thought the companies followed the railroads into bankruptcy.

Last I heard, the flight to New York was canceled and rescheduled for 7 AM. Last I saw Seymour, he was heading for the gate. Maybe he should have taken the highway.

And after two hours of insight with Seymour, covering the history of the music industry from Sid Nathan to Lyor Cohen, he was replaced in his seat by Vince. Who I’d seen flying in the front of the plane on the way in.

NO, Getty Images doesn’t pay for business class. Vince is EXECUTIVE PLATINUM! Shit, the CEO of Getty flies in the back of the plane. At least that’s the ticket he buys. At least that’s what Vince said.

And like Bonnie Raitt sang, the luck of the draw got me upgraded to one of the two empty seats in business class. Which was a godsend, having already spent the length of the journey to L.A. at the airport.

And the ride was bumpy. But I read an article in “Vanity Fair”…

Did you read Michael Lewis’ “Liar’s Poker”? He worked at Salomon Brothers and told the story. One I’ve never forgotten. Of blowing up bankers all over the world. Yup, Goldman Sachs had to unload paper, and if someone in a far-flung country, or the keeper of the pension funds lost a bundle, hell, it was just business.

And it freaked Lewis out so much he quit, married Tabitha Soren and started following baseball.

Well, not exactly. He did end up marrying the MTV News queen. His most famous book is “Moneyball”. But he’s still an expert on Wall Street. He’s one of the few writers who can make it comprehensible. Wow, you can read this story online!

http://www.vanityfair.com/business/features/2010/04/wall-street-excerpt-201004

You’re never going to read it online. Hell, you’re probably never even going to read it. And that’s just the point. The article is about Michael Burry, who figured out the mortgage market was gonna tank and bet against it. Burry was the leading edge.

But this story isn’t about money. It’s about dedication.

You see Michael Burry was passionate. He was a doctor, training at the hospital, enduring those endless hours, but still he found time to pore over prospectuses, study stocks and pontificate online. To the point when he went pro, some of the most famous traders in America found him, invested in him!

Let me make this clear. This is like making music in your basement and getting a call from Doug Morris or Timbaland or David Foster. But they don’t want to mold you, they don’t want to change you, they don’t want you to do anything different, they just want A PIECE OF YOUR ACTION!

Yup, they found Burry on the Internet.

Isn’t it interesting that warhorses in the music business will pooh-pooh the Net, saying you can’t break an act there, that it comes down to radio and television, but the real money men are trolling for info online?

And how did Burry get so good at picking stocks? BY STUDYING!

Yup, doing the work.

This is Gladwell time.

We live in a country where no one wants to do the work.

Oh, I know that’s an overstatement. But most people want to watch television. They want to focus on their image. Is it any wonder they’re left behind?

Not that you need a formal education to make it. You can’t learn the stock market in school. You’ve got to learn it on your own, like the music business.

And Burry’s returns at his Scion fund are confoundingly large. It’s all about value. He bets on fundamentally sound companies that are experiencing a bit of trouble. He hangs in there during the downward spiral in order to ride the roller coaster to the top, making beaucoup bucks along the way.

This is like investing in a band that may not look great, may need to woodshed a bit, may need to make three or four albums, but when it gets it together will be a gold mine. We can call it the Kings of Leon. We can call it artist development. We can call it ANYTHING but flavor of the moment.

That’s the point. Are you willing to do it differently? Are you willing to do the work and come up with your own conclusions, your own solutions? That’s Steve Jobs’ way. When everybody said you’ve got to have open standards, he promoted closed systems. And now he’s the big winner.

And Burry got so deep into it, figuring out when and what mortgage bonds were gonna tank, that he bought credit default swaps and made…enough money to buy your entire neighborhood. And the one next to you. And the one next to that.

By being brilliant. Even though so many investors said his plan was lunacy and wanted no part of it.

THIS is the American story. Not making a mix tape and partying with Paris Hilton and getting a photo in TMZ… Snooki is a diversion for the masses, the losers. Do you want to be a winner?

Winners start off in the wilderness. They do it their own way. They stick to their guns. They work incessantly and they never give up.

Whew. That just does not sound like enough people in the record business, on either side of the fence, talent or businessman.

We live in a confusing, crazy world. But one thing is constant. The winners pay their dues. And it’s not solely time on the chain gang. No, there’s a ton of anxiety involved. Questioning yourself, taking risks, sticking to your guns when no one believes in you.

It’s every man for himself out there. Shouldn’t be, but it is.

There’s a safety net in Canada. In Sweden. That’s the socialism you decry. But in the good old United States, the game is stacked against you. Those with power, with money, have erected walls to keep you out. And if you think kissing butt is the way to get ahead, you’re delusional. It’s not about how you can get signed, it’s about how you can beat Universal at its own game. You’ve got to be smarter than Lucian Grainge. Believe me, these people exist. And they’re gonna be the winners. They’re the ones we’re gonna be reading about in “Vanity Fair” five years from now.

Chart of the Day takes a broad — perhaps over broad– look at trading rallies. They found that major rallies (73%) result in a gains ranging from 30% to 150%. Typically, they last between 200 and 800 trading days.

Based on this data, you can conclude that the present rally is still young, and potentially has a long way to run.

That might be a premature assumption.

As we’ve discussed before, there are huge differences between cyclical and secular markets. I have been describing the current short sharp run as a cyclical bull within a longer, secular bear.

If we were to look at the duration and intensity of rallies between 1929-38 or 1966-82, or 2000-09, I suspect we would find they are both shorter, sharper. By definition, cyclical bulls are of smaller duration than secular bull markets.

Here’s your daily chart porn:

>

Age and Duration of Rallies

Source: Chart of the Day

The Reserve Bank of India has raised interest rates by 25 bps to 3.5% from 3.25%. The timing is unexpected but inflation has been a growing concern of theirs.

~~~

STOCKS

As I discussed in the Special Update on January 30, “Based on a number of momentum indicators, the market has reached an oversold level, comparable to readings at the July and November lows. Any additional weakness will get the market even more oversold, and stretched, laying the foundation for a rally. The odds favor the S&P bottoming above 1,030, and sometime in the coming week.” The S&P made a low on Friday February 5 at 1,044.50

I also discussed in the January 30 Update what it would take for the rally I expected to take hold. “Two pieces will have to fall into place for new highs. The overseas issues will have to settle down. China is not likely to make additional tightening steps in coming weeks, and the problems with Greece and the EU will also have to recede. And the economic data points in the U.S. must continue to support the recovery story. If so, large institutions will shift back to the buy side, after it becomes apparent the correction has run its course. A self sustaining recovery is far from a sure thing, but that doesn’t mean the illusion of one can’t be sustained for another 2 or 3 months.”

As noted in the February 22, 2010 letter, “The EU gave Greece 30 days to get their house in order, which has stabilized the Euro, and the majority of U.S. economic reports have supported the recovery story. The back bone of the rally since July has been a lack of selling pressure, rather than a surge in buying conviction. The low level of volume during this move up supports this conclusion. This isn’t the most healthy technical action, but as long as selling pressure remains at bay, the market can move higher. Although the upside is likely limited to modest new highs, any substantial market decline will be postponed until a secondary phase of the financial crisis erupts overseas, or institutional money managers are confronted with a series of economic reports that severely challenge their recovery thesis.”

Last week, the S&P made a modest new high (1,153.41 vs. 1,150.45 on 1/19/2010) on the back of a number of less than stellar economic reports that investors warmly embraced, and on exceptionally low volume. In five of the past ten trading sessions, total volume didn’t even reach 1 billion shares. The last time the 21 day average of total volume was this low was on August 29, 2008, which was followed by the explosion of the financial crisis in September. One has to go back to the summer of 2001 to find another example when total volume was so low, and that was just before the events of 9/11. However, the overall technical condition of the stock market is far different and far stronger than in those other instances of low volume. The advance/decline line is making new highs, while in 2001, the A/D line was neutral at best, and in 2008 it was very weak. In July and August of 2001, the 21 day average of stocks making new 52 week highs ran between +60 and +114. In 2008, it ranged between -469 and -72. It ended last week at +279. For the week of March 8, 2010, 898 stocks made new highs, with just 7 recording a new low. Although total volume is pathetically low, the market’s internal strength is quite healthy.

As I have noted repeatedly since last summer, large institutional money managers believe a sustainable recovery is developing. As long as they believe, they will not do much selling, other than to sell one sector to buy another. This lack of selling pressure has been an important factor, and has created a supply vacuum, allowing even a modest increase in buying pressure to move the market higher. Recent economic reports underscore just how much most economists and large institutional money managers believe in the recovery story. When only 36,000 jobs were lost in February, it was hailed as good news, since bad weather had lowered estimates to a loss of -65,000. BOO Yeah! And when same store sales rose over 4% from February 2009, it was like the second coming of Christmas! Never mind that comparisons to the first quarter of 2009 make everything look better, since anything looks up from the bottom of the abyss. The mentality of most economists and money managers reminds me of what happens about 30 minutes before the bar closes at 2 a.m. Suddenly, the joint is crowded with girls and guys who are looking fine!

The secular and cyclical headwinds facing the economy are substantial and suggest any transition to a sustainable recovery will not be smooth, and may even fail. The goal of the Federal Reserve and policy makers has been to buy time, in hopes that time and a ton of borrowed money will allow the economy to heal, and stabilize the deflating credit bubble. When your house is on fire, and the firemen rush to extinguish the blaze, who criticizes the firemen for water damage once the fire is out? The fact that a larger longer term problem is being created is secondary to keeping the game going now, especially with another election cycle coming in November.

If the economy does not produce the expected sustainable recovery, I think the technical action of the market will weaken before the fundamental economic news softens. Since most economists and money managers do not pay much attention to technical analysis, they will not see it coming. A softening in the economy would surprise the economists and money managers who have priced a recovery into the market, and lead to a rise in selling pressure. The market gave back 10 weeks of gains in two weeks, when selling pressure increased in late January, which might foreshadow the type of decline that could occur if the economy doesn’t deliver. The healthy technical condition of the market at this point suggests the day of reckoning is further down the road. Whether it is weeks or months, I don’t know.

The sharp break between January 19 and February 5 resulted in a swift pick up in negativity as measured by numerous sentiment surveys and the call/put ratio. The rally of the last few weeks has swept aside that caution. Most sentiment readings now show much more optimism. This suggests that the upside will be limited in the short run (1,160-1,180), and likely lead to a choppy period, until the overbought status of most technical indicators is worked off. Short term support should come in around 1,130. If sentiment remains bullish during this process, a larger correction would be set up, once the internal strength shows signs of weakening. The bottom line is: Sell into strength and become a bit more defensive.

Jim Welsh