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Bloomberg’s Olivia Sterns reports on the rising value of classic sports cars. This report includes comments from Pink Floyd drummer Nick Mason, an advisor to the IGA Automobile LP fund that aims to buy $150 million worth of classic cars and make annual returns of 15 percent.

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April 19 (Bloomberg)

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I participated in this online discussion last night about S&P’s downgrade/negative watch of US debt. My piece is here.

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Source:
Is Anyone Listening to the S.&P.?
Room for Debate, April 18, 2011 08:57 PM
http://www.nytimes.com/roomfordebate/2011/04/18/is-anyone-listening-to-the-standard-poors

Scylla and Charybdis
The FDIC and the Federal Reserve
David R. Kotok

http://www.cumber.com

April 19, 2011

The Strait of Messina separates the eastern coast of Sicily from the southern tip, or “boot,” of Italy. This passage, three kilometers wide at its narrowest, is known for its strong tidal currents. Here is where Greek mythology recounted the tales of Scylla and Charybdis. These two monsters were believed to reside in the Strait of Messina, threatening ships and their crews as they transited through the strait from the Ionian Sea in the Mediterranean to the Tyrrhenian Sea, which lies off the western coast of Italy.

The Greeks described Charybdis as a monster who manifested herself as a whirlpool, gulping and spitting out huge amounts of water several times a day, creating the treacherous currents. Scylla was a six-headed and twelve-armed monster, who would consume everything that crossed her path. It was by the presence of these two monsters Greek legend explained the shipwrecks and destruction that took place in these perilous waters.

Gazing out at the Strait of Messina from the city of Taormina, I have fulfilled a lifelong dream. I remember, over half a century ago, being struck by the stories of Scylla and Charybdis in the course of studying antiquity and reading Greek mythology. A question within me: What led the Greeks to create these two mythological characters?

The answer was clarified by our tour guide. He described how the tidal rise and fall of the Ionian Sea level was substantial. He then explained that the Greeks were completely unaware of how the tides were created. They did not conceive of the power of the moon to pull on water gravitationally. Because they lacked this knowledge, they created mythological explanations for the geographical phenomenon they witnessed.

At peak velocity, the currents flow in the Strait of Messina at nine knots. This is a fierce current with which to contend, especially in such a narrow body of water. Such a force would easily overwhelm sailing vessels of the types used in ancient times.

It is now understandable how Greek legend brought forth the myths of Scylla and Charybdis. What else could possibly explain the deadly surges ships and their crews had to fight against? Had the sailors known about the tides, would they have operated differently? Would they have timed the tides? How much of history would have changed if the epistemological questions were answered, not with mythological characters but with facts and experience?

In addition to touring in Sicily, the GIC meetings in Italy afforded conversations with economists, financial advisors, investors, and colleagues. They lead me to a difficult and intricate question. Does the Federal Reserve face its own version of Scylla and Charybdis?

The Fed is completing its program of asset purchases, called by many “QE2.” As this program reaches its completion this summer, many participants expect the Fed to call it quits on additional purchases. The current market expectation is that the Fed will then go into a mode of preserving the then-existing size of its balance sheet. As maturities occur or paydowns take place in the mortgage-related portfolio, the Fed will replace those maturities and paydowns with purchases of treasuries. Essentially, the Fed will go into a holding pattern and await “incoming data.”

Meanwhile, the Federal Deposit Insurance Corporation (FDIC) has just introduced a new factor. We have written about it in the past. Since April 1, the FDIC now costs a bank an additional between and ten and forty-five basis points as a fee on its assets. That is a payment the bank must make – any American bank – to the FDIC.

In making monetary policy decisions, the Fed did not have to contend with this cost prior to April 1. Now the FDIC has interfered in a way that adds a cost to the banking system at the very time the Fed is engaged in easing. The mechanics of the FDIC fee act as a form of a tightening. We estimate that the impact is the nearly the same as if the Fed were to have raised interest rates about 15 basis points. By some “guess”timates, the FDIC has taken back all the easing provided by all of QE2.

In the last day or two, we have seen the Federal Funds rate trade under ten basis points. Nine basis points is the price of a transaction between two banks, in which one takes excess or additional reserves and sells it to the other. It is also the price at which the government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, take their incoming cash flows and sell them to the banking system. GSEs are not permitted to deposit monies with the Federal Reserve, so they have no choice but to sell into the Federal Funds market and get whatever they can, or otherwise earn nothing. Clearly, the selling pressure from the GSEs is driving the Federal Funds rate down. At the same time, the FDIC fee means that it is costing more for banks that would buy the Fed Funds, so we have a double-edged sword at work. Is this interfering with the Fed’s monetary policy intentions? Is it setting the Fed or the markets up for a shock when the policy changes?

Epistemological questions may be answered with facts, examination, research, and experience. However, the United States has never engaged in monetary policies of the type presently underway. We have no experience to guide us. Has that led us to the error of the Greeks?

The alternative to relying on legend would be to see if anything can illuminate our present circumstances. Then we can build models for guidance. Our assertions may be right or wrong. That remains to be seen, but what we do now know is that we have a construction in which the Federal Reserve pays banks 25 basis points for its excess reserves, which are deposited at the Fed. At the same time, the pricing of overnight reserves traded between banks is now down to nine basis points and has been falling erratically. Simultaneously, there is a fee structure that costs banks 10 to 45 basis points, depending on the size and characteristics of the bank, and therefore that pricing is acting as a “wedge” and altering the composition of monetary policy.

Think of it in the following way: a basis point on one million dollars is one hundred dollars. As stated before, the overnight interest rate on Federal Funds is nine basis points. Nine basis points are 900 dollars per year on one million dollars of reserves traded between two banks. If you divide 900 dollars by 365 days, you can see that for a smaller bank to do an overnight, million-dollar transaction in Federal Funds is to gain that bank about two and a half dollars. It is simply too much trouble for the bank to go through for such little result.

Add three zeros and think in terms of one billion instead of one million. You can see that for a large bank it is still not substantial, and so the intention of Federal Reserve policy making is being altered by this present combination of pricing. We are already seeing banks reorganize themselves to qualify for the lower FDIC fee schedule.

What does the pricing indicate? Does it tell us that the value of excess reserves has reached zero? There are indications that affirm this. When you look at the repo market and the pricing of the collateral used in the repo market, you have an indication of how repo is priced. It is currently near zero. One has to ask oneself why this is so. Is there such weak demand as to price the value of overnight liquidity at zero? The alternative question is: has the FDIC effect driven that overnight liquidity pricing to zero? In fact, is there so much excess liquidity that we now face the true confrontation of the “zero bound” in monetary policy?

The epistemological question is as classic as Greek mythology: how do we know, and how can we arrive at an answer? The second derivative of that question is what happens when the Fed finally changes this policy. Furthermore, is this FDIC-altered policy the policy that the Fed wants? The home-mortgage interest rate is higher than when the Fed started QE2. The housing market continues to be in doubt and prices in many regions are falling. The economy got an initial burst after the financial crash of Lehman and AIG, but subsequently, economic growth rates are falling. We see revisions of growth rates ratcheting downward. The policy has clearly weakened the US dollar, as allocations of dollars are going elsewhere. What is not clear is whether that reallocation is taking place because of choices made by holders of dollars, like state sovereign oil funds, or being made by investors, or both.

Epistemological questions face the Federal Reserve, investors, the US economy, and the world. The true origins of tidal forces were not apparent to the Greeks as they transited the Strait of Messina. They thought they understood; they held strongly to their belief system. The Greeks described their theories through mythological figures, and even deified them. 2500 years later, we understand how some epistemology failings misled the Greeks. As for the US and its policy at the Federal Reserve, we are operating on legend and uncertainty.

As investors, we confront the likelihood that the short-term interest rate will remain near zero for the rest of this year. The gulping and spitting of excess reserves is coming from the modern Charybdis. The FDIC fee is the modern-day Scylla.

Investors will face the “zero bound” in interest rates for a while longer. They can sit on their cash and earn nothing. They can fret and wring their hands about a ramp-up in inflation, but the evidence so far does not support it. They can stay in the US dollar, in which case they can watch their dollars weaken relative to the rest of the world. Travelling in Sicily or Rome validates how strong the euro is relative to the dollar. All you have to do is buy a dinner or hotel room.

We are back in our office. It has been an enlightening trip. We have been able to examine some history while discussing monetary policy and financial affairs. This writer, finally, and after nearly 60 years, was able to witness Scylla, Charybdis, and the Strait of Messina.

Lastly, we return during the Christian Holy Week and during the Jewish Passover festival. We celebrate faith and freedom. We do not actually burn a sacrificial animal. We invoke it as a symbol of the past.

This year we do so after being reminded that those ruins of temples and amphitheaters, those paths and stone quarries, are evidence of slavery. The Trojan, Carthaginian, Greek, Roman, Arab, Norman, Spanish and other conquerors of Sicily all used slaves.

To a human being, legend and deification can be a dangerous thing. Freedom is as fragile as a weakened monetary and political system will make it. Modern mythology resides in the temples in Washington, not in the Messina.

David R. Kotok, Chairman and Chief Investment Officer

You ain’t a beauty, but hey you’re alright…Talking its position as the 2nd biggest foreign holder of US Treasuries, Japan’s Finance Minister said “We continue to see US debt as an attractive investment.” Geithner, our Chief Treasury Salesman, will be making the rounds today discussing S&P’s move and likely doing his best in convincing the rest of the world to keep on buying. It’s not what S&P said per se that matters as we all know our current debt plight, it’s what the political response to it that matters. The UK got its stable AAA outlook back from negative 17 months after S&P’s move on them after the UK government responded with a tough budget. European stocks are bouncing after Euro Zone manufacturing and services composite index was better than expected led again by Germany and France. Greece sold 87 day paper at a yield of 4.1% vs 3.85% two months ago. That is 336 bps above the German 3 mo yield and another Greek official said there is “no such thought and no such decision” to restructure its debt. Lastly, Canada’s Mar CPI was 3.3% y/o/y, well above expectations of 2.8%, the highest since Sept ’08 and comes one week after the BoC left rates unchanged at 1%.

In last year’s grand legal battle, Goldman Sachs allowed a minor case of misrepresentation in a sale of mortgage backed securities to a sophisticated investor to become a calamity. The end result of the Abacus case was a record setting $550 million dollar SEC fine.

Last week, Senator Carl Levin released a massive report on the credit crisis. He suggested that the committee might refer their report to the Justice Department for consideration of criminal charges of Perjury or Obstruction of Congress.

When the Abacus case was pending, I warned Goldie that it was a slam dunk case of violating black letter security law. Had they not listened to the crowd, they could have saved about a half a billion dollars in fines. This current issue is far more murky; I would suggest against settling it, and I would be much more willing to fight criminal charges.

This post marks the very first time I ever found myself advising Goldman Sachs not to settle.

The prosecution will turn on the language Goldman’s CEO and CFO used in describing the short bets GS made against the residential mortgage market while selling similar investments to clients. That turns out to be far more ambiguous than you might surmise. This is a much harder case to prove than the “material misrepresentation” of the Fabulous Fab case.

Consider the following:

• Goldman is a huge firm, with many different divisions, proprietary traders, and hedging strategies. Think of them as 100 hedge funds together under one roof. The firm does not have a single coordinated position.

• At various times, GS was simultaneous long and short positions in mortgage backed paper. But at various times, the firm was also simultaneously long and short in various stocks, bonds, etc.

• Different traders may have put on short trades against residential real estate, but that was their own trades. In a firm made up of traders, there is a difference between a firm position and an individual putting on a trade.

• Until the year 200X, GS the firm had no official position on the mortgage market. They will argue that once they decided, on a firm wide basis, to get out of the mortgage market, they began to wound down their sales to clients.  This was a process that took about 6 months, and there may have been some overlap.

Dealbook notes that the governing statute is 18 U.S.C. § 1515(b), and it states “acting with an improper purpose, personally or by influencing another, including making a false or misleading statement.”

Thus, the “improper purpose” turns on the intent of the witnesses in front of Congress. In order to succeed at proving this was criminal, the prosecutors would need to show a clear intent. The full testimony of Blankfein would need to be considered, and include the overall frankness of what was said. A jury watching the entire testimony is likely to find it challenging to reach that conclusion.

To the prosecutors, I would exhort that there is so much low hanging fruit in terms of bank fraud that you should focus your efforts there: There was “Origination Fraud” that took place; Nonfeasant Regulators who refused to do their legal duty because it disagreed with their personal philosophy. MERS engaged in dubious behavior that can best be described as “Extra-Legal;” Foreclosure Fraud remains rampant; All prosecutors need to do is follow the money to see how systemic bank fraud contributed to the financial crisis.

But Blankfein’s testimony? That is going to be a more challenging case to make . . .

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See also:
Finding Goldman at Fault in the Crisis
PETER J. HENNING
NYT, APRIL 18, 2011, 12:59 PM 
http://dealbook.nytimes.com/2011/04/18/finding-goldman-at-fault-in-the-financial-crisis/

Washington’s Blog strives to provide real-time, well-researched and actionable information.  George – the head writer at Washington’s Blog – is a busy professional and a former adjunct professor.

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As I’ve been warning for years, America’s irresponsible financial policy will lead to a credit downgrade.

Today, S&P cut its U.S. outlook to negative, warning of a 1 in 3 chance of a credit downgrade in the next couple of years.

As the Wall Street Journal notes:

Standard & Poor’s Ratings Services Inc. cut its outlook on the U.S. to negative, increasing the likelihood of a potential downgrade from its triple-A rating, as the path from large budget deficits and rising government debt remains unclear.

“More than two years after the beginning of the recent crisis, U.S. policy makers have still not agreed on how to reverse recent fiscal deterioration or address longer-term fiscal pressures,” S&P credit analyst Nikola G. Swann said. He said the rating agency puts the chance of a U.S. downgrade within two years at least one-in-three.

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S&P said Monday it sees material risk that policymakers might not agree on how to address budgetary challenges by 2013, which would render the U.S. fiscal profile weaker than that of other triple-A-rated countries.

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S&P said that if an agreement isn’t reached and meaningful implementation is not begun by 2013, it would make the U.S. fiscal profile meaningfully weaker than that of other triple-A-rated sovereigns.

While the Democratic and Republican leadership point fingers at the other side, and bicker about ideological pet peeves, this is not a question of left-versus-right.

The war between liberals and conservatives is a false divide-and-conquer dog-and-pony show created by the powers that be to keep the American people divided and distracted. See this, this, this, this, this, this, this, this, this and this.

The real problem is that both Democrats and Republicans want to fund endless wars, give endless bailouts to the too big to fail banks and corporations, and perpetuate the expensive Ponzi scheme of printing money out of thin air.

Imperial wars reduce our national security. Indeed, our top military and intelligence officials say that debt is the main threat to our national security, and have said that the Pentagon must cut spending. See this and this.

Moreover, endless bailouts harm the economy. Ponzi finance costs trillions of dollars (and leads to a decrease in loans to Main Street). And see this and this.

To the extent that both the Republican and Democratic parties slavishly follow these meta-policies – which supersede the stated “conservative” and “liberal” goals – they will ensure that we lose our AAA credit, and they will destroy our economy.

From an institutional trading desk:

S&P’s revision to the outlook on the United States’ sovereign credit rating to negative from stable this morning provoked a wide range of reactions. Not terribly significant in the sense that the outlooks on issuers’ credit ratings are revised up and down by the ratings agencies every day, and not terribly significant in the sense that the markets didn’t move all that much, the revision has nonetheless touched a nerve. Why?

For starters, it is the first admission by what I call “officialdom” that the means by which we extricated ourselves from the debt deflation of 2007-09 carry negative consequences. Who knows if the big swings in the market are caused by shifts in the dominant narrative or whether the narrative shifts in response to the swings in the market, but either way today’s action by S&P introduces a new narrative into the mix. This crisis isn’t over; it’s just entered into a new phase. This was never a mere cyclical recession anyway and now we have a choice: tighten our belts to preserve our preeminent financial standing in the world, or roll the dice on further policy accommodation at the risk of the a debilitating, Greece-like implosion.

That’s a far cry from the present dominant narrative which goes something like this: Short-termism of the kind displayed during last December’s “budget compromise” is irresponsible and will cost us dearly at some point, but it also symbolizes policymakers’ desire to do “whatever it takes” in the short term in order to keep this recovery going. Don’t fight these policymakers – at least, not until after the 2012 elections.

One of these narratives is bearish for financial asset prices and one of them is bullish. No prizes for guessing which is which.

Secondly, should an actual downgrade of the U.S.’s issuer rating to AA+ materialize, and should it be followed by downgrades by Moody’s and Fitch, there are all sorts of question marks about what kind of friction would result from institutional rigidities. For example, many institutions around the world have mandates to invest certain percentages of their funds in AAA securities. Presumably, downgrades by two or three of the agencies would spark a good deal of selling by those institutions.

What about Treasuries’ hypothecation value? If they’re not AAA anymore, would they be accepted as collateral in the repo market on the same terms that are offered today? Or, would extra collateral need to be posted – or would the interest rate charged need to rise? What effect would this have on liquidity, on the very “money-ness” – to borrow Doug Noland’s term – of Treasury securities? Male model Derek Zoolander once said, “Water is the essence of wetness, and wetness is the essence of beauty.” Likewise, 100% hypothecation value is the essence of risk-free, and risk-free is the essence of moneyness. In Minskian terms, a decline in the moneyness of Treasuries would make it more difficult for levered entities to “make position” which in turn would make the financial system more fragile, more susceptible to crises.

I’ll go one step further: this revision, this oh-so-minor revision, is in fact a policy tightening. Despite the fact that several additional steps would need to be taken by the ratings agencies before any of these liquidity difficulties came to pass, I believe that the shock of today’s announcement amounts to a more significant policy tightening than that which will occur in June when the Fed ends QE2. The end of QE2 is part of a carefully prepared script and therefore will have no real impact on market participants’ behavior (by design). Besides, quantitative easing produces diminishing returns (it puts cash assets on banks’ balance sheets, enhancing their ability to make position, but relaxed FAS 167 guidance has already alleviated any difficulty in making position by absolving the really bad assets from mark-to-market accounting) which means that ending QE2 will not be significant in the context of financial sector liquidity.

Check out the chart below which shows the implied yield difference between 3-month Eurodollar futures and the 3-month overnight index swap (a proxy for interbank lending risk) on an intraday basis going back about a month. It shows that the yield difference spiked about 3 basis points higher on the heels of S&P’s announcement this morning.

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It’s not an insignificant move, that 3 basis point spike, but the chart above on the right puts it into context. If I’m right and S&P’s announcement does in fact constitute an actual policy tightening, it either hasn’t hit full bore yet or it’s simply a very slight tightening. This context is important because even the cleverest theories amount to nothing if there’s no follow-through in the markets.

However, if, after the political and financial establishment gets done telling us all to quit our worrying and that today’s action by S&P has no practical significance, traders get to thinking about the very real implications this action has for financial instability in the future (and traders are forward-looking, right?), we might be looking at a downside catalyst for risk assets including stocks.

At this point, I want to soak up any and all arguments the conclusion of which is that S&P’s revision is not significant before revising my own near-term bullish stance. It was definitely an unnerving day, though, wasn’t it? Between that and the European difficulties (the True Finns!), it’s a testament to traders’ undying optimism that the market managed to pare nearly half of its losses in the afternoon.

No, not reading about Passover — just reading the same day as Passover!

• A century of inflation forecast (Vox)
• Japan’s Economy Takes a Hit (The Diplomat)
• Foreclosure Probe Talks Said to Yield Some Agreements With Banks (Bloomberg)
• Confessions of an Inside Trader (WSJ)
• Today’s WTF headline: Greenspan Steps Up Call to End Bush-Era Tax Cuts (Washington Wire)
• Tax Facts Hardly Anyone Knows. (Monterey County Weekly) From the 2001 Pulitzer Prize winner for beat reporting on U.S. tax code
• NYTimes Columnist Douthat Needs a Clue on Taxes (Yahoo Finance)
• The Possibilian (New Yorker) What a brush with death taught David Eagleman about the mysteries of time and the brain
• Songs Of The Great Depression (Vaughn Trapp)
• The Redesigned 2012 Volkswagen Beetle (AutoWeek)

What are you reading ?

The Pulitzer Prizes have been announced –

Congrats to Jesse Eisinger, Jake Bernstein and David Leonhardt for winning Pulitzers (all of whom have been noted here previously).

Its nice to see for economic reporting:

•  National Reporting: Jesse Eisinger and Jake Bernstein of ProPublica
Awarded to Jesse Eisinger and Jake Bernstein of ProPublica for their exposure of questionable practices on Wall Street that contributed to the nation’s economic meltdown, using digital tools to help explain the complex subject to lay readers.

•  Commentary: David Leonhardt of The New York Times
Awarded to David Leonhardt of The New York Times for his graceful penetration of America’s complicated economic questions, from the federal budget deficit to health care reform.

There are pockets of mainstream press that do an excellent job covering the economic world and crisis. These are just two . . .