Fin/Inv

Verse I

I use price alerts across a wide spectrum of non index stocks to show me whats happening outside the manipulated or at least suspect dow naz and spy. Yesterday several of them tripped and the shadow world beneath the dow started to panic.

Lets look at a fine example of the non index backroom hopefuls.

BSDM - The story in a nutshell. They have some kind of awesome phaser that shoots a hot anti cancer death ray. Wow. What do they really do? Who cares. The point is they released a headline on September 22nd that states:

A Phase III study, which utilized the BSD-2000 Hyperthermia System, demonstrated that patients with high risk soft-tissue sarcomas were 30% more likely to be alive and cancer free almost three years after starting treatment if targeted heat therapy (hyperthermia) was added to their chemotherapy treatment.

Good enough for blind optimism to pile in. Never mind the fact that the company has been releasing the same headline since the 1980's. Lets look at what happened next:

Solid! Pretty exciting pop but look closer at the filing and what do you see? 3% institutional ownership. Dimensional Fund Advisors is the largest institutional owner with 466,864 shares. This safely identifies BSDM as a probable valueless stock (which i think comprises about 96% of the stock market but thats another post) and is therefore only good in a bullish era or in the unlikely event their technology becomes viable. 

The illusion of value is only sustainable when the market is absorbing optimism in the form of hopeful capital.

The stock pulled back as it should but what happened to it this week:

It fell off the line it had formed in the 2.50ish area and is now trading at its pre pop anti cancer headline share price. BSDM and all its ilk are probable canaries for the market at large and should warrant attention. 

Verse II

I am a closet admirer of the Bear Masters here as I do not short stocks. I always play long no matter what (except for extreme events) because I believe real value is a rarity, therefore stocks are kept high on an illusion and magic is far more powerful than reality. Reality is what sends stocks down and I am terrible with reality. 

Earnings gaps have been strong against market headwinds as of late and the first hour scalps have been superb. Look at NTRI and PEET yesterday. Most of the time I don't know what I am going to scalp until after the open when my screener data kicks in but today so far my pre open list has MOT (droid release) and AKAM (strong name post earnings play).

I just noticed we ticked through our 50 millionth visitor, and 65 millionth page view — pretty astounding stuff.

Thank you to everyone who has contributed to the success of The Big Picture: The thoughtful commentors, the Think Tank Authors, the designers who made the site look good, our programmers who made it slick, the reviews that told people about the place, and FM for putting the ads here that pays for the whole thing.

And, it took just 7 years to become an overnight sensation.

Im Vergleich zum Vorjahr hat die Unterbeschaeftigung (noch ohne Kurzarbeit) erheblich zugenommen, zuletzt um 9 %, wenn man den Schaetzzahlen der Agentur folgt. Die Leiharbeiter fliegen als erste aus den Jobs (-21,4 %). Die Zahl der Kurzarbeiter ist bis zu den letzten Zahlen vom Juni auf 1,43 Millionen stark angestiegen. Die Nachfrage nach Arbeitskraeften ist ueber die letzten Monate deutlich gefallen und stagniert nun mit zuletzt minimalem Anstieg auf niedrigem Niveau. Die Beschaeftigung ging nicht nur gegenueber dem Vorjahr sondern auch dem Vormonat weiter zurueck.

The surrealities of a "healthy" economy never end. The latest indication of the new banrkupt normal is New York State itself. A new report by NY state comptroller Thomas DiNapoli entitled "Highway Robbery: State's ailing road and bridges robbed; State siphoned money to pay for operations and debt service" tells you all you need to know about just how prosperous the ailing economy really is. According to DiNapoli, "only one-third of the money in the Highway and Bridge Trust Fund has actually been used to pay for highways and bridges. The rest has been siphoned off to pay for debt service on back-door borrowing and to fund operational costs for the DMV and the state Department of Transportation." Is that lack of stolen pocket change Mr. DiNapoli can believe in? Apparently not - Mr. DiNapoli's words: "I think outrage and anger is certainly appropriate; we need to channel that into thoughtful public policy." Yet anger is so September 2008. Welcome to the Xanax highs of the new credit bubble.

“This money should be going toward keeping our roads and bridges safe, not to fund state agency operations. The bridge closing in Crown Point is just one more example of why this is so important. If this trend continues, the state will have to transfer nearly $4 billion into the Trust Fund over the next five years. Using this dedicated capital money to pay for operations and debt service is just one more gimmick on the list of New York’s bad fiscal choices.”

Should one cry or laugh here? New York State is stealing from itself, and its own comptroller is bitching against this practice, seemingly powerless to do anything to prevent it in the first place. Perhaps the state's transportation trust fund should put all its stimulus money in CIT stock or whatever the HFT megavol stock de jour is and hope and pray. These days the market has odds that are just a little better than Craps (although the likelihood of being comped by your broker when the ponzi market loses all your money, are still slim to none).

Full DiNapoli report below.

 

I’ve been in meetings all afternoon, but BAM! The market sure liked Q3 GDP data. Stocks rallied right back to resistance at 1068-75 (se chart below).

• Stocks in U.S., Commodities Rally as GDP Signals `Waterloo of the Bears’

>

S&P500 Intraday

I hate it when I’m right - actually, scratch that - I love it when I’m right. Especially when everyone else thinks I’m an idiot and that I’m paranoid, that I am going to miss the big one because I capitulated, I lost my mojo, my dick is too small, [fill in allegation/insult of your choice].

It’s not that I didn’t tell you so - of course admittedly it could have come a day or two later, but today was good enough for me. Let’s get to Mr. Zero:

I saw a lot of divergences today and was not shy about pointing them out to my subs. But I also cautioned them that a resolution might not come before tomorrow and I guess thus far I was right. Of course this might mean nothing and we may just bust higher on more fumes - let’s see if the bears make their move tomorrow - nothing is guaranteed and this will be an acid test for Soylent Orange. Otherwise, it was a very solid up day on the Zero - nicely played.

I rarely post other bloggers’ charts here but this one is so spot on that it deserves a prime spot here:

Thanks T.K. - I couldn’t agree more Hey, George Carlin would have a field day with that expression… I am a connoisseure of Tim’s charts and I think he might be remembered by this one (or it’ll haunt him - hehehe). Of course that assumes we turn here. Diagonal support lines have a weakness in that the market needs to keep running from them in order to sustain a trend. But once they turn into resistance they run away from the bears and we might be ‘testing/kissing’ this thing for a few more days, even if we drop eventually. Of course EWT comes to the rescue and as long as we stay below 1074.31 [i.e. Minuette (i)] we should be okay.

Program Trading Update:

evil.rat/ES: +8.5
geronimo/ES: +5.25 (3 trades - all winners and subs probably got a better fill on the last one)

Looks like geronimo got his mojo back

FYI - if you were getting my twitter you know that I backed up the truck here. And yes, in case you wonder - if it’s Soylent Blue I will hold and add on the way up.

3:40pm EDT: BloodWine pointed out that the argument could be made that (iv) breached into (i) on the Dow - that was a bit of a cold shower for me as I frankly was so busy trading that I hadn’t checked the Dow’s short term wave count. In short and without weasel talk - yes, that argument could be very well made and the only saving grace for the bears would be this count:

Now, I am the first one to admit that this count is 90% wishful thinking. The reason why I bother offering it at all is that the Dow has been pretty tough to count as of late and that it does not conflict with any EWT rules. The a-b-c is also known as a running flat in our bible (psalm 48:1-38) and the orthodox top is covered there as well (psalm 55). Also, that count maintains a clean motive to the downside, which slightly supports its case. However, this scenario breaks the second we breach 9992.81. So there’s a chance but I rather would not have have seen this, so thanks for ruining my day, BloodWine!

Cheers,

Mole

A release out of Moody's today does not seem to jive too well with the prevalent assumption that 90%+ of a 3.5% bounce in GDP being driven by non-recurring events is the greatest way to ramp the market after several down days. The rating agency, always asleep at the wheel, has waited until the proverbial "end of the recession" to say that not only is it extending the cliff for the house price floor by 2 quarters (from 2009 to Q2 2010, expect a comparable extension some time in June 2010), because the last thing they need is to be proven wrong once again, and additionally it is increasing its estimates for loan loss severities for virtually all RMBS classes issued between 2005 and 2007. However, as all those losses will be eaten by the taxpayer and promptly funded by even more dollar devaluing pieces of paper, this release is likely to have no material impact on anything at all.

What is funny is that even Moody's acknowledges the gaping discrepancy between rosy data such as the Case-Shiller and actual cash flows as well as debt servicing, which continue deteriorating: "Even though the Case-Shiller index reported home price gains for three consecutive months starting in June, Moody's believes the overhang of impending foreclosures and the continued rise in unemployment rates will impact home prices negatively in the coming months."

We fully expect the mainstream media will ignore this particular Moody's release.

From Moody's:

---

Moody's Investors Service announced today that it will update certain assumptions underlying its loss projections for each of the major U.S. residential mortgage-backed securities (RMBS) sectors in the coming weeks.

 

Moody's now expects that a trough in home prices will not be reached until the middle of 2010. In addition, based on recent loan loss severities, Moody's will increase its projected lifetime loan losses for pools backing U.S. Jumbo, Alt-A, Option ARM, and Subprime RMBS issued between 2005 and 2008.

 

The impact of the revisions is expected to be significant for Alt-A, Option ARM, and some Jumbo pools backing securitizations from 2005-2007, with the most pronounced changes expected for the 2005 pools. Performance has deteriorated significantly in the last six to nine months, with loss severities trending higher than Moody's previous expectations. The impact will be less pronounced for Subprime, but still notable for the 2005 pools.

 

Since the first quarter of 2009, when Moody's last announced revised lifetime loss expectations for the major RMBS sectors, several key economic indicators and performance metrics have worsened relative to expectations. Even though the Case-Shiller index reported home price gains for three consecutive months starting in June, Moody's believes the overhang of impending foreclosures and the continued rise in unemployment rates will impact home prices negatively in the coming months.

 

Moody's Economy.com (MEDC) now forecasts a third quarter 2010 home price trough. When Moody's last revised RMBS loss projections the trough was projected to occur at the end of 2009. MEDC projects a total peak-to-trough decline of 38% (versus 35%), compounded by muted subsequent home price growth of less than 5% in the year following the trough. Although the magnitude of forecast peak-to-trough decline has only worsened by 3 percentage points, the extended timeline will have an adverse impact on mortgage pools and stressed borrowers will continue to default at high rates.

 

Adding to borrowers' financial pressure, unemployment is now projected to peak at over 10% in mid-2010 and to remain in the high single digits for two years following.

 

Borrowers' refinancing options are still slim, and the benefits of loan modifications have yet to be seen due to the 5-month trial period during which modified loans must be reported as delinquent. In addition, modifications of loans owned by the GSEs have outpaced modifications of loans owned by private-label securitization trusts. Moody's will continue to consider the effect of loan modifications in its assessment of RMBS pools, potentially including Alt-A and Option ARM deals, and will continue to monitor success and redefault rates as information becomes available.

 

Moody's will update specific assumptions and announce the likely implications for each of the major RMBS sectors, in the coming weeks. In addition to the revisions to the home price trough and severity assumptions, other parameters will also be re-assessed, including the degree to which defaults are expected to slow down after the trough is reached.

 

Moody's will begin taking rating actions as needed this quarter, and will continue through the first quarter of next year.

 

Submitted by Nic Lenoir of ICAP

I shall not comment on the GDP number, nor the fact that estimates were revised down yesterday. Anybody who pays half attention to the market knows that it is an old trick used on a down day ahead of numbers to suck the last sellers in before the bounce. Last NFP day is a good example that should be fresh enough to most traders' memories. Let's focus on where we are now after this rally.

First, I hate to admit it since I am bearish, but today was an obvious move. Looking at EURUSD we tested the bottom of the channel on the sell-off and flirted within half a figure of the 50-dma. S&P futures came close to the 1,032 support of the bullish channel as well yesterday, and gold tested the 1,026 support area. The move today is brutal, and we need to look at the levels to watch to determine whether this is another ramp up, or if this bounce needs to be sold.

For the S&P future 1,070.50 is the line in the sand. If we go beyond then game over, new highs are upon us. On the Dax future we are back testing the former support of the channel, now resistance around 5,600. The 50-dma is at 5,609, right above us, and the key barrier would be on a further push 5,713, which corresponds to 1,070.5 in S&P future and would invalidate the impulse structure of the sellf-off the past few days. I would argue it is worth selling the Dax around here rather than any of the other markets. That will require discipline however when watching the stops. EURUSD we are already back on the overlap we broke the other day at 1.4845 and we have retraced almost 50% of the move already. Selling here requires to be religious respecting the 1.4974 stop, but the 1.4920/1.4974 is probably a better zone to reload on shorts. Gold is back almost on the resistance area between 1,050 and 1,055. A break past the top of this range probably invalidates further weakness as well.

If you want to play the carry I will bring attention to GBPUSD. I think you are still exposed to weakness for risky assets until you break the resistances mentioned here above, but GBPUSD is a trade that could work either way. Given it has decorrelated recently from the rest of the short-USD/pro-risk space it could be one way to play the anti-US theme without getting annihilated if equities do sell-off further. GBP has partly become a funding currency for carry trades. We had a H&S triggered on 09/24, and we retraced 38.2% of the rally since March 11. The correction shaped into an ABC with C=A. We have broken back above the neckline and the 50-dma, and on the pull back a few days ago we tested and held succesfully the moving average. It looks like a perfect technical set-up for an acceleration higher. Of all the pairs against the USD, it is the only one that offers a compelling bullish case other than just following the trend. The upside target if the move plays out is 1.7902, so the upside is quite significant, and a break below 1.6263 (the 50-dma) and the former neckline should be used as a stop on a close.
 
The Fed has now completed its treasury buy-back program. It will be interesting to see if the US Treasuries market comes under pressure as a result, especially given that the 7-year auction did not go that well today. Maybe the fact dealers can't hope buying at auctions to sell it right back to the Fed at a profit means they won't be buying. It is well documented that Treasury dealers have had a relatively easy time taking a commission on bonds issued by the Treasury and headed to the Fed's balance sheet, and POMO reports have shown that bonds purchased by the Fed had often times been issued in the weeks or even days before the Fed bid on them. More on the yield/risky-assets relationship later, for now let's see what charts say about the 10Y Treasury futures, and the key support levels to watch that would indicate yields are about to rise aggressively. The 180-minute chart shows we have a potential H&S triggered if we break 116-29 on the downside (I would observe the break on a daily close). What is even more interesting is looking at the weekly chart, one realize that this H&S is itself within the shoulder of bigger picture H&S. The big picture neckline is just about at 113. The next support below that is 106-21, so it is very important to kee all of this in mind. My conviction is that if equities push much higher here past 1,070.50 instead of retraceing we will go test the 113 level. A full point for the Treasury contract is about 14.4 basis points in yields, so that would imply rates would be 75 basis points higher for the 10Y Treasury approximately. I think if we get there it would put enough of a lid on recovery hopes that stocks would sell-off and balance the move in Treasuries. With the Fed no longer purchasing Treasuries, it is hard to contend equity markets can keep going much higher, even though some will argue that MBS purchases will still put pressure on overall rates.

Good luck trading,

Nic

I'm working on a GDP post for later ...

Click on graph for larger image in new window.

From Doug Short of dshort.com (financial planner).

Note that the Great Depression crash is based on the DOW; the three others are for the S&P 500.

The S&P was up 2.24% today ...

From Bloomberg: Moody’s May Downgrade Mortgage Bonds With New Outlook (ht Brian)

Moody’s Investors Service said it’s planning a review of U.S. home-loan securities that will likely lead to another round of rating changes based on a new view that property prices won’t bottom until next year’s third quarter.

The firm will boost its loss projections by “significant” amounts for prime-jumbo, Alt-A, option adjustable-rate and subprime mortgages backing bonds issued between 2005 and 2008, also after seeing higher losses per foreclosure than expected ... Recent data showing rising home prices doesn’t prove the slump is over, the company said.

“The overhang of impending foreclosures and the continued rise in unemployment rates will impact home prices negatively in the coming months,” New York-based Moody’s said.
emphasis added

And the Fed has finished its $300 billion Treasury purchase program - from Bloomberg: Fed Ends Treasury Buys That Capped Rates

Gee, let's see....

One executive who dealt with Galleon said: “They wanted anything the public did not have. They got various pieces and put them together and that was their edge.”

Uhhhhhh..

"Anything the public did not have" eh?

I thought that trading on material non-public information was unlawful?

Who is alleged to have provided that information?  Guess:

The latest development in the Galleon story makes Wall Street banks, like Morgan Stanley (MS) and Goldman Sachs (GS), look pretty bad.

Oh gee, why I am I not surprised?

When will the public - and the rest of the Hedge Fund community - say "enough!"

As noted in the linked article if Galleon was getting information on the order flow of other clients then there are a whole host of questions raised, both from a standpoint of potential legal exposure and from a standpoint of reputational and client risk.

After all, if you're a customer of these houses, do you want your order flow disclosed to those who pony up $250 million dollars for an "inside edge" - that is then used against you?

Uhhhhhh....

At this rate, we wouldn't reach anything that feels like full employment until well into the second Palin administration.

Stocks and risky assets stumble

I concluded a post on stock markets over the weekend saying: “After equities’ seven-month climb, stock markets certainly look vulnerable for a decline. Two downside reversal days – on Wednesday and Friday – would seem to indicate that stocks could commence a pullback to work off the overbought condition, allowing fundamentals to reassert themselves.”

Global stock markets, as well as other risky assets, closed sharply lower over the past few days as concerns mounted over the sustainability of the global economic recovery and the outlook for central bank policy.

The performance of the major asset classes is summarized by the charts below, with the top one showing the period from the March 9 stock market lows until October 19 peak and the second one the subsequent period. The numbers indicate an all-change pattern in the performances as risk aversion re-entered financial markets and government bonds and the US dollar regained some favor.

Source: StockCharts.com

Source: StockCharts.com

A summary of the movements of major global stock markets since the March 19 peak, as well as various other measurement periods, is given in the table below.

The MSCI World Index and the MSCI Emerging Markets Index have declined by 5.3% and 6.2% respectively since the highs of October 19, with markets like Ireland (‑13.2%), Brazil (-10.5%), Austria (-10.8%) and Belgium (-9.0%) falling by significantly more. Also, higher risk indices such as small caps have borne the brunt of the selling, with the Russell 2000 Index down by 9.0%. This is a pattern that one would expect as investors shift the emphasis to higher quality.

Click here or on the table below for a larger image.

The major moving-average levels for the benchmark US indices, the BRIC countries and South Africa (where I am based) are given in the table below. A number of indices, including the S&P 500 Index, have fallen below their 50-day moving averages over the past few days, but all the indices are still holding above their respective 200-day moving averages. The 50-day lines are also above the 200-day lines in all instances.

The October lows are also given in the table as a break below these levels would indicate a reversal of the uptrend since March, i.e. reversing the progression of higher reaction lows.

Click here or on the table below for a larger image.

Over the past few days a number of commentators have made pronouncements about the extent of a possible decline. For example, Jeremy Grantham (GMO) expects the S&P 500 to drop by 15% to 25%, David Rosenberg (Gluskin Sheff & Associates) sees markets falling by 20% and Doug Kass is looking at -5% to -12%.

This brings me to the topic of valuations. Based on operating earnings (i.e. stripping out everything that is bad), the historical price/earnings (PE) multiple of the S&P 500 is 27.0; using “as reported” (GAAP) earnings the figure shoots up to a giddy 95.7! Getting past the loss-making fourth quarter of 2008 and calculating prospective multiples through December 31, 2009 reduce the valuations to 19.0 and 24.4 respectively. Looking further out to the end of 2010, the prospective PEs are 14.1 and 22.9 respectively – still hardly the type of valuations that will inspire one to be a buyer across the board. (The earnings estimates are courtesy of Standard & Poor’s.)

Another way of looking at valuation levels, and cutting through the uncertainty of having to forecast earnings, is by means of Robert Shiller’s cyclically adjusted price-earnings ratio (CAPE), effectively muting the impact of the business cycle by averaging ten years of earnings. Using rolling ten-year reported earnings, my research (based on Shiller’s methodology, but including some refinements) shows that the “normalized” price-earnings ratio of the S&P 500 Index is currently 18.7. This compares with a long-term average of just more than 16.3 and implies an overvaluation of 15%. Considering a geometric rather than an arithmetic average of earnings, the overvaluation increases to 25%. The graphs below show data since 1950, but the actual calculations date back to 1871

Meanwhile, David Rosenberg highlights that this is not the onset of a sustainable secular bull market as we had coming off the fundamental lows of prior bear phases, such as August 1982, when:

• Dividend yields were 6%, not sub-2%.

• Price-to-earnings multiples were 8x, not 27x.

• The market traded at book value, not more than twice book.

• Inflation and bond yields were in double digits and headed down in the future, not near-zero and only headed higher.

• The stock market competed with 18% cash rates, not zero, and as such had a much higher hurdle to clear.

• Sentiment was universally bearish; hardly the case today.

• Global trade flows were in the process of accelerating as barriers were taken down; today, we are seeing trade flows recede as frictions, disputes and tariffs become the order of the day.

• A Reagan-led movement was afoot to reduce the role of government with attendant productivity gains in the future, as opposed to the infiltration by the public sector into the capital markets, union sector, economy and of course, the realm of CEO compensation.

Back to charting, Adam Hewison (INO.com) also sounded a cautious note on the outlook for the S&P 500 as explained in one of his popular technical analysis presentations. Click here to access the presentation.

I conclude with a comment from David Fuller (Fullermoney) who said: “At this stage of the bull cycle, I think a correction of approximately 10-15% for developed country stock markets and somewhat more for emerging markets would be good news for investors with cash to invest. Such a mean reversion towards rising 200-day moving averages would blow the recent froth off valuations and stem talk of an early change in monetary policy.”

I will bide my time while the fundamentals play catch-up. Meanwhile, caution remains the operative word.

Did you enjoy this post? If so, click here to subscribe to updates to Investment Postcards from Cape Town by e-mail.

Elizabeth Warren sums things up pretty succinctly:

The banking lobby is as powerful and deeply entrenched as ever, but it was powerful in the 1930s, too. Nonetheless, the New Dealers learned the Great Lesson: Powerful insiders cannot be permitted to write the rules, and prosperity and security depend on a playing field that supports a vibrant middle class. Today, we face a similar set of questions as we faced then. Will the institutions that created the crisis continue calling the shots and writing the rules, or will Washington take the side of families? Have we learned the Great Lesson?

To date, of course, the White House and Congress are siding with "the institutions that created the crisis" and not families.

As PhD economist Craig Pirrong makes clear, all of the talk of "reform" and "regulation" coming out of Washington is just for show (without any substance), to appease the populist anger:

Rather than a serious effort to address systemic risk, this [proposal on bank oversight] seems to be populist boob bait, a response to popular outrage against taxpayer banking bailouts, rather than a serious attempt to address TBTF. Not a surprise, and quite understandable, but not a major improvement of incentives.

Indeed, a 725-word story from Harper's proves (again) that Congress is trying to fool the American people:

Everyone rational knows that there is an enormous need to seriously reform the derivatives market, but [on October 7th, the House Financial Services] committee, headed by Congressman Barney Frank (D-Wall Street), invited a panel of eight guests who were distinguished by their uniformly pro-industry positions...

In response to complaints from Americans for Financial Reform, which represents hundreds of consumer groups and labor unions, the committee issued an invitation—the night before the hearing was held — to Rob Johnson of the Roosevelt Institute. For the committee, the last minute inclusion of Johnson — a former managing director at Bankers Trust Company and former economist at the Senate Banking Committee and Senate Budget Committee — apparently constituted sufficient balance.

Predictably, witnesses at the hearing trotted out positions urging caution in regard to the matter of reform. Derivatives and other exotic financial devices have reaped the finance industry vast profits, but for Hixson of Cargill the common man and woman would be the real losers if Congress were to act too severely. “We offer customized hedges to help bakeries manage price volatility of their flour so that their retail prices for baked goods can be as stable as possible for consumers and grocery stores,” he told the committee’s wagging heads. “We offer customized hedges to help a restaurant chain maintain stable prices on their chicken so that the company can offer consistent prices and value for their retail customers when selling chicken sandwiches.”

Johnson, who came last, offered the only serious critical viewpoint, saying that the American public had been “quite demoralized by…the bailouts that we experienced last fall.” After about five minutes of his testimony, Congresswoman Melissa Bean—another industry-funded committee member who chaired the hearing because Frank was absent—had heard enough. “I’m just going to ask you to wrap up because we’re running out of time,” she told Johnson.

Johnson gamely continued. “When I hear the testimony today that are largely financial institutions and end users, I believe that I represent a third group that comes to the table, which is the taxpayers, the working people of the United States,” he said.

“I do need a final comment,” Bean interjected seconds later.

That put an end to Johnson’s testimony. “I was just called to this hearing last night, so I will provide detailed comments on your bill and a statement for the record that will finish my comments,” he concluded.

About five days later Johnson submitted his full testimony to the committee, to be included on its website along with the statements of the other eight panelists. When it wasn’t posted, Johnson asked Lynn Parramore, editor of the Roosevelt Institute’s blog, to see what was up. Parramore emailed and spoke to staffers at the Financial Services Committee, and received a number of explanations for why Johnson’s testimony had not been posted: first she was told it hadn’t been received, then that it had to be submitted as a PDF, then that the committee was having IT problems. “I couldn’t decide whether it was incompetence or mischief, but I began to suspect the latter,” Parramore told me.

Finally, she was informed that the committee’s general counsel would not allow posting of the testimony because Johnson had not submitted it during the hearing. (Of course, since Johnson had been invited at the last minute it was impossible for him to fulfill this pointless requirement.) So you still can’t read Johnson’s prepared testimony at the committee website, but you can check it out on the Roosevelt Institute’s blog.

Meanwhile, Frank’s committee has put forth its “reform” bill. “Too tepid, too weak, too late,” Johnson says of the legislation. “Very industry influenced. We had a crisis and they are pandering to the perpetrators.”

Yves Smith summed it up well:

The House Financial Services Committee has refused to publish his testimony, offering “the dog ate my homework” level excuses.

By George Washington of Washington’s Blog.

When a liberal labor leader and a conservative financial policy analyst unite against something, you know that something is really bad (actually, I don’t believe in the whole false left-right dichotomy; I think its Americans versus those trying to steal our wallets and our rights, but that’s another story).

Today, AFL-CIO president Richard Trumka has slammed the Fed and the proposed “Tarp on steroids” legislation in his testimony to Congress today. Here are the must-read parts of Trumka’s prepared remarks to the House Financial Services Committee:

We are deeply concerned that the Committee’s work thus far on the fundamental issues of regulating shadow financial markets and institutions will allow the very practices that led to the financial crisis to continue. The loopholes in the derivatives bill and the failure to require any public disclosures by hedge funds and private equity funds fundamentally will leave the shadow markets in the shadows. We urge the Committee to work with the leadership to strengthen these bills before they come to the House floor.

However, these powers must be given to a fully public body, and one that is able to
benefit from the information and perspective of the routine regulators of the financial system. We believe a new agency, with a board made up of a mixture of the heads of the routine regulators and direct Presidential appointees would be the best structure. However, if the Federal Reserve were made a fully public body, it would be an acceptable alternative.

But we cannot support the discussion draft made public earlier this week because it gives dramatic new powers to the Federal Reserve without reforming its governance so that the banks themselves are removed from the governance of the Federal Reserve System. Even more alarmingly, the discussion draft would appear to give power to the Federal Reserve to preempt a wide range of rules regulating the capital markets—power which could be used to gut investor and consumer protections. If this Committee wishes to give more power to the Federal Reserve, it must make clear this power is only to strengthen safety and soundness regulation and it must simultaneously reform the Federal Reserve’s governance. Reform cannot be put off until another day.

The Federal Reserve currently is the regulator for bank holding companies. In that
capacity, it was responsible throughout the period of the bubble for regulating the parent companies of the nation’s largest banks. While regulatory authority rests in the Board of Governors of the Federal Reserve in Washington, routine responsibility for regulatory oversight has been delegated by the Board of Governors to the regional Federal Reserve Banks. The Federal Reserve System’s regulatory expertise resides in these regional banks.

The problem is that these regional Federal Reserve Banks are actually controlled by their member banks—the very banks whose holding companies the Fed regulates. The member banks control the selection of the majority of the regional bank boards, and the boards pick the regional bank presidents, who are effectively the CEO’s of the regulatory staff.

These arrangements may explain why the Federal Reserve has never given any account of how it allowed bank holding companies like Citigroup and Bank of America to arrive at a point where they required tens of billions of dollars of direct equity infusions from the public purse to avoid bankruptcy.

Giving the Federal Reserve with its current governance control over which financial
institutions are bailed out in a crisis is effectively giving the banks the ability to raid the Treasury for their own benefit.

We are also deeply troubled by provisions in the discussion draft that would allow the Federal Reserve to use taxpayer funds to rescue failing banks, and then bill other nonfailing banks for the costs. The incentive structure created by this system seems likely to increase systemic risk.

We believe it would be more appropriate to require financial institutions to pay into an insurance fund on an ongoing basis. Financial institutions should be subject to progressively higher fee assessments, and stricter capital requirements, as they get larger. This would be a way of actually discouraging “too big to fail.”

In addition, language in the draft that appears to limit taxpayer bailouts of bank
stockholders actually does no such thing, rather it simply ensures that when stockholders are rescued with public funds, bondholders and other creditors are rescued with them…

Finally, and not least, the discussion draft appears to envision a process for identifying and regulating systemically significant institutions, and for resolving failing institutions, that is secretive and optional—in other words, the Federal Reserve could choose to take no steps to strengthen the safety and soundness regulation of systemically significant institutions. In these respects, the discussion draft appears to take the most problematic and unpopular aspects of the TARP and makes them the model for permanent legislation.

Instead of repeating and deepening the mistakes associated with the bank bailout,
Congress should be looking to create transparent, fully publicly accountable mechanisms for regulating systemic risk and for acting to protect our economy in any future financial crises.

Conservative Peter Wallison – financial policy study analyst at the American Enterprise Institute – largely agrees. In his prepared remarks to Congress, Wallison says:

The Discussion Draft of October 27 contains an extremely troubling set of proposals which, if adopted, will bring economic growth in this country to a standstill, essentially turn over the control of the financial system to the government, and seriously impair competition in all areas of finance.

Rather than ending too big to fail, the Draft makes it national policy. By designating certain companies for special prudential regulation, the Draft would signal to the markets that these companies are too big to fail, creating Fannies and Freddies in every sector of the economy where they are designated. This will impair competition by giving large companies funding and other advantages over small ones.

The idea that the designation of these companies will be kept secret is, with all due respect, absurd; securities laws alone will require them to disclose their special status; simple truthfulness will do the rest…

If this legislation is passed, every industry will be in Washington, asking for special treatment or exemption. Competition in the market will become competition before this committee or in the halls of the Fed, lobbyist-to-lobbyist and lawyer-to-lawyer…

This will not only create uncertainty and moral hazard, but it will give the large and powerful companies special advantages over small ones. Those that seem likely to be taken over by the government will have easier access to credit, at lower rates, than those likely to be sent to bankruptcy.

In other words, the Draft proposes nothing more or less than a permanent TARP, using government money to bail out the large or politically favored companies, and then taxes the remaining healthy companies to reimburse the government for its costs of competing with them…

The [proposed bill] would take control of the financial industry in the United States, stifle risk-taking and initiative, and change competitive conditions in every sector of the economy so that they favor large, government-backed, too big to fail enterprises…

The Draft … would now give the Fed authority to regulate any financial company that the Council determines should be subject to “heightened prudential standards,” even if there is no insured bank in the group…

The result is that the question becomes one of political clout, with industries fighting in Congress for the competitive result they want. Some industries want to invade others’ turf; the invaded industry uses the law to fend off the competition; consumers are the losers. Congress becomes the battleground. It’s not just unseemly; it’s a frightening example of what happens when the government starts picking winners…

Congress will be injecting itself into competitive fights between firms and industries, further politicizing what should be economic or financial decisions…

The Designated Companies are under the complete control of the Fed. They will not be able to initiate new activities without the Fed’s approval, or enter new competitive fields, or perhaps even open new offices in new places. This is a degree of political control of business that has never been attempted before. Not only will it place the dead hand of government on the activities of financial companies, but it will almost certainly drive many financial companies out of the United States before they submit to these restrictions.

The effect of these restrictions for the U.S. economy will be dire. First, Designated Companies will clearly have been labeled as too big to fail. In effect, the government has notified the capital markets that these firms will not be allowed to go into bankruptcy—they will be rescued in the ways I will describe below. This means they will be less risky borrowers than smaller companies that are not going to be controlled in the same way. As less risky borrowers, the Designated Companies will have lower costs of funding and will be able to drive smaller competitors from the markets they enter. Sound familiar? Yes, it’s Fannie Mae and Freddie Mac all over again. The existence of these Designated Companies will impair competition in every market they are allowed to enter, and will force the consolidation of competitors so that markets become dominated by government-backed giants like themselves….

[The bill assumes that] our entire financial system must be subjected, today, to far-reaching control by the Federal Reserve Board. With all due respect, this is absurd, and certainly disastrous for economic growth in the future.

The Draft also contains language that suggest some of the problems of identifying Designated Companies in advance—and thus creating the Fannie/Freddie too big to fail problem—can be avoided if the designation of these companies is not disclosed to the public. This, too, with all due respect, is absurd…

In addition, there is very little incentive for the government not to rescue failing Designated Companies, because the Draft provides that the surviving members of the financial industry larger than $10 billion in assets—whether Designated Companies or not—will be taxed to reimburse the government for its costs in the bailout…

As in the GM and Chrysler bailouts, preferences are going to go to favored groups, and disfavored groups will suffer disproportionate losses. It will be a political free for all, with important legislators pressing the FDIC to treat their constituents better than someone else’s constituents.

What we know is that no losses will be taken immediately by creditors. This is because the objective of the resolution authority is to prevent a “disorderly” failure, which actually means a failure in which creditors suffer immediate losses…

The proposals in the Draft reflect very bad policy—far more likely to be destructive of the financial system and damaging to the economy than an improvement on what exists today.

Governor Daniel K. Tarullo

Regulatory reform

Before the Committee on Financial Services, U.S. House of Representatives, Washington, D.C., October 29, 2009

Chairman Frank, Ranking Member Bachus, and other members of the Committee, thank you for the invitation to testify this morning on systemic regulation, prudential matters, resolution authority, and securitization. The financial crisis was the product of many factors, including the tight integration of lending activities with the issuance, trading, and financing of securities; gaps in the financial regulatory structure; widespread failures of risk management across a range of financial institutions; and, to be sure, significant shortcomings in financial supervision. More fundamentally, though, it demonstrated that the regulatory framework had not kept pace with far-reaching changes in the financial sector, and the concomitant growth of new sources of risk to both individual institutions and the financial system as a whole.

Because the roots of the crisis reached so deeply into the very nature of the financial system, a broad program of reform is required. Much can be, and needs to be, done by supervisors–under their existing statutory authorities–to contain systemic risk generally and the too-big-to-fail problem in particular. As the discussion draft released by Chairman Frank recognizes, there is also a clear need for the Congress to provide significant additional authority and direction to the regulatory agencies.

Essential elements of this legislative agenda include: ensuring that all financial institutions that may pose significant risk to the financial system are subject to robust consolidated supervision; establishing a systemic risk oversight council to identify, and coordinate responses to, emerging risks to financial stability; directing all financial supervisors to take account of risks to the broader financial system as part of their normal oversight responsibilities; establishing a new special resolution process that allows the government to wind down in an orderly way a failing financial institution that threatens the entire financial system while also creating a credible process for imposing losses on the firm’s shareholders and creditors and assuring that the financial industry, not taxpayers, ultimately bears any additional costs associated with the resolution process; providing for consistent and robust prudential supervision of key payment, clearing, and settlement arrangements; and addressing weaknesses in the securitization process that came to light during the crisis.

Chairman Frank’s discussion draft addresses each of these areas and, in the Board’s view, provides a strong framework for achieving a safer, more stable financial system. In addition to addressing these areas for legislative change, I will discuss some of the actions the Federal Reserve and our supervisory colleagues are taking under existing authorities to strengthen the supervision and regulation of financial institutions–particularly large, complex institutions–and to prevent regulatory arbitrage.

Consolidated Supervision of Systemically Important Financial Institutions
The current financial crisis has clearly demonstrated that risks to the financial system can arise not only in the banking sector, but also from the activities of other large, interconnected financial firms–such as investment banks and insurance companies–that traditionally have not been subject to the type of mandatory prudential regulation and consolidated supervision applicable to bank holding companies. Chairman Frank’s discussion draft would close this important gap in our regulatory structure by providing for all financial institutions that may pose significant risks to the financial system to be subject to the framework for consolidated prudential supervision that currently applies to bank holding companies. As I will discuss shortly, it also provides for these firms to be subject to enhanced standards, reflective of the risk they pose to the financial system. These provisions should prevent financial firms that do not own a bank–but that nonetheless pose risks to the overall financial system because of the size, risks, or interconnectedness of their financial activities–from avoiding comprehensive supervisory oversight.

In one sense, a requirement that all systemically important firms be subject to prudential supervision would not lead to a major change in our regulatory system. During the financial crisis, a number of very large financial firms became bank holding companies. Thus, the Federal Reserve has already become the consolidated supervisor of most of the nation’s large, interconnected financial institutions. Yet a critical part of a reform agenda directed at systemic risk and the too-big-to-fail problem is ensuring that other financial firms that may pose a systemic threat also are subject to robust consolidated supervision. Such a measure would allow the regulatory system to adapt if activities migrate from supervised institutions to other firms, leading those firms to become very large and interconnected, or in response to other developments in the financial system. Moreover, such a provision would serve as a kind of insurance policy against the possibility of a firm that opted for the benefits of being a bank holding company during the financial crisis deciding to exit that status during calmer times.

The discussion draft also would require the development of enhanced regulation and supervision, including robust capital, liquidity, and risk-management requirements, to address and mitigate systemic risks. Enhanced requirements, particularly for large, interconnected firms, are needed not only to protect the stability of individual institutions and the financial system as a whole, but also to counteract any incentive for financial firms to become very large in order to be perceived as too big to fail. This perception can materially weaken what should be the normal market incentive of creditors to monitor the firm’s risk-taking and appropriately price these risks in their transactions with the firm. When this incentive is weakened, moral hazard increases, allowing the firm to raise funds at a price that may not fully reflect the firm’s risk profile. As a result, the firm is likely to choose a level of risk that is excessive both for itself and, potentially, for society at large. Moreover, this distortion creates a playing field that is tilted against smaller firms not perceived as having the same degree of government support. Development of a mechanism for the orderly resolution of nonbank financial firms that threaten financial stability, which I will discuss later, is an important additional tool for addressing the too-big-to-fail problem.

The discussion draft would reinforce the changes in supervision already under way at the Federal Reserve and the other banking agencies. As already announced, we have strengthened capital requirements for trading activities and securitization exposures. We continue to work with other regulators to strengthen the capital requirements for other types of on- and off-balance-sheet exposures and to improve the quality of capital overall.¹

Beyond these generally applicable capital requirements, we must develop capital standards and other supervisory tools addressed specifically to the systemic risks of large, interconnected firms. One possible approach is a special charge–possibly a special capital requirement–that would adjust based on the risks posed by the firm to the financial system. Ideally, this requirement would be calibrated to become more stringent as the firm’s systemic risks increase, although developing a metric for such a requirement would be highly challenging. Another potentially promising option is to require that selected financial institutions issue specified amounts of contingent capital. Such capital could take the form of debt instruments that convert to common equity during times of macroeconomic stress or when losses erode the institution’s capital base. Such instruments would pre-position capital on the balance sheets of each of these institutions, ready to be converted into the form that provides the best loss-absorption capacity precisely when that capacity is most needed. And, if well devised, it would inject an additional element of market discipline into large financial firms, because the price of those instruments would reflect market perceptions of the stability of the firm.

The financial crisis also highlighted weaknesses in liquidity risk management at major financial institutions, including an overreliance on short-term funding. To address these issues, the Federal Reserve helped lead the development of revised international principles for sound liquidity risk management, which have been incorporated into new interagency guidance now out for public comment.² Together with our U.S. and international counterparts, we are also considering quantitative standards for liquidity exposures similar to those for capital adequacy, with the goal of ensuring that internationally active firms can fund themselves even during periods of severe market instability. With supervisory encouragement, large banking organizations have, for the most part, already significantly increased their liquidity buffers and are strengthening their management of liquidity risks.

Beyond modifying applicable rules and standards, the Federal Reserve is revamping its approach toward supervising the largest financial institutions. In doing so, we have drawn on our experience earlier this year in conducting the special Supervisory Capital Assessment Program (SCAP), which involved forward-looking, cross-firm, aggregate analyses of 19 of the largest bank holding companies. While the SCAP itself was an extraordinary exercise for an extraordinary time, we are incorporating into our ongoing supervisory process the essential SCAP approach of bringing firm-specific assessments of on-site examiners together with systematic analyses of industry experience, economic trends, and possible stress scenarios. Thus, we have increased our emphasis on horizontal examinations, which focus on particular risks or activities across a group of banking organizations, and we have broadened the scope of the resources we bring to bear on these reviews.

For example, we currently are conducting a horizontal assessment of internal processes for evaluating capital adequacy at the largest U.S. banking organizations, focusing in particular on how shortcomings in fundamental risk management and governance for these processes could impair firms’ abilities to estimate capital needs. This exercise is central to the goal of having each firm maintain adequate capital to provide a buffer against possible losses associated with its particular set of activities and exposures. Using findings from these reviews, we will work with firms over the next year to bring their processes into line with supervisory expectations. Supervisors will use the information provided by firms about their processes as one factor in the assessment of the adequacy of firms’ overall capital levels. For instance, if a firm cannot demonstrate a strong ability to estimate capital needs, then supervisors will place less credence on the firm’s own internal capital evaluation and may demand higher capital cushions, among other things.

As part of this overall approach to large institution supervision, we are creating an enhanced quantitative surveillance program for large, complex organizations that would use supervisory information, firm-specific data analysis, and market-based indicators in an effort to identify emerging risks to specific firms as well as to the industry as a whole. This work will be performed by a multidisciplinary group composed of our economic and market researchers, supervisors, market operations specialists, and other experts within the Federal Reserve System. In addition, periodic scenario analysis will be used to enhance our understanding of the consequences of changes in the economic environment for both individual firms and for the broader system. Finally, to support and complement these initiatives, we are working with the other federal banking agencies to develop more-comprehensive and more-frequent information-reporting requirements for the largest firms.

The crisis also has highlighted the potential for compensation practices at financial institutions to encourage excessive risk-taking and unsafe and unsound behavior–not just by senior executives, but also by other managers or employees who have the ability, individually or collectively, to materially alter the risk profile of the institution. Bonuses and other compensation arrangements should not provide incentives for employees at any level to behave in ways that imprudently increase risks to the institution, and potentially to the financial system as a whole.

Last week, the Federal Reserve issued proposed guidance on incentive compensation practices to promote the prompt improvement of incentive compensation practices throughout the banking industry.³ This guidance, which is consistent with the international principles and standards issued by the Financial Stability Board earlier this year, will be supplemented by supervisory initiatives to spur and monitor the industry’s progress toward the implementation of safe and sound incentive compensation arrangements, identify emerging best practices, and advance the state of practice more generally in the industry.⁴ One of these initiatives involves a special horizontal review of incentive compensation practices at 28 large, complex banking organizations under the Federal Reserve’s supervision.

To be fully effective, consolidated supervisors must have clear authority to monitor and address safety and soundness concerns and systemic risks in all parts of an organization, working in coordination with other supervisors wherever possible. As the crisis has demonstrated, large firms increasingly operate and manage their businesses on an integrated, firmwide basis, with little regard for the corporate or national boundaries that define the jurisdictions of individual functional supervisors, and stresses at one subsidiary can rapidly spread within the consolidated organization. A consolidated supervisor thus needs the ability to understand and address risks that may affect the risk profile of the organization as a whole, whether those risks arise from one subsidiary or from the linkages between depository institutions and nondepository affiliates. Chairman Frank’s proposal would make useful modifications to the provisions added to the law by the Gramm-Leach-Bliley Act in 1999 that limit the ability of a consolidated supervisor to monitor and address risks within an organization and its subsidiaries on a groupwide basis.

Systemic Risk Oversight
For purposes of both effectiveness and accountability, the consolidated supervision of an individual firm, whether or not it is systemically important, is best vested with a single agency. However, the broader task of monitoring and identifying systemic risks that might arise from the interaction of different types of financial institutions and markets–both regulated and unregulated–may exceed the capacity of any individual supervisor. Instead, we should seek to marshal the collective expertise and information of all financial supervisors to identify and respond to developments that threaten the stability of the system as a whole.

The discussion draft released by Chairman Frank would advance this objective in two important ways. First, it would establish an oversight council–composed of representatives of the agencies and departments involved in the oversight of the financial sector–that would be responsible for monitoring and identifying emerging systemic risks across the full range of financial institutions and markets. In addition, the council would have the ability to coordinate responses by member agencies to mitigate identified threats to financial stability. And, importantly, the oversight council would have the authority to recommend that its member agencies, either individually or collectively, adopt heightened prudential standards for the firms under the agencies’ supervision in order to mitigate potential systemic risks. Examples of such risks could include rising and correlated risk exposures across firms and markets; significant increases in leverage that could result in systemic fragility; and gaps in regulatory coverage that arise in the course of financial change and innovation, including the development of new practices, products, and institutions. The council also would identify those financial firms that should be subjected to enhanced prudential standards and supervision on a consolidated basis.⁵

Second, the discussion draft would reinforce the authority of individual financial agencies to take macroprudential considerations into account in exercising their supervisory and regulatory functions. A macroprudential outlook, which considers interlinkages and interdependencies among firms and markets that could threaten the financial system in a crisis, provides an important complement to the current microprudential focus of financial supervision and regulation. Each supervisor’s participation in the oversight council would greatly strengthen that supervisor’s ability to see and understand threats to financial stability and craft appropriate responses for the institutions and markets under their supervision.

The Federal Reserve already has begun to incorporate a systemically focused approach into our supervision of large, interconnected firms. Doing so requires that we go beyond considering each institution in isolation and pay careful attention to interlinkages and interdependencies among firms and markets that could threaten the financial system in a crisis. For example, the failure of one firm may lead to runs by wholesale funders of other firms that are seen by investors as similarly situated or that have exposures to the failing firm. These efforts are reflected, for example, in the expansion of horizontal reviews and the quantitative surveillance program I discussed earlier.

Improved Resolution Process
Another critical element of an agenda to contain systemic risk is the creation of a new regime that would allow financial firms to fail without posing risks to the broader financial system or the economy. In most cases, the federal bankruptcy laws provide an appropriate framework for the resolution of nonbank financial institutions. However, the bankruptcy code does not sufficiently protect the public’s strong interest in ensuring the orderly resolution of a nonbank financial firm whose failure would pose substantial risks to the financial system and to the economy. Indeed, after the Lehman Brothers and AIG experiences, there is little doubt that we need an alternative to the existing options of bankruptcy and bailout for such firms.

The discussion draft released by Chairman Frank would provide the government with important new tools to restructure or wind down a failing firm in a way that passes on losses to shareholders and creditors of the firm while mitigating the risks to financial stability and the economy. For example, it would allow the government to sell assets, liabilities, and business units of the firm; transfer the systemically significant operations of the firm to a new bridge entity that can continue these operations with minimal disruptions; and repudiate contracts of the firm, subject to appropriate recompense.

This proposal would not guarantee the survival of any financial firm, nor is it designed to aid shareholders or creditors of a failing firm. To the contrary, the proposal would establish the expectation that shareholders and creditors of the firm will bear losses as a result of the firm’s failure. And any assistance provided in the course of the resolution process to prevent severe disruptions to the financial system would be repaid by the firm or the financial services industry. Establishing credible processes for imposing losses on the shareholders and creditors of a failing firm is essential to restoring a meaningful degree of market discipline and addressing the too-big-to-fail problem. Indeed, restoring discipline through changes directed at the behavior of investors and counterparties would be an important complement to the regulatory and supervisory changes that I discussed earlier, which seek to address the too-big-to-fail problem through actions directed at the firms themselves.

Financial firms of any size should be resolved under the bankruptcy code whenever possible. Thus, this new regime should serve only as an alternative to the bankruptcy code, available when needed to address systemic concerns, and its use should be subject to high standards and checks and balances. The discussion draft would allow the new regime to be invoked with respect to a particular firm only with the approval of multiple agencies, and only upon a determination that the firm’s failure and resolution under the bankruptcy code or otherwise applicable law would have serious adverse effects on financial stability and the U.S. economy. These standards, which are similar to those governing the use of the systemic risk exception to least-cost resolution in the Federal Deposit Insurance Act, appear appropriate and should help ensure that these new powers are invoked only when circumstances dictate their use.

The discussion draft provides that the ultimate costs of any assistance needed to facilitate the orderly resolution of a large, highly interconnected financial firm be recouped through the sale or dissolution of the troubled firm, supplemented by assessments on financial firms over an extended period of time if necessary. We believe this approach provides a path to resolution for financial firms in a way that both mitigates risk to the financial system and protects taxpayers. The availability of a workable resolution regime with appropriate funding would eliminate the need for the Federal Reserve to use its emergency lending authority under section 13(3) of the Federal Reserve Act to prevent the disorderly failure of specific failing institutions.

It is important, however, that the Federal Reserve, as the nation’s central bank, retain our long-standing authority to address broader liquidity needs within the financial system under section 13(3) when necessary to maintain financial stability. During the recent crisis, our ability to establish broad-based liquidity facilities proved critical in containing the severe pressures that threatened the financial system as a whole and in reopening key financial markets. We used this authority only when the need for action was evident to both the Federal Reserve and the Treasury, a practice that could be formalized by the Congress.

Payment, Clearing, and Settlement Arrangements
As I mentioned at the outset, in revising the financial regulatory system, we must look beyond the causes of the current crisis and seek to address areas of potential systemic risk in the future. Such areas include critical payment, clearing, and settlement arrangements, which are the foundation of the nation’s financial infrastructure. These arrangements include centralized market utilities for clearing and settling payments, securities, and derivatives transactions, as well as the decentralized activities through which financial institutions clear and settle such transactions bilaterally. While these arrangements can create significant efficiencies and promote transparency in the financial markets, they also may concentrate substantial credit, liquidity, and operational risks. In addition, many of these arrangements have direct and indirect financial or operational linkages and, absent strong risk controls, can themselves be a source of contagion in times of stress. Thus, it is critical that systemically important payment, clearing, and settlement systems and activities be subject to strong and consistent prudential standards designed to ensure the identification and sound management of credit, liquidity, and operational risks.

Unfortunately, the current regulatory and supervisory framework for systemically important payment, clearing, and settlement arrangements is fragmented, creating the potential for inconsistent standards to be adopted or applied. In light of the increasing integration of global financial markets, it is important that these arrangements be viewed from a systemwide perspective, and that they be subject to strong and consistent prudential standards and supervisory oversight.

The Federal Reserve has direct supervisory responsibility for some of the largest and most critical systems in the United States and has a role in overseeing several other systemically important systems. But a coherent framework for supervision of these systems does not exist, and our current authority depends to a considerable extent on the specific organizational form of these systems. Chairman Frank’s discussion draft would provide the Federal Reserve with additional authorities to ensure that appropriate standards and oversight are applied to systemically important payment, clearing, and settlement arrangements.

Improving the Securitization Process
The financial crisis revealed a number of significant shortcomings in the securitization process that contributed importantly to the stresses experienced by the markets as well as to the outsized losses some firms faced once markets began to deteriorate. The ability of brokers and lenders to readily securitize and sell to third parties loans that they were making, regardless of their risks, contributed to the overall decline in underwriting standards in the years leading up to the crisis. Moreover, capital requirements failed to provide adequate incentives for firms to maintain capital and liquidity buffers sufficient to absorb extreme systemwide shocks without taking actions that could tend to amplify the effects of the shocks. In addition, institutional investors of all sorts–including financial institutions, pension funds, and overseas investors–put excessive reliance on the rating agencies’ assessment of the risks associated with a range of structured products. In part, investors’ reliance on ratings reflected the lack of transparency of many structured products, which made independent assessments of risk difficult. However, it subsequently became clear that the rating agencies had not themselves understood the extent of the risks associated with complex structured instruments, particularly those related to subprime mortgages. Once those risks were realized, the ratings of many of these securities were downgraded sharply, with investors taking very large and unexpected losses.

Addressing these weaknesses will require action on several fronts. As I noted earlier, the Basel Committee has announced improvements to bank capital standards for securitization-related exposures, thereby better aligning these standards with the risks presented by securitizations. Improved transparency regarding the individual loans backing a securitization, as well as regarding the originators of such loans, also is needed to reduce the opacity that has impeded effective discipline in the market for asset-backed securities (ABS) and encouraged undue reliance on credit rating agencies. Chairman Frank’s discussion draft would advance this goal by authorizing the Securities and Exchange Commission (SEC) to develop enhanced disclosure requirements for ABS, including loan-level information and information identifying the originators or brokers of the underlying loans.⁶ Using authority granted by the Congress in 2006, the SEC already has adopted or proposed several rules to improve the transparency, quality, and integrity of the credit rating process for securitizations and other structured finance products.⁷

Requiring that originators or securitizers of loans packaged for securitization retain some exposure to the credit risk associated with the loans also could help restore confidence in the securitization market and encourage the application of sound underwriting criteria to all loans, including those intended for securitization. The details of such a requirement are probably best left to rulemaking by the implementing agencies. Complexities are created by the broad range of assets that are, or may be, securitized, as well as by the different approaches that may be taken to securitization. A credit exposure retention requirement may thus need to be implemented somewhat differently across the full spectrum of securitizations in order to properly align the interests of originators, securitizers, and investors without unduly restricting the availability of credit or threatening the safety and soundness of financial institutions.

Charter Conversions and Regulatory Arbitrage
Finally, I am pleased to note that one potential gap, which I know is of interest to this Committee, already has been addressed by the joint efforts of the banking agencies. The dual banking system and the existence of different federal supervisors create the opportunity for insured depository institutions to change charters or federal supervisors. While institutions may engage in charter conversions for a variety of sound business reasons, conversions that are motivated by hopes of escaping current or prospective supervisory actions by the institutions’ existing supervisors undermine the efficacy of the prudential supervisory framework.

Accordingly, the Federal Reserve welcomed and immediately supported an initiative led by the Federal Deposit Insurance Corporation to address such regulatory arbitrage. This initiative resulted in a recent statement of the Federal Financial Institutions Examination Council reaffirming that a charter conversion or other action by an insured depository institution that would result in a change in its primary supervisor should occur only for legitimate business and strategic reasons.⁸ Importantly, this statement also provides that conversion requests should not be entertained by the proposed new chartering authority or supervisor while serious or material enforcement actions are pending with the institution’s current chartering authority or primary federal supervisor. In addition, it provides that the examination rating of an institution and any outstanding corrective action programs should remain in place when a valid conversion or supervisory change does occur.

Conclusion
In closing, let me reiterate the importance of moving ahead with the elements of the administrative and legislative reform agenda that I have discussed. These reforms, taken together, will enhance financial stability, increase market discipline in transactions involving large financial firms, and reduce both the probability and severity of future crises. The Federal Reserve looks forward to continuing work with the Congress and the Administration as the legislative process moves forward.

---

Footnotes

1. See Bank for International Settlements (2009), “Basel II Capital Framework Enhancements Announced by the Basel Committee,” press release, July 13; and Basel Committee on Banking Supervision (2009), Enhancements to the Basel II Framework (188 KB PDF) (Basel, Switzerland: Basel Committee, July). Return to text

2. See Basel Committee on Banking Supervision (2008), Principles for Sound Liquidity Risk Management and Supervision (153 KB PDF) (Basel: Basel Committee, September). Information about the proposed guidance is available at Board of Governors of the Federal Reserve System, Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation, Office of Thrift Supervision, and National Credit Union Administration (2009), “Agencies Seek Comment on Proposed Interagency Guidance on Funding and Liquidity Risk Management“, joint press release, June 30. Return to text

3. See Board of Governors of the Federal Reserve System (2009), “Federal Reserve Issues Proposed Guidance on Incentive Compensation,” press release, October 22. Return to text

4. See Financial Stability Forum (2009), FSF Principles for Sound Compensation Practices (87 KB PDF),  April, available on the Financial Stability Board’s website. (The Financial Stability Forum has subsequently been renamed the Financial Stability Board.) Also see Financial Stability Board (2009), FSB Principles for Sound Compensation Practices: Implementation Standards (35 KB PDF), September. Return to text

5. To fulfill these responsibilities, the discussion draft would provide the council access to a broad range of information from its member agencies regarding the institutions and markets that the agencies supervise and, when the necessary information is not available through that source, the authority to collect such information directly from financial institutions and markets. Return to text

6. Encouraged by the Federal Reserve and others, the American Securitization Forum already has taken important steps along these lines, developing model disclosures for residential mortgage-backed securities that would provide investors standardized loan-level information. Return to text

7. Increased transparency regarding the pricing of ABS also can support enhanced market discipline by providing investors important signals regarding other market participants’ assessments of the quality of individual issues. Along these lines, the Financial Industry Regulatory Authority recently proposed including ABS in its post-trade reporting system, a step that deserves the support of policymakers. Return to text

8. See Federal Financial Institutions Examination Council (2009), “FFIEC Issues Statement on Regulatory Conversions,” press release, July 1.

Original text
http://www.federalreserve.gov/newsevents/testimony/tarullo20091029a.htm

New Name Floated In Geithner Replacement Talks Dealbreaker (What up, bankster? I said I wouldn’t be using that word but it’s in context and I had to say it. This will be the new Treasury lyrical theme – just replace the word gangsta with the other one.)

America’s Next President? YouTube (Oops. wrong link at first. In the same vein as the last link. Hat tip Andrew Sullivan)

Galleon paid banks millions for ‘edge’ FT (Proof the system is rigged)

How to avoid a repeat of the Great Crash FT

Struggling in a recovering economy BBC

Soros: General Theory of Reflexivity FT (Not much chatter on this yet. Hat tip reader Scott)

What if George W. Bush had done that? Politico

The Presidency and The Rise of the New Partisan Press Balkinization (Hat tip reader Scott)

North Carolina Sea Levels Rising Three Times Faster Than In Previous 500 Years, Study Finds Science Daily

US swine flu vaccine too late to beat autumn wave New Scientist (Let’s hope worst fears are not realized)

What Does a Smart Brain Look Like?: Inner Views Show How We Think Scientific American (Very cool science)

When Ants Attack: Chemicals That Trigger Aggression In Argentine Ants Synthesized Science Daily

With investors cheering the government's and Cash for Clunkers' massive contributions to preliminary Q3 GDP, numerous questions remain unanswered, chief among them being why is the dollar now so completely disconnected from any fundamental economic news, and how long can it remain a plaything in the constant shuffle to procure cheap risky assets even when it should get at least a moderate pop on an improving US economy. With the Fed expected to not raise rates for almost two years, the economy will not have an impact on the US currency for a long time, as such putting the country in a position where it may well face hyperinflation as the Fed continues to combat the current deflationary episode with every instrument imaginable.

Ironically, ongoing "good" data which are simply the result of various one-time, presumably non-recurring stimulus and subsidy programs will sooner or later translate into inflation, if pushed long and hard enough. And as broad based deflation is still the primary threat, courtesy of declining wages, even with gas again approaching $3.00/gallon, Obama may have boxed himself into a corner with his numerous TV appearance claiming that the economy has essentially mended.  Of course, even first year analysts at investment banks know to exclude one-time benefits/charges from ongoing operations. It is a pity the US president, however, never sat in on the Goldman Sachs analyst class: one imagines the firm owes him at least that much.

Either way, as stimulus and liquidity benefits taper off, with the Fed's inability to buy any more treasuries a key case in point, the economy has rebounded sufficiently high for even some of the most violent bears to throw in the towel. Yet Q4 GDP will see the impact of the stimulus programs falling away (and one hopes at least one regional Fed will support some of this inventory build data that the government is doing all it can to make the population believe is currently occurring). So even as Goldman engineered a perfect bear trap with their surprise revision lower, expect Q4 GDP to provide not only a likely lower adjustment to Q3 economic data, but to be a real miss to the 2.4% consensus reading (regardless of what Goldman does a few minutes before the number's official release). And with a range of GDP expectations from -1.5% from Mizuho to 5.5% for First Trust (good luck boys), it is pretty safe to say that nobody really knows what will happen, except that everyone has grown increasingly optimistic on Q4 GDP over time. What is simply ludicrous is that Q4 GDP now is expected to be higher than what it was expected to be in March of 2008 (2.2%). Gotta love government interventions.

 

And for those who care to think between the lines, UBS has released a client note which has observations on what, briefly, one can expect out of the US economy. Nothing earthshattering here, but useful to see that someone still is capable of some rational thought out there. Point 3 is particularly notable.

1. Good data could translate into inflation expectations

We acknowledge up front that the Fed does not have a very strong inflation mandate (compared to the ECB) and this is one reason market expectations for FOMC policy rates are relatively subdued at this stage. In addition, the first step for policy 'tightening' will be balance sheet reduction and cessation of liquidity programs, rather than outright rate hikes. However, this does not mean that interest rate expectations can be ignored indefinitely as growth figures pick up. The chart below shows the relationship between inflation expectations, as measured by the 5y5y forward breakeven, and arguably the two most important data points in the US economic calendar: Non-farm payrolls and manufacturing ISM. Both releases have been gaining since Q4 this year and inflation expectations  appear to be tracking the trends through Q2 this year before stabilising. At present, the jump in inflation expectations is likely due to a combination of Fed debasement fears or actual a return in trend growth, but the former will become the dominant driver if trend growth does pick up materially, as markets view current Fed policy as incompatible with economic performance. The end result would likely be a shift in the Fed's bias to contain inflation expectations.

2. Good data may steepen the yield curve

The steepening in the US yield curve has attracted a lot of attention in recent days, even though the specific drivers of the move remain unclear. Over the past decade, better growth, especially during a recovery phase of an economic cycle has translated into a steeper yield curve, but this certainly does not spell good news for equity markets either, as the chart below clearly shows an inverse correlation between the two. This relationship appears to have broken down during the phase of the crisis but it is premature to suggest the status quo can be maintained indefinitely. The rebound in the S&P has largely been liquidity driven rather than growth-driven, and once markets will need to revert back to fundamentals, a steep yield curve would hinder advance in equities, especially as it implies steeper
borrowing costs across the board. Add on the fact that the US Treasury is expected to drastically  increase the amount of supply due to stimulus efforts, and anecdotal evidence pointing to reserve manager purchases reverting towards maturities, steepening pressure will unlikely subside anytime soon.

3. Remember, policy is about liquidity, not rates

When the FOMC sets policy, fundamental economic developments will still determine where policy is headed, but at this stage, policy is balance sheet policy rather than the Fed's target rate. As the chart below shows, trends in the Fed's balance sheet are playing a role in where markets are headed to globally, and going back one step, the US' growth patterns up ahead will determine in which direction the Fed's liquidity policy will evolve. At this stage the risks are balanced. The size of the Treasury purchase programme does not look like being revisited anytime soon, and the Fed's MBS purchases will be somewhat offset by existing programmes expiring, though nominally the balance sheet is still expected to expand. If data over the next few months improves to the extent that the Fed will confirm its balance sheet growth will cease, current correlations suggest markets will also stop rallying, despite data coming through as positive. One could even argue that risk markets' gains have already fully priced in economic growth under Fed stimulus. As such, Q3 and Q4 growth figures will have a significant bearing on where policy globally is heading next year, especially as most central banks will not move ahead of the Fed. If the recovery is sufficient enough for liquidity growth to stop, risk appetite may well correct rather than improve.

So, we got a nice bounce to the 38.2% fib line - it’s possible that we push to the 50% but I’m seeing some divergences on the Lite. However, it is a POMO day and maybe they manage to bang the tape higher before the bell. BTW, the auction today yielded only a lousy $1.93 Billion - that’s chump change compared with the average amount they used to accept (i.e. $6 Billion - $7 Billion):

So, I’m getting very tempted here to plunk some cash into long term puts - this is why:

My count right now has us in a lower degree fourth wave. If this is X instead (i.e. Soylent Blue), then we know fairly quickly and while Mr. VIX is relatively low still. Technically I however see us retest the current highs in Minute {ii} of Minor 1 of Intermediate (1) of {3}. Boy - a lot of first waves in there, do we have a looong way to go - LOL But if you are conservative this might be your preferred opportunity to get exposed to the dark side.

So, it’s a matter of choice - if we bust higher here before the bell then I’d be happy to start backing up the truck. And if I’m wrong we should know in a fairly short order - meaning we run higher and breach into into Minuette (1) at 1074.31. BTW, the ole’ buck is hanging on to 75.87 thus far and it looks like it might be holding we might see 75.8 or lower. No guarantees guys - I can’t really tell you where/when we turn (if we do) - perhaps it’s best to place your bets around the bell.

3:33pm EDT: The NYSE A/D ratio peaked at 4.7 and is currently at 4.35 - a bit too strong for my taste - but let’s see where we close. The last time we got a snap back after a drop along with a strong reading was on 9/28. We then popped a little higher the next day along with a much lower (and divergent) reading, and then made new lows. So we might see a little follow up tomorrow morning and then a drop - OR - we are in blue and bust higher.

If you missed last nights special Bloomberg event, the full podcast is available at their site or on ITMS.

The global financial crisis hasn’t ended, said Harvard University professors Kenneth Rogoff and Niall Ferguson, who challenged assertions made by Group of 20 leaders at their meeting in Pittsburgh last month.

“The G-20 is right that it’s over for all the banks they guaranteed,” Rogoff, 56, a former chief economist at the International Monetary Fund, said yesterday in an interview with Bloomberg Radio. Even so, as a consequence of bailouts and stimulus measures, “the financial crisis may eventually morph into a government-debt crisis.”

G-20 leaders last month adopted a framework for more durable economic growth as they sought to prevent a replay of the worst crisis since the Great Depression.

>

See also:
Rogoff, Ferguson Say Global Financial Crisis Is Not Yet Over
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aGbRse3KUmgU

The better than expected Q3 Real GDP report has raised the debate over whether the American Recovery and Reinvestment Act of 2009, aka the stimulus package, was a positive catalyst in helping. I will not get into the political discussion and will only specifically discuss the tax cut that was given to individuals that qualified under certain income levels and put this into perspective with the evils of inflation and the damage it can do to lower income earners specifically. In the stimulus package, a payroll tax credit of $400 per worker and $800 per couple in 2009 and 2010 with income thresholds of $75k for individuals and $150k for joint filers was given. This equates to an $8 tax cut per week per person. According to AAA, the average gallon of gasoline yesterday hit its highest level in a year at $2.69 up $1.06 from Jan 1. That equates to an extra cost of about $12.50 per person per week on average.

Hmmmm....

Despite that fact, delinquencies have moved steadily higher with the 30 day + delinquency now reaching close to 50% of all outstanding Option Arms.

"I told you so!"

These loans were never designed to lead to actual home ownership.

They were sold as a means to "buy" a home, but the lenders knew full well that this could never, ever happen given the structure of the note.

These notes were more akin to a levered bet placed on commercial real estate, in that they were worse than the typical commercial "interest-only" loan in their inclusion of a requirement that values continually increase to stay ahead of the negative amortization.

These loans cannot be cured. 

The typical OptionARM customer was qualified on the initial rate on the minimum payment, which was usually 2%, interest-only.

For a typical $500,000 California or Florida home, this resulted in a monthly payment requirement of roughly $850 (2% of $500,000 is $833 a month.)

The "real rate", however, on the loan was typically around 6 or 7%, and the rest of the principal and interest was "capitalized".  If the amortizing rate was 6% on the note then the P&I for a "full payment" would be $2,982.83, resulting in about $2,100 a month in negative amortization.

If you try to "work these out" and manage to go "to the wall" on the note with a 40 year, 4% amortizing refinance, the note still comes up to $2,082.75 - more than a clean double of the original payment!

The "homeowner", however, can't afford the doubling of the payment.  Further, the house isn't worth $500,000 any more - at best it is worth $300,000, which is a big part of why he stopped paying.

These notes were the worst sort of abuse and they're littering the landscape.  I know people who have them here in Florida and have defaulted, and there are a scad load of them in California.  My prediction originally was that half or more of them would wind up being worth recovery value at best, and this appears to be the case.  Since these were nearly all written in the bubble areas, recovery will be fortunate to be 50% of face value.

How many of these are out there?  Good question.  I have seen numbers from $200 - $500 billion, all from reputable sources.  Why don't we have an accurate number from the banks and Fed on these things?

In the "best case" this is another $50 billion in losses and about 25% of the homes purchased in bubble areas from 2003-2006.  In the "worst case" this is well over another $100 billion in losses and perhaps as much as half of the homes purchased in those areas during the bubble years.

Either way you slice these losses have not been recognized or accounted for nor has their impact on home inventory and price.

Not much commentary needed here. Algorithms have succeeded in creaing another bear trap, as a function of a low-volume short squeeze, as all those who sold yesterday, remain out.

Airtime: Thurs. Oct. 29 2009 | 8:56 AM ET

Getting the trader’s edge from the NYSE floor, with Art Cashin, UBS Financial Services.