Another closing

By Bob Eisenbeis

REPOST WITH CORRECTIONS

As the Year Winds Down
December 23, 2011, Bob Eisenbeis, Managing Director, Chief Monetary Economist

As the year winds down, it is customary to take a look at the year ahead.  Unfortunately, the next one doesn’t necessarily look much different from this one when it comes to some of the key risks.  Europe is a mess and continues to be unwilling to face up to the fact that monetizing debt inf the form of providing short-term liquidity, won’t solve the structural design flaws in either its fiscal arrangements or the European system of central banks.  We in the US are not any better at managing our fiscal affairs, and the most recent replay of the threatened closure of the government demonstrates that politicians in DC show no signs of changing their dysfunctional behavior.

Parts of the rest of the world also continue in turmoil, and this too is likely to increase next year.  The Arab spring morphed into summer, then fall, now winter, and likely a new spring, to possibly be joined by unrest in Russia.  Worse yet is the change in leadership in North Korea, where things could get very nasty.  The established military and political leaders will likely make short work of Kim Jung Un.  He may feel it necessary to resort to purges to eliminate rivals and saber rattling to keep the outside world at bay.  How the Chinese react will be key.  As an economist, it is risky to stray too far afield, so suffice it to say that uncertainty and volatility will likely plague world markets for the coming year.

As for the US economy, there may actually be some signs of hope, notwithstanding our budget problems.  The US real economy has continued to grow, albeit slower than we might wish.  We have now had positive real GDP growth for all nine quarters since the NBER Economic Cycle Dating Committee declared an end to the recession.  Inflation remains subdued for the time being, and has actually abated a bit the last couple of months.  Consumer confidence, as measured by both the Michigan and Conference Board surveys, and business confidence seem to have stopped their declines and may even be picking up a bit.  The interesting area to keep a watch on, however, is the US labor market.

Recent attention has been paid to the fact that some states may be actually turning around, but at first glance they appear to be states like Utah and South Dakota, which are not the major movers in terms of GDP share but, like other key states, can serve as important bellwethers of real improvement. The US unemployment rate surprisingly dropped to 8.6% in November of this year.  Nevertheless, over 13 million people are officially unemployed.  This number gets even more serious when one considers that another 2.6 million workers are marginally attached to the labor force, and some 8.5 million people are employed part-time for economic reasons.  In total, we have over 24 million people who are either unemployed or underemployed.  Finally, since the start of the recession, the economy has officially lost about 6.3 million jobs, many of which will not return.

But there is some good news.  Unemployment has been dropping.  In November a total of 43 states showed a reduction in unemployment from the previous month, although part of this was due to a decline in the size of the labor force.

The task ahead when it comes to job growth is daunting. We have estimated that it will take 3.5 to 4 years for the economy to replace those 6.3 million jobs, if it grows at about 3 percent.  This does not consider the fact that we need to create about 150K jobs per month per year just to absorb new entrants into the job market. Where will these jobs be created?

It seems reasonable to conclude that we won’t see significant growth until those states that account for the bulk of US GDP show signs of meaningful improvement. It is nice to point out that the unemployment rate in South Dakota is only 4.3%, but that state is not going to be a job engine for the US, since it only accounts for less than one quarter of one percent of US GDP. What matters is looking “where the beef is.”  There are 14 states that account for about 66% of US GDP. The attached table shows who they are and the percentages of GDP, as of yearend 2010, they produced.

What are the employment and job creation situations in these key states?  First of all, California, which accounts for nearly 14% of US GDP, is a laggard.  Its unemployment rate remains second highest in the nation at 11.3, exceeded only by that of Nevada at 13%.  California hasn’t shown much improvement this year from its peak unemployment of 12.5% in the fourth quarter of last year.  California has also been by far the biggest job loser since the start of the crisis.  California job losses peaked at slightly over one and a half million, and the deficit still stands at about 940 thousand.  This accounts for 15% of the total current cumulative job loss for the nation as a whole since the start of the recession, down from the 17.5% at its peak.  Second, all the rest of the states in the top 14 GDP list have done comparatively well, in that 12 of the 14 experienced a decline in unemployment last month.  Only New York actually experienced a one-tenth of a percentage point increase, which probably isn’t statistically significant.

While it is true that the employment situation is improving, performance is still mixed in the states that count the most.  Interestingly, half of the 14 economically significant states have unemployment rates that have trended above the national average, and these seven states account for 27% of US GDP.  The other half, accounting for 39% of GDP, have consistently done better, led by Virginia.  The attached chart shows the unemployment paths for the 14 key states.  The good news is that those that rank above the national average have shown great improvement in their employment situations.  If they continue to do so, then we may be presently surprised by both the jobs numbers and GDP growth in 2012.

content/commentary/Bob122311.gif

There are several important conclusions from this brief analysis.  First, the employment situation is improving where it matters most.  Second, from an investor prospective, it may pay to watch the performance of the improving states for signs of further growth and fiscal improvement.  Some of the investment underperformers may also show signs of life.  Third, any deterioration in the employment or GDP performance of those states that have outperformed the nation should serve as a warning sign.  All in all, there are encouraging signs that suggest we may have turned the corner and 2012 may be a better year than even the forecasters are suggesting.

Bob Eisenbeis, Managing Director, Chief Monetary Economist

As the Year Winds Down
December 23, 2011

Bob Eisenbeis is Cumberland’s Chief Monetary Economist. Prior to joining Cumberland Advisors he was the Executive Vice President and Director of Research at the Federal Reserve Bank of Atlanta. Bob is presently a member of the U.S. Shadow Financial Regulatory Committee and the Financial Economist Roundtable. His bio is found at www.cumber.com.  He may be reached at Bob.Eisenbeis@cumber.com.

As the year winds down, it is customary to take a look at the year ahead.  Unfortunately, the next one doesn’t necessarily look much different from this one when it comes to some of the key risks.  Europe is a mess and continues to be unwilling to face up to the fact that monetizing debt in the form of providing short-term liquidity, won’t solve the structural design flaws in either its fiscal arrangements or the European system of central banks.  We in the US are not any better at managing our fiscal affairs, and the most recent replay of the threatened closure of the government demonstrates that politicians in DC show no signs of changing their dysfunctional behavior.

Parts of the rest of the world also continue in turmoil, and this too is likely to increase next year.  The Arab spring morphed into summer, then fall, now winter, and likely a new spring, to possibly be joined by unrest in Russia.  Worse yet is the change in leadership in North Korea, where things could get very nasty.  The established military and political leaders will likely make short work of Kim Jung Un.  He may feel it necessary to resort to purges to eliminate rivals and saber rattling to keep the outside world at bay.  How the Chinese react will be key.  As an economist, it is risky to stray too far afield, so suffice it to say that uncertainty and volatility will likely plague world markets for the coming year.

As for the US economy, there may actually be some signs of hope, notwithstanding our budget problems.  The US real economy has continued to grow, albeit slower than we might wish.  We have now had positive real GDP growth for all nine quarters since the NBER Economic Cycle Dating Committee declared an end to the recession.  Inflation remains subdued for the time being, and has actually abated a bit the last couple of months.  Consumer confidence, as measured by both the Michigan and Conference Board surveys, and business confidence seem to have stopped their declines and may even be picking up a bit.  The interesting area to keep a watch on, however, is the US labor market.

Recent attention has been paid to the fact that some states may be actually turning around, but at first glance they appear to be states like Utah and South Dakota, which are not the major movers in terms of GDP share but, like other key states, can serve as important bellwethers of real improvement. The US unemployment rate surprisingly dropped to 8.6% in November of this year.  Nevertheless, over 13 million people are officially unemployed.  This number gets even more serious when one considers that another 2.6 million workers are marginally attached to the labor force, and some 8.5 million people are employed part-time for economic reasons.  In total, we have over 24 million people who are either unemployed or underemployed.  Finally, since the start of the recession, the economy has officially lost about 6.3 million jobs, many of which will not return.

But there is some good news.  Unemployment has been dropping.  In November a total of 43 states showed a reduction in unemployment from the previous month, although part of this was due to a decline in the size of the labor force.

The task ahead when it comes to job growth is daunting.  We have estimated that it will take 3.5 to 4 years for the economy to replace those 6.3 million jobs, if it grows at about 3 percent.  This does not consider the fact that we need to create about 150K jobs per year just to absorb new entrants into the job market. Where will these jobs be created?

It seems reasonable to conclude that we won’t see significant growth until those states that account for the bulk of US GDP show signs of meaningful improvement. It is nice to point out that the unemployment rate in South Dakota is only 4.3%, but that state is not going to be a job engine for the US, since it only accounts for less than one quarter of one percent of US GDP.  What matters is looking “where the beef is.”  There are 14 states that account for about 66% of US GDP. The attached table shows who they are and the percentages of GDP, as of yearend 2010, they produced.

What are the employment and job creation situations in these key states?  First of all, California, which accounts for nearly 14% of US GDP, is a laggard.  Its unemployment rate remains second highest in the nation at 11.3, exceeded only by that of Nevada at 13%.  California hasn’t shown much improvement this year from its peak unemployment of 12.5% in the fourth quarter of last year.  California has also been by far the biggest job loser since the start of the crisis.  California job losses peaked at slightly over one and a half million, and the deficit still stands at about 940 thousand.  This accounts for 15% of the total current cumulative job loss for the nation as a whole since the start of the recession, down from the 17.5% at its peak.  Second, all the rest of the states in the top 14 GDP list have done comparatively well, in that 12 of the 14 experienced a decline in unemployment last month.  Only New York actually experienced a one-tenth of a percentage point increase, which probably isn’t statistically significant.

While it is true that the employment situation is improving, performance is still mixed in the states that count the most.  Interestingly, half of the 14 economically significant states have unemployment rates that have trended above the national average, and these seven states account for 27% of US GDP.  The other half, accounting for 39% of GDP, have consistently done better, led by Virginia.  The attached chart shows the unemployment paths for the 14 key states.  The good news is that those that rank above the national average have shown great improvement in their employment situations.  If they continue to do so, then we may be presently surprised by both the jobs numbers and GDP growth in 2012.

There are several important conclusions from this brief analysis.  First, the employment situation is improving where it matters most.  Second, from an investor prospective, it may pay to watch the performance of the improving states for signs of further growth and fiscal improvement.  Some of the investment underperformers may also show signs of life.  Third, any deterioration in the employment or GDP performance of those states that have outperformed the nation should serve as a warning sign.  All in all, there are encouraging signs that suggest we may have turned the corner and 2012 may be a better year than even the forecasters are suggesting.

Bob Eisenbeis, Chief Monetary Economist

Resources:
To sign-up for Market Commentaries from Cumberland Advisors: http://www.cumber.com/signup.aspx
For Cumberland Advisors Investment Portfolio Styles: http://www.cumber.com/styles.aspx?file=styles_index.asp
For personal correspondence: bob.eisenbeis@cumber.com

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CLOSING THE YEAR WITH…

HAPPY HOLIDAYS TO ALL READERS

& MY FRIEND DAVID KOTOK WHO SHARES HIS WORKS WITH US

Christian Noyer
December 21, 2011

This week, financial market observers witnessed Christian Noyer, France’s central bank governor, clearly and firmly discuss some issues involving rating agencies.  He defended the AAA rating of his country.  And he described the economics of the United Kingdom as a comparison.  Why did he do this?

 

A central banker does not often specifically comment in the manner of the remarks we saw from Christian Noyer.  In this case, they seem warranted.  They were precise and supported by statistics.  Essentially, Noyer said that if you are thinking about downgrading the creditworthiness of France, you must also analyze the economics that drive the ratings for others like the UK.  He offered economic comparisons that measure  the creditworthiness of the UK in a poorer light than that of France.

 

What Noyer did not say, but what market observers clearly saw, was that the frustration demonstrated in these comments had its origin in the actions of the UK.  They effectively worked to undermine the position of the UK within the European Union.  And they make EU financial-market repairs more difficult.  For those who did not follow the events, of the 27 members of the European Union, 26 of them agreed or indicated commitment to the development and preservation of the European Union.  The UK, under the leadership of Prime Minister David Cameron, cast the only negative vote.

 

It seems clear that Prime Minister Cameron is motivated by the political lobbying force of the financial sector in the UK.  Known as “the City,” the financial sector in Britain is the home turf of many of the wealthiest people in the country.  It has a very high per-capita income.  What Cameron does not say is that the rest of the British population lives at a standard somewhat lower than Italy, yet higher than Greece.  In other words, the UK is divided between the wealthy financial/economic types in or associated with the City, and all the rest.  Clearly, Cameron’s politics and his decision to take the UK out of participation in EU decisions will weaken its status with respect to the European Union.  The EU is dealing with the financial repairs that must take place in Europe.  Cameron has hurt his country’s ability to influence that process.  He succumbed to political pressures and lobbying of the same type that we see in the United States.

 

Let’s take this even farther.  Within a couple of days, Cameron, was soundly criticized in editorials and commentaries.  Then he faced a second embarrassing moment.  The revelations of MF Global in terms of hypothecation and re-hypothecation in London have become widely known.  For contrast note that  Canada was not exposed to MF Global losses thanks to its regulations and rule making.  The US also has tighter rules than the City.  In fact, the City is now tainted with very serious questions concerning its capacity to regulate, to maintain safety of securities, and to supervise financial agents.  All of this comes on the heels of Cameron’s politically-driven strategic gaffe and negative vote, and haunts the Prime Minister.

 

Readers may not know that the European Union is busily working on another approach to sovereign debt ratings.  For good reason, agents in the EU and around the world find the behavior of the rating agencies to be a puzzle.  One agency downgraded the creditworthiness of the United States, a bizarre rating that is still not completely understood.  Other rating agencies took different approaches.

 

If you read Norbert Gaillard’s book, A Century of Sovereign Ratings, you can see how he outlines the very recent history of rating agencies dealing with sovereign debt.  The conclusion is simply that they do not have much experience doing it, they have not done it for a very long period of time, and they very rarely get it right.  So, relying on the rating agencies to assess the capability of sovereigns to pay, and to evaluate their governance, is a problematic exercise before they even begin.  The rating agencies have failed investors and institutional players for several years.  Their credibility is terribly damaged, and their behaviors of threatening ratings changes and issuing warnings dealing with sovereign debt have called into serious question their capabilities in this area.

 

Let’s get back to Christian Noyer.  He has watched the evolution of the euro from the beginning.  He was involved on behalf of his country in the early stages, before the euro was launched.  He then joined the first European Central Bank president, Wim Duisenberg, in the leadership of the launch of the euro.  Noyer was the ECB vice-president during its first five years.  He was intimately and actively involved in its creation.  His motivation was to make it a success, to bring about convergence, to bring about integration in Europe.  He wanted to blunt the forces of European history that have shown themselves to surface when Europe is under economic stress.  In Europe this has often ended in bloodshed.  The Nazi occupation of France happened after the rise of Hitler and the collapse of the Weimar regime.  Noyer is a student of his history.  He knows that a thousand years of history says Europe is a very dangerous place when it is not involved in peaceful integration of finance and commercial activity. 

 

Now, Noyer is in the throes of a tremendous test of the durability of the European Union.  This is a fight for preservation of the concept of cooperation rather than confrontation.  Christian Noyer functions in his capacity as the governor of the central bank of the second largest country in the euro zone.  And he confronts rating agencies that are not credible but that can cause damage.  And he sees behavior from the UK that defies logic and explanation.

 

Noyer therefore speaks out and forthrightly confronts the economics that drive the decisions of rating agencies.  He is right, and he deserves to be applauded for it.

 

A personal disclosure is in order at the end of this commentary.  During the past decade, I have chaired the central banking series of the Global Interdependence Center, www.interdependence.org.  In that capacity, I have personally come to know a number of central bankers throughout the world.  One of them is Christian Noyer.  We have broken bread together.  We have attempted to advance the dialogue that originates from seeking the goals of increased transparency, rather than opacity, and more integrity in our financial and economic world.  Christian Noyer is a recipient of the GIC’s Global Citizen Award; and he has been a participant, speaker, and supporter of GIC events throughout the world.  He is my personal friend.

 

He did the right thing.  But I am biased by friendship some critics may say..  He said what was necessary.  But my opinion is biased some would argue.  He articulated clarity about the division that is occurring in Europe.  He’s right.  He stated his pro-Europe, pro-rapprochement (cooperation), strategic view of policy.  He is right again.  He chastised rating agencies.  Right again.  Dear reader, when it comes to this issue, I am not a fence sitter.  A divisive breakup of this marvelous European experiment would be a disaster.  It must be avoided.  Noyer is right.

 

David R. Kotok, Chairman and Chief Investment Officer

 

Resources:
To sign-up for Market Commentaries from Cumberland Advisors: http://www.cumber.com/signup.aspx
For Cumberland Advisors Investment Portfolio Styles: http://www.cumber.com/styles.aspx?file=styles_index.asp
For personal correspondence: david.kotok@cumber.com

Looking Back

 

From my friend David Kotok:

 

Meredith Redux – One Year Later
December 19, 2011

 

 

John Mousseau is a portfolio manager and heads the tax-free Muni section of Cumberland.  He is a member of the Management Committee of Cumberland Advisors.  His bio is found at www.cumber.com.  His email is John.Mousseau@cumber.com.

 

 

December 19th marks one year since Meredith Whitney appeared on the CBS newsmagazine 60 Minutes and sent the municipal bond market into a tailspin from which it took months to recover.  To recap that event:  Ms. Whitney, a noted bank analyst, appeared on 60 Minutes and forecast “hundreds of billions” in municipal defaults during 2011.  The result was a two- to three-month siege on the municipal bond market, which was already in the throes of a supply bulge because the Build America Bonds (BABs) program had expired.

 

As we have written previously, the first few post-Whitney months were marked by huge redemptions in municipal bond funds.

 

 

 

One can see that the redemptions approached hemorrhage levels in the early part of 2011.  They got LESS negative as the spring wore on, and finally began to turn positive during the fall.  It is important to note that while the mostly retail-oriented municipal bond funds were having crushing outflows, sending longer-maturity yields skyrocketing, the demand for the TAXABLE versions of the same credits (BABs) was sending BABs yields lower, as pension funds, foreign buyers, and charitable foundations scooped up the generous yields afforded by year-end 2010 BABs issuance.  This was one of the clear signs that the Whitney-led meltdown was one related to liquidity and not to overall credit concern.

 

 

 

MMA

 

2

5

10

30

12/18/2010

0.77

1.66

3.18

4.88

01/15/2011

0.89

1.92

3.49

5.28

12/14/2011

0.48

1.19

2.37

4.33

 

 

One can see from the chart that the skyrocketing of intermediate and LONGER term yields that occurred due to the 60 Minutes broadcast continued unabated through mid-January.  This, of course, correlated with the massive amount of bond fund liquidations. And then began the long trip down in longer yields that has continued until now.

 

What were the keys to the turnaround?

 

Credit

 

State governments recently finished the seventh consecutive quarter of rising tax receipts.  This followed five straight quarters of declines from the fall of 2008 through the end of 2009.  To be sure, many states and cities are still struggling to rein in rising pension costs, as well as dealing with the loss of federal dollars.  But many states have made deep cuts in expenses and, in most cases, budget gaps have been closed without reliance on one-time solutions.  The market dealt with the bankruptcies of Harrisburg, PA and Jefferson County, AL without seeing a backup in overall tax-free yields.  It treated these bankruptcies as “one-off events, caused by specific problems of municipal malfeasance, and not as being indicative of overall municipal health.  As we have also written, overall financial health is better at the state level than at the local level – but all levels of government have been learning how to do more with less.

 

Supply

 

The sharp decline in long-term interest rates has spurred on issuers in recent months.  However, even with robust issuance at year end, 2011 is poised to finish with under $300 billion in total municipal bond issuance, a far cry from the $433 billion of issuance in 2010.  There is clearly a greater air of austerity at many different levels of municipal government, from the state level down to towns.  Certainly, in many cases, additional bond debt is being voted down by electorates.  In addition, many issuers decided to forego issuing bonds at the very high interest-rate levels that Meredith-mania caused in the early part of this year.  And, once the Build America Bonds program expired at the end of 2010, many officials decided to forego projects that might have been financed with the federally subsidized BABs.

 

Demand

 

Again, the municipal bond mutual fund flows tell a lot of the story. Much of the bond fund selling was replaced with INDIVIDUAL bond purchases earlier in the year.  But now bond fund flow has turned positive and should show overall positive flows for calendar year 2011.  Volatility in the equity markets has caused money to be pulled from stock funds and, presumably, some of this has found its way into the municipal bond market.  In addition, the prospect of higher taxes has also pushed investors toward tax-free municipals.  Although the rise in federal marginal tax rates now looks like it might be on hold until AFTER the 2012 election, northeastern states like New York, New Jersey, and Connecticut have seen a hike in marginal income taxes, thus raising demand for tax-exempt income.  We expect more states to raise income taxes at the margin in 2012 – and, no doubt, to aim the increases at higher-income individuals.

 

 

January 15, 2011

2

5

10

30

MMA

0.89

1.92

3.49

5.28

US TREASURY

0.58

1.94

3.42

4.52

RATIO

1.53

0.99

1.02

1.17

December 16, 2011

2

5

10

30

MMA

0.46

1.14

2.33

4.30

US TREASURY

0.27

0.87

2.02

2.94

RATIO

1.72

1.31

1.15

1.46

 

 

So as we head into the last two weeks of 2011, we can look at how tax-exempt yields stack up against US Treasuries on a relative basis now and in the middle of the Meredith meltdown last January.  There is no question that munis are cheaper, on a relative basis, across the whole yield curve, particularly on the front end.  But it is extremely important to note that municipal yields have moved in the same direction (down) as Treasuries – just not as much. The Congressional squabble over the debt ceiling, the downgrade of the United States by Standard & Poor’s, and the Federal Reserve announcement of its “Operation Twist “ in September all led to drops in Treasury yields, and munis – begrudgingly, in some cases – followed along.  The muni market fought those events off, along with the Harrisburg and Jefferson County situations, and made the long trip back from the despair of a year ago.  And for that we are thankful.

 

Happy Holidays!

 

 

John Mousseau, CFA, Managing Director and Portfolio Manager

 

Resources:
To sign-up for Market Commentaries from Cumberland Advisors: http://www.cumber.com/signup.aspx
For Cumberland Advisors Investment Portfolio Styles: http://www.cumber.com/styles.aspx?file=styles_index.asp
For personal correspondence: john.mousseau@cumber.com

Pictures on Contagion

A pictorial presentation from David Kotok

G4 Central Balance Sheets /European Contagion
December 17, 2011

“A picture is worth one thousand words.”  We present 13 pictures to describe the title subject, on our website, www.cumber.com.

 

Scroll to the two chart stacks.  In the first, we reflect changes in the balance sheets of the G4 central banks.  The G4 central banks are the Bank of England (BOE), the Bank of Japan (BOJ), the Federal Reserve (FED), and the European Central Bank (ECB).  Other central banks are important; however, the G4 comprises the four central banks managing the currency blocks of nearly 85% of the capital markets that trade in the world.  Other large capital markets are linked to one of them.  Therefore, China’s central bank is not shown, because China manages its currency exchange rate via a peg to the others.

 

If you capture the G4 transactional changes, you get most of the financial impacts of the world.  Paging though the G4, one sees the following information leap from the charts.  The central bank balance sheets of the BOE, BOJ, and ECB have all recently increased in size.  That of the FED has not.  In fact, the FED’s balance sheet is actually slightly smaller than it was a few weeks ago.

 

Why is two weeks so important?  Two weeks have elapsed since the central banks announced a coordinated activity on November 30th.  Notice how those balance sheets have expanded; note also where they have expanded.  We have color-coded the various compositions of both assets and liabilities of each balance sheet.  The recent growth in total assets of the four central banks is clear.

 

The one central bank balance sheet that did not grow is that of the United States’ central bank, the Federal Reserve.  Notice what happened in the last few weeks when the others expanded and the FED did not.  The US dollar actually started to strengthen against other currencies, particularly the euro.  As we have been writing and stating for some time, there is a relationship between the foreign exchange markets and changes in the exchange rates among and between the currencies, and the actions of the central banks involved with those currencies.  We see the reaction in the foreign exchange market almost at once.  A central bank takes an action, makes a statement, initiates a policy – whatever the case may be – and the foreign exchange markets readjust the ratios among and between the currencies.  That is apparent in the past two weeks, and it is apparent in an examination of those four central bank balance sheets.

 

Cumberland has stacked the four central bank balance sheets so they can be flipped easily by any interested party.  We will update them regularly.  The other stack of charts shows the “good” countries and the “bad” countries in the Eurozone.  And it shows the spreads of interest rates between the good countries and the benchmark German 10-year sovereign debt instrument, known as the “bund”, and the spreads between the bad countries and the bund.  Notice how the spreads peaked in almost every case a few days prior to the November 30th announcement of the change in central bank policies.  We speculate that someone somewhere got wind the policy change was coming and may have made themselves a lot of money on that trade.

 

We have pointed out the peaks in interest rates and in spreads with a question mark, since we do not know if these will be ultimate peaks, interim peaks, or if this is just more market volatility.  Clearly, the central bank actions during the past two weeks have caused interest rates to peak and fall, both among both good and bad players in the Eurozone.  Concomitantly, spreads too have narrowed among the good and the bad players.

 

Cumberland will continuously update this series as new information is obtainable.  We are experiencing an increase in visitors to our website obtaining and reviewing this information, and we are more than happy to share this with all interested readers.  You are permitted to use this information and the charts.  Please do so with full attribution to our firm.

 

One conclusion is becoming evident.  The central banks of the world are continuing to coordinate their efforts to meet liquidity requirements under nearly every circumstance.  They have determined that they must keep the functioning of the world’s financial system unimpaired.  To do that, liquidity has to increase, and the manner in which they accomplish this is to expand their balance sheets.  A Lehman-type liquidity constraint will not be permitted to occur again if the central banks can avoid it.

 

In addition, on detailed examination of the balance sheets, you can see how the actions of the central bank on the asset side are balanced by rising reserve deposits on the liability side.  In other words, a central bank goes into the market, buys a debt instrument or otherwise acquires an asset, pays for it or lends to a bank, and the bank then pledges it – in any case, the central bank creates a reserve or cash that within hours is redeposited at the central bank as an excess reserve deposit.  There is no credit multiplier in the monetary system when the newly created central bank money is circulated right back to the central bank.

 

Essentially, the commercial banks within each currency zone have excess reserves.  They have excess liquidity, and they are electing to redeposit those reserves back with the safety of the central bank rather than do something else.  That behavior reflects the uncertainty that exists throughout the financial system.  For example, in the United States, a commercial bank can deposit excess reserves with the Federal Reserve System and receive an annualized interest rate of 0.25% or 25 basis points.  The commercial bank could do other things as well.  In the United States, we see a very large sum reflected in the liabilities side of our chart stack, in a darker green color that shows the huge excess reserve deposit at the Federal Reserve.  Banks in the US are not engaged in the expansion of credit.  They are redepositing their excess reserves at 25 basis points.  The same thing is happening in most of the world.  That is now apparent and easy to see in the color coding of the G4 central bank liability side of the balance sheets.

 

Liquidity, liquidity, liquidity.  That is the theme by which the central banks are operating today.

 

Liquidity and solvency are two different issues.  They should not be confused with one another.  Greece remains insolvent as a sovereign country.  In Europe and in the rest of the world, however, the insolvency is not being allowed to impart a liquidity crunch.  The recent use of swaps and other vehicles to enhance liquidity continues to be expanded by the central banks of the world.  Santa Claus is coming, and his name is Bernanke, Draghi, Shirakawa, or King.  Whether or not their noses are red remains to be seen.

 

 

For personal correspondence: david.kotok@cumber.com

More from Kotok in Paris

My great appreciation to my friend David Kotok for his insightful post :

Report from Paris – 3
December 13, 2011

 The rain, fog, and mist have returned to Paris.  Along with them came our deeper probing into eurozone central banking and bank-related issues.  Some of the interconnections among the seventeen national central banks (NCB) within the eurozone remain clouded in mystery.  We summarize our observations with the following bullets:

·  Europeans themselves are questioning the interrelationships of the seventeen national central banks (NCB) that compose the European Central Bank.  In some respects they all function alike, such as in the interchange of payments via their TARGET2 payment-clearing mechanism.  In other respects they operate under different rules, such as the Emergency Liquidity Assistance facilities (ELA) each NCB can have with the commercial banks within its particular country.

·  The European Central Bank (ECB) presents aggregate data in a similar way to the Federal Reserve in the United States.  The ECB has only a minimal balance sheet of its own, so the depiction of its assets and liabilities that we see and use in our macro-monetary and economic examination really consists of the assets and liabilities of the seventeen NCBs.  That is similar to the construction in the United States, in which the Board of Governors of the Federal Reserve has no balance sheet of its own.  The Federal Reserve System essentially has a balance sheet that consists of the allocation of assets and liabilities distributed among the twelve regional Federal Reserve Banks.

·  Within the US and the Federal Reserve, no concern is given to solvency of the twelve regional Federal Reserve Banks.  In the US, we clear payments, issue currency, and deal with central banking functionality daily.  We never give central bank credit risk a second thought.  In the eurozone, the construction was based upon that same concept.  The presumption was that sovereigns would not default, that sovereign debt was absolutely creditworthy, and that the central banks of each country would fully and completely honor all obligations that occurred between and among the seventeen members of the eurozone.

·  That underlying assumption of the eurozone is now flawed because of the lack of creditworthiness of the government of Greece.  Everyone knows Greece is insolvent, and everyone recognizes that Greece must have a haircut on its sovereign debt and must restructure.  Negotiations towards an eventual more sustainable and durable solution involving Greek debt are constant.  The current operative framework is simply a small advance of funds to keep liquidity flowing through the Greek system while the next round of negotiations occurs.  The Greeks have no choice but to participate, and the leadership of Greece understands that they must either comply to advance the restructuring agenda or they will run out of money and default.

·  Greece is bleeding cash.  Its banks are experiencing runs and withdrawals.  Its commercial enterprises, economic activity, and employment characteristics are all deteriorating.  Capital is leaving Greece.

·  Similar activity is underway in other peripheral countries.  One by one, an investor, depositor, commercial enterprise, or individual account – any agent within the economies of Portugal, Italy, or others that senses growing insecurity in the banking and financial system – one by one they move their euro balances to safer venues.  We see withdrawals coming out of Italian banks and being deposited in German and other banks.  There is a movement of finance from the periphery to the core of Europe, since the core is perceived as safer and more creditworthy.

·  The flows of funds that flow from weaker eurozone members to stronger eurozone ones create an imbalance among the seventeen central banks.  The NCBs of the weaker peripheral countries have growing liabilities to the euro system, and the stronger NCBs of countries such as Germany have growing assets.  Those assets and liabilities are all balanced through the ECB, so Germany’s claim on the ECB grows and Greece’s liability to the ECB grows, and that process has not been arrested by the political negotiations to date.

·  Two issues are essential:  the TARGET2 payment system and the issuance of currency occur through the mechanics of adjustment that take place at the ECB.  To understand them is to understand the flows of funds between the NCBs and how they clear through the ECB according to the “capital key.”  The capital key is the structure in which the financial characteristics of the ECB are apportioned among the seventeen member countries.  Germany is the largest at 27%.

·  The ELA activity is a separate function.  It occurs between each NCB and its internal, national commercial banks.  ELA is specific to each nation and not governed by the ECB unless the Governing Council of the ECB overrules an NCB by a two-thirds majority vote.  In the case of Greece, ELA involves collateral that is not qualified for direct pledge to the ECB.  The rules that apply to the ELA in Greece may differ from the rules that apply to the ELA in another country.  The data reporting on ELA is somewhat obscure.  It is difficult to find, it is simply listed by NCB, and the reporting time frame is not precise.  From what we were able to observe in Europe, the NCB emergency ELA lending in Greece now exceeds 40 billion euros.  It appears to be by Greek commercial bank-pledged collateral, which is of lesser credit quality than that acceptable by the ECB.

·  ELA is taking place in other eurozone member venues as well.  The total is estimated above 100 billion euros and steadily growing.  ELA can indicate any number of characteristics.  A key one is that the commercial banks within the country have exhausted the use of ECB-eligible collateral.  Since they can no longer obtain additional funds from the ECB, they must use the NCB’s ELA  facility.

·  The assets of each NCB are still merged into the ECB assets and liabilities, so that if the NCB of Greece lends to a commercial bank and takes collateral below the ECB standard in return, those assets and liabilities of the Greek NCB appear in the aggregate data of the ECB.  One can find the aggregate lumped into categories, which do not reveal the specific characteristics of each of the NCBs.  It takes considerable investigation to sort out these details.

·  The process by which NCBs clear their payments is a simple either/or system.  They either pay or fail.  In the end, it comes down to the creditworthiness of each NCB.  It is theoretically possible for the government of Greece to take a haircut on its outstanding sovereign debt and restructure it, while the Greek NCB continues to pay its obligations within the euro system without default.  The central bank payment exchange mechanism is different from the sovereign debt pledge.  The contingent liability of the ELA is not counted in the nation’s debt aggregate.

·  What the European restructuring is attempting to accomplish is to facilitate a haircut on the sovereign debt of a country like Greece, and create a mechanism by which debt can roll until it can be restructured and market access obtained.  These political changes are expected to occur, while at the same time the eurozone members preserve the payment system within the seventeen eurozone countries.  This is an intricate, difficult task, but it is possible to obtain such an outcome.  European leaders are determined to work toward that end.

·  We attempted to examine the structure of the NCBs and European Central Bank under the most extreme terms.  Suppose a new Greek government were to take office, repudiate all debt, withdraw from the European Union and from the eurozone, launch a new drachma, and for all intents and purposes default on all of its euro-denominated liabilities.  We know the holders of sovereign debt of Greece would suffer 100% loss.  However, what about the internal payment structure of the European Central Bank?  The NCB of Greece would not pay.  Its liabilities to the ECB would remain unpaid; in addition, it has liabilities created through the ELA, directly between the NCB and the commercial banks of Greece.  Those liabilities of the NCB also would not be paid.  Where are the assets?  The assets that are collateralized from the Greek commercial banks are in one category; they are internal to Greece.  However, the liabilities of the NCB run though to the ECB, either directly or indirectly.  They are part of the composition of the ECB balance sheet.  If Greece has 100 billion euros of NCB liability to the euro system, and the Greek government defaults along with the NCB of Greece, those liabilities would be unpaid.  Who would suffer this loss?  As far as we can determine, the loss would end up distributed among the remaining sixteen members of the ECB.  Germany, for example, with 27% of the ECB, would take 27% of the loss.  It would have to make up that portion of the capital deficiency in the ECB.  Could the ECB or its other member countries assert claims against the NCB of Greece or against its government?  Of course; there is international law that deals with some of these issues, but they would take years to resolve.  The uncertainties surrounding such claims and how they would be resolved are clearly unknown.  We admit, too, that this is an extreme case and not likely to happen.  We leave Europe with the puzzle that the answers to these claims and how they are asserted and what is their priority is indeterminate.

Our conversations involved nearly fifty people during our stay in Paris.  They represented observers of Europe with many years of experience and great skill: central bankers, economists, market professionals, money managers.  We found several characteristics that gave us a European view of how this process might unfold.

Europeans understand that the deleveraging taking place worldwide and especially in Europe has a deflationary characteristic.  They recognize that they are going from a system in which debt was expanding faster than income and faster than growth, to a new system in which debt will have to contract or expand more slowly than growth.  This is a transition that is difficult for Europe due to its many promised social obligations.  It is not impossible to manage.  Difficult but not impossible.  European intent is to find a way to bridge from the old paradigm of debt-financed expansion to a new paradigm of debt control, growth, and rising income-financed expansion.

Can the Europeans accomplish this?  That remains to be seen.  I leave Europe with the view that it is possible; but the outcome is still unclear, hence the uncertainty premium is high.  Do Europeans want to do this?  The answer universally seems to be yes.  Continental Europe understands that any option other than a durable European Union and sustainable eurozone will be much more painful than working through the difficulties they currently face.  In the case of Greece, which is the extreme example, withdrawal from the eurozone could condemn Greece to a generation of poverty.  About that there is universal agreement.

Another important take-away from this trip is the response of Europeans to what they see and read in the American media when the eurozone is discussed.  Europeans universally feel they are not understood, that their problems are not correctly identified, and that there is much hyperbole coming from the American media.  Having examined this issue from both sides of the Atlantic, I believe the Europeans are right.  My own experience in gauging television and mass media in public debate over the issues is that Americans do not understand the payment mechanisms in Europe.  They do not take the time to do the research.  Instead they jump to conclusions and make dramatic assertions.  In fact, they do not delve into the details, where the devil dwells – and where the answers may be revealed.

I believe the eurozone will continue to exist and that the European leaders will eventually restructure their debt-determined problems.  They are in a struggle; it will be volatile with uncertain moments, but their determination to succeed is clear.  Europe is on a path to strengthen itself as an outcome of this current test of its monetary experiment.  Continental Europe is headed for a more robust fiscal union, which is what it needs to get to the restructuring of its debt.

We leave Paris to return to the US and face the rest of the difficulties that exist in financial markets worldwide.  The best thing to do now is to leave you with recommendations and comments about some Parisian restaurants:

Aux Anysetiers du Roy, 61, rue Saint-Louis en L’Isle 01-56-24-84-58.  This is a recurring favorite.  Tell Lilliane I sent you. Try her lapin or cassoulet.  Her foie gras is homemade.  Yum.

Dorr, Place de Vosges, 33 bv Beaumarchais, 01-48-87-98-92.  Take the metro to Bastille and walk three blocks. An exciting place for oysters, crab, and shellfish.  They make a good soupe de poisson.

Chez Francis, 7 Place de l’Alma, take #9 metro to Alma, 01-47-20-86-83.  Delicious food and lovely view of the Tower.  Kidneys with a mustard sauce made a marvelous lunch.

Chez Flottes, 2 rue Cambon 01-42-60-80-89.  Always a favorite. Close to Concorde.  They have never missed and are a regular stop for me.

Vent et Marée, restaurant de poissons, 165 rue Saint-Honore, 01-42-86-06-96, v.msainthonore@hotmail.fr.  This restaurant is a new addition to my list.  Near the Louvre and with a somewhat nondescript exterior, it is a real gem for seafood. Their soupe de poisson was extraordinary.  A superb masterpiece, as was the lobster salad and an excellent dame blanche for dessert.

 

Bon Nuit.

 

David R. Kotok, Chairman and Chief Investment Officer

 

For Cumberland Advisors Investment Portfolio Styles: http://www.cumber.com/styles.aspx?file=styles_index.asp

More insights from Paris

From my friend David Kotok

Report from Paris, Part 2
December 12, 2011

During this trip to Paris, an ongoing e-mail chat has been underway with a number of North American colleagues.  Some have asked to remain anonymous, and I will respect their wishes.  The conversation centered on the current crisis and political negotiations in Europe, as seen from a North American perspective.  Primary drivers of the chat were Americans who function as consultants, professionals, and activists in the financial markets.

 

One associate forwarded a quote by Terry Smith, chief executive of Tullett Prebon:  “[the UK] might be as isolated as somebody who refused to join the Titanic just before it sailed.”  This was said in response to the decision of the United Kingdom with regard to the collective bargaining taking place among European Union leaders.  Here is the link to an audio clip of Smith’s discussion: http://news.bbc.co.uk/today/hi/today/newsid_9658000/9658489.stm.

 

Those who follow the news know well that the UK has opted out of an agreement, while the rest of the leadership of the European Union has either concurred (twenty-three countries) or left openings for further discussion (three countries).  Twenty-six of twenty-seven countries have at least acknowledged the importance of the European Union and the eurozone.

 

Smith’s quote implies that the 23 are the countries sailing on the Titanic, destined to sink, and that the UK has made the wiser decision and is still standing on the dock.  Through my e-mail exchanges, I raised this issue.  My respondents quickly explained to me why it is desirable to be standing on the dock and not on a sinking ship.

 

However, discussions with other consultants and those here in Europe who are witnessing the ongoing crisis proposed an interesting question.  Simply stated, the question is: Who is really standing on the dock and who is sailing away on the Titanic?

 

The answer is yet to be determined.  In fact, as was revealed during our discussion, the position taken by David Cameron, Prime Minister of the United Kingdom, and by the political leadership of the UK, is one that the financial district in London, affectionately known as “the City,” was able to influence.  In doing so, it has put Cameron in the position of sponsoring protectionism in its most extreme form.  That may be a short-term response to the political pressures his government faces; but in the long run, has he hurt or helped the UK?

 

More information was revealed at our lunch, which included two expert observers of Europe and European markets who live in Europe and have watched these events unfold.  They noted that if you take the income of London’s financial district out of the equation and look at the rest of the UK, you find that it is at a very low level.  One expert stated, “It’s almost like Greece.”

 

What has happened that prompted the UK to isolate itself from 26 other countries in the European Union?  Was it a political force incorrectly applied by a leadership that faces political difficulties within its own coalition?  Did the UK cast a lot that will eventually weaken the City?  Is it possible that it is the UK that has sailed away on the Titanic and the coalition forming in Europe that is left standing on the dock?

 

European leadership is making every effort to respect history, with which they are very much in tune.  The important thing is to look at what created the European Union and the eurozone in the beginning.  The concept formed after World War II.  It happened because the French and the Germans decided they needed to stop killing each other and that others in Europe needed to do the same.  They replaced confrontation with rapprochement, with cooperation, with an attempt to unify points of view.  The same leadership that evolved in the ’50s and ’60s also knew the profound distrust that citizens in all countries in Europe had for their currencies.  The history of the Weimar Republic and the subsequent rise of Hitler were still fresh in their memories.  So, they launched an attempt that led to the euro.  They created by treaty a structure in which a central bank would be empowered with seigniorage and the maintenance of the value of the currency, and that it would have the same powers as the sovereign member states of the European Union.

 

Giving up a degree of sovereignty in return for a set of rules that were supposed to handle the governance of the central bank is the key aspect of the Maastricht Treaty that launched the euro.

 

There were flaws from inception.  A monetary union is not a fiscal union.  Fiscal authorities have to deal with taxes and spending, and this power was left in the hands of the sovereign member states.  Each of them dealt with it in its own way.  In the beginning, there were rules that were adhered to, and the system worked.

 

Then violations occurred; the leading and most profligate spender, the one that distorted the rules by the largest amounts, was Greece.  It restated financial reports after the fact.  It continued its behavior in violation of the rules, and did so repeatedly.  The crisis started with Greece; but in fact it was the popularity of the concept of bending the rules, and the tacit permission granted by the leadership of the eurozone, that allowed the negative behavior to continue.

 

The eurozone’s financial crisis is an example of moral hazard at work.  Bend the rules once, and they will be bent again.  The second time, they will be bent even further, and the eventual penalty may be even more severe.  It is the classic case of the child with his hand in the cookie jar.  Petulant children have difficulty with moral hazard – especially when the threatened penalty is finally imposed.

 

That is what has happened with some of the countries in peripheral Europe.  The leading example is Greece, which has now become insolvent as a government.  The next candidate is Italy, which is the third largest debtor in the world, and is now attempting to close the cookie jar by force.

 

Now, what lies ahead?  We see a coalition of leadership that does not want the eurozone or the European Union to end in failure.  Those leaders, including Angela Merkel and Nicolas Sarkosy, have agreed to continue the attempt at rapprochement, cooperation, and have agreed to reject confrontation.  They understand that the risk in Europe is exceptionally high and that discussions about dismemberment of Europe and the outcomes from it are intense and reveal ongoing recognition of Europe’s history.  Many commentators believe full dismemberment could lead to some modern version of war.  They also recognize that Mr. Putin and others of his ilk lurk farther east, watching this dismemberment debate and already fomenting difficulties where they are able to do so.

 

Lastly, they look at the behavior of the United States.  While polite and attentive, since Europeans are very good at such diplomacy, they wonder privately about American arrogance.  Think about this in light of the following situation:  The Secretary of the Treasury of the United States comes to Europe to lecture Europeans on what to do about policy and financial-market disarray and about dealing with deficits, currencies, and economic issues.  He brings nothing but words.  He has no political power.  His government, the Obama Administration, is stymied by a divided Congress.  It cannot add funds to the IMF, even if it wanted to.  Geithner traipses around Europe telling people whatever he chooses, making bland commentary about the need to correct imbalances; and then he returns home.  He returns to a country that is running deficits as large as the worst deficits in Europe.  He returns to a country politically divided and rancorous in its inability to solve a problem.  He leaves an impression of American arrogance and failure.  For an American in Paris, this is a troubling observation to make.

 

How will this all play out?  I am reminded of the words of Philadelphia Federal Reserve President Charles Plosser on December 2nd.  He opened the discussion at a special policy forum of the Philadelphia Fed.  The conference title was “Budgets on the Brink: Perspectives on Debt and Monetary Policy.”  In his opening remarks, President Plosser raised questions that need to be discussed publically in the United States as well as in Europe.  The problems are very similar: when you borrow more than you take in, you fuel the growth of a fiscal juggernaut that will eventually catch up with you and then, if you do not correct yourself, can crush you.

 

President Plosser offered the following:  “Given the magnitude of the fiscal shortfalls in many countries, the way in which fiscal discipline is restored will have profound implications for some time to come. Will there be higher taxes on productive investments by the private sector and higher taxes on wage earners – which would discourage both investment and work effort? Or will there be cutbacks on government purchases of goods and services from certain industries, such as aerospace and defense, or cutbacks on entitlements that would affect health care and social insurance? Or will a viable fiscal plan combine various types of tax increases and spending cuts?”  Charles I. Plosser, President and CEO, Federal Reserve Bank of Philadelphia, The Philadelphia Fed Policy Forum: “Budgets on the Brink: Perspectives on Debt and Monetary Policy,” December 2, 2011

 

This is our second report from Paris.  More meetings lie ahead.  We will attempt to examine the details and intricacies involving 17 national central banks and the collective mechanics and transactional arrangements that take place in this entity called the European Central Bank.  We want to question how the emergency lending assistance structure works with central banks.  We have observed that over 40 billion euros in emergency lending has occurred between the Bank of Greece (the central bank of the government of Greece) and Greek commercial banks.  The collateral used to secure that lending from the central bank was pledged by the commercial banks but did not qualify as collateral that could be used directly with the European Central Bank.  In other words, commercial banks used lesser-quality collateral and borrowed from their own central bank, because they did not qualify with the ECB.

 

What happens if Greece defaults?  What is the position of the central bank of Greece with those claims?  How do they fit within the context of the 17 independent national central banks that collectively make up the European Central Bank?  Remember, the ECB is just an umbrella of the 17 national central banks; on its own, it has a very minimal balance sheet.  It is modeled after the US Federal Reserve System, in which the Federal Reserve has no balance sheet; rather, it is the collective balance sheet of the twelve regional Federal Reserve banks.

 

We have many questions to ask about TARGET2, the ECB clearing system; about the issuance of currencies; about the policing of collateral; and about reporting.  It is going to be a fascinating trip.  The rain has stopped in Paris.  It’s cold but clear, and one hopes the same visibility that allows the eyes to feast on the festivities in this glorious city can also reveal with some clarity and transparency the monetary and fiscal affairs of Europe.

 

At a lunch with my friend and fellow GIC board colleague Paul Horne, he recalled the Salomon Smith Barney/Citigroup economists’ report on the UK, done in the late 1990s. At that time, they recognized the importance of the City in the UK economy and noted that without the City the UK would rank, on a per-capita GDP basis, among the poorer of EU countries.

After a quick search, Paul, whose Europe-based research credentials are impeccable, found an interesting report from 2008 on the importance of finance to the UK economy.  See:  http://postrecession.files.wordpress.com/2009/01/whitepaper6.pdf. The author is Rob Killick, CEO of cScape Strategic Internet Services Ltd. Most of his footnoted sources are reliable, i.e., they are the UK Treasury and BoE. See Section 3 for the importance of the financial sector in the UK.  Chart 1.10 is particularly telling in showing the growing importance of finance and business services, relative to GDP.

In addition, check the 2010 rankings of countries by per-capita GDP, using nominal GDP and PPP which, if you take out the 10% of GDP represented by finance, leaves the UK around the level of Italy but well above Greece. See: http://en.wikipedia.org/wiki/Economy_of_the_United_Kingdom.

In my view, Cameron is playing with fire.  Britain may be the Titanic, sailing away and leaving continental Europe at the dock.  In a world of globalism, he chose isolationism and protectionism.  Horne asked, “Given the City’s many advantages, relative to Frankfurt and Paris, would a Tobin tax or increased EU regulation really cause finance to desert London?  Is protecting the City worth isolating the UK from EU decision making?”
We are going to find out.  Cameron may have put the UK on an irreversible course.  Continental Europe must coalesce fiscally to survive and for the euro to endure. Continental Europe has no other choice.  It will happen without the Queen’s picture on the currency.

 

 

David R. Kotok, Chairman and Chief Investment Officer
For Cumberland Advisors Investment Portfolio Styles: http://www.cumber.com/styles.aspx?file=styles_index.asp
For personal correspondence: david.kotok@cumber.com

More insights by David Kotok

In Paris, fear is growing among investors, bankers, and financial professionals.  They recall the history of previous generations, when governments failed.  They worry about an end to the grand “rapprochement” that led six decades of peace. Does the euro crisis portend that era may be drawing to a close?  They watch from afar as another American firm blows up, as another Federal Reserve primary dealer joins the list of failures, alongside Countrywide and Lehman Brothers.

Comments from Paris
December 9, 2011

 

“I simply do not know where the money is.”  Former MF Global CEO Jon Corzine.

 

Current events again support the notion of a three-silo approach to money management.  Cumberland has recommended and supported that concept from inception.

 

MF Global is the latest example of what can happen when you mix custody with advice and transactions.  We witnessed this during the explosion involving Madoff.  We have seen it occur in other, lesser-known firms.  Now we see it writ large in this most recent sad tale.

 

The safety of investing in asset management is greatest when the parties are independent; when all fees and expenses are separately shown; and when the clients, consultants, and professionals can evaluate each party and process independently.

 

This three-silo approach simply means to separate custody: the safe-keeping and accounting of assets, from transactions; the brokerage, exchanges, and intermediary actions by which one transacts and accomplishes the purchase or sale; and the advisor, the consultant, the recommending party, or the analytical professional who offers help to the investor.

 

By separating all three, you diminish the risk of the types of events that we continue to read about in the media as this ongoing financial crisis unfolds.  MF Global is the latest in a saga that has other names attached, such as Lehman Brothers, Madoff, Nadel, and so forth.

 

Since 1973, when my now-deceased founding partner, Shep Goldberg, and I created Cumberland Advisors, we sponsored the notion of a complete division of services.  Cumberland does not take custody of client funds.  Cumberland is not a broker dealer, and does not transact for commission.  We are only a fee-for-service advisor.  We only advise on separate accounts, not comingled funds.

 

It is this latest tragic event that requires a restatement of this basic principle.  The world is such that we now confront a continuum of tragic events on a daily basis.  We cannot depend on the regulators to protect us.  Clearly, they can falter.  We cannot depend on the rating agencies to accomplish valuations that give us comfort that there is soundness and creditworthiness.  Clearly, they have failed.  The nature of the world today is that one has to be self-sufficient and seek safety in the way things get structured.

 

In our view, separating every service, evaluating it independently, and avoiding comingled assets is one of the soundest principles.  It matches diversification of risk as the type of approach that can protect investors in a world that seems to be rife with Lehmans, Madoffs, MF Globals, and others yet to be revealed.

 

In Paris, fear is growing among investors, bankers, and financial professionals.  They recall the history of previous generations, when governments failed.  They worry about an end to the grand “rapprochement” that led six decades of peace. Does the euro crisis portend that era may be drawing to a close?  They watch from afar as another American firm blows up, as another Federal Reserve primary dealer joins the list of failures, alongside Countrywide and Lehman Brothers.


It is raining here.  The holiday lights are dimmed by fog, just as the outlook is dimmed by uncertainty.

 

 

David R. Kotok, Chairman and Chief Investment Officer

 

Resources:
For Cumberland Advisors Investment Portfolio Styles: http://www.cumber.com/styles.aspx?file=styles_index.asp
For personal correspondence: david.kotok@cumber.com