The Current Economic Cycle: U, V, W or Zigzag?

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

Are we coming out of the recession, slowly but surely, and ascending to sustainable economic growth? Martin Feldstein, a senior professor of economics at Harvard, says no: "I think we’re going to see a temporary substantial improvement," Feldstein stated, adding. "I emphasize the words temporary and substantial." Feldstein was formerly head of the National Bureau of Economic Research, a private research group that analyzes economic growth, including the timing of recessions and recoveries. Feldstein predicts that the domestic economy will contract sharply again in 2010. He foresees not a V-shape--into recession and then out--or even a “beautiful, symmetrical W,” but more of a seesaw pattern. Source: Bloomberg Radio; see Feldstein's Remarks.

Feldstein’s “seesaw” metaphor is particularly striking because the consensus calls for a gradual U-shaped recession to recovery cycle. As the consensus of blue chip economists and forecasters is often dead wrong, it is prudent to consider alternatives. One factor that might support Feldstein’s remarks: money supply, as influenced by federal spending.

The fiscal stimulus package so far consists of three parts: immediate, intermediate and long-term. Immediate stimuli included the $400 individual tax credit, which has passed through the system already. The package also included improvements in unemployment benefits. Stimuli of a more intermediate nature included support for state Medicaid plans, a tax credit for first time home buyers, tax incentives for new car purchases and trade-in of “clunkers,” tax incentives for modest income families to weatherize their homes, and temporary extension of COBRA health coverage benefits beyond statutory limits.

Long-term stimuli include: over $100 billion for education and job training; $27.5 billion for highways and bridges; $11 billion to improve the nation’s electricity grid; and $7 billion for broadband development in rural areas. Source: The Stimulus Plan: How to Spend $787 Billion - The New York Times. These projects will take many years to design, approve and build or implement. However laudable some of these purposes are, most of the money may not enter the economy until after the recession has ended, and the spending may fuel future inflationary pressures. Such are the pitfalls of quasi-Keynesian economics as proposed by the Executive Branch and massaged in Congress.

In the meantime, cutbacks in aid to states and cities by the federal government—enacted as part of a political compromise with moderate Republicans—are starting to counteract the federal stimulus.

An unknown factor is the willingness of commercial banks to increase now depressed levels of commercial and consumer lending. Commercial banks and financial institutions so far have used most of their TARP funds to improve their balance sheets rather than to re-circulate the money to borrowers.

Consider also credit creation outside of the commercial bank balance sheets. As economist and independent trader Gary Evans has often reminded me, the overall shrinkage of this “shadow banking system” is severely contractionary. The shadow financial system includes all sorts of institutions and processes that put investors and borrowers together, other than by bank lending. It includes: investment banks; the corporate bond and commercial paper markets; conduits for mortgages and corporate bonds; off balance sheet structured investment vehicles (SIV’s); securitizations of assets [including mortgage-backed passthrough securties (MBS), collateralized debt obligations (CDO's), collateralized loan obligations (CLO's); collateralized mortgage obligations(CMO's); and asset-backed securities (ABS) such as credit cards and utility billings]; monoline insurance companies; over the counter swaps and options; bank loan funds; insurance company funding schemes, including fixed and variable annuities and guaranteed investment contracts; and non-bank finance companies.

Another unknown factor is international trade. We are embedded in an increasingly global economy, and our fortunes are tied to the problems and opportunities of other economies, many of whom are still mired in recession.

Yet another unknown factor is the ability and willingness of the Fed to maintain an unprecedented accommodative stance, with nominal rates for Federal Funds targeted between 0% and ¼%. Four factors that could tilt the Fed toward tightening would be sharp rises in the consumer price index, labor market scarcities, severe weakness in the US dollar or a marked steepening of the yield curve (implying rising long-term inflationary expectations among bond investors).

An implication of Professor Feldstein’s forecast is that the current round of economic stimulus may not be enough to lead to sustained growth. Setbacks would lead to pressure for further fiscal stimulus, lower tax receipts and even greater federal deficit spending. Such conditions could in turn raise the cost of cost of raising capital privately, which would retard corporate recovery.

Shakespeare wrote that the “course of love never did run smooth”, and the same is probably true for the current economic cycle. In this recovery, we may zig and zag more than we zoom.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions: e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

Aftermath of the Madoff Scandal

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

On June 29th, federal Judge Denny Chin sentenced Bernard Madoff to 150 years in prison. The fallen financier pled guilty to an eleven count criminal complaint. He made a contrite statement in court, turning to face spectators who included some of his defrauded investors. However, the US trustee overseeing the bankruptcy proceedings of Madoff’s securities firm reported that Madoff did not provide “meaningful cooperation or assistance.” The judge characterized the Ponzi scheme as “evil”, “staggering” and “off the charts.”

Madoff claimed that his scheme began 19 years ago, but government officials believe it started at least ten years earlier. Judge Chin will probably order Madoff to make restitution of $170 billion, approximately equal to the total amount deposited in his business checking account at Chase Manhattan Bank (of which only a small fraction will be collectible).

How could this scheme have gone on for so long and grown so big? One answer is the modesty of the returns promised. The infamous Charles Ponzi promised 50% return in 45 days or 100% in 90 days. Such a scheme will obviously fall apart fast. See Financial Illusions--Greenwich Financial Website. Madoff’s malign genius was to promise steady but not stellar returns—perhaps 10% a year, give or take. He appealed to the craving of many people for a good yielding investment with little risk. Ironically, the longer the scheme went on, the more impressive the track record appeared to be. Second, Madoff claimed to practice a known and legitimate investment style called “split strike conversion.” This is true even though no firm could practice that style—which entails owning stocks and writing call options against them—in such massive size or low volatility. Third, Madoff perfected a masterful marketing scheme in which his reluctant posture was offset by a merry-go-round of aggressive “feeder funds.” Many investors in the feeders never heard of the Madoff sub-investment. The largest of these feeders included various funds of Fairfield Greenwich Partners (about $7.5 billion in affected assets) and Ezra Merkin (about $2.4 billion in affected assets). Finally, Madoff cruelly exploited a circle of trust within the Jewish community, including individuals (both wealthy and not), college endowments and charities.

What will follow? A few points:

• Although Madoff did not cooperate meaningfully, prosecutors may have enough information to prosecute up to ten others. Source: Newsweek.com


• There will be a tremendous incentive for hedge funds (even including startups) to use blue chip, name brand law firms, accountants, administrators, prime brokers and pricing sources. Madoff’s firm lacked each of these. This will further extend the power of these entrenched firms.


• Changes will certainly occur in the federal regulatory system. The scandal calls into question the system of internal enforcement by industry players. It also raises doubts about the ability of the SEC to police financial fraud and even in some cases to understand it.


• Investor trust will remain depressed for many years, and properly so. Enlightened skepticism is a good attitude for all investors to take regarding the management of their money.

A Mushy Recovery

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

The economy may start to show some growth toward the end of 2009. However, the recovery is likely to be anemic.

One factor holding back industrial recovery: very low levels of usage of our industrial capacity. When our industrial capacity utilization is low, expansion does not call for much new investment in capital goods equipment. (Capital goods equipment includes plant and machines to make new goods.) At the same time, inventories are high in many industries.

To take a striking and important example, before General Motors makes a lot more cars in the U.S., it needs to find a way to clear out the overstuffed parking lots of its franchised dealers, including the ones it will be closing down. GM feels pressure too from the glutted inventories of its competitors, even including industry technology leaders like Toyota. If GM does need to produce more cars, it can open up one of its idle plants rather than build a new one (leaving aside retooling for new models.) GM can draw steel and many parts from its own overstocked inventory. Let’s say GM does need to order new steel sheet. US Steel and others can deliver it from their own inventories, or they can restart idle capacity rather than building new capacity. On it goes. This glut of capacity is typical of recessions but is especially severe in this downturn.

Economist John Mauldin, in a recent issue of his newsletter (“This Time It’s Different, 6/19/2009), drew attention to the following data compiled by the St. Louis Fed:

As the graph indicates, US capacity utilization has fallen to about 68%, where any level below 80% normally reflects a business recession. As Mauldin aptly asks, “Does anyone really think that businesses (in general) are going to invest more money in expanding capacity, in the face of the lowest level of production relative to potential since the 1930s?”

If demand does not come much from the capital goods sector, then maybe it could come from consumer goods. But here too, there is a major problem: the dramatic restriction in credit to consumers--both as to equity lines of credit on real estate and credit cards—and the reduced sense of wealth and well-being that many feel. What’s more, consumers are tending to save more and spend less: the U.S. savings rate has increased from just below 0% to about 6% since the beginning of the crisis, and it may go higher (Mauldin says 9% is plausible).

Finally, increased exports could spur economic growth. However, this outlet is limited by the continued competitive problems of US industry, but even more importantly, by the worldwide nature of the recession. Demand is slack almost everywhere.

For these reasons, the recently ebullient US stock market, so relieved that we have come out of utter panic, that this is not the end of the world, is likely to stumble. The sky doesn’t have to fall for us to face some harsh weather.

Obama to Propose Regulatory Reform

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

The Obama Administration is about to propose an overhaul of our system of oversight and regulation of financial markets. Treasury Secretary Timothy Geithner and Director of the National Economic Council Lawrence Summers have laid out what seems to be a blueprint for the proposed reforms, in an Op-Ed piece published in the Washington Post. The Case for Financial Regulatory Reform - washingtonpost.com (6/15/09)

Geithner and Summers indict the existing system: “Over the past two years, we have faced the most severe financial crisis since the Great Depression. The financial system failed to perform its function as a reducer and distributor of risk. Instead, it magnified risks, precipitating an economic contraction that has hurt families and businesses around the world.” They add that this “crisis had many causes. It had its roots in the global imbalance in saving and consumption, in the widespread use of poorly understood financial instruments, in shortsightedness and excessive leverage at financial institutions. But it was also the product of basic failures in financial supervision and regulation.”

Geithner and Summers make these proposals:

• An increase in the capital and liquidity requirements of all financial institutions. The largest and most “interconnected” institutions would face more stringent requirements and would be subject to the consolidated supervision of the Federal Reserve Board.


• Establishment of a “council of regulators” with broad supervisory power over the whole financial system.


• Concerning asset-backed securities: more robust reporting requirements; reduced reliance on credit rating agencies (how?); a requirement that originators, sponsors or brokers of a securitization retain a financial interest in each securitization (how much?).


• Enhanced regulation of derivative securities, especially of over-the-counter (customized) derivatives. More robust safeguards for payment and settlement of over the counter derivatives. [No mention here of a centralized clearing house for such derivatives, which is sorely needed, as we have argued before in this column.]


• Greater consumer protection against fraud and deception in financial marketing.
  Procedures for the orderly resolution of any potential failure of a bank holding company, without inappropriate reliance on the Fed’s lending authority, to “help insure that the government is no longer forced to choose between bailout and [systemic] financial collapse.”


• New efforts at international coordination of financial regulation.

Institutionally, here is what I foresee:

• There will be no master regulator.


• The Fed will come out stronger.


• The Office of Thrift Supervision (OTS), an agency of the US Treasury, has been extremely ineffective and will probably be faded out of existence. OTS supervises a number of holding companies with respect to non-bank financial subsidiaries, which includes such major firms as AIG, General Electric, American Express and Morgan Stanley; this power will devolve to the Fed, the Comptroller of the Currency, and perhaps FDIC.


• Finally, the Commodities and Futures Trading Commission, which ought to be merged into the SEC to avoid overlapping jurisdiction, will unfortunately maintain its independence.

Thus, the so-called “alphabet soup” of federal entities overseeing financial markets will by and large continue, but some of the rules will be tightened up. Given President Obama’s pattern of compromise (and, perhaps, political shrewdness), expect incremental change, not revolutionary—particularly after Congress and the interest groups have their say.

The Compensation Controversy

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

In the wake of massive bailouts in the financial services industry, Congress and the Administration feel increasing pressure to do something about executive compensation on Wall Street.

It is not hard to understand feelings of outrage. Take Citigroup. “If you’ve never worked on Wall Street, it is hard to wrap your head around the idea that a company that lost nearly $19 billion in a single year, as Citigroup did in 2008, could still pay its employees [almost $4 billion] in bonuses.” Getting Theirs Cuts Both Ways on Wall Street - NYTimes.com

Note that Wall Street is nothing if not ingenious (part of what got us into this mess). As the Administration was making a commotion about bonuses, some of the remaining investment banks—including Morgan Stanley, Crédit Suisse and UBS—stepped up many executives’ salaries handsomely. See UBS Raises Top Bankers’ Salaries as Bonuses Fall - DealBook Blog - NYTimes.com and Bonuses abandoned for higher salaries. To some extent, the high proportion of bonus to salary of many executives on Wall Street harked back to the partnership era, and this new regime will further corporatize the financial environment.

I heard talk on the radio that traders may be exempted from new federal compensation guidelines—I don’t why. I was a trader on Wall Street for some time, and we definitely had the power to make as much mischief as the investment bankers, and probably more.
If this exemption goes through, everyone on the Street will want to get reclassified as a trader!

Of course, as to Congress, and both major political parties, there is some hypocrisy. In Congressional hearings during the Bush Administration, Alan Greenspan had clearly expressed alarm at the size of the balance sheets of Fannie Mae and Freddie Mac, and he questioned their need to hold massive amounts of mortgage-backed securities in portfolio. Congress nevertheless abetted the misuse of implicit federal guarantees by these two agencies.

Executives at many financial institutions that accepted TARP assistance—including Goldman Sachs, for example-- are racing to return the government loans. The government recently offered a bailout to a number of insurance companies, and only the most desperate are inclined to accept it. See Investment Value Digest: TARP for Insurance Companies.

There are really four issues: 1> Is Wall Street compensation too high, and if so, relative to what? 2> Is Wall Street compensation too much geared to short-term gains, without regard to long-term profitability and sound practices? 3> If the first or second question are answered yes, does government need to intervene? 4> If proper, should this regulation apply to all financial institutions, only to banks, only to investment banks, only to TARP recipients, or only to repeating TARP recipients?

My judgment is that public financial institutions are right that they may lose top talent if they suppress compensation excessively. Although there is currently a surplus of Wall Street professionals out looking for jobs, there is never a surplus of the most profitable employees, and these are the ones who can cut loose most easily. However, it is probably a good thing that the government seeks to restrict compensation for TARP recipients. It gives the recipients a strong incentive to pay the government back, assuming they meet tests of balance sheet adequacy. In this way, the funds can be recycled to new emergency cases.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions: e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.