Fed Flushes $1.7B Worth of Taxpayer Funds Down the Toilet

Last week, under the cover of darkness and in an extraordinary show of Government incompetence, the FDIC seized United Commercial Bank. The problem is that Mingsheng, a Chinese bank, had already approached the Fed about a potential acquisition of UCB. Mingsheng, which had already invested $129M into UCB, was presumably trying to salvage some portion of it's investment. Unfortunately, Mingsheng's application was destined to whither away on a bureaucrats desk, as various branches of the federal government bumbled about in an attempt to resolve the problems at UCB - oblivious it seems to the cost effective solution right before their eyes. They (Mingsheng) were not the only investors though; last year the Treasury injected $298M into UCB as part of the now infamous TARP program. Furthermore, the FDIC estimates that the UCB failure will cost it's Deposit Insurance Fund $1.4B. The DCF is theoretically funded through premia leveled on the banking industry; however, we all know that this cost gets passed onto consumers in the form of higher overdraft, ATM, inactivity etc. fees. Therefore, the Treasury/Fed/FDIC - acting in disorganized concert - managed to flush $1.7B worth of taxpayer money down the toilet.

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Treasury Spends $90 Million to Create New Housing Inventory

The Treasury Department announced yesterday that it has allocated $90M from the American Recovery and Reinvestment Act towards affordable housing in several states. Based upon the details included in the press release, it appears that Treasury will be providing funding for stalled development projects located - in at least one instance - in a town of less than 5000 persons. This particular expenditure, directed towards a previously failed elderly housing development, will flow to the town of Osawatomie, Kansas.

To be clear, we do not have an issue with elderly persons being provided a place to live. Our contention arises from what appears to be the creation of new housing inventory by the federal government. For the housing market to recover, a very simple dynamic needs to emerge: housing starts must remain subdued for a period, and be accompanied by higher sales that are a function of depressed prices. We have already seen some positive data points emerge as of recent in terms of the rate of home sales; signaling that at least to some degree, prices have dropped sufficiently to spur new demand. This trend will be rendered useless by the creation of new inventory, which will serve to negate the positive inventory reductions associated with higher sales. Furthermore, Treasury's strategy is another example of inefficient government spending; it is directing funds towards projects that the free market has abandoned, for the purpose of achieving a political agenda. Although the roots of said agenda may be fastened to a moral purpose, the continuation of these policies will only serve to prolong the housing slump.

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Goodbye CIT? Hello Job Losses

CIT Group Inc. (CIT) has announced that, insofar as it's prospects of receiving some sort of Government aid/backing/assistance are concerned, "there is no appreciable liklihood". This development occurs after a week long speculation concerning the likely fate of the middle market lender, largely focused on the question of whether the FDIC will guarantee the Company's debt. The issue managed to create a divergence of opinion amongst ratings agencies S&P and Moody's, which had the former stating it's expectation that CIT would receive FDIC assistance, while the latter argued otherwise. More significant we believe, was the bifurcation of opinion that occurred amongst market commentators, economists, and the like. It seems that some folks are against further government bailouts on principle alone, while others perceive the cost/benefit to be in favor of saving the lender. Although we would concur with the view that a CIT failure will not pose a systemic risk to the financial system as a whole, we would argue that a CIT bankruptcy filing will serve to further deteriorate both the labor market, and the economic condition of Main Street.

First of all, we consider it an entirely presumptuous notion that other financial institutions will be able to step in and pick up CIT's "slack". Frankly, many small businesses that rely on credit lines from companies like CIT do not have the wherewithal to simply wait for help. They will choose to lay off workers first, and evaluate the situation later. Many will simply close their doors in lieu of burning through cash reserves while waiting for replacement financing.

Ultimately, allowing CIT to fail does not make sense in light of the Administration's aspirations to create a small business lending program. We know that the Treasury will immediately book a >$2B loss on the TARP funds it has already injected into CIT, and that a bankruptcy will be a major setback to small business funding. Thus, any SB "rescue" measure will have to be all the more expensive just to get us back to where we currently stand. We aren't completely sure as to what the Government must be thinking, however, it is likely that the agency turf war between the Fed, Treasury and FDIC has managed to obfuscate the real issue at hand. What a surprise.

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The S&P 500 and the Money Supply: A Long Term Look

Andy Kessler wrote a rather frank op-ed in today's Wall Street Journal, at one point devoting an entire sentence to the phrase "dumb move" as he issued a critique of Fed/Treasury/Government behavior since the onset of the "Crisis". Mr. Kessler asserts, rightly so we believe, that the recent stock market rally is the result of the Federal Reserve's $1Trillion increase to the monetary base. To illustrate his point, Mr. Kessler includes an intriguing chart, which plots the WSBASE (via St. Louis Fed) and the Dow Jones Industrial Average for the period of January-July 2009. For the most part, the WSBASE represents the sum of currency in circulation, plus reserve balances held by Federal Reserve Banks. The theory goes that even though the majority of Fed activity has focused on the purchase of Treasuries and Mortgage Backed Securities, the stock market has served as the primary recipient of the newly created portion of the monetary base. We would tend to agree.

So enamored were we by Mr. Kessler's 6-month WSBASE v Dow chart that we couldn't help create a similar chart; ours however includes the entire available time series of WSBASE data, beginning in 1984. We chose to use the S&P 500 as the comparison index, simply because the Dow is a rather poorly constructed index that doesn't lend itself to long term comparisons. For accuracy and presentation's sake we went with the logarithmic scale.

It's interesting to note that the the WSBASE and the S&P 500 do appear to trend together, diverging slightly during times of over-valued equity markets (the late 90's). However, if one hone's in on the disruptive period of stock market action following the Lehman collapse - referred to in jest in our circles as "The Death March" - it is clear that the Fed pulled violently on it's monetary levers in an attempt to bolster the equity market. This backstop may be effective for some period of time, however, the Market will ultimately prevail. Caveat Emptor.

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Treasury Unveils PPIP Choices

The Treasury Department has just announced the identity of the anointed few that may preside over the Legacy Securities Public-Private Investment Program ("PPIP"). The winners are:

• BlackRock
• Invesco
• AllianceBernstein
• Marathon Asset Management
• Oaktree Capital Management
• RLJ Western Asset Management
• TCW Group
• Wellington Management Co.
• Angelo, Gordon & Co. / GE Capital Real Estate

A handful of other "established small-,veteran-,minority-, and women-owned business partnerships" were chosen to participate in the program in a role ancillary to that of the large firms listed above (Congress just could not resist forcing this issue, could they?).

We definitely weren't surprised to see GE Capital make the cut; the Company has world renowned lobbying capabilities. Altogether though, today's announcement felt a bit anticlimactic (irrelevant even?) now that the Government has bastardized it's reputation with the private sector beyond recognition. PPIP will go on, and some will participate; however, history will likely view it as one in a long line of failed attempts to cleanse the balance sheets of US financial institutions.

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What Has the Fed Accomplished?

The Fed has purchased roughly $610Billion worth of mortgage-backed securities and Treasury bonds in the past several months alone. What have these actions actually accomplished? In terms of substantive improvement of the economy, it is still unclear whether history may yet judge the campaign of aggressive quantative easing as a net positive. However, we have come across several bits of analysis which cause us to lean towards the opinion that the Fed's actions have amounted to a Net Nothing.

In a recent analysis, J.P. Morgan estimated that the Fed's recent MBS and Treasury buying spree have allowed some 2 million borrowers to refinance their mortgages at lower interest rates. Unfortunately, this all comes at an estimated cost of $2500/borrower. Logic would tell us that more refinancings equals more affordable payments equals less foreclosures. In reality however, certain economic relationships are often correlated in an entirely illogical fashion - think tax rates v. tax revenue. In fact, we are co-signers of the theory, already shown by the most recent data, that a pool of modified mortgages will grow delinquent at a Faster Rate than a similar pool of non-modified mortgages. 

More importantly we believe, is the fact that the Fed has failed to control that what it was created to control: interest rates. Recent days have brought violent fluctuations in Treasury yields, to the point that one might confuse the associated price/yield chart with a stock market snapshot from October of last year. In our opinion, the upward rate pressure is merely the manifestation of a concept that ordinary folks understand at a basic level: There is no such thing as a free lunch.

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Puerto Rico's Bailout

On October 14th, 2008, the Treasury Department posted an announcement, the full text of which can be found at http://www.treas.gov/press/releases/hp1207.htm . Below is the first paragraph of said announcement:

Treasury Announces TARP Capital Purchase Program Description

Washington- Treasury today announced a voluntary Capital Purchase Program to encourage U.S. financial institutions to build capital to increase the flow of financing to U.S. businesses and consumers and to support the U.S. economy.

Throughout this announcement, in three separate instances, "U.S" is used as an adjective to emphasize the fact that these activities are being conducted for the benefit of the United States. However, the Treasury, on its own website(http://www.financialstability.gov/impact/index.html ), posts information that would seem to contradict the stated purpose of the Capital Purchase Program as advertised to the public. According to the impressive interactive map, Treasury has funded $1,335,000,000 worth of transactions in Puerto Rico. A closer look at the reports reveal that the lions share of this amount, $935,000,000, went to Banco Popular (Popular, Inc.) , a San Juan based conglomerate with assets in excess of $45Billion. The most compelling piece of information that we can identify concerning Popular is that, in early 2008, it sold its US consumer finance division to AIG. This transaction was apparently quite beneficial, if not necessary for Popular- both Moody's and Fitch had placed the Company on "negative" outlook and were reviewing it for a possible credit downgrade. After the sale however, Moody's immediately assigned a "stable" rating to Popular.

To put Banco Popular's amount of US Government support in perspective, consider that it received more Federal support than the did the financial institutions of 34 individual US states. 

We did not choose to bring this information to light out of xenophobia(or any other phobia), but rather to point out that the public's attention has been skillfully manipulated throughout this entire economic episode. Case in point: there has been considerable rage leveled at Banks who received TARP money, and then planned to hire recent MBA's who happened to be from another country. However, there has been zero mention in the traditional media of the billion or so that has flowed directly to Puerto Rico.

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Federal Reserve Impotence

In mid-March, the Federal Reserve announced its intention to purchase $300Billion worth of US Treasuries, triggering an almost immediate 50 basis point decline in the 10 Year Treasury yield. At the time we proposed that the Market, being a force far superior to the Federal Reserve, would eventually counter-strike, much to the dismay of the Fed. We also stated that this initial $300Billion figure would be a mere drop in the bucket when compared to the volume of Treasuries ultimately purchased by the Fed. At present, approximately one month after the Federal Reserve officially embarked upon a program of Quantitative Easing, the Market has already counter struck, rendering the practical effect of the Fed's program useless. The yield on the 10 Year Treasury has returned to 3%, the same level it sat prior to the QE announcement.

The sheer speed at which the Market has assessed the Federal Reserve, formulated a counter strike, and implemented said strike is troubling at the least. The 10 Year is by the far the most important part of the Treasury Curve-its yield influences a vast spectrum of financial instruments, including but not limited to Mortgage Rates, the lowering of which has become a centerpiece of Government policy. That the Fed could only influence this rate by 50 basis points, for approximately one month, is a testament to that Institutions dwindling credibility and ability to manage the economy.

As for the Fed's next move, we are sticking with our assertion that Trillions more will need to be committed to the Treasury Market in order to keep the cost of capital sufficiently low throughout the economy. The alternative, allowing the Treasury Market to proceed unimpeded, would be the equivalent of dousing the purported "green shoots" with a solution comprised of 1/2 Raid and 1/2 Arsenic. We think the Fed's next move is quite clear.

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