The battle of the Dr. Doom's on CNBC (CNBC Video), between Marc Faber and Nouriel Roubini, was uneventful, but did provide some interesting comments. While Dr. Roubini views are pretty well known, even if he is currently a little less pessimistic, Dr. Faber's views may not be as well known, and are worth mentioning. Some observations from the Faber portion of the interview include the following:

• There was a bull market in assets from 2002-2007, along with a weak dollar. In 2008, we had the opposite - a strong dollar, with all assets going down except for bonds. Now, in 2009, assets have rallied, especially in emerging markets as the dollar has weakened.
• For the next couple of months we should see the dollar recover as assets correct downward.
• The dollar will strengthen not because the U.S. economy is the best, but because it is the least cyclical. As the dollar strengthens, global liquidity will tighten.
• As liquidity tightens, growth will begin to disappoint, and emerging markets will become vulnerable, especially after being a favorite of momentum investors who may flee the trade.
• Nonetheless, even with slower economic growth, markets may still go up given that there are a number of worldwide central bankers who are nothing more than money printers and continue to feel the need to intervene when prices go down (except for crude oil).
• To exit this cycle, we may still need a crisis to cause us to fully change behavior and clean the system. Therefore, a total breakdown of the system is likely ahead of us (even if 1, 5, or 10 years away) since we have not let those who caused the problems fail. We cannot continue to provide bailouts that do not help the average person.
• Nonetheless, the Fed and other central bankers will most likely leave rates too low for too long, as household deficits continue to increase.
  
• Finally, when asked what would have happen if central banks would not have stepped in to stop the credit and market collapse, Faber believes that the market would have dropped more, but the system would be healthier, in part because the debt load on taxpayers would be less.
  

Nassim Taleb was interviewed on CNBC's Squaw Box Wednesday morning (CNBC Video), along with Nouriel Roubini. Some observations from Taleb include the following (the first one still worth repeating, especially given the recent market moves and short covering, the remaining ideas being essentially repeats from other interviews/columns):

• Short-term markets mean nothing. They are driven by the marginal buyer/seller.
• The risk and problems that we had before - debt, poor leadership - are still there.
• Converting private debt to public debt is just causing more problems.
• Structural problems have not been addressed.
• Too much reliance / susceptibility to forecast errors for the recovery, budget, and debt forecast.
• Policy makers are still not working on the main problems and there cures, just the symptoms.
• We are continuing to reward those who got us into our current problems.
  
• Nouriel Roubini is usually correct, except for wanting to reappoint Federal Reserve Chairman Bernanke (comment after some praise - to easy, just cannot help himself).
  

Now that the Obama Administration has released its proposed Financial Regulatory Reform: A New Foundation for updating the regulatory structure of the financial system (pdf file of reform, WSJ article), the public debate will begin in earnest regarding the details and proposals in the document. Ironically, while the public seems open to new financial regulation, the release of the document is coming at a time when some citizens are starting to worry about growing deficits and government intervention (see WSJ/NBC poll article), with almost seven in 10 people surveyed saying that they had concerns about federal interventions into the economy. Nonetheless, finding ways to limit risk and prevent another credit crisis through added regulation of banks and hedge funds still rings a populist tone, and is likely to continue to receive support.

Like many others, I feel that there are aspects of the new regulations that seem appropriate and make sense, with others that seem counterproductive. As for those that concern me, I agree with some who point out that it seems odd that the Fed is going to be given greater power (and responsibility) to fix some of the very problems it may have caused or contributed to (see Larry Kudlow article). I also worry that the new proposed Consumer Financial Protection Agency could end up just adding new and potentially unnecessary regulations and red-tape paperwork, along with producing counterproductive limits on rates and fees that will do less to protect individual consumers and more to reduce the availability of needed products that are offered to such individuals. Such restrictions, if not properly crafted, are likely to reduce the earnings of financial services companies, and even worse, limit their ability to effectively manage risk (through fee and rate changes).

The idea of requiring companies to retain 5% of all structured product offerings also has me concerned, even though this specific proposal seems to be generating some of the most support, at least initially. Recently I wrote that I have worries about forcing companies to retain a stake in each securitized product they develop since I believe it could actually make companies more risky (since they cannot off-load and manage all their risk, see previous post). Furthermore, while I agree that forcing companies to have some "skin-in-the-game" would make it less likely that they would offer risky products, it also makes it more likely, in my opinion, that they would offer less structured products. While this may be a desired outcome for some, the impact of this would be less liquidity and available credit at a time when the country can least afford it.

Another area that is generating support involves the idea of controlling systemic risk. I too believe that this is a good idea in theory, but am unclear exactly how this would be measured and acted upon. As recently reported in the WSJ (see article), one potential area to start with is leverage. As the chart below illustrates, financial sector borrowing increased steadily between 2004-2007, before dropping in 2008 as companies began unwinding leveraged positions. It is now well known that banks, hedge funds, and average citizens were carrying too much debt, thereby helping to increase systemic risk, and trigger the credit crunch.

Source: WSJ, Fed data
Yale economist John Geanakoplos, who has studied leverage in the economy, believes that regulators need to gather daily data from all market participants and then publish aggregate data. The feeling is that if market participants knew that leverage values were getting to extreme levels, they would be more likely to begin backing-off their own debt and leverage levels in anticipation of eventual market corrections, or restrictions imposed by regulators. Focusing at least in part on debt and leverage seems to make sense.

Unfortunately, measuring system-wide daily leverage changes at banks and hedge funds may be difficult at best, and suspect at worst. Yet, maybe the focus does not need to be on the three person hedge funds that are investing $10-50 million in capital. Getting comprehensive data which includes smaller players may not be necessary. Risk manager Richard Bookstaber - whose book "A Demon of Our Own Design" is recommended reading - believes that focusing on just the largest financial firms and hedge funds would cover roughly 80% of the risk, allowing you to see systemic trends.

At this point it is unclear if such trending information on leverage levels would be enough. Other related areas that could also cause potential cascading effects, such as specific derivative use (i.e., CDS) and counter-party risk, should also be examine - although regulating that which has not yet been developed is obviously difficult. Nonetheless, looking for new ways to measure leverage might be a good place to start for spotting worrisome trends. Such a signal could allow investors, funds, and the Fed (or other regulator) to take action. Of course, what action they take is another area of debate, and potential new area of concern.

There is an excellent opinion article in the Wall Street Journal today by Arthur Laffer (see WSJ article). In the article, Laffer discusses the increase in the monetary base, and how in the past 95% of the monetary base was composed of currency-in-circulation. Even with the recent unprecedented increase, cash-in-circulation has risen only 10%, now making up less than 50% of the monetary base, whereas bank reserves have increased nearly 20-fold. Granted, an increase in bank reserves was needed as a result of the liquidity issues of 2008 in order to make it possible for banks to begin lending again, but the balance has shifted too far. Laffer points out that banks will no doubt continue to make loans until they are once again reserved constrained. Currently, as banks make more loans and put more money into the system, the growth rate of M1 (currency in circulation, demand deposits, and travelers checks - see wikipedia article) is now around 15%. This of course will result in higher inflation and higher interest rates. As mentioned by Laffer,

"In shorter time frames, the expansion of money can also result in higher stock prices, a weaker currency, and increases in commodity prices such as oil and gold."

Does this market situation seem familiar? Unless the Fed acts to reduce the monetary base, which appears unlikely anytime soon given that there is no easy approach or outcome (see the Laffer article), it appears likely that the Fed will continue to lose control over rates (see previous post), and the markets will continue to tip towards inflation (see additional previous post). Plan accordingly.

Once again we have a weak dollar helping to push the price of crude oil even higher (see Bloomberg article, see first WSJ article on crude, second WSJ article on the dollar). In the CNBC video below, the technical analysts Nicole Elliott is absolutely beside herself, and even giddy at times, regarding the absurdity of the move in 2-year U.S. Treasuries. She eventually comes to the conclusion that the central banks have lost all control of the setting of interest rates, not to mention the long bond and interbank loans which have been outside of their control for a while.

Source: CNBC Video
Yet the 44.4 basis point move between June 5-8, along with the recent move in the Fed funds rates, are being dismissed by some firms that trade directly with the Fed, implying that it is simply speculators that are driving rates up (see Bloomberg article). Many dealers go on to predict that the Fed will hold tight well into 2010. Maybe so, but does it matter? While the Fed has recently retreated from seeking debt-issuing power to help control inflation (see Bloomberg article), the markets certainly are nervous about what they are seeing, regardless of the policy and wishes of the Fed. The TIPS market has also been active (see previous post).

Of course, what many traders are seeing and are nervous about begins with the unprecedented amounts of cash that is flowing into the world economies, much of which will eventually trigger higher inflation, higher taxes, and lower profit margins. To make matters worse, there is a feeling that much of the spending and printing is not necessary, and even worse, that no one at the Fed is really even minding the store. For instance, in the YouTube video below, one politician questions the Inspector General of the Federal Reserve. During the questioning, the Inspector General seems to have no idea where the trillion-plus dollars the Fed has put into the system actually ended up, or who received the money. There also seems to be no postmortem or investigation on the impact of not bailing out Lehman Brothers, or auditing of any off-balance sheet transactions.


Source: YouTube
Given the market reactions, the inflation-driven moves are beginning to appear a little more obvious (see excellent Michael Pento greenfaucet post), even if the size and timing are still under debate. Yet the moves can happen quickly. Just ask those trading the 2-year Treasury, or those who were looking to lock-in to a 30-year mortgage under 5 percent just a few weeks ago. This certainly seems encouraging for commodities long-term, and even short-term, regardless of the current rallies. Just think if demand actually catches up?

In the wake of the 2008 financial meltdown, it was easy to look the other way as governments and regulators considered nearly every course of action for keeping the engines of the economy from totally falling off the tracks, let alone from moving too fast in the wrong direction. But now, after massive stimulus spending, failures, and private-company ownership stakes, governments are dealing with numerous unintended consequences, forcing them to perform a difficult balancing act between immediate stimulus and long-term growth and stability.

This is now becoming evident in the Treasury market, where rising interest rates are putting pressure on the Fed's plan to bring down borrowing costs and help revive the housing market (see Bloomberg article). Mortgage rates, which have been increasing recently (see Bloomberg article and Reuters article), are now reaching high enough levels (if 5.25% is high) where they are beginning to decrease the number of new refinancing, not to mention making new home purchases more expensive and less attractive. While the increasing yield curve has been good for the net interest margins of the banks, the higher rates are coming at a bad time. It was recently reported that the number of homeowners who are getting behind on their mortgages is increasing, causing a spike in foreclosures (see NY Times article). Also, while the median price of a new home was up 3.7 percent in April, the general longer-term trend is still down, and will require a few more positive months to confirm a reversal. Sales of new homes also rose less than expected in April, with a downward revision of the March figures adding additional concern. Durable goods orders did see their largest gain in 16 months in April, but the March number was revised down sharply, causing concern for the accuracy of the current April reading.

Commodities and commodity-related stocks, on the other hand, have been rallying, with gold marching towards $1,000 an ounce, and oil rising above $65 a barrel (see WSJ article), up nearly 50 percent over the last five weeks (see Reuters article). The moves have come in part due to the falling greenback, with the dollar index down 10 percent over the last 3-months. Higher commodity prices have helped resource-rich emerging markets, lifting specific international indexes and causing a rally in emerging market bonds as the higher prices reflect an improved outlook concerning these nations ability to repay their debts (see Bloomberg article). Yet domestically, rising crude oil prices may slow down consumer spending as U.S. consumers find they once again have less disposal income (see Reuters article). Further increases in commodity prices, especially crude oil, will certainly draw concern from the Federal Reserve as it wrestles with the balancing act of growth and inflation, and subsequent worries about stagflation, making it difficult to raise rates. Capacity utilization is still low enough to make one believe that broad-based inflation is at least a year away, yet higher gasoline prices will influence consumer spending - which is vital to GDP and growth - with higher market rates adding extra pressure on spending.

In the area of "the news is good since it was not as bad as expected" camp, reported revisions highlight that GDP only contracted 5.7 percent in Q1, less than expected and previously reported, while corporate profits after taxes increased by 12.9 percent after falling 28.4 percent in Q4 (see WSJ article). Yet, not everything is rosy. Within the last few days, Tiffany posted a 64 percent drop in Q1 earnings, as margins slumped (see WSJ article). Cintas, the uniform maker, gave a weak Q4 outlook, saying that it also expects to have another round of layoffs, bringing its total workforce reduction to 12 percent over the past year (see WSJ article), and signaling further expected weakness in the broader labor market. As for technology, Dell warned that the PC market has not yet hit bottom (see WSJ article). Isolated, insignificant, and cheery-picked? Possibly. But certainly cause for concern.

All of this leaves the Fed and the Treasury with a difficult balancing act going forward. Fortunately for the Fed, or maybe unfortunately depending on your perspective, they may be off the hook, as investors and the markets take action themselves, and in the process drive up Treasury yields on debt and inflation fears (see Financial Post article). As equities enter the summer and currently appear to be stuck in a range as traders collectively make a market, the Fed may also find that it too could benefit from a little monetary consolidation. Unfortunately, the dollar, Treasuries, and commodity prices seem to have a mind of their own, with traders spotting the handwriting on the wall, and taking matters into their own hands. Quite possibility, the inflation train may have already left the station. Maybe the most the Fed can hope for is to make sure it simply arrives later than expected. Even those that feel inflation is a distant reality, see it as a reality, nonetheless. As investors and traders, we can prepare, and maybe make a little money along the way. Gold and commodity traders, as well as those shorting the dollar, are off to a good start.

The Worlds' Largest Hedge Fund (yes, that one, the one owned by you and I, the U.S. taxpayer) may now be adding additional securities to its portfolio. According to a recent Bloomberg article, the Fed is considering expanding the Term Asset-Backed Securities Loan Facility (TALF) to include loans for the purchase of Commercial Mortgage Backed Securities (CMBS). As you may recall, the TALF was developed to provide low-cost Federal Reverse loans that would be used to buy securities backed by consumer debt - essentially using taxpayer money to provide debt to help other taxpayers purchase the debt of still other taxpayers that took out too much debt [Yes, I know, using debt to solve a problem caused by too much debt does not really make sense, but I digress]. Anyway, since the TALF has previously been used to purchase securities tied to automotive debt and credit cards by offering three-year loans, why not try it now using five-year loans for commercial real estate? After all, it has been so successful for the auto and credit card industries (GM, Chrysler, and a White House Presidential scolding of credit card executives, notwithstanding - tongue in cheek, of course).

All kidding aside, it is hoped that such loans will create buying pressure for CBMS, thereby decreasing yields - many of which are near junk levels, making it unprofitable for banks to make new loans at such high yields. The down fall, of course, is that with such loans having a five instead of three year maturity, it will be even harder for the Fed to timely withdraw money from the system in later years, just when inflation is likely to creep back with a vengeance as the economy begins to hopefully recover. While maybe too late, at some point we are going to have to ask, are we preventing collapse and saving entire industries, or are we simply, and needlessly, juicing the system in order to save a few select companies, all the while unnaturally speeding-up the recovery? If the later, we may want to start planning for the hangover now.

The flood of borrowing in the U.S. is eventually going to force us to pay the piper, with some arguing that the bill may come sooner than later. Others have argued for continued deflation over the next 12-18 months (see previous post). Fortunately, or unfortunately, depending on your perspective, the move from deflation to inflation might not be as sharp as expected (see Bloomberg article). As it turns out, rising home vacancies across the U.S. are depressing rents, the largest item in the consumer price index released by the labor department. Home and apartment rents, as well as owners' equivalent rent, make up 30 percent of the CPI. As of the third quarter of 2008, the number of empty homes stood at 19 million, signaling that deflation may be here to stay for a while - or at least worries of inflation can wait until 2010, at the earliest. While not a perfect scenario, an environment with lower inflation will allow the Fed some extra time before it needs to start raising rates, thereby giving lower rates more time to do their magic without the threat of stagflation.

Just yesterday I wrote a post about how the IMF is predicting that toxic debt will increase to nearly $4 trillion worldwide. Now, a recent report released by the Congressional Oversight Panel - those in charge of overseeing the TARP - indicates that $700 billion may be just the beginning in the U.S. (see ABC News article). To date, the TARP, Fed, and FDIC have set aside, lent, or spend more than $4 trillion.

The gap between the 10-year Treasury note and the 15-year / 30-year fixed-rate mortgages has narrowed, not surprisingly, since the Federal Reserve began actively buying mortgage securities in January (see Bloomberg article). The average rate on a 30-year fixed mortgage fell to 4.96 percent in January, the lowest it has been when considering data that goes back to 1971. Rates were recently at 4.98 percent. With a promise to increase mortgage-backed security purchases by an additional $750 billion, along with as much as $300 billion in Treasury purchases over the next 6 months, rates should continue to be under pressure in the near term. As the Fed continues to support low rates in hopes that consumers will either refinance or make a new home purchase, others are also encouraging consumers to purchase now, but for different reasons. Given the flood of money entering the market, consumers will eventually begin seeing inflationary pressures. Now may be the time to act while both rates and prices are low.

It appears that efforts by the central bank to encourage investors to purchase corporate debt are not having much success (see CNN Money article). While it is often the case that companies are hesitant in the fourth quarter of a fiscal year to purchase debt for fear of creating problems on their balance sheets, this year the policy decisions of the Fed also appear to be having an impact. Currently, the Fed is offering a much lower borrowing rate than the market, with rates as low as 1.55 percent for three-month paper. The market is offering closer to 2.6 percent for similar debt. Until the market rates are lower, or the Fed rates become higher, it is not likely that investors will take the extra risk of buying corporate debt.

In a seemingly unrelated story, automakers are apparently unhappy with the $25 billion in loans they are set to receive for making more fuel efficient cars, with paperwork and administrative hurdles delaying the money (see Reuters article). As a result, the industry is continuing to burn through cash at a faster pace, causing GM to warn that the industry is now "near collapse," requiring further assistance. New aid is now being demanded, possibly up to another $25 billion in loans. The difference is that now these loans would come with no strings attached, with the expectation is that the companies would use the money to pay retiree health care obligations.

As the current financial crisis continues to unfold, one can expect that similar market circumstances (interest in cheaper Fed debt) and stimulus requests (taxpayers covering operating costs) will continue. At some point the response to such request will have to be no, and the results of such decision will have to be felt. Unfortunately, the longer that requests are accepted and government intervention occurs, that longer it will take to separate business from government and allow the free markets to get back to doing what they do best - rewarding with cheaper capital those companies that are managed well and properly positioned, while punishing those that aren't.

The Libor rate is once again signaling problems, but this time it is unclear who has the problem (see WSJ article). Just a few months ago there was some concern that Libor was understating the true borrowing cost (see previous posts here and here). Since the British Bankers' Association collects data from banks regarding their borrowing costs, it was speculated that banks were reporting costs that were actually lower than their true cost, mainly to keep from signaling to the market that others might be worried about potential problems with their company (ie., forcing higher lending cost). Now on Monday of this week, the rate for the 28-day Federal Reserve lending was 3.75 percent, higher than the one-month dollar Libor rate of 3.19 percent. This would normally not make sense given that the Federal Reserve requires collateral to secure the loans, whereas the short-term Libor lending between banks does not. Of course, within the last week Treasury yields have nearly disappeared as investors moved cash from money market funds to Treasuries after worries of some money market funds "breaking the buck." No doubt that as the government continues to debate possible bailout plans, and the Federal Reserve continues to find new ways to inject liquidity, anomalies such as what is being observed in credit markets will continue to keep investors scratching their heads and looking for safe places to park their money.

As reported at the Financial Times, US banks are being asked by the Federal Reserve to run a comprehensive series of stress tests to ensure they have enough liquidity to withstand various types of financial shock. The Fed regulators are asking for scenario analysis and testing to get an idea of how the banks would perform if there was a sudden and sharp downturn in the markets, or if an individual bank had to endure a major liquidity shortage, such as the one that brought down Bear Stearns. The tests are simulating mild to catastrophic disruptions, and appear to be focusing on the balances held for the various prime brokerage businesses that lend money to hedge funds. A few hedge funds have blown-up as a result of the recent credit meltdown. It is unclear if these failures were simply a warning sign of something bigger that is worrying the Fed, or just one of many areas in need of scrutiny.

While it is unknown if and how the Fed will use the specific data, the results could provide the information they need to implement new regulatory requirements if as proposed by policymakers they eventually take over some of the responsibility currently given to the SEC and other regulators. New requirements for regulatory capital are always met with mixed emotions. On the one hand, diligent and conservative risk management can provide confidence to both the markets and investors that a company can remain solvent, even in tough times. On the other hand, stricter regulation is usually followed by higher levels of regulatory capital that must be set aside, thereby reducing the banks ability to deploy its capital in the most profitable manner. The Fed and SEC recently identified the monitoring of liquidity as something they want to cooperate on with the investment banks. This current move appears to be one of the initial steps.

There is a interesting short paper written by Ryan Faulkner that is available for download at Faulkner Capital or at Barclay Hedge (registration required). In the paper, Faulkner discusses the cost and consequences of the FOMC's decision late last year to lower interest rates and keep them low. While Faulkner recognizes that lower rates have provided short-term relief for the financial markets in the wake of recent credit problems, he argues that the consequences of price instability will present consequences for the markets that may have longer lasting negative effects.

Faulkner provides a comparison to the problems of the mid-1970s (I know, the stagflation comparisons are everywhere, but hang in there). At this time the real federal funds rate was negative. During, and shortly after this period, commodity prices increased rapidly. Now fast forward to 2001 and a similar trend was developing - the real federal funds rate was also negative, and commodity prices began their assent upward to the point that in June of 2004, commodity prices were rising on average 13.5% over the previous 12 months.

As rate increases took the fed funds rate from 1.0% to 5.25%, prices for commodities began to decelerate, but the move was short-lived as the Federal Reserve began drastically cutting rates in September of 2007. Not surprising, commodity prices once again took off, with real prices rising 31.9% from May 2007 to May 2008. In fact, while numerous reasons are often given for higher commodity prices, empirical studies looking at the data show that commodity prices can be modeled as a monetary phenomena (see Barsky and Kilian, 2000). Often the rise in commodity prices were either directly or indirectly driven by monetary expansion.

Of interest is that during economic expansions, it is normal that demand for commodities will increase, with commodity prices following suit. Yet if monetary policy is such that it continues to encourage growth beyond what is normal for the economic environment, then markets run the risk of entering bubble territory, such that demand and prices continue to rise, even when not justified by current economic activity. We certainly appear to be entering, or are in the midst of such a reaction to low interest rates. How do we get out of this cycle? Two scenarios come to mind and are mentioned by Faulkner. For one, the Fed could begin raising rates, but the impact on the credit markets, and subsequent fallout for the entire economy, is difficult to predict and something the Fed appears to believe is not the best course of action, or simply something they are unwilling to risk. As an alternative, the Fed could continue to keep rates low, but this scenario is likely to cause the markets to take matters into their own hands, such as selling Treasuries in mass as inflation continues to rise.

Given recent Fed moves, it is likely that the markets will need to take matters into their own hands. Regardless, the impact and repercussions may be long lasting and are likely to repeat themselves if the Fed continues to give the impression of being more interested in managing quarterly GDP numbers, and less on controlling inflation and supporting the dollar for fear of occasional lower growth. Granted, the current Fed has its hands tied somewhat, so current motivations may be based more on walking the credit tightrope, and less on any long-term bias. Only until the current credit issues are behind us (or at least manageable), and commodity prices are somewhat controlled (it is too soon to tell if the current correction will continue and last), will we get to see whether the current Fed chairman is of the Alan Greenspan or Paul Volcker mold, or some hybrid in between. In the mean time we have to wait and hope that no rate move is the right move.

Reference:
Barsky, R. B., and L. Kilian, "A Monetary Explanation of the Great
Stagflation of the 1970s," NBER Working paper, 7547 (http://www.nber.org/papers/w7547), 2000.

Reuters reports that while the failure of Bear Stearns would have likely triggered a series of counterparty failures in the credit default swaps market had the Fed not come to the rescue, CDS securities have actually held up pretty well and remained relatively liquid even while other financial markets have had their challenges. To date, since the market for credit derivatives has come into being, there has not been a default from a major dealer or bank. Ironically, the Bear Stearns issues themselves may have helped bolster the CDS market since not only did the Fed prevent potential counterparty failures associated with Bear, but they also gave the impressions that other major derivative counterparties were too big to fail.

Other markets have not fared as well. Recent credit problems and housing related losses have reduced the flow of capital in the mortgage-backed security, CDO, auction-rate security, corporate bond, and preferred shares markets. On the other hand, liquidity in the CDS market, especially for 5-year duration securities, has been better than other markets, even though it too has experience less dealers, lower liquidity, and wider bid-ask spreads than normal. Yet, it is still functioning and allowing investors with illiquid corporate bond exposure to buy protection with credit derivatives.

Of interest for traders is that in some instances CDS securities have weakened ahead of stock prices, giving traders some clue as to what equities are a cause for concern. As an example, the CDS spreads for Bear Stearns widened by 10 times over two months last summer, significantly under-performing the stock and giving some insight into potential problems. Shortly near the end of the two month period, two Bear Stearns hedge funds collapsed from bad mortgage bets. The traders that were focused on credit risk hedged their exposure in the CDS market long before problems became evident to the equity market. Something worth noting as we hear of new activity in the credit derivative markets going forward.

The NY Times has an article regarding the preliminary results of a task force study headed by the Commodity Futures Trading Commission, along with staff from the departments of Agriculture and Energy, Treasury, the Federal Reserve, the FTC, and the SEC. While some will argue with the composition and motivations of the task force group, the study found that speculators were not responsible for driving crude oil prices higher. As an example of their findings, swap dealers who provide investors a future return tied to commodity market performance were nearly balanced between purchases and sales of energy futures contracts. In fact, from January to May of 2008, more of these swap positions were selling than buying, even while oil prices rose 28% during the same period. Furthermore, the task force found that speculators were more likely to change their positions after prices had moved, and not before, suggesting they were responding to new information as is typical in an efficient market. The compete report is due in September, but the initial findings are interesting nonetheless.

Today I got a chance to watch a little more of CNBC and other financial news shows and noticed a few things. First, there is a growing chorus about whether or not we have reached a bottom in the financial companies, and the market in general. There is a lot of talk about how "just think, if you had bought Fannie or Feddie or JPM or LEH last week, you would be up x%." It is common to do "what if" scenarios, but the coverage seems to be a little more intense today.

There was also a comment today on CNBC from Bill Seidman that was interesting. When asked about the recent actions of the Treasury Secretary, he mention that while current moves could positively affect the market near-term, even over the next year, the proposed actions are a longer-term disaster. He gave the analogy of how Secretary Paulson was running the Treasury like he ran Goldman Sachs, making sure he makes his numbers next year. Great stuff. While not mentioned by Seidman, you might also be able to make the same argument regarding the Fed, which seems to be managing quarterly GDP numbers and not focusing on controlling inflation and supporting the dollar for fear of occasional lower growth.

As reported a few days ago at the Financial Times, the Federal Reserve is reviewing whether or not to consider changing or loosen existing restrictions for non-bank holding companies, allowing them to take larger stakes in the banks without getting regulators involved. Some private equity firms have been interested in taking larger stakes, and providing the banks with much needed capital, but have stayed away due to existing limitations. Currently, companies that are not holding companies are prevented from owning more than 25% of a bank, and even less if they hold a board seat. Holders of large positions are also required to make what are called "source of strength" commitments, in essence agreeing to put up additional funds if necessary. While private equity funds are willing to take initial positions, many are reluctant to keep funding a decreasing asset.

The review by the Fed is in response to the need from banks to raise additional capital. Sovereign wealth funds provided some initial capital, but many have been shying away from U.S. financial companies, even at their current cheaper levels. To date banks have raised as much as $400 billion, but may need closer to $1,300 billion. To close the gap, the Fed may be forced to loosen restrictions in order to provide new ways to get the necessary capital to the struggling financial companies. The fact that the Fed is even considering such actions gives you an idea of how worried they are that another failure could develop. Even today there is an article in Vanity Fair discussing how rumor may have been the main contributer for initiating the run on Bear Stearns. The last thing the Fed, or the U.S. economy needs right now is for worries of capital concerns to cause another financial company to go under. Given the recent price action in LEH, C, JPM, MER, MS, and GS, the market certainly seems to be hinting at this possibility. Given that the Fed has its hands tied with regard to interest rates, unconventional approaches, such as making it easier for private equity to invest, or continuing to work through the discount window, may be its only current options.

Video Source: Clip Syndicate Bloomberg
Richmond Federal Reserve Bank president Jeffery Lacker is warning about consequences from the decision of the Fed to lend to securities dealers. Of concern is how investment banks are not subject to the same level of regulation and oversight as are commercial banks. Paraphrasing, Lacker points out that the effect of the recent credit extension on the incentives of financial market participants might induce greater risk-taking, and that this increased risk-taking could give rise to more frequent crises - the classic case of moral hazard.

Robert Eisenbeis from Cumberland Advisors points out that some of the Fed officials may be having "buyers remorse" with regard to going down the path of opening-up securities lending to investment bank. As a result, some are starting to discuss potential problems in public, possibly in an attempt to begin sending a message to the market that this is not something that the investment banks can always rely on. Many economist have pointed out that once the Fed bailed out Bear Stearns and opened up the discount window, they let the cat out of the bag and will have a difficult time getting it back in. As other investment banks run into trouble, they will no doubt be expecting similar treatment, including cheap borrowing and a market for illiquid assets.

Eisenbeis mentions possible ways to begin correcting the perception, including preventing investment banks from being prime dealers - in effect preventing them from being a conduit for implementing Federal Reserve policy. The Fed could also force the investment banks to change their charter, allowing the Fed more flexibility to take necessary actions to secure the assets available for borrowing. Nonetheless, any changes will be difficult. Since it is unlikely that the Fed will make any formal declarations, the market will no doubt have to wait until the next potential failure before it will know for sure what actions the Federal Reserve is willing to take. Hopefully this will not come sooner than later.

As recently reported in a Bloomberg article and elsewhere, the TED spread has been shrinking, and a number of analysts are stating this as evidence that the economy is getting back on firmer footing. While the spread does get mentioned when it starts spiking, and correcting, it is not as widely followed as some of the other more popular indicators.

In short, the TED spread is the difference between the yield on 3-month Treasury bill interest rates and the 3-month Libor. It was originally the spread between the 3-month Treasury contract and the 3-month Eurodollar contract represented by Libor before the CME quit offering T-bill futures contracts - thus giving the name TED (Treasury - Eurodollar) spread. The current quote is around 0.8. The normal range is usually between 0.1% and 0.5%. The spread has been over 2% on three different occasions in the last year, and has been elevated above it normal range since August of last year. The combination of investors looking for the safety of Treasuries (driving prices up and yields down), while incurring higher borrowing costs due to credit issues (driving 3 month Libor yields up), have increased the spread over the last year.

But now the spread is decreasing. Does this imply that all is clear in the economy? Maybe, but maybe not. A decreasing spread is a sign that liquidity is increasing, reflecting at least in part the success of the recent unconventional Federal Reserve actions to increase liquidity. The overnight Libor rate has dropped to around 2.11%, the lowest value in three and a half years. The 3-month rate has also declined to around 2.66%. Yet lenders still continue to hold cash, given that the Libor-OIS spread, the spread between the 3-month loans and the overnight indexed swap rate, is still around 0.66%, compared to an average rate of about 0.11%.

In fact, when you dig deeper, as discussed at the WSJ marketbeat blog, the recent narrowing of the TED spread is due mainly to an increase in T-bill yields which have risen by about 1.25% in the last few months. This has had a bigger impact than a drop in Libor, which has only fallen about 0.25% in the last month. As a result, traders are not as impressed, at least not quite yet. If the situation was reversed, where Libor was falling by 1.25%, this would imply that the liquidity issue and credit problems were abating, but this is not yet being indicated by the action in Libor. Instead, the T-bill supply is above average, putting pressure on prices and raising the yields, thereby lowering the spread. Things are improving, but it may still be too early to assume the credit and liquidity problems are behind us.