The Fed's $7.77 Trillion Secret Funding Plan

As the ECB considers stepping up to the plate and acting as the lender of last resort, yesterday's blockbuster Bloomberg article on the US Fed's secret funding program (forced out in the open via a Bloomberg lawsuit) could not be more timely.

Here are a few excerpts:

"The Federal Reserve and the big banks fought for more than two years to keep details of the largest bailout in U.S. history a secret. Now, the rest of the world can see what it was missing.

The Fed didn’t tell anyone which banks were in trouble so deep they required a combined $1.2 trillion on Dec. 5, 2008, their single neediest day..."

"The amount of money the central bank parceled out was surprising even to Gary H. Stern, president of the Federal Reserve Bank of Minneapolis from 1985 to 2009, who says he “wasn’t aware of the magnitude.” It dwarfed the Treasury Department’s better-known $700 billion Troubled Asset Relief Program, or TARP. Add up guarantees and lending limits, and the Fed had committed $7.77 trillion as of March 2009 to rescuing the financial system, more than half the value of everything produced in the U.S. that year..."

"The secrecy extended even to members of President George W. Bush’s administration who managed TARP. Top aides to Paulson weren’t privy to Fed lending details during the creation of the program that provided crisis funding to more than 700 banks, say two former senior Treasury officials who requested anonymity because they weren’t authorized to speak..."

"TARP and the Fed lending programs went “hand in hand,” says Sherrill Shaffer, a banking professor at the University of Wyoming in Laramie and a former chief economist at the New York Fed. While the TARP money helped insulate the central bank from losses, the Fed’s willingness to supply seemingly unlimited financing to the banks assured they wouldn’t collapse, protecting the Treasury’s TARP investments, he says..."

"On Jan. 14, 2009, six days before the company’s central bank loans peaked, the New York Fed gave CEO Vikram Pandit a report declaring Citigroup’s financial strength to be “superficial,” bolstered largely by its $45 billion of Treasury funds..."

To read the full story, click here

Bottoms Up!

Giving the devil his due, the bottom-up crowd has won this round, as earnings results are not disappointing as economists did for the third quarter. Therefore, in light of the recent market action, it seems more than productive to understand the nature of this important (but not dominant) segment of the market.

Most investors are bottom-up oriented. They buy and sell stocks with a passing reference to the sector and style tilt their portfolios produce. Like many sports teams, portfolios are populated with the best ideas. Sectors and styles are a by-product. Individual company earnings results, performance metrics (such as profit margins, growth rates, etc.), and valuation levels determine the buy/sell/hold decisions made. From that comes the action taken.

This situation is largely due to tradition and training: traditional among individual investors, training among the professional crowd (the CFA program, for example). It is what the financial media obsesses on while providing limited, yet sorely needed, education on what constitutes good portfolio management.

As one of the two essential elements that drive stock prices up or down (the other being financial market liquidity), earnings results can dominate the moment, as they appear to have done thus far this month. When good earnings results motivate investors to act positively, the momos (the real power in today’s market) join the party, as they are indifferent to the reasons that drive investors and are far more interested in an excuse to act. As long as money is abundant (financial market liquidity), the upside bias exists. Which brings us back to earnings results.

As long as companies deliver positive earnings results and financial market liquidity remains ample, the bottom-up crew can move markets (aided and abetted by the momos, of course) to a significant degree. Should earnings falter, however, then the dual impact of declining results and diminution of financial market liquidity (in the form of redemptions and withdrawals) can produce a negative feedback loop to the real economy (Soros’ “reflexivity”). Yet, more importantly, within this investing approach lie the seeds of its own destruction.

Bottom-up investing is aided and abetted by ivy tower fantasies about efficient markets, assisted with high-sounding phrases like “price discovery” and “capital asset pricing models”, and supported by economic methodologies that are anchored in traditional metric analyses. Such traditional economic methodologies do, however, come with two significant blind spots: the inability to forecast with any degree of accuracy and consistency (certainly commensurate with a practice that fancies itself as a “science”) and an inability to do global macro analysis particularly well.

The first point is self evident and saturated with historical fact. For example, one need only look at today’s consumer confidence miss to see just how off the mark these “social scientists” can be. The second point was made most evident in the debacle known as the Great Recession. Moreover, the inability to do global macro well also comes with an inability to incorporate contagion’s speed and source (real and/or financial economy).

This is a big part of how the world works in Wall Street. It is the dynamic reality that exists in the surreal world of finance. It is the state of denial that many who play the investing game occupy. And it is why it is so essential to step back and smell the global macro rose, which right now has a decidedly foul odor to it.

But, hey! “Who cares?”, say the bottom-up boys and girls. "Earnings are good and that’s all that matters to me."

Toward A New Valuation Model

Approximately five years ago at a meeting with many of the leading behavioral finance thinkers, I asked the following question: "When will behavioral finance produce the successor to the centerpiece of the rational investor efficient markets theory - the capital asset pricing model?" The answer from one of the leading lights in attendance was ten years. If true, we are only half way toward a key component of finance, a component that is sorely needed as the valuation model used by nearly every traditionally-trained investor is broken.

For most investors bound to a methodology that hasn't made much sense for decades, the path ahead is a highly uncertain one. Company analyses and portfolio management tools and processes are anchored in the ancient art of the efficient market hypothesis and its central equity valuation tool, the capital asset pricing model. To retool established, well entrenched ways of doing business will not be easy for those locked in the ways of the past.

In a recent CFA Institute meeting, PIMCO Co-CEO and CIO, Mohammed El-Erian, brings to light many of the issues that all investors need to think through, especially those whose livelihoods depend on managing other people's money. Mr. El-Erian's speech renders advice that investors should "think the unthinkable" and brings the credit crisis into full valuation and financial modeling view as he places the recent crisis in context.

To listen to his insightful and unnerving views, click here.

Investment Strategy Implications

The behavioral finance clock is ticking and its arrival cannot come too soon for a new world economic order that cannot effectively proceed without the necessary evolution in valuation modeling. And as it does occur, investors who position themselves to take advantage of our brave new economic and financial world to be will reap the benefits.

Welcome to The New Era of Complexity

excerpts from this week's report

"Entering the year, the three components of valuation – earnings/cash flows, growth rates, and discount factors – were fully supportive of higher prices. Moreover, the lifeblood of higher values - liquidity – was abundant. Therefore, the potential for a closing of the valuation gap was very good. The primary caveat expressed on these pages stemmed from a concern re the high degree of complacency among the majority of professional investors. As I conducted my early 2007 Market Forecast events, I was surprised by the degree of the sanguine certainty of so many in a world rife with uncertainty.

The primary concern I expressed at the start of the year was centered not on traditional economic issues..."

"Risk in a complex, interdependent world is different from risk in the traditional sense. It is comparable to the difference between a closed economic system and one that more globalized. More moving parts mean more potential for both reward and risk. Thus far, all that has been seen is the good stuff. The Great Moderation, as it is called, is cited as..."

"I became aware of issues like fat tails thanks their constant references in speeches by Ben Bernanke and NY Fed President Timothy Geithner, among others. Naturally, whenever a phrase that key Fed officials and other learned thinkers appears with a fair degree of frequency, I want to..."

"Fat tails are high volatility occurrences that are several standard deviations away from the norm. Such low probability events using Gaussian distribution principles are so rare as to render them irrelevant. But using a distribution rule such as Power Laws, the probability of such occurrences increases exponentially..."

"According various research reports, the more networked the world becomes, the more interdependent it becomes. And a more interdependent world adheres more to Power Law distributions than Bell Curve ones..."

"The implications for valuation under a Power Law versus a Bell Curve are significant..."

also in this week's report

* Current Blue Marble Research Fed Model
* Model Growth Portfolio
* Key Economic Indicators

Note: To view this week's report, please click on the Blue Marble Research services link to your left.

You Don’t Know What You Don’t Know

Question: How knowledgeable do you suspect investors are with the following terms: Fat Tails, Complexity Science, Interdependency Risk, and Emergence? How familiar do you suppose investors are with phrases like “the brake becomes the accelerator”?

And how many investors are aware that “U.S. financial institutions now hold only 15 percent of total credit outstanding by the nonfarm nonfinancial sector: that is less than half the level of two decades ago. For the largest U.S. banks, credit exposures in over-the-counter derivatives is approaching the level of more traditional forms of credit exposure. Hedge funds, according to one recent survey, account for 58 percent of the volume in credit derivatives in the year to the first quarter of 2006.*”?

Investment Strategy Implications

If ever there was a case where the title of today’s blog applied, it is the state of investor knowledge regarding a transformed world, the “end of capitalism as we know it.**” Yet, many investors appear comfortable with the risk management tools of the financial engineers, and in the process have apparently bought into the idea that the social science of investing has become sufficiently exact as to resemble the physical sciences.

The problems surrounding the thus far contained crisis of credit derivatives, hedge funds, and Bear Stearns are simply a manifestation of this certainty gone awry. Yet, to get swept up in the obvious (i.e. contagion) is to fail to see the larger, more thematic, and, therefore, more significant picture.

Circumstances are far more complex than is apparent. We don’t know how deep the rabbit hole is. We don’t know what we don’t know.

*”Credit Markets Innovations and Their Implications”
Timothy Geithner
President and Chief Executive Officer, Federal Reserve Bank of New York
Vice Chairman, Federal Reserve Bank

**Tom Wolfe