The Financial Times and Goldman Sachs have put forth their long list for Business Book of the Year.  The  winner amongst the many terrific nominees should be Lords of Finance by Liaquat Ahamed.

That its richness in detail flows as easily as a Harry Potter novel is certainly laudable. It is the presentation of the cause and effect of monetary policy, its struggle to co-exist independently with its fiscal policy counterpart, and the depiction of the US Central Banking system in its infancy that make it mandatory to read in detail today. The composite presentation of key actions, key “inaction” and ignorance of bubble causing behavior are reticent today not only for comparing the similarities of the times, but further as a reminder of how fragile our institutions can truly become when put through such stress. As Mr Ahamed concludes in his final chapters, the story is further a stark reminder of the effects of prolonged economic despair.

If you have not done so, you must read Lords of Finance. It certainly is Business Book of the Year.

The Federal Reserve released its combined 2008 Financial Statements on April 20, 2009. 2008 was stunning, with the balance sheet growing from $915 billion to $2.245 trillion. The major increases were in the commercial paper facility, foreign currency swaps, and term asset backed facility. Essentially - stabilizing mechanisms for short term market operations (both foreign and domestic) to continue.

The increase of $1.33 trillion is slightly larger than the gain in US GDP from $13.178 trillion to $14.264 trillion from 2006 to 2008. Essentially, the gains in US GDP from 2006 - when the Case-Shiller Composite Housing Index reached its peak - to 2008 are now sitting on the Fed’s books when they should be out in the private economy, on the balance sheets of companies, creating the next wave of products and services.

There are those who have argued the Fed’s actions will cause tremendous inflation. It is important to remember the major actions of the Fed are all preventing short term credit disruptions, which if not collectively implemented,  would have all lead to price declines, deflation.

Currency Swaps, worth roughly $553 billion or 1% of world GDP, are held against a basket of G-20 currencies, have most likely prevented an increasing demand for dollar. In the fall of 2008, the demand for the dollar reached a recent record high. Further appreciation would have further pressured US producers, unable to compete on price for various goods/services. The only solution would have been to cut costs to reduce prices.

Commercial Paper, worth $333 billion, is necessary to keep working capital afloat. Without it, the only solution to meet existing funding needs or return previously funded commercial paper would have been to liquidate existing inventory at reduced prices.

Term Asset-Backed Facility (TAF), worth roughly $450 billion, is further short term financing to allow banks to continue liquidity while suffering losses on their longest duration assets - CMOs. Without access to short term financing, again the only choice would be asset liquidation, further forcing price declines.

True, CPI did not increase in 2008. But added together, the Commercial Paper and TAF are roughly 5% of US GDP. As most companies were levered to the tilt, if the Federal Reserve funding was not there, the US price and consequentially unemployment situation would have been far worse.

As to worries of runaway inflation, the jury is still out. My belief is that the capital these facilities are replacing - in a sense - is now shoring up the balance sheets of various banks and companies. By increasing  equity ratios at companies and banks, future invested dollars from these newly shored up institutions will need higher returns on capital (all else equal), which is equivalent to the Fed raising fed funds rates to control inflation.

Until a recovery though, it is a good thing our economy has not faced deflation, certainly a real possibility in the fall of 2008.

Paul Krugman writes this week about the Irish Economy. In his column and blog, Paul notes Ireland is painfully transitioning, raising taxes to keep its fiscal position in line.

Let’s pause. If you have not read Lords of Finance yet by Liaquat Ahamed, stop reading this blog (or any other) and give the book a go. It is the cornerstone to understanding the current economic/financial crisis and comprehending possible solutions of both short and long duration.

In Lords of Finance, Ahamed writes of an eerily similar situation during the 1920s when Great Britain, starved for credit to funds its fiscal deficits, had to seek tacit approval from the House of Morgan on its proposed budget. Upon approval, Morgan helped raise a consortium of funding to help Great Britain stay afloat.

No doubt the same conversation was probably occurring in Ireland before it made its proposed increase in taxes. In the months since the world Financial Meltdown, Ireland raised debt in November 08 ($4bn),  January (Euro 6bn), and February (Euro 4bn). Then on March 30, 2009 Standard and Poors dropped Ireland’s sovereign credit rating from AAA to AA+ with a negative outlook. Since then, Ireland has not tapped the capital markets and has now tightened its fiscal belt.

This is now the choice of Ireland and other European Countries with current account deficits.  There is an immediate need to shore up the balance sheet, repay existing debts, and wait until domestic prices decline to a point where goods and services are competitive enough to be readily exported, regrowing the economy.  But waiting for prices to decline is a very painful phenomenon. Prices only decline when demand drops and a drop in demand across the board is synonymous with higher unemployment.

Ireland may be a small country (GDP wise), but its decisions are no different than California’s or many other states and municipalities here in the US. Without complete currency control, acting prudently (although potentially not economically), is the only choice to continue to tap existing capital markets, paying teachers, fire fighters and policemen. Economies in trouble and with a net debt position and complete currency control would either see a currency devaluation (in the form of a crash) or would choose to devalue their currency. Currency devaluation would hopefully occur faster than responsive domestic inflation allowing goods to be exported at a more competitive basis. Yet without currency controls, deflation is the only mechanism to getting prices to a point where exports can repay existing net debts (assuming those debts are denominated in the domestic currency).

Ireland is being used as an example of when economies are too reliant on the financial sector. To be clear, robust capital markets are critical to any functioning economy. Yet it is also important to note the following function: The limits to the magnitude (1x, 2x, 3x) of a sale of any business are equivalent to its estimated Rate of Return on Assets divided by its weighted average cost of capital - In a simpler Mogdliani Miller world this is the rate of asset return divided by the sum of the funding spread above the risk free rate and the risk free rate of return. In other words, the numerator to any business sale is the Rate of Return on Assets and the denominator is the return a new buyer is willing to accept. In the last eight years, we’ve grown because of the denominator: capital became cheap and offered increasingly attractive multiples for business transactions. In the next eight years, we must focus on the upper bound, the return on assets, the productivity of the country and its ability to make goods and services, representative of its currency.

Paul Krugman, in a blog post last week, offers an explanation for how private investors would think about asset purchases under the treasury plan. With no disrespect, here is my explanation:

Assume the purchase of a “legacy asset” (or purchase of a toxic asset, or the purchase of a pool of subprime mortgage) is a the purchase of cash flows for a period of 20 years. Many mortgages go out beyond 20 years, but let’s keep this at 20 for argument’s sake.

How much would I be willing to pay?

Well, a review of march-27-world-bond-yields, with at least an A rating, that go out 20 years, make me think I should get at least 8%. So, if I buy that asset for $100.00 (for which it is valued on the banks books), I’m expecting annual cash flows of $10.25 for the next 20 years.

It is fair to say, that given the horror stories everyone has heard about subprime mortgages, one would need a return far greater than 8% in order to buy one your own.

So the Treasury and the FDIC step in, and debt financing for up to 85% of the assets, with a matching equity contribution.  Assume then that the FDIC is able to offer 85% of the price on a non-recourse basis (meaning no other assets of me, as the the investor, would be touched eg - my home, my car should I be unable to service the debt). Then assume the FDIC offers 5% financing for the full 20 years. This, however, is a big IF, based on the Legacy Loan Terms sheet offered by the Treasury. Rates and Length could be far less generous.

Yet, if I were to receive 5% and 20 years of FDIC debt, my pre-tax return as the equity investor would be ~21%.

Assuming the FDIC offers these terms, the question then is, is a 21% pre-tax return to equity enough to entice investors to buy bank assets at their listed price? Secondly, is the program, with loans and equity contributions enough to remove the glut on bank books and get lending activity going again?

If the answer to either question is no, then the program has not (by itself) done enough to re-gain control of the credit markets, restart lending, and grow the economy.

But back to the 21% return for a second. In an article earlier this month in the FT, there were some pretty grim statistics about households behind on their mortgages. Nearly 12% of all home loans were either a month behind or in foreclosure. This statistic across of all households, but imagine what it is for those carrying “subprime” mortgages. Was this statistic modeled into the asset, valued at $100, on the bank’s books? That is not clear. As the equity investor, if I stress tested not receiving 12% of my cash flows annually, just to be conservative, my equity return under this scenario drops down to 12%. Given that this is a subprime mortgage pool, it could be fair to say, this investment is now not worth it.

Suppose then that a 21% return is the magic number. How much, assuming my stress test, would I offer a bank then for a $100 asset? The answer is $90, or a 10% haircut. The final question then is: Is losing 10% enough to to entice banks to still sell and remain solvent? Again, if the answer is no, then the program has not helped get lending going again.

Reading over this plan, it is my assessment that it will take time to start this program and get it functioning. The key then will be: what might happen in the mean time to banks and the economy and will we need a new set of assumptions to value these assets at that time?

Much concern exists over Obama’s proposal to make tax cuts a major portion of fiscal stimulus.  Through a tax cut, we (the government) are increasing the income of those still employed. Hopefully, tax savings will buy goods and services, increasing GDP. In today’s environment, we’re not enacting a stimulus to buy goods, we’re enacting a stimulus to buy jobs.

GDP = government spending + investment + consumption + net exports. The marginal dollars in a tax cut will either be saved or spent.

While savings should be encouraged in the long term, a savings glut currently exists. Fed Funds rate trades near zero, while cash reserves within the Fed have ballooned.

More damaging, marginal spending could be directed at imported goods. From Martin Wolf to Warren Buffet, many shudder at no improvement in our trade balances. Dollars used for imports are either locked up as foreign reserves or exchanged for investments in future US cash flows. Those future cash flows are either US tax receipts or profits distributed as interest or dividends. Those tax receipts could have put new teachers in the class room. Those profits could have built new factories. Those cash flows will never to be re-invested in the US.

By definition then, an increasing current account deficit means the same standard of living - GDP - costs more. If this is not the purest form of inflation, I do not know what is.

Many believe  too great a mismatch exists between jobs lost and jobs needed for “shovel ready”.  Cokie Roberts on “This Week” opined on finance professionals helping on infrastructure: “Well maybe instead of going to their personal trainers, they can actually get out there and start digging.”

The purchase of infrastructure projects buys jobs across the food chain.  Almost every project will go out for private competitive tender. Forget defunct residential home construction (shovel ready employees), companies bidding will require talent to prepare bids, obtain financing, manage payroll, and review costs. Every contract guarantied by the government (state or federal) will give lenders the confidence to finance, spurring new growth.

The long term benefits (aside from jobs) are then improved transportation, reduced energy costs and reduction of barriers to education. Thus reduction of risks for future runaway inflation - those risks prevalent in increasing current account deficits. Faith in government is presently difficult yet now we must make our congress the direct investors of last resort.

Preparing for 2009, this week marked a terrific example of de-leveraging in practice.

• As of Friday, December 19th, according to the Financial Times One year US Libor was 2.09%
• As of Friday, December 19th, according to the Wall Street Journal, no Treasury expiring prior to 2015 yielded more than 2%.
• And, as of Friday, December 19th, according to the Financial Times, the Fed Funds effective rate was 0.11%

So, there has never been a cheaper time to borrow, right? Only if you have an FDIC (taxpayer) stamp next to your offering. Take a look who issued debt this past week, courtesy of the Financial Times.

Financial Times: Week ofDec-19th-bond-issues-us

One side note: Even John Deere Capital got into the FDIC mix! So don’t tell GM and Chrysler they can’t have taxpayer loans.

According to the WSJ, this week was the final week in 2008 for private bond offerings. The lack of Corporate Debt issued should provide guidance that the US Economy (by force or by choice) is continuing its de-leveraging.

Final side note: According to the Wall Street Journal, The Illinois Finance Authority is set to offer $500 million in bonds on December 26th. Though it is independent of the State, this should be an interesting post-Christmas verdict on Governor Blagojevich.

Robert Shiller, in his book The Subprime Solution offers a risk management tool for governments. It is a “Trill” and it pays a perpetual share of GDP.

As GDP increases, the instrument pays a higher coupon. During a recession, it pays less. Quite the floating instrument. Shiller assumes each share would pay roughly $15, believing perpetual GDP would average $15 trillion annually. (Hence the “Trill”). Each Trill would be worth roughly $300. This assumes the US Risk Free rate is 5%. The risk-less rate of the US economy is 5%.

The “Risk” that is managed is during hard times, the government obviously owes less in debt service costs. In times of plenty, the government can afford to pay more. But in bad times, governments would have more cash on hand to handle a crisis (such as today).

The Pros.

• This instrument allows the market to truly estimate GDP growth. In some ways, the instrument is worth issuing simply to have a market view (a great view) of GDP growth.
• One now has the ability- with TIPS, Treasuries, and Trills- to estimate real GDP growth given  market views.
• Instead of perpetual Instruments, it could be more beneficial to issue “Trills” expiring annually, similar to TIPS and Treasuries. This way, one could have the market truly predicting GDP growth.

The Reasons for Pause:

• Reviewing the LM curve, as output grows, interest rates rise. As the economy falters, interest rates fall. Even in today’s crisis, this relationship holds true. The Trill’s desired hedge already exists. Further, this means the government has the ability to re-finance higher yielding paper in tougher times.
• The Hedge: Shiller’s main reason for the GDP indexed Trill is to provide government “room to spare” should a contraction occur. As GDP declines, so would tax receipts, lowering government revenue. It then is hard to argue the Government would have spare cash to attack a crisis.
• Other Financings: GDP, remember, is defined as Consumption + Investment + Government Expenditure + Net Exports. GDP could remain stable year on year, but Imports could still rise. In this example, Investment (Foreign Direct Investment) remains unchanged meaning the Current Account Deficit is in the form of domestic bonds and stocks, essentially payments to foreigners from US income. Trill payments could remain unchanged, but the country as a whole would pay more to maintain the same standard of living (in the short run).

Robert Shiller is one of our smartest thinkers on real property. Let’s work on the Trill as it has definite promise as a positive instrument for US Debt.

First off, Happy Thanksgiving to you and yours!

Last week Goldman Sachs became the first “bank” to float a bond issue guaranteed by the FDIC.   A look at the weekly debt issues from the Financial Times shows US banks springing back into action, all issuing FDIC guaranteed debt. As I can tell, these are the first bond issues of any major financial institution in Dollars since Lehman’s declaration of bankruptcy.

(For the purposes of this post, all noted bonds sold close enough to par that coupon yields as first order approximations for true yields will suffice. Sorry Professor Jenter!)

• Goldman Sachs issued $5 billion due in June 2012 yielding 3.25%
• Morgan Stanley issued $2.25 billion due in Dec 2010 yielding 2.90% and $2.5 billion expiring in December 2011 3.25% and $1 billion due in June 2011, half of which has a known floating rate of   1 month LIBOR plus 74 bp.
• JP Morgan issued $5 billion due in December 2011 yielding 3.125% and $1billion due in December 2010 with floating rate interest of 3 month LIBOR plus 50bp .

Thanks to the FDIC guarantee, the yields on these bonds are very low, making them very favorable for the issuing banks. Yet the FDIC has only $34.6 billion in funds for this purpose or general insurance on accounts up to $250,000.

I would argue the FDIC’s funds are too small to take on insuring now larger accounts as well as guaranteeing bank bonds. So, the taxpayer is on the hook for  $16.75 billion of new bank debt.

Let’s put that amount in perspective.

• GM, Ford, and Chrysler are asking for $25 billion
• The net CDS exposure on GM and Ford amounts to $9.6 billion
• As I wrote in Note Four A, as part of the TARP program, the tax payer is due to receive roughly $18 billion in dividends from the first $250 billion the Treasury is injecting as preferred equity capital into these same banks.
• John McCain railed against earmarks all campaign long. President Elect Barack Obama said earmarks amount to $18 billion a year.

Further, it is important to compare the incredibly low yields on these bonds:

• In the week of November 7, 2008 Ireland, a sovereign euro denominated nation that stated it would guarantee all deposits from six of its largest financial institutions, sold 4 billion of euro debt, due in November 2011, yielding 4.0%

And during the Year of Cheap Credit, Fall of 2006-Spring of 2007 (without any FDIC backing)

• In September of 2006, Goldman Sachs issued 750 million euros due in October, 2021 yielding 4.75%
• In September of 2006, Citi issued 1.25 billion euros due in October, 2013 yielding 3.95%
• In February of 2007, three banks no longer in existence in the same form issued long duration debt:

1. Wachovia issued 1 billion euros due in February 2014 yielding 3 month Euro LIBOR plus 15 bp.
2. Lehman Brothers issued 1 billion euros due in March, 2019 yielding 4.625%
3. Merrill Lynch issued 1 billion euros due in February , 2012 yielding 3 month Euro LIBOR plus 18 bp.

Side Note: it is amazing reviewing that year of cheap credit how few bonds were issued in dollars relative to Euros and Sterling. It made me believe Mayor Mike Bloomberg was right to worry New York was losing out as the capital of global finance.

IN SUM: This is new uncharted waters for the US Taxpayer. What if one of the banks uses the funding to underwrite new acquisitions that create “synergies” resulting in laid off workers? What if the funds are used  to lever up a commodities bet? I do not believe banks raised enough capital to make single bets of that systemic threatening magnitude, but the overall point is this:

• In large part, banks and autos are short term inelastic industries. Without a bank, its hard to save currency and its hard to do commerce. Without a car in the USA, its hard to travel from point A to B.
• There are plenty of foreign banks and plenty of foreign car companies.
• I reckon between the FDIC, Treasury and Fed plans, we are spending close or guaranteeing close to $2 trillion, ~15% of GDP, for our private sector banking industry. While congress has made “noises” on insufficient bank lending, there is no plan attached to this funding. Yet produce autos and ask for $25 billion, you’d better have a plan.
• Bottom line for CEOs learning how to manage through a future crises: It sure pays to be the industry first in line for help.

For Taxpayers, the returns depend on your view.

• The terms of the treasury (on behalf of the tax-payer) investment are a dividend of 5% of invested capital.
• The preferred share investment is callable anytime after three years.
• Should the banks issue new equity prior to three years, they can buy out the tax-payer at par with that funding. In essence, any current equity owner is diluted regardless.

The taxpayer does not have any savings (found in lack in government surplus), so it must raise debt to fund the bank bailout.

Examining two and five year treasury yields, they are priced at 1.555% and 2.609%. respectively.  Assuming the Treasury Department does the right thing (See Note Four A), it will sell five year debt to finance the bailout.

Doing the math, paying 2.609% to receive 5% seems like a good deal. It does make a lot of arguments against it seem not as compelling.

Here’s another way to look at the deal though.

Assume the treasury invests up to $250 Billion, the returns over three years are $6 Billion a year. Enough to pay for approximately one year of pork projects John McCain rails against continuously.

Is this then a good investment? You decide.

The Treasury can choose how to finance this purchase.

First though, the plan gives us insight into when Treasury foresees the US Economy recovering. If all preferred shares are callable in three years, but only redeemable through equity (and not debt) prior to, then in essence, Treasury believes we will not fully calm the credit markets until three years from now.

At present, The Treasury issues 2 Years, 5 Years, and 10 Years. Yet Treasury must know most banks will call the preferred shares by year five when the dividend percentage increases from 5% to 9%.

Yet how many banks will take out the preferred shares prior to year three? Probably not many.

The safest debt instrument then is a five year treasury debt instrument. Here is why:

• The Yield on Five Year Treasuries is 2.609%, cheap money.

• No refinance risk. The preferred shares are retired back piece by piece through the next five years. While there is a chance of buying back treasuries at a premium when the debt is retired, the debt is so cheap; this problem is hard to imagine.

• Isolates the problem to the current administration. No doubt, models exist predicting when various banks will pay back the preferred shares, estimating duration and a possible combination of two year debt, five year debt and accept some refinance risk if funding is further needed.