So the end game in Europe will very likely be a departure of Greece, Portugal, and possibly Spain from the Euro. I would expect that this will ultimately strengthen the euro, because remember, the outstanding currency is backed by the sovereign debt of European member states. The main thing that will assault the value of the Euro is if the ECB goes through with its plan to debase its balance sheet by loading it up with the insolvent debt of Greece and weaker members. The clearest path to a strong euro is to restructure, not defend, the insolvent debt of those countries. Needless to say, a similar point holds true for insolvent liabilities in the U.S., which the Fed should not be holding.
I am not convinced that the Fannie Mae and Freddie Mac debt held by the Fed can be assumed to be backed by the full faith and credit of the U.S. government. It is true that the Treasury announced last Christmas eve that it would provide unlimited amounts to make Fannie and Freddie debt whole for a three-year period, citing the Housing and Economic Recovery Act of 2008 as its authority to do so. However, that law (in all caps, mind you) places a clear limit of $300 billion on the total amount of principal that the Treasury has the authority to insure. So either the Treasury's action exploited a loophole that was clearly no part of Congressional intent, or the open-ended commitment is lip service that actually has a statutory limit of $300 billion of principal (not losses, but principal). The third possibility, of course, is that the Treasury's action was illegal. In any event, as the Fed has purchased debt that does not, in fact, have the explicit long-term backing of the Federal government, it follows that it has created U.S. dollar liabilities in return for assets that are subject to loss and are not actually debt obligations of the Federal government. This in turn means that the Federal Reserve is engaging in unlegislated fiscal policy.
I am also not at all convinced that the recent financial regulation bill passed by Congress contains the one essential provision that will be required to avoid a full replay of the credit crisis we saw in 2008. That provision is to endow a regulator - one with an explicit mandate of consumer and depositor protection - with the ability to take receivership of insolvent financial institutions, to cut away the operating entity from the bondholder and stockholder liabilities, sell it to an acquirer or re-issue it to the market as a whole recapitalized entity, and give the residual to the bondholders as partial recovery. This is how the FDIC deals with failed banks, and the threat of this should create a credible incentive for bank bondholders to restructure those obligations in a way that makes those investors, not the public, responsible for the losses that banks incur.
The only reason that bank "failures" in the Depression (and the "failure" of Lehman) were problematic is that the institutions had to be liquidated in a disorganized, piecemeal fashion, because there was no receivership and resolution authority that could cut away the operating entity and sell it as a "whole bank" entity ex-bondholder and -stockholder liabilities. I put "failure" in quotations because there is a tendency to think of such events as something to be avoided even at the cost of public funds. Failure only means that bondholders don't get 100 cents on the dollar. As I've repeatedly emphasized (and don't believe can be emphasized enough), it is essential to invoke the word "restructuring" wherever possible, because it immediately leads us to seek constructive solutions between borrowers and lenders, without public expenditure.
In my view, the regulator with resolution authority should not be the Federal Reserve. It is often argued that the Fed's involvement would insulate bailouts from political influence. But it is important to recognize that the Federal Reserve acts not in the interest of the public, but in the interest of the banking system itself, because it is an arm of the banking system, with leadership staffed by representatives from the banking system. Indeed, J.P. Morgan's CEO, Jamie Dimon was on the Board of Directors of the New York Federal Reserve at the same time that J.P. Morgan was awarded a sweetheart deal to acquire Bear Stearns, while the Fed itself took on tens of billions of "Maiden Lane" liabilities to facilitate the transaction. Moreover, if bailouts are to be effected, what could possibly be more deserving of political deliberation and subject to the oversight of elected representatives than the use of public funds? The resolution authority should have clear transparency. My vote would be the FDIC, but in any event, an agency with a mandate of public protection, and answerable to our elected representatives, is essential.
Narrow bells and high micro-volatility
Last week, I noted that on the heels of a vertical (and almost textbook) "air pocket" that followed the overvalued, overbought, overbullish, rising yields syndrome of recent months, we had observed another "Aunt Minnie" characterized by a breakdown in market internals. Most notably, we saw a leadership reversal which took weekly new lows above weekly new highs on the NYSE for the first time in three quarters. Coupled with other elements of that Aunt Minnie, we can count 19 such breakdowns since the 1960's, only 4 of which had benign outcomes, and the others being associated with a typical (additional) loss of about 7% within the next 12 weeks, expanding to an average loss of about 20% within the following year, as measured from the point the leadership reversal was observed.
Given this relatively narrow set of outcomes, coupled with my ongoing concern about further credit strains (not simply abroad, but also becoming aggravated in the U.S.), there seems to be little reason to depart from last November's comment in Reckless Myopia: "In my estimation, there is still close to an 80% probability (Bayes' Rule) that a second market plunge and economic downturn will unfold during the coming year. This is not certainty, but the evidence that we've observed in the equity market, labor market, and credit markets to-date is simply much more consistent with the recent advance being a component of a more drawn-out and painful deleveraging cycle."
As long-term readers of these comments know, I try to refrain from talking about the markets in terms of specific "forecasts." Instead, we tend to use the phrase "on average." The only time you can make a reasonable "point forecast" about the market is when all of the historical outcomes have a very narrow range of variation around them. That's rarely the case. Even the most favorable and unfavorable Market Climates we identify generally look (more or less) like bell curves, and all of them include both positive and negative returns. So the data generally don't support specific forecasts that the market will do this or that. The best you can usually do is to compare the average expected return with the range of possible risk.
For example, a set of market conditions that is associated with a high average return, but a huge bell curve of dispersion around it (as we sometimes see in the gold market) tends to warrant only a moderate investment exposure, unless one is willing accept a great deal of volatility and risk. In contrast, a set of market conditions that is associated with a moderately high return, but a narrow bell of dispersion, can be approached with a more aggressive investment exposure.
