FESLs Could Provide Much Needed Stability to the Euro

Includes: DRR, ERO, EU, EUO, FXE, ULE, URR
by: Amit Chokshi, CFA

Technology's Breaking Point

On May 6, 2010, US equity markets basically saw an entire four months of gains nearly wiped out in one day. According to Bloomberg, the Dow Jones Industrial Average (“DJIA”) lost 600 points from 2:42PM-2:47PM, a story that is sure to be extensively covered for the next few days. I personally think this was a healthy correction and was needed in that it resulted in high volume (19.2B across US exchanges, highest since October 2008) and flushed out a number of investors. The volatility index (“VIX”) screamed up to over 40 before settling at 34, much higher than the high teens where the VIX has traded in recent months. The sharp sell-off will be discussed over the next few weeks but there seems to be a much larger problem that hopefully the media and policymakers will address.

While technological innovations can provide a number of massive benefits, they can also threaten system stability if improperly accounted for. It seems that this is the trend in financial markets whereby “innovation” continues to ironically contribute to more systemic risk. This was the case not only in the origination of a variety of derivative securities but also with a number of technological “innovations”. For example, dark pools have grown in recent years and have often been touted as a source of extra market liquidity. However, it’s clear that market liquidity disappears on days when it’s most needed, despite the growth in dark pools. This area should be examined by policymakers.

Another more critical area policymakers should focus their attention on is program/flash and algorithmic trading. May 6, 2010 probably provided the clearest example of the limitations and risks associated with having programs handle order flow with minimal intervention from floor specialists. For example, Procter & Gamble (NYSE:PG), one of the most stable global companies, saw its stock drop from the $60s to $48 in a matter of minutes before sharply rebounding.

This pales in comparison to the performance of other stocks. For example, Accenture (NYSE:ACN), which sports a market capitalization of roughly $26B, saw its share price drop from $41 down to $0.04 in a matter of minutes before rebounding back to its initial level. The same phenomenon occurred with the iShares Russell 1000 Value Index ETF (NYSEARCA:IWD) which plunged from roughly $60 to $0.08 before bounding.

The technology behind the trading systems supporting financial markets worldwide clearly has its limitations. As more trading and portfolio management activities have fallen into the realm of complex programs, it appears that more bizarre occurrences are manifesting themselves.

Fundamentals do win out in the long-term but policymakers should consider the circular downward impact these extreme trades can have. The notion of rational investors has generally been dispensed of and these types of trades, whereby a company like ACN can essentially be valued at zero because investors are worried about riots in Greece (which somehow overwhelms global trading infrastructure), should stoke some serious concern by market participants and regulators. Even if there is no fire in the movie theatre, if investors believe there is, they will react accordingly and these trading anomalies only reinforce the agony of market participants. Volatility in capital markets is normal and healthy, but when the infrastructure behind trading has blatant flaws, volatility is unnecessarily amplified and reduces confidence. The actions by the Nasdaq and NYSE, which both elected to rescind certain trades that occurred during the most volatile time period on May 6, will only spur an additional lack of confidence in the backbone of financial markets.

The Fed Needs to Take Charge

The market sell off on May 6 was accompanied by live feeds of rioters in Greece who were protesting the recently passed austerity plans that were a condition for Greece receiving the bailout package from the International Monetary Fund (“IMF”) and European Central Bank (“ECB”). Markets were in part selling off because of a lack of confidence in the ability of Greece to actually implement the austerity plans. While the government passed these measures, large crowds of rioters suggested the actual adoption of these austerity plans would be challenging at best. Since the bailout Greece needs is tied to the ability to address its budget deficit and debt levels, the inability to pass these measures would increase the likelihood of default, which would rattle continental European banks. It would also set a bad precedent for other PIIGS countries to follow and further pressure the Euro.

The Euro is widely held and its rapid devaluation due to the crisis is what contagion is all about. Financial institutions worldwide have Euro holdings and this contagion is what is pressuring global markets. With the rapid devaluation in the Euro relative to the USD and JPY, financial institutions’ capital positions are under stress. European banks may fund many of their assets with Euros but the current crisis is pressuring the Euro, requiring these banks to find alternative funding sources for some assets (i.e. USD). This in turn is what spooks the markets.

The ECB is also much less sensitive to market activity relative to the Federal Reserve, which may have resulted in further market pressure as participants have less confidence in the ECB relative to the Fed. However, if the Euro continues to decline in value, the Fed should step in as they did after 9/11 and in 2007 with the establishment of foreign exchange swap lines (“FESL”).

While the Fed deserves considerable criticism for a variety of actions over the decades, including a number of actions during the height of the financial crisis, the FESL program was a crucial program that helped alleviate global financial and funding pressures, both in the first month or so following 9/11 and then during the financial crisis starting in 2007. With a rapidly declining Euro, establishment of FESLs would be a way to calm markets because it would eliminate exchange rate risk between central banks and provide a solid funding source for financial institutions in Europe.

Under normal conditions, foreign central banks (“FCBs”) can provide funding in USD for the banks under their purview, either by depleting their USD reserves or through open market transactions. The problem is that in times of stress, these actions exacerbate the problem. First of all, FCBs don’t typically stock up on large amounts of USD, so in a liquidity crunch these USD reserves could be rapidly depleted. Second, in open market transactions, FCBs would be selling their domestic currency to buy USDs, which would add to the pressure on their domestic currency and increase the value of USDs, expanding the exchange rate and funding gap.

This is why the FESLs were needed and why they alleviated funding pressures. Under FESLs, the FCB would sell a set amount of its currency to the Fed in exchange for USD with an agreement whereby the FCB would repurchase its currency at the exact same exchange rate in the future. From there the FCB could dispense the USD as it saw fit to banks under its authority. The FCB would also pass on interest from its USD lent to its member banks on to the Fed. In addition, the Fed agrees to hold the FCB’s currency on its balance sheet as opposed to circulating it into financial markets.

The FESLs could provide some much needed stability to the Euro because it eliminates exchange rate risk, in effect providing back-stop funding for the Euro’s value. In addition, the FESLs have precedent for successful implementation both after 9/11 and during the credit crisis of 2007-2008. In fact during the credit crisis, the FESLs were established between a number of FCBs including the ECB, Swiss National Bank, Bank of Japan, Bank of England, Bank of Canada, Reserve Bank of Australia, Reserve Bank of New Zealand, Sveriges Riksbank, Norges Bank, Danmarks Nationalbank, Banco Central do Brasil, Banco de Mexico, Bank of Korea, and the Monetary Authority of Singapore.

This period may arguably have been more challenging in that it included an inflated asset backed commercial paper (“ABCP”) market that was imploding along with the implosion of SIVs –essentially poor, short-term and widely used funding sources (ABCP) for generally perceived garbage assets (SIVs) that needed to be carefully worked down. This period also included the bankruptcy of Lehman Brothers. Unlike other programs, the FESLs were wound down in an orderly fashion once stability was established as demonstrated in the graph above. As illustrated, outstanding amounts on FESLs peaked near $600B before being wound down.

Given the fumbling by the ECB, the Fed should seriously consider intervention due to the ongoing pressure on the Euro. Market participants have indicated that they have significant doubts about Greece’s ability to execute its austerity programs, thus posing the risk of a default. The $500B question is whether a Greek default could be a Lehman Brothers redux in terms of cascading, negative market impacts or if establishment of support systems like the FESLs are worth the effort in heading off a potentially huge crisis at the pass. Given the previous successful implementations of FESLs, I’m hopeful that the Fed will consider utilizing this tool once again.

Stimulus Plan Part II?

USD bears have been slowly realizing that in a relative value world the USD reigns supreme. While deficit hawks were screaming bloody murder about the US debt when US Ten Year rates hit 3.9% (US funding costs were about 6% when the US had a surplus but surprisingly deficit hawks ignore this or are unaware of this), the Greek crisis has sparked a flight to safety with rates now at 3.4%. With unemployment incredibly high in parts of the world – much of it structurally – and funding for many of these countries such as the PIIGS highly constrained, the US should capitalize on the cheap funding and launch a second stimulus plan.

Countries such as the PIIGS, which include the world’s 9th largest economy in Spain, will be adopting austerity measures that are likely to foist even more economic malaise on these countries and in effect the global economy. The US, given its cheap funding, could pick up the economic slack for these countries which would also benefit the US and the many unemployed. In addition, the current US recovery is very anemic and if global markets are expressing a strong appetite for USD, we should take advantage of it.

The first stimulus program, although not ideally structured for maximum benefit, produced roughly 2MM jobs. These estimates come from Moody’s, IHS Global Insight, Macroeconomic Advisers, and the Congressional Budget Office (“CBO”). However, by H2 2010, the stimulus programs will have been expended and current economic data suggests the recovery is very fragile. Given a funding cost of 4.2% for 30 year paper, the US could borrow considerable capital and invest it in the country, providing jobs and improving the country’s diminishing infrastructure.

Activity in certain commodities such as copper and oil suggests that these economically sensitive asset classes could roll over. The US could be getting a good deal on these assets which would be required for rebuilding infrastructure as they decline in value. So not only would those that are having the most difficulty in obtaining jobs have the opportunity to be employed, the actual cost for the US to improve infrastructure could be fairly low as funding costs are low and commodities such as cement, copper, and oil appear to be rolling over.

Deficit and debt hawks would state that the US is borrowing “too much”. History demonstrates that this is not the case. The US is on track to have Debt/GDP of roughly 60%. That may sound like a lot but Debt/GDP exceeded 100% in the late 1940s after World War II. Despite having this sizable consumption source eliminated, Debt/GDP still steadily declined. Of more relevance is the data presented by Kenneth Rogoff and Carmen Reinhart in This Time It’s Different, which suggests that borrowing costs for countries are not impacted until Debt/GDP exceeds 90%, suggesting the US still has significant borrowing capacity.

What’s important to note is that Debt/GDP can be reduced either by actually paying down debt or increasing GDP. In most cases increasing GDP is what reduces the ratio. So as an investor, I see that the US can fund its capital projects for 4.2%. I can observe that with considerable slack in the labor force, labor costs will be lower than normal. I can also observe that electricity usage is tepid such that power costs would be low. Key commodities like copper and oil appear to be rolling over which would also present lower input costs. So cheap funding and cheap input costs should allow for a high net present value and internal rate of return on a number of infrastructure projects which can provide long-term societal benefits and stoke the economy. Unfortunately, this seems politically untenable although economic data such as US light vehicle sales, Chicago Fed’s National Activity Index, and stubbornly high unemployment suggest the US could use an extra shot in the arm. Market data, with US rates pulled in, also suggests market participants are more than willing to fund US projects for very cheap rates, in the hopes that it can spark the global economy.

Don’t Trade Yourself Out of Big, Long-term Gains

The past two weeks have had more action than the past four months. Markets ran into a brick wall in mid April, sparked first by the SEC’s civil suit against Goldman Sachs (NYSE:GS), followed by the ongoing European sovereign debt crisis, and then the British Petroleum (NYSE:BP) oil spill in the Gulf of Mexico. On May 6, US equity markets essentially wiped out gains for 2010 in one day. After twelve months of rapid gains across various asset classes, the possibility of a pullback was on investors’ minds and the recent flurry of events contributed to this pullback.

Now investors that were waiting to “get in” and hoping for a pullback when markets were on a tear are balking at the chance to invest, with the events of 2008 still seared into their psyches. Some investors that bought smaller amounts of stocks that they liked and wanted to add on a pull-back are not, preferring to wait and conduct a séance for guidance.

While these times are scary, investors should not shy away from legitimate, deep value opportunities. For example, I was recently interviewed by Seeking Alpha regarding Sprint-Nextel Corp (NYSE:S). At the time S was trading for about $4.15. Whether it trades at $4.15 or $4.30 or $3.60 is not a huge factor relative to my intrinsic valuation of the business and it’s hard to lose a lot of sleep if it gets beaten down from a fundamental perspective. As a fund manager, however, it is very painful to see big drawdowns irrespective of your conviction and track record, since fund marketing is always predicated on your most recent monthly performance. However, investors that can take a 2-3 year time horizon and are willing to accept a 50% drawdown on some special situations that have the potential to return 300% should step away from the noise, focus on fundamentals and valuation, and dive in. The current crisis is likely to serve up a number of those types of opportunities.

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