Saturday, January 31, 2009

Double Secret Insolvency

(Either backstop us or you'll be throwing even more billions down the blackholio. Besides you're only protecting your interests wouldn't want us to blow our brains out and muss up your balance sheet would you? - AM)

JANUARY 31, 2009
Wall Street Journal

American International Group Inc. is in discussions with the government about Washington backstopping some of its troubled assets and is considering selling units through initial public offerings.

"We're looking at a broader array of recapitalization options," said Paula Reynolds, an AIG vice chairman who is overseeing the restructuring of AIG, which was rescued by the government in September with a bailout package that now totals $150 billion.

"We both realize that the environment's changing and we have to adjust to that environment," Ms. Reynolds said in an interview, referring to the federal government. She joined the company after the bailout to help the giant insurer break itself up to repay a massive federal loan.

Backstopping of assets would be similar to government guarantees on troubled assets owned by Citigroup Inc. and Bank of America Corp.

Ms. Reynolds in the interview also suggested that AIG could adjust its roster of units for sale. "We might sell some things that aren't for sale, and we might not sell some things that are for sale."

MOD wants to be part of the solution

(Kind of an expansion of Taleb's idea to make the banksters utilities and then let other folks take risk under the knowledge that they will never be bailed out. - AM)

By Lasse Pedersen and Nouriel Roubini
Published: January 29 2009 19:35
Financial Times

The worst financial crisis since the Great Depression has highlighted the risks from the collapse of systemically important financial institutions. Huge bail-outs were undertaken based on a fear that the collapse of such institutions would cause havoc, with collateral damage to the real economy. Examples include Bear Stearns, Fannie, Freddie, AIG, Citi­group, the insurance of money market funds and new US Federal Reserve programmes for banks and broker-dealers. Allowing Lehman Brothers to collapse had such severe systemic effects that the global financial system went into cardiac arrest and is still dealing with the aftermath.

We propose a way to measure and limit this systemic risk and reduce the moral hazard and the cost of bail-outs. Our proposal is to impose a new systemic capital requirement and systemic insurance programme.

The current situation leaves the system vulnerable to financial contagion when big banks (or many small ones) go bust. The root of the problem is that banks have little incentive to take into account the costs they impose on the wider economy if their failure prompts a systemic liquidity spiral. This is akin to when a company pollutes as part of its production without incurring the full costs of this pollution. To prevent this, pollution is regulated and taxed.

Unfortunately bank regulation, such as the Basel accord, ignores systemic risk since it analyses the risk of failure of each bank in isolation. It seeks to limit the probability of failure by each bank, treating isolated failures and systemic ones in the same way (and also ignoring how much a bank loses if it fails). However the move by many large banks to lever their balance sheets with similar mortgage-backed securities is more dangerous than if they had made loans to diverse borrowers.

More broadly, a systemic crisis that feeds on itself is more dangerous than the isolated failure of smaller banks. A small bank will probably be taken over with a smooth transition of operations – it does not bring down the economy.

There are two challenges associated with reducing the risk of a liquidity crisis. Systemic risk must be first measured and then managed. We propose to define a bank’s systemic risk as the extent to which it is likely to contribute to a general financial crisis. This measure can be estimated using standard risk-management techniques already used inside banks – but not across banks, as we propose – to weigh how much each trading desk or division contributes to the overall risk of a bank. We set this out in an NYU Stern project on restoring financial stability.

With this measure of systemic risk in hand, a regulator can manage it. We propose two ways to manage systemic risk. First, the regulator would assess each bank’s systemic risk. The higher it is, the more capital the bank should hold. This would seek to ensure that the banking system as a whole had sufficient capital relative to the system-wide risk. This is just like the headquarters of a bank charging each trading desk or division for use of economic capital measured by its contribution to overall firm risk.

Second, each institution would be required to buy insurance against its systemic risk – that is, against its own losses in a scenario in which the whole financial sector is doing poorly. In the event of a pay-off on the insurance, the payment should not go to the company, but to the regulator in charge of stabilising the financial sector. This would provide incentives for a bank to limit systemic risk (to lower its insurance premium), provide a market-based estimate of the risk (the cost of insurance), and reduce the fiscal costs and the moral hazard of government bail-outs (because the company does not get the insurance pay-off). Since the private sector may not be able to put aside enough capital for all the systemic risk insurance, government could provide part of it. Government already provides such partnership on insurance with the private sector in terrorism insurance.

We believe our proposal offers several advantages by explicitly addressing systemic risk based on tools already in use by private companies to manage internal risks. Our proposal is a better way to deal with the trade-off between letting a large institution go bust (Lehman, for example) and causing a global cardiac arrest of the financial system or being forced to spend trillions of dollars of taxpayers’ money to bail out such systemically critical institutions.

Civic upset that leads to revolution


To aid their ailing commercial banks, central banks in Europe have relied on huge currency swaps, borrowing nearly $400 billion from the U.S. Federal Reserve. But as European commercial banks and European currencies deteriorate, repaying all that money to the Fed is becoming ever more difficult.

"[Fed Chairman Ben] Bernanke's assurances aside, I don't see how they can easily be repaid," warns Gerald O'Driscoll, senior fellow with the Cato Institute and formerly with Citigroup and the Dallas Fed.

Here is how the swaps work. The Fed and, say, the European Central Bank agree to exchange a set amount of each other's currencies at a certain exchange rate for six months, with a provision to renew the terms at maturity. The ECB uses the money to help aid bank-bailout packages for countries like Belgium, Finland, Hungary and Ireland that have troubled dollar-based assets. (Asian central banks are also part of the program, but haven't utilized it nearly as heavily.) The Fed gets a promise from the ECB to repay the debt in six months.

A big hitch: Europe's commercial banks have more exposure to wounded emerging markets than U.S. counterparts. By one estimate, European banks provided three-quarters of the $4.7 trillion in cross-border loans to the Baltic countries, Eastern Europe, Latin America and emerging Asia. Their emerging-markets exposure exceeds that of U.S. lenders to Alt-A and subprime loans.

The swaps may merely delay the inevitable major shake-up of Europe's banking system, O'Driscoll fears, and move the U.S. Fed beyond its original operating brief. Adds Neil Mellor, currency strategist at Bank of New York Mellon: "The aftershocks of the current global credit crisis are continuing to induce huge turbulence in the foreign-exchange markets, which is only now being more keenly felt in the Eurozone and Britain."

You can debate the merits, but not the size of the swaps program. It is big. The Fed's currency swaps have expanded from zero a year ago to $506 billion. Of the 14 central banks involved, the ECB by far has been the biggest counterparty to date, drawing down $264 billion (versus Mexico's $33 billion drawdown via a similar program at the height of the 1995 peso crisis). Skeptics contend that the swaps are thinly disguised spending that was carried out without Congressional approval.

"A case can obviously be made for [swaps] in the current global crisis," says Al Broaddus, a former president of the Federal Reserve Bank of Richmond. "But these swaps always struck me as uncomfortably close to the Fed making fiscal policy. That is why, whenever they came up for authorization, I voted against them." Last week, current Richmond Fed President Jeffrey Lacker voted against the Fed's targeted-credit programs. It is rare for a Fed official to openly oppose the Federal Reserve Board.

Traditionalists would prefer that the Fed stick to guiding interest rates and controlling the money supply. Fiscal policy, by contrast, forces the bank to decide who gets what, which can become a political calculation.

In a Jan. 13 speech at the London School of Economics, Bernanke said the joint actions of the Fed and foreign central bankers "prevented a global financial meltdown in the fall." Were these loans not made, he said, there would have been a much greater risk of crossborder financial collapses that would have left the global economy in even worse shape.

The swap lines, Bernanke continued, were necessary and will be self-liquidating, running off the Fed's book like some of its commercial-paper programs already have. "Liquidity provision by the central bank reduces systemic risk by assuring market participants that, should short-term investors begin to lose confidence, financial institutions will be able to meet the resulting demands for cash without resorting to potentially destabilizing fire sales of assets," Bernanke said.

Yet in recent weeks, the situation seems to have worsened for European banks and their home countries alike. The Dow Jones Euro Stoxx Banks Index is off 66% since Bernanke spoke. The Royal Bank of Scotland (ticker: RBS) is now a government property, as is Belgium's Fortis (FORB.Belgium).

"I would say that most of the big banks in Europe are insolvent," says Dory Wiley, president of Commerce Street Capital, a money-management firm that invests in banking stocks. "That is what made them great -- but unpredictable -- shorts. They represent major components in those country funds everyone buys." The danger is that governments, being the prime backstops for their commercial banks, will be forced into default or be downgraded. One hedge-fund manager advises retail investors to simply steer clear of Europe.

Particularly vulnerable to further decline seem to be: Switzerland's Credit Suisse (CS) and UBS (UBS), as well as Britain's Barclays (BCS), Austria's Erste Bank (EBS.Austria), Sweden's Nordea (NDA.Sweden), the Netherlands' ING (ING), Belgium's Fortis and Spain's Banco Santander (STD). These highly leveraged banks have huge emerging-market exposure, and reside in European countries whose financial resources are small relative to the assets of the giant banks they host.

Little wonder that countries have had a difficult time selling their own debt to investors worried about both general economic conditions and the possibility that the banks' problems may overwhelm their governments' ability to cope with them. Moody's Investors Service recently downgraded the credit ratings of Latvia, and commented on Greece; the agency cited, in part, bank problems in both countries. Ireland was just put on credit watch with a view to downgrade by Moody's because of its banking crisis.

How can the governments raise the cash to repay the Fed? The possibilities include printing more currency, thus undermining the euro's value and increasing inflation; selling more sovereign debt; or raising taxes. None is a pleasing prospect.

European banks face a new round of challenges. Most vulnerable: Credit Suisse, UBS, Barclays, Erste Bank, Nordea, ING, Fortis and Banco Santander.

A further complication: Countries such as Ireland must go along with whatever currency policy the European Central Bank chooses, even if it isn't necessarily the right one for the nation. Those outside the ECB currency regime -- like Switzerland -- can custom-tailor their monetary response. Ireland has gone so far as to threaten to leave the monetary union unless it gets more help.

Recently Lativia, whose central bank has bailed out the country's banking system, was the scene of demonstrations and populist rhetoric aimed at granting borrowers relief on loans from Swedish banks -- which have a big presence in the Baltic nation. If the Latvian government grants this relief, it would seriously hurt Swedish lenders, whose central bank has borrowed $25 billion from the Fed in these currency-swap lines.

"This is the kind of fiscal pressure that can easily rip the European Union apart, and cause the kind of civic upset that leads to revolution," says Sean Egan, co-founder of Egan-Jones, a credit-rating firm in Pennsylvania.

And some of the most stable countries are involved. Switzerland, whose banking system has assets valued at eight times the nation's annual economic output, is in hock to the Federal Reserve to the tune of $20 billion, a massive amount for a small country. Britain, with its highly leveraged financial system, has had to bail out its banks three times so far, yet must repay the Fed $54 billion.

These pressures are starting to affect sovereign borrowing, too: Germany recently auctioned 10-year government bonds -- but the government was left holding 32% of the offer, in what analysts regarded as a failed deal.

Economists Carmen Reinhart of the University of Maryland and Ken Rogoff of Harvard have studied sovereign defaults going back to the 14th century, and found that mass sovereign defaults tend to run in waves when currencies begin to melt down. Says Reinhart, "We've found that global banking crises cause the kind of turbulence that leads to sovereign defaults. It's just beginning."

Lee Hoskins, former president of the Cleveland Fed, in the early '90s led a move to stop the U.S. central bank from using swap agreements to warehouse foreign currencies to help the Treasury implement its foreign-exchange policy. Hoskins views the Fed as pursuing a policy of credit allocation rather than targeting monetary aggregates or interest rates. Hoskins believes the Fed should let some of the banks here and abroad go under. "Unless we stop the forbearance and dispose of the insolvent banks, the problems are only going to get worse," says Hoskins.

Meanwhile, Bernanke says he isn't so much managing the money supply on a quantitative basis, but rather pursuing "credit easing," focusing on a mix of loans and securities affecting household- and business-credit conditions. Emergency loans and swap lines made to central banks will essentially be repaid once things return to normal for the big banks.

Walker Todd, a former lawyer for the New York Fed, would prefer that Congress review these swap lines and the agreements behind them -- to make sure they were made with the proper authority.

Bernanke concedes that the banking sector is far from saved at this point: Worsening growth prospects, continued credit losses and markdowns will keep pressure on the capital and balance sheets of financial institutions.

"More capital injections and guarantees may become necessary to ensure stability and the normalization of credit markets," says the Fed chief.

But shouldn't Congress have a say in how much more the Fed lends to Europe?

The devil is in the derivatives...

(If true this is extremely bad news. Frankly it means that not only are the major banks insolvent they are hopelessly insolvent. My fear all along was that the cancer was much bigger than the patient. The devil is in the derivatives, don't believe the narrative DTCC pablum, don't for a moment think that the problem is anywhere near contained. The original solution put out as a trial balloon was for the aggregator bank to take only those assets that have been written down and for guarantees to cover those assets that are completely marked-to-fantasy. Treasury has been resistant to buy too many assets due to cost, Bair wants to bring more assets into the bad bank. Methinks Treasury has the inside track on the real deal. Reading the tea leaves it would appear that not only are the major banks insolvent, they are damn insolvent. If its' any consolation we kept the best of the worst, so folks such as the UK, Japan and Germany are well ... completely screwed. Would think even money that UK does a bank holiday in 2009. Deleveraging 2.0 is next on the agenda ... trades of a lifetime on the horizon. - AM)

Reporting by Tim Ahmann and John Poirier
Fri Jan 30, 2009 5:49pm EST

WASHINGTON (Reuters) - Policy-makers have yet to reach a consensus on how a U.S. government-run bad bank would work and the idea may not move forward, CNBC television reported on Friday, citing unnamed sources.

"The government-run bad bank idea that was being floated ... apparently has hit a snag, it might not happen," a CNBC anchor said recapping an earlier report. "Charlie (Gasparino) says the government has no consensus right now on how the bad bank would work, the issue is pricing."

"Making that thing work right now from what I understand is proving to be very difficult," CNBC's Gasparino said in his report.

Gasparino said the Treasury Department has been talking with the chief executives at the biggest Wall Street banks on how to proceed and may shelve the idea of an aggregator bank and instead provide across-the-board guarantees for the troubled assets clogging up banks' balance sheets.

"The aggregator bank is been put on hold indefinitely," he said. "They may do a hybrid: aggregator bank-guarantees. This thing right now has hit a major snag."

Another issue plaguing the proceeding on how to purchase the assets from the banks is the lack of senior staffing under Treasury Secretary Timothy Geithner

Geithner was meeting on Friday with Federal Reserve Chairman Ben Bernanke, Federal Deposit Insurance Corp Chairman Sheila Bair and Comptroller of the Currency John Dugan, with the Treasury saying it was "to discuss financial and regulatory reform.(They may end up serving bankster pudding at a Swedish restaurant ... - AM)

Friday, January 30, 2009

Goldie says 'Nancy wants some crackers'

By Lu Wang
Jan. 30 (Bloomberg)

U.S. stocks won’t rally until Congress approves President Barack Obama’s economic stimulus plan and the Treasury resolves how to use its remaining financial- rescue funds, according to Goldman Sachs Group Inc.

The Standard & Poor’s 500 Index will probably “retest,” or fall toward or below, the 11-year low of 752.44 it sank to in November, strategist David Kostin wrote in a report today. Still, the benchmark index for U.S. stocks will end this year at 1,100, a 30 percent surge from yesterday’s close, he said. (So is Goldie basically saying that the dollar will be crushed by year's end? - AM)

“Passage of a stimulus plan and resolution regarding the remaining TARP capital are critical milestones that must be passed for the S&P 500 to trade higher,” wrote Kostin, Goldman Sachs’s U.S. investment strategist.

Kaboom! Moody napalms Alt- A

(Over 1800 tranches were downgraded. Put a few hundred billion more in writedowns on the fire. - AM)
January 30, 2009

Moody’s Investors Service last week quadrupled its projected cumulative loss expectations for Alt A mortgage-backed securities and warned that most deals will be downgraded, many to below investment-grade. The actions confirm that Alt A MBS will perform worse, ratings-wise, than already battered subprime MBS.

Bottom is nowhere in sight

By Kevin Done in London
Published: January 30 2009 02:00
Financial Times

The airline industry yesterday reported an "unprecedented and shocking" plunge in global air cargo traffic.

The International Air Transport Association said traffic volumes fell 22.6 per cent year-on-year in December. Air freight accounts for 35 per cent of the value of goods traded internationally.

Giovanni Bisignani, Iata director-general, said: "There is no clearer description of the slowdown in world trade. Even in September 2001 [after the terror attacks in the US] when much of the global fleet was grounded, the decline was only 13.9 per cent. 2009 is shaping up to be one of the toughest years ever for international aviation. The 22.6 per cent drop in international cargo traffic in December puts us in uncharted territory and the bottom is nowhere in sight."

Gloomy Gus drivin' the Davos bus

By Gillian Tett and Peter Thal Larsen
Published: January 30 2009 02:00
Financial Times

Amid the recrimination and hand-wringing over the causes and consequences of the financial crisis, bankers and policymakers at the World Economic Forum in Davos have identified a new threat to global prosperity: the rise of financial protectionism.

The huge state-backed bank bail-outs in Europe and the US, while necessary to prevent a collapse of confidence in the financial system, have forced banks to withdraw from overseas markets in order to concentrate their limited resources at home.

A survey by Oliver Wyman showed that leaders of global banks fear that the process of deleveraging - or the reduction of debt - could continue for another three years, leading to grim economic conditions until 2011.

It also suggested that 75 per cent of CEOs in the financial sector do not expect to see any recovery in credit and equity markets until next year - and half fear it will be delayed until at least 2011, due to the scale of deleveraging now under way. The survey calculates that about 50 per cent of the market value of the financial sector has been wiped out during the last 18 months, eroding all shareholder value created since 2003.

"Logic bomb" almost blows up Fannie

By Rick C. Hodgin
Friday, January 30, 2009 09:34
Washington (DC)

On October 29, 2008, a vigilant senior Unix engineer happened across a "logic bomb" that was allegedly planted by a contractor, Rajendrasinh Babubhai Makwana, who had worked in their Urbana, MD facility until October 24, 2008 when his contract was terminated. The script was set to activate on January 31, 2009 and would completely wipe all of Fannie Mae's 4,000 servers. According to engineers, had it done so it would've caused "millions of dollars in damage, and possibly shut down operations for a week."

Fannie Mae is a government-sponsored mortgage lender. Makwana, 35, was indicted for "unauthorized computer access" this past Tuesday in a Maryland District Court, though he is currently free on $100,000 bail after surrendering his passport. Makwana's public defender told reporters he would enter a plea of "not guilty" today, but did not comment further.

According to an FBI affidavit by the Unix engineer who found Makwana's alleged work, "The malicious script [called only 'SK'] was at the bottom of the legitimate script, separated by approximately one page of blank lines, apparently in an effort to hide the malicious script within the legitimate script."

As a result, the script was removed immediately and a lockdown of all Fannie Mae servers was ordered to prevent additional hostile access.

Makwana allegedly used a Fannie Mae laptop computer, which had been assigned IP address, to gain root access to the system and implant the script. This is how the senior Unix engineer was able to discover who may have inserted it.

Reflexive asymmetries

By George Soros
Published: January 29 2009 02:00
Financial Times

In the past, whenever the financial system came close to a breakdown, the authorities rode to the rescue and prevented it from going over the brink. That is what I expected in 2008 but that is not what happened. On Monday September 15, Lehman Brothers, the US investment bank, was allowed to go into bankruptcy without proper preparation. It was a game-changing event with catastrophic consequences.

For a start, the price of credit default swaps, a form of insurance against companies defaulting on debt, went through the roof as investors took cover. AIG, the insurance giant, was carrying a large short position in CDS and faced imminent default. By the next day Hank Paulson, then US Treasury secretary, had to reverse himself and come to the rescue of AIG.

But worse was to come. Lehman was one of the main market-makers in commercial paper and a large issuer of these short-term obligations to boot. Reserve Primary, an independent money market fund, held Lehman paper and, since it had no deep pocket to turn to, it had to "break the buck" - stop redeeming its shares at par. That caused panic among depositors: by Thursday a run on money market funds was in full swing.

The panic then spread to the stock market. The financial system suffered cardiac arrest and had to be put on artificial life support.

How could Lehman have been left to go under? The responsibility lies squarely with the financial authorities, notably the Treasury and the Federal Reserve. The claim that they lacked the necessary legal powers is a lame excuse. In an emergency they could and should have done whatever was necessary to prevent the system from collapsing. That is what they have done on other occasions. The fact is, they allowed it to happen.

On a deeper level, too, credit default swaps played a critical role in Lehman's demise. My explanation is controversial and all three steps of my argument will take the reader to unfamiliar ground.

First, there is an asymmetry in the risk/reward ratio between being long or short in the stock market. (Being long means owning a stock, being short means selling a stock one does not own.) Being long has unlimited potential on the upside but limited exposure on the downside. Being short is the reverse. The asymmetry manifests itself in the following way: losing on a long position reduces one's risk exposure while losing on a short position increases it. As a result, one can be more patient being long and wrong than being short and wrong. The asymmetry serves to discourage the short-selling of stocks.

The second step is to understand credit default swaps and to recognise that the CDS market offers a convenient way of shorting bonds. In that market the asymmetry in risk/reward works in the opposite way to stocks. Going short on bonds by buying a CDS contract carries limited risk but unlimited profit potential; by contrast, selling credit default swaps offers limited profits but practically unlimited risks.

The asymmetry encourages speculating on the short side, which in turn exerts a downward pressure on the underlying bonds. When an adverse development is expected, the negative effect can become overwhelming because CDS tend to be priced as warrants, not as options: people buy them not because they expect an eventual default but because they expect the CDS to appreciate during the lifetime of the contract.

No arbitrage can correct the mispricing. That can be clearly seen in US and UK government bonds, whose actual price is much higher than that implied by CDS. These asymmetries are difficult to reconcile with the efficient market hypothesis, the notion that securities prices accurately reflect all known information.

The third step is to recognise reflexivity - that is to say, the mispricing of financial instruments can affect the fundamentals that market prices are supposed to reflect. Nowhere is this phenomenon more pronounced than in the case of financial institutions, whose ability to do business is dependent on confidence and trust. That means that "bear raids" to drive down the share prices of these institutions can be self-validating. That is in direct contradiction to the efficient market hypothesis.

Putting these three considerations together leads to the conclusion that Lehman, AIG and other financial institutions were destroyed by bear raids in which the shorting of stocks and buying of CDS amplified and reinforced each other. Unlimited shorting was made possible by the 2007 abolition of the uptick rule (which hindered bear raids by allowing short-selling only when prices were rising). The unlimited selling of bonds was facilitated by the CDS market. Together, the two made a lethal combination.

That is what AIG, one of the most successful insurance companies in the world, failed to understand. Its business was selling insurance and, when it saw a seriously mispriced risk, it went to town insuring it, in the belief that diversifying risk reduces it. It expected to make a fortune in the long run but it was destroyed in short order.

My argument raises some interesting questions. What would have happened if the uptick rule on shorting shares had been kept, in effect, but "naked" short-selling (where the vendor has not borrowed the stock in advance) and speculating in CDS had both been outlawed? The bankruptcy of Lehman might have been avoided but what would have happened to the asset super-bubble? One can only conjecture. My guess is that the bubble would have been deflated more slowly, with less catastrophic results, but that the after-effects would have lingered longer. It would have resembled more the Japanese experience than what is happening now.

What is the proper role of shortselling? Undoubtedly it gives markets greater depth and continuity, making them more resilient, but it is not without dangers. As bear raids can be self-validating, they ought to be kept under control. If the efficient market hypothesis were valid, there would be an a priori reason for imposing no constraints. As it is, both the uptick rule and allowing short-selling only when it is covered by borrowed stock are useful pragmatic measures that seem to work well without any clear-cut theoretical justification.

What about credit default swaps? Here I take a more radical view than most people. The prevailing view is that they ought to be traded on regulated exchanges. I believe they are toxic and should be used only by prescription. They could be used to insure actual bonds but - in light of their asymmetric character - not to speculate against countries or companies.

CDS are not, however, the only synthetic financial instruments that have proved toxic. The same applies to the slicing and dicing of collateralised debt obligations and to the portfolio insurance contracts that caused the stock market crash of 1987, to mention only two that have done a lot of damage. The issuance of stock is closely regulated by authorities such as the Securities and Exchange Commission; why not the issuance of derivatives and other synthetic instruments? The role of reflexivity and the asymmetries identified earlier ought to prompt a rejection of the efficient market hypothesis and a thorough reconsideration of the regulatory regime.

Now that the bankruptcy of Lehman has had the same shock effect on the behaviour of consumers and businesses as the bank failures of the 1930s, the problems facing the administration of President Barack Obama are even greater than those that confronted Franklin D. Roosevelt. Total credit outstanding was 160 per cent of gross domestic product in 1929 and rose to 260 per cent in 1932; we entered the crash of 2008 at 365 per cent and the ratio is bound to rise to 500 per cent. This is without taking into account the pervasive use of derivatives, which was absent in the 1930s but immensely complicates the current situation. On the positive side, we have the experience of the 1930s and the prescriptions of John Maynard Keynes to draw on.

The bursting of bubbles causes credit contraction, the forced liquidation of assets, deflation and wealth destruction that may reach catastrophic proportions. In a deflationary environment, the weight of accumulated debt can sink the banking system and push the economy into depression. That is what needs to be prevented at all costs.

It can be done - by creating money to offset the contraction of credit, recapitalising the banking system and writing off or down the accumulated debt in an orderly manner. They require radical and unorthodox policy measures. For best results, the three processes should be combined.

If these measures were successful and credit started to expand, deflationary pressures would be replaced by the spectre of inflation and the authorities would have to drain the excess money supply from the economy almost as fast as they had pumped it in. There is no way to escape from a far-fromequilibrium situation - global deflation and depression - except by first inducing its opposite and then reducing it.

To prevent the US economy from sliding into a depression, Mr Obama must implement a radical and comprehensive set of policies. Alongside the well advanced fiscal stimulus package, these should include a system-wide and compulsory recapitalisation of the banking system and a thorough overhaul of the mortgage system - reducing the cost of mortgages and foreclosures.

Energy policy could also play an important role in counteracting both depression and deflation. The American consumer can no longer act as the motor of the global economy. Alternative energy and developments that produce energy savings could serve as a new motor, but only if the price of conventional fuels is kept high enough to justify investing in those activities. That would involve putting a floor under the price of fossil fuels by imposing a price on carbon emissions and import duties on oil to keep the domestic price above, say, $70 per barrel.

Finally, the international financial system must be reformed. Far from providing a level playing field, the current system favours the countries in control of the international financial institutions, notably the US, to the detriment of nations at the periphery. The periphery countries have been subject to the market discipline dictated by the Washington consensus but the US was exempt from it.

How unfair the system is has been revealed by a crisis that originated in the US yet is doing more damage to the periphery. Assistance is needed to protect the financial systems of periphery countries, including trade finance, something that will require large contingency funds available at little notice for brief periods of time. Periphery governments will also need long-term financing to enable them to engage in counter-cyclical fiscal policies.

In addition, banking regulations need to be internationally co-ordinated. Market regulations should be global as well. National governments also need to co-ordinate their macroeconomic policies in order to avoid wide currency swings and other disruption.

This is a condensed, almost shorthand account of what needs to be done to turn the global economy around. It should give a sense of how difficult a task it is.

Wednesday, January 28, 2009

From Perma-Bear to Future Bull

by Steve Forbes
01.26.09, 06:00 AM EST

Steve Forbes: Well thank you, Jeremy, for joining us today. First, since you have bragging rights in this situation, what made you a bear, [a] great skeptic? Between 1999 until about a couple of months ago, you were saying, "Stay out."

Jeremy Grantham Well, really very simple. Not rocket science. We take a long-term view, which makes life, in our opinion, much easier.

Steve Forbes: Well everyone says it, but you certainly practiced it.

Jeremy Grantham We actually do it. Well, we tried the short-term stuff and it was so hard; we thought we'd better do the long-term. We just assume that at the end, in those days, of 10 years, profit margins will be normal and price-earnings ratios will be normal. And that will create a normal, fair price. And more recently, we've moved to seven years, because we've found in our research that financial series tend to mean revert a little bit faster than 10 years--actually about six-and-a-half years. So we rounded to seven.

And that's how we do it. And it just happened from October '98 to October of '08, the 10-year forecast was right. Because for one second in its flight path, the U.S. market and other markets flashed through normal price. Normal price is about 950 on the S&P; it's a little bit below that today.

And on my birthday, October the 6th, the U.S. market, 10 years and four trading days later, hit exactly our 10-year forecast of October '98, which is worth talking about if only to enjoy spectacular luck. The P/E was a little bit lower than average and the profit margins were a little bit higher, so they beautifully offset. And given our methodology, that would mean that on October the 6th, the market should have been fairly priced on our current approach. And indeed it was--that was even more remarkable--950, plus or minus a couple of percent.

Steve Forbes: And what did you see during that 10-year period that made you feel--other than your own models--that this was something highly abnormal, that this couldn't last?

Jeremy Grantham Well, first of all, the magnitude of the overrun in 2000 was legendary. As historians, you know we've massaged the past until it begs for mercy. And we saw that it was 21 times earnings in 1929, 21 times earnings in 1965 and 35 times current earnings in 2000. And 35 is bigger than 21 by enough that you'd expect everyone would see it. Indeed, it looks like a Himalayan peak coming out of the plain.

And it begs the question, "Why didn't everybody see it?" And I think the answer to that is, "Everybody did see it." But agency risk or career risk is so profound, that even if you think the market is gloriously overpriced, you still have to get up and dance. Because if you sit down too quickly--

Steve Forbes: Famous words of Mr. Prince.

Jeremy Grantham If you sit down too quickly, you're likely to get yourself fired for being too conservative. And that's precisely what we did in '98 and '99. We didn't dance long enough and got out of the growth stocks completely, and underperformed. We produced pretty good numbers, but they're way behind the benchmark. And we were fired in droves.

I think our asset allocation, which is the division I'm now involved in, we lost 60% of our asset base in two-and-a-half years for making the right bets for the right reasons and winning them. But we still lost more money than any other person in that field that we came across, which is a fitting reminder that career risk runs the business.

Steve Forbes: So it's alright to be wrong as long as everyone else is wrong.

Jeremy Grantham That's right. "I never saw it. Nobody saw it," that's what they say about today's fiasco, which actually makes me quite disgusted, because almost everyone we talked to did see it coming. And I described it in June of last year as the most widely predicted "surprise: in the history of finance. And that's 18 months ago.

Steve Forbes: What was it about this bubble, do you think distinguished it, if one can distinguish bubbles from past bubbles?

Jeremy Grantham Yeah, oh, I think this was distinguishable in many ways. I described it, I think, accurately as the first truly global bubble. It had every asset class, notably real estate, as well as stocks. But bonds were also overpriced and fine arts, of course, were ridiculous. And secondly, it was global. So, you know, Indian fine arts were going out of control. And Chinese modern art --

Steve Forbes: But you still bought them, right? Indian fine arts, aren't you?

Jeremy Grantham I, perhaps, I participated too much in Indian antiquities, which I have a soft spot for. But so, it was unique in breadth of asset class, in breadth of reach, globally. Quite unlike anything else since the Depression and even much broader than the bubble of 1929.

Steve Forbes: You mentioned about career risk, that it's better to be with the crowd than going against it and paying a price because people don't like what you're saying. Did people really believe, do you think, their risk models that said you can take this outsized risk but, 1) you've hedged it, and 2) if this goes up, this goes down, and therefore, it's not-- as risky as it looks?

Jeremy Grantham Oh yes, I think they did. I think you should never underestimate the ability of really serious quants to believe quant models. They can really do faith big-time in those models. There's something about having a PhD in some serious topic like particle physics or math that, when you've finished a couple of years of hard work and you've produced a model, then your faith in it can be intense. I think these people really did believe in that stuff.

Steve Forbes: And now that you feel the tide is turning, what should investors do now? First of all, during that 10-year period, where did you invest money when you saw this bubbly atmosphere? And what are you doing now?

Jeremy Grantham Most of our money is in specific funds for institutions. So, we have an emerging market equity fund. And for institutions, they don't want us messing around, moving up and down our cash balance. So, they're fully invested in equities and we're trying to do the best job that we can. We have an asset allocation group with about 40% of our money today.

And there, we are allowed to move around. but even there, we have a clear job description so that in one account, for example, a fairly typical flavor, we are not allowed to drop below 45% equity or go above 75%. So in the institutional business, people are pretty hemmed in most of the time, and we are. Most of the last 10 years, we have been promoting the idea of not taking a lot of unnecessary risk, and that's probably been the most constant theme.

The single exception to that, until quite recently, was emerging markets. We felt that if you had this irresistible urge to take risk, you should exercise it on emerging, because you'd get a better bang for your buck. And we were overweighted for 12 years, ending in this July. And we kind of blew the whistle in July.

We had been thinking that emerging was strong enough and fundamental [enough] that we'd ride out the unpleasantness. And then, on June the 26th, precisely, the penny dropped that I had been quite optimistic on lots of little fundamentals. None of them, perhaps, profoundly optimistic, but they accumulated to considerable optimism. And it was revealed to me that I had just misevaluated how bad things were going to be fundamentally. And one of the reasons was career risk. Because we were the best, there was a kind of disinclination to wrack your brains to be even further off the spectrum than you were already.

And since I was already considered a perma-bear, I thought, "Well, we're the most bearish people around, let's leave it at that. Don't look for trouble." And then, June the 26th, we had a Glaswegian arrive to kind of review the data with us, an economic strategist. And he had this dour Glasgow accent. I think that had something to do with it.

And I came out of the meeting thinking, "Holy cow, this is going to be really, really awful." And I wrote a courtly letter immediately saying, "I recant on emerging. Up until now, we'd been advising for two years, 'Take as little risk as you can, except for emerging.' Our new advice is 'Take as little risk as you can, period.'" And we held up the letter for two weeks.

We did the biggest trade in our history. And for the first time in 12 years, we went to underweight emerging across the board, which in some accounts meant zero. And for the only time in my career, the emerging market immediately nosedived. I mean immediately--like the day after we did our trade, it headed south, and three months later, it was down 40%. I mean, I've never seen anything like that. So we replaced it. We thought, "Well, 40% makes a lot of difference to anybody." We were looking at 11%, 12% imputed real returns for seven years in emerging, and we replaced the bet in October.

Steve Forbes: You went back in emerging markets.

Jeremy Grantham Back in emerging markets.

Steve Forbes: And in terms of evaluating markets, and stocks in particular, you have a pretty disciplined formula. So you can say precisely 950 and--

Jeremy Grantham That's exactly right. It may be wrong, but it's precise. And we've had a long history of doing it the way I described, that everything will be normal in seven years. And it's turned out to be quite robust. And probably pretty simple and straightforward-- an effective way of doing it. And right now, what it says is that, since October, global equity markets have been cheap. Not dramatically cheap--not cheap like you and I have seen [in] a couple of markets. 1982, 1974--that was very cheap indeed.

This is merely ordinarily cheap. But it's the cheapest it's been for 20 years. For 20 years, we had this remarkable period when the markets were never cheap. They got less expensive, you know, too, but they were never cheap. And so now, you have this terrible creative tension between, on one hand, they're the cheapest they've been for 20 years.

They're pretty decent numbers. For seven years, we expect seven-and-a-half [percent] real [return] from the U.S., from the S&P. And perhaps nine-and-a-half from EAFE and emerging. These are not bad numbers for seven years. And on the other hand, as historians, we all recognize that the great bubbles tend to overrun.

Steve Forbes: Right.

Jeremy Grantham And they're not normally satisfied--you can't buy them off by being slightly cheap; they insist on becoming very cheap. So, we've said for several months that we thought this cycle would go to 600 or 800 on the S&P. Eight hundred if it was a mild recession--ho-ho, [we] can throw that one away. And 600 would be quite normal if it was a severe recession like '82, '74, which I think, I don't know if you agree, is pretty well baked in the pie today. It may be worse, but it's probably not going to be much less bad than '74 or '82.

Steve Forbes: And so, in terms of the markets today, even though they're cheap, you're going in gingerly, since it could theoretically go down to 600, and given the emotions you get in these things.

Jeremy Grantham Yes, I would say two-to-one, by the way, my instinct plus looking at the history books, that it will go to a new low [in 2009]. So this is the problem; we're underweighted still. In an ordinary asset allocation account that has 65% in equities, we have moved up to 55%. So, we're still underweight, even though they're cheaper than they've been, and they're reasonably cheap.

Now what happens? If we throw in the client's money and it goes down, indeed, as I think it will [in 2009], they will complain quite bitterly that we weren't very smart. We thought it was going down, and yet we threw their money in. So that's one kind of regret. And the other kind of regret is that we hang back and the market runs away, the one-in-three comes up and they say, "You told us the market was cheap. You told us that you had these 9% or 10% real return opportunities, and you're still underweight and the market's back up 200 points. You're an idiot."

So, there's no way you can avoid some regret. You have to look at your own personal balance sheet. How much pain can you stand? If you absolutely can't stand a 20% hit, you'd better carry quite a lot of cash, because you're quite likely to get it. If, on the other hand, you're made of steel, you can concentrate on the seven-year horizon and filter money in, and having a lot of cash here is probably a bit dangerous from the other point of view.

But in any case, it's a very personal judgment of risk avoidance and how tough you are under stress. The worst situation that will befall probably quite a lot of people is that they exaggerate their toughness. The market goes down 30% from here to 600 and they panic, dump their stocks and never get back. And that's the worst outcome.

Steve Forbes: And one of the areas you seem to be interested in is Japanese stocks?

Jeremy Grantham I think Japan may turn out, finally, in a curious way, to be a blue chip here. They've been through a lot of the problems. Their ordinary corporations are no longer super-leveraged as they were. It took them 15 years, but finally, they got there about three years ago. The banking system is not at the cutting edge of all the problems, so they look relatively blue chip.

And yes, they're exposed to the global export problem, but when you look at Japan, they are [a] deceptively low exporting country. It's only 12% of their GDP; it's much lower than most European countries, etc. So I think they're fundamentally a candidate for the blue chip, and plus, they're stock prices of course have been terrible.

Steve Forbes: Right.

Jeremy Grantham It's taken them 17 years to lose 78% of their money. This is what I say: That exhibit is called "stock for the very, very long run." Aimed at Jeremy Siegel, if you think that people are machines, then of course you can tuck stocks away and hold them forever. But ordinary human beings don't like to wait 17 years to lose 78% of their money or 28 years to round trip in Japan.

They haven't made a penny in 28 years, including dividends, in real terms. And people have dismissed that, "That's Japan, we're the U.S." And that is, in a way, the most simple minded of logic. Of course, every country is different. But do not think that we can't have terrible times. I sincerely hope we will not, and I don't expect that we will. But you have to consider it a possibility.

Steve Forbes: Now, looking at emerging markets, what ones stand out as particularly enticing right now, or do you try to merge them all together?

Jeremy Grantham Merge the emerging, yes. We do, I think. Emerging market is no longer at all monolithic. There is an exporting clutch, there is a handful of eastern European that looks a little shaky. There are two or three that have forgotten the rules of the Asian crisis and have accumulated some foreign-denominated debt that leaves them very vulnerable. And increasingly, each one looks separate. But in general, many of them have better finances than they had in other crises.

Steve Forbes: Any ones particularly stand out that you?

Jeremy Grantham Well, Brazil, of course, is much improved from the way it used to be and has a nice position in natural resources. And on a very long horizon, I like its style. I'm not making a recommendation based on today's price. Indeed, I don't know today's price, they most so fast. We had one day the other day when their entire fund and the index was up over 10% for the day. So the numbers change at bewildering speed these days.

Steve Forbes: And U.S. blue chips, you--

Jeremy Grantham No, U.S. blue chips, I think is manna from heaven. They're conservative in a risky world. The best companies on the face of Earth, right? And from '02 to '07, they were considered boring and all the action was in the racier, more leveraged stuff. They underperformed every single year from '02 onwards and five years in a row. So, when this trouble started to escalate, they were about as cheap, on a relative basis, as they ever get.

They were not absolutely cheap, but they were relatively very cheap. And the best bet, for my money, then and now, a year later, was to buy the great franchise companies, the great quality companies and to go short the junkier, more leveraged companies. That's been a very profitable strategy and one of the few things that has been working this year. This year, of course, as you know, has been the year from hell for money managers.

The value traps, the likes of which we haven't seen since the 1930s, the great value managers all made their reputation by being braver than the next guy, by buying the WaMus of the world when they'd fallen to seven and they'd bounce back to 28. And this time they went from seven to three and they doubled up again and they went to zero.

It's been a nightmare. And the quants, who use momentum as well as value, have had no better luck with momentum. And the quant techniques of balancing risk have also failed, as we were discussing. So, this has been a dreadful year for money management. And quality has been the one theme that has worked. And interestingly, from our firm's point of view, it's not a theme that other people seem to have adopted.

There are not quality funds, there are large cap and growth and value, but there are no quality funds. And so, it's been hard for people to pick up that theme. But it has been very, very good since September.

Steve Forbes: What are a couple of examples of what you consider quality companies?

Jeremy Grantham I'm not recommending these companies, except generically.

Steve Forbes: Right.

Jeremy Grantham But, no surprise is Coca-Cola, Microsoft, Procter & Gamble, Johnson & Johnson. These are the essence of the great franchise companies. And collectively, they're not that dependable in bear markets, but they're incredibly dependable when people's confidence in the fundamentals start to go. In Japan, for example, the quality companies in Japan outperformed for nine consecutive years when their troubles came.

They accumulated again against the Japanese market of 98% points. They were brilliant in the Great Depression between '29 and '32. Even though the Coca-Colas were relatively overpriced in '29, they still went down dramatically less than the junky companies. But they're the great test of quality. So, you wouldn't expect quality to be dependable unless we were having the kind of environment that we seem to be having. And I think they will have legs, they will, the high quality companies can outperform, handsomely still, from here.

Steve Forbes: Commodities--you were short oil; your firm was short copper. When do you go long, or is that just a side show?

Jeremy Grantham That's a very good question. I was thinking about that in the taxi today. When you see oil breaking $40, I believe oil is the great exception. I asked over 2,000 full-time professionals to find me a paradigm shift in a major asset class and they never offered me one, so I was very pleased to offer oil a couple of years ago. I thought it was the genuine paradigm shift. I thought that after 100 years at $16 a barrel, it had jumped to maybe $36 or $37 in real terms. And I think it has probably jumped again. It will be revealed in 20 years to what level. But my guess is $60, $65, maybe even $70. But what people underestimate, even in the oil industry, is how volatile the asset class is. In other words, if the trend is $65, it is fairly routine for oil to sell below half, say $30, and more than double, say $145.

And people never get that. So you don't want to be too quick to buy into weakness or sell into strength, necessarily. But it can go a long way. But below 40, I must say, I do get a bit interested. And below 30, I'm definitely a buyer.

Steve Forbes: Wow.

Jeremy Grantham And copper, copper's done so brilliantly on the downside that you really begin to ask--it must be approaching cost of production somewhere in the next 10% or 15%--you have to say, "That was very nice, thank you," and cover.

Steve Forbes: Now, in terms of the U.S. economy, you've seemed to be saying that the Fed is doing right, print all [the money] you can, and for the government, to spend all you can.

Jeremy Grantham Yes, which I have to choke on, as I have no doubt you would. Because, normally, it's a terrible--

Steve Forbes: That's why I'm not drinking the water, I don't want to choke.

Jeremy Grantham It's normally terrible advice. It's only useful when it's the real McCoy. And I think it is. And if there's unemployment, having the government help reduce that unemployment, increase employment directly is a pretty good idea. It's not driving out competition, it's not crowding out. As long as there's excess unemployed people sitting around like the Great Depression, you should do everything you can to get them employed and get the system going again, just as a temporary stop gap, I believe.

And I think by combining that with energy sufficiency, particularly labor-intensive kind of energy avoidance--installing insulation, storm windows, very labor-intensive. Battering down solar cells on the roofs of Wal-Marts in California. I think that will be some of the highest return investments that anyone ever makes.

Just return on capital is very, very high in efficient light bulbs, and therefore should be done. And I don't mind the government accruing debts as long as every dollar is spent effectively with a high return. That works out fine. If you accumulate debts and waste your money, that's, of course, a disaster. I know I'm preaching to choir on that one.

Steve Forbes: And what about tax rates? Isn't that the best stimulus? Lowering tax rates, changing incentives?

Jeremy Grantham The trouble is, in these very rare occasions, that sometimes does not work. Normally, of course, it's a lay-up. But if you give Japanese corporations were the real crunch there. Here it's consumers. Japanese corporations had so much debt, that as you threw money at them, they paid down their debt. They didn't build new factories. They were waking up at 3 o'clock in the morning sweating that they were insolvent.

Of course, technically, they were insolvent. So, they paid down debt and they paid down debt. Our consumers are so leveraged that you run the risk with a tax cut that they're in the same boat. You write them a check, even--same thing as a tax cut, really. Write them a check for $250 and they'll pay down their credit card debt because they're getting desperate. They are hugely overstretched. So it doesn't necessarily work anymore, pushing on a string. And whereas, if you get out there and spend money to employ people directly, bashing insulation into your attic, that does work.

Steve Forbes: So, what is the one big misplaced assumption today when you look around at this?

Jeremy Grantham Reviewing the last two years, of course, it's a misplaced trust in the competence of our leadership, from the very top. But certainly, notably, the Fed, the arch villains of this piece; Treasury, little better; the SEC. They were cheerleaders, all of them. And they encouraged reckless leverage and low-quality debt. Complicated, unresearched, generally disgraceful.

And they made no effort to resist it in any way. Even jawboning would have been a great advantage over nothing. Greenspan encouraged, admired the ingenuity of the new instruments for sub-rime. I mean, went out of his way to encourage it. Some, as in Greenspan, beat back an attempt to do some regulating of subprime markets. And I think it looked pretty bad.

Hank Paulson did not move fast enough to recognize that the impending decline of house prices would create some problems. And Bernanke couldn't even see the house bubble. On our data and Robert Shillers, it was a three-sigma, one-in-100-year event. After 100 years of being flat, it soared after 2000. You could not miss it. And right at the peak, October '06, Bernanke said--quote--"The U.S. housing market merely reflects a strong economy"--unquote.

What was he looking at? Where were his statisticians? These are the guys we picked out of millions to lead us in a crisis. And they can't see a three-sigma bubble? Every single bubble of that kind has broken. Asset classes are incredibly dangerous when they form a bubble and when the bubble breaks. And Greenspan did not get that, and I've been screaming “abuse” forever. It seems like as long as I can remember, but I wrote a piece in 2001 called “Feet of Clay,” saying basically, "This bubble from 2000 will be hard to forgive."

And of course, it was the ancestor of the current problem and the housing bubble. The housing bubble is even more dangerous because more people own houses. It's more for the ordinary people. And borrowing is so much easier. So, that is really the most dangerous. And to do two at once this time around, and to do it globally, is to truly play with fire. We have lost, or will have lost, is my estimate, at the bottom, $20 trillion of formerly perceived wealth, from $50 trillion to $30 [trillion].

And at $50 trillion, we had $42 trillion of debt of all kinds, which is a fairly suspiciously high 80% ratio of assets. But at $30 [trillion], we will have $42 trillion of debt, which is much more than suspicious. And bankers, who always get religion after the event, are now going to say that 60% ratio might look better.

And 60% of $20 [trillion] is not going to make much of an impression on the $42 trillion of debt that we have. So we have a lot of what I call "stranded debt," $15, $20 trillion. Even at fair price, which is, perhaps, $25 trillion. There's still a lot of stranded debt. This is going to take years to work through the system, not [just] a year or two.

Steve Forbes: So what is the best financial lesson you've learned? You've been in this business for decades.

Jeremy Grantham The market is incredibly inefficient and capable on rare occasions of being utterly dysfunctional. And people have a really hard time getting their brain around that fact. They want to believe that it's approximately efficient almost all the time and it simply isn't true.

Steve Forbes: So what is your bold prediction for the future, now?

Jeremy Grantham In the long run, things will be back to normal. In the short run, I think China will be a bitter disappointment. I can't believe that the hardest job in economic history--guiding a vast empire of people and assets, growing at double-digit industrial production rates--can be anything but difficult. And they've had much less experience than most capitalist countries.

And they have been, because of 20 years of wonderfully good luck and favorable circumstances, we have all been seduced into believing that there walk on water. And I don't think they do. I think they have a terrible situation, which will be under stress from all sides.

They export 40% of their GDP. The global economy gives a passably good impression of having run, head down, into a very thick cement wall. And I can't imagine that their exports will be anything other than mildly disastrous. And yet, two months ago, the official forecast was still that it wouldn't drop below nine. I mean, that is at least faintly ludicrous.

Steve Forbes: What are the other fault lines you see in China?

Jeremy Grantham I'm not a China expert, so I'd be happy to leave it.

Steve Forbes: Well, the experts weren't, either.

Jeremy Grantham They have a very small consumer sector, so it's hard to stimulate that. A very large capital spending sector. How low does an interest rate have to get to build another steel mill when there are seven up the road empty, not operating. It's not an easy situation, I think. Direct spending on roads and so on is something that might work.

But can they do it big enough, since they're already doing it at a dramatic level? Can they increase it enough to rev their economy? I don't think so. I think their economy will be very flattish for a while. And that will be a bitter shock to everybody who's learned to depend on them.

Steve Forbes: And one last question on China. Their financial sector, their stock market--in your mind, is that still very primitive? Does it really provide capital for genuine entrepreneurs, or is it still all still?

Jeremy Grantham I can't. I really am not an expert. You look back, and what you do see about the Chinese market is that it was again, a classic bubble. It's a beautiful shape, symmetrical, it rises, it peaks and it drops slightly faster than it went up, which is actually quite typical. And it was a great opportunity that I regret not having capitalized on more than I did.

Steve Forbes: But now you're staying away.

Jeremy Grantham Well, now it's completed the obvious part of the bubble. It's back to kind of trend line. It may not be, you know, on a long-term perspective, particularly more vulnerable than others. Even though their economy will be disappointing in the short-term, of course, it has enormous long-term potential. I do think emerging is the place to be in the long run. I think it has all the indicators that will be required for the next bubble. It has wonderful top-lying growth relative to an increasingly sluggish developed world. It has a very high savings rate and investment rate. And I think it will become a cliché how passé we all are--the U.S., the U.K., Europe, Japan.

We're running out of people. The number of man-hours offered to the markets have been dropping without anyone talking about it for 10 or 12 years. Collectively, the G7 is way off its old trend line. By next year, the U.S. will be 14, 15 points behind its long-term trend rates. It's never come close to [that] since the Great Depression.

Steve Forbes: Trend line, meaning?

Jeremy Grantham Just to take the 100-year battleship trend line, which never deviated at 3.4 or something like this. The Great Depression, it went back to trend very quickly. And now, we have been drifting off for this is year 13 of drifting below trend. We're simply getting more mature, and all the other developed countries are doing the same thing. But emerging has not fallen off its trend line, and has a lot of people coming into the workforce and a huge savings rate.

I think it will do very well. Put it this way, it will appeal to investors. It may not make any more earnings per share, in other words. I'm not talking about true fundamental value. I'm talking about how people buy stocks. They love top-line growth. If they're going to grow at four-and-a-half and we're going to slow down to two-and-a-half, it's going to look like a no-brainer. So, I think the next big event in emerging will be that they will sell it at a big P/E premium over us developed countries, who are suffering from a terminal case of middle-aged spread, I think.

Steve Forbes: Well, clearly, the way you look at life is anything but a no-brainer. Thank you very much.

Jeremy Grantham Thank you. I enjoyed it

He ain't kidding

Shortly before a meeting with business leaders on the economy at the White House, Obama said he wanted to make an unrelated comment to the press. In a slightly amused tone, he noted that his daughters' school, Sidwell Friends, was canceled today because of a snow and ice storm that hit Washington.

The suburban schools systems and many private schools in the region were closed today and the District public schools opted for a delayed opening because of the sleet and freezing rain that made some roads and many sidewalks treacherous.

"Because of what? Because of some ice?" Obama said to laughter around the table. He said Sasha, his 7-year-old, pointed out that in Chicago, not only is school never canceled for snow, "you'd go outside for recess. You wouldn't even stay indoors."

He concluded by saying: "We're going to have to apply some flinty Chicago toughness to this town. I'm saying that when it comes to the weather, folks in Washington don't seem to be able to handle things."

Tough love from Bair or tough luck for us

Institutional Risk Analyst
January 26, 2009

The term "bad bank" is being tossed around Washington dinner tables this week, a sign that the situation facing the largest banks is reaching a boiling point. It is amazing to us to see how little people understand the choices facing us with the big banks, how narrow those choices truly are and how the numbers in terms of losses are so BIG that they will ultimately force us to do the right thing. A couple of points:

First, IRA's estimate for accumulated bank charge offs for 2009 is in the neighborhood of $1 trillion vs. $1.5 trillion in Tier 1 Risk Based Capital at all US banks today. Good news, though, is that 2/3 to 3/4 of that loss number comes from the top 4 - Citigroup (NYSE:C), Bank of America (NYES:BAC), JPMorganChase (NYSE:JPM) and Wells Fargo (NYSE:WFC), in that order of risk profile. (Roubini says 1.8 trillion. - AM)

Since most of the toxicity in the banking system is concentrated among the larger banks, with perhaps US Bacorp (NYSE:USB) on down viable in the long run, perhaps we can rebuild the industry using the next round of TARP funds to bulk up these relatively smaller banks and thereby end up with 10-15 larger super regionals in the $300-$500 billion asset range. There may even be banks of this size still doing business under the current names of C, JPM, BAC, etc, but these new banks will have new owners and creditors.

Second, the Good Bank/Bad Bank debate is really a political battle between the large banks listed above plus Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS) et al among the Sell Side survivors in NYC vs. the rest of the industry and the US economy. In preparing their plans for review by the White House, we hear that the Fed and OCC are supporting further bailouts for the larger banks, while the rest of the industry is being resolved and recapitalized a la Washington Mutual and Lehman Brothers.

Perhaps we ought to feed the "good bank" parts of the "too big to fail" crowd, a crowd prone to leverage and bad risk management, to the smaller and plain vanilla bankers that comprise the nominal majority of the industry. This would solve many things including reducing the lobbying power that Wall Street has in Washington. Come to think of it, President Obama should think about banning lobbying by any company participating in the TARP.

Remember that the entire banking industry stands in front of the taxpayers in terms of loss absorption at the FDIC, so you can understand why the smaller banks in the industry are SERIOUSLY PISSED OFF at the large banks and their minions in the Obama Administration like Tim Geithner and Robert Rubin. Oh, and don't forget Chairman Ben Bernanke and the entire Fed board of governors. These leading officials are increasingly talking the side of the large banks in the battle over limited financial resources, a fact that is causing the community bankers to rise in anger. Stay tuned.

Third, juxtapose the Fed/OCC position of 'let's bail out the big banks' (equity and debt) which Tim Geithner established in the Bear Stearns and AIG rescues, and reiterated in his confirmation testimony, with the modified "tough love" position of Sheila Bair, where she proposes to buy bad assets from the Big Four Zombies w/o a resolution. It seems clear that both sides of the equation in Washington are prepared to socialize the large bank losses and in particular subsidize the bond holders at public expense, an act of generosity that could cost the industry and taxpayers another $1 trillion before all is said and done.

But at least with the modified tough love proposed by Bair, the US government still would clearly end up as the explicit owner and the existing equity and preferred would be diluted out of existence as the quid pro quo for the bad asset purchases. That is the little detail people in Washington still don't understand. Indeed, if you think about C as perhaps accounting for one third of the $1 trillion IRA charge off estimate, then Washington must impose a haircut on debt or ask the banking industry and the taxpayer to subsidize the loss.

The better course for the economy outside NYC is to resolve these large institutions over the course of 2009 and beyond, first by diluting the equity (common and preferred) and effecting a conservatorship a la Fannie/Freddie. This eliminates the issue for the markets. A formal open bank assistance might be a default under the ISDA contract template, something the Fed's conflicted madarins would not initially accept, but when the charge-offs at C rise above total risk based capital and keep rising, perhaps minds in DC will begin to change. Then we can haircut the Big Four Bank debt in a negotiated deal pre-receivership, and sell the non M2M bank assets and liabilities to stronger hands. This is the traditional American way of dealing with insolvency in the absence of political meddling by the Fed and the Congress. Let Sheila Bair and the FDIC do the job and we can make the economy rebound with surprising speed. It only takes political courage. We have the money.

Roundtable: David Kotok & Josh Rosner

For additional perspective on this issue, The IRA spoke last week to Josh Rosner of Graham Fisher & Co and David Kotok of Cumberland Advisors:

The IRA: The basic question everyone's asking is what do we do with the big banks, particularly C and BAC and the growing tension between the cost of supporting the big banks w/o a resolution and the rest of the industry, which is being resolved according to the law. You can see our discussion of the issue and our view of loss rates above.

Rosner: First, I am very cautious about making loss estimates because your loss number could be very low. I can actually draw a scenario that gets us well above that level of charge offs, especially if we assume worsening macro conditions and their further impacts on ADC books, corporate defaults and other areas outside of the structured exposures.

The IRA: We shall so stipulate. Let's just say we all agree that the actual level of 2009 losses will probably not be below our 2x 1990 estimate.

Kotok: At the end of the day, what difference does it make? Either way, the path to a solution must deal with the number whatever it ends up to be.

Rosner: Yes and this is why I wanted to have this conversation. I am hearing very clearly from within the regulatory community that it is their primary concern that whatever they are planning is predicated on the notion that we must keep the large banks alive. But if we start off with saving the big banks as the point of departure, then there is no way we can marry that to an efficient or effective proposal. Lets define the solution based first on what is workable not by tying a hand behind our back with preconceptions.

Kotok: I am hearing the same thing. The motivation of keeping big banks alive is driven by a desire to avoid another Lehman on the Obama watch. I hear people saying that we cannot have another Lehman, therefore we cannot permit a failure…

The IRA: And by that we mean a good old fashioned failure of a publicly listed parent holding company a la Lehman or Washington Mutual, where the equity was entirely wiped out and the unsecured debt holders got pennies on the dollar?

Kotok: Yes, precisely. Hence, whatever it takes we must avoid it. It is the Lehman failure and the contagion that is driving this policy.

The IRA: Well this just confirms that nobody in Washington understand the problem. As we have heard from many people in the industry who did the diligence on Lehman, there was no way for a private buyer to do the deal, so bankruptcy was the only choice w/o a very large, several hundred billion public bailout. The fact that the Fed and Treasury professional staff support this type of idiocy, over time, will destabilize the political consensus in this country behind an independent central bank. We might as well just make the Fed part of Treasury now.

Kotok: It looks to me as well that we now have Paul Volcker saying that we cannot tolerate another Lehman failure. Maybe Chris has some thoughts on this?

The IRA: My conversations with Chairman Volcker are OTR unless he says otherwise.

Rosner: In the Lehman failure, we had the tree that came down in a windstorm that nobody had prepared to allow to fall. But when you fell a tree deliberately, that is another matter. Remember, even if you wipe out these banks, the debt holders are guaranteed under the new temporary FDIC powers so the tree can safely fall.

Kotok: If they can find a way to fell the tree without new risk of contagion, perhaps, but remember that the big banks are also the primary dealers of US government bonds and agency paper. Of the 16 primary dealers that remain, nine of them are foreign owned. Therein lies the other problem.

The IRA: So fine, we resolve C and sell the bank, the branches and the capital markets business to the new investors on the other side. Take a couple of years to complete the process for say C, BAC and JPM. Not sure if WFC will need a restructure. Look, Barclays bought the Lehman broker dealer on the other side of a bankruptcy and JPM bought a clean WaMu. This is the way to fix the problem. The loss rates coming out of C, then BAC, then JPM this year are going to be so large that a managed sale process is the only rational choice. The equity is impaired in economic terms. Thus the question comes, what do you do with the debt? I don't think Paul Volcker is embracing a subsidy for debt holders of banks, but maybe so.

Rosner: I think what you are going to see is, on the one hand, the Fed, Treasury and OCC put together a proposal for a continuing or institutionalization of the "insurance wrap" approach used with C and BAC. This is a useless approach, in my view, and as we saw in the case of C because it created greater market confusion, which assets were circled, etc. The market does not seem to be confident based on the performance of C stock. It is also unclear how it will be possible to get an independent view of the government's share of losses since they will be managed by the banks themselves.

The IRA: Nobody in the Congress or the White House wants to acknowledge that the policy prescriptions coming from the Fed and Treasury are badly flawed when it comes to bank solvency. The market liquidity measures have had success, but the "save the big banks" approach by the Fed is just more of the same nonsense that cause the problem in the first place.

Rosner: Exactly. In operational terms, there are no longer institutions that are too big to be resolved. As we discussed with the tree analogy, that is different from 'failing'. Any risk of a run on C or the other banks is now ameliorated. The recently enacted changes to guarantees on deposits, non-interest bearing transactions accounts, etc, addressed that issue. The other systemic issue was counterparty risk, but with the qualified financial contract rule just put in place by the FDIC that risk is also largely gone and you can resolve a bank's counterparty exposures into a good bank/bad bank configuration with little problem and without creating larger systemic risk. If the counterparty's financial contracts are adequately collateralized, then they can go with the good bank, but the FDIC must retain unilateral power as receiver to reject or accept contracts. The notion that we can't allow C to be wound down and broken up is a spurious argument. I think this arguement has less to with Lehman and more to do with the fact that the Fed of New York and the Board have always benefited from the failure of small institutions and the absorption of those assets by the big banks. There is no way that they can stomach seeing their regulatory power dissipated by those institutions now being broken up and sold. Perhaps we have to go back to the question of whether it makes sense for the Fed to be a regulator as well as a central bank.

The IRA: Especially to investors outside of the New York district and even outside the Fed's immediate jurisdiction, to foreign investors. But whether anyone at the Fed or Treasury likes it or not, we are talking about the absorption by the US Treasury of at least half a trillion in losses for the top three banks in the next 12-18 months if an FDIC resolution is to be avoided. Putting the ill-informed discussion in Washington aside, we see a continuation of the open bank assistance now in place for C, with asset sales and an eventual pre-pack for the debt holders, in a process that lasts years. The dealers will be kept open. If we use the power of time and changes in accounting rules, the C bond holders might see some recovery but make no mistake that the bond holders of C are the current owners in economic terms.

Rosner: If the FDIC, which is supposed to be the sole and non-politically motivated regulator in charge of winding down troubled institutions, play their cards right, they may come closer to what we all agree is good policy in terms of forcing a resolution. I would guess that the bad bank approach we have heard the FDIC float would be to buy the bad assets. You mark the assets to value (not market price) in a relatively fair way, closer to what a mark plus a reversal of the liquidity discount would suggest and then buy them. If the bank is then able to privately raise 50% of the capital that it would take to get them to CAMELS level 1 or 2 the government can invest the rest at the same terms. If they can't do it then they are out of luck. This is not nationalization, many of these banks are ill enough that in any other environment we would just resolve them. The government would probably take equity warrants or hopefully new preferred. Unfortunately, the FDIC can't own straight equity and I hate the idea of warrants. Warrants create a conflict where regulators can't resolve an unsafe institutions because lobbyists will say "if you resolve that institution you will be wiping out taxpayer assets." They also push off the day of dilution. People forget that Chrysler was bailed out in 1980 and after they returned to profitability they almost succeeded in having Congress rip up the warrants.

The IRA: The taxpayer equity in C is already gone, at least in economic terms. David, are you playing in this investment opportunity Rosner describes?

Kotok: No and I think that as soon as you do anything conditional it fails.

Rosner: Well, but understand the motive. The FDIC is essentially telling the markets what bad assets it will buy and then offers an opportunity for investors to participate. Banks that are able to raise money in this way are given another chance. Those that cannot, then the FDIC can go back to the Fed and Treasury and say "look, we tried, this bank needs to be resolved." Then we take all the assets into the FDIC.

Kotok: Tell me who sells this to whom and under what authorities does it occur?

Rosner: If the FDIC determined C is sick enough, were it not politically blocked by the Fed and OCC, then the FDIC has the authority to resolve C tomorrow.

The IRA: We are reminded of one of the drafts of the TARP legislation where somebody inserted language that would have allowed the FDIC unilateral authority to declare an institution insolvent without first getting a declaration of same from the primary regulator. Needless to say, the provision was not included in the final bill, but this illustrates the civil war that rages between the Fed and OCC, on the one hand, and the FDIC and the state regulators on the other. This issue of resolving the larger banks has been a political issue going back to Paul Volcker's day. Democracy is inefficient.

Kotok: The Fed has a problem here because it cannot function without the dealers. The lesson of Lehman was that a foreign government ended up making the decision about the failure of a primary dealer. I hear that the FSA and the Bank of England stopped Barclays from advancing a deal with Lehman and essentially the BOE, through Barclays, put requirements on the deal that the Fed could not swallow. Or Bernanke decided that he did to want to lose $180 billion of the taxpayers money and have to account for this to the Congress later. Because he couldn't explain it, nobody would believe him, but today if he said he needed $180 billion to prevent another Lehman they would give it to him. Bernanke changed his story on Lehman, don't forget, from saying that they did not bring us a plan at the NABE luncheon last year right after the Lehman bankruptcy to his current story which is "we did not have the legal authority." Geithner took the same "lack of authority" position in his testimony.

The IRA: Well, we were speaking to one investor who actually did the diligence and he said that the fact that Lehman had outsourced much of the record keeping for their MBS conduit and portfolio was a major obstacle to completing a deal. What is the view on Geithner? Looks like a confirmation?

Rosner: Yes, the conservative Republicans refuse to skewer this guy because they are afraid that there is a socialist in the wings.

The IRA: You mean Larry Summers? How could an avowed socialist be any worse than the statist policies followed by Geithner, Paulson and Bernanke today? We think the conservatives are making a big mistake turning their backs on the community bankers. The small banks will be paying higher insurance premiums for decades to offset the large bank losses to the DIF.

Kotok: Bill Dudley will go to the NY Fed presidency and he'll be fine from a policy perspective, but it remains to be seen if he can hammer out deals in the internal battles. Geithner is sufficiently wounded that he is not going to be a factor, so the drivers end up as Volcker and Summers, in my view. My question to you Chris, tell me if I am right, but Volcker is the elder statesman here. Volcker will propose, Obama will approve and Geithner will implement. Do you agree?

The IRA: Well, I don't think that the final battle internally between Rubin and Volcker has been decided. IMHO, Paul Volcker and Robert Rubin, and Larry Summers, represent very different and ultimately incompatible world views. Volcker is all about public service, transparency and fairness. Rubin and also Summers represent political duplicity and malfeasance on a grand scale, especially when you look at their role in blocking regulation of OTC derivatives and structured finance. Ultimately, one tendency or the other will prevail and if the winner is Volcker, then Rubin must be publicly rejected by Obama, especially as the situation at C unfolds and the true cost of the large bank rescue is made public. Otherwise the Democrats end up owning this mess politically.

Kotok: They will reject Rubin, but you have known Paul Volcker for a long time. Did you ever think you would see the day when he would go before the Congress and embrace a tax scofflaw?

The IRA: No, it is an indication of the fear and uncertainty that prevails within the Obama Administration and in our society. Our leaders including Volcker are grasping for straws and Geithner is a very slender reed indeed. There are some conservatives in the House who will be glad to see Geithner confirmed. They plan to use him as a punching bag, especially with conservative audience that are antithetical to the big New York banks and Wall Street. But Geithner seems to have Volcker's full support.

Rosner: I don't think that it is Volcker at this point, but rather Summers on a day-to-day basis that will be calling in the plays that Geithner will execute. Unlike Paulson, I expect Geithner will have to manage up and report back to Summers and the White House. He is expected to be on the team executing the President's policies and not creating his own. My only concern with Summers is that while he is a fine economist, he is not a financial markets guy either.

The IRA: We'd be happier with Summers if he would publicly acknowledge the policy mistakes of which he was a part. I'm not sure there is any hope of turning Larry Summers into a proponents of resolving the large banks.

Rosner: Summers is just as capable of being misdirected by the same Wall Street inputs as caused this mess. We need to somehow communicate to Summers et al, though the media if necessary, that the managed breakup of the big New York banks does not necessarily mean a systemic failure and another crisis. I believe that we can restructure these banks without a resolution, wipe the equity and maybe the preferred, and start from there.

The IRA: How do you avoid a haircut for the C bond holders if we see loss rates at 5-6% of total loans and leases? A 30% loss rate at C wipes out the equity several times.

Kotok: I agree. How do you restructure these banks without a bankruptcy for the parent, especially given the loss estimate from you and Chris among others?

Rosner: The answer is that the FDIC has the power to abrogate contracts and seize institutions, we have already guaranteed the debt holders. The Machiavellian mandarins at the Treasury and the Fed seem to have sold us on the notion of taking equity warrants. It means that if the FDIC comes in to do their jobs, they must wipe out the taxpayer equity.

Kotok: But the problem you have is how do you get the bond holders to agree? These are very loss-averse, well-organized investors. Why should they agree to a haircut? This is why the sub-debt of Fannie and Freddie has not been touched.

The IRA: At least not yet. As we've said before, the loss numbers from the GSEs and the large banks will be so large that we will no longer have a choice but to embrace a resolution and receivership. We'll leave it there. Thanks.

At least it isn't clearly stupid ...

By Robert Schmidt and Alison Vekshin
Jan. 28 (Bloomberg)

The Federal Deposit Insurance Corp. may manage the so-called bad bank that the Obama administration is likely to set up as it tries to break the back of the credit crisis, two people familiar with the matter said.

FDIC Chairman Sheila Bair is pushing to run the operation, which would buy the toxic assets clogging banks’ balance sheets, one of the people said. Bair is arguing that her agency has expertise and could help finance the effort by issuing bonds guaranteed by the FDIC, a second person said. President Barack Obama’s team may announce the outlines of its financial-rescue plan as early as next week, an administration official said.

“It doesn’t make sense to give the authority to anybody else but the FDIC,” said John Douglas, a former general counsel at the agency who now is a partner in Atlanta at the law firm Paul, Hastings, Janofsky & Walker. “That’s what the FDIC does, it takes bad assets out of banks and manages and sells them.”

The bad-bank initiative may allow the government to rewrite some of the mortgages that underpin banks’ bad debt, in the hopes of stemming a crisis that has stripped more than 1.3 million Americans of their homes. Some lenders may be taken over by regulators and some management teams could be ousted as the government seeks to provide a shield to taxpayers. (This sounds good. - AM)

Bank seizures are “going to happen,” Senator Bob Corker, a Tennessee Republican, said in an interview after a meeting between Obama and Republican lawmakers in Washington yesterday. “I know it. They know it. The banks know it.” (Busting up the insolvent banks is the type of medicine that the patient needs. - AM)

Laura Tyson, an adviser to Obama during his campaign, said banks need to be recapitalized “with different management” so they start lending again. “You find some new sophisticated management unlike the failed management of the past,” Tyson, a University of California, Berkeley, professor, said at the World Economic Forum conference in Davos, Switzerland today. (The danger is if the new capo is a 'political appointee' the banks become zombies, lending needs to be based on economic merits not political. - AM)

Still, nationalization of a swath of the banking industry is unlikely. House Financial Services Chairman Barney Frank said yesterday “the government should not take over all the banks.” Bair said earlier this month she would be “very surprised if that happened.” (Operative word here is 'all'. Hearing Pandit say this morning that nationalizing one bank means you nationalize all makes me think that he knows that Citi be the first.- AM)

A key question for the bad bank would be how to value the toxic assets it would buy. Geithner, in a Jan. 21 hearing before the Senate Finance Committee, outlined three possible alternatives: look at how the market is pricing similar assets; use computer model-based estimates from independent firms; and seek the judgment of bank supervisors.( If the model considers the bad bank as having a 'low cost of interest' and being able to hold to maturity you could really overpay for the crappy paper. Here's hoping they split the baby down the middle and cause pain in all directions. - AM)

“They all have limitations,” he said. “I think you need to look at a mix of those types of measures.” (Sounds promising.- AM)

Bair has said that cash from the TARP may help capitalize the bad bank and that commercial lenders may kick in some money of their own. One possibility that’s been discussed is issuing firms some kind of stock in the new organization as partial payment for their impaired assets.(21st century equivalent of giving the executioner a few coins so he kills you quickly and painlessly? - AM)

In any new rescue efforts, the Treasury is likely to continue to require banks to hand over ownership stakes to the government as a condition of receiving aid. Programs so far have sought preferred shares and warrants, which can be converted into common stock and cashed out on the government’s request. (Translation : thar be major dilution ahead. Only the suckers will be long at the bank equity table.- AM)

The Fed has participated in Treasury-led initiatives that insured toxic assets remaining on the balance sheets of Citigroup and Bank of America, and analysts said such measures could be used to complement the bad bank.(Devil is in the details. At least it isn't clearly stupid, that is a small bit of progress.- AM)

The government will likely use its ownership of toxic assets to rework soured mortgages and prevent foreclosures.

The FDIC is already modifying troubled mortgages held by IndyMac Federal Bank FSB, the successor to the failed lender managed by the agency since July. Bair, a longtime advocate of foreclosure relief, said the initiative was meant to serve as a model for the mortgage industry. (The only government sponsored plan that has shown any success so far. - AM)

The Fed also said in a policy paper released yesterday by the House Financial Services Committee that it will ease terms on residential mortgages acquired in the rescues of Bear Stearns Cos. and insurer American International Group Inc.

Crappy Mae

Nancy capitalists rejoice as the market front-runs the 'bad bank' plan.

Enquiring minds would like to know however:

Will it be price covering or price discovery?

Will it be a freebie or free markets?

If the latter, then the banks get blutarski'ed,that is, a common equity price of ZERO point ZERO.

If the former, the Fed becomes the baddest bank of all.

There are no easy solutions only least stupid ones : fearing the clearing will subject all of us to a 'markdown.'

Let's hope that Barry chooses wisely and administers pain as opposed to attempting to mask it.