The initial first quarter corporate earnings reports and economic releases pointed toward growth again this week. Financial conditions remained firm and credit spreads remained near two-year lows. The Greek sovereign debt roller coaster continued to weigh on the euro-zone and threatened to spread to other European entities as well; the euro fell against the U.S. dollar. U.S. equity markets rallied but U.S. bonds traded lower. Elsewhere the capital markets were mixed. Oil prices inched higher to just over $85 per barrel. U.S. regulatory reform and its impact claimed space on the front burner.


In free and open capital markets the fear of failure is a powerful risk management tool. When governments step in to take over to prevent failure, the risk-taking entities have incentive to maximize their short-term profits by taking on as much risk as possible because there is no “fear of failure.”

More than 18 months have passed since the collapse of Lehman. When the credit markets seized up, central banks and governments around the world stepped in to prevent another Great Depression. Now the economy is well on its way to recovery and investment banks have returned to a path of profitability. Unfortunately, the United States has yet to establish the necessary global regulatory reform to replace the fear of failure. What should that reform look like? What standards should we use to judge the proposed legislation? Here are a few of my thoughts:

1) Capital and leverage requirements: Higher risk activities should require higher capital for banks. Bank leverage should be limited.

2) Volcker rule: This rule will push the risk-taking activities of banks outside and turn banks into providers of liquidity. This rule has merit, but it also has consequences. Will the proprietary trading activity outside the bank escape transparency and regulation?

3) Global approach: We need to establish a coordinated effort so that we don’t push risk taking off shore.

4) FNMA and FHLMC: Fannie Mae and Freddie Mac have written down $260 billion of assets and have been infused with $148 billion of government capital (more than any other single U.S. financial institution). Regulatory reform should define their role, if any, establish capital requirements, and limit leverage.

5) CDS clearing: Establishment of centralized clearing and margin requirements for credit default swaps would go a long way to promote transparency and ensure the integrity of the transactions. The current record keeping and counter-party risks in this market leave it vulnerable as a centerpiece for the next crisis.

6) Too big to fail: This term has been so overused that I am not sure what it means. If it means that there will be no government bailout using taxpayer funds, but it will establish a fund using bank money to facilitate a bailout, it will not mitigate risk taking.

7) Hedge fund: Hedge funds did not require a government bailout this go-around. Yet the experience with long-term capital shows that excessive leverage in hedge funds could do damage to the system. My hedge fund friends will not agree, but some form of registration and disclosure is necessary.

8) Rating agencies: Rating agency conflicts of interest and failure to react in a timely manner contributed to the recent credit crisis. Financial reform should define the role and hold rating agencies accountable. Good bond managers do their own security analysis; they don’t rely on the agencies’ ratings. Yet the rating agencies serve a purpose in defining risk exposure limits.

9) Compensation: The politicians have repeatedly pointed to excessive CEO compensation and severance packages as a cause of the financial collapse. It was not a cause; it may have been a symptom in some cases. This issue is political, not economic. An argument could be made that the high compensation was necessary to reward the smart allocation of risk. If the risk-taking activities are taken from the bank, compensation should be lower as well. If banks merely provide liquidity, maybe they should look like a utility company, not an intelligent allocator of risk capital. Given time and transparency, the market should be able to sort out this issue for what it is.

I believe the current legislation falls short in a number of these issues, but acknowledge that the politics of the day will not allow the United States to get to a best-of-class solution. Therefore, the United States needs to pass legislation with as many of these components as possible with the hope that the regulatory bodies will be able to fill in the gaps as they will rapidly appear.

Economic releases

In the United States, leading indicators rose 1.4 percent in March. Durable goods orders fell -1.3 percent, but ex-transportation, orders rose 2.8 percent and February’s orders were revised up over a half point to +1.1 percent. Producer prices rose +0.7 percent in March, but, ex-food and -energy, PPI rose only a tick. Initial jobless claims dropped to 456,000 the week of April 17.

In the UK, first quarter GDP rose +0.2 percent. March retail sales rose +0.7 percent and CPI rose +0.6 percent. In Germany the April IFO and ZEW surveys were up. In France, consumer spending rose 1.2 percent in March.

The two lagging components of U.S. recovery have been employment and housing. The previous week the United States reported an increase in non-farm payrolls and, this week, the United States reported an uptick in home sales. The chart below shows new (blue) and existing (red) housing sales. Both increased in March as a result of the home-buyer tax incentives. New home sales increased to 411,000 while existing home sales increased to 5.35 million in March.


Apr 16 Bonds


In order to keep U.S. housing on the recovery track we have reduced the price of our house in Riverside, Conn. Check the link below:
Sources: Bloomberg LP

Equities markets

Initial weeks of the corporate earnings reports were positive with over 80 percent reporting positive surprises. The U.S. markets rallied with recovery optimism, but most of Europe was held back with Greek worry.

Apr 16 Bonds


Bond markets

With optimism about recovery, U.S. government bonds fell and showed the yield curve flattened since short-term rates rose more than long-term rates. Elsewhere, bonds were mixed.


Apr 16 Bonds



The U.S. dollar rallied against the euro and yen.

Apr 16 Bonds


Economic sectors

Small cap value stocks and REITS had the best returns while health care and large cap growth fared the worst on the week. On a QTD and YTD basis, small cap value stocks and consumer durables were the strongest; large cap growth fared the worst.

Apr 16 Bonds