Stephen Sexauer Jan 1411 (2)

The US Central Bank: Superhero and Profits Maker

Stephen Sexauer GIC Santiago Chile January 2010

2008 to 2010 A Stunningly Large Non-bank Bank Run A Sudden Stop in Everything Everywhere The Superheroes Arrive Corporate Profits: What Recession?

The Grand Teton and Mount Rainier

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Stephen Sexauer GIC January 2010

A Stunning Large Non-Bank Bank Run 11% of US GDP, Q4 2008 US Non-Bank Bank Lending ($ billions, aar) --Flows: non-bank bank lending --Flows: total lending--all sources --US GDP (2007 and 2008)

2007 Q2

2008 Q4

807 4,179 14,062

-1,602 2,558 14,369

570 356 -89 -32 2 807

-599 -241 -439 -94 -229 -1,602

869

2,259

Details Flows ($ billions aar)*

Q4 Z1

9

53

9

47

9

56

9

55

9

54

Non-bank bank lending --asset backed securities --mutual funds --broker-dealers --REITs --Finance companies --total non-bank bank lending Levels ($ billions)

29-Dec-09

h.4.1

Federal Reserve--total balance sheet**

* source: Federal Reserve statistical release, Z1, 12 March 2009. Data through 2008 Q4 ** Note: Some of this can also be seen in the flow of funds: Funding Companies, which include the commercial paper funding facility and the Maiden lane facilities. Page 9, line 57 for Q4 2008 flows, page 58 line 57 for levels

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Stephen Sexauer GIC January 2010

No Funding, No Survival Liquidity—Before and After Section 13.3  While the Lehman bankruptcy is almost exclusively seen as the triggering event, it may be worth considering a second event. This one is tied to liquidity.  Tuesday, September 16th o The $89 billion Reserve Money Market fund let it be known that due to its holdings of Lehman securities it would “break the buck.” o Before the close, clients holding approximately $40 billion in the fund logged on and “hit” the withdrawal key. o All kind of stories that day when commercial paper bid lists flood the Street. With no parent company and no one to lend against the Reserve Fund holdings and no ability to sell $40 billion of commercial paper in a few hours, the Reserve Fund suspended withdrawals. o It took most investors a very long time to get their money back.  In Q4 08, Morgan Stanley also experienced a $46 billion run of money market withdrawals. o Of the $46 billion, $26 billion of fund assets were sold to the Morgan Stanley broker-dealer. o These assets (CP, Munis, CDs, and notes) were in turn financed by repo to the Fed under the available stabilization facilities (13.3). This was only possible because of the new Fed programs and Morgan Stanley converting to a bank holding company. o As a result, all the Morgan Stanley client redemptions were met. The total Morgan Stanley Funds money market mutual fund balances fell to $82 billion from $132 billion.

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Stephen Sexauer GIC January 2010

Survival and Rational Panic An example: Caterpillar Tractor

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Stephen Sexauer GIC January 2010

A Sudden Stop in Everything Everywhere

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Stephen Sexauer GIC January 2010

Saved The Superheroes:  

The Fed and rule 13.3 The FDIC guarantees bank debt

The Non-bank Bank Run and the Bank Run end

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Stephen Sexauer GIC January 2010

A Picture of Salvation Non-bank bank lending $ billions saar 1,000 500 0 2007Q2

2008 Q4

2009 Q1

-500 -1,000 -1,500 -2,000

Fed balance sheet $ billions saar

2,500 2,000 1,500 1,000 500 0 2007Q2

2008 Q4

2009 Q1

Source: Fed Z1 and H.4.1

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Stephen Sexauer GIC January 2010

US Corporate Profits: What Recession?

Profits (NIPA) with and without the Great Recession 1,700

dollars billions

1,500

1,300

1,100

Q3.2010 NIPA profits after tax no IVA CCA 900

700

500

date 2007.Q1 2007.Q2 2007.Q3 2007.Q4 2008.Q1 2008.Q2 2008.Q3 2008.Q4 2009.Q1 2009.Q2 2009.Q3 2009.Q4 2010.Q1 2010.Q2 2010.Q3 2010.Q4

e(NIPA profits) after tax no IVA and CCA with Actual NIPA profits after tax no 5% per year GDP nominal aar IVA and CCA growth

13,790 14,008 14,158 14,291 14,328 14,472 14,485 14,191 14,050 14,035 14,115 14,277 14,446 14,598 14,745

1,264 1,316 1,284 1,308 1,178 1,150 1,129 642 908 997 1,114 1,229 1,370 1,388 1,416

Actual NIPA profits after tax no IVA and CCA e(NIPA profits) after tax no IVA and CCA with 5% per year growth

Source: BEA and Stephen Sexauer (calculation)

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Stephen Sexauer GIC January 2010

1,264 1,316 1,284 1,308 1,324 1,340 1,357 1,374 1,391 1,409 1,426 1,444 1,462 1,480 1,499 1,518

US Corporate Profits and Wages: Brutal Arithmetic Compensation Profits Taxes 100% 80% 60% 40% 20%

19 6 19 0-I 6 19 2-II 6 19 4-II 66 I 19 IV 6 19 9-I 7 19 1-II 73 19 -II 75 I 19 IV 7 19 8-I 8 19 0-II 8 19 2-II 84 I 19 IV 8 19 7-I 8 19 9-II 9 19 1-II 93 I 19 IV 9 19 6-I 9 20 8-II 0 20 0-II 02 I 20 IV 0 20 5-I 0 20 7-II 09 -II I

0%

Compensation

Profits before tax w/out iva cca

taxes

Ratios to GDP

Q2.2010 2000 1990 1980 1970 1960

Compensation 54.3% 58.6% 55.8% 56.6% 57.2% 57.1%

Profits b/t no IVA CCA

taxes 2.8% 2.8% 3.0% 3.0% 2.3% 2.4%

12.3% 8.2% 9.8% 9.0% 7.3% 6.9%

Profits a/t no IVA CCA

Profits b/t with IVA CCA

9.5% 5.4% 6.8% 6.0% 5.0% 4.5%

11.1% 8.7% 10.8% 9.2% 7.5% 7.5%

Source: BEA 10

Stephen Sexauer GIC January 2010

The Fed as Houdini at Q4 2009 Fed arithmetic窶馬o calculator needed: Begin: $1 trillion (treasuries and agencies) Add: $1 trillion Repo funding of commercial paper assets and other bank/broker repo-type assets. These are shorter-term self-liquidating assets.

Add: $1.1 trillion in direct purchases of treasuries, agencies, and mortgages.

Subtract: $0.9 trillion in private sector funding (commercial paper assets and other bank/broker repo-type assets). Self-liquidating assets liquidate.

Net: $2.2 trillion, of which the majority is the new Fed Mortgage Bank

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Stephen Sexauer GIC January 2010

The Fed, Repo, and the Grand Teton The Fed at Lombard Street, lending against good self-liquidating assets.

500,000

400,000

300,000

200,000

100,000

0 2008Q4

2009Q1

2009Q2

2009Q3

2009Q4

Term Asset Credit Facility Commercial Paper Fund Facility Central Bank Swaps Broker-Dealer Credit Facility Asset Backed CP TALF

Source: Fed H.4.1

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Stephen Sexauer GIC January 2010

Mount Rainier and the Fed’s New Mortgage Bank Fed MBS holdings ($ millions) 1,200,000

1,000,000

800,000

600,000

400,000

200,000

0 2009M01

2009M07

2010M01

2010M07

‌and an estimate of the Fed carry trade profits: $ Billions 2009 2010 e(2011)

Mortgage Assets (weekly ave.)

Coupon Carry cost 477 4.00% 0.25% 1,070 3.81% 0.25% 1,001 3.88% 0.25%

Cummulative Mortgage Profit

Gross Profit 18 38 36 92

Source: Fed (assets) and Stephen Sexauer (rates and calculation)

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Stephen Sexauer GIC January 2010

Mount Rainier Summiting was optional, getting down is mandatory Getting down—a net profit: $ Billions e(2012) e(2013) e(2014) e(2015) "Cost"

Mortgage Assets 801 601 401 200

Coupon (earned) 3.88% 3.88% 3.88% 3.88%

Funding Costs 0.0000 0.0000 0.0000 0.0000

Bank Matched Repo payments Loss ** 6.25% -19 6.25% -14 6.25% -9 6.25% -5 -47 NET to Fed 45

* Assumes: (1) a growing and self-funding economy, (2) GDP real growth of 2.5%, inflation of 1.5%, and inflation expectations of 1% = 5% 10 year treasury, and (3) a 6.25% 15 year mortgage Banks can lend at at risk at 6.25% or higher, or do credit risk-free matched repo with the Fed. ** Fed Mortgage balance * [Costs (funding costs + matched book pay) less Coupons earned]

Interest rates and sterilizing bank reserves: Interest rates for “at-risk” lending will compete with “risk-free” matched repo with the Fed. Hence, higher rates courtesy of the Fed. Source: Stephen Sexauer (rates and calculation)

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Stephen Sexauer GIC January 2010

How Long Does a Growing Global Economy Stay on the Fed’s “Rope Team”?

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Stephen Sexauer GIC January 2010

Appendix I: A Chronology of Crisis Management “Lombard Street” in 2008 and 2009

Source: Dick Berner, Morgan Stanley

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Stephen Sexauer GIC January 2010

Stephen Sexauer Allianz Global Investors Solutions: Chief Investment Officer Allianz Global Investors: Performance and Risk: Performance Portal and Risk-Return analysis for AGI WW equity portfolios (2007-2008) Allianz Global Investors-Nicholas Applegate Capital Management: Portfolio manager Large-cap Core and Large-cap Value (2003-2004) Morgan Stanley Asset Management (1989 – 2002)  Portfolio manager Large-cap value; application of optimization techniques  Risk structures for US Value and Growth portfolios Salomon Brothers: (1988-1989) Mr. Sexauer holds an MBA from the University of Chicago (economics and statistics) and a BS (economics) from the University of Illinois.

Economic data in this presentation are derived from internal research publicly available statistics published by the U.S. Federal Reserve, the Government of Canada, the U.S. Department of Commerce and the International Monetary Fund.

The information herein is provided for informational purposes only and should not be construed as a recommendation of any security, strategy or investment product, nor an offer or solicitation for the purchase or sale of any financial instrument. This material contains the current opinions of the author, which are subject to change without notice.

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Stephen Sexauer GIC January 2010