Saving Private Greed

Fed Emergency Rate Cut of 75 Basis Points
First emergency rate cut since the 9/11 terror attacks.

WASHINGTON (Reuters) - The Federal Reserve on Tuesday slashed a key interest rate by a hefty three-quarters of a percentage point, the biggest cut in more than 23 years, after a two-day global stocks rout sparked by fears of a U.S. recession.

The move, a rare one made between the U.S. central bank's regularly scheduled meetings, took the federal funds rate governing overnight lending between banks down to 3.5 percent, its lowest level since September 2005. The Fed also lowered the discount rate it charges on direct loans to banks to 4 percent.

"The Fed is very, very, very worried," said John Tierney, an analyst at Deutsche Bank in New York.

The Fed's bold bid failed to instill confidence in shaken financial markets as U.S. stocks, playing catch-up with sell-offs around the world, fell sharply at the open. The Dow Jones industrial average (.DJI) was down about 1.1 percent in late morning.

Prices for U.S. government bonds slipped, while the dollar fell sharply against the euro.

"The committee took this action in view of a weakening of the economic outlook and increasing downside risks to growth," the Fed said, referring to its policy-setting Federal Open Market Committee.

"While strains in short-term funding markets have eased somewhat, broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households," it said.

What Is Driving the Price of Gold?

As regular readers know, we keep a number of spreadsheets with economic data on them, to help us in tracking various measures of the markets and the economy. One of the things we like to do is to look for intermarket correlations using some relatively good multivariate regression software.

We last took a look at the price of gold a few years ago, and not surprisingly found a high correlation to M3. Since the Fed no longer supplies this data, we thought it might be interesting to see what a fresh analysis turned up for this leg of the gold bull market.

The spreadsheet we used contains weekly data on 35 categories of economic and market measures since January, 2003 which is 265 observations and more than enough for statistical validity. Most of the data comes from the St. Louis Federal Reserve official database.

We aren't going to go into the methodology we used to find correlations, as it gets a bit technical and very tedious. Let's just say its all about finding the prime candidates, and then trying a significant number of 'better or worse' fits. The measure of 'fit' used is the R-Square Adjusted which is expressed as a percentage. The higher the percentage, the more the model explains the price of gold. And before the quant geeks come out of the woodwork, we stipulate that we have simplified and rounded both the equations and the concepts for more generalized readers.

The US dollar is the most obvious factor to check as a driver for the price of gold (in dollars), but our analysis showed that the dollar only explains about 58% of the price of gold since 2003. Money supply is the next most obvious factor. Since we no longer have M3 available as data, we went a different broad measure of money supply, Money of Zero Maturity, MZM. It is what the Fed refers to as the best measure of liquidity in the system, and is M2 less small-denomination time deposits plus institutional money funds. If it included eurodollars and net repos, it would be roughly equivalent to M3.

As you can see from this equation, the Price of Gold (POG) equals .261 times the Money of Zero Maturity supply NSA (Not Seasonally Adjusted). Since .261 is a positive number, we say the correlation is positive, meaning as MZM goes up, the price of gold will go up. The actual number itself means little since we are comparing the price of gold in dollars versus the MZM in billions. The R-Square Adjusted is about 89% which is a very high correlation for a single variable.

POG = 0.26 * MZM NSA billions - 1281
R-Square Adjusted 89%

The way we would state the above result is that the Price of Gold is positively correlated with MZM (NSA) to about 89% from 2003 to today. While the money supply as measured by the broad liquidity measure MZM is increasing, the price of gold will be increasing over time, with an accuracy of about 89%. You could say that each billion in MZM results in about 26 cents to the price of gold, but that is a little misleading since its happening over such a long period of time.

Now, 89 percent sounds good and it is for one variable. As the usual suspects go, liquidity supply of the US dollar is the prime candidate. But we wanted to add some of the other suspects in combinations, to see if we can improve on that without getting ridiculous. When we worked many years ago at Bell Labs, we sometimes saw techs taking projects like this to an impractical degree of fineness, certainly well beyond anything that might be applied to the practical problem at hand. We used to call it "trying to measure the depth of the ocean with a micrometer."

Without getting into too many details, about 50 software runs later we arrived at the following best fit for the price of gold since 2003.

POG = 0.1607 MZM NSA billions + 34.3 EFF + 12.3 Moody's Baa - 740
R-Square Adjusted 94.6%

EFF is the Effective Fed Funds Rate. This is the market expectation of what the Fed Funds rate as expressed as a volume weighted average of all the actual transactions. Moody's Baa is the interest rate for Baa corporate bonds. Its a measure of perceived riskiness in the corporate environment.

So we would say that the price of gold is positively correlated to the growth in the liquid money supply (MZM) and negatively correlated to the higher short term official interest rates and positively correlated to corporate risk. with about 95% accuracy. Makes sense? Passes the red face test? Pretty much we think.

So, if you think on the whole that MZM will keep increasing and the Fed will be lowering short term rates, with a dash of corporate risk in the mix, the price of gold should continue to do well over the long run. Since these variables also feed into the valuation of the US dollar as expressed as DX, without the noise of currency manipulation, we should see a similar negative correlation to the dollar over time.

Well, you might say, that's all very well and good if you are a long term holder of gold for five or more years AND things remain as they are, but what about the shorter term price of gold?

We've been doing a lot of work in this area, and most of it would become incredibly complicated very quickly if we tried to explain it here. Let's just say that the relationship to money supply and EFF is definitely still there, but with a great deal more noise in the model, even if the statistical sample is no smaller than one year. This is where DX comes back into play as a modifier and adds something to the mix. By introducing a risk variable like VIX we have been able to take the R-Square up to 94%.

The market place of buyers and sellers obviously sets the price of gold. As the saying goes, in the short run it's a voting machine (with appropriate antics) and in the longer term its a fundamental discounting machine; what drives it in the short term is somewhat different from what drives it in the longer term.

One might ask, "why don't you factor in Central Bank gold sales?" Prior to 2003 we think they were a significant factor in the price of gold, and several people did quite a bit of work in this area. Since 2002 the data leads us to believe that central bank gold sales have had an increasingly weak and temporary effect on the direction of the price of gold. Why engage in complexity when the data analysis is so straightforward without it?

In summary, the data indicates that since 2003 the price of gold in US dollars is strongly related to the growth in a broad money supply measure like MZM or M3. What the market thinks the Fed intends to do with short term interest rates and therefore money supply growth, Effective Fed Funds, is also a powerful factor. Finally, the perception of riskiness in the business world has a smaller but significant effect, as we see in using Moody's Baa rates and also the VIX.

We expected DX to play a stronger role in driving this leg of the gold bull market, but apparently it is playing a role only in the short term wiggles. If it is money supply expansion and lower short term interest rates that has been driving the price of gold for the past five years, with a bit of riskiness tossed in for spice, then the outlook for the price of gold over the forseeable future looks bright. In some future pieces we will touch upon deflation and credit crunches, but for now those remain possibilities and not certainties.

So what drives the price of gold? In this case, as in so many other financial questions, it always seems that we must follow the money.

Why is Bank of America Buying Countrywide Financial?

There is plenty of room to question the decision by Bank of America, "the US's biggest bank by stock market value," to proceed with an acquisition of troubled mortgage lender Countrywide Finanical, since they took a two billion dollar cash position at a considerably higher price, when the company appeared to be healthier, and are now buying the rest of the company at a cheaper price in an all stock transaction.

Herb Greenberg does his usual excellent job of digging into the deal and providing a reasonable range of speculations as to the motivations: The Real Story on Countrywide Cont'd - Herb Greenberg

To summarize:

1. The Fed brokered or facilitated the deal because Countrywide was on the verge of insolvency which would have had a significantly negative impact on the financial markets, a la LTCM. Bank of America had significant skin in the game already because of their two billion cash already in, AND significant counterparty entanglements that might have jeopardized BAC itself should CFC have failed.

a. Moody's had just downgraded thirty tranches of Countrywide's mortgage debt. Similar downgrades preceded the American Home Mortgage bankruptcy. It was well known that Countrywide was in capital and cash flow difficulties.

b. As counterparties go, they do not get much bigger than Countrywide when it comes to holding US mortgage debt. One can only speculate at this point what sort of entangling obligations CFC had with mortgage reinsurers AND the Credit Default Swaps that may have be put on Countrywide (in huge multiples of their book value).

There is little doubt in our minds that the Fed helped to broker the deal. Unlike Hank, we don't think necessarily that the Fed 'promised' anything as part of the deal, any moreso than they had done with LTCM. But we have an open mind on this topic. The Fed seems to be taking quite a bit of opaque assets on, judging by the recent precipitous drop in their Treasuries holdings in the past few weeks, to be supplanted by "other loans and repos." But this begs the question, Why Bank of America, and why now?

We'd like to add two reasons for this acquisition based on our experience in the M&A business, in our own case as both acquisitor throughout the 90's specializing in valuing high tech startups in Boston and Northern California, and as an acquiree, having sold our own company to a tech behemoth in late 1999.

1. Never, ever, discount the impact of egos and momentum in corporate decision-making, especially in a poorly managed company where personalities and not principles rule the day. We do not know enough about Ken Lewis and BAC to make any judgement here, but we can't rule it out either. They are the right size and structure for it.

Some have suggested that the company did the deal to try and salvage their two billion cash initial investment. If this is true chalk one up for egos and poor management. That initial position was a sunk cost. Period.

2. Is Bank of America paying in what they consider to be an overvalued currency? Their first tranche was cash. But the acquisition itself is for stock, as in their own stock. Let's take a look at a chart of Bank of America:

Compare the chart of Bank of America with that of Countrywide Financial. Perhaps BoA received a much closer and better look at CFC as a big investor, and decided not to acquire some of the key pieces of the operation, and avoid any of the pending litigation for various lending infractions, but decided it was strategic to buy the whole thing (with stock). Plausible? Kind of.

Or is BAC looking at its own balance sheet, its own stock price, and thinking, 'there but for a little time and disclosure goes our own stock price, down to pre-bubble levels. At 7 dollars equivalent CFC might have been 'cheap' at least compared to the 40 it was worth before it imploded. But if BAC's stock follows a similar course, then at 3 dollars equivalent and two billion dollars it looks a whole lot cheaper.

As a veteran CEO once told us, "You may think I'm paying too much for this company, based on your valuation. But in order to say that you'd have to know more about what my own stock is worth than I do, since that's what I'm buying it with." By the end of 2000, we could not help but see his point, and agree.