At the close of business on February 2, 2011, the Federal Reserve System recorded a total of $1.1 trillion of U. S, Treasury securities on its balance sheet. To be more exact, the number was $1,138,166 million.
Thirteen weeks ago, the Fed held just $842,008 million in Treasury securities. Thus, the Fed’s holdings of these securities have gone up by almost $300,000 million or $300 billion or $0.3 trillion over this time. QE2 seems to be in full swing?
Thus, in the last three months, the Federal Reserve has surpassed the holdings of U. S. Treasury securities of China, a little less than $900 billion, and of Japan, a little less than the China.
At January 31, 2011, the Total Public Debt of the United States Government was $14.13 trillion.
Thus, the Federal Reserve System currently holds a little over 8 percent of its government’s debt!
The QE2 program of the Fed stated that the Federal Reserve would buy $600 billion of United States Treasury securities over a six month period and would buy an additional $300 billion in these securities to offset the amount of Federal Agency securities and Mortgage-backed securities that resided on the Fed’s balance sheet and were maturing during this time period.
As stated above, the Federal Reserve added $296 billion of U. S. Treasury securities to its balance sheet. During this time period the Fed lost $91 billion in Federal Agency securities and Mortgage-backed securities reducing the net addition of $205 trillion to its overall portfolio of securities as a part of QE2.
Over the last four week period, the Fed acquired $107 billion in U. S. Treasury securities, but had a runoff of $30 billion in these other securities so that the “net” new purchases added up to $77 billion.
But, this was not all going on that affected the amount of reserves in the banking system. One very big “happening” was that the settlement of the AIG bailout as the Fed’s involvement in this effor. “The Board's statistical release, "Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks," reflects the closing of the American International Group, Inc. (AIG) recapitalization plan, which occurred on January 14, 2011. The recapitalization plan was designed to restructure and facilitate repayment of the financial support provided to AIG by the U.S. Department of the Treasury (Treasury) and the Federal Reserve. Upon closing of the recapitalization plan, the cash proceeds from certain asset dispositions, specifically the initial public offering of AIA Group Limited (AIA) and the sale of American Life Insurance Company (ALICO), were used first to repay in full the credit extended to AIG by the FRBNY under the revolving credit facility (AIG loan), including accrued interest and fees, and then to redeem a portion of the FRBNY's preferred interests in ALICO Holdings LLC taken earlier by the FRBNY in satisfaction of a portion of the AIG loan. The remaining FRBNY preferred interests in ALICO Holdings LLC and AIA Aurora LLC, valued at approximately $20 billion, were purchased by AIG through a draw on the Treasury's Series F preferred stock commitment and then transferred by AIG to the Treasury as consideration for the draw on the available Series F funds.”
Basically, this adjustment, along with some other minor runoffs of other “financial emergency” management accounts, removed about $35 billion from the banking system over the past 13-week period and about $22 billion in the past 4-week period. Assuming the Fed offset this reduction in bank reserve with the open-market purchase of Treasury securities, this drops the “net” QE2 injections of reserves into the banking system to $170 billion over the last quarter and $55 billion over the last four weeks.
As always, there are the ordinary operating transactions the Federal Reserve must account for because these transactions, like movements in currency in circulation and movements of Treasury Tax and Loan monies, impact bank reserves. The Federal Reserve usually offsets these items so as to smooth bank adjustments in the regular course of business.
Over the past 13-week period, the Fed had approximately a net of $72 billion in operating transactions to offset. Over the past 4-week period, this total was approximately $7 billion.
Removing these amounts from the Fed purchases of Treasury securities, we find that the Fed bought $98 billion in securities that added to bank reserves over the past 13 weeks, and bought $48 billion over the past 4 weeks. In effect, these numbers reflect the “net” impact of securities purchased to increase bank reserves over this period of time.
Thus, one cannot say that over the last 13-week period the Fed bought almost $300 billion in U. S. Treasury securities as a part of the QE2 program because of all the other things going on during this time.
The Fed did buy over $90 billion in Treasury securities to offset the amount of securities that were running off in the rest of the portfolio, part of the $300 billion the Fed said it was going to do, but this cannot truthfully be considered a part of the $600 billion of new purchases it was supposed to undertake. And, one can make the case that the full amount of the almost $200 billion in purchases was not a part of QE2.
The real question concerns the effects this increase had on the banks and the economic system. Because of timing differences the following data don’t exactly foot. For example, reserve balances held at the Fed increased by $98 billion over this time period. The information we currently have from other sources indicate that the monetary base, which consists of bank reserves and coin and currency held outside of commercial banks, rose by almost $95 billion at the same time. So, we are roughly in the same ball park. One should also note at this time that all these data are non-seasonally adjusted!
Of the $95 billion, roughly $80 billion in the increase came in bank reserves and $15 billion came in currency held outside of banks. Of the $80 billion increase in bank reserves, about $12 billion of this was due to the increase of required reserves of commercial banks. Note that individuals and businesses are still moving their funds from money market accounts and small time and savings accounts, to demand deposits and other checkable deposits, and away from thrift institutions to commercial banks. (We will have more to say on this later this week.) The demand and checkable counts have higher reserve requirements than do the accounts that the funds have been moved from. This still remains the major reason why required reserves have increased over the past several years as well as currently.
So, $68 billion of the increase in total reserves went into excess reserves. Bank loans continued to decline in January (I will address this next Monday) so it appears as if commercial banks are still taking the excess reserves and putting them into “cash” rather than lending them. (Again there is a difference between the behavior of the big banks versus that of the smaller banks.)
The conclusion one can draw from this is that the Fed has been executing QE2, but has not been as aggressive as some people have thought when looking at just the aggregate dollar amount in the Fed’s portfolio of Treasury securities. The Fed still has other things going on that must be taken care of and this modifies any interpretation one can give to the aggregate figures. In terms of the banks: the banks still appear to be putting the “new” reserves the Fed is injecting into the banking system into excess reserves. So far, QE2 does not seem to be producing any substantial results in the banking system.
Showing posts with label AIG. Show all posts
Showing posts with label AIG. Show all posts
Monday, February 7, 2011
Friday, December 3, 2010
Step on the Gas; Hit the Brakes; and at the same time!
There has been lots of words and press spilled on the recent revelations about who the Federal Reserve “bailed out” during the recent financial crisis. Let me just use one such article to capture some of the attitudes being expressed about this information.
Sebastian Mallaby, a senior fellow at the Council on Foreign Relations and the author of the book “More Money than God”, writes in the Financial Times” (http://www.ft.com/cms/s/0/9f5584f2-fe1d-11df-853b-00144feab49a.html#axzz173T61Eok):
“The point is that the Fed bail-outs were hair-raisingly enormous, and that neither the regulators nor the regulated should be allowed to forget that. Wall Street institutions that now walk tall again survived only because the taxpayers saved them. Goldman Sachs turned to the Fed for funding on 84 occasions, and Morgan Stanley did so 212 times; Blackrock, Fidelity, Dreyfus, GE Capital – all of these depended on taxpayer backstops. The message from this data dump is that, two years ago, these too-big-to-fail behemoths drove the world to the brink of a 1930s-style disaster – and that, if regulators don’t break them up or otherwise restrain them, they may do worse next time.”
There doesn’t seem to be much movement afoot to “break them up” at this time, but there has been, and will continue to be, great efforts to “restrain them”. I don’t see the will or the leadership to “break them up”. I have my own views about the ability of the government to “restrain them” but I treat that question elsewhere.
I would like to raise another issue at this time which I believe to be integral to the situation mentioned above.
Discussions about the actions of the Federal Reserve during the financial crisis tend to be completely void of any discussion about the actions of the federal government or the Federal Reserve in creating the environment that resulted in the financial collapse.
Leading up to the financial crisis of 2008-2009 was approximated fifty years of governmental actions that created the largest credit inflation in the history of the United States. The gross federal debt of the United States government increased at a compound rate of approximately 9 percent per year from 1961 to the start of the crisis. Monetary policy, throughout this time period, accommodated this growth in debt. And, this period saw the greatest burst of financial innovation and credit creation in world history.
Why did this happen?
Two major reasons: first, the short-run emphasis of the government to sustain high, perhaps unsustainable, levels of employment; second, the goal of the government to put as many Americans in their own home and provide them with a financial “piggybank” to secure their future.
The first reason meant that the government had to keep stimulating the economy to keep people employed in the jobs they had. As a consequence, many American workers did not have the incentive to grow and prepare themselves for the “jobs of the future.” As a consequence, about one out of every four Americans of employment age is “under-employed”! Furthermore, the length of being unemployed has trended upwards from the 1950s and in October 2010 the average duration of unemployment is just about 34 weeks, almost three years. (See “Unemployed and Likely to Stay That Way,” http://www.nytimes.com/2010/12/03/business/economy/03unemployed.html?ref=todayspaper.)
The second reason meant that the government had to build programs and provide financial innovation and finance so that more people could own their own homes. The inflation that took place in the real estate sector resulted in home ownership becoming the real “piggybank” of the middle class, producing for them the “best” investment they could experience over this time until, of course, the bubble burst.
The federal government set up the environment and the incentives that everyone else had to live within.
Chuck Prince, the former Chairman and CEO of Citigroup, made the now famous statement that “while the music keeps playing, you must keep dancing.”
The environment created by a government that set the example of “living beyond one’s means” created an almost perfect environment for taking financial risk, mismatching maturities, leveraging up debt, and financial innovation. The “Greenspan Put” during the 1990s and early 2000s sustained this environment by providing downside protection thereby creating greater “moral hazard.” In essence, the federal government “kept the music playing” and businesses, both financial and non-financial, had to “keep dancing” in order to remain competitive.
The question was constantly asked by executives, “How can I get a few more basis points return to be competitive with others in the industry?” The answer within such an environment was more leverage, more risk, and new financial innovations. At least, until the load became too heavy to bear.
But, in the rush to “break” companies up or to regulate and “restrain” them from such activity, most people have forgotten that the whole environment and the incentives set up were created by the same people now interested in breaking up these companies or restraining them.
So, within this call for breaking up these companies and regulating them more closely we hear
the same people calling for more government spending, more tax cuts, more quantitative easy on the part of the central bank, and greater welfare benefits to those that are hurting.
This is why the whole scenario seems to be one of trying to drive your car as fast as you can while at the same time trying to drive your car as safely as possible.
You are stepping on the gas and stepping on the car brakes at the same time!
So, where does this discussion take us? Really nowhere.
In my view, the people calling for the federal government to constantly provide fiscal and monetary stimulus to the economy are still in control and I don’t see their demise anytime soon.
People will try to regulate and restrain the financial sector, but, as I have written many times before, they will not be able to be successful. Given the global nature of finance today and the tools brought to the finance industry by information technology, these attempts to regulate and restrain will not succeed.
And, there will be renewed calls for providing social services and payments for those being hurt by the actions mentioned in the preceding two paragraphs. What is really needed to resolve the problems of the modern economy is of a long term nature and our short-sighted politicians will never implement these solutions, at least, anytime soon.
So, we must continue to face a bumpy ride. Stepping on the gas and the brake pedal at the same time produces such a ride.
Sebastian Mallaby, a senior fellow at the Council on Foreign Relations and the author of the book “More Money than God”, writes in the Financial Times” (http://www.ft.com/cms/s/0/9f5584f2-fe1d-11df-853b-00144feab49a.html#axzz173T61Eok):
“The point is that the Fed bail-outs were hair-raisingly enormous, and that neither the regulators nor the regulated should be allowed to forget that. Wall Street institutions that now walk tall again survived only because the taxpayers saved them. Goldman Sachs turned to the Fed for funding on 84 occasions, and Morgan Stanley did so 212 times; Blackrock, Fidelity, Dreyfus, GE Capital – all of these depended on taxpayer backstops. The message from this data dump is that, two years ago, these too-big-to-fail behemoths drove the world to the brink of a 1930s-style disaster – and that, if regulators don’t break them up or otherwise restrain them, they may do worse next time.”
There doesn’t seem to be much movement afoot to “break them up” at this time, but there has been, and will continue to be, great efforts to “restrain them”. I don’t see the will or the leadership to “break them up”. I have my own views about the ability of the government to “restrain them” but I treat that question elsewhere.
I would like to raise another issue at this time which I believe to be integral to the situation mentioned above.
Discussions about the actions of the Federal Reserve during the financial crisis tend to be completely void of any discussion about the actions of the federal government or the Federal Reserve in creating the environment that resulted in the financial collapse.
Leading up to the financial crisis of 2008-2009 was approximated fifty years of governmental actions that created the largest credit inflation in the history of the United States. The gross federal debt of the United States government increased at a compound rate of approximately 9 percent per year from 1961 to the start of the crisis. Monetary policy, throughout this time period, accommodated this growth in debt. And, this period saw the greatest burst of financial innovation and credit creation in world history.
Why did this happen?
Two major reasons: first, the short-run emphasis of the government to sustain high, perhaps unsustainable, levels of employment; second, the goal of the government to put as many Americans in their own home and provide them with a financial “piggybank” to secure their future.
The first reason meant that the government had to keep stimulating the economy to keep people employed in the jobs they had. As a consequence, many American workers did not have the incentive to grow and prepare themselves for the “jobs of the future.” As a consequence, about one out of every four Americans of employment age is “under-employed”! Furthermore, the length of being unemployed has trended upwards from the 1950s and in October 2010 the average duration of unemployment is just about 34 weeks, almost three years. (See “Unemployed and Likely to Stay That Way,” http://www.nytimes.com/2010/12/03/business/economy/03unemployed.html?ref=todayspaper.)
The second reason meant that the government had to build programs and provide financial innovation and finance so that more people could own their own homes. The inflation that took place in the real estate sector resulted in home ownership becoming the real “piggybank” of the middle class, producing for them the “best” investment they could experience over this time until, of course, the bubble burst.
The federal government set up the environment and the incentives that everyone else had to live within.
Chuck Prince, the former Chairman and CEO of Citigroup, made the now famous statement that “while the music keeps playing, you must keep dancing.”
The environment created by a government that set the example of “living beyond one’s means” created an almost perfect environment for taking financial risk, mismatching maturities, leveraging up debt, and financial innovation. The “Greenspan Put” during the 1990s and early 2000s sustained this environment by providing downside protection thereby creating greater “moral hazard.” In essence, the federal government “kept the music playing” and businesses, both financial and non-financial, had to “keep dancing” in order to remain competitive.
The question was constantly asked by executives, “How can I get a few more basis points return to be competitive with others in the industry?” The answer within such an environment was more leverage, more risk, and new financial innovations. At least, until the load became too heavy to bear.
But, in the rush to “break” companies up or to regulate and “restrain” them from such activity, most people have forgotten that the whole environment and the incentives set up were created by the same people now interested in breaking up these companies or restraining them.
So, within this call for breaking up these companies and regulating them more closely we hear
the same people calling for more government spending, more tax cuts, more quantitative easy on the part of the central bank, and greater welfare benefits to those that are hurting.
This is why the whole scenario seems to be one of trying to drive your car as fast as you can while at the same time trying to drive your car as safely as possible.
You are stepping on the gas and stepping on the car brakes at the same time!
So, where does this discussion take us? Really nowhere.
In my view, the people calling for the federal government to constantly provide fiscal and monetary stimulus to the economy are still in control and I don’t see their demise anytime soon.
People will try to regulate and restrain the financial sector, but, as I have written many times before, they will not be able to be successful. Given the global nature of finance today and the tools brought to the finance industry by information technology, these attempts to regulate and restrain will not succeed.
And, there will be renewed calls for providing social services and payments for those being hurt by the actions mentioned in the preceding two paragraphs. What is really needed to resolve the problems of the modern economy is of a long term nature and our short-sighted politicians will never implement these solutions, at least, anytime soon.
So, we must continue to face a bumpy ride. Stepping on the gas and the brake pedal at the same time produces such a ride.
Thursday, August 6, 2009
Bank of America and the Appointment of Sallie Krawcheck
This continues to be a trying time for the finance industry. Articles like the one that appeared this morning in the Wall Street Journal just do no good for the stature of those who admit to working in finance in one way or another. The article I am referring to is “Behind BofA’s Silence on Merrill,” http://online.wsj.com/article/SB124952686109510009.html.
The problem is one similar to that described by John Plender, the Chairman of Quintain PLC, in the Financial Times yesterday, “Ditch Theory and Take Away the Punchbowl,” http://www.ft.com/cms/s/0/e8b88624-8107-11de-92e7-00144feabdc0.html. Plender presents the folksy strategy for central banking ascribed to William McChesney Martin, former Chairman of the Board of Governors of the Federal Reserve System. Martin is reported to have said that the task of a central banker was to take away the punchbowl before the party got out of hand.
To me, the role a financial officer, especially a Chief Financial Officer, is similar. A financial officer ultimately must be the naysayer in an organization. If the financial officer does not act out this role in an organization then the Chief Executive Officer is not going to be well served by the finance function and the organization is going to be exposed as it grows and considers alternative business options!
No one else in the organization performs this function. A “good” Chief Executive Officer wants a strong person in this position because without someone there to say “no” from time-to-time, the CEO will be like the emperor that is wearing no clothes. A “good” CEO knows this. One thing I look for in evaluating a management team is the strength of the people a CEO surrounds him- or herself with, especially the strength of the CFO.
A strong Chief Financial Officer knows that there is no such thing as a free lunch. That is, when it comes to finance, you never get something for nothing. If you want a greater return on your assets, you can take on riskier assets, or you can increase you financial leverage which, of course, increases risk, or you can mismatch the maturities of your assets and liabilities which, of course, increases risk. Of course, we can extend the idea of “no free lunch” to proposals coming from marketing, or information processing, or purchasing as well, but I am sticking with financial issues because that is where the concern is today.
In the euphoria of the credit bubbles that took place in the 1990s and the 2000s, CFOs and other finance people that believed that there was “no fee lunch” and acted upon this belief seem to have fallen out of favor with CEOs seeking to make bundles of money in the bubbles. Of course, not everyone acted in this way but a significant number did and we are all paying the price for this today.
When one sees articles like the one in the Wall Street Journal mentioned above, you can understand why people on Main Street and why Senators and Representatives in Congress can pick on bankers and others who are in the finance profession. It certainly seems as if a trust was broken and greed ruled the kingdom.
The hiring of Sallie Krawcheck by BofA is, therefore, a hint that maybe BofA understands that it needs to build up its credibility. Krawcheck has a reputation for openness and integrity that has stayed with her throughout her career. The argument is that this trait got her in trouble with the CEO of Citigroup, Vikram Pandit, and cost her the position of CFO which she held at Citi. Taking over responsibility for BofAs global wealth and investment management business in not the same as becoming CFO of the institution, but it indicates that BofA is pulling in someone that is not only talented and capable in finance, but also will add some credibility to the organization in terms of honesty and transparency.
One can learn a lot about leaders and the organizations they lead by observing how they respond to people that possess these qualities, especially in times of trouble. Citigroup seems to have a history of releasing top people that question how financial affairs are being handled. Richard Bookstaber comments on how Citi operated in the area of risk management in his book “A Demon of Our Own Design”. We also see that Jamie Dimon was asked to leave Citi when he began to clash with the leadership of that organization on issues of risk and management. (See my review of a book about Dimon: http://seekingalpha.com/article/148179-book-review-the-house-of-dimon-by-patricia-crisafulli.) It seems as if Citigroup worked hard and long to get itself into the position it is now in.
Of course, BOA and Citi are not isolated cases. One can name any number of organizations from Bear Sterns to Lehman Brothers to AIG to Wachovia to Countrywide to so and so and on and on. The depth and breadth of the problem just indicates how far the finance profession has lost credibility.
That is why I would advise at this time that investors look even more closely at the people, especially the finance people, that the leadership of an organization brings on board. Strong financial leadership is needed within an organization, leadership that stresses telling the truth, reporting asset values at realistic levels, and leadership that rejects accounting rules that only muddle if not mislead investors and regulators.
In this regard I would argue that we have to get back to mark-to-market accounting. To me, people only kid themselves when they finance long term assets with short term liabilities in order to capture additional return and cry and whine when they have to mark down the values of their longer term assets if the market goes against them. They are brave enough to gamble on this mismatch of maturities. They also need to be brave enough to accept the consequences of their actions. There is no free lunch!
In my experience there is one thing that financial integrity does: it causes people to act earlier than they would otherwise. The situation I saw over and over again in doing bank turnarounds was that people postponed doing anything about a bad position because they were not forced to recognize a problem early on. As a consequence they put off doing something about the bad situation and put it off until the problem grew into a much larger problem where they could not postpone action any longer. Good management recognizes problems and deals with them early on.
Hopefully, the hiring of Sallie Krawcheck is a sign that organizations are recognizing the need for strong financial leadership. Then, in hiring more people like her, maybe emperors won’t have to go out into crowds to discover that they don’t have any clothes on. The absence of clothes will have been discovered long before then and the situation will have been corrected.
The problem is one similar to that described by John Plender, the Chairman of Quintain PLC, in the Financial Times yesterday, “Ditch Theory and Take Away the Punchbowl,” http://www.ft.com/cms/s/0/e8b88624-8107-11de-92e7-00144feabdc0.html. Plender presents the folksy strategy for central banking ascribed to William McChesney Martin, former Chairman of the Board of Governors of the Federal Reserve System. Martin is reported to have said that the task of a central banker was to take away the punchbowl before the party got out of hand.
To me, the role a financial officer, especially a Chief Financial Officer, is similar. A financial officer ultimately must be the naysayer in an organization. If the financial officer does not act out this role in an organization then the Chief Executive Officer is not going to be well served by the finance function and the organization is going to be exposed as it grows and considers alternative business options!
No one else in the organization performs this function. A “good” Chief Executive Officer wants a strong person in this position because without someone there to say “no” from time-to-time, the CEO will be like the emperor that is wearing no clothes. A “good” CEO knows this. One thing I look for in evaluating a management team is the strength of the people a CEO surrounds him- or herself with, especially the strength of the CFO.
A strong Chief Financial Officer knows that there is no such thing as a free lunch. That is, when it comes to finance, you never get something for nothing. If you want a greater return on your assets, you can take on riskier assets, or you can increase you financial leverage which, of course, increases risk, or you can mismatch the maturities of your assets and liabilities which, of course, increases risk. Of course, we can extend the idea of “no free lunch” to proposals coming from marketing, or information processing, or purchasing as well, but I am sticking with financial issues because that is where the concern is today.
In the euphoria of the credit bubbles that took place in the 1990s and the 2000s, CFOs and other finance people that believed that there was “no fee lunch” and acted upon this belief seem to have fallen out of favor with CEOs seeking to make bundles of money in the bubbles. Of course, not everyone acted in this way but a significant number did and we are all paying the price for this today.
When one sees articles like the one in the Wall Street Journal mentioned above, you can understand why people on Main Street and why Senators and Representatives in Congress can pick on bankers and others who are in the finance profession. It certainly seems as if a trust was broken and greed ruled the kingdom.
The hiring of Sallie Krawcheck by BofA is, therefore, a hint that maybe BofA understands that it needs to build up its credibility. Krawcheck has a reputation for openness and integrity that has stayed with her throughout her career. The argument is that this trait got her in trouble with the CEO of Citigroup, Vikram Pandit, and cost her the position of CFO which she held at Citi. Taking over responsibility for BofAs global wealth and investment management business in not the same as becoming CFO of the institution, but it indicates that BofA is pulling in someone that is not only talented and capable in finance, but also will add some credibility to the organization in terms of honesty and transparency.
One can learn a lot about leaders and the organizations they lead by observing how they respond to people that possess these qualities, especially in times of trouble. Citigroup seems to have a history of releasing top people that question how financial affairs are being handled. Richard Bookstaber comments on how Citi operated in the area of risk management in his book “A Demon of Our Own Design”. We also see that Jamie Dimon was asked to leave Citi when he began to clash with the leadership of that organization on issues of risk and management. (See my review of a book about Dimon: http://seekingalpha.com/article/148179-book-review-the-house-of-dimon-by-patricia-crisafulli.) It seems as if Citigroup worked hard and long to get itself into the position it is now in.
Of course, BOA and Citi are not isolated cases. One can name any number of organizations from Bear Sterns to Lehman Brothers to AIG to Wachovia to Countrywide to so and so and on and on. The depth and breadth of the problem just indicates how far the finance profession has lost credibility.
That is why I would advise at this time that investors look even more closely at the people, especially the finance people, that the leadership of an organization brings on board. Strong financial leadership is needed within an organization, leadership that stresses telling the truth, reporting asset values at realistic levels, and leadership that rejects accounting rules that only muddle if not mislead investors and regulators.
In this regard I would argue that we have to get back to mark-to-market accounting. To me, people only kid themselves when they finance long term assets with short term liabilities in order to capture additional return and cry and whine when they have to mark down the values of their longer term assets if the market goes against them. They are brave enough to gamble on this mismatch of maturities. They also need to be brave enough to accept the consequences of their actions. There is no free lunch!
In my experience there is one thing that financial integrity does: it causes people to act earlier than they would otherwise. The situation I saw over and over again in doing bank turnarounds was that people postponed doing anything about a bad position because they were not forced to recognize a problem early on. As a consequence they put off doing something about the bad situation and put it off until the problem grew into a much larger problem where they could not postpone action any longer. Good management recognizes problems and deals with them early on.
Hopefully, the hiring of Sallie Krawcheck is a sign that organizations are recognizing the need for strong financial leadership. Then, in hiring more people like her, maybe emperors won’t have to go out into crowds to discover that they don’t have any clothes on. The absence of clothes will have been discovered long before then and the situation will have been corrected.
Thursday, April 23, 2009
Bank of America dot Gov
It is becoming clearer and clearer what it means to have government involved in the affairs of banks and businesses. Where all the initial talk was about the “moral hazard” presented by government bailing out the private sector and how this just means that in the future banks, and other organizations, will just take on more and more risk because they know that if things go bad, the government will be there with a rescue net to save the institution.
Now, we are seeing the other side of the bailout business. In the AIG case executives and others were angry because the government interfered with bonuses and other executive decisions. And, we have the government putting lids on executive pay. And, we have government wanting to rewrite mortgages, and cap interest rates on credit card debt, and so on and so on.
This is the other side of the coin.
And, now we learn from testimony given by Ken Lewis, the CEO of Bank of America, that Hank Paulson and Ben Bernanke put a “sock” in his mouth and strongly advised him that he say nothing to the shareholders or anybody else about the implications of the merger between Bank of America and Merrill Lynch.
Furthermore, we hear from New York’s Attorney General Cuomo that Paulson threatened to fire Lewis and remove the entire Board of Directors it Bank of America did not go through with the merger with Merrill Lynch! The reward—money from the Government to help BOA through the process.
The shareholders? Well, they lost on the value of their stock. And, they also will have higher taxes or an inflation tax that they will have to pay in the future.
In addition, why should any company, financial or non-financial even think of an acquisition in the future because the government may force the management to swallow hard, take on something that is not necessarily desirable for the company, and, of course, not inform investors as to the implications of the merger transaction?
And, why should the stockholders of any company approve any acquisition that is at all questionable? The precedent has been set that they might be approving something that will cost them considerable wealth as the stock of their company tanks, and they are given no information to give them any confidence that the transaction might be a worthy one.
What if the shareholders balk? What if they fail to approve such a merger? Will the government step in and force through the merger anyway?
Talk about a mess!
Two thoughts come to mind that I must express.
First, the combination of Paulson and Bernanke was a disaster as far as I can see. I have written about how Bernanke seemed to panic last fall and the result was the TARP. (See my post “The Bailout Plan: Did Bernanke Panic”, http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.)
Paulson didn’t do much better in his handling of the crisis and the creation and oversight of the TARP. I always thought that Paulson found the whole bailout idea not to his taste and had hoped that he would be able to get out of Washington before the collapse. Unfortunately for him—and for us—he didn’t make it. As a consequence here was a man doing something that he despised, and his heart, and mind, was really not in the effort. He has left us a very unhappy legacy!
When I reflect on the events of the last fall I keep coming up with the feeling that we would be hard pressed to have found two people less capable of handling the situation than the two that were then in charge. And, then there was the “Decider”, but he was AWOL!
The second thing has to do with the fact that the bankers, and other business leaders, are getting pelted with all the blame for the financial collapse and crisis that we have experienced. Thus we have the “bad guys” in our sights. Thus, they should pay.
But, what if the conditions that existed were created by the government and these bankers and other business leaders were just responding to the incentives initiated by the government? We had a credit bubble connected with the stock market in the 1990s. The credit bubble resulted in negative real rates of interest and consumers stopped saving. The saving rate fell from 7.7% of disposable income in 1992 to about 2.0% by the end of the decade. Then there was the huge deficits that resulted from the 2001 tax cuts and the “war on terror”. This was accompanied by negative real interest rates gain which resulted in the credit bubble in the 2000s and the housing boom. The consumer savings rate remained around two or below, even becoming negative for a short period of time.
The foreign exchange market in the 2000s indicated a fear of a renewal of inflation as the value of the dollar fell by more than 40% against major currencies. What were financial managers to do in such an environment? Generally, because spreads narrow in such times and arbitrage opportunities are based on smaller differences, you tend to leverage up and mismatch maturities. This response is a normal one to gain the needed returns on equity to keep money from leaving your fund or institution.
Is this greed? Yes, but it is also just the natural response of competitive people to the incentives that are created, in this case, by the government. The Bush 43 administration may have been composed of “Free Market Capitalists” but this “gang that couldn’t shoot straight” did more to harm capitalism than most other administrations in the history of the United States.
So, government gets it both ways. It can create the crisis. And, then it can impose itself on the economy to right the system after the crisis occurs. And, best of all, the blame can all be put on “greedy” bankers and the lack of regulation.
I am sure that before this is over we will hear many more horror stories.
Now, we are seeing the other side of the bailout business. In the AIG case executives and others were angry because the government interfered with bonuses and other executive decisions. And, we have the government putting lids on executive pay. And, we have government wanting to rewrite mortgages, and cap interest rates on credit card debt, and so on and so on.
This is the other side of the coin.
And, now we learn from testimony given by Ken Lewis, the CEO of Bank of America, that Hank Paulson and Ben Bernanke put a “sock” in his mouth and strongly advised him that he say nothing to the shareholders or anybody else about the implications of the merger between Bank of America and Merrill Lynch.
Furthermore, we hear from New York’s Attorney General Cuomo that Paulson threatened to fire Lewis and remove the entire Board of Directors it Bank of America did not go through with the merger with Merrill Lynch! The reward—money from the Government to help BOA through the process.
The shareholders? Well, they lost on the value of their stock. And, they also will have higher taxes or an inflation tax that they will have to pay in the future.
In addition, why should any company, financial or non-financial even think of an acquisition in the future because the government may force the management to swallow hard, take on something that is not necessarily desirable for the company, and, of course, not inform investors as to the implications of the merger transaction?
And, why should the stockholders of any company approve any acquisition that is at all questionable? The precedent has been set that they might be approving something that will cost them considerable wealth as the stock of their company tanks, and they are given no information to give them any confidence that the transaction might be a worthy one.
What if the shareholders balk? What if they fail to approve such a merger? Will the government step in and force through the merger anyway?
Talk about a mess!
Two thoughts come to mind that I must express.
First, the combination of Paulson and Bernanke was a disaster as far as I can see. I have written about how Bernanke seemed to panic last fall and the result was the TARP. (See my post “The Bailout Plan: Did Bernanke Panic”, http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.)
Paulson didn’t do much better in his handling of the crisis and the creation and oversight of the TARP. I always thought that Paulson found the whole bailout idea not to his taste and had hoped that he would be able to get out of Washington before the collapse. Unfortunately for him—and for us—he didn’t make it. As a consequence here was a man doing something that he despised, and his heart, and mind, was really not in the effort. He has left us a very unhappy legacy!
When I reflect on the events of the last fall I keep coming up with the feeling that we would be hard pressed to have found two people less capable of handling the situation than the two that were then in charge. And, then there was the “Decider”, but he was AWOL!
The second thing has to do with the fact that the bankers, and other business leaders, are getting pelted with all the blame for the financial collapse and crisis that we have experienced. Thus we have the “bad guys” in our sights. Thus, they should pay.
But, what if the conditions that existed were created by the government and these bankers and other business leaders were just responding to the incentives initiated by the government? We had a credit bubble connected with the stock market in the 1990s. The credit bubble resulted in negative real rates of interest and consumers stopped saving. The saving rate fell from 7.7% of disposable income in 1992 to about 2.0% by the end of the decade. Then there was the huge deficits that resulted from the 2001 tax cuts and the “war on terror”. This was accompanied by negative real interest rates gain which resulted in the credit bubble in the 2000s and the housing boom. The consumer savings rate remained around two or below, even becoming negative for a short period of time.
The foreign exchange market in the 2000s indicated a fear of a renewal of inflation as the value of the dollar fell by more than 40% against major currencies. What were financial managers to do in such an environment? Generally, because spreads narrow in such times and arbitrage opportunities are based on smaller differences, you tend to leverage up and mismatch maturities. This response is a normal one to gain the needed returns on equity to keep money from leaving your fund or institution.
Is this greed? Yes, but it is also just the natural response of competitive people to the incentives that are created, in this case, by the government. The Bush 43 administration may have been composed of “Free Market Capitalists” but this “gang that couldn’t shoot straight” did more to harm capitalism than most other administrations in the history of the United States.
So, government gets it both ways. It can create the crisis. And, then it can impose itself on the economy to right the system after the crisis occurs. And, best of all, the blame can all be put on “greedy” bankers and the lack of regulation.
I am sure that before this is over we will hear many more horror stories.
Monday, April 13, 2009
Are Banks Telling the Truth?
On the front page of the Financial Times this morning we read the disconcerting headlines, “’Tarp cop’ to investigate whether banks have ‘cooked their books.’” (See http://www.ft.com/cms/s/0/163c85c4-2789-11de-9b77-00144feabdc0.html.) Neil Barofsky, special investigator-general for the Troubled Asset Relief Program (TARP), is “seeking evidence of wrongdoing on the part of banks receiving help from the fund.”
The game—“institutions applying for TARP money had to show they were fundamentally sound, potentially prompting them to misstate assets and liabilities.” Barofsky is quoted as saying, “I hope we don’t find a single bank that’s cooked its books to try to get money but I don’t think that’s going to be the case.”
Mr. Barofsky also said the Treasury’s expanded Term Asset-Backed Securities Loan Facility (TALF) was ripe for fraud.
The potential—fraudsters would be receiving indictments!
Two thoughts cross my mind when reading this. First, bankers in deteriorating situations tend to hide their heads in the sand when it comes to bad assets because they keep hoping that things will get better and the assets will recover their value. Having (successfully) completed several bank turnarounds I have found that this is one of the first things that becomes obvious when you initially investigate the loans and other assets of a troubled institution. Bankers, lenders, or portfolio managers continually think that ‘the economy will turn around’ or that ‘the company is getting its act in order’ or that some other event will come along that will result in the ‘asset gone bad’ becoming the ‘asset has become good again.’ And, so the asset is carried along but never comes back to life.
The problem with this is that these bad assets continually undermine the ability of the financial institution to right itself and become profitable again. The example is always there on the books of the banks and whether the executives or officers admit the fact, internally they know that things are not right and this drains efforts to instill a healthy culture to “do the right thing.” Managements that allow this unhealthy culture to continue are just perpetrating a bad situation, one that very rarely ever turns itself around.
The managements that participate in such a charade tend to be desperate and susceptible to moving to the next step when they are thrown a life boat like many financial institutions received in the past nine months or so.
Before following up on this point, let me just say that, historically, the bank either brings in someone to turn the institution around, or, a regulatory agency steps in and dissolves the organization. The American banking system has worked very well in the past with respect to “sick” banks. Contagion has been avoided through quick action connected with the swift resolution of problem assets. Financial institutions that were in trouble were taken care of—period!
But, that is not the case in the current situation. We have had a bailout. The banks have been tossed a life boat. However, financial institutions were supposed to be “fundamentally sound” in order to obtain TARP money. Here we get into the muddy waters of conducting a “general” bailout.
Let me just say that I have been suspicious from the start when government officials claimed that the need for the TARP funds was because the banks were facing “a liquidity problem” with respect to their troubled assets.
Again, my experience in doing bank turnaround’s is that the officers of the bank that claimed their assets were in trouble because of liquidity problems were attempting to cover up the real difficulties connected with the assets which were almost always associated with the issue of solvency.
It would not be much of a surprise to me to hear that the banks justified to the government that they were “fundamentally sound” because their asset problems were associated with liquidity issues rather than ones of solvency. This assessment could perhaps be supported if government officials only took a cursory glance at the assets. But, one could argue that this is the conclusion that government officials wanted to hear at that time.
Is this fraud? That is what Mr. Barofsky is going to have to find out.
Other than outright “cooking of the books”, in many cases the distinction between liquidity and solvency may fall back on an argument about “judgment”, about the “eye of the beholder.” Thus, Mr. Barofsky is going to have his problems proving his case.
In my opinion, many of the banks that received bailout relief had and still have a solvency problem and until the situation is handled that way the dislocations associated with the banking industry and the financial markets are going to continue. Consequently, I believe that Mr. Barofsky and others are going to find evidence that all along the issue has been solvency and not liquidity. If so, then there is a real issue of whether or not that these institutions that received TARP money were “fundamentally sound.”
My second thought on this issue is a very simple one. If people inside the banks covered up the real issues related to solvency heads should roll. Those that committed fraud should be indicted! Those that knowingly misled should be dismissed!
And, top executives, even though they were not directly involved in fraud or in a cover up, should be removed from their positions as well. They have proven that they cannot manage their institutions with sufficient control to justify their ability to move those institutions on into the future. The “buck stops with the top position” and the argument that they didn’t know what was going on is insufficient. It was their responsibility to know what was going on!
Risk management, the other “bug-in-the-coffee”, and financial control are not glamorous pursuits, especially when compared with the “jet pilots” of finance that were tossing around all sorts of money chasing narrow spreads with lots and lots of leverage. Performance over time, however, is closely related to an institution’s ability to successfully exert risk management and financial control.
We have to know what is going on in the banks and other financial institutions. The pressure needs to be stepped up to find out where things are. And, the sooner this pressure is exerted the sooner we will be able to find ways out of the mess we are in.
And this brings me to one final point. The Financial Times also had another headline on its front page that I found disturbing. The article cried out “AIG in derivatives spotlight.” (See http://www.ft.com/cms/s/0/cb2ddafc-278c-11de-9b77-00144feabdc0.html.) “The unit that all but destroyed AIG has failed to sign up for the overhaul of the global derivatives market, which was given added impetus by the troubles at the US insurance group.” The government is involved with AIG—the government owns most of AIG. It is mind boggling to me that a government that supposedly wants to bring greater openness and transparency to the financial markets allowed this to happen!
The game—“institutions applying for TARP money had to show they were fundamentally sound, potentially prompting them to misstate assets and liabilities.” Barofsky is quoted as saying, “I hope we don’t find a single bank that’s cooked its books to try to get money but I don’t think that’s going to be the case.”
Mr. Barofsky also said the Treasury’s expanded Term Asset-Backed Securities Loan Facility (TALF) was ripe for fraud.
The potential—fraudsters would be receiving indictments!
Two thoughts cross my mind when reading this. First, bankers in deteriorating situations tend to hide their heads in the sand when it comes to bad assets because they keep hoping that things will get better and the assets will recover their value. Having (successfully) completed several bank turnarounds I have found that this is one of the first things that becomes obvious when you initially investigate the loans and other assets of a troubled institution. Bankers, lenders, or portfolio managers continually think that ‘the economy will turn around’ or that ‘the company is getting its act in order’ or that some other event will come along that will result in the ‘asset gone bad’ becoming the ‘asset has become good again.’ And, so the asset is carried along but never comes back to life.
The problem with this is that these bad assets continually undermine the ability of the financial institution to right itself and become profitable again. The example is always there on the books of the banks and whether the executives or officers admit the fact, internally they know that things are not right and this drains efforts to instill a healthy culture to “do the right thing.” Managements that allow this unhealthy culture to continue are just perpetrating a bad situation, one that very rarely ever turns itself around.
The managements that participate in such a charade tend to be desperate and susceptible to moving to the next step when they are thrown a life boat like many financial institutions received in the past nine months or so.
Before following up on this point, let me just say that, historically, the bank either brings in someone to turn the institution around, or, a regulatory agency steps in and dissolves the organization. The American banking system has worked very well in the past with respect to “sick” banks. Contagion has been avoided through quick action connected with the swift resolution of problem assets. Financial institutions that were in trouble were taken care of—period!
But, that is not the case in the current situation. We have had a bailout. The banks have been tossed a life boat. However, financial institutions were supposed to be “fundamentally sound” in order to obtain TARP money. Here we get into the muddy waters of conducting a “general” bailout.
Let me just say that I have been suspicious from the start when government officials claimed that the need for the TARP funds was because the banks were facing “a liquidity problem” with respect to their troubled assets.
Again, my experience in doing bank turnaround’s is that the officers of the bank that claimed their assets were in trouble because of liquidity problems were attempting to cover up the real difficulties connected with the assets which were almost always associated with the issue of solvency.
It would not be much of a surprise to me to hear that the banks justified to the government that they were “fundamentally sound” because their asset problems were associated with liquidity issues rather than ones of solvency. This assessment could perhaps be supported if government officials only took a cursory glance at the assets. But, one could argue that this is the conclusion that government officials wanted to hear at that time.
Is this fraud? That is what Mr. Barofsky is going to have to find out.
Other than outright “cooking of the books”, in many cases the distinction between liquidity and solvency may fall back on an argument about “judgment”, about the “eye of the beholder.” Thus, Mr. Barofsky is going to have his problems proving his case.
In my opinion, many of the banks that received bailout relief had and still have a solvency problem and until the situation is handled that way the dislocations associated with the banking industry and the financial markets are going to continue. Consequently, I believe that Mr. Barofsky and others are going to find evidence that all along the issue has been solvency and not liquidity. If so, then there is a real issue of whether or not that these institutions that received TARP money were “fundamentally sound.”
My second thought on this issue is a very simple one. If people inside the banks covered up the real issues related to solvency heads should roll. Those that committed fraud should be indicted! Those that knowingly misled should be dismissed!
And, top executives, even though they were not directly involved in fraud or in a cover up, should be removed from their positions as well. They have proven that they cannot manage their institutions with sufficient control to justify their ability to move those institutions on into the future. The “buck stops with the top position” and the argument that they didn’t know what was going on is insufficient. It was their responsibility to know what was going on!
Risk management, the other “bug-in-the-coffee”, and financial control are not glamorous pursuits, especially when compared with the “jet pilots” of finance that were tossing around all sorts of money chasing narrow spreads with lots and lots of leverage. Performance over time, however, is closely related to an institution’s ability to successfully exert risk management and financial control.
We have to know what is going on in the banks and other financial institutions. The pressure needs to be stepped up to find out where things are. And, the sooner this pressure is exerted the sooner we will be able to find ways out of the mess we are in.
And this brings me to one final point. The Financial Times also had another headline on its front page that I found disturbing. The article cried out “AIG in derivatives spotlight.” (See http://www.ft.com/cms/s/0/cb2ddafc-278c-11de-9b77-00144feabdc0.html.) “The unit that all but destroyed AIG has failed to sign up for the overhaul of the global derivatives market, which was given added impetus by the troubles at the US insurance group.” The government is involved with AIG—the government owns most of AIG. It is mind boggling to me that a government that supposedly wants to bring greater openness and transparency to the financial markets allowed this to happen!
Tuesday, March 24, 2009
Liquidity or Solvency?
The debate over the Public-Private Investment Program (P-PIP) put forward by Treasury Secretary Timothy Geithner seems to be focusing upon a technical point concerning the condition of the market for troubled assets. In the eyes of some, the question relating to whether or not the program will work depends upon whether the problem being dealt with is a liquidity problem or a solvency problem.
The preliminary judgment is that if the problem is a liquidity problem then P-PIP will be an adequate solution. If the problem is a solvency problem then P-PIP will probably not do the job.
Unfortunately, this debate has gone on for a long time…going back to at least December 2007 when the Federal Reserve initiated its Term Auction Facility (TAF). The Fed’s action at that time was an effort to relieve pressures on the banking system by providing a more direct and more liquid approach (than borrowing at the discount window) toward getting short-term funds to the banks that needed liquidity. Additional efforts have been made since then to provide liquidity for different sectors of the financial markets.
The crucial issue connected with a liquidity crisis is addressed in the first sentence of the last paragraph. A “liquidity crisis” by its very nature is a short-term phenomenon. To say that the debate has gone on for a long time is to confirm that the “crisis” we are in is NOT a liquidity crisis.
A liquidity crisis occurs when some kind of shock hits short term financial markets. The “shock” usually takes the form of a new piece of information that is contrary to the current beliefs held by the participants in these markets. A classic example is the situation that revolved around the Penn Central Railroad and the commercial paper market. Because of financial problems at Penn Central the rating given to Penn Central’s commercial paper was revised downward. This revision shocked the commercial paper market and the market basically closed down. The reason was that if the Penn Central rating needed to be lowered, the question became “what other commercial paper ratings needed to be lowered?” The buy-side left the market. Hence, the “liquidity crisis.”
Since borrowers in the commercial paper market could not roll-over their paper, they had to go into the commercial banks and draw on their back-up lines of credit. The problem then fell to the banking system. And, if the banks tried to sell short-term securities to get funds for to honor the lines of credit this would cause security prices to plummet.
The Federal Reserve responded in classic central bank style by opening the discount window, supplying sufficient liquidity to the banks that needed funds to support lines of credit. The banks were able to honor the back-up lines of credit without having to sell securities and the commercial paper market was given the time to access the information on borrowers in the commercial paper market and the buyers returned and the market stabilized.
The point of this is that a “liquidity crisis” is a short-run problem. The crisis occurs because market participants get some information that is not consistent with what they had formerly believed. They need to process the new information and until they do, the buy-side of the market usually disappears. The solution to this problem is for the central bank to supply sufficient liquidity to the market so that the participants have time to process the new information. Liquidity problems usually last only a few weeks.
Solvency problems are of a completely different nature. And, as I have written about over the past year or so, resolving solvency problems take a long, long time. And, with solvency problems it is not an issue of providing liquidity to the market so that assets can get sold. Solvency problems have to do with charging off book values to reflect the underlying economic values of assets. Yes, there is uncertainty with respect to what is the underlying economic value of the assets, but that is why time is needed and cannot be hurried along.
There is only one way to hurry time along in issues relating to solvency and that is to charge off the asset, or at least charge off a major part of the asset. The problem is that banks, and other institutions, don’t like to rush this process. They want to see how the situation with respect to the asset can be worked out, what can be recovered, and whether or not they can hold onto the asset long enough so that economic conditions can improve which will lead to higher asset values. This is not a liquidity problem!
Why would private investment funds want to get into such a deal?
Only if they smell blood!
And, where would this smell of blood come from? It could come from two places: first, if the probability of the improving economy were high enough to cause these private investors to believe that their speculation on these assets has a fair chance of turning out favorably; and second, these investors believe that the government is providing them a rich enough protection of their money to make it worthwhile to commit to such a speculation.
These private investment funds will not purchase these assets as a public service. Thus, they will only purchase assets if they believe that they can earn a bunch of money, because it is a risky investment. Thus, they either have to see the opportunity to make a lot of money or to believe that they are sufficiently protected on the down side to take a chance.
The two issues for the public on the P-PIP are these: first, is the government, once again, giving away a lot of loot to the ‘bad guys’ in the financial community; and second, is the government providing protection on the down-side that will cost the tax payer a lot of money in the future if P-PIP doesn’t work.
But there are still several other issues hanging around. For one, the success of P-PIP depends upon the economic recovery beginning later this year as Chairman Bernanke has projected. For another, the success of P-PIP depends upon the willingness of the financial institutions that now hold the “toxic” assets—whoops—the “legacy” assets, to begin lending once they are able to dispose of these assets. And, the success of the P-PIP depends upon the ability of existing managements to really turn their businesses around (see my post of March 23, 2009, “A Lesson from AIG for the Bank Bailout Plan”, http://maseportfolio.blogspot.com/), a possibility of which we are not yet certain. And, there are more.
As is obvious, I still have concerns about policymakers (as I have had for the past 18 months or so) and whether or not they are attacking the correct problems. In the case of the P-PIP, if they are fighting a liquidity problem I fear that the program will not be very successful. We have a solvency problem and a solvency problem, by its very nature involves a concern about capital adequacy. In my mind, the capital problem is going to have to be faced, one way or another, before we get out of this crisis. The sooner we realize this and attempt to do something about it, the better off we will all be.
The preliminary judgment is that if the problem is a liquidity problem then P-PIP will be an adequate solution. If the problem is a solvency problem then P-PIP will probably not do the job.
Unfortunately, this debate has gone on for a long time…going back to at least December 2007 when the Federal Reserve initiated its Term Auction Facility (TAF). The Fed’s action at that time was an effort to relieve pressures on the banking system by providing a more direct and more liquid approach (than borrowing at the discount window) toward getting short-term funds to the banks that needed liquidity. Additional efforts have been made since then to provide liquidity for different sectors of the financial markets.
The crucial issue connected with a liquidity crisis is addressed in the first sentence of the last paragraph. A “liquidity crisis” by its very nature is a short-term phenomenon. To say that the debate has gone on for a long time is to confirm that the “crisis” we are in is NOT a liquidity crisis.
A liquidity crisis occurs when some kind of shock hits short term financial markets. The “shock” usually takes the form of a new piece of information that is contrary to the current beliefs held by the participants in these markets. A classic example is the situation that revolved around the Penn Central Railroad and the commercial paper market. Because of financial problems at Penn Central the rating given to Penn Central’s commercial paper was revised downward. This revision shocked the commercial paper market and the market basically closed down. The reason was that if the Penn Central rating needed to be lowered, the question became “what other commercial paper ratings needed to be lowered?” The buy-side left the market. Hence, the “liquidity crisis.”
Since borrowers in the commercial paper market could not roll-over their paper, they had to go into the commercial banks and draw on their back-up lines of credit. The problem then fell to the banking system. And, if the banks tried to sell short-term securities to get funds for to honor the lines of credit this would cause security prices to plummet.
The Federal Reserve responded in classic central bank style by opening the discount window, supplying sufficient liquidity to the banks that needed funds to support lines of credit. The banks were able to honor the back-up lines of credit without having to sell securities and the commercial paper market was given the time to access the information on borrowers in the commercial paper market and the buyers returned and the market stabilized.
The point of this is that a “liquidity crisis” is a short-run problem. The crisis occurs because market participants get some information that is not consistent with what they had formerly believed. They need to process the new information and until they do, the buy-side of the market usually disappears. The solution to this problem is for the central bank to supply sufficient liquidity to the market so that the participants have time to process the new information. Liquidity problems usually last only a few weeks.
Solvency problems are of a completely different nature. And, as I have written about over the past year or so, resolving solvency problems take a long, long time. And, with solvency problems it is not an issue of providing liquidity to the market so that assets can get sold. Solvency problems have to do with charging off book values to reflect the underlying economic values of assets. Yes, there is uncertainty with respect to what is the underlying economic value of the assets, but that is why time is needed and cannot be hurried along.
There is only one way to hurry time along in issues relating to solvency and that is to charge off the asset, or at least charge off a major part of the asset. The problem is that banks, and other institutions, don’t like to rush this process. They want to see how the situation with respect to the asset can be worked out, what can be recovered, and whether or not they can hold onto the asset long enough so that economic conditions can improve which will lead to higher asset values. This is not a liquidity problem!
Why would private investment funds want to get into such a deal?
Only if they smell blood!
And, where would this smell of blood come from? It could come from two places: first, if the probability of the improving economy were high enough to cause these private investors to believe that their speculation on these assets has a fair chance of turning out favorably; and second, these investors believe that the government is providing them a rich enough protection of their money to make it worthwhile to commit to such a speculation.
These private investment funds will not purchase these assets as a public service. Thus, they will only purchase assets if they believe that they can earn a bunch of money, because it is a risky investment. Thus, they either have to see the opportunity to make a lot of money or to believe that they are sufficiently protected on the down side to take a chance.
The two issues for the public on the P-PIP are these: first, is the government, once again, giving away a lot of loot to the ‘bad guys’ in the financial community; and second, is the government providing protection on the down-side that will cost the tax payer a lot of money in the future if P-PIP doesn’t work.
But there are still several other issues hanging around. For one, the success of P-PIP depends upon the economic recovery beginning later this year as Chairman Bernanke has projected. For another, the success of P-PIP depends upon the willingness of the financial institutions that now hold the “toxic” assets—whoops—the “legacy” assets, to begin lending once they are able to dispose of these assets. And, the success of the P-PIP depends upon the ability of existing managements to really turn their businesses around (see my post of March 23, 2009, “A Lesson from AIG for the Bank Bailout Plan”, http://maseportfolio.blogspot.com/), a possibility of which we are not yet certain. And, there are more.
As is obvious, I still have concerns about policymakers (as I have had for the past 18 months or so) and whether or not they are attacking the correct problems. In the case of the P-PIP, if they are fighting a liquidity problem I fear that the program will not be very successful. We have a solvency problem and a solvency problem, by its very nature involves a concern about capital adequacy. In my mind, the capital problem is going to have to be faced, one way or another, before we get out of this crisis. The sooner we realize this and attempt to do something about it, the better off we will all be.
Tuesday, March 17, 2009
AIG, an example of a bailout!
“If there is a single episode in this entire 18 months that has made me more angry, I can’t think of one other than AIG. AIG exploited a huge gap in the regulatory system.”
These words were spoken by Ben Bernanke, Chairman of the Board of Governors of the Federal Reserve System in testimony on Tuesday, March 3, 2009 before the Senate Banking Committee. Bernanke expressed further anguish at the behavior of AIG on Sixty Minutes Sunday evening.
Professor, welcome to the real world!
Treasury Secretary Timothy Geithner echoed some of the same feelings in testimony on the same day before the House Ways and Means Committee when he stated that some areas of AIG were not under “adult supervision.”
Come on, Timmy, I try and stop people from making the same claim about the bank bailout plans of the Treasury Department.
Is the Obama team becoming so defensive about their program that they are beginning to resort to name calling to deflect criticism?
Did AIG exploit a huge gap in the regulatory system? Yes, they did. And that is what people do over and over again in the real world. It is called “responding to incentives.” The world is full of incentives…some positive incentives…some negative incentives…and so on. That is what the study of economics is all about! Give the people in the Obama administration a copy of “Freakonomics”!
I have been in the Federal Reserve System…I have worked for a cabinet Secretary in Washington, D. C….and I have run publically traded financial institutions…and one thing is especially clear…people respond to incentives.
Some of those incentives are to innovate in products and markets. And, what do economists tell potential innovators to look for? Missing markets. Incomplete Markets. Places that are not being served or regulated.
Why do you look in these areas? Well, because that is where a person…or a business…can find a place to achieve a competitive advantage. Being a “first-mover” or a “second-mover” into a market is a way to achieve exceptional returns…at least for a short time period. And, this is plenty of incentive to draw people into the effort.
It is a highly risky effort and a lot of people and businesses fail because it is so risky. But, the incentives are substantial enough that people are continually drawn into the exercise.
A competitive advantage may not last for a very long time. People that find opportunities to arbitrage markets…traders…may find segments in a market place to exploit for a period of time…but, over time competitive advantage does not seem to last for specific trading schemes…see Enron and Long Term Capital Management. In such cases, you need to keep coming up with something new. That is what businesses producing Information Goods do.
One of the games played in the financial services area…and I have experienced this in my professional life beginning in the 1960s…is to find the hole in the regulatory structure. It is a game that the regulators are always behind in. The private sector does something…the regulators close the gap with new regulations…the private sector finds a way around this…and the regulators have to close the gap again. And, the game goes on and on because the incentives are such that it is still worthwhile to the private sector to continue to innovate.
Furthermore, anything the government does sets up incentives. And that is why the Obama “recovery plan” is so important…it changes a lot of the incentives that exist within the economy…for better or for worse. Notice the long, long lines of governors, mayors, and other officials that have gathered with their hands out for funds from the “recovery plan”. I am not going to comment any further on the “recovery plan” at this time other than to just highlight the fact that this plan changes incentives…regardless of how much stimulus it provides.
But, to be an equal-opportunity critic, I must mention that the previous administration created incentives that resulted in the present financial crisis. Maintaining negative real rates of interest for at least 18 months created plenty of incentive to leverage and innovate in financial structures and instruments. This period of innovation has created a massive crisis with respect to asset values. (For more on this see my blog post “AIG and Our Core Economic Issue: Unknown Asset Values” http://seekingalpha.com/article/123867-aig-and-our-core-economic-issue-unknown-asset-values.) In my mind, there is going to have to be a resolution to the asset value problem before any stimulus package is going to have much of an effect on the economy.
Anytime the government attempts to impose its hand on the private sector “things happen.” The government is just not attuned to enter the very complex tangled web of the real world with simplistic plans to “set things straight.” Even within the government public officials have started pointing fingers at each other when events don’t go as desired. Last night I saw Barney Frank interviewed by Rachael Maddow. Frank made it very clear that we got into the AIG mess because “the Fed”, without coming to Congress, gave AIG $85 billion last September and this started off all the mess. And, the reason why this bonus thing and other events have occurred is that “the Fed” without the advice or consultation of Congress gave AIG the $85 billion with “no strings attached”!
Wow! Go figur’ that, will ya!
Now, the Wall Street Journal has the headline this morning…”Obama to Avoid Auto Bankruptcies.” The “experts” in the government, we are told, are going to restructure General Motors Corp. and Chrysler LLC outside of the bankruptcy courts. This, we are expected to believe, will give the taxpayers a better and more protected solution than will a court solution. We wait the conclusion…
The real world is tough. People don’t always do what you want them to do. Incentives matter. We must be careful about the incentives we are creating for the future, for one other fact from the field of economics is very clear: sometimes it takes a long time for the full effect of incentives to work their way through an economy. As a consequence, we can often lose sight of the cause of a problem because the incentives that created the problem are embedded somewhere in the distant past.
These words were spoken by Ben Bernanke, Chairman of the Board of Governors of the Federal Reserve System in testimony on Tuesday, March 3, 2009 before the Senate Banking Committee. Bernanke expressed further anguish at the behavior of AIG on Sixty Minutes Sunday evening.
Professor, welcome to the real world!
Treasury Secretary Timothy Geithner echoed some of the same feelings in testimony on the same day before the House Ways and Means Committee when he stated that some areas of AIG were not under “adult supervision.”
Come on, Timmy, I try and stop people from making the same claim about the bank bailout plans of the Treasury Department.
Is the Obama team becoming so defensive about their program that they are beginning to resort to name calling to deflect criticism?
Did AIG exploit a huge gap in the regulatory system? Yes, they did. And that is what people do over and over again in the real world. It is called “responding to incentives.” The world is full of incentives…some positive incentives…some negative incentives…and so on. That is what the study of economics is all about! Give the people in the Obama administration a copy of “Freakonomics”!
I have been in the Federal Reserve System…I have worked for a cabinet Secretary in Washington, D. C….and I have run publically traded financial institutions…and one thing is especially clear…people respond to incentives.
Some of those incentives are to innovate in products and markets. And, what do economists tell potential innovators to look for? Missing markets. Incomplete Markets. Places that are not being served or regulated.
Why do you look in these areas? Well, because that is where a person…or a business…can find a place to achieve a competitive advantage. Being a “first-mover” or a “second-mover” into a market is a way to achieve exceptional returns…at least for a short time period. And, this is plenty of incentive to draw people into the effort.
It is a highly risky effort and a lot of people and businesses fail because it is so risky. But, the incentives are substantial enough that people are continually drawn into the exercise.
A competitive advantage may not last for a very long time. People that find opportunities to arbitrage markets…traders…may find segments in a market place to exploit for a period of time…but, over time competitive advantage does not seem to last for specific trading schemes…see Enron and Long Term Capital Management. In such cases, you need to keep coming up with something new. That is what businesses producing Information Goods do.
One of the games played in the financial services area…and I have experienced this in my professional life beginning in the 1960s…is to find the hole in the regulatory structure. It is a game that the regulators are always behind in. The private sector does something…the regulators close the gap with new regulations…the private sector finds a way around this…and the regulators have to close the gap again. And, the game goes on and on because the incentives are such that it is still worthwhile to the private sector to continue to innovate.
Furthermore, anything the government does sets up incentives. And that is why the Obama “recovery plan” is so important…it changes a lot of the incentives that exist within the economy…for better or for worse. Notice the long, long lines of governors, mayors, and other officials that have gathered with their hands out for funds from the “recovery plan”. I am not going to comment any further on the “recovery plan” at this time other than to just highlight the fact that this plan changes incentives…regardless of how much stimulus it provides.
But, to be an equal-opportunity critic, I must mention that the previous administration created incentives that resulted in the present financial crisis. Maintaining negative real rates of interest for at least 18 months created plenty of incentive to leverage and innovate in financial structures and instruments. This period of innovation has created a massive crisis with respect to asset values. (For more on this see my blog post “AIG and Our Core Economic Issue: Unknown Asset Values” http://seekingalpha.com/article/123867-aig-and-our-core-economic-issue-unknown-asset-values.) In my mind, there is going to have to be a resolution to the asset value problem before any stimulus package is going to have much of an effect on the economy.
Anytime the government attempts to impose its hand on the private sector “things happen.” The government is just not attuned to enter the very complex tangled web of the real world with simplistic plans to “set things straight.” Even within the government public officials have started pointing fingers at each other when events don’t go as desired. Last night I saw Barney Frank interviewed by Rachael Maddow. Frank made it very clear that we got into the AIG mess because “the Fed”, without coming to Congress, gave AIG $85 billion last September and this started off all the mess. And, the reason why this bonus thing and other events have occurred is that “the Fed” without the advice or consultation of Congress gave AIG the $85 billion with “no strings attached”!
Wow! Go figur’ that, will ya!
Now, the Wall Street Journal has the headline this morning…”Obama to Avoid Auto Bankruptcies.” The “experts” in the government, we are told, are going to restructure General Motors Corp. and Chrysler LLC outside of the bankruptcy courts. This, we are expected to believe, will give the taxpayers a better and more protected solution than will a court solution. We wait the conclusion…
The real world is tough. People don’t always do what you want them to do. Incentives matter. We must be careful about the incentives we are creating for the future, for one other fact from the field of economics is very clear: sometimes it takes a long time for the full effect of incentives to work their way through an economy. As a consequence, we can often lose sight of the cause of a problem because the incentives that created the problem are embedded somewhere in the distant past.
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