Second European Market Response: Italian Borrowing Costs Surge

The first response of world financial markets to the eurozone package produced early Thursday morning was positive. 

The second response…

“Italy issued 10-year debt on Friday but paid the highest price since joining the euro as investors demonstrated skepticism over the center-right government’s economic reform program in the first bond auction in the region since new steps were agreed to tackle the eurozone debt crisis.

The auction served to underline Italy’s current dependence on purchases of its bonds on the open market by the European Central Bank in a program that began on August 8 as yields rose above 6 per cent.” (http://www.ft.com/intl/cms/s/0/c7d47b22-0146-11e1-ae24-00144feabdc0.html#axzz1c10EG1Ea)

The underlying concern with the new eurozone package is that the officials in Europe still believe that the problem is one of liquidity, a crisis in confidence, which can be resolved by more bailout gimmicks.  As a consequence, these officials have, once again, avoided the fact that the problems they are facing are solvency problems and that eventually someone will have to bear losses.  The solvency issue has not been resolved since little or no new money is being put on the table.

Yes, there is an agreement for a 50 percent write down of “private” holdings of Greek debt.  But, note, that “public” holdings of Greek debt amount to about 40 percent of the total Greek debt outstanding.  These “public” holdings will not be subject to the haircut reducing the debt. 

The “public” holdings include the Greek securities held by the European Central Bank, the International Monetary Fund, and eurozone governments. 

Furthermore, the “haircut” is a “voluntary” write down in the hopes that a payout on Credit Default Swaps will not be triggered.  European leaders feared that if a “non-voluntary” event occurred, a CDS payment would be kicked off and this might cause a “Lehman Brothers affect” which would create more funding problems for banking institutions throughout the continent.

Also, this funding problem might expose other countries…like Italy, Spain, Portugal and France…in their efforts to place their sovereign debt.

The difficulty Italy had in placing its debt on Friday might be an indication that this effect is already at work.

 And what additional pressure does this put on the European Central Bank?

“
The ECB remained firmly in crisis management mode following the marathon Brussels summit to stem the sovereign debt crisis.

Within hours of the meeting, traders reported that the ECB was intervening again in the Italian government bond market – a clear sign that its controversial purchases were far from being wound down. “ (http://www.ft.com/intl/cms/s/0/7d4850e6-00a7-11e1-ba33-00144feabdc0.html#axzz1c10EG1Ea)

Included in the plan was a proposal for the recapitalization of European banks.  But, the question is, will these new requirements actually provide the protection needed.  In the recent failure of the Dexia bank, the bank met the initial requirements for capital.  It seems as if the regulators of the European financial system are still reluctant to admit the serious needs of the banking system to add capital…a shortcoming that is related to the “joke” these regulators perpetrated in the two applications of “stress tests” to the banks of Europe. 


But, the European officials also included in their bank recapitalization plan a proposal that the national governments in Europe would increase guarantees of their banks.  This just increases the specter that these national governments will have additional liabilities adding to their already heavy debt loads. 

Finally, there is the European Financial Stability Facility (EFSF).  This is the last resort lender in which everyone in Europe commits to bailing out everyone else in Europe.  That is, the EFSF is a scheme that says that “Europe is Solvent”…even though individual nations within the eurozone are not solvent.

Whether or not “Europe is Solvent” depends on the willingness of the solvent countries within the EU to continue to pay for the shortcomings of those countries that are not solvent.  The success of this depends upon whether or not the existing problems are “liquidity” problems or “solvency” problems.  “Liquidity” problems relate to a lack of confidence and a lack of confidence can only be a short-term phenomenon. 

Officials hope that by “re-arranging the chairs” once again that the crisis of confidence will come to an end.  The thing these European officials fail to understand that in the game of “musical chairs”, every time the music begins to play again another chair is taken from the game.  At some point, the fact that the eurozone does not have sufficient capital to cover its outstanding debt will become evident.

The efforts to bring money in from China, Japan, or elsewhere, seem like a desperate move.   

Again, it seems as if Europe has come up short again. 

Euro Solvency?

The financial markets hate uncertainty. It is the unknown that creates uncertainty and unexpected new information often creates uncertainty because investors must not only absorb the new information but must also translate what they have learned into action!

This is what I tried to emphasize in my post of April 28, 2010, “Greece: The ‘Surprise’ That Breaks The Camel’s Back” (http://seekingalpha.com/article/201382-greece-the-surprise-that-breaks-the-camel-s-back). Recently we were given knowledge that the budget deficit of the Greek government was much worse than we had been told, and, as a result of this news, the rating on Greek bonds was lowered. Immediately, investors began to sell off these bonds.

The financial market unrest continued. Then the European Union and the International Monetary Fund came up with its bailout package of €110 billion “to save the euro by providing Greece with enough cash to meet its financial obligations over the next twelve months or so.” (http://seekingalpha.com/article/202754-greece-and-insolvency-finding-a-way-out)

The problem is, as I pointed out in this last post, that the response was aimed at preventing a liquidity crisis and not a solvency crisis. These two types of financial crises are different and a failure to understand the difference and react in the appropriate way can just exacerbate a problem and not solve it.

The Federal Reserve under Ben Bernanke has been guilty of this very thing and, as a consequence, has contributed to the lingering solvency problem in the “less than mammoth” banks in the United States banking system today. (I have discussed this in many other posts.)

A liquidity crisis is a short run phenomenon related to the disclosure that the price of a certain financial asset should be different from what it had recently been trading at. The buy side of the market disappears and the price of the financial asset drops, sometimes precipitously. In the classical case, the central bank comes into the market and makes sure that there is sufficient liquidity in the market so that the price of the asset in question stabilizes and trading can resume.

The prices of other similar assets may be caught up in this uncertainty but the response of the central bank is enough to stabilize the market.

A solvency crisis is different. In a solvency crisis the value of the assets must be written down, but the concern is over the ability of the institutions that own the assets to cover the value write down with the equity capital they possess. Of course, the value of the assets may go up at some time in the future but in general these institutions must “work off” these assets over time in a way that does not exhaust their capital base.

Otherwise, if the effected institutions have to write off these “underwater” assets immediately they may have to be closed.

A solvency crisis takes a much longer time to get over than does a liquidity crisis. That is why so many small- to medium-sized banks are still having so much difficulty even with massive amounts of liquidity available in the banking system.

The problem with the current situation in the European Union is that the situation is not one of liquidity, but one of solvency. There is a very real concern in the market for sovereign debt about whether or not certain nations within the EU can maintain their solvency given the debt load their governments have assumed and given the very weak nature of their economies.

There is a question about the ability of certain governments to be able to pay-off their debts. And, if these debts cannot be re-paid, what will happen to the solvency of the banks and other institutions that now hold this sovereign debt. Special concern exists about commercial banks in Germany and France. Some think that the real reason for the Greek bailout is to keep several major banks in Germany and France from failing. (See the second post mentioned above.)

Just providing Greece the ability to be able to roll over its debt in the next twelve months or so is an attempt to make Greek debt “liquid”. The hopes are that this will buy time for the Greek government to “right its ship” so that it will be able to meet its financial obligations and then go bravely forward. The financial markets have responded by saying that the Greek situation is not a problem of market liquidity but a problem of government solvency: the government, as it appears now, cannot pay its bills.

The concern over solvency has spread. If Greece lied to its debtors, maybe other countries have been doing so as well. Maybe these other countries are not as well off as was thought. Hence, a need to check other “undisciplined” countries out.

The credit ratings of Spain and Portugal were lowered (with Portugal facing additional review concerning its credit rating). Isn’t this evidence enough. But, of course, other countries are on the radar screen: countries that have been particularly profligate like Great Britain where the Labour Government outspent the rate of inflation since 1997 by 41%! But also Italy and Ireland.

What we seem to be seeing in the world is a realignment away from countries that have over-stayed their welcome in the credit markets. We see this especially in the currency markets. The value of the euro has plunged against the dollar and other major currencies. Today, May 6 it hit a 52-week low around 1.26. In other areas of the currency market the move seems to be away from the currencies of countries having “debt problems” to those that appear to be more secure.

The same thing has occurred in bond markets. The rush to United States Treasury bonds has been phenomenal over the past week. The two-year Treasury was yielding about 1.07% April 23 while the ten-year Treasury was yielding around 3.82%. These two yields have dropped to 0.79% and 3.39%, respectively, a major move!

When uncertainty increases, market volatility also increases. If we look at one index of market volatility, the CBOE’s VIX index, we see it peaking over 40 today, up from around 20 or so over the past week and in the 15-20 range before that. The market appears to be spooked and this means one might expect the volatility of the financial markets to remain high in the near future.

The major problem going forward is leadership: who can lead the eurozone and Great Britain out of this mess? The concern is captured in Landon Thomas’ article in the New York Times, “Bold Stroke May Be Beyond Europe’s Means,” (http://dealbook.blogs.nytimes.com/2010/05/06/bold-stroke-may-be-beyond-europes-means/?scp=5&sq=landon%20thomas%20jr.&st=cse). In the case of the eurozone, there is no leader. And, this has been a problem the detractors of this union have pointed to since before the euro was put into place. There is an economic union but no political union. It is like herding cats and given the cracks that are occurring in the structure, many are wondering if this economic union can last for more than two or three years more.

In Great Britain, there is going to be a “hung” Parliament. But, who really wants to rule in jolly ole England. Some are saying that if the new government (‘hung’ or not) really does what it needs to do with respect to the fiscal condition of the nation, these politicians will not be able to be re-elected for the next ten- to fifteen years because they will be so unpopular. Shades of Greece?

The bottom line: governments have lived beyond their means. Certain ‘brands of economics’ have argued that this is possible because people don’t really take into account future tax liabilities or future inflation. They are very ‘current minded.’ It just seems possible that this philosophy has run its course!

Greece and Insolvency

A financial crisis that is a result of the potential insolvency of a borrower is connected with the “true” value of the underlying assets held by the lender. In the case of the Greece bailout, the European Union (EU) and the International Monetary Fund (IMF) are working to keep the value of Greek bonds at 100% of face value.

Thus, the €110 billion (or $145 billion) package put together over the weekend is an effort to save the Euro by providing Greece with enough cash to meet its financial obligations over the next twelve months or so. Hopefully, at the end of this time Greece will be welcomed back into the capital markets so that it can raise its own cash, something it needs lots of.

Then, as is usually the assumption in insolvency situations like this, the debtor will grow out of its difficulties so that its debt will return to 100% of face value in the financial markets. The problem with this is that Greece is expected, at best, to return to the level of real GDP it achieved in 2009 in or around 2017. The austerity moves required by the IMF of the Greek government is not expected to contribute to a strong rebound in its economy.

Many analysts are contending that the bailout is really to protect the banks in Germany and France. The commercial banks in these two countries hold a massive amount of Greek debt. If one gives the Greek debt a haircut of 40% to 50%, several banks in these two countries will fail and require government support to keep the banking systems functioning. If this were to happen both nations would find themselves in deep economic trouble, threatening the recovery of all Europe.

But, note…”The European Central Bank (ECB) agreed to continue accepting as collateral any current or future Greek government bonds, no matter how much debt-rating companies downgraded them.” (See http://online.wsj.com/article/SB20001424052748703612804575222331434882588.html#mod=todays_us_page_one.)

By doing this, the ECB is attempting to prevent a liquidity crisis at Greek banks, because these banks can use the new collateral rule to get cash from the ECB by pledging their Greek bonds as collateral. Also, this rule will benefit euro-zone banks because it will mean that these banks can also get money from the ECB by pledging their Greek bonds as collateral.

There seems to be a special effort on the part of EU and IMF officials to take all discussions of losses on Greek debt “off-the-table.” The emphasis is upon ensuring that the banks that hold Greek debt and the financial markets that everyone will be “paid-in-full” over the next year or two. Anyone that talks differently will have his or her hand slapped!

The ultimate mechanism for insuring that debt is covered over the longer run is to produce an inflationary environment. And, in a severe financial crisis, the concern of the policy makers is to err on the side of providing too much liquidity. The policy makers do not want people, at some time in the future, to accuse them of not providing enough liquidity to the system which resulted in an even greater financial crisis.

Jean-Claude Trichet, the President of the European Central Bank certainly is adhering to this principle in the current situation. Trichet, the stern defender of central bank fight against inflation in 2007 and 2008, now seems to be putty in the hands of current circumstances.

Trichet, however, still seems to be a amateur when compared with his counterpart Ben Bernanke at the Board of Governors of the United States’ Federal Reserve System. When it comes to “throwing stuff against the wall to see if it sticks” Bernanke is the poster-child.

Inflation may be the ultimate tool that Europe uses to save the Euro and the European Union. The reason for this is the other nations that are on the brink of financial disaster: Spain, Portugal, Italy, and Ireland. Also, there is the U. K. sitting across the channel showing us the very real possibility of having a “hung” Parliament which would find it very difficult to do what it needs to do to get its own act in order. There may just be too much to do in the current state of affairs to overcome the lack of national discipline that has been exhibited in this the European region in the recent past.

The factor that might set this all off is the reaction of the government employees and the working classes in these nations to the austerity programs that are being forced down the throats of the governments in question. Europe has a long and proud history of labor movements and working class unrest. These movements have been relatively quiet in recent years. In Greece we are seeing a resurgence of protest that could fuel further unrest in other countries, especially in Italy.

It was fear of such unrest in Europe in the 1920s and 1930s that led to a philosophy of government policies that supported the creation of an inflationary environment to keep people employed with ever increasing wages. These policies were implemented in many countries once the disruptions created by World War II subsided. The history of labor movements in Europe in the twentieth century is long and rich. It is unlikely that the austerity programs will be easily accepted by the people being impacted by them.

Again, the problem we are seeing is that there are no attractive options to governments or governmental bodies after a long period in which financial discipline has been absent. As Carmen Reinhart and Ken Rogoff have shown in their book “This Time is Different”, every time that governments (or people, or, businesses) lose their fiscal discipline the time is never different.

The Piper eventually has to be paid.

The effort to prevent too much pain, however, is to bail out governments (and people, and, businesses) and then stimulate the economy to put businesses, and, people, and, governments, back where they were before the crisis began. This is done by inflating the economy through extensions of liquidity and programs to maintain asset prices. The goal: to get the economy back to where it was before the crisis began.

This is what the European Union, with the help of the International Monetary Fund, is attempting to do. Unfortunately, the underlying problem has not been solved. There are major amounts of assets on the books of financial institutions and other organizations that are substantially over valued. The question that lingers in an insolvency crisis relates to how long these financial institutions and other organizations can continue to hold onto the assets without marking them to a more realistic value or working the losses off through charges against other earnings?

The State of the Banking System

There are three preliminary indicators that the banking system is coming along on its way to recovery. First, there is the “letting go” of CIT Group, Inc. The government must feel that it does not need to extend itself to help out this institution given its present troubles. (See my recent post on the CIT situation: http://seekingalpha.com/article/148730-cit-s-debt-issues-show-why-the-economy-won-t-be-picking-up-any-time-soon.) We’ll see if they continue this approach with other troubled institutions as additional situations arise.

Second, there is evidence that the regulators are taking a harder line at Bank of America and Citigroup. Each has its own problems, but the Feds seem to believe that they can step up their demands on these two financial institutions concerning boards, managements, business affairs, and so forth. They would not do this if they believed the system to be too fragile.

Third, I sense the Federal Reserve backing off from the more aggressive stance it took with respect to the bond markets one to two months ago. This is just a feeling that I will be following up on in the near future.

These actions provide some preliminary evidence that we are in the “working out” stage of the credit cycle where time is the biggest factor to contend with. Bailouts are needed to prevent “liquidity” problems when markets might crumble under cumulative selling pressures. But, this is a short run problem.

The “work out” phase of a financial crisis is the period when institutions still have severe credit problems but are not under short term pressures to relieve their balance sheets of “toxic” or “underwater” assets.

This does not mean that there will not be more failures of financial institutions and some of them may be relatively large ones. What it does mean is that the problems that still exist within the financial sector can be handled in a relatively orderly fashion. So, the banks and the regulators can operate within an environment that does not seem “desperate.” Severely troubled still, but not in a state of panic.

Within this scenario, the questions that remain about the banking system relate to earnings. We have seen Goldman Sachs and JPMorgan Chase & Co. post strong gains for the second quarter. However, most of the gains were attributed to trading activities, with secondary help from their underwriting business. These are not good, solid “banking” results. And, these organizations are highly diversified and can post returns from these areas, something that most other banks in the United States cannot do.

Still, the banking system seems to be in the stage of recovery where current cash flows can allow the individual banks to write off more and more of their loans and other assets over time and thereby restore the integrity of their balance sheets. With the results it achieved in trading and underwriting, JPMorgan Chase was able to take large write downs of home equity loans, mortgage defaults, and credit card charge offs while also increasing the amount of funds it set aside to increase its loan loss reserve. This is what other banks will be doing to reduce the burden of bad assets they are now carrying.

Overall, Total Assets in the commercial banking system grew by 8.9% from June 2008 to June 2009. The capital residual (Assets less Liabilities) in the system grew by 7.6% so that the capital asset ratio of the banking system dropped from 10.2% to 10.1%.

In terms of how the banks are attempting to protect themselves, the Cash assets of Commercial Banks in the United States were up 186%, year-over-year, in June 2009, although this rate of increase is down from a year-over-year rate of increase of 236% increase in May 2009.

Total Loans and Leases in the banking system rose just about 1.4%, year-over-year, in June while Commercial and Industrial Loans actually decreased by 3.1%. Commercial banks are just not lending to businesses which continues the trend which began last year. Banks are lending to consumers, up 5.5% year-over-year (primarily on credit cards and other revolving credit plans), and on real estate, up 6.4% year-over-year (the largest jump coming in revolving home equity loans).

The cash assets held in the commercial banking system declined regularly throughout June as the peak in cash assets held was reached in May. Thus, it appears that banks are backing off from taking everything the Federal Reserve has put into the banking system and stashing it away in “cash accounts”. This is confirmed by the aggregate banking data put out by the Federal Reserve which indicates that total reserves in the banking system dropped throughout June 2009 and the excess reserves also fell from peak levels reached in late May.

Thus, it appears that things are working out pretty much as the Fed hoped they would. (See my explanation of what the Fed has been trying to do, http://seekingalpha.com/article/145913-is-treasury-s-tarp-debt-already-monetized-part-ii.) Of course, the game is not over yet!

Bottom line: the banking system is working through its problems. The Federal Reserve and the regulators seem to be backing off a little, allowing the system to adjust over time to its dislocations. There is still room for a surprise, but, the more time passes, the less likely a surprise is likely to occur. In other words, the unknown unknowns have been substantially reduced and the known unknowns are what we are working on.

The banks are not lending except on established credit lines (credit cards and home equity loans) and there appears to be plenty of liquidity in the system as a whole. Whereas the lack of lending slows up the possibility for an economic recovery, it is an essential component of getting the banking system healthy again which is needed if there is to be any chance of a robust economic recovery in our future.

The Fate of Rick Wagoner

Rick Wagoner, Chairman and Chief Executive Officer of General Motors, will resign as a part of the agreement with the federal government in which the company will receive additional federal aid. General Motors is a turnaround situation; it is not a restructuring exercise. The odds are against a company pulling off a turnaround with the same people that led them into the situation they now face.

Some people argue that the problem is the bad economy, something that the executives are not responsible for and therefore should be allowed to continue in their positions. This, to me, is like saying that executives in financial institutions are not responsible for the collapse in the financial market that exposed to the world the increased risk they imposed upon their companies or the large increases in leverage that accompanied their use of more exotic financial instruments.

When you make bad decisions, a bad economy will exacerbate the results that come from these choices. But, one cannot just place all the blame on the bad economy.

This analysis puts us back into a discussion about our understanding of exactly what it is that we are now facing in the financial markets and the economy. One way to distinguish the two views that seem to be the predominant ones now in vogue concerning our current situation is between those that believe the main problem relating to financial assets is the liquidity of these assets.

In this argument, people insist that banks and other financial institutions are caught in a trap where the markets for many of their assets are so illiquid that these organizations are unable to price the assets and then, possibly sell them. This seems to be the assumption behind the recently presented investment program, the P-PIP, that was announced by the Treasury last week.

The alternative view is that many financial institutions are insolvent and that what is really needed is a recapitalization of those organizations that still have a future while those that are not capable of being salvaged should be closed. Those that take this approach contend that this problem will not go away and will have to be addressed sooner or later. They also argue that dealing with it sooner will speed on a recovery and will also cost the taxpayer less in the longer run. (See my post http://seekingalpha.com/article/127639-public-private-investment-program-liquidity-or-solvency.)

The other area of concern is the status of many of the firms that find themselves in trouble. One group of analysts believes that the problem is one of a bad economy and a bad financial market and that all the companies need to do is restructure their current operations. This can be done, they argue, with the existing management and with just “tweaking” the existing business model.

Yet, here we are with General Motors. Over 20,000 employees were given the option of taking a buyout of their employment contracts. A total of about 7,500 took the buyout, but this was a disappointing result. Several of the product lines are going to be discontinued and/or sold off to bailouts in other nations. Contracts with labor unions regarding working arrangements and conditions must be massively changed. And, a substantial number of the bondholders must convert their bond holdings into equity. This doesn’t even touch the fact that the auto companies are substantially behind the curve in terms of real innovations and preparations for future technologies and products.

Given these factors that need to be addressed and resolved, I believe that one can only call this a turnaround situation, a condition in which new eyes and ears must be applied. To me there is little hope that the executives that got the company into this position are the executives that will bring these companies into the 21st century let alone into the 1980s.

This judgment applies not only to the automobile industry: it also applies to banks and other financial institutions, as well as many manufacturing organizations and other companies that require major changes in their business models. (See my post http://seekingalpha.com/article/127625-let-go-the-experts-who-have-learned-to-fail.)

This country (and the world) is facing a series of serious structural dislocations. The problems are not ones of liquidity or keeping on, keeping on. Lobbying to maintain the status quo will not give us much hope for the future. Inflating our way out of the bad debt or band-aiding inadequate business models will only postpone what needs to be done.

The arrogance that Rick Wagoner exhibited in his first appearance in front of Congress probably doomed him to this result. The behavior of other executives from both the financial and non-financial sectors has not endeared them to either the people of the country or to their representatives in Congress. This will probably not help the executives in the long run. Sometimes a little humility is a good thing!

Bankruptcy is another option for many firms. One could argue that taking this path would probably be an efficient way to get companies into the turnaround mode although it would not include government money as a part of the process. It would keep government officials out of the turnaround process and avoid relationships that are uncomfortable for the new managements that will be leading the companies out of the bankruptcy.

This in not a normal, relatively mild recession that will be ended through the injection of liquidity into the monetary system. The economy is facing a management problem and a debt problem that must be worked through. It is not clear that this is fully understood by those attempting to turn the economy around.

Has the Monetization Really Started?

Headlines on the Wall Street Journal website Thursday afternoon, “Treasurys Climb After Solid Auction.” (See http://online.wsj.com/article/SB123807273254847621.html#mod=testMod.)

Success!

The issue Thursday was a seven-year note sale of $24 billion and this capped the issuance of $98 billion in Treasury offerings this week. The day before, Wednesday, the auction of five-year notes was “tepid” and the market was nervous at the beginning of the day.

But, something else happened on Wednesday. The Fed began its planned purchases of existing securities. In fact, the Fed bought securities that matured between February 29, 2016 and February 15, 2019. Gosh, that’s right in the range of the new issue that sold so well on Thursday. Imagine!

Primary dealers offered the Fed a total of $21.9 billion in Treasury securities that matured in this time period and the central bank bought back $7.5 billion of them. Apparently, this will be the procedure that the Fed will follow in upcoming weeks as the indication is that they will purchase outstanding securities on a regular basis.

The Fed is expected to buy roughly $12 billion of Treasury securities every week until they exhaust the planned $300 billion in purchases as announced last week. Friday, March 27, they are going to be purchasing at the short end of the yield curve with dates running from March 2011 to April 2012. Planned are three purchases next week, with some maturity dates expected to run from August 2026 through February 2039.

One of the prominent explanations for the intermediate-term purchases is that the Fed thinks it will help keep mortgage rates down since most 30-year mortgages have an average life of about seven years. If choosing this maturity just happens to provide liquidity to the market so that the Treasury has an easier time of placing its new issues, well so be it!

So, it looks as if we are on our way.

Where?

To the land of Oz?

We are starting to see the Fed get serious about monetizing the debt. The talking is over and the direct impact on the market is now under way. At $12 billion in purchases every week, this means that for the next 25 weeks or so, the Fed will be entering the Treasury market acquiring more securities. And, this doesn’t include the provision to purchase mortgage-backed securities in large dollar amounts.

On the other side, as we saw with the $98 billion in new issues this week, the “recovery program” will be providing plenty of additional debt to the market during this period of time. Relieving primary dealers of outstanding issues will certainly “grease the wheels” for the Treasury in terms of the additional debt issue that will need to be placed.

So now we are seeing the future. The Wizard is waving his magic hand. Monetizing the government debt! Providing a scheme whereby private interests can make tons of money buying up “legacy assets”! And, a new regulatory scheme to keep the “bad guys” under control! It is a wonder land with a whole new geography.

It’s ironic. Last September, I remember feeling as if the world had changed, shifted, and would not be the same again. The specific time—a Tuesday evening--when I learned that AIG was being nationalized. I just felt different.

I feel that way again. The rules have changed. Maybe better said, the old rules are no longer applicable and we really don’t know what the new rules are—but we know that they will be different.

Will all this work and restore the banking system and speed the economy on to recovery? No one really knows. I guess we are all waiting for a “tipping” point. But the tipping point can mean different things to different people. The administration sees the tipping point producing a recovery. Critics of the administration see the tipping point creating a whole new cycle of inflation.

And, what if no tipping point appears? Well, that will just mean that a greater effort will be put into the attempt to spur the financial system and the economy along.

The most specific thing going right now is what the Federal Reserve is doing. They are purchasing the debt of the government and they are going to continue to do it for a substantial period of time. For today, we see that this effort has helped the Treasury Department place $24 billion of that debt. And, the Fed’s actions will probably continue to ease the placement of the additional new debt in the future.

What we need to look for, in my estimation, is what happens to the value of the dollar in foreign exchange markets. When the Federal Reserve initially announced this program the value of the dollar fell. When this policy of regularly purchasing Treasury securities up to the $300 billion proposed becomes excessive in the minds of currency traders, the value of the dollar will begin to decline again. My guess is that this will happen sooner rather than later.

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.

A Case Study in Unknown Asset Values: A. I. G.

My blog of March 1, 2009, “Uncertain Asset Values and the Stock Market” (http://maseportfolio.blogspot.com/), was written before the most recent news surfaced about the continuing bailout of A. I. G. I believe that the example of A. I. G. represents a perfect ‘test case’ for what was presented in that post.

The March 1 blog contended that the major uncertainty facing the investment community…and the Federal Government…is the value of assets on the books of many of the nations businesses…especially many large and important firms that are “too big to fail.” The argument is that this uncertainty has to be cleared up as much as possible before the economy is really going to have a chance to regain its health.

The problem now is that not only are companies withholding information from the investing public…but the government is also withholding information from the investing public. Specifically, companies…and the government…are afraid to release information on who they are dealing with…the “web of counterparties”…because of their concern that the release of these names would cause a panic leading to deposit withdrawals or the cashing in of insurance policies and so forth.

This is the old “after-the-fact” problem. I used to be a part of “information sessions” for journalists to help them understand banking and the issues that surrounded the banking industry. One of the concerns that always came up at these sessions was about what responsibilities “the press” had in reporting on troubled banks. That is, if a journalist “knew” that a bank was in trouble…what responsibility did that person have to report that the bank was having problems…and thus, perhaps, cause a “run” on the bank.

This is an “after-the-fact” problem. The bank is already a troubled bank…now what do I do?

One of the arguments I made was that journalists should keep up closely enough with banks to report when banks were starting to experience difficulties. By making this information public, the press could help prevent the bank getting too far into a mess because it would want to avoid the bad publicity and work to rectify the difficulties before they got “out-of-hand.”

This, of course, was very difficult because of the insufficient reporting requirements applied to banks and the secrecy surrounding the regulatory examinations. And, if banks knew that they were being scrutinized that closely by “the press” they would certainty make it just that much more difficult for the “outsiders” to obtain information.

So, investors and communities had little information on financial institutions that were important to them and had to “trust” the regulatory agencies to apply the appropriate oversight to the banking system. Of course, the regulatory agencies did not always have “full information”, especially as the financial conglomerates began transacting in very sophisticated derivative securities and taking many assets “off balance sheet.”

I believe that the company A. I. G. is a striking picture of how this scenario played out. A. I. G. is a holding company that began as an insurance company and then diversified itself into a financial conglomerate that included a hedge fund and other “black box” investment vehicles. Their primary regulators were the state insurance regulators (and some international regulatory requirements) and the state laws caused the subsidiaries to be highly segregated so as to ensure the safety of those the insurance subsidiary had insured.

The rest of the company was not regulated to any degree. As a consequence, A. I. G. was able to build up a huge financial conglomerate that could engage in untold transactions that were both un-regulated…and un-disclosed! The accounting and reporting rules were such that investors…and the public…and the government…and even other areas within the company did not have any idea about the risk exposure of the holding company or the “spider-web” of relationships that made it a potential “carrier of contagion.”

And, we…and the government…still don’t know what the potential damage could be from this dismal situation!

As a consequence, the probability of a fifth (this last bailout was the fourth return to A. I. G.) is a lot higher than we would like it to be. And a sixth? And a seventh?

With the government owning almost 80% of the company it would seem like any additional funds would be relatively small.

But, that is the problem…we don’t know! No one seems to have a handle on the value of the A. I. G. assets!

And, as I argued in “Uncertain Asset Values and the Stock Market”, this problem exists throughout the economy. What about the assets of Citigroup? What about the assets of Bank of America? Again, to quote the earlier blog, “It is not altogether clear that even the people running a large part of this economy have any idea about the value of their own assets.” Again, I take A. I. G. as the example.

And, then we have General Electric…and the problems of GE Capital. Again…we have another conglomerate with few pieces that go together. For years, GE Capital carried the rest of General Electric. And, what happens if you have one subsidiary making up for the “not-so-good” performance of other subsidiaries? You put more and more pressure on the performing subsidiary to produce exceptional results. And, how do you do that? You take riskier assets into your portfolio and you increase leverage. Simple!

Now, GE Capital is suffering along with other financial companies that attempted to extend “exceptional” returns. And, with GE Capital failing to perform…the spotlight is being focused on all the other subsidiaries that were only mediocre performers. Consequently, General Electric must face the value of ALL of its companies and determine what are the asset values under its umbrella.

This, to me, is the picture that is unfolding…and the problems we face are not going to be resolved until we get a better grasp on asset values. But, we need to do this quickly because…and this is the problem of bad assets…the value keeps dropping if the difficulties are not resolved. This is true of bad assets in an individual institution…I saw this over and over again in the banks I helped turnaround…and it is true with the financial and economic system. In fact, that is the problem with a contagion…bad assets tend to play off of bad assets…and the difficulties cumulate. This is all the more reason for attempting to get a handle on asset values as soon as possible.

A $787 billion economic recovery plan is insufficient to overcome the possibilities of a multi-trillion dollar write-down of assets!

The Obama Speech: The Day After

The Obama speech to the Congress on Tuesday night was “well given” and, basically, “well received”. It has been criticized for, among other things, not being specific enough. But, this was not the purpose of the speech. The speech was the first effort of the new President to lay out a vision for the near term and the future.

It was about the “vision” thing. A leader is, first and foremost, supposed to give us the “big picture” and not the details. The leader is supposed to provide us with something we can hold onto because we like the worldview it represents…or, provide us with something to disagree with because it does not conform to our worldview. I think that President Obama did that.

In terms of the crises in the economy and the financial markets, the thing that does not seem to come through in the “big picture”, however, is that there are two categories of problems we face. These two sets of problems can be put into boxes that are labeled…the problems of the past…and the problems of the future.

These are different issues and must receive different attention if they are to be resolved. Too often we lump them together for a bastard “Keynesian” solution.

The first set of problems has to do with debt…too much of it…and inappropriately assumed. This is the box of problems from the past…the box labeled “Insolvency Crisis”.

Too much debt, inappropriately assumed is a burden…it can cause finance and commerce to slow down or stop…and this can lead to a cumulative result in which the burden of the debt gets heavier and heavier. This burden is exacerbated as insolvencies grow and deflation becomes the problem (not inflation).

It has been argued that the only thing government can do to counter this problem is to reflate (Irving Fisher) or inflate (Keynes). That is, the only way government can lessen the burden of this excessive load of debt is to reduce the “real” value of the debt by causing prices to rise rapidly. But, this only recreates the environment in which the excessive debt was created! And, the consequence of this is just more and more leverage…which, in the longer run only makes the situation that much worse.

The excessive debt was created within the asset bubble world of the last decade or so. This world of asset price inflation resulted in a greater assumption of riskier assets and an overly aggressive assumption of leverage.

Financial and economic positions were taken than could only be justified within the rarefied world of the bubble!

The valuations from that time cannot stand up…outside the bubble!

In the case of the “Insolvency Crisis”, I believe that the only three choices are:
1. let the economy adjust to more realistic valuations by itself and just accept that we have to bear the burden of this adjustment;
2. help to smooth out the adjustment to more realistic valuations;
3. inflate our way out of the crisis…which, of course, would mean that we were just postponing the resolution of the foundation of the crisis.

The third of these choices is often attributed to Keynes and it is, I believe, an inappropriate application of Keynesian thinking…because it does not really resolve the situation.

President Obama is opting for choice number two…a choice I think most of us agree with. He is saying that choice number one is just too painful for the country and it’s people to go through. Hence, government must play a role in helping people and institutions work through the “debt problem” and that is going to cost…how much, we just don’t know.

That is the vision…the devil is in the details. And, that, I believe, is the problem right now. Most of us can agree with the vision…we just haven’t received sufficient information on how this is going to be done and how much it might cost. And, without greater certainty…markets will drop!

The second set of problems has to do with the future…and the box containing this set of problems is labeled “What We Want To Be.” President Obama stated in his speech Tuesday evening that in his vision of the future, he sees America as energy independent…he sees Americans protected with some form of universal healthcare…he sees Americans as among the best educated in the world. President Obama sees an America that is energetic and innovative…a continuation of what America has been in the past.

This, to me, is the stimulative part of the President’s program…the part of the program that is not focused on the consolidation of past ills, as is the part of the program discussed above. This part of the program is an effort to provide incentives to create the next era and not “bailout” the old.

That is the vision…the devil is in the details. A first look at some of the specifics came in the stimulus package recently passed. More will be coming in the near future. Again, more details will help us get over the grey areas of uncertainty that constrain our willingness to commit.

We need to keep these two sets of problems separate as we go forward. The first set of problems is going to take time…and not everything that is done to resolve these issues is going to be “fair”. As I have said before, once one has created this set of problems, one finds that all the choices available for solving the problems are not happy ones. But, “inflating” our way out of these problems is not the solution…it can only, ultimately, make more pain for the future.

The second set of problems must be looked upon in terms of the opportunities that are available to us. In my view, no serious economic crisis has ever been resolved without the creation of new innovations and new technological platforms. In the Great Depression, the innovations and the new technologies did really come about until the end of the 1930s and into the 1940s and were related to war. Earlier stimulus efforts in the 1930s tended to support what existed in the past.

We don’t want government providing stimulus to the economy that will just result in the old world being “re-created”…we do not want the “old” products or the “old” managements renewed and rewarded! We must move on to the future.

By providing his “vision” of this future, President Obama has changed the field of engagement. President Obama is not just talking “stimulus”…he is talking about the world we want to live in. We may not agree with him on everything. We may not agree with him on most things. But, we must accept the challenge, and…while we are attempting to resolve the debt problems from the past…we must enter the dialogue and debate about what the shape of the future will be.

In this sense, what President Obama has put forth is a stimulus plan…but with more than just one meaning of the word stimulus.

Can an Economic Expansion take place without the Banking Sector?

The Obama team has put forward the outline of its economic stimulus plan. The United States Congress has released the last $350 bill of the TARP funds. Will this get the United States economy going again?

It seems to me that the answer to this depends upon whether or not the United States economy needs a banking sector to accompany the journey. Again, the earnings reports coming out of the financial sector last week hardly gives us much confidence that banking institutions are in any kind of shape to contribute to a regeneration of economic growth.

Losses are still huge…and one doesn’t gain much confidence from the executives running these institutions that the flow of losses is over. And, it is in the larger financial institutions that the problems are so great. But, this doesn’t mean that smaller institutions are out of harm’s way.

The fundamental issue is about the value of the assets the banks are holding. I don’t see or hear anyone claiming that bank managements really have their arms around the valuation problem. And, after all we have heard from bank presidents trying to build up confidence in their institutions, very little faith can be taken from anything else they might say. My strong feeling is that banks still do not know how deep their problems are right now and whether of not many of them are still solvent. This is a scary fact.

But, that is the past. We are only at the beginning of the real economic slowdown. Bankruptcies are on the rise and will continue to do so through the first half of the year. With the tremendous slowdown in retail sales in the fourth quarter of 2008 the accounting results for the end-of-the-year are bound to be horrible. What will be the fallout from these results is any one’s guess right now. There will not be bail outs for many or most of these poor performers and so there will be more and more doors shut going forward.

One suggested solution to arrest some of these closures is mergers or acquisitions. However, given all the uncertainty that exists in the economy at the present time…who wants to buy anything…and at what price.

Two cases, both in the news, should serve as examples: first the acquisition of Merrill Lynch by Bank of America; and second, the liquidation of Circuit City. The case of Bank of America is a sad one indeed…regardless of how you read the tea leaves. Merrill Lynch…like Citigroup…like AIG…and so on…didn’t know the value of its assets. The CEO of Bank of America wanted Merrill…very badly. Did BOA not do its due diligence? Did it do a crappy job? Did the hubris of the chief executive, as in many other cases in both good times as well as bad, go into the deal with blinders on? Did BOA try to get out of the acquisition of Merrill and the government would not let them out?

Whatever, the Bank of America/Merrill Lynch is a deal that went very, very badly. But, I go back to my main point…Merrill Lynch did not have a good handle on the value of its assets. They may have thought that they did…but they didn’t! And, this seems to be the story over and over again.

Financial institutions do not seem to have any real idea of what is the value of their assets. So, beware…mergers and acquisitions are dangerous to your health!

And, hence, we can move on to Circuit City. The rumor was that Circuit City had three parties that were potentially interested in acquiring the company. All three apparently were not willing to pay a price sufficiently high that would exceed what Circuit City thought they could gain by selling off inventories and closing their doors. Again, here is a bet the potential acquirers were not willing to make…a bet on the value of the assets of Circuit City. And, this seems to be the other side of the Bank of America/Merrill Lynch transaction…how can a company buy someone else when they don’t have a good feel for what the underlying assets are worth.

This gets us into the second part of the dilemma of the banks…making loans. If the banks don’t know the value of the assets on their books, how likely is it for potential borrowers to know the value of the assets on their books…consumers as well as businesses? Not very likely at all!

Why should banks get criticized for not lending to potential borrowers and potential acquirers of businesses be excused from any criticism? What is the difference between a potential acquirer that is not willing to pay very much to obtain the assets of another company and a bank that is not willing to loan money to someone because if, in both cases, the value of the assets of the potential acquisition or the potential borrower is highly uncertain? What I am saying is that right now there is so much uncertainty over who is going to be around in the future and what can be salvaged from existing economic units the people are unwilling to commit any more resources for lending or for acquiring.

Furthermore, why should banks be lending more when they are facing over the next two years or so at least two periods where there will be major adjustments of interest rates on mortgages and other loans on assets. These repricings may create many more foreclosure or bankruptcy problems on the banks and this would mean that banks would need even more resources to back up the decline in the value of their assets.

The question that still remains to be discussed is the solvency issue. Financial crises generally follow the pattern that first there is the liquidity crisis. Then there develops the asset crisis. Finally, there is the solvency crisis.

We finished with the liquidity crisis in December 2007. The asset crisis hit in March 2008 and grew into and through the fall of that year. We are, I believe, in the period of the solvency crisis…the life and death struggle of a large number of financial institutions.

Hopefully, TARP has provided a little relief toward the solvency of banks. The big question is whether the funds that have gone to bank capital have reached any where near the total that will be needed. If banks do not know the value of their assets now, there are still big holes to be filled in balance sheets…existing bank capital may be no where near that needed to keep the banking system going. In addition, if there are still shocks that the banks must face in terms of future bad loans…even more pressure is going to be added to the capital needs of the banking system.

There are two issues here. First, how is the government going to keep those banks that are relatively healthy going? Second, how is the government going to close those banks that are not healthy and how is the government going to dispose of the assets of these banks? In the first case…and I never ever thought I would ever be in a situation where I would be saying this…the government may have to nationalize a fair portion of the banking industry…more than it already has.

In the second case, the government is going to need something like the Resolution Trust Corporation (RTC) to manage the assets it takes over from the banks that have to be closed. Furthermore, it would seem as if the government would have to come up with a relatively large amount of funds to cover the losses on assets that would have to be shelled out in the closing of these banks. Many analysts have argued that this is not such a bad solution since the original RTC, formed in 1989 actually made money in its asset sales. However, this organization sold into a rising housing market. A rising market does not seem likely in the near future.

Now back to the original question. Can an economic expansion take place without a banking sector to support it? My feeling is that it would be very hard for an expansion to take place under such circumstances. If the banking system is not functioning…even a large economic stimulus package will not be very effective in getting the economic system going again.

Discipline or the Lack Thereof

When a person or an organization is disciplined, they usually have plenty of options…many of them good ones.

When a person or an organization is undisciplined, options are usually limited…and none of them are good!

We are seeing or have seen quite a few examples of the second of these statements in recent days and in recent months. Where does one begin?

· The auto industry…
· The financial industry…
· The housing industry…
· And the list goes on…

Oh, how about the American government?

Doesn’t seem like our government has many options these days…and none of them seem to be good ones.

I have made clear over the past eleven months that I believe that culture starts at the top…and in this case, it starts with the leadership of the United States government. Right from the beginning the current administration exhibited an exceptional lack of discipline…except for the requirement of loyalty to its own people and programs. Large tax cuts followed by an expensive war underwritten by the monetary authority could in no way be considered to be a “conservative” economic program. And, this was just the start!

But, the culture spreads…and once others began to see that “lack of discipline” was the standard of the day, they too began to feast on the beast. And, the lack of discipline spread throughout the land.

My biggest disappointment is that financial discipline broke down in a major way. My background is in finance and I was brought up with the idea that finance people were the ultimate arbiters of discipline, both in terms of individual behavior as well as organizational behavior. The first CEO I worked for told me that I had to speak up strongly from the discipline of finance for if I didn’t…there was no one else in the organization that would take that position!

Well, we have seen that when the financial standards break down…there is no one left to maintain discipline.

That is the past. We now have to deal with the future. The options are not good for anyone!

Let me reiterate the statement I made above…

I believe that culture starts at the top!

Right now there is no leadership at the top and we will not have any until January 20, 2009. This is nothing new…we have not had any leadership at the top for quite some time now…and that is one reason for our current dilemma. Those at the top, early on, wanted to sneak out of the door before things broke loose in the financial or product markets…but they didn’t make it. Even though their hearts were not in it and they had no idea what to do, they were forced to act in some way in an attempt to alleviate the financial mess. But, now, more than ever, they are looking for the door.

So here we are…and we still have to do something…invest our money…run our businesses…live our lives…

There are several things, I believe, that have to take place…

First, we have to re-establish discipline…individually…in our families…in our businesses…in our government.

Second, we have got to retrench. Here we have conflicting objectives. On the one side, we have to get back to basics, strengthen our balance sheets, and focus on what we do best. In this we have to do the best that we can…and we should not assume that someone is going to bail us out. If we do…we are bound for disappointment.

The other side of this is that retrenchment weakens the economy because the basic plan is to “pull back”, cut spending, reduce debt, and, if we can, save. This is the other side of the lack of discipline. It is fun on the upside when discipline is eased…it is tough on the down side when discipline is being re-established. This leads to the third point.

Third, we must also be community focused, locally, regionally, nationally, and internationally. While we are establishing discipline once again, we must not isolate ourselves and refuse to talk with one another. We must engage one another, talk and dialogue about what is needed, and work together to introduce solutions that build up communities in this time of trial. This will include government programs to stimulate the economy. This will include new regulations to improve the process of finance and economics. This will include new efforts at international cooperation to help us to work together and support one another. This must include the acceptance of change because the world that is coming is going to be different from the world that we have left behind.

But, this effort is going to require leadership and it is going to require leadership at the very top. Hopefully, we are going to get that leadership.

Hopefully.

People are looking for the bottom…the bottom of the stock market plunge…the bottom of the housing collapse…the bottom of the financial crisis…and so on.

My view is unchanged. Until the United States gets some leadership in place with a strong vision of what it is going to do and moves forward in a very disciplined way…the search for a bottom in these areas is premature.

Did Bernanke Panic?

I have been going over and over the events of the week beginning September 15, 2008 and I continue to come up with one basic conclusion: the reaction of Fed Chairman Ben Bernanke to the existing financial market strains was somewhat precipitous. A good start to understanding the time-line for that week is the article that appeared in the November 10 Wall Street Journal: “Paulson, Bernanke strained for consensus in Bailout” http://online.wsj.com/article/SB122628169939012475.html?mod=todays_us_page_one. The article begins “Federal Reserve Chairman Ben Bernanke reached the end of his rope on Wednesday afternoon, September 17.”

The week before, the week beginning September 8, the government nationalized Fannie Mae and Freddie Mac. Lehman Brothers was next. Secretary of the Treasury Hank Paulson put his foot down on this one…no bailout for Lehman…that’s final! Monday, September 15 Lehman Brothers filed for bankruptcy. The next troubled firm was AIG and frantic efforts were made to find additional cash for AIG. The basic signal being given to the market was…the bailouts are over. Lehman had to find its own way out or declare bankruptcy. AIG also had to find its own solution. The ‘free-market’ leanings of Paulson and others made for a reluctant leadership.

And then Tuesday evening came and the world changed. That evening the AIG $85 billion bailout was announced. When I heard this news around 9:00 PM that night, things just seemed to feel different: this was a different world than it was before. One didn’t know how…but it was different.

The Wall Street Journal article reports that by Wednesday afternoon “Bernanke reached the end of his rope”. He called Paulson and “with an occasional quaver in his voice” he spoke “unusually bluntly” to the Treasury Secretary. Paulson did not move immediately. He had to sleep on it. Thursday morning he committed.

Paulson called the leadership in Congress and asked for them to have a meeting with himself and Bernanke on Friday evening. The few members of Congress that talked with the press after that meeting said that Bernanke did most of the talking and “scared the daylights out of everyone.” Bernanke knew his history of the Great Depression and he knew currents events. He was very logical and very articulate. The leaders were told that they had to act and they had to act fast. The plan was to have a bill before Congress on Monday seeking Congressional approval (of both houses) by the following Friday. The Treasury Department had a bill ready (3 pages long) by midnight Saturday evening. The price tag…$700 billion. Why $700 billion? Because it was a big number!

As we know, the bill was rewritten and finally passed on Friday, October 3. What was the bill to do? No one really knew. The important thing, according to Bernanke, was that something was being done and that something was big!

And, the Fed did not stand idle. Helicopter Ben began to flood the financial markets with liquidity. The important thing was to get a lot of liquidity “out there” and worry about cleaning it up later, once the crisis was over. As I have reported elsewhere Reserve Bank Credit has risen from $890 billion in the banking week ending September 10, 2008 to about $2.2 trillion in the banking week ending November 12, 2008. (I have also noted that it took 94 years to get Reserve Bank Credit up to $890 billion and only nine weeks to have it more than double.) The rationale for this increase…the financial markets are in a liquidity trap and we don’t know how much is needed…we just cannot fail to supply enough!

Here we are in the middle of November. The basic conclusion relating to the financial crisis so far is that although we cannot tell whether or not the effort is working, we believe that things are better off than they would have been if the actions of Paulson and Bernanke had not been taken.

However, discontent is now being expressed. Paulson has changed the direction of the $700 billion bailout package and Congress is not particularly happy with this move and expressing its discontent. No one really seems to know what to do. Since events have slowed down and the ‘immediate’ need for the rapid passage of the package seems to have passed away…as might be expected…everyone and his brother and sister have got their hands out to get a piece of the bailout pie. Apparently, lobbyists are over-running the Treasury Department trying to get their share. And, Henry Paulson’s reputation has seemed to tank along with the stock market. (See the article by Rebecca Christie and Matthew Benjamin on Bloomberg.com titled “Paulson Credibility Takes Hit with Rescue-Plan Shift." It seems like no one can be a part of this administration without having their image tarnished.)

And, one question still remains. While Paulson and Bernanke seem to be running this whole show…where is the “decider”? The “decider” has apparently decided to hide out in the White House bunker. This has left Paulson and Bernanke hanging…trying to do something…with no steady hand overseeing their efforts and no vision for a plan.

It seems obvious that the driving force behind all the activity over the last nine weeks has been Ben Bernanke…he is, in a real sense, the initiator, if not the architect, of the hasty and ill-thought out bailout effort. On Wednesday afternoon, September 17 Bernanke reached the end of his rope. The rest, as they say, is history.

It is my personal hope that President-elect Obama will be able to name his own Chairman of the Board of Governors of the Federal Reserve System when he becomes President.

The State of the Bailout

Treasury Secretary Paulson gave a press conference yesterday and indicated that things had changed…that the focus of the bailout effort would not be on the purchase of ‘toxic assets’ but would be aimed to assist the capital needs of financial institutions and consumer finance. This ‘shift’ in focus has been duly noted by the press.

Is the ‘bailout’ program having any success?

To answer this question, I am roughly in the same spot of someone I heard being interviewed on Marketplace on NPR radio: the ‘expert’ was asked the following question “Has the efforts to add liquidity to financial markets and financial institutions shown any results to date?” His reply: “I think things are better than they would have been if the efforts had not been made.”

Does that give you a lot of confidence?

I just don’t think that at this time anyone can say more. We are in the middle of a situation that no one present has ever been through. Fed Chairman Ben Bernanke, an expert on the Great Depression, has seen to it that financial markets and financial institutions have been flooded with liquidity. From the banking week ending September 10, 2008, Reserve Bank Credit has risen from about $890 billion to $2.1 trillion in the banking week ending November 5, 2008. This is roughly a 210% increase in a matter of 8 weeks. (Dare I remind you that it took 94 years for the total of Reserve Bank Credit to reach just $890 billion and only eight weeks to add $1,167 billion more!)

The $700 billion bailout bill…is now turning into a provision of capital for financial institutions…a provision that the Treasury hopes will buy time for institutions to work out their bad asset problems. The unknown question here is whether or not $700 billion is enough or will Congress have to float more funds.

The underlying rationale for the provision of all this liquidity is that either (1) officials are going to be blamed for allowing another MAJOR economic bust to take place or (2) these officials are going to have a problem cleaning up for all the liquidity that they have supplied to the financial markets on such short notice. Success, in the eyes of the officials means that they will have to clean up all the liquidity once the financial markets begin working again. Failure…”is not an option.”

No one knows at this time what is going to happen…

The idea is to keep tossing more and more liquidity into the pot until financial institutions feel that enough is enough! No one has been here before! This is all new!

Your guess is as good as mine…

And then there is the need for fiscal stimulus. The Congress is going to consider a stimulus package which seems to be similar to the first stimulus package they passed earlier this year. It will be aimed at consumers and, although it may not be any more effective than the first package, it can be done quickly, and it will show that the Congress IS doing something AND any little stimulus to the economy will be appreciated.

But, a second stimulus bill is being talked up. This one would be more capital intensive and aim at real projects like projects to rebuild the United States infrastructure. The idea here is that consumers are not going to start spending much until their job security is enhanced and they are sure that they will hold onto their homes. Businesses are going to have to restructure their balance sheets and have some confidence that consumers are going to start spending again before they loosen their purse strings and begin to invest in capital projects again. We seem to be a long way from either of these so the argument goes that the Government needs to engage in some real “Keynesian” pump-priming. The problem with a Government expenditure program like this is that it takes time to prepare and then, once the bill is passed, it takes time for the projects to be implemented. So, help does not come quickly.

And, what about the stock markets? When are they going to come back? Well, we hear all the time that the price an investor is willing to pay for a stock is dependent upon future cash flows. Right now, market expectations concerning future cash flows are pretty depressed and uncertain. Investors must be able to sense a turnaround in future cash flows for them to develop any confidence to begin purchasing stocks. And, investors don’t really know the value of the assets on the books of a large number of companies. To me, a good argument can still be made for more asset charge offs, more bankruptcies, and more depressed forecasts of future cash flows. In my mind, we are not near the bottom here, particularly given the situation described above.

What about uncertainty?

There is lots of it. Much of the uncertainty pertains to the programs that will be coming out of the new administration and the leadership that is put into place by that administration. It is still a long way until January 20, 2009. The current administration has been reluctant to do anything in the past until it became absolutely necessary to do something about the financial markets and the economy. They still want to pass on as much of the decision making as possible to the newly elected administration. So, we are still in a limbo as far as the national leadership is concerned.

What about the international situation and international leadership?

Also an unknown. People are talking about a new Bretton Woods…the international financial structure set up after the second world war. First off, that conference had two years of preparation and negotiation before the meeting was held. There has basically been little or no preparation for the meetings to take place this weekend. Second, the first Bretton Woods conference had seasoned world leadership behind it. That is not the case at the current time. Third, there is almost no intellectual consensus concerning the cause of the current situation and what should be done about it. Fourth, the world is still going through a economic downturn with more countries declaring every week that they are now in a recession.

International coordination and cooperation are going to have to be vital components of the world economic and financial markets in the future but for right now, I don’t think that we can expect much concrete to be forthcoming from the world community.

So, in my view, we will continue to see a downward drift to stock markets with a substantial amount of volatility. What else is new?

For bond markets, United States government securities are going to continue to be the pick for risk-averse investors and spreads will continue to rise between the least risky debt and that considered to be more risky. I saw that the spread between Baa corporate bonds and Aaa corporate bonds exceeded 300 basis points last week. For even lesser credits the spread has been increasing at an almost exponential rate. If there is any indication that the credit crisis is NOT over, it can be picked up from the market place.

The only thing that seems to be positive news at this time is that the Bush plan to get the price of oil below $60 a barrel has been tremendously successful so far!

The Threat Of Too Much Regulation

Once again, Tom Friedman of the New York Times has some very worthwhile things to say. Whereas one may not totally agree with all of his arguments, I believe that one can always gain something by reading him.

This past Sunday, Friedman commented upon the government bailout and the coming effort to re-regulate the financial markets: http://www.nytimes.com/2008/10/26/opinion/26friedman.html. He quotes the consultant David Smick: “Government bailouts and guarantees, while at times needed, always come with unintended consequences.” Then he goes on to say that he, Friedman, “is not criticizing the decision to shore up the banks…We need better regulation. But, most of all, we need better management.”

Friedman concludes, however, that “We must not overshoot in regulating the markets because they (the bankers) overshot in their risk-taking.”

This is all the further the argument is carried these days: they (the bankers) “overshot in their risk-taking.” There is very little discussion about how the environment was created in which this excessive risk-taking arose. Since almost all of the blame is falling on the bankers, it is to be expected that almost all the re-regulation will also fall on the bankers.

But, Friedman argues, “We must not overshoot in regulating the markets…” and rightfully so. We must not overshoot in regulating the markets because maybe…just maybe…the environment for excessive risk-taking was created by the government and not by the bankers. This is not a new argument, but it is one that tends to be forgotten while people focus primarily on the current turmoil that is swirling around them. It also tends to be forgotten because economic consequences tend to occur with a substantial lag behind the causative events that started everything off.

In looking for such a cause, I once again return to the failure of the current administration to combat the decline in the value of the United States dollar. The performance of a currency relative to other currencies depends upon market perceptions about future rates of inflation. If the inflation rate in the home country is expected to be more rapid than the inflation rates in other countries, the value of the home country’s currency will tend to decline. The value of the home country’s currency will tend to appreciate when the opposite is the case.

The value of the United States dollar began to decline in 2002 and continued to decline through August 2008. This decline followed about seven years in which the value of the United States dollar rose. So, it can be assumed that participants in foreign exchange markets came to believe that future inflation in the United States would exceed that in other countries, a reversal of the belief that had existed over the previous decade.

What seemed to be the cause of this change in expectations? The change seems to be very closely related to the Bush tax cuts, the consequent anticipation of substantial deficits in the Federal budget, and the acceleration in the costs associated with the war on terror and in Iraq. The deficits themselves are not considered to be inflationary, but in the western world, every major increase in government budget deficits were connected with a monetization of the debt at some time in the future. Given the size of the projected deficits it was expected that the United States government could not avoid monetizing a large portion of these anticipated deficits.

In the case of the United States, however, an unexpected path was taken. The large deficits of the United States government were underwritten by China, Middle-Eastern oil producing nations, and others. In effect, foreign governments monetized the Bush deficits taking the pressure off the Federal Reserve, even allowing the Fed to keep short term interest rates at extremely low levels for three-to-four years. This was something unheard of in terms of global economics.

And, where did a great deal of the funds connected with the monetized debt go? It went into the United States housing market. The history of financial innovation in the late twentieth century is a fascinating one. Of especial interest is the growth of the market for securitized mortgages. The first package of securitized mortgages came to market in the first half of the 1970s. By the middle of the 1980s, mortgage-related securities became the largest component of the capital markets. Playing in this end of the market became ‘sexier’ than any other. And, the attraction grew and grew and drew in more and more new players from around the world. The market for securitized mortgages became the playground for the world and attracted a large portion of the United States dollars now circulating around the globe.

Thus, through the market for securitized mortgages, the United States housing market became one of the bubbles that resulted from the ‘monetizing’ of the large deficits that were created by the United States government. The expected United States inflation came about through unusual channels, but the participants in the foreign exchange markets were correct in calling for the decline in the value of the United States dollar.

In my view, the speculative atmosphere that evolved in financial markets and financial institutions which resulted in excessive risk-taking was the result of the failure of policy makers to defend the value of the United States dollar. Most other countries in the world that created government deficits that were monetized had to back off from such policies as the value of their currencies declined on foreign exchange markets. This response was due to the resulting inflation in those countries. (France in the 1980s is a prime example.) These countries did not have others within the world like China and the countries of the Middle East, to absorb their debt the way that China and the Middle East purchased the United States debt.

The massive United States government deficits went global and in going global helped flood world financial markets with funds that narrowed interest rate spreads and created an environment where more and more risk had to be taken to keep institutional returns up. Financial leverage and other techniques of financial engineering became commonplace. The structure of the marketplace became more and more fragile.

The rest is history. But, now we have to deal with the aftermath. In my mind, the fault for the financial collapse does not lie solely with the bankers…a large share of blame should fall to the Government officials that created the environment in which the bankers had to operate. Yes, one can argue that the bankers took on excessive risk. But, one cannot let the Government officials off the hook. We cannot afford to over-regulate the financial markets because the government was irresponsible.

Yes, the financial markets need to be regulated but…who is going to regulate the regulators and the policymakers? Congress does not seem capable of it.

It seems to me that the regulators and the policy makers need some oversight but the only ones
that can ultimately provide that oversight are you and me…the voters. How can we, therefore, react in a timely manner against “bad policy” and bring about a change in direction? That, as always, remains the main question.

A Government Bank Takeover Plan?

“The Treasury Department is considering taking ownership stakes in many United States banks to try to restore confidence in the financial system.”

So reads the New York Times in the middle of the afternoon on Thursday. This was in advance of the rapid sell off that again came at the end of the trading day. Dow Jones…down…680 points!

Treasury Secretary Paulson made remarks to this effect on Wednesday and the possibility of this happening was supported by the White House before 2:00 PM Thursday afternoon.

This, of course, is a real confidence builder. But, the administration has become very adept at letting out clues that the system is falling apart. Two weeks ago, Fed Chairman Bernanke made allusions to the fact that the economy might not be around the next Monday. The whole Paulson Plan was based on the assumption that many financial institutions could not exist unless they had a “buyer of last resort” to put a floor under securities prices. And the good news just continues to come out.

No wonder the financial system is frozen. No one knows what institutions are going to fail…or be bailed out. Yet, the Treasury Secretary and the Fed Chairman continue to talk about how bad things are. Why should anyone lend to anyone else when there is no idea about who might not be able to pay back their loans. Still, we hear from these high officials that things are terribly bad!

And, these officials are the ones that supposedly have inside information on the condition of individual institutions!

What do these officials know that we don’t know?

These officials are not getting any sleep…but they really need to think through what they say. They may think that they are giving out information that will build confidence…but, the limited amount of information that is being given out only creates more distrust. The reason being is that market participants interpret what the officials are saying as an indication that there is more negative information known by the officials than they are telling. This leaves bankers and others adrift for they do not know who the negative information applies to.