China Buys the World

I missed the news.

And, I presume a lot of others also missed the news.

“In the weeks ahead, a 104-year-old unit of General Motors will be sold to new owners from China. The unit made steering equipment for decades under the name Saginaw Steering Gear. Now known as Nexteer, it employs 8,300 people around the world. It new Beijing owners call themselves Pacific Century Motors.” (http://professional.wsj.com/article/SB10001424052748703957804575602943255219552.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj)

China is, and has been, buying companies throughout the world.

“But,” the above article goes on, “it is one of the landmark deals of the era, the first time Chinese investors have bought a U. S. industrial operation of such scale and history: Twenty-two factories around the globe, six engineering centers, 14 customer-support centers.”

The only direct way to stop this activity is through capital controls and other forms of protectionism.

The United States Congress did balk at some earlier attempts by China to purchase U. S. companies that were considered to be threatening to American security interests. Still, China continues to seek out and acquire United States companies.

I have mentioned this behavior on the part of the Chinese before. But, the Chinese are not alone…other emerging countries are engaging in the purchase of American companies as well.

And, the United States government continues to feed China and these other countries with the means to buy American countries.

“Ironically, at the G-20 conference in Seoul this week, U. S. leaders are trying to cajole China to buy more from the U. S., to help right a trade deficit that hit $28 billion in August alone. Such imbalances, they say, helped feed the credit craze that culminated in the 2008 financial crisis.”

In my mind, the “U. S. leaders” don’t get it!

The United States government continues to inflate the world with dollars and dollar-denominated U. S. Treasury securities and then encourages these foreign governments to buy American companies to combat the trade deficits that they have been instrumental in creating.

What am I missing here?

The United States government is inflating the world with dollars because the unemployment rate is too high and then encouraging foreign governments to buy American companies to put these people back to work again.

Again, what am I missing here?

And, why should the Chinese government want the situation to change. The Chinese government is in the driver’s seat and the United States is just feeding it with the means to buy companies both in the United States and in the rest of the world.

The Chinese have no reason to change the existing situation.

And, as long as the leaders in the United States government keep pointing their fingers at the Chinese and saying that the problem is out there…the problem will be that of the United States continuing to feed the rest of the world the means to acquire America.

But, this will not continue forever. The United States Congress will not allow it.

The threat, then, is as described by the German chancellor Angela Merkel stated in an interview with the Financial Times, is the imposition of controls and protectionism. (http://www.ft.com/cms/s/0/3cb912ca-eb6f-11df-b482-00144feab49a.html#axzz14tWucN4h)

This will not be good for either world trade or for international cooperation and peace.

But, the United States government shows no inclination to change its behavior. The leaders in the government are still working off of an outdated and inappropriate economic model. They are also working with an outdated ego that claims that America can still “go-it-alone” in the world.

Unfortunately, these outdated ideas are working entirely against what the United States would like to achieve. It is hard when you are your own worst enemy!

And, the United States continues to shoot itself in the foot. There is an excellent op-ed piece in the Wall Street Journal this morning by Alan Reynolds. (See Ben Bernanke’s Impossible Dream”: http://professional.wsj.com/article/SB10001424052702303467004575574610003111250.html?mod=ITP_opinion_0&mg=reno-wsj)

Although though Reynolds concentrates the focus of the article on the Bubble Ben’s quantitative easing plan, I could not help but think about who would benefit from the consequences of the “easing” that is presented. All the consequences described by Reynolds will benefit the wealthy because they are the only ones that are in a position to take advantage of the incentives that will be created by the quantitative easing.

This policy, then, will have three ultimate effects. First, income (wealth) inequality will continue to increase in the United States. The economic policies followed by the United States over the past fifty years which are just variations on the quantitative easing policy, have created a massive shift toward a more unequal distribution of income (wealth) in America. But, in an attempt to help the less-well-off, the government will continue to follow its existing policy-prescriptions.

Second, the United States will continue to become less and less productive. This is one of the criticisms leveled by Wolfgang Schäuble, the German Finance Minister. Schäuble stated that the reason for the strength of German exports was the fact that German industry was so effectively productive. He implied that other countries, like the United States, were not as competitive. The United States will be even less so if the results Reynolds foresees are achieved.

Third, given the current economic philosophy of the United States government, the leaders of the government will continue to combat this loss of competitiveness by “more-of-the-same” in terms of economic policies. This will just continue to hand the Chinese, and others, the means to acquire American companies.

Following such a path will result in the Obama administration achieving exactly what it does not want to happen. But, this is precisely what the Obama administration has achieved in the less than two years it has been in charge of the United States government.

And, why should China want anything different?

A Tipping Point?

Almost everyone is looking for a tipping point. At this time we are looking for signs that the decline in the economy and in the financial markets is lessening and that we might be somewhere near the bottom. If this is the case then can the turn to recovery be far behind?

It seems that every piece of information currently being released carries with it the claim that “this decline was less than expected” or ‘the decline was smaller than the last information released.” These are taken as signs of hope.

Even the results of the Treasury’s “stress tests” on the banks are accompanied by the assessment that the major banks that have just been examined are better off than was thought. Therefore, the banking system is not in as bad a condition as feared, and, stock prices can now continue moving upwards.

Fed Chairman Bernanke is still the leading spokesperson and “cheer-leader” in the administration and he stated this week that the economy will begin to expand later this year. So we must be at or near the bottom if the administration thinks so. Right?

We still have the nay-sayers out there claiming that things remain in terribly bad shape. Nicolas Taleb, of Black Swan fame, is saying that the economic situation is worse than it was in the 1930s because world markets are much more integrated now than it was then. And, Nouriel Roubini continues to sound alarms about how bad things could get. Part of his argument rests on the fact that the worst case scenario used in the Treasury’s “stress test” is out-of-date due to the recently released estimates issued by the International Monetary Fund that financial sector losses have doubled in the last six months. Yet are their claims sounding awfully shrill these days amidst the hope others are seeing?

Where are we?

To me, the uncertainties still outweigh any real sense of which direction the economy might take. I would tend to lean on the side that we have not seen the bottom yet, but what odds would I place on this possibility? Maybe I would give odds of 2-to-1 that the economy still will decline further. Maybe they should be 3-to-1. Maybe they should be 3-to-2. Somewhere in there.

First off, I am not convinced that the banks are coming out-of-the woods yet. Even if they are able to obtain more capital, I don’t see their lending picking up in any major way. Personal and business bankruptcies are still on the rise and there are still several major “black clouds” on the horizon that threaten that the storm that has hit bank balance sheets is not over. There are still large companies that are going out-of-business on a regular basis, in retail, in commercial real estate, in some areas of manufacturing, and we are waiting for the full ramifications of the collapses in the auto industry. Car dealerships are being closed, parts supply companies are on the edge, and the spread of these closures are affecting many other organizations and geographic regions. If unemployment is going to continue to rise, since it is a lagging economic indicator, then there still are houses that are going to need to be sold if not foreclosed upon and some credit card debt and auto loans that will need repayment.

And, speaking of cars. Last time I looked the price of a barrel of oil was approaching $60. Where is the price of oil going? And, the price of other commodities? The Financial Times has had several articles recently about why the price of commodities, including oil, might be going higher if a trough or bottom has been reached. What would higher commodity prices do to any recovery?

Then there is the level of interest rates. The government held an auction today for $14 billion of 30-year Treasury securities. The result? The yield of the new issue came out at 4.288% higher than the expected 4.192%. This caused a decline in bond prices with the 10-year Treasury note trading around 3.30% up from 3.14% late last week which was above the 3.00% level, reached earlier last week a level that had not been crossed since November 24, 2008.

How high are these interest rates going to go and what impact will these higher rates have on mortgage rates and corporate rates? We are already seeing spreads between Treasuries and corporates reach levels since last October and November. And the interest rate spreads on lesser credits have also been increasing. And, there is still much more Treasury debt to come.

Furthermore, the economic structure of the United States (and the world) has changed. The manufacturing base is going to be different in upcoming years and everything is going to be more connected technologically than before. And, what if the personal savings rate in the United States reverts back to 8% or so as it was before 1992? We are not going to be able to force employment, human or otherwise, back into the same industrial and financial structure with the same employment intensity as existed before this economic collapse.

I am not intentionally trying to stay on the “dark side”. It would be great if things were bottoming out and the economy were about to start on an upward path once again. But, there still seem to be too many “unknowns” out there, unknowns that relate to serious problems, for us to get our hopes up too high at this point. Managements must still re-focus their businesses and must deleverage their balance sheets. Boards of Directors still must make sure they have the right executives in the right places, and if the Boards don’t do this then the shareholders must become more aggressive. Many executives that managed in the pre-2007 period, I believe, are not the executives to lead our companies in the post-2009 period.

Are we at a tipping point? Are we at or near the bottom of the downturn?

The most important questions are still going unanswered: even with the results of the Treasury stress tests. Will a major bank fail? How many regional banks might fail? So far there have been 32 bank failures this year, up from 25 last year and 8 the year before. How will a General Motors bankruptcy impact the economy? What other possibilities are out there?

Other company failures? Bloomberg reports today "Moody’s is forecasting the default rate among high-yield companies globally to soar to 14.8 percent by year-end from 8.3percent in April as companies that financed a record amount of high-yield, high-risk debt leading up to the credit crisis struggle to refinance."

And, I haven’t mentioned the debt overload that exists throughout the country. The list goes on.

It seems to me that what we are seeing a lot of these days is wishful thinking. I really haven’t seen anything yet that one could argue was a “hard” fact pointing to a bottom of the downturn. I really don’t think we are going to see any “hard” facts in the near future, so the stock market and other areas of the economy will just to continue to live off of wishful thinking. This is a situation made for traders. Uncertainty creates volatility and traders feast off of volatility. I guess it is good to know that at least some people profit from this environment.

Renouncing the Debt

There are three ways to get out of a debt crisis. First, you can work off the debt, but this takes a long time. An impatient public and an impatient government will not have the stomach the wait that would be necessary for individuals, families, and businesses to get their balance sheets in order so that a recovery can get started.

The second method is to inflate or reflate yourself out of the nominal debt burden you have created. The Federal Reserve is doing its best to create an inflationary environment so that the real value of the debt will be reduced and individuals, families, and businesses will feel comfortable enough to begin borrowing and spending once again.

The third way to reduce the burden of your debt is to repudiate the debt. That is, declare that you will not pay the debt and that those that issued the credit to you will have to take only a partial payment on the amount of funds that they advanced to you. The partial payment, of course, can be zero.

The latter two methods have an “honorable” history that goes back centuries. (Read almost anything by Niall Ferguson.) Usually, it is the government that can get away with either or both of these efforts, but in the 20th century, the private sector got much better in following the lead established by governments, especially repudiating the debt. Individuals, families, and businesses learned the ropes of debt repudiation and are now taking this knowledge to new extremes.

The case that is before everyone’s eyes these days is that of the automobile industry. Both General Motors and Chrysler argue that bondholders must take a huge cut in the amount of money they are owed by these companies so that the companies can survive and thousands and thousands of jobs can be saved. The bondholders, remarkably, have some reluctance to consent to this offer. As of this date, the aimed for restructuring of these two companies depend upon what is worked out between the companies and the bondholders.

Best guess is that the bondholders will lose. And, who will own the auto companies? Not the existing shareholders. The figure I have heard for General Motors is that existing shareholders will end up with about 1% of the ownership of the company after the restructuring takes place. And, not the existing bondholders. The biggest shareholders? The federal government and the labor unions.

The important thing, however, is that the debt problem being experienced by these automobile companies will be resolved. That is, the companies can move forward, leaner and meaner, without the terrible burden of having to honor the debts they had contracted for.

Furthermore, this is what has been proposed for the banking industry. In the plan to sell off bad assets, aren’t the banks being asked to repudiate a large portion of the debt they have on their balance sheets? The assets will be sold to investors and private equity firms to “manage” and this will get the banks out from under the burden of the “toxic assets” they have accumulated.

And, who will bear the risk of this buyout? The federal government, with the real possibility that it may, depending upon the way things work out, end up owning large portions of some of the larger banks. (An important critique of this program is presented by the economist Joseph Stiglitz in “Obama’s Ersatz Capitalism,” http://www.nytimes.com/2009/04/01/opinion/01stiglitz.html?scp=8&sq=jospeh%20stiglitz&st=cse.)

Might this plan work? Well, the people that the federal government wanted to get interested in the plan seemingly smell blood. We read this morning that Wilbur Ross and his firm’s parent company, Invesco, are leading a consortium that is going to bid on some of the assets in the government’s P-PIP. He is joining some other prominent money, like BlackRock, Pimco and Bank of New York Mellon, interested in getting involved in the program.

Do these people think that they might make some money out of this program? Do they believe that the risk-reward tradeoff is skewed in their direction? Damn betcha’.

Here is another case of “watch where the big money players put their money.” My guess for the future is that the evolving banking system is going to be somehow connected with the hedge funds and the private equity funds and will not have the same old “bank on the corner” feel to it that we experience now. And, somehow, this new banking system will be even harder to regulate than the current one. Otherwise, this money will not flow there. (Something to think about for the future.)

With these funds flowing into the P-PIP, one of the things the federal government is going to have to face is the huge profits that these companies will make out of the program. On the one hand, if P-PIP is successful in this way and these funds make huge profits, the banks will be freed up of their “toxic assets” and the tax payer will not be burdened with more taxes. On the other hand, the federal government will have to explain how it catered to all these “Wall Street Interests” and left the poor Main Streeter in his or her poverty.

The essence of the plan, getting back to the story here, is that the banks will have to take the “haircut”, the write down on the value of their assets. This is just another way of repudiating the debt, with the federal government standing behind the banks. Is it fair? Of course not!

A fund that made the wrong bet was Cerberus Capital Management. In a real sense, it hoped to do with Chrysler Corp. what Invesco, BlackRock, Pimco, and others, are hoping to do with the bank assets. It just got in too early when Chrysler was not in bad enough shape for the federal government to attach a “put” to the investment Cerberus made in the company. Too bad for Cerberus.

But, what about all the other debt out there? Mortgages on homes, debt on commercial real estate, consumer credit and credit cards, and small business loans? Why shouldn’t the people that accumulated all this debt get some relief as well? This is, of course, the big question and the big issue in terms of fairness. The basic answer to this is, as usual, size. The banks and the auto companies and others are big, their failures could case systemic problems for the system, and they have expensive lawyers and lobbyists working for them. Is it fair? Of course not!

The fundamental problem that is being faced around the world is a debt problem. There is just too much debt outstanding. And, actually, the amount of debt outstanding in the world is really not shrinking. Especially, as governments increase their debt to cover the debt that has been built up in the private sector. The debt problem is going to be with us for a while and will continue to get in the way, one way or another, of any kind of a robust recovery. How we get through it is going to set the stage for the type of world we have to deal with in the 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.

A Lesson from AIG for the Bank Bailout Plan

One of the reasons given for the awarding of bonuses at AIG was the need to keep people around that had “expertise.” That is, if we lose the “experts” we are really in trouble!

This, to me, is one of the greatest fallacies in the corporate world.

It is a fallacy for two very important reasons. The first fallacy is that people are irreplaceable. The second fallacy is that the people that performed badly in the past can get you out of the mess they got you into.

In my experience, no one is irreplaceable and the minute that you begin to believe that either you or the people in charge are irreplaceable you are setting yourself up for big problems. We do not need Rick Wagoner of General Motors nor do we need Vikram Pandit of Citigroup. They are not indispensable in any recovery or turnaround of the companies that they are a part of. Neither are the traders, or the quants, or other executives that got these companies where they are.

We are sold a “bill of goods” about how important these people are to the organization, yet it is remarkably surprising that when they are gone things don’t fall apart. In most cases the situation improves and the company performs at a higher level. It just seems as if in a complex and difficult situation that putting “someone new” in authority is the more dangerous path.

Time-after-time we see that replacing these people is not dangerous. In fact, it turns out to be the best thing that could happen.

Obviously, the incumbents want you to believe that they are indispensable. They will do everything that they need to do to convince you of their importance to future success. And, this includes groveling to the government to assure that they will be kept in place when and if the government bails out their organization or takes it over. Rick Wagoner is sure acting different these days when he is desperate to retain his position at General Motors that he did when he arrogantly arrived in Washington, D. C. on his first trip to the “big” city to appear at Congressional hearings.

Let me add here, however, that this is one of the worst things that the government does when it bails out a company. Because government doesn’t know any better, it often buys into the argument that the current leadership should stay on after the bailout because it has the experience and knows the company better than anyone else does. Government assistance tends to entrench existing management. After all, since the government has worked with this management team to create the bailout in which they are now companions rather than adversaries. That is, they are in bed together.

This is a good reason why government needs to let the shareholders or the bankruptcy courts handle most of these situations. If a management change is needed, there needs to be a practiced means of proceeding toward an orderly transition of power rather than have government insert its heavy hand into the process. Even if government appoints new executive leadership, the choice is usually a person who is an “expert” with “experience” in that firm, which, again, limits the possibilities that the firm will move ahead into the future rather than stay mired in the past.

My experience with the second fallacy also leads me to believe that the “experienced” people should be removed. During the savings and loan crisis, I don’t know how many times I heard the executives of failing thrift institutions seeking money in an IPO tell potential investors, “Yes, we were the ones that managed the organization that brought it to the edge of failure, but, we have learned from this experience! You should give us $100 million in our IPO.”
What have these executives learned?

They have learned how to fail, that’s what they have learned!

There was an interesting article in the business section of the Sunday New York Times which discussed investing in start up companies. I remember myself, because I have worked in that space, that one of the old “truths” of investing in young entrepreneurs is that you should look at people who have failed in earlier business attempts and it even was a “badge of honor” to have failed many times. Recent research does not support this conclusion. On average, those that have failed starting businesses tend to continue to fail. This attitude relating to failure was advice given to venture capitalists or angel investors that are looking desperately to place money. The situation arose during “booms” when there was too much money chasing too few deals. Nothing replaces the success of an entrepreneur as a guide to potential future success.

Still one has to be careful here. Two cases come to mind. First, Nassim Nicholas Taleb in his book “Fooled by Randomness” discusses traders that succeed fantastically because they are in the right spot at the right time. Through no skill of their own do they achieve success, and, because they now think that they are geniuses, go on and lose most if not all of what they gained in their one success. Obviously, these people are not geniuses and should not be treated as such. What you want is people that continue to succeed and succeed in ways that are not just lucky successes.

Second, in an “up” market, almost everyone can succeed, sometimes spectacularly. This can happen in overheated housing markets, in firms that are of the dot.com variety, and in growing and running financial institutions. Credit bubbles help. The sad thing about this is that the people that have just benefited from the “bubble” and not from their “skill” are not found out until the “bubble” bursts. Then the true reason for the success of these individuals becomes obvious.

Furthermore, if a chief executive or a management operated in an environment that was “hot” and where increased risk taking and adding additional leverage were the skills needed in order to succeed they are not the chief executive or management to operate within an environment that is “cool” and where reducing risk and de-leveraging are the tools required. Speed racers are not needed on streets where the speed limit is 25 miles per hour.

It should be clear that the people that get you into a mess are not the people you should count on to get you out of the mess. But, again, the government usually does not see this except in cases of fraud or other types of criminal behavior. Therefore, the government will often stick with those people that are experienced in failure.

These comments can be applied to any approach the government takes to resolving issues in the private sector, whether it be in terms of dealing with the toxic assets of financial institutions or bailing out failed managements in the auto industry. The government must be realistic in what it can do. A bank bailout plan that just brings in private investors to relieve institutions of bad debts while leaving bank managements in place is not going to give the financial sector and the economy what it needs.

Yes, something needs to be done about the bad assets banks have on their books. Losses have to be absorbed by the banks and their owners, themselves, or the government must absorb the losses. The insolvent banks, and auto companies, need to be closed or put into bankruptcy. The world needs to move on and the bad decisions of the past must be accounted for. Someone must pay—sometime. Unfortunately, when government gets involved, the solutions to things often only get postponed or delayed. That is not what the financial markets or the economy needs at this time.

And, this includes Cerberus and Chrysler Corp. Cerberus made a wrong deal at the wrong time. They need to move on.

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.

Households and the Debt Problem

The Federal Reserve released new data on the financial condition of the household sector of the United States. Like other sectors of the economy, the financial condition of this sector has deteriorated over the past year.

The value of household assets dropped about 15% falling from $77.3 trillion to around $65.7 trillion. Most of the decline came from the fall in housing values and in their stock market portfolios.

In terms of household holdings of stocks, the value of the stocks households owned, mutual funds that were held and funds in retirement plans, the loss was $8.5 trillion. That is, the value of stock holdings fell from $20.6 trillion to $12.1 trillion.

Although mortgage credit fell during the year, total household liabilities stayed roughly the same at about $14.2 trillion. This means that debt as a percentage of assets rose from around 18% to 22% during the year (or net worth as a percentage of assets dropped from 82% to 78%).

Mortgage credit at the end of 2008 was $10.5 trillion so that other household liabilities totaled around $3.7 trillion, with consumer credit making up $2.6 trillion of this latter number. Mortgage credit fell during the year, but not because the household sector was trying to get out of mortgage debt. The primary reason for the decline was foreclosures and the reduction in the willingness of financial institutions to lend.

What this means is that households took on increased leverage during the year, not because they wanted to in order to grow their balance sheets, but because of the decrease in the value of their assets and because of the need to borrow due to lower incomes. The increased leverage was a result of the collapse of the mortgage market, in particular, and the economy, in general. The increased leverage just happened—it was not planned.

In order to protect themselves in the face of these changes, households moved assets into cash and cash equivalent accounts. Banks deposits held by households were at about $7.7 trillion at year end.

This is important information for understanding the state of the economy and the contribution the household sector might make toward turning the economy around. The household sector was in free fall in 2008 and was reacting to events, not leading them.

Households took three major shocks last year: first was the decline in housing prices; the second was the rise in unemployment; and the third was the fall in the stock market. Not only was their cash flow significantly hurt, but the value of their assets fell precipitously. They borrowed in an effort to hold on and they became more liquid so as to be prepared for that “rainy day.”

The year 2009 does not look any better than 2008. Housing prices continue to plummet. The stock market has dropped since the first of the year. And, unemployment has ratcheted up. That is, one can assume that the direction observed in the balance sheets of American household in 2008 will continue to be followed this year. Even if the stock market were to stabilize or rise through the rest of the year consumer spending, I believe, will continue to be weak. Even if housing prices stabilize. Even with the implementation of the Obama stimulus plan.

According to the best information we have there are three further shocks looming on the horizon. The first two have to do with the mortgage market: over the next 18 a large amount of Alt-A and Options mortgages are supposed to re-price. Given the weakness in employment that is expected to continue and the lower household incomes, this event could be devastating. And, on top of that credit card delinquencies are rising and these are expected to grow given the financial condition of the household sector.

Consumers will continue to withdraw from the marketplace as they add debt where they can in order to maintain at least a part of their former living standards. Also, consumers will continue to try and become more liquid so that they can be prepared should they need to need cash to tide them over a rough time. Any improvement in the stock market will be met with households selling more stock so as to move the funds into more liquid assets, the rise in the market making it easier for them to get rid of stocks—even at a loss.

And where are the funds going to go that come to households from the Obama recovery plan? My guess is that a good portion of them will go into liquid assets, or into paying down debt. Households are scared right now. They are going to use whatever they have as conservatively as possible. This even goes for those that have some security in their employment condition.

The data that are coming out confirm the strength of the problem that the policy makers face. The United States has a tremendous debt overhang. This debt problem is going to have to be worked off. Economists talk about “the paradox of thrift”, the problem that consumers are not spending at this time and probably will not spend much in the near future, even though if everyone opened up their pocketbooks and spent, everyone would be better off.

This situation is like a “Prisoner’s Dilemma” game. If everyone else increases their spending reducing their savings and, willingly, increasing their debt and I don’t follow their lead, then I will be a lot better off that all these other people. But, if everyone else believes as I do and doesn’t reduce their savings and doesn’t increase their debt, then I end up losing big to everyone else. So, as in the “Prisoner’s Dilemma” everyone defaults to the decision to save more where they can and to pay off their debt. The consequence of this will be that consumer spending will remain weak and much effort will be extended, where possible, to work themselves out of debt.

The overall problem is that there is too much debt outstanding. The policy makers are focusing upon stimulating the economy by increasing spending. If the debt overhang is truly too great, then the stimulus package will only have a small multiplier effect on the economy as households try and get their balance sheets back in some kind of order.

Such behavior will not have much affect on the economy, and it will also not have much affect on the stock market. Government policy makers must direct more attention to resolving this debt problem. It seems to me that this is what the financial markets are trying to tell them. As Citigroup and Bank of America claim they are showing some signs of profitability. As General Electric survives a reduction in its credit rating, meaning that GE Capital has more of a chance to re-structure itself. As General Motors indicates that it has reduced costs sufficiently to rescind the request for another $2 billion from the government in March. And, as other financial institutions seek to repay to TARP money they had received last fall, the stock market rebounds.

It is the debt problem that is the big concern of the financial markets. In my opinion, as long as the government policy makers put their primary focus on stimulating spending, the financial markets—and the economy—will continue to flounder. When they refocus on the more crucial problem they will find that the financial markets will be more supportive of what they are doing.

It's All A Matter Of Incentives

Cerberus Capital Management has asked for a bailout! Who would have thought that a private equity fund would be seeking the help of the Federal Government to provide it with bailout funds?

The United States government is the largest creator of incentives in the world. Whatever it does it sets up incentives that people respond to in order to gain whatever edge they can obtain. And, the competition can sometimes become extremely fierce.

Incentives can either be positive or negative. They can either encourage us to do something…like pursue an education…or they can discourage us from doing something…like quitting smoking. They can work to make the society better…like improving the environment…or they can cause criminal behavior…like prohibition resulted in an underground business boom.

Whatever it is that the government does…it sets up incentives that people respond to. And, making lots and lots of funds available to people creates a huge incentive for those individuals to line up…with their hands out.

We saw this earlier with TARP. I thought that this effort supposedly had something to do with the “toxic assets” that were on the balance sheets of banks. But, as soon as it was passed…all of a sudden mayors and governors had their hands out for some of the money. Somewhere I missed their inclusion in the bill passed by Congress.

The major criteria now for getting money from the Obama stimulus plan just passed by Congress is “shovel ready.” Wow…I didn’t know that so many governmental bodies in the United States had so many proposals ready to begin putting the shovel into the ground next Monday!

Most incentives in an economy evolve out of the workings of the economic and social system that exists within a country. One could say these incentives are “endogenous” to the system…that is, they are created through the normal functioning of daily life. One could say that these incentives arise naturally.

Governments and some large organizations can create incentives “exogenously”…that is, they can impose incentives on a society from outside the system…say, because they think that certain incentives create “right” behavior. A church, for example, is one such system. A government can create incentives that will raise the nation to fight a war…and the incentives must be strong enough to get the nation to pay for that war by paying taxes to support the war.

One of the problems with these “exogenous” incentives is that they may ultimately be harmful to the people that they were trying to help. This problem is observed quite often in economics because most changes in incentives take a substantial time period to work themselves out. Consequently it is difficult to attach the “consequence” of a government policy with the underlying “cause” of the result. Especially since modern society and its sources of information…television, newspapers, and radio…tend to focus on the current and the dramatic “consequences” without any recognition of what might have started off the whole chain of events leading to this end.

This leaves us with an uncomfortable situation in which we must deal with the existing problem and with the emotions and psychology of current events isolated from what got us into the mess we are in.

Last Friday, we saw an announcer on public television ranting and raving about how the people that have followed the rules and responsibly sheparded their resources now have to dig into their pockets and cover those that have not behaved in such a sensible manner and now are experiencing financial and economic difficulties. And, this tirade has gained national attention by both sides of the argument.

The auto industry “big-guys” are down on their knees begging for some “bread and water” so as to keep their positions of power and control. Yet, these are the people that have been protected for years by the same state and national politicians they are now seeking mercy from.

And, the bankers…what a bad lot they are…those greedy “b……s”! Of course, bankers are always an easy bunch to pick on…and this picking goes back centuries. The auto-guys are just wimps in comparison to bankers when it comes to taking criticism.

The question that goes unanswered is “What was the environment created by government that set up the incentives that resulted in the results just described?” I have already answered this for the auto industry. But, who wouldn’t go to the government and get protection of their industry when it was so possible to do so?

Who wouldn’t support the Federal Reserve keeping interest rates so low for an extended period of time…of course, real interest costs were negative…so that business could be continued at a furious pace? Who wouldn’t be in favor of substantial tax cuts for the wealthy…especially if you happen to be wealthy? Who wouldn’t support going after that bad dictator who had those…what was it now? Oh, yes…weapons of mass destruction.

The obvious point to this discussion is that government got us into the mess we are in through the incentives it created eight or so years ago…and now we are faced with a situation in which it appears that government must set up a new set of incentives in order to make up for the mess that resulted from the incentives set up from an earlier time.

Yes, we have to take some money from those that did not over play their fiscal hand and transfer it to some that did. Yes, we have to help those financial institutions that responded in too extreme a form to the perceived opportunities that existed for them. Yes, we may need to do more for the auto industry…and for other industries.

But, where does it stop? Is everyone entitled to a bailout? (Well, as a matter of fact…I think I need a billion or two to get me through the next several years! I’m sure you are deserving of a bailout as well!) And, what are the consequences down-the-road a piece for the people and the society that are getting the bailouts?

Does Cerberus Capital Management really deserve a bailout? I thought private equity firms were risk takers and that is why they got the big bucks? Maybe Cerberus should face a "stress test" like the commercial banks.

What kind of a society are we creating through the incentives that are being developed today? What mess is the government going to have to bail us out of in two or three, or, five or six years from now…the mess that we are now creating…but we don’t know what mess that will be?

Of course, the final question is…how are you going to respond to the incentives now being created? Is it wise for certain Republican governors to turn down the bailout money because of…what was that…because of their principles?