In the last few days we have seen a ton of headlines and articles talking about how President Obama is going to tax the major banks of the country (including US branches of foreign banks) in order to recoup the bailout funds paid to the banks that went to save them.
The President pledged to “recover every single dime the American people are owed.”
Remember that Mr. Obama is the protector of the dime since he vowed that the health care plan would not cost the American public “one dime”!
The estimated bottom-line cost to the banking system is about $100 billion over a ten-year period.
The banking system is, of course, lobbying as hard as it can to prevent such a tax from being levied. And, lobbyists are earning a lot of money off of this.
But, the President has heard the voice of the little people who are angry at the bankers.
Oh, and then there is the need for new bank regulation.
The estimated cost of this new regulation is in the billions of dollars.
The banking system is, of course, lobbying as hard as it can to prevent such regulation from being inacted. And, lobbyists are earning a lot of money off of this.
But, the President has heard the voice of the little people who are angry at the bankers.
What can we bet on?
My experience in running banks and in studying banks and the banking industry is that the big banks will not, ultimately, pay much of the bill at all.
The reason for this is that the banks will find many, many ways to get around any new laws, regulations, and taxes or will pass the cost of the new laws, regulations, and taxes on to others.
Let me just say here that I don’t mean to single out just the banks in this area. In this Age of Information and with a global network of business and finance almost everyone that has wealth or financial clout or is big can find ways to avoid laws, regulations, and taxes. And, if you don’t believe this it just shows how good these people and organizations are at evading them.
And, the people and organizations that can evade or avoid these new laws, regulations, and taxes the best are the ones that the President and the “populists” are after. The people and businesses that are the least able to avoid the new laws, regulations, and taxes are those that can least afford the consequences of the new laws, regulations, and taxes. This will include the small- and medium-sized banks and people from Main Street. This has happened over and over again throughout history.
Just an example: in the 1960s it was almost the mantra of a certain brand of economist that a little inflation (an inflation tax, if you will) would help the “little people” because it would result in more employment. This was captured in something called “the Phillips Curve.”
The result? In the short run employment was a little higher but people found that inflationary expectations adjusted and over a longer period of time it took more and more inflation to sustain the small rise in employment associated with the higher inflation. By the end of the 1970s we had a real crisis!
Furthermore, those with more wealth or who were better connected could protect themselves from inflation. They could purchase assets, like homes, and art, and securities that appreciated in value with increases in prices. The less well-to-do or the less well-connected could not do this and so the wealth distribution in the country became more skewed.
Thirdly, higher and higher inflation affects productivity and this impacted the use of existing capital and the hiring of the less educated and less trained worker. Unused capacity in manufacturing and under-employment rose over time again hurting those that were the least able to protect themselves.
The purchasing power of the dollar declined from 1961 to the present: where one dollar could buy one dollar’s worth of goods at the former time, it could only buy 17 cents worth of goods now. And, who has suffered the most? Main Street and not Wall Street!
There are two forces dominating the banking scene right now and neither one of them can lead to the construction of sound banking regulations and banking practices. The first is the emotion of the present. People may be upset about what has happened and are particularly incensed at the profits that the large banks are posting. However, an emotional response to current events cannot lead to a rational result. Basing laws, regulations, and taxes on a populist outburst will only produce consequences that are regretted in the future.
Second, it has been my observation that politicians only fight the last war. This is popular because the “last war” is discussed in the press and it is what the constituents of the politicians are responding to. Furthermore, the issues are so complex that the politicians don’t even understand what happened in the “last war”. If you don’t believe this take a look at the initial work the Financial Crisis Inquiry Commission.
Finally, the big banks that the politicians are going after have already moved on “light years” ahead of what happened in the “last war”. I have written several posts on this very fact. Thus, the politicians are firing at the wake of a rapidly moving boat and will miss their target by a lot!
Oh, well, politicians have to get their 15 minutes of fame and try and get re-elected: Seems like we could spend our time concentrating of more productive efforts.
BIG BANK PROFITS
If anyone should be congratulated for the massive profits that have been posted by the “big banks” over the past nine months it should be Ben Bernanke and the Federal Reserve System. Since the real strength of the earnings, especially in banks like JPMorgan Chase, have been in investment banking and trading, one can argue that the Federal Reserve policy of keeping short-term interest rates near zero has subsidized the pockets of the big bankers. Thus one could ask if any of the huge bonuses being paid out by the “big banks” are going to the Chairman and his officers in the Federal Reserve System. They certainly deserve them!
Showing posts with label bank bailout. Show all posts
Showing posts with label bank bailout. Show all posts
Friday, January 15, 2010
Tuesday, April 28, 2009
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 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.
Thursday, April 23, 2009
Bank of America dot Gov
It is becoming clearer and clearer what it means to have government involved in the affairs of banks and businesses. Where all the initial talk was about the “moral hazard” presented by government bailing out the private sector and how this just means that in the future banks, and other organizations, will just take on more and more risk because they know that if things go bad, the government will be there with a rescue net to save the institution.
Now, we are seeing the other side of the bailout business. In the AIG case executives and others were angry because the government interfered with bonuses and other executive decisions. And, we have the government putting lids on executive pay. And, we have government wanting to rewrite mortgages, and cap interest rates on credit card debt, and so on and so on.
This is the other side of the coin.
And, now we learn from testimony given by Ken Lewis, the CEO of Bank of America, that Hank Paulson and Ben Bernanke put a “sock” in his mouth and strongly advised him that he say nothing to the shareholders or anybody else about the implications of the merger between Bank of America and Merrill Lynch.
Furthermore, we hear from New York’s Attorney General Cuomo that Paulson threatened to fire Lewis and remove the entire Board of Directors it Bank of America did not go through with the merger with Merrill Lynch! The reward—money from the Government to help BOA through the process.
The shareholders? Well, they lost on the value of their stock. And, they also will have higher taxes or an inflation tax that they will have to pay in the future.
In addition, why should any company, financial or non-financial even think of an acquisition in the future because the government may force the management to swallow hard, take on something that is not necessarily desirable for the company, and, of course, not inform investors as to the implications of the merger transaction?
And, why should the stockholders of any company approve any acquisition that is at all questionable? The precedent has been set that they might be approving something that will cost them considerable wealth as the stock of their company tanks, and they are given no information to give them any confidence that the transaction might be a worthy one.
What if the shareholders balk? What if they fail to approve such a merger? Will the government step in and force through the merger anyway?
Talk about a mess!
Two thoughts come to mind that I must express.
First, the combination of Paulson and Bernanke was a disaster as far as I can see. I have written about how Bernanke seemed to panic last fall and the result was the TARP. (See my post “The Bailout Plan: Did Bernanke Panic”, http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.)
Paulson didn’t do much better in his handling of the crisis and the creation and oversight of the TARP. I always thought that Paulson found the whole bailout idea not to his taste and had hoped that he would be able to get out of Washington before the collapse. Unfortunately for him—and for us—he didn’t make it. As a consequence here was a man doing something that he despised, and his heart, and mind, was really not in the effort. He has left us a very unhappy legacy!
When I reflect on the events of the last fall I keep coming up with the feeling that we would be hard pressed to have found two people less capable of handling the situation than the two that were then in charge. And, then there was the “Decider”, but he was AWOL!
The second thing has to do with the fact that the bankers, and other business leaders, are getting pelted with all the blame for the financial collapse and crisis that we have experienced. Thus we have the “bad guys” in our sights. Thus, they should pay.
But, what if the conditions that existed were created by the government and these bankers and other business leaders were just responding to the incentives initiated by the government? We had a credit bubble connected with the stock market in the 1990s. The credit bubble resulted in negative real rates of interest and consumers stopped saving. The saving rate fell from 7.7% of disposable income in 1992 to about 2.0% by the end of the decade. Then there was the huge deficits that resulted from the 2001 tax cuts and the “war on terror”. This was accompanied by negative real interest rates gain which resulted in the credit bubble in the 2000s and the housing boom. The consumer savings rate remained around two or below, even becoming negative for a short period of time.
The foreign exchange market in the 2000s indicated a fear of a renewal of inflation as the value of the dollar fell by more than 40% against major currencies. What were financial managers to do in such an environment? Generally, because spreads narrow in such times and arbitrage opportunities are based on smaller differences, you tend to leverage up and mismatch maturities. This response is a normal one to gain the needed returns on equity to keep money from leaving your fund or institution.
Is this greed? Yes, but it is also just the natural response of competitive people to the incentives that are created, in this case, by the government. The Bush 43 administration may have been composed of “Free Market Capitalists” but this “gang that couldn’t shoot straight” did more to harm capitalism than most other administrations in the history of the United States.
So, government gets it both ways. It can create the crisis. And, then it can impose itself on the economy to right the system after the crisis occurs. And, best of all, the blame can all be put on “greedy” bankers and the lack of regulation.
I am sure that before this is over we will hear many more horror stories.
Now, we are seeing the other side of the bailout business. In the AIG case executives and others were angry because the government interfered with bonuses and other executive decisions. And, we have the government putting lids on executive pay. And, we have government wanting to rewrite mortgages, and cap interest rates on credit card debt, and so on and so on.
This is the other side of the coin.
And, now we learn from testimony given by Ken Lewis, the CEO of Bank of America, that Hank Paulson and Ben Bernanke put a “sock” in his mouth and strongly advised him that he say nothing to the shareholders or anybody else about the implications of the merger between Bank of America and Merrill Lynch.
Furthermore, we hear from New York’s Attorney General Cuomo that Paulson threatened to fire Lewis and remove the entire Board of Directors it Bank of America did not go through with the merger with Merrill Lynch! The reward—money from the Government to help BOA through the process.
The shareholders? Well, they lost on the value of their stock. And, they also will have higher taxes or an inflation tax that they will have to pay in the future.
In addition, why should any company, financial or non-financial even think of an acquisition in the future because the government may force the management to swallow hard, take on something that is not necessarily desirable for the company, and, of course, not inform investors as to the implications of the merger transaction?
And, why should the stockholders of any company approve any acquisition that is at all questionable? The precedent has been set that they might be approving something that will cost them considerable wealth as the stock of their company tanks, and they are given no information to give them any confidence that the transaction might be a worthy one.
What if the shareholders balk? What if they fail to approve such a merger? Will the government step in and force through the merger anyway?
Talk about a mess!
Two thoughts come to mind that I must express.
First, the combination of Paulson and Bernanke was a disaster as far as I can see. I have written about how Bernanke seemed to panic last fall and the result was the TARP. (See my post “The Bailout Plan: Did Bernanke Panic”, http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.)
Paulson didn’t do much better in his handling of the crisis and the creation and oversight of the TARP. I always thought that Paulson found the whole bailout idea not to his taste and had hoped that he would be able to get out of Washington before the collapse. Unfortunately for him—and for us—he didn’t make it. As a consequence here was a man doing something that he despised, and his heart, and mind, was really not in the effort. He has left us a very unhappy legacy!
When I reflect on the events of the last fall I keep coming up with the feeling that we would be hard pressed to have found two people less capable of handling the situation than the two that were then in charge. And, then there was the “Decider”, but he was AWOL!
The second thing has to do with the fact that the bankers, and other business leaders, are getting pelted with all the blame for the financial collapse and crisis that we have experienced. Thus we have the “bad guys” in our sights. Thus, they should pay.
But, what if the conditions that existed were created by the government and these bankers and other business leaders were just responding to the incentives initiated by the government? We had a credit bubble connected with the stock market in the 1990s. The credit bubble resulted in negative real rates of interest and consumers stopped saving. The saving rate fell from 7.7% of disposable income in 1992 to about 2.0% by the end of the decade. Then there was the huge deficits that resulted from the 2001 tax cuts and the “war on terror”. This was accompanied by negative real interest rates gain which resulted in the credit bubble in the 2000s and the housing boom. The consumer savings rate remained around two or below, even becoming negative for a short period of time.
The foreign exchange market in the 2000s indicated a fear of a renewal of inflation as the value of the dollar fell by more than 40% against major currencies. What were financial managers to do in such an environment? Generally, because spreads narrow in such times and arbitrage opportunities are based on smaller differences, you tend to leverage up and mismatch maturities. This response is a normal one to gain the needed returns on equity to keep money from leaving your fund or institution.
Is this greed? Yes, but it is also just the natural response of competitive people to the incentives that are created, in this case, by the government. The Bush 43 administration may have been composed of “Free Market Capitalists” but this “gang that couldn’t shoot straight” did more to harm capitalism than most other administrations in the history of the United States.
So, government gets it both ways. It can create the crisis. And, then it can impose itself on the economy to right the system after the crisis occurs. And, best of all, the blame can all be put on “greedy” bankers and the lack of regulation.
I am sure that before this is over we will hear many more horror stories.
Tuesday, March 24, 2009
Liquidity or Solvency?
The debate over the Public-Private Investment Program (P-PIP) put forward by Treasury Secretary Timothy Geithner seems to be focusing upon a technical point concerning the condition of the market for troubled assets. In the eyes of some, the question relating to whether or not the program will work depends upon whether the problem being dealt with is a liquidity problem or a solvency problem.
The preliminary judgment is that if the problem is a liquidity problem then P-PIP will be an adequate solution. If the problem is a solvency problem then P-PIP will probably not do the job.
Unfortunately, this debate has gone on for a long time…going back to at least December 2007 when the Federal Reserve initiated its Term Auction Facility (TAF). The Fed’s action at that time was an effort to relieve pressures on the banking system by providing a more direct and more liquid approach (than borrowing at the discount window) toward getting short-term funds to the banks that needed liquidity. Additional efforts have been made since then to provide liquidity for different sectors of the financial markets.
The crucial issue connected with a liquidity crisis is addressed in the first sentence of the last paragraph. A “liquidity crisis” by its very nature is a short-term phenomenon. To say that the debate has gone on for a long time is to confirm that the “crisis” we are in is NOT a liquidity crisis.
A liquidity crisis occurs when some kind of shock hits short term financial markets. The “shock” usually takes the form of a new piece of information that is contrary to the current beliefs held by the participants in these markets. A classic example is the situation that revolved around the Penn Central Railroad and the commercial paper market. Because of financial problems at Penn Central the rating given to Penn Central’s commercial paper was revised downward. This revision shocked the commercial paper market and the market basically closed down. The reason was that if the Penn Central rating needed to be lowered, the question became “what other commercial paper ratings needed to be lowered?” The buy-side left the market. Hence, the “liquidity crisis.”
Since borrowers in the commercial paper market could not roll-over their paper, they had to go into the commercial banks and draw on their back-up lines of credit. The problem then fell to the banking system. And, if the banks tried to sell short-term securities to get funds for to honor the lines of credit this would cause security prices to plummet.
The Federal Reserve responded in classic central bank style by opening the discount window, supplying sufficient liquidity to the banks that needed funds to support lines of credit. The banks were able to honor the back-up lines of credit without having to sell securities and the commercial paper market was given the time to access the information on borrowers in the commercial paper market and the buyers returned and the market stabilized.
The point of this is that a “liquidity crisis” is a short-run problem. The crisis occurs because market participants get some information that is not consistent with what they had formerly believed. They need to process the new information and until they do, the buy-side of the market usually disappears. The solution to this problem is for the central bank to supply sufficient liquidity to the market so that the participants have time to process the new information. Liquidity problems usually last only a few weeks.
Solvency problems are of a completely different nature. And, as I have written about over the past year or so, resolving solvency problems take a long, long time. And, with solvency problems it is not an issue of providing liquidity to the market so that assets can get sold. Solvency problems have to do with charging off book values to reflect the underlying economic values of assets. Yes, there is uncertainty with respect to what is the underlying economic value of the assets, but that is why time is needed and cannot be hurried along.
There is only one way to hurry time along in issues relating to solvency and that is to charge off the asset, or at least charge off a major part of the asset. The problem is that banks, and other institutions, don’t like to rush this process. They want to see how the situation with respect to the asset can be worked out, what can be recovered, and whether or not they can hold onto the asset long enough so that economic conditions can improve which will lead to higher asset values. This is not a liquidity problem!
Why would private investment funds want to get into such a deal?
Only if they smell blood!
And, where would this smell of blood come from? It could come from two places: first, if the probability of the improving economy were high enough to cause these private investors to believe that their speculation on these assets has a fair chance of turning out favorably; and second, these investors believe that the government is providing them a rich enough protection of their money to make it worthwhile to commit to such a speculation.
These private investment funds will not purchase these assets as a public service. Thus, they will only purchase assets if they believe that they can earn a bunch of money, because it is a risky investment. Thus, they either have to see the opportunity to make a lot of money or to believe that they are sufficiently protected on the down side to take a chance.
The two issues for the public on the P-PIP are these: first, is the government, once again, giving away a lot of loot to the ‘bad guys’ in the financial community; and second, is the government providing protection on the down-side that will cost the tax payer a lot of money in the future if P-PIP doesn’t work.
But there are still several other issues hanging around. For one, the success of P-PIP depends upon the economic recovery beginning later this year as Chairman Bernanke has projected. For another, the success of P-PIP depends upon the willingness of the financial institutions that now hold the “toxic” assets—whoops—the “legacy” assets, to begin lending once they are able to dispose of these assets. And, the success of the P-PIP depends upon the ability of existing managements to really turn their businesses around (see my post of March 23, 2009, “A Lesson from AIG for the Bank Bailout Plan”, http://maseportfolio.blogspot.com/), a possibility of which we are not yet certain. And, there are more.
As is obvious, I still have concerns about policymakers (as I have had for the past 18 months or so) and whether or not they are attacking the correct problems. In the case of the P-PIP, if they are fighting a liquidity problem I fear that the program will not be very successful. We have a solvency problem and a solvency problem, by its very nature involves a concern about capital adequacy. In my mind, the capital problem is going to have to be faced, one way or another, before we get out of this crisis. The sooner we realize this and attempt to do something about it, the better off we will all be.
The preliminary judgment is that if the problem is a liquidity problem then P-PIP will be an adequate solution. If the problem is a solvency problem then P-PIP will probably not do the job.
Unfortunately, this debate has gone on for a long time…going back to at least December 2007 when the Federal Reserve initiated its Term Auction Facility (TAF). The Fed’s action at that time was an effort to relieve pressures on the banking system by providing a more direct and more liquid approach (than borrowing at the discount window) toward getting short-term funds to the banks that needed liquidity. Additional efforts have been made since then to provide liquidity for different sectors of the financial markets.
The crucial issue connected with a liquidity crisis is addressed in the first sentence of the last paragraph. A “liquidity crisis” by its very nature is a short-term phenomenon. To say that the debate has gone on for a long time is to confirm that the “crisis” we are in is NOT a liquidity crisis.
A liquidity crisis occurs when some kind of shock hits short term financial markets. The “shock” usually takes the form of a new piece of information that is contrary to the current beliefs held by the participants in these markets. A classic example is the situation that revolved around the Penn Central Railroad and the commercial paper market. Because of financial problems at Penn Central the rating given to Penn Central’s commercial paper was revised downward. This revision shocked the commercial paper market and the market basically closed down. The reason was that if the Penn Central rating needed to be lowered, the question became “what other commercial paper ratings needed to be lowered?” The buy-side left the market. Hence, the “liquidity crisis.”
Since borrowers in the commercial paper market could not roll-over their paper, they had to go into the commercial banks and draw on their back-up lines of credit. The problem then fell to the banking system. And, if the banks tried to sell short-term securities to get funds for to honor the lines of credit this would cause security prices to plummet.
The Federal Reserve responded in classic central bank style by opening the discount window, supplying sufficient liquidity to the banks that needed funds to support lines of credit. The banks were able to honor the back-up lines of credit without having to sell securities and the commercial paper market was given the time to access the information on borrowers in the commercial paper market and the buyers returned and the market stabilized.
The point of this is that a “liquidity crisis” is a short-run problem. The crisis occurs because market participants get some information that is not consistent with what they had formerly believed. They need to process the new information and until they do, the buy-side of the market usually disappears. The solution to this problem is for the central bank to supply sufficient liquidity to the market so that the participants have time to process the new information. Liquidity problems usually last only a few weeks.
Solvency problems are of a completely different nature. And, as I have written about over the past year or so, resolving solvency problems take a long, long time. And, with solvency problems it is not an issue of providing liquidity to the market so that assets can get sold. Solvency problems have to do with charging off book values to reflect the underlying economic values of assets. Yes, there is uncertainty with respect to what is the underlying economic value of the assets, but that is why time is needed and cannot be hurried along.
There is only one way to hurry time along in issues relating to solvency and that is to charge off the asset, or at least charge off a major part of the asset. The problem is that banks, and other institutions, don’t like to rush this process. They want to see how the situation with respect to the asset can be worked out, what can be recovered, and whether or not they can hold onto the asset long enough so that economic conditions can improve which will lead to higher asset values. This is not a liquidity problem!
Why would private investment funds want to get into such a deal?
Only if they smell blood!
And, where would this smell of blood come from? It could come from two places: first, if the probability of the improving economy were high enough to cause these private investors to believe that their speculation on these assets has a fair chance of turning out favorably; and second, these investors believe that the government is providing them a rich enough protection of their money to make it worthwhile to commit to such a speculation.
These private investment funds will not purchase these assets as a public service. Thus, they will only purchase assets if they believe that they can earn a bunch of money, because it is a risky investment. Thus, they either have to see the opportunity to make a lot of money or to believe that they are sufficiently protected on the down side to take a chance.
The two issues for the public on the P-PIP are these: first, is the government, once again, giving away a lot of loot to the ‘bad guys’ in the financial community; and second, is the government providing protection on the down-side that will cost the tax payer a lot of money in the future if P-PIP doesn’t work.
But there are still several other issues hanging around. For one, the success of P-PIP depends upon the economic recovery beginning later this year as Chairman Bernanke has projected. For another, the success of P-PIP depends upon the willingness of the financial institutions that now hold the “toxic” assets—whoops—the “legacy” assets, to begin lending once they are able to dispose of these assets. And, the success of the P-PIP depends upon the ability of existing managements to really turn their businesses around (see my post of March 23, 2009, “A Lesson from AIG for the Bank Bailout Plan”, http://maseportfolio.blogspot.com/), a possibility of which we are not yet certain. And, there are more.
As is obvious, I still have concerns about policymakers (as I have had for the past 18 months or so) and whether or not they are attacking the correct problems. In the case of the P-PIP, if they are fighting a liquidity problem I fear that the program will not be very successful. We have a solvency problem and a solvency problem, by its very nature involves a concern about capital adequacy. In my mind, the capital problem is going to have to be faced, one way or another, before we get out of this crisis. The sooner we realize this and attempt to do something about it, the better off we will all be.
Monday, March 23, 2009
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.
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.
Wednesday, February 11, 2009
The Three Problems We Face: Debt, Debt, and Debt!
The focus is wrong. The focus is on the demand side of the economy. As John Maynard Keynes argued, “most practical men are indeed in thrall to the ideas of some long dead economist”…and that long dead economist is John Maynard Keynes. Niall Ferguson refers to the policy makers of today as “born again Keynesians”! And, so the focus remains on stimulating demand.
As a consequence there seems to be a disconnect between what the policy makers are producing in terms of stimulus and bailout and what others, financial markets and individual consumers and families, are experiencing. The debt overhang is stifling everything and this must be corrected before the contraction can be stopped.
This makes the problem in the economy a “supply” problem and not a problem of demand. It is a supply problem because the response to excessive amounts of debt is to save and to reduce leverage. And, this delevering is a cumulative process and either must be overcome by massive inflation…or, it must work itself out.
The explosion of credit is like a house of cards…with the underlying danger being that once the house begins to collapse…the whole house is affected. Given the incentives created by Bush43, the credit pyramid grew. The increases in government debt and the excessively low interest rates maintained by the Greenspan Fed set the standard for the day. And, the private sector followed…the private sector took on more and more risk…and financed their riskier positions with more and more leverage. The whole credit structure became shakier and shakier.
The problem with a house of cards is that once one of the cards on a lower level is removed…the whole house can come down. Experience teaches us that some portions of the house may not collapse…but, if the card removed is at the base of the house…it will likely be the case that a large amount of the house will fall…
The card that was pulled out of the house of cards this time was housing finance. As we know now the subprime market can be identified as the place where the collapse began. But, this level of finance supported a large component of the house of credit in the form of mortgage-backed securities and then other derivative securities and tools that used this base of mortgages as the foundation of the structure. And, the house began to fall.
Of course, we are waiting for other parts of the mortgage house to fall…those connected with the next wave of interest rate re-pricings connected with Alt-A mortgages and options mortgages that will be taking place over the next 18 months or so. And, this does not include other consumer debt like equity lines, credit cards, car loans and so forth. It also does not include the collapse of the banking system and other components of the finance industry.
As we have seen the collapse in the housing market has spread to other areas of the financial market. Contagion is the word to describe this spread. And, the problem has become a world wide problem with problems in financial institutions and beyond throughout the developed world and into the emerging nations.
What is the response to the existence of too much debt?
Well, there are two. The first response is to create inflation. Pour money into the system and artificially create spending so that resources are put back to work…eventually creating sufficient demand so that prices begin rising again. This is the Keynesian way…reduce the real value of the debt outstanding. And, the only way to do this is by “printing money.” If the banking system seems to be clogged up…why then let the Federal government begin to spend…finance the spending by selling Treasury securities…but sell the debt directly to the Federal Reserve where the central bank will just give the Treasury Department a demand deposit at some commercial bank. That is the demand side response.
The other response to the fact that there is too much debt is for people to pull back their expenditures…withdraw from the spending stream…and pay down debt in whatever way they can. This is what is happening now and this has been called historically a debt/deflation. It is basically the process of delevering the economy so that economic units can return to reasonable debt levels on their balance sheet.
Unless people come to believe that the government is going to create a substantial enough inflation to reduce the “real” value of their debt to reasonable levels…they will not stop their attempt to get their lives back in order with a reduced amount of debt on their balance sheets. This is why this process is a cumulative one…a process that eventually must work itself out before the economy bottoms out and a return to growth can occur.
One of solution to this overhang is to write down the debt. I dealt with this issue in my post of February 4, 2009, “Two Painful Proposals to Reduce Our Excess Debt,” http://seekingalpha.com/article/118475-two-painful-proposals-to-reduce-our-excess-debt, so I won’t go into it further here. A plan like this is politically difficult because writing down the debt of those that over-extended themselves looks like we are bailing out the undisciplined or the scoundrels at the expense of the prudent and honest. Such an appearance carries with it severe political risks.
However, if the debt levels have to be reduced at some time…this overhang of excessive debt is going to have to be worked out one way or another. Half-way plans are not going to work. (See my post of February 9, 2009, “Obama Stimulus Plan: Bailout or Wimp Out?”, http://seekingalpha.com/article/119347-obama-stimulus-plan-bailout-or-wimp-out.) The government in Washington, D. C. is going to have to bite-the-bullet sometime…the question is just whether they are going to do it now…or do it later when things get worse.
And, let me just re-enforce my argument of above. Ultimately, this is a supply side problem…not a demand side problem. The attempt to pull off a demand side victory hangs on the balance of when inflation can be restarted and how much inflation can be generated to significantly reduce the “real” value of the debt.
The problem with this effort, however, is that an inflationary environment is one in which the incentive is to add on more debt…just what we are trying to get away from. Hasn’t the experience of the 2000s convinced us that this is not what we want to do?
The problem with supply side solutions is that they take time and are not as showing as are demand side “stimulus plans.” Also, they tend to be directed toward those individuals and organizations that are under a dark cloud these days. For example, there is the proposal put forward by Bob Barro to eliminate the corporate income tax. (See “Government Spending is No Free Lunch,” http://online.wsj.com/article/SB123258618204604599.html?mod=todays_us_opinion.)
The stock market did not respond well to the initial showing of the Obama Bank Bailout plan presented by Tim Geithner yesterday. To me this plan is sending mixed signals…mainly because it is on the tepid side. We have a demand side plan…the Obama Stimulus Plan…and we have a plan to cushion the problem of excessive debt…the Obama Bank Bailout Plan. The two plans don’t seem to mesh and give off the signal that the administration has not yet got its act together. The question then becomes…will it get its act together?
The debt issue must be dealt with…and firmly. At this time…firmly is not a word I would use.
As a consequence there seems to be a disconnect between what the policy makers are producing in terms of stimulus and bailout and what others, financial markets and individual consumers and families, are experiencing. The debt overhang is stifling everything and this must be corrected before the contraction can be stopped.
This makes the problem in the economy a “supply” problem and not a problem of demand. It is a supply problem because the response to excessive amounts of debt is to save and to reduce leverage. And, this delevering is a cumulative process and either must be overcome by massive inflation…or, it must work itself out.
The explosion of credit is like a house of cards…with the underlying danger being that once the house begins to collapse…the whole house is affected. Given the incentives created by Bush43, the credit pyramid grew. The increases in government debt and the excessively low interest rates maintained by the Greenspan Fed set the standard for the day. And, the private sector followed…the private sector took on more and more risk…and financed their riskier positions with more and more leverage. The whole credit structure became shakier and shakier.
The problem with a house of cards is that once one of the cards on a lower level is removed…the whole house can come down. Experience teaches us that some portions of the house may not collapse…but, if the card removed is at the base of the house…it will likely be the case that a large amount of the house will fall…
The card that was pulled out of the house of cards this time was housing finance. As we know now the subprime market can be identified as the place where the collapse began. But, this level of finance supported a large component of the house of credit in the form of mortgage-backed securities and then other derivative securities and tools that used this base of mortgages as the foundation of the structure. And, the house began to fall.
Of course, we are waiting for other parts of the mortgage house to fall…those connected with the next wave of interest rate re-pricings connected with Alt-A mortgages and options mortgages that will be taking place over the next 18 months or so. And, this does not include other consumer debt like equity lines, credit cards, car loans and so forth. It also does not include the collapse of the banking system and other components of the finance industry.
As we have seen the collapse in the housing market has spread to other areas of the financial market. Contagion is the word to describe this spread. And, the problem has become a world wide problem with problems in financial institutions and beyond throughout the developed world and into the emerging nations.
What is the response to the existence of too much debt?
Well, there are two. The first response is to create inflation. Pour money into the system and artificially create spending so that resources are put back to work…eventually creating sufficient demand so that prices begin rising again. This is the Keynesian way…reduce the real value of the debt outstanding. And, the only way to do this is by “printing money.” If the banking system seems to be clogged up…why then let the Federal government begin to spend…finance the spending by selling Treasury securities…but sell the debt directly to the Federal Reserve where the central bank will just give the Treasury Department a demand deposit at some commercial bank. That is the demand side response.
The other response to the fact that there is too much debt is for people to pull back their expenditures…withdraw from the spending stream…and pay down debt in whatever way they can. This is what is happening now and this has been called historically a debt/deflation. It is basically the process of delevering the economy so that economic units can return to reasonable debt levels on their balance sheet.
Unless people come to believe that the government is going to create a substantial enough inflation to reduce the “real” value of their debt to reasonable levels…they will not stop their attempt to get their lives back in order with a reduced amount of debt on their balance sheets. This is why this process is a cumulative one…a process that eventually must work itself out before the economy bottoms out and a return to growth can occur.
One of solution to this overhang is to write down the debt. I dealt with this issue in my post of February 4, 2009, “Two Painful Proposals to Reduce Our Excess Debt,” http://seekingalpha.com/article/118475-two-painful-proposals-to-reduce-our-excess-debt, so I won’t go into it further here. A plan like this is politically difficult because writing down the debt of those that over-extended themselves looks like we are bailing out the undisciplined or the scoundrels at the expense of the prudent and honest. Such an appearance carries with it severe political risks.
However, if the debt levels have to be reduced at some time…this overhang of excessive debt is going to have to be worked out one way or another. Half-way plans are not going to work. (See my post of February 9, 2009, “Obama Stimulus Plan: Bailout or Wimp Out?”, http://seekingalpha.com/article/119347-obama-stimulus-plan-bailout-or-wimp-out.) The government in Washington, D. C. is going to have to bite-the-bullet sometime…the question is just whether they are going to do it now…or do it later when things get worse.
And, let me just re-enforce my argument of above. Ultimately, this is a supply side problem…not a demand side problem. The attempt to pull off a demand side victory hangs on the balance of when inflation can be restarted and how much inflation can be generated to significantly reduce the “real” value of the debt.
The problem with this effort, however, is that an inflationary environment is one in which the incentive is to add on more debt…just what we are trying to get away from. Hasn’t the experience of the 2000s convinced us that this is not what we want to do?
The problem with supply side solutions is that they take time and are not as showing as are demand side “stimulus plans.” Also, they tend to be directed toward those individuals and organizations that are under a dark cloud these days. For example, there is the proposal put forward by Bob Barro to eliminate the corporate income tax. (See “Government Spending is No Free Lunch,” http://online.wsj.com/article/SB123258618204604599.html?mod=todays_us_opinion.)
The stock market did not respond well to the initial showing of the Obama Bank Bailout plan presented by Tim Geithner yesterday. To me this plan is sending mixed signals…mainly because it is on the tepid side. We have a demand side plan…the Obama Stimulus Plan…and we have a plan to cushion the problem of excessive debt…the Obama Bank Bailout Plan. The two plans don’t seem to mesh and give off the signal that the administration has not yet got its act together. The question then becomes…will it get its act together?
The debt issue must be dealt with…and firmly. At this time…firmly is not a word I would use.
Sunday, February 8, 2009
Bail Out or Wimp Out?
The Obama administration is going to have to make a decision soon…is it going to try and commit to a program that will actually do something for banking and other financial institutions or is it going to extend the waffling on this issue that began last fall?
People in the administration say that something has to be done…and it has to be done fast…but, there is this problem about buying assets from these troubled institutions…we don’t know what price we should pay for them.
All I can advise them in terms of setting prices is…do the very best you can…at this moment in time! Yes, there is great uncertainty as to the prices of many or most of these assets…but, that is not the issue at this stage of the game.
Beginning in December 2007, things changed in Washington, D. C. The Federal Reserve System did something that had never been done before. It innovated! It created the Term Auction Facility; it introduced a dollar swap facility with other central banks around the world; as well as the Primary Dealer credit facility. Since that time the Fed has developed several other new ways to put dollars into the banking system.
In March 2008, the Fed and the Treasury engineered the Bear Stearns takeover and in September 2008 the world changed even more as Lehman Brothers was allowed to fail and AIG was essentially nationalized. The American model of financial markets and institutions would never be the same again.
And, things continued on from there with the $700 billion bailout bill passed by Congress and the efforts of Treasury Secretary Paulson and Fed Chairman Bernanke to sooth markets and get credit flowing once again.
The Obama administration has taken over from Bush43 and argued that with the crisis at hand…something must be done to avoid a “catastrophe”…in the words of President Obama himself.
My point is…it is not time to waffle on trying to save the banking and financial system from the bad assets they have on the books.
The government IS involved…up to its neck and beyond! The Obama stimulus package is an attempt to stimulate the economy. But, in my estimation, it will not do a lot. If the current size of the package is, being generous, around $850 billion and the multiplier of this spending is between 0.4 and 0.6 (see my post of January 26, 2009, http://seekingalpha.com/article/116414-what-will-be-the-impact-of-obama-s-stimulus-plan) then the effect on the economy will be between $340 billion and $510 billion of additional output. Not a great “bang-for-the-buck”, but, we are told, it is the effort that is so important at this particular moment.
There will be more to come…promises the Obama administration. Additional programs need to follow this package. More dollars need to be thrown at the problem.
Still, there is the problem of bad assets. What is going to be done with all the toxic waste that is now held by our financial institutions?
Well, since there is way too much debt in the financial system, there could be a massive write down of assets…the banks and other financial institutions absorbing the hair cut. (See my post of February 4, 2009, http://seekingalpha.com/article/118475-two-painful-proposals-to-reduce-our-excess-debt.) At this stage of the effort there does not seem to be a lot of interest in this approach so we probably should put this idea on the back burner for another time.
Thus, if something has to be done…along with the $850 billion stimulus plan…let the Federal Government buy these toxic assets from the banks and other financial institutions. Many estimates place the difference between what these institutions value the assets on their books and the price that the Federal Government would buy them at is a minimum of $2.0 trillion. If the banks and other financial institutions took this kind of a hit to their balance sheets…many of the organizations would be bankrupt…kaput…out-of-business.
My question to this is…aren’t they bankrupt…kaput…out-of-business…already?
The issue is that many of these institutions are large…would require a lot of management talent to run them…and what about the shareholders? Well, the shareholders have no rights…because there is no equity left in these institutions. Let us recognize this and get on with it. Many of these institutions are large…which means there is a major need for management talent. But…why should the managements that got these institutions into the positions they now are in be expected to get them straightened out and healthy again?
This reminds me of many of the “dog-and-pony shows” that I observed during the S & L crisis twenty-some years ago. In these “shows” the existing management would get up in front of potential investors and say…”Yes, we have run this bank for the past 20-some years…and, yes, we basically bankrupted the band…but…WE HAVE LEARNED our lessons! Give us $100.0 million so that we can turn this bank around and make it into something you will be proud of!”
In most cases, the potential investors dug into their pockets and forked over the $100.0 million. Few, if any, of the “born again” managements were successful in turning their institutions around. Oh, well…live and learn!
Unfortunately, the same thing seems to be in play here. The managements that got us here claim that they can be the managements that get us back to health again. What did P. T. Barnum say?
A number of these banks and other financial institutions appear to be insolvent…their managements are hanging on by their finger nails…the credit system is not functioning as it might…and the government is dawdling.
Buy the assets. Remove the shareholders…they had their turn to oversee these institutions. Take over these banks…and see that the banks get new top managements. If you are going to do it…then, do it! Cut out the half-fast programs. Postponing government action only creates more uncertainty, and, as we know too well, the market hates uncertainty.
The Obama campaign called for change in Washington, D. C. It said an Obama administration would change things…action would be taken. Well, action needs to be taken. Obama was right the other evening when he said that his administration will be remembered for stopping the economic downturn and getting things moving upwards again…or not. Not much else is going to matter. And, whether or not you agree with the policies and programs that are being presented…and to a large extent I don’t…I do agree with the general feeling that if you are going to fail…or succeed…you will have to do it in a very committed way. Half-measures are bound to fail…if for no other reason than they won’t raise the confidence of the nation.
So, Mr. Obama, come out with a strong plan for taking care of these toxic assets and come out with a strong plan for removing the chaff from the banking system. Half-way measures are not going to resolve the issue because there will still need to be further adjustments sometime down the road. Be strong! All you can do is what you think is best for the country!
People in the administration say that something has to be done…and it has to be done fast…but, there is this problem about buying assets from these troubled institutions…we don’t know what price we should pay for them.
All I can advise them in terms of setting prices is…do the very best you can…at this moment in time! Yes, there is great uncertainty as to the prices of many or most of these assets…but, that is not the issue at this stage of the game.
Beginning in December 2007, things changed in Washington, D. C. The Federal Reserve System did something that had never been done before. It innovated! It created the Term Auction Facility; it introduced a dollar swap facility with other central banks around the world; as well as the Primary Dealer credit facility. Since that time the Fed has developed several other new ways to put dollars into the banking system.
In March 2008, the Fed and the Treasury engineered the Bear Stearns takeover and in September 2008 the world changed even more as Lehman Brothers was allowed to fail and AIG was essentially nationalized. The American model of financial markets and institutions would never be the same again.
And, things continued on from there with the $700 billion bailout bill passed by Congress and the efforts of Treasury Secretary Paulson and Fed Chairman Bernanke to sooth markets and get credit flowing once again.
The Obama administration has taken over from Bush43 and argued that with the crisis at hand…something must be done to avoid a “catastrophe”…in the words of President Obama himself.
My point is…it is not time to waffle on trying to save the banking and financial system from the bad assets they have on the books.
The government IS involved…up to its neck and beyond! The Obama stimulus package is an attempt to stimulate the economy. But, in my estimation, it will not do a lot. If the current size of the package is, being generous, around $850 billion and the multiplier of this spending is between 0.4 and 0.6 (see my post of January 26, 2009, http://seekingalpha.com/article/116414-what-will-be-the-impact-of-obama-s-stimulus-plan) then the effect on the economy will be between $340 billion and $510 billion of additional output. Not a great “bang-for-the-buck”, but, we are told, it is the effort that is so important at this particular moment.
There will be more to come…promises the Obama administration. Additional programs need to follow this package. More dollars need to be thrown at the problem.
Still, there is the problem of bad assets. What is going to be done with all the toxic waste that is now held by our financial institutions?
Well, since there is way too much debt in the financial system, there could be a massive write down of assets…the banks and other financial institutions absorbing the hair cut. (See my post of February 4, 2009, http://seekingalpha.com/article/118475-two-painful-proposals-to-reduce-our-excess-debt.) At this stage of the effort there does not seem to be a lot of interest in this approach so we probably should put this idea on the back burner for another time.
Thus, if something has to be done…along with the $850 billion stimulus plan…let the Federal Government buy these toxic assets from the banks and other financial institutions. Many estimates place the difference between what these institutions value the assets on their books and the price that the Federal Government would buy them at is a minimum of $2.0 trillion. If the banks and other financial institutions took this kind of a hit to their balance sheets…many of the organizations would be bankrupt…kaput…out-of-business.
My question to this is…aren’t they bankrupt…kaput…out-of-business…already?
The issue is that many of these institutions are large…would require a lot of management talent to run them…and what about the shareholders? Well, the shareholders have no rights…because there is no equity left in these institutions. Let us recognize this and get on with it. Many of these institutions are large…which means there is a major need for management talent. But…why should the managements that got these institutions into the positions they now are in be expected to get them straightened out and healthy again?
This reminds me of many of the “dog-and-pony shows” that I observed during the S & L crisis twenty-some years ago. In these “shows” the existing management would get up in front of potential investors and say…”Yes, we have run this bank for the past 20-some years…and, yes, we basically bankrupted the band…but…WE HAVE LEARNED our lessons! Give us $100.0 million so that we can turn this bank around and make it into something you will be proud of!”
In most cases, the potential investors dug into their pockets and forked over the $100.0 million. Few, if any, of the “born again” managements were successful in turning their institutions around. Oh, well…live and learn!
Unfortunately, the same thing seems to be in play here. The managements that got us here claim that they can be the managements that get us back to health again. What did P. T. Barnum say?
A number of these banks and other financial institutions appear to be insolvent…their managements are hanging on by their finger nails…the credit system is not functioning as it might…and the government is dawdling.
Buy the assets. Remove the shareholders…they had their turn to oversee these institutions. Take over these banks…and see that the banks get new top managements. If you are going to do it…then, do it! Cut out the half-fast programs. Postponing government action only creates more uncertainty, and, as we know too well, the market hates uncertainty.
The Obama campaign called for change in Washington, D. C. It said an Obama administration would change things…action would be taken. Well, action needs to be taken. Obama was right the other evening when he said that his administration will be remembered for stopping the economic downturn and getting things moving upwards again…or not. Not much else is going to matter. And, whether or not you agree with the policies and programs that are being presented…and to a large extent I don’t…I do agree with the general feeling that if you are going to fail…or succeed…you will have to do it in a very committed way. Half-measures are bound to fail…if for no other reason than they won’t raise the confidence of the nation.
So, Mr. Obama, come out with a strong plan for taking care of these toxic assets and come out with a strong plan for removing the chaff from the banking system. Half-way measures are not going to resolve the issue because there will still need to be further adjustments sometime down the road. Be strong! All you can do is what you think is best for the country!
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