The economy is recovering. The areas that seem to show the most life are those sectors that have had sufficient debt relief so as to be able to move forward. The big banks are moving out in a very robust fashion, just how robust we will begin to hear this week. The auto industry seems to be moving ahead, albeit a little more slowly than the big banks. And, there are other areas that show signs of moving forward, the health industry and firms in the information technology industry.
The big cloud hanging over all of this is the debt that still is outstanding in many sectors of the economy. The problem with debt is that it just won’t go away. Regardless of any adjustments made to who owes what to whom, if there is debt outstanding, someone has to pay for it in some fashion.
The big banks were saved, but who picked up the tab for the bailout? The taxpayer did, or, at least the taxpayer has footed the bill pending a potential Obama tax on the banks to “recover” some of the bailout monies.
Who saved the auto industry and subsequently holds the IOU for the rescue? A large part of the financial restructuring came at the expense of those that had provided credit or equity funds to the car companies. And, the federal government also paid a share.
If homeowners got relief from their mortgage and consumer debt, who would pay the bill? Shareholders of the bank, holders of mortgage-backed securities, and the federal government. (You might check out this little piece by Peter Eavis in today’s Wall Street Journal: http://online.wsj.com/article/SB20001424052748704081704574652660161217386.html#mod=todays_us_money_and_investing.)
And, what about the debt that is related to commercial real estate lending? Shareholders of banks, holders of commercial mortgage vehicles, and the federal government.
Then we move to the financial problems of the states. Recent information points to the fact that 36 states in the United States are having financial problems and these could lead to deficits in the state budgets of around $350 billion this year and next. Where is the money going to come to pay for these shortfalls? States have already attempted to sell off properties, outsource functions to the private sector, and even turn some things over to the federal government.
Part of the problem here is that the tax base in most states has collapsed as unemployment and under-employment have risen, as property values have fallen, and as business earnings have collapsed. Rating agencies have begun to lower credit ratings on some states. The best guess is that ratings will drop on many other states before the year is over.
And, what about local and municipal governments? Same problems.
And, then, what about the federal government? Without totaling up the bill for the problems mentioned above, let alone the escalation of wars here and there all over the world, health care reform, and some kind of energy bill, many expect federal deficits over the next ten years to total $15 to $18 trillion!
Who is going to purchase all or almost all of this debt? China?
What I find scary is that our “friends” are voicing concern in different ways. For example, the Financial Times this morning carries the opinion piece of Gideon Rachman titled “Bankruptcy Could Be Good for America”: http://www.ft.com/cms/s/0/a8486284-fee9-11de-a677-00144feab49a.html. The point Rachman makes is that the Brics, Brazil, Russia, India, and China all went through economic reform before they “broke out” into their current ascendency. Brazil’s reform came in the 1990s, Russia defaulted in the late 1990s, India embraced economic reform in 1991, and China moved to a new mindset in the early 1990s. “Those much discussed emerging powers, the Brics, all needed a fiscal crisis to set them on the road to economic reform and national resurgence. America may one day be lucky enough to experience its very own national fiscal crisis.”
Even if we print money to pay for the federal debt, as the Federal Reserve has done over the last year or so, (the monetary base rose 23% from December 2008 to December 2009, and rose by 101% over the previous 12 months) someone, somewhere will pay this debt in terms of a reduction in purchasing power.
Need I mention that since January 1961 the purchasing power of one dollar has dropped to roughly $0.15. Inflating the United States government out of its debts has a long, post-World War II history.
Might this process of “printing money” continue?
Seems like a lot of people believe that it will. For one there is the problem of rising long term interest rates. More and more worry is being expressed about the expected increases. Why? Well most analysts believe that the Federal Reserve has helped to keep long term interest rates lower than they would have been in order to provide liquidity to the financial markets and to support the mortgage market. On January 6, 2010, the Fed held on their balance sheet $777 billion in U. S. Treasury securities, $160 billion in Federal Agency debt securities, and $909 billion in Mortgage-backed securities.
This totals $1.846 trillion in securities held by the central bank! The concern is that in the last week of August, 2008, the Fed had provided only $741 billion in funds to the banking system through some kind of market or auction based transaction.
How much affect these purchases have had on keeping long term interest rates lower than they would have been is currently being debated. What is not in question is that, sooner or later, interest rates are going to begin to rise, first because the Fed’s artificial support will be removed, but rates will rise as the economy begins to improve, further pressure will be put on rates as issuers of bonds race to place debt before the rise takes place (See “Rate Rise Fears Spark Rush to Issue Bonds: http://www.ft.com/cms/s/0/6f46f226-fef2-11de-a677-00144feab49a.html), and as inflationary expectations are incorporated into bond yields.
How fast will the Fed allow interest rates to rise because rising interest rates will slow down economic recovery. Also, the Fed has created another problem by keeping short term interest rates so low. Not only have these low rates created arbitrage possibilities for domestic investment, borrow short term money in the 35 to 65 basis point range and invest in 10-year government bonds at 3.50% to 3.80% but also for the international carry trade. It is argued that the Fed cannot allow rates to go up too fast or big financial institutions and other investors will get trapped in losses that will not help the economic recovery.
The point of all this discussion is that any “exit” strategy that the Fed is planning to reduce the securities held on its balance sheet from current levels to even a level of $1.0 trillion, let alone the $741 billion mentioned above, is already in jeopardy. And, many are arguing that in the face of such overwhelming future deficits, the Fed will be forced to print even more money than it has over the last 17 months.
The problem with debt is that debt, once issued, really does not go away. Someone has to pay for it!
Showing posts with label bank bailouts. Show all posts
Showing posts with label bank bailouts. Show all posts
Tuesday, January 12, 2010
Tuesday, December 15, 2009
Banking, Banks, and the President: Defining the Issues
The side that wins the political battles is usually the one that presents the issues in such a way that the “public” responds to this presentation and goes with them rather than with the “other side.”
There is an election coming up next year and the campaigning has already begun. The battle: whether or not the Democrats are going to be able to maintain a large enough majority in Congress to control the action in Washington, D. C. Already, the Democrats are looking back over their shoulders to 1994 mid-term election and their loss of control of Congress at that time. And, they are scared.
The way to operate in politics is to “frame” important issues in such a way that they will resonate with a majority of the electorate. It takes time for specific issues to “take hold” with the public so the framing effort must be started well in advance of the election. The process of “framing” is moving ahead, full steam.
The economy is obviously going to be an issue. How it is framed will determine the result. It appears that the banking industry is going to play a big role in how the discussion on the
economy evolves. The battle lines: Main Street versus Wall Street. The issues: an unemployment rate of 10% and an underemployment rate at 17-18% versus lots of taxpayer money to bail out the banks and the subsequent profitability of the big banks. A further issue: people losing their homes through foreclosure versus the payment of large bonuses by the big banks to their executives.
Sure the meeting between the President and the heads of the major banks in the United States was a great photo op. But, what did the photo op turn into? Let me just say that a headline like “Bankers Put Obama on Hold” accompanied by a picture of the President at his desk holding a phone does not create a very favorable image of the bankers (see the article by Andrew Ross Sorkin in the New York Times: http://www.nytimes.com/2009/12/15/business/15sorkin.html?_r=1).
Paul Volcker, former Chairman of the Board of Governors of the Federal Reserve System, is still a hero to many people, myself included, and is perhaps the most respected person in finance in the world today. He stated very bluntly in West Sussex, England this week that the bankers just didn’t get it. Great headlines!
In debates like this it doesn’t always matter who is right and who is wrong. We have seen over and over again that in economics, identifying the cause and effect of an economic situation is so difficult and the lags between the cause and the effect are so long, that explaining a situation to the public in terms that they understand is almost impossible.
Here I am specifically writing about the run-up to the financial collapse of 2008. To me the causes of this collapse go back to the almost 50 years of inflationary finance perpetrated by the United States government, Republican and Democratic alike, on the American people. This includes the huge deficits run up by the federal government since 9/11 and the inexcusable monetary ease that kept real interest rates negative for two to three years in the 2002-2005 period. The financial bubbles that resulted in housing and the stock market this decade produced the conditions that led to the subsequent events.
An economy with an inflationary bias is ideal for the evolution of financial innovation. It is ideal for leveraging up the balance sheet. It is ideal for assuming more and more risk.
It is difficult, however, to explain this cause and effect to the public.
Financial innovation looks like greed run amok. Assuming more and more risk looks like greed run amok. And, excessive amounts of leverage looks like greed run amok.
But, what about the government policy makers that created the incentives that made financial innovation valuable? What about those that contributed to the inflation that made high degrees of leverage worthwhile and edgy risk taking more attractive?
The connection is very difficult to put into sound bites and win the hearts and minds of voters.
In terms of financial regulation? My belief is that banks, especially the big banks have moved beyond the recent financial collapse. Congress and the regulators are always fighting the last war. The goal of Congress and the regulators is to not let the events of 2008 and 2009 happen again.
Guess what? The events of 2008 and 2009 will not happen again. The banks have moved beyond that. The reformed regulations will probably hurt the smaller banks much more than the larger banks. The smaller banks are still the ones dealing with the past, the questionable commercial real estate loans, the residential mortgages that are in arrears or are not paying at all, the consumer credit, the credit of state and local governments and so on and so on.
But, the big banks. They are already into 2010 and 2011 and beyond! More on this in another post.
This is why the banking industry must be careful at this time. In a real sense, Volcker is right; the bankers just don’t get it!
They can’t afford to look as if they are making the President look silly. They can’t afford to make themselves look like they are “fat cats.” Whoops, that is what the President called them Sunday night and it is all over the country. The bankers can’t afford to look as if they are staunchly against regulation reform. The bankers can’t look like they don’t care about mortgage foreclosures, or small-business loans, or getting people back to work.
The issues are being “framed” right now. The bankers cannot put themselves in a position to be characterized as “Scrooge” while the Obama administration comes on as “Tiny Tim.”
There is an election coming up next year and the campaigning has already begun. The battle: whether or not the Democrats are going to be able to maintain a large enough majority in Congress to control the action in Washington, D. C. Already, the Democrats are looking back over their shoulders to 1994 mid-term election and their loss of control of Congress at that time. And, they are scared.
The way to operate in politics is to “frame” important issues in such a way that they will resonate with a majority of the electorate. It takes time for specific issues to “take hold” with the public so the framing effort must be started well in advance of the election. The process of “framing” is moving ahead, full steam.
The economy is obviously going to be an issue. How it is framed will determine the result. It appears that the banking industry is going to play a big role in how the discussion on the
economy evolves. The battle lines: Main Street versus Wall Street. The issues: an unemployment rate of 10% and an underemployment rate at 17-18% versus lots of taxpayer money to bail out the banks and the subsequent profitability of the big banks. A further issue: people losing their homes through foreclosure versus the payment of large bonuses by the big banks to their executives.
Sure the meeting between the President and the heads of the major banks in the United States was a great photo op. But, what did the photo op turn into? Let me just say that a headline like “Bankers Put Obama on Hold” accompanied by a picture of the President at his desk holding a phone does not create a very favorable image of the bankers (see the article by Andrew Ross Sorkin in the New York Times: http://www.nytimes.com/2009/12/15/business/15sorkin.html?_r=1).
Paul Volcker, former Chairman of the Board of Governors of the Federal Reserve System, is still a hero to many people, myself included, and is perhaps the most respected person in finance in the world today. He stated very bluntly in West Sussex, England this week that the bankers just didn’t get it. Great headlines!
In debates like this it doesn’t always matter who is right and who is wrong. We have seen over and over again that in economics, identifying the cause and effect of an economic situation is so difficult and the lags between the cause and the effect are so long, that explaining a situation to the public in terms that they understand is almost impossible.
Here I am specifically writing about the run-up to the financial collapse of 2008. To me the causes of this collapse go back to the almost 50 years of inflationary finance perpetrated by the United States government, Republican and Democratic alike, on the American people. This includes the huge deficits run up by the federal government since 9/11 and the inexcusable monetary ease that kept real interest rates negative for two to three years in the 2002-2005 period. The financial bubbles that resulted in housing and the stock market this decade produced the conditions that led to the subsequent events.
An economy with an inflationary bias is ideal for the evolution of financial innovation. It is ideal for leveraging up the balance sheet. It is ideal for assuming more and more risk.
It is difficult, however, to explain this cause and effect to the public.
Financial innovation looks like greed run amok. Assuming more and more risk looks like greed run amok. And, excessive amounts of leverage looks like greed run amok.
But, what about the government policy makers that created the incentives that made financial innovation valuable? What about those that contributed to the inflation that made high degrees of leverage worthwhile and edgy risk taking more attractive?
The connection is very difficult to put into sound bites and win the hearts and minds of voters.
In terms of financial regulation? My belief is that banks, especially the big banks have moved beyond the recent financial collapse. Congress and the regulators are always fighting the last war. The goal of Congress and the regulators is to not let the events of 2008 and 2009 happen again.
Guess what? The events of 2008 and 2009 will not happen again. The banks have moved beyond that. The reformed regulations will probably hurt the smaller banks much more than the larger banks. The smaller banks are still the ones dealing with the past, the questionable commercial real estate loans, the residential mortgages that are in arrears or are not paying at all, the consumer credit, the credit of state and local governments and so on and so on.
But, the big banks. They are already into 2010 and 2011 and beyond! More on this in another post.
This is why the banking industry must be careful at this time. In a real sense, Volcker is right; the bankers just don’t get it!
They can’t afford to look as if they are making the President look silly. They can’t afford to make themselves look like they are “fat cats.” Whoops, that is what the President called them Sunday night and it is all over the country. The bankers can’t afford to look as if they are staunchly against regulation reform. The bankers can’t look like they don’t care about mortgage foreclosures, or small-business loans, or getting people back to work.
The issues are being “framed” right now. The bankers cannot put themselves in a position to be characterized as “Scrooge” while the Obama administration comes on as “Tiny Tim.”
Tuesday, December 1, 2009
The Secret No One Wants to Tell
The one thing that seems to provide an explanation for a lot of the things going on today is the continued weakness of the banking sector. It explains the actions of the Federal Reserve System. It explains the actions of the Treasury Department. It explains much of the data that are being released. And, it explains much of the behavior of the banking sector, itself.
The secret: the banking sector is a lot weaker than the government is letting on and the government does not want to publically recognize the fact.
The FDIC recently released numbers on the banking industry for the third quarter. Profit-wise, the industry is very skewed. It is skewed toward the larger banks. The results have been summarized this way:
The secret: the banking sector is a lot weaker than the government is letting on and the government does not want to publically recognize the fact.
The FDIC recently released numbers on the banking industry for the third quarter. Profit-wise, the industry is very skewed. It is skewed toward the larger banks. The results have been summarized this way:
- Banks with assets less than $1 billion in assets roughly broke even in the third quarter;
- Banks with assets between $1 billion and $10 billion, on average, lost $3 million apiece;
- Banks with assets in excess of $10 billion recorded an average profit of nearly $42 million each.
The big banks, the banks that the regulators were most concerned with, are reaping a bonanza. And, why not? The Fed is keeping short term interest rates down: financial institutions can borrow for three-months in the range of 20-25 basis points in the commercial paper market and the large CD market; they can borrow for six-months in the 30-65 basis points in the CD market or the Eurodollar market. They can buy Treasury bonds that can yield 330 to 400 basis points. This is a nice spread. Plus these banks are traders and there has been plenty of volatility in the bond market in recent months. And, this does not even include the possibilities that exist in the carry trade.
As Eddy, Clarke's brother-in-law, remarked in the movie “A Christmas Vacation”: “This is the gift that just keeps on giving!”
Why?
Because the Fed is going to keep short term interest rates low for an “extended period” of time.
This effort is just another way to “bail out” the big banks!
But, what about the banks that are smaller than $10 billion in asset size?
Here the commercial banking industry has been given a gift of $1 trillion in excess reserves.
And, what is going on in this part of the banking industry? The FDIC released the third quarter information on problem banks. The total of problem banks in the country is 552, up from 416 at the end of the second quarter. Almost all of these banks are of the smaller variety. Given that 50 banks were closed in the third quarter this means that 186 new banks achieved the honor of being placed on the problem list in the third quarter.
It is estimated that at least one-third of the 552 “problem” banks, or 182, will fail in the next 12 to 18 months. If this is true then the United States will experience 2.5 to 3.5 bank closures a week for the next year to a year-and-a-half. This is slightly below the rate of 3.8 bank closures per week that was achieved in the third quarter. The hope is that this situation won’t get worse.
The path ahead for even those banks that are not on the problem list is treacherous. Real Estate Econometrics released information that the US default rate for commercial mortgages hit 3.4% in the third quarter of 2009. This is a 16-year high. The company also released projections indicating that this default rate could rise to more than 5% in 2011. Many of the banks in the middle tier possess millions of dollars of these loans on their balance sheet, relatively more so than do the big banks.
The huge debt of Dubai and Greece and others hang over this market.
In terms of residential mortgages, the picture does not improve. First American CoreLogic, a real-estate information company, recently released data that indicated that roughly one out of four borrowers is underwater in terms of their mortgages. Even 11% of the borrowers who took out mortgages in 2009 owe more than their home’s value.
The Treasury continues to push mortgage firms and others for loan relief. There is an indication that some borrowers are not really helped by the relief measures already promoted and that many who have been helped still face the possibility of re-default going forward.
And, layoffs continue in large numbers, foreclosures continue to take place at a high rate, and large numbers of bankruptcies, both personal and business, continue to occur. Another fact, out this morning, is that delinquencies on auto loans are on the rise.
And, banks are not really lending in any form. The Federal Reserve continues to pump funds into the banking system, yet commercial banks seem to be very content to accept the funds and just hold onto them in the most riskless way possible. If you don’t make a loan, it won’t turn bad on you. Furthermore, commercial banks face the situation in which the longer term liabilities they had accumulated earlier in the decade are going to be maturing. They will need money to pay off these liabilities without replacing them.
Charles Goodhart, Senior Economic Consultant at Morgan Stanley, writes in the Financial Times that central banks should declare victory in the war against financial collapse and cease their policy of quantitative easing. (See “Deflating the Bubble”, http://www.ft.com/cms/s/0/2b7b26de-ddcd-11de-b8e2-00144feabdc0.html.) He writes, “If the authorities go on blowing up financial markets too much, at some point yet another bubble will develop. The last time the financial bubble burst, the taxpayers got soaked...Certainly, we can never get the timing exactly right, but now does seem the moment to declare victory for (Quantitative Easing) and withdraw.”
That is, unless there is something we don’t know and the government is not telling us, like the extent of the weaknesses that exist within the banking sector.
Tuesday, September 15, 2009
Too much power to too few people: the Lehman debacle.
It is so easy to blame the private sector. And, the government can hide behind “good intentions” and “the public interest.”
For a different view, read the article by John Cochrane and Luigi Zingales who write on “Lehman and the Financial Crisis” in the Wall Street Journal, http://online.wsj.com/article/SB10001424052970203440104574403144004792338.html#mod=todays_us_opinion. The argument is presented here that it was not the failure of Lehman Brothers that set off the financial crisis. It was the panic move by Ben Bernanke and Hank Paulson that resulted in the financial crisis. This mirrors something I wrote last fall on November 16 titled “The Bailout Plan: Did Bernanke Panic?”: http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.
As Cochrane and Zingales write, Fannie Mae and Freddie Mac were taken over on September 7, 2008. Lehman Brothers filed for bankruptcy on September 15. AIG was bailed out on September 16. I believe, as I say in the post above, that everything changed that Tuesday evening when the bailout of AIG was announced.
Bernanke called Paulson on Wednesday September 17. As reported later in the Wall Street Journal, and I quote from my post: The Wall Street Journal article reports that by Wednesday afternoon “Bernanke reached the end of his rope.” He called Paulson and “with an occasional quaver in his voice” he spoke “unusually bluntly” to the Treasury Secretary. Paulson did not move immediately. He had to sleep on it, and on Thursday morning, he committed.
Friday evening Bernanke and Paulson met with Congressional leaders and again I quote from the earlier post: Paulson called the leadership in Congress and asked them to have a meeting with himself and Bernanke on Friday evening. The few members of Congress that talked with the press after that meeting said that Bernanke did most of the talking and “scared the daylights out of everyone.” Bernanke knew his history of the Great Depression and he knew currents events. He was very logical and very articulate. The leaders were told that they had to act and they had to act fast. The plan was to have a bill before Congress on Monday seeking Congressional approval (of both houses) by the following Friday. The Treasury Department had a bill ready (three pages long) by midnight Saturday evening. The price tag - $700 billion. Why $700 billion? Because it was a big number!
But, Cochrane and Zingales state that on Monday September 22, “bank credit-default swap (CDS) spreads were at the same level as on September 12…The Libor-OIS spread—which captures the perceived riskiness of short-term interbank lending—rose only 18 points the day of Lehman’s collapse, while it shot up more than 60 points from September 23 to September 25, after the TARP testimony.” That is Bernanke and Paulson appeared in front of Congress on September 23 and 24 and gave speeches on the need for the TARP funding.
The reason for the subsequent market activity? Cochrane and Zingales claim that “In effect, these speeches amounted to ‘The financial system is about to collapse. We can’t tell you why. We need $700 billion. We can’t tell you what we’re going to do with it.” The authors conclude with “That’s a pretty good way to start a financial crisis.”
The conclusion: putting all the blame on the Lehman failure takes the focus off the main story. The main story is not that there was just one policy failure at this time. The main story is that the government continued to screw up after creating the financial environment and credit inflation that resulted in the asset bubble of earlier in the decade. It continued to screw up in the series of band aids that the Fed and the Treasury imposed on the economy and financial system beginning in December 2007. And, in doing so, the government continued to build up the moral hazard in existence in the system and continued to expand the federal debt outstanding to met ever larger needs for financial bailouts.
By not focusing on the main story, we risk an even larger series of policy failures in the future. That is, the federal government now is doing pretty much what the federal government did last year and the year before and is creating even more massive amounts of debt in the process.
For a different view, read the article by John Cochrane and Luigi Zingales who write on “Lehman and the Financial Crisis” in the Wall Street Journal, http://online.wsj.com/article/SB10001424052970203440104574403144004792338.html#mod=todays_us_opinion. The argument is presented here that it was not the failure of Lehman Brothers that set off the financial crisis. It was the panic move by Ben Bernanke and Hank Paulson that resulted in the financial crisis. This mirrors something I wrote last fall on November 16 titled “The Bailout Plan: Did Bernanke Panic?”: http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.
As Cochrane and Zingales write, Fannie Mae and Freddie Mac were taken over on September 7, 2008. Lehman Brothers filed for bankruptcy on September 15. AIG was bailed out on September 16. I believe, as I say in the post above, that everything changed that Tuesday evening when the bailout of AIG was announced.
Bernanke called Paulson on Wednesday September 17. As reported later in the Wall Street Journal, and I quote from my post: The Wall Street Journal article reports that by Wednesday afternoon “Bernanke reached the end of his rope.” He called Paulson and “with an occasional quaver in his voice” he spoke “unusually bluntly” to the Treasury Secretary. Paulson did not move immediately. He had to sleep on it, and on Thursday morning, he committed.
Friday evening Bernanke and Paulson met with Congressional leaders and again I quote from the earlier post: Paulson called the leadership in Congress and asked them to have a meeting with himself and Bernanke on Friday evening. The few members of Congress that talked with the press after that meeting said that Bernanke did most of the talking and “scared the daylights out of everyone.” Bernanke knew his history of the Great Depression and he knew currents events. He was very logical and very articulate. The leaders were told that they had to act and they had to act fast. The plan was to have a bill before Congress on Monday seeking Congressional approval (of both houses) by the following Friday. The Treasury Department had a bill ready (three pages long) by midnight Saturday evening. The price tag - $700 billion. Why $700 billion? Because it was a big number!
But, Cochrane and Zingales state that on Monday September 22, “bank credit-default swap (CDS) spreads were at the same level as on September 12…The Libor-OIS spread—which captures the perceived riskiness of short-term interbank lending—rose only 18 points the day of Lehman’s collapse, while it shot up more than 60 points from September 23 to September 25, after the TARP testimony.” That is Bernanke and Paulson appeared in front of Congress on September 23 and 24 and gave speeches on the need for the TARP funding.
The reason for the subsequent market activity? Cochrane and Zingales claim that “In effect, these speeches amounted to ‘The financial system is about to collapse. We can’t tell you why. We need $700 billion. We can’t tell you what we’re going to do with it.” The authors conclude with “That’s a pretty good way to start a financial crisis.”
The conclusion: putting all the blame on the Lehman failure takes the focus off the main story. The main story is not that there was just one policy failure at this time. The main story is that the government continued to screw up after creating the financial environment and credit inflation that resulted in the asset bubble of earlier in the decade. It continued to screw up in the series of band aids that the Fed and the Treasury imposed on the economy and financial system beginning in December 2007. And, in doing so, the government continued to build up the moral hazard in existence in the system and continued to expand the federal debt outstanding to met ever larger needs for financial bailouts.
By not focusing on the main story, we risk an even larger series of policy failures in the future. That is, the federal government now is doing pretty much what the federal government did last year and the year before and is creating even more massive amounts of debt in the process.
Monday, September 14, 2009
The Regulation of Banks and Financial Markets: One Year Later
The papers and the news broadcasts over the last week have been filled with stories about the failure of Lehman Brothers and the need to re-regulate the financial system. The second-guessing has been enormous on the failure of the federal government to come to the aid of the troubled investment banking firm, especially when put into the context of the bailout of AIG and the help given to other investment banks and commercial banks.
Furthermore, the report card on the government’s effort to re-regulate the financial system seems to be hovering between D and F! The consensus review of what has happened over the past year is: nothing!
In terms of letting Lehman Brothers go, let me just say that the second-guessing is a fun game and provides a diversion for journalists and makes good reading but is not very productive. This is the problem with decision making under very stressful conditions with very little information on what the potential outcomes of actions might be.
For one thing, very few people in the summer of 2008 even considered that the financial might be on the verge of collapse. That is what makes situations risky, the lack of knowledge of what might happen in the future. Yes, we can talk about Black Swans and so forth, but the probability of a severe financial crises occurring is a very unlikely event and business is not conducted on a “what-if-the-worst-happens” scenario. Second, no one has “experience” in dealing with a very serious financial crisis. It is entirely different studying previous examples of financial crisis, but to have to deal with one face-to-face is an entirely different matter. Third, the biases and prejudices and world views of the individuals in charge of making these decisions play a role in how people respond to a crises and no one, before-the-fact, can make an adequate prediction of how leaders will perform in a “once-in-a-lifetime” situation.
The financial system is still functioning and the economy seems to be working its way out of a deep recession. Could things have been done better? Yes. Could things have turned out worse? Of course. But, we seem to have muddled through the real crisis period. Hopefully, we will not have a second shock wave that sends us back into another panic mode.
In terms of re-regulating the financial system, I have several opinions I would like to share. First, to try and re-regulate a financial system immediately after a financial crisis occurs is, in my mind, not the thing to do. For one thing, you don’t really know what happened or what caused the crisis and to rush to judgment is often to rush into folly. Furthermore, villains are usually identified that may or may not really be the “bad guys” that need punishment or controlling. Powerful politicians or government officials impose their own biases and prejudices into the discussion and they are not always the best forces to design a new regulatory system. Also, new regulatory systems that are quickly put into place following a debacle are often designed to “fight the last war” and are not really appropriate for the environment the world is moving into.
The problem with not moving to re-regulate relatively quickly is that the movement to re-regulate loses its urgency.
My second concern has to do with the causes of the financial crisis. Since the financial collapse has to do with financial institutions and financial instruments, people look first at the individuals running these organizations or dealing in these instruments for the culprits of the crisis. The problem I have with this is that the leaders and practitioners of finance are responding to the economic and financial environment that they work within. The macro-incentives that exist within an economy are oftentimes created by others with very little insight into the incentives that they are actually setting up. The “others” I am talking about are, of course, our governmental leaders. Who created the macro-environment that produced the incentives for individuals to act in the way they did? What about Mr. Greenspan and Mr. Bernanke and the credit inflation that they spawned in the early part of this decade? What about the Bush 43 administration that created the huge fiscal deficits that resulted in a more than 40% decline in the value of the dollar?
The federal government represents more than 25% of GDP in the United States and with this impact on economic activity as well as through the rules and regulations it creates, the government has a very pervasive influence on the incentives that individuals and businesses have to respond to and operate within. The leaders in the federal government go free of blame while the people that have to live within the environment these leaders created must bear the burden of shame and guilt for the financial crisis that resulted.
My concern here is that maybe the re-regulation of the financial system is not the entire problem. My concern here is that people do not really understand who created the environment in which a financial meltdown could occur. Maybe better government policy making is in order, but maybe that is too much to ask for.
Finally, I would like to argue that financial types, human beings, are going to continue to innovate in the future and there is ultimately very little that governments or regulators can do to prevent financial innovation from taking place. (Human beings, by their very nature are problem-solvers and innovators.) Financial innovation has existed throughout history. Finance, really, is nothing more than information. That is one reason why financial innovation was able to explode beginning in the 1990s with the advancements in computer technology. The computer just allowed people to “slice and dice” massive amounts of information flows more efficiently and more quickly. (Even one of the staunchest proponents of behavioral finance, Robert Shiller, proposes using computer assisted financial innovation to take contribute to the evolution of new financial markets and instruments: see his books “Macro Markets” and “The New Financial Order.”) The whole idea of “information markets” builds upon models of financial innovation and how these models can be extended to other markets using massive new data base systems and the advanced computing power that is available in the ever-evolving world of information technology.
There must be oversight of the financial system and this oversight must be accompanied by increases in the openness and transparency of financial transactions and financial reporting. The innovation, in my mind, cannot be controlled. Therefore, we (business leaders, investors, and regulators) must also have more and more information available to us on a more timely basis in order to try and understand what is happening and to react to it. This, to me, is the world of the future.
It is this world of the future that must be considered in any effort to re-regulate the financial system. Fighting the last war is not going to produce the regulatory system we need. Ignoring the incentives that government creates is not going to produce the regulatory system we need. Regulations to produce specific “results” will not work. To my mind, it is not all bad that the rush to re-regulate or to develop a new regulatory system has stalled or been put on the bad burner.
Furthermore, the report card on the government’s effort to re-regulate the financial system seems to be hovering between D and F! The consensus review of what has happened over the past year is: nothing!
In terms of letting Lehman Brothers go, let me just say that the second-guessing is a fun game and provides a diversion for journalists and makes good reading but is not very productive. This is the problem with decision making under very stressful conditions with very little information on what the potential outcomes of actions might be.
For one thing, very few people in the summer of 2008 even considered that the financial might be on the verge of collapse. That is what makes situations risky, the lack of knowledge of what might happen in the future. Yes, we can talk about Black Swans and so forth, but the probability of a severe financial crises occurring is a very unlikely event and business is not conducted on a “what-if-the-worst-happens” scenario. Second, no one has “experience” in dealing with a very serious financial crisis. It is entirely different studying previous examples of financial crisis, but to have to deal with one face-to-face is an entirely different matter. Third, the biases and prejudices and world views of the individuals in charge of making these decisions play a role in how people respond to a crises and no one, before-the-fact, can make an adequate prediction of how leaders will perform in a “once-in-a-lifetime” situation.
The financial system is still functioning and the economy seems to be working its way out of a deep recession. Could things have been done better? Yes. Could things have turned out worse? Of course. But, we seem to have muddled through the real crisis period. Hopefully, we will not have a second shock wave that sends us back into another panic mode.
In terms of re-regulating the financial system, I have several opinions I would like to share. First, to try and re-regulate a financial system immediately after a financial crisis occurs is, in my mind, not the thing to do. For one thing, you don’t really know what happened or what caused the crisis and to rush to judgment is often to rush into folly. Furthermore, villains are usually identified that may or may not really be the “bad guys” that need punishment or controlling. Powerful politicians or government officials impose their own biases and prejudices into the discussion and they are not always the best forces to design a new regulatory system. Also, new regulatory systems that are quickly put into place following a debacle are often designed to “fight the last war” and are not really appropriate for the environment the world is moving into.
The problem with not moving to re-regulate relatively quickly is that the movement to re-regulate loses its urgency.
My second concern has to do with the causes of the financial crisis. Since the financial collapse has to do with financial institutions and financial instruments, people look first at the individuals running these organizations or dealing in these instruments for the culprits of the crisis. The problem I have with this is that the leaders and practitioners of finance are responding to the economic and financial environment that they work within. The macro-incentives that exist within an economy are oftentimes created by others with very little insight into the incentives that they are actually setting up. The “others” I am talking about are, of course, our governmental leaders. Who created the macro-environment that produced the incentives for individuals to act in the way they did? What about Mr. Greenspan and Mr. Bernanke and the credit inflation that they spawned in the early part of this decade? What about the Bush 43 administration that created the huge fiscal deficits that resulted in a more than 40% decline in the value of the dollar?
The federal government represents more than 25% of GDP in the United States and with this impact on economic activity as well as through the rules and regulations it creates, the government has a very pervasive influence on the incentives that individuals and businesses have to respond to and operate within. The leaders in the federal government go free of blame while the people that have to live within the environment these leaders created must bear the burden of shame and guilt for the financial crisis that resulted.
My concern here is that maybe the re-regulation of the financial system is not the entire problem. My concern here is that people do not really understand who created the environment in which a financial meltdown could occur. Maybe better government policy making is in order, but maybe that is too much to ask for.
Finally, I would like to argue that financial types, human beings, are going to continue to innovate in the future and there is ultimately very little that governments or regulators can do to prevent financial innovation from taking place. (Human beings, by their very nature are problem-solvers and innovators.) Financial innovation has existed throughout history. Finance, really, is nothing more than information. That is one reason why financial innovation was able to explode beginning in the 1990s with the advancements in computer technology. The computer just allowed people to “slice and dice” massive amounts of information flows more efficiently and more quickly. (Even one of the staunchest proponents of behavioral finance, Robert Shiller, proposes using computer assisted financial innovation to take contribute to the evolution of new financial markets and instruments: see his books “Macro Markets” and “The New Financial Order.”) The whole idea of “information markets” builds upon models of financial innovation and how these models can be extended to other markets using massive new data base systems and the advanced computing power that is available in the ever-evolving world of information technology.
There must be oversight of the financial system and this oversight must be accompanied by increases in the openness and transparency of financial transactions and financial reporting. The innovation, in my mind, cannot be controlled. Therefore, we (business leaders, investors, and regulators) must also have more and more information available to us on a more timely basis in order to try and understand what is happening and to react to it. This, to me, is the world of the future.
It is this world of the future that must be considered in any effort to re-regulate the financial system. Fighting the last war is not going to produce the regulatory system we need. Ignoring the incentives that government creates is not going to produce the regulatory system we need. Regulations to produce specific “results” will not work. To my mind, it is not all bad that the rush to re-regulate or to develop a new regulatory system has stalled or been put on the bad burner.
Monday, April 13, 2009
Are Banks Telling the Truth?
On the front page of the Financial Times this morning we read the disconcerting headlines, “’Tarp cop’ to investigate whether banks have ‘cooked their books.’” (See http://www.ft.com/cms/s/0/163c85c4-2789-11de-9b77-00144feabdc0.html.) Neil Barofsky, special investigator-general for the Troubled Asset Relief Program (TARP), is “seeking evidence of wrongdoing on the part of banks receiving help from the fund.”
The game—“institutions applying for TARP money had to show they were fundamentally sound, potentially prompting them to misstate assets and liabilities.” Barofsky is quoted as saying, “I hope we don’t find a single bank that’s cooked its books to try to get money but I don’t think that’s going to be the case.”
Mr. Barofsky also said the Treasury’s expanded Term Asset-Backed Securities Loan Facility (TALF) was ripe for fraud.
The potential—fraudsters would be receiving indictments!
Two thoughts cross my mind when reading this. First, bankers in deteriorating situations tend to hide their heads in the sand when it comes to bad assets because they keep hoping that things will get better and the assets will recover their value. Having (successfully) completed several bank turnarounds I have found that this is one of the first things that becomes obvious when you initially investigate the loans and other assets of a troubled institution. Bankers, lenders, or portfolio managers continually think that ‘the economy will turn around’ or that ‘the company is getting its act in order’ or that some other event will come along that will result in the ‘asset gone bad’ becoming the ‘asset has become good again.’ And, so the asset is carried along but never comes back to life.
The problem with this is that these bad assets continually undermine the ability of the financial institution to right itself and become profitable again. The example is always there on the books of the banks and whether the executives or officers admit the fact, internally they know that things are not right and this drains efforts to instill a healthy culture to “do the right thing.” Managements that allow this unhealthy culture to continue are just perpetrating a bad situation, one that very rarely ever turns itself around.
The managements that participate in such a charade tend to be desperate and susceptible to moving to the next step when they are thrown a life boat like many financial institutions received in the past nine months or so.
Before following up on this point, let me just say that, historically, the bank either brings in someone to turn the institution around, or, a regulatory agency steps in and dissolves the organization. The American banking system has worked very well in the past with respect to “sick” banks. Contagion has been avoided through quick action connected with the swift resolution of problem assets. Financial institutions that were in trouble were taken care of—period!
But, that is not the case in the current situation. We have had a bailout. The banks have been tossed a life boat. However, financial institutions were supposed to be “fundamentally sound” in order to obtain TARP money. Here we get into the muddy waters of conducting a “general” bailout.
Let me just say that I have been suspicious from the start when government officials claimed that the need for the TARP funds was because the banks were facing “a liquidity problem” with respect to their troubled assets.
Again, my experience in doing bank turnaround’s is that the officers of the bank that claimed their assets were in trouble because of liquidity problems were attempting to cover up the real difficulties connected with the assets which were almost always associated with the issue of solvency.
It would not be much of a surprise to me to hear that the banks justified to the government that they were “fundamentally sound” because their asset problems were associated with liquidity issues rather than ones of solvency. This assessment could perhaps be supported if government officials only took a cursory glance at the assets. But, one could argue that this is the conclusion that government officials wanted to hear at that time.
Is this fraud? That is what Mr. Barofsky is going to have to find out.
Other than outright “cooking of the books”, in many cases the distinction between liquidity and solvency may fall back on an argument about “judgment”, about the “eye of the beholder.” Thus, Mr. Barofsky is going to have his problems proving his case.
In my opinion, many of the banks that received bailout relief had and still have a solvency problem and until the situation is handled that way the dislocations associated with the banking industry and the financial markets are going to continue. Consequently, I believe that Mr. Barofsky and others are going to find evidence that all along the issue has been solvency and not liquidity. If so, then there is a real issue of whether or not that these institutions that received TARP money were “fundamentally sound.”
My second thought on this issue is a very simple one. If people inside the banks covered up the real issues related to solvency heads should roll. Those that committed fraud should be indicted! Those that knowingly misled should be dismissed!
And, top executives, even though they were not directly involved in fraud or in a cover up, should be removed from their positions as well. They have proven that they cannot manage their institutions with sufficient control to justify their ability to move those institutions on into the future. The “buck stops with the top position” and the argument that they didn’t know what was going on is insufficient. It was their responsibility to know what was going on!
Risk management, the other “bug-in-the-coffee”, and financial control are not glamorous pursuits, especially when compared with the “jet pilots” of finance that were tossing around all sorts of money chasing narrow spreads with lots and lots of leverage. Performance over time, however, is closely related to an institution’s ability to successfully exert risk management and financial control.
We have to know what is going on in the banks and other financial institutions. The pressure needs to be stepped up to find out where things are. And, the sooner this pressure is exerted the sooner we will be able to find ways out of the mess we are in.
And this brings me to one final point. The Financial Times also had another headline on its front page that I found disturbing. The article cried out “AIG in derivatives spotlight.” (See http://www.ft.com/cms/s/0/cb2ddafc-278c-11de-9b77-00144feabdc0.html.) “The unit that all but destroyed AIG has failed to sign up for the overhaul of the global derivatives market, which was given added impetus by the troubles at the US insurance group.” The government is involved with AIG—the government owns most of AIG. It is mind boggling to me that a government that supposedly wants to bring greater openness and transparency to the financial markets allowed this to happen!
The game—“institutions applying for TARP money had to show they were fundamentally sound, potentially prompting them to misstate assets and liabilities.” Barofsky is quoted as saying, “I hope we don’t find a single bank that’s cooked its books to try to get money but I don’t think that’s going to be the case.”
Mr. Barofsky also said the Treasury’s expanded Term Asset-Backed Securities Loan Facility (TALF) was ripe for fraud.
The potential—fraudsters would be receiving indictments!
Two thoughts cross my mind when reading this. First, bankers in deteriorating situations tend to hide their heads in the sand when it comes to bad assets because they keep hoping that things will get better and the assets will recover their value. Having (successfully) completed several bank turnarounds I have found that this is one of the first things that becomes obvious when you initially investigate the loans and other assets of a troubled institution. Bankers, lenders, or portfolio managers continually think that ‘the economy will turn around’ or that ‘the company is getting its act in order’ or that some other event will come along that will result in the ‘asset gone bad’ becoming the ‘asset has become good again.’ And, so the asset is carried along but never comes back to life.
The problem with this is that these bad assets continually undermine the ability of the financial institution to right itself and become profitable again. The example is always there on the books of the banks and whether the executives or officers admit the fact, internally they know that things are not right and this drains efforts to instill a healthy culture to “do the right thing.” Managements that allow this unhealthy culture to continue are just perpetrating a bad situation, one that very rarely ever turns itself around.
The managements that participate in such a charade tend to be desperate and susceptible to moving to the next step when they are thrown a life boat like many financial institutions received in the past nine months or so.
Before following up on this point, let me just say that, historically, the bank either brings in someone to turn the institution around, or, a regulatory agency steps in and dissolves the organization. The American banking system has worked very well in the past with respect to “sick” banks. Contagion has been avoided through quick action connected with the swift resolution of problem assets. Financial institutions that were in trouble were taken care of—period!
But, that is not the case in the current situation. We have had a bailout. The banks have been tossed a life boat. However, financial institutions were supposed to be “fundamentally sound” in order to obtain TARP money. Here we get into the muddy waters of conducting a “general” bailout.
Let me just say that I have been suspicious from the start when government officials claimed that the need for the TARP funds was because the banks were facing “a liquidity problem” with respect to their troubled assets.
Again, my experience in doing bank turnaround’s is that the officers of the bank that claimed their assets were in trouble because of liquidity problems were attempting to cover up the real difficulties connected with the assets which were almost always associated with the issue of solvency.
It would not be much of a surprise to me to hear that the banks justified to the government that they were “fundamentally sound” because their asset problems were associated with liquidity issues rather than ones of solvency. This assessment could perhaps be supported if government officials only took a cursory glance at the assets. But, one could argue that this is the conclusion that government officials wanted to hear at that time.
Is this fraud? That is what Mr. Barofsky is going to have to find out.
Other than outright “cooking of the books”, in many cases the distinction between liquidity and solvency may fall back on an argument about “judgment”, about the “eye of the beholder.” Thus, Mr. Barofsky is going to have his problems proving his case.
In my opinion, many of the banks that received bailout relief had and still have a solvency problem and until the situation is handled that way the dislocations associated with the banking industry and the financial markets are going to continue. Consequently, I believe that Mr. Barofsky and others are going to find evidence that all along the issue has been solvency and not liquidity. If so, then there is a real issue of whether or not that these institutions that received TARP money were “fundamentally sound.”
My second thought on this issue is a very simple one. If people inside the banks covered up the real issues related to solvency heads should roll. Those that committed fraud should be indicted! Those that knowingly misled should be dismissed!
And, top executives, even though they were not directly involved in fraud or in a cover up, should be removed from their positions as well. They have proven that they cannot manage their institutions with sufficient control to justify their ability to move those institutions on into the future. The “buck stops with the top position” and the argument that they didn’t know what was going on is insufficient. It was their responsibility to know what was going on!
Risk management, the other “bug-in-the-coffee”, and financial control are not glamorous pursuits, especially when compared with the “jet pilots” of finance that were tossing around all sorts of money chasing narrow spreads with lots and lots of leverage. Performance over time, however, is closely related to an institution’s ability to successfully exert risk management and financial control.
We have to know what is going on in the banks and other financial institutions. The pressure needs to be stepped up to find out where things are. And, the sooner this pressure is exerted the sooner we will be able to find ways out of the mess we are in.
And this brings me to one final point. The Financial Times also had another headline on its front page that I found disturbing. The article cried out “AIG in derivatives spotlight.” (See http://www.ft.com/cms/s/0/cb2ddafc-278c-11de-9b77-00144feabdc0.html.) “The unit that all but destroyed AIG has failed to sign up for the overhaul of the global derivatives market, which was given added impetus by the troubles at the US insurance group.” The government is involved with AIG—the government owns most of AIG. It is mind boggling to me that a government that supposedly wants to bring greater openness and transparency to the financial markets allowed this to happen!
Tuesday, March 3, 2009
A Case Study in Unknown Asset Values: A. I. G.
My blog of March 1, 2009, “Uncertain Asset Values and the Stock Market” (http://maseportfolio.blogspot.com/), was written before the most recent news surfaced about the continuing bailout of A. I. G. I believe that the example of A. I. G. represents a perfect ‘test case’ for what was presented in that post.
The March 1 blog contended that the major uncertainty facing the investment community…and the Federal Government…is the value of assets on the books of many of the nations businesses…especially many large and important firms that are “too big to fail.” The argument is that this uncertainty has to be cleared up as much as possible before the economy is really going to have a chance to regain its health.
The problem now is that not only are companies withholding information from the investing public…but the government is also withholding information from the investing public. Specifically, companies…and the government…are afraid to release information on who they are dealing with…the “web of counterparties”…because of their concern that the release of these names would cause a panic leading to deposit withdrawals or the cashing in of insurance policies and so forth.
This is the old “after-the-fact” problem. I used to be a part of “information sessions” for journalists to help them understand banking and the issues that surrounded the banking industry. One of the concerns that always came up at these sessions was about what responsibilities “the press” had in reporting on troubled banks. That is, if a journalist “knew” that a bank was in trouble…what responsibility did that person have to report that the bank was having problems…and thus, perhaps, cause a “run” on the bank.
This is an “after-the-fact” problem. The bank is already a troubled bank…now what do I do?
One of the arguments I made was that journalists should keep up closely enough with banks to report when banks were starting to experience difficulties. By making this information public, the press could help prevent the bank getting too far into a mess because it would want to avoid the bad publicity and work to rectify the difficulties before they got “out-of-hand.”
This, of course, was very difficult because of the insufficient reporting requirements applied to banks and the secrecy surrounding the regulatory examinations. And, if banks knew that they were being scrutinized that closely by “the press” they would certainty make it just that much more difficult for the “outsiders” to obtain information.
So, investors and communities had little information on financial institutions that were important to them and had to “trust” the regulatory agencies to apply the appropriate oversight to the banking system. Of course, the regulatory agencies did not always have “full information”, especially as the financial conglomerates began transacting in very sophisticated derivative securities and taking many assets “off balance sheet.”
I believe that the company A. I. G. is a striking picture of how this scenario played out. A. I. G. is a holding company that began as an insurance company and then diversified itself into a financial conglomerate that included a hedge fund and other “black box” investment vehicles. Their primary regulators were the state insurance regulators (and some international regulatory requirements) and the state laws caused the subsidiaries to be highly segregated so as to ensure the safety of those the insurance subsidiary had insured.
The rest of the company was not regulated to any degree. As a consequence, A. I. G. was able to build up a huge financial conglomerate that could engage in untold transactions that were both un-regulated…and un-disclosed! The accounting and reporting rules were such that investors…and the public…and the government…and even other areas within the company did not have any idea about the risk exposure of the holding company or the “spider-web” of relationships that made it a potential “carrier of contagion.”
And, we…and the government…still don’t know what the potential damage could be from this dismal situation!
As a consequence, the probability of a fifth (this last bailout was the fourth return to A. I. G.) is a lot higher than we would like it to be. And a sixth? And a seventh?
With the government owning almost 80% of the company it would seem like any additional funds would be relatively small.
But, that is the problem…we don’t know! No one seems to have a handle on the value of the A. I. G. assets!
And, as I argued in “Uncertain Asset Values and the Stock Market”, this problem exists throughout the economy. What about the assets of Citigroup? What about the assets of Bank of America? Again, to quote the earlier blog, “It is not altogether clear that even the people running a large part of this economy have any idea about the value of their own assets.” Again, I take A. I. G. as the example.
And, then we have General Electric…and the problems of GE Capital. Again…we have another conglomerate with few pieces that go together. For years, GE Capital carried the rest of General Electric. And, what happens if you have one subsidiary making up for the “not-so-good” performance of other subsidiaries? You put more and more pressure on the performing subsidiary to produce exceptional results. And, how do you do that? You take riskier assets into your portfolio and you increase leverage. Simple!
Now, GE Capital is suffering along with other financial companies that attempted to extend “exceptional” returns. And, with GE Capital failing to perform…the spotlight is being focused on all the other subsidiaries that were only mediocre performers. Consequently, General Electric must face the value of ALL of its companies and determine what are the asset values under its umbrella.
This, to me, is the picture that is unfolding…and the problems we face are not going to be resolved until we get a better grasp on asset values. But, we need to do this quickly because…and this is the problem of bad assets…the value keeps dropping if the difficulties are not resolved. This is true of bad assets in an individual institution…I saw this over and over again in the banks I helped turnaround…and it is true with the financial and economic system. In fact, that is the problem with a contagion…bad assets tend to play off of bad assets…and the difficulties cumulate. This is all the more reason for attempting to get a handle on asset values as soon as possible.
A $787 billion economic recovery plan is insufficient to overcome the possibilities of a multi-trillion dollar write-down of assets!
The March 1 blog contended that the major uncertainty facing the investment community…and the Federal Government…is the value of assets on the books of many of the nations businesses…especially many large and important firms that are “too big to fail.” The argument is that this uncertainty has to be cleared up as much as possible before the economy is really going to have a chance to regain its health.
The problem now is that not only are companies withholding information from the investing public…but the government is also withholding information from the investing public. Specifically, companies…and the government…are afraid to release information on who they are dealing with…the “web of counterparties”…because of their concern that the release of these names would cause a panic leading to deposit withdrawals or the cashing in of insurance policies and so forth.
This is the old “after-the-fact” problem. I used to be a part of “information sessions” for journalists to help them understand banking and the issues that surrounded the banking industry. One of the concerns that always came up at these sessions was about what responsibilities “the press” had in reporting on troubled banks. That is, if a journalist “knew” that a bank was in trouble…what responsibility did that person have to report that the bank was having problems…and thus, perhaps, cause a “run” on the bank.
This is an “after-the-fact” problem. The bank is already a troubled bank…now what do I do?
One of the arguments I made was that journalists should keep up closely enough with banks to report when banks were starting to experience difficulties. By making this information public, the press could help prevent the bank getting too far into a mess because it would want to avoid the bad publicity and work to rectify the difficulties before they got “out-of-hand.”
This, of course, was very difficult because of the insufficient reporting requirements applied to banks and the secrecy surrounding the regulatory examinations. And, if banks knew that they were being scrutinized that closely by “the press” they would certainty make it just that much more difficult for the “outsiders” to obtain information.
So, investors and communities had little information on financial institutions that were important to them and had to “trust” the regulatory agencies to apply the appropriate oversight to the banking system. Of course, the regulatory agencies did not always have “full information”, especially as the financial conglomerates began transacting in very sophisticated derivative securities and taking many assets “off balance sheet.”
I believe that the company A. I. G. is a striking picture of how this scenario played out. A. I. G. is a holding company that began as an insurance company and then diversified itself into a financial conglomerate that included a hedge fund and other “black box” investment vehicles. Their primary regulators were the state insurance regulators (and some international regulatory requirements) and the state laws caused the subsidiaries to be highly segregated so as to ensure the safety of those the insurance subsidiary had insured.
The rest of the company was not regulated to any degree. As a consequence, A. I. G. was able to build up a huge financial conglomerate that could engage in untold transactions that were both un-regulated…and un-disclosed! The accounting and reporting rules were such that investors…and the public…and the government…and even other areas within the company did not have any idea about the risk exposure of the holding company or the “spider-web” of relationships that made it a potential “carrier of contagion.”
And, we…and the government…still don’t know what the potential damage could be from this dismal situation!
As a consequence, the probability of a fifth (this last bailout was the fourth return to A. I. G.) is a lot higher than we would like it to be. And a sixth? And a seventh?
With the government owning almost 80% of the company it would seem like any additional funds would be relatively small.
But, that is the problem…we don’t know! No one seems to have a handle on the value of the A. I. G. assets!
And, as I argued in “Uncertain Asset Values and the Stock Market”, this problem exists throughout the economy. What about the assets of Citigroup? What about the assets of Bank of America? Again, to quote the earlier blog, “It is not altogether clear that even the people running a large part of this economy have any idea about the value of their own assets.” Again, I take A. I. G. as the example.
And, then we have General Electric…and the problems of GE Capital. Again…we have another conglomerate with few pieces that go together. For years, GE Capital carried the rest of General Electric. And, what happens if you have one subsidiary making up for the “not-so-good” performance of other subsidiaries? You put more and more pressure on the performing subsidiary to produce exceptional results. And, how do you do that? You take riskier assets into your portfolio and you increase leverage. Simple!
Now, GE Capital is suffering along with other financial companies that attempted to extend “exceptional” returns. And, with GE Capital failing to perform…the spotlight is being focused on all the other subsidiaries that were only mediocre performers. Consequently, General Electric must face the value of ALL of its companies and determine what are the asset values under its umbrella.
This, to me, is the picture that is unfolding…and the problems we face are not going to be resolved until we get a better grasp on asset values. But, we need to do this quickly because…and this is the problem of bad assets…the value keeps dropping if the difficulties are not resolved. This is true of bad assets in an individual institution…I saw this over and over again in the banks I helped turnaround…and it is true with the financial and economic system. In fact, that is the problem with a contagion…bad assets tend to play off of bad assets…and the difficulties cumulate. This is all the more reason for attempting to get a handle on asset values as soon as possible.
A $787 billion economic recovery plan is insufficient to overcome the possibilities of a multi-trillion dollar write-down of assets!
Wednesday, February 25, 2009
The Obama Speech: The Day After
The Obama speech to the Congress on Tuesday night was “well given” and, basically, “well received”. It has been criticized for, among other things, not being specific enough. But, this was not the purpose of the speech. The speech was the first effort of the new President to lay out a vision for the near term and the future.
It was about the “vision” thing. A leader is, first and foremost, supposed to give us the “big picture” and not the details. The leader is supposed to provide us with something we can hold onto because we like the worldview it represents…or, provide us with something to disagree with because it does not conform to our worldview. I think that President Obama did that.
In terms of the crises in the economy and the financial markets, the thing that does not seem to come through in the “big picture”, however, is that there are two categories of problems we face. These two sets of problems can be put into boxes that are labeled…the problems of the past…and the problems of the future.
These are different issues and must receive different attention if they are to be resolved. Too often we lump them together for a bastard “Keynesian” solution.
The first set of problems has to do with debt…too much of it…and inappropriately assumed. This is the box of problems from the past…the box labeled “Insolvency Crisis”.
Too much debt, inappropriately assumed is a burden…it can cause finance and commerce to slow down or stop…and this can lead to a cumulative result in which the burden of the debt gets heavier and heavier. This burden is exacerbated as insolvencies grow and deflation becomes the problem (not inflation).
It has been argued that the only thing government can do to counter this problem is to reflate (Irving Fisher) or inflate (Keynes). That is, the only way government can lessen the burden of this excessive load of debt is to reduce the “real” value of the debt by causing prices to rise rapidly. But, this only recreates the environment in which the excessive debt was created! And, the consequence of this is just more and more leverage…which, in the longer run only makes the situation that much worse.
The excessive debt was created within the asset bubble world of the last decade or so. This world of asset price inflation resulted in a greater assumption of riskier assets and an overly aggressive assumption of leverage.
Financial and economic positions were taken than could only be justified within the rarefied world of the bubble!
The valuations from that time cannot stand up…outside the bubble!
In the case of the “Insolvency Crisis”, I believe that the only three choices are:
1. let the economy adjust to more realistic valuations by itself and just accept that we have to bear the burden of this adjustment;
2. help to smooth out the adjustment to more realistic valuations;
3. inflate our way out of the crisis…which, of course, would mean that we were just postponing the resolution of the foundation of the crisis.
The third of these choices is often attributed to Keynes and it is, I believe, an inappropriate application of Keynesian thinking…because it does not really resolve the situation.
President Obama is opting for choice number two…a choice I think most of us agree with. He is saying that choice number one is just too painful for the country and it’s people to go through. Hence, government must play a role in helping people and institutions work through the “debt problem” and that is going to cost…how much, we just don’t know.
That is the vision…the devil is in the details. And, that, I believe, is the problem right now. Most of us can agree with the vision…we just haven’t received sufficient information on how this is going to be done and how much it might cost. And, without greater certainty…markets will drop!
The second set of problems has to do with the future…and the box containing this set of problems is labeled “What We Want To Be.” President Obama stated in his speech Tuesday evening that in his vision of the future, he sees America as energy independent…he sees Americans protected with some form of universal healthcare…he sees Americans as among the best educated in the world. President Obama sees an America that is energetic and innovative…a continuation of what America has been in the past.
This, to me, is the stimulative part of the President’s program…the part of the program that is not focused on the consolidation of past ills, as is the part of the program discussed above. This part of the program is an effort to provide incentives to create the next era and not “bailout” the old.
That is the vision…the devil is in the details. A first look at some of the specifics came in the stimulus package recently passed. More will be coming in the near future. Again, more details will help us get over the grey areas of uncertainty that constrain our willingness to commit.
We need to keep these two sets of problems separate as we go forward. The first set of problems is going to take time…and not everything that is done to resolve these issues is going to be “fair”. As I have said before, once one has created this set of problems, one finds that all the choices available for solving the problems are not happy ones. But, “inflating” our way out of these problems is not the solution…it can only, ultimately, make more pain for the future.
The second set of problems must be looked upon in terms of the opportunities that are available to us. In my view, no serious economic crisis has ever been resolved without the creation of new innovations and new technological platforms. In the Great Depression, the innovations and the new technologies did really come about until the end of the 1930s and into the 1940s and were related to war. Earlier stimulus efforts in the 1930s tended to support what existed in the past.
We don’t want government providing stimulus to the economy that will just result in the old world being “re-created”…we do not want the “old” products or the “old” managements renewed and rewarded! We must move on to the future.
By providing his “vision” of this future, President Obama has changed the field of engagement. President Obama is not just talking “stimulus”…he is talking about the world we want to live in. We may not agree with him on everything. We may not agree with him on most things. But, we must accept the challenge, and…while we are attempting to resolve the debt problems from the past…we must enter the dialogue and debate about what the shape of the future will be.
In this sense, what President Obama has put forth is a stimulus plan…but with more than just one meaning of the word stimulus.
It was about the “vision” thing. A leader is, first and foremost, supposed to give us the “big picture” and not the details. The leader is supposed to provide us with something we can hold onto because we like the worldview it represents…or, provide us with something to disagree with because it does not conform to our worldview. I think that President Obama did that.
In terms of the crises in the economy and the financial markets, the thing that does not seem to come through in the “big picture”, however, is that there are two categories of problems we face. These two sets of problems can be put into boxes that are labeled…the problems of the past…and the problems of the future.
These are different issues and must receive different attention if they are to be resolved. Too often we lump them together for a bastard “Keynesian” solution.
The first set of problems has to do with debt…too much of it…and inappropriately assumed. This is the box of problems from the past…the box labeled “Insolvency Crisis”.
Too much debt, inappropriately assumed is a burden…it can cause finance and commerce to slow down or stop…and this can lead to a cumulative result in which the burden of the debt gets heavier and heavier. This burden is exacerbated as insolvencies grow and deflation becomes the problem (not inflation).
It has been argued that the only thing government can do to counter this problem is to reflate (Irving Fisher) or inflate (Keynes). That is, the only way government can lessen the burden of this excessive load of debt is to reduce the “real” value of the debt by causing prices to rise rapidly. But, this only recreates the environment in which the excessive debt was created! And, the consequence of this is just more and more leverage…which, in the longer run only makes the situation that much worse.
The excessive debt was created within the asset bubble world of the last decade or so. This world of asset price inflation resulted in a greater assumption of riskier assets and an overly aggressive assumption of leverage.
Financial and economic positions were taken than could only be justified within the rarefied world of the bubble!
The valuations from that time cannot stand up…outside the bubble!
In the case of the “Insolvency Crisis”, I believe that the only three choices are:
1. let the economy adjust to more realistic valuations by itself and just accept that we have to bear the burden of this adjustment;
2. help to smooth out the adjustment to more realistic valuations;
3. inflate our way out of the crisis…which, of course, would mean that we were just postponing the resolution of the foundation of the crisis.
The third of these choices is often attributed to Keynes and it is, I believe, an inappropriate application of Keynesian thinking…because it does not really resolve the situation.
President Obama is opting for choice number two…a choice I think most of us agree with. He is saying that choice number one is just too painful for the country and it’s people to go through. Hence, government must play a role in helping people and institutions work through the “debt problem” and that is going to cost…how much, we just don’t know.
That is the vision…the devil is in the details. And, that, I believe, is the problem right now. Most of us can agree with the vision…we just haven’t received sufficient information on how this is going to be done and how much it might cost. And, without greater certainty…markets will drop!
The second set of problems has to do with the future…and the box containing this set of problems is labeled “What We Want To Be.” President Obama stated in his speech Tuesday evening that in his vision of the future, he sees America as energy independent…he sees Americans protected with some form of universal healthcare…he sees Americans as among the best educated in the world. President Obama sees an America that is energetic and innovative…a continuation of what America has been in the past.
This, to me, is the stimulative part of the President’s program…the part of the program that is not focused on the consolidation of past ills, as is the part of the program discussed above. This part of the program is an effort to provide incentives to create the next era and not “bailout” the old.
That is the vision…the devil is in the details. A first look at some of the specifics came in the stimulus package recently passed. More will be coming in the near future. Again, more details will help us get over the grey areas of uncertainty that constrain our willingness to commit.
We need to keep these two sets of problems separate as we go forward. The first set of problems is going to take time…and not everything that is done to resolve these issues is going to be “fair”. As I have said before, once one has created this set of problems, one finds that all the choices available for solving the problems are not happy ones. But, “inflating” our way out of these problems is not the solution…it can only, ultimately, make more pain for the future.
The second set of problems must be looked upon in terms of the opportunities that are available to us. In my view, no serious economic crisis has ever been resolved without the creation of new innovations and new technological platforms. In the Great Depression, the innovations and the new technologies did really come about until the end of the 1930s and into the 1940s and were related to war. Earlier stimulus efforts in the 1930s tended to support what existed in the past.
We don’t want government providing stimulus to the economy that will just result in the old world being “re-created”…we do not want the “old” products or the “old” managements renewed and rewarded! We must move on to the future.
By providing his “vision” of this future, President Obama has changed the field of engagement. President Obama is not just talking “stimulus”…he is talking about the world we want to live in. We may not agree with him on everything. We may not agree with him on most things. But, we must accept the challenge, and…while we are attempting to resolve the debt problems from the past…we must enter the dialogue and debate about what the shape of the future will be.
In this sense, what President Obama has put forth is a stimulus plan…but with more than just one meaning of the word stimulus.
Monday, February 23, 2009
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?
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?
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