Rick Wagoner, Chairman and Chief Executive Officer of General Motors, will resign as a part of the agreement with the federal government in which the company will receive additional federal aid. General Motors is a turnaround situation; it is not a restructuring exercise. The odds are against a company pulling off a turnaround with the same people that led them into the situation they now face.
Some people argue that the problem is the bad economy, something that the executives are not responsible for and therefore should be allowed to continue in their positions. This, to me, is like saying that executives in financial institutions are not responsible for the collapse in the financial market that exposed to the world the increased risk they imposed upon their companies or the large increases in leverage that accompanied their use of more exotic financial instruments.
When you make bad decisions, a bad economy will exacerbate the results that come from these choices. But, one cannot just place all the blame on the bad economy.
This analysis puts us back into a discussion about our understanding of exactly what it is that we are now facing in the financial markets and the economy. One way to distinguish the two views that seem to be the predominant ones now in vogue concerning our current situation is between those that believe the main problem relating to financial assets is the liquidity of these assets.
In this argument, people insist that banks and other financial institutions are caught in a trap where the markets for many of their assets are so illiquid that these organizations are unable to price the assets and then, possibly sell them. This seems to be the assumption behind the recently presented investment program, the P-PIP, that was announced by the Treasury last week.
The alternative view is that many financial institutions are insolvent and that what is really needed is a recapitalization of those organizations that still have a future while those that are not capable of being salvaged should be closed. Those that take this approach contend that this problem will not go away and will have to be addressed sooner or later. They also argue that dealing with it sooner will speed on a recovery and will also cost the taxpayer less in the longer run. (See my post http://seekingalpha.com/article/127639-public-private-investment-program-liquidity-or-solvency.)
The other area of concern is the status of many of the firms that find themselves in trouble. One group of analysts believes that the problem is one of a bad economy and a bad financial market and that all the companies need to do is restructure their current operations. This can be done, they argue, with the existing management and with just “tweaking” the existing business model.
Yet, here we are with General Motors. Over 20,000 employees were given the option of taking a buyout of their employment contracts. A total of about 7,500 took the buyout, but this was a disappointing result. Several of the product lines are going to be discontinued and/or sold off to bailouts in other nations. Contracts with labor unions regarding working arrangements and conditions must be massively changed. And, a substantial number of the bondholders must convert their bond holdings into equity. This doesn’t even touch the fact that the auto companies are substantially behind the curve in terms of real innovations and preparations for future technologies and products.
Given these factors that need to be addressed and resolved, I believe that one can only call this a turnaround situation, a condition in which new eyes and ears must be applied. To me there is little hope that the executives that got the company into this position are the executives that will bring these companies into the 21st century let alone into the 1980s.
This judgment applies not only to the automobile industry: it also applies to banks and other financial institutions, as well as many manufacturing organizations and other companies that require major changes in their business models. (See my post http://seekingalpha.com/article/127625-let-go-the-experts-who-have-learned-to-fail.)
This country (and the world) is facing a series of serious structural dislocations. The problems are not ones of liquidity or keeping on, keeping on. Lobbying to maintain the status quo will not give us much hope for the future. Inflating our way out of the bad debt or band-aiding inadequate business models will only postpone what needs to be done.
The arrogance that Rick Wagoner exhibited in his first appearance in front of Congress probably doomed him to this result. The behavior of other executives from both the financial and non-financial sectors has not endeared them to either the people of the country or to their representatives in Congress. This will probably not help the executives in the long run. Sometimes a little humility is a good thing!
Bankruptcy is another option for many firms. One could argue that taking this path would probably be an efficient way to get companies into the turnaround mode although it would not include government money as a part of the process. It would keep government officials out of the turnaround process and avoid relationships that are uncomfortable for the new managements that will be leading the companies out of the bankruptcy.
This in not a normal, relatively mild recession that will be ended through the injection of liquidity into the monetary system. The economy is facing a management problem and a debt problem that must be worked through. It is not clear that this is fully understood by those attempting to turn the economy around.
Sunday, March 29, 2009
Thursday, March 26, 2009
Has the Monetization Really Started?
Headlines on the Wall Street Journal website Thursday afternoon, “Treasurys Climb After Solid Auction.” (See http://online.wsj.com/article/SB123807273254847621.html#mod=testMod.)
Success!
The issue Thursday was a seven-year note sale of $24 billion and this capped the issuance of $98 billion in Treasury offerings this week. The day before, Wednesday, the auction of five-year notes was “tepid” and the market was nervous at the beginning of the day.
But, something else happened on Wednesday. The Fed began its planned purchases of existing securities. In fact, the Fed bought securities that matured between February 29, 2016 and February 15, 2019. Gosh, that’s right in the range of the new issue that sold so well on Thursday. Imagine!
Primary dealers offered the Fed a total of $21.9 billion in Treasury securities that matured in this time period and the central bank bought back $7.5 billion of them. Apparently, this will be the procedure that the Fed will follow in upcoming weeks as the indication is that they will purchase outstanding securities on a regular basis.
The Fed is expected to buy roughly $12 billion of Treasury securities every week until they exhaust the planned $300 billion in purchases as announced last week. Friday, March 27, they are going to be purchasing at the short end of the yield curve with dates running from March 2011 to April 2012. Planned are three purchases next week, with some maturity dates expected to run from August 2026 through February 2039.
One of the prominent explanations for the intermediate-term purchases is that the Fed thinks it will help keep mortgage rates down since most 30-year mortgages have an average life of about seven years. If choosing this maturity just happens to provide liquidity to the market so that the Treasury has an easier time of placing its new issues, well so be it!
So, it looks as if we are on our way.
Where?
To the land of Oz?
We are starting to see the Fed get serious about monetizing the debt. The talking is over and the direct impact on the market is now under way. At $12 billion in purchases every week, this means that for the next 25 weeks or so, the Fed will be entering the Treasury market acquiring more securities. And, this doesn’t include the provision to purchase mortgage-backed securities in large dollar amounts.
On the other side, as we saw with the $98 billion in new issues this week, the “recovery program” will be providing plenty of additional debt to the market during this period of time. Relieving primary dealers of outstanding issues will certainly “grease the wheels” for the Treasury in terms of the additional debt issue that will need to be placed.
So now we are seeing the future. The Wizard is waving his magic hand. Monetizing the government debt! Providing a scheme whereby private interests can make tons of money buying up “legacy assets”! And, a new regulatory scheme to keep the “bad guys” under control! It is a wonder land with a whole new geography.
It’s ironic. Last September, I remember feeling as if the world had changed, shifted, and would not be the same again. The specific time—a Tuesday evening--when I learned that AIG was being nationalized. I just felt different.
I feel that way again. The rules have changed. Maybe better said, the old rules are no longer applicable and we really don’t know what the new rules are—but we know that they will be different.
Will all this work and restore the banking system and speed the economy on to recovery? No one really knows. I guess we are all waiting for a “tipping” point. But the tipping point can mean different things to different people. The administration sees the tipping point producing a recovery. Critics of the administration see the tipping point creating a whole new cycle of inflation.
And, what if no tipping point appears? Well, that will just mean that a greater effort will be put into the attempt to spur the financial system and the economy along.
The most specific thing going right now is what the Federal Reserve is doing. They are purchasing the debt of the government and they are going to continue to do it for a substantial period of time. For today, we see that this effort has helped the Treasury Department place $24 billion of that debt. And, the Fed’s actions will probably continue to ease the placement of the additional new debt in the future.
What we need to look for, in my estimation, is what happens to the value of the dollar in foreign exchange markets. When the Federal Reserve initially announced this program the value of the dollar fell. When this policy of regularly purchasing Treasury securities up to the $300 billion proposed becomes excessive in the minds of currency traders, the value of the dollar will begin to decline again. My guess is that this will happen sooner rather than later.
Success!
The issue Thursday was a seven-year note sale of $24 billion and this capped the issuance of $98 billion in Treasury offerings this week. The day before, Wednesday, the auction of five-year notes was “tepid” and the market was nervous at the beginning of the day.
But, something else happened on Wednesday. The Fed began its planned purchases of existing securities. In fact, the Fed bought securities that matured between February 29, 2016 and February 15, 2019. Gosh, that’s right in the range of the new issue that sold so well on Thursday. Imagine!
Primary dealers offered the Fed a total of $21.9 billion in Treasury securities that matured in this time period and the central bank bought back $7.5 billion of them. Apparently, this will be the procedure that the Fed will follow in upcoming weeks as the indication is that they will purchase outstanding securities on a regular basis.
The Fed is expected to buy roughly $12 billion of Treasury securities every week until they exhaust the planned $300 billion in purchases as announced last week. Friday, March 27, they are going to be purchasing at the short end of the yield curve with dates running from March 2011 to April 2012. Planned are three purchases next week, with some maturity dates expected to run from August 2026 through February 2039.
One of the prominent explanations for the intermediate-term purchases is that the Fed thinks it will help keep mortgage rates down since most 30-year mortgages have an average life of about seven years. If choosing this maturity just happens to provide liquidity to the market so that the Treasury has an easier time of placing its new issues, well so be it!
So, it looks as if we are on our way.
Where?
To the land of Oz?
We are starting to see the Fed get serious about monetizing the debt. The talking is over and the direct impact on the market is now under way. At $12 billion in purchases every week, this means that for the next 25 weeks or so, the Fed will be entering the Treasury market acquiring more securities. And, this doesn’t include the provision to purchase mortgage-backed securities in large dollar amounts.
On the other side, as we saw with the $98 billion in new issues this week, the “recovery program” will be providing plenty of additional debt to the market during this period of time. Relieving primary dealers of outstanding issues will certainly “grease the wheels” for the Treasury in terms of the additional debt issue that will need to be placed.
So now we are seeing the future. The Wizard is waving his magic hand. Monetizing the government debt! Providing a scheme whereby private interests can make tons of money buying up “legacy assets”! And, a new regulatory scheme to keep the “bad guys” under control! It is a wonder land with a whole new geography.
It’s ironic. Last September, I remember feeling as if the world had changed, shifted, and would not be the same again. The specific time—a Tuesday evening--when I learned that AIG was being nationalized. I just felt different.
I feel that way again. The rules have changed. Maybe better said, the old rules are no longer applicable and we really don’t know what the new rules are—but we know that they will be different.
Will all this work and restore the banking system and speed the economy on to recovery? No one really knows. I guess we are all waiting for a “tipping” point. But the tipping point can mean different things to different people. The administration sees the tipping point producing a recovery. Critics of the administration see the tipping point creating a whole new cycle of inflation.
And, what if no tipping point appears? Well, that will just mean that a greater effort will be put into the attempt to spur the financial system and the economy along.
The most specific thing going right now is what the Federal Reserve is doing. They are purchasing the debt of the government and they are going to continue to do it for a substantial period of time. For today, we see that this effort has helped the Treasury Department place $24 billion of that debt. And, the Fed’s actions will probably continue to ease the placement of the additional new debt in the future.
What we need to look for, in my estimation, is what happens to the value of the dollar in foreign exchange markets. When the Federal Reserve initially announced this program the value of the dollar fell. When this policy of regularly purchasing Treasury securities up to the $300 billion proposed becomes excessive in the minds of currency traders, the value of the dollar will begin to decline again. My guess is that this will happen sooner rather than later.
Tuesday, March 24, 2009
Liquidity or Solvency?
The debate over the Public-Private Investment Program (P-PIP) put forward by Treasury Secretary Timothy Geithner seems to be focusing upon a technical point concerning the condition of the market for troubled assets. In the eyes of some, the question relating to whether or not the program will work depends upon whether the problem being dealt with is a liquidity problem or a solvency problem.
The preliminary judgment is that if the problem is a liquidity problem then P-PIP will be an adequate solution. If the problem is a solvency problem then P-PIP will probably not do the job.
Unfortunately, this debate has gone on for a long time…going back to at least December 2007 when the Federal Reserve initiated its Term Auction Facility (TAF). The Fed’s action at that time was an effort to relieve pressures on the banking system by providing a more direct and more liquid approach (than borrowing at the discount window) toward getting short-term funds to the banks that needed liquidity. Additional efforts have been made since then to provide liquidity for different sectors of the financial markets.
The crucial issue connected with a liquidity crisis is addressed in the first sentence of the last paragraph. A “liquidity crisis” by its very nature is a short-term phenomenon. To say that the debate has gone on for a long time is to confirm that the “crisis” we are in is NOT a liquidity crisis.
A liquidity crisis occurs when some kind of shock hits short term financial markets. The “shock” usually takes the form of a new piece of information that is contrary to the current beliefs held by the participants in these markets. A classic example is the situation that revolved around the Penn Central Railroad and the commercial paper market. Because of financial problems at Penn Central the rating given to Penn Central’s commercial paper was revised downward. This revision shocked the commercial paper market and the market basically closed down. The reason was that if the Penn Central rating needed to be lowered, the question became “what other commercial paper ratings needed to be lowered?” The buy-side left the market. Hence, the “liquidity crisis.”
Since borrowers in the commercial paper market could not roll-over their paper, they had to go into the commercial banks and draw on their back-up lines of credit. The problem then fell to the banking system. And, if the banks tried to sell short-term securities to get funds for to honor the lines of credit this would cause security prices to plummet.
The Federal Reserve responded in classic central bank style by opening the discount window, supplying sufficient liquidity to the banks that needed funds to support lines of credit. The banks were able to honor the back-up lines of credit without having to sell securities and the commercial paper market was given the time to access the information on borrowers in the commercial paper market and the buyers returned and the market stabilized.
The point of this is that a “liquidity crisis” is a short-run problem. The crisis occurs because market participants get some information that is not consistent with what they had formerly believed. They need to process the new information and until they do, the buy-side of the market usually disappears. The solution to this problem is for the central bank to supply sufficient liquidity to the market so that the participants have time to process the new information. Liquidity problems usually last only a few weeks.
Solvency problems are of a completely different nature. And, as I have written about over the past year or so, resolving solvency problems take a long, long time. And, with solvency problems it is not an issue of providing liquidity to the market so that assets can get sold. Solvency problems have to do with charging off book values to reflect the underlying economic values of assets. Yes, there is uncertainty with respect to what is the underlying economic value of the assets, but that is why time is needed and cannot be hurried along.
There is only one way to hurry time along in issues relating to solvency and that is to charge off the asset, or at least charge off a major part of the asset. The problem is that banks, and other institutions, don’t like to rush this process. They want to see how the situation with respect to the asset can be worked out, what can be recovered, and whether or not they can hold onto the asset long enough so that economic conditions can improve which will lead to higher asset values. This is not a liquidity problem!
Why would private investment funds want to get into such a deal?
Only if they smell blood!
And, where would this smell of blood come from? It could come from two places: first, if the probability of the improving economy were high enough to cause these private investors to believe that their speculation on these assets has a fair chance of turning out favorably; and second, these investors believe that the government is providing them a rich enough protection of their money to make it worthwhile to commit to such a speculation.
These private investment funds will not purchase these assets as a public service. Thus, they will only purchase assets if they believe that they can earn a bunch of money, because it is a risky investment. Thus, they either have to see the opportunity to make a lot of money or to believe that they are sufficiently protected on the down side to take a chance.
The two issues for the public on the P-PIP are these: first, is the government, once again, giving away a lot of loot to the ‘bad guys’ in the financial community; and second, is the government providing protection on the down-side that will cost the tax payer a lot of money in the future if P-PIP doesn’t work.
But there are still several other issues hanging around. For one, the success of P-PIP depends upon the economic recovery beginning later this year as Chairman Bernanke has projected. For another, the success of P-PIP depends upon the willingness of the financial institutions that now hold the “toxic” assets—whoops—the “legacy” assets, to begin lending once they are able to dispose of these assets. And, the success of the P-PIP depends upon the ability of existing managements to really turn their businesses around (see my post of March 23, 2009, “A Lesson from AIG for the Bank Bailout Plan”, http://maseportfolio.blogspot.com/), a possibility of which we are not yet certain. And, there are more.
As is obvious, I still have concerns about policymakers (as I have had for the past 18 months or so) and whether or not they are attacking the correct problems. In the case of the P-PIP, if they are fighting a liquidity problem I fear that the program will not be very successful. We have a solvency problem and a solvency problem, by its very nature involves a concern about capital adequacy. In my mind, the capital problem is going to have to be faced, one way or another, before we get out of this crisis. The sooner we realize this and attempt to do something about it, the better off we will all be.
The preliminary judgment is that if the problem is a liquidity problem then P-PIP will be an adequate solution. If the problem is a solvency problem then P-PIP will probably not do the job.
Unfortunately, this debate has gone on for a long time…going back to at least December 2007 when the Federal Reserve initiated its Term Auction Facility (TAF). The Fed’s action at that time was an effort to relieve pressures on the banking system by providing a more direct and more liquid approach (than borrowing at the discount window) toward getting short-term funds to the banks that needed liquidity. Additional efforts have been made since then to provide liquidity for different sectors of the financial markets.
The crucial issue connected with a liquidity crisis is addressed in the first sentence of the last paragraph. A “liquidity crisis” by its very nature is a short-term phenomenon. To say that the debate has gone on for a long time is to confirm that the “crisis” we are in is NOT a liquidity crisis.
A liquidity crisis occurs when some kind of shock hits short term financial markets. The “shock” usually takes the form of a new piece of information that is contrary to the current beliefs held by the participants in these markets. A classic example is the situation that revolved around the Penn Central Railroad and the commercial paper market. Because of financial problems at Penn Central the rating given to Penn Central’s commercial paper was revised downward. This revision shocked the commercial paper market and the market basically closed down. The reason was that if the Penn Central rating needed to be lowered, the question became “what other commercial paper ratings needed to be lowered?” The buy-side left the market. Hence, the “liquidity crisis.”
Since borrowers in the commercial paper market could not roll-over their paper, they had to go into the commercial banks and draw on their back-up lines of credit. The problem then fell to the banking system. And, if the banks tried to sell short-term securities to get funds for to honor the lines of credit this would cause security prices to plummet.
The Federal Reserve responded in classic central bank style by opening the discount window, supplying sufficient liquidity to the banks that needed funds to support lines of credit. The banks were able to honor the back-up lines of credit without having to sell securities and the commercial paper market was given the time to access the information on borrowers in the commercial paper market and the buyers returned and the market stabilized.
The point of this is that a “liquidity crisis” is a short-run problem. The crisis occurs because market participants get some information that is not consistent with what they had formerly believed. They need to process the new information and until they do, the buy-side of the market usually disappears. The solution to this problem is for the central bank to supply sufficient liquidity to the market so that the participants have time to process the new information. Liquidity problems usually last only a few weeks.
Solvency problems are of a completely different nature. And, as I have written about over the past year or so, resolving solvency problems take a long, long time. And, with solvency problems it is not an issue of providing liquidity to the market so that assets can get sold. Solvency problems have to do with charging off book values to reflect the underlying economic values of assets. Yes, there is uncertainty with respect to what is the underlying economic value of the assets, but that is why time is needed and cannot be hurried along.
There is only one way to hurry time along in issues relating to solvency and that is to charge off the asset, or at least charge off a major part of the asset. The problem is that banks, and other institutions, don’t like to rush this process. They want to see how the situation with respect to the asset can be worked out, what can be recovered, and whether or not they can hold onto the asset long enough so that economic conditions can improve which will lead to higher asset values. This is not a liquidity problem!
Why would private investment funds want to get into such a deal?
Only if they smell blood!
And, where would this smell of blood come from? It could come from two places: first, if the probability of the improving economy were high enough to cause these private investors to believe that their speculation on these assets has a fair chance of turning out favorably; and second, these investors believe that the government is providing them a rich enough protection of their money to make it worthwhile to commit to such a speculation.
These private investment funds will not purchase these assets as a public service. Thus, they will only purchase assets if they believe that they can earn a bunch of money, because it is a risky investment. Thus, they either have to see the opportunity to make a lot of money or to believe that they are sufficiently protected on the down side to take a chance.
The two issues for the public on the P-PIP are these: first, is the government, once again, giving away a lot of loot to the ‘bad guys’ in the financial community; and second, is the government providing protection on the down-side that will cost the tax payer a lot of money in the future if P-PIP doesn’t work.
But there are still several other issues hanging around. For one, the success of P-PIP depends upon the economic recovery beginning later this year as Chairman Bernanke has projected. For another, the success of P-PIP depends upon the willingness of the financial institutions that now hold the “toxic” assets—whoops—the “legacy” assets, to begin lending once they are able to dispose of these assets. And, the success of the P-PIP depends upon the ability of existing managements to really turn their businesses around (see my post of March 23, 2009, “A Lesson from AIG for the Bank Bailout Plan”, http://maseportfolio.blogspot.com/), a possibility of which we are not yet certain. And, there are more.
As is obvious, I still have concerns about policymakers (as I have had for the past 18 months or so) and whether or not they are attacking the correct problems. In the case of the P-PIP, if they are fighting a liquidity problem I fear that the program will not be very successful. We have a solvency problem and a solvency problem, by its very nature involves a concern about capital adequacy. In my mind, the capital problem is going to have to be faced, one way or another, before we get out of this crisis. The sooner we realize this and attempt to do something about it, the better off we will all be.
Monday, March 23, 2009
A Lesson from AIG for the Bank Bailout Plan
One of the reasons given for the awarding of bonuses at AIG was the need to keep people around that had “expertise.” That is, if we lose the “experts” we are really in trouble!
This, to me, is one of the greatest fallacies in the corporate world.
It is a fallacy for two very important reasons. The first fallacy is that people are irreplaceable. The second fallacy is that the people that performed badly in the past can get you out of the mess they got you into.
In my experience, no one is irreplaceable and the minute that you begin to believe that either you or the people in charge are irreplaceable you are setting yourself up for big problems. We do not need Rick Wagoner of General Motors nor do we need Vikram Pandit of Citigroup. They are not indispensable in any recovery or turnaround of the companies that they are a part of. Neither are the traders, or the quants, or other executives that got these companies where they are.
We are sold a “bill of goods” about how important these people are to the organization, yet it is remarkably surprising that when they are gone things don’t fall apart. In most cases the situation improves and the company performs at a higher level. It just seems as if in a complex and difficult situation that putting “someone new” in authority is the more dangerous path.
Time-after-time we see that replacing these people is not dangerous. In fact, it turns out to be the best thing that could happen.
Obviously, the incumbents want you to believe that they are indispensable. They will do everything that they need to do to convince you of their importance to future success. And, this includes groveling to the government to assure that they will be kept in place when and if the government bails out their organization or takes it over. Rick Wagoner is sure acting different these days when he is desperate to retain his position at General Motors that he did when he arrogantly arrived in Washington, D. C. on his first trip to the “big” city to appear at Congressional hearings.
Let me add here, however, that this is one of the worst things that the government does when it bails out a company. Because government doesn’t know any better, it often buys into the argument that the current leadership should stay on after the bailout because it has the experience and knows the company better than anyone else does. Government assistance tends to entrench existing management. After all, since the government has worked with this management team to create the bailout in which they are now companions rather than adversaries. That is, they are in bed together.
This is a good reason why government needs to let the shareholders or the bankruptcy courts handle most of these situations. If a management change is needed, there needs to be a practiced means of proceeding toward an orderly transition of power rather than have government insert its heavy hand into the process. Even if government appoints new executive leadership, the choice is usually a person who is an “expert” with “experience” in that firm, which, again, limits the possibilities that the firm will move ahead into the future rather than stay mired in the past.
My experience with the second fallacy also leads me to believe that the “experienced” people should be removed. During the savings and loan crisis, I don’t know how many times I heard the executives of failing thrift institutions seeking money in an IPO tell potential investors, “Yes, we were the ones that managed the organization that brought it to the edge of failure, but, we have learned from this experience! You should give us $100 million in our IPO.”
What have these executives learned?
They have learned how to fail, that’s what they have learned!
There was an interesting article in the business section of the Sunday New York Times which discussed investing in start up companies. I remember myself, because I have worked in that space, that one of the old “truths” of investing in young entrepreneurs is that you should look at people who have failed in earlier business attempts and it even was a “badge of honor” to have failed many times. Recent research does not support this conclusion. On average, those that have failed starting businesses tend to continue to fail. This attitude relating to failure was advice given to venture capitalists or angel investors that are looking desperately to place money. The situation arose during “booms” when there was too much money chasing too few deals. Nothing replaces the success of an entrepreneur as a guide to potential future success.
Still one has to be careful here. Two cases come to mind. First, Nassim Nicholas Taleb in his book “Fooled by Randomness” discusses traders that succeed fantastically because they are in the right spot at the right time. Through no skill of their own do they achieve success, and, because they now think that they are geniuses, go on and lose most if not all of what they gained in their one success. Obviously, these people are not geniuses and should not be treated as such. What you want is people that continue to succeed and succeed in ways that are not just lucky successes.
Second, in an “up” market, almost everyone can succeed, sometimes spectacularly. This can happen in overheated housing markets, in firms that are of the dot.com variety, and in growing and running financial institutions. Credit bubbles help. The sad thing about this is that the people that have just benefited from the “bubble” and not from their “skill” are not found out until the “bubble” bursts. Then the true reason for the success of these individuals becomes obvious.
Furthermore, if a chief executive or a management operated in an environment that was “hot” and where increased risk taking and adding additional leverage were the skills needed in order to succeed they are not the chief executive or management to operate within an environment that is “cool” and where reducing risk and de-leveraging are the tools required. Speed racers are not needed on streets where the speed limit is 25 miles per hour.
It should be clear that the people that get you into a mess are not the people you should count on to get you out of the mess. But, again, the government usually does not see this except in cases of fraud or other types of criminal behavior. Therefore, the government will often stick with those people that are experienced in failure.
These comments can be applied to any approach the government takes to resolving issues in the private sector, whether it be in terms of dealing with the toxic assets of financial institutions or bailing out failed managements in the auto industry. The government must be realistic in what it can do. A bank bailout plan that just brings in private investors to relieve institutions of bad debts while leaving bank managements in place is not going to give the financial sector and the economy what it needs.
Yes, something needs to be done about the bad assets banks have on their books. Losses have to be absorbed by the banks and their owners, themselves, or the government must absorb the losses. The insolvent banks, and auto companies, need to be closed or put into bankruptcy. The world needs to move on and the bad decisions of the past must be accounted for. Someone must pay—sometime. Unfortunately, when government gets involved, the solutions to things often only get postponed or delayed. That is not what the financial markets or the economy needs at this time.
And, this includes Cerberus and Chrysler Corp. Cerberus made a wrong deal at the wrong time. They need to move on.
This, to me, is one of the greatest fallacies in the corporate world.
It is a fallacy for two very important reasons. The first fallacy is that people are irreplaceable. The second fallacy is that the people that performed badly in the past can get you out of the mess they got you into.
In my experience, no one is irreplaceable and the minute that you begin to believe that either you or the people in charge are irreplaceable you are setting yourself up for big problems. We do not need Rick Wagoner of General Motors nor do we need Vikram Pandit of Citigroup. They are not indispensable in any recovery or turnaround of the companies that they are a part of. Neither are the traders, or the quants, or other executives that got these companies where they are.
We are sold a “bill of goods” about how important these people are to the organization, yet it is remarkably surprising that when they are gone things don’t fall apart. In most cases the situation improves and the company performs at a higher level. It just seems as if in a complex and difficult situation that putting “someone new” in authority is the more dangerous path.
Time-after-time we see that replacing these people is not dangerous. In fact, it turns out to be the best thing that could happen.
Obviously, the incumbents want you to believe that they are indispensable. They will do everything that they need to do to convince you of their importance to future success. And, this includes groveling to the government to assure that they will be kept in place when and if the government bails out their organization or takes it over. Rick Wagoner is sure acting different these days when he is desperate to retain his position at General Motors that he did when he arrogantly arrived in Washington, D. C. on his first trip to the “big” city to appear at Congressional hearings.
Let me add here, however, that this is one of the worst things that the government does when it bails out a company. Because government doesn’t know any better, it often buys into the argument that the current leadership should stay on after the bailout because it has the experience and knows the company better than anyone else does. Government assistance tends to entrench existing management. After all, since the government has worked with this management team to create the bailout in which they are now companions rather than adversaries. That is, they are in bed together.
This is a good reason why government needs to let the shareholders or the bankruptcy courts handle most of these situations. If a management change is needed, there needs to be a practiced means of proceeding toward an orderly transition of power rather than have government insert its heavy hand into the process. Even if government appoints new executive leadership, the choice is usually a person who is an “expert” with “experience” in that firm, which, again, limits the possibilities that the firm will move ahead into the future rather than stay mired in the past.
My experience with the second fallacy also leads me to believe that the “experienced” people should be removed. During the savings and loan crisis, I don’t know how many times I heard the executives of failing thrift institutions seeking money in an IPO tell potential investors, “Yes, we were the ones that managed the organization that brought it to the edge of failure, but, we have learned from this experience! You should give us $100 million in our IPO.”
What have these executives learned?
They have learned how to fail, that’s what they have learned!
There was an interesting article in the business section of the Sunday New York Times which discussed investing in start up companies. I remember myself, because I have worked in that space, that one of the old “truths” of investing in young entrepreneurs is that you should look at people who have failed in earlier business attempts and it even was a “badge of honor” to have failed many times. Recent research does not support this conclusion. On average, those that have failed starting businesses tend to continue to fail. This attitude relating to failure was advice given to venture capitalists or angel investors that are looking desperately to place money. The situation arose during “booms” when there was too much money chasing too few deals. Nothing replaces the success of an entrepreneur as a guide to potential future success.
Still one has to be careful here. Two cases come to mind. First, Nassim Nicholas Taleb in his book “Fooled by Randomness” discusses traders that succeed fantastically because they are in the right spot at the right time. Through no skill of their own do they achieve success, and, because they now think that they are geniuses, go on and lose most if not all of what they gained in their one success. Obviously, these people are not geniuses and should not be treated as such. What you want is people that continue to succeed and succeed in ways that are not just lucky successes.
Second, in an “up” market, almost everyone can succeed, sometimes spectacularly. This can happen in overheated housing markets, in firms that are of the dot.com variety, and in growing and running financial institutions. Credit bubbles help. The sad thing about this is that the people that have just benefited from the “bubble” and not from their “skill” are not found out until the “bubble” bursts. Then the true reason for the success of these individuals becomes obvious.
Furthermore, if a chief executive or a management operated in an environment that was “hot” and where increased risk taking and adding additional leverage were the skills needed in order to succeed they are not the chief executive or management to operate within an environment that is “cool” and where reducing risk and de-leveraging are the tools required. Speed racers are not needed on streets where the speed limit is 25 miles per hour.
It should be clear that the people that get you into a mess are not the people you should count on to get you out of the mess. But, again, the government usually does not see this except in cases of fraud or other types of criminal behavior. Therefore, the government will often stick with those people that are experienced in failure.
These comments can be applied to any approach the government takes to resolving issues in the private sector, whether it be in terms of dealing with the toxic assets of financial institutions or bailing out failed managements in the auto industry. The government must be realistic in what it can do. A bank bailout plan that just brings in private investors to relieve institutions of bad debts while leaving bank managements in place is not going to give the financial sector and the economy what it needs.
Yes, something needs to be done about the bad assets banks have on their books. Losses have to be absorbed by the banks and their owners, themselves, or the government must absorb the losses. The insolvent banks, and auto companies, need to be closed or put into bankruptcy. The world needs to move on and the bad decisions of the past must be accounted for. Someone must pay—sometime. Unfortunately, when government gets involved, the solutions to things often only get postponed or delayed. That is not what the financial markets or the economy needs at this time.
And, this includes Cerberus and Chrysler Corp. Cerberus made a wrong deal at the wrong time. They need to move on.
Thursday, March 19, 2009
The Fed Moves to Monetize
The Federal Reserve shocked the financial markets yesterday. The Fed released the results of its just-ended Federal Open Market Committee meeting and the response was immediate—stock market indices went up—and the value of the dollar went down!
The reason—the Open Market Committee approved a plan to purchase up to $300 billion of longer-term Treasury securities over the next six months. This is in addition to a plan to increase the Fed’s purchase of up to an additional $750 billion of agency mortgage-backed securities.
The stock markets took this surprise as a positive sign that the Fed was being true to what Chairman Ben Bernanke had indicated in recent speeches and interviews—“the Federal Reserve will employ all available tools to promote economic recovery.” (Oh, he also added “and to preserve price stability.”) Good news—right? Well, the stock market seemed to be “mixed” today.
The foreign exchange markets took another view and the value of the dollar dropped sharply, and the selloff was “widespread” according to the Wall Street Journal. Bad news—right? Well, the value of the dollar continued to decline today.
It is a complex story. I have been one that has continuously expressed concern over the long term prospects for the dollar in foreign exchange markets. See for example my post “The Obama Stimulus Plan and the Dollar: Is There a Connection (http://seekingalpha.com/article/114310-the-obama-stimulus-plan-and-the-dollar-is-there-a-connection). The concern is over the huge United States budget deficit and how this deficit is to be financed in future years. The long-run view of such large deficits is that a substantial portion of them will have to be monetized by the central bank. The fundamental effort of all Keynesian fiscal policy is to inflate or reflate the economy.
There are some complicating factors to this simple story. Through all the financial and economic turmoil of the past six months the dollar has not declined in value but has actually strengthened. If participants in the financial markets are so concerned about the deficits of the United States government and the possibility that the Federal Reserve will monetize a bunch of the debt, why has the value of the dollar gone in the direction it has? Why hasn’t the value of the dollar tanked, instead?
For one, the United States dollar is the “world” currency and it still is the currency of choice in times of uncertainty and turmoil. Thus, the strength of the dollar has, to a large extent, been the result of a “flight to safety” on the part of many investors in the world. It will, undoubtedly, continue to be a “safe haven” for much of the world’s wealth for a long while into the future.
Second, because most of the whole world is in some kind of a recession and are following similar fiscal and monetary policies, it becomes difficult to discern which currencies throughout the world are going to be the worst off. If changes in the value of currencies are a result of changes in the relative prospect for future inflation in different countries, then the exchange rates will ultimately be dependent upon just how each of these countries handles the pressures created by their own stimulus packages.
As for the United States dollar, the most important factor determining its value in the near term is going to be the “safety” factor. Still, other factors, like the aggressive posture of the Federal Open Market Committee cannot be ignored. And, this seems to be what is happening right now in foreign exchange markets. I would argue that even though this latter movement might be a short-run phenomenon, a person concerned with the future health of the United States economy should not ignore what the foreign exchange market might be telling us.
I continue to go to this statement of Paul Volcker: “a nation’s exchange rate is the single most important price in the economy.” (Paul Volcker and Toyoo Gyohten, “Changing Fortunes: the World’s Money and the Threat to American Leadership,” (New York: Times Books, 1992), p. 232.) Consequently, what is happening or will happen to this price should be of major concern to investors. This price will carry with it the view of the world investment community about how the United States is conducting its fiscal and monetary policies.
This is something that the Obama administration and the Federal Reserve System need to pay attention to. The most recent example of ignoring information like this came during the years of the Bush administration. In 2001 a tax cut was passed by the government that took the government budget from a surplus to a deficit position. This was followed by increasing expenditures that went to support several military engagements around the world. The fundamental market response to this was that the value of the dollar began to decline early in 2002.
In addition to this the Federal Reserve System kept short term interest rates at very low levels (the effective Federal Funds rate was below 2% from early in 2002 until the beginning of 2005) for an extended period of time which resulted in negative real rates of interest during this interval. Participants in foreign exchange markets continued to put pressure on the value of the dollar into the summer of 2008. Even though officials in the Bush administration and the Federal Reserve System claimed that they were watching the value of the dollar and maintaining its value was an important goal, little or nothing was done about this decline and the market value continued to sink.
The value of the dollar is something that we need to continue to watch closely. The concern over the monetary and fiscal policies of the Obama administration is not misplaced. A warning shot was issued this week by the Chinese Premier Wen Jiabao when he indicated that he was a “little bit worried” about the safety of the U. S. Treasury bonds that his government owns. The reaction of the foreign exchange market to the Fed’s announcement about their plan to buy up to $300 billion of longer-term Treasury securities is another. And, there is also the concern of some analysts that the real financial and economic issue facing the United States is one of “too much debt” and that this debt overload is exacerbating the economic slowdown. As the historian Niall Ferguson, author of “The Ascent of Money” (see review at http://seekingalpha.com/article/120595-a-financial-history-of-the-world), has stated, “the solution to the problem of having too much debt around is not creating more debt.”
Is the decision of the Federal Open Market Committee to purchase up to $300 billion of longer-term Treasury issues the next step in the monetizing of the debt? Will the release of this information contribute to a further decline in the value of the dollar? There are, of course, a lot of “known unknowns” and “unknown unknowns” at this time. Obviously, it is a very risky time. However, in my view, eventually the value of the dollar will continue to erode. History has shown that this is what eventually happens in situations like the one we are in.
The reason—the Open Market Committee approved a plan to purchase up to $300 billion of longer-term Treasury securities over the next six months. This is in addition to a plan to increase the Fed’s purchase of up to an additional $750 billion of agency mortgage-backed securities.
The stock markets took this surprise as a positive sign that the Fed was being true to what Chairman Ben Bernanke had indicated in recent speeches and interviews—“the Federal Reserve will employ all available tools to promote economic recovery.” (Oh, he also added “and to preserve price stability.”) Good news—right? Well, the stock market seemed to be “mixed” today.
The foreign exchange markets took another view and the value of the dollar dropped sharply, and the selloff was “widespread” according to the Wall Street Journal. Bad news—right? Well, the value of the dollar continued to decline today.
It is a complex story. I have been one that has continuously expressed concern over the long term prospects for the dollar in foreign exchange markets. See for example my post “The Obama Stimulus Plan and the Dollar: Is There a Connection (http://seekingalpha.com/article/114310-the-obama-stimulus-plan-and-the-dollar-is-there-a-connection). The concern is over the huge United States budget deficit and how this deficit is to be financed in future years. The long-run view of such large deficits is that a substantial portion of them will have to be monetized by the central bank. The fundamental effort of all Keynesian fiscal policy is to inflate or reflate the economy.
There are some complicating factors to this simple story. Through all the financial and economic turmoil of the past six months the dollar has not declined in value but has actually strengthened. If participants in the financial markets are so concerned about the deficits of the United States government and the possibility that the Federal Reserve will monetize a bunch of the debt, why has the value of the dollar gone in the direction it has? Why hasn’t the value of the dollar tanked, instead?
For one, the United States dollar is the “world” currency and it still is the currency of choice in times of uncertainty and turmoil. Thus, the strength of the dollar has, to a large extent, been the result of a “flight to safety” on the part of many investors in the world. It will, undoubtedly, continue to be a “safe haven” for much of the world’s wealth for a long while into the future.
Second, because most of the whole world is in some kind of a recession and are following similar fiscal and monetary policies, it becomes difficult to discern which currencies throughout the world are going to be the worst off. If changes in the value of currencies are a result of changes in the relative prospect for future inflation in different countries, then the exchange rates will ultimately be dependent upon just how each of these countries handles the pressures created by their own stimulus packages.
As for the United States dollar, the most important factor determining its value in the near term is going to be the “safety” factor. Still, other factors, like the aggressive posture of the Federal Open Market Committee cannot be ignored. And, this seems to be what is happening right now in foreign exchange markets. I would argue that even though this latter movement might be a short-run phenomenon, a person concerned with the future health of the United States economy should not ignore what the foreign exchange market might be telling us.
I continue to go to this statement of Paul Volcker: “a nation’s exchange rate is the single most important price in the economy.” (Paul Volcker and Toyoo Gyohten, “Changing Fortunes: the World’s Money and the Threat to American Leadership,” (New York: Times Books, 1992), p. 232.) Consequently, what is happening or will happen to this price should be of major concern to investors. This price will carry with it the view of the world investment community about how the United States is conducting its fiscal and monetary policies.
This is something that the Obama administration and the Federal Reserve System need to pay attention to. The most recent example of ignoring information like this came during the years of the Bush administration. In 2001 a tax cut was passed by the government that took the government budget from a surplus to a deficit position. This was followed by increasing expenditures that went to support several military engagements around the world. The fundamental market response to this was that the value of the dollar began to decline early in 2002.
In addition to this the Federal Reserve System kept short term interest rates at very low levels (the effective Federal Funds rate was below 2% from early in 2002 until the beginning of 2005) for an extended period of time which resulted in negative real rates of interest during this interval. Participants in foreign exchange markets continued to put pressure on the value of the dollar into the summer of 2008. Even though officials in the Bush administration and the Federal Reserve System claimed that they were watching the value of the dollar and maintaining its value was an important goal, little or nothing was done about this decline and the market value continued to sink.
The value of the dollar is something that we need to continue to watch closely. The concern over the monetary and fiscal policies of the Obama administration is not misplaced. A warning shot was issued this week by the Chinese Premier Wen Jiabao when he indicated that he was a “little bit worried” about the safety of the U. S. Treasury bonds that his government owns. The reaction of the foreign exchange market to the Fed’s announcement about their plan to buy up to $300 billion of longer-term Treasury securities is another. And, there is also the concern of some analysts that the real financial and economic issue facing the United States is one of “too much debt” and that this debt overload is exacerbating the economic slowdown. As the historian Niall Ferguson, author of “The Ascent of Money” (see review at http://seekingalpha.com/article/120595-a-financial-history-of-the-world), has stated, “the solution to the problem of having too much debt around is not creating more debt.”
Is the decision of the Federal Open Market Committee to purchase up to $300 billion of longer-term Treasury issues the next step in the monetizing of the debt? Will the release of this information contribute to a further decline in the value of the dollar? There are, of course, a lot of “known unknowns” and “unknown unknowns” at this time. Obviously, it is a very risky time. However, in my view, eventually the value of the dollar will continue to erode. History has shown that this is what eventually happens in situations like the one we are in.
Tuesday, March 17, 2009
AIG, an example of a bailout!
“If there is a single episode in this entire 18 months that has made me more angry, I can’t think of one other than AIG. AIG exploited a huge gap in the regulatory system.”
These words were spoken by Ben Bernanke, Chairman of the Board of Governors of the Federal Reserve System in testimony on Tuesday, March 3, 2009 before the Senate Banking Committee. Bernanke expressed further anguish at the behavior of AIG on Sixty Minutes Sunday evening.
Professor, welcome to the real world!
Treasury Secretary Timothy Geithner echoed some of the same feelings in testimony on the same day before the House Ways and Means Committee when he stated that some areas of AIG were not under “adult supervision.”
Come on, Timmy, I try and stop people from making the same claim about the bank bailout plans of the Treasury Department.
Is the Obama team becoming so defensive about their program that they are beginning to resort to name calling to deflect criticism?
Did AIG exploit a huge gap in the regulatory system? Yes, they did. And that is what people do over and over again in the real world. It is called “responding to incentives.” The world is full of incentives…some positive incentives…some negative incentives…and so on. That is what the study of economics is all about! Give the people in the Obama administration a copy of “Freakonomics”!
I have been in the Federal Reserve System…I have worked for a cabinet Secretary in Washington, D. C….and I have run publically traded financial institutions…and one thing is especially clear…people respond to incentives.
Some of those incentives are to innovate in products and markets. And, what do economists tell potential innovators to look for? Missing markets. Incomplete Markets. Places that are not being served or regulated.
Why do you look in these areas? Well, because that is where a person…or a business…can find a place to achieve a competitive advantage. Being a “first-mover” or a “second-mover” into a market is a way to achieve exceptional returns…at least for a short time period. And, this is plenty of incentive to draw people into the effort.
It is a highly risky effort and a lot of people and businesses fail because it is so risky. But, the incentives are substantial enough that people are continually drawn into the exercise.
A competitive advantage may not last for a very long time. People that find opportunities to arbitrage markets…traders…may find segments in a market place to exploit for a period of time…but, over time competitive advantage does not seem to last for specific trading schemes…see Enron and Long Term Capital Management. In such cases, you need to keep coming up with something new. That is what businesses producing Information Goods do.
One of the games played in the financial services area…and I have experienced this in my professional life beginning in the 1960s…is to find the hole in the regulatory structure. It is a game that the regulators are always behind in. The private sector does something…the regulators close the gap with new regulations…the private sector finds a way around this…and the regulators have to close the gap again. And, the game goes on and on because the incentives are such that it is still worthwhile to the private sector to continue to innovate.
Furthermore, anything the government does sets up incentives. And that is why the Obama “recovery plan” is so important…it changes a lot of the incentives that exist within the economy…for better or for worse. Notice the long, long lines of governors, mayors, and other officials that have gathered with their hands out for funds from the “recovery plan”. I am not going to comment any further on the “recovery plan” at this time other than to just highlight the fact that this plan changes incentives…regardless of how much stimulus it provides.
But, to be an equal-opportunity critic, I must mention that the previous administration created incentives that resulted in the present financial crisis. Maintaining negative real rates of interest for at least 18 months created plenty of incentive to leverage and innovate in financial structures and instruments. This period of innovation has created a massive crisis with respect to asset values. (For more on this see my blog post “AIG and Our Core Economic Issue: Unknown Asset Values” http://seekingalpha.com/article/123867-aig-and-our-core-economic-issue-unknown-asset-values.) In my mind, there is going to have to be a resolution to the asset value problem before any stimulus package is going to have much of an effect on the economy.
Anytime the government attempts to impose its hand on the private sector “things happen.” The government is just not attuned to enter the very complex tangled web of the real world with simplistic plans to “set things straight.” Even within the government public officials have started pointing fingers at each other when events don’t go as desired. Last night I saw Barney Frank interviewed by Rachael Maddow. Frank made it very clear that we got into the AIG mess because “the Fed”, without coming to Congress, gave AIG $85 billion last September and this started off all the mess. And, the reason why this bonus thing and other events have occurred is that “the Fed” without the advice or consultation of Congress gave AIG the $85 billion with “no strings attached”!
Wow! Go figur’ that, will ya!
Now, the Wall Street Journal has the headline this morning…”Obama to Avoid Auto Bankruptcies.” The “experts” in the government, we are told, are going to restructure General Motors Corp. and Chrysler LLC outside of the bankruptcy courts. This, we are expected to believe, will give the taxpayers a better and more protected solution than will a court solution. We wait the conclusion…
The real world is tough. People don’t always do what you want them to do. Incentives matter. We must be careful about the incentives we are creating for the future, for one other fact from the field of economics is very clear: sometimes it takes a long time for the full effect of incentives to work their way through an economy. As a consequence, we can often lose sight of the cause of a problem because the incentives that created the problem are embedded somewhere in the distant past.
These words were spoken by Ben Bernanke, Chairman of the Board of Governors of the Federal Reserve System in testimony on Tuesday, March 3, 2009 before the Senate Banking Committee. Bernanke expressed further anguish at the behavior of AIG on Sixty Minutes Sunday evening.
Professor, welcome to the real world!
Treasury Secretary Timothy Geithner echoed some of the same feelings in testimony on the same day before the House Ways and Means Committee when he stated that some areas of AIG were not under “adult supervision.”
Come on, Timmy, I try and stop people from making the same claim about the bank bailout plans of the Treasury Department.
Is the Obama team becoming so defensive about their program that they are beginning to resort to name calling to deflect criticism?
Did AIG exploit a huge gap in the regulatory system? Yes, they did. And that is what people do over and over again in the real world. It is called “responding to incentives.” The world is full of incentives…some positive incentives…some negative incentives…and so on. That is what the study of economics is all about! Give the people in the Obama administration a copy of “Freakonomics”!
I have been in the Federal Reserve System…I have worked for a cabinet Secretary in Washington, D. C….and I have run publically traded financial institutions…and one thing is especially clear…people respond to incentives.
Some of those incentives are to innovate in products and markets. And, what do economists tell potential innovators to look for? Missing markets. Incomplete Markets. Places that are not being served or regulated.
Why do you look in these areas? Well, because that is where a person…or a business…can find a place to achieve a competitive advantage. Being a “first-mover” or a “second-mover” into a market is a way to achieve exceptional returns…at least for a short time period. And, this is plenty of incentive to draw people into the effort.
It is a highly risky effort and a lot of people and businesses fail because it is so risky. But, the incentives are substantial enough that people are continually drawn into the exercise.
A competitive advantage may not last for a very long time. People that find opportunities to arbitrage markets…traders…may find segments in a market place to exploit for a period of time…but, over time competitive advantage does not seem to last for specific trading schemes…see Enron and Long Term Capital Management. In such cases, you need to keep coming up with something new. That is what businesses producing Information Goods do.
One of the games played in the financial services area…and I have experienced this in my professional life beginning in the 1960s…is to find the hole in the regulatory structure. It is a game that the regulators are always behind in. The private sector does something…the regulators close the gap with new regulations…the private sector finds a way around this…and the regulators have to close the gap again. And, the game goes on and on because the incentives are such that it is still worthwhile to the private sector to continue to innovate.
Furthermore, anything the government does sets up incentives. And that is why the Obama “recovery plan” is so important…it changes a lot of the incentives that exist within the economy…for better or for worse. Notice the long, long lines of governors, mayors, and other officials that have gathered with their hands out for funds from the “recovery plan”. I am not going to comment any further on the “recovery plan” at this time other than to just highlight the fact that this plan changes incentives…regardless of how much stimulus it provides.
But, to be an equal-opportunity critic, I must mention that the previous administration created incentives that resulted in the present financial crisis. Maintaining negative real rates of interest for at least 18 months created plenty of incentive to leverage and innovate in financial structures and instruments. This period of innovation has created a massive crisis with respect to asset values. (For more on this see my blog post “AIG and Our Core Economic Issue: Unknown Asset Values” http://seekingalpha.com/article/123867-aig-and-our-core-economic-issue-unknown-asset-values.) In my mind, there is going to have to be a resolution to the asset value problem before any stimulus package is going to have much of an effect on the economy.
Anytime the government attempts to impose its hand on the private sector “things happen.” The government is just not attuned to enter the very complex tangled web of the real world with simplistic plans to “set things straight.” Even within the government public officials have started pointing fingers at each other when events don’t go as desired. Last night I saw Barney Frank interviewed by Rachael Maddow. Frank made it very clear that we got into the AIG mess because “the Fed”, without coming to Congress, gave AIG $85 billion last September and this started off all the mess. And, the reason why this bonus thing and other events have occurred is that “the Fed” without the advice or consultation of Congress gave AIG the $85 billion with “no strings attached”!
Wow! Go figur’ that, will ya!
Now, the Wall Street Journal has the headline this morning…”Obama to Avoid Auto Bankruptcies.” The “experts” in the government, we are told, are going to restructure General Motors Corp. and Chrysler LLC outside of the bankruptcy courts. This, we are expected to believe, will give the taxpayers a better and more protected solution than will a court solution. We wait the conclusion…
The real world is tough. People don’t always do what you want them to do. Incentives matter. We must be careful about the incentives we are creating for the future, for one other fact from the field of economics is very clear: sometimes it takes a long time for the full effect of incentives to work their way through an economy. As a consequence, we can often lose sight of the cause of a problem because the incentives that created the problem are embedded somewhere in the distant past.
Thursday, March 12, 2009
Households and the Debt Problem
The Federal Reserve released new data on the financial condition of the household sector of the United States. Like other sectors of the economy, the financial condition of this sector has deteriorated over the past year.
The value of household assets dropped about 15% falling from $77.3 trillion to around $65.7 trillion. Most of the decline came from the fall in housing values and in their stock market portfolios.
In terms of household holdings of stocks, the value of the stocks households owned, mutual funds that were held and funds in retirement plans, the loss was $8.5 trillion. That is, the value of stock holdings fell from $20.6 trillion to $12.1 trillion.
Although mortgage credit fell during the year, total household liabilities stayed roughly the same at about $14.2 trillion. This means that debt as a percentage of assets rose from around 18% to 22% during the year (or net worth as a percentage of assets dropped from 82% to 78%).
Mortgage credit at the end of 2008 was $10.5 trillion so that other household liabilities totaled around $3.7 trillion, with consumer credit making up $2.6 trillion of this latter number. Mortgage credit fell during the year, but not because the household sector was trying to get out of mortgage debt. The primary reason for the decline was foreclosures and the reduction in the willingness of financial institutions to lend.
What this means is that households took on increased leverage during the year, not because they wanted to in order to grow their balance sheets, but because of the decrease in the value of their assets and because of the need to borrow due to lower incomes. The increased leverage was a result of the collapse of the mortgage market, in particular, and the economy, in general. The increased leverage just happened—it was not planned.
In order to protect themselves in the face of these changes, households moved assets into cash and cash equivalent accounts. Banks deposits held by households were at about $7.7 trillion at year end.
This is important information for understanding the state of the economy and the contribution the household sector might make toward turning the economy around. The household sector was in free fall in 2008 and was reacting to events, not leading them.
Households took three major shocks last year: first was the decline in housing prices; the second was the rise in unemployment; and the third was the fall in the stock market. Not only was their cash flow significantly hurt, but the value of their assets fell precipitously. They borrowed in an effort to hold on and they became more liquid so as to be prepared for that “rainy day.”
The year 2009 does not look any better than 2008. Housing prices continue to plummet. The stock market has dropped since the first of the year. And, unemployment has ratcheted up. That is, one can assume that the direction observed in the balance sheets of American household in 2008 will continue to be followed this year. Even if the stock market were to stabilize or rise through the rest of the year consumer spending, I believe, will continue to be weak. Even if housing prices stabilize. Even with the implementation of the Obama stimulus plan.
According to the best information we have there are three further shocks looming on the horizon. The first two have to do with the mortgage market: over the next 18 a large amount of Alt-A and Options mortgages are supposed to re-price. Given the weakness in employment that is expected to continue and the lower household incomes, this event could be devastating. And, on top of that credit card delinquencies are rising and these are expected to grow given the financial condition of the household sector.
Consumers will continue to withdraw from the marketplace as they add debt where they can in order to maintain at least a part of their former living standards. Also, consumers will continue to try and become more liquid so that they can be prepared should they need to need cash to tide them over a rough time. Any improvement in the stock market will be met with households selling more stock so as to move the funds into more liquid assets, the rise in the market making it easier for them to get rid of stocks—even at a loss.
And where are the funds going to go that come to households from the Obama recovery plan? My guess is that a good portion of them will go into liquid assets, or into paying down debt. Households are scared right now. They are going to use whatever they have as conservatively as possible. This even goes for those that have some security in their employment condition.
The data that are coming out confirm the strength of the problem that the policy makers face. The United States has a tremendous debt overhang. This debt problem is going to have to be worked off. Economists talk about “the paradox of thrift”, the problem that consumers are not spending at this time and probably will not spend much in the near future, even though if everyone opened up their pocketbooks and spent, everyone would be better off.
This situation is like a “Prisoner’s Dilemma” game. If everyone else increases their spending reducing their savings and, willingly, increasing their debt and I don’t follow their lead, then I will be a lot better off that all these other people. But, if everyone else believes as I do and doesn’t reduce their savings and doesn’t increase their debt, then I end up losing big to everyone else. So, as in the “Prisoner’s Dilemma” everyone defaults to the decision to save more where they can and to pay off their debt. The consequence of this will be that consumer spending will remain weak and much effort will be extended, where possible, to work themselves out of debt.
The overall problem is that there is too much debt outstanding. The policy makers are focusing upon stimulating the economy by increasing spending. If the debt overhang is truly too great, then the stimulus package will only have a small multiplier effect on the economy as households try and get their balance sheets back in some kind of order.
Such behavior will not have much affect on the economy, and it will also not have much affect on the stock market. Government policy makers must direct more attention to resolving this debt problem. It seems to me that this is what the financial markets are trying to tell them. As Citigroup and Bank of America claim they are showing some signs of profitability. As General Electric survives a reduction in its credit rating, meaning that GE Capital has more of a chance to re-structure itself. As General Motors indicates that it has reduced costs sufficiently to rescind the request for another $2 billion from the government in March. And, as other financial institutions seek to repay to TARP money they had received last fall, the stock market rebounds.
It is the debt problem that is the big concern of the financial markets. In my opinion, as long as the government policy makers put their primary focus on stimulating spending, the financial markets—and the economy—will continue to flounder. When they refocus on the more crucial problem they will find that the financial markets will be more supportive of what they are doing.
The value of household assets dropped about 15% falling from $77.3 trillion to around $65.7 trillion. Most of the decline came from the fall in housing values and in their stock market portfolios.
In terms of household holdings of stocks, the value of the stocks households owned, mutual funds that were held and funds in retirement plans, the loss was $8.5 trillion. That is, the value of stock holdings fell from $20.6 trillion to $12.1 trillion.
Although mortgage credit fell during the year, total household liabilities stayed roughly the same at about $14.2 trillion. This means that debt as a percentage of assets rose from around 18% to 22% during the year (or net worth as a percentage of assets dropped from 82% to 78%).
Mortgage credit at the end of 2008 was $10.5 trillion so that other household liabilities totaled around $3.7 trillion, with consumer credit making up $2.6 trillion of this latter number. Mortgage credit fell during the year, but not because the household sector was trying to get out of mortgage debt. The primary reason for the decline was foreclosures and the reduction in the willingness of financial institutions to lend.
What this means is that households took on increased leverage during the year, not because they wanted to in order to grow their balance sheets, but because of the decrease in the value of their assets and because of the need to borrow due to lower incomes. The increased leverage was a result of the collapse of the mortgage market, in particular, and the economy, in general. The increased leverage just happened—it was not planned.
In order to protect themselves in the face of these changes, households moved assets into cash and cash equivalent accounts. Banks deposits held by households were at about $7.7 trillion at year end.
This is important information for understanding the state of the economy and the contribution the household sector might make toward turning the economy around. The household sector was in free fall in 2008 and was reacting to events, not leading them.
Households took three major shocks last year: first was the decline in housing prices; the second was the rise in unemployment; and the third was the fall in the stock market. Not only was their cash flow significantly hurt, but the value of their assets fell precipitously. They borrowed in an effort to hold on and they became more liquid so as to be prepared for that “rainy day.”
The year 2009 does not look any better than 2008. Housing prices continue to plummet. The stock market has dropped since the first of the year. And, unemployment has ratcheted up. That is, one can assume that the direction observed in the balance sheets of American household in 2008 will continue to be followed this year. Even if the stock market were to stabilize or rise through the rest of the year consumer spending, I believe, will continue to be weak. Even if housing prices stabilize. Even with the implementation of the Obama stimulus plan.
According to the best information we have there are three further shocks looming on the horizon. The first two have to do with the mortgage market: over the next 18 a large amount of Alt-A and Options mortgages are supposed to re-price. Given the weakness in employment that is expected to continue and the lower household incomes, this event could be devastating. And, on top of that credit card delinquencies are rising and these are expected to grow given the financial condition of the household sector.
Consumers will continue to withdraw from the marketplace as they add debt where they can in order to maintain at least a part of their former living standards. Also, consumers will continue to try and become more liquid so that they can be prepared should they need to need cash to tide them over a rough time. Any improvement in the stock market will be met with households selling more stock so as to move the funds into more liquid assets, the rise in the market making it easier for them to get rid of stocks—even at a loss.
And where are the funds going to go that come to households from the Obama recovery plan? My guess is that a good portion of them will go into liquid assets, or into paying down debt. Households are scared right now. They are going to use whatever they have as conservatively as possible. This even goes for those that have some security in their employment condition.
The data that are coming out confirm the strength of the problem that the policy makers face. The United States has a tremendous debt overhang. This debt problem is going to have to be worked off. Economists talk about “the paradox of thrift”, the problem that consumers are not spending at this time and probably will not spend much in the near future, even though if everyone opened up their pocketbooks and spent, everyone would be better off.
This situation is like a “Prisoner’s Dilemma” game. If everyone else increases their spending reducing their savings and, willingly, increasing their debt and I don’t follow their lead, then I will be a lot better off that all these other people. But, if everyone else believes as I do and doesn’t reduce their savings and doesn’t increase their debt, then I end up losing big to everyone else. So, as in the “Prisoner’s Dilemma” everyone defaults to the decision to save more where they can and to pay off their debt. The consequence of this will be that consumer spending will remain weak and much effort will be extended, where possible, to work themselves out of debt.
The overall problem is that there is too much debt outstanding. The policy makers are focusing upon stimulating the economy by increasing spending. If the debt overhang is truly too great, then the stimulus package will only have a small multiplier effect on the economy as households try and get their balance sheets back in some kind of order.
Such behavior will not have much affect on the economy, and it will also not have much affect on the stock market. Government policy makers must direct more attention to resolving this debt problem. It seems to me that this is what the financial markets are trying to tell them. As Citigroup and Bank of America claim they are showing some signs of profitability. As General Electric survives a reduction in its credit rating, meaning that GE Capital has more of a chance to re-structure itself. As General Motors indicates that it has reduced costs sufficiently to rescind the request for another $2 billion from the government in March. And, as other financial institutions seek to repay to TARP money they had received last fall, the stock market rebounds.
It is the debt problem that is the big concern of the financial markets. In my opinion, as long as the government policy makers put their primary focus on stimulating spending, the financial markets—and the economy—will continue to flounder. When they refocus on the more crucial problem they will find that the financial markets will be more supportive of what they are doing.
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