Relevant and even prescient commentary on news, politics and the economy.

Dear Brad, This is the person you say we "don ‘t have time" to worry about

My Loyal Reader sends another example of those glorious, worthy individuals about whom “we do not have time” to worry:

Former [AIG] Chief Executive Officer Maurice “Hank” Greenberg may try to end government involvement in the company “as prompt [sic] as possible,” his attorney David Boies said in an interview this week. Greenberg…has said the takeover might have been avoided if AIG got a bridge loan, tapped private investors and sold assets.

Aye, and if my grandmother had wheels, she’d be a wagon!

Did I mention that Greenberg has frequent contact with AIG’s Board of Directors of AIG, so assuming that he’s stupid enough to only be suggesting this now is a real stretch? Did I mention that the Fed Rule cited specifically restricts their action to “unusual and exigent circumstances”?

Did I mention that the odds that Hank Greenberg was deliberately deceiving some reporter (and that his deception was cited as reality by a rather optimistic Bloomberg scribe) probably approach infinity?

The sainted 83-year-old Trilateral Commission member continues:

“How can it be the right move if shareholders lose 80 percent of their equity?” he said in a Sept. 17 interview. Greenberg, the CEO for almost four decades until [he was ousted in] 2005, controlled about 11 percent of the shares through personal holdings and investment firms he runs before the takeover agreement, the largest stake.

Yep, I really want to bail this guy’s company out, since clearly shareholders “losing 80% [or 79.9%] of their equity” would never happen to any public company. (Yes, I picked obvious ones.)

Apparently, Maurice “Hank” Greenberg believes we have time, and he’s a lot more involving in the genesis and exigesis of the current crisis than we are. So why would we disagree with him? The return to the “good” intertemporal equilibrium may be at stake.

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What is an Asset?

I like Brad DeLong, conceptually. Even his errors in judgment are based on rational principles. And he has a really useful piece up right now about “dealing with financial crises.” (One of the nice things about it is that it also completely undermines his earlier suggestion that the Fed was wrong not to ease on Tuesday. As Mark Thoma and I, among others, suggested, they clearly knew it would do no good, and “saved their powder” accordingly.)

There are only a few problems, key of which is the title of this piece. Derivatives may have a value, but are they actually assets? Worse, if the Fed buys an asset, does it also have to buy all of the associated derivative contracts, one side of which may—by that simple—become worthless or become payable?

I’m not suggesting that Helicopter Henry and Biplane Ben’s $100B inflation solution isn’t going to work,* but if you’re trying to limit contagion, you generally don’t start by infecting healthy entities.

Of course, that assumes the entities are healthy. The commenters at Infectious Greed have gotten more astute as the day goes by:

AIG, Leucadia, Loews, Berkshire Bancorp and Berkshire Hills Bancorp (gotta protect the high ground!) but not Berkshire Hathaway, AmEx or Capital One. Also Affiliated Managers Group and Pzena but not Legg Mason. Fascinating; like a train wreck in progress.


That “do not short” list is basically the list of companies you must to sell if you have any of them in your portfolio.

Or, as an old friend just e-mailed me, “So. I see there’s a list of 799 financial forms that cannot be shorted….that is by no means all the financials in the US market…is there any reason at all that we shouldn’t take this as a list of financial companies KNOWN TO BE UNSOUND?”

So maybe I shouldn’t be worrying so much about possible contagions.

DeLong rather cavalierly, though, throws out a straw man to reject it:

Fourth, there is now no time for tolerance of the three objections to this analysis and this plan of action, roughly: (1) it’s immoral, (2) it’s unfair, and (3) it can’t work in the long run. To expand a bit:

1. It’s immoral because people have a right to be treated like adults–which means that they have a right not to be rescued by the government from the consequences of their bad judgment, and we are violating that right.
2. It’s unfair because feckless greedy financiers who caused the problem ought to lose money and aren’t–or aren’t losing enough money–and because feckless greedy imprudent thriftless borrowers who caused the problem ought to lose money and aren’t–or aren’t losing enough money.
3. It won’t work–at least not in the long run.[emphasis mine]

Let’s ignore that, given that he dismisses (1) and (2), (3) becomes inevitable. Let’s even grant (1)—while noting that he deliberately phrased to place it in the poorest light possible—since a bailout is necessary,** and targeted bailout isn’t going to work.***

Let’s just say #2 sticks in my craw a bit. Especially if you’re making the absurd claim that there “is now no time.”

Helicopter Hank and Biplane Ben have had six months since The Old Firm went the way of all Southern Pacific Railroads. During that time, they have created Special Purpose Vehicles (SPVs) like a derivatives shop on Gramm-crack. They have red-socked**** us more times than we can count to provide nearly a billion dollars worth of liquidity so that those risky assets could be managed, marked appropriately, unwound, or sold.

And now they’re going to throw “hundreds of billions of dollars” more into the giant Money Pit that is ever-increasing its lending standards to companies that are far better run than they are.

And Brad DeLong has just declared that we shouldn’t hold anyone responsible; indeed, the Hank Greenbergs and Dick Fulds and Jimmy Effing Caynes of the world should continue to be rewarded by the U.S. taxpayer, because “there is no time.”

So, Brad, when you tell us that we don’t have the time to hold people responsible for their actions, and we tell you it won’t work in the long run, remember the reason we’re saying that. Because, in pre-Paulson/Bernanke economic theory, actions used to have consequences. Now, they can just cost the taxpayers.

And when I add that to your final graph—the one that is supposed to get us back to that “good equilibrium” point—I stop seeing it as an intertemporal equilibrium point and more as an outlier from the payoff-dominant strategies you are effectively advocating be concretized.

*It’s not the way to bet, but you go to war with the policies you have.
**Just as it was for Argentina in 2001 and…what…Washington Consensus? Sorry, no habla ingles.
***We shall ignore, since he does, that the reason targeted bailouts didn’t work is that companies smelled blood (money) in the water and decided to go for it, leaving us with Chris “stocks can only go up” Cox bending the U.S. taxpayer over a little more.
****Trust me, if you don’t know this phrase, you do not want to look it up. Assume from context.

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We have part of an answer

Documentation of a minor disruption:

Lehman won’t return “billions” of frozen prime-brokerage assets “in the short term,” said PricewaterhouseCoopers, administrator for the Lehman bankruptcy.

Meanwhile, several hedge funds are planning to sing the Bono phrase from “Do They Know It’s Xmastime?”* to their cohorts at Morgan Stanley:

Hedge funds that account for less than 10 percent of Morgan Stanley’s prime-brokerage balances this week withdrew their money or told the firm they planned to, according to a person with direct knowledge of the matter.

And the really good news:

The loss of all hedge-fund accounts wouldn’t materially affect the company’s access to reserves, said the person, who asked not to be identified because the information is confidential.

I’m not certain I would take that as encouraging.

“Hedge funds tend to look at counterparty risk as they would an equity investment,” said Adam Sussman, director of research at TABB Group LLC, a New York-based adviser to financial-services companies. “If they’d bet against the stock, they’d also be likely to minimize their exposure to their prime brokerage and trading over-the-counter derivatives with them.”

I believe Bloomberg just indicated that the hedge funds leaving Morgan Stanley are “voting with their feet.”

“Foremost on people’s minds is ensuring that wherever they decide to put assets, they will be secure,” [BNP Paribas SA’s global head of hedge-fund relationships, Talbot Stark] said in an interview today.

With Treasuries yielding 0.00%—about the same as your mattress, except with no option value—”security” has become more important than (to borrow an old phrase from a deceased-but-no-longer-mourned firm) Risk-Adjusted Return on Capital (RAROC).

And it appears that the Wizard of Id’s version of the Golden Rule** still applies. Even if it really was their fault:

The people who ran the financial firms chose to program their risk-management systems with overly optimistic assumptions and to feed them oversimplified data. This kept them from sounding the alarm early enough.

Maybe more on this later.

*”Well tonight thank G-d it’s them/Instead of you”
**”He who has the gold makes the rules”

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Its All Just a Little Bit of History Repeating

Bruno Behrend wrote a layman’s view of the Repo Market. As he noted,

…the entire US (and international) financial system is so laden with funny money (essentially un-quantifyable assets), that even after billions have been written down, no one is willing to price them.

This “plain vanilla” repo market, that is “decades old” is so full of rotten apples (CDOs and synthetic CDOs), that the Fed couldn’t allow the market to price it. Too many institutions would have been exposed as holding essentially worthless assets.

We had a brief e-mail exchange, in which I included the following vague:

1. The difference between the transparent products and the opaque ones is a bit more risk of failure, but if the failure does occur, it will be years later.
2. Because they got a bit more of a margin on the opaque instruments (remember – any failures would happen years in the future), the banks stared issuing more of these opaque instruments.
3. Over time, everyone got used to them. And they couldn’t be so bad – after all, so far nobody lost money on them, right? (That’s 2004, 2005, 2006).
4. So the market grew and grew, and after a while, because the process went on and on and nobody lost money on those instruments, they became, as far as everyone was concerned, no more risky than plain vanilla.
5. If you have the choice between two flavors of vanilla, you go with the one (opaque) that has the higher pay-ff.
6. The future arrived.

It occurs to me this is the timeline that exists with many financial meltdowns. To a large extent, it explains how South American countries fell heavily in debt in the last century. It explains how large (mostly American) banks got in trouble for lending money to South American countries. To some extent, it explains the S&L and junk bond fiasco, and the dotcom bubble.

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Bear Stearns – The End of the Beginning, and a Preview of the Ending

I had a few posts in the past few weeks noting that whatever terms were announced for the Bear Stearns deal (and related deals), it was irrelevant, because in the end, the taxpayer would be footing the bill. The Fed’s M.O. so far has been to announce a little bit of help, then to announce a little bit more, and so forth. In the end, what it comes down to is this: someone is going to have to pay, and that someone will be the taxpayer.

Which leads to this Calculated Risk post that I’m going to just go ahead and steal whole:

Treasury Agrees to Absorb any Losses to the Fed from Bear Stearns

Video from CNBC (hat tip idoc)

CNBC’s Steve Liesman reports on a letter from Treasury Secretary Paulson to New York Fed President Tim Geithner. In the letter, Treasury agrees that the Fed can bill Treasury for any losses from the Bear Stearns deal.

We’re not quite at the end-state yet. We have JPM paying $2 and now $10 a share for BS, we have the Fed agreeing to take on at least a big portion of the losses that JPM might suffer for that purchase, and now we have the Treasury promising to take on a big part of the losses the Fed might suffer for that deal. In nine months, the circle closes, and we’ll start to find about the size of those losses, which in turn will depend on the magnitude of BS’ obligations. (As I noted many times, my expectation, based on cynicism alone, is that they’re negative.) By then, the story will be off the front page, Paulson won’t be at the Treasury, Jim Cayne will have a few hundred million more in the bank, and folks like Kudlow and Cramer will be telling us how things are going to go to pot if the new President raises taxes to pay for the GW-sized hole in the nation’s balance sheet or tries to regulate banks to ensure this kind of thing won’t happen again.

Update… Title originally contained a mis-spelling.

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What Scares Me

Reader João Carlos notes in comments:

The real problem guys isn’t that the FED needs to save the banks or the economy goes caput.

The real problem is that maybe the FED doesn’t have enough ammunition to save the banks.

There are a lot of derivatives in the banks’ books. While all mortgages’ securities are currently caput (yes, all, with the house’s prices going down down down down, everyone is sub-prime, including those that are prime), soon we will see other derivatives (commercial estates, credit cards, etc) going caput too.

So, it is possible that FED will try everything possible and impossible and still fail, because the hole is a Black Hole.

Cactus here. I’m not at all sold on the idea that even if half the investment banks on Wall Street collapsed, we’d be in Great Depression-land. But I do note this… if the problem really is severe enough that the Fed cannot handle it, its best to let Wall Street melt to the ground. See, what creates something resembling a South American country during the hyperinflation days is the public catching a whiff that there’s something going on that both the central government and the Central Bank are powerless to stop. Citibank collapsing won’t do it. An attempt to save Citibank that fails will.

Note to Ben Bernanke and Henry Paulson: having the public pay for Jim Cayne’s country club membership and other retirement bennies just isn’t worth the risk. Please stop. Please.

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Yves Smith on Bear Stearns

Yves Smith has a post about JPM’s buyout of Bear Stearns, that, coincidentally, says something that I was thinking when I woke up this morning. If I hadn’t read his post, I might have written something like this myself after letting it simmer for a bit:

A hedge fund correspondent pointed us to an article at Institutional Risk Analytics on the Bear-JP Morgan deal. While we don’t subscribe to its view that Bear was “raped” (please, the firm was going to file for bankruptcy a week ago Monday), it contains an intriguing analysis of JP Morgan.

Differing with popular opinion, IRA argues that JPM is far from a financially strong institution. It has the highest gearing of any of the three large US banks (and remember, that includes the CDO-laden, walking wounded Citigroup) and by their measures, also has the highest level of economic risk per their metrics. JPM’s chickens have not yet come home to roost because its book is heavily weighed toward consumer business, and those problems are coming to the fore later. (The cognoscenti may take issue with their use of RAROC as another measure, but I’m not troubled when making cross company comparisons if you have access only to published financials).

Although IRA does not say so explicitly, the reasoning appears to be that the Fed pushed Bear into JPM’s arms as a way to shore up JPM. If asking a firm to take on a $13 trillion derivatives book, of which only $2 trillion is exchange traded, is a favor, I’d hate to see what punishment looks like.

The Fed is guaranteeing JPM it will cover any losses if JPM buys BS. That started out as a $2 a share gift to BS shareholders (since the value of BS’ assets without any assurances from the Fed are exceeded by its obligations) and now that gift seems about to get sweetened.

But… I was wondering, why not give the gift directly? Why do it in this convoluted way? My first thought was – well, if you go through JPM, its somewhat more opaque (and hence less likely to raise the taxpayer’s ire). But the Fed could be opaque in more direct ways too… which leaves one thing… for whatever reason, the Fed wants to provide a gift to JPM too.

And BTW, Ken Houghton has another collection of follow-ups to this mess.

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Why the Bailout of Bear Stearns Really is a Bailout

There seems to be a reluctance among many people to accept that the whole Bear Stearns thing constitutes a bailout. Let me try an analogy…

Let’s say The Cactus Corp. sells squirrel carcasses as fillet mignon. After a few years, The Cactus Corp. is a strong business with a market cap of $150 million. Eventually, a few of the customers realize that fillet mignon purchased from The Cactus Corp. tastes very, very different than fillet mignon purchased (at much greater expense) from a reputable grocer. After a few months, there are no buyers for The Cactus Corp.’s products.

Now, you may be thinking: The Cactus Corp. is worth nothing. But you’d be wrong. See, The Cactus Corp., like any other company, is going to have a big inventory… and health code regulations don’t just allow it to chuck its inventory onto the street. Worse, it has forward contracts to purchase as many more squirrel carcasses as folks who troll the highways can provide for the next few years. Which means that The Cactus Corp. is not worth nothing – its value is negative.

Now, the gubmint decides that guaranteeing a safe supply of food is important, and that The Cactus Corp. is an important part of that process. So they make the following offer to the guy down the street: “We know that The Cactus Corp. has negative value. But, if you buy out The Cactus Corp. for $2 million, you might still find some use for all those squirrel carcasses and make money. People do eat squirrel meat, after all, and you’re getting it very cheap. But we’ll also sweeten the pot – if you don’t make money, we’ll make up whatever losses you might have.”

When that happens, shareholders, officers, and employees of The Cactus Corp. will complain because they’re getting $2 million for an entity that not long ago was valued at $150 million. They’ll insist this was no bailout. But the fact that company no longer has any positive value whatsoever means that the $2 million is not just a bailout, its a gift. And its a gift to both those associated with The Cactus Corp. and to the guy down the street. And its a gift paid for by the tax payer.

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The Bailout of Greater Fools

While I was away, Tyler Cowen wrote something with which I strongly disagree:

If you’re a critic of bailouts, you can’t have it both ways. If the Fed or Treasury is guaranteeing loans, yes that does put taxpayer dollars on the line. But if you think the system can hold up, as do most bailout critics, those guarantees are unlikely to cost very much. The Fed or Treasury may even turn a profit. If you think the system cannot hold up, the bailout is probably necessary even if costly. So you can’t claim: “The bailout isn’t needed” and also “The bailout will burden taxpayers.”

Uh, no. I think the bailouts (of both homeowners and banks) are a bad mistake despite, or rather, in fact, because I think the system cannot hold up. The system revolves around the sale of squirrel carcasses. The folks involved in the system made a lot of money selling squirrel carcasses and calling them fillet mignon. Now that we all know what the “market” was about, the best thing that can happen is for it to be severed as quickly and efficiently as possible from the rest of the economy, which means, to make all of those who are involved pay the price.

But Cowen is right about one thing, though – it is possible (though I wonder how likely) that the Fed or the Treasury may turn a profit. But if it does so, its by making the last greater fools, and the greater fool theory tells us someone is always a last greater fool, pay. Not all the folks who were involved are still there – when the problems began, they found someone else, a bit less informed, a bit less sophisticated, to buy their share of the bag. Many of those greater fools are homeowners, many are shareholders or employees of some of the big banks. In some cases, the big perps themselves may take a hit. But not in all.

Regardless, I can’t see any excuse for a bailout at this point, and if there is a bailout, I can’t see any excuse for one that doesn’t provide the taxpayer with the potential for a lot of upside (i.e., nationalization).

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