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

Georgia is #1; Citigroup is worse than bankrupt

A heartfelt congratulations to the United State of Georgia (from whose namesake “University of” I got my Finance MBA), which today passed California in the battle for Most Failed Banks (9 v 8) in the past year.

In fairness, California did not have a failure until July, while Georgia waited until August.

The two states have been running virtually neck-and-neck, but Georgia’s third failure of this month, and second in two weeks, allowed it to close the month with the overall lead.

In other news, those who are still foolishly holding out the hope that p*ss*ng away several Billion more dollars will make The Big C solvent are invited to meet the reality of their asset mix. Or the staid, less optimistic version here (companion text here).

Dear Brad and Mark (et al.)

This is why we don’t believe the bailout will work the way you think it will (i.e., to increase lending):

Recently, securities rated AAA have changed hands for roughly 30 cents on the dollar, and most of the buyers have been hedge funds acting opportunistically on a bet that prices will rise over time. However, sources said Citi and BofA have trumped those bids.

Instead of using the bailout monies to lend, or even make their balance sheets more creditworthy, the firms have been doubling-down on the assumption that they will be fellated by Timmeh and Larry. (At least Bill Gross and PIMCO (h/t Robert) did it when there was still a chance of sane monetary policy.)

I take back part of what I said earlier: this isn’t comparable to hitting on 17 because you’re drunk; it’s hitting on 19 because you’re desperate and insane. As Barry R. closes:

If anything, this argues against bailouts and in favor of nationalization, firing management, wiping out S/Hs, zeroing out debt, haircutting bond holders, etc.

Some economists may need to spend less time reviewing brilliant analysis from Barry Eichengreen (link is to PDF) and more reviewing Friedman and Savage (link is to PDF) in the context of principal-agent problems.

Interlude

What my brain wants to do:

Bank capitalisation, stress testing, book value, and discussion of other data that clearly indicates the need for the nationalisation of several LARGE banks.

What my brain is currently capable of doing:

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Legacy Merrill Lynch employees better hope BofA doesn’t declare bankrutcy before late June

A correspondent notes CJR found a good scoop by the FT:

Merrill Lynch paid out about $4 billion in bonuses just days before Bank of America took it over, the Financial Times says this morning.

What raises the eyebrows is the timing: Merrill paid its bonuses before the year was even up, “an unusual step” because bonuses in past years weren’t paid until late January or early February.

But, of course, by then, the bonuses would have been under the auspices of Bank of America, since that deal closed 1 January 2009.*

My favorite pull quote combines issues of corporate governance, moral hazard, and risk (mis)management:

The timing is notable because the money was paid as Merrill’s losses were mounting and Ken Lewis, BofA’s chief executive, was seeking additional funds from the government’s troubled asset recovery programme to help close the deal.

Merrill and BofA shareholders voted to approve the takeover on December 5. Three days later, Merrill’s compensation committee approved the bonuses, which were paid on December 29.

I’ve never been a believer in Ken Lewis’s alleged skills as a banker—his wins have been ones of sewlf-admitted collusion, while his “free market” purchases have generally been abject failures, the cost savings more than lost in knowledge failures—and this specific instance looks as if he got played badly.

If BofA paid or is paying retention bonuses as well, Lewis should be terminated with extreme prejudice and the entire BofA board should be removed by the shareholders.** It’s not as if (it is filled with crack financial wizards.):

[T]he Bank of America board, whose ranks include the mayor of Spartanburg, S.C.; a retired general, Tommy R. Franks; and the former chairman and chief executive of Lowe’s….

*BofA, memory serving, pays its bonuses in early February—but one somehow suspects that the question would not have been about the timing of the payments.

**I was going to say “with pitchforks, if necessary,” but that might be taken as extremism, since we’re not talking about civilians.

If Ever There Were a Tipping Point in the Nationalisation Discussions…

Willem Buiter, whose early posts at Maverecon were the epitome of restraint, calls for nationalisation:

By throwing cheap money with little conditionality at the banks, the Fed and the US Treasury may get bank lending going again. By subsidizing new capital injections, they reward bad porfolio choices by the existing shareholders. By letting the executive leadership and the board stay on, they further increase moral hazard, by rewarding failed managers and boards that have failed in their fiduciary duties. All this strengthens the incentives for future excessive risk taking.

There is a better alternative. The alternative is to inject additional capital into the banks by taking all the banks into full public ownership. With the state as sole owner, the existing top executives and the existing board members can be fired without any golden handshakes. That takes care of one important form of moral hazard. Although publicly owned, the banks would be mandated to operate on ordinary commercial principles. Managers could be incentivised by linking remuneration to multi-year profitability. The incentives for excessive liquidity accumulation and for excessively cautious lending policies that exist for partially nationalised banks and for banks fearing nationalisation would, however, be eliminated.

He also addresses the sticking point on the formation of the “bad bank”: if the government already owns the assets, the sale price becomes an accounting question. Not that that is necessarily good, but at least it limits some of the profiteering.

Read the whole thing.

Via Krugman, who was via Robert.

GMAC Flashback

The whining has started, with most people (e.g., Chris Whalen at The Big Picture) making the obvious mistake of confusing GMAC with General Motors.

In the interest of history, I quote myself from the Dark Ages (March 2007) at Tom’s Place:

The next time GM explains that its pensioners need to take a hit, it won’t be because car sales have fallen.

It will be because of their subprime mortgage lending [original link expired]:

GMAC’s ResCap unit, which specializes in housing finance, reported $48 billion in subprime loans — about 76 percent of its mortgage portfolio as of year end.

ResCap increased its allowance for loan losses to 2.17 percent at year-end from 1.55 percent a year earlier and reported a spike in nonperforming loans to 10.5 percent of its mortgage portfolio.

GMAC said it earned $1 billion in the fourth quarter of 2006, compared with $112 million a year earlier. The results included a $791 million tax benefit from its conversion to a limited liability company.

Translation: that’s another $791 million that GM pensioners and others will have to pay into the general fund.

Loaning to the auto industry may be dicey, but it pales compared to a mortgage portfolio that was 76% subprime at the end of 2006.

GMAC may “need” to be bailed out, but that’s not because of its auto industry exposure.

Can we please broaden our thinking in this crisis?

by Divorced one like Bush

February 26, 2008 I posted a question: How are we going to fix a money from money economy. Quoting that post: There is a nice chart. (A few actually). Especially this one.”

And this:

Total financial turnover went from $17,804 billion in 1980 to $508,456 billion in 2000. We’ve seen GDP go from 37.8% of turnover to 1.9% of turnover. That’s how big the money from money train is. Our GDP is only 1.9% of the money from money machine.”

The first response in comments was: “Fix what?”
I think that person has their answer now.

October 6, 2007 I posted: Money from money, not good.

It was about an interview by Bill Moyers of John Bogle. He noted:

JOHN BOGLE: Well, it’s gotten misshapen because the financial side of the economy is dominating the productive side of the economy…We’ve become a financial economy which has overwhelmed the productive economy to the detriment of investors and the detriment ultimately of our society.

I want to come back to the difference between the financial system and the productive system. The productive system adds to the value of our economy. And, by and large, the financial system subtracts. And, yet, it’s growing and growing and growing. And this short term thing where short term orientation in which trading pieces of paper is regarded as a social value. It is not a social value.

Go listen to it. Then listen to Mr. Moyers latest interview with Kevin Philips.

But what’s here that doesn’t get the attention is the United States in the last 20 years undertook an enormous transformation of itself with no attention paid. And what it means is and what makes all this so frightening is the country is at risk because of the size of the financial sector that has never been graded on its competence and behavior in any serious way. They are the economy at this point. And we are now seeing what happens when a 20 to 21 percent of GDP financial sector starts to come unglued.
You had essentially a financial sector that, let’s say, was sort of neck and neck with manufacturing back in the late 1980s. But they got control in a lot of ways in the agenda. Finance has been bailed out. I mean, everybody thinks this is horrible now what we’re seeing in terms of bailouts. Even a lot of the people who do it think it’s bad.

This has been going on since the beginning of the 1980s. Finance has been preferred as the sector that got government support. Manufacturing slides, nobody helps. Finance has a problem, Federal Reserve to the rescue. Treasury to the rescue. Subsidies this, that, and other.

I am certain we have to do something to help the money flow such that it does not take down the entire system. It would be cutting off our noses to spite our faces not to protect ourselves from what a few have done. We have to be adults, suck it up and clean up the alcohol aroma vomit all over our bathroom.

But, we do not have to let it happen again. There is only one solution to this and no one, not anyone is pointing it out: Put the financial sector of the economy back in alignment with the productive sector. What got us in this mess is our (well not all of us) belief that the financial sector can stand on it’s own as a primary wealth/money creator. It can not. Never could. But, believing it put the impetus to the creation of “vehicles” for creating trades. You know all those securitized whatevers, and alphabet monikers, and insurance for insurance for insurance based on alphabet monikers of securitized whatevers. What did people expect would happen when you turn the part of your system that is dependent on activity in an other part for it’s existence into a stand alone money creator. If you are going to keep generating money from money, then you are going to have to keep coming up with new “product”. New designs, new marketing to create an need and want, new packaging, BRANDING.
Again, Mr. Philip put’s it this way:

But we’ve seen the central component of the rise of the financial sector is the rise of the debt industry. Mortgage, credit cards, all these gimmicks that Wall Street sells– just all kinds of products. And, of course, the products are laying an egg all over the world right now.

Get it? We take an industry subservient to the needs of production and turn it into a competitor of production. I can polish and sell rocks without a bank to borrow from. I can accumulate wealth over time. My business may grow slowly and so may my wealth, but I can do it. But, remove all none financial activities and what does financial do to survive? What does it do to survive with no one needing a loan, backing, no desire to produce in a way that increases our productivity such that we have more time to purse happiness (that constitution purpose)? We treat finance as if it is the chicken/egg question. It is not. Finance came second and is dependent.

For those from the 80’s, we have now learned exactly what was being said when we were told our economy was moving toward a service economy. We were told it was just as good, solid and viable as the producer economy so get trained and be ready. Remember that? Remember those who said no way, it can’t work? Have you watched the movie Other People’s Money yet?

Well, all we do now is complain about the cost of the service economy sector known as health care. It cost too much. And, we have now proven that the service economy sector known as finance can’t create any real material wealth as a prime generator. So, why is no one talking about the need and means to realign our economy?

HOW MANY TIMES DO WE HAVE TO DO THIS? HOW MANY FREAKIN’ TIMES DO WE HAVE TO LEARN THE LESSON?

According to Mr. Philips:

It’s been a bipartisan phenomenon. You can go back to the 1980s and say Reagan and George Bush, Sr., got a bubble started. Clinton got in and got an even bigger bubble going. And then George W. Bush with the biggest bubble of all. But it’s not that the Clintonites didn’t play. They did. Bob Rubin as Secretary of the Treasury — I mean, if he was a Hindu and he was being reincarnated, he’d come back as a pail because this guy bailed out everything you can imagine. They had the Mexican loan bailout. They had the long-term capital management bailout, the Russian Southeast Asian currency bailouts.

Think about any of the concerns voiced here at AB regarding this current “crisis” and read Dean Baker’s list of Principles for Restructuring the Financial System and ask how much of this could be accomplished by simply realigning our economy such that finance is in service to our needs of producing primarily and I guess consume in part. Putting it another way, none of what Mr. Baker is suggesting can come to fruition such that we protect ourself from repeating this experience for a 3rd time (fourth if you count 1987) unless we get our minds back to how true wealth and money are created. Which I happen to post on October 8, 2007: Human Capital is where it’s at. It reports on a World Bank study from 2005 in which I us the quote:

The rest of the story is intangible capital. That encompasses raw labor; human capital, which includes the sum of a population’s knowledge and skills; and the level of trust in a society and the quality of its formal and informal institutions. Worldwide, the study finds, “natural capital accounts for 5 percent of total wealth, produced capital for 18 percent, and intangible capital 77 percent.

All of this relates to some graphs I put up December 12, 2007 in: It’s the big one honey, I know it, showing that personal income for the 99% had fallen below personal outlays since 1996. Something that had not existed since 1941 but was present from 1929 and before. What I found most interesting from that post was that there were only 9 comments. Just 9. Are we going to pretend income distribution is not part of this current crisis? Are we the 3 monkeys of see, hear, speak no income inequality?

So, we can talk about the hundreds of billions, we can total them up, we can debate ethics, we can talk morals and argue who is being partisan and what regulation is needed, what’s fair or….we can face the fact that who we think we are is not who we are; that we have been blowing smoke up our own butts regarding wealth, money, economy and the pursuit of happiness. It’s intervention time folks. Just putting up road blocks to the elixir’s and potions, or setting up games with ourself without changing our world view about what money is and how wealth is created and why we want to create it in the first place won’t cut it.

We use to know all this. It is represented in our Declaration of Independence and our Constitution. An example of the materialization of our realization was put in place in our tax code as we learned the lessons we are relearning now. For example, an instance of need of integration in our thinking, one issue with the current crisis is the mega pay of those that created the mess. Well, one of the reason’s for having a graduated income tax to the point of 90% at the top was to prevent exactly what we are now discussing as one of the issues that needs to be addressed in the bailouts. It was to prevent economic royalty, to preserve democracy, to assure one voice – one vote, to prevent some from being so powerful that they would be insulated from responsibility for the problems they could create. But we’re not hearing about taxing as a solution. One that worked very well because it addressed many of our goals. No, we now will create an entire new set of rules and paper filing…a new game to address one aspect of a crisis of one aspect of our economy because we have isolated taxation as an issue of personal freedom as oppose to an integrated tool of our economy based on our goals as laid out in our founding documents.

How small the discussion has been during this crisis so far.

The Safest Senator

When calling Congresscritters tomorrow, especially for those in NY State, please feel free to remind Senator Schumer’s office that he and Barack Obama were the two people [in contested elections] who finished with the widest margin of victory in 20062004 [h/t to my Loyal Reader and Kohole in comments]—about a 50% margin in both cases.

A few fewer dollars from Hank Paulson’s brethren four years from now aren’t going to cost him anything but bragging rights.

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”

Roubini’s not wrong, but…

Let’s stipulate what “everybody knows”:

  1. There are some assets in the capital markets, many of which are mortgage-related, that were seriously overvalued over the past several years.
  2. Many of the others are Credit-related (CDS and CDOs and the like).
    1. Most of the two asset types listed above are reasonable concepts that, if they are commoditized, appear more liquid than they are. (Ask any homeseller in the current market.)
    2. Multiple sequences, while they don’t increase the total systemic risk (algebraically impossible), can have a distorting effect on risk, and
    3. Leveraging assets that are not so liquid can lead to cash flow mismatches in the best of circumstances.

  3. Attempting to arbitrage a perceived opportunity between a long-term obligation and a similar short-term obligation depends very much on funding, carry considerations, and liquidity. (Not certain if everyone knows that one—but everyone who does risk management should.)
  4. The Fed fears a “contagion effect” that will do more damage to the financial system than the “moral hazard” that accompanies “saving” any given firm.
  5. The Fed “saved” Bear Stearns (a.k.a., The Old Firm, or BS for short), to extent that they guaranteed the second through thirty-first billion dollars in losses that JPMC may (or may not) realise from having bought the firm.
  6. The Fed “saved” Fannie Mae and Freddie Mac in the stupidest way possible, ending their forty years in the desert as semi-private entities.
    1. The leaders who drove Fannie and Freddie into the Fed’s arms were rewarded handsomely for their not-so-creative destruction of their firms, most especially Daniel “acted-like-Harry” Mudd.

  7. On the surface, a Fed that saved BS should be likely to save LEH. (See rdan’s post below, citing Nouriel Roubini discussing the similarities.)

The center of Roubini’s argument seems to be this:

But then if on Monday no deal is done Lehman collapses and goes into Chapter 11 court and you have the beginning of a systemic financial meltdown as the run on the other broker dealers will start. Thus, what Fed and Treasury are trying to do this weekend is another 1998 LTCM bailin or Korea 1997 bailin, i.e. trying to convince all the major institutions to either support a purchase of Lehman or maintain their exposure to Lehman if no buyers is found.

The Chapter 11 filing appears to be what is about to happen. The rest is, perhaps, unfolding as it should.

What Roubini is talking about is, basically, the same thing as the “contagion effect” referenced in bullet (4) above. If Lehmann gets protection, many of its obligations will be reduced. So if LEH owes you $100 million, you may only get some fraction of that amount, or nothing, depending on the value of the assets and how secured a creditor you are. So if that $100 million exposure to LEH is essential to your operations, and you haven’t been able to take actions to mitigate it in the past six months, you may fail. Etc., as the Turtles once said.

So, yes, there will probably be some businesses that—despite almost six months of warning, since Bear and Lehmann were spoken of in the same breath, and had approximately the same leverage, when BS was purchased—who will suffer, and probably a few will go out of business.

But the effect of LEH going out of business would not be so severe as the effect of BS going out of business for one reason that Roubini, for some reason, appears not to have mentioned.

Lehmann has no clearing business.

Had Bear gone out of business, about 30% of the hedge funds in the country would not have been able to execute virtually any transaction for the following thirty days. Not a payment. Not a redemption. Not a trade on a listed exchange. Not a receipt. Not a de-leveraging. Not a swap payment, not a CDS payment, not fulfilling an option exercised against them.

There’s not just a “maybe” about financial collapse in such a scenario; P probably well in excess of 0.9944. $30 billion is a “bargain” in such a situation.

LEH has been on the ropes for at least six months, probably longer.* They were given a “word of confidence” by Goldman at the same time the Street was conspicuously silent about the prospects for BS.*** Anyone who has been looking at their risk positions without looking at their LEH exposure over the past six months doesn’t belong in the risk management business. As DealBook noted last Wednesday:

Financial institutions have been closely measuring their exposure to Lehman. On Tuesday, commercial and investment banks said they continued to do business with Lehman, and hedge funds did not appear to be pulling their accounts with the firm, events that helped precipitate the fall of Bear Stearns.

There’s a brilliant moment in Janet Tavakoli’s Credit Derivatives and Synthetic Structures:

[B]efore the fall 1997 [Korean banking] crisis, I took a call from a trader at a securities firm….The trader told me that several Korean banks were willing to offer credit default protection on other Korean names. In order to bolster up their own credit perception, they were willing to post 30 to 40 percent of the notional amount with G7…collateral….The trader then went on to tell me that Commercial Bank of Korea would sell credit default protection on bonds issued by the Commercial Bank of Korea.
“That’s very interesting,” I countered, “but the credit default option is worthless.”
“But people are doing it,” persisted the trader.
“That’s because they don’t know what they’re doing,” I affirmed. “The correlation between Commercial Bank of Korea and itself is 100 percent. I would pay nothing for that credit protection. It is worthless for this purpose.”
The trader mustered his best grammar, chilliest tone, and most authoritative voice: “There are those who would disagree with you.” (p. 85)

Several months later, those people were, presumably, downsized. Eleven years after that, no one in the market today would make the mistake of not considering the risk of the guarantor as well as the guaranteed.

LEH will file bankruptcy, but the market has largely priced that into its current market valuations. There will be failures, and there will be many stories about the suffering of former LEH employees, and the occasional counterparty without another option close at hand.

But its failure would not have a contagion effect, and any Fed support should be not to save the firm itself but, in the manner of the SBA’s efforts in NYC seven years ago, small loans to ensure that as few of those counterparties whose businesses are impaired by the LEH bankruptcy are unable to find other sources of capital.

As for the other firms—MER, AIG, etc.—those that can be saved are already taking action, if they still can.

After a necessary saving of BS, and an ill-timed, ill-considered deprivatization (h/t Brad DeLong) of Fannie and Freddie, letting LEH declare bankruptcy—assuming it remains necessary through the night—is the best choice.

Even if Alan Greenspan does agree with it.

*If you look at the debt market, they knew BS was a junk or near-junk credit in August of 2007 (5-yr notes at 245 over), when the stock was still trading at levels well north of 100.** LEH debt at the time was priced significantly higher (10-year notes in July 2007 ca. 140 over [same as Bear link]). “Lehman’s credit-default swaps [then] carr[ied] an implied rating of Ba1, according to Moody’s.” And no one believes things go better since then.
**There is a reason everyone agrees that fixed income is more difficult to price than equity. Accordingly, FI people dig a lot deeper in their evaluations. Or, at least, that appears to be the case here.
***LTCM memories, anyone?