In a word: "No."
The structure of the US workforce does not lend itself to competing with Asia for semi-skilled manufacturing. In China factories work 12 hour shifts six days a week, and for many factories the work force lives on-site in company dormitories. This means that to staff a plant running full time the factory needs two shifts. In the US (with five 8-hour workdays) to run factories at comparable capacity we would need four shifts - 2x the number of workers.
In addition, of course, the wages in Asia are also much lower. So it is much more expensive and more complicated to run a factory here, and you have a less dedicated (at least based upon proximity) workforce. None of these factors are ever likely to change.
Can we increase manufacturing in the US? Sure. But modestly. We are unlikely to ever return to the manufacturing driven economy of the 1950s, 1960s, and 1970s.
The US is the world's leader in intellectual capital. We are a nation driven by ideas. Our technology powers the world, our medical products keep it healthy and our media products entertain it. We therefore need to invest in and produce knowledge workers. The days of large scale manufacturing driving our economy is over. Rather than devoting resources to reversing this trend, we instead need to invest in enabling workers to compete in the new reality.
What is the new reality? More companies are being created, and the number of employees in them is smaller. The skillsets required by these companies are broader. Workers need to be fascile with technology as a basic skillset, not as a specialization. Workers need to be cross trained across many disciplines, because in smaller companies everyone needs to wear multiple hats. Workers need to be able to think outside the box to be creative problem solvers.
How do we get there? We need to drastically change the way our schools are educating kids. Our schools encourage kids to sit down, be quiet, pay attention, and focus on one thing and/or one teacher for 50-60 minutes at a time. That might be fine for training assembly line employees, but not for developing multi-tasking, cross-discipline problem solvers.
Our kids need to be fascile with technology by the time they reach 3rd grade. They should be able to: search the web; use social media; chose, download and use on-line tools; craft websites; set-up local networks and add devices to these networks; and download and install software to these devices. At a minimum.
They need to be creative problem solvers, and be able to work in groups. Schools need to encourage this creativity rather than enforce rules. There is no "one right answer" for most of the problems in the world, so lets not encourage kids to seek it. Studies have shown that on average creativity declines with age and higher levels of education. We are educating people to be less creative, not more!
The objective of education should not be performance on standardized tests, but development of creativity to enable multi-faceted problem solving abilities. Today our schools and especially our colleges encourage specialization. There should not be a separation between liberal arts, engineering, math and science - they should be integrated. We need engineers who can develop creatively, and we need artists and service professional with the ability to reach us using technology, and teachers who can utilize technology seamlessly.
So, every kid should have access to a computer, and every kid should have access to high speed broadband internet. From the age of four, if not earlier.
This will take investment in broadband infrastructure. And investment in computers and networking equipment at our libraries and schools. Massive investment.
Which brings up another point - factory work may be on the decline, but skilled labor should not be. In order to deploy broadband internet everywhere we need skilled installers. In addition we will need more investment in physical infrastructure - new schools, roads, clean energy installations and extended power grid to serve it. All this requires two things - massive investment and skilled, well paid labor.
Lets not waste a dollar or a minute of time trying to encourage companies to manufacture a $3.00 part or produce a $2.00 assembly in the US. Lets instead spend our time and money developing the infrastructure necessary to support the economy of the future and in schools that will teach the skillset necessary to thrive in it.
Wednesday, January 25, 2012
Saturday, February 13, 2010
Regulating the Banks
Is the structure of our banking system, in and of itself, a risk to our financial markets generally and, more broadly, our economy as a whole?
The answer is a resounding: "Yes!"
Part I - History
Banking used to be a relatively staid, unexciting business. After the collapse of the financial markets in 1929 and the failure of hundreds of banks in the early 1930's, our government sought to place regulations on both the financial markets and banks. They created the Securities Acts of 1933 and 1934 which regulated how securities were sold to the public. They also created the Glass-Steagall Act, which required separation of banks, or lenders, from investment banks - or purveyors of securities.
This forced institutions such as JP Morgan to spin out their investment bank (which became Morgan Stanley) into separate institutions. The banks were large publicly traded entities in order to have the necessary access to capital to support lending; the investment banks were typically private partnerships with limited capital that relied on their wits.
Further, the government created the deposit insurance system (now called the FDIC) to insure depositors against bank failures, and created rules which set capital and operating requirements upon the banks.
This worked extremely well, until 1984, when excessive lending to the "oil patch" in 1984 brought down a number of banks. Continental Illinois was deemed "too big to fail" at that time, and so it was rescued through government intervention - ie financial support. The oil patch fiasco deflated the real estate markets of Texas and Colorado significantly, leading to flat values in those markets for almost ten years. But the rest of the country was largely left untouched as a result of the Continental bailout. It was generally considered a success.
When the financial markets failed in 1990-1991, the government took quite a different tact. Government action exacerbated the issue, shutting down the leveraged lending markets. Instead of bailing out large institutions they aggressively foreclosed on them, including Lincoln Savings and Bank of New England. The government's Resolution Trust Company (RTC) then aggressively sold large portfolios of loans and securities inherited from the failed banks and S&Ls at fire-sale prices, further depressing their prices and making overnight fortunes for the owners of Apollo Investments, the Bass family, as well as TCW and others.
The smart view after this fiasco was that aggressive government intervention (via foreclosing and liquidation of financial institutions) was the real problem. Markets were deemed to be efficient, and banks/investment banks were deemed to be more effectively regulated by market pressure and moral suasion than by government officials who were too unsophisticated to understand these complicated issues.
Glass-Steagall was deemed out-dated: let banks and investment banks compete against each other and eliminate the distinction. After all, that is the way it was done in Europe and Japan and they had created behemoth institutions. This will lead to great liquidity in the capital markets, greater availability of funds and lower cost financings = the argument went. Indeed this did come to pass, and in the mid 1990s the line between banks and investment banks disappeared.
Interest rates dropped due to aggressive inflation management by Alan Greenspan, causing the cost of borrowing to drop to previously unheard of levels. On the equity front lower interest rates led to higher stock prices (for explanation of the math google: CAPM). But what drove equity prices further was a phenomena little commented upon: the widespread adoption of the 401k.
In the 1990s retirement accounts moved from defined benefit programs (which generally had been funded through investment grade bonds to match the expected liabilities) to defined contribution programs (with individuals moving into equities). As a result record amounts of money flowed into the equity markets, leading to previously unforeseen price levels: On April 17th, 1991 the Dow Jones Industrial Average exceeded 3000! Four years later on February 23, 1995 the Dow crossed 4000. Only nine months later it hit, 5000, and so on until it peaked at over 14,000 in October 2007.
At the same time banks created new products and new markets. As big as the equity markets became, the bond markets became many times bigger fueled by low interest rates.
Next: Part II - Path to Destruction
The answer is a resounding: "Yes!"
Part I - History
Banking used to be a relatively staid, unexciting business. After the collapse of the financial markets in 1929 and the failure of hundreds of banks in the early 1930's, our government sought to place regulations on both the financial markets and banks. They created the Securities Acts of 1933 and 1934 which regulated how securities were sold to the public. They also created the Glass-Steagall Act, which required separation of banks, or lenders, from investment banks - or purveyors of securities.
This forced institutions such as JP Morgan to spin out their investment bank (which became Morgan Stanley) into separate institutions. The banks were large publicly traded entities in order to have the necessary access to capital to support lending; the investment banks were typically private partnerships with limited capital that relied on their wits.
Further, the government created the deposit insurance system (now called the FDIC) to insure depositors against bank failures, and created rules which set capital and operating requirements upon the banks.
This worked extremely well, until 1984, when excessive lending to the "oil patch" in 1984 brought down a number of banks. Continental Illinois was deemed "too big to fail" at that time, and so it was rescued through government intervention - ie financial support. The oil patch fiasco deflated the real estate markets of Texas and Colorado significantly, leading to flat values in those markets for almost ten years. But the rest of the country was largely left untouched as a result of the Continental bailout. It was generally considered a success.
When the financial markets failed in 1990-1991, the government took quite a different tact. Government action exacerbated the issue, shutting down the leveraged lending markets. Instead of bailing out large institutions they aggressively foreclosed on them, including Lincoln Savings and Bank of New England. The government's Resolution Trust Company (RTC) then aggressively sold large portfolios of loans and securities inherited from the failed banks and S&Ls at fire-sale prices, further depressing their prices and making overnight fortunes for the owners of Apollo Investments, the Bass family, as well as TCW and others.
The smart view after this fiasco was that aggressive government intervention (via foreclosing and liquidation of financial institutions) was the real problem. Markets were deemed to be efficient, and banks/investment banks were deemed to be more effectively regulated by market pressure and moral suasion than by government officials who were too unsophisticated to understand these complicated issues.
Glass-Steagall was deemed out-dated: let banks and investment banks compete against each other and eliminate the distinction. After all, that is the way it was done in Europe and Japan and they had created behemoth institutions. This will lead to great liquidity in the capital markets, greater availability of funds and lower cost financings = the argument went. Indeed this did come to pass, and in the mid 1990s the line between banks and investment banks disappeared.
Interest rates dropped due to aggressive inflation management by Alan Greenspan, causing the cost of borrowing to drop to previously unheard of levels. On the equity front lower interest rates led to higher stock prices (for explanation of the math google: CAPM). But what drove equity prices further was a phenomena little commented upon: the widespread adoption of the 401k.
In the 1990s retirement accounts moved from defined benefit programs (which generally had been funded through investment grade bonds to match the expected liabilities) to defined contribution programs (with individuals moving into equities). As a result record amounts of money flowed into the equity markets, leading to previously unforeseen price levels: On April 17th, 1991 the Dow Jones Industrial Average exceeded 3000! Four years later on February 23, 1995 the Dow crossed 4000. Only nine months later it hit, 5000, and so on until it peaked at over 14,000 in October 2007.
At the same time banks created new products and new markets. As big as the equity markets became, the bond markets became many times bigger fueled by low interest rates.
Next: Part II - Path to Destruction
Saturday, October 3, 2009
Health Care Eden?
It amazes me the ridiculous rhetoric regarding a new health care plan.
Can anyone deny that our current situation of roughly 40 million uninsured Americans - 12% of our population - works? Or that our infant mortality rate ranking of 33rd in the world is acceptable? Or that the infant mortality rate for black mothers, which would equate to a world ranking of 74th, behind Jamaica, is a reasonable standard of care.
People talk about our cancer survival rate, which is 1st or second (depending upon the year) with Japan, versus the UK and Canada which are in the teens. However, the reason for the survival rate is early testing, which is more of a social norm, rather than poor or unavailable surgeons. The survival rate for people who are diagnosed at the same stage are the same.
Why is it that people on the anti-side of the "public option" either spout nonsense or outright lie?
On the other hand, how does the government intend to implement this plan? Providing insurance without providing care is a waste of energy and time. We need more rural and inner city care. Where is the plan to set up clinics that can diagnose problems and dispense meds, provide nutrition advice, and pre + post natal care?
Making rural or inner city patients drive to the burbs will not have a meaningful effect on the uptake of health care. It needs to be convenient, efficient, and inexpensive for it to work.
Lets get more details please.
Can anyone deny that our current situation of roughly 40 million uninsured Americans - 12% of our population - works? Or that our infant mortality rate ranking of 33rd in the world is acceptable? Or that the infant mortality rate for black mothers, which would equate to a world ranking of 74th, behind Jamaica, is a reasonable standard of care.
People talk about our cancer survival rate, which is 1st or second (depending upon the year) with Japan, versus the UK and Canada which are in the teens. However, the reason for the survival rate is early testing, which is more of a social norm, rather than poor or unavailable surgeons. The survival rate for people who are diagnosed at the same stage are the same.
Why is it that people on the anti-side of the "public option" either spout nonsense or outright lie?
On the other hand, how does the government intend to implement this plan? Providing insurance without providing care is a waste of energy and time. We need more rural and inner city care. Where is the plan to set up clinics that can diagnose problems and dispense meds, provide nutrition advice, and pre + post natal care?
Making rural or inner city patients drive to the burbs will not have a meaningful effect on the uptake of health care. It needs to be convenient, efficient, and inexpensive for it to work.
Lets get more details please.
Friday, March 20, 2009
FDIC Getting it Right? Finally
Perhaps the FDIC is reading this blog.
It took a week, but yesterday Sheila C. Bair, the new head of the FDIC, re-stated the argument our argument on banks: Instead of stepping in to support institutions "too big to fail," the government should not allow firms to get that big in the first place. Ms. Bair testified to Congress that current regulation places too much risk on the financial system, and that the Congress proposed idea of a "systemic risk regulatory" will be inadequate to change that level of risk.
The other concern is that Congress' current proposal will lead to the creation of a massive regulatory body which will increase beauracracy and red tape, but no fundamental change in the nature of the risks. Not everyone in her audience got it - hopefully they will soon.
Go Sheila - we are with you.
See today's article in the NY Times:
http://www.nytimes.com/2009/03/20/business/economy/20regulate.html?dlbk
It took a week, but yesterday Sheila C. Bair, the new head of the FDIC, re-stated the argument our argument on banks: Instead of stepping in to support institutions "too big to fail," the government should not allow firms to get that big in the first place. Ms. Bair testified to Congress that current regulation places too much risk on the financial system, and that the Congress proposed idea of a "systemic risk regulatory" will be inadequate to change that level of risk.
The other concern is that Congress' current proposal will lead to the creation of a massive regulatory body which will increase beauracracy and red tape, but no fundamental change in the nature of the risks. Not everyone in her audience got it - hopefully they will soon.
Go Sheila - we are with you.
See today's article in the NY Times:
http://www.nytimes.com/2009/03/20/business/economy/20regulate.html?dlbk
Friday, March 13, 2009
Too Big To Fail
Sometimes, albeit rarely, politicians get it right. Such was the case yesterday, when Senator Bernard Sanders, Vermont independent, stated:“If an organization is too big to fail, it is too big to exist.”
Some background: In trying to prevent a financial meltdown, the previous Secretary of the Treasury, Henry Paulson, encouraged and in fact forced certain mergers to occur: JP Morgan took over Bear Sterns and later Washington Mutual, Wells took over Wachovia, and Bank of America took over Merrill Lynch. After absorbing these dwindling businesses, each of the previously strong firms needed to take down significant funds from the government to stay afloat. The government had determined that these financial behemoths, as well as AIG and others, were "too big to fail," i.e. the repurcussions to the economy were too great to allow one of them to default on their many obligations.
The argument previously for allowing combinations of large financial institutions had been that competition among financial institutions had become global, and to compete globally you needed to be big and have the ability to deliver every product. So banks merged, merged, merged until they could deliver all these products and underwrite huge sums. But as they became more competitive globally, they spread the risk of their failure throughout the world. Now, if Citibank fails, it affects not just the US but also Europe, Asia, and Latin America in a meaningful way.
Further, until the early 1990s the businesses of banks and investment banks were quite separate. With the fall of Glass Steagle, a depression era law requiring those businesses to remain apart, the lines distinguishing the two businesses fell away. Banks became investment banks, investment banks became banks. The consequences, as we know now, were disastrous.
The answer is simple - these firms are too big, they need to be broken up. Just as there are limits on the market share of broadcast companies and cable tv companies, there needs to be limits on banks. Also, the lines of business need to again be separated. This is the only way that the failure of a single institution or a single market will have less impact on the economy and financial markets as a whole.
So score one point for Senator Sanders. It may be a long time before another politician gets one right again!
Some background: In trying to prevent a financial meltdown, the previous Secretary of the Treasury, Henry Paulson, encouraged and in fact forced certain mergers to occur: JP Morgan took over Bear Sterns and later Washington Mutual, Wells took over Wachovia, and Bank of America took over Merrill Lynch. After absorbing these dwindling businesses, each of the previously strong firms needed to take down significant funds from the government to stay afloat. The government had determined that these financial behemoths, as well as AIG and others, were "too big to fail," i.e. the repurcussions to the economy were too great to allow one of them to default on their many obligations.
The argument previously for allowing combinations of large financial institutions had been that competition among financial institutions had become global, and to compete globally you needed to be big and have the ability to deliver every product. So banks merged, merged, merged until they could deliver all these products and underwrite huge sums. But as they became more competitive globally, they spread the risk of their failure throughout the world. Now, if Citibank fails, it affects not just the US but also Europe, Asia, and Latin America in a meaningful way.
Further, until the early 1990s the businesses of banks and investment banks were quite separate. With the fall of Glass Steagle, a depression era law requiring those businesses to remain apart, the lines distinguishing the two businesses fell away. Banks became investment banks, investment banks became banks. The consequences, as we know now, were disastrous.
The answer is simple - these firms are too big, they need to be broken up. Just as there are limits on the market share of broadcast companies and cable tv companies, there needs to be limits on banks. Also, the lines of business need to again be separated. This is the only way that the failure of a single institution or a single market will have less impact on the economy and financial markets as a whole.
So score one point for Senator Sanders. It may be a long time before another politician gets one right again!
Saturday, March 7, 2009
Why Banks Failed
I see pundits using lots of jargon, charts, and ratios trying to determine why banks failed. Some argue that leverage ratios of the investment banks are largely unchanged from those of the mid 1990s, and those of commercial banks actually declined, so are puzzled as to why we have the problem that we have now.
The bottom line is that banks (no distinction between commercial or investment) did not adhere to strict mortgage underwriting policies, largely because either a) they did not intend to hold the mortgages, or b) in the case of banks that held mortgages, they felt they had to in order to compete with the big conduit players.
Banks and investors relied on Loan To Value (asset value) as first way out - which as we know is always a mistake. Assets are only worth what someone will pay for them - unless they are cash flow generating, assets do not have inherent value.
The other issue, which often goes undiscussed because it is difficult to track statistically, is the impact of the CDS debacle. There are roughly $20 trillion in corporate and mortgage backed debt securities outstanding. Yet there are $56 trillion in Credit Default Swaps - or 2.8x the entire traded debt market. The counter party risk of such a pervasive, mispriced, and unregulated market is staggering, and we will feel its effects for years to come. Leverage ratios of banks and I-banks do not accurately reflect this risk - and therefore are grossly understated. This is a market that really only took off starting in 2002 - so comparing recent leverage levels to that of the 1990s is non-meaningful.
Our current market failure is also misunderstood - but is quite simple. Liquidity has been driven by both the issuance of $20 trillion in traded debt and $56 trillion in CDS, not to mention the untraded loan markets. There is zero net new issuance in any of these markets - in fact there is contraction. A contracting liquidity market means a contracting economy. Period.
As Bette Davis famously said in "All About Eve": "Fasten your seatbelt - its going to be a bumpy night."
The bottom line is that banks (no distinction between commercial or investment) did not adhere to strict mortgage underwriting policies, largely because either a) they did not intend to hold the mortgages, or b) in the case of banks that held mortgages, they felt they had to in order to compete with the big conduit players.
Banks and investors relied on Loan To Value (asset value) as first way out - which as we know is always a mistake. Assets are only worth what someone will pay for them - unless they are cash flow generating, assets do not have inherent value.
The other issue, which often goes undiscussed because it is difficult to track statistically, is the impact of the CDS debacle. There are roughly $20 trillion in corporate and mortgage backed debt securities outstanding. Yet there are $56 trillion in Credit Default Swaps - or 2.8x the entire traded debt market. The counter party risk of such a pervasive, mispriced, and unregulated market is staggering, and we will feel its effects for years to come. Leverage ratios of banks and I-banks do not accurately reflect this risk - and therefore are grossly understated. This is a market that really only took off starting in 2002 - so comparing recent leverage levels to that of the 1990s is non-meaningful.
Our current market failure is also misunderstood - but is quite simple. Liquidity has been driven by both the issuance of $20 trillion in traded debt and $56 trillion in CDS, not to mention the untraded loan markets. There is zero net new issuance in any of these markets - in fact there is contraction. A contracting liquidity market means a contracting economy. Period.
As Bette Davis famously said in "All About Eve": "Fasten your seatbelt - its going to be a bumpy night."
Wednesday, February 25, 2009
Why the Banks Broke
Here is an interesting article about the rise of mortgage securities CDOs and Credit Default Swaps. The problem is too great to put at the feet of any one man (unless that person is Alan Greenspan) but it is still interesting. I will post some more analysis later.
http://www.wired.com/techbiz/it/magazine/17-03/wp_quant?currentPage=3
http://www.wired.com/techbiz/it/magazine/17-03/wp_quant?currentPage=3
Wednesday, February 18, 2009
Auto Bailout redux
See this article in today's NY Times. It outlines, as I have on two occasions, the need to put GM (and probably Chrysler) into bankruptcy:
http://dealbook.blogs.nytimes.com/2009/02/16/altman-a-gm-bankruptcy-to-save-taxpayer-money/
The sooner this is done, the sooner GM can get back to business of making cars instead of wasting time on fruitless negotiations.
http://dealbook.blogs.nytimes.com/2009/02/16/altman-a-gm-bankruptcy-to-save-taxpayer-money/
The sooner this is done, the sooner GM can get back to business of making cars instead of wasting time on fruitless negotiations.
Monday, February 16, 2009
Auto Bail-out: Take 2
The Auto Industry has until tomorrow to come back to Congress with the terms of its restructuring. Having the automakers develop the terms of their restructuring strikes me somewhat like asking a heroine user to develop their methadone treatment plan: they may be best educated to understand the problem but the least prepared to deal with it realistically.
The problems facing the industry are many, and for the most part were avoidable had the industry recognized and embraced the need for change earlier rather than fighting it and maintaining business as usual. The truth is that the models developed by Detroit are largely uncompetitive, the costs are too high, there is too much debt on the corporate books, there are too many models and too many parts, and there is too much investment stranded in plants supporting uncompetitive and overlapping models. The dealership model is costly and largely unnecessary.
The numbers seem to vary depending upon the source, but based on reasonably reliable sources it appears that on average an auto worker makes about $28/hour. However, the labor costs per employee including benefits for existing and retired employees are more than double that. Huh? The reason is that the unions demanded and the auto companies complied with providing a level of benefits that is unsustainable. Foreign manufacturers, who are newer to the US labor pool, are not burdened with these costs, which equal (depending upon the estimator) approximately $2000 more per car for the US models.
So the question now is, who should bear the brunt of the restructuring? The answer is simple - all constituents:
1) The automakers need to trim the number of nameplates they maintain and models they produce by roughly half, close plants accordingly, and lay-off a proportionate number of workers. This will be painful, but not doing so puts all models, plants, and workers at risk. The unions must accept this.
2) Workers will need to accept benefits more in line with other industries.
3) Retirees who are under 67 years old will see some reduction in benefits. Those over 67 will not be affected.
4) Lenders will need to accept a reduction in the principal amounts of the debt they have lent to the industry. They were irrational in providing this level of credit, prolonging the industry's lack of recognition of their problems, and need to share the pain. They should convert a significant portion of their indebtedness to equity.
5) Dealers will be shut down. There is simply no reason, with fewer makes and fewer models, to maintain the same number of dealers. In addition, the advent of the internet diminishes the need for them. Dealers should be replaced with regional showcases for new models. Existing dealers should focus on service, and perhaps selling used cars, rather than stocking new models.
6) Automaker leadership will need to be examined sternly, and for the most part, replaced.
7) The above mentioned items will only be able to be accomplished through bankruptcy. Unfortunately, many of my elected California representatives, as well as representatives from other states, equate bankruptcy with "failure" and therefore oppose it. This simply is not true, and it is disingenius to continue repeating it.
Chapter 7 would in fact be a "failure," ie a liquidation of the companies. But no one is advocating, or ever has advocated, Chapter 7, rather Chapter 11 bankruptcy is what has been proposed. Chapter 11 is a "reorganization," and does not require that the automakers shut down. This process gives the companies the power to reject untenable contracts, including leases, dealer arrangements, and employment contracts. Without this power, the automakers are subject to the whims of too many competing interests.
8) The government will need to step in - A: Congress must address the benefits of the retirees. Reducing the number of workers in the industry will actually increase the average cost per worker, so the government will need to take on some of this pension and benefit obligation. Perhaps all of it. If not, the industry will never be able to be competitive.
9) The government steps in - B: The companies will need to receive what is called Debtor in Possession financing during the bankruptcy process. However, in order to get banks to provide this capital, the government will need to guarantee it.
10) The government steps in - C: The government will need to provide buyer incentives to get models moving. These should include tax rebates for fuel efficient and electric cars. In addition, the government will need to guarantee loans for the sale of new cars - preferably fuel efficient ones.
11) Existing shareholders (including management), as a consequence of the foregoing, will be wiped out. At best they may participate in the recovery through substantially out of the money options.
None of the government activities should occur unilaterally - they should occur pursuant to a negotiated - or prepackaged - bankruptcy, ie chapter 11. The government needs to stop taking it on faith that its bailout targets will do the right thing - they have all proven they won't.
The problems facing the industry are many, and for the most part were avoidable had the industry recognized and embraced the need for change earlier rather than fighting it and maintaining business as usual. The truth is that the models developed by Detroit are largely uncompetitive, the costs are too high, there is too much debt on the corporate books, there are too many models and too many parts, and there is too much investment stranded in plants supporting uncompetitive and overlapping models. The dealership model is costly and largely unnecessary.
The numbers seem to vary depending upon the source, but based on reasonably reliable sources it appears that on average an auto worker makes about $28/hour. However, the labor costs per employee including benefits for existing and retired employees are more than double that. Huh? The reason is that the unions demanded and the auto companies complied with providing a level of benefits that is unsustainable. Foreign manufacturers, who are newer to the US labor pool, are not burdened with these costs, which equal (depending upon the estimator) approximately $2000 more per car for the US models.
So the question now is, who should bear the brunt of the restructuring? The answer is simple - all constituents:
1) The automakers need to trim the number of nameplates they maintain and models they produce by roughly half, close plants accordingly, and lay-off a proportionate number of workers. This will be painful, but not doing so puts all models, plants, and workers at risk. The unions must accept this.
2) Workers will need to accept benefits more in line with other industries.
3) Retirees who are under 67 years old will see some reduction in benefits. Those over 67 will not be affected.
4) Lenders will need to accept a reduction in the principal amounts of the debt they have lent to the industry. They were irrational in providing this level of credit, prolonging the industry's lack of recognition of their problems, and need to share the pain. They should convert a significant portion of their indebtedness to equity.
5) Dealers will be shut down. There is simply no reason, with fewer makes and fewer models, to maintain the same number of dealers. In addition, the advent of the internet diminishes the need for them. Dealers should be replaced with regional showcases for new models. Existing dealers should focus on service, and perhaps selling used cars, rather than stocking new models.
6) Automaker leadership will need to be examined sternly, and for the most part, replaced.
7) The above mentioned items will only be able to be accomplished through bankruptcy. Unfortunately, many of my elected California representatives, as well as representatives from other states, equate bankruptcy with "failure" and therefore oppose it. This simply is not true, and it is disingenius to continue repeating it.
Chapter 7 would in fact be a "failure," ie a liquidation of the companies. But no one is advocating, or ever has advocated, Chapter 7, rather Chapter 11 bankruptcy is what has been proposed. Chapter 11 is a "reorganization," and does not require that the automakers shut down. This process gives the companies the power to reject untenable contracts, including leases, dealer arrangements, and employment contracts. Without this power, the automakers are subject to the whims of too many competing interests.
8) The government will need to step in - A: Congress must address the benefits of the retirees. Reducing the number of workers in the industry will actually increase the average cost per worker, so the government will need to take on some of this pension and benefit obligation. Perhaps all of it. If not, the industry will never be able to be competitive.
9) The government steps in - B: The companies will need to receive what is called Debtor in Possession financing during the bankruptcy process. However, in order to get banks to provide this capital, the government will need to guarantee it.
10) The government steps in - C: The government will need to provide buyer incentives to get models moving. These should include tax rebates for fuel efficient and electric cars. In addition, the government will need to guarantee loans for the sale of new cars - preferably fuel efficient ones.
11) Existing shareholders (including management), as a consequence of the foregoing, will be wiped out. At best they may participate in the recovery through substantially out of the money options.
None of the government activities should occur unilaterally - they should occur pursuant to a negotiated - or prepackaged - bankruptcy, ie chapter 11. The government needs to stop taking it on faith that its bailout targets will do the right thing - they have all proven they won't.
Friday, February 13, 2009
Happy Birthday Mayor Jack Maltester
I was fortunate enough to attend a small luncheon in honor of Jack Maltester on the occasion of his 96th birthday. The luncheon was hosted by the gracious Jake Francesca at his wonderful restaurant Vila Cereja, a fixture in the San Leandro community for 40 years. Others in our party included former Oakland Raider and Pro Bowl player Raymond Chester, San Francisco radio personality and comedian Brian Copeland, long time real estate businessman Doug Federighi, and attorney Tom Armstrong of the White & Lee.
Mr. Maltester served as the honourable Mayor of San Leandro, CA for 20 years, from 1958 to 1978. He was an early supporter of the Civil Rights movement, proposing a Committee on Human Rights and Responsibilities to the City Council, first in 1963, that was rejected three times. He twice served as Chairman of the United States Conference of Mayors.
In 1971, Jack "sponsored a resolution at the annual USCM meeting in Philadelphia, entitled "Withdrawal from Vietnam and Reordering of National Priorities", calling upon then-President of the United States, Richard Nixon, "to do all within his power to bring about a complete withdrawal of all American forces from Vietnam by December 31, 1971."" (Nationmaster Encyclopedia.)
Mr. Maltester was an influential member of California's Democratic party, and a key campaigner for Jack Kennedy in his 1960 election bid, receiving a personal thank you call from President Kennedy upon his installation in office. At 96 years old, Jack may not be as spry as he once was, but he still has a sharp intellect and a rapier wit.
Happy birthday, Jack.
Mr. Maltester served as the honourable Mayor of San Leandro, CA for 20 years, from 1958 to 1978. He was an early supporter of the Civil Rights movement, proposing a Committee on Human Rights and Responsibilities to the City Council, first in 1963, that was rejected three times. He twice served as Chairman of the United States Conference of Mayors.
In 1971, Jack "sponsored a resolution at the annual USCM meeting in Philadelphia, entitled "Withdrawal from Vietnam and Reordering of National Priorities", calling upon then-President of the United States, Richard Nixon, "to do all within his power to bring about a complete withdrawal of all American forces from Vietnam by December 31, 1971."" (Nationmaster Encyclopedia.)
Mr. Maltester was an influential member of California's Democratic party, and a key campaigner for Jack Kennedy in his 1960 election bid, receiving a personal thank you call from President Kennedy upon his installation in office. At 96 years old, Jack may not be as spry as he once was, but he still has a sharp intellect and a rapier wit.
Happy birthday, Jack.
Where is the Money?
During the luncheon, Raymond Chester asked a seemingly simple question: "Where did all the money go? What happened to the money?" Understand that Ray is an intelligent and thoughtful person, having led a very successful post football career developing and operating golf courses. He recently served as Chair of the Oakland-Alameda County Coliseum Commission. But the answer to his question is difficult for many people to grasp.
Tremendous wealth has been destroyed in the last 18 months. Property values have declined precipitously, and much of the money in our economy was based on real estate values: second mortgages were used to buy cars, boats, furniture, stereo equipment, take vacations, and refinance credit cards. That source of capital into our economy has disappeared.
Dropping values have wiped out the equity in many homes, making it impossible for many homeowners in adjustable rate mortgages to refinance, causing them to default and lose their homes. Construction of new homes and remodeling of existing ones has been ground to a halt, causing construction companies and real estate developers to go bankrupt and close their doors.
Further, stocks have dropped 50%+ from their highs, and margin calls have wiped out many investors. Dividends have been cut, reducing incomes for many investors, particularly retirees.
In short, much of the cash in our economy had been supplied by leveraging rising asset values. With the dimunition of those values, the ability to lever them for either commercial or consumer lending is kaput. And with it went "the money."
The reduction of debt available both commercially and for consumers has led to a drastic reduction in the fortunes of contractors, retailers, automobile manufacturers, makers of durable goods, and all their suppliers. Unemployment is pointing towards 10% nationally and in Michigan may already be 20%. In the US - not latin America.
The only thing that is going to turn the economy around is the availability of credit for commerce, real estate, and consumers. Until that happens, Raymond, don't expect to see "the money" again any time soon.
Tremendous wealth has been destroyed in the last 18 months. Property values have declined precipitously, and much of the money in our economy was based on real estate values: second mortgages were used to buy cars, boats, furniture, stereo equipment, take vacations, and refinance credit cards. That source of capital into our economy has disappeared.
Dropping values have wiped out the equity in many homes, making it impossible for many homeowners in adjustable rate mortgages to refinance, causing them to default and lose their homes. Construction of new homes and remodeling of existing ones has been ground to a halt, causing construction companies and real estate developers to go bankrupt and close their doors.
Further, stocks have dropped 50%+ from their highs, and margin calls have wiped out many investors. Dividends have been cut, reducing incomes for many investors, particularly retirees.
In short, much of the cash in our economy had been supplied by leveraging rising asset values. With the dimunition of those values, the ability to lever them for either commercial or consumer lending is kaput. And with it went "the money."
The reduction of debt available both commercially and for consumers has led to a drastic reduction in the fortunes of contractors, retailers, automobile manufacturers, makers of durable goods, and all their suppliers. Unemployment is pointing towards 10% nationally and in Michigan may already be 20%. In the US - not latin America.
The only thing that is going to turn the economy around is the availability of credit for commerce, real estate, and consumers. Until that happens, Raymond, don't expect to see "the money" again any time soon.
Thursday, February 12, 2009
Venture Capital - A Broken Model
The stock market is low. The price of private deals is even lower. This should present great buying opportunities for Venture Capital, right?
Well, that would be true if Venture firms were actually in business today.
The Venture Capital model of recent years barely resembles the industry the one that I first learned of in the 1980s. In those days, investment funds made small investments ($1 - 3 million) in companies with modest valuations (single digit millions). The funds played a significant role in the oversight of their portfolio companies. The likely exit was through a sale - IPO activity was modest, and when IPOs occurred the deal sizes were small.
In those days, the funds themselves were modest size - $40- $50 million funds were big. The interests of the limited partners (ie the investors in the funds) and the general partner (the fund management) were aligned. They GP took a modest annual management fee (2%) and received 20% of the profits in good deals.
This changed in the middle 1990s. An IPO became the most likely exit. Some of the successes were mammoth (Netscape, Google, Yahoo) and this changed the business. The funds attracted huge pools of capital, and it was no longer efficient to make small investments or to provide much oversight. Further, the pricing changed: funds now charged 2.5% annually and as much as 30% of the profits on very successful deals.
When a manager makes 2% on $50 million ($1 million/year), from which he pays all his costs (rent, salaries, travel, deal expenses), it is clear that his interests are aligned with investors: he depends upon good deals, and lots of them, to meet his wealth objectives. When, as is the case with many funds now, a manager makes 2.5% on $1 billion annually ($25 million/year) - well lets just say that the wolf is certainly not at the door.
With a billion dollars or more to invest, managers started putting $15 million or more to work in deals, with the intention to provide follow-on investments of $10 million or more. And since venture firms rarely invest alone, that means another manager was investing similar dollars. Greater investment dollars drove up the pre-money valuations - it became commonplace for start-ups to have pre-money valuations of $25 million or more.
A "home run" might generate 20x. On a $25 million investment thats $500 million - and with 30% to the GP (up from the 20% of the old days) that's a cool $150 million. Since losers were not (and are not) netted against winners the Venture Capital firm had plenty of incentive to swing for the fences.
To justify these large investments, investors brought in high priced talent to operate these businesses and sell them to Wall Street as IPO candidates. Never mind whether they had the appropriate experience to run a small developing business. This jacked up the operating costs and the cash burn rates - essentially accelerating the rate of failure. But with a frothy market promising a quick exit via IPO at huge valuations - who cared?
Now - the IPO exit is non-existent. Funds have piles of cash, but little understanding of what to do with them. They cannot efficiently make small investments and expect to keep track of them, much less provide oversight. And even if they do, the nominal dollar returns on these smaller investments don't "move the needle" - ie are not large enough to make the VCs interested. So they sit, collecting their 2.5% annually - not a bad consolation prize - and hoping that Wall Street will revert to the way it was. Or worse - chase renewable energy deals by investing huge sums at a time with the same frothy misguided enthusiasm ( a recent solar energy deal had a pre-money valuation of $1 billion!).
What they should do is reduce the size of their funds (canceling commitments to $50 million or so), or split them into small sector funds with separate management. They should make modest investments in promising companies at modest valuations. They should plan on holding investments for longer periods, and assume that their exits will be through responsible M&A. In this way the managers actually have to work and be successful to get rich. They will bring in management appropriate for small entrepreneurial ventures. And they will provide the kind of oversight to maximize the likelihood that all of their portfolio companies can achieve some level of success.
Small, entrepreneurial companies that deserve funding will receive it.
And the interests of the Venture Capitalists will once again be aligned with that of their investors.
Well, that would be true if Venture firms were actually in business today.
The Venture Capital model of recent years barely resembles the industry the one that I first learned of in the 1980s. In those days, investment funds made small investments ($1 - 3 million) in companies with modest valuations (single digit millions). The funds played a significant role in the oversight of their portfolio companies. The likely exit was through a sale - IPO activity was modest, and when IPOs occurred the deal sizes were small.
In those days, the funds themselves were modest size - $40- $50 million funds were big. The interests of the limited partners (ie the investors in the funds) and the general partner (the fund management) were aligned. They GP took a modest annual management fee (2%) and received 20% of the profits in good deals.
This changed in the middle 1990s. An IPO became the most likely exit. Some of the successes were mammoth (Netscape, Google, Yahoo) and this changed the business. The funds attracted huge pools of capital, and it was no longer efficient to make small investments or to provide much oversight. Further, the pricing changed: funds now charged 2.5% annually and as much as 30% of the profits on very successful deals.
When a manager makes 2% on $50 million ($1 million/year), from which he pays all his costs (rent, salaries, travel, deal expenses), it is clear that his interests are aligned with investors: he depends upon good deals, and lots of them, to meet his wealth objectives. When, as is the case with many funds now, a manager makes 2.5% on $1 billion annually ($25 million/year) - well lets just say that the wolf is certainly not at the door.
With a billion dollars or more to invest, managers started putting $15 million or more to work in deals, with the intention to provide follow-on investments of $10 million or more. And since venture firms rarely invest alone, that means another manager was investing similar dollars. Greater investment dollars drove up the pre-money valuations - it became commonplace for start-ups to have pre-money valuations of $25 million or more.
A "home run" might generate 20x. On a $25 million investment thats $500 million - and with 30% to the GP (up from the 20% of the old days) that's a cool $150 million. Since losers were not (and are not) netted against winners the Venture Capital firm had plenty of incentive to swing for the fences.
To justify these large investments, investors brought in high priced talent to operate these businesses and sell them to Wall Street as IPO candidates. Never mind whether they had the appropriate experience to run a small developing business. This jacked up the operating costs and the cash burn rates - essentially accelerating the rate of failure. But with a frothy market promising a quick exit via IPO at huge valuations - who cared?
Now - the IPO exit is non-existent. Funds have piles of cash, but little understanding of what to do with them. They cannot efficiently make small investments and expect to keep track of them, much less provide oversight. And even if they do, the nominal dollar returns on these smaller investments don't "move the needle" - ie are not large enough to make the VCs interested. So they sit, collecting their 2.5% annually - not a bad consolation prize - and hoping that Wall Street will revert to the way it was. Or worse - chase renewable energy deals by investing huge sums at a time with the same frothy misguided enthusiasm ( a recent solar energy deal had a pre-money valuation of $1 billion!).
What they should do is reduce the size of their funds (canceling commitments to $50 million or so), or split them into small sector funds with separate management. They should make modest investments in promising companies at modest valuations. They should plan on holding investments for longer periods, and assume that their exits will be through responsible M&A. In this way the managers actually have to work and be successful to get rich. They will bring in management appropriate for small entrepreneurial ventures. And they will provide the kind of oversight to maximize the likelihood that all of their portfolio companies can achieve some level of success.
Small, entrepreneurial companies that deserve funding will receive it.
And the interests of the Venture Capitalists will once again be aligned with that of their investors.
Wednesday, February 11, 2009
Wall Street Comp
Sorry everyone for the hiatus. I am back on the job!
There has been a lot of discussion of Wall Street compensation over the past two weeks. Compensation that equaled 2004 levels, when the "street" had a then record year for profits, strikes many on Main Street as problematic when these firms received over $250 billion in TARP (bailout) funds because they were unable to meet the minimum required capital ratios.
Often Main Street is wrong - this time they are not. At a time when the street should be shoring up its balance sheet, and using its capital to make markets and make loans, the street paid out $18.4 billion in bonuses - or roughly 8% of its TARP funds. The firms claim that they didnt use any TARP funds to pay bonuses, but that flies in the face of a common street expression: "Money is fungible." Translation: A dollar is a dollar, and if you put money in one pocket and spend it from the other, it still has the same effect - you still are down those dollars.
The firms' answer is that if they didn't pay out these bonuses they would experience a significant defection of top talent - the dreaded "brain drain." But aren't these the same brains that got the firms into trouble in the first place?
I for one think that the "brain drain" would be a good thing. Where will they go - to other big firms? No, because they won't be able to pay up either. No, they will start new boutique investment banking firms.
Wall Street was a much better place when much of the better talent resided at these smaller, private partnerships with limited capital. In those days, firms relied on their wits instead of their balance sheets (or more rightly, their shareholders' balance sheets). In those days care of clients was paramount, not short term trading profits. And in those days, you "ate what you killed;" i.e. if you brought in business - based on your intellectual capital - you got paid well. If you didn't, well you didn't.
In recent years Wall Street has made its money by maker larger and more complex bets using the balance sheet. This is not the same thing, and quite frankly does not deserve the same level of compensation. For example, in the past, a department might get paid out 40%-60% of the profits, with the balance being paid to the partners or retained as capital. However, if you are using risk capital, it is not appropriate to get paid that way. Unfortunately, the Universal banking model has meshed the pay practices of the private partnerships with the brute force capital approach of the traditional money center banks.
In a competitive moving market, with lots of participants, the only way to make more money risking capital is to take larger & riskier bets. If you are going to get paid the same ratio for risking shareholder capital as not, then the law of large numbers kicks in and you have incentive to risk larger and larger amounts. This is in fact what happened over the last decade or so.
I really do not care what someone makes - provided he earns his living either risking little capital or his own. If he is risking shareholder capital, then compensation needs to be reigned in. The same applies to corporate CEOs. You are playing with shareholder money - you are an employee - act like it and get paid accordingly!
Andrew Ross Sorkin of the New York Times has, in a recent article, proposed that instead of decreasing Wall Street compensation, we simply pay the regulators Wall Street-like wages. That way we attract the "best and the brightest" to the regulatory side. Andy, Andy, Andy. Consider who is feeding you this nonsense - Wall Street and Private Equity houses.
Look, having the best and the brightest didn't keep Wall Street from making disastrous bets on mortgages, CDOs, and credit derivatives, and it didn't keep Rumsfeld and Wolfowitz (very smart guys) from making idiotic decisions on Iraq. Best and brightest is not the issue - the aura of being beyond reproach is the issue.
Pay bankers for performance? - sure. Pay them for risking shareholder capital ? - not so much. If bankers got paid less for risking capital than for not, believe me they would spend more time on non-capital intensive strategies.
There has been a lot of discussion of Wall Street compensation over the past two weeks. Compensation that equaled 2004 levels, when the "street" had a then record year for profits, strikes many on Main Street as problematic when these firms received over $250 billion in TARP (bailout) funds because they were unable to meet the minimum required capital ratios.
Often Main Street is wrong - this time they are not. At a time when the street should be shoring up its balance sheet, and using its capital to make markets and make loans, the street paid out $18.4 billion in bonuses - or roughly 8% of its TARP funds. The firms claim that they didnt use any TARP funds to pay bonuses, but that flies in the face of a common street expression: "Money is fungible." Translation: A dollar is a dollar, and if you put money in one pocket and spend it from the other, it still has the same effect - you still are down those dollars.
The firms' answer is that if they didn't pay out these bonuses they would experience a significant defection of top talent - the dreaded "brain drain." But aren't these the same brains that got the firms into trouble in the first place?
I for one think that the "brain drain" would be a good thing. Where will they go - to other big firms? No, because they won't be able to pay up either. No, they will start new boutique investment banking firms.
Wall Street was a much better place when much of the better talent resided at these smaller, private partnerships with limited capital. In those days, firms relied on their wits instead of their balance sheets (or more rightly, their shareholders' balance sheets). In those days care of clients was paramount, not short term trading profits. And in those days, you "ate what you killed;" i.e. if you brought in business - based on your intellectual capital - you got paid well. If you didn't, well you didn't.
In recent years Wall Street has made its money by maker larger and more complex bets using the balance sheet. This is not the same thing, and quite frankly does not deserve the same level of compensation. For example, in the past, a department might get paid out 40%-60% of the profits, with the balance being paid to the partners or retained as capital. However, if you are using risk capital, it is not appropriate to get paid that way. Unfortunately, the Universal banking model has meshed the pay practices of the private partnerships with the brute force capital approach of the traditional money center banks.
In a competitive moving market, with lots of participants, the only way to make more money risking capital is to take larger & riskier bets. If you are going to get paid the same ratio for risking shareholder capital as not, then the law of large numbers kicks in and you have incentive to risk larger and larger amounts. This is in fact what happened over the last decade or so.
I really do not care what someone makes - provided he earns his living either risking little capital or his own. If he is risking shareholder capital, then compensation needs to be reigned in. The same applies to corporate CEOs. You are playing with shareholder money - you are an employee - act like it and get paid accordingly!
Andrew Ross Sorkin of the New York Times has, in a recent article, proposed that instead of decreasing Wall Street compensation, we simply pay the regulators Wall Street-like wages. That way we attract the "best and the brightest" to the regulatory side. Andy, Andy, Andy. Consider who is feeding you this nonsense - Wall Street and Private Equity houses.
Look, having the best and the brightest didn't keep Wall Street from making disastrous bets on mortgages, CDOs, and credit derivatives, and it didn't keep Rumsfeld and Wolfowitz (very smart guys) from making idiotic decisions on Iraq. Best and brightest is not the issue - the aura of being beyond reproach is the issue.
Pay bankers for performance? - sure. Pay them for risking shareholder capital ? - not so much. If bankers got paid less for risking capital than for not, believe me they would spend more time on non-capital intensive strategies.
Wednesday, November 19, 2008
Open Letter to our Senate
Senators Feinstein, Boxer & Colleagues:
Please vote "No" on the proposed Auto Industry bailout. This plan will be a disaster for our nation and taxpayers, and will only serve to prolong the destructive practices of the industry.
Rick Waggoner, GM CEO, testified yesterday that GM was losing $5 billion per month. If he received the entire bailout his firm would still run out of money in five months!
The industry needs restructuring, and the only credible path to achieve this is Chapter 11 reorganization. In this forum the companies can reject contracts that are not suited to the long term viability of the industry. This includes leases, supply contracts, and labor contracts, among others. It also gives the companies the opportunity to negotiate with lenders. Finally, it will not reward shareholders, as a bailout might (at least temporarily).
Please review this article in yesterday's NY Times - it is well thought out: http://www.nytimes.com/2008/11/18/business/economy/18sorkin.html?dlbk
I am not a big fan of Mitt Romney the politician, but as a corporate financier he knows a thing or two. Please review his op-ed piece that appeared today: http://www.nytimes.com/2008/11/19/opinion/19romney.html?hp
In lieu of a bailout, government should be ready to provide a "DIP" financing to these companies so that they can meet their operating obligations while in bankruptcy. This can be provided either in the form of a direct loan, or via a guarantee to banks providing these funds.
But funding without fundamental change will only prolong their disastrous strategy of gas guzzling and polluting cars, outdated models, over capacity, and over priced labor (on average $70/hour).
These companies need to be redirected to 50 MPG cars which pollute less and reduce our reliance on foreign oil (a national security issue). Currently hybrids cost over $8,000 more than their traditional counterparts. An effective corollary strategy would be an $8,000 tax credit for buyers of hybrids.
We need to be aware of the failure of other auto industry bailouts. Please review this article about the disastrous results of the bailout of the British industry:
http://www.nytimes.com/2008/11/18/business/economy/18car.html?em
Please vote "NO" on the proposed bailout.
Sincerely,
Michael Bloom
Please vote "No" on the proposed Auto Industry bailout. This plan will be a disaster for our nation and taxpayers, and will only serve to prolong the destructive practices of the industry.
Rick Waggoner, GM CEO, testified yesterday that GM was losing $5 billion per month. If he received the entire bailout his firm would still run out of money in five months!
The industry needs restructuring, and the only credible path to achieve this is Chapter 11 reorganization. In this forum the companies can reject contracts that are not suited to the long term viability of the industry. This includes leases, supply contracts, and labor contracts, among others. It also gives the companies the opportunity to negotiate with lenders. Finally, it will not reward shareholders, as a bailout might (at least temporarily).
Please review this article in yesterday's NY Times - it is well thought out: http://www.nytimes.com/2008/11/18/business/economy/18sorkin.html?dlbk
I am not a big fan of Mitt Romney the politician, but as a corporate financier he knows a thing or two. Please review his op-ed piece that appeared today: http://www.nytimes.com/2008/11/19/opinion/19romney.html?hp
In lieu of a bailout, government should be ready to provide a "DIP" financing to these companies so that they can meet their operating obligations while in bankruptcy. This can be provided either in the form of a direct loan, or via a guarantee to banks providing these funds.
But funding without fundamental change will only prolong their disastrous strategy of gas guzzling and polluting cars, outdated models, over capacity, and over priced labor (on average $70/hour).
These companies need to be redirected to 50 MPG cars which pollute less and reduce our reliance on foreign oil (a national security issue). Currently hybrids cost over $8,000 more than their traditional counterparts. An effective corollary strategy would be an $8,000 tax credit for buyers of hybrids.
We need to be aware of the failure of other auto industry bailouts. Please review this article about the disastrous results of the bailout of the British industry:
http://www.nytimes.com/2008/11/18/business/economy/18car.html?em
Please vote "NO" on the proposed bailout.
Sincerely,
Michael Bloom
Monday, November 17, 2008
Bail-out (AIG), Bail-out (Banks), and more Bail-out (Cars)
OK, so I get to say: "I told you so." Unfortunately.
Our Treasury Secretray handed the largest US banks $250 billion. This was supposed to get the banks back on their feet, and encourage lending. Some background here:
The market crash of 1929 is widely thought to be the cause of the Great Depression. Not so. What caused the depression was a lack of liquidity among the banks - ie they simply stopped lending. This occurred a couple years later. When the banks stopped lending, businesses were unable to finance themselves. Farmer's could not afford to plant. Homes could only be sold to cash buyers. And so businesses and farms failed, people were cast out of work, and their homes, their nest eggs, plunged in value because few people had cash to purchase.
Fed Chairman Bernanke is an economist and historian, specializing in the Great Depression, so he is keenly aware of this. It is at his urging that the Treasury developed a plan to save the banks and encourage lending. Mr. Paulson said explicitly that the intention of the Treasury was to encourage the banks to lend.
So, what has been the effect? Since the infusion, lending has declined. Credit cards are being reduced. Auto loans, traditionally approved over 90% of the time, are at 60% approval and declining. Home equity lines are virtually non-existent. But even more worrying, business/commercial lending is at its lowest levels in a decade, which limits investment in new business initiatives and new technologies.
In short, lending is virtually non-existent.
How could this happen?
Well, when Mr. Paulson "negotiated" the terms of the capital infusion he failed to include one little detail: a requirement to lend! Overlooked this small point, somehow.
Now lets put this in perspective: in virtually every securities offering or bank deal there is a section called "Use of Proceeds." In other words, when bankers/investors provide a company with cash, they like to know what the cash will be used for. Sometimes this is merely a general statement by the company, other times it is an actual and highly specific requirement. But it almost always exists as an explicit statement - the cash will be used for X.
Now if investors who are putting, let say, $1 million in a company know to ask and even require what the money will be used for, how could our Treasury invest $250 billion and not require, or even ask, for the same?
Somehow Treasury overlooked this. How can that be? Wasn't Henry Paulson the former Chairman of Goldman Sachs, the most active and prestigious investment bank in the land? Didn't they hire Simpson Thacher, one of Wall Street's most prestigious and experienced law firms, to document these deals? Was this just one big Homer Simpson moment? "Doh!"
Apparently, in their zeal to get something, anything, done, Paulson and Simpson forgot to actually negotiate a deal. No wonder it took only, on average, an hour each to get the banks to approve such a transaction - there was nothing to negotiate!
Perhaps Paulson simply trusted his friends from the "Street" to do the right thing. Much as the now discredited Alan Greenspan trusted the "Street" to do the right thing with derivatives and mortgage backed securities. In short, allow the regulated to make their own rules.
This is one of the most colossal screw-ups in the history of our government and of government regulation. No first year banker or lawyer would be allowed to make such an error. Yet the former Chairman of Goldman, our Treasury Secretary, made it. This is a Ripley's Believe It or Not! type story.
And lets add a couple other "Can you believe it" points. One bank that received $25 billion is scheduled to pay employee bonuses of $10.7 billion this year. That's right - it is not misprint. Over 40% of the proceeds of our government's investment will be paid to executives who put the firm in the dire condition of needing the funds. Paulson forgot to negotiate that away as well.
Finally, as David Levine, Professor of Economics at Cal's Haas School of Business emphatically points out, these banks still pay a dividend. In other words, the proceeds of our government's bailout funds will be used to pay investors!
It is estimated that on average the banks may spend approximately 1/2 the bailout proceeds on bonuses and dividends within the next year. Well done Hank Paulson, Wall Street's friend!!!
Paulson did make one smart decision - that was to do a 180 on buying specific securities from banks. This was always a bad idea, and if Treasury's performance on the bank investments is any indication, purchasing securities (a much more complicated venture than investing in preferred shares of banks) would have been a disaster.
What about today's news? Paulson apparently realizes he is in way over his head, and has therefore announced that $350 billion of the $700 billion in bailout proceeds for which he vigorously campaigned Congress will not be spent. He will leave the rest for the Obama administration to decide what to do with starting January 20, 2009. Hopefully our President elect can find someone to lead this effort with more common sense and who is less prone to knee jerk reactions.
Speaking of knee-jerk reactions, the Democrats had to get in on the act as well by today demanding an auto industry bailout with all the same problems of the Wall Street bailout - and then some! The only positive is that at a mere $25 billion it is a much smaller tax payer problem.
Lets enumerate the flaws:
1) UAW workers make as much as $75/hour. That is over $150k per year, largely to push a button at a factory. US auto labor is obscenely overpriced compared to the rest of the world. There are 17 non-union auto factories in the US whose wages do not exceed $50/hour - these factories actually make money. The UAW has stated that they will not accept concessions of any kind, wage or otherwise. Well at least they make the best cars, right?
2) Wrong. Our industry is based on an unlimited supply of $2.00/gallon gasoline with no concern for greenhoue emissions. Hummers, SUVs, mini-vans and trucks are the staple of the American line of cars. Poor mileage, and poor performance, are its hallmark.
3) These companies are hemorrhaging cash. GM alone loses over $1 billion per month! And the rate of loss is accelerating. If GM receives 1/2 of the proposed bailout proceeds, it will lose all of it within 12 months. Between the three car makers, $25 billion provides less than a one year stopgap.
4) Consumers are not buying cars. They want higher MPG cars, but hybrids on average are over $8,000 more expensive than conventional counterparts. Plus, they are still not made in numbers by the US manufacturers: this is a Japanese dominated auto segment.
5) Credit has dried up. Private lenders such as GE capital dominated the auto lending industry, and they have not been given access to the bailout funds. With 40% declines for auto loans, how can consumer purchasing accelerate?
6) Retiree benefits are outrageous, growing, and underfunded.
I think there is no question that the government will provide funds to this industry. It is too far reaching - the jobs of too many voters and the fortunes of too many midwest cities are tied it, as are the jobs at the parts manufacturers who sell to the Big 3. But lets not rush into anything; lets insist upon some requirements for our money.
Our investment in the US Auto Industry should be subject to the following:
1) USE OF PROCEEDS: Invest in new car lines that provide 50 miles per gallon.
2) LABOR: UAW must accept concessions, including capping wages at $50/hr, and allowing for labor reductions. If UAW refuses, de-certify the union.
3) CONSUMER FINANCE: Part of the proceeds must be used to fund consumer loans.
4) TAX CREDITS: Consumers who buy cars with 50 MPG get a $8,000 tax credit.
5) RETIREE BENEFITS: Government takes over the unfunded portion of the benefits. Going forward benefits must be funded, at the risk of criminal penalties to auto executives.
6) PRE-PACKAGED BANKRUPTCY: Invest pursuant to a pre-pack bankruptcy which allows the automakers to reject contracts that are no longer relevant to their business going forward.
7) SUSPEND DIVIDENDS: All monies of the automakers should be reinvested in making safer, more fuel efficient autos.
Saving our auto industry is imperative. What is even more important is saving them from themselves.
Our Treasury Secretray handed the largest US banks $250 billion. This was supposed to get the banks back on their feet, and encourage lending. Some background here:
The market crash of 1929 is widely thought to be the cause of the Great Depression. Not so. What caused the depression was a lack of liquidity among the banks - ie they simply stopped lending. This occurred a couple years later. When the banks stopped lending, businesses were unable to finance themselves. Farmer's could not afford to plant. Homes could only be sold to cash buyers. And so businesses and farms failed, people were cast out of work, and their homes, their nest eggs, plunged in value because few people had cash to purchase.
Fed Chairman Bernanke is an economist and historian, specializing in the Great Depression, so he is keenly aware of this. It is at his urging that the Treasury developed a plan to save the banks and encourage lending. Mr. Paulson said explicitly that the intention of the Treasury was to encourage the banks to lend.
So, what has been the effect? Since the infusion, lending has declined. Credit cards are being reduced. Auto loans, traditionally approved over 90% of the time, are at 60% approval and declining. Home equity lines are virtually non-existent. But even more worrying, business/commercial lending is at its lowest levels in a decade, which limits investment in new business initiatives and new technologies.
In short, lending is virtually non-existent.
How could this happen?
Well, when Mr. Paulson "negotiated" the terms of the capital infusion he failed to include one little detail: a requirement to lend! Overlooked this small point, somehow.
Now lets put this in perspective: in virtually every securities offering or bank deal there is a section called "Use of Proceeds." In other words, when bankers/investors provide a company with cash, they like to know what the cash will be used for. Sometimes this is merely a general statement by the company, other times it is an actual and highly specific requirement. But it almost always exists as an explicit statement - the cash will be used for X.
Now if investors who are putting, let say, $1 million in a company know to ask and even require what the money will be used for, how could our Treasury invest $250 billion and not require, or even ask, for the same?
Somehow Treasury overlooked this. How can that be? Wasn't Henry Paulson the former Chairman of Goldman Sachs, the most active and prestigious investment bank in the land? Didn't they hire Simpson Thacher, one of Wall Street's most prestigious and experienced law firms, to document these deals? Was this just one big Homer Simpson moment? "Doh!"
Apparently, in their zeal to get something, anything, done, Paulson and Simpson forgot to actually negotiate a deal. No wonder it took only, on average, an hour each to get the banks to approve such a transaction - there was nothing to negotiate!
Perhaps Paulson simply trusted his friends from the "Street" to do the right thing. Much as the now discredited Alan Greenspan trusted the "Street" to do the right thing with derivatives and mortgage backed securities. In short, allow the regulated to make their own rules.
This is one of the most colossal screw-ups in the history of our government and of government regulation. No first year banker or lawyer would be allowed to make such an error. Yet the former Chairman of Goldman, our Treasury Secretary, made it. This is a Ripley's Believe It or Not! type story.
And lets add a couple other "Can you believe it" points. One bank that received $25 billion is scheduled to pay employee bonuses of $10.7 billion this year. That's right - it is not misprint. Over 40% of the proceeds of our government's investment will be paid to executives who put the firm in the dire condition of needing the funds. Paulson forgot to negotiate that away as well.
Finally, as David Levine, Professor of Economics at Cal's Haas School of Business emphatically points out, these banks still pay a dividend. In other words, the proceeds of our government's bailout funds will be used to pay investors!
It is estimated that on average the banks may spend approximately 1/2 the bailout proceeds on bonuses and dividends within the next year. Well done Hank Paulson, Wall Street's friend!!!
Paulson did make one smart decision - that was to do a 180 on buying specific securities from banks. This was always a bad idea, and if Treasury's performance on the bank investments is any indication, purchasing securities (a much more complicated venture than investing in preferred shares of banks) would have been a disaster.
What about today's news? Paulson apparently realizes he is in way over his head, and has therefore announced that $350 billion of the $700 billion in bailout proceeds for which he vigorously campaigned Congress will not be spent. He will leave the rest for the Obama administration to decide what to do with starting January 20, 2009. Hopefully our President elect can find someone to lead this effort with more common sense and who is less prone to knee jerk reactions.
Speaking of knee-jerk reactions, the Democrats had to get in on the act as well by today demanding an auto industry bailout with all the same problems of the Wall Street bailout - and then some! The only positive is that at a mere $25 billion it is a much smaller tax payer problem.
Lets enumerate the flaws:
1) UAW workers make as much as $75/hour. That is over $150k per year, largely to push a button at a factory. US auto labor is obscenely overpriced compared to the rest of the world. There are 17 non-union auto factories in the US whose wages do not exceed $50/hour - these factories actually make money. The UAW has stated that they will not accept concessions of any kind, wage or otherwise. Well at least they make the best cars, right?
2) Wrong. Our industry is based on an unlimited supply of $2.00/gallon gasoline with no concern for greenhoue emissions. Hummers, SUVs, mini-vans and trucks are the staple of the American line of cars. Poor mileage, and poor performance, are its hallmark.
3) These companies are hemorrhaging cash. GM alone loses over $1 billion per month! And the rate of loss is accelerating. If GM receives 1/2 of the proposed bailout proceeds, it will lose all of it within 12 months. Between the three car makers, $25 billion provides less than a one year stopgap.
4) Consumers are not buying cars. They want higher MPG cars, but hybrids on average are over $8,000 more expensive than conventional counterparts. Plus, they are still not made in numbers by the US manufacturers: this is a Japanese dominated auto segment.
5) Credit has dried up. Private lenders such as GE capital dominated the auto lending industry, and they have not been given access to the bailout funds. With 40% declines for auto loans, how can consumer purchasing accelerate?
6) Retiree benefits are outrageous, growing, and underfunded.
I think there is no question that the government will provide funds to this industry. It is too far reaching - the jobs of too many voters and the fortunes of too many midwest cities are tied it, as are the jobs at the parts manufacturers who sell to the Big 3. But lets not rush into anything; lets insist upon some requirements for our money.
Our investment in the US Auto Industry should be subject to the following:
1) USE OF PROCEEDS: Invest in new car lines that provide 50 miles per gallon.
2) LABOR: UAW must accept concessions, including capping wages at $50/hr, and allowing for labor reductions. If UAW refuses, de-certify the union.
3) CONSUMER FINANCE: Part of the proceeds must be used to fund consumer loans.
4) TAX CREDITS: Consumers who buy cars with 50 MPG get a $8,000 tax credit.
5) RETIREE BENEFITS: Government takes over the unfunded portion of the benefits. Going forward benefits must be funded, at the risk of criminal penalties to auto executives.
6) PRE-PACKAGED BANKRUPTCY: Invest pursuant to a pre-pack bankruptcy which allows the automakers to reject contracts that are no longer relevant to their business going forward.
7) SUSPEND DIVIDENDS: All monies of the automakers should be reinvested in making safer, more fuel efficient autos.
Saving our auto industry is imperative. What is even more important is saving them from themselves.
Sunday, November 2, 2008
A Novel Bail-Out Approach: Buy it All!
In the past I have expressed the fundamental problems with the bailout, namely:
What are we buying?
From whom?
At what price?
Until these are answered Neel Kashkari, Treasury's choice to run the bailout, is sitting on a real big pile of cash while our banking system and economy continue to falter. Kashkari's previous experience was serving six years as a Goldman technology M&A banker, most recently as a Vice President. Six whole years - none of it working with banks or lending. Clearly this makes Neel eminently qualified to handle the bailout.
While Paulson, Bernanke and Kashkari have been sitting around, they have floated the notion of using a dutch auction to acquire assets. This mechanism would allow banks to identify and price assets to be auctioned. The lowest priced assets would be acquired by the Treasury until it had used up its allocation of bailout funds.
This is a nonsensical approach.
Banks would be forced to prioritize what they want to get off their books, at what price, and in what amounts. This sounds good, right? Not really. If banks price their assets too high, they will remain stuck with them as the funds go to other less aggressive banks. If they price them too low they will take a disproportionate hit to capital reserves, and will crowd out other banks who price prudently but need to get assets off their books and the funds from Treasury.
The only way this type of asset sale works is if banks collude. Unfortunately collusion would be illegal.
Another option Treasury has explored is having a third party manage the purchases. Blackrock founder Larry Fink and PIMCO founder Bill Gross have thrown their firms' hats in the ring to handle that assignment, and Gross has gone so far as to suggest that PIMCO would do it for free. Gross and Fink would certainly understand the business better than Kashkari, but might have a slight conflict of interest here, being significant holders of many of these same asset classes.
So, what to do?
Tom Campbell has an idea.
I had the good fortune to meet Mr. Campbell last week and to speak with him at length. Mr. Campbell is so accomplished that he pisses the rest of us off: Harvard law grad and University of Chicago PhD in Economics under Milton Friedman; Stanford Law Professor; Professor of Economics and former Dean of the Haas School of Business at Berkeley; former state Senator; and former four (4) term US Congressman from California. Some other cool gigs too. No pocket protector, no bow tie. Oh, and he is a nice guy. Enough already.
Mr. Campbell (Dr. Campbell? Professor Campbell? Sheesh!) advocates a unique solution to the problem. In Campbell's world, the government decides what assets are most problematic for financial institutions, and buys them all at 53.7% of face value. There is no negotiating, no auction, no determining market value, no deciding whether to accept the price. The government buys them all. From everybody.
This avoids the crowding out of a Dutch auction. It also alleviates the problem of a fixed price purchase, where the only sellers are those who think their assets are worth less than the purchase price. In that system, almost by definition, as a buyer our government would overpay.
In Mr. Campbell's plan, price is not really the point, and the 53.7% price is somewhat arbitrary. It has to be low enough to not unduly reward banks, but high enough to give them some liquidity. And it needs to be fair to everyone - or at least equally unfair to everyone. Finally, the purchases cannot help just a select few firms, they need to be universal.
Mr. Campbell's premise is that for the institutions to get back to work - and their work is financing the investment required to drive our economy forward - the toxic assets (or at least the ones with huge bid-ask spreads) need to come off their books. And it needs to happen now. This is mission critical, and in his view whether the tax payer receives a return on that investment is not at issue.
Certainly many banks would oppose such a plan, arguing that it comprised a "taking" of assets and therefore was unconstitutional. Ah, but Mr. Campbell didn't go to Harvard law for nothing: his research suggests that provided banks are "compensated fairly," a taking is well within the government's rights. Fair needn't be "full value," just fair. Equal treatment, for example, could connote fairness.
Mr. Campbell is not a banker, so he is not intimately familiar with the assets that banks hold, the amounts, or their current market values. But he realizes that the Treasury's process is going too slowly and has inherent flaws. His plan would get us going again quickly. Treasury's Mr. Kashkari could then focus his efforts on exactly what the most problematic assets were, and buy them, rather than on negotiating their purchase with folks far more experienced than he.
Campbell's plan is unique - especially for a long serving Republican politician. It is elegant in its simplicity and scope. And it is fair.
So, Mr. Paulson, what are you waiting for? Lets get Neel working on it!
What are we buying?
From whom?
At what price?
Until these are answered Neel Kashkari, Treasury's choice to run the bailout, is sitting on a real big pile of cash while our banking system and economy continue to falter. Kashkari's previous experience was serving six years as a Goldman technology M&A banker, most recently as a Vice President. Six whole years - none of it working with banks or lending. Clearly this makes Neel eminently qualified to handle the bailout.
While Paulson, Bernanke and Kashkari have been sitting around, they have floated the notion of using a dutch auction to acquire assets. This mechanism would allow banks to identify and price assets to be auctioned. The lowest priced assets would be acquired by the Treasury until it had used up its allocation of bailout funds.
This is a nonsensical approach.
Banks would be forced to prioritize what they want to get off their books, at what price, and in what amounts. This sounds good, right? Not really. If banks price their assets too high, they will remain stuck with them as the funds go to other less aggressive banks. If they price them too low they will take a disproportionate hit to capital reserves, and will crowd out other banks who price prudently but need to get assets off their books and the funds from Treasury.
The only way this type of asset sale works is if banks collude. Unfortunately collusion would be illegal.
Another option Treasury has explored is having a third party manage the purchases. Blackrock founder Larry Fink and PIMCO founder Bill Gross have thrown their firms' hats in the ring to handle that assignment, and Gross has gone so far as to suggest that PIMCO would do it for free. Gross and Fink would certainly understand the business better than Kashkari, but might have a slight conflict of interest here, being significant holders of many of these same asset classes.
So, what to do?
Tom Campbell has an idea.
I had the good fortune to meet Mr. Campbell last week and to speak with him at length. Mr. Campbell is so accomplished that he pisses the rest of us off: Harvard law grad and University of Chicago PhD in Economics under Milton Friedman; Stanford Law Professor; Professor of Economics and former Dean of the Haas School of Business at Berkeley; former state Senator; and former four (4) term US Congressman from California. Some other cool gigs too. No pocket protector, no bow tie. Oh, and he is a nice guy. Enough already.
Mr. Campbell (Dr. Campbell? Professor Campbell? Sheesh!) advocates a unique solution to the problem. In Campbell's world, the government decides what assets are most problematic for financial institutions, and buys them all at 53.7% of face value. There is no negotiating, no auction, no determining market value, no deciding whether to accept the price. The government buys them all. From everybody.
This avoids the crowding out of a Dutch auction. It also alleviates the problem of a fixed price purchase, where the only sellers are those who think their assets are worth less than the purchase price. In that system, almost by definition, as a buyer our government would overpay.
In Mr. Campbell's plan, price is not really the point, and the 53.7% price is somewhat arbitrary. It has to be low enough to not unduly reward banks, but high enough to give them some liquidity. And it needs to be fair to everyone - or at least equally unfair to everyone. Finally, the purchases cannot help just a select few firms, they need to be universal.
Mr. Campbell's premise is that for the institutions to get back to work - and their work is financing the investment required to drive our economy forward - the toxic assets (or at least the ones with huge bid-ask spreads) need to come off their books. And it needs to happen now. This is mission critical, and in his view whether the tax payer receives a return on that investment is not at issue.
Certainly many banks would oppose such a plan, arguing that it comprised a "taking" of assets and therefore was unconstitutional. Ah, but Mr. Campbell didn't go to Harvard law for nothing: his research suggests that provided banks are "compensated fairly," a taking is well within the government's rights. Fair needn't be "full value," just fair. Equal treatment, for example, could connote fairness.
Mr. Campbell is not a banker, so he is not intimately familiar with the assets that banks hold, the amounts, or their current market values. But he realizes that the Treasury's process is going too slowly and has inherent flaws. His plan would get us going again quickly. Treasury's Mr. Kashkari could then focus his efforts on exactly what the most problematic assets were, and buy them, rather than on negotiating their purchase with folks far more experienced than he.
Campbell's plan is unique - especially for a long serving Republican politician. It is elegant in its simplicity and scope. And it is fair.
So, Mr. Paulson, what are you waiting for? Lets get Neel working on it!
Wednesday, October 29, 2008
Pay Regulation To Creep Into Wall Street
You cannot take their money and expect they won't have something to say about how you run your business. Well, Congress does have something to say, and today's something regarding executive pay is: Are You Kidding Me!
In an election year, when the government has allocated $860 billion to a bailout, given $250 billion already to the banks, given almost $40 billion to AIG, back stopped deposits in excess of FDIC insurance, and forced the takeover of Bear and Merrill and WaaMu and Wachovia, the executive pay of these same firms is an easy target. So Congress is taking aim.
http://www.reuters.com/article/ousiv/idUSTRE49R7WC20081028
Congressman Waxman has requested a break down of compensation from banks receiving half the bailout money. Don't worry you other half, a similar document should be in a Fed-ex pouch very soon.
Wall Street has always argued that it is a meritocracy, in a meritocracy pay for performance is fair, and that there should not be a cap on it.
This may be true, it may not be. In the old days, when Wall Street rarely committed capital, when it made its money on expertise and execution rather than prop trading, this was probably true. Now, when it makes its money on allocating capital, making directional bets, and competing with its customers with seemingly limitless funds, perhaps not. Profit derived exclusively from your wits is one thing, profit requiring the use of investor capital quite something else, irrespective of the brilliance.
Congress is questioning how much pay is merited while trillions of investor and taxpayer dollars are lost.
Wall Street has also always warned that capping pay would lead to a brain drain: that all those clever MBAs will go elsewhere; and that experienced deal makers and rocket scientist product guys won't have enough incentive to stick around. I for one think most guys still show up to work earning $1 million - $5 million instead of $10 million to $50 million, but thats just my opinion.
In any case, we are soon to find out.
In an election year, when the government has allocated $860 billion to a bailout, given $250 billion already to the banks, given almost $40 billion to AIG, back stopped deposits in excess of FDIC insurance, and forced the takeover of Bear and Merrill and WaaMu and Wachovia, the executive pay of these same firms is an easy target. So Congress is taking aim.
http://www.reuters.com/article/ousiv/idUSTRE49R7WC20081028
Congressman Waxman has requested a break down of compensation from banks receiving half the bailout money. Don't worry you other half, a similar document should be in a Fed-ex pouch very soon.
Wall Street has always argued that it is a meritocracy, in a meritocracy pay for performance is fair, and that there should not be a cap on it.
This may be true, it may not be. In the old days, when Wall Street rarely committed capital, when it made its money on expertise and execution rather than prop trading, this was probably true. Now, when it makes its money on allocating capital, making directional bets, and competing with its customers with seemingly limitless funds, perhaps not. Profit derived exclusively from your wits is one thing, profit requiring the use of investor capital quite something else, irrespective of the brilliance.
Congress is questioning how much pay is merited while trillions of investor and taxpayer dollars are lost.
Wall Street has also always warned that capping pay would lead to a brain drain: that all those clever MBAs will go elsewhere; and that experienced deal makers and rocket scientist product guys won't have enough incentive to stick around. I for one think most guys still show up to work earning $1 million - $5 million instead of $10 million to $50 million, but thats just my opinion.
In any case, we are soon to find out.
Saturday, October 18, 2008
The Economy: Does Either Candidate Get It?
Watching the final Presidential debate Wednesday evening, my undergrad classmate Mike Markowitz blogged " Must Kill... Joe the Plumber... Must Kill..."
I am significantly less clever, so my thoughts went to Winston Churchill: "Those who fail to learn from history are doomed to repeat it."
Sen. McCain's failing: Mistakenly placing the blame for our failing economy on the sub prime market.
Sen. Obama's failing: No proposal to get the liquidity into our markets.
Both candidates spent more time arguing that their proposals would lower taxes for Joe the Plumber. Meanwhile neither is really addressing ways to generate sustained growth of our economy, and therefore either one is likely to kill Joe the Plumber - at least financially.
I have said it in previous posts, and its important, so lets repeat it: Sub prime lending did not cause our economic downturn.
If it had, then the actions taken which have eliminated sub-prime lending would have corrected the problem. We wish it were that simple, but of course it is not; so McCain, the press, and everyone else needs to stop banging that sub prime drum, because that instrument is out of tune with the music of our economy and markets.
If sub-prime lending was not the culprit, what was?
A lack of economic growth outside of the real estate industry, and an abrupt termination of liquidity, including and specifically sub prime lending, but also leveraged lending.
The 1990s were a time of information technology development that literally changed the way everyone of you reading this post does business. Companies such as Amazon, Ebay, Google and Yahoo came into being, and modest size companies such as Microsoft, Cisco, Oracle, and Intel became the behemoths that they are today. Information technology was a key driver of the productivity gains in the
The current decade has seen no such transformational development, and no such productivity gains. We need to change that if the economy is to improve.
How?
Stop the bleeding. The candidates talked about a short term moratorium on foreclosures, which ultimately doesn't address the problem. Instead, they should implement an 18 month freeze on mortgage rate resets. Make it retroactive for six months, and waive accrued fees, so folks that are in default due to resets can get current. This will allow people to stay in their homes, while giving the real estate market time to firm. In 12 months the freeze should be reviewed for a possible one year extension.
Increase liquidity - lower short term rates - a lot. This allows banks to keep rates low and still make a profit, getting them healthy in a hurry. One month Libor is roughly 4.40%. It needs to be 200 basis points lower and needs to stay there for awhile.
Increase liquidity - encourage mortgage lending including sub prime - but not mortgages with short term rate resets. Why do we care if a home owner borrows 50% or 100% of the home price provided he/she can AFFORD THE PAYMENTS!!!! Fannie Mae and Freddie Mac are a catastrophe, so start a new entity to buy mortgages from banks. In a previous post we named that entity Billie-Mike after Bill Gross and yours truly - I think its kinda catchy.
Now, onto industrial growth.
Develop non-polluting energy resources. OK, this isn't new, but lets put some numbers on this:
Exxon-Mobil and Chevron, the nation's largest oil companies, earned record profits this year of $40.6 billion and $18.7 billion, respectively. Yet the industry devotes annually less than 1/2% of their revenue to R&D. For Exxon-Mobil that’s roughly $2 billion, and for Chevron thats roughly $1 billion for total R&D that includes but is not exclusive to renewable energy. It is simply not enough. We need to devote 20x that amount solely to renewables if we really hope to make any meaningful progress.
The benefits? Reduce payments for foreign oil. Reduce demand for oil which should reduce the price, which should reduce corporate energy costs. Reduce emissions, which lead to pollution and global warming. And most importantly, create new companies and hundreds of thousands of new jobs! But without order of magnitude increases in investment this will be nothing more than a pet project for a few engineers for the foreseeable future.
Encourage auto lending, particularly for hybrids and battery powered cars. Previously 90+% of auto loan applications were approved, currently its down to 60%. Meanwhile the auto industry has declined from selling 17 million new autos per year to 12 million. That’s a whole lot of lost GDP and a bunch of lost jobs. Hybrids are $5000 - $8000 more than their polluting alternatives. GM's Volt, to be released in 2-3 years, is estimated to cost $43000, or about $20k more than its current comparable gas powered autos. We need to subsidize these costs through loan programs and tax credits to get more of these in the hands of consumers quickly and drive job growth (pun intended).
Contain medical costs. Extend basic coverage to those without care. Create a system of free clinics so that pregnant women get pre-natal care, and mothers get basic care for their kids. Create trauma centers so people can get treated for injuries. Staff both with doctors and nurses who will get college loans waived in exchange for serving in these facilities for three years after leaving med school. Use technology to allow for remote chart and test reading by specialists. Create a payor system that reimburses providers, therefore cutting insurance rates for the rest of us.
These changes will reduce the cost of providing health insurance to employees, which should lead to a healthier workforce with less worker down time - ie increased productivity.
Invest in medical technologies, whether adult stem cell, nanotechnology, or other research approaches. In addition to longevity and quality of life benefits, this will create jobs!
Finance start-up businesses. Where can a start-up get financed today, particularly with the IPO window closed? Without start-ups, where will the next Google come from? Fund the Small Business Administration, and restart SBIC venture and buyout programs.
So? By following these recommendations, we will get liquidity into our markets and fund new industries, thereby creating GDP growth and jobs.
And maybe we won't actually kill Joe the Plumber......
Friday, October 17, 2008
Why Isn't Our Economy and Stock Market Behaving Like the 1990s?
In the 1990s our economy and stock market grew due to the following fundamentals:
1) Productivity Expansion due to
- implementation of computing and related technologies,
- outsourcing - ie lower costs for same or even better work product
- declining (in real dollars) energy costs and increasing energy efficiency
Today, we lag behind the other developed nations in productivity growth. Our technology adoption rate has slowed, the benefit of outsourcing already realized (in fact outsourcing costs are rising due to inflation in China, India, and Mexico), and energy costs are much higher, not just for gasoline but also for natural gas.
2) Historically Low Interest Rates allowed banks and investors to realize outsized ROE's from moderate nominal returns on investment.
In November 1990 one-month LIBOR (the base index for corporate loans) stood at 9.125%, and the 10-year treasury yield was 8.39%. Through the rest of the 1990s both rates averaged roughly 1/2 those levels, allowing companies to access debt markets cheaply.
3) Massive Increases in Market Liquidity drove stock prices. In-flows came from:
- Companies switching from defined benefit retirement programs to defined contribution (eg 401k) plans.
- Increases in leveraged lending fueled by the development of the syndicated lending and the participation of non-bank lenders (ie increased demand for bank product); and
- meteoric increases in high yield bond issuance, which together with bank syndication drove a huge spike in M+A activity, which in turn drove stock valuations.
From 1990 - 1999 investment in IRAs and 401k programs tripled from $4 trillion to $12 trillion. From virtually $0 issuance in 1990, high yield bond issuance exceeded $140 billion in both 1998 and 1999, and averaged almost $100 billion per year from 1993 through 1999. Leveraged bank lending over the same period was 3x - 4x the bond issuance levels (my estimate).
The net effect on stocks? From December 1990 to December 1999 the Dow and S+P 500 grew in value over 4x (Dow 2633 to 11470, S+P from 330 to 1469). The tech heavy NASDAQ composite over the same period grew almost 11x, from 374 to 4069.
More telling, S+P PE ratios increased from roughly 12.5x in 1990 to roughly 35x in 1999. In other words, in relative terms investors were paying almost three times as much for stocks.
The bottom line: Market Liquidity Matters!
What is different now?
We talked about productivity - it has slowed and some argue that we have not had any real increase in productivity since 2000. Our energy costs are much higher. The growth of IRAs and 401Ks has slowed, and the credit markets are dead, so liquidity is down.
Rather than productivity, our economy has been dependent over the last 8 years on real estate and related industries (construction, raw materials, furnishings). As we all know, real estate has been neutered.
With no fundamental industrial growth, and no market inflows to drive stock demand, and a deflating real estate market, there is nothing in our economy to drag us out of the mire.
1) Productivity Expansion due to
- implementation of computing and related technologies,
- outsourcing - ie lower costs for same or even better work product
- declining (in real dollars) energy costs and increasing energy efficiency
Today, we lag behind the other developed nations in productivity growth. Our technology adoption rate has slowed, the benefit of outsourcing already realized (in fact outsourcing costs are rising due to inflation in China, India, and Mexico), and energy costs are much higher, not just for gasoline but also for natural gas.
2) Historically Low Interest Rates allowed banks and investors to realize outsized ROE's from moderate nominal returns on investment.
In November 1990 one-month LIBOR (the base index for corporate loans) stood at 9.125%, and the 10-year treasury yield was 8.39%. Through the rest of the 1990s both rates averaged roughly 1/2 those levels, allowing companies to access debt markets cheaply.
3) Massive Increases in Market Liquidity drove stock prices. In-flows came from:
- Companies switching from defined benefit retirement programs to defined contribution (eg 401k) plans.
- Increases in leveraged lending fueled by the development of the syndicated lending and the participation of non-bank lenders (ie increased demand for bank product); and
- meteoric increases in high yield bond issuance, which together with bank syndication drove a huge spike in M+A activity, which in turn drove stock valuations.
From 1990 - 1999 investment in IRAs and 401k programs tripled from $4 trillion to $12 trillion. From virtually $0 issuance in 1990, high yield bond issuance exceeded $140 billion in both 1998 and 1999, and averaged almost $100 billion per year from 1993 through 1999. Leveraged bank lending over the same period was 3x - 4x the bond issuance levels (my estimate).
The net effect on stocks? From December 1990 to December 1999 the Dow and S+P 500 grew in value over 4x (Dow 2633 to 11470, S+P from 330 to 1469). The tech heavy NASDAQ composite over the same period grew almost 11x, from 374 to 4069.
More telling, S+P PE ratios increased from roughly 12.5x in 1990 to roughly 35x in 1999. In other words, in relative terms investors were paying almost three times as much for stocks.
The bottom line: Market Liquidity Matters!
What is different now?
We talked about productivity - it has slowed and some argue that we have not had any real increase in productivity since 2000. Our energy costs are much higher. The growth of IRAs and 401Ks has slowed, and the credit markets are dead, so liquidity is down.
Rather than productivity, our economy has been dependent over the last 8 years on real estate and related industries (construction, raw materials, furnishings). As we all know, real estate has been neutered.
With no fundamental industrial growth, and no market inflows to drive stock demand, and a deflating real estate market, there is nothing in our economy to drag us out of the mire.
Friday, October 10, 2008
The Bailout Passed: So Why Do Stocks Continue to Fall?
To no one's surprise, after a slight delay and an extended drum roll, the $700 billion "bailout" package was approved last week. Also not surprisingly, after a one day stabilization, markets continued their free fall as we had said they would.
Why?
Because "$700 billion bailout" is a headline, not a plan. It passed without determining: exactly what was to be acquired; from whom; who was going to actually make the purchases: at what price; and how that price would be determined.
It didn't address the real issue: A lack of confidence in our financial institutions based on not knowing what is in their portfolios. In short, we worry, "is the situation even worse than we realize?"
How could our House of Representatives pass such an extraordinary measure with such little information? Confidence that President Bush got it right? Treasury Secretary Paulson? Fed Chairman Bernanke?
Nope. Because Warren Buffet said so.
It went something like this:
Warren: "Golly gee, Republican Congressmen, 60% of you objected to this bailout. If I had known that I would never have purchased $5 billion of Goldman Sachs stock at a huge discount and with a previously unheard of 10% dividend. And with an option for $5 billion more. Boys and girls, you better rethink this, because Goldman only has a $50 billion war chest, and we need the government to buy all the illiquid, unpriced crap on Goldman's books (at prices we will be happy to establish) so Goldman is free to purchase all the banks assets that the Fed is going to foreclose upon and sell at a discount in the next 12 months." (More on that later.)
What Republican politician can resist Warren Buffet? It is un-American to deny this guy a 20%+ return on his capital year after year. Somewhere it is written that the world's richest man must be the one to capitalize on the downfall of the American financial markets, and Congress had better buck up and make it so, even if his argument is self serving and has no logical rationale. Hey, this is Warren freaking Buffet we are talking about here!
So now the bill has passed and somebody, not sure exactly who, is sitting on a real big pile of cash, and at least the "from whom?" question is partially answered: Goldman Sachs.
What has this done and what will it do for our markets? To date, absolutely nothing. We have suffered a 2000 point drop in the DJIA since its passage. The smart folks on Wall Street (I prefer Rob Rubin, the former head of Goldman, to Warren Buffet, when it comes to matters of financial firms) knew this would be the case.
So what should we do next? What are the "smart guys" clamoring for?
Suspension or elimination of FASB 115, the so-called "Mark to Market Accounting" rule, and its recent follow-on FASB 157, the "Fair Value Measurement" rule, which they believe is the real cause of our financial crisis.
I can hear your resounding: "Huh?... What the heck are these FASBs? Mike, explain."
My pleasure.
FASB 115 and 157 contain the seemingly common sense rule that financial firms need to account for (or "mark") their assets (stocks, bonds, loans, etc ) at their current market price, rather than simply leaving them at the price paid for them. If the prices of these assets decline, then firms needs to mark them down, not unlike a retailer marking down its spring stock once summer rolls around.
"Mike, What is wrong with that? Sounds like common sense!" you say.
Well, it seemed that way for a long time, so much so that the assets to which FASB 115 applied continued to expand. And in "normal" markets, which I will define as one with both a "bid" (offer to purchase) and and an "ask" (offer to sell), it works fine. But what about when you do not have a bid? Or when the bid-ask spread (the difference between offers to purchase and to sell) is exceedingly wide? What is the market price then? And does this reflect "true value?"
Lets make a simplified example:
Suppose a financial institution owns a sub prime loan, which in this example we will define as a mortgage with zero money down (100% loan) to a credit worthy borrower. That borrower continues to make payments on time. Lets further suppose that a home in the same neighborhood, with the same layout and built by the same builder at the same time, recently sold in a foreclosure sale at a 40% discount to the face amount of our financial institution's loan amount. Now, where should we "mark" our loan, i.e. what is its market value?
There are three possible answers:
1) Par. After all, the borrower continues to perform on his obligation and is expected to continue to do so.
2) 60% of par; reflecting the 40% discount in market value of homes in that neighborhood.
3) Something less than 60%, reflecting the fact that if a financial buyer was to purchase the loan it would be at a discount to the market value of the home.
Now, repeat this example several million times, and throw in millions more derivative instruments based on these underlying mortgages, and you will start to understand the magnitude of what Wall Street is calling the "Mark to Market Problem."
There are roughly 8500 banks in the US, and thousands of fund managers, and they all are to some degree facing this dilemma. If they all were to mark the assets in their portfolio to the bid price (or implied bid price) for those assets, in almost every case their capital base would wiped out, despite in many cases only a negligible effect on their cash flow.
Simplistically, this is what led to the failure of both Bear Sterns and Lehman Brothers. Because there was a perception that their assets had drastically declined in value, Bear and Lehman were unable to get the short term financing that financial institutions rely upon, thus forcing them (in Bear's case) to sell for next to nothing or (in Lehman's case) declare bankruptcy where they are currently selling themselves for even less.
Turnaround/Vulture investor Wilbur Ross recently predicted that 1000 banks will be forced to close within the next year or so (and he has raised a fund to buy a bunch of assets). History suggests that his claim is modest. In its existence, the Fed has closed 3,286 banks. 82% of these, or roughly 2600, were closed or forcibly sold in 1990-1992, the last time the government stepped in to help us out of a financial mess with an imbecilic strategy. (Check out the companion post "Legislative Idiocy - Its Like Deja Vu All Over Again" to rehash that government imposed debacle.) Goldman, Buffet, Ross and others are counting on this happening again, and are well positioned to acquire cheaply assets when they come up for sale.
Back to our current issue: Would a change to the mark-to-market rules solve our problem?
Wall Street argues that marking illiquid assets to market does not reflect their true value, and that marking them down will only damage the firms rather than impart the intent of FASB 115 - to reflect "impairment." In other words, the losses incurred from writing these assets down are imaginary, not real.
What is real is what can and has happened after these writedowns occur - the firms' capital bases are diminished, on paper, so that they are out of compliance with required regulatory capital causing:
1) investor panic which leads to a stock price freefall;
2) depositor panic which leads to deposit outflows;
3) trading partner panic which leads to elimination of trading lines and short term loans.
A precipitous stock drop is bad. Losing deposits and lines of credit eliminates liquidity and causes firms to shut the doors, ala Bear, Lehman, Indy Mac, and WaMu.
So will suspension of Mark-to-Market rules stop this trend? No. and, Yes.
No, in that I am not so sure that if previously written down assets were to be written back up, that the stocks and liquidity would suddenly return to previous levels. The cat is out of the bag, ie investors and analysts would be skeptical of capital bases suddenly inflated by an 180 degree turn on this issue.
Yes, however, it should help in respect to additional writedowns. Financial firms have not written down all their assets to the extent that they truly reflect the price at which they would trade, or that would reflect their value in today's world. This is particularly true in that prices keep dropping every day. It is an impossible task, and it largely depends upon assumptions of supply - what assets are assumed to be traded and how much at any one time.
So what to do? Certainly, we need to do SOMETHING!
So I yield to Wall Street: Lets temporarily suspend FASB 115 and FASB 157. But we need to make sure that this isn't an opportunity for weak institutions to mask their problems.
In Japan's economic crisis of the late 1980s through the 1990's, the banks did not write down assets to reflect true losses due collusion with government officials. Instead the government lowered interest rates to 0% in order to stimulate the economy. This lack of recognition delayed banking reform and caused Japan's financial markets to be stagnant for almost 15 years.
This could certainly happen in the US.
So, instead of writing down assets per the Mark-to-Market rules, financial institutions would identify with much more specificity the assets affected. How much real estate backed bonds and related derivatives do they have? How much in direct loans? How much in credit default swaps? What are their lines to other financial institutions? How much of each asset type are in default?
Clearer information about the portfolios would allow investors and lenders to make better decisions about which financial institutions are healthy, and which need help.
Also, since writedowns are subjective, this approach would not penalize or reward firms for being conservative or aggressive with their valuations.
However, do not think that this will suddenly float our markets. That will take time, more capital, and an economy not solely driven by real estate.
Subjects for future posts.
Why?
Because "$700 billion bailout" is a headline, not a plan. It passed without determining: exactly what was to be acquired; from whom; who was going to actually make the purchases: at what price; and how that price would be determined.
It didn't address the real issue: A lack of confidence in our financial institutions based on not knowing what is in their portfolios. In short, we worry, "is the situation even worse than we realize?"
How could our House of Representatives pass such an extraordinary measure with such little information? Confidence that President Bush got it right? Treasury Secretary Paulson? Fed Chairman Bernanke?
Nope. Because Warren Buffet said so.
It went something like this:
Warren: "Golly gee, Republican Congressmen, 60% of you objected to this bailout. If I had known that I would never have purchased $5 billion of Goldman Sachs stock at a huge discount and with a previously unheard of 10% dividend. And with an option for $5 billion more. Boys and girls, you better rethink this, because Goldman only has a $50 billion war chest, and we need the government to buy all the illiquid, unpriced crap on Goldman's books (at prices we will be happy to establish) so Goldman is free to purchase all the banks assets that the Fed is going to foreclose upon and sell at a discount in the next 12 months." (More on that later.)
What Republican politician can resist Warren Buffet? It is un-American to deny this guy a 20%+ return on his capital year after year. Somewhere it is written that the world's richest man must be the one to capitalize on the downfall of the American financial markets, and Congress had better buck up and make it so, even if his argument is self serving and has no logical rationale. Hey, this is Warren freaking Buffet we are talking about here!
So now the bill has passed and somebody, not sure exactly who, is sitting on a real big pile of cash, and at least the "from whom?" question is partially answered: Goldman Sachs.
What has this done and what will it do for our markets? To date, absolutely nothing. We have suffered a 2000 point drop in the DJIA since its passage. The smart folks on Wall Street (I prefer Rob Rubin, the former head of Goldman, to Warren Buffet, when it comes to matters of financial firms) knew this would be the case.
So what should we do next? What are the "smart guys" clamoring for?
Suspension or elimination of FASB 115, the so-called "Mark to Market Accounting" rule, and its recent follow-on FASB 157, the "Fair Value Measurement" rule, which they believe is the real cause of our financial crisis.
I can hear your resounding: "Huh?... What the heck are these FASBs? Mike, explain."
My pleasure.
FASB 115 and 157 contain the seemingly common sense rule that financial firms need to account for (or "mark") their assets (stocks, bonds, loans, etc ) at their current market price, rather than simply leaving them at the price paid for them. If the prices of these assets decline, then firms needs to mark them down, not unlike a retailer marking down its spring stock once summer rolls around.
"Mike, What is wrong with that? Sounds like common sense!" you say.
Well, it seemed that way for a long time, so much so that the assets to which FASB 115 applied continued to expand. And in "normal" markets, which I will define as one with both a "bid" (offer to purchase) and and an "ask" (offer to sell), it works fine. But what about when you do not have a bid? Or when the bid-ask spread (the difference between offers to purchase and to sell) is exceedingly wide? What is the market price then? And does this reflect "true value?"
Lets make a simplified example:
Suppose a financial institution owns a sub prime loan, which in this example we will define as a mortgage with zero money down (100% loan) to a credit worthy borrower. That borrower continues to make payments on time. Lets further suppose that a home in the same neighborhood, with the same layout and built by the same builder at the same time, recently sold in a foreclosure sale at a 40% discount to the face amount of our financial institution's loan amount. Now, where should we "mark" our loan, i.e. what is its market value?
There are three possible answers:
1) Par. After all, the borrower continues to perform on his obligation and is expected to continue to do so.
2) 60% of par; reflecting the 40% discount in market value of homes in that neighborhood.
3) Something less than 60%, reflecting the fact that if a financial buyer was to purchase the loan it would be at a discount to the market value of the home.
Now, repeat this example several million times, and throw in millions more derivative instruments based on these underlying mortgages, and you will start to understand the magnitude of what Wall Street is calling the "Mark to Market Problem."
There are roughly 8500 banks in the US, and thousands of fund managers, and they all are to some degree facing this dilemma. If they all were to mark the assets in their portfolio to the bid price (or implied bid price) for those assets, in almost every case their capital base would wiped out, despite in many cases only a negligible effect on their cash flow.
Simplistically, this is what led to the failure of both Bear Sterns and Lehman Brothers. Because there was a perception that their assets had drastically declined in value, Bear and Lehman were unable to get the short term financing that financial institutions rely upon, thus forcing them (in Bear's case) to sell for next to nothing or (in Lehman's case) declare bankruptcy where they are currently selling themselves for even less.
Turnaround/Vulture investor Wilbur Ross recently predicted that 1000 banks will be forced to close within the next year or so (and he has raised a fund to buy a bunch of assets). History suggests that his claim is modest. In its existence, the Fed has closed 3,286 banks. 82% of these, or roughly 2600, were closed or forcibly sold in 1990-1992, the last time the government stepped in to help us out of a financial mess with an imbecilic strategy. (Check out the companion post "Legislative Idiocy - Its Like Deja Vu All Over Again" to rehash that government imposed debacle.) Goldman, Buffet, Ross and others are counting on this happening again, and are well positioned to acquire cheaply assets when they come up for sale.
Back to our current issue: Would a change to the mark-to-market rules solve our problem?
Wall Street argues that marking illiquid assets to market does not reflect their true value, and that marking them down will only damage the firms rather than impart the intent of FASB 115 - to reflect "impairment." In other words, the losses incurred from writing these assets down are imaginary, not real.
What is real is what can and has happened after these writedowns occur - the firms' capital bases are diminished, on paper, so that they are out of compliance with required regulatory capital causing:
1) investor panic which leads to a stock price freefall;
2) depositor panic which leads to deposit outflows;
3) trading partner panic which leads to elimination of trading lines and short term loans.
A precipitous stock drop is bad. Losing deposits and lines of credit eliminates liquidity and causes firms to shut the doors, ala Bear, Lehman, Indy Mac, and WaMu.
So will suspension of Mark-to-Market rules stop this trend? No. and, Yes.
No, in that I am not so sure that if previously written down assets were to be written back up, that the stocks and liquidity would suddenly return to previous levels. The cat is out of the bag, ie investors and analysts would be skeptical of capital bases suddenly inflated by an 180 degree turn on this issue.
Yes, however, it should help in respect to additional writedowns. Financial firms have not written down all their assets to the extent that they truly reflect the price at which they would trade, or that would reflect their value in today's world. This is particularly true in that prices keep dropping every day. It is an impossible task, and it largely depends upon assumptions of supply - what assets are assumed to be traded and how much at any one time.
So what to do? Certainly, we need to do SOMETHING!
So I yield to Wall Street: Lets temporarily suspend FASB 115 and FASB 157. But we need to make sure that this isn't an opportunity for weak institutions to mask their problems.
In Japan's economic crisis of the late 1980s through the 1990's, the banks did not write down assets to reflect true losses due collusion with government officials. Instead the government lowered interest rates to 0% in order to stimulate the economy. This lack of recognition delayed banking reform and caused Japan's financial markets to be stagnant for almost 15 years.
This could certainly happen in the US.
So, instead of writing down assets per the Mark-to-Market rules, financial institutions would identify with much more specificity the assets affected. How much real estate backed bonds and related derivatives do they have? How much in direct loans? How much in credit default swaps? What are their lines to other financial institutions? How much of each asset type are in default?
Clearer information about the portfolios would allow investors and lenders to make better decisions about which financial institutions are healthy, and which need help.
Also, since writedowns are subjective, this approach would not penalize or reward firms for being conservative or aggressive with their valuations.
However, do not think that this will suddenly float our markets. That will take time, more capital, and an economy not solely driven by real estate.
Subjects for future posts.
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