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.
Showing posts with label bailout. Show all posts
Showing posts with label bailout. Show all posts
Monday, November 17, 2008
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.
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.
Monday, September 29, 2008
The $700 Billion Falling Knife
OK, so the market fell 777 points, dove like a jumbo jet that ran out of fuel. Clearly Wall Street didn't like the news that Congress had demurred on the $700 million bailout package.
But what was to like about the plan in the first place? OK, if you are holding some funky real-estate based derivative assets that you cannot figure out how to price, then sure, you were looking forward to having a naive $700 billion buyer in the market to pay way too much for these assets. But how was that going to stabilize the markets, and more importantly get the US economy and financial markets moving the right way?
There are so many problems with this plan that it is hard to enumerate them all, but lets start with a problem that Bill Gross at PIMCO hit on: Who is making the decision of which assets to buy, and who is determining the appropriate / fair price? I got news for you, neither Paulson nor Bernanke have any clue how to price these assets. Bill Gross was recommending a price of roughly 65% of face value, but what about the derivative assets that do not have a face value? And why is 65% a magic number?
Is it possible that our government could purchase $700 billion in assets that are worth materially less? Is it a possibility that after our government purchases these securities that our markets will still drift downward? The answers are yes and yes.
A downward market absorbs capital. Lots of it. It creates a vortex that sucks everything in its path into the abyss. Just ask TPG. Those smart fellows learned a $1.7 billion lesson about the sharpness of a falling knife. Sure, $700 billion is a whole lot more than TPG threw into the pit, but arguably TPG threw their dough in a much shallower hole. We have no idea how big the entire real estate related market pit is, and certainly no conclusive evidence that $700 billion will plug it.
A smarter idea would be to stop, take a step back and review what put us in this predicament in the first place. Sure, there were lots of bad mortgages out there, and lots of dumb securities formed and derivatized (new word? Honk if you like it). But the problem wasn't that banks were making sub prime loans. The problem is that they stopped.
OK, take a deep breath, and stay with me on this.
Since 2001, the engine of our economy has been real estate. This has driven construction, which has driven commodities and labor. The average American was wealthier, and used his home as a blank check. New homes meant new furniture, new drapes, new paint, new dishes. Remodeled homes meant media rooms, new flat screen TVs and other electronic toys. New communities meant new shopping centers, new health clubs and preschools. And of course, new mortgages, second mortgages, and credit cards bills to finance all the purchases.
Say this with me: It was good. Very good.
So the problem wasn't the real estate lending based boom. The problem was it STOPPED.
Why did it stop? Well, thats is a complicated question, but basically, the market stopped purchasing loans because of all those scary, evil, and bad sub prime mortgages out there (we will come back to that in a second).
Who was the market? Basically Wall Street packagers, and a couple agencies you no doubt have heard a lot about, Fannie Mae and Freddie Mac. A couple of Bear Sterns hedge funds go "tits up" (to use the street's vernacular), and the market ran for the hills. Soon, all across the media we were hearing about the evils of these sub prime mortgages.
So these Wall Streeters and Agencies responded to pressure from the government and the media, and these folks stopped buying loans from banks. When they stopped buying, the banks couldn't make any more loans.
And so the real estate market ground to a halt. No more liquidity. Prices fell. People could not refinance. They were foreclosed upon. Prices fell some more. Banks were damaged and began to close. And so on. The vortex had been formed.
Wrong idea, wrong response.
Markets are based upon liquidity much more than underlying value. Value is a tenuous thing, its what the buyers agree to pay and sellers agree to receive. Its ephemeral, fleeting, and based on psyche. Primarily that psyche depends on: If I had to resell this thing, what could I get for it?
So were sub prime mortgages bad? How about so called liar's loans? In each case, a resounding "No." Really, who cares whether you leverage your home 50% or 100%, so long as you can afford the payments? If you can afford to make the payments, the fluctuation in the market prices for real estate do not really matter in the short term.
Were there problem loans? Of course there were. These were the loans that I classify as "designed to fail" loans: negative amortization, teaser rate, pick a payment, call them what you like. They all had one characteristic: The borrowers could not afford a traditional mortgage. These mortgages were relatively short term before they reset, and depended upon either 1) real estate prices increasing significantly so that the loans could be refinanced, or 2) that the buyer's cash flow would significantly increase. Or in some cases both!
Well, what happens to borrowers with negative amortization loans when prices don't go up but rather go down? Well friends, we are living it.
So what does that have to do with our $700 billion debate? The issue is this: Now that lending has ceased, and prices have dropped, piggy banks have gone dry, and the economy has faltered, will propping up the owners of these crazy derivatives make a damn difference to Joe and Jane homeowner? And by extension the economy? The answer is "NO."
A Better Idea: Take that same money, or even less, and create a new Fannie Mae or Freddie Mac to purchase MORE LOANS! We would have to call it something else; how about in honor of Bill Gross and me we call it Billie Mike. Whatever.
The point is to start buying new loans again. Lots of them. This will drive down the spread in mortgages, and create liquidity. Liquidity will support real estate prices. Construction will restart, and people will start buying furniture, etc..... you are seeing my point I think.
So how can we be sure that the same mistakes are not made? First, no neg am loans. They cannot be sold into pools. Also, require that borrowers sign a statement acknowledging the risk. Further, require that lenders segregate their portfolios so that they disclose exactly how many of their loans are this toxic waste. Perhaps require 100% capital against negative am loans that are more than 50% loan to value.
Also, on the intermediary side, its time to require much more capital against derivatives. How much? and won't this damage liquidity? Well, I don't know how much, that's a subject for a different blog. And certainly it will diminish liquidity. But remember the 1990s when Alan Greenspan developed the concept of "soft landing." Soft landings are ok. Hard stops are not. If liquidity is a bit less than 2005, that's ok. We just can't have the hard stop of 2008.
So there you have it - a simple, elegant, and aptly named (Billie Mike) solution to our economic woes. Messiers Bernanke and Paulson, you're welcome and you know where to reach me.
But what was to like about the plan in the first place? OK, if you are holding some funky real-estate based derivative assets that you cannot figure out how to price, then sure, you were looking forward to having a naive $700 billion buyer in the market to pay way too much for these assets. But how was that going to stabilize the markets, and more importantly get the US economy and financial markets moving the right way?
There are so many problems with this plan that it is hard to enumerate them all, but lets start with a problem that Bill Gross at PIMCO hit on: Who is making the decision of which assets to buy, and who is determining the appropriate / fair price? I got news for you, neither Paulson nor Bernanke have any clue how to price these assets. Bill Gross was recommending a price of roughly 65% of face value, but what about the derivative assets that do not have a face value? And why is 65% a magic number?
Is it possible that our government could purchase $700 billion in assets that are worth materially less? Is it a possibility that after our government purchases these securities that our markets will still drift downward? The answers are yes and yes.
A downward market absorbs capital. Lots of it. It creates a vortex that sucks everything in its path into the abyss. Just ask TPG. Those smart fellows learned a $1.7 billion lesson about the sharpness of a falling knife. Sure, $700 billion is a whole lot more than TPG threw into the pit, but arguably TPG threw their dough in a much shallower hole. We have no idea how big the entire real estate related market pit is, and certainly no conclusive evidence that $700 billion will plug it.
A smarter idea would be to stop, take a step back and review what put us in this predicament in the first place. Sure, there were lots of bad mortgages out there, and lots of dumb securities formed and derivatized (new word? Honk if you like it). But the problem wasn't that banks were making sub prime loans. The problem is that they stopped.
OK, take a deep breath, and stay with me on this.
Since 2001, the engine of our economy has been real estate. This has driven construction, which has driven commodities and labor. The average American was wealthier, and used his home as a blank check. New homes meant new furniture, new drapes, new paint, new dishes. Remodeled homes meant media rooms, new flat screen TVs and other electronic toys. New communities meant new shopping centers, new health clubs and preschools. And of course, new mortgages, second mortgages, and credit cards bills to finance all the purchases.
Say this with me: It was good. Very good.
So the problem wasn't the real estate lending based boom. The problem was it STOPPED.
Why did it stop? Well, thats is a complicated question, but basically, the market stopped purchasing loans because of all those scary, evil, and bad sub prime mortgages out there (we will come back to that in a second).
Who was the market? Basically Wall Street packagers, and a couple agencies you no doubt have heard a lot about, Fannie Mae and Freddie Mac. A couple of Bear Sterns hedge funds go "tits up" (to use the street's vernacular), and the market ran for the hills. Soon, all across the media we were hearing about the evils of these sub prime mortgages.
So these Wall Streeters and Agencies responded to pressure from the government and the media, and these folks stopped buying loans from banks. When they stopped buying, the banks couldn't make any more loans.
And so the real estate market ground to a halt. No more liquidity. Prices fell. People could not refinance. They were foreclosed upon. Prices fell some more. Banks were damaged and began to close. And so on. The vortex had been formed.
Wrong idea, wrong response.
Markets are based upon liquidity much more than underlying value. Value is a tenuous thing, its what the buyers agree to pay and sellers agree to receive. Its ephemeral, fleeting, and based on psyche. Primarily that psyche depends on: If I had to resell this thing, what could I get for it?
So were sub prime mortgages bad? How about so called liar's loans? In each case, a resounding "No." Really, who cares whether you leverage your home 50% or 100%, so long as you can afford the payments? If you can afford to make the payments, the fluctuation in the market prices for real estate do not really matter in the short term.
Were there problem loans? Of course there were. These were the loans that I classify as "designed to fail" loans: negative amortization, teaser rate, pick a payment, call them what you like. They all had one characteristic: The borrowers could not afford a traditional mortgage. These mortgages were relatively short term before they reset, and depended upon either 1) real estate prices increasing significantly so that the loans could be refinanced, or 2) that the buyer's cash flow would significantly increase. Or in some cases both!
Well, what happens to borrowers with negative amortization loans when prices don't go up but rather go down? Well friends, we are living it.
So what does that have to do with our $700 billion debate? The issue is this: Now that lending has ceased, and prices have dropped, piggy banks have gone dry, and the economy has faltered, will propping up the owners of these crazy derivatives make a damn difference to Joe and Jane homeowner? And by extension the economy? The answer is "NO."
A Better Idea: Take that same money, or even less, and create a new Fannie Mae or Freddie Mac to purchase MORE LOANS! We would have to call it something else; how about in honor of Bill Gross and me we call it Billie Mike. Whatever.
The point is to start buying new loans again. Lots of them. This will drive down the spread in mortgages, and create liquidity. Liquidity will support real estate prices. Construction will restart, and people will start buying furniture, etc..... you are seeing my point I think.
So how can we be sure that the same mistakes are not made? First, no neg am loans. They cannot be sold into pools. Also, require that borrowers sign a statement acknowledging the risk. Further, require that lenders segregate their portfolios so that they disclose exactly how many of their loans are this toxic waste. Perhaps require 100% capital against negative am loans that are more than 50% loan to value.
Also, on the intermediary side, its time to require much more capital against derivatives. How much? and won't this damage liquidity? Well, I don't know how much, that's a subject for a different blog. And certainly it will diminish liquidity. But remember the 1990s when Alan Greenspan developed the concept of "soft landing." Soft landings are ok. Hard stops are not. If liquidity is a bit less than 2005, that's ok. We just can't have the hard stop of 2008.
So there you have it - a simple, elegant, and aptly named (Billie Mike) solution to our economic woes. Messiers Bernanke and Paulson, you're welcome and you know where to reach me.
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