Archive for September, 2008
Out of Their Elements
Has President Bush, Secretary Paulson, Chairman Bernanke, or Speaker Pelosi taken a single action or spoken a single phrase during the past month to inspire confidence in their ability – not to solve the problem – but to simply comprehend it and characterize it?
By “it,” of course, we mean the current liquidity crisis facing certain institutions that seem to have lax boards and managements that encouraged excessive risking-taking behavior that led to over-concentrations of holdings in certain (nearly worthless) asset classes.
Perhaps, that question is too harsh; so, we shall ask a different one. Has President Bush, Secretary Paulson, Chairman Bernanke, or Speaker Pelosi taken a single action or spoken a single phrase that has mitigated, rather than exacerbated, the current crisis?
As regular readers know, we often urge those with decision-making authority to take a shortened version of the Hippocratic Oath and pledge to “do no harm.” Today we go beyond that and recommend: just shut up!
Of the most recognizable national politicians – sorry most House members – the most intelligent quote that we heard was from John McCain in an Obama, anti-McCain ad. It’s the one with the bad cover of Sam Cooke’s “Wonderful World” with the lyrics “don’t know much about…”
In the quote, McCain admits to not knowing much about economics. If he and the other national politicians could remain that humble and thoughtful during the crisis, there is much less chance that they would exacerbate it and create a real panic. (Clearly, a former “community-organizer” would have a better grasp of subtle economic issues and concepts and thus be able to provide such insights as – and we paraphrase–we’ll solve the problem with common sense solutions and, as a bonus for the envious and spiteful, we’ll screw the rich while we’re at it. (Regular readers will recall our use of italics to denote sarcarm.))
Bigger Is Not Necessarily Better.
Today’s (September 30) Wall Street Journal contains a front-page article, Industry Is Remade in a Wave of Mergers, which reports that the three largest banks now control over 30% of the nation’s deposits.
We’re writing because we take issue with the paper edition’s blurb: “For the economy and government officials, the very size of these banks means they should be better insulated from big shocks…” In our mind, there seems to be an implicit, but unjustified, diversification-benefit argument behind such statements.
We see no evidence that massive size has insulated any financial firm in this current crisis or any previous crisis in this country or any other country. In fact, we argue that the opposite is quite possibly true.
As we’ve written in the past, e.g., two weeks ago Forced Mergers? Bigger Is Not Necessarily Better! and reiterated Sunday in What Will Wachovia’s Presumed Demise Mean for B of A?, permitting centralization (of asset allocation) into the hands of fewer and fewer individuals creates its own systematic risk. Each senior decision-maker’s idiosyncratic (and possibly irrational) beliefs and judgments affect a larger and larger share of the economy’s resource decisions, and that can’t be a good thing. Thus, there is a trade-off of the cost savings (of consolidation) versus the additional risk of such centralized decisions.
Such idiosyncrasies go beyond any single individual and include organizational factors, as well. For example they include the behaviors both consciously and unconsciously induced by control schemes, including performance measures and reward schemes; culture and ethics; history; and even modeling techniques and assumptions. All of these together create a firm-specific, idiosyncratic component to the probability of income and losses being realized, which could amplify variability and the probability or magnitude of bad outcomes.
When we have the time, we’ll try to graph an example of an efficient frontier as the number of firms shrink. It is not simply the consolidation of past (or prospective) uncorrelated positions, which on average would produce realized diversification benefits, e.g., higher low outcomes. Instead, unlike much of traditional financial theory, which assumes certain distributions and completely rational decision-makers, it is easy to imagine someone’s past successes unduly influencing their decision-making and creating a concentration of risk within a particular industry, region, or asset class. Perhaps Wachovia and mortgages is a good example of this behavior?
The second part of the blurb, which we did not reproduce, contains a “too big to fail” statement, and the writers correctly note that this mentality intensifies moral hazard problems by providing a perceived limited liability on the loss side, thus making such institutions more likely to take risks and get into trouble. That’s not our argument, but it does exacerbate the issue that we’ve identified.
Beyond the Financial Crisis: a Theological Question
On Monday in a post, A Better Solution (than a government takeover), we proposed a serious, alternative solution to the financial liquidity crisis that is decentralized and free-market oriented. In addition, it could quickly be implemented with a few changes to the tax code. The main idea: permit private buyers of distressed securities to immediately expense the purchase price and pay low tax rates of subsequent sales or recoveries.
At the end of that post, we mentioned that we had a few details to work out, including the optimal (subsequent) capital gains tax rate, the appropriate tax basis, and any participation restrictions, i.e., should sellers of distressed securities also be permitted to buy them from others?
Unfortunately, we must now defer consideration of these issues to investigate a more pressing theological one: is our dog’s eternal happiness at stake now that he has bitten the priest’s elderly dog? (To be clear, the dog is old, not the priest.) We’re guessing mortal sin, not venal.
You see, Our Poster Boy for the Credit Crisis bit the poor old dog on the head when the duo visited this evening. So, is Bootsy doomed? And are we personally doomed for our failure to control our Basenji’s transgressions against the church Lab?
In other words, will Boots and I be forced to spend a hellacious eternity listening to the insipid prattlings of Mike Tirico, Ron Jaworski, and Tony Kornheiser, ESPN’s Monday Night Football announcing crew?
We’re both sorry: very, very sorry.
A Better Solution (than a government takeover)
Update: the House failed to pass the first bailout bill. Here is a serious and efficient alternative that could be implemented very quickly…
But first a bit of our usual criticism: while dismayed, we were not surprised by the political response to the financial crisis surrounding the issuance and holding of suspect mortgages and mortgage-related securities.
We’re peeved at Republicans because many of them claim to be conservatives, yet propose no serious free market solutions. Their insurance plan seemed lame and little different than subsidized, under-priced flood insurance offered to hurricanes victims – sometimes after the fact. It exacerbates moral hazard problems.
We are upset with the Democrats, too, who claim that it is a crisis of free markets, when many know that a substantial part of the intertwined set of problems was the result of Congressional meddling and the usual (and expected) ineffective regulation.
In addition, we are especially annoyed with many, so-called conservative commentators and investors who claim to be for freedom and free markets, but run to the federal government whenever times get tough: “Mama, Mama, do something, I’m scared.” (That’s one of our general criticisms of baby-boomers; many whom seemed to have never grown-up, particularly the older ones.)
The Wall Street Journal has failed us: Unfortunately, our criticism extends to that former beacon of free markets, The Wall Street Journal’s editorial page. Its published principles seem to dissolve when the staff becomes afraid of possibly lower ad revenue, circulation, or home values.1 See today’s A Main Street Rescue, for an example of their inconsistency.
In that respect, we agree with many of the letter writers on today’s editorial page, who complain about the bailout and the journal’s recent lack of free-market principles. (We particularly like James Lang’s letter, which states that $700 billion is enough to buy outright the equity in the top 11 banks by market capitalization.) Of course, that may have changed over the weekend to include, say, the top twenty.)
Regular readers know that we’ve spent much of our blogging effort during the past week criticizing the bailout and government officials, primarily Mr. Paulson and Mr. Bernanke, but to date we haven’t offered a solution of our own.
As always, we do think that the best start to solving a complex problem is to do nothing and think. (We do offer more than that below.) That strategy tends to minimize negative, unintended consequences and follows from our motto of “thought before calculation,” which in this case would generalize to “thought before action.” That’s why we often admonish readers to take the crucial part of the Hippocratic Oath in all such activities: do no harm.
Our Proposed Solution goes beyond the previous paragraph’s recommendation of thoughtful inertia, but does not require central planning by federal bureaucrats or constant oversight by a myopic and expedient Congress.
Change the tax code to motivate private investors and investment managers (and other firms) to solve the problem without federal assistance. How?
By allowing (new) private purchasers of certain classes of mortgages and securities to immediately expense the item’s historical cost or take an unrealized loss for the full purchase price (without the usual loss-limiting, gain-offsetting rules for capital losses that lead to loss carry-forwards, etc.).
The upfront tax savings would be at the buyer’s marginal rate. Does the reader think this would provide substantial liquidity for these distressed assets? We do! Do you think that hedge funds, private equity funds, and other financial firms would be willing to purchase these assets, organize funds, and distribute ownership rights to other investors, including individuals? We do!
We believe this immediate tax benefit would induce investors to bear the risks of loss associated with valuing and buying these difficult-to-understand securities, and it would require a substantially smaller investment by the US government – this time in terms of temporary opportunity cost of lost tax revenue, rather than as a direct investment.
We also propose to tax the realized capital gains when these items are resold or realized at some minimal rate, say, 5%. We have no theoretical justification for the 5% rate, but we want it low enough to reward the purchasers for bearing the risk, but high enough to recoup some of the lost revenue of permitting the immediate tax write-offs.
In that regard, we need to determine the optimal tax basis for such sales, as well as participant eligibility, i.e, who would be allowed to participate? Could current distressed holders be buyers, too?
As it stands we would argue that the tax basis to calculate realized gains should be zero, rather than the original purchase price. We need to think about how this rate-basis combination affects incentives to buy and hold or sell these mortgages and issues, as well as the effect of such a plan on values of other asset classes, e.g., CMBS. Similarly, our initial impulse would be exclude the major, current holders, i.e., the likely largest sellers, from also buying, but see arguments both ways.
We conjecture that such rewards would generate sufficient interest from investors and fund managers to quickly organize and invest thereby (privately) mitigating the liquidity crisis in a market-based solution.
Neither our proposal nor any other proposal – short of nationalization – will eliminate liquidity issues. The crisis has taught banks and investors that certain institutions are not as capable or safe as was once thought. Those diminished firms and organizations will continue to suffer from a lack of willing lenders and investors, but isn’t that the way it is supposed to be?
There is more to write on the issue, but we’d prefer to publish the idea and perform a few afternoon activities that generate current – rather than potential future – revenue. Moreover, we need to think more about some of the details mentioned above. (Look for revisions to this post and new, related posts tonight and tomorrow.)
So, dear reader, what do you think? Should the federal government implement its a new, House-approved version of its current plan. Or should it step aside and simply provide an environment for entrepreneurs and investors to bear the risk and solve the problem themselves? We frequently quote Austin Powers: “It’s freeedom baby, yeah,” which we prefer to some squares in the government running the show. So, unsurprisingly, we’re all for our plan.
- See “About Us” towards the bottom and to the right on http://online.wsj.com/public/page/news-opinion-commentary.html for a summary of their philosophy. It appears everyday. ↩
The Financial Bailout, Reverse Auctions and Marking to “Market”
During the past week, we have criticized the President’s and Congress’s proposed financial bailout on principle and for what we will call strategic and tactical reasons. The title of this post pertains to some of the tactics, which we’ll mention later in the post. However, we’ll take a moment to reiterate our primary opposition.
First, we disagree in principle with the proposed bailout/subsidization of financial firms that either (1) recklessly lent money for mortgages to unqualified borrows or (2) recklessly purchased mortgages, mortgage-backed securities, or CDOs without sufficient analysis. By “recklessly” we mean that lax management permitted excessive risk-taking, and by “excessive risk-taking” we mean both (1) the elimination of lending standards and (2) the determined ignorance the environment by employees and managers about all of the bad things that could happen, particularly the systematic components of real-estate values in communities and regions, which they tend to be highly related. (There’s a domino effect when prices are going up or down.)
We could make a technical argument, which would use a model similar to Moody’s correlated, binomial expansion technique, but doubt that most readers care about the details. So, we refer interested readers to a post from April, Trading, Incentives and Organizational Structure and Risk Management, which explains how we see home prices being set. See the section entitled Thinly-traded “markets,” but we think the entire post is worthwhile.
Secondly, we don’t like the strategic decision to overestimate of the negative implications of not passing the bailout. We view the wolf-crying, sky-is-falling bureaucrats at the Fed and the Treasury with deep suspicion. We think that many of our fellow members of the hoi polloi harbor similar suspicions. We think those suspicions (and the implicit lack of respect for the audience/crowd) is one reason why most opinion polls have shown that majorities of respondents are against the bailout.
Thirdly, from what we’ve read this evening, we also disagree with the devil in the details. An article on The Wall Street Journal’s web site tonight, Crisis Hits Europe’s Banks As U.S. Seals Bailout Deal, has emphasized the reverse auction aspect of the proposed purchase plan. If that is the case, then for a particular mortgage-related securitization issue – MBS or CDO – the Treasury will buy at the lowest asking price. Presumably, this mechanism is being emphasized to minimize complaints (from people like us) about subsidizing irresponsible behavior.
Unfortunately, as we mentioned Friday in Moral Hazard and Another Problem with Illiquid Assets…in a Mark-to-Market Accounting Régime, the problem with illiquid assets is that there are few – if any – prices to observe.
So, the Treasury’s purchase price will set the market price (and the mark) for all the other holders of the issue. And, that price is the lowest asking price; so, all else equal, every firm that doesn’t sell now has an unrealized loss, and having banks recognize additional unrealized losses is not the way to regain financial stability in the industry.
We’re not an expert on auctions, but maybe some type of second-price, reverse auction is would work out best. We need to think more about it, and – as always – are willing to entertain comments and other perspectives.
Best Line That We’ve Read in a While
Is from an article, Bailout Plan Gains Key Support, at The Wall Street Journal’s web site today, Sunday, September 28. U.S. Representative Mark Udall speaking about his constituents’ phone calls regarding the proposed financial bailout: “My calls are mixed between people who say no and people who say hell, no.”
We’re not a constituent of the rep from Colorado, but we think that we fall into both groups.
What Will Wachovia’s Presumed Demise Mean for B of A?
We’d bet that Bank of America is too busy swallowing Merrill Lynch and attempting to identify its own problem assets to ask (and answer) our question, but we really hope that is not the case.
It would be a shame because B of A should have asked it before the Merrill Lynch acquisition rather than now when, now, when its capital is scarcer. We know that the purchase price of Merrill was relatively small compared to B of A’s massive asset size, but that’s not our point today as we’ll explain below.
Of course, we can’t mention B of A and Merrill without also mentioning our objection to the “semi-forced” merger in Forced Mergers? Bigger Is Not Necessarily Better! So, please bear with us. (Was it really only two weeks ago?)
Our point in that post was that an individual senior manager – with any authority – brings idiosyncratic risk to asset allocation decisions, e.g., any of the behavioral finance irrationalities and irregularities that have been documented. That idiosyncratic risk becomes systemic as his firm controls more and more of the economy’s assets, and so the concentration of decisions eliminates or at least reduces any natural (or textbook) diversification benefit that one would “normally” expect. (That’s one of the many problems with centrally-planned economies, but it is often ignored.)
The idiosyncrasies can go beyond tastes and risk preferences. In fact, all else equal, that personal, idiosyncratic risk is most surely inversely-related to the individual’s ability and competencies. That’s why we really, really wish more government officials, regulators, board members, and senior managers would have read and internalized Nassim Nicholas Taleb’s book, Fooled By Randomness.
In it, Taleb describes one type of fool as the person who attributes his success solely to his ability rather than to his good fortune or luck and is therefore willing to take bigger and bigger bets, and does so until he “blows up” or loses more in one shot than he ever made. Sound familiar?
If our reader is too busy to read Taleb’s entire book, perhaps he or she has time to read St. James’ admonition on our quotes page. We think it is eight lines at most.
Now, we certainly hope that Bank of America is not gloating as its crosstown rival, Wachovia, nears its end – figuratively or literally – and we say that because moves and mergers made a mere two weeks ago to generate “temporary stability” seem to have failed badly. Moreover, the loss of one’s biggest rival isn’t a rosy outcome if both you and that rival are harmed by the same negative factors. Thus, we urge B of A to consider those implicationsof its rival’s demise (or takeover) to its own value. Unfortunately for Bank of America, it is not a zero-sum game.
In that respect, we’ve discussed some of the relationships between Wachovia and Bank of America in couple of posts during this past summer. Clearly there are industry, national, and regional feedback loops at work.
Within the industry, many banks are hurting. Supposing that B of A had absolutely nothing to hide, it (and its assets) would (and will) certainly suffer from guilt-by-association, regardless of what it says.
Moreover, as we’ve been warned any number of times by any number of commentators, failures in the banking industry affect the economy as a whole; thus, B of A’s future business prospects are dimmed as Wachovia’s (and others’) troubles affect the overall economy. It is a two-way street, after all; despite what one may have heard, banks don’t drive the economy.1
Regionally, B of A may gain market share, but the size of that market is likely to be substantially smaller. So, the net gain in regional revenue may be negative for a variety of reasons. More importantly, the Charlotte area seems to be highly dependent upon those two firms, and the loss of either one will likely have a huge negative affect on home values (and business values and creditworthiness and, eventually the size of the population) within the region. That, too, will hurt the survivor, and it is why we subtitled our June post, “Or how banking in ‘08 in Charlotte might be like steel in Pittsburgh in ‘72,” i.e, the beginning of the end.
Remember, none of our analysis depends upon any existing, inherent problems within Bank of America. If such problems exist, they will certainly exacerbate matters. However, it does seems that Merrill and Wachovia share certain problems, e.g. exposure to bad mortgage, and that will consume further capital.
In that way, B of A has just agreed to add something that looks similar to its failing crosstown rival. In our opinion, there is no time to gloat. Its risks are more concentrated than it may have thought.
Let us know what you think. Are we off-base or prescient or on target but lucky?
- We don’t doubt the hypothesized negative direction of the bank-to-economy affect in a crisis, but we do doubt the magnitude, especially when many estimates seem to be self-serving, hyperbolic rhetoric. ↩
A Sign of the Economy’s Strength
We view the huge sums spent on advertising various causes and issues to be a sign of the economy’s general health – or at least a sign that some folks have more money than they need.
We’re not talking about the politicians. We’re talking about AARP and One and the rest of the groups and alliances that have supplanted failed banks and failing auto manufacturers as major advertisers this fall.
The one we like best: the call, nay the demand, for the equivalent of a perpetual motion machine within ten years. Hey, no one said the demands had to be reasonable or even make sense, and we’re sure that the broadcast networks don’t mind.
The First Presidential Debate
As a test of our will and discipline, we attempted to watch tonight’s debate. We are weak, and we failed the test, or perhaps we weren’t sufficiently self-loathing to fully appreciate the event. On the other hand, perhaps we place a unreasonably high value on wit, and therefore the disappointment was ours and ours alone.
Regardless, we found all parties lacking, particularly the execrable Mr. Jim Lehrer. Did we hear him say something about the next President being the ruler of the country? Yes, unfortunately, we did.
May we suggest a civics class before his next moderation attempt in 2012? Or better yet, perhaps he may consider retiring (or at least retiring that “talk to him, not to me” shtick). At this point we are undecided. We’re not sure if he reminds us of a very bad therapist or a stereotypical, TV, prison b*tch. (Yeah, The Longest Yard was on the other channel.) Ah, let’s split the small difference and call it a draw.
The other two seemed to be as articulate and clear-headed as two very tired children at the end of a long and eventful day that had involved lots of sugar.
They reminded us of our return from an amusement park late one night last summer. Each of the princesses had a friend in the car. The little one’s friend, who was five-turning-six at the time, was extremely tired but hungry. She kept asking the chairman, “Mrs. Spero, do you have any of those things in the car? You know, like the ones my mom has in her car? Do you have any of those little things in the box? I’m kind of hungry. Could I have some of them?” Later, we learned that her mother kept a certain brand of cookies in their car, which were not what we had to offer thus the tired confusion.
Combine that level of speaking ability with the two snapping at each other like two, very tired siblings, and we were quickly underwhelmed. Hey, we can get that at home from two real princesses on their pre-dinner LBS (low blood sugar) dive. We don’t need to watch it on TV!
In sum, we found the debate to be unwatchable, and have little hope for the remaining ones although Biden condescending to Palin might be worth seeing.
If the reader watched tonight’s debate, does he or she now understand why we prefer a very limited federal government, with minimal regulation and interference by the equivalent of tired children? Perhaps they also now understand why we insist upon the fallen nature of man as the foundational principle upon which institutions are built.
Thank God that the Founding Fathers shared our perspective of mankind and the need for appropriate checks and balances and incentives or one of those two might be an actual ruler. Ick!
Moral Hazard and Another Problem with Illiquid Assets
in a Mark-to-Market Accounting Régime.
Here’s a couple of related issues that we can discuss in the context of today’s The Wall Street Journal article, Bailout Proposal Gets Hung Up Over Central Issue: Will It Work?
We’re deeply concerned about the moral hazard implications of any government bailout, and we doubt that we are the only observer to harbor such dark thoughts. However, we also think that those implications could be realized immediately rather than, say, during the “next” downturn in some far distant time. Thus our pessimism grows as does our annoyance with the federal officials who have proposed massive snd expensive actions without sufficient levels of thought.
In that respect, can the reader say, “commercial real-estate loans and CMBS?” And, does the reader know that illiquid CMBS – that’s redundant by the way-is very difficult to value, too? Not much different than CDOs of MBS. We commented on some of those valuation issues three months ago in this post: On Nedges and Sledges and Paving the Road to Hell.
We mention CMBS because we saw in the referenced article that many banks, not just the ailing ones, are trying to round-up everything they don’t want, i.e., crappy loans and securities, to make it available for sale to the government.
Can you, dear reader, blame the banks? We can’t. We’d certainly like the feds to buy our Suburban at its historical cost, too. Mr. Paulson are you listening? Can you help me, here?
As the article mentions, it turns out that the banks would rather sell these items at their currently marked values than be forced to possibly devalue them at the end of the next reporting period, which happens to be next Tuesday.
It is probably too late, so we doubt that it will happen on Monday, but we could see a banker trying to convince a government bureaucrat that the bank’s mark from June is still the best guess of where an item sells (if it were to sell to anyone in the market that doesn’t exist.)
We could also see the bankers’ expectations of the sales (to the government) to color their valuations next week. As we wrote yesterday in The Uncertain Value of Mortgage Securities that expectation will likely lead to greater adverse selection problems because of the possible increase in the uncertainty regarding the value of each bank’s assets. In our view, this will exacerbate, not mitigate, the current panicky behavior among banks as they deal with each other (until such exchanges with the government actually occur). However, we could see it leading to problems after the bailout, too.
With that in mind, we ask the dear reader to guess the multiple of $700 billion that banks have identified as assets they’d like to sell? We’re guessing a multiple of at least three – a few trillion dollars worth – with a substantial amount of CMBS and inventoried, pipelined, commercial mortgages thrown into that mix. (Those are loans that conduits made and planned to bundle into securities but are currently stuck with because no one wants the CMBS that would be structured from them.) Does the reader believe that only homes were overbuilt in former boom towns?
So, for argument’s sake, and to be excruciatingly precise, let’s say that we are correct that the bank’s collectively think that they’ll be able to sell $2.1 trillion worth of thingies to the government at prices that the banks like. How will take affect next week’s third quarter valuations, and what will happen when they’re stuck with $1.4 trillion of stuff that they wish the government had bought?
And that leads us to our second issue about the nature of disjointed and illiquid markets and how a little information can hurt a lot. You see, in social situations, more information is not necessarily better.
The fact that no one wants to buy the stuff doesn’t mean that there aren’t a lot of firms holding similar securities. So, let’s say that 20 firms are holding a part of a particular illiquid CDO issue or CMBS issue or whatever it is that no one else wants.
If the thing is illiquid then – nowadays – that means it’s not traded at all; so, there is no observable price; so, it is likely that the current marks vary across the 20 firms because they are all using slightly different models or all have slightly different – albeit, likely inflated – expectations of what a sale to the government will bring.
All things equal, it would seem to us that the most desperate firm would accept the lowest price offered by the Treasury. Again, all else equal, that’s usually how its works; otherwise, we have to add an adverse selection argument, too.
If that is true, then depending upon how much of the issue the Treasury purchases, that lowest price is now an observable “market” price for the other 19 firms, and that’s not good with mark-to-market accounting where a little bit of information, based possibly upon one firm’s desperation sale to the government set the new (likely lower) mark for the other 19 firms. It might be information and it might be the truth, but it certainly wouldn’t help society. More information isn’t always better.
That means additional write-downs may be forthcoming from, say, the other 19 firms. If that issue is part of our hypothesized $1.4 trillion above, then those write-downs in the future after the government purchase will be larger than they would have otherwise been without the bailout. Of course, that’s based upon our argument that the book values of the issues would be higher than they otherwise would have been (due to each bank’s anticipation of selling to the government at an inflated price). Such a scenaroi would lengthen the duration of the crisis and negatively influence the behavior of the firms when they lend to each other in the near term. There will be more panics that occur farther into the future.
Is this all idle speculation? Of course, we were a theorist in college. Are we wrong? It is quite possible – the chairman mentions that it often happens – but we doubt it in this case. Let us know what you think.
If ‘If’s and ‘But’s Were Candy and Nuts…(#2)
Oh, what a party we’d have. We used that title once before and got a decent number of hits from it, and we’re nothing if not an opportunistic – albeit neophytic – SEOer, which is why we mention Lipstick Jungle, too.
Since August, when we began paying closer attention to our daily hits and the rankings of various posts, our silly little post during the Olympics, What Do They Want From Us?, about NBC’s promos for Lipstick Jungle remains among our most viewed articles
Actually, for new readers we’d like to mention that our reuse of the title is part of Spero Consulting’s green strategy of recycling still valuable material so as not to harm the environment. Perhaps we’re more gentle and caring because we’re majority-owned by a woman, or perhaps it’s because we are lazy, er, efficient.
Regardless, it is an apt title to introduce our criticism of Lucian Bebchuk’s op-ed piece in today’s (the September 26) edition of The Wall Street Journal, entitled How to Pay Less for Distressed Financial Assets.
Mr. Bebchuk’s entire essay summarizes to a single point: the government should pay only the fair market value for the distressed, illiquid mortgage assets and securities that financial institutions own (that don’t have market). Now, why didn’t anyone else think of that? Clearly, it takes a Harvard Law prof with, as the article mentions, a “white paper” to reach such a heady conclusion.
Presumably, the white paper’s argument goes something like this: let’s ignore for the moment that there is no market for these items, and let us assume that one exists. In that case, the government should pay no more than fair market value. Hmm, very clever. (Regular readers may recall that we occasionally use italics to signify deep and meaningful sarcasm.)
Now, we must admit that up to this point, we’ve been a tad bit unfair. See, Mr. Bebchuck’s essay actually makes three points, not just one. The second one is very similar to the first: pay fair market value for other stuff, too. So there is no need to dwell on it.
The third recommendation goes beyond either of the first two has to do with selling the illiquid securities that the government buys. We would negligent and misleading if we didn’t mention it. See, Mr. Bebchuk recommends that the government design optimal incentive schemes to sell the inventory of illiquid, mortgage-related securities at the highest possible price. Again, brilliant.
He recommends, placing the securities with managers who do not have conflicting interests – any good economic theorist could have continuüm of them in a flash – and he concludes that competition will produce prices at fair market values in a jiffy. Brilliant, indeed. So, assume away conflicts-of-interest and have the government design optimal incentive schemes because we all know that the federal government is a very efficient designer of incentive schemes: see The Government Will Save Us! Not! for a recent example of the federal government’s efficiency at inducing cost-saving behavior. We’re sure that you could supply your own, too.
Interested readers are also encouraged to read a few posts from yesterday: The Uncertain Value of Mortgage Securities discusses the fact that no one seems to know how to value the securities and The Crisis and Free Market Critics provides a bit of detail about the nature of the valuation problem – see the aside towards the end, which is about CDOs. We also have a few other posts about the bailout in which we criticize the plan’s likely efficacy and oppose it for a variety of reasons. (Note that our argument against subsidization, or having the government pay more than the thingies are worth does not presume a market for them but does presume that they can be valued in some manner. Despite the upcoming double negative, we’re not being inconsistent or hypocritical by accusing Mr. Bebchuk of doing something and then doing it ourselves.)
Like most posts, we’ll probably revise this slightly in the next day or two.
OMG! OMG! OMG! Largest US Bank Failure Ever!
Wolf! Wolf! Wolf!
The sky is falling! The sky is falling! The sky is falling!
The biggest banking collapse in US history, and, as far as we can tell, Chicken Little, despite all the noise nothing much has happened. Oh, certainly some folks, including a private equity firm, lost a good deal of money, but that seems to be the nature of private equity and speculation, especially during highly volatile times. We don’t make light of their losses, but we’ve lost lots on particularly investments in the past, and we suspect that most of our readers have, too. So, we say join the crowd and try to repress your bad experience like the rest of us.
JP Morgan was able to substantially increase its retail network – at what seems to be a relatively low cost. Good for them. If all of WaMu’s bad stuff is now Morgan’s responsibility – and it seems to be – then that merger should remove a substantial amount of bad mortgages and mortgage securities from the bailout pot, and that seems to be good for all of us.
We’ll be interested in seeing whether the Treasury and the Fed reduce the asking size of the proposed bailout now that Morgan stepped up to cover Washington Mutual’s losses. (Various reports suggest that WaMu expects to lose about $19 billion on its mortgage portfolio.) We’re not sure of the estimated size of WaMu’s assets that the Fed and Treasury planned to purchase, i.e., the supposed market value or non-loss portion of those mortgages.
The $700 billion had to include some of those mortgages, right? So, shouldn’t the $700 billion be smaller now? By the way, how was that $700 billion estimated? Does anyone know? Mr. Paulson? Mr Bernanke? We have a sneaking suspicion that no one quite knows for sure, but it chosen because it seemed relatively big – more than half a trillion but less than a whole trillion.
Will Investment Banks Go the Way of the Dinosaur?
We doubt it.
But maybe cicadas or General MacArthur.
With Goldman Sachs and Morgan Stanley becoming commercial banks, many commentators are noting the demise and extinction of investment banks. We’re not so sure.
This is clearly a highly-speculative and long-term prediction but we think private investment banks, circa the 1980’s, will be back. Why? They provide control mechanisms and levels of oversight and scrutiny that seem difficult to duplicate in public corporations. So, yeah, we could see relatively-large, limited partnerships return via spin-offs, mergers of boutique firms, or, possibly, mutations of hedge funds and private equity funds and consulting firms.
Of course, the eventual validity of our idle speculation depends upon future changes in the law and the regulatory environment, and that is highly uncertain at this stage, but we could see it happening in less time than it takes cicadas to normally return.
The Crisis and Free Market Critics
(And a long aside about the nature of CDOs.)
The Wall Street Journal has an incredibly inane article in today’s (September 25) edition. It is entitled Crisis Stirs Critics of Free Markets. Actually, the crisis has stirred advocates of free markets, including the entire senior management at Spero Consulting.
The three writers of article don’t seem to understand that the US is hardly a pure free market economy, and many of the current financial problems were either caused or exacerbated by governmental regulations or authorities or politics. In fact, it almost seems that the troika doesn’t read its own paper.[1. As we’ve written a few times over the past couple of days, it is quite possible that the government’s proposed bailout will exacerbate the problem, especially if it attempts to stretch-out the term of the bailout. That’s one of the reasons that we’re against it.]
For example, in Tuesday’s journal, Blame Fannie Mae and Congress For the Credit Mess Congress the authors of that column explain that Fannie Mae and Freddie Mac are government sponsored enterprises – not quite free enterprise startups – and their recent, hard push into sub-prime and Alt-A mortgages was clearly politically motivated. It is right there in the journal (and probably 10,000 other places) that the writers could not find.
In addition, regulations and laws permitting only investment-grade purchases – e.g., for pension plans etc. – created a demand to “highly-rated” credit products, and that was a major impetus for the creation of CDOs (or securitizations of securitizations). Those ratings were mandated by federal law and the provision of such ratings is highly-regulated, including entry into the industry. The journal has had any number of articles and op-ed columns on those topics, too.
Moreover, most CDOs were designed to meet particular ratings guidelines, i.e., the objective was to segment the cash flows from the mortgages (or mortgage-backed securities or CDOs) into different tranches with different probabilities of default and losses given default. The idea was to take bunch of relatively average things (mortgages or MBS) and synergistically create a lot of really good, investment grade, stuff and a little bit of bad stuff, known as the equity tranche. The ratio of these good-to-bad tranches depends crucially on assumptions about collateral’s interrelationships and dependencies. So, optimistic assumptions – meaning independent or uncorrelated collateral values – generated more good stuff than bad stuff, and unfortunately, more good stuff than recent history shown to be the case.
Aside: these estimations are performed via some type of Monte Carlo simulation and as mentioned above require making assumptions about those relationships, i.e., the joint distributions of randomly-distributed cash flows. That’s very hard to do without making many, many simplifying theoretical assumptions, and because so many of those assumptions were violated in practice, no one honestly knows how to value those securities today.
It’s that interrelationship that is particularly tricky to know: look up “copulas.” Folks generally define them in ways that they can solve them, regardless of whether the solvable copulas represent reality or not, and that empirical validity is difficult to determine because there isn’t as much data and history as one would think, and recent history hasn’t been that favorable or representative. There’s a file in On Nedges and Sledges and Paving the Road to Hell that illustrates how to relate three independent variables to create to correlated ones.
So, a demand for investment grade securities combined with some clever – but ultimately inaccurate math and statistics – permitted the manufacture of more investment grade CDOS. Kind of reminds us of Chinese baby formula, and in that respect makes in seem less like bad luck and more like the lax management and excessive risk-taking that we criticize.
Our criticisms are fair and justified. Complaining that the US is too much of a free economy is not, and falling for international political rhetoric is just plain stupid. We don’t expect much from three reporters – were they Moe, Larry, and Curly? – but editors of The Wall Street Journal should know better. Shame on them.
The Uncertain Value of Mortgage Securities
A few days ago we read an article – it was likely in The Wall Street Journal–where a trader from Chicago complained about a question that Ohio Senator Sherrod Brown asked of either Mr. Paulson or Mr. Bernanke; we don’t recall to whom it was directed.
Senator Brown had asked something to the effect of: at what price will these securities sell, i.e., be purchased by the Treasury? The trader complained that it was a stupid question because Senator Brown should know that no one knows the price. We chuckled. We know nothing about Senator Brown, other than he is from Ohio and is probably a Democrat, but we thought: dear trader, that is EXACTLY why he asked the question so that appointee would have to publicly admit as much.
In that spirit, yesterday we asked, Could a “Bailout” Prolong the Financial Crisis? because the prospect of selling mortgage-related securities to the government introduces additional uncertainty into possible valuations (and therefore into the “marketplace”). Uncertainty that could be partially eliminated – at least for the commercial banks – via their third quarter marks next week.
Moreover, this afternoon’s news that Congress has agreed – not voted, yet, but agreed – to provide the funds in stages will not help matters and, per our thinking, should worsen them. Such a long, drawn-out process will create additional uncertainty and distrust among lenders – not to industrial firms or consumers but to each other – so, expect more panicky days and mini-runs and Chicken Littles.
In today’s (September 25) The Wall Street Journal, we see that Peter Eavis and David Reilly make a similar point about uncertainty in the Heard on the Street Financial Analysis and Commentary Section: Bailout’s Flaw of Large Numbers.
In addition, they make the same point that we have made about the nature of the bailout. If it is a fair exchange, the banks are only marginally better-off because they have a more liquid asset – cash – rather than one of those thingies (that most board members can’t explain). If it is an unfair exchange, the banks may be better capitalized, but then the government is overpaying: see last night’s post in response to the President’s speech: Sorry Mr. Bush, We Respectfully Disagree. As they note, the banks need private capital, and as we note it is not in short supply: look at Mr. Buffet, private equity’s interest in commercial banks, hedge funds, etc., and also look at the low levels of Treasury yields. (Yeah, we know about flights to “quality,” too.)
Lastly, in any number of posts, we’ve discussed how the losses in this crisis seem to be highly concentrated within certain segments of the financial industry. Two other columns in today’s issue provide further support for our conjecture.
In the same Heard on the Street section, Liam Denning writes in Earnings Reports: The Audacity of Hope that consensus, expected growth of cumulative S&P 500 earnings will be flat for 2008 (over 2007) and 25% higher in 2009. In fact, analysts estimate that financial sector should make more next year than in 2007, which wasn’t a bad year. (Of course, we know that these analyst estimates needs to be taken with a grain of salt the size of Lot’s wife.)
On the editorial page, Andy Kessler makes a similar point about the concentration in his essay, The Paulson Plan Will Make Money for Taxpayers: “Eventually and stupidly, these institutions owned them for themselves – lots of them, often at 30-to-1 leverage.” That’s the problem with hubris. Sometimes you can’t help falling in love with yourself, eh, Narcissus. (Of course, we don’t care that on a time-value of money basis, the plan makes money for taxpayers. If that is true, it could make money for private investors, too, who are more willing than even the democrats to extract a proper pound of flesh, er, we mean a dilution in ownership (per Goldman and Warren Buffett.)
Craig Ferguson on the Proposed Bailout
He goes quite a bit farther than we have in our opposition to the bailout, but then we must admit that Craig Ferguson’s monologue last night (September 24) was much funnier than our posts on the topic. Here is a link to the entire monologue on YouTube. It’s about eight minutes long.
As we’ve briefly remarked before, Mr. Ferguson seems to be the only remaining comedian to host a late night show. (Even his version of the daily, requisite “McCain is old” joke was funny last night.) The others have either not been funny for decades (Leno and Letterman and Conan) or never were: like those other two clowns, whoever they are.
If your corporate censors don’t permit a visit to YouTube, you might be able to view it through this embedded object, but please don’t needlessly waste our precious bandwidth. We’re just a small firm on a medium-sized hosting platform (with the excellent, English-speaking and helpful folks at www.FusedNetwork.com).
