Spero Consulting

Archive for October, 2008

Dis­parate issues linked by their over­whelm­ing smallness.

It’s been a few of weeks since our last post, and such a long gap is highly unusual as we’re rarely at a short­age for words. We’ve been busy, but more impor­tantly, we didn’t feel com­pelled to write about our nor­mal top­ics of inter­est; despite the mar­ket volatil­ity, lit­tle has changed in the inter­ven­ing days.

In addi­tion, the accu­mu­lated effect of see­ing so many behave in such small ways over large mat­ters was and is rather sad and depress­ing. No, we’re not talk­ing about the elec­tion cam­paigns, which, by the grace of God do have a def­i­nite end­ings – if only for a year or so until the next ones begins.

The Small­ness of Our Lead­ers: in the finan­cial cri­sis, few indi­vid­u­als took right, rea­soned, and prin­ci­pled courses of action or both­ered to think before they spoke. While we expect such fallen behav­ior on a day-​to-​day basis, we do hope that our elected and appointed offi­cials are able to rise to the occa­sion. Their fail­ures to do so – their panic and expe­di­ency – remain sources of dis­ap­point­ment. Here is a very, very, very small exam­ple that has stuck with us for nearly a month and was likely unno­ticed by most.

In the days between the two Con­gres­sional votes on the bailout, we saw a Con­gress­man from Ten­nessee rant about mark-​to-​market account­ing. He knew no more about account­ing issue than he did about any­thing else, except talk­ing per­haps, but that didn’t stop him.

While we lis­tened to his dia­tribe against it, we thought, hmmm, not a sin­gle spe­cific ref­er­ence to the under­ly­ing issues of rel­e­vancy, reli­a­bil­ity, eco­nomic effi­ciency, etc. Replace “mark-​to-​market account­ing” in his oth­er­wise generic spiel, “we have to some­thing about mark-​to-​market account­ing before it…,” and he had a ready-​made speech for all that is evil du jour: AIDs in Africa, the lack of clean water in vil­lages, ille­gal drugs, legal drugs, drunk dri­ving, inter­na­tional piracy, child labor, greed, for­eign car man­u­fac­tur­ers, can­cer, dia­betes, Wall Street exec­u­tives, oil prices, etc., and no other words would have changed. He had a handy demo­niza­tion tem­plate, and that made actual con­tem­pla­tion super­flu­ous; so, he had changed his mind and would vote for the bailout.

A the time, we thought, unfor­tu­nately, there are no lit­er­acy or poll tests for vot­ing in Con­gress. Or was it another exam­ple of voter fraud.

As we men­tioned, it is a very small exam­ple, but it suf­fices for small men and their lack of depth, and it also relates to the main pur­pose of this post.

A Few Words on Finan­cial Mar­kets: By the way, on those mar­ket and incen­tive top­ics – our nor­mal blog fod­der – we stand by every­thing that we’ve writ­ten and con­tinue to believe the bailout was and is a mis­take. Even if it does mit­i­gate the liq­uid­ity cri­sis – and we’re not sure that it has – we ask, at what cost to our econ­omy and our freedom?

For exam­ple, we’ve been mus­ing that many gov­ern­ment offi­cials have been able to quite inad­ver­tently meet their elec­tion year promise of sub­stan­tially reduc­ing energy costs – even before the elec­tion. But at what cost? They can rightly argue that their actions – whether planned or not – have saved bil­lions for the Amer­i­can peo­ple as oil has moved from its peak of $147 dol­lars per bar­rel to its cur­rent range in the mid-​60s. Unfor­tu­nately, it has been at the cost of tril­lions of dol­lars of wealth.

On that topic, in April, we pre­dicted (wildly guessed) that oil could be at $40 per bar­rel by year end. We could actu­ally see it quite lower – even in the $25 per bar­rel range. Our ratio­nale: the cohe­sion of OPEC and its part­ners, par­tic­u­larly Rus­sia, will likely fail­ure, and we expect large invest­ment funds – like CALPERS – to con­tinue to liq­ui­date their com­mod­ity hold­ings since equity val­ues have plummeted.

We’ll have more to say about eco­nomic issues in the next few days, par­tic­u­larly with respect to the recent change in tax poli­cies that pro­vide a ben­e­fit – the absorp­tion and use of loss car­ry­for­wards – that the IRS is per­mit­ting acquir­ing banks to take in the recent mergers.

That pol­icy change, while far less grace­ful and effi­cient, is not much dif­fer­ent than our idea to solve the mort­gage cri­sis – but not the liq­uid­ity cri­sis; so, pro­vides a small bit of hope. (Search the archives or read just about any­thing we wrote in Sep­tem­ber and early Octo­ber. We’ll still not sure that offi­cials real­ize that these two crises are distinct._ It is not nearly as clean or as pre­cise as our approach, but that’s not why we are writing.

Sarah Palin: as we wrote almost two months ago, we con­tinue to be amazed at the sense­less vit­riol and sheer hatred spewed towards Mrs. Palin, par­tic­u­larly among Hol­ly­wood and New York celebri­ties, who put forth as much thought as the above-​referenced Con­gress­man from Ten­nessee. As we wrote in our ini­tial post, they hated her before they knew her, and they could hate her with such ease because of who she is – some­one very sim­i­lar to many peo­ple we know, like, and love: con­ser­v­a­tive, pro-​family, pro-​life, middle-​aged, reli­gious and gun-​totin’.

But, we must add, we’re not sur­prised that so many thought­less and dull folks dis­miss her small town may­oral expe­ri­ence and her small pop­u­la­tion guber­na­to­r­ial expe­ri­ence. It says more about them and their lack of expe­ri­ence and intel­lec­tual empa­thy than it does about her.

We spent ten years in acad­e­mia, but it didn’t take that nearly long to appre­ci­ate the valid­ity of Henry Kissinger’s quote that – and we para­phrase – the fight­ing in acad­e­mia is so vicious pre­cisely because the stakes are so small.

What’s true in uni­ver­si­ties it is also true in small towns and most other orga­ni­za­tions as well, includ­ing the staff depart­ments of large corporations.

Regard­less of all the many ways that one can describe func­tions of gov­ern­ments, at a min­i­mum it involves resource allo­ca­tion and gath­er­ing (fund­ing). In other words, who gets what the gov­ern­ment has and who has to give for the gov­ern­ment to have.

Does the reader think that resource allo­ca­tion deci­sions are eas­ier in a small town than in the naiton’s cap­i­tal? One’s pur­chase deci­sions in a small town may aid or bank­rupt a neigh­bor, an acquain­tance or a for­mer class­mate who walks or dri­ves by your home every­day or attends the same church or shops at the same stores or eats in the same restau­rants. Con­sider that as opposed to doing this or that to a neb­u­lous and abstract groups like “small busi­ness­men” or “big cor­po­ra­tions?” in a locale where almost every­one – mostly strangers – are rep­re­sent­ing some­thing or some­one else: rather than directly feel­ing the pain of actions and decisions.

Does the reader think that tax­ing deci­sions are eas­ier in small towns than within the fed­eral gov­ern­ment? Raise prop­erty assess­ments and earn the wrath of those same neigh­bors, acquain­tances, and for­mer friends.

[Where is one more likely to receive the imme­di­ate feed­back from uncom­fort­able con­ver­sa­tions and cold stares? In Wash­ing­ton or Wasilla? Where is one more likely to receive neg­a­tive feed­back fil­tered and diluted through a staff of gut­less, careerist syco­phants? Wash­ing­ton or Wasilla? Yeah, the ques­tions really do answer them­selves. (Our hypoth­e­sis: local politi­cians find more dog waste in their front yards than aver­age cit­i­zens do.)

In one of our own vol­un­teer activ­i­ties, we allo­cate a pre­cious, scarce, and first-​class resource among a group of indi­vid­u­als who do not pay for its use. Such a set­ting is, of course, a recipe for exces­sive demand. Based upon that expe­ri­ence we’d cer­tainly argue in Mrs. Palin’s favor over some­one whose main pri­vate sec­tor expe­ri­ence seemed to be orga­niz­ing beg­ging efforts directed towards the fed­eral gov­ern­ment. (In our case, we joke that the best evi­dence of fair treat­ment is when every user is annoyed with us so try to ensure it.)

Of course, the con­tentious reader might always argue that such small towns are so cor­rupt that there is no notion of tak­ing actions that annoy friends and acquain­tances, i.e., the whole objec­tive is to enrich them (and one­self) while in town hall. In that case we’d then argue that it, indeed, pro­vides excel­lent train­ing for work in the nation’s cap­i­tal. But, that’s not really why we’re writ­ing, either.

Our point is much smaller though it is related to Mrs. Palin.

Mr. Letterman’s Per­sis­tent Lack of Humor: we were too involved in our work to change the chan­nel when David Letterman’s show began last night. We don’t recall any of the mono­logue bits, but they were as lame as usual. (No one, in good con­science, could call his lines jokes.)

What we do recall was a skit where one of the child actors wore an over-​sized ver­sion of Sarah Palin’s pass­port as a Hal­loween cos­tume. It was stamped Mex­ico and Canada (and the USA) and nowhere else, and that was it. That was the whole “joke.”

The car­di­nal that flies into and bangs its head on the fam­ily room win­dows hun­dreds of times each morn­ing exhibits about the same level of wit.

I guess the point of the pass­port cos­tume was to show that Mrs. Palin hasn’t trav­eled much out­side of Alaska or the US. Pre­sum­ably, such travel is now a qual­i­fi­ca­tion for Vice Pres­i­dent because…well, who knows why. It must be some­thing that only some­one as sophis­ti­cated and learned and cul­tured as our Ball State grad, Mr. Let­ter­man, could appre­ci­ate. Per­son­ally, we’ll take some­one will­ing to kill a moose. It takes more skill and courage.

Now, maybe we’re slow or just don’t pay enough atten­tion, but that’s when it finally hit us.

Mr. Let­ter­man has been unfunny for years; that’s not news, we and many oth­ers have writ­ten about that, and it seems to be true since at least the Rea­gan administration.

No, what we’ve con­cluded is last night was not only is Mr. Let­ter­man inher­ently unfunny, but to do that night-​after-​night, year-​after-​year, requires a staff. He can’t be doing the very lit­tle that he does alone. It is very likely that he has a very large and equally untal­ented staff of writ­ers excret­ing such mate­r­ial like ele­phants with dysen­tery five nights a week.

As we see it, it would take a sub­stan­tial num­ber of inse­cure and untal­ented indi­vid­u­als to gen­er­ate the group think required to per­mit such crap to air. Why, at its essence, it almost seems like gov­ern­ment work.

If it were only a few writ­ers, it seems that they would be more likely that they would be able (1) to main­tain their self-​respect and dig­nity and judg­ment, which would then per­mit killing such lame ideas when they were ini­tially dis­cussed or (2) to have the dis­cre­tion not to men­tion them to oth­ers in the first place.

Of course, we must con­sider all pos­si­bil­i­ties, and it could be the case that Mr. Let­ter­man only hires degraded indi­vid­u­als will­ing to do any­thing for money or nox­ious house­hold chem­i­cals. (In that case, he might be a bit more effi­cient than we sus­pect and is able to gen­er­ate his (albeit low-​quality) out­put with only a few comrades.)

So, why does he get the big money? Well, this is one time when we must pro­pose a labor the­ory of value as the answer. Per­haps, the per­sonal effort and sac­ri­fice required to asso­ciate with Paul Shaf­fer for an hour a day jus­ti­fies the com­pen­sa­tion. Bet­ter he than we.

Happy Hal­loween, and don’t worry, it gets worse before it gets bet­ter. The elec­tion is next week.

We must admit, this is our first post that is truly in bad taste, but it seems so appro­pri­ate that we just could not help our­selves. TARP. TARP.

We’re try­ing to write seri­ously about the government’s – the Trea­sury Department’s – lat­est expe­di­en­cies and tac­tics to … well, we’re not sure of the objec­tive… pre­sum­ably, to make it all go away so that Mr. Bush and his appointees can enjoy their last Autumn and Christ­mas in D.C. (Why would any­one want to ruin Mr. Bush’s last Christ­mas in the White House by caus­ing the pos­si­ble finan­cial ruin of much of the world. Peo­ple can be so mean and self­ish some­times! Can’t we just use the tax­pay­ers’ money to pay them to go away!)

So here is our per­sonal prob­lem. Every time we think of TARP we are reminded of Garp as in John Irving’s The World Accord­ing to Garp. It has been a long time since we’ve read it; so, the details are slightly hazy, but we think we’ve remem­bered enough to draw the cor­rect analogy.

We’re not actu­ally reminded of Garp him­self, so much, but more of his father T.S. Garp, the critically-​wounded, WWII sol­dier, who spends his last days bedrid­den and sense­less in a state­side army hos­pi­tal. As we recall, he had been a ball-​turret gun­ner on per­haps the under­side of a B17 or B24, who took shrap­nel to the head dur­ing a bomb­ing raid over Germany.

“T.S.” were not his first two ini­tials, but rep­re­sented his rank, Tech­ni­cal Sergeant, which is about all of the back­ground his mother, an attend­ing hos­pi­tal nurse in the same ward, knew of his father.

As we recall, despite his dimin­ished state, T.S. Garp had one com­pul­sion, which he seemed to be able to do uncon­sciously and def­i­nitely not self-​consciously. Dur­ing these com­pul­sive episodes, he would repeat his name, “Garp, Garp.…” As his con­di­tion wors­ened, his mantra changed to “Arp, Arp…” and finally, just before his death to “Ar, Ar…”

In our mind, many of the Treasury’s recent tac­tics don’t seem that dif­fer­ent than T.S. Garp’s last efforts. How­ever, within a shorter period of time – less than two weeks – they seemed to have gone from “TARP, TARP…” to “RP, RP.…”

The injec­tion of cap­i­tal to “save the banks” seems to be noth­ing more than a Relief Pro­gram. Cor­po­rate wel­fare and crony­ism at its self-​indulgent best.

So did yesterday’s tough talk go like this? “We’re forc­ing you to take this money, which no one else will lend to you, and you won’t lend to each other. Fur­ther­more, to show you we mean busi­ness, we’re going to guar­an­tee your debt for a frac­tion of the true, underlying, insurance pre­mium, and finally, before you say any­thing, know that we’re going to insure your deposits, too. That should teach you to get into a mess like this, again.” Maybe Mr. Paul­son should read John Rose­mond, rather than con­tact­ing his for­mer employ­ees and his friends for advice on how to save themselves.

Once again, shame on them.

As they spend our money–all of our money–the cru­elty of those two near-​homonyms, sense and cents – all 70 tril­lion of the lat­ter – becomes bru­tally clear.

As the IMF, the G7 and the Pres­i­dent “endeavor to per­se­vere,” we have of own rec­om­men­da­tion to end the global finan­cial crisis.

We’re Not Social­ists or Statists:

We very much believe in free­dom and per­sonal responsibility; strongly pre­fer pri­vate enter­prise to gov­ern­ment ser­vices and bureau­cracy; pre­fer democ­racy – well, repub­li­can democ­racy, at least – to cen­tral­iza­tion and author­i­tar­i­an­ism (except in mat­ters of reli­gion); and pre­fer free mar­kets and cap­i­tal­ism to any of their failed alter­na­tives. We’re not lib­er­tar­ian, but on eco­nomic issues, we’re not that far away.

We’re cer­tainly not leftists.

We’ll hold our nose and vote for McCain despite his recent, wrong-​headed plan to buy bad mort­gages at face value; despite McCain-​Feingold, and despite his views on global-​warming. As we wrote in Well, This Is a Fine Mess You’ve Got­ten Us into…. if only Mr. McCain would retain a sem­blance of humil­ity that we have seen in the past. (It must be quite easy to rec­om­mend buy­ing over-​priced crap when it is not your own money, per Mr. McCain, Mr. Hub­bard, et. al.)

Morover, we don’t view the unprece­dented decreases in global equity mar­kets as a mar­ket fail­ure, nor – despite the lack of trad­ing – we do not view the near shut­down of intra-​bank credit mar­kets as a mar­ket fail­ure. We view both as evi­dence that mar­kets work and that in both cases they inform about the true under­ly­ing fail­ure: the weak­ness of our finan­cial intermediaries.

We Face Two Problems:

Nei­ther the cur­rent finan­cial cri­sis nor the mort­gage cri­sis that pre­ceded it was caused by exoge­nous vari­ables or fac­tors. The mort­gage cri­sis did not result from an earth­quake or vol­cano or tsunami or influenza or wild­fire or any other nat­ural cause. It did not result from the destruc­tion of war or any non-​financial, man-​made action. It resulted from the actions of finance indus­try employ­ees, elected rep­re­sen­ta­tives, and gov­ern­ment bureau­crats. In Saturday’s The Wall Street Jour­nal, on page A13, imme­di­ately below Peggy Noonan’s excel­lent scolding, there is a good sum­mary: The Gov­ern­ment is Con­tribut­ing to the Panic.

Before con­tin­u­ing, please notice that we sep­a­rate the mort­gage cri­sis from the cur­rent, global crisis. 

Despite our government’s obtuse­ness, these crises are indeed sep­a­rate issues. By that we mean that if the mort­gage cri­sis were solved, the banks would still face deep, deep sus­pi­cions and face fund­ing prob­lems. We think that lack of con­fi­dence would be suf­fi­cient to sus­tain the global cri­sis, which at its root is a deep dis­trust of major finan­cial inter­me­di­aries. (See Even A Per­fect Bailout Will Fail for exam­ple.) Conversely, if that sus­pi­cion were elim­i­nated, there would still be a need to deal with the epi­demic of bad loans, par­tic­u­larly in the Sun­belt. (See our pro­posal: A Bet­ter Solu­tion (than a gov­ern­ment takeover).)

The Global Prob­lem: The mort­gage cri­sis has informed investors, the pop­u­lace, and bank­ing indus­try cohorts – every­one pre­sum­ably except Messrs. Paul­son and Bernanke – that the global cri­sis stems from a lack of con­fi­dence in many of the nation’s largest, most prestigious banks.

It seems that no one has con­fi­dence in the banks’ business judg­ment, finan­cial acumen, viability, or cred­it­wor­thi­ness, includ­ing their abil­ity to repay an overnight loan, espe­cially other banks. (See Finan­cial Pro­jec­tion in a Cri­sis or most of what we’ve writ­ten recently.)

The Mort­gage Prob­lem: We’ve writ­ten exten­sively about the mort­gage cri­sis and pro­duced a sim­ple, imple­mentable, tax-​based, private-​enterprise solu­tion to THAT prob­lem: A Bet­ter Solu­tion (than a gov­ern­ment takeover). That cri­sis was not inevitable, but it was the result of bad luck com­bined with ridicu­lously flawed gov­ern­ment poli­cies and very poor cor­po­rate over­sight that turned bad luck into hor­ri­bly bad luck via incred­i­bly fast feed­back loops – among both bor­row­ers and lenders – in the hous­ing and mort­gage mar­kets. That’s as close as we’ve come to a wild­fire or any other con­ta­gious cat­a­stro­phe. (We wrote about that, too.)

As we have men­tioned fre­quently, the mortgage-​related losses were indeed con­cen­trated in the finan­cial indus­try because of its lax man­age­ment, poorly-​structured incen­tives and the resul­tant exces­sive and con­cen­trated risk-​taking. In our opin­ion, any­one who states oth­er­wise is either a liar or a fool. One can­not see the egre­giously bad mort­gages made to the undoc­u­mented and the uncred­it­wor­thy and based on the hopes of extrap­o­lated past price increases onto future house val­ues and view it as any­thing except wild bets gone bad – bets per­mit­ted by lax man­age­ment and poorly-​designed incen­tives result­ing in exces­sive and con­cen­trated risk-​taking.

So where does that leave us?

The ini­tial gov­ern­ment bailout was never designed to deal with this larger prob­lem of lost con­fi­dence. If it was, then it is a fur­ther indict­ment of the Trea­sury Sec­re­tary and the Fed Chair­man. In fact, per many of our crit­i­cisms and yesterday’s WSJ edi­to­r­ial, Gov­ern­ment Fear Itself, it doesn’t seem to have been designed for any pur­pose at all, which of course should make every­one sus­pi­cious of Mr. Paulson’s abil­i­ties. (We obvi­ously don’t agree with the Journal’s view against nation­al­iza­tion, but we think they’re miss­ing the big­ger point of not decou­pling the problems.)

Guar­an­tee­ing all deposits? How does that help pro­vide overnight fund­ing or mit­i­gate moral haz­ard or instill con­fi­dence in the decision-​making abil­ity of these (not all) bankers? We’d argue that at least a few depos­i­tors would remove their money just for the prin­ci­ple of it. (Yeah, some peo­ple still have those things.) More impor­tantly, it does not seem to solve any of the intra-​bank lend­ing problems.

Guar­an­tee all bank bor­row­ing? How does that per­mit effi­cient asset allo­ca­tion in the economy? Moreover, it also leaves the per­sons who made the prob­lem still in charge and sub­si­dizes those actors and firms at the expense of every­one else. So, it seems nei­ther effi­cient nor just. (It is expe­di­ent, which was prob­a­bly why it was rec­om­mended.) In our view the guar­an­tee would need to be inter­mi­nate, or the prob­lem would reap­pear when the guar­an­tee expired.

We’d imag­ine that based upon the mag­ni­tude of gains on many deriv­a­tive trades, espe­cially for buy­ers of credit deriv­a­tives and other spread and­ba­sis prod­ucts, the gov­ern­ment would face sub­stan­tial calls for cash as those guar­an­tees would likely quickly turn into such calls – not quite the same, but not that dif­fer­ent than AI. – especially as those instru­ments matured and settled.

No, if the gov­ern­ment is respon­si­ble for all claims on those banks, then it (we tax­pay­ers)) should directly con­trol (own) the assets. So, we say:

Fire, Close, Nation­al­ize, Fire, Reor­ga­nize, Sell

It’s not a 12-​step pro­gram, only six, but it does require the Pres­i­dent to accept the nature of the cri­sis like most 12-​step programs: “God grant us the seren­ity to accept the things we can­not change, courage to change the things we can, and wis­dom to know the difference.”

Fire: Mr. Paul­son and Mr. Bernanke were out-​of-​their-​element in the mort­gage cri­sis, let alone in this larger, more seri­ous prob­lem. The Wall Street Jour­nal edi­to­r­ial staff, pro­po­nents of the $700 bil­lion bailout, admit that Mr. Paul­son had no plan once that money was his to control. On Sat­ur­day morn­ing we lamented Where Have All the Grownups Gone? But we’ve com­plained fre­quently about the lack of thought and analy­sis regard­ing the cur­rent prob­lems and pro­posed solu­tions. (See: Prin­ci­ples Lost and More or Friday’s The Unex­am­ined Cri­sis.)

So, Mr. Bush, please stop clue­lessly talk­ing about endeav­or­ing to per­se­vere and please fire Mr. Paul­son and force Mr. Bernanke to resign.* (We don’t recall every­thing from our Money & Bank­ing class, but we believe that you do not have the author­ity to directly fire him.)

Close: Next, shut the equity mar­kets for one week. After 9/​11, the equity mar­kets were closed that Tues­day and the rest of the week, and this cur­rent cri­sis is at least as seri­ous to the nation’s eco­nomic health as ⁹⁄₁₁. (We know there were facil­ity issues, too.) While this may seem extreme, it is nec­es­sary to give investors, cred­i­tors, and bank cus­tomers the time needed under­stand the nature of true prob­lem and to inter­nal­ize our next rec­om­men­da­tion and what it means to them, i.e., renewed sta­bil­ity and restored faith in finan­cial intermediaries.

Nation­al­ize: Mr. Bush and the United States should nation­al­ize the worst banks. By “worst” we mean ones that have, say, the low­est com­bi­na­tion of (1) equity mar­ket value to total assets, (2) esti­mated unre­al­ized losses to reg­u­la­tory cap­i­tal, and (3) the com­ple­ment of Fed bor­row­ing to total assets, but we’re will­ing to take sug­ges­tions from oth­ers on the exact nature of this metric.

As we have men­tioned, we do not view the cur­rent cri­sis as a fail­ure of the mar­kets. We view it as a fail­ure of gov­ern­ment poli­cies and government-​regulated insti­tu­tions, includ­ing the gov­ern­ment spon­sored enti­ties, and heavily-​regulated banks. So our gov­ern­ment solu­tion is not designed to mit­i­gate a mar­ket prob­lem but instead to reverse prob­lems cre­ated by other gov­ern­ment errors or government-​induced errors.

In that regard, we rec­om­mend that the gov­ern­ment take 100% own­er­ship sub­ject to one caveat. Per­mit non-​executive, employee-​owners who pos­sess restricted shares to main­tain their a stake in the entity. (Over­all, it seems unlikely that other small share­hold­ers would suf­fer as much, par­tic­u­larly if the when the equity mar­kets rebound as they regain con­fi­dence in finan­cial intermediaries.)

Also note, we are not rec­om­mend­ing the nation­al­iza­tion of the entire indus­try – only the weak­est, least trusted banks. For exam­ple, at this point, we see no rea­son for the gov­ern­ment to con­sider nation­al­iz­ing firms like Wells Fargo, PNC, or USB among others.

Fire: Dis­man­tle the boards of direc­tors and fire senior man­age­ments. We rec­om­mend this for two reasons. First, it is the just thing to do. We base that state­ment on our inter­pre­ta­tion of the Para­ble of the Faith­ful and Unfaith­ful Ser­vant, which describes moral haz­ard issues. Sec­ond, it pro­vides a severe warn­ing to sur­viv­ing insti­tu­tions to get their firms’ affairs in order and instill more rig­or­ous over­sight of poten­tially risky activ­i­ties. So, we view it as effi­cient, too. One of the best ways to solve moral haz­ard prob­lems is through the imple­men­ta­tion of severe penal­ties for unde­sir­able out­comes. (We know it is an infor­ma­tion argu­ment based upon likelihoods, but we’re being infor­mal here.)

Reor­ga­nize: Imple­ment our market-​based solu­tion to the mort­gage cri­sis. We’ve linked to it twice already in this post; so, won’t do so again, but it is based upon per­mit­ting either invest­ment tax cred­its or cash-​basis account­ing (extreme accel­er­ated depre­ci­a­tion) for prospec­tive pur­chasers of trou­bled mort­gages, MBS, and mortgage-​related CDOs. That reduces the ini­tial cost and pro­vides a cush­ion for mis­pric­ing. We’d also rec­om­mend low tax rates on sub­se­quent resales or cash flow realizations.

It would also seem that a gov­ern­ment takeover of sev­eral of the weak­est banks would make it much eas­ier to sort and can­cel out mar­gin calls and overnight loans, etc., and to offer promis­sory notes rather than asset pledges or cash for deep-​out-​of-​money trades (in-​the-​money for the other party).

Sell: Offer the refor­mu­lated banks as IPOs as soon as pos­si­ble – hope­fully by next sum­mer. We greatly pre­fer IPOs to forc­ing merg­ers and cre­at­ing ever larger banks. We believe that such merg­ers cre­ate over-​concentration of oth­er­wise idio­syn­cratic risk; they made the idio­syn­cratic sys­tem­atic so-​to-​speak. We wrote about that on sev­eral occa­sions, too. (See, for exam­ple, Forced Merg­ers? Big­ger Is Not Nec­es­sar­ily Bet­ter!, Big­ger Is Not Nec­es­sar­ily Bet­ter or Idio­syn­cratic and Con­cen­tra­tion Risk, Again.)

We real­ize that we could offer more details, but we’re a small orga­ni­za­tion with lim­ited time. More­over, there are far more specifics here than in the Treasury’s ini­tial bailout plan, and we’re not ask­ing for $700 billion.

We’d be happy to receive your com­ments and feed­back on our pro­posal. Are we miss­ing some­thing? Have we ignored cru­cial weak­nesses? If so, let us know. If not, we say, “it’s time.”

As always, we’ll update and revise this in the com­ing days as we clar­ify our thoughts and rework our sen­tence struc­tures and elim­i­nate typos.

Copy­right © 2008 Spero Consulting.

*Yeah, that’s our allu­sion to Chief Dan George’s char­ac­ter, Lone Watie, in The Out­law Josey Wales. Get dressed up in civ­i­lized clothes, go to Wash­ing­ton to meet the Pres­i­dent, and pledge to be united. How exactly does that help?

Today, Octo­ber 11, we’ve been orga­niz­ing our thoughts about the ongo­ing finan­cial cri­sis. We’ll have more to say about ways to rem­edy the imme­di­ate cri­sis, but this post con­tains a spe­cific rec­om­men­da­tion for when the cri­sis ends, which today may seem to be far, far off. We’re sure that – whether jus­ti­fied or not – many laws and reg­u­la­tions will be revised and tough­ened, and this should be one of them.

We make this rec­om­men­da­tion because from our expe­ri­ence and from the infer­ences that we’ve made about firms through­out this cri­sis, it seems that nei­ther many senior man­agers nor reg­u­la­tors fully under­stand many prop trad­ing activ­i­ties although, of course, neither set of indi­vid­u­als would ever admit as much. 

With gov­ern­ment sup­port comes oblig­a­tions, includ­ing the com­mit­ment not to take out­sized risks or ones that are par­tic­u­larly dif­fi­cult to mea­sure or approx­i­mate, and that seems rea­son­able to us.

In that regard, it seems very likely that the fed­eral gov­ern­ment will con­tinue to pro­vide higher lev­els of deposit insur­ance above the past limit of $100,000. Already that limit has been increased to $250,000, and there is talk of, at least tem­porar­ily, guar­an­tee­ing all deposits. (The guar­an­tee of all deposits is stu­pid and coun­ter­pro­duc­tive, and if it goes into effect, it will elim­i­nate a use­ful dis­ci­plin­ing and warn­ing mechanism. Having large, unin­sured depos­i­tors flee risky finan­cial insti­tu­tions warns man­age­ments to change and informs reg­u­la­tors of impend­ing prob­lems. We plan a sep­a­rate post on that topic in the near future.)

Now, how­ever, along with the indem­nity that insur­ance pro­vides should come the oblig­a­tions of the insured – a quid pro quo if you will. It seems that the gov­ern­ment has done a very poor job of set­ting risk-​sharing mech­a­nisms, i.e., the equiv­a­lent of deductibles, i.e., inflicting finan­cial pain on the senior man­age­ment when a bank fails – beyond the loss of share value.

We won’t com­ment on that aspect today; instead, we pro­pose a lim­i­ta­tion on insured-​institution trad­ing activ­i­ties. Insured banks should not be per­mit­ted to have pro­pri­etary trad­ing desks in their cap­i­tal mar­kets departments.

Note that this will not stop banks from harm­ing them­selves by (1) lend­ing or (2) mak­ing bad invest­ments or trades in their trea­sury depart­ments or (3) mis­man­ag­ing cus­tomer trad­ing desks. 

It will how­ever, allow reg­u­la­tors to focus their atten­tion on where the major risks are taken within the firms. With­out going into details, we real­ize that their is a cer­tain fun­gi­bil­ity between trea­sury trades and prop trades in cap­i­tal mar­kets depart­ments and to a cer­tain degree between prop desks and cus­tomer desks in said depart­ments, but it would seem to be more dif­fi­cult to jus­tify cer­tain trades and strate­gies if the desks were within typ­i­cal, bank-​related busi­ness activ­i­ties. (When could write much about this but it likely wouldn’t change minds; so, we defer.)

We’re com­pletely for the free-​market–more so than most bank man­agers – but until such insti­tu­tions for­sake their gov­ern­ment insur­ance, we’ll insist that they have an oblig­a­tion to the cit­i­zenry – through the gov­ern­ment – to behave in a respon­si­ble, low risk man­ner. If that gen­er­ates lower returns for them on aver­age, then so be it. That’s the nature of the risk-​return spec­trum and their legal and fidu­ciary responsibilities.

By the way, if an all-​in, full-​accounting were ever per­formed, we’d be doubt­ful that such prop trad­ing oper­a­tions were prof­itable or value-​creating, espe­cially at the com­mer­cial banks. From what we’ve observed, trading PnL (profit and loss) is con­sid­ered and some­times trading-​related PnL is con­sid­ered for per­for­mance eval­u­a­tion, but rarely an all-​in account­ing is per­formed. The mar­ginal over­head costs risk-​management, back-​office oper­a­tions, audit­ing, account­ing, etc., asso­ci­ated with such activ­i­ties are often ignored. Moreover, on a risk-​adjusted basis, it is sub­stan­tially less likely that over­all, net returns are positive.

Finally, we actu­ally think that many senior man­agers of com­mer­cial banks would wel­come the ban. We sus­pect that many of them are sus­pi­cious of such activ­i­ties but don’t feel qual­i­fied to eval­u­ate and elim­i­nate them. We think it is true of most reg­u­la­tors, too. They don’t object because they don’t want to seem unso­phis­ti­cated; pride goeth before the fall.

When will they ever learn?

Peggy Noo­nan has another excel­lent opin­ion col­umn in today’s The Wall Street Jour­nal. It is enti­tled, Play­ing Fris­bee on a Precipice. The title and the column’s blurb say it all: “Our polit­i­cal class lacks the seri­ous­ness this moment demands.” Clearly, her essay is about the small­ness of our present day politi­cians and their advisers.

She has per­fected the abil­ity to lament, yet simul­ta­ne­ously expect, the fallen nature of man.

We’ve writ­ten about our admi­ra­tion for Ms. Noo­nan on a num­ber of occa­sions, and once again she strikes the metaphor­i­cal nail directly on the head. There is an over­whelm­ing small­ness of the cur­rent polit­i­cal class where every­thing, regard­less of the cri­sis, is attempted to be used for short-​term polit­i­cal gain. What small, small peo­ple in both parties.

It’s obvi­ous from her title that she uses the metaphor of play­ing Fris­bee on a cliff to show their utter lack of seri­ous­ness, pri­mar­ily within the two Pres­i­den­tial cam­paigns and with can­di­dates. Per­haps deep down inside, our polit­i­cal actors real­ize that they are not up to the task and there­fore con­tinue to play games as the fel­low cit­i­zens lose tril­lions of dollars. 

In that sense our politi­cians are like young sib­lings or friends mak­ing out­ra­geous claims against each other know­ing full well that their par­ents would step-​in and never per­mit such events to tran­spire. Unfor­tu­nately, the grownups are gone, and the noise down­stairs isn’t an older sib­ling try­ing to scare via a the equiv­a­lent of a Hal­loween prank.

It’s worth men­tion­ing that a month ago we used some­what sim­i­lar imagery to Ms. Noonan’s about the mort­gage cri­sis in Our Poster Boy for the Credit Cri­sis.

In that post we com­pared many Wall Street firms to our hun­gri­est Basenji, Boots. As the photo shows, Bootsy had his head buried so far in the food bag that he had no idea where he was. To his good for­tune he was in the kitchen, and not near the base­ment steps as he pushed on. 

Due to lax man­age­ment, poorly designed incen­tives, and the result­ing exces­sive risk-​taking, Wall Street’s metaphoric head was buried just as far in the food bag seek­ing ever smaller and smaller morsels as it pushed closer and closer to the precipice of the Grand Canyon – located in to hous­ing bust of the South­west, no less.

We still pre­fer our graphic to the one in her column:

By the way, Ms. Noo­nan and Sarah Palin share that trait that seems to be fem­i­nine but which Ronald Rea­gan also pos­sessed. It per­mits a severe scold­ing but in a gen­tle, humor­ous way. 

We don’t know of Mrs. Palin well enough to include her, but we’d argue that it worked for Mr. Rea­gan and works for Ms. Noo­nan because their cen­tral core was/​is so per­ma­nent, solid, and robust that one knows exactly their posi­tion before they speak. That inner sense of com­plete­ness, com­bined with the con­fi­dence that nat­u­rally fol­lows from such maturity, means that lis­tener or the reader knows the words are from the heart, the essence, the core and not just cheap rhetoric. That depth of con­vic­tion per­mits the humor and irony to be appre­ci­ated for what it is, and also what it is not: it is not mean­ness or cheap tactic.

Enough about peo­ple big­ger than us. Out of our own small­ness, we couldn’t help link­ing the failed lead­er­ship of the nation’s old­est baby­boomers, who are now in charge of many gov­ern­ment func­tions and large cor­po­ra­tions, to one of their favorite, Pete Seeger protest songs from the six­ties. It was about gov­ern­ment mis­steps, too. “When will they ever learn? When will they ever learn?”

Update (Octo­ber 14): Den­nis Berman has a nice arti­cle about last week’s panel dis­cus­sion, Street’s Demands May Stir Pub­lic Wrath, in The Wall Street Jour­nal. It is very sim­i­lar to this post from Fri­day. While we lament the lack of intel­lec­tual curios­ity – or any type of curi­ousity or self-​examination or self-​criticism – in our entry, Mr. Berman men­tions the pos­si­ble impli­ca­tions of such obtuse­ness. Being self-​absorbed and self-​involved makes it dif­fi­cult to know when the hoi pol­loi and politi­cians have turned against one­self. We like Mr. Berman’s seem­ingly non­plussed res­ig­na­tion and matter-​of-​fact state­ments to that effect.

“The unex­am­ined life is not worth living.”

–Socrates (via Plato in The Apol­ogy)

Please read: Stew­ards of Cap­i­tal Gather at NYSE. What Hap­pens Next? Who Knows? at The Wall Street Jour­nal’s blog, Deal Jour­nal, which reports on a panel dis­cus­sion involv­ing sev­eral finance indus­try executives.

Then, con­sider the above Socrates quote as it per­tains – or more pre­cisely does not per­tain – to our lead­ing finan­cial exec­u­tives. Is there an iota of mar­ginal, new insight in any­thing that they said dur­ing the session? 

Per­haps they have deep insights, but they are unwill­ing to share them with the com­pe­ti­tion. Or per­haps their insights would induce fur­ther panic in the mar­kets, and so they keep them them deeply hid­den? Perhaps.

We ask: was there any­thing said beyond mere plat­i­tude or per­son­al­ity, e.g., “they did it right” (at the Trea­sury), or more than a mere ad hoc statement?

No, we’re not that naïve. We have no such expec­ta­tions, but such reports are dis­ap­point­ing nonetheless.

We’re always search­ing for that one, rare indi­vid­ual who will stop and think dur­ing such a cri­sis. Unfortunately, this time around cor­po­rate and gov­ern­ment lead­ers remind us of a middle-​school, girls bas­ket­ball team in full, “hot pota­toes” panic. The biggest dif­fer­ence is the girls do under­stand their short­com­ings and lim­i­ta­tions. At what point after high school does that leave us?

Messrs Paul­son, Bernanke, Bush, Reid, and Mrs. Pelosi.

(Edited and slightly revised on 10−11−08)

We’re always deeply sus­pi­cious when a politi­cian tells us how he or she is going to “fix the econ­omy.” The best they can do is get out of the way, but unfor­tu­nately they rarely do. That’s the sin­ful, human prob­lem cre­ated by that all-​too-​common com­bi­na­tion of hubris and ignorance.

As we men­tioned in a pre­vi­ous post, the most hon­est moment of the cur­rent Pres­i­den­tial cam­paign was an ad in which McCain admits that he doesn’t know much about eco­nom­ics, and it was an Obama, Anti–McCain ad.

If only, if only, McCain would act in the hum­ble spirit of that ad. Instead he announces a new bailout plan for those who can’t pay their mort­gages. It is an admirable sentiment. Unfortunately, it is likely to be very unwise (given the way such pro­grams are implemented).

We ask: if you’re close to default­ing on your mort­gage, why strug­gle? Why liq­ui­date retire­ment accounts, why take a sec­ond job, cut enter­tain­ment costs or pare down vaca­tion bud­gets? Why not default dear reader and let the gov­ern­ment pickup the dif­fer­ence? We haven’t looked at the specifics of his plan, but we would be very, very sur­prised if it didn’t intro­duce such dys­func­tional incen­tives for those strug­gling to make their monthly payments.

But Mr. McCain’s lat­est mis­step isn’t why we’re writing.

This evening, (Thurs­day, Octo­ber 9) we saw this head­line on The Wall Street Jour­nal’s web site: Trea­sury Weighs Next Step to Stem Cri­sis. 

Isn’t it obvi­ous? Isn’t it time for Mr. Paul­son to go? And Mr. Bernanke, too, over at the Fed? (Except for next three plus months with Mr. Bush, we seem to be stuck with oth­ers – kind of like our shoul­der bur­si­tis or chronic disc problems.)

Do you think the mar­kets would react neg­a­tively to those res­ig­na­tions? We doubt it. Would you? Would they?

They’ve made any num­ber of mis­takes since 2007, and below we try to cat­e­go­rize the col­lec­tive errors into as few groups as pos­si­ble. In our opinion:

1. The gang mis­spec­i­fied the ini­tial prob­lem. This might have been due to the fact that Paul­son and Bernanke may have been too close to the sit­u­a­tion and much of it involved their friends, for­mer col­leagues, acquain­tances, and prob­a­bly their neihbors. The rest the gang missed it because they seem inher­ently clueless.
2. They had/​have no viable solu­tion to the mis­spec­i­fied prob­lem, let alone the real prob­lem. We’ve writ­ten exten­sively about why the bailout would fail and, in fact, how it would lengthen and deepen the cri­sis. Try this link or just go to the blog; many of our recent posts have talked about these issues. The real prob­lem is no one trusts the banks.
3. They over­stated and (gen­er­ally) over­re­acted to the ini­tial prob­lems. It was like scream­ing that a flam­ing wolf was falling with the sky in a crowded the­ater of sheep and chick­ens. Well, we’re seri­ously mix­ing our metaphors but their cries of “wolf” and “the sky is falling” were like shout­ing fire in a the­ater, whether or not it is true. They were wrong, yet cre­ated fear nonethe­less. Quite a feat to be sure.
4. They had no under­stand­ing of the impli­ca­tions of their over­state­ments. It seems that their ini­tial over­state­ments were mere rhetoric designed to get their mis­guided bailout bill passed into law, but words have impli­ca­tions, too. Those words weren’t very confidence-​inspiring. In fact, at the time and in ret­ro­spect, those words seem(ed) to be panic-​inducing because the solu­tion seemed (seems) very hokey to many but investors remem­bered the words of fear, espe­cially in the con­text of a doubt­ful plan. In other words, investors seemed to believe that there was a prob­lem but didn’t seem to believe the exist­ing bailout or its fed­eral over­seers could solve the real one. Ergo, the unprece­dented equity losses.

We believe the group’s col­lec­tive actions and state­ments showed that our gov­ern­ment offi­cials were and are fear­ful, scared, and espe­cially clue­less about true under­ly­ing prob­lem. In fact, they seem to have made the sit­u­a­tion worse by offer­ing a solu­tion that didn’t fit the prob­lem and by forc­ing large banks to merge and. (See Big­ger Is Not Nec­es­sar­ily Bet­ter for a dis­cus­sion of the forced mega-​mergers and the future prob­lems that might cause.)

As we wrote Tues­day in Even A Per­fect Bailout Will Fail, the prob­lem isn’t the bad mort­gages or tech­ni­cal defaults or mark-​to-​market account­ing. The mas­sive mort­gages losses were the vehi­cle that con­veyed neg­a­tive infor­ma­tion about the banks. The prob­lem is that many banks bought the bad mort­gages at very high prices (and rather recently, too) and those mort­gages aren’t worth much today. The market’s judg­ment is that the banks should have known better. 

Those mortgage-​related pur­chases show the banks to be far less com­pe­tent and far less trust­wor­thy and far less cred­it­wor­thy than almost any­one imag­ined just a short time ago.

It wasn’t just bad luck. It was incom­pe­tence on a grand scale. That’s what turned bad luck with pos­si­bly a small num­ber of mort­gages into a global cri­sis. We don’t believe that either the mort­gage cri­sis or the larger finan­cial cri­sis were inevitable, but we do believe that it is quite pos­si­ble for a lit­tle bad luck, so-to-speak, to turn very ugly, very fast. (Good for­tune would have pre­vented the prob­lem and few would have real­ized the poten­tial for it existed. That makes us won­dered: how many times in the past have we been lucky, i.e., “there but by the grace of God go I?”

Given the lax (yet very com­mon) lend­ing stan­dards used more many mortgages, it was easy to gen­er­ate a domino-​effect where a con­cen­trated but small num­ber of defaults (and result­ing house deval­u­a­tions) could have gen­er­ate unbelievably-fast, feedback loops that quickly (and neg­a­tively) affect local and regional hous­ing val­ues, and the national (and global) economies. It appears that these feed­back loops could jump across regions, say, from Cal­i­for­nia to Char­lotte, as we men­tioned in Wachovia, the Hold-​up Prob­lem, and Feed­back Loops.

It seems that no firm’s ana­lyt­i­cal mod­els included this con­ta­gion phe­nom­ena and none of their analy­ses cap­tured these neigh­bor­hood, town, and regional depen­den­cies and inter­pde­pen­den­cies. (See our Trad­ing, Incen­tives and Orga­ni­za­tional Struc­ture and Risk Man­age­ment from the Spring.)

Only a very small num­ber of geo­graph­i­cally close (neigh­bor­hood) defaults, can be treated as inde­pen­dent tri­als, like sep­a­rate, unre­lated coin flips. 

Once a (low) thresh­old is met, however, it seems that every­one in the neigh­bor­hood is (neg­a­tively) affected. Such a phe­nom­e­non is often called as a tipping-​point. 

A few fore­clo­sures on a street can be attrib­uted to idio­syn­cratic fac­tors, e.g., divorce, relo­ca­tion, gam­bling, etc. However, after a crit­i­cal, but still small, num­ber is of defaults is reached, the value of many or all of the homes on the street or in neigh­bor­hood is dimin­ished and pos­si­bly destroyed. Depend­ing upon the fragility of bor­row­ers’ cred­it­wor­thi­ness, includ­ing the per­cent­age of the value financed, these losses on a street can roll up and induce losses within sub­di­vi­sions, then towns, and then regions, and then even across regions.

We’ve men­tioned repeat­edly that these mortgage-​related losses seem to be espe­cially con­cen­trated among banks this time, and despite the recent mas­sive losses in the equity mar­kets, that still seems true. We believe this was due to lax man­age­ment, includ­ing poorly-​structured incen­tives, which led to exces­sive–risk tak­ing of both well-​understood prod­ucts (mortgages) and poorly under­stood ones (MBS and CDOs). See this post, for exam­ple: Idio­syn­cratic and Con­cen­tra­tion Risk, Again.

At present, it seems that few out­siders trust the banks. Worse yet, it seems that no insid­ers – other banks – trust each other. A few days ago, we attrib­uted that sus­pi­cion to the equiv­a­lent of psy­cho­log­i­cal pro­jec­tion in Finan­cial Pro­jec­tion in a Cri­sis. Each bank projects its own dimin­ished via­bil­ity onto the oth­ers. Unfor­tu­nately, it seems many of them are mak­ing the cor­rect infer­ence and draw­ing the right con­clu­sion. (Note: we don’t mean all banks as many, par­tic­u­larly the smaller ones, seem to be avoid­ing the cur­rent mort­gage mess.)

This lack of trust among banks has led to many col­lat­eral calls, and it is why AIG, the writer (insurer) of many credit default swaps (CDS) has eaten through over $120 bil­lion in a few weeks. (That’s seems to have been another mis­judg­ment by the Fed.)

Cer­tain com­men­ta­tors have called for estab­lish­ing clear­ing­houses for other-​the-​counter (OTC) deriv­a­tives like CDS. We doubt that it could be done quickly enough to instill con­fi­dence. More­over, that doesn’t solve the exist­ing prob­lem of not being able to meet mar­gin calls today.

We’re begin­ning to believe that the gov­ern­ment must act imme­di­ately to nation­al­ize cer­tain large banks. At a min­i­mum, it would solve issues related to mar­gin calls and col­lat­eral prob­lems and elim­i­nate the need to take other silly actions.

We’re almost an eco­nomic Lib­er­tar­ian, so it gives us pause to con­tem­plate nation­al­iz­ing cer­tain insti­tu­tions, but we con­sider such a plan to be a rem­edy to past gov­ern­ment mis­takes, includ­ing almost every­thing our gov­ern­ment offi­cials have done in the last month or so, and includ­ing the mis­guided “bailout.” (By the way, we know that gov­ern­ment helped cre­ate the mess, and we don’t trust them to do a great job, but by def­i­n­i­tion, no one can nationalize.)

We write it par­tially to con­vince our­self, but there seems to be lit­tle left to do but nation­al­ize those banks with the biggest rep­u­ta­tion prob­lems and the low­est per­cent­age of cap­i­tal to assets. 

If that hap­pens, the gov­ern­ment needs to do it swiftly and by sur­prise. It needs to take 100% of their equity thereby wip­ing out exist­ing share­hold­ers. All boards and senior man­agers must go, too. Cer­tain trad­ing desks with cap­i­tal mar­kets’ depart­ments and – where nec­es­sary – trea­sury depart­ments would need to be quickly split (to the extent pos­si­ble) from gen­eral bank oper­a­tions. Once sta­bi­lized, the new enti­ties would need to be sold as soon as possible.

Sep­a­rately, we believe that our pro­posed, pri­vate solu­tion to the mort­gage cri­sis, i.e., A Bet­ter Solu­tion (than a gov­ern­ment takeover), would solve that prob­lem, which is now a minor aspect of the big­ger prob­lem. A mere symp­tom of the finan­cial industry’s big­ger prob­lem, and nei­ther our very clever plan nor the gov­ern­ment silly bailout will solve that big­ger prob­lem: a com­plete lack of con­fi­dence in many of our largest finan­cial institutions.

The econ­omy requires finan­cial inter­me­di­aries that can be trusted, and the rep­u­ta­tions of many of the cur­rent ones have been shat­tered; so, it seems that some­thing big has to change: pos­si­bly they need to be taken over and then resold them. We’re not sure that we com­pletely believe it, yet, but it is some­thing to contemplate.

We don’t see the cur­rent cri­sis as a fail­ure of mar­kets. It was a fail­ure of gov­ern­ment inter­ven­tion and poli­cies at many dif­fer­ent times and stages, with the lat­est ones being the most visible. 

So, ossi­bly, a gov­ern­ment solu­tion is required to reverse the dam­age it caused?

Mr. Paul­son and Mr. Bernanke must leave before that can occur, regard­less of the pro­posed mech­a­nism to fix the prob­lem. They are doing noth­ing to mit­i­gate the prob­lem, and in fact seem to unin­ten­tion­ally exac­er­bate it.

We need to think more about it, but as scary as it is to write, the quick nation­al­iza­tion of the worst banks MAY be the cheap­est and best solution.

We’ll likely con­tinue to revise this post as we clar­ify our thoughts.

We’re not sure whether to start this post on a sar­cas­tic tone or not. The sar­cas­tic start is “it’s too bad the short-​selling ban expired, could the dear reader imag­ine how far stocks would have fallen with­out it?” But, the mar­ket did tank again today.

Instead, we’ll note that when such a ban is arbi­trar­ily imposed dur­ing a seem­ingly neg­a­tive event, most par­tic­i­pants infer/​conclude that the event is worse or much worse than they would have oth­er­wise thought or were led to believe – pos­si­bly worse than any­one ever imagined. (By arbi­trar­ily, we mean spur-​of-​the-​moment and not due to a mechan­i­cal, pre­com­mit­ment to impose such a ban when, say, a mar­ket vari­able hits a pre-​established barrier.)

Such infer­ences tend to make investors and other indi­vid­u­als ner­vous, pos­si­bly pan­icky, and much more likely to sell their hold­ings thereby neg­a­tively affect­ing prices and bring­ing about a result oppo­site of the ini­tial desire affect.

Now, such a con­clu­sion seems obvi­ous even to some­one as unso­phis­ti­cated as we; so, that makes it seem that gov­ern­ment offi­cial are so extremely ner­vous, pan­icky, and out-​of-​their-​element that they are at or pass the point of sense­less­ness. They remind us of middle-​schoolers play­ing bas­ket­ball, as the ten­sion increases, they tend to stop breath­ing when they have the ball. The lack of oxy­gen does not enhance judg­ment, and bad things – turnovers and missed shots – tend to accu­mu­late (and exac­er­bate that nervousness_​. It almost looks like they’re play­ing with plas­tic bags over their heads or play­ing under­wa­ter with­out SCUBA: must…get…rid…of…ball…to…restore…air…flow…gasp…gasp.

When other firms, out­side of the ini­tial ban, try to be cov­ered by it, too, investors tend to get sus­pi­cious of them, too. (It is like being sub­poe­naed as a wit­ness and ask­ing for immu­nity.) The nat­ural response by both inter­ested and indif­fer­ent par­ties is that the firm is hid­ing some­thing, and they tend not to hide good news.

As we have stated repeat­edly in other posts dur­ing the past sev­eral weeks, we think that both elected and unelected fed­eral offi­cials have per­formed mis­er­ably dur­ing the recent cri­sis, and, in fact, have made it worse through their conduct. See almost any­thing that we have writ­ten in the past few weeks, includ­ing, Planes, Trains, and Auto­mo­biles and Banks and Farms and States…, Shame on Them!, Prin­ci­ples Lost and More, SOX’s Roles in the Finan­cial Cri­sis of ‘08, and >Out of Their Ele­ments to list just a few.

The Fed’s recent deci­sion to lend directly to firms (via the com­mer­cial paper mar­kets) and the SEC’s unwill­ing­ness to extend the ban are the only hope­ful, sen­si­ble actions that we’ve observed are fear­ful lead­ers take in quite some time.

the rest of the world complains.

On Tues­day, we posted The Impor­tance of the Rule of Law, which describes how Russia’s prob­lems are unique from the West’s and, as we see it, are the result of self-​destructive poli­cies and desires.

In that entry, with­out pro­vid­ing addi­tional links to arti­cles, we insin­u­ated that The Wall Street Jour­nal’s reporters seemed to be agree­ing with Russ­ian lead­ers that, of course, Rus­sia was an inter­na­tional vic­tim of the credit cri­sis in the USA. 

In our mind, the only link­age – while large – is the decline in energy prices as the US econ­omy adjusts – by using less – to the higher level of oil and gas prices.

It is nice to see the The Wall Street Jour­nal edi­to­r­ial page crit­i­ciz­ing the Russ­ian Pres­i­dent for his attack on the U.S in its essay, Dmitry’s Dia­tribe.

Don’t expect other coun­tries to come to our defense when the US is crit­i­cized, how­ever. The recent losses in global equity mar­kets show that the rest of the world still heav­ily depends upon the USA. Those coun­tries, big and small, fast or slow-​growing, suf­fer at least pro­por­tion­ally when some­thing neg­a­tive hap­pens in the U.S., and many remain crit­i­cally depen­dent upon the US.

It seems that if we don’t buy their stuff, no one does, either, espe­cially their own citizens.

Don’t expect grat­i­tude for keep­ing the world afloat. Instead expect con­tin­ued resent­ment for that depen­dence upon us; for­eign lead­ers are kind of like teenagers in that respect.

So, while the teenagers of the world will crit­i­cize us, the inse­cure politi­cians in the US will try to be more like them, when all-​the-​while, they want to be more like us. (Kind of like Danny and Sandy in Grease.)

Aside: say, doesn’t adopt­ing inter­na­tional account­ing stan­dards seem like a great idea right about now? We hear that stan­dards elim­i­nate greed, stu­pid­ity, inef­fec­tive gov­ern­ment poli­cies, and risk con­cen­tra­tions. If we’d fol­lowed them, we could be as well of as the rest of the world right now. (And, had we fol­lowed them sev­eral years ago, Con­gress would never, ever have pres­sured Fan­nie Mae and Fred­die Mac to do stu­pid things, but who knew?)

Update: we have newer posts on the topic, too, includ­ing Risk Neu­tral Val­u­a­tion: There Are at Least Two Expected Val­ues, that describes the dif­fer­ence between real and risk neu­tral dis­tri­b­u­tions. We also have: Price Implied Default Rates that pro­vides an exam­ple more like a risky bond, and a multi-​period exam­ple: Multi-​period Bond Price Implied Default Rates and CDS.

The Wall Street Jour­nal has an arti­cle about Iceland’s finan­cial prob­lems in today’s paper: After­shocks Felt From Ice­land. It turns out that the coun­try has more prob­lems than being a small, cold island in the mid­dle of the North Atlantic.

Any way, we’re not writ­ing about its cli­mate, espe­cially since West­ern PA’s is prob­a­bly worse and we have no beaches and few tall blonds. No, we’re writ­ing about the graph in the arti­cle and the blurb that states, “Trad­ing in the credit default swap mar­ket puts the prob­a­bil­ity of a default by Ice­land on its debt at a lit­tle over 50%.”

As pre­sented, that state­ment is highly mis­lead­ing and non­sense, and the pur­pose of this post is to explain why.

We’ve writ­ten about Implied RISK NEUTRAL prob­a­bil­i­ties of default a few times. In the aptly titled Implied Risk Neu­tral Prob­a­bil­i­ties (of Default) we pro­vided an exam­ple that illus­trated the dif­fer­ence between the actual prob­a­bil­ity of default, which is never known in the real world, and the model–implied prob­a­bil­ity of default, which could be cal­cu­lated from ANY model–regard­less of its valid­ity–that per­mits at least two out­comes, e.g., survival and fail­ure of the entity. Such a model may or may not assume risk neu­tral­ity, but risk neu­tral­ity makes the cal­cu­la­tion simpler.

Regard­less of whether Ice­land goes bank­rupt or not, we pro­vide sev­eral exam­ples that dis­tin­guish the risk-​neutral, implied default rate from the true default rate.

In our ear­lier post, Implied Default Prob­a­bil­i­ties and Risk Neu­tral Mod­els, we com­mented on a sim­i­lar graph in another WSJ arti­cle from last June, and men­tioned many of the fac­tors that would be involved in such a cal­cu­la­tion. Unfor­tu­nately, we recently and acci­den­tally deleted a very nice com­ment about that post, which expanded the analy­sis to include coun­ter­party credit risk: the risk that the pur­chaser of a CDS con­tract would not get paid (the insur­ance pro­ceeds) in case of bank­ruptcy because the insurer or CDS writer was also insol­vent – kind of like AIG.

In this post, we’ll pro­vide another numer­i­cal exam­ple with a dif­fer­ent assumed, risk-​averse, util­ity func­tion for the insur­ance buyer.

We’ll again assume a sin­gle period, but we will not use the 50% prob­a­bil­ity of bank­ruptcy that we did in the ear­lier post; it would be too confusing. In fact, the 50% prob­a­bil­ity of default men­tioned in the arti­cle is likely the cumu­la­tive prob­a­bil­ity of default over the five years. It may or may not be based on equal mar­ginal prob­a­bil­i­ties of default for each of the five years, regard­less the annual mar­ginal prob­a­bil­ity of default is not 10%; the 50% men­tioned for five years was not found by mul­ti­ply­ing five years times 10%.

Read­ers inter­ested in an exam­ple of a discrete-​time, multi-​period sur­vival prob­lem that illus­trates these issues should see Good Col­umn, Bad Math. Read­ers inter­ested in a calculation-​intensive, similarly-​structured, discrete-​time prob­lem, should see our research paper on moral haz­ard: Dead­lines as Man­age­ment Con­trol Devices, which is based upon our dis­ser­ta­tion. In that paper, the game ends with suc­cess, rather than fail­ure, but the out­come tree is very similar.

So, will pro­vide a cou­ple exam­ples sim­i­lar to our square root prob­lem in August.

Case 1: Assume that the per­son has nat­ural log­a­rith­mic util­ity, which is strictly con­cave fun­tion and makes him risk-​averse. We’ll also assume that the per­son has an ini­tial endow­ment of $75.858, which we choose for con­ve­nience as you’ll see below. We’ll ignore time-​value-​money cal­cu­la­tions and inter­est rates today; they’re inessential.

Assume that a firm will be worth $100 if it sur­vives and $10 if if fails. That makes the loss given default (LGD) $90, and the loss given default rate $90/$100 equal to 90%. In the real world, e don’t know the loss given default until a default occurs, the firm’s assets are liq­ui­dated, and the resid­ual cash is paid to the debtholders. LGD rate is always assumed in CDS and other sim­i­lar cal­cu­la­tions and, from our experience, seems to be con­sid­ered much less than implied default rates.

Assume that the actual prob­a­bil­ity of default is 12%, i.e., the prob­a­bil­ity of get­ting $10 from the invest­ment is 12%. REMEMBER, two items that we never know in real life are the mar­ket par­tic­i­pants pref­er­ences – expressed here as a ln(·) util­ity func­tion – and the actual prob­a­bil­ity of default, 12%. It is cru­cial never to for­get this ignorance.

Also, we gen­er­ally don’t know the person’s entire endow­ment, specif­i­cally his other wealth inde­pen­dent of the gam­ble. In this first case, we clev­erly chose the person’s endow­ment so that his other wealth, not tied up in this par­tic­u­lar invest­ment, is zero. (You’ll that fact below.)

We’ll do what we need to do to cal­cu­late the risk-​neutral prob­a­bil­ity of default and then later we’ll change a few assump­tions to see how those changes affect the answer.

First, we’ll cal­cu­late the person’s expected util­ity with the invest­ment. Now, with log­a­rith­mic util­ity it is:

10% × ln($10) + 90% × $ln($100) = 4.375 utils.

Now, to get the same 4.375 utils of sat­is­fac­tion from a cer­tain gam­ble (involv­ing no risk), the per­son should be will­ing to spend up to:

e^4.375 = $75.858.

So, that $75.858 is his cer­tainty equiv­a­lent, or the most he would pay for the uncer­tain invest­ment. (That’s why we clev­erly set his ini­tial wealth at the same $75.858, so there would be no money left-​over after the invest­ment.) With the same hand-​waving (about mar­ket inter­ac­tions) that we per­formed in August, we’ll sup­pose that the $75.858 is also the price, i.e., com­pe­ti­tion among similarly-​preferenced and endowed buy­ers drive the price to the break-​even point; tech­ni­cally, it is an indif­fer­ence point but only pedan­tics like our­selves care.

Now, a risk neu­tral per­son could–but need not – be mod­eled as car­ing only about expected cash flows on a dollar-​for-​dollar basis; so, for a risk-​neutral per­son, we could set his util­ity equal to dol­lar val­ues and expected dol­lar val­ues. In other words, he would value $10, $75.858, and $100 as 10 utils, 75.858 utils, and 100 utils, respec­tively. (We wrote “but need not” above, because we could add a con­stant and mul­ti­ply by a pos­i­tive num­ber with­out chang­ing the essence of the analysis.)

Remem­ber, in the real world, we don’t know the 12% or the actual mar­ket participant’s pref­er­ences, which we assumed to be log­a­rith­mic here, or his start­ing wealth, BUT if we assumed that he was risk neu­tral in our dollar-​for-​dollar way, then we solve for the cor­re­spond­ing prob­a­bil­ity of default, i.e., find p such that:

p × 10 + (1 — p) × 100 = 75.858.

Rear­rang­ing and solv­ing for p, we get the risk neutral-​implied prob­a­bil­ity of default, p, equals about 26.83% (ver­sus the real prob­a­bil­ity of default of 12%, which, again, we never know in real life).

So, the WSJ writer or edi­tor is call­ing that 26.83% the prob­a­bil­ity of default, when it is, in fact, the implied prob­a­bil­ity of default assum­ing that mar­ket par­tic­i­pants were risk-​neutral. (Here, our “model” is so sim­ple as to be innocu­ous, but in more robust set­tings – with more details – that’s not the case.)

That risk-​neutrality, which pro­vides lin­ear­ity of pref­er­ences, is what allows the ana­lyst to view the price and set it equal to the expected value of the cash flows in the pos­si­ble out­comes, e.g., sur­vive or fail, for a pos­si­ble prob­a­bil­ity, p. In real life, ana­lysts would use dif­fer­ent dis­tri­b­u­tions to cal­cu­late an implied prob­a­bil­ity of default based upon their spe­cific model in much the same way that they would cal­cu­late a model-​implied volatil­ity when using Black-​Scholes or a vari­ant. (Pro­vide mar­ket vari­ables or guesses about those vari­ables, pro­vide a model, and solve for the last remain­ing unknown. Notice that there are quite a lot of assump­tions in such a process.)

(By the way, for those with a lit­tle knowl­edge of sto­chas­tic processes, set­ting the price equal to the expected value (under risk neu­tral val­u­a­tion) is why the phrase Mar­tin­gale Method is used. That’s what a Mar­tin­gale is: a process where the value today is equal to the expected value in the future, and it doesn’t really change if we add inter­est rates and discounting.)

Now please note, unlike in real-​life, in this exam­ple, we know that the true prob­a­bil­ity of default is 12%. To an out­side observer, with­out our infor­ma­tion to con­struct the cal­cu­la­tions, there is no clear rela­tion­ship between the 12% and the 26.83%. In other words, know­ing only the 26.83% says noth­ing about the true prob­a­bil­ity of default, and that is the error that the jour­nal­ist makes in today’s article.

Because the 50% for Ice­land is such a large num­ber, the graph and the blurb seem almost designed to insight hys­te­ria; how­ever, actual – albeit unknown rate – could be sub­stan­tially lower.

We’re sure that many WSJ read­ers along with the article’s writer mis­in­ter­pret that num­ber. We were and con­tinue to be amazed (and shocked) at the num­ber of folks who work or trade in the area who do not under­stand it. Thus, we view this post as a pub­lic service.

It is about 5:00 EDT, and proof­read the post like we promised. We’ll add to this post this later today with more exam­ples; so, please check back for updates that show why the price could drop and the implied RISK NEUTRAL prob­a­bil­ity of default could rise despite the TRUE prob­a­bil­ity remain­ing at 12%. (Note: the true default rate has lit­tle or noth­ing to do with the his­toric default rate. We’ve writ­ten a lot about that notion, too. See our essay on uncer­tainty man­age­ment for that discussion.)

Case 2: let’s keep every­thing the same, but make the per­son “more” risk-​averse. In micro­eco­nom­ics, that has a par­tic­u­lar, tech­ni­cal mean­ing hav­ing to do with the con­cav­ity (the curved­ness) of the util­ity func­tion, but here we’ll avoid the issue by reusing the nat­ural log­a­rth­mic func­tion recur­sively, i.e., our util­ity func­tion is now ln(ln(·)).

In such a prob­lem, the addi­tional con­cav­ity reduces the cer­tainty equiv­a­lent of the gam­ble, and pos­si­bly the price. We’ll wave our hands again as a way to stay on course, and assume that the price falls to the new cer­tainty equiv­a­lent. To make it work, with­out try­ing to hard, we’ll arbi­trary assume that as soon as the per­son pur­chases the firm, his pref­er­ences, via util­ity func­tion, (and risk aver­sion) changes to the double-​log thing, ie.,

12% × ln(ln($10)) + 88% × ln(ln($100)) = 1.444 utils.

For the changed per­son to get the same 1.444 utils of sat­is­fac­tion for sure, he’d be will­ing to sell it for:

e^exp(1.444) = $69.243.

(As his risk aver­sion increases, the value of a gam­bles decreases.) Now, in the real world, a decrease in a poten­tial seller’s reser­va­tion price doesn’t nec­es­sar­ily change the mar­ket price, but we’ll assume that it does. So, imme­di­ately, the price is $69.243. We can now find the revised risk-​neutral probabilities:

p × 10 + (1 — p) × 100 = 69.243.

Solv­ing for p yields a new, risk-​neutral, implied prob­a­bil­ity of default of 34.175%. So, a change in risk pref­er­ences will change the implied prob­a­bil­ity of default. You may call it the mar­ket implied prob­a­bil­ity of default, but it is really the implied prob­a­bil­ity of default using the mar­ket price and assum­ing that buy­ers are risk-​neutral, but that gets kind of long. The real prob­a­bil­ity of default is still 12%.

Case 3: Now, let’s go back to our first case, where we used the nat­ural log, ln, only once, not twice. Let’s assume that right after the pur­chase, the new owner dis­cov­ers that the loss given default is really $99 dol­lars, not the $90 that (it was assumed that) the mar­ket knows.

In that case, the new expected util­ity is 0 + .88 × ln(100) or 4.145 utils. Tak­ing the inverse gives e^4.053 = 57.544.

Now, IF every­one knows that the two states are {$1, $100}, then the risk-​neutral prob­a­bil­ity of default satisfies:

p × 1 + (1 — p) × 100 = 57.544,

and equals 42.9%. Remem­ber the actual prob­a­bil­ity of default is still 12%, but the low out­come is par­tic­u­larly low for a log util­ity func­tion. So, the implied, risk-​neutral prob­a­bil­ity of default is more than 3.5 times the true prob­a­bil­ity of default.

Case 4: let’s take Case 3, and assume that the buyer knows that the loss given default has increased from $90 to $99, but a trader or ana­lyst at another firm has not observed that change but has observed the new price of $57.544. In that case, the ana­lyst very likely keep the same LGD assump­tion and solve for a new implied prob­a­bil­ity of default of (using the erro­neous, but assumed $10, rather than the cor­rect $1:

p × 10 + (1 — p) × 100 = 57.544.

In that case, solv­ing for p gives an model-​implied, under the assump­tion of risk-​neutrality prob­a­bil­ity of default of 47.2%. Of course, once again, the real prob­a­bil­ity of default is 12%.

The dif­fer­ence between the 47.2% and $42.9% implied default rates is solely attrib­uted to the (incor­rect) assump­tion about the loss given default. In our expe­ri­ence, the LGD is the least-​challenged, least-​investigated assump­tion used to price CDS and related prod­ucts. In real-​life, it would be extremely com­mon to main­tain that assump­tion in the face of falling prices.

We’ll prob­a­bly refine this post in the com­ing days, but our four sim­ple cases should be suf­fi­cient to cast deep sus­pi­cion on Iceland’s reported prob­a­bil­ity of default, when it is really a model-​implied, default rate under the assump­tion of risk neu­tral­ity. Remem­ber in all of our cases, the real prob­a­bil­ity of default is 12%. The mod­els used to cal­cu­late that rates involve more vari­ables and more cal­cu­la­tions, but apply no more knowl­edge than do our sim­ple exam­ples here.

If you have any ques­tions or com­ments, please write.

Copy­right © 2008 Spero Consulting.

From Big Bets Come Back to Bite Fund Man­agers in today’s Heard on the Street sec­tion of The Wall Street Jour­nal:

“To wit, a bas­ket of stocks most pop­u­lar among hedge funds tum­bled 19% in Sep­tem­ber, more than the 9% drop for the Stan­dard & Poor’s 500, accord­ing to Gold­man Sachs.”

We doubt that early Octo­ber has been any kinder.

We don’t want to make too much out of a sin­gle month’s or sin­gle year’s results or a sin­gle fund’s mis­for­tunes, but we are won­der­ing: were gains in past years due to sheer genius or were they due to the (equity) funds being invested in a highly-​leveraged man­ner, in a rel­a­tively sta­ble (low volatil­ity) envi­ron­ment, dur­ing a period of gen­er­ally increas­ing stock prices cou­pled with a period of very low bor­row­ing costs? (Whether such posi­tions were con­structed directly in stocks or options or other deriv­a­tives is irrelevant.)

We don’t fol­low hedge fund mar­ket­ing very closely, but we doubt that any fund claimed such a strat­egy, i.e., “we’re going to take your money, lever­age it as much as we can, take a bet, and hope for the best.” In which case, it would seem that “hedge” is defined as “speculation.” 

We’re also won­der­ing how many wealthy, “sophis­ti­cated” investors would have invested were such schemes explained in such an explicit, straight-​forward man­ner rather than via the var­i­ous sell­ing pitches used to appeal to the pseudo sophisticated.

Nei­ther the (1) frequency of trades, (2) exclu­siv­ity of the pro­pri­etary algo­rithms, (3) level of automa­tion, (4) speed of exe­cu­tion, nor (5) even the vol­ume of ‘tude exuded seems to have mat­tered. At the end of the trad­ing day, it is dif­fi­cult to not to be either long or short or lev­ered or not, and recent returns pro­vide evi­dence that despite all the machi­na­tions and claims to the con­trary, the de facto fund posi­tion was long and (highly) levered.

As the chair­man asks, aren’t the funds, their man­agers, and their infra­struc­tures still in place today? Why don’t we see out-​sized (pos­i­tive) returns now?

By the way, regard­less of the strat­egy, we’re not talk­ing about how inter­nal mod­els or investor reports show flat­ness to the mar­ket, etc., we’re talk­ing about real life, which is much more dif­fi­cult to accu­rately quan­tify. (Please see our dis­cus­sions of nedges and sledges for more on this topic. We’re also in the midst of writ­ing Hedg­ing the Pen­ny­wise and Pound-​Foolish Way, which dis­cusses the myopic and nar­row focus of hedg­ing tac­tics. Also, please see our essay on uncer­tainty man­age­ment for our broader per­spec­tive in the area.)

So for all the hyper-​frenetic, high fre­quency trad­ing, etc., many equity funds seem to pro­vide noth­ing more than a volatile play on the equity mar­ket – not exactly our def­i­n­i­tion of “hedge.” 

Then again, many fund man­agers received HUGE rewards on the upside and faced lim­ited losses on the down­side; so, they seem to be much bet­ter pro­tected. Oh, we get it! Never mind. We see why they’re called hedge funds. It is for thee, not me.

How­ever, an uncer­tainty remains: were fund man­agers try­ing to fool investors or were they just fool­ing themselves?

Now Lend and Shut-​up, Mr. Fed Chairman!

Tonight, The Wall Street Jour­nal reports that the Fed Will Lend Directly to Cor­po­ra­tions. They mean the Fed­eral Reserve will lend to non-​financial corporations.

This is the first sen­si­ble action that we’ve seen any­one in the fed­eral gov­ern­ment take since the finan­cial cri­sis began. No, we’re quite seri­ous. The Pres­i­dent, Con­gress, the Trea­sury, the Fed: all dis­as­ters: seem­ingly ner­vous and clue­less but with­out the good sense to hide either emo­tion from each other or from the Amer­i­can people. 

We’ve argued that the ridicu­lous bailout plan will fail. (See almost any­thing we’ve writ­ten in the past sev­eral weeks.) We also think that the Sep­tem­ber panic-​speeches of Bernanke and Paul­son were equiv­a­lent to shout­ing “Fire” in a the­ater, and if Pres­i­dent Bush had any remain­ing inter­est in the coun­try or econ­omy, he would have fired Paul­son and asked Bernanke to resign for their shame­ful behavior.

This evening we just fin­ished writ­ing Even a Per­fect Bailout Will Fail. In it and many of other recent posts, we men­tion that the prob­lem is the banks and the banks, alone. That prob­lem is the gen­eral and jus­ti­fi­able lack of con­fi­dence in them, includ­ing – or should we write espe­cially – their lack of con­fi­dence in each other is the prob­lem. Even if all the bad assets were exchanged, would the reader trust the banks and their management’s?

Reg­u­lar read­ers will note that for quite some time, we’ve been ask­ing why the losses seem so con­cen­trated? The short answer is that they seem con­cen­trated because they are con­cen­trated. Lax man­age­ment begat poorly-​structured incen­tives, which begat exces­sive risk-​taking, which begat risk con­cen­tra­tion, which begat the mas­sive losses. (Those who would argue that such rea­son­ing is faulty – and there are some – would have to claim that the finan­cial firms are vic­tims of very, very, bad luck, but there doesn’t seem to be much evi­dence of that.)

As far as we can tell, it is not the rest of the econ­omy – not yet, at least. There are areas of the coun­try that have been over­built, and cities like Char­lotte and New York will suf­fer because they rely so heav­ily on the banks and the finan­cial ser­vices indus­try for income, spend­ing, and taxes, but in many places the econ­omy has been remark­ably resilient. 

We see the panic-​speech and a lack of a clear artic­u­la­tion of (1) the prob­lem, (2) the place­ment of blame, and (3) the pro­posed solu­tion and how it would work as the largest prob­lems fac­ing the gen­eral econ­omy, and we see it as the rea­son why the Dow has lost over 1,400 point since the plan was approved. At best we can hope that our politi­cians and gov­ern­ment offi­cials shut-​up before they can cause too much harm.

So, we applaud the Fed, the lender of last resort, for ful­fill­ing its mis­sion and act­ing rather than talk­ing. Banks are the prob­lem, and this lat­est action avodis them and goes directly towards mit­i­gat­ing the prob­lem. By the way, new read­ers may be inter­ested in our alter­na­tive bailout plan: A Bet­ter Solu­tion (than a gov­ern­ment takeover).

What Hope of Suc­cess with Typ­i­cal Bureau­cratic Efficiency?

We have crit­i­cized the “$700 bil­lion” fed­eral bailout of banks for the past two weeks and have done so for a vari­ety of rea­sons. (We used the scare quotes to denote the unre­li­a­bil­ity of the esti­mate, which seems to have been grasped from thin air.) We won’t cite all of the rea­sons for its likely fail­ure, because in this post, we’ll sup­pose that the “bailout” is per­fectly executed.

Would such per­fectly exe­cuted plan return us to the pre-​crisis, hal­cyon days of early 2007? No! To any­thing close to it? No.

Sup­pose that each and every crappy mort­gage, mortgage-​backed secu­rity, and CDO held by a com­mer­cial bank is pur­chased by the gov­ern­ment at a fair price, and so, let’s sup­pose that the banks have $700 bil­lion in cash instead of semi-​worthless thin­gies that they may or may not understand.

Now, under such an incred­i­bly for­tu­nate cir­cum­stance, would the dear reader have con­fi­dence in those banks? Would he or she have more con­fi­dence or less con­fi­dence in the bank that sold the most thin­gies to the Treasury?

This first rea­son explain­ing the bailout’s likely inef­fec­tive­ness is a “types” argu­ment. They’re lower types than we thought. 

We now know that many banks made a tremen­dous num­ber of very, very costly mis­takes and mis-​estimations dur­ing the past sev­eral years. Thus, they now seem sub­stan­tially less capa­ble they did two years ago. (Does any reader think more highly of the banks today than in, say, 2006?) The cap­i­tal mar­kets depart­ments, boards, senior man­agers, traders, risk man­agers, and trea­sur­ers seem less able today than one or two years ago.

More­over, it is not just the losers. We recall a con­ver­sa­tion with a for­mer trader and cur­rent risk man­ager whose bank seems to have avoided many pit­falls that have dam­aged or destroyed other insti­tu­tions. When asked why it was so for­tu­nate, he replied, “it wasn’t due to any com­pe­tence. In fact, it was quite the oppo­site. They had planned to be just like their peers but were inca­pable of exe­cut­ing it (the plan).” So, it seems that there are rea­sons to sus­pect the non-​losers, too.

So, we ask, do you trust the banks with $700 Bil­lion in new cash or do you think they will waste it or take exces­sive risks? Have they done any­thing to earn to earn your trust, and is there any­thing in place, like revised incen­tives schemes, that would indi­cate a change in phi­los­o­phy and an improve­ment in control?

Sec­ondly, we now know that for many banks, a sub­stan­tial por­tion of their pre-​2008 earn­ings were bogus. As those assets were los­ing value, the banks were rec­og­niz­ing income on them. Much of those earn­ings have now been reversed via losses, and it is likely that addi­tional losses will be rec­og­nized in the next two quar­ters. (Recall: we’re assum­ing that the assets trade at a fair price.) So, we know that the banks’ future earn­ings will not return to pre-​2008 lev­els, and it is unlikely that their equity base and cap­i­tal lev­els will per­mit lend­ing and invest­ing at those past lev­els. More­over, where will they invest? In real-​estate? In sum, we expect lower earn­ings for the fore­see­able future.

Thirdly, all of these points should be known – at least, col­lec­tively – by the sur­viv­ing banks. As we wrote (tongue-in-cheek) in Finan­cial Pro­jec­tion in a Cri­sis, if banks project their own abil­i­ties onto their peers, they may con­tinue to be sus­pect of each other thereby keep­ing the credit mar­kets “frozen.” How much does the dear reader trust them beyond the $100,000 or $250,000 deposit insur­ance limit?

Fourthly, with the mega-​consolidations, and an asso­ci­ated too-​big-​to-​fail mentality, moral haz­ard becomes an issue that exac­er­bates these sus­pi­cions. Will these mega-​banks take out­sized risks know­ing that the gov­ern­ment will cover losses? Will the gov­ern­ment cover such losses? So, how long will it takes banks to trust each other, now that there are fewer trad­ing part­ners? (Will banks trust the debt rat­ing agencies? Do you?)

Finally, does the reader imag­ine that once the cri­sis recedes, the fed­eral gov­ern­ment will vol­un­tar­ily give up con­trol of the new por­tion of the econ­omy that it con­trols? Gen­er­ally, to induce the gov­ern­ment to shrink requires, if not a lit­eral rev­o­lu­tion, at least a fig­u­ra­tive one, e.g., the Rea­gan Rev­o­lu­tion. With­out such a rev­o­lu­tion, what hope does the econ­omy have with more gov­ern­ment interference?

Those look­ing for reg­u­la­tion as a solu­tion should note that invest­ment banks and large com­mer­cial banks were already heav­ily reg­u­lated. Most reports to senior man­age­ment and the board of direc­tors are also sent to the reg­u­la­tors, who may ques­tion them. Did the reader not in the indus­try know that those regulators, maintain per­ma­nent offices in each bank’s head­quar­ters and are almost like employees?

Besides read­ing such reports, the reg­u­la­tors also con­duct fre­quent exam­i­na­tions, and, of course, they did so repeat­edly dur­ing the past sev­eral years. Did they catch any­thing? More­over, as we’ve writ­ten in the past, do they have the incen­tive to do so? Or would the dis­cov­ery of an risky issue merely show that they had missed it in a pre­vi­ous year?

Also, remem­ber that Fan­nie Mae and Fred­die Mac were heav­ily reg­u­lated, too. Many mem­bers of Con­gress, e.g., Bar­ney Frank, et. al., wanted less reg­u­la­tion for those two gov­ern­ment spon­sored enti­ties. When will faith in such enti­ties be restored? When will Con­gress have an approval rat­ing above 20%? (With­out search­ing to ver­ify it, as low as Mr. Bush’s approval rat­ing is, we don’t being that Congress’s is even 50% of it: some­where between one-​third and one-​half.)

As we under­stand it, while “Spero” is not an Ital­ian name, the word means “to hope” in Latin. We’re think­ing about chang­ing it to some­thing more real­is­tic when we com­ment on the bailout. Why not try our solu­tion: A Bet­ter Solu­tion (than a gov­ern­ment takeover)?

We might add to and revise this post through time.

“You’re rid­ing high in April, shot down in May.”

–Dean Kay Thomp­son, composer(s), of (Frank Sinatra’s) That’s Life!

Okay, so the line is sev­eral months pre­ma­ture, but it reminds us very much of Russia’s August and Sep­tem­ber. Unfor­tu­nately, it’s not “back on top in June,” err, October.

We men­tioned Rus­sia twice last month, pri­mar­ily in It’s Free­dom, Baby! Yeah! Mr. Putin.

Today, we read in The Wall Street Jour­nal that its bailout is fail­ing: Russ­ian Investors Want Bailout of Bailout.

Given the cir­cum­stances, par­tic­u­larly the unfor­tu­nate tim­ing of its recent inva­sion, we ask rhetor­i­cally: how could it not fail?

In August, when Rus­sia invaded Geor­gia, it was on the top o’ the world, and it once again showed itself to be a less-​than-​reliable neigh­bor and part­ner. When the good times end, that’s not the rep­u­ta­tion to have.

See, when times are good and every­one wants your stuff, maybe it doesn’t hurt to remind one’s trad­ing and invest­ing part­ners of one’s unco­op­er­a­tive past, e.g., the Russ­ian bond cri­sis of 1998, the czarist bond cri­sis of 1918, etc. When times turn bad it seems unrea­son­able to expect pos­i­tive out­comes from such a stark reminder, and that is the case this autumn.

Like the Russ­ian gov­ern­ment, it seems that the WSJ is try­ing to make the cur­rent Russ­ian cri­sis part of the global finan­cial cri­sis, but we think it is only tan­gen­tially related via the price of oil. Per­haps “only tan­gen­tially” is an under­state­ment, but we mean that we view Russia’s prob­lems to be dis­tinct and unique and unre­lated to dubi­ous mort­gages and mortgage-​related secu­ri­ties in the USA.

While we see a dis­trust of cer­tain asset classes and banks in the West, we think that investors dis­trust the entire Russ­ian polit­i­cal and finan­cial sys­tem, but maybe we’re pro­ject­ing. (Maybe they’re just ahead of their time.) 

That dis­trust wouldn’t be so harm­ful if oil were at $150 per bar­rel, but that’s not the case when oil is at $90.¹

As we see it, if oil is around $90 per bar­rel today, it might well be at $45 or lower by Decem­ber. Why? Because, these are the times and set­tings when car­tels fail; each mem­ber devi­ates from the pub­li­cized and agreed-​upon strat­egy to try to gen­er­ate the mar­ginal cash flow needed to pay for its commitments.

Many of those com­mit­ments could only be sup­ported by high prices and were likely set under the assump­tion that those high prices would con­tinue from here to eter­nity. (That has a famil­iar ring to it, doesn’t it Lehman, WaMu, Wachovia, and friends? Or any­one one that remem­bers oil prices in the 80s.)

So, dear reader, we ask: if in the past, Rus­sia has defaulted on its debt; tried to squeeze its west­ern neigh­bors using the sup­ply of nat­ural gas as a vice; nation­al­ized var­i­ous indus­tries; impris­oned and harassed inter­nal crit­ics; and invaded its south­ern neigh­bors – Geor­gia this time – does the reader think that it would not behave oppor­tunis­ti­cally within the oil car­tel? (Note: exclud­ing movie scripts, there is rarely honor among thieves.) Ergo, our pre­dic­tion of sub­stan­tially lower prices in the near future.

See, what our Russ­ian cousins have not learned is that the Rule of Law does not only pro­tect oth­ers or only pro­tect only the weak. It also pro­tects one from his or her own self; it pro­tects one­self from being shunned and avoided by oth­ers – even the weak. For as weak as they are, the strong may still need them to sur­vive. If those same lead­ers had learned that les­son and prac­ticed it, we doubt that there would be a new Russ­ian cri­sis ten years after the last one.

Back in June, we wrote Jus­tice and E-​mails in part to reply to the chairman’s ques­tion about whether finan­cial firms would con­tinue to lose money and in part to crit­i­cize the egre­gious behav­ior of few for­mer Bear Stearns employees.

At the time, we said that we expected the losses to con­tinue, and offered her a vari­ety of rea­sons. One of the rea­sons we gave was not a log­i­cal argu­ment related to finance or eco­nom­ics or behav­ior; instead, it was a “ter­res­trial jus­tice” obser­va­tion. (We’ll leave con­sid­er­a­tions of cos­mic jus­tice to higher pow­ers and pray for the best.) We spec­u­lated that the extant losses still seemed quite small given the egre­gious­ness of the behav­ior of many. In fact, they seemed to be smaller by orders of magnitude, and so for that rea­son alone, we could see the loses continuing.

We have no pre­tense about our abil­ity to mea­sure and weigh such notions, but despite the mas­sive losses incurred dur­ing the past three months, we’re still not sure if an equi­lib­rium has been reached, and that is espe­cially true after the bailout was signed into law.

Now the con­tentious reader may argue that such a post is silly, and that may be true. But we would argue that such impres­sions are real and often seem to be shared by believ­ers and athe­ists alike. Unfor­tu­nately, the fact that, say, econ­o­mists can’t quan­tify the notion doesn’t mean that it doesn’t exist. (Also note that we have in mind the eco­nomic jus­tice of finan­cial losses, not crim­i­nal jus­tice or social jus­tice – what­ever that it.)

In the cur­rent cri­sis, it seems that mem­bers of both the polit­i­cal left and right have per­formed dif­fer­ent reck­on­ings but have reached con­clu­sions sim­i­lar to ours. In fact, we believe that zeit­geist would be more evi­dent except for the loom­ing Pres­i­den­tial elec­tion. (On Fri­day we did note in What Mon­ster Hath They Wrought? that politi­cians across the spec­trum may be sur­prised by the level of cyn­i­cism that they have uncon­sciously incul­cated into the cit­i­zenry, and we hypoth­e­sized that it will lead to a result­ing fick­le­ness and feck­less­ness and, therefore, unpredictability of the vot­ing population.)

The fact that the bailout seems to have united both the prin­ci­pled right and left against the expe­di­ent mid­dle is quite an achieve­ment, indeed. In fact, for what­ever rea­son, we see the spokesman for both sides as “the car­pet­bag­ger” in Clint Eastwood’s 1976 mas­ter­piece, The Out­law Josey Wales (the Mis­souri ferry boat scene): “… …No, no, Mr. Josey Wales; there is such a thing in this coun­try called jus­tice!” We don’t think that either side has seen it, yet, and as much as it indi­rectly hurts our port­fo­lio, we don’t think that we have, either.

Read­ers inter­ested in more economics-​based argu­ments against the bailout can search on that term above and will find no short­age of prose to occupy their time. In fact, we offered our own tax-​based, pri­vate cap­i­tal solu­tion in A Bet­ter Solu­tion (than a gov­ern­ment takeover) that seemed rather obvi­ous and cer­tainly worth attempt­ing before the mas­sive gov­ern­ment takeover.

One of America’s largest com­pa­nies had a dis­as­trous Sep­tem­ber, and it was touch-​and-​go there for awhile. A com­pany that some thought too big to fail, failed miserably. 

As we have all seen, when a gigan­tic com­pany on the coast suf­fers, even from self-​inflicted wounds, it can neg­a­tively affect all of us in the fly-​over.

There were clear warn­ing signs in August. In fact, we wrote about them, but it was too lit­tle, too late, and the metaphor­i­cal train wreck occurred.

Despite our near-​Libertarian stance on eco­nomic issues, we were pre­pared to call for gov­ern­ment inter­ven­tion. For­tu­nately, it never came to that.

Microsoft seems to have ditched the Jerry Sein­feld adver­tis­ing campaign.

We ini­tially wrote about Microsoft’s deci­sion to use the for­mer come­dian in Sein­feld, a Youth­ful 54.

After the first ad, we wrote, Sein­feld + Gates = Mac Sales, Or Maybe Not, where we began to sus­pect that Bill Gates had an ulte­rior motive and was more clever than the hir­ing of Sein­feld would indicate.

Until now, we have never men­tioned the sec­ond ad; it was just too weird and way too creepy and we were try­ing to repress it. Had we seen it twice we might have had night­mares about those two doing their nails in the older princess’s room.

We’re glad to see the “I’m a PC” com­mer­cials, and much pre­fer the mus­cu­lar, “tyranny of the masses” approach – where almost every­one in every field uses PCs (hope­fully, peer pres­sure may be enough to get the other 300 peo­ple to switch) – to two old men act­ing like teenage girls. Err, let’s hope they were acting.

In con­clu­sion, we say, good job Mr. Gates! The next time we buy a PC, we promise to also pur­chase your Win­dows software.