Spero Consulting

Archive for October 7th, 2008

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.