Archive for October 7th, 2008
Even A Perfect Bailout Will Fail
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.
The Importance of the Rule of Law
“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.
- Oh, look, Dr. Spero’s May 1st prediction in Commodity Bubbles? Yeah, probably, might be turn out to be an incredibly lucky guess. ↩
Justice and Untethered Ferry Rides
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.
