Spero Consulting

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.