Spero Consulting

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.