Spero Consulting

Archive for November, 2008

The Curi­ous Case of Robert Rubin

The week­end edi­tion of The Wall Street Jour­nal has a front page inter­view with Robert Rubin: Rubin, Under Fire, Defends His Role at Citi.

We’ve crit­i­cized Citi’s board in the (recent) past, and we’re still par­tic­u­larly fix­ated on the fact that few direc­tors had finan­cial indus­try expe­ri­ence. That seems nei­ther wise nor even pru­dent for a finan­cial insti­tu­tion with over $3,000,000,000,000 of assets. (That’s $3 tril­lion, but we like to write it out for effect, because it seems like a lot of money.)

As the arti­cle men­tions, Mr. Rubin was “the only board mem­ber with expe­ri­ence as a trader or risk manager.”

Since 1999, Mr. Rubin has made about $119 mil­lion from Cit­i­group while hav­ing no oper­at­ing respon­si­bil­i­ties. We have absolutely no prob­lem with that, and, in fact, are look­ing for sim­i­lar “work” our­selves. (Inter­ested par­ties may use our con­tact form.)

Where we do have a prob­lem is his insis­tence that none of Citi’s prob­lems is his respon­si­bil­ity. As the inside head­line reads: “Rubin Blames Citigroup’s Woes on the Broader Finan­cial Cri­sis.” He almost seems to imply that Cit­i­group is a hap­less, unwit­ting vic­tim of some­thing big­ger than itself – some­thing it couldn’t be expected to con­sider, man­age, of fathom: “Nobody was pre­pared for this…”

In that case, exactly what type of stew­ard­ship, guid­ance, and pro­fun­di­ties did he provide? 

Sup­pose it is true that Citi and its board were fault­less. Shouldn’t they have been able to con­sider how they might be dam­aged by a gen­eral down­turn or a finan­cial cri­sis that was no fault of its (their) own. Thus, our lit­tle proof-​by-​contradiction shows the silli­ness of the argument.

More­over, we doubt that even the gullible buys the story that Citi was sim­ple a vic­tim of exoge­nous fac­tors, which were unpre­dictable and beyond its control.

There is a cri­sis of con­fi­dence, but that cri­sis erupted and sur­vives because mar­kets and investors real­ized the large finan­cial insti­tu­tions, includ­ing Citigroup, were far less com­pe­tent invest­ing and trad­ing than they pre­vi­ously believed, i.e., that in ret­ro­spect, pre­vi­ous reported prof­its were unreal and unsustainable.

Citigroup’s share price of $8.29, which is about dou­ble where it was last week­end, has lost about 85% of its value in two years. (In the first three years of the Great Depres­sion – 1929 — 1932 – the Dow Jones Indus­trial Aver­age lost the same per­cent­age with­out a back­stop by gov­ern­ment.) That is an indict­ment against Citigroup’s way of doing busi­ness far beyond the gen­eral con­dem­na­tion of the finan­cial ser­vices indus­try in gen­eral and with all of the sub­si­dies pro­vided by tax pay­ers through the var­i­ous recent gov­ern­ment guar­an­tees and bailout measures. 

Clearly, investors find fault with Citi’s strate­gic and oper­at­ing deci­sions. So, if Mr. Rubin wasn’t mak­ing oper­at­ing deci­sions, what type was he mak­ing? If they weren’t strate­gic, what remains? As other crit­ics note, Mr. Rubin is “try­ing to have it both ways.”

Of course, his pos­tur­ing is silly, as it was he, him­self, who pushed senior man­age­ment to bear more risk in 2004 — 2005. If that’s not a strate­gic, board-level, decision, what is? From our read­ing, it seems that he may now be try­ing to blame a con­sul­tant for sug­gest­ing the board instruct man­agers to take addi­tional risk.

He also blames senior man­age­ment for not exe­cut­ing the strate­gic plans prop­erly and risk man­age­ment for, well, weak risk management. 

“I wouldn’t run a finan­cial insti­tu­tion based upon someone’s view about what mar­kets would do.”

Of course, as the arti­cle explains that is exactly what he did in 2004 — 2005. (We wouldn’t doubt that he did it at other times, too, but don’t have the time or energy to search for quotes or sto­ries.) Well, he didn’t do it based upon some­one else’s view; instead, Citi’s strat­egy seemed to be based upon his own views. (We could well imag­ine board­room dis­cus­sions where inex­pe­ri­enced direc­tors imme­di­ately defer to the for­mer Trea­sury Sec­re­tary and Gold­man Sachs Co-​Chair.

Now, Mr. Rubin should know that devel­op­ing and acknowl­edg­ing such a world-​view is exactly how finan­cial insti­tu­tions are run, whether that view is explic­itly stated or not. (If it is not explicit, then not pro­vid­ing such a view and or con­sid­er­ing its impli­ca­tions seems neg­li­gent at worst and imma­ture at best, ergo, our title.) What else could strate­gic and oper­at­ing plans be based upon? How else could risks be mea­sured, uncer­tain­ties be con­sid­ered, and con­tin­gen­cies be planned? Or are those con­sid­er­a­tions too much like work? If so, it is not dif­fi­cult to see why Citi is where it is at this Novem­ber, and that is com­pletely con­sis­tent with both a spe­cific and the more gen­eral cri­sis in confidence.

As we see it, Mr. Rubin is seventy-​years-​old. He should grow-​up and accept the respon­si­bil­i­ties that come with his posi­tion and rewards, and stop behav­ing like a petu­lant teenager.

That’s a title we never thought that we would write, but before we chase away our reg­u­lar read­ers who share our polit­i­cal and eco­nomic world-​view, please let us explain: it’s not as bad as it looks.

In Kim­berly Strassel’s WSJ col­umn, Hillary of State, Ms. Strassel describes how the main­stream media have now returned to pro­vid­ing a favor­able opin­ion of Hillary Clinton’s for­eign affairs qual­i­fi­ca­tions (to be Sec­re­tary of State). 

We must admit that that this is the first time in our life that we viewed overly-​favorable cov­er­age of any Clin­ton to be a good thing, or even the pos­si­ble indi­ca­tion of a good thing.

But, again, we cau­tion reg­u­lar read­ers: it’s not as bad as it looks. 

Take that excla­ma­tion both ways: first, we’ve not changed, and sec­ond, we spec­u­late that the econ­omy isn’t as bad as the recent losses in the stock mar­ket sug­gest. Although, we have no doubt that cur­rent gov­ern­ment offi­cials could turn that neg­a­tive per­cep­tion into real­ity, and may have already done so with their extant actions.

So here’s our short argument:

1. Prior to the col­lapse of the stock mar­ket, losses were highly con­cen­trated among finan­cial intermediaries. 
2. Now, words can hurt…the econ­omy. The hyper­bole and/​or out­right pan­icky speech (or some com­bi­na­tion of both) by elected offi­cials and appointees, pri­mar­ily Messrs. Paul­son and Bernanke, helps cre­ate the recent collapse. 
3. Mis­guided actions can be dam­ag­ing, too. The government’s effort to stem the crises, which we believe that they still con­sider to be a sin­gu­lar cri­sis, has been very dam­ag­ing, too.
4. So, equity val­ues have decreased sub­stan­tially and the econ­omy is less sound than it was. There maybe be some­thing close to a depres­sion or not.
5. For­tu­nately, the media’s gen­eral high regard for Mr. Obama, and their desire to help him suc­ceed dur­ing the new administration’s hon­ey­moon period, may gen­er­ate suf­fi­cient good­will to pos­i­tively influ­ence the atti­tudes and per­cep­tions of con­sumers and investors to pre­vent the poten­tial dis­as­ter that we have been talked and erred into by said offi­cials. Ergo, in this instance, media bias may be a good thing if it influ­ences the zeit­geist towards opti­mism and away from eco­nomic devastation.

Now here’s the longer argument.

Con­cen­trated Losses

We very much enjoyed Peggy Noonan’s col­umn this week, Tur­bu­lence Ahead. Much of it deals with the lack of evi­dence for what she abbre­vi­ates as GDII, or Great Depres­sion II.

Despite the eco­nomic slow-​down this autumn and the stock mar­ket crash, we’ll take her obser­va­tions as evi­dence of a phe­nom­e­non that we have writ­ten about exten­sively: the high con­cen­tra­tion of losses in this mort­gage and finan­cial cri­sis com­pared to ear­lier ones. Please con­tinue to ignore the “domes­tic” auto man­u­fac­turer (as most of you have through the many years of buy­ing “for­eign” cars that were made in other coun­tries and in our coun­try). The out­sized pub­lic­ity that the indus­try receives about its prob­lems far over­state its value to the econ­omy. More­over, bank­ruptcy does not imply liq­ui­da­tion; so, there is no rea­son to think that at least two of the three will not survive.[1. Smart Japan­ese or Ger­man man­u­fac­tur­ers might wish to con­sider mov­ing their head­quar­ters to the U.S.A., and becom­ing a lead­ing domes­tic man­u­fac­turer. Think of the good­will such an act would engen­der, includ­ing the invalu­able free publicity.]

While not directly related to this post, Ms. Noo­nan spec­u­lates about the nature of GDII, and her com­ments are wise and con­sis­tent with our obser­va­tions liv­ing in a rel­a­tively depressed region of the coun­try: West­ern Penn­syl­va­nia, dur­ing and after the col­lapse of the steel indus­try. She talks about the grad­ual, almost imper­cep­ti­ble changes that may take years to real­ize. Those who spent their lives here were/​are much less sen­si­tive to the change, whereas hav­ing spent a decade away, we noticed the gen­eral unkempt shab­bi­ness imme­di­ately upon return; one can con­tinue to see it in the peel­ing paint and dirty facades of many small businesses.

Epic Gov­ern­men­tal Mismanagement

See most of what we wrote about the cri­sis since Sep­tem­ber although we might have crit­i­cized Mr. Paul­son before that. This morn­ing, in More Evi­dence of the Lack of Fore­thought that is TARP we sum­ma­rized our crit­i­cism of cer­tain aspects of the government’s response: the words and actions of elected and appointed offi­cials have been extremely dam­ag­ing and their efforts often coun­ter­pro­duc­tive at best.

As we wrote sev­eral months ago, no sin­gle firm could destroy our econ­omy. Such an out­come can only be achieved through gov­ern­ment action.

Like Ms. Noo­nan, we’ve really not seen any panic among con­sumer – whether they are fam­ily, friends, acquain­tances or strangers at the mall. How­ever, the government’s response to the cri­sis has the con­tin­ued poten­tial to (con­tinue to) harm the nation’s eco­nomic psy­che and make bad times worse.

When Will We See the Bottom?

We had a con­ver­sa­tion with friend ear­lier in the week who was much con­cerned about the future (who’s not?). He won­dered if equity mar­kets had reached their nadir and had cited some anec­do­tal evi­dence sug­gest­ing that his acquain­tances were inter­nal­iz­ing their sub­stan­tial loss of wealth. They were not par­a­lyzed with fear but had sur­veyed the eco­nomic envi­ron­ment and their own weak­ened finan­cial con­di­tion and were get­ting on with life.

The Poten­tial Ben­e­fit of Media Bias

Clearly, words do mat­ter, and the media can frame and empha­size issues and perspectives. Directly and indi­rectly those words affect the behav­ior of cit­i­zens, con­sumers, investors, and entrepreneurs. 

If the mass-media’s desires to aid Mr. Obama pos­i­tively affect per­cep­tions and improves the gen­eral eco­nomic out­look of the nation (and there­fore the world), then the prob­a­bil­ity of escap­ing truly dev­as­tat­ing eco­nomic con­di­tions improves.

In that and many other respects, we cer­tainly hope the best for Mr. Obama.¹

So, start­ing today and con­tin­u­ing for a few months, we’re all for left-​wing media bias.

Of course, we ask Obama? BWAMA?

This post greatly expands upon a com­ment we made about reg­u­la­tion in Even A Per­fect Bailout Will Fail and pos­si­bly elsewhere.

Reg­u­la­tors as wise monkeys.

Today’s The Wall Street Jour­nal has an arti­cle enti­tled, Bank Exam­in­ers Are Told to Step Up Sanc­tions on Lenders.

The first sen­tence of the arti­cle says it all: “The U.S. government’s armies of bank exam­in­ers have been ordered to be more aggres­sive in apply­ing for­mal sanc­tions to finan­cial insti­tu­tions when prob­lems are found.”

Unfor­tu­nately, order­ing does not make it so, and we doubt that it will work. We’re not mak­ing a blan­ket con­dem­na­tion here, but we’d be inter­ested in know­ing if and how the gov­ern­ment deals with the incen­tive prob­lems that we address below.

Unless the Fed, the OCC, and the OTS imme­di­ately trans­fer and reas­sign exam­in­ers, we doubt that many new issues will be found. Fur­ther­more, if such issues are dis­cov­ered, we doubt that those issues will be reported. (In this post, we’ll call such bank-​related prob­lems “issues,” and reserve the word “prob­lem” for the dys­func­tional incen­tives that may exist within the reg­u­la­tory agen­cies.) Of course, there are many obvi­ous issues that can be noticed with­out for­mal exam­i­na­tions and investigations.

Incen­tive Problems

There are, in fact, a cou­ple of related incen­tive prob­lems worth men­tion­ing. (1) Many exam­in­ers spend many years exam­in­ing only one firm. At large insti­tu­tions, the exam­iner is usu­ally located on the bank’s premises – pos­si­bly shar­ing office space, e-​mail sys­tems, and din­ing room priv­i­leges with bank employ­ees and managers. (2) Many exam­in­ers seek (and gain) employ­ment with the same finan­cial insti­tu­tion that they pre­vi­ously examined.

We’ll briefly address the sec­ond issue first by ask­ing: what incen­tive does an exam­iner have to take a “hard-​line” by ques­tion­ing the value of assets or cap­i­tal reserved if it may infu­ri­ate or alien­ate a poten­tial employer? (We’ll return to this issue at the end of the post, too.)

The elim­i­na­tion of the prospect of future employ­ment, however, does not elim­i­nate the incen­tive prob­lem for long-​time exam­in­ers. For rep­u­ta­tional rea­sons, they may still lack the moti­va­tion to closely scru­ti­nize and report issues.

Now, clearly some degree of famil­iar­ity is ben­e­fi­cial when exam­in­ing or audit­ing insti­tu­tions because that knowl­edge reduces the set-​up and oper­at­ing costs of per­form­ing the exam­i­na­tion: port­fo­lios, sys­tems, and key per­son­nel are all known by the repeat exam­iner. In addi­tion, it becomes quite expen­sive for the gov­ern­ment to move exam­in­ers and quite dis­rup­tive for exam­in­ers and their fam­i­lies to be peri­od­i­cally relo­cated to dif­fer­ent insti­tu­tions in pos­si­bly dif­fer­ent regions of the coun­try (or to travel extensively).

It is the case that cer­tain higher-​level man­agers are rotated, but that seems insuf­fi­cient to ensure that lower-​level work­ers will nec­es­sar­ily report issues of which they know. More­over, who is more likely to dis­cover (or be infor­mally informed of) such issues?

Sunk Cost Fallacy

Our long-​time exam­iner incen­tive prob­lem is sim­i­lar to the sunk cost fal­lacy that has been exten­sively stud­ied by econ­o­mists – includ­ing infor­ma­tion econ­o­mists – who address the question: why do man­agers keep invest­ing in (seem­ingly obvi­ous) los­ing projects?[1. There are other expla­na­tions, too. For exam­ple, we like this quote by Father Joseph Holzner, author of Paul of Tar­sus,: “When a man feels the bur­den of guilt on his soul, he tries hard to jus­tify him­self before his own con­science and before oth­ers by increas­ing his false zeal, and thus he sinks yet deeper into evil.”] 

There is an option-​value expla­na­tion that if (exoge­nous) cir­cum­stances change, the poorly-​performing project may become valu­able; so, it is worth the cost to main­tain that flex­i­bil­ity (and pay the equiv­a­lent of an option pre­mium). That expla­na­tion makes the deci­sion to invest to be very much like insurance.

The infor­ma­tion story is dif­fer­ent and involves adverse selec­tion and reputation. A man­ager who made or who sup­ported the ini­tial invest­ment may feel that his rep­u­ta­tion is at stake and his judg­ment may be ques­tioned by admit­ting that a project that they had picked as a win­ner was actu­ally a loser (and so oth­ers may infer that the said man­ager is a loser, too.)

How It Relates to Regulation

Most bank activ­i­ties are long-​lived – because they are or because they are like invest­ments. Thus, for dubi­ous ongo­ing ven­tures, the exam­iner must decide whether or not to crit­i­cize or men­tion them.

Imag­ine a multi-​year ven­ture, activ­ity, or invest­ment that the exam­iner has not men­tioned or crit­i­cized in pre­vi­ous years. Gen­er­ally, it would be highly unlikely that there were no warn­ing signs in prior peri­ods, espe­cially if the examiner’s supe­rior were gifted with per­fect, ²⁰⁄₂₀ hind­sight, which is quite easy to pos­sess (and requires much dis­ci­pline to control).

In that case, we could imag­ine the undis­ci­plined supe­rior ques­tion­ing the examiner’s past per­for­mance: “did you miss it because you are incom­pe­tent or did you catch it and fail to men­tion it because you are duplic­i­tous?” (Here is an essay on Strate­gic Con­sis­tency and Man­age­r­ial Dis­ci­pline.) It seems that any exam­iner with any bit of fore­sight could also make this inference.

Thus, it may be in the ratio­nal – though not con­sci­en­tious – examiner’s best inter­ests to act as a trin­ity of wise mon­keys and sup­press his pri­vate infor­ma­tion and discoveries.

Empir­i­cally and as a tax payer, we do believe it is fair to ask: how many exam­in­ers or final­ized exam­i­na­tion reports warned about any of the prob­lems that we are now expe­ri­enc­ing? How many of those unre­ported mortgage-​related issues arose only in 2008 or the lat­ter half of 2008? In that respect, the reg­u­la­tory agen­cies seem much like the government-​regulated credit agen­cies with their over-​optimistic scenarios.

We can’t hypoth­e­size all of the blame lower-​level work­ers. There are cer­tainly con­sci­en­tious exam­in­ers who may or may have men­tioned issues. Given our quite skep­ti­cal view of the (fallen) nature of man, it is quite easy to believe that in some cases their warn­ings were sup­pressed by their supe­ri­ors, who despite rota­tion, may be have attempted to main­tain good feel­ings with their sub­ject banks in their desire for a well-​paying cor­po­rate job.

Reg­u­la­tion as a Crutch (Causes Atrophy)

We’ll have more to say about the dele­te­ri­ous effects of reg­u­la­tion. We’re for­mu­lat­ing a post about the false sense of secu­rity that risk man­agers may pos­sess after they sat­isfy the ques­tions of (seem­ingly simian, albeit intel­li­gent simian) reg­u­la­tors. In other words, there is no rea­son to believe that pass­ing reg­u­la­tory hur­dles alone is equiv­a­lent to effec­tive risk or uncer­tainty management.

The Wall Street Jour­nal today, Novem­ber 28, reports Res­cue Plan Strained by Lack of Staff.

We’ve crit­i­cized the government’s response to both the domes­tic mort­gage cri­sis and the larger global con­fi­dence cri­sis since it – that which became TARP – was first pro­posed. (We use the sin­gu­lar “it” because we’ve not heard any gov­ern­ment offi­cial decou­ple the prob­lems either in their ini­tial panic or in the inter­ven­ing months.)

Since mid-​September, other than times when we were too busy to write, our crit­i­cism as been con­sis­tent, harsh, and steady: (1) ini­tially the gov­ern­ment offi­cials, led by Trea­sury Sec­re­tary Henry Paul­son, over­re­acted. That hys­te­ria – or maybe it was (indistinguishable) hyperbole – exac­er­bated the sit­u­a­tion and cre­ated real panic and extremely high volatil­ity, which remains. (2) Their solu­tion – which, as Trea­sury offi­cials now implic­itly admit did not meet the def­i­n­i­tion of a plan – was poorly con­structed and des­tined to fail. And (3) as we wrote nearly two months ago, in Even A Per­fect Bailout Will Fail, “What Hope of Suc­cess with Typ­i­cal Bureau­cratic Efficiency?”

The arti­cle cited above pro­vides evi­dence of that “Bureau­cratic Effi­ciency,” by which of course we meant inef­fi­ciency. (We should have included “inef­fec­tive­ness,” too, but it seemed like overkill at the time.) The key line in today’s arti­cle: “The cur­rent Trea­sury has so far strug­gled to keep up with the task of hir­ing enough peo­ple to han­dle the $700 bil­lion finan­cial res­cue package…”

Would any rea­son­able per­son expect any more (or less) from a mas­sive, cen­tral­ized bureau­cracy? In that regard, is the fed­eral government’s response to this dis­as­ter or cat­a­stro­phe any dif­fer­ent than its response to Hur­ri­canes Kat­rina and Ike? (Ike has escaped national atten­tion due to the more destruc­tive finan­cial cri­sis and the recent Pres­i­den­tial election.) 

Thus, our gov­ern­ment seems to be unable to deal with either large-​scale nat­ural or man-​made dis­as­ters. How­ever, while Michael Brown, the Direc­tor of FEMA at the time of Kat­rina, could never be blamed for caus­ing Kat­rina, can the same be said of Mr. Bush’s finan­cial appointees in the cur­rent crisis?

In today’s (Novem­ber 26) edi­tion of The Wall Street Jour­nal, there is a Deal Jour­nal arti­cle enti­tled, “Paul­son Plan: ‘Truly Idiotic.’”

Although we’ve not gone that far in describ­ing TARP et al, we’ve been harshly crit­i­cal of Mr. Paul­son. In fact, we’ve men­tioned that his series of actions don’t seem to con­sti­tute an actual plan, because the word “plan” implies a cer­tain degree of, well, plan­ning or fore­sight and forethought, and those pre­req­ui­sites seemed absent in his Panic of ’08.

The quoted accuser in the Deal Jour­nal arti­cle is Charles Calomiris, a prof at Colum­bia, and he make sev­eral good points, includ­ing “we’re using half-​measures designed in an inap­pro­pri­ate way,” and “The prob­lem is the com­pletely opaque dis­tri­b­u­tion of losses because no one knows how to value these mort­gage losses.”

We’ve made sim­i­lar remarks any num­ber of times, and it is exactly those opaque joint dis­tri­b­u­tions of cash flows (and there­fore losses) that cause all the trou­ble and makes the pools impos­si­ble to value with any degree of precision.

While we do agree with his crit­i­cism, we don’t agree with his rec­om­men­da­tions. Pri­mar­ily his sug­ges­tion that “the gov­ern­ment offer to buy any mort­gage for 40 cents on the dollar.”

It is unclear how the 40% solu­tion is derived, and think­ing in terms of Akerlof’s Lemons Model, you can be sure that only one type of mort­gage would be offered: one with a value between zero and 40% of face value.¹ Thus, if the gov­ern­ment com­mits to pur­chase any mort­gage, it would cer­tain over-​pay, and thus sub­si­dize the worst cases, and if the gov­ern­ment does not com­mit, then it is likely the mech­a­nism would fail with few or any trans­ac­tions. (The dif­fi­culty of valu­ing the mort­gages does com­pli­cate mat­ters as does their cur­rent book value.)

Why not try a pri­vate solu­tion? Why not offer mort­gage invest­ment tax cred­its or per­mit imme­di­ate and accel­er­ated amor­ti­za­tion (depre­ci­a­tion) of the pur­chase price of those mort­gages and mortgage-​related secu­ri­ties for prospec­tive buy­ers? Then set low tax rates for prospec­tive real­ized cash flows.

We’re sure that many buy­ers have some val­u­a­tion model, but likely (and jus­ti­fi­ably) do not trust it. Giv­ing a 30% — 40% tax break should pro­vide them with an ample cush­ion to take a chance. How could such a plan be any worse than a government-​administered plan, or a government-​regulated, fixed-​price one? (Remem­ber the government’s suc­cess at other attempts at price con­trols: both sup­ports and ceilings.)

By the way, folks who think this Thanks­giv­ing week’s mini-​rally sig­ni­fies that the worst is over are likely to be sadly mis­taken. We do hope that we’re wrong, but doubt it.

Noth­ing has solved the over­whelm­ing prob­lem that the mar­kets do not trust the large finan­cial inter­me­di­aries, and those banks do not trust each other. The mort­gage cri­sis informed about the banks’ short­com­ings; so, solv­ing that mort­gage cri­sis won’t cause any­one to believe that the bank’s judg­ment has improved – at least for quite some time. In that respect, Mr. Calomiris is quite right. Mr. Paul­son has done noth­ing to help.

Thank god we live in a coun­try that can with­stand such epic mis­man­age­ment. What was the total $7.5 trillion?

(New read­ers can search the archives from the past sev­eral months to find many related articles.)

This year – the found­ing year of our var­i­ous inde­pen­dent ven­tures – we are espe­cially grate­ful for all that we have and have experienced.

So, we wish a Happy Thanks­giv­ing to our fam­ily, friends, clients, and acquain­tances (and even to our detrac­tors and ene­mies, who unknow­ingly have pro­vided truly invalu­able assis­tance to us.)

How­ever, we can’t offer Thanks­giv­ing wishes with­out men­tion­ing an excel­lent col­umn that appeared in The Wall Street Jour­nal three years ago this week. It was an excerpt of His­tory of Plimoth Plan­ta­tion, which was writ­ten by colony’s gov­er­nor, William Bradford.

The jour­nal col­umn was enti­tled, How the Pil­grims Made Progress, and as you can see from the hyper­link, it is still freely avail­able on-​line at www​.Opin​ion​Jour​nal​.com. (The entire Ply­mouth his­tory seems to be avail­able at http://​www​.swarth​more​.edu/​S​o​c​S​c​i​/​b​d​o​r​s​e​y​1​/​4​1​d​o​c​s​/​1​4​-​b​r​a​.​h​tml.)

Brad­ford has a short, but fas­ci­nat­ing, account of the Pil­grims’ inabil­ity to gen­er­ate a boun­ti­ful har­vest for the first two years of their colo­nial adventure.

Mr. Brad­ford attrib­uted that fail­ure to the colony’s ini­tial col­lec­tivist men­tal­ity and the shar­ing of prop­erty, effort, and output.

At roughly the same time that Plymouth’s exper­i­ment was pro­vid­ing empir­i­cal evi­dence of the fail­ure of collectivism, the Late Scholas­tic Econ­o­mists – fol­low­ing the tra­di­tion of Saint Thomas Aquinas – were dis­cred­it­ing it the­o­ret­i­cally.¹

The Scholas­tic argu­ment was short but sweet: sup­pose there are two types of peo­ple in the world: good and evil.² It involved two questions.

In a col­lec­tivist soci­ety, who will do the work, i.e., take pro­duc­tive effort on behalf of the com­mon weal? The good or the evil?

In a col­lec­tivist soci­ety, who will attempt to take more than their share of the col­lec­tive out­put? (Sup­pose it is some crop stored in a silo or barn?) The good or the evil?

Thus, on both ends – pro­duc­tion and con­sump­tion – col­lec­tivism sub­si­dizes evil, and that’s not a good thing.

The failed boards and man­age­ments of sev­eral of our largest finan­cial firms are not evil – merely incom­pe­tent and out-​of-​their-​element. (Mr. Paul­son fits seam­lessly with that crowd.)

As we’ve writ­ten exten­sively, we see no rea­son why the masses – nei­ther entirely good nor entirely evil – should sub­si­dize the mis­takes of our pri­vate and pub­lic pol­icy mak­ers. Like Ply­mouth, and with­out reform, it can only lead to the reduced wel­fare expe­ri­enced by Ply­mouth; the for­mer Soviet Union; Cuba; China prior to its loos­en­ing of eco­nomic free­dom; the UK before Thatcher; Poland; etc, etc. 

So among the many things that we are thank­ful for this year, we do thank God that we live in a coun­try where we can freely and harshly crit­i­cize our elected and appointed offi­cials. That is not the case in much of the world: whether mea­sured by pop­u­la­tion or land mass. (So we pray for indi­vid­u­als in those coun­tries that they may one day live in the same free­dom that we enjoy.)

Copy­right © 2008 Spero Consulting.

Bill’s and Bill’s, Bill’s and Bill’s
It’s bailout time, for the Citi
Plead-​a-​ling, hear them sing
To-day, it is our bail-​out day!

Citi side­ways, Wall Street side­ways
Dressed in bank hol-​i-​day style
In the air there’s a feel­ing of Christ­mas
Bankers laugh­ing, taxes pass­ing
Wast­ing pile after pile
And on every street cor­ner you’ll hear…

Trill’s and Trill’s, Trill’s and Trill’s
It’s Christ­mas time for the Citi
Plead-​a-​ling, hear them all sing
“We want our own bail-​out day!”

*With all due respect and apolo­gies to Ray Evans and Jay Liv­ingston and their clas­sic, Sil­ver Bells, and for the truly clue­less, note that we’re abbre­vi­at­ing bil­lions and tril­lions to fit the tune.

Update: Well this post is already obso­lete, but we stand by our crit­i­cism. We tax pay­ers should not sub­si­dize Cit­i­group shareholders.

Tonight (Novem­ber 23), The Wall Street Jour­nal reports in Bailout Talks Accel­er­ate for Ail­ing Cit­i­group that the gov­ern­ment is nego­ti­at­ing to be the resid­ual claimant of a sep­a­rate entity that would house Citigroup’s worst assets and deriv­a­tive bets.

Cit­i­group could lose up to $50,000,000,000, and then the gov­ern­ment would absorb the losses. It is kind of like buy­ing flood or hur­ri­cane insur­ance after the flood or hur­ri­cane. (Seems kind of silly and like a mas­sive sub­si­diza­tion of a lot of bad decisions.)

If that’s the case, wouldn’t that guar­an­tee make tax pay­ers the resid­ual claimants of the entire entity?

Let’s rephrase our ques­tion in another way: in nego­ti­a­tions between (1) inter­ested and profit-​motivated Cit­i­group bankers and (2) less inter­ested gov­ern­ment appointees and fed­eral civil ser­vants with no claims on the assets, does the reader believe the expected losses – or, pos­si­bly the privately-​known, undocumented, extant losses– will be greater or less than $50,000,000,000?

So, shouldn’t the tax pay­ers own the entire entity?

Unfor­tu­nately, it’s not clear whether the gov­ern­ment will get any equity share of the “good” bank.

Now the reader might argue that it would be dif­fi­cult to lose $50,000,000,000 on $2,000,000,000,000 (that’s tril­lion) of assets; so, there’s really not much sub­si­dizin’ goin’ on.

First, if that were the case, then there really wouldn’t be any need for a sub­sidy would there?

Sec­ond, it turns out that the $2,000,000,000,000 is a bit on the low side. Cit­i­group has more than $3,000,000,000,000 of assets when its off-​balance sheet assets are included.

By the way, that increase of a $1,000,000,000,000? The arti­cle men­tions that $667,000,000 of it are in mortgage-​related secu­ri­ties. (They’re prob­a­bly of the high­est cal­iber because, you know, every­one tries to hide their most valu­able assets in off-​balance sheet accounts.)

We love the sen­tence: “Cit­i­group has tried repeat­edly to rid itself of its expo­sure to those assets.” Do ya think?

We start­ing a new con­ven­tion of writ­ing all the trail­ing zeroes. We think it com­mu­ni­cates the size of the stakes more clearly. Things like three-​digit “bil­lions” and one-​digit “tril­lions” are so abstract, but nine or twelve zeroes mean some­thing. We do wish that the bureau­crats within the gov­ern­ment and with firms would start­ing fol­low­ing suit.

As we wrote on Fri­day, if US tax pay­ers are sup­posed to cover the down­side, they should get the upside, too. This isn’t like deposit insur­ance, where there was a prior con­tract and exchange of pre­mi­ums for pro­tec­tion. This is the sub­si­diza­tion of mistakes.

Guar­an­tee­ing the bad bank is bad indus­trial pol­icy, and it would accel­er­ate mas­sive merg­ers (in attempts to become too big too fail) and exac­er­bate moral haz­ard as there would be no down­side to failure.

We say: Nation­al­ize Citi. Wipe out the own­er­ship inter­est of all exist­ing share­hold­ers, except non-​executive employ­ees with restricted stock, and let them retain the same own­er­ship inter­est in a new entity when it is privatized.

Do it as a les­son to other banks to find cre­ative ways to improve the cred­it­wor­thi­ness of their indi­vid­ual insti­tu­tions. That’s prefer­able to pledg­ing much of our nation’s cur­rent and future wealth to a small sub­set of its cit­i­zens, who hap­pened to own bank stocks in 2008.

With­out try­ing to be melo­dra­matic, we ask: who’s chil­dren and grand­chil­dren should pay for and sub­si­dize Citi’s errors?

Note: We’ll likely expand and edit this post in the morn­ing, but wanted to cir­cu­late the idea before bedtime.

We’re rather dili­gent – but not obsessed– about keep­ing up with finan­cial new.¹ We’ve heard many finan­cial firms announce lay-​offs and have read how at a few, like Gold­man, senior man­agers have decided to forgo bonuses.

As we recall, most banks have announced with­drawals from sub­prime mort­gage orig­i­na­tion and loans, which seems like a wise move, but given the mag­ni­tude of their errors and mis­takes, we’re very sur­prised that we haven’t read more about banks tak­ing dra­matic and dras­tic actions to limit risks and exposures.

We don’t mean hoard­ing cash and the knee-​jerk reac­tions not to lend. We’re think­ing more about their invest­ing, trad­ing, and struc­tur­ing operations.

Maybe the banks are elim­i­nat­ing desks and floors, but they just aren’t talk­ing about it, or maybe they have men­tioned it, but we’ve missed it.

We’d cer­tainly encour­age finan­cial firms to change their ways. In fact, while we’re close to Lib­er­tar­ian on many eco­nomic issues, we wrote on Octo­ber 11, to Elim­i­nate Pro­pri­etary Trad­ing at Insured Insti­tu­tions as a way to mit­i­gate moral haz­ard and pro­tect tax-​payer interests. (Once they’re insured, it is no longer a free mar­ket, and there should be quid pro quo, not just subsidization.)

On Sep­tem­ber 24, in our post Could a “Bailout” Pro­long the Finan­cial Cri­sis?, we wrote:

So, if the government’s pur­chase of these thin­gies is approved, we would expect to see a con­tin­u­a­tion of the pan­icky behav­ior until the secu­ri­ties are actu­ally trans­ferred to the gov­ern­ment because it is unlikely that any­one will know who has the worse ones so (means that) all remain sus­pect. (Also note that the most pan­icky firms might be ones who are pro­ject­ing their port­fo­lios onto oth­ers, and so might be the ones that other firms would like to avoid.)

Now that the TA is out of TARP, it seems that this week’s equity mar­ket per­for­mance, par­tic­u­larly among finan­cial firms, sup­ports our Sep­tem­ber 24^th pre­dic­tion above, i.e., the con­tin­u­a­tion of pan­icky behav­ior until actual trans­fers occur. We dis­cussed related issues on Octo­ber 7, in Even A Per­fect Bailout Will Fail.

Or maybe they’re just tak­ing a wait-​and-​see approach. That’s what we pre­dicted in early Octo­ber when we described the very high prob­a­bil­ity of fail­ure of TARP.

Today’s Wall Street Jour­nal reports that Citi Weighs Its Options, Includ­ing Firm’s Sale, and we won­der if it will sur­vive the weekend.

As we argued in Big­ger Is Not Nec­es­sar­ily Bet­ter way back in Sep­tem­ber, we see no rea­son to encour­age mega-​mergers and we based that argu­ment on both moral haz­ard and sys­tem­ati­za­tion of idio­syn­cratic risk considerations.

So, as we argued in around Octo­ber 10, we believe that It’s Time! to nation­al­ize the worst offend­ers leav­ing no share­hold­ers, except non-​executive employ­ees, with any own­er­ship inter­ests. We reit­er­ated much of the same argu­ment in a very long post from Wednes­day: OMG, Mr. Paul­son Agreed with Us Twice in One Week! (Yeah, we have a teenager.)

It seems that given its size of around $2,000,000,000,000, we tax­pay­ers will be on the hook for Citi, any­ways, so why not elim­i­nate the mid­dle­man and pro­vide any upside ben­e­fit to the true resid­ual claimants?

In two recent posts, The Fail­ure of Boards to Direct and When the Going Gets Tough…Quit, we’ve crit­i­cized the com­po­si­tion of Citigroup’s board because of their gen­eral lack of finan­cial indus­try expe­ri­ence. (We’re sorry, but that seems uncon­scionable to us.)

We won’t repeat all of our argu­ments for nation­al­iza­tion, but the expro­pri­a­tion of Cit­i­group would cer­tainly moti­vate other banks to act quickly and largely to mit­i­gate risks and sta­bi­lize cash flows. (It would likely stop insur­ance com­pa­nies and oth­ers from buy­ing small banks or S&Ls in their beg­garly attempts to become bank hold­ing companies.)

By the way, for new read­ers, we’re not just for the nation­al­iza­tion of a few banks, we actu­ally have a pri­vate solu­tion for the mort­gage cri­sis that involves pro­vid­ing the right tax incen­tives – like invest­ment tax cred­its – to indi­vid­u­als, firms, and fund man­agers. (Read about it here: A Bet­ter Solu­tion (than a gov­ern­ment takeover).)

That solu­tion to the mort­gage cri­sis stills leaves the larger liq­uid­ity or con­fi­dence cri­sis for banks. That has arisen because the mort­gage cri­sis has informed us (and oth­ers) that despite their pseudo-​sophistication and the veneer of objec­tiv­ity and sci­ence (almost), there is a very good chance that they don’t under­stand their envi­ron­ment or have reli­able ways to value many of their prod­ucts – despite their mas­sive invest­ments and activ­i­ties for those pur­poses. In terms of an adverse selec­tion prob­lem, they’ve reveal them­selves to be low types. (See last week’s Global Warm­ing and the Mort­gage Cri­sis for a dis­cus­sion on that topic.)

So, as a nation, we should want (and attempt to moti­vate) the banks to act quickly and deci­sively (and with their pri­vate infor­ma­tion) to get their accounts in order.

The ben­e­fits of TARP don’t seem to have pro­vided the cor­rect moti­va­tion to the bank­ing firms to act to main­tain their own liq­uid­ity and cap­i­tal posi­tions. We’d argue that this is an incen­tive prob­lem and that if the ben­e­fit of the TARP “car­rots” have been insuf­fi­cient moti­vate socially-​optimal behavior. So, per­haps a “stick,” like the threat of expro­pri­a­tion, induce clean-​up. More­over, it is seems that Citi will be ours any­way, so, why not give it a try on tax­pay­ers’ terms rather than tax­pay­ers’ backs?

We very much enjoyed the arti­cle, As Firms Floun­der, Direc­tors Quit, in today’s (Novem­ber 21) Wall Street Jour­nal.

The title com­pletely sum­ma­rizes the con­tent: as many firms have faced finan­cial dif­fi­cul­ties, out­side direc­tors have quit because they’re “too busy” to direct the firm that they agreed to help direct before it was in such dire trouble.

A week ago Thurs­day, we wrote The Fail­ure of Boards to Direct in response to a dif­fer­ent WSJ arti­cle about Cit­i­group. We con­sider the key line of the arti­cle to be an off-​hand ref­er­ence to the fact Richard Par­sons was “one of the few Cit­i­group direc­tors with expe­ri­ence in financial services.”

One of the few! $2 tril­lion – that’s $2,000,000,000,000 – of assets and a mar­ket value of $25 bil­lion. Despite the ben­e­fi­cial gov­ern­ment sub­si­dies and guar­an­tees of many lia­bil­i­ties, that mar­ket value is barely over one per­cent of the assets at work.

So we ask: do you think that there is a rela­tion­ship between a(n at least par­tially) unqual­i­fied board of direc­tors and the prob­a­bil­ity of fac­ing finan­cial dif­fi­culty – if not out­right ruin – par­tic­u­larly dur­ing a global crisis?

If not, why not?

We do note, how­ever, if this cur­rent dis­com­fort demo­ti­vates dilet­tantes from serv­ing on other boards in the future, then maybe some good will come out of the crisis.

If It Is Much Ado About Noth­ing, Then It Is an Indict­ment of Congress.

Since we wrote CMBS Is Like Lumpy MBS and That’s Not Good on Wednes­day, AAA CMBX spreads have increased another 300 basis points to a level about ten times greater than where they started the year.

That means that there has been either a large increase in the num­ber of buy­ers of the insur­ance or a decrease in the num­ber of sell­ers (or both), and that could be due to panic or not.

Unfor­tu­nately, unless one is exposed (in the same pro­por­tions) to the CMBS that com­prise the index or the loans to the same under­ly­ing firms, then pur­chases of CMBX are more sledge than hedge. (See On N’edges and Sl’edges and Bil­lions Lost and On Nedges and Sledges and Paving the Road to Hell.)

With sledges it is quite pos­si­ble to lose on both legs. (It’s kind of like buy­ing fire insur­ance on another’s house when you can’t buy it on your own. It may be valu­able in a wide­spread for­est fire, but it won’t pro­vide any value if you burn down the house with a cig­a­rette ash and that causes the pre­mium on the other house to rise.)

When we see the type of panic observed this week, it makes us won­der whether CMBX buy­ers are mak­ing infer­ences based upon infor­ma­tion about oth­ers or whether they’re pro­ject­ing their own prob­lems on oth­ers. We wrote about that on Octo­ber 1^st, when we defined “finan­cial pro­jec­tion in a cri­sis” (with respect to LIBOR) as:

a bank’s deter­mi­na­tion not to lend overnight to a peer because of the sus­pi­cion that the peer’s via­bil­ity (or bal­ance sheet or asset qual­ity or future prospects) is sim­i­lar to its own.

If these recent extreme increases are anal­o­gous to our pithy and tongue-​in-​cheek def­i­n­i­tion of finan­cial pro­jec­tion, then it seems that prospec­tive losses related to com­mer­cial real-​estate will be enormous.

That con­clu­sion makes us won­der: what are the odds that banks would give res­i­den­tial mort­gages to (almost) any­one but wouldn’t do the same for com­mer­cial mort­gages? It is pos­si­ble; so, we don’t con­sider to be a rhetor­i­cal question.

If they were just as reck­less, then God help us all.

If they weren’t, and it turns out that they were far more pru­dent mak­ing com­mer­cial loans than res­i­den­tial, then that is a fur­ther and com­plete indict­ment of the sense­less and destruc­tive med­dling of Con­gress in our econ­omy (via Fan­nie and Freddie).

This is one time we’d pre­fer it to be a case of record-​breaking Con­gres­sional incompetence.

& eBay’s Asym­met­ric Infor­ma­tion Problem.

We’ll actu­ally tackle those top­ics in reverse order.

The older princess needed a new pair of head­phones for her Zen Photo.

The Zen is a par­tic­u­larly sturdy lit­tle 20GB hard drive. It’s almost two years old and still going strong. In fact, it has sur­vived a few pair of ear­phones: the orig­i­nal pair of Sennheiser CX300s that we bought with the Zen and an almost iden­ti­cal pair of Cre­atives that came with a Dell XPS lap­top. (The ear buds that were included with the Zen were an insult to all that is decent and good in this world, but prob­a­bly wor­thy of a few of her High School Musi­cal tracks.)

Asym­met­ric Infor­ma­tion and Mar­ket Fail­ure: this time we wanted the Sennheiser CX-​500 model for her, and for awhile we debated between buy­ing the replace­ments on eBay ver­sus an online store.

We finally set­tled for an online store because there was no price point on eBay that would ensure that they were gen­uine Sennheis­ers rather than coun­ter­feits, and that’s eBay’s prob­lem where sell­ers with infe­rior goods can pre­tend to be otherwise.

The prices at online stores var­ied from about $50 to $115 although noth­ing below $60 or so was in-​stock.

The non-​auction, “buy-​it-​now” prices on eBay ranged from about $15 to $115.

We like to save money, but the prob­a­bil­ity that we’d receive gen­uine Sennheis­ers for $15 seemed very small. More­over, at that price, if they were gen­uine, the prob­a­bil­ity that they weren’t con­tra­band or weren’t stolen seemed exceed­ingly small.

As we worked our way up the price range, we couldn’t con­vince our­selves that we’d actu­ally receive gen­uine Sennheis­ers. $28? Doubt­ful. $38? Pos­si­ble for a des­per­ate seller, but it is not dif­fi­cult to fake such des­per­a­tion. $48? Start­ing to get near online store prices; so, it would seem like there was a bet­ter chance of authen­tic­ity, but if we were devi­ous, we’d offer units at one store for $15 and for $50 per unit at another. At the $50 store, we’d den­i­grate the $15 ones. (In fact, that seems to have had occurred at point in the past.)

Using that or a sim­i­lar ratio­nale, we elim­i­nated of all eBay’s offer­ings – even the ones adver­tised at Sennheiser’s MSRP.

We must admit that we didn’t actu­ally read through every sin­gle list­ing; so it is pos­si­ble that there is a seller who could have cred­i­bly sig­naled the authen­tic­ity of their mer­chan­dise to us, but we didn’t find them in allot­ted time. More­over, we weren’t clever enough to design a screen­ing device to sep­a­rate the authen­tic from the not.

So, for head­phones and sim­i­lar goods, it would seem that eBay’s elec­tronic mar­ket may fail oth­ers as it did fail us.

Of course, we’ve bought a vari­ety of goods (and types of goods) on eBay, but those have been either from large sell­ers with non-​eBay rep­u­ta­tions to pro­tect or small sell­ers with spe­cial­ized, non-​brand-​name offer­ings, and with eBay rep­u­ta­tions to pro­tect. So, rep­u­ta­tion would seem to be cru­cial. (We haven’t searched, but it is quite pos­si­ble that some­one has com­mented on this phe­nom­e­non before, and we’ll try to have more to say about it in the com­ing days, as we think about the effects of cost struc­ture and profit margin.)

Our Coun­ter­feit­ing Pre­dic­tion: even in good times, coun­ter­feit goods from the Far East are a large prob­lem for cer­tain firms, and Sennheiser’s prob­lems with head­phones are a good exam­ple of that.

We sus­pect that many coun­ter­feit units are made in the same fac­to­ries – though not nec­es­sar­ily to the same stan­dards or with the same qual­ity mate­ri­als – as authen­tic goods.

With the seem­ing inevitabil­ity of dif­fi­cult eco­nomic times in the US, which pretty much means a reduc­tion in con­sumer demand, we’d expect that many con­sumer prod­uct firms will order less from their Far East fac­to­ries. So, we could eas­ily imag­ine worse eco­nomic con­di­tions in coun­tries like China com­pared to the US.

With sub­stan­tial excess capac­ity due to that reduced demand for authen­tic goods, will the fac­tory own­ers be able to avoid the temp­ta­tion of counterfeiting?

We think it is a rhetor­i­cal ques­tion with an obvi­ous answer.

Unfor­tu­nately, in dif­fi­cult eco­nomic times, we could also eas­ily imag­ine an increased demand for such infe­rior goods.

Update (01−20−09): now that Mr. Paulson’s term as Trea­sury Sec­re­tary has ended, we must admit that the small bit of opti­mism we exhib­ited in this post was sadly and unfor­tu­nately mis­placed. It was out-​of-​character for us, but we’re a hope­ful pes­imist. He quickly reverted to his behav­ior of Sep­tem­ber and Octo­ber, and for that, the mar­kets, the nation, and the world have and will con­tinue to suffer.

We hope that his ear­lier actions haven’t caused irrepara­ble dam­age, but we’re doubtful.

This is a longish post that cov­ers sev­eral aspects of the ongo­ing finan­cial cri­sis and, for the con­ve­nience of new vis­i­tors, con­tains plenty of ref­er­ence links to ear­lier posts.

In our mind, until last week, the cur­rent Trea­sury Sec­re­tary had an incred­i­bly long and unbro­ken string of wrong deci­sions and actions. Start­ing in March if not ear­lier, and through early Novem­ber, in almost every impor­tant deci­sion, when Mr. Paul­son zigged we would have zagged, and vice versa.

Well, actu­ally, we wouldn’t have zagged or zigged as that requires effort. Instead, we hope our rhetor­i­cal flour­ish illus­trates our oppo­si­tion to many of Mr. Paulson’s deci­sions. We would have done what we have advised all along, and what Mr. Paul­son finally, finally seems to be doing: nothing.

As we advised in Sep­tem­ber, par­tic­u­larly in the posts Over­re­ac­tion and Moral Haz­ard: Now That Will Be a Cri­sis and Pub­lic Bailout? Why Rush or Do It at All? among others, we rec­om­mend Mr. Paul­son to vig­or­ously do noth­ing, and advice Mr. Obama and the next Trea­sury Sec­re­tary do the same: noth­ing or more pre­cisely, noth­ing much. 

We ital­i­cize the “much” because we con­tinue to (1) offer our pri­vate, non-​governmental solu­tion to the mort­gage cri­sis, which the gov­ern­ment has yet to address since TARP become law, and (2) offer advice on the best way to mit­i­gate the big­ger and more wor­ri­some liq­uid­ity cri­sis, and that will require a bit of aggres­sive gov­ern­ment action to moti­vate remain­ing bank man­agers to act or sell. See, we don’t think that the gov­ern­ment should act (much), but we do think that banks and share­hold­ers should.

In gen­eral, we’re strongly in favor of an eco­nomic ver­sion of the Hip­po­cratic Oath: do no harm. Thus, we advise: do very lit­tle for which there will be few unin­tended con­se­quences. (Although we do have two spe­cific rec­om­men­da­tions in mind that we’ll men­tion later.)

So lit­tle time, so many mis­takes: what’s the point?

The Treasury’s ear­lier insid­i­ous approach of get­ting the government’s many, spindly, lit­tle fin­gers on all of its Vishnu-​like arms into hun­dreds of firms will likely have no end, ever. (Our pre­dic­tion: they’ll rene­go­ti­ate rates when tax­pay­ers are sup­posed to reap the ben­e­fit of rate increases.) It was so very dis­ap­point­ing – not sur­pris­ing, but so very dis­ap­point­ing – to see our fed­eral offi­cials act in such rushed and expe­di­ent manners. 

Until last week there didn’t seem to be any thought – even an after­thought – of the havoc they were wreaking. Given shal­low­ness their depth of thought, we would have been con­vinced that Mssrs Paul­son and Bush were teenagers with Prog­e­ria had text-​messaged their inter­views and press releases.

What’s the point: when we taught decision-​making to MBAs we heav­ily empha­sized (1) know­ing the deci­sion cri­te­rion – the objec­tive func­tion – and (2) iden­ti­fy­ing rel­e­vant or incre­men­tal costs and ben­e­fits across alter­na­tive courses of action.

We saw no indi­ca­tion that our government’s lead­ers oper­ated under such a frame­work, par­tic­u­larly in Sep­tem­ber and Octo­ber of this year.

In other words, it should be very clear how to account for the fed­eral government’s deci­sions and actions. One would hope that offi­cials would have some met­ric by which they mea­sure the effect of their actions, but that seems to have been beyond them.

What were Mssrs. Bush, Paul­son, and Bernanke try­ing to accom­plish? What were (or are) the costs and ben­e­fits of their fea­si­ble alter­na­tives? Which cat­e­gories of costs and ben­e­fits seemed to have the most reli­able and firm esti­mates? What deci­sions were most sen­si­tive to under­ly­ing vari­ables and assump­tions? Which deci­sions seemed the most robust across poten­tial changes in the eco­nomic environment?

Dur­ing the both the orig­i­nal mort­gage cri­sis and the larger, ensu­ing and ongo­ing liq­uid­ity cri­sis, has the reader heard any gov­ern­ment offi­cial speak in those terms? Or, until last week, when Mr. Paul­son said, “Nyet,” were their state­ments more like: “Eek! We’ve got to do some­thing! We don’t have time to think?” Yeah, it was a rhetor­i­cal question.

As reg­u­lar read­ers know, we have very seri­ous doubts about the effec­tive­ness of var­i­ous aspects of the government’s plan – although “plan” seems to be too thought­ful and orga­nized a term to describe the government’s response to the cri­sis of 2008. Like­wise, we have even greater doubts about its effi­ciency, or the ratio of ben­e­fits to costs. (Is it not approach­ing zero?) We mean that there are at least two issues to con­sider: (1) will the government’s response ulti­mately be suc­cess­ful? Will it be effec­tive? And (2) If achieved, what will that “suc­cess” cost? Will it be efficient?

Unfor­tu­nately, so far, we’ve not heard a def­i­n­i­tion of success.

However, seven weeks after the approval of TARP, the results don’t look good. In fact, unless “suc­cess” has been defined down­ward, the results look more like fail­ure. The NASDAQ Index sits at roughly half of its twelve-​month high, and has lost as much value since the pas­sage of TARP – about 700 points – as it did in the period from its high last Decem­ber to the end of Sep­tem­ber. Like­wise, the S&P 500 has gone from about 1,524 last Decem­ber to 806 today, with 366 points of that 718 point drop occur­ing since Sep­tem­ber 30. Ditto for the DJIA: down from 13,991 last Decem­ber to today’s close three points below 8,000. It stood at 10,831 on Sep­tem­ber 30. Tril­lions and tril­lions of dol­lars of value destruc­tion – both before and after TARP.

Thus, “suc­cess” how­ever defined, seems doubt­ful. More­over, any claim of suc­cess must be tem­pered by the very heavy cost bourne by tax­pay­ers and investors. So, given those results, we’re very encour­aged by Mr. Paulson’s new­found hes­ti­tancy to act. But is the too lit­tle arriv­ing too late?

Don’t just do something. Stand there.

Given its sim­i­lar­ity to our position, we very much enjoyed the recent opin­ion essay by our for­mer Wash­ing­ton Uni­vesity col­league, Rus­sell Roberts in The Wall Street Jour­nal. It was enti­tled, “Don’t Just Do Something. Stand There.” A month after our post, Out of Their Ele­ments, and weeks after related posts like Well, This Is a Fine Mess You’ve Got­ten Us into…., Mr. Roberts makes sim­i­lar points, and he draws sim­i­lar, dis­cour­ag­ing, and almost depress­ing con­clu­sions about the future. Unfor­tu­nately, that doesn’t give us even a quan­tum of solace.

For­tu­nately, how­ever, it does seem that Mr. Paul­son may have read Mr. Roberts’ col­umn dur­ing the sec­ond week­end of November, internalized it, and vowed swift inac­tion in the tur­bu­lent finan­cial markets.

Finally: doing noth­ing! But why did it take so long?

We write that because last Tues­day, Novem­ber 11, Mr. Paul­son rebuked the automak­ers and their advo­cates seek­ing TARP funds, and news reports both last week and this week note that the Trea­sury have no plans to buy trou­bled assets or imple­ment new schemes. (Last Wednes­day, in response to the news, we wrote Tak­ing the TA out of TARP, and ungra­ciously gloated over the fact that we had cor­rectly pre­dicted the law’s inef­fec­tive­ness and poten­tial harm nearly six weeks earlier.)

Last Mon­day, the day before Mr. Paul­son denied TARP funds to the auto indus­try, we wrote Patience Please! They Just Need More Time!, which noted that the car man­u­fac­tur­ers had 35 years – that’s THIRTY-​FIVE YEARS – since the first oil cri­sis to change their ways. It seems that through the entire time – almost the life expetancy of a Russ­ian male – man­age­ment, the unions, and the deal­er­ships have been locked in an inter­minable game of “chicken” with each wait­ing for the other swerve to avoid col­li­sion and death to reap the pride­ful spoils of victory. 

While in some ways, Chicken seems like an apt metaphor, it ignores the fact that over the past 35 years, with each myopic deci­sion the spoils have become smaller and smaller – and are now almost noth­ing. In that sense, the auto indus­try seems more like a black hole where a mas­sive expanse (of warm sun­shine and fren­zied activity) has shrunken to a cold, shriv­eled, and nearly non-​existent state. Yet, its mass – or more pre­cisely, the mass of its lia­bil­i­ties – seems to warp and dis­tort nearby space as it smoth­ers and destroys every­thing within reach.

Unfor­tu­nately, the self-​destruction of a once-​vital and proud indus­try is not a game or a black­hole mil­lions of ligh years away. It col­lapse is tragic and close and the col­lat­eral dam­age of the col­lec­tive, short-​sighted self­ish­ness – mea­sured in the hun­dreds of bil­lions if not tril­lions of dol­lars and in terms of lives ruined – has been all too real. More­over, the siu­ta­tion is not interminable, but it finite, and the end is near.[1. We admit to being a bit overly harsh as it seems the ill-​advised CAFE stan­dards wouldn’t per­mit the Big Three to lever their com­pete­tive advan­tages with large cars and trucks. At one time, they did make the best large cars in the world (and we still love our Suburban.)]

So, in our mind, ignor­ing GM, Ford, and Chrysler seems to be both the effi­cient and just thing do, and we admire Mr. Paul­son for admit­ting – even if only implic­itly – that his ear­lier actions were mis­takes. Clearly, we wish that he could have been a faster learner. It might have saved all of us hun­dreds of bil­lions of dol­lars of cash and tril­lions of dol­lars of equity value.

It’s our view that The Gov­ern­ment Will Save Us! Not!. Instead, we’d pre­fer that it get out of the way and pro­vide incen­tives to pri­vate enter­prise to act autonomously. In that spirit, we still pro­pose A Bet­ter Solu­tion (than a gov­ern­ment takeover), which involves tax incen­tives for buy­ers of trou­bled assets. Those incen­tives could be imple­mented as invest­ment tax cred­its or as extremely accel­er­ated depre­ci­a­tion, and would pro­vide large (30%-40%) and imme­di­ate tax sav­ings that would cush­ion the down­side risk of uncer­tain val­u­a­tions. (The things are hard to value.)

Make an example: nationalize the worst one(s).

We’re gen­er­ally almost lib­er­tar­ian in our free mar­ket approach to eco­nom­ics, but don’t get us wrong, we con­tinue to urge the gov­ern­ment to nation­al­ize the worst cap­i­tal­ized banks: the very few, not the many. We’d much pre­fer the out­right expro­pri­a­tion of the worst offend­ers both out of a sense of jus­tice and as a warn­ing to other firms to act quickly to save them­selves rather than to wait for gov­ern­ment handouts. 

Just as importantly, with com­plete own­er­ship of a few firms, it is much more likely that there would be many calls from many par­ties, espe­cially com­peti­tors and poten­tial investors, to re-​privatize the nation­al­ized insti­tu­tions ASAP. That polit­i­cal pres­sure would prove to be very ben­e­fi­cial to reduc­ing the government’s influ­ence in finan­cial intermediation.

Imag­ine if the gov­ern­ment would have nation­al­ized AIG, would the out­come have been any worse than what we’ve seen in the past two month? Would it have been any more expen­sive than it has already been? We’d argue – and have argued – that issues with col­lat­eral, includ­ing those related to AIG’s dimin­ished credit rat­ing, would have been mit­i­gated through gov­ern­ment own­er­ship and creditworthiness.

More­over, other than non-​executive employ­ees hold­ing shares, we’d argue that none – not 10% nor 20% – of the old own­er­ship struc­ture should remain. That might induce share­hold­ers in other firms to become a bit more activist and demand stronger and more knowl­edge­able rep­re­sen­ta­tion on their boards of direc­tors. (See our recent: The Fail­ure of Boards to Direct.)

We’d pre­fer the fren­zied, moti­vated efforts of bankers seek­ing cre­ative solu­tions to their most vex­ing prob­lem over the cur­rent sce­nario where hoard­ing of funds and wait­ing seem to be the pre­ferred tac­tics. In that sense we as an econ­omy, a nation, and a soci­ety are in no bet­ter posi­tion today than we were six or seven weeks ago.

We wrote about what has and con­tin­ues to occur in Even A Per­fect Bailout Will Fail and Finan­cial Pro­jec­tion in a Cri­sis among other posts.

Unfor­tu­nately, the biggest dif­fer­ence between now and the end of Sep­tem­ber is that our col­lec­tive equity hold­ings have lost about one third of their value, and new asset classes like CMBS are likely to depre­ci­ate like MBS already has. How­ever, on the upside, it seems that Mr. Paul­son is mov­ing (or more accu­rately not mov­ing) in the right direction.

In all seri­ous­ness, we do pray that our senior gov­ern­ment offi­cials take the right, rea­soned, and thought­ful actions. We hope you’ll join us. Per­haps it’s working.

(This a long post; so, there are prob­a­bly a num­ber of typos, which we’ll cor­rect dur­ing the com­ing days.)

We were surf­ing the web this morn­ing, and found this very nice analy­sis of War­ren Buf­fet at Yahoo Finance: Down $16 Bil­lion — Has War­ren Buf­fett Lost His Touch?

It’s well-​balanced and well-​written, but the author, Simon Maier­hofer, notes that the last two months of real­ity have not been very kind to Mr. Buffett.

We’re not into hero wor­ship; so, we could never under­stand the fas­ci­na­tion with Mr. Buf­fett (or any­one else for that matter).

We under­stand that the busi­ness media focus on per­son­al­i­ties as they are much more inter­est­ing than writ­ing about finan­cial state­ments, eco­nom­ics, and sta­tis­tics but not nec­es­sar­ily inter­est­ing in an absolute sense.

We’ve often viewed the large busi­ness mag­a­zines as the cor­po­rate equiv­a­lents of Peo­ple, US, and the star-​obsessed rags. (We view it as a good thing that we don’t know their titles.) In fact, in June – a mere three months before Lehman’s bank­ruptcy – we teased The Wall Street Jour­nal for fix­at­ing on then-​CFO Erin Callan’s wardrobe rather on Lehman’s losses and risks.

Now, we much pre­fer Jimmy to War­ren and would argue that the one has been lucky, writes pithy lyrics, and can play music, and the other has been, well, lucky.

We’re not sure which of the two has been luck­ier because we’re not sure who’s hap­pier or has been more ben­e­fi­cial to soci­ety and the world. Although we’ve derived much more per­sonal sat­is­fac­tion lis­ten­ing to Jimmy than read­ing about Warren, we’re not sure which met­ric to apply to the broader population. For soci­ety as a whole, it’s impor­tant to note that Jimmy does enter­tain, but he also leaves a dis­gust­ing trail of drunken (and pos­si­bly embar­rassed) baby-​boomers wher­ever he vis­its. So, how those ben­e­fits and costs should be weighed and net­ted is unclear.

Our phi­los­o­phy about star investors has been influ­ences by admon­ish­ments of that star musi­cian and lyri­cist, Bruce Spring­steen, and that star trader-​philosopher, Nas­sim Nicholas Taleb.

Spring­steen wrote about self-​reliance in Thun­der Road, as in don’t “…waste your sum­mer pray­ing in vain for a sav­ior to rise from these streets…”

In his book Fooled By Ran­dom­ness, Taleb wrote – and we are para­phras­ing and greatly sim­pli­fy­ing – that with a large enough start­ing pop­u­la­tion of ran­dom traders, one of them is likely to be extremely lucky in the rel­a­tive long-​run. In our observed real­iza­tion of the world (in the late 20^th and early 21^st centuries), that per­son seems to be War­ren Buffett. As one should be able to deduce from Taleb’s book’s title, much of it involves dis­tin­guish­ing between luck and abil­ity and crit­i­ciz­ing those who con­fuse the two, par­tic­u­larly those who have had a mod­icum of suc­cess and attribute that suc­cess to their own innate abil­i­ties rather than Lady For­tuna. Taleb then dis­cusses how inflated (and con­flated?) egos often then “blow-up” by los­ing more in one trade or strat­egy than they made cumu­la­tively. We wish him no ill will; so, we hope Mr. Buffett’s luck holds.

But enough about the Buf­fett boys. We say, “BWAM?”

We’ve dis­cussed Com­mer­cial Mortgage-​Backed Secu­ri­ties or CMBS in a num­ber of posts. So, it’s worth men­tion­ing that spreads on AAA CMBX (CDS) increased sub­stan­tially on Tues­day. At about 550 basis points, those spreads seem to be twice as high as the pre­vi­ous all-​time high, which was reached in the late win­ter of this year, and are seven or eight times higher than on Jan­u­ary 1.

It’s much harder to say where spreads on CMBS (bonds) are since they tend not to trade. His­tor­i­cally, they didn’t trade much, and now it is even less fre­quent. In fact, in June, we had a long post, On Nedges and Sledges and Paving the Road to Hell, on the dif­fi­cul­ties of using CMBX to hedge expo­sure to CMBS. As that post men­tioned, the now-​defunct Lehman Broth­ers was one of the firms hav­ing dif­fi­culty with things that were Some­what Like Hedges.

If the reader is unsure of the notion of CMBS, know that CMBS is very much like any other mortgage-​backed secu­rity, except: (1) the num­ber of loans in the col­lat­eral pool is smaller; (2) the dol­lar value per loan is sub­stan­tially greater (into the hun­dreds of mil­lions of dol­lar); (3) the bor­row­ers tend to be much more sophis­ti­cated and have bet­ter legal rep­re­sen­ta­tion; and (4) in our opin­ion, there is more sys­tem­atic risk, which mean less diver­si­fi­ca­tion and higher lev­els of default dur­ing eco­nomic downturns.

Like almost every­one else, we’re not sure how the loss given defaults would dif­fer res­i­den­tial mort­gages, but we doubt that it would be favor­able for com­mer­cial real estate. (By the way, read­ers look­ing for an illus­tra­tion of basic MBS should see the last part of Gos­samery Argu­ments for Trans­parency and Our Reply, in which we describe it in the sim­ple terms of a spreadsheet.)

We ask: what are the odds that the hous­ing mar­ket could crash in many parts of the coun­try, res­i­den­tial mort­gages defaults would rise, the econ­omy would seem­ingly slow down, unem­ploy­ment would increase, and the stock mar­ket would decrease sub­stan­tially AND com­mer­cial real estate would not suf­fer? Yeah, when stated pre­cisely, it seems like a silly ques­tion doesn’t it. 

So, with CMBS, we’d guess that the really bad times are just beginning.

In fact, we’d spec­u­late that pro­por­tion­ally – given the dif­fer­ent sizes of the mar­kets – the bad times may be sub­stan­tially worse for com­mer­cial mort­gages than for res­i­den­tial mortgages.

For exam­ple, in CMBS Mar­ket Begins to Show Fis­sures, two writ­ers for The Wall Street Jour­nal, describe two large –$209 mil­lion and $125 mil­lion – and recent (Decem­ber, 2007 and July, 2007, respec­tively) mort­gages that are close to default and men­tion that news was the impe­tus for spreads to increase on Tuesday.

Of course, we wouldn’t be a pedant if we didn’t men­tion that sev­eral of the fac­tors men­tioned above were start­ing to be present in July, 2007, and were cer­tainly evi­dent by Decem­ber, 2007, when those two loans were made.

In that respect, and given the ongo­ing col­lapse of the CMBS new issues mar­ket, we won­der how many other bad com­mer­cial real-​estate loans cur­rently sit in banks’ con­duits. As we under­stand it, the mar­ket for new issues has been dead for quite awhile; so, many pipelines likely con­tain similarly-​aged mort­gages (that never went into CMBS pools) and now sit in the nether world of loans avail­able for sale (although no one wants to buy them). (Kind of like pur­ga­tory, but with­out hope of heaven. In this case, inside the gates of hell.)

If J.P. Mor­gan, the orig­i­na­tor of those two loans, or other large play­ers made sim­i­lar loans in expec­ta­tion of con­tin­ued good times or a quick rebound, then one should expect larger loan-​loss reserves within the next six months or so.

In fact, (1) ithout prior large and pub­lic defaults and (2) given the mag­ni­tude of losses that many banks have incurred in their other port­fo­lios and (3) given the illiq­uid nature of the com­mer­cial mort­gage mar­ket that leads to a lack of “marks,” it seems highly unlikely that banks have already aggres­sively written-​down the value of their CMBS or their inven­tory of com­mer­cial mort­gage loans. 

In that case, one could infer that they – the banks (and their conduits) – were bet­ting that mar­kets would return to nor­mal. Unfor­tu­nately, if that was the bet, and if the above-​mentioned defaults are fol­lowed by oth­ers so spread lev­els stay high, then those banks will be forced to rec­og­nize addi­tional losses at the end the fourth quar­ter and into next year. 

We’d hate to be sit­ting on a large pile of recent, unse­cu­ri­tized, com­mer­cial mort­gages. It’s likely that they’re com­post­ing. While that might improve the prospect of growth in the future, it prob­a­bly stinks now.

…And Your Mother Wears Com­bat Boots!

Back on Hal­loween we wrote that Sarah Palin’s expe­ri­ence as mayor of a small town was greatly under-​appreciated, and that lack of appre­ci­a­tion said more about her crit­ics’ inex­pe­ri­ence and lack of empa­thy than did it about her.

In fact, we related her expe­ri­ences to Henry Kissinger’s quote about acad­e­mia: the (in)fighting is so vicious pre­cisely because the stakes are so small. 

We went on to reit­er­ate that what’s true in uni­ver­si­ties is true in small towns and many other orga­ni­za­tions, as well. So, Mrs. Palin was likely very expe­ri­enced deal­ing with con­tentious, resource-​allocation deci­sions and their asso­ci­ated ani­mosi­ties, espe­cially since her expe­ri­ence included a per­sonal ele­ment, which is often absent or can be eas­ily dis­missed at the national level. 

At that broader level, there is more abstrac­tion, and one is less likely to have daily or even occa­sional con­tact with one’s foes. So, while dis­agree­ments are cer­tainly more pub­lic at the national level, such dif­fer­ences are usu­ally taken “with a grain of salt,” e.g., wit­ness the recent cor­dial meet­ing between President-​Elect Obama and Sen­a­tor McCain.

As we have men­tioned, 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. They’re vol­un­teers; so, they can’t pay for it, but they do derive ben­e­fits from it; so, substantial excess demand exists.

Hav­ing taught the pros and cons of var­i­ous cost allo­ca­tion method­olo­gies to MBAs for many years, we joke that the best evi­dence of fair treat­ment arises when every­one is dis­sat­is­fied with their allo­ca­tion. Seri­ously, much ten­sion is alle­vi­ated by (1) cre­at­ing very clear and sen­si­ble poli­cies that pri­or­i­tize usage and (2) hav­ing the dis­ci­pline to stick to those poli­cies. Addi­tional ten­sion is alle­vi­ated by deal­ing with folks who have some degree of empa­thy (for the unpaid allocator’s plight). On that dimen­sion we ben­e­fit and note that it is not the case in for-​profit organizations.

Also in that role, we hire sup­pli­ers for cer­tain ser­vices and try to diver­sify the sup­plier base to sat­isfy our organization’s goals rather than the sup­pli­ers’ wants. Except for the lower eco­nomic classes of third-​world nations, most indi­vid­u­als would con­sider these arrange­ments to be of very small dol­lar value.

Need­less to say, very much like acad­e­mia, and cer­tainly counter-​intuitive for those lack­ing small-​town expe­ri­ence, that’s exactly when the fight­ing is fiercest, and thus we were deemed “…basicly…clueless a coach…” (among other things) by the gram­mat­i­cally and spelling challenged.

Now, clearly with regards to our own expe­ri­ence, our post is some­what “tongue-​in-​cheek.” How­ever, the reader should not under­es­ti­mate the vit­riol spewed by those with a sense of enti­tle­ment when out­comes aren’t just so (to their lik­ing). In fact, we were accused of other worse things, includ­ing giv­ing more and bet­ter busi­ness to our friends. (As it turns out, we’ve never met the other suppliers.)

We write this not to “make moun­tains out of mole­hills,” but to note to the dear reader that inside both large (for-​profit) firms and non-​profit orga­ni­za­tions, on a fre­quent if not daily basis, such resource and cost allo­ca­tion deci­sions affect employ­ees and groups of employ­ees – pos­si­bly struc­tured as divi­sions, depart­ments, or busi­ness units.

As most know, within orga­ni­za­tions it is socially accept­able to express one­self as our for­mer sup­plier did; however, resource allo­ca­tors should know while they may not hear dis­cour­ag­ing words and may see the smiles on the faces of sub­or­di­nates (and oth­ers), those indi­vid­u­als may feel no dif­fer­ent than our upset acquaintance.

Whether that mat­ters depends upon the impli­ca­tions – mean­ing the costs and ben­e­fits – of induc­ing such (hid­den) ani­mos­ity as well as the resource allo­ca­tors goal. In our case, we’ll live with the stigma of being clue­less as a coach if it achieves our goals. (We’ve been called much worse.)

In that respect, within orga­ni­za­tions senior man­agers must deter­mine whether they want har­mony or prof­its as the two are not nec­es­sar­ily mutually-​achievable. In fact, mechanisms like trans­fer pric­ing pur­posely intro­duce fric­tions, ani­mos­ity, and dishar­mony into firms as a way to max­i­mize prof­its (or value if you will), and in those cases attempts to mit­i­gate the fric­tion will likely reduce long-​term prof­its (and leave one of the par­ties qui­etly seething.