Archive for November, 2008
The Seventy-Year-Old Teenager
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.
Left Wing Bias: Let’s Hope So!
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:
- Prior to the collapse of the stock market, losses were highly concentrated among financial intermediaries.
- 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.
- 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.
- 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.
- 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?
Footnotes:
- We’ll ignore the issues where we disagree like abortion, gun control, healthcare, taxes, the environment, subsidies, etc. ↩
Good Luck with that: Getting Bank Examiners to Act
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.
More Evidence of the Lack of Forethought that is TARP
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?
The Mortgage Crisis: Why Not Incentivize the Private Sector?
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.)
- We admit to making several simplifying assumptions, especially the fact that the standard Akerlof-adverse selection-market failure model is a single-period static model, and the real world tends to be multi-period (let’s hope so, at least). ↩
Happy Thanksgiving!
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.OpinionJournal.com. (The entire Plymouth history seems to be available at http://www.swarthmore.edu/SocSci/bdorsey1/41docs/14-bra.html.)
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.
Footnotes:
Bill’s and Bill’s*
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.
Citibank? Bad Bank? Good Bank? How About Our Bank?
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?
Should Citi Be Nationalized as a Warning to Others?
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 24th 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?
- “Not obsessed” means we haven’t performed a thorough web search. ↩
When the Going Gets Tough…Quit.
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.
Increases in CMBX Spreads as Evidence of “Financial Projection in a 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 1st, 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.
If You Thought Counterfeiting Was a Problem Before…
& 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.
OMG, Mr. Paulson Agreed with Us Twice in One Week!
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.)
Warren Buffett, Jimmy Buffett and Luck
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 20th and early 21st 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?”
CMBS Is Like Lumpy MBS and That’s Not Good
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.
“…Basicly (sic) I deemed you clueless as a coach…”
…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.
