Spero Consulting

Archive for November 19th, 2008

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.