Spero Consulting

Archive for November 21st, 2008

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.