Spero Consulting

Posts Tagged ‘lack of confidence in many financial intermediaries’

Her­nando de Soto has an inter­est­ing opin­ion col­umn, Toxic Assets Were Hid­den Assets, in today’s Wall Street Jour­nal.

He makes the point that we’ve been mak­ing since Sep­tem­ber: that the mort­gage débâ­cle is sep­a­rate from the liquidity/​confidence crisis.

We think that he over­states the effect of deriv­a­tives – what he calls hid­den assets – in cre­at­ing the prob­lem; how­ever, we do think that the lack of account­ing and the opac­ity of the con­tin­gent claims have exac­er­bated the liquidity/​confidence cri­sis and make more dif­fi­cult any restora­tion of con­fi­dence in large finan­cial firms. Despite the mas­sive gov­ern­ment sub­sidiaries and guar­an­tees, few investors have lit­tle faith in firms like AIG and Citicorp.

Investors, cred­i­tors, and pos­si­bly the firms them­selves, can’t answer the ques­tion: what would the firms owe to whom under which cir­cum­stances (when), and that knowl­edge seems to be a nec­es­sary con­di­tion for the restora­tion of confidence.

As we see it, the mort­gage débâ­cle helped engen­der the liq­uid­ity cri­sis because it informed investors that bank man­age­ments were far less com­pe­tent than they had pre­vi­ously thought; so, investors and cred­i­tors lost confidence.

Risk man­age­ment was lax, incen­tives were mis­aligned, and over­sight at these firms was per­func­tory at best. We have writ­ten exten­sively about these issues dur­ing the past year.)

An aside: as reg­u­lar read­ers know, we think risk man­age­ment is too nar­row of a field to cap­ture the true nature of the task at hand–uncer­tainty man­age­ment–because nei­ther the like­li­hoods nor the mag­ni­tudes of all pos­si­ble bad out­comes can be mea­sured or even iden­ti­fied. Some­one can cal­cu­late a “sta­tis­tic” from a his­tor­i­cal times series, but that doesn’t mean that the notion exists or is usable. In arith­metic, num­bers can always be added together – even if what they rep­re­sent can’t be, e.g., seven oceans and a dozen apples; ergo, our motto, “thought before calculation.”

Any­way, it was the mort­gage débâ­cle and its impli­ca­tions, com­bined with either panic (Henry Paul­son and Con­gress) or dis­in­ter­est (Pres­i­dent Bush) that cre­ated and then extended the liq­uid­ity cri­sis. (See what we wrote in late September/​early Octo­ber about the government’s reac­tion and how that would pro­long the crisis.)

Clearly, Mr. de Soto’s focus of atten­tion speaks to another fail­ure of the finan­cial report­ing sys­tem and its pro­mul­ga­tors – the SEC and FASB – par­tic­u­larly the lack of pub­lished details about con­tin­gent claim con­tracts. This isn’t a val­u­a­tion issue, it is sim­ply pub­lish­ing the nature of the con­tracts and the claims. It’s quite sim­ple (although detailed and bor­ing), and it is as much count­ing as account­ing, but that lack of detailed breadth in finan­cial reports will harm recov­ery efforts.

He offers sev­eral six sen­si­ble rec­om­men­da­tions to mit­i­gate such opac­ity prob­lems in the future. As we read them and his con­clu­sion, those six can be nar­rowed down to two (or so) basic prin­ci­ples: clear prop­erty rights and pre­cise (and valid) language.

Has any econ­omy, includ­ing this nation’s, ever long-​prospered with­out those basic prin­ci­ples? It’s a rhetor­i­cal question.

If you haven’t read it, For the Vix, 40 Looks Like It’s the New 20 in today’s The Wall Street Jour­nal please know that is a decent column.

We par­tic­u­larly like the paragraph:

“Volatil­ity may not return to its highs, but it isn’t clear when it will get back to nor­mal, either. Volatil­ity breeds fear, which breeds more volatil­ity. There is still too much uncer­tainty about the losses lurk­ing on bank bal­ance sheets and about the depth and breadth of the cur­rent reces­sion to inspire much calm.”

Now, the first sen­tence is true but says absolutely noth­ing. We’re not try­ing to ridicule Mark Gon­gloff the writer of the Ahead of the Tape column; instead, we empathize with the dif­fi­culty he faces writ­ing about mar­kets and uncertainty.

The notion of uncer­tainty about uncer­tainty–and the inabil­ity to mea­sure it in a sim­ple man­ner – tends to make state­ments about the topic either sound overly-​complex and overly-​qualified (by all of the nec­es­sary descrip­tive qual­i­fi­ca­tions to the state­ment) or makes them sound trite. Some­times that’s the writer’s fault, but often it is the reader’s fault, too, espe­cially when the reader incor­rectly pos­sess no uncer­tainty about their own “knowledge.”)

Now, we espe­cially like Mr. Gongloff’s fol­low­ing sen­tences because that’s almost exactly what we’ve writ­ten dur­ing the past sev­eral months – almost three months now.

The mort­gage cri­sis that cre­ated the con­fi­dence and liq­uid­ity cri­sis and the result­ing equity mar­ket volatil­ity all con­tin­ued unabated. Last Wednes­day, in The Mort­gage Cri­sis: Why Not Incen­tivize the Pri­vate Sec­tor? we wrote: “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.” 

While we try not to make much of one-​day changes, even when they are as large as today’s drop of 680 points in the DJIA and the nearly 9% decreases in the S&P 500 and NASDAQ indices, we do believe both the con­tin­u­ing volatil­ity and losses pro­vide evi­dence that the government’s actions to date have not helped instill con­fi­dence. In all like­li­hood have hin­dered econ­omy and finan­cial activ­i­ties by not allow­ing any res­o­lu­tion of the uncer­tainty of the value and via­bil­ity of large finan­cial intermediaries.

We wrote about that in Could a “Bailout” Pro­long the Finan­cial Cri­sis? and The Uncer­tain Value of Mort­gage Secu­ri­ties (among other posts) in late Sep­tem­ber. How­ever, the government’s exe­cu­tion and lack of plan­ning has been even worse than we could have imag­ined, and we had extremely low expec­ta­tions to begin with. 

As we have been men­tion­ing since that time, we wish fed­eral gov­ern­ment would pro­vide tax incen­tives – say, mort­gage invest­ment tax cred­its – to moti­vate pri­vate pur­chases of trou­bled assets. 

We also wish the gov­ern­ment would expro­pri­ate the worst offend­ers – the most poorly cap­i­tal­ized large banks. We know that the Trea­sury can’t run banks any bet­ter than the exist­ing man­age­ments, but that’s not one of our reasons. A main rea­son is to moti­vate other health­ier insti­tu­tions to act. Hav­ing ready buy­ers – moti­vated by such tax cred­its – would cer­tainly help those banks exchange assets for cash, and that lack of trade keeps the analy­ses of each bank’s finan­cial con­di­tional need­lessly opaque, and that’s (by def­i­n­i­tion) no way to resolve uncertainty.

We’re not sure when dur­ing the day, Mr. Paul­son spoke of new pro­grams (Paul­son Says Trea­sury Actively Mulling New Res­cue Pro­grams), but we doubt if that stemmed the (ebbing) tide of sharply decreas­ing equity val­ues. Unfor­tu­nately, there is no rea­son to expect any pos­i­tive news any time soon.

As the IMF, the G7 and the Pres­i­dent “endeavor to per­se­vere,” we have of own rec­om­men­da­tion to end the global finan­cial crisis.

We’re Not Social­ists or Statists:

We very much believe in free­dom and per­sonal responsibility; strongly pre­fer pri­vate enter­prise to gov­ern­ment ser­vices and bureau­cracy; pre­fer democ­racy – well, repub­li­can democ­racy, at least – to cen­tral­iza­tion and author­i­tar­i­an­ism (except in mat­ters of reli­gion); and pre­fer free mar­kets and cap­i­tal­ism to any of their failed alter­na­tives. We’re not lib­er­tar­ian, but on eco­nomic issues, we’re not that far away.

We’re cer­tainly not leftists.

We’ll hold our nose and vote for McCain despite his recent, wrong-​headed plan to buy bad mort­gages at face value; despite McCain-​Feingold, and despite his views on global-​warming. As we wrote in Well, This Is a Fine Mess You’ve Got­ten Us into…. if only Mr. McCain would retain a sem­blance of humil­ity that we have seen in the past. (It must be quite easy to rec­om­mend buy­ing over-​priced crap when it is not your own money, per Mr. McCain, Mr. Hub­bard, et. al.)

Morover, we don’t view the unprece­dented decreases in global equity mar­kets as a mar­ket fail­ure, nor – despite the lack of trad­ing – we do not view the near shut­down of intra-​bank credit mar­kets as a mar­ket fail­ure. We view both as evi­dence that mar­kets work and that in both cases they inform about the true under­ly­ing fail­ure: the weak­ness of our finan­cial intermediaries.

We Face Two Problems:

Nei­ther the cur­rent finan­cial cri­sis nor the mort­gage cri­sis that pre­ceded it was caused by exoge­nous vari­ables or fac­tors. The mort­gage cri­sis did not result from an earth­quake or vol­cano or tsunami or influenza or wild­fire or any other nat­ural cause. It did not result from the destruc­tion of war or any non-​financial, man-​made action. It resulted from the actions of finance indus­try employ­ees, elected rep­re­sen­ta­tives, and gov­ern­ment bureau­crats. In Saturday’s The Wall Street Jour­nal, on page A13, imme­di­ately below Peggy Noonan’s excel­lent scolding, there is a good sum­mary: The Gov­ern­ment is Con­tribut­ing to the Panic.

Before con­tin­u­ing, please notice that we sep­a­rate the mort­gage cri­sis from the cur­rent, global crisis. 

Despite our government’s obtuse­ness, these crises are indeed sep­a­rate issues. By that we mean that if the mort­gage cri­sis were solved, the banks would still face deep, deep sus­pi­cions and face fund­ing prob­lems. We think that lack of con­fi­dence would be suf­fi­cient to sus­tain the global cri­sis, which at its root is a deep dis­trust of major finan­cial inter­me­di­aries. (See Even A Per­fect Bailout Will Fail for exam­ple.) Conversely, if that sus­pi­cion were elim­i­nated, there would still be a need to deal with the epi­demic of bad loans, par­tic­u­larly in the Sun­belt. (See our pro­posal: A Bet­ter Solu­tion (than a gov­ern­ment takeover).)

The Global Prob­lem: The mort­gage cri­sis has informed investors, the pop­u­lace, and bank­ing indus­try cohorts – every­one pre­sum­ably except Messrs. Paul­son and Bernanke – that the global cri­sis stems from a lack of con­fi­dence in many of the nation’s largest, most prestigious banks.

It seems that no one has con­fi­dence in the banks’ business judg­ment, finan­cial acumen, viability, or cred­it­wor­thi­ness, includ­ing their abil­ity to repay an overnight loan, espe­cially other banks. (See Finan­cial Pro­jec­tion in a Cri­sis or most of what we’ve writ­ten recently.)

The Mort­gage Prob­lem: We’ve writ­ten exten­sively about the mort­gage cri­sis and pro­duced a sim­ple, imple­mentable, tax-​based, private-​enterprise solu­tion to THAT prob­lem: A Bet­ter Solu­tion (than a gov­ern­ment takeover). That cri­sis was not inevitable, but it was the result of bad luck com­bined with ridicu­lously flawed gov­ern­ment poli­cies and very poor cor­po­rate over­sight that turned bad luck into hor­ri­bly bad luck via incred­i­bly fast feed­back loops – among both bor­row­ers and lenders – in the hous­ing and mort­gage mar­kets. That’s as close as we’ve come to a wild­fire or any other con­ta­gious cat­a­stro­phe. (We wrote about that, too.)

As we have men­tioned fre­quently, the mortgage-​related losses were indeed con­cen­trated in the finan­cial indus­try because of its lax man­age­ment, poorly-​structured incen­tives and the resul­tant exces­sive and con­cen­trated risk-​taking. In our opin­ion, any­one who states oth­er­wise is either a liar or a fool. One can­not see the egre­giously bad mort­gages made to the undoc­u­mented and the uncred­it­wor­thy and based on the hopes of extrap­o­lated past price increases onto future house val­ues and view it as any­thing except wild bets gone bad – bets per­mit­ted by lax man­age­ment and poorly-​designed incen­tives result­ing in exces­sive and con­cen­trated risk-​taking.

So where does that leave us?

The ini­tial gov­ern­ment bailout was never designed to deal with this larger prob­lem of lost con­fi­dence. If it was, then it is a fur­ther indict­ment of the Trea­sury Sec­re­tary and the Fed Chair­man. In fact, per many of our crit­i­cisms and yesterday’s WSJ edi­to­r­ial, Gov­ern­ment Fear Itself, it doesn’t seem to have been designed for any pur­pose at all, which of course should make every­one sus­pi­cious of Mr. Paulson’s abil­i­ties. (We obvi­ously don’t agree with the Journal’s view against nation­al­iza­tion, but we think they’re miss­ing the big­ger point of not decou­pling the problems.)

Guar­an­tee­ing all deposits? How does that help pro­vide overnight fund­ing or mit­i­gate moral haz­ard or instill con­fi­dence in the decision-​making abil­ity of these (not all) bankers? We’d argue that at least a few depos­i­tors would remove their money just for the prin­ci­ple of it. (Yeah, some peo­ple still have those things.) More impor­tantly, it does not seem to solve any of the intra-​bank lend­ing problems.

Guar­an­tee all bank bor­row­ing? How does that per­mit effi­cient asset allo­ca­tion in the economy? Moreover, it also leaves the per­sons who made the prob­lem still in charge and sub­si­dizes those actors and firms at the expense of every­one else. So, it seems nei­ther effi­cient nor just. (It is expe­di­ent, which was prob­a­bly why it was rec­om­mended.) In our view the guar­an­tee would need to be inter­mi­nate, or the prob­lem would reap­pear when the guar­an­tee expired.

We’d imag­ine that based upon the mag­ni­tude of gains on many deriv­a­tive trades, espe­cially for buy­ers of credit deriv­a­tives and other spread and­ba­sis prod­ucts, the gov­ern­ment would face sub­stan­tial calls for cash as those guar­an­tees would likely quickly turn into such calls – not quite the same, but not that dif­fer­ent than AI. – especially as those instru­ments matured and settled.

No, if the gov­ern­ment is respon­si­ble for all claims on those banks, then it (we tax­pay­ers)) should directly con­trol (own) the assets. So, we say:

Fire, Close, Nation­al­ize, Fire, Reor­ga­nize, Sell

It’s not a 12-​step pro­gram, only six, but it does require the Pres­i­dent to accept the nature of the cri­sis like most 12-​step programs: “God grant us the seren­ity to accept the things we can­not change, courage to change the things we can, and wis­dom to know the difference.”

Fire: Mr. Paul­son and Mr. Bernanke were out-​of-​their-​element in the mort­gage cri­sis, let alone in this larger, more seri­ous prob­lem. The Wall Street Jour­nal edi­to­r­ial staff, pro­po­nents of the $700 bil­lion bailout, admit that Mr. Paul­son had no plan once that money was his to control. On Sat­ur­day morn­ing we lamented Where Have All the Grownups Gone? But we’ve com­plained fre­quently about the lack of thought and analy­sis regard­ing the cur­rent prob­lems and pro­posed solu­tions. (See: Prin­ci­ples Lost and More or Friday’s The Unex­am­ined Cri­sis.)

So, Mr. Bush, please stop clue­lessly talk­ing about endeav­or­ing to per­se­vere and please fire Mr. Paul­son and force Mr. Bernanke to resign.* (We don’t recall every­thing from our Money & Bank­ing class, but we believe that you do not have the author­ity to directly fire him.)

Close: Next, shut the equity mar­kets for one week. After 9/​11, the equity mar­kets were closed that Tues­day and the rest of the week, and this cur­rent cri­sis is at least as seri­ous to the nation’s eco­nomic health as ⁹⁄₁₁. (We know there were facil­ity issues, too.) While this may seem extreme, it is nec­es­sary to give investors, cred­i­tors, and bank cus­tomers the time needed under­stand the nature of true prob­lem and to inter­nal­ize our next rec­om­men­da­tion and what it means to them, i.e., renewed sta­bil­ity and restored faith in finan­cial intermediaries.

Nation­al­ize: Mr. Bush and the United States should nation­al­ize the worst banks. By “worst” we mean ones that have, say, the low­est com­bi­na­tion of (1) equity mar­ket value to total assets, (2) esti­mated unre­al­ized losses to reg­u­la­tory cap­i­tal, and (3) the com­ple­ment of Fed bor­row­ing to total assets, but we’re will­ing to take sug­ges­tions from oth­ers on the exact nature of this metric.

As we have men­tioned, we do not view the cur­rent cri­sis as a fail­ure of the mar­kets. We view it as a fail­ure of gov­ern­ment poli­cies and government-​regulated insti­tu­tions, includ­ing the gov­ern­ment spon­sored enti­ties, and heavily-​regulated banks. So our gov­ern­ment solu­tion is not designed to mit­i­gate a mar­ket prob­lem but instead to reverse prob­lems cre­ated by other gov­ern­ment errors or government-​induced errors.

In that regard, we rec­om­mend that the gov­ern­ment take 100% own­er­ship sub­ject to one caveat. Per­mit non-​executive, employee-​owners who pos­sess restricted shares to main­tain their a stake in the entity. (Over­all, it seems unlikely that other small share­hold­ers would suf­fer as much, par­tic­u­larly if the when the equity mar­kets rebound as they regain con­fi­dence in finan­cial intermediaries.)

Also note, we are not rec­om­mend­ing the nation­al­iza­tion of the entire indus­try – only the weak­est, least trusted banks. For exam­ple, at this point, we see no rea­son for the gov­ern­ment to con­sider nation­al­iz­ing firms like Wells Fargo, PNC, or USB among others.

Fire: Dis­man­tle the boards of direc­tors and fire senior man­age­ments. We rec­om­mend this for two reasons. First, it is the just thing to do. We base that state­ment on our inter­pre­ta­tion of the Para­ble of the Faith­ful and Unfaith­ful Ser­vant, which describes moral haz­ard issues. Sec­ond, it pro­vides a severe warn­ing to sur­viv­ing insti­tu­tions to get their firms’ affairs in order and instill more rig­or­ous over­sight of poten­tially risky activ­i­ties. So, we view it as effi­cient, too. One of the best ways to solve moral haz­ard prob­lems is through the imple­men­ta­tion of severe penal­ties for unde­sir­able out­comes. (We know it is an infor­ma­tion argu­ment based upon likelihoods, but we’re being infor­mal here.)

Reor­ga­nize: Imple­ment our market-​based solu­tion to the mort­gage cri­sis. We’ve linked to it twice already in this post; so, won’t do so again, but it is based upon per­mit­ting either invest­ment tax cred­its or cash-​basis account­ing (extreme accel­er­ated depre­ci­a­tion) for prospec­tive pur­chasers of trou­bled mort­gages, MBS, and mortgage-​related CDOs. That reduces the ini­tial cost and pro­vides a cush­ion for mis­pric­ing. We’d also rec­om­mend low tax rates on sub­se­quent resales or cash flow realizations.

It would also seem that a gov­ern­ment takeover of sev­eral of the weak­est banks would make it much eas­ier to sort and can­cel out mar­gin calls and overnight loans, etc., and to offer promis­sory notes rather than asset pledges or cash for deep-​out-​of-​money trades (in-​the-​money for the other party).

Sell: Offer the refor­mu­lated banks as IPOs as soon as pos­si­ble – hope­fully by next sum­mer. We greatly pre­fer IPOs to forc­ing merg­ers and cre­at­ing ever larger banks. We believe that such merg­ers cre­ate over-​concentration of oth­er­wise idio­syn­cratic risk; they made the idio­syn­cratic sys­tem­atic so-​to-​speak. We wrote about that on sev­eral occa­sions, too. (See, for exam­ple, Forced Merg­ers? Big­ger Is Not Nec­es­sar­ily Bet­ter!, Big­ger Is Not Nec­es­sar­ily Bet­ter or Idio­syn­cratic and Con­cen­tra­tion Risk, Again.)

We real­ize that we could offer more details, but we’re a small orga­ni­za­tion with lim­ited time. More­over, there are far more specifics here than in the Treasury’s ini­tial bailout plan, and we’re not ask­ing for $700 billion.

We’d be happy to receive your com­ments and feed­back on our pro­posal. Are we miss­ing some­thing? Have we ignored cru­cial weak­nesses? If so, let us know. If not, we say, “it’s time.”

As always, we’ll update and revise this in the com­ing days as we clar­ify our thoughts and rework our sen­tence struc­tures and elim­i­nate typos.

Copy­right © 2008 Spero Consulting.

*Yeah, that’s our allu­sion to Chief Dan George’s char­ac­ter, Lone Watie, in The Out­law Josey Wales. Get dressed up in civ­i­lized clothes, go to Wash­ing­ton to meet the Pres­i­dent, and pledge to be united. How exactly does that help?