Spero Consulting

Posts Tagged ‘liquidity crisis’

FWIW: we say no to a sec­ond term.

This week­end there are many reports and com­men­taries regard­ing the U.S. Sen­ate vote to con­firm Ben Bernanke to a sec­ond term as the Chair­man of the Fed­eral Reserve. For exam­ple, see the arti­cle Back­ers Rally to Bernanke in The Wall Street Jour­nal.

Mr. Bernanke nei­ther deserves a sec­ond term nor can we, as a nation and econ­omy, afford it.

Don’t Blame Him for any Bubbles

Many com­men­ta­tors, ana­lysts, and econ­o­mists blame Mr. Bernanke’s (and his pre­de­ces­sor, Alan Greenspan’s) easy money poli­cies for cre­at­ing a sequence of bubbles.

We don’t. As far as we can tell, prior to 2008, Mr. Bernanke did not force a sin­gle per­son or firm to bor­row an addi­tional dol­lar or invest in assets and secu­ri­ties that they did not under­stand. See our post The Low Inter­est Rates Made Us Do It: Oh, How Lame! from August, 2008. Note that Com­mu­nity Rein­vest­ment Account (CRA) poli­cies were not his dik­tat. In fact, their ini­tial imple­men­ta­tion in 1977 far pre­cede his involve­ment at the Fed.

His Flawed Poli­cies Aren’t Disqualifying

In addi­tion, as much as we dis­like his sta­tist pol­icy pre­scrip­tions to end the liq­uid­ity cri­sis that began in the Fall of 2008, we don’t think that alone is rea­son to deny his confirmation.

How­ever, every TARP-​addled, self-​congratulatory politi­cian, bureau­crat, and reg­u­la­tor wish­ing to take credit for staving off a new depres­sion, should note that dur­ing the “The Great Depres­sion,” the Dow Jones Indus­trial Aver­age gained 63.74% in 1932. HOWEVER, it took an addi­tional 20 years – that’s 20 years – for the Dow to reach its pre-​crash highs of 1929.

Thus, if you, dear reader, con­fi­dently “know” or strongly believe that because the Dow has ral­lied since last March, that nec­es­sar­ily means that the cri­sis has ended with lit­tle or no chance of return­ing, then you are, indeed, a short-​sighted fool (with lit­tle aware­ness of history).

So, if (1) we don’t blame him for the con­sumer and investor behav­ior that led to the mort­gage débâ­cle that led to the liq­uid­ity cri­sis and (2) we don’t think that his pol­icy response to the cri­sis, in and of itself, is dis­qual­i­fy­ing, then what is it?

His Panic & Ter­ror Were Unconscionable

It was his pan­icked response to the mort­gage débâ­cle that helped turn it into a liq­uid­ity cri­sis and severe reces­sion. It wasn’t his pol­icy pre­scrip­tions, it was the way he tried to sell them. He wasn’t alone. For­mer Pres­i­dent Bush, Con­gres­sional lead­ers, and ex-​Treasury Sec­re­tary Hank Paul­son also deserve much of the blame, and we gave it to them, but he should have known bet­ter. (See, for exam­ple, Well, This Is a Fine Mess You’ve Got­ten Us into.… or just about any­thing else that we wrote from Sep­tem­ber — Decem­ber, 2008.)

Dur­ing the spring and sum­mer of 2008, we asked on sev­eral occa­sions: why are the losses so con­cen­trated this time? See, for exam­ple, this search or this tag or this one. (There’s some overlap.)

The rather con­cen­trated mort­gage débâ­cle informed investors and cred­i­tors that bank man­agers were far less capa­ble than had been believed. As con­fi­dence in the banks shrank, our pub­lic ser­vants pan­icked and eeked and squeaked like lit­tle girls.

Their col­lec­tive panic and ter­ror destroyed pub­lic con­fi­dence – not just in the banks – that was jus­ti­fi­able – but in the econ­omy as a whole. Their threats and over­state­ments became self-​fulfilling, and per­mit­ted cyn­i­cal man­age­ments at non-​financial cor­po­ra­tions to lay-​off employ­ees. Those actions imme­di­ately deep­ened the down­turn and destroyed con­sumer and investor con­fi­dence. It still has not recov­ered. (By the way, by non-​financial, we don’t mean that hope­less and hap­less auto man­u­fac­tur­ers. Given their pre­car­i­ous states, they were doomed to fail when­ever a reces­sion occurred.)

Per­haps by 2008, he had spent too much time in Wash­ing­ton and had for­got­ten that words and state­ments have real impli­ca­tions. There are sound rea­sons why it is ille­gal to shouts “Fire!” in a crowded the­ater (and risk a pub­lic cat­a­stro­phe). In our mind, that’s what Mr. Bernanke and his cronies did. Words are not merely “throw-​away” rhetoric used to attempt to influ­ence unde­cided sen­a­tors and rep­re­sen­ta­tives to sup­port a hastily-​composed bill, espe­cially when done publicly.

Clearly, we don’t believe that “if you don’t have any­thing nice to say you shouldn’t say any­thing at all.” If we did, we would have pub­lished a total of about fif­teen posts since we started writ­ing on April 1, 2008.

We do, how­ever, think that if one have a posi­tion of respon­si­bil­ity, then one should act and speak respon­si­bly, and Mr. Bernanke did not do so when it mat­tered the most. We can for­give such behav­ior, but we can’t for­get it, so we don’t trust him. So, for what it’s worth, we rec­om­mend that Mr. Bernanke not be reconfirmed.

Or, Is It the Naïve Government’s Stress Test­ing Exercise?

More Lack of Plan­ning and Insight from Our Reg­u­la­tors and Gov­ern­ment Officials

About one month ago – on April 7, to be pre­cise – we asked, Where Will the Bank Stress Test­ing Exer­cise Lead?

In that post, we wrote that the tests could be designed one of three ways: (1) with a pos­i­tive bias to ensure that all or almost all of the banks could pass the tests, (2) with no bias to get a hon­est — though not nec­es­sar­ily accu­rate — assess­ment of each bank’s finan­cial con­di­tion (with accu­racy con­strained by the implicit and explicit assump­tions built into the exer­cise), or (3) with a neg­a­tive bias to ensure that most or all banks fail the test.

Given the var­i­ous news reports that four­teen of the 19 banks may have “failed” the tests and that the four­teen have since been nego­ti­ated down to ten that may “require cap­i­tal,” it doesn’t seem that the tests were designed or biased to gen­er­ate pos­i­tive results. In ret­ro­spect, it doesn’t seem that the eco­nomic assump­tions were par­tic­u­larly neg­a­tive – see We Can’t Sub­si­dize the Banks For­ever in today’s edi­tion of The Wall Street Jour­nal for evi­dence that first quar­ter eco­nomic activ­ity and sta­tis­tics were worse than pro­jected in the exer­cise. Note, how­ever, that if they were designed with a pos­i­tive or opti­mistic bias, then the reg­u­la­tors who designed the Super­vi­sory Cap­i­tal Assess­ment Pro­gram (SCAP) wre/​are hor­ren­dously clue­less and incom­pe­tent, and that’s not out­side the realm of possibility.

As we wrote last month, we can’t imag­ine any­one design­ing a neg­a­tive bias into the tests; so, that means that, most likely, the gov­ern­ment sought an “hon­est” though not nec­es­sar­ily accu­rate assess­ment of each bank’s abil­ity to absorb addi­tional losses.

That was and is prob­lem­atic given the amount of pub­lic­ity gen­er­ated about the pro­gram. It would have been much bet­ter to per­form the tests in total secrecy – in what appeared to be a dis­jointed, dis­or­ga­nized, ad hoc, and unsys­tem­atic man­ner to belie any sense that a thor­ough inves­ti­ga­tion or com­pre­hen­sive and national approach was being under­taken. (They should have been stan­dard­ized but secret tests with no pub­lic­ity or acknowl­edge­ments of their existence.)

The three-​day delay in announc­ing their find­ings shows that the reg­u­la­tors – the Fed, the OCC, etc – were unpre­pared for the results. As we wrote back then, there was no sce­nario analy­ses of the stress test out­comes. For exam­ples, what will we do if four­teen banks require more cap­i­tal, all nine­teen, what about two giant ones, etc?

It’s another exam­ple of gov­ern­ment offi­cials being too rash and not thought­ful enough for their own – and the economy’s – sake. That’s why the road to hell is paved with good intentions.

When we find the time, we’ll expand this post later today or tomor­row, but the events of this week show that the government’s response to the Liq­uid­ity Cri­sis, which is, in fact, a cri­sis in con­fi­dence in finan­cial inter­me­di­aries, is no more thought­ful than its reac­tion to the Mort­gage Débâ­cle, and that pan­icked and over-​publicized response cre­ated the Liq­uid­ity Cri­sis in the first place.

Please, folks, first “do no harm,” which means that you have to think before act­ing or cal­cu­lat­ing. Now where have you seen that before?

Respond­ing to our request for com­ments in yesterday’s post, Happy Anniver­sary to…Us!, a reader from Aus­tralia pointed us to an excel­lent and quite com­pre­hen­sive arti­cle in May’s edi­tion of The Atlantic Monthly. (Thanks Steven.)

The arti­cle is enti­tled “The Quiet Coup,” and was writ­ten by Simon John­son, an econ prof at MIT and the for­mer Chief Econ­o­mist at the Inter­na­tional Mon­e­tary Fund (IMF). For­tu­nately, as you can tell by the link, the arti­cle is freely avail­able from The Atlantic’s web site.¹

Mr. John­son seems to be a very smart man with vast and use­ful expe­ri­ence and knowl­edge, and he uses his back­ground and skills to frame the cur­rent eco­nomic cri­sis in a very inter­est­ing way.

In much of the arti­cle, he treats the US as a poten­tial IMF client, and ana­lyzes the sit­u­a­tion the same way he would (or has) viewed emerg­ing mar­ket coun­tries faced by sim­i­lar crises, par­tic­u­larly with respect to the inter­ac­tions of the country’s oli­garchy and the gov­ern­ment. How­ever, he does rec­og­nize that the US is different.

“Of course, the U.S. is unique. And just as we have the world’s most advanced econ­omy, mil­i­tary, and tech­nol­ogy, we also have its most advanced oligarchy.”

We’ve talked about crony cap­i­tal­ism on sev­eral occa­sions, and Mr. John­son brings sev­eral insights to light. (We define oth­ers’ insights as things we haven’t thought, yet, or things that took us a long time to fig­ure out.)

Need­less to say, if you like our analy­ses of and pre­scrip­tions for the mort­gage débâ­cle and liq­uid­ity cri­sis, then you’ll like his, too. (If your new to our site, sam­ple our cat­e­gories and archives for related con­tent. There are vast quan­ti­ties of it.) For exam­ple, he writes:

“…This is what Ben Bernanke, the man who suc­ceeded him, said in 2006: “The man­age­ment of mar­ket risk and credit risk has become increas­ingly sophis­ti­cated. … Bank­ing orga­ni­za­tions of all sizes have made sub­stan­tial strides over the past two decades in their abil­ity to mea­sure and man­age risks.”

Of course, this was mostly an illu­sion. Reg­u­la­tors, leg­is­la­tors, and aca­d­e­mics almost all assumed that the man­agers of these banks knew what they were doing. In ret­ro­spect, they didn’t…”

and,

“To break this cycle, the gov­ern­ment must force the banks to acknowl­edge the scale of their prob­lems. As the IMF under­stands (and as the U.S. gov­ern­ment itself has insisted to mul­ti­ple emerging-​market coun­tries in the past), the most direct way to do this is nationalization…”

The entire arti­cle is well worth read­ing, and view­ing the cri­sis through the prism of an IMF econ­o­mist pro­vides fresh insights that few can offer.

We very much like James Freeman’s brief col­umn, Fight­ing Gei­th­ner­ism, in today’s (Sat­ur­day, March 28) edi­tion of The Wall Street Jour­nal.

In it, he sum­ma­rizes Richard Breeden’s Con­gres­sional tes­ti­mony, par­tic­u­larly his crit­i­cism of Trea­sury Sec­re­tary Geithner’s pro­posed changes in reg­u­la­tions and over­sight of finan­cial firms.

We liked it very much, because Mr. Bree­den sounds so much like…well, like us, as it turns out.

In early Feb­ru­ary, we wrote Sys­temic Risk Reg­u­la­tion and Irony , which we sub­ti­tled, “Or Cen­tral Plan­ning as a Mar­ket Solu­tion,” and we strongly encour­age inter­ested par­ties to read it.

Some­how the thought of a sin­gle agency “con­trol­ling” sys­temic risk reminds us of that arcade game whack-​a-​mole. Of course, in whack-​a-​mole – and unlike in real-​life – the lit­tle ver­min can only pop-​up from a cer­tain, known num­ber of loca­tions, but real-​life isn’t so well-​specified. (That’s also the rea­son we refer to the field as uncer­tainty man­age­ment, rather than risk man­age­ment.) In fact, it’s that impos­si­bil­ity of iden­ti­fy­ing poten­tial holes (and the size of the moles) that makes the task futile and the cal­cu­la­tion of cer­tain prob­a­bil­i­ties senseless.

Mr. Bree­den refers to the Soviet Union, as we did in this para­graph: “By far, the eas­i­est way — and the historically-​proven way — to con­trol sys­temic risk would be to destroy the economy. That would cer­tainly elim­i­nate vari­a­tions — the ups and down — because the ups would be gone: kind of like the for­mer Soviet Union or modern-​day Cuba.”

He also notes that given the reg­u­la­tory agen­cies’ per­for­mance prior and dur­ing the mort­gage débâ­cle and the liq­uid­ity cri­sis, he sees no rea­son to reward any of them with addi­tional responsibility.

In late Novem­ber, we wrote about a related topic in Good Luck with that: Get­ting Bank Exam­in­ers to Act. In that post we equated reg­u­la­tors with the “three wise mon­keys” (see no evil, hear no evil, speak no evil), and described how mis­aligned incen­tives among reg­u­la­tors would keep neg­a­tive infor­ma­tion hidden.

In addi­tion, we writ­ten sev­eral times about how when decision-​making becomes cen­tral­ized, the “idio­syn­cratic” become sys­tem­atic. For exam­ple, see these three arti­cles from late September-​early Octo­ber: Forced Merg­ers? Big­ger Is Not Nec­es­sar­ily Bet­ter, Big­ger Is Not Nec­es­sar­ily Bet­ter, and Idio­syn­cratic and Con­cen­tra­tion Risk, Again. That is, cen­tral­iz­ing decision-​making in one per­son or in small group of peo­ple, each with their own flaws, beliefs, and biases, and per­mit­ting them to (1) allo­cate a large per­cent­age of the economy’s assets or (2) reg­u­late or gov­ern the econ­omy cre­ates addi­tional sys­temic risk – that they can’t see – that is to the detri­ment of all.

In that third of those three posts, we also made the same point that Mr. Bree­den made in his tes­ti­mony regard­ing moral haz­ard. No one should think that they are too big to fail, and no counter-​party should think that their trad­ing part­ner is too big too fail. Both impres­sions sup­press due dili­gence and increase the prob­a­bil­ity and the costs asso­ci­ated with fail­ure, i.e., mar­ket crashes and breakdowns.

The stock mar­ket may have ral­lied this week in antic­i­pa­tion of the mas­sive wealth trans­fer from tax pay­ers to finan­cial insti­tu­tions, but Mr Geithner’s solu­tions, like Mr. Paulson’s before him, are worse than the prob­lems they are try­ing fix.

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.

In a mist­i­tled arti­cle, Gei­th­ner Banks on Pri­vate Cash, The Wall Street Jour­nal reports that the Trea­sury Sec­re­tary plans to unveil some type of pri­vate–pub­lic part­ner­ship tomor­row, and, of course, “pub­lic” means “gov­ern­ment,” not you and us.¹ (Wasn’t that Neal guy try­ing to hire pri­vate money man­agers for the TARP stuff since Octo­ber? How well did that work?)

If only Mr. Gei­th­ner would con­sider a pri­vate solu­tion, but we don’t think that the our elected and appointed offi­cials have the dis­ci­pline (nor guts nor imag­i­na­tion) to offer such a plan.

From what we’ve read, his pro­posal sounds like a finance-​industry equiv­a­lent of a public-​private urban rede­vel­op­ment plan, and we’d be sur­prised if the out­come was any dif­fer­ent than most of those unsuc­cess­ful and dehu­man­iz­ing land­scapes and archi­tec­tures that blight so many or our cities.

(If they’re not already, reg­u­lar read­ers will likely be bored by the rest of the post.)

Since late Sep­tem­ber, we’ve crit­i­cized the government’s actions and have pro­posed alter­na­tive solu­tions. We have a private/​government plan, too, and it works like a typ­i­cal NYPD, Andy Sipowitz, good cop-​bad cop ploy.

The Good Cop: Incen­tives to Buy

The pri­vate part does require a very small bit of gov­ern­ment action, i.e., for Con­gress to pass new tax codes that pro­vide either (1) gen­er­ous invest­ment tax cred­its for the pur­chase of mort­gages and mortgage-​backed secu­ri­ties or (2) accel­er­ated amor­ti­za­tion that would per­mit pur­chasers to imme­di­ately expense the pur­chase price of the assets. (Taxes would then be paid on future cash receipts.)

Either option would pro­vide an imme­di­ate and large tax ben­e­fit (shel­ter) to buy­ers and thus a cush­ion against overly-​optimistic val­u­a­tions, and that’s the key ele­ment. (By def­i­n­i­tion) the mar­ket for these assets is illiq­uid because no one wants to buy them. No one wants to buy them because no one is con­fi­dent of their own val­u­a­tion meth­ods, espe­cially how the prospec­tive cash flows are inter-​related – the cor­re­la­tion to be brief but impre­cise.²

So, a gen­er­ous invest­ment tax credit or an imme­di­ate write-​down of the entire pur­chase price would pro­vide a cush­ion of about 40% to buy­ers, and at the very wide mar­gin, it would increase their incen­tives to buy. (That’s not a bad cush­ion, is it?)

The Bad Cop: Incen­tives to Sell

We don’t care if you call it nation­al­iza­tion or forced receiver­ship or bank­ruptcy or what­ever, but as an incen­tive to get non-​horrible insti­tu­tions to purge their bal­ance sheets, the gov­ern­ment should bank­rupt and take-​over the bad ones. (They already own sub­stan­tial por­tions of them.) Fire the senior man­age­ments and the boards, and wipe-​out all com­mon equity, EXCEPT the shares owned by non-​executive employees.

Those insti­tu­tions are doomed any­way, but our solu­tion isn’t about them. (Tech­ni­cally, our solu­tion may be a crime: abuse of corpses.) Seri­ously, look at the mag­ni­tude of the government’s equity injec­tions and debt guar­an­tees, yet look at how lit­tle those firms are worth.

They’re doomed, and it is highly likely that the sum of the parts is greater than the whole. It’s reverse syn­ergy and kind of like a fail­ing, organ-​transplant donor: in the end, you might as well try to help oth­ers. So, expro­pri­ate those firms and sell-​off the indi­vid­ual sub­sidiaries ASAP. It’s the only humane thing to do – like euth­a­niz­ing a terminally-​ill pet. (Well, it’s not quite like that since most folks love their pets.)

Our plan is designed to scare the “moral haz­ard” out of the semi-​bad firms to get them to act. That means get­ting them to sell their “bad” assets, and by bad we mean those worth sub­stan­tially less than face value. Right now, those firms are afraid to do any­thing until the gov­ern­ment acts, and the gov­ern­ment, well, it’s the gov­ern­ment, what do you expect? The last time we checked, it still hadn’t pur­chased any “TARP” assets despite spend­ing all of the money.

So, our plan is designed to moti­vate pri­vate buy­ers and sell­ers to move bad assets away from oth­er­wise healthy finan­cial insti­tu­tions. Even if the reader doesn’t like it, have they heard of a bet­ter, sim­pler solu­tion since the cri­sis began? More­over, how bad would the cri­sis have been if our sug­ges­tions had be enacted in late September/​early Octo­ber? You know how we’d answer those questions.

If our crit­i­cisms and sug­ges­tions intrigue you, we encour­age you to search the archives. We write about what­ever inter­ests, annoys, or amuses us. For more than six months, that has meant the finan­cial cri­sis and the government’s inept and harm­ful reactions.

We may update and edit this post tomorrow.

Last week, in The Stock Mar­ket and the Stim­u­lus Pack­age we wrote how we doubted the effi­cacy of the pro­posed “stim­u­lus” pack­ages, and asked if there was any evi­dence – via the stock mar­ket – of expec­ta­tions of wealth cre­ation from those pro­posed wealth trans­fers. Even prior to Tuesday’s nearly 5% drop, there didn’t seem to be any.

Yes­ter­day, the Sen­ate passed its ver­sion of the bill, and min­utes after the vote the Dow-​Jones Indus­trial Aver­age increased about ten points before sink­ing a cou­ple hun­dred more points by the end of the day. Wow, all that for a fleet­ing ten points?

Now, the Sen­ate and House must rec­on­cile the final details of the two bloated and inef­fec­tive pack­ages. Other than the pro­posed tax cuts, expect noth­ing good from the final result. As Peter Fer­rara points out in today’s edi­tion of The Wall Street Jour­nal, Mr. Obama’s “plans” are not very Rea­ganesque, i.e., growth-​oriented. In fact, those plans are pretty much the oppo­site of Reagan’s (and unfor­tu­nately that reminds us of the sin­gle worst Pres­i­dent in our life­time, the ter­ri­bly incom­pe­tent, Jimmy Carter. (Update: he wasn’t ter­ri­bly incom­pe­tent. He was supremely incompetent.))

Also yes­ter­day, Trea­sury Sec­re­tary Gei­th­ner spoke of the Obama administration’s plans for our nation’s failed banks and dis­tressed assets. The stock mar­ket promptly dove and many finan­cial insti­tu­tions lost sub­stan­tially more than the mar­ket as a whole – despite the fact that their share prices are already quite low.

Like the Bush Administration’s actions in the Fall, the Obama administration’s pro­posed actions seem equally inept. (As we’ve men­tioned in the past, we don’t like to use the word “plans” because that con­notes some level of orga­ni­za­tion and fore­thought that we deem lack­ing in both reactions.)

A few weeks ago, we likened the government’s attempt to prop-​up dead banks to Week­end at Bernie’s, but we think that Mr. Geithner’s appointed task deserves some­thing larger than a ref­er­ence – how­ever apt – to a bad movie from 1989.

It seems closer to the Her­culean task of clean­ing the Augean Sta­bles of excretion-​backed secu­ri­ties. Unfor­tu­nately, we doubt that Mr. Gei­th­ner is as capa­ble or clever as Her­cules was or as he needs to be to craft a work­able solu­tion (or mit­i­ga­tion). By the way, yes­ter­day, he appeared to be a ter­ri­ble pub­lic speaker with lit­tle or no con­trol of his brow, his expres­sions, his pace, and his monot­o­nic­ity. Per­haps, some nerve– and forehead-​numbing Botox would help.

When­ever we write about this topic, we men­tion are our pro­posed solu­tions to the mort­gage (and mortgage-​backed secu­ri­ties) débâ­cle and the larger and more harm­ful liq­uid­ity cri­sis, and this post is no exception.

Yes­ter­day, Mr. Gei­th­ner pro­posed some type of public-​private part­ner­ship, and that it induces us to ask, why not just a pri­vate solution?

Why not pro­vide tax incen­tives – either the imme­di­ate write-​off of the pur­chase price à la cash-​basis account­ing or mort­gage invest­ment tax cred­its to moti­vate the pur­chase of the dis­tressed assets by provi­dong pri­vate buy­ers with a cush­ion against over­es­ti­ma­tion of the under­ly­ing value? (As we all know, no one knows how to value to the things; no one ever did; they just thought that they did. So, why not reduce the risk of over-​paying?)

It’s not a mytho­log­i­cal and cleans­ing flood, but we think it is the best and sim­plest way to move vast vol­umes of the manure that cur­rently befoul many finan­cial institutions.

In addi­tion, in today’s WSJ, Andy Kessler has an essay enti­tled, Why Mar­kets Dissed the Gei­th­ner Plan. In it, he pro­poses the same type of nation­al­iza­tion that we’ve been propos­ing since late Sep­tem­ber and early Octo­ber.

He goes fur­ther and rec­om­mends that new shares in the nation­al­ized banks be dis­trib­uted to tax-​payers, pre­sum­ably pro­por­tional to the taxes they paid over a given period of time. We doubt that such dis­tri­b­u­tions are as work­able or as speedy as IPOs, but it is good to read that oth­ers are start­ing to make rec­om­men­da­tions sim­i­lar to those that we have made since the liq­uid­ity cri­sis began in late Sep­tem­ber. (And as we men­tioned back then, much of the liq­uid­ity cri­sis could be attrib­uted to dis­or­ga­nized, thought­less, and pan­icked reac­tions of our elected offi­cials and senior appointees, e.g., Mr. Paul­son, to the impli­ca­tions of the mort­gage débâ­cle – the main one being the incom­pe­tence on many bank managements.)

We say: be more clever than Her­cules. Pro­vide tax incen­tives so that investors will buy the crap from the banks. Plus, Her­cules solu­tion is less ten­able these days. We’re sure that it vio­lates any num­ber of EPA and Army Corp of Engi­neer reg­u­la­tions. (Note: for what it’s worth, Hercules was smart enough to get paid for the task.)

Or Cen­tral Plan­ning as a Mar­ket Solution

We saw in yesterday’s (Feb­ru­ary 4^th) edi­tion of The Wall Street Jour­nal that cer­tain leg­is­la­tors, includ­ing Bar­ney Frank, want a gov­ern­ment agency, pos­si­bly the Fed­eral Reserve, to “con­trol” sys­temic risk in the econ­omy, par­tic­u­larly in the finan­cial markets.

We’ll ignore the fact that this is the same Bar­ney Frank who induced much sys­temic risk by insist­ing for many years that Fan­nie Mae and Fred­die Mac make home own­er­ship afford­able for those who could not afford a home. He was then shocked, shocked, and dis­mayed that a good per­cent­age of those folks couldn’t afford their new homes. Yes, very sur­pris­ing, indeed!

Doing more harm than good: Instead, we’re writ­ing because we find it quite ironic that an agency, i.e., a sin­gle gov­ern­ment reg­u­la­tor or a small group of reg­u­la­tors would be able to “con­trol” and “man­age” some­thing like sys­temic risk with­out either (1) com­pletely destroy­ing the econ­omy they’re assigned to pro­tect or (2) con­vert­ing their own idio­syn­cratic per­spec­tives and pref­er­ences into more or new kinds of sys­temic risk.

Good inten­tions and the road to hell: The first out­come is actu­ally the worst-​case sce­nario of the sec­ond one and isn’t much dif­fer­ent than Mr. Frank con­vert­ing his own idio­syn­cratic pref­er­ences about home own­er­ship into the gigan­tic mort­gage losses incurred by Fan­nie and Fred­die, among oth­ers. One need not be greedy or self­ish to be misguided.

By far, the eas­i­est way – and the historically-​proven way – to con­trol sys­temic risk would be to destroy the econ­omy. That would cer­tainly elim­i­nate vari­a­tions – the ups and down – because the ups would be gone: kind of like the for­mer Soviet Union or modern-​day Cuba.

We’re sure that the destruc­tion would be inad­ver­tent and would be the out­come of well-​intentioned efforts, but that wouldn’t lessen the pain.

We ask: which past (and failed) attempt at cen­tral plan­ning has not been about “pre­serv­ing jobs” or “cre­at­ing jobs” or doing some­thing won­der­ful for human­ity? We can’t think of any.

The irony of sys­tem­atiz­ing idio­syn­cratic risk: As we men­tioned above, our point is that cen­tral­iz­ing decision-​making in one per­son or small group of peo­ple and per­mit­ting them to reg­u­late or gov­ern the econ­omy cre­ates addi­tional sys­temic risk to the detri­ment of all.

We have dis­cussed these issues in a num­ber of posts, includ­ing Com­mon Sense? Smart Money? Oh, Please! 

We’ve focused on the notion that the idio­syn­cratic becomes the sys­temic as port­fo­lios get larger and the decision-​making becomes more cen­tral­ized, and we’ve men­tioned it quite often because it is gen­er­ally ignored by folks. Such risk is assumed-​away in intro­duc­tory finance mod­els that show ben­e­fits of diver­si­fi­ca­tion; so, most folks don’t think about it.

We men­tioned it when dis­cussing merg­ers in Big­ger Is Not Nec­es­sar­ily Bet­ter:

“Each senior decision-maker’s idio­syn­cratic (and pos­si­bly irra­tional) beliefs and judg­ments affect a larger and larger share of the economy’s resource deci­sions, and that can’t be a good thing. Thus, there is a trade-​off of the cost sav­ings (of con­sol­i­da­tion) ver­sus the addi­tional risk of such centralized decisions.”

Think of it as the undi­ver­si­fi­able risk due to the fact that the port­fo­lio is cho­sen by a semi-​rational human or small group of humans, each with their own unique and shared flaws and assump­tions. The fact that such an error term does not exist in these finan­cial mod­els does not mean it is absent. It means that the model is an abstract, stream-​lined ver­sion of real­ity that ignores cer­tain fac­tors – often­times, impor­tant factors.

As we’ve often men­tioned, given our con­ser­v­a­tive nature, we do wish our elected lead­ers and appointed reg­u­la­tors would take an equiv­a­lent of the Hip­po­cratic Oath: beyond all else, “do no harm.” Unfor­tu­nately, as their actions over the past sev­eral months have shown, that is ask­ing far too much of them.

So we ask: can’t we all just wear our “WIN” but­tons from the sev­en­ties? We can change the “I” from “infla­tion” to “illiq­uid­ity” to “Whip Illiq­uid­ity Now!” It would be silly today as it was when Ger­ald Ford was Pres­i­dent, but it would be far less harm­ful than hav­ing a cou­ple geniuses – like, say, Bar­ney Frank or Henry Paul­son – sort through and “solve” our problems.

Geez, The Wall Street Jour­nal edi­to­r­ial board really hasn’t fared well dur­ing the ongo­ing mort­gage débâ­cle and liq­uid­ity cri­sis. They’ve come across look­ing incon­sis­tent and reac­tionary and kind of weak.

Now, on their opin­ion page, they start their “About Us” descrip­tion with the phrase “We are for free mar­kets and free people…”

We sup­pose they’re for free­dom, except when they’re not – like when the edi­tors sup­ported the orig­i­nal TARP plan. It seems that they didn’t con­sider the risks of fur­ther politi­ciza­tion of the econ­omy or how gov­ern­ment encroach­ment might harm “free people.”

It seems that the edi­to­r­ial board rues what was an eas­ily pre­dictable outcome. 

In today’s (Jan­u­ary 31) edi­tion, in a Review & Out­look piece enti­tled  ‘Idiots,’ Indeed, the edi­tors com­plain about (1) Pres­i­dent Obama denounc­ing Wall Street exec­u­tives for pay­ing bonuses; (2) Claire McCaskill attempt­ing to limit com­pen­sa­tion and call­ing Wall Streeters “a bunch of idiots,” and (3) New York Attor­ney Gen­eral Andrew Cuomo start­ing to inves­ti­gate last year’s bonuses, among other things.

What did they expect would happen?

Did they really believe that the gov­ern­ment would hand out cash for free and not seek vengeance for severe (pri­vate sec­tor) incom­pe­tence? What type of pan­icky tizzy must the edi­tors have been in not to con­sider those implications? 

We recall the last time a bub­ble broke they were com­plain­ing about pros­e­cu­to­r­ial over-​reach; crim­i­nal­iza­tion of (what we’d call) incom­pe­tence; and Sarbanes-​Oxley (SOX).

When, in a fit of panic, they aban­doned their free mar­ket prin­ci­ples why should they expect oth­ers, whom don’t even claim such prin­ci­ples, to keep them? See what we mean: kind of weak, incon­sis­tent, and reactionary.

Here’s what we wrote on Sep­tem­ber 24 in Sorry Mr. Bush, We Respect­fully Dis­agree:

Let’s be clear. Some­one should be held account­able, BUT we do NOT mean crim­i­nally. We fear that when eco­nomic mat­ters becomes politi­cized as in the cur­rent crisis, the feds will look to put some­one in jail, e.g., the ongo­ing FBI fish­ing expe­di­tions, err, inves­ti­ga­tions. No, we mean be held account­able eco­nom­i­cally, which we would pre­fer to see happen privately.

If a hum­ble ‘burgher such as our­selves could see what would hap­pen with more gov­ern­ment inter­ven­tion – uh, basi­cally, more gov­ern­ment inter­ven­tion – how could the folks in New York, who pre­tend to defend free­dom and lib­erty not see the immi­nent loss of it?

P.S. We also dis­agree with their assess­ment that “com­pen­sa­tion lev­els are a busi­ness judg­ment made under the pres­sure of com­pe­ti­tion.” That might be true if the firms were part­ner­ships or oth­er­wise privately-​owned, there was no agency costs, and there was no self-​dealing, i.e., the firms were run by inde­pen­dent and knowl­edge­able boards. Per­haps that’s where their tit­u­lar pejo­ra­tive descrip­tion of intel­lect best fits.

P.P.S. Yeah, we’re for the nation­al­iza­tion of the weak­est large banks, but see no incon­sis­tency with our crit­i­cism of the WSJ edi­to­r­ial board. We think those legal enti­ties for­feited their right to exist, and their share­hold­ers lost their rights to con­trol those entities.

We think the cur­rent gov­ern­ment and indus­try strat­egy of attempt­ing to prop-​up the dead as a way to re-​energize the party and stay alive (or rel­e­vant) is bound to fail. In reminds us of the plot from the 1989 com­edy, Week­end at Bernie’s. Is TARP II noth­ing more than a remake of the 1993 sequel?

We read in The Wall Street Jour­nal today that Bank of Amer­ica to Get Bil­lions in U.S. Aid, and as usual we won­der whether it is necessary.

We doubted the neces­sity of TARP the first time our money was wasted, and con­tinue to do so now. Well, we did more than doubt the neces­sity, we pre­dicted that the government’s plan – and, again, plan is too strong, too “orga­nized,” of a word to describe the sequence of actions – would exac­er­bate and elon­gate the crisis. 

And three months later…well, here we are. The weather is colder, but lit­tle else has changed – much as we predicted.

Accord­ing to today’s arti­cle, last month Mr. Paul­son, in another – and hope­fully final – fit of panic, promised our tax dol­lars to B of A to com­plete its merger with Mer­rill Lynch. Per­haps, we should say “to sur­vive its merger with Mer­rill Lynch,” because sur­prise, sur­prise, the arti­cle men­tions that Mer­rill lost even more than it had pre­vi­ously guessed.

Now the reg­u­lar reader may ask: why do we con­tinue to crit­i­cize this cor­po­rate wel­fare and crony-​capitalism? For all of the same rea­sons we’ve used in the past, but also with a new one, too.

Despite the con­tin­u­ing volatil­ity and losses – as we write, the DJIA is near 8,000, again – the finan­cial world is a dif­fer­ent place today than it was a mere three months ago. Either out of sheer panic or self-​preservation, many orga­ni­za­tions have reigned in their trad­ing oper­a­tions and have attempted to limit or elim­i­nate their counter-​party credit risk. (Uh, that’s the nature of a liq­uid­ity cri­sis, which we’ve joked is the psy­cho­log­i­cal pro­jec­tion of finan­cial state­ments; see the top two posts.)

So, we doubt that the demise of Mer­rill in late Decem­ber or the demise of other firms today would have been as “harm­ful” as the demise of Lehman, AND we seri­ously doubt that the demise of Lehman was as harm­ful as our pan­icky policy-​makers and cor­po­rate pro­pa­gan­dists and blame-​shifters would like to have oth­ers believe. 

For exam­ple, in another arti­cle in today’s paper, Deutsche Bank Warns of Loss, Blam­ing Its Trad­ing Mis­fires, it is men­tioned three times that Lehman was the cause of much of Deutsche’s trou­bles. (That thrice-​repetition reminds us of ancient Greek lit­er­a­ture and Bible pas­sages. As we’ve been told by both edu­ca­tors and priest, when you see it in threes, then you should know that it must be impor­tant! Ha!)

We’re sure that Lehman’s demise caused sub­stan­tial pain to many firms and indi­vid­u­als. But all the pain? No, much of that pain should be attrib­uted to lax con­trols, includ­ing poorly designed incen­tive schemes, and lax risk man­age­ment. We view much of the blame cur­rently put upon Lehman to be a school of red her­rings (either of the top two def­i­n­i­tions will suffice).

How­ever, we’ll use those con­ve­nient excuses to turn the argu­ment against the call for fur­ther bailouts. If Lehman’s demise – whether alone or in con­cert with other events – did cause mar­kets to seize and did cause many orga­ni­za­tions to begin to avoid risk and limit the exten­sion of credit, then it would seem that the fail­ure of another large firm would have less impact today than in Sep­tem­ber. So, what’s the harm.

Of course, as we writ­ten about on numer­ous occa­sions, despite our near Lib­er­tar­ian stance on eco­nomic issues, we’d pre­fer to see the gov­ern­ment nation­al­ize the worst offend­ers as a way to moti­vate the remain­ing firms to ratio­nal­ize their oper­a­tions: wipe-​out exist­ing share­hold­ers, except non-​executive employ­ees; fire the boards and senior man­agers; take 100% own­er­ship; and resell it as soon as possible.

Also, we’d still like to see changes in tax pol­icy to moti­vate the exchange of the moun­tains of cur­rently illiq­uid and deval­ued mort­gage secu­ri­ties: either res­i­den­tial mort­gage invest­ment tax cred­its or the imme­di­ate write-​off of the pur­chase price would suf­fice to pro­vide pur­chasers with a cush­ion against overly-​optimistic val­u­a­tions. (You might as well include com­mer­cial mortgage-​backed secu­ri­ties, too.)

As we wrote in early Octo­ber, the government’s solu­tion will extend the cri­sis because no one knows how to value those secu­ri­ties, and by the government’s own admis­sion, that hasn’t changed.

We think that com­bi­na­tion of moti­vat­ing the sell­ers with sticks and the buy­ers with car­rots, so-​to-​speak, would work.

The Wall Street Jour­nal has an edi­to­r­ial in today’s paper – Jan­u­ary 14 – that seems to be ripped from our head­lines: it calls for the dis­mem­ber­ment of Cit­i­group, and it implies that Citi has lost its right to exist. (See When Is Enough Enough?, for exam­ple, or any of our calls to nation­al­ize it.)

As we’ve seen in var­i­ous news reports, Cit­i­group has lost about $30,000,000,000 or so in the last five quar­ters and has received about $45,000,000,000 in TARP funds, and the fed­eral gov­ern­ment has guar­an­teed another $250,000,000,000 or so of its debts.

And yet, and yet, Citigroup’s stock price is about $5, which gives it a mar­ket value, accord­ing to Google Finance of about $32 bil­lion. That’s less than 10% of its share price two years ago and about 20% of its share price this time last year.

As a point of com­par­i­son, if the fed­eral gov­ern­ment gave us $45 bil­lion, we would be worth $45 bil­lion. (Well, almost $45 bil­lion, but a lot closer to $45 bil­lion than $32 bil­lion. And, yes, we know there is a dif­fer­ence between the government’s pre­ferred invest­ment and mar­ket value of the com­mon shares.)

Hmmm, with­out both­er­ing to check the tax impli­ca­tions, let’s gross-​up the loss of about $30,000,000,000 to the $45 bil­lion. That means that the gov­ern­ment has sub­si­dized all of the rec­og­nized losses to date.

So, despite the guar­an­tee of debt, which could be val­ued the same way that banks esti­mate val­ues of their insured deposits, and despite the addi­tional deposit insur­ance cov­er­age, etc., soci­ety and the world econ­omy think that Cit­i­group isn’t worth a whole lot.¹

Dili­gent, and younger read­ers with good mem­o­ries, may recall that as far back as Sep­tem­ber we sep­a­rated the mort­gage fiasco from the larger, and far more seri­ous, liq­uid­ity cri­sis in con­fi­dence. (Here’s an entry from early Octo­ber: Even A Per­fect Bailout Will Fail.)

We cite Cit­i­group as prima facie evi­dence of that dis­tinc­tion. Based upon equity val­ues – despite the government’s mas­sive injec­tion of funds and its guar­an­tees – we’d say that the mort­gage fiasco has informed investors through­out this coun­try and across the world that’s Citi’s man­age­ment excels at value destruc­tion, and that’s the con­sen­sus prospec­tive esti­ma­tion. That is, of course, unless investors esti­mate that rec­og­nized losses, which appear on finan­cial state­ments, are only a frac­tion of Citigroup’s true losses so far.

This wouldn’t be the first time that Cit­i­group under-​estimated its losses. As the Jour­nal edi­to­r­ial notes, in Octo­ber, 2007, Citi offi­cials claimed that it had only “$70 mil­lion in indi­rect expo­sure to sub­prime assets.” Now, how many orders of mag­ni­tude is that from the truth? So whether clue­less or duplic­i­tous, “why trust them?” the mar­ket seems to be saying.

In this case, it seems hard to argue with that logic.

By the way, the front page head­line of today’s paper is “Cit­i­group Ready to Shrink Itself by a Third.” We won­dered – in jest – why the sec­ond line didn’t read, “In Small Attempt to Align Assets with Equity Values.”

Like always, we may edit this post in the future, in case our early-​morning, frost­bit­ten fin­gers have erred.

Copy­right © 2009 Spero Consulting.

Foot­note:

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.

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.)

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?

Dis­parate issues linked by their over­whelm­ing smallness.

It’s been a few of weeks since our last post, and such a long gap is highly unusual as we’re rarely at a short­age for words. We’ve been busy, but more impor­tantly, we didn’t feel com­pelled to write about our nor­mal top­ics of inter­est; despite the mar­ket volatil­ity, lit­tle has changed in the inter­ven­ing days.

In addi­tion, the accu­mu­lated effect of see­ing so many behave in such small ways over large mat­ters was and is rather sad and depress­ing. No, we’re not talk­ing about the elec­tion cam­paigns, which, by the grace of God do have a def­i­nite end­ings – if only for a year or so until the next ones begins.

The Small­ness of Our Lead­ers: in the finan­cial cri­sis, few indi­vid­u­als took right, rea­soned, and prin­ci­pled courses of action or both­ered to think before they spoke. While we expect such fallen behav­ior on a day-​to-​day basis, we do hope that our elected and appointed offi­cials are able to rise to the occa­sion. Their fail­ures to do so – their panic and expe­di­ency – remain sources of dis­ap­point­ment. Here is a very, very, very small exam­ple that has stuck with us for nearly a month and was likely unno­ticed by most.

In the days between the two Con­gres­sional votes on the bailout, we saw a Con­gress­man from Ten­nessee rant about mark-​to-​market account­ing. He knew no more about account­ing issue than he did about any­thing else, except talk­ing per­haps, but that didn’t stop him.

While we lis­tened to his dia­tribe against it, we thought, hmmm, not a sin­gle spe­cific ref­er­ence to the under­ly­ing issues of rel­e­vancy, reli­a­bil­ity, eco­nomic effi­ciency, etc. Replace “mark-​to-​market account­ing” in his oth­er­wise generic spiel, “we have to some­thing about mark-​to-​market account­ing before it…,” and he had a ready-​made speech for all that is evil du jour: AIDs in Africa, the lack of clean water in vil­lages, ille­gal drugs, legal drugs, drunk dri­ving, inter­na­tional piracy, child labor, greed, for­eign car man­u­fac­tur­ers, can­cer, dia­betes, Wall Street exec­u­tives, oil prices, etc., and no other words would have changed. He had a handy demo­niza­tion tem­plate, and that made actual con­tem­pla­tion super­flu­ous; so, he had changed his mind and would vote for the bailout.

A the time, we thought, unfor­tu­nately, there are no lit­er­acy or poll tests for vot­ing in Con­gress. Or was it another exam­ple of voter fraud.

As we men­tioned, it is a very small exam­ple, but it suf­fices for small men and their lack of depth, and it also relates to the main pur­pose of this post.

A Few Words on Finan­cial Mar­kets: By the way, on those mar­ket and incen­tive top­ics – our nor­mal blog fod­der – we stand by every­thing that we’ve writ­ten and con­tinue to believe the bailout was and is a mis­take. Even if it does mit­i­gate the liq­uid­ity cri­sis – and we’re not sure that it has – we ask, at what cost to our econ­omy and our freedom?

For exam­ple, we’ve been mus­ing that many gov­ern­ment offi­cials have been able to quite inad­ver­tently meet their elec­tion year promise of sub­stan­tially reduc­ing energy costs – even before the elec­tion. But at what cost? They can rightly argue that their actions – whether planned or not – have saved bil­lions for the Amer­i­can peo­ple as oil has moved from its peak of $147 dol­lars per bar­rel to its cur­rent range in the mid-​60s. Unfor­tu­nately, it has been at the cost of tril­lions of dol­lars of wealth.

On that topic, in April, we pre­dicted (wildly guessed) that oil could be at $40 per bar­rel by year end. We could actu­ally see it quite lower – even in the $25 per bar­rel range. Our ratio­nale: the cohe­sion of OPEC and its part­ners, par­tic­u­larly Rus­sia, will likely fail­ure, and we expect large invest­ment funds – like CALPERS – to con­tinue to liq­ui­date their com­mod­ity hold­ings since equity val­ues have plummeted.

We’ll have more to say about eco­nomic issues in the next few days, par­tic­u­larly with respect to the recent change in tax poli­cies that pro­vide a ben­e­fit – the absorp­tion and use of loss car­ry­for­wards – that the IRS is per­mit­ting acquir­ing banks to take in the recent mergers.

That pol­icy change, while far less grace­ful and effi­cient, is not much dif­fer­ent than our idea to solve the mort­gage cri­sis – but not the liq­uid­ity cri­sis; so, pro­vides a small bit of hope. (Search the archives or read just about any­thing we wrote in Sep­tem­ber and early Octo­ber. We’ll still not sure that offi­cials real­ize that these two crises are distinct._ It is not nearly as clean or as pre­cise as our approach, but that’s not why we are writing.

Sarah Palin: as we wrote almost two months ago, we con­tinue to be amazed at the sense­less vit­riol and sheer hatred spewed towards Mrs. Palin, par­tic­u­larly among Hol­ly­wood and New York celebri­ties, who put forth as much thought as the above-​referenced Con­gress­man from Ten­nessee. As we wrote in our ini­tial post, they hated her before they knew her, and they could hate her with such ease because of who she is – some­one very sim­i­lar to many peo­ple we know, like, and love: con­ser­v­a­tive, pro-​family, pro-​life, middle-​aged, reli­gious and gun-​totin’.

But, we must add, we’re not sur­prised that so many thought­less and dull folks dis­miss her small town may­oral expe­ri­ence and her small pop­u­la­tion guber­na­to­r­ial expe­ri­ence. It says more about them and their lack of expe­ri­ence and intel­lec­tual empa­thy than it does about her.

We spent ten years in acad­e­mia, but it didn’t take that nearly long to appre­ci­ate the valid­ity of Henry Kissinger’s quote that – and we para­phrase – the fight­ing in acad­e­mia is so vicious pre­cisely because the stakes are so small.

What’s true in uni­ver­si­ties it is also true in small towns and most other orga­ni­za­tions as well, includ­ing the staff depart­ments of large corporations.

Regard­less of all the many ways that one can describe func­tions of gov­ern­ments, at a min­i­mum it involves resource allo­ca­tion and gath­er­ing (fund­ing). In other words, who gets what the gov­ern­ment has and who has to give for the gov­ern­ment to have.

Does the reader think that resource allo­ca­tion deci­sions are eas­ier in a small town than in the naiton’s cap­i­tal? One’s pur­chase deci­sions in a small town may aid or bank­rupt a neigh­bor, an acquain­tance or a for­mer class­mate who walks or dri­ves by your home every­day or attends the same church or shops at the same stores or eats in the same restau­rants. Con­sider that as opposed to doing this or that to a neb­u­lous and abstract groups like “small busi­ness­men” or “big cor­po­ra­tions?” in a locale where almost every­one – mostly strangers – are rep­re­sent­ing some­thing or some­one else: rather than directly feel­ing the pain of actions and decisions.

Does the reader think that tax­ing deci­sions are eas­ier in small towns than within the fed­eral gov­ern­ment? Raise prop­erty assess­ments and earn the wrath of those same neigh­bors, acquain­tances, and for­mer friends.

[Where is one more likely to receive the imme­di­ate feed­back from uncom­fort­able con­ver­sa­tions and cold stares? In Wash­ing­ton or Wasilla? Where is one more likely to receive neg­a­tive feed­back fil­tered and diluted through a staff of gut­less, careerist syco­phants? Wash­ing­ton or Wasilla? Yeah, the ques­tions really do answer them­selves. (Our hypoth­e­sis: local politi­cians find more dog waste in their front yards than aver­age cit­i­zens do.)

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. Such a set­ting is, of course, a recipe for exces­sive demand. Based upon that expe­ri­ence we’d cer­tainly argue in Mrs. Palin’s favor over some­one whose main pri­vate sec­tor expe­ri­ence seemed to be orga­niz­ing beg­ging efforts directed towards the fed­eral gov­ern­ment. (In our case, we joke that the best evi­dence of fair treat­ment is when every user is annoyed with us so try to ensure it.)

Of course, the con­tentious reader might always argue that such small towns are so cor­rupt that there is no notion of tak­ing actions that annoy friends and acquain­tances, i.e., the whole objec­tive is to enrich them (and one­self) while in town hall. In that case we’d then argue that it, indeed, pro­vides excel­lent train­ing for work in the nation’s cap­i­tal. But, that’s not really why we’re writ­ing, either.

Our point is much smaller though it is related to Mrs. Palin.

Mr. Letterman’s Per­sis­tent Lack of Humor: we were too involved in our work to change the chan­nel when David Letterman’s show began last night. We don’t recall any of the mono­logue bits, but they were as lame as usual. (No one, in good con­science, could call his lines jokes.)

What we do recall was a skit where one of the child actors wore an over-​sized ver­sion of Sarah Palin’s pass­port as a Hal­loween cos­tume. It was stamped Mex­ico and Canada (and the USA) and nowhere else, and that was it. That was the whole “joke.”

The car­di­nal that flies into and bangs its head on the fam­ily room win­dows hun­dreds of times each morn­ing exhibits about the same level of wit.

I guess the point of the pass­port cos­tume was to show that Mrs. Palin hasn’t trav­eled much out­side of Alaska or the US. Pre­sum­ably, such travel is now a qual­i­fi­ca­tion for Vice Pres­i­dent because…well, who knows why. It must be some­thing that only some­one as sophis­ti­cated and learned and cul­tured as our Ball State grad, Mr. Let­ter­man, could appre­ci­ate. Per­son­ally, we’ll take some­one will­ing to kill a moose. It takes more skill and courage.

Now, maybe we’re slow or just don’t pay enough atten­tion, but that’s when it finally hit us.

Mr. Let­ter­man has been unfunny for years; that’s not news, we and many oth­ers have writ­ten about that, and it seems to be true since at least the Rea­gan administration.

No, what we’ve con­cluded is last night was not only is Mr. Let­ter­man inher­ently unfunny, but to do that night-​after-​night, year-​after-​year, requires a staff. He can’t be doing the very lit­tle that he does alone. It is very likely that he has a very large and equally untal­ented staff of writ­ers excret­ing such mate­r­ial like ele­phants with dysen­tery five nights a week.

As we see it, it would take a sub­stan­tial num­ber of inse­cure and untal­ented indi­vid­u­als to gen­er­ate the group think required to per­mit such crap to air. Why, at its essence, it almost seems like gov­ern­ment work.

If it were only a few writ­ers, it seems that they would be more likely that they would be able (1) to main­tain their self-​respect and dig­nity and judg­ment, which would then per­mit killing such lame ideas when they were ini­tially dis­cussed or (2) to have the dis­cre­tion not to men­tion them to oth­ers in the first place.

Of course, we must con­sider all pos­si­bil­i­ties, and it could be the case that Mr. Let­ter­man only hires degraded indi­vid­u­als will­ing to do any­thing for money or nox­ious house­hold chem­i­cals. (In that case, he might be a bit more effi­cient than we sus­pect and is able to gen­er­ate his (albeit low-​quality) out­put with only a few comrades.)

So, why does he get the big money? Well, this is one time when we must pro­pose a labor the­ory of value as the answer. Per­haps, the per­sonal effort and sac­ri­fice required to asso­ciate with Paul Shaf­fer for an hour a day jus­ti­fies the com­pen­sa­tion. Bet­ter he than we.

Happy Hal­loween, and don’t worry, it gets worse before it gets bet­ter. The elec­tion is next week.

Has Pres­i­dent Bush, Sec­re­tary Paul­son, Chair­man Bernanke, or Speaker Pelosi taken a sin­gle action or spo­ken a sin­gle phrase dur­ing the past month to inspire con­fi­dence in their abil­ity – not to solve the prob­lem – but to sim­ply com­pre­hend it and char­ac­ter­ize it?

By “it,” of course, we mean the cur­rent liq­uid­ity cri­sis fac­ing cer­tain insti­tu­tions that seem to have lax boards and man­age­ments that encour­aged exces­sive risking-​taking behav­ior that led to over-​concentrations of hold­ings in cer­tain (nearly worth­less) asset classes.

Per­haps, that ques­tion is too harsh; so, we shall ask a dif­fer­ent one. Has Pres­i­dent Bush, Sec­re­tary Paul­son, Chair­man Bernanke, or Speaker Pelosi taken a sin­gle action or spo­ken a sin­gle phrase that has mit­i­gated, rather than exac­er­bated, the cur­rent crisis?

As reg­u­lar read­ers know, we often urge those with decision-​making author­ity to take a short­ened ver­sion of the Hip­po­cratic Oath and pledge to “do no harm.” Today we go beyond that and rec­om­mend: just shut up!

Of the most rec­og­niz­able national politi­cians – sorry most House mem­bers – the most intel­li­gent quote that we heard was from John McCain in an Obama, anti-​McCain ad. It’s the one with the bad cover of Sam Cooke’s “Won­der­ful World” with the lyrics “don’t know much about…”

In the quote, McCain admits to not know­ing much about eco­nom­ics. If he and the other national politi­cians could remain that hum­ble and thought­ful dur­ing the cri­sis, there is much less chance that they would exac­er­bate it and cre­ate a real panic. (Clearly, a for­mer “community-​organizer” would have a bet­ter grasp of sub­tle eco­nomic issues and con­cepts and thus be able to pro­vide such insights as – and we para­phrase–we’ll solve the prob­lem with com­mon sense solu­tions and, as a bonus for the envi­ous and spite­ful, we’ll screw the rich while we’re at it. (Reg­u­lar read­ers will recall our use of ital­ics to denote sarcarm.))