Bailout Misuse 2

Yesterday Binyanim Appelbaum reported in the Washington Post that "U.S. banks getting more than $163 billion from the Treasury Department for new lending are on pace to pay more than half of that sum to their shareholders, with government permission, over the next three years."

The 33 banks signed up so far plan to pay shareholders about $7 billion this quarter. Companies generally try to pay consistent dividends and, at the present pace, those dividends will consume 52 percent of the Treasury's investment over the initial three-year term.

"The terms of our capital purchase program were set to encourage participation by a broad array of financial institutions so they strengthen their financial positions," Treasury spokeswoman Michele Davis said.

The Treasury's approach contrasts with decisions by foreign governments, including Britain and Germany, to require banks that accept public investments to suspend dividend payments until the government is repaid. The U.S. government similarly required Chrysler to suspend its dividend payments as a condition of the government's 1979 bailout.

The legislation passed by Congress authorizing the Treasury's current bailout program is silent on the issue.

The Financial Times reports today that AIG, the huge bailout beneficiary, has borrowed from one federal program to pay back loans taken out from another federal program. The reason? "Analysts said that AIG might have used the commercial paper facility to pay back the loan because the interest rates charged were lower. The government demanded a punitive rate of 8.5 per cent over the London Interbank Borrowing Rate on its $85bn two-year loan, while the Fed is charges interest of around 2-3 per cent for three-month commercial paper."

Another contrast with Europe: the German Bundestag's bailout legislation, passed October 17th, restricts executive salaries at any beneficiary institution to 500,000 Euros per year. Some executives warned that this would discourage banks from participating, thus admitting that many executives would consider letting their banks default rather than try to survive on the minimum wage of 500k a year. But it passed nonetheless, the conservative prime minister Angela Merkel intoning, "no aid without a quid pro quo."

Use and Abuse

The bailout money was supposed to pay banks to do their actual job and lend money. There are reports that the money will be used for a new round of bank mergers and acquisitions. Amy Goodman reported on October 28th that "Bank Bailout May Lead to Greater Consolidation".

A similar message came from the other end of the political spectrum, the investment advisers at Money Morning:

Those billions are a virtual lock to set off a merger tsunami in which the biggest banks use taxpayer money to get bigger – admittedly removing the smaller, weaker banks from the market, but ultimately also reducing the competition that benefited consumers and kept the explosion in banking fees from being far worse than it already is. . . .

According to Dealogic, government investments in financial institutions has reached $76 billion this year – eight times as much as in all of 2007, which was the previous record year. And that total doesn’t include the $125 billion the U.S. government is investing in the large U.S. banks as part of its rescue package, the similar amount it may invest in smaller banks, or other deals that the feds are helping engineer (JPMorgan Chase & Co.’s (JPM) buyouts of The Bear Stearns Cos. and Washington Mutual Inc. (WAMUQ) are two such examples).

MM quotes an M&A analyst explaining why: "When it comes to M&A, there’s always a pronounced ‘domino effect.’ Consolidation breeds more consolidation as industry leaders conclude they have to keep acquiring in order to remain competitive.” The crisis hasn't made the drive toward concentration go away: it's made it worse.

Market logics aren't being checked by government money. They are using government money to carry on business as usual. That is of course the point of government efforts, most effectively laid out by Sarkozy in France: reassure the public, but also get market leaders back on their feet, which will mean plowing a lot of weaklings - aka your local regional bank - into the topsoil, fertilizing it with tax dollars, and giving the financial giants a whole new root system.

Money Morning says, invest in a regional bank today, before it gets bought! Especially in the Southeastern US!

The amount of leveraging is so enormous that the bailout money can't stop it. Think of leverage as Hurricane Katrina and the bailout as the New Orleans levees. Here's MM's Keith Fitz-Gerald on the combination of size and the absence of real knowledge about what's sitting out there.

As scores of highly leveraged hedge funds dump billions of dollars worth of holdings at once, they effectively “flood” the markets with whatever the asset is that they are trying to sell. In doing so, they push the values down for the rest of us. For an example, imagine a house in your neighborhood selling for 50% of its appraised value. Upon completion of the sale, all “comparables” in the area, including your own home, will likely take a hit as a result. So it’s in everybody’s interest to keep prices as high as possible.

But nobody can do that when there are more homes than buyers – even in the best neighborhoods.
So when is it going to stop?

We don’t know. No one does. Hedge funds are notoriously secretive in their reporting, so even though there are estimates as to how much they own and (by implication) how much they owe, it’s hard to gain perspective on how much leverage is actually being used. Nor do we really know who holds what asset – especially as it relates to potential liquidations.

Over the weekend, rumors were flying that U.S. Federal Reserve examiners are hounding Citadel Investment Group LLC regarding “counterparty risk” and its exposure to debt. Citadel, naturally, vehemently denies this, but lately where there’s smoke, there’s certainly been the potential for fire.

Then there’s Europe. Despite the fact that many Europeans find it fashionable to blame the whole financial-system meltdown on the United States, mounting evidence suggests they may be the biggest hypocrites of all.

Data from the Bank of International Settlements shows that Western European Banks may hold as much as $4.7 trillion in cross-border bank loans to Eastern Europe, Latin America and emerging Asian markets, which means, as Bloomberg News journalist Tom Cahill described it as “the exposure of continental European banks to a whole set of ‘sub-prime’ nations in the form the former Communist bloc may be the Achilles heel of the European banking system.”

That means that “the elephant in the room is that while public sector debt was held in check by policymakers, private debt as a percentage of GDP exploded, as that was not part of convergence criteria to join the Eurozone."

Secrecy, no public figures, no knowledge - that's the core of all of this.

Fools Who Run Things

The most shockingly dumb moment of the week was former Fed chairman Alan Greenspan apparently said this to the House Committee of Oversight and Government Reform:

I made a mistake in presuming that the self-interest of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms."

If Greenspan really said this, it is admission that markets do not self-regulate and that self-interest is not the highest form of government. It then follows that you need actual governments, and that democratic processes can control markets if they want to.

This is in short the self-immolation of 50 years of the right-wing market ideology that he has championed his entire career, that was advanced by the Reagan era, and that Greenspan implemented during his 18 years as the summit of global financial policymaking at the Fed.

The Wall Street Journal reports it slightly differently. And neither statement appears in Greenspan's prepared remarks. The latter are baldly incoherent. Greenspan offers several different explanations for the crazy mispricing of mortgage-backed and other assets, and then says this:

It was the failure to properly price such risky assets that precipitated the crisis. In recent decades, a vast risk management and pricing system has evolved, combining the best insights of mathematicians and finance experts supported by major advances in computer and communications technology. A Nobel Prize was awarded for the discovery of the pricing model that underpins much of the advance in derivatives markets. This modern risk management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year because the data inputted into the risk management models generally covered only the past two decades, a period of euphoria.

The model collapsed. It collapsed was based on bad history? Think about what this says about the ruling paradigm of finance capital for the last 30 years - gone - and about economic models in general - no better than historical data.

Greenspan is finished, but rescues are being attempted in John McCain's non-stop clown show. Many people have commented on his weird performance on Fox News on Sunday, where he denounces socialism while praising the government bailout. Actually, McCain's position is totally coherent. "Socialism" for McCain means "redistribution" in which incomes become more equal (we've been in the midst of an inequality boom for 30 years). "Bailout" means giving $700 billion to banks, which means maintaining if not extending income inequality. "Socialism" means more money below. The bailout means more money above. McCain's support for bailouts makes perfect sense. (Rick McArthur does a nice job explaining to Amy Goodman why Obama is a conservative and not a socialist.)

Another act that had the center ring for a while was famous investment genius Warren Buffett, who used a piece in the NYT to try to talk all the little frogs back into the boiling water. Buffett says his money is now in stocks, tells everyone to buy stocks without the disclaimer of his own self-interest in helping himself out with this advice, and then tells everyone the only way to make real money is to do the opposite of everyone else. In other words, buy when they panic sell, sell when they frantically buy.

This is irresponsible, reprehensible advice: regular people cannot do the opposite of what everyone else is doing, since the only basis for doing that is the kind of professional training and experience that Buffett has and that you and I do not. Nor do we have Buffett's billions to gamble on buying some real crap cheap, only to see it go down for ever.

Buffett is at least nice about it. Another circus act in the Wall Street Journal abuses Joe Blow investor for not taking enough risks, then for taking too many risks by, at age 55, still being in stocks! The springs are flying out of the Jack-in-the-box.

Maureen Dowd issues the first call for revenge I've seen in the NYT. Now we're getting somewhere.

Dean Baker is best skewerer of the "sorry, it was an accident" school of letting big financial fish off the hook. He was predicting the collapse of the housing bubble for years, and is wonderfully vicious about the protestations of financier innocence that are justifying the bailout. He describes an alternate universe in which Alan Greenspan says in 2002 that there is a housing bubble and uses the Fed to educate the press and the economists and the realtors and the public. Had this happened, he asks,

Does anyone think that the execs at Goldman Sachs, Citigroup, Merrill Lynch and the rest could say "who could have known?" to their shareholders, who just saw most of the value of their stock disappear? My guess is that all of these execs would be out of their jobs and facing lawsuits for neglecting their responsibilities to their shareholders.

(See his equally valid dig at the NYT for attributing noble educational motives to wealthy conservatives but not to organizations like his.)

This has been another horrible financial week for Earth, especially its regular folks. While my Google news feeder was telling me that Obama was going to visit his grandmother, Monday's Financial Times was a slow-motion train wreck. " ING takes 10bn E injection from state." "Silicon Valley suffers wave of job losses amid pessimism." "Crisis engulfs the Emirates." That's just the front page. Page 2: "Call for west Europe to support east." "Mexico inquiry into derivatives is widened." "Soeul launches $130bn loan and liquidity rescure." "Pakistan seeking IMF help. " "Rations cut for army of buyers." "Public blame bankers for abusing system." Page 3: "US faces its worst recession in 26 years." "Indicators hint China on verge of sharp slump." The only thing making any money is the Obama campaign (page 4) - and some of the giant banks that got us here. By today it was even worse, with markets in Japan, Korea, and Hong Kong having now lost 50% just this year .

And that doesn't even get to the real economy, where companies are busy flinging their employees into the water.

Years of Counterfeiting

The big news for most people in the US this week was not the equities plunge but the plunge's impact on retirement assets - they've lost 20 percent of their value in the past 15 months. This will cause a seismic shift in retirees' feelings about markets - right as the boomers try to retire in earnest.

The other big news is that the confidence fixes didn't work. The feds didn't do nothing like 1929. But they did next to nothing like 1987. Actually more than 1987. But junk wasn't enough, and buying commercial paper wasn't enough, and the math still doesn't work out - the market in Credit Default Swaps is worth $62 trillion! So now the Repubs have to tear their hearts out and take government ownership positions in exchange for cash. And it still won't work.

Why not? Because banks won't lend to other banks whose assets are counterfeit. Many many many assets consist of notes whose value was created in the writing of the notes, and which hinged on leveraged debt. These notes had that value once in a specific exchange. They don't have it anymore.

I'm not saying credit isn't real. I'm saying issuing credit is like printing money. There was way too much of it. The amount of "M3" money increased from 1971 to 2006 by a factor of 14. People depended too much on it for their standard of living. It also made life to expensive. The deflating of invented assets isn't over yet.

Costs of other bailouts (from Le Monde October 3, 2008 p 9):

1986 -1995: savings and loan bailout - $160 billion, or 3.7% of GDP, 78% paid by the government

1991-1993: Swedish banking crisis - $65 billion crowns, or 4% of GDP

1998-2001: Japanese banking crisis - Y60 trillion, or $500 billion dollars, 12% of GDP; 70% of cost to state paid by selling shares on the market

Scarier than Usual

Here's a piece from today's Financial Times that gets at the underlying instability in the financial markets - at the underlying insolvency, to be exact.

Reshaping the banks: time to ask the IMF for help

by Raghuram Rajan

Financial markets are in panic. Central banks are willing to lend against all manner of collateral. Yet inter-bank credit markets are freezing up. Why? Have central banks contributed to the problem? And what do we do now?

The root of the problem, of course, lies in one class of assets, mortgage backed securities, rising in complexity as a result of defaults on the underlying housing mortgages, and falling in liquidity and value. Banks found they could no longer pledge these assets as collateral against borrowing. A bank now had two problems.

One was an immediate liquidity problem. It had to find a way to finance the mortgage backed securities that were previously financed with debt. The second was a capital problem. Because the market value of its assets had fallen, it was very thinly capitalized on a market value basis. But this problem could be handled later.

This, in a sense, was the Bear Sterns situation – illiquidity rather than insolvency. Central banks reacted by expanding the range of entities they would lend to and the range of assets they would accept as collateral. This immediately alleviated the liquidity problem, as banks borrowed pledging illiquid assets at the central bank.


But having solved the liquidity problem, banks did little to bolster their capital. Indeed, the capital problem has been getting worse. Moreover, with much of the collateral pledged, the bank has to rely on unsecured funding. Unsecured lenders to the bank (and the inter-bank market is unsecured) are now unwilling to lend, knowing that their claims will be hit when the bank defaults. And unless the central bank is willing to substitute for the entire unsecured loan market, the bank will have to default. What was a liquidity problem is now a solvency problem, which cannot be solved by further small increases in liquidity infusion.

Why have the banks not been more pro-active in raising capital? Clearly they felt they had time, in large part because the assistance from the central banks alleviated the liquidity problem. Rather than selling equity when asset prices were moderately depressed, they thought they could wait the crisis out. And central banks may have been at fault in not pressing the issue harder when it was easier to raise capital, especially given that their liquidity assistance was helping banks postpone capital raising.

What now? In the United States, the Treasury Plan has focused on buying distressed assets rather than on recapitalizing banks. Of course, if the price of mortgage backed assets can be boosted sufficiently and quickly, some banks will be recapitalized, but given that the values of many other assets are falling, this may only be a partial fix, even if it works. And it may be too late. Hopefully, the authority obtained from Congress can be quickly redeployed in recapitalizing banks more directly.

The reluctance to call this a problem of inadequate capital is, partly, prudence (which central banker wants to say parts of the banking system are insolvent) and partly optics. A liquidity intervention could perhaps be passed off as something that need not cost the taxpayer, while a capital infusion by the government seems a more final use of taxpayer money. Politicians still may believe drastic action is not warranted, though it seems that buying assets at made-up prices is as drastic, if not more, than buying equity or preferred shares at market prices.

The more Machiavellian view is that large players in the banking sector like the way it is currently being reshaped, as these too-big-to-fail entities are willing to run down their capital ratios buying the lucrative businesses of entities that have failed. They prefer a selective and limited rescue. While a reshaping of the banking system may be needed, it would be unfortunate if access to government protection rather than efficiency determined how it was reshaped.

There have been many suggestions on what to do. A temporary guarantee of the short term liabilities of all levered financial institutions, a quick audit, followed by speedy resolution of those that are beyond revival, and a recapitalization plan, perhaps including government money, for those that can survive, are all elements of what needs to be done. Key here is to provide incentives for private capital to participate, and even do the bulk of the lifting. Purchases of distressed assets from banks will be part of the solution, but it cannot be the sole item. Indeed, there is tremendous experience in the IMF of how this can be done. All the United States needs to do is ask!

The author is a professor of finance at the GSB, University of Chicago.

October 7th, 2008

What the Numbers Mean

Listening to French Bloomberg in Lyon, seeing the shocked face of the newscaster as she looks at a world of red ink, seeing the CAC 40 fall over 9 percent in one day, Germany's DAX down 8 and the Dow back under 10,000, I think that this will destroy the blind faith in markets for a generation.
As you watch the sheep heading over the cliff, you naturally wonder why you followed them in the first place.

There's lots of anger everywhere about giving $700-800 billion to the same people who created the need for it in the first place. Here's the sound of an angry economist. Here's an apologetic columnist, misusing the kind of argument I made yesterday about peer pressure in markets to say new regulation might stifle innovation. He's right to say that "The returns on what turned out to be toxic assets were just too good to miss. Any banking chief who had dared pull out of the market for, say, leveraged loans or mortgage-backed securities in 2005 and 2006 would have been lynched by investors for destroying shareholder value."

It went way beyond that. Covering today's Congressional hearings on the Lehman Brothers' collapse, the New York Times noted that "Another document showed that executives were warned in a January 2008 meeting that the company was facing liquidity problems. Yet the firm moved forward with capital outlays, including $5 billion in bonuses, $4 billion in shares and $750,000 in dividend payments between 2007 and the firm’s bankruptcy filing on Sept. 15." Massive debt, leverage, invented investment vehicles, obscured risk, deception, wishful thinking, free credit sponsored by the US government - all maxed out to max out gains.

Meanwhile, in France, Le Figaro, the conservative newspaper, published a poll (Friday October 3, p 21) in which they asked with which of 2 views on the current crisis their readers agreed the most. One was that the current crisis was like the others capitalist systems have, and that the system will soon get back on its feet. One-third agreed with this. The other was "the financial crisis is a crisis that shows that it is necessary to change fundamentally the capitalist system." 59% chose this.

Avoiding the Tailspin

Behind every failure there is the moment of coercion. With Fannie Mae, it was the moment in which Angelo Mozilo, then the head of Countywide Financial - now defunct - told Daniel Mudd, the head of Fannie Mae, that Fannie Mae would either buy all the subprime mortgages that Countwide wanted to sell it, or they would take all their business directly to Bear Stearns and similar firms.

Charles Duhigg reports the following conversation in the New York Times:

“You’re becoming irrelevant,” Mr. Mozilo told Mr. Mudd, according to two people with knowledge of the meeting who requested anonymity because the talks were confidential. In the previous year, Fannie had already lost 56 percent of its loan-reselling business to Wall Street and other competitors.

“You need us more than we need you,” Mr. Mozilo said, “and if you don’t take these loans, you’ll find you can lose much more.”

Then Mr. Mozilo offered everyone a breath mint.

These and many similar pressures forced Fannie Mae to contradict its own judgement and lap up subprimes. It's easy for us on Sunday morning to say that Mr. Mudd shouldn't have gotten drunk on Saturday night. But actually they put a funnel down his throat and poured the beer down for him.

Different pressures were coming from Congress. Duhigg summarizes them as wanting Fannie Mae to support more affordable housing. Here's another key moment:

“When homes are doubling in price in every six years and incomes are increasing by a mere one percent per year, Fannie’s mission is of paramount importance,” Senator Jack Reed, a Rhode Island Democrat, lectured Mr. Mudd at a Congressional hearing in 2006. “In fact, Fannie and Freddie can do more, a lot more.”

This is the moment when unthreatened people realize that they've caught the wrong guy - the perpetrator is not Fannie Mae, but the new financialized economy itself. But everyone was caught in the squeeze. And everyone did the wrong thing.

The argument for regulation is not that citizens, especially leading bankers, need to be under tighter government control. The argument is that regulation sets standards such that a few especially aggressive operations don't drag everyone else down.

Another example is retail underpricing. France still has a lot of local bookstores because the maximum legal discount is 5 percent. The Fnac, France's equivalent of Borders and Circuit City rolled into one, can't get people to avoid their local and cross town for a 40 percent discount. The same goes for bread and a lot of other products where quality matters to society, and so does a healthy distribution network that keeps neighborhoods thriving.

Why can't we figure this out in the US?

For an economist's version of this argument, see Robert Frank, who has to again state a case for minimum collatoral standards that should be obvious. Why isn't it obvious?

My gut feeling is that it's the prevalence of the threats.