Monthly Archives: September 2008

Stop The Blame Game. Pass The Bill.

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Stop pointing fingers.

A friend of mine asked me tonight: didn’t you tell me you were against a bailout a few weeks ago? 

The reality is: Yes, I was against a bailout of any kind until Congress proved they were capable of coming up with a reasonable compromise in the context of a very dire situation. As discussed, I discussed below, I believe the regulatory process is working. Whether the bill as it currently stands is the best solution is debatable, but that intervention is necessary at this point has become almost certain.

However, unfortunately, as discussed here (Barnum and Bailey Would Be Proud) today’s House vote on the proposed bailout turned into a finger-pointing session with the politics of old ruling the day: Democrats pointed fingers at Republicans and Republicans defiantly stood against supporting Democrats.

All the while, the stability of our economy is suffering. The stock market was down more than it has been in history…and this was not a matter of pointing fingers. It was the market’s reaction to the outlook for the economy if nothing is done.

So why should you care? Shouldn’t we dig our heels in and protect our “free market ideals”?

Why the Bill should pass.

1) Normal people depend on credit in a number of ways in their daily lives. From grocery shopping, to buying a car, to paying for college, the majority of Americans rely on credit to live. Although people have legitimate concerns about an over-reliance on credit over the last half-decade, we are not living in an academic textbook. We should address financial literacy with education, not with a smack to the head.

2) If we do not do something, many more banks will fail, and credit will significantly contract as a result. As you have seen, a number of banks made mistakes and lent too much money to people based on a failed economic models. If we do not do something, many more banks will fail. In fact, even if we do intervene, it is almost certain that there will be continued bank failures as the economy begins to slow and corporate defaults begin. As the credit crisis continues, the reality of credit evaporation will hurt normal people in real ways. We should seek to minimize this unfortunate reality.

3) Our economic theories have been proven wrong…why rely on them now? Those who want to take a hand’s off approach to the current situation don’t have much of a leg to stand on. If you believe in the effectiveness of the free market, how can you explain the excesses that put us where we are today? The market failed. Of course it did. It was based on models built by human beings. We are imperfect, so we built imperfect models. This isn’t rocket science. Continuing to bang our head into the wall based on economic principles that have been disproven is not only illogical, it is dangerous.

4) People are afraid. When I first started learning about economics, I remember thinking the ideas of “consumer confidence” and “economic sentiment” were wishy washy terms. Why would we care about people’s opinions when thinking about economic growth? The reason people’s opinions matter is because people are our economy. The market is comprised of millions of people, and their subjective understanding of the economic outlook can be just as important, perhaps more important, than what that understanding should be. Watching the stock market plummet today and gyrate over the last few months has made everyday Americans wary of our future. We need to rebuild confidence in our economy to keep it from slowing more than it already inevitably will.

Is the Bill perfect? No. Will it create moral hazard issues for future executives? Maybe. Will the economy really suffer if the government does nothing? Almost certainly.

The government needs to put party politics behind us.

Unfortunately, the government is facing a credibility crisis.

Sure the Bush Administration has made mistakes.  It is unfortunate that our confidence in government has sunk to such a low level that people are finding it difficult to believe how bad things will get if we do not intervene. As John Stewart cleverly pointed out in a side by-side view of Iraq and Economy announcments, President Bush’s speech last week was similar to the announcement of the War in Iraq.

However, the fact that you disagree with the President about Iraq should not lead you to stubbornly refuse to recognize how bad things are looking for our economy. No matter what some people might believe, the stock market is not controlled by anyone, and today’s market downturn showed that investors – Democrats, Independents, and Republicans - are worried about our economy. And they should be. We are witnessing an historic failure of our financial institutions the ramifications of which will be felt for years to come no matter what we do.

Now is not the time to put Party before Country.

Remember…at the end of the story of The Boy Who Cried Wolf the wolf comes. He is now standing on our doorstep. The question now is what are we going to do about it?

I remain confident that we will do the right thing.

Just One Of Those Days (Video)

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As all of you are now aware, the proposed bailout Bill did not pass.

Here are some thoughts on what was a difficult day in many ways…even on a day like today, though, there were good moments for all of us. I hope we can focus on these moments rather than on the negative. I am confident Congress will come back and pass a Bill later this week…until then, good luck in the markets.

The Bailout Proposal – The Regulatory Process Is Working

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Congress has released a draft of the proposed bailout Bill, the full text of which is embedded below (information on download is here: Bailout Bill)

In summary, it seems like 3 major positives have emerged from the negotiations. On the whole, I think people are making reasonable compromises and that as a result something will get passed shortly.

1) Mortgage Modifications. Beginning on page 27, the bill discusses the requirement that the fund work with homeowners to modify their mortgages to the extent doing so would save money for all involved (i.e. foreclosures can destroy value for all involved if home values in the area are already severely depressed). This is an excellent idea, and for those of you who are familiar with my work on this topic, it is one that strikes close to home. Basically, it looks like Congress is trying to take some of the stumbling blocks out of the way for rational the renegotiation of home mortgages.

2) Equity Participation. Beginning on page 45, the bill introduces a requirement that the fund take warrants in any company that is registered, or has approval to be registered (Read: Goldman Sachs or Morgan Stanley), and is aided by the bill. The purpose of which is to:

provide for reasonable participation by the Secretary, for the benefit of taxpayers, in equity appreciation [created by the bailout]

This is great news, and this addresses my primary concern with the initial draft. Although it does not eliminate moral hazard, at least we (taxpayers) get to benefit with those who are bailed out.

3) Judicial Review. As expected, on page 65, the Bill introduces the concept of judicial oversight which was lacking in Mr. Paulson’s initial proposal.

These are phenomenal developments, and it shows that the regulatory process is working. I would love it if a bailout was unnecessary and preventable. However, given that it is inevitable at this point, I am very glad to see that our government and our leaders are coming to reasonable and rational conclusions on these matters.

It gives me faith in our government and our country. Let’s hope they keep moving in this direction.

Another interesting structuring detail: On page 50-51, the bill discusses a gradual provisioning of authority. Basically, the fund will start with $250B, then with Presidential authority and Congressional notice, the limit is raised to $350B, and finally it can be raised to $700B (it looks like Congress has veto power over any amounts over $350B, although it must exercise disapproval before the limitation kicks in).

One final somewhat “negative” develoment. Suspension of Mark-to-Market Accounting. A sign of the likely trade-offs made to get the bill closer to the finish line is buried near the back of the Bill, starting on page 95. It appears that the Bill gives the SEC authority to ban mark-to-market accounting as well as requiring a report on the accounting standard. This seems like an example of the regulators getting the cart before the horse. One would imagine that a study should precede any rule change, but it seems like Banking lobbyists have a lot of pull.

Here is the bill:


Bailout Plan – Get more Legal Forms

An Explanation Of The Crisis: Why Do We Need The Bailout? (Video)

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Following President Bush’s excellent speech last night, I thought it might be worthwhile to review the various issues contributing to this crisis with a focus on the institutional side of the problem and why these companies need to be bailed out. Having spent the last year and half focused on this problem, I thought my perspective might be worthwhile.

To be clear, I think intervention may very well be necessary and preferred at this point. My biggest concern with the proposals to date is that they: 1) do not allow taxpayers to particpate in the upside of saved financial institutions and 2) have not made it clear that taxpayers may suffer losses on these investments.

The video is a bit long, because I tried to walk through the history as simply as possible. Hope it is helpful.

Is Mr. Bernanke A Good Artist?

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Mr. Bernanke says he wants to hold the securities purchased in the bail out until maturity, but how much will they be worth at that point? Via Bloomberg: Paulson, Bernanke Put Bank Aid Ahead of Best Deal

“I am not advocating that the government intentionally overpay,” Bernanke told the Joint Economic Committee today, in response to a question from U.S. Rep. Jim Saxton, a New Jersey Republican.

At the same time, Bernanke also repeated his view that the government won’t pay “fire-sale prices” for the mainly mortgage-related securities Paulson aims to buy in a proposed $700 billion rescue. Officials want to set a long-term value on assets, holding them until they mature or markets improve.

To predict what such a scenario will look like involves answering a number of questions that are far from scientific…this is where the “art” of finance comes into play.

What will the world look like when the markets improve? Will the real estate market rebound? Will the global de-coupling thesis take hold with foreign economies pulling the U.S. out of a shallow recession? How much will losses be in the meantime? What discount rate should apply to such a set of cash flows? Just how successful will these bailout measures be if all previous actions have not slowed down the crisis?

These and literally hundreds of other assumptions will go into the valuation of the securities that Mr. Paulson and Mr. Bernanke are suggesting that we will purchase from banks at a price above the current market value.

The failure to properly value these securities by some of the smartest minds in the world and the collective wisdom of the markets has brought us to where we are today.

Why do we think Mr. Bernanke is a better artist?

The unfortunate result of the bailout will likely be losses for the American taxpayer. And without my suggestion below that we take an ownership stake in the companies we aid, the direct benefit of these purchases will accrue to the companies we aid.

However, it is important to also realize that if we can be confident that his this manoevre will avert greater financial disaster, we will collectively benefit from a shallower recession. This will provide an economic benefit to society as a whole, and this is what the administration is banking on.

One thing is clear: we should not expect to get out of this taxpayer losses if this bailout measure is approved. Being honest with these challenges is important as Americans wrestle with how they feel about the current proposals…and let’s hope that Mr. Bernanke is good at Art.

Let’s Own The Banks – Not Regulate Their Pay

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As I have discussed the bail-out with friends and professors over the last few days, one question keeps emerging:

If we are at the point where we need to infuse this capital into the system to break-up the logjam, Why not participate in the upside?

This is a question that I can’t seem to answer in the negative besides pointing to the pragmatic challenges of having our government run the bailed out institutions. However, at least one nation apparently faced a similar crisis with just this approach. From the NY Times, Stopping A Financial Crisis, The Swedish Way:

Sweden did not just bail out its financial institutions by having the government take over the bad debts. It extracted pounds of flesh from bank shareholders before writing checks. Banks had to write down losses and issue warrants to the government.

That strategy held banks responsible and turned the government into an owner. When distressed assets were sold, the profits flowed to taxpayers, and the government was able to recoup more money later by selling its shares in the companies as well.

“If I go into a bank,” said Bo Lundgren, who was Sweden’s finance minister at the time, “I’d rather get equity so that there is some upside for the taxpayer.”

This seems relatively straightforward, although dealing with the reality of running a number of large financial institutions including Freddie, Fannie, and AIG may not be something we want to leave to our Federal Government. One way around this is to become minority shareholders much in the same way Warren Buffett is now a minority shareholder of Goldman Sachs after his investment in the firm overnight. That way we can participate in the upside without having to take complete control.

In the let’s get angry and irrationally make bad decisions camp: there has been a lot of talk in the last couple of days about capping salaries on Wall Street. From In Bailout Furor, Wall Street Pay Becomes a Target:

The stratospheric pay packages of Wall Street executives have become a lightning rod issue as Congress shapes a $700 billion bailout for financial firms. Proposals circulating on Capitol Hill vary, but they all would impose some limits or approval authority on salaries of executives whose firms seek help.

This is simply ludicrous in my opinion. If we want to run these institutions, then let’s do it as owners not by creating some massive regulatory overhang that will have deterrent effects for decades to come.

We cannot forget the fact that even after this recession America will still have been the greatest economy in the history of the world, and part of that success is driven by the entrepreneurial drive to succeed. Limiting incentives can only have negative effects here and does not do anything except appease embittered politicians and impassioned constituents.

The political process is grinding through these various considerations, and as of yet nothing crazy has emerged. I am still optimistic that our system will come up with the best possible solution for a very bad situation.

Trying To Find Clarity

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Searching for clarity in a world as cluttered as the one we live in today could possibly be the hardest task we face in the twenty-first century.

In trading parlance, it is known as deciphering the “signal” from the “noise.”

In everyday language it is called making good decisions.

The government is currently facing a massively complex decision with conflicting data points, and principles pointing in every direction.

If you believe in free markets, you should not support government intervention. But, all economists know the markets need a little nudge now and again, so some intervention is ok…but not too much.

We also don’t want the financial system to collapse because credit and financing is one of the central driving forces behind our economy. Should we stand behind our principles and spite our face?

What about Moral Hazard? Everyone hates that. No one wants to create bad “incentives” for future decisions by management.

But what does this mean really? Do we think that companies will intentionally drive themselves into the ground so that they can receive $10 / share rather than $0 (as was the case in Bear Stearns)?

People should face the consequences of their own actions…but what if said consequences were unpredictable by anyone? If I step outside my door and a satellite falls from the sky, am I responsible? If I am a Nasa satellite expert might I be?

We should ensure that the American economy remains the strongest in the world…but if we couldn’t predict the repercussions of securitization and its spawn, how can we predict what the impact on the USD will be from these bailouts? Is Ron Paul right to worry about a collapse of the system entirely? But isn’t he being pessimistic? What about my argument below about taking our chances with ourselves in the drivers seat rather than foreign owners?

In times like these, it seems best to sleep on it and see what tomorrow brings. Unfortunately, the decision-makers and market participants are in a frantic race with night-filled negotiations to try to predict the best possible outcome.

I genuinely appreciate that effort and their attempt at crafting the best possible solution.

It is also in such trying times that the foresight of the founders of our nation are put to the test. They created a constitutional arrangement that has heretofore allowed us to be the greatest nation in the history of the planet.

And so, I reluctantly admit I don’t know what the best outcome is. I don’t know what the government should do. I won’t give up trying to figure it out, but the best I can hope for today is to trust that somehow, through some collective wrangling and wrestling some kind of clarity will come out of this mess.

And, thankfully, tomorrow is another day.

The Bailout Is A “Good” Idea: The Lesser of Two Evils

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It is worthwhile to read this accurate, though somewhat pessimistic, take on the proposed bail out, and why it is a bad idea: Why You Should Hate the Treasury Bailout Proposal

I am starting to come to a more moderate conclusion: Given how bad the economy is going to inevitably get, anything we can do to help moderate the crisis is probably the best option on the table at this point. The primary reason is that I don’t think we want to rely on foreign investors to buy our banking assets. Although we clearly must rely on foreign capital through the issuance of treasuries, I would rather have a foreign government as a creditor to our economy than an owner of our banks.

It seems like we are left with a choice of 2 evils:

Option 1: Let the “market” clear the assets of the banking system.

Unfortunately, given the precarious position of U.S. financial institutions and insurance companies (the largest and preferred purchasers of troubled assets) foreign investors and governments are the next logical market-clearing purchaser of these assets.

As you can see in the below chart from a Lehman Brothers report written in April, a large portion of the securities in the residential asset-backed security market have historically been purchased by insurance companies and financial institutions, both of which are in challenged positions today. Furthermore, this chart only shows residential asset-backed securities. A similar chart could be created for commercial real estate and other asset classes.

Thus, the marginal buyer of these and similar assets will likely have to come from another participant, and it seems like foreign buyers are next in line.

Option 2: Clear the market ourselves.

The government already tried an indirect form of this approach, through increased liquidity (low rates) and direct funding (borrowing window), but last week showed that this approach is not working primarily because the would be facilitators of said purchases are under so much pressure themselves.

Thus, Mr. Paulson has proposed the next best alternative: the U.S. Government becomes the market clearing mechanism.

Although this clearly flies in the face of so-called “free market” economics, we should not continue to bang our heads into the glass door, pointing at our obviously flawed text-books as a rationalization.

It pains me to see it come to this, but given the prospect of a troubled financial system even *with* the bail out, I am not sure that we want to see how bad things would get if we left things to their own devices.

It is certain that the long term consequences of such a move are unknown and unknowable: there has never been a world like the one we are in today.

And concerns about oversight mentioned in the above-linked post are surely important, as is the prospect for moral hazard if equity holders in existing institutions are allowed to remain in control and profit from the bail out.

However, I would much rather experiment with my government in the driver’s seat than leaving it to the mercy of the rest of the world.

Stop Blaming the Hedge Funds

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As Alan Greenspan stated this week, banning the short selling of financial stocks is a “bad idea.”

Although Mr. Greenspan likely has economic theories to back up his reasoning, my rationale is somewhat simpler.

It is a bad idea, because it is part of a series of actions, which seek to point the finger at the wrong party – here the “bad” short-sellers – rather than dealing with the true causes of the financial crisis.

Last year, when people were still naively assuming this was a problem that could be “contained” and that it was only an issue of “subprime mortgages”, both the popular press and regulatory responses pointed fingers at the easy victims of criticisms – the mortgage brokers and the so-called “subprime borrowers” who manipulated Wall Street into giving them a mortgage.

Now that it has become clear that this crisis is far more complex and far reaching, regulators continue to look outside of Wall Street for someone to blame for the crisis. Here they point the fingers at investors who have anticipated the failures we are now seeing materialize.

Perhaps this is an example of the common psychological experience that is at the failure of many relationships and careers: when things go wrong, it is very hard to look in the mirror and recognize that you are the cause of the problem.

As a fellow Harvard JD-MBA, I have a lot of respect for Mr. Cox and his SEC, and perhaps by demanding that investors explain “under oath” why they have the positions they do, he is looking in the mirror at the best ways his organization can address the regulation of financial trades.

However, this article (SEC Pushes Hedge Fund Oath in Manipulation Probe), which discusses the proposed “oath,” seems to indicate that what is going on is something deeper. That somehow Mr. Cox and others think that hedge funds really are to blame is a sad example of today’s politics: rather than looking the root causes of the crisis – bad incentives and too much leverage at financial institutions – the government is looking for an easy explanation.

Unfortunately, wasting time on issues like this will only make fixing the real causes of the problem that much harder and more difficult as would be investors become more skittish as they await the next regulatory intervention.