Monthly Archives: October 2008

Yes. This Is A Bailout

Any question as to whether the government was going to use its powers to directly prop up failing financial institutions will soon be eliminated.
According to Bloomberg: U.S. Treasury Said to Invest $125 Billion in Major U.S. Banks

The Bush administration will invest about $125 billion in nine of the biggest U.S. banks, including Citigroup Inc. and Goldman Sachs Group Inc., in the government’s latest attempt to shore up confidence in the financial system.

The Treasury plans to spend $25 billion each for stakes in Citigroup and JPMorgan, people said. Another $25 billion will be divided between Bank of America and Merrill, which agreed last month to be acquired by Bank of America. Wells Fargo is to get at least $20 billion, Goldman and Morgan Stanley will each get $10 billion, and State Street and Bank of New York will get about $3 billion each, people said.

The government will obtain its stakes with a type of security designed not to dilute the value of common shares.

It is this last piece of the plan – that existing common equity holders will not get diluted by the government’s investments – that I hope is not accurate.

One of the key ingredients to getting the bailout proposal to the finish line was that any entity that sold assets to the government would have to give up equity. It seems unfair to allow existing equity holders to have a free pass at government funds in any case.

The warrant concept included in the bailout bill served 2 functions: 1) It allowed the government to participate in the upside of any plan to save these institutions, and 2) It forced existing management to take a hit, by sharing the pie with taxpayers.

Given Mr. Paulson’s sophistication and the job he has done to date, I would venture to guess that the article has this piece wrong.

But one thing appears to be clear: Mr. Fuld’s company, and my former employer, Lehman Brothers will likely be the first and the last major investment bank to fail if the government has anything to say about it. I would imagine he as well as investors in institutions like Washington Mutual are wondering why they got left out in the cold.

Dealing With Bad News

Although the news around the financial crisis continues to worsen, an equally important and self-perpetuating component of this crisis is people’s reaction to the news.

Where We Are In The Crisis

To re-iterate: It has been obvious for two years that a recession was inevitable, and it is likely we will see more losses for real people and companies of all sizes before we get through this.

That the crisis is spreading in a logical manner was indicated by GE’s announcement on Friday that they are seeing rising consumer defaults: GE takes hit as consumers default on debt. The next step is slowing retail sales, failures by more companies exposed to these sales, more layoffs, etc.

However, a recession does not mean the economy does not continue to function, and some losses does not mean everyone will lose their job or savings.

We have seen recessions before and we will see them again, and we will be ok. It is all a part of capitalism!

Dealing with the reality of how this crisis has unfolded has been hard because – like everywhere else in life – predicting the future of how people react is very difficult.

The “Markets” = People

We can not lose sight of the fact that, at base, these markets are comprised of individuals or computer programs built by individuals. When the complexity of predicting human behavior is multiplied by a series of financial innovations like derivatives and highly levered institutions with connections across global capital markets, predicting the outcome of shocks becomes nearly impossible.

If I was better at math, I would draw a fancy formula to “prove” such a proposition, but like most true things in life, it seems obvious without much explanation.

One of the most difficult aspects of this predictive process is figuring out how individual decision-makers (including bankers, investors and consumers) will react to the ongoing crisis. This is important because pessimism can make a bad problem worse.

The recent downward spirals in markets from the LIBOR market to the stock market to the local corner market are partially based on the reality of weakening fundamentals in the economy, but they are also based on a normal human reaction to bad news.

People = Irrational

Jeremy Grantham of GMO, one of the smartest investors around in my opinion, talks about how “career risk” is a very important element to understanding market movements. When everyone is buying, it is more risky for your career to be the one to stop buying first…and today, when everyone is selling, if you are the first one to start buying and you are wrong, it might look bad to your boss.

I think this explains part of the herd mentality that we are witnessing.

However, I think part of it is also explained by something like The Kübler-Ross grief cycle:

The initial state before the cycle is received is stable, at least in terms of the subsequent reaction on hearing the bad news. Compared with the ups and downs to come, even if there is some variation, this is indeed a stable state.

And then, into the calm of this relative paradise, a bombshell bursts…

* Shock stage: Initial paralysis at hearing the bad news.
* Denial stage: Trying to avoid the inevitable.
* Anger stage: Frustrated outpouring of bottled-up emotion.
* Bargaining stage: Seeking in vain for a way out.
* Depression stage: Final realization of the inevitable.
* Testing stage: Seeking realistic solutions.
* Acceptance stage: Finally finding the way forward.

As people across the economy, in whatever role they are playing, get the bad news that the world is in a more disappointing state than they expected, it is only natural that they will react with grief. As explained by they framework above, this is usually experienced in distinct phases marked by one’s emotional response and mental reaction.

Of course, this theoretical framework, like every framework, is limited and it likely does not apply to everyone, but I think it highlights the basic idea that people do not act rationally when they are faced with shocks to their world view.

They – being human beings – react emotionally as well as rationally.

That is why I have been trying to shift my focus to optimism as much as possible lately. Seeing the glass as half-full, or even one-quarter-full, makes it much easier to start thinking about ways to move forward. It helps to move to the next “stage” in the above cycle, or more simply, it allows for one to think creatively about how to improve things rather than wallowing in the disappointment of the losses we face.

I can promise you that there will be more bad news on the television and on the Internet tomorrow and for months to come. But there will also be good news. I hope that we can collectively deal with our losses and griefs in such a way that allows us to move forward more quickly than the alternative, and I think that starts by seeing the good in the world.

In the mean time, be careful out there in the markets.

Unforeseen Side-Effects of Lehman Bankruptcy

Apparently there may be up to $360B dollars in losses tomorrow as the auction for the Lehman CDS contracts are settled according to this Reuters article: Lehman CDS sellers face massive losses in auction

Banks, hedge funds and other sellers of protection on Lehman Brothers’ debt are facing losses in the area of 90 percent the insurance sold when the value of the failed bank’s credit default swaps are settled in an auction on Friday.
The auction to settle credit default swaps protecting the debt will be one of the largest settlements of contracts in the $55 trillion market, with around $400 billion in contract volumes estimated on Lehman’s debt.

Fannie Mae and Freddie Mac’s credit default swap settlements on Monday were the largest to date. But unlike swaps on the agency debt, which recovered more than 90 percent of their value, Lehman’s protection sellers face the possibility of being virtually wiped out.

This component of the Lehman bankruptcy highlights some of the unforeseen repercussions of their filing that are causing ripples throughout the financial markets.

It also highlights the magnitude of the $60 Trillion notional value CDS market. One way to think about this is that there is somewhere between $15 and 20 Trillion of face value between MBS, CMBS, and Corporate bonds. The CDS market thus represents 3-4x the total amount of credit outstanding in the economy.

Thus, whenever corporate defaults happen, the losses associated with these failures can be much larger than the “balance sheet” of the failing company. Given the fact that there are people on both sides of these CDS transactions, this arguably should not be a net loss to the economy (i.e. there are both winners and losers).

However, when losses come in spikes like this, it can clearly threaten the viability of individual firms, forcing them to sell other securities, which exacerbates the pressure of normal losses.

Furthermore, given the already strained nature of a number of these firms, it is clear that continued losses like this will cause failures.

As we are in the midst of the turn of a credit cycle, losses are inevitable and part of a slowing economy. The problem this time around is that institutions are highly levered and losses are being felt in ways that were unforeseen…causing more firms to lose money, sell assets, and creating further downward pressure on asset classes globally.

All of this adds to the fear and uncertainty that you are feeling and seeing in the markets right now.

Things are looking bad. Things will probably get worse.

BUT, don’t forget, things are also very good. There are a lot of phenomenal companies that are going down with those that are challenged, and particularly in technology, these companies will be making money for years to come.

I am convinced our best days are ahead of us…we just may have a few more bad ones in between now and then.

UPDATE: Last night’s estimates were accurate. According to this arcticle, losses will be upwards of $360B: Lehman Debt Protection Cost Set at Auction

Issuers of unregulated derivatives promising a payout in the event of a Lehman Brothers default will pay more than 91 cents on the dollar to settle credit default swaps related to the bankrupt company.

Warren Buffett On The Crisis By Charlie Rose (video)

A long, but worthwhile explanation on where we are…and why the bailout was necessary. Thx to ADK.

Some highlight Buffett-isms from the video:

  • I would rather be approximately right than precisely wrong
  • This is truly an economic Pearl Harbor.
  • The patient on the floor in cardiac arrest is not Wall Street, it is the American Economy
  • Everyday you don’t react to Pearl Harbor you are otherwise behind in a war that you would have fought.
  • Sheila Bear and Hank Paulson are great leaders…need more tools. They need money and flexibility.
  • Derivatives…financial weapons of mass destruction.
  • We naturally go through the 3 I’s: Innovators, Imitators, and the Idiots.
  • Leverage is a lot like Cinderella at the ball…we all know they turn into pumpkins at 12…nobody wants to leave before then.
  • Confidence in institutions is a lot like oxygen…when it is gone for 5 minutes it is the only thing you think about.
  • The American System unleashed more potential in human beings…we have all the ingredients for an incredible future.
  • Beware of Geeks bearing formulas.
  • I’m not worried about the country, I’m worried about anything that gums up the potential of the country.
  • The recession is going to get worse…best case is 6 months. Worst case is a long time….5 years.
  • It is more important who the Treasury Secretary is than who the Vice President is.
  • I would hand a blank check to someone like Hank Paulson.
  • Mark to market is a good idea. Telling the truth never hurt anybody. You get in a lot of trouble when you start putting fictitious numbers on assets.
  • I am paying the lowest tax rate in my life…and that is crazy. I should be paying more taxes.
  • We need real leadership in government. Someone who can explain things to people.
  • If AIG had tried to unwind its derivatives book, it would have hit every financial institution in the world.
  • It would be crazy not to do this….you are going to see more bad news. But over time the system will work.

On Laughter And The Importance Of Leadership

Have you ever noticed that when you are sitting in around a table in a meeting, when the “alpha” laughs everyone else typically follows suit?

Often this is the boss, and I remember reading somewhere this is explained by some social-psychological theory about pecking order or something like that.

I think of it as another example of the fact that most people in the world are followers. It is really hard to be a leader, because leadership implies taking chances and putting yourself out there, which is scary.

But this phenomenon also explains why leadership is so important.

On the global stage it is hard to argue with the fact that America is the alpha. Foreigners follow our media, our companies and our politics.

That’s why it is not surprising to see that foreign governments are now following suit in applying the “too big to fail” moniker.

Hypo Real Gets EU50 Billion Government-Led Bailout

The German government and the country’s banks and insurers agreed on a 50 billion euro ($68 billion) rescue package for commercial property lender Hypo Real Estate Holding AG after an earlier bailout faltered.


The government and the Bundesbank have said that Hypo Real Estate, Germany’s second-biggest property lender, is too big to fail.

In these challenging times it is important for leaders to be principled in their decision making and in their actions.

This need for leadership is all the more reason why the “pork” included in last week’s bailout bill is all the more troubling.

The government had the chance to take a decisive step in the direction of bringing the country together to help stave off a deeper economic crisis. But in this moment, when the spotlight was shining and the microphone was in our hands, we faltered. Rather than booming with laughter, we mumbled, and stuttered. And although we did take a step in the right direction, because of the body-language, the message was not nearly as powerful as it could have been.

This need for clarity and precision is somehow related to the appeal of clean design in user interfaces, but I’m not sure that I understand Aristotelian ethics enough to make the connection intelligible. I think it has something to do with simplicity and directness.

In any event, as we head into the final months of this election season and beyond, it is important that we demand this kind of leadership from our government. The world is watching.

The Problem With Binary Thinking (And The 2 Party System)

What caused the credit crisis?

People have been speculating about this for months, and until recently most of the conversation on the topic was relegated to our corner of the blogosphere and academia.

During the lead up to the current headline events, this debate has been enriching, and although people disagree about the fundamental causes, it is clear that a full accounting of the problems includes a variety of the following:

  1. Everyone was overconfident in their understanding of the world and risk
  2. Mortgages were issued to people who could not afford it with terms that some people didn’t understand
  3. Sophisticated institutional investors invested in products with risks they misunderstood
  4. Credit Rating Agencies rated securities much more highly than they should have
  5. “Wall Street” created complex securities (including CDOs and CLOs) which increased leverage throughout the system, making the repercussions of failure greater, and they were highly incentivized to do so
  6. Insurance companies and bond insurers guaranteed far more risk than they realized or should have
  7. Mortgage brokers and originators were incentivized to issue as many mortgages as possible
  8. Banks were allowed to create off balance sheet entities, which did not affect their regulatory capital requirements
  9. No one (with any clout) was standing outside the system thinking about and measuring what would happen if things went wrong
  10. Etc.

However, now that the credit crisis has entered the mainstream dialogue, rather than recognizing that this issue is complicated and that many factors are to blame, people are trying to wrap a bow around things and blame it on the “left” or the “right”.

Case in point, one of many similar blog posts from this morning:Who is to Blame for the Economic Crisis? The Republican Argument

The post references a video suggesting that somehow the push to issue people affordable mortgages is to blame for the credit crisis.

This blatantly political maneuver would be more infuriating if it was not so obviously overly simplistic and false. One simple counterargument to this is that if institutional investors bothered to do their homework on the securities they were purchasing rather than relying on credit ratings and the assurances of “derivatives” salesmen, they would have charged more, pricing in the reality of people’s inabilty to pay. But they didn’t…for lots of reasons.

Overly simplistic binary thinking is widespread in politics.

Unfortunately, this idiotic binary debate is symptomatic of a broader phenomena in our society: politicians are too intellectually condescending to describe things in the honest and nuanced way that they are in the world.

I refuse to believe that the American people are too stupid to understand. In fact, perhaps the reason people are fed up with politics is because the smokescreen is so obviously false.

Throughout my life I have found the “us against them” mentality of the two-party political system to be stomach-churningly simplistic. There are far more people and ideas than can be represented by “red and blue.”

It is no coincidence that the two presidential candidates both espouse politics beyond “party”. In times like today, it is clear that people “hope” that things will “change” and that someday it will be true that politicians put “America first.”

In the mean time, why don’t we seek to engage in a more nuanced debate. I for one reject this antiquated binary thinking. Computers can’t replicate human ingenuity, and I think we can avoid using their language.

Fatigue = Complacency

So the Senate passed the bill…kind of.

They passed a bailout plan, but they also included a load of pork along with the bill.

Although arguably not a bad development, the fact that a website called “” is blogging about the fact that this bill has a tax credit for plug-in vehicles shows you how business really gets done in Washington (Pork-Laden Senate Version of Bailout Bill has Plug-In Hybrid Vehicle Credits).

The self-congratulatory Senate praised themselves for coming together to aid the American people in their time of need. As I have grudgingly acknowledged here, I think some kind of bailout is arguably necessary in order to keep systemic risk contained. Out of respect for someone I really admire, I wanted to acknowledge a logical counterpoint to the bailout that is probably right:

  • $700B is arguably not enough unless we do something to stem the decline in housing values and household credit which are driving the majority of this contraction.

But, even though that is likely true, I think we need to get this thing done before the glad-handers go off to parade around the nation.

Although the Senate did get something done, it is disappointing that rather than focusing on passing the bill we needed, special interests lobbed in requests to get their pet projects included in what is now an over 400 page document…this one is even too long for me to micro-analyze.

And that is part of the problem. America is so shell-shocked at considering the prospect of an economic crisis that we have complacently shrugged our shoulders as Washington jammed this bill full of pork.

Even people like me, who have been shouting into the blogosphere for the last two years on this topic, are starting to simmer with our diatribes.

I am somewhat disappointed in myself for not even mentioning it when the government slipped a $25B loan to U.S. automakers through Congress last week.

Or that the SEC is helping banks cook the books by altering Mark-to-Market accounting rules: S.E.C. Move May Relax Asset Rule:

Under pressure from banks and legislators, the Securities and Exchange Commission issued an interpretation of an accounting standard that could make it easier for banks to report smaller losses, or perhaps even profits, when they announce results for the third quarter, which ended Tuesday.

The move on Tuesday drew praise from the American Bankers Association

Can you believe the Bankers Association is happy that the SEC is going to let them manipulate their financial statements in the open and get away with it?

I think that we have collectively become so worn out with the emotional debate and dialogue around what is going on in the financial markets, that we are running the risk of complacency.

Anytime in life when fatigue sets in, it is sometimes easy to just push snooze and roll over. But I think it is important that we keep paying attention and that we keep our elected representatives accountable in the upcoming election season.

I expect the House will pass the pork bailout bill tomorrow. And hopefully that along with the SEC manipulations will help stabilize things for the time being. Unfortunately, I think the economy is going to be in for some tough times for awhile, so be careful out there if you are an individual investor with any kind of short term horizon.

Hopefully, I can turn to brighter topics sometime soon. In the mean time, I’m going to get a cup of coffee, watch the debates, and try to keep my eyes open to see what other shenanigans come across the screen.