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Each of the three programs announced by the Secretary of the Treasury today has the same theme: the private investor has a limited downside and a huge upside – the American taxpayer bears almost all the downside and gets shafted on the upside.

Read my preliminary analysis of the three programs.

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Cam Harvey is featured in the following “5-Question Interview” in Duke Research, the university’s main research publication.

Campbell R. Harvey is the J. Paul Sticht Professor of International Business at the Fuqua School of Business at Duke University. He is an internationally recognized expert in portfolio management, asset allocation, the cost of capital and global risk management. He has been quoted widely in the media about the global financial crisis and has created a web page with resources and information as well as a blog.  He also is founding director of the Duke University/CFO Magazine Global Business Outlook Survey, which asks thousands of CFOs from a broad range of global public and private companies about their expectations for the economy.

Q – How did Southern California homeowners bring down the global economy?

Southern California home prices were not the cause of the crisis. There were many different causes. Cheap money policy at the Greenspan Fed led to an expansion of debt in general. Financial institutions employed a high degree of leverage. Rising home prices made it easy for a bank making a loan to an unqualified customer (because the future home price appreciation could be used to pay the interest). In short, there was extreme risk-taking on the part of financial institutions and many individual home buyers. As for the financial institutions, given the leverage they employed, it made them extremely vulnerable to a downturn.

I think it is important to understand the concept of leverage. Suppose I spend $100 on an asset. The asset price over the year goes to zero. I lose $100, and we are done. Now suppose I borrow $100 and invest my own money, $100 plus the borrowed money — a total of $200. Over the year, suppose the asset price drops by 50% (so the overall value drops from $200 to $100). I pay my loan off and am left with zero. Now let’s really increase the leverage. Suppose I borrow $900 to invest along with my original $100. Now a total of $1,000. If the asset price drops by 10% (from $1,000 to $900), I can pay back my loan and I am left with zero. But what happens if prices drop by more than 10%? It means that I will be defaulting on my loans. You think this is a lot of leverage (it is so called “9 to 1,” or nine dollars borrowed for every dollar you have)? No. It is common for banks to have much higher leverage. Morgan Stanley and Goldman both had leverage greater than 30. European banks have leverage in the 50 range. The lesson here is that when you employ extreme leverage, small changes in prices can wipe you  out.

Q – The stimulus plan and the now seemingly endless bailouts of banks and insurance firms don’t seem to be moving the needle on the stock exchanges. Is this just panic, or are the markets saying the government investments still aren’t enough?

Some of the bailouts are simply wasting taxpayer money. We had thousands of financial institutions fail during the S&L crisis. We simply shipped their assets to a Resolution Trust Corporation to be unwound – in an orderly way — not in a fire sale. In this crisis, we have had only 50 institutions fail. I contend that there are thousands of Zombie (alive but really dead) financial institutions.

One problem we have is that there are some institutions that are “too big to fail”. As a result, they take reckless risks because they know they will be bailed out. Essentially, in good times, they get huge rewards (and huge bonuses) and in bad times, the taxpayers bail them out. That is not a very good system — as we now know.

Q – When do we hit bottom, and what will it look like?

Right now, there are no positive indicators. Most believe that the bottom will occur in early 2010. In the last recession, strong housing price appreciation pulled us into recovery as people refinanced and withdrew equity from their houses for spending. That will not occur this time. Housing will be very slow to recover – especially when you have 19 million vacant houses.

You will see a sharp movement up in the stock market at the beginning of the recovery. However, there will likely be a few false starts.

Q – In every big market turmoil, there seem to be some winners. Is anybody winning right now?

The clear winners are the distressed investors — fondly referred to as the vulture investors. They have been circling for about a year and are waiting to swoop down to get deals of a lifetime. We hear about houses being sold for $1,000. There are plenty of other assets out there at amazingly cheap prices.

To make things even sweeter, the Treasury secretary wants to lend money to some of these investors to get them to buy the so-called Toxic assets. This is a bad idea. It means that the private investors get all the upside profits and the taxpayer gets the downside losses.

Q – What’s the difference between a depression and where we are now? I’ve heard some people start to use the D-word, and others say, no it’s not that at all. What’s the definition?

There is no official definition. However, the informal definition is a drawdown in GDP of 10% in real terms. So far in this recession we have had a drawdown of 2%. (Remember that the quarterly GDP numbers are annualized, so -6% is really -1.5%). We would need a GDP growth rate of -8% in all of 2009 to qualify as a depression. To me, that seems unlikely. In the Great Depression the drawdown in GDP was an astounding 25%.

While it will be bad, there are a number of factors that will moderate the recession. First, there are substantial government safety nets that did not exist in the 1930s. Second, the U.S. economy is much more diversified today and able to withstand large shocks. Third, the government can actually afford to bail out the banks. That is not true for all countries, especially in Europe. Fourth, the leverage of U.S. non-financial corporations is moderate to low, giving most of them the ability to dodge bankruptcy. Fifth, if protectionist sentiment increases in the world, the U.S. is in a position to win. That is, other countries have much more to lose than the U.S. from protectionist measures.

Dan Ariely’s TED2009 presentation, “Why we think it’s OK to cheat and steal (sometimes),” is now available for viewing.  Watch it here:

Image courtesy of flickr/John Wardell

AIG disclosed some of the firms that benefited from the government bailout. Essentially, the government money was largely used to pay off other firms. I have a few comments.

1. AIG’s customers were either using AIG for hedging positions or speculative positions. This was mainly done through Credit Default Swaps. These CDS essentially “insure” risky corporate debt – if the CDS is used along with a position in corporate debt. For example, you could buy Ford bonds and simultaneously protect against a default by purchasing CDS from someone like AIG. You are hedged but (and this is a big but) only fully hedged if AIG stays in business.

2. For the hedgers, they failed to properly take the risk of the insurer into account. Parties on the other side of these contracts need to share some of the responsibility. Goldman, for example, was not doing business with the U.S. government – they were doing business with a corporation. This is not the same thing as Goldman having a savings account where the FDIC is covering $250,000 – yet that is how we are treating it. The U.S. taxpayer should not be obligated to make whole all these counterparties who miscalculated the risk of AIG. We are bailing out bad risk management and it is not fair to the American taxpayer. As for the speculators, why should they be bailed out? It’s like bailing out someone who lost at the craps table.

3. It is not surprising that many of the counterparties are foreign. I don’t think the foreign firms should be treated differently. Domestic firms, foreign firms, municipalities, all failed in their risk management. They all should bear some of the cost.

4. From the AIG press release:

American International Group, Inc. (AIG) recognizes the importance of upholding a high degree of transparency with respect to the use of public funds. As a result, after close consultation with the Federal Reserve, AIG is disclosing information identifying certain credit default swap counterparties, municipal counterparties and securities lending counterparties.

What does “certain” mean? Does it mean “a select number”? Does it mean “”all”? If it was “all”, why didn’t they say “all”. How can they call this a “high degree of transparency”?

5. The real story here is for someone to figure out how much more the American taxpayer is potentially on the hook for. AIG has been to the trough four times and now has $180 billion of our money, roughly $1,200 for every working (and seeking work) American. It seems like there was little or no due diligence done on the original government dole out. Transparency to me implies a level of disclosure such that we can figure out the future obligations. How much more will they likely need? $50b, $100b, $300b? We have no way of determining this. This type of forward looking analysis needs to be done as a prerequisite for any future taxpayer money.

6. The other sub-story here is size. AIG has many good business units. However, because they were a conglomerate, the good businesses are being punished for the incompetence of a small number of their business units. With smaller specialized units, we would not be in this situation. AIG could not make the “systemic risk” AKA “too big to fail” argument (as they do on their website).

7. The final sub-story is the following. The U.S. taxpayer is “the” stakeholder in AIG. It is not clear to me that the corporate governance in AIG has shifted from maximize shareholder value to ‘do what’s best for the American economy’. For example, full transparency is necessary. Uncertainty about the future health of AIG and the size of future government obligations, works against the recovery of the U.S. economy.

Read the AIG release here.

The losses are staggering. If the pace of January and February continued through the year, we would lose 8.4 million jobs in 2009.

That is unlikely, but it will be ugly. Consider the following facts.

The percentage job losses have now exceeded the deep 1981 recession. Since December 2007, we have lost 3.17% of nonfarm jobs. In 1981, we lost 3.07%. But we are not done yet.

The recent survey by Duke University and CFO Magazine had CFOs cutting 5.7% of their workforce in 2009. Further, they see the recession lasting another 14 months.

Let’s do some calculations. There are 111 million private sector jobs. 5.7% layoffs means 6.3 million jobs lost in the private sector.

Currently, the labor force is 154 million and there are 12.5 million unemployed, implying an unemployment rate of 8.1%.

Now suppose the CFOs are correct and we lose another 6.3 million jobs and the unemployed rise to 18.8 million (12.5+6.3). That implies an unemployment rate of 12.2%.

So you think the CFOs are pessimistic? Well, maybe they are. But we are forgetting something. We are measuring “planned” workforce reductions. This number does not include the layoffs that result from firms going out of business. Hence, there is reason to believe the number could be greater than 6.3 million.

Wait, we have forgotton the “stimulus” plan. In the most optimistic (and unrealistic) projection, 3 million jobs are created. This means (only) 15.8 million unemployed and a rate of 10.2%. In my opinion, it is more realistic to think that 1.5 million new jobs are created by the plan. This leaves us with 11.2% unemployment.

There is a serious disconnect here.

The Obama economic team’s analysis of the stimulus plan had unemployment capping out at 8% (with the plan). We have already blown through 8%.

More seriously, the so called “stress test” assumes a worst case scenario of average 8.9% unemployment in 2009. That is not a worst case. That is not even a realistic projection. We could hit 8.9% in the next two months! Oddly, the “baseline” scenario, also has 8.9% unemployment in 2009. What kind of scenario analysis has identical projections for “baseline” and “severe”?

Unfortunately, the news gets worse. Unemployment lags the business cycle. This means that even if there is a recovery in the economy in 2010 unemployment will likely continue to increase. The stress test worst case had unemployment increasing 1.4 points in 2010.

The recent data suggest: (1) the situation is much more severe than our policy makers are letting on and (2) the stress test exercise for our financial institutions will have little value because of the unrealistic assumptions about the economy in 2009.

Given the trillions that we are shelling out, I think we deserve transparency and straight talk. It is better to tell us how bad it really is than to sugar-coat some economic projections that will surely lead to future disappointments — and decreased confidence.

Duke Operations Management Professor Paul Zipkin has authored a new thought piece interpreting the financial crisis from the perspective of quality management.  Zipkin argues that lessons learned about quality in the manufacturing setting should be applied within financial institutions and across financial supply chains in order to aid recovery from the financial crisis.

Zipkin’s paper “Quality Snags in the Mortgage-Finance Supply Chain,” is available here: quality_mortgages_0902112.

Image courtesy of flickr/David Wild

AIG is back to the trough for another $30 billion. We already gave them $150 billion.

AIG — supposedly a firm in the insurance business — got into trouble taking an astounding $450B unhedged bet in the Credit Default Swap (CDS) markets. They insured the holders of mortgages and other asset backed securities.

I have no idea how you can consider yourself an insurance company and take the largest unhedged bet in the history of business.

Folklore suggests that the original $150B deal was made quickly over the telephone with former Treasury Secretary Paulson. A default by AIG would sent many firms instantly into bankruptcy — including UBS and Goldman Sachs (need I say more?). These banks were technically hedged – but their hedges assumed no counterparty risk (i.e. their hedges would only work if AIG was solvent). FYI, a hedge with counterparty risk is not a real hedge. So these banks share some blame too. In addition, our regulators were asleep at the wheel. Essentially, there was no oversight – even though the taxpayer is covering the downside.

At the time, the deal seemed like a good one. The taxpayer (in contrast to a number of other deals) got equity worth 79.9% of the firm. We had the upside!

However, we now know that there was no attempt to value the firm. If the most basic valuation was done, it would be evident that the firm had a huge negative net worth – probably -$250B!

Valuation? –You gotta be kidding. Knowing the value of what you are buying? — Not required! This is the legacy of our government’s actions during the financial crisis.

For each working American, we have written a check to AIG for $1,200 because of the reckless bets they took.

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Fuqua Professor Sim Sitkin recently authored an op-ed column that has generated questions and responses from readers whose interest was piqued by his views on home ownership.  In the op-ed, which was published in several U.S. newspapers, Sitkin offered three suggestions for increasing home ownership in the U.S. (the text of the op-ed is included at the end of this post).

In this post, Sitkin responds to several of the questions he has received.

Responses to Questions Raised:

This isn’t a new idea, is it?
No.  It is my understanding that versions of these ideas have been proposed a number of times in the past. It is also my understanding that versions have also been used in Japan (with some fatal flaws in my view) and in Switzerland, as well as Hong Kong.  I desire no claims to originality — but I must say that I was unaware of much of this, as were the economists and finance experts I spoke with.  To me the point is not whose idea it was originally, nor even if it is correct.  Rather, my objective was simply to raise the issue as a challenge to try to stimulate some more creative thinking about how best to pursue home ownership opportunities while retaining appropriate financial safeguards.  As a note of caution – the details matter.  Sometimes similar ideas have been proposed ways that I believe make the basic idea fatally flawed.  If as longer term loan is simply a way to allow unqualified buyers to purchase homes they cannot afford (e.g., very small payments in the beginning and then balloon payments or a significant jumps as can happen with ARMs), this is obviously a bad idea.  So it must be combined with strict qualification standards, as should be applied to all loans.

Why not allow people to sell their homes sooner than 10 or 20 years?
This misreads the proposal – I am sorry if I was not clear on this point.  The proposal was that lenders could not flip the loan.  There was no constraint proposed on the homeowner at all, who should be able to freely sell their property or just pay off a loan.

Why is this a sensible thing to do when the accrual of equity is so slow compared with other ways of investing money?
For the same reason most people do not take advantage of 15 or 20 year loans, and some go to 40 year loans where they are available. People take out mortgages at a rate they can afford to pay back and for which lenders view them as a reasonable risk (at least this worked until the past few years).   The people this would target are those who could pay reliably and steadily (so qualify using strict standards) but not at a high monthly rate. They are probably seeing this as an alternative to paying rent (from which they capture no value), not seeing this as an option as contrasted with socking away money in the stock market.  So I think that it is often a false and hypothetical trade-off you are raising, but a natural one to think about.  With the proposal, individuals who take on very long term loans certainly do end up paying lots of interest but do very slowly accumulate an asset over a period of time — the other actual alternative is that they pay rent but end up with no asset.  This is why people buy houses to begin with.  The typical loan term was arbitrarily set at 30 years some 70 years ago — so why is 50 or 100 any less arbitrary?

Doesn’t a really long-term loan only make sense for smaller investments rather than big home loans for which so much interest is accrued?
Maybe.  But if this only makes sense for smaller investments, then it might be used only for very inexpensive properties — and 30 year loans may stay the norm for middle class home while 15-20 year loans might be more applicable to homes for the very wealthy.

Why is it helpful to constrain a lender by not allowing them to sell the loan for along period of time?
The objective was that if a lender had to service the loan for a long period of time, it would remove the incentive to make bad loans for a quick buck and then pass on the bad loan to another ill-informed party. This is partly designed to address the problem that created the financial mess we are in at the moment. It would also give homeowners more control as consumers.  A borrower might select a lender not only because of their rates or other terms, but also because of their convenience or high quality customer service . . . only to learn that one week after the mortgage the carefully chosen lender sold it to another bank whose customer service is unsatisfactory.

Are you requiring children to take on their parents’ debt through assumable mortgages?
No not at all. An assumable mortgage does not require that it be assumed, but it makes that an option. It used to be that one could get a mortgage that could be assumable by anyone who purchased your home. Of course, that would only be attractive if interest rates had risen. So if you got a mortgage at 6% and rates had fallen to 4%, you would never assume the mortgage, you would get a new at the lower rate. No prospective buyer was required to assume your mortgage, it was an option they could take or leave. Similarly, children would never be required to acquire the home nor to assume the mortgage — but if the conditions were right, it could be a very attractive as an option.

Sitkin’s Original Op-Ed: Read the rest of this entry »