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.

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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Image courtesy of flickr/Stuart Crawford

We finally got the information on the stress tests.

The government will consider two scenarios: baseline and worst case.

The goal of the stress test is to see if banks have the capital to weather a darker storm.

However, and incredibly, the worst case scenario is not really a worst case.

The government’s idea of the worst case is a GDP decrease of 3.3% this year and growth of 0.5% in 2010; 8.9 unemployment rate in 2009 and 10.3% in 2010.

That is not the worst case! That is what I call the “baseline”. We are probably at 8% unemployment in February.

As a result, the stress test is a sham. It yields very little information. The government’s rosey worst-case scenario perpetuates the incompetent risk management that got us into this mess.

See my comments on this topic on BNN.

You hear the buzz about the nationalization of Citi?

What does this mean?

The U.S. government has dropped $45 billion of cash on Citi and another $250b in debt backstops (guarantees).

There is talk of converting some of the $45b in preferred stock into equity to get 40%.

Well, the current market value of Citi’s equity is only $10b. Hence, you don’t need to use all of the $45b to get 40%. However, I am afraid that they will use (or blow) all of it. That would be like the American taxpayer shelling out $10 for stock that’s worth $2. It is like buying toxic assets worth only 20 cents on a dollar for full value. It would be yet another incarnation of the trademark government strategy during this crisis (whether Democrat or Republican): Taxpayer=Loser

See my interview on the topic on BNN.

Read more …

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Here are three new video blogs.

1) Bank CEOs Testify before Congress

Eight bank CEOs appeared before Congress on February 11, 2009 to explain how their institutions used the TARP funds they received in 2008. I comment on their testimony and the American taxpayer’s role as primary stakeholder of many of these firms.

Watch on YouTube

Watch streaming video from Duke University.

2) The Positive Aspects of the Treasury’s New Plan

On February 10, 2009, Treasury Secretary Geithner delivered a speech and released a 7-page fact sheet describing the government’s new moves to address the financial crisis. I detail what I believe are the strengths of the plan.

Watch on YouTube

Watch streaming video from Duke University.

3) The Negative Aspects of the Treasury’s New Plan

Unfortunately, the new plan has many flaws. I outline a few of the many problems.

Watch on YouTube

Watch streaming video from Duke University.

The international banking system is at great risk in the current environment.

This week Fortis shareholders rejected a takeover offer. This puts the whole country of Beligium at risk. Fortis’ assets are more than 200% of the GDP of Beligium.

I know that Iceland gets a lot of press — but that country is tiny.

If you combine UBS and CS, they represent 700% of Swiss GDP. RBS assets are about 140% of U.K. GDP.

Fortunately, the U.S. is no where near as exposed. The largest banks assets, like Bank of America and Citigroup, each represent less than 20% of U.S. GDP.

My BNN interview explores these issues in more detail. I argue that no bank is safe in today’s environment. Previously thought of safe assets are not necessarily safe.

Watch BNN Interview.

What we saw yesterday was more of the same.

I was flabbergasted that the plan was so light on details. They have had 3 months to put something together and the best they could deliver is a 7-page fact sheet.

In addition, the plan seemed scattered. It was reminiscent of the original 3-pager for the TARP. Say you will do many things, then figure out later what to do.

I was particularly disturbed by the following remark by the Treasury Secretary: “We believe that the United States has to send a clear and consistent signal that we will act to prevent the catastrophic failure of financial institutions that would damage the broader economy.”

Huh? “clear and consistent”?, you gotta be kidding.

There are two ways to translate this. First, he knows more than we do and he is telling us that our financial system is insolvent. Second, it is fear-mongering to get support for this (as well as the so called ’stimulus’).

Here my take on the positives and negatives.

Read more …

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Many economists argue that recessions are a good thing. How is that possible? Well, recessions give companies the excuse to lay off unproductive workers – both blue and white collar and make other tough decisions that make the firm stronger in the long term.

The logic is appealing. Importantly, this line of reasoning only applies in mild recessions. For example, the last two recessions, 1991 and 2001 each lasted only 9 months.

However, the current recession is different. It is deep. Firms have gone into survivor mode. They are slashing productive workers. They are cutting capital investment that they know is good for the firm’s future.

Duke University and CFO Magazine conducted a survey of 569 CFOs in December that tried to measure the potential long-term costs to the credit crisis and this deep recession.

We found two surprising findings.

First, firms were set to layoff 5% of their work force. If this is true, it means a staggering 7 million additional people unemployed.

Second, firms are cancelling or scaling back on productive investments because they can’t get financing.

This second item is the subject of a new research paper of mine. It speaks to the long-term cost of the credit crisis. These investments are designed to create profits and employment in the long-term. They make the firm and the economy stronger in the future. Much of the media attention is focused on the current layoffs. However, no one is talking about the jobs that will be lost in the future because firms are not investing for the future. They can’t invest because they can’t get loans — or the loan rate is unreasonably high.

Watch a video that details the main findings of our paper.

Streaming Video from Duke University

or

Watch on YouTube

For more details, read on …

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“Fed To Hold Rates Near Zero” is the news headline today.

It is not really news. What were they supposed to do? They can’t increase the rates. Zero is as low as you can go.

There were about six notable items in the announcement.

1. The description of credit conditions changed. December 16, 2008 read: “markets remain quite strained and credit conditions tight.” January 28, 2009 reads: “credit conditions for households and firms remain extremely tight.” The key word is “extremely”. I am glad the Fed is on the same page as the rest of us now.

2. They are very worried about deflation. This is a big one. December 16, 2008 read that the Committee expected inflation “to moderate further in coming quarters.” That’s hugely different from January 28, 2009: “inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.” This also gives extra emphasis to keeping interest rates low for a long period of time as well as expanding the balance sheet for a longer period of time. In short, they want to stamp out deflation.

3. Looks like they will buy long-term Treasuries. In December, they were “evaluating the benefits”. Now on January 28, 2009 they say “The Committee also is prepared to purchase longer-term Treasury securities…” Buying Treasuries will reduce interest rates. But hey, the 10-year bond is trading at 2.6%. It is already rock bottom. What we need is a reduction of risk premia. That can only happen if they buy risky assets.

4. Other notables are the fact that they ” are likely to keep the size of the Federal Reserve’s balance sheet at a high level”. Again, that spells inflation. Expect to see longer-term inflation expectations (as reflected in inflation-indexed bond) to increase.

5. There is no change in the all available tools language. Both December 16, 2008 and January 28, 2008 use the identical language: “The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability.” No news here.

6. It was a split vote. In December, it was unanimous. However, I don’t think the split is that notable. Lacker simply preferred to target Treasuries rather than the credit programs.

Overall, the announcement today did not offer any new ideas. That is disappointing.

Image courtesy of MicksGuns.com