Obama scorecard

President Obama means well and is doing a great job in many areas. However, I fear that we are perpetuating the same policies of the previous administration when it comes to the financial sector. It is simply not fair that each of the 19 big banks are bailed out. If you take risk, then there must be some consequence. Right now it is a blanket insurance policy that will lead to similar problems down the road.

See video.

Stress testing the banks

The so-called stress test is a sham. They delayed the release of the test because it is really hard to explain why so many of the banks (including the very largest ones) are offside when the adverse scenario is looking like an optimistic scenario. Note the adverse scenario has 8.9% unemployment in 2009. We could be there next week. It has 10.3% in 2010 and we could be there by the end of the summer. The whole idea of a stress test is to see what happens in a scenario that is worse that what we expect. The test fails on that dimension. It is misleading, increases uncertainty, and decreases confidence.

See video.

Professor Harvey interviews Len Blum of Westport Capital

See video.

Westport Capital conducted a stress test based on leaked information. They estimate a further impairment of $200 billion. I question why they would use the government rosey assumptions. I specifically ask for their assumptions on the prime mortgage impairment. It is rumored that the U.S. Treasury is using an assumption of 5% impairment which, in my opinion, is way too low given the surging unemployment.

Are we seeing the end of the recession

While the stock market is up and consumer confidence is up, it is hard to see any economic fundamentals that point to a trough. In particular, the surging unemployment will likely cause a second wave of mortgage defaults. We don’t see the defaults right now because people are drawing down their savings. We will see it soon.

See video.

At best, we have seen a pause in the economic decline. It is too early to call a trough.

Surging unemployment will act like Agent Orange on those “green shoots”. While we have every reason to be worried about a swine flu pandemic, the recovery was at risk well before the first reported cases. That is, the economic fundamentals suggest a second wave of hardship.

The Past

The first quarter of 2009 is behind us and it was a disaster with GDP plunging at a 6.3% annual rate. While consumption stabilized, investment was slashed by 16.7%. That’s not an annual rate! The annualized change in private domestic investment was an astonishing -66.7%. We thought that the previous quarter was bad at -24.2%. The freefall in investment has more than doubled.

The Future

The IMF recently revised their estimates of losses in the U.S. to a staggering $2.7 trillion. The report can be viewed here. These are deeper losses than one would be led to expect by statements from our government.

But I think we are missing something.

We are bleeding jobs to the tune of 600,000 per month. In addition, we know that even after a trough in economic activity, job losses continue. We are not factoring into the economic equation the impact of the job losses.

To be more clear, the first wave of subprime losses were caused by loans being made to people that had jobs but their income was insufficient to pay their mortgage payments. Banks made these loans assuming either their incomes would increase by the time the reverse amortization ended (for example, the end of the low teaser rate) or their house would appreciate by enough so that a mortgage equity withdrawal could be made to pay the interest on the original loan (in true Ponzi fashion). Note, in both cases, the homeowner has a job.

The situation is different today. We have a wave of people that will not be able to pay their mortgages because they are unemployed. It is not critical right now because these homeowners are drawing down what little savings they have. However, time is running out as these saving are depleated.

The market is seizing whatever little piece of good news. However, it will soon be reckonning time for the second wave.

The Trouble

There are three other troubling developments.

1. The Stress Test is Bogus

On Monday we will get the first official results of the stress test.

The so-called “adverse” scenario assumes an unemployment rate of 8.9% in 2009. That is a sham. We will likely have that rate for April! It effectively assumes a dramatic end to job losses in May 2009. Who believes that?

Equally bogus is the fact that we are relying on the bank’s own models to run the stress test. These are precisely the failed risk management models that got us into this mess.

To make things even worse, the Treasury secretary has said that anybody who fails will get recapitalized. Whatever happened to the idea that if you take a bad bet, you lose. If you are reckless, you go out of business. All of that is gone. You get bailed no matter what you do. We reward incompetence with hard earned taxpayer money.

2. No Transparency

There is no transparency. I have no idea what these bank “earnings” announcements mean. Accounting “earnings” depend on the loan loss reserve assumptions as well as the valuations of their assets. I have no way to assess the quality of the bank assumptions – but I have strong suspicion of low quality.

FASB has recently said that banks don’t need to use market prices. What does this mean? It means that if you don’t like the market price (i.e. too low), then you can use your model price (which is likely too high). If you think about it, you could easily argue that the so-called fire-sale price is too high. You observe a price but that’s before you need to sell your asset. When you put your asset on the market, that will likely cause the price to fall even more. All of this makes the financial statements impossible to interpret. Right now, I have little idea of who is solvent and who is insolvement. However, I have a strong suspicion that there are many insolvement banks.

3. Too Big to Fail

Pass the barf bag. I don’t think I am the only one. This policy encourgages reckless risk taking on the part of large banks. They know they will be bailed out so there is no risk for them – it is the American taxpayer that bears the cost of their mistakes.

We need to end this policy. There are two ways. First, you let some big players fail – but do it in an orderly way (i.e. no repeat of the Lehman fiasco). The alternative is to break up these firms. Either way, we put our financial institutions and our economy in a stronger position for the future.

Weird Zombie Game

Yes, it is true that some credit spreads have improved. Consumer confidence has also increased. But these are fleeting. A recovery must be sustainable. On the financial side, there are two prerequisties to the proper functioning of financial markets and a sustainable recovery: transparency and purging. Right now, we have neither. The stress test will provide little or worse — potentially misleading information. The losers are rewarded with bailouts, guarantees — and bonuses. The taxpayer is shafted. The economy is sloshing around is a sea of Zombies.

Operations Management Professor Paul Zipkin offers the following suggestions for easing the credit crisis with a supply chain management approach to banking.

Who needs banks, anyway? The enormous recent damage to the economy has been caused mainly by the disappearance of working capital for supply chains, plus consumer panic. Maybe firms in supply chains need to become their own banks, much as they do in impoverished countries. This is already happening on a small scale.1

Seriously, our economic civilization works much better with banks. The current crisis has amply demonstrated this fact. Various remedies have been proposed to unfreeze the financial system. Here is another one: Banks can fund whole supply chains, not just individual firms. This practice already exists, again on a small scale. It’s called supply-chain finance.2

To appreciate this notion, some background will help. Why did the subprime crisis lead to a full-blown credit crisis? Why did banks stop lending? Various plausible stories have been put forth, but none of them is based on convincing facts, and none is entirely satisfactory. Right, the banks own “toxic” assets of questionable worth, but the money already injected by the government should suffice to sustain a reasonable level of commercial lending. The banks are not talking. They say they are indeed lending, despite abundant evidence to the contrary.3

I don’t have any facts, either. But here’s a better story than any I’ve heard: Banks don’t trust each other. Each one can see only its own financial condition. Even that is not so certain. There have been lots of stories over the last year of seemingly solid banks, which turned out in fact to be broke, to their own surprise as well as to others’. Still, why should that prevent a bank from lending to a real business? The reason is, banks are tied to each other in part through real businesses. Read the rest of this entry »

Image courtesy of AllPosters.com/J. Thompson

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.

Read the rest of this entry »

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.

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.

Read the rest of this entry »

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.