Let’s go through the long list that paints a picture of both short-term and longer-term risk to the economy.

1. We are not creating enough jobs to cover the growth of the population.
2. The stimulus policy is not working.
3. Consumer and business confidence is down.
4. For a large number of firms, credit conditions  have not improved since the crisis.
5. The U.S. faces Europe-like debt/GDP and deficit/GDP ratios.
6. Financial reform bill seen by many as institutionalizing the cult of bailouts.
7. Discouragement about the massive Gulf spill
8. Disappointment about the progress in Afghanistan

What about the good news? Uhhh… Maybe your favorite team advanced in the World Cup?

I have some other thoughts. Read the rest of this entry »

What single word best characterizes policy responses in this on-going financial crisis? “BAILOUT”.

It goes something like this. You take a lot of risk and reap lots of rewards (be it in pay, bonus, or social programs). You get into trouble. The government bails you out.

How often have we seen this same story repeating? It seems like we are in an infinite loop.

But we aren’t. This cannot last forever. The bailouts have many implications – some seen immediately and some will play out later.

On the positive side, bailouts buy time and short-term stability. Importantly, we see the results immediately. A good example was the big jump in world stock markets when the EU announced its 750 billion Euro bailout.

On the negative side, the list is longer. Also importantly, you do not see the results immediately. Here are a few of the implications:

1. Moral hazard. When you reward people for taking risk or going beyond their means, you will perpetuate this type of behavior in the future. That is, the cost of the bailout is not just the immediate cost but also the cost of new future bailouts that become more likely as a result of the current bailout.
2. Throwing good money at bad. We tax the productive assets to support the failed assets. Whether it is the U.S. government throwing away money on GM, Fannie or Freddy, or the German people paying for unrealistic social programs in Greece, the effect is identical. This reduces future growth opportunities in the productive economies. Think of it this way. Would you prefer to invest in a U.S. tech start up that is risky or buy some overpriced Greek assets.
3. We have to pay for it. It is naive to think that we can simply roll over debt forever. This is exactly what Greece thought. Please note that the size of the U.S. government deficit to GDP is not much different than Greece’s. [However, to be fair, the U.S. is in a much stronger starting position - but does face some similar risks.] Government debt financing competes with corporations trying to raise money. Corporations are forced to offer higher yields as more and more government debt floods the market. Increased borrowing costs means that fewer investment projects are viable. Less corporate investment leads to lower growth opportunities and lower long term growth for the economy in general. Lower growth means a smaller number of jobs.
4. Who are we really bailing out? Yes, the EU package has drastically reduced the cost to the Greek government (and other peripheral countries) of financing their debt. However, the main beneficiary are the banks and investment funds that hold the sovereign debt. They foolishly overpaid for this debt. Effectively, they thought Greek sovereign debt had the same risk as German debt. That was their mistake. However, the bailout makes them whole. That does not make any sense to me. They made a mistake and they are made whole. Remind you of AIG? Yes. It is the same thing. People that did business with AIG misestimated the “counterparty risk”. But no big deal. The government will make you whole.

I have some other thoughts.

Read the rest of this entry »

Here are my talking points for my Fox Business News interview.

Watch my interview.

1. Why should all the bailout money be focused on financial institutions? It is seems a matter of fact but no one has really challenged the logic.
2. We must act now to prevent the second wave of the credit crisis. The first wave was partially caused by people with jobs buying houses well beyond their means. The second wave will be people with prime mortgages who have lost their jobs. They are paying out of savings right now (and that accounts for the lull) — but savings will run out.
3. Fed stress test had unrealistic 2-4% assumption for loan losses in prime mortgages.
4. Prime is by far the biggest market. Close to $9T. Hence, every percent mistake in the Fed assumption is worth $90B. So a small error in prime loan losses could make many financial institutions insolvent.
5. We can’t afford any more spending – hence, we should redirect some funds.
6. Will be moral hazard problem (people want to be bailed out that don’t need to be bailed out). But not a valid critique of mortgage loan restructuing. The current policy has an even more extreme moral hazard problem. Financial institutions faced with coin flips where “head I win., tails you lose” — you being the American tax payer.
7. Target: 1) responsible borrowers – those that put at least 25% down on their houses; 2) simple means test based on 2008 tax filing + investment portfolio information; 3) priority in the process to recently unemployed. Reckless borrowers should be foreclosed.
8. Restructuring should be handled by bank or service provider — not the government or the courts. Not much has happened because little capital has been directed to the individual mortgages.
9. Proactive action to head off second wave. All of this could have been done two years ago and muted the impact of the sub-prime problem.

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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.

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 »

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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Once upon a time, there were three good banks: Bank of America, JP Morgan, and Citigroup.

When the financial crisis started, these banks stepped up and seemingly did some favors for the government. JP Morgan acquired Bear Stearns (with some government help). Bank of America gobbled up Countrywide (the infamous sub-prime lender) and then devoured Merrill Lynch. Citigroup made a deal to grab the troubled Wachovia (with government help).

But the financial crisis kept on going and questions started to arise.

Now the government is barfing money to save both Citi and Bank of America.

And there is no end in sight.

Read on…..

Image courtesy of flickr/assbach

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Duke Strategy Professor Will Mitchell argues that rather than bailing out firms, we should build stronger businesses and employees via reorganization and education.

Recently, I filed a post on the value of allowing firms to reorganize, while using public resources to support education rather than bail outs. Today, let’s look at an example of the success of this strategy, which is right here in North Carolina.

Learn from North Carolina. North Carolina is a great example of the success of education and reorganization. I have been here eight years. In that time, the state has largely lost its tobacco and textile industries, and has lost much of its historical furniture manufacturing base. Rather than being in a deep slump, however, the state is one of the most dynamic economies in the country. The reasons are simple to state, even if somewhat complex to implement in practice.

1. Allow low margin business to go abroad. Rather than remaining stuck in what had become low margin businesses, the state allowed businesses that had become globally uncompetitive to move operations to Asia and Mexico or simply to fail. This unquestionably has disrupted some communities and been painful for many individuals. But, because of the next four points, most people and communities have been able to adapt and thrive

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I appeared on Business News Network November 24, 2008 to talk about how the U.S. tax payer got shafted by the deal to save Citigroup.

While there is no doubt that federal intervention was necessary, the terms of the deal were terrible for the government. The real cost is not just this deal but the precedent it sets.

View the clip