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18
Apr 10

A Disturbance at the Casino – Goldman Faces SEC Charges

Captain Renault: I’m shocked, shocked to find that gambling is going on in here! Casablanca

The SEC awoke from its long slumber to file a civil complaint against Goldman Sachs.  Paragraph 3 outlines the case:

“In sum, GS&Co arranged a transaction at Paulson’s request [ed. note - Paulson &Co. is a hedge fund  firm unrelated to the former Treasury Secretary Henry Paulson] in which Paulson heavily influenced the selection of the portfolio to suit its economic interests, but failed to disclose to investors, as part of the description of the portfolio selection process contained in the marketing materials used to promote the transaction, Paulson’s role in the portfolio selection process or its adverse economic interests.”

Paulson helped Goldman shape a portfolio of mortgage-backed securities which were virtually guaranteed to fail.  The firm did not disclose Paulson’s influence or that he was shorting these securities.  Losses totaled a billion dollars.

On February 18th, I described and criticized this and other Goldman transactions as not in their customers’ best interests.  See A Reputation as Good as Goldman Part I.

From an SEC perspective Goldman’s only failure was in failing to disclose Paulson’s influence and his role in shorting the securities.  That Goldman knowingly put together a collection of poor quality assets which immediately became worthless was not at issue.  So designing junk, destined to fail, is not an issue?

The Over-Financialized Economy and Fraud

But, notably, Goldman got caught.  The firm is the prime example in an over-financialized economy of an institution run amok wherein investors are nothing more than easy marks.  A look at headline stories over the last several weeks clearly and sadly illustrates the point:

Beginning of the End?   Business as Usual?

Wall Street bemoans that volume in the current stock market rally is light and that the retail investor has not returned.  Why would any investor trust banks and Wall Street firms?  Synthesizing these headlines investors are exposed to the following risks:

-          An SEC too slow to take effective action

-          Complicit Office of Thrift Supervision

-          Fraud

-          Creation of near worthless securities

-          Taking an adverse interest to your own customers

-          Failure to Disclose

-          Excessive fees

-          Accounting Trickery

-          Excessive executive compensation flowing from accounting trickery

-          More protection is afforded to a used or new car buyer under state consumer protection laws.

The time has come for the casino operators masquerading as investment firms to stop viewing investors as “marks” ripe for fleecing.  These firms need to return to their historic roles as trusted investment advisers.  Maybe then investors can return to the markets with renewed confidence. Friday’s indictments were small ripples in a larger, very dirty pond.

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11
Apr 10

A Prince of a Fellow

Being Chief Executive Officer (“CEO”) of a Fortune 50 company is not an easy job.  CEOs get paid a lot of money.  How do they earn that money?  To assert that outsized CEO compensation bears any relationship to the position, the person must demonstrate extraordinary leadership skills, in depth business knowledge and foresight.  Thursday, Charles Prince, former CEO of Citigroup testified before the Financial Crisis Inquiry Commission.  He fell far short of these measures of excellence.

A Prince’s Testimony

Peggy Noonan, in the Weekend Wall Street Journal dismissed Mr. Prince’s testimony as bland. See After the Crash, A Crashing Bore.  I found the testimony fascinating for what he said and did NOT say:

-          The financial crisis occurred because interest rates remained too low for too long and “investors were reaching for yield.”

-          To satisfy demand for higher yielding instruments investors turned to securitized mortgage investments.

-          We were also satisfying the political agenda of encouraging home ownership.

-          We relied on statistical models and rating agencies.

-          Too many subprime mortgages were written and securitized

-          We had to announce an estimated $8-$11 billion write off

-          I resigned

-          The biggest problems were in the “super senior” mortgage tranches which my senior traders held in Citigroup’s portfolio. These caused some of the largest losses.

-          I was not aware of decisions made at our trading desk. I cannot fault our traders.

-          When I became CEO, I named a sophisticated chief risk officer who also missed the problem with the senior tranches.

-          We became aware of these problems in the fall of 2007 and held many high level management and special Board meetings. We were not able to avert this problem.

-          I am sorry for the damage Citigroup caused to homeowners, investors and others.

-          Citigroup is not “Too Big to Manage.” See Prince Testimony.

According to Mr. Prince, Citigroup “still had to keep dancing” as the subprime crisis worsened or it would lose business and employees to competitors.

The Banality of a Prince

Hannah Arendt, author of books on the Holocaust, coined the phrase the “banality of evil.” The phrase referred to great evil perpetrated by ordinary people who accepted  rules of the system, no matter how wrong or ill advised  Whether Mr. Prince is evil is for moral philosophers and historians to decide, but he is surely banal.  He looked like he was scripted for the hearings to be as bland and apologetic as possible.  What was missing from this performance was any personal responsibility.

Four themes pervaded Prince’s testimony:

  1. I had very smart traders and a sophisticated risk officer surrounding me, so how could you expect me to anticipate the problem when those on the front line were unaware of the problem?
  2. We were passive and ineffectual observers of external events such as low interest rates, greedy investors, federal housing policy, ineffective rating agencies and others.
  3. These actors conspired (woe is me!) to cause this problem and
  4. Everybody was in the same securitization business so it would have been unfair to our shareholders and our employees to exit the business; hence we had “to keep dancing.”

The Role of the CEO

In exchange for hefty pay a CEO needs to “see around corners.”  By his own admission, Mr. Prince saw nothing.  While the extremely well paid Mr. Prince received a $40 million severance package, he obviously did not fulfill his part of the contract.

In conjunction with attorneys, speech writers and public relations specialists we can now identify the “confluence” of factors that caused the crisis.  Where was Mr. Prince’s foresight to analyze these factors in advance and avoid the pitfalls?

Mr. Prince argues that the bank is not too big to manage. I would differ.  Mr. Prince either lacked the time, interest or acuity to grill his chief risk officer and senior traders on what could go wrong in subprime securitizations.  I was a senior executive of a corporation and an attorney by training. The first question I would always ask was: what could go wrong? What events and circumstances could close down the business?

Was Mr. Prince asking these questions?

Everyone Was Doing It

Finally, Mr. Prince brings us the classic defense used by generations of teenagers: “Mom, everyone is doing it, so why can’t I?”  His unarticulated motivation is apparent anyway: “if I had the moral and intellectual courage to exit the subprime business, my competitors would remain in, might make a lot of money and I would lose face before my senior management, Board and shareholders.  I might even lose my job!”

In the end Mr. Prince lacked the intellectual honesty, moral courage and leadership skills to be a CEO.  A Prince turned his shareholders and the American taxpayer into paupers.

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16
Mar 10

The Failure of Extrapolation

The human mind loves linear extrapolation over time.  We build 5-year plans.  Graphically, five-year plans look like hockey sticks: first, slow and minuscule income, revenue growth in the first year, and then spectacular growth by the fifth year.  I have sat through a dizzying number of presentations for start up businesses which rarely, if ever, achieve their predicted spectacular growth.  For every Apple or Google there is a Pets.com and bankruptcy. ­­­ However, hope springs eternal.

Rosy Scenario and Her Evil Twin

Investment analysts, CEOs and government officials constantly project questionable positivity.  Prosperity is always around the corner, green shoots of recovery are everywhere, and a chicken will appear in every pot.  We pillory realistic if negative analysts as pessimistic naysayers, prophets of doom or worse.  But we ignore reality at our peril. More often than not Rosy Scenario often clashes with her evil twin Dashed Expectation.  The results are often calamitous.

Ignoring Reality

The last decade has brought ignoring reality to a high art form.  Linear extrapolation has brought the following prophesies:

  • Dow 36,000
  • Internet businesses with no customers and unrealistic business plans worth several times the value of established companies (IBM, DuPont)
  • Ever-rising housing prices
  • The FIRE economy (Financial, Insurance, Real Estate) supporting the entire American economy
  • Sustained non-problematic leverage ratios of 30 and 40:1
  • Debt growth several standard deviations greater than GDP
  • Counterparties to derivative contracts always making good
  • Never defaulting on sovereign debt
  • Pension fund assets always earning between 7-9%
  • Federal debt growing faster than tax receipts
  • Public sector wages growing faster than GDP and tax receipts
  • Aggressive accounting (Enron, Lehman) considered good financial engineering
  • Zero interest rates restoring economic prosperity.

Past is Not Always Prologue

We are prisoners of our past experiences.  We expect the Federal Reserve to cut interest rates and the economy to magically recover.  We are surprised when the nominal unemployment rate is at 9.7% and the actual is 17%.   We are surprised when Wall Street bonuses soar and Main Street suffers.  We are surprised when Moody’s threatens to downgrade US debt from AAA rating. See Moody’s Says U.S. Debt Could Test Triple-A Rating

Rarely do we say that this time is different.   As a society, we have incurred debt far exceeding our capacity to repay.  Balance sheet recessions/depressions are far worse than previous inventory recessions.  Just as the Vietnamese fooled our World War II trained generals, the Federal Reserve and Administration are intent on fighting an outdated economic war.

It is time for some nonlinear thinking.  Instead of posturing, Congress should be asking Ben Bernanke for a Plan B.  Averting financial Armageddon is not enough.  JP Morgan CEO, Jamie Dimon, projected a banking crisis every five to seven years.  See Elizabeth Warren Exposes Jamie Dimon. As a society we can ill afford another year like 2008.  Reality is gaining on us.

How well did the five-year plans work out for the brittle Soviet system?   Is it time to ditch Rosy Scenario and deal with reality?

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10
Mar 10

Can We Afford Our Criminal Justice System?

Based on 2007 data, the United States has 7.3 million (up from 2.4 million in 1982) in jail or prison, paroled or on probation. That is, 1 in 31 adults, compared to an earlier 1 in 77.  With the ongoing financial crisis, desperate state and local politicians are looking for any means to reduce these costs, including early release.  A recent New York Times article, Safety is Issue as Budget Cuts Free Prisoners, highlights the dilemma:

In the rush to save money in grim budgetary times, states nationwide have trimmed their prison populations by expanding parole programs and early releases. But the result — more convicted felons on the streets, not behind bars — has unleashed a backlash, and state officials now find themselves trying to maneuver between saving money and maintaining the public’s sense of safety.

One result: many of the newly released prisoners commit crimes!  How do we keep society safe against the growing cost of incarcerating the bad guys?

The State and Local Financial Crisis

In Where Are We Now? we discussed the budget deficits in 48 of 50 states, while all states but Vermont require them to be balanced.  The situation has deteriorated.  Michael Shedlock (“Mish”) has chronicled these massive budget problems and some state and local responses:

- Illinois – “The state is in utter crisis,” said Representative Suzie Bassi. “We are next to bankruptcy. We have a $13bn hole in a $28bn budget.”The state has been paying bills with unfunded vouchers since October. A fifth of buses have stopped. Libraries, owed $400m (£263m), are closing one day a week. Schools are owed $725m. Unable to pay teachers, they are preparing mass lay-offs. “It’s a catastrophe”, said the Schools Superintendent. See Rep. Suzie Bassi: “Illinois in Utter Crisis, Next to Bankruptcy, $13bn Hole in a $28bn Budget

-   New Jersey – Newly elected Governor Chris Christie found that: In the time we got here, of the approximately $29 billion budget there was only $14 billion left. Of the $14 billion, $8 billion could not be touched because of contracts with public worker unions, because of bond covenants, because of commitments we made accepting stimulus money. So we had to find a way to save $2.3 billion in a $6 billion pool of money.

When I went into the treasurer’s off in the first two weeks of my term, there was no happy meetings. They presented me with 378 possible freezes and lapses to be able to balance the budget. I accepted 375 of them. See Governor Christie: “Time to Hold Hands and Jump Off the Cliff” – Chris Christie For President?

-   California – Last year the state assured markets that it had solved its budget problem.  To meet deficits and cash shortages, the state treasurer is contemplating creditors in state IOUs, delaying payments to school programs and demanding that 80% of state tax be paid before it is earned. See California Delays Payments, Ponders IOUs Again, Demands 80% of Income Tax Paid Before It’s Even Earned

The Prison Industrial Complex

In his 1961 farewell address, President Eisenhower warned Americans against the military industrial complex.  We have created a “prison industrial complex,” with its expensive, unmanageable system of incarceration and monitoring.  One Connecticut study showed an average annual cost of $44k per prisoner.  Public sector unions with high salaries, generous overtime, defined benefit pension plans and retiree health care benefits are hugely expensive, and prison staffs are heavily unionized.

A Way Out

We have suggested in the past that government needs radical reengineering.  See Why Not Reengineer Government? Overhauling the criminal justice system should be a part of that effort. And there are possible solutions:

  • Privatize prisons.
  • Decriminalize certain offenses such as illegal drugs and gambling.
  • Non-violent criminals should pay financial penalties, be confined to their homes, placed in half-way houses or paroled immediately.
  • Community service programs should be re-thought to make best use of talents and skills of otherwise imprisoned citizens.
  • Shorten prison sentences for all but the most violent felons.

Our criminal justice system has mushroomed with little regard to the financial costs to taxpayers. We have over-criminalized non-violent behaviors to all our detriment.  A reform in that system can pay both societal dividends, fewer citizens locked up and a financial dividend, lower taxes.  Perhaps this is one silver lining from the financial crisis.

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10
Mar 10

Are We a Socialist Country?

Europeans and Russians are socialists.  Americans are staunch capitalists.  Maybe all it took was a financial crisis to reveal the slide toward socialism in America.  During the Cold War, faced with a military threat from the Soviet Union, Americans would rather have died than become socialists:  better dead than red.  Unwittingly, we now invite socialism into our lives.  Ironically Wall Street firms and large industrial corporations, the purported bastions of capitalism, have paved the way to socialism.  A left-leaning Administration has been only too happy to oblige.

The Slippery Slope

The road to hell is paved with good intentions.  I do not think any of the pillars of our economy intended that the country become socialistic.   Each entity was merely maximizing its own position, seeking to enhance shareholder value.   When financial crisis hit, our formerly capitalistic businesses could not rush to Washington fast enough to seek support, bailouts and guarantees from the government.   The government was only too happy to oblige with the passage of TARP and then an alphabet soup of government support and guarantee programs.  In one short crisis period from summer 2008 to spring 2009, the government ignored 200 years of American economic and constitutional history to save a group of greedy and profligate bankers and industrial corporations.   The end result: we privatized profit and socialized losses.

A Factual Progression

Here are the events that have taken us on the path to socialism:

  • The Federal Reserve’s active role in the forced sale of Bear Stearns to JP Morgan
  • The Government seizure of Fannie Mae and Freddie Mac
  • TARP:  Government purchase of troubled assets from private financial institutions
  • Goldman Sachs and Morgan Stanley become banks by expedited process  to obtain government guarantees
  • Government seizure of AIG and complete payback to private institutions for credit derivative losses
  • Federal Reserve intervention in broker mergers, with guarantees against losses (Washington Mutual with JP Morgan, Wachovia with Wells Fargo)
  • Federal Reserve intervention with $1.3 trillion in loans to companies outside the financial sector (GE).
  • Government removal of management at GM and Chrysler
  • Restrictions on executive pay for banks receiving bailout funds
  • Government restrictions on foreclosures unless there has been a Home Affordable Modification Program review.
  • Administration desperation to pass comprehensive health insurance program.   See Timeline:Global  Economy in Crisis

How Did We Get Here?

We invited the devil in the door.  Banks claimed that they could not withstand loan and derivative losses.  Unemployed Americans wanted extensions in unemployment benefits and stimulus programs.  Nobody wanted to see the stock market crash and their portfolios and retirement plans decimated.  Big business wanted the profit opportunity in universal health care coverage.  Insurance companies did not want to hurt their policy holders.  Auto workers wanted to maintain their rich union contracts.  The litany goes on.

Once we were a brave, independent and self-reliant nation.  Now when adversity strikes our first inclination is to blame others and call Washington for a bailout or a handout.  I do believe in the concept of welfare.  Welfare was meant for the truly dire circumstance, the impoverished citizen. Welfare was not meant for auto workers to maintain above market wages and job guarantees, banks to get paid in full for risky derivative bets, GE or GM, homeowners who falsified their income disclosures to remain in McMansions or every insurance policy to be paid in full.

Capitalism is about freedom, risk and failure.  Without failure there can be no progress.  The slide toward socialism is an escape from freedom and ultimately an end to progress.

My European immigrant grandfather lived through the Depression, World War Two, and into the 1980’s.  He once told me he was most proud that he never went on relief (welfare).  We should return to the ways of our forbearers, regain our mettle and become too proud to ask for a handout or bailout.   Our freedom and that of our children depend on it.

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15
Jan 10

Decision Making in a Crisis

Act in haste, repent at leisure.”  – Source unknown

US Treasury Secretary, Timothy Geithner is in real trouble. The New York Times (Jan. 13) reports:

Representative Edolphus Towns of New York, said Wednesday that the committee had subpoenaed Mr. Geithner’s e-mails, phone logs and meeting notes from when he was president of the Federal Reserve Bank of New York in late 2008. The committee has already asked Mr. Geithner, now the Treasury secretary, to testify at a hearing next week about why the New York Fed told A.I.G. not to disclose that its trading partners were being paid 100 cents on the dollar to unwind tens of billions of dollars in derivatives.

Mr. Towns argued that A.I.G.’s counterparties would have received, at best, 30 to 40 cents on the dollar if the troubled insurance giant had filed for bankruptcy.

Mr. Geithner’s activities as Fed president drew additional scrutiny as he is suspected of encouraging, ordering or actually modifying AIG SEC-required disclosures to hide AIG’s payment of monies to its large bank counterparties.

It will take a Congressional investigation and maybe appointment of a special prosecutor to determine Mr. Geithner’s culpability.  Nevertheless, his behavior in crisis is instructive.

Lessons Learned from Crisis Management

After almost an entire career in a corporate environment, crises seemed to be an every day event to the point where I thought crisis was normal.   Crisis management yields valuable lessons and reveals the best and worst human behavior.  Some thoughts and advice:

  • A former boss said “fifty percent of the facts told to a manager of a crisis are correct the first time, and seventy five percent are correct the second time.”  Keep sending your subordinates back for correct information until you are satisfied they have done their due diligence.
  • The situation is never is bad as it looks.  One’s worst fears are rarely realized.
  • The cool hand always wins.  Those who panic and predict doom are seldom correct.
  • As a corollary, think more and react less.  At the inception of a crisis there is a lot of motion but, unless you have the skills of gurus like the ones described in Blink (Malcolm Gladwell), avoid “knee jerk” reactions.
  • Every problem has a solution.  Applying logic and keeping a cool hand allows the crafting of a solution.  Everyone may not like it, but some sort of solution presents itself.
  • Everything looks better the next day.   Every bad day ends. Every first day of a crisis is finite.  Putting some time and distance between the onset of a crisis and the arrival at a solution yields a better result.
  • If you  are willing to give up credit you can move mountains.  If you are truly committed to solving a crisis do not worry about getting credit.  Letting your superiors take credit is great, even better is letting them think that they came up with the idea.
  • Make the crisis a one day story. Own up publicly to the problem quickly and be as candid as possible.  Failure to do so will make the crisis a multi-day story. Avoid making the crisis a multiple day “Page One” story.
  • Avoid acting it haste, as it will only end in tears.  Throwing prudence, deep thinking and obedience to the law out the window leads to a bad result and often later prosecution.

Paulson, Geithner and Bernanke – The Committee to Save the World

I knew the country was in trouble when Henry Paulson, then Treasury Secretary at the start of the financial crisis, got down on his knees to beg Nancy Pelosi to pass the $700b TARP plan.  The original plan had panic written all over it: massive give away of funds, unreviewable actions and virtually dictatorial powers.  Somehow hundreds of years of constitutional development and the rule of law went out the window because our banks had some serious problems. Eventually, Paulson, Bernanke and Geithner were viewed as the Committee that Saved the World. See Steve Rattner article.

Given the panic displayed by senior members of government at a time of financial crisis it is no surpise that Mr. Geithner is being questioned by Congressional Committees.  Going further, I  doubt that he incorporated any or all of  the above bullet points in his management style or action planning at the time he made these decisions.

Perhaps we should end with the maxim – - ” Act in haste, repent at leisure.”

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8
Jan 10

The Greediest Generation – Where Has Shared Sacrifice Gone?

America used to be different.  During World War II both blue collar men and the elite served in the military.  Everyone lived with rationing: sugar, butter, tires bicycles, automobiles, coffee and a host of other consumer items.  The tax rate in 1944 on incomes over $200,000 was raised from 93% to 94%.  Hardly anyone complained.

Labor journalist Sam Pizzigati argues that this shared sacrifice from the top down helped define the “Greatest Generation” and pulled the country—including the elites—together in wartime.  See Shared Sacrifice, Shared Glory.

Today we are mired in a global financial crisis and two wars on foreign soil, Iraq and Afghanistan.   But our prior generation’s shared sacrifice is noticeably absent. What happened?

“Buy an SUV”

Perhaps the defining change in our national character came after 9/11.  What was our response to this vicious attack?   We did not re-institute mandatory military (or even national) service. We did not raise taxes. We did not demand or undertake dramatic new energy savings initiatives.  Instead Americans were encouraged to keep shopping and buy SUVs.  In fact, Congress enacted large tax incentives in 2003 to buy SUVs.  In effect, we encouraged energy profligacy in light of deadly attacks by Saudi Arabian.  Did the always unstable Middle East (with the exception of Israel) suddenly become our greater ally by attacking us?

Greed is Good

The eminent (if fictional) philosopher Gordon Gekko insisted “greed is right, greed works.”  See Wall Street.  And we have become Mr. Gekko’s devout followers:

  • The Petulance of Jamie Dimon – The United Kingdom proposed to tax banker bonuses above 25,000 GBP and require some bankers to defer bonuses for three years. In response, Jamie Dimon, CEO of JP Morgan Chase threatened to cancel a 1.5b GBP project in the Canary Wharf financial complex. See JP Morgan Plans in Doubt.
  • The Blindness of Public Sector Unions – Cleveland public employee unions were given an ultimatum to accept a modest 4.17% wage reduction or face large layoffs.  See Showdown in Cleveland: Unions Refuse Nominal Pay Cuts.
  • The Blindness of Private Sector Unions – Ford Motor Company proposed a concession package along the lines of the UAW agreements with Chrysler and GM management.  The UAW rejected these concessions.  While Ford has recently reported improved car sales, the company is saddled with debt, pension and health care obligations.See UAW Reject Ford Contract Concessions.
  • Record Wall Street Payouts – As I previously chronicled, see What Went Wrong? Disconnecting Effort and Reward, Wall Street firms have reported record bonuses this year. In many cases they will be paying out more than 50% of revenue.

I Want it Now

Like the very spoiled Veruca Salt, our ethos has become:  I want it and “I want it now. What’s the matter with those twerps down there?”  See Willy Wonka & the Chocolate Factory.   Maybe we have become fatalistic and believe the end is nigh.  Should we grab as much as possible before the end?  Our two intractable wars are remote for most Americans.  With no universal draft, these conflicts are being fought by mercenaries.  This is virtually unprecedented in our history. Why should we care? We have the NFL playoffs, college bowl games and American Idol to look forward to.

So, as a nation we have come a long way from the Greatest Generation. Will future historians call us the Greediest Generation?

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26
Nov 09

Can We Continue the Status Quo?

Every so often one comes across a brilliant essay that cuts to the heart of the problem.  Writing for the Prudent Bear in “Wanted: Iconoclasts,” Martin Hutchinson identifies the rising political anger at the “partnering” of the Obama Administration and Wall Street:

In such an atmosphere, with unemployment above 10% and rising, and U.S. living standards descending inexorably towards those of the Third World, it is not surprising that the public beyond the Washington Beltway is in an iconoclastic mood. Its iconoclasm is rational, economically speaking. The tight oligopoly of Wall Street is profiting excessively from its 2008 bailout by taxpayers, with the payments to Goldman Sachs and others on the AIG credit default swaps coming to seem increasingly misguided and possibly corrupt, given Goldman Sachs’s close connection with the Treasury Secretary Hank Paulson who disbursed taxpayers’ money in such an unproductive manner. AIG and Citigroup remain in business, with even AIG Financial Products, the cause of much of 2008′s pain, still in operation. Fannie Mae and Freddie Mac remain dispensing their guarantees to the housing market, noticed by the media only at the end of each quarter as they tote up their losses and demand further billions of the taxpayers’ money. The economically damaging subsidies to home purchase, diverting as they do scarce U.S. capital towards yet more unproductive housing, have just been extended both in time, for a further six months and in scope, to existing homeowners. The economic recovery, such as it is, appears to [be] sic producing almost no jobs but only an ever-widening spiral in commodity prices, affecting the costs of everything the public consumes and eroding the value of its meager savings.

Mr. Hutchison levels his criticism of the management of the financial crisis at the behavior of Obama, Bernanke and Geithner, whose knee jerk response was to maintain rather than reform system.  They chose to bolster bankrupt financial institutions at taxpayer expense. Further, they chose zero interest rate policies which punish savers and trillion dollar deficits ad infinitum which punish all taxpayers and future generations.  They created a giant irrational structure. (See Why Do All Irrational Structures Fail?).

Offering Solutions

Mr. Hutchinson does not deliver a jeremiad.  Instead, he departs from dire rants and prognostications and points to a rational way out of the ongoing crisis.  Recognizing that the current economic-political trajectory we are currently on is unsustainable, he provides policy prescriptions to end the crisis:

It will thus have become obvious that the housing market needs to be restored to a fully private market state, in which government subsidies are confined to the truly indigent. Zombie banks must be closed down, while the beneficiaries of “too big to fail” must be forced to slim down and divest operations until they are of a size where failure is conceivable. Commercial banks will simply become regional entities, whose failure would damage a regional economy but not the entire financial system. The trading behemoths will be broken into several competitors, whose market share will be too small for them to profit from “insider information” about market flows – a modest transactions tax will also reduce trading’s dominance. Home mortgages will once again be granted locally, with derivatives and securitization technology used only to prevent cost squeezes in high-growth areas. The obvious cost reductions in health-care, eliminating the current system’s cross-subsidizations, will be legislated to reduce the sector’s oppressive cost growth. Public expenditure generally will be put on a strict diet, with expansionist foreign policy ended, both in its belligerent and its globalist forms.  Finally, monetary policy will set interest rates at a level that rewards savers properly and prevents bubbles.

Conclusion

Staying on our current course of action is irrational.  Mr. Hutchinson clearly links together politics and economics.  Often economists take a narrower view, ignoring political realities.  Since this is not a normal recession and has all the hallmarks of a depression, “business as usual” policy measures taken to date have been ineffective and have deepened the crisis. There is a growing political reaction among the masses of Americans who face unemployment, inflated gasoline prices and foreclosure.  Democratic losses in recent elections were an early harbinger of that discontent.  There is still time for Obama, Bernanke and Geithner to become iconoclasts, break with orthodoxy and restore economic growth which will benefit all Americans.  Continuing the status quo will be harmful to the current ruling political class, the Wall Street elite and the economy.

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18
Sep 09

Too Much Information and Too Little Wisdom

In the early 1990s Andy Grove, then CEO of Intel, addressed a management meeting which I attended.  Addressing the East Coast management meeting, he sat in his tiny California cubicle and streamed video to the attendees.   Before the advent of Google and the project to digitize books, Mr. Grove predicted that the internet would be like having the Library of Congress at your fingertips.  His prediction has come true.  We now have a torrent of information more voluminous than the Library of Congress.  What is lacking is wisdom to interpret this torrent.

Confusing Information, Knowledge and Wisdom

We confuse information with knowledge and knowledge with wisdom.  A short trip to the dictionary:

Information: the communication or reception of knowledge or intelligence

Knowledge: (1) the fact or condition of knowing something with familiarity gained through experience or association (2) acquaintance with or understanding of a science, art, or technique

Wisdom: a. accumulated philosophic or scientific learning b. ability to discern inner qualities and relationships

These words are sequential: information leads to knowledge, knowledge properly applied leads to wisdom. I submit that the internet supercharged by search engines does not move the meter past “information.”

CNBC creates an expectation that a glut of information conveyed through catchy sight and sound is meaningful.  Breathless announcers countdown to the 8:30 AM unemployment numbers, new home sales, the Case Shiller Home Price Index, the ADP Employment Report, the Consumer Price Index, the Baltic Dry Index, preliminary GDP results, retail sales, etc.  The Wall Street Journal website provides a myriad of national and global market indices.  Financial websites such as Yahoo, Marketwatch and Google only add to the economic information overload.  The media is capable of showcasing a wide variety of experts knowledgeable in their field, but displaying little, if any wisdom.

Commentators in both old and new media were happy for their fifteen minutes of fame.  But in the new media age, Andy Warhol’s fifteen minutes have been reduced to thirty second sound bites.

Wisdom and the 2008 Financial Crisis

A thoughtful observer of the 2008 financial crisis could have foreseen that there were major imbalances in the US and global economy.

  • The US ran huge trade deficits.
  • Manufacturing moved off shore to low wage countries
  • Credit, on every level, was too easily available.
  • Wall Street created fiendishly complex derivatives incapable of valuation.
  • Congress and the administration outdid each other cutting taxes while increasing expenditures.
  • Family incomes were stagnant.
  • Interest rates remained at absurdly low levels.
  • States ran deficits during boom times, lowered taxes and cut back on funding pension liabilities.

In other words, something was horribly wrong.

Despite the claims of many financial and political establishment leaders that “no one could see this coming,” many did.  Commentators such as Michael Shedlock, Bill Fleckenstein, Karl Denninger and a small band of others were able to connect the economic dots.  Why?  These commentators possessed wisdom.  They examined the entire economic picture, thought about the effect of the imbalances and extrapolated the economic harm from these imbalances.  To do so and achieve wisdom, certain traits are required: thoughtfulness, a coherent theoretical starting point, real world experience, integrity, humility, critical thinking, a willingness to go against conventional wisdom and mindfulness of the whole.  Wisdom often comes from being the lone voice in the wilderness.

Wisdom today is still in short supply.  We are again bombarded with the range of unemployment, CPI, retail sales, and GDP reports, but little time is spent in the media on putting this information into context or wider perspective.  Can you really rely on one month’s worth of numbers to declare a recession over?  What if unemployment is really not a lagging indicator, but a precursor of greater economic harm?  Why does it make a difference that unemployment dropped from 564,000 newly unemployed versus 550,000 unemployed when over 6 million people are out of work and the number climbing?  Why does the stock market rebound look suspiciously like the 1930 stock market rebound?

Why do We Lack Wisdom?

We lack wisdom in our leaders for a number of reasons.  We overvalue credentials, an Ivy League education, a Harvard MBA, a Yale law degree. We do not spend the same amount of time evaluating and training our workers with deliberation and care.  Critical thinking is absent in our school systems and universities.  We favor the business leader or politician who can deliver the quick answer and pithy sound bite. Mindfulness and humility are just not “cool.”

Before the next phase of the financial downturn hits, we should launch a financial Manhattan Project and hope that wise leaders emerge.

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16
Sep 09

Credit Ghettos

Ghetto” is defined as;

a quarter of a city in which members of a minority group live especially because of social, legal, or economic pressure or a      situation that resembles a ghetto especially in conferring inferior status or limiting opportunity <the pink-collar ghetto>

Whether by design or happenstance the actions of the Treasury, the Federal Reserve and other executive branches of the government have created “credit ghettos.”  The unintended consequences of credit ghettos may take years to unfold, but the effect will be pernicious.

Government Guarantees and the Credit Ghetto

Both the Bush Administration and the Obama administration responded to the fall 2008 financial crisis through guaranteeing and backstopping financial institutions, government lending enterprises  (FNMA, GNMA, etc), insurance companies (AIG), near financial institutions (GE, GM, Chrysler), money market funds and other entities.  Neal Barofsky, special investigator for the Trouble Asset Relief Program (TARP), released a report in July 2009, detailing that there are now 50 government guaranty programs that potentially expose the taxpayer to a staggering 23.7 trillion dollars debt.

23.7 Support

Thus, a giant bubble of protection has been placed over government-favored financial institutions.  Those within this bubble can borrow money as low as .25% from the Federal Reserve and have virtually unlimited access to the credit markets.  These favored lenders have been able to raise capital from depositors and equity and debt investors.  Citicorp, one of the favored entities has watched its stock soar from under $1 dollar per share to over $5 per share, not because its business has improved measurably, but because of these backstops.  Who wouldn’t want to lend to company where the full faith and credit of the US government is protecting the loan?   The remainder of American business has been relegated to a “credit ghetto” where life is much more expensive.

Rewriting the Bankruptcy Code

Never leaving bad enough alone, the government also decided to try its hand at rewriting the bankruptcy code through executive fiat.  In the Chrysler bankruptcy, senior creditors with contractual rights were pushed aside and the politically-favored, unsecured creditor unions were arbitrarily awarded 55% of the company.  The senior creditors were offered 30-35 cents on the dollar for their debt.  Former GE Chairman, Jack Welch succinctly put it, “The creditors’ rights were trashed and the unions got 55 percent of the company.”

Alas, unlike the world of politics, bad deeds get punished in the credit markets. The reaction was immediate and angry:

Fund Managers Burned by Obama Now Say They are Wary

May 20 (Bloomberg) — Hedge fund manager George Schultze says he may avoid lending to any more unionized companies after being burned by President Barack Obama in Chrysler LLC’s Fridson Investment Advisors have joined Schultze Asset Management LLC in saying lenders may be unwilling to back unionized companies with underfunded pension and medical obligations, such as airlines and auto-industry suppliers, because Chrysler’s creditors failed to block Obama’s move. The reluctance may put additional pressure on borrowers seeking capital in the worst financial crisis since the Great Depression.

“Lenders will have to figure out how to price this risk,” Schultze, 39, said in a telephone interview from his office in Purchase, New York. “The obvious one is: Don’t lend to a company with big legacy liabilities or demand a much higher rate of interest because you may be leapfrogged in a bankruptcy.”

Thus, another credit ghetto has been created: unionized companies with underfunded pension and retiree medical obligations.

Why We Should Care – The Unintended Consequences

Why should we care as this is just esoteric credit market maneuverings?  We should care a lot.  Credit is a company’s lifeblood.  The government either intentionally or unintentionally is providing the “lifeblood” on favorable terms to the politically favored.  It is creating a protected bubble where low cost borrowing takes place.  Outside the bubble the government has created “credit ghettos.” First are non-union companies who can borrow at the “free market” rate. Second, are union companies that have been threatened with either no access to money or money at a penalty rate.  In essence, any company outside the bubble is borrowing at a penalty rate.  While banks can borrow from the Federal Reserve at close to a 0% interest rate, corporate borrowers (non-high yield) are borrowing on average of 4.5% for intermediate debt and 6.20% for long-term debt.  (Source – WSJ)

It is obvious that those relegated to the “credit ghetto” are paying a penalty rate which flows through to net income and stock price. In truth it is a hidden tax on non-financial companies who did not get into trouble.  The Federal Reserve has grossly distorted credit allocation to the detriment of these companies.  Today, with the Federal Reserve showering credit on the markets, availability of credit for non-financial companies is not an issue – yet!  Once the torrent slows to a trickle, the non-financial companies will be in a world of pain.

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