On Thursday, the Dow Jones Industrial Average dropped below 11,000. In the past I have avoided giving investment advice as I am not a registered financial adviser. However, many of my friends and family have asked my opinion on the current market. Thus, in this blog, I will offer my opinion. As always, consult your own adviser for specific advice. Some thoughts:
The Federal Reserve has made two significant policy mistakes: (1) it has kept interest rates near zero, and (2) it has openly targeted higher stock prices to boost the recovery. This has created enormous distortions.
Zero interest rates have encouraged speculative market players to utilize cheap leverage (borrowing) to increase investment returns.
Ordinary investors who were previously happy to invest in relatively safe bank certificates of deposit or money market funds have been convinced to invest in stocks to try to achieve a higher investment return.
Zero interest rates have also depressed the value of the dollar. Many large multinationals which earn a significant portion of their revenue overseas therefore have received an artificial boost in earnings, inflating their stock prices.
Targeting higher stock prices has led to the belief that the Federal Reserve has created a floor under the market to protect investors, the so called “Bernanke Put,” This is bogus. The so called Bernanke Put did not stop the market from declining 50% in 2008. Why should it work now?
Given these distortions reputable market commentators such as John Hussman and Jeremy Grantham believe that the market would be fairly valued at S&P 950 (which would be equal to about 9000 on the DJIA). Thus, based on Thursday’s S&P close of 1140 and DJIA close of 10,990 the market remains significantly overvalued. Other commentators such as Michael Shedlock believe that Hussman and Grantham are too optimistic. My view is that markets go from massive overvaluation to massive undervaluation. I do not think we are at the undervaluation point yet.
There are a couple of “investment rules of thumb” I have tried to adhere to:
Never use leverage. When you are borrowing money to buy stock it distorts investment thinking and makes you much more susceptible to emotion.
If you are leveraged and receive a margin call, do not add additional capital to your position. Accept the loss and sell the stock.
If you are heavily invested in the market, sell down to your “sleeping point.” That is, hold only as much stock as permits you to sleep at night.
Remember that short term investing has become more like gambling than investing. Why? Because government intervention and high frequency trading controls the market. Individuals are unlikely to be successful in trying to trade on a short-term basis. Professionals are sometimes successful, but even most professionals have difficulty being successful on a sustained basis trading short term.
The percentage to hold in equity should be 100 minus your age. Thus, if you are 60 years old, you should not have more than 40 percent of your funds in equity investments. This is my rule of thumb for prudent trading.
Many of my friends want to recoup their 2008 losses. The market does not care that you may have lost half of your 401k account in 2008. There is no “getting even” in the market. There is only the here and now. The best current strategy is to invest your remaining capital based on the best information you have in 2011.
Look for value stocks that have good earnings, a dividend, decent earnings prospects and a depressed stock price. The Comstock Partners indicate that we may be a long way from such a favorable environment. They expect stock price earnings ratios will fall to the mid single digits, and dividends to be in excess of 6%.
Investing is an individual pursuit. Crises in Europe, China, the real estate collapse, near recession conditions in the US, are all warning signs for equity investors. You need to seek professional advice and make your own decisions. Again, this is not investment advice, just opinion. But in the words of Sergeant Phil Esterhaus of Hill Street Blues: “Hey, let’s be careful out there.”
This magic moment, so different and so new,
Was like any other, until I met you.
And then it happened, it took me by surprise…
I knew that you felt it too, I could see by the look in your eyes… This Magic Moment – Lou Reed
Wise investing is difficult. Constant spin and deception in the mainstream media only make it harder. A sudden event that changes everything is, in parlance, a magic moment. Previously, I discussed how one bank, HSBC, took a $10b write off in 2007. This was our initial warning, the “magic moment,” that predicted a major financial crisis. SeeWatershed Event in the Financial Crisis. In that case, the smoke-and-mirror financial atmosphere at the time prevented most of us from seeing what was happening.
To make things more frustrating, an old saying on Wall Street goes: “no one rings a bell at the top.” That means, no one is ever going to alert us to the market’s magic moments. We have to be smart enough to peer through the smoke, push aside the mirrors, and see clearly what may be right in front of us. And we can never count on the same set of circumstances to happen twice. The lack of that bell leads us to an epiphany: things are never going to be the same again.
We are again approaching a magic moment – “Foreclosuregate”. JP Morgan, Ally and Bank of America are imposing moratoriums on foreclosures and 40 state attorneys general are on the verge of announcing a joint investigation into the practices of the mortgage servicing industry. 40 States Expected to Investigate Foreclosures. Two major title companies, Old Republic and Stewart, have ordered their agents to stop writing title policies on foreclosed homes. Stewart Title Clamps Down on Foreclosure Sales. The Wall Street Journal and the New York Times have tried to downplay the issue; they so far dismiss the problem as one of technical defects and paperwork errors. Why does this remind us of Ben Bernanke”s 2007 assertions that the subprime crisis was “well contained?” Fed’s Bernanke: Subprime Mortgage Problems Contained
Elements of “Foreclosuregate”
First, a disclaimer: although I am an attorney, I worked on only two real estate closings in 35 years of law practice. I did learn, however, that real estate transactions are document intensive, detailed and precise. Disclosures must be crystal clear. All legal formalities must be observed, such as notarizations, fees, stamps, seals, etc. Documents must be promptly and correctly recorded to protect the buyer and the mortgage holder. Any shortcuts could harm one’s client, law license and malpractice premium.
Apparently, in the frenzy of mortgage backed securities, banks and lenders took many such shortcuts. It is beyond the scope of this blog to detail every bit of malfeasance and poor legal practice during the Roaring 2000’s in the housing market. But here are some of the pitiful truths fueling the developing crisis:
Poor underwriting standards – Individuals who clearly did not qualify received loans. Stories are legion of low wage workers taking out loans of several hundred thousand dollars. Interest only and teaser rate loans were used to generate fees for the mortgage broker. The broker was hoping that the borrower would return in a couple of years, refinance the home based on an inflating house price and generate more fees.
Poor Documentation – Mortgages consist of the mortgage itself and an accompanying promissory note. These documents are usually promptly filed at the county level to perfect a lien on the property. It appears that this step may have been handled incorrectly or bypassed (See MERS).
MERS (Mortgage Electronic Registration System) – MERS is a bank creation to enable financial firms to securitize (create mortgage backed bonds – MBOs) quickly and to avoid county filing procedures and attendant filing fees. Let’s take a quick look at how and why the banks did this:
In the mid-1990s mortgage bankers decided they did not want to pay recording fees for assigning mortgages anymore. This decision was driven by securitization—a process of pooling many mortgages into a trust and selling income from the trust to investors on Wall Street. Securitization, also sometimes called structured finance, usually required several successive mortgage assignments to different companies. To avoid paying county recording fees, mortgage bankers formed a plan to create one shell company that would pretend to own all the mortgages in the country—that way, the mortgage bankers would never have to record assignments since the same company would always “own” all the mortgages.
They incorporated the shell company in Delaware and called it Mortgage Electronic Registration Systems, Inc.
Even though not a single state legislature or appellate court had authorized this change in the real property recording, investors interested in subprime and exotic mortgage backed securities were still willing to buy mortgages recorded through this new proxy system. The MERS Edifice Quavers
Poor Foreclosure Processes – To foreclose on a property, one needs proof of ownership of the note, supporting affidavits and notarizations. An affidavit requires personal knowledge of the bank official seeking to foreclose, who then swears that he has reviewed all documents and that they are true. MERS has thousands of assistant secretaries, who are not employees of the firm, but employees of the bank, seeking to foreclose on their behalf. Some courts have ruled that MERS has no legal standing to foreclose. Moreover, many of these assistant secretaries sign thousands of these foreclosure documents each month, and have no personal knowledge of the documents or file. These individuals have been called “robo signers” and are arguably acting in violation of court rules. In addition, it appears that original documents do not exist and have been recreated, raising the issue of forged documents.
Poor Securitization Processes - Real Estate Mortgage Investment Conduits (REMIC) are investment vehicles designed to hold commercial and residential mortgages in trust and issue mortgage backed securities representing an undivided interest in the mortgages. Under IRS regulations and NY Trust law, the mortgages must be contributed on the startup day. A problem arises if MERS claims to have title to the mortgage:
… all rights to a mortgage loan must be deposited into the trust for it to achieve tax exempt status under federal REMIC law—which does not contemplate the use of a proxy mortgagee. Yet, despite claiming sole ownership of mortgages sold to investors, in documents regularly recorded with county officials these same institutions maintain that MERS is the sole owner of the mortgage. The chain of financial institutions linking originators to securitization depositors collectively want to have their lien and sell it too. The MERS Edifice Quavers
These are just some of the myriad problems arising from the mortgage mess.
Implications
This is not a problem that is going to be resolved quickly. Banks are vulnerable on a number of fronts:
- At best, the banks will have a delayed right of foreclosure thereby reducing the value of the mortgage note.
- Banks could be charged with fraud or required to take back the mortgages from MBS purchasers who were misled as to the value of mortgages and the shoddy securitization practices now imperiling their investment.
- The banks could owe tax penalties for failing to have the mortgages and notes conveyed to the REMICs on startup date.
- Plaintiffs’ lawyers have already brought a number of class actions against the banks seeking damages and a stay of foreclosures.
- State attorneys general will be seeking recording fees, foreclosure stays and other penalties for these practices.
- Title companies will be forced to pay out policies and seek redress from the banks. .
- Courts may impose sanctions against the banks and their attorneys and may delay or dismiss foreclosure proceedings.
Mistakenly, the press has focused only on the issue of residential foreclosures. There are two more issues to be concerned about: securitized commercial mortgages and MERS procedures were used in that part of the market as well. Second, failure to follow procedures may affect homeowners not in foreclosure. When an owner has paid off his mortgage and the mortgage and note has been resold and assigned numerous times, how does he know he has a legally binding accord and satisfaction of his mortgage? The chain of title may have been compromised on a national level. In fact recently a website encouraging homeowners to demand proof that one’s servicer is holding one’s mortgage note has gone online , Where’s the Note?
The market continues to rally much as it did after the HSBC subprime confession and write down in 2007. Another financial aphorism goes: economic facts don’t matter, until they matter. See It Doesn’t Matter Until It Matters. Disturbing facts are just entering the public consciousness. In this volatile, thinly traded market dominated by computer traders, I would rather exit two months early and sell my bank stocks, rather than be five minutes late and thousands of dollars poorer.
Disclaimer: The Prophet does not have a position in any banks, title insurance companies or other financial institutions and this is not a recommendation to buy or sell any security. Consult your own financial advisor.
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. SeeA 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:
Senate Panel Finds Major Fraud at Washington Mutual – A Senate investigation found that the Office of Thrift Supervision failed miserably in their oversight of WAMU. In two top producing offices of the bank fraudulent loans exceed 58% and 8% of the loans written. Senior WAMU executives were aware of the fraud.
Big Banks Mask Risk Levels – Reminiscent of the notorious Lehman 105 strategy, The Wall Street reports that 18 major banks used strategies at the end of five straight quarters to lower their risk level 42%. The SEC is looking into this practice.
GE Capital, Jack Welch and Jeff Immelt: A Tissue of Lies and Subterfuge – It is alleged that GE CEO Welch managed earnings through creative accounting in recognizing gains and losses at Capital. It is further alleged that current CEO Immelt continued these practices. These practices were undertaken to enrich investors.
Ankle Bracelets for High-Frequency Traders– The SEC is struggling to control practices that give large Wall Street firms unfair advantage over the public. The SEC is seeking to put limits on high-frequency trading, off-exchange dark pools and broker-sponsored access to the markets.
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.
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. SeeAfter 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.
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:
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?
We were passive and ineffectual observers of external events such as low interest rates, greedy investors, federal housing policy, ineffective rating agencies and others.
These actors conspired (woe is me!) to cause this problem and
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.
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:
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. SeeMoody’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. SeeElizabeth 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?
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.
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.
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.
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.
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. SeeSteve 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.”
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. SeeShared 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.” SeeWall 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. SeeJP 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. SeeShowdown 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?” SeeWilly 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?
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.
For more than 32 years, I worked as an attorney. In addition to a clerkship and law firm experience, I worked for some of America’s biggest corporations. I have an academic background in both law and economics. Unfortunately, when one works for any big corporation or bureaucracy, one often has to self-censor one’s more provocative thoughts. But…it’s a living. More
