Posts Tagged: GM

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11
Aug 10

Awash in Legacy Costs

Legacy costs have strangled many American iconic and venerable American industrial firms.  The automobile and steel companies are recent victims of this growing scenario:  diminishing work force and profits supporting large and growing pension and retiree medical costs.  In many instances bankruptcy has been the corporation’s only way out.

The Financial Dictionary defines legacy costs in the private sector as follows:

Ongoing costs to a company that come from funding activities that, by definition, do not increase revenue. Perhaps the most prominent example of legacy costs is the funding of pension plans. Legacy costs often accrue when a company takes on too many responsibilities in times of strong performance or when it takes on an appropriate level of responsibility and then its priorities change.

Legacy costs also include retiree medical, life insurance and other promised benefits.

The recent turmoil in the financial markets has revealed a potentially larger legacy problem.  Not only is private industry suffering this stranglehold; legacy costs are also drowning state budgets in red ink. Like private business, the public sector is also saddled with pension, retiree medical and life insurance benefits.   Completing the analogy, many of these costs were taken on when state tax revenues (think profits) were high.  Politicians avoided confronting public employees and unions and chose the path of least resistance; that is, they capitulated to exorbitant demands.  Then they compounded the problem:  instead of direct layoffs, states resorted to early retirement pension sweeteners, which depleted pension assets.

The Current Status of Public Pension Plans and Other Benefits

On August 6th, the New York Times reported the massive underfunding of public pensions.  See Battle Looms over Huge Cost of Public Pensions. The Times discovered a February Pew Center for States study showing a $1 trillion pension underfunding. (We could have a whole different post as to why it took until August for the Times to report a study published in February.)   Worse yet, the Pew study may have been overly optimistic.  In other words, their methodology understated the liability and the deficit.  In contrast, the National Center for Policy Analysis’ Unfunded Liabilities of State and Government Employee Retirement Benefit Plans found that states were using too high a discount rate to determine employee liabilities.  Under the National Center for Policy Analysis deficits are far more alarming:

  • Unfunded liabilities for health and other benefits are
    $558 billion, compared to the reported $537 billion.
  • Thus, total unfunded liabilities for all benefit plans are an
    estimated $
  • Unfunded pension liabilities are approximately $2.5
    trillion, compared to the reported amount of $493 billion.
  • 3.1 trillion — nearly three times higher than
    the plans report. See Reality Beckons (Government Pensions)

While pensions are funded, other benefits like retiree medical, vision and dental have no assets side aside to fund them.  Moreover, based on current trends, medical costs are growing exponentially.

The New Battle Ground

Colorado undertook modest changes to its pension plans to lower future pension payments. The state legislature reduced its cost of living adjustment cap from 3.5% to 2%. The result was an immediate lawsuit from public employees:

Earlier this year, in an act of rare political courage, a bipartisan coalition of state legislators passed a pension overhaul bill. Among other things, the bill reduced the raise that people who are already retired get in their pension checks each year.

This sort of thing just isn’t done. States have asked current workers to contribute more, tweaked the formula for future hires or banned them from the pension plan altogether. But this was apparently the first time that state legislators had forced current retirees to share the pain.

Sharing the burden seems to be the obvious solution so we don’t continue to kick the problem into the future. See Battle Looms over Huge Cost of Public Pensions

Employees view their pensions as inviolable contracts, while the state is invoking changes as actuarial necessities.

Who Thinks About the Taxpayers?

Taxpayers are facing unemployment, the risk of losing their jobs and increasing costs of education, medical and energy.   Public employees are well paid, largely insulated against layoffs, and receive top of the line current and retiree benefit packages.  Barron’s points out that: “[m]ost public employees, if they hang around to retirement, can count on pensions equal to 75% to 90% of their pay in their highest-earning years.”  The $2 Trillion Hole.  Frequently, supervisors and employees collude to inflate final pay with shift and overtime pay in the last year of work.  Current and retiree medical benefits require minimum or no contribution.

In contrast, private sector benefit plans pale in generosity to public benefit plans.  I worked for a company for 32 years and my pension is a little more than 40% of my last five years of pay.  Retiree medical requires a 20% contribution.   Our plans had no cost of living adjustments.   My company’s plans were probably in the top 5% of benefit plans in America.   Most companies offer little more than a basic medical plan and no retiree benefits.

The federal government will soon run out of borrowing capacity.  In addition, there are questions of federalism; that is, the states are supposed to be responsible for their own finances.   Federal and state legislators and public unions  have to be far more realistic than they have been.  If they are not,  some of our largest states (think New York, New Jersey, California, Illinois) will suffer as did  GM and  Greece:  drowning in legacy costs.

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15
Jul 10

Pension Insecurity

Substantial recent financial media focus has been lavished on subprime mortgages, credit derivative bets on a decline in the residential housing market, flash crashes in the stock market, bank insolvencies, major corporate bankruptcies, and sovereign debt defaults. They have paid less attention and provided less insight into the perilous state of pension funds.

Both public and private pension funds face an emerging crisis.  We need to examine some disturbing trends in both sectors.

New Jersey Pension Fund Crisis

In No Garden-Variety Pension Crisis, Andrew Briggs asks hard questions about the funding of New Jersey’s public pension plans.  If the state used private sector pension accounting, the underfunding would rise from an already horrendous $46b to a mindboggling $170b.  This deficit is more than five times the 2011 $29.4b state budget.

The real question is, when will the plan run out of money?  Assuming the plan can earn 8%, which may be an aggressive assumption in the current environment, the plan would run out of money in 2019.  However, NJ has increased its risk profile for the fund.  The state has moved 60% of its pension assets into riskier alternative investments, such as hedge funds and private equity.  Thus, there is a 25% chance the fund can run out of money as early as 2017.

The article concludes that NJ is not alone.  Connecticut, Indiana, Illinois and other states are due to run out of money before the end of the decade.  (See Bailout Nation Lives: Revisited, a Short Update).

Diageo

And while we are worried about risky funding strategies utilizing hedge funds and private equity, pension funding creativity reaches new heights with a plan by the Diageo Corporation. This beverage conglomerate intends to “fund” its plan with more than 2 million barrels of scotch whiskey.

Diageo said … it would transfer ownership of £430 million, or $645 million, worth of whiskey to a pension funding partnership. Diageo employees would not receive their pensions in whiskey rather than cash, but the move does give them a guarantee that they would not walk away empty-handed should the company default.

“A pension funding partnership will be formed, which will hold maturing whiskey spirit as assets,” ….

As part of the deal, Diageo agreed to pay the pension partnership £25 million a year as it sells the recently distilled whiskey once it matures after three years and replaces it with new stock. The agreement would expire after 15 years, at which point Diageo would buy back the whiskey, which comes from distilleries such [as] sic Oban on the west coast of Scotland. See Diageo Uses Scotch to Plug Gap in Pension Plan.

I personally love Diageo products.  Talisker, Lagavulin, Oban and others are some of the finest whiskies in the world.  See Tis’ the Season for Deflation and Update on Deflation. In my prior posts on Diageo, I pointed out that some of their premium products were in dramatic price decline.  Now it becomes clear that weak pricing power and pension underfunding for Diageo are connected.  If Diageo had pricing power, it would have sufficient profits to fund its pension plan with cash.  In a deflationary world, should their pension plan beneficiaries hope to count on the future price of scotch whiskey in order to receive their benefits?

GM, A Cautionary Tale

We have seen innovate funding techniques before.  In 1993, GM asked federal pension regulators to approve an innovative plan to meet a $24b pension deficit.

Under the plan announced today, GM would contribute shares of its class E common stock to the pension plan. The value of that stock is tied to the performance of a wholly owned subsidiary, Electronic Data Systems. Its closing price today on the New York Stock Exchange was $31; based on that price, the total value of the contribution would be $5.7 billion.  See G.M.Acts to Secure Pension Using Stock.

Regulators acceded to the GM request.  The rest is economic history:   GM recently went bankrupt, and the plans remain massively underfunded.

Poverty Follows Financial Innovation

In its time of pension deficit, Diageo is not the only creative funder. The UK is rife with new schemes:

The British supermarket chain J Sainsbury said earlier this year it would transfer property into a pension vehicle, while Whitbread agreed to hand over a share in its portfolio of restaurants and hotels. The investment firm Man Group moved some hedge fund assets into a trust as a security for its British pension plan in March.

“We’re seeing a huge growth in the use of non-cash funding,” Marc Hommel, leader of the pensions practice at PricewaterhouseCoopers in London, said. “There are big pension deficits and sponsors are cash-strapped. These mechanisms provide security for the pension plans in exchange for less cash.”  See Diageo Uses Scotch to Plug Gap in Pension Plan.

Mr. Hommel probably did not intend to be humorous, but one must ask whether these new methods of providing  “security” make the funds more or less secure.  I would submit that when one has to innovate and pull financial “rabbits out of the hat” both equity holders and pensioners of these companies face a lot more risk.  And so do we, the taxpayers and funders of our enormous public pension funds and guarantors of private pensions through the Pension Benefit Guaranty Corporation.

In this current age of funding gimmicks, maybe we should refer to pensions as a social insecurity system.

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10
Jun 10

Bailout Nation Lives

Where is the coordination of economic policy among the Federal Reserve, the Treasury and Congress?  In testimony before Congress, Ben Bernanke, Chairman of the Federal Reserve warned against large budget deficits:

The Fed chief repeated his call for lawmakers to come up with a long-term plan to reduce the federal budget deficit, which is projected to widen to a record $1.55 trillion this fiscal year. “Unless we as a nation make a strong commitment to fiscal responsibility, in the longer run, we will have neither financial stability nor healthy economic growth,” he said.  See Bernanke Says Fed Prepared to Counter Effects of Europe Crisis

It is clear that bailouts are not consistent with fiscal responsibility.  But it seems the Administration and Congress are tone deaf to these no more bailout pleas.

No Constituency Left Behind

We have analyzed the bailout actions of the Bush and Obama administrations. See Are We a Socialist Country? It has been a long and undistinguished progression from Bear Stearns, AIG, American Express, GM, Chrysler, GE and others.  We have collectively decided that banks, insurance, automotive, industrial, credit card and other companies are too systemically important to fail, and are therefore bailout worthy.

Despite all protestation the Obama Administration appears to be on a constant search for new bailout candidates:

-          A $23B Bailout for Teachers – Education Secretary Arne Duncan urged Congress to support a $23b jobs bill to prevent teacher layoffs.

-          Why Leave Out Pension Funds? – Senator Casey, D-PA proposes affording two large multi-employer Teamster pension plans federal protection.  The estimated cost would be $8-10b.

-          US Largesse Goes Global – Through IMF membership, the US taxpayer will be funding the bailout of Greece and other European nations. IMF Chairman Boutros-Ghali pointed out the perilous financial position of the IMF and the need for more member capital contributions.  Rep. McMorris Rodgers, R-CA highlights the hidden cost to us:

“This should give pause to Treasury Secretary Geithner and others who boasted that the IMF’s bailout bonanza wouldn’t cost U.S. taxpayers a dime,” said Rep. McMorris Rodgers.  “In truth, the cost to U.S. taxpayers goes up every few weeks.  After the Greek bailout, it stood at about $7 billion; after the EU bailout, it stood at about $60 billion.  Now – based on Mr. Boutros-Ghali’s comments – we’re talking at possibly $100 billion or more.  This has got to stop.” See Congresswoman McMorris Rodgers Responds to IMF Statement Europe Bailout will Cost  US Taxpayers 100 billion+

-          As we have pointed out, Fannie Mae and Freddie Mac are uncapped, growing, perpetual bailouts. See Shredding the Social Fabric.

The Hidden Costs of Bailouts

Politicians are constantly on the prowl for a free lunch.  Bailouts and promises of “little cost to the taxpayer” provide that seemingly free repast.  A closer look at the bailout phenomenon shows us its high and hidden price tag.  A look at some unintended consequences:

  • Bailouts only add to the burgeoning federal deficit.
  • Ultimately, they will be paid for either through higher taxes, higher inflation or both.
  • We are eroding financial discipline.  GM was roundly criticized for giving away a new Corvette to a Detroit Tiger, who pitched a near perfect game.
  • Likewise, we are eroding fiscal discipline in states and municipalities, which should be cutting budgets and raising taxes rather than seeking bailouts.
  • We are compromising our most basic federal system of separation of powers, as a state and local function, education, becomes a federal ward.
  • We are encouraging moral hazard with reckless and profligate behavior (and prudent behavior is punished).
  • Bailouts beget other bailouts, as it become impossible to draw the line when future constituencies come to Washington for their bailout.
  • Today’s funding of bailouts limits the flexibility of the Administration to respond to future, more serious crises.

Fundamentally, bailouts are unfair, as one group is leveraging its political clout to earn a bailout at the expense of innocent taxpayers.  Rewarding the profligate and the irresponsible makes little sense as public policy.  It is time to end the bailouts.

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11
May 10

Extend, Pretend and Crash?

After Monday’s European Union’s (“EU”) trillion dollar bailout, Zero Hedge’s headline encapsulated what had transpired:  “Even Keynes Is Spinning in His Grave.” “Extend and pretend” is now official worldwide economic dogma, as embodied in this unprecedented bailout. Why extend and pretend?  Has anything really changed?

Pretending as Public Policy

We live in an age of irresponsibility.  We seem to be responding to all types of crises with sluggish denial and finger pointing.  From Katrina to the Financial Crisis to the Deepwater Horizon oil rig disaster, government massages the news, assigns culprits and acts only when pushed by market events or an outraged public.  Instead of thoughtful, real and comprehensive solutions the policy is “extend or pretend.”  More plainly, the goal is to conjure a stop gap solution and pray that time and luck will save the day.

A History of Extend and Pretend

At the end of the Bush Administration, the financial crisis lent itself to “extend and pretend” policymaking.  The fractious, polarized political culture made it ever easier to opt for this policy choice.  Obama, if anything a master politician, has adhered to these same choices.  Let’s look at how “extend and pretend” continues even now:

-          Mark to Market Accounting – Facing pressure from the banks and Congress, in April 2009, the SEC suspended the mark to market accounting rules for bank assets. Given mounting foreclosures in the housing market, it is highly likely that the banks are not properly valuing these assets.  Pundits believe that many major banks are insolvent.

-          The Federal Reserve – Through the TARP and other bail out programs, as of March 31, 2010, the Federal Reserve balance sheet has expanded to over $2 trillion, mainly in dubious mortgage backed securities.  Once again, analysts are questioning the worth of these securities and the Fed’s solvency.

-          Government Sponsored Enterprises (“GSEs”) –We are ignoring the hapless Fannie Mae and Freddie Mac agencies in the midst of our stock market and banking dramas.  Despite the vaunted financial reform efforts, we haven’t even considered crafting a solution to the GSE mess.  Instead of reform, on Christmas Eve 2009, the Administration extended unlimited financial assistance to these businesses.   Buried in our naïve enthusiasm for the ECB bailout is a painful reminder of taxpayer obligations.  Fannie Mae posted a quarterly loss of $11.5b and needs at least $8.4b from the government to continue.

-          General Motors – After proudly proclaiming in a national ad campaign that they had re-paid loans to the government, Senator Grassley found that the company merely tapped a US Treasury escrow account to repay its TARP loan.

Extend and Pretend Goes Global

Today’s EU trillion dollar bailout is more of the same. The three part program is to create a 750 billion Euro fiscal support program, buy bonds in dysfunctional markets (quantitative easing) and enter into swap lines with the Federal Reserve to obtain dollars.   This is “extend and pretend” taken to an entirely new level.  It is not even clear or sure whether the EU can obtain IMF approval to move forward. Problem countries will require austerity measures.  In sum, this is exponential “extend and pretend,” as troubled governments pretend to have a program to calm their markets and citizens.  And even if they enact these programs they do not deal with underlying structural issues in the EU, where too little income supports too much debt.

It All Comes Down to Honesty

The political elites in the US and Europe do not want to face the economic realities.  Honesty and candor with electorates are in short supply.  Instead of leaders we have a class of venal and calculating politicians. Happy to solve the problems of today with band aids, they invite greater calamities, where the patient may be lucky to make it out of intensive care and may yet succumb to massive infection.

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26
Apr 10

Let It Be

When I find myself in times of trouble
Mother Mary comes to me
Speaking words of wisdom, let it be

And in my hour of darkness
She is standing right in front of me
Speaking words of wisdom, let it be

“Let it Be” – The Beatles

Over the years, I led or was a member of the inner circle of many high level corporate crisis teams.  A problem or crisis challenges many a senior business leader to immediate action.  Enshrined in books on leaders is the leader who embraces action rather than “thinking more and reacting less.”  The unfortunate corollary ethic is that inaction is weak, unmanly, lazy or worse.  Even more dramatically, many times, a problem creates an adrenalin rush that is antithetical to rumination or reflection.

An entire lexicon fuels this response to problems and crises.  The language itself has military connotations: we are calling general quarters; battle stations;  red alert; the bunker mentality.  We need to deploy our troops, plot a strategy or prepare a measured response.  We applaud bold action and deride thoughtfulness.

Rarely does a leader publicly pause, reflect, and ask:  “What if I do nothing…what if I let it be?

Reaction to the Financial Crisis

Both the Bush and Obama administrations overreacted to the financial crisis.  In short order, they created TARP and an alphabet soup of borrowing programs. The government then impulsively guaranteed close to $23 trillion of debt. Compounding the folly, the government became a partner in GM, Chrysler, AIG and Citicorp.  Stimulus programs barreled through Congress bringing us first time home buyer credits, “cash for clunkers,” and interest rates at or near zero.

What If?

What if the government had done nothing when the crisis exploded into the public’s conscientiousness?  We purport to be a capitalist economy whose basic tenet is simple and understandable:  reward risk that succeeds, punish risk that fails.  The necessary adjunct to this tenet makes perfect sense:  punishing failure encourages the capitalist to be careful with his assets, thus limiting misallocation of funds. Unfortunately, what has happened in the US economy is not capitalism: successful enterprises are forced to compete with failed, government propped up ones. And new capital will not be available for new enterprises.

If we did nothing it would be painful for a short period of time.  Yes, there would be hardship, unemployment and business failures. However, the self correcting nature of capitalism would mitigate the length of the hardship, as capital would rapidly re-deploy to successful and new enterprises: an economic version of “no pain, no gain.”  Instead we have persistently high unemployment, “zombie banks” afraid to lend and, compared to prior recoveries, sub optimal economic performance.

Legislative Reform

In response to problems in health care the current Administration rammed through a complex, little understood health care proposal.  We know taxes will rise dramatically.  We have no idea how costly, efficient or effective the new health care system will be.  Given typically heavy handed government involvement, I am not optimistic.   Nancy Pelosi’s comment that we need to pass the bill so we can find out what is inside is not exactly a confidence builder.

Similarly, the Administration is trying to pass another gargantuan and little understood financial reform bill.  I have been critical in other essays about the financial institutions that got us into the financial crisis, but there are laws on the books right now that would go a long way to curbing some of the excesses.  We simply have to enforce them.  Another simple fix: reinstate Glass Steagall, which separates commercial banking from the securities business.

Stop the Committees Who Saved the World

In 1999, Time Magazine featured Robert Rubin, Alan Greenspan and Lawrence Summers as the Committee who Save the World from a global financial meltdown. What if there had been no Committee to Save the World?  A smaller failure in 1999 might have led to a more chastened financial sector.  Perhaps sub-prime lending, overbuilding in residential housing and commercial real estate,  the 2008 stock market meltdown and now the potential for sovereign debt defaults in Greece, Spain, Dubai and other countries would not have taken place.

Our current “Committee to Save the World” (Geithner, Bernanke and Summers) is certainly falling short of the mark. Perhaps our bold men of action should be a lot less bold, a lot more thoughtful, reflective and yes, inactive.  Might we all be better off?  In the immortal words of the Liverpool Philosophy Society (AKA the Beatles) could we not just “Let It Be?”

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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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25
Jan 10

Freedom to Fail

In his 1941 State of the Union address, President Franklin Roosevelt articulated four iconic freedoms:

  • Freedom of speech
  • Freedom of religion
  • Freedom from want
  • Freedom from fear

In our current situation, capitalism needs a fifth freedom, the freedom to fail

The Systematic Destruction of the Freedom to Fail

In the 1950’s, Dr. Benjamin Spock’s child rearing advice focused on a child’s self-esteem rather than discipline, performance, success or accomplishment.  This emphasis correlated to a new and pervasive permissiveness which sought to prevent failure as a childhood experience rather than process it for personal growth when it inevitably occurs.  And so the advent of the “Lake Wobegon effect:”

where ‘all the women are strong, all the men are good looking, and all the children are above average,’ … used to describe a real and pervasive human tendency to overestimate one’s achievements and capabilities in relation to others. The Lake Wobegon effect, where all or nearly all of a group claim to be above average, has been observed among drivers, CEOs, stock market analysts, college students, parents, and state education officials, among others.

And so we coddled the Baby Boom Generation.  If our child failed a course, get a tutor.  If College Board scores were not high enough, enroll the child in a review course.  Everyone was entitled to a college education, a house and a good paying job. Originally, affirmative action was designed to overcome discrimination.  It morphed from its original intent, equality of opportunity, to equality of outcome.   In the corporate environment, one’s status (that is, minority, female, disabled among others) many times trumped one’s accomplishments. I am in favor of the original purpose of affirmative action, but not its wrong-headed incarnation.

The Financial Crisis and the Freedom to Fail

The government stepped into the breach to prevent major institutions– AIG, GE, American Express, Capital One, GM, Chrysler, Fannie Mae and Freddie Mac– from failing.  In an economic analogy to Dr. Spock parenting, the Fed reacted as a permissive and nonjudgmental parent to a child eminently deserving of a failure experience from which to learn something.  By not permitting these institutions to fail, we may have exposed ourselves to much larger systemic failure with a default or devaluation of our currency.

Failure is Integral to Success

We should think about our own personal life paths.  Did we learn more from success or failure?  If we are honest with ourselves, we would admit that we learn much more from failure.  It builds resilience, humility and,  if we absorb the lessons, a path to success.  It is almost immoral to take away the ability to fail and learn.

Joseph Schumpeter, an Austrian economist, in Capitalism, Socialism and Democracy, theorized that “creative destruction” was integral to capitalism:

the same process of industrial mutation–if I may use that biological term–that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism. It is what capitalism consists in and what every capitalist concern has got to live in. . . .

Failure is an excellent teacher.  Permitting smaller failures after the internet boom would have saved the country the anguish of millions of people losing their houses, the near destruction of our banking system and the collapse of the stock market.

Now the government would be prudent to permit business failures regardless of business size or political connections.  Sparing the rod of failure only spoils the childlike business with more reckless behavior.  Without the “hell” of failure, there can be no “heaven” of success.

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22
Dec 09

Collateral Damage

Last week President Obama gathered key bankers at the White House to implore them to lend more. Past blogs have examined the structural changes in the economy which have affected unemployment. See Are There Too Many People? One of the cornerstones of lending is integrity of the collateral backing any loan. Our new economy has done much to undermine the worth of any collateral.

The Old Industrial Economy

In Can You Lend for Thirty Years?, I described the industrial economy led by General Motors, US Steel, Goodyear and DuPont.  Industrial formation was characterized by large plants, large numbers of workers and sophisticated machinery.  These companies generated large amounts of cash and had substantial financial reserves.  There was a “wall of equity” and substantial assets for a banker to lend against.

The Modern Economy

The old industrial economy has been withering away.  Witness bankruptcies of many of our industrial icons:  GM, Chrysler, Bethlehem Steel, Delphi and a host of other companies.  We have shifted to a service based economy.  Gone are the “hard assets” that bankers loved.   Collateral to support a loan to Accenture or Home Depot is entirely different:

  • Software
  • Patents
  • Knowledge Workers
  • Distribution Networks
  • Commercial real estate
  • Leases
  • Good Will

Bankers desire easily marketable collateral with determinable market value.  A patent usually lacks an easily determinable value (reference the enormous growth in patent litigation) and is not easily saleable.  Couple this with workers who can take their knowledge with them to the next employer and a declining real estate and lease market and you can understand the  bankers’ reluctance to lend.

Focusing on Old Solutions

Faux Powerlessness Part Deux highlighted the White House banker summit and President Obama’s pleas to the bankers to lend.  But why would they do this? Recessions lead to declining asset values.  There are even more disincentives to loans to small businesses.  Small businesses have the added problem of declining residential real estate which is often used as collateral.

The Federal Reserve has worsened the lending environment by encouraging banks to use virtually free money to speculate and “play the yield curve.”  Thus, it is not surprising that bankers have abandoned traditional lending to businesses.

New Ideas

What the White House has not focused on is the change in the nature of businesses and the new kinds of collateral necessary to support loans.  The more “ethereal” nature of collateral in a service based business economy retards traditional lending.  Perhaps the White House should be encouraging equity stakes rather than debt solutions.  But, creative thinking outside the box has not been a hallmark of the first year of the Obama Administration and its economic advisers.

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12
Dec 09

Perverse Incentives

Government has distorted our economic choices.  Through pumping irrational amounts of liquidity, the economy has stabilized for the moment.  However, we live in a post apocalyptic financial world wherein this interference has created perverse incentives.  Some examples:

  • Free Car Rentals from GM

Why rent a car from Avis or Hertz?   GM, now owned by the US government and financed through its generous checkbook, permits a buyer to drive a newly purchased car for 60 days, travel up to 4,000 miles and return the car for a full refund for any reason (GM 60-Day Satisfaction Guarantee). Doesn’t this put non-government owned auto manufacturers at a significant disadvantage?

  • Can’t Qualify for a Private Mortgage?  Try the FHA

To stem the decline in house prices, the FHA has stepped in to make loans that no sensible private party would make.  Buyers can put as little as 3.5% down.  (In “What does the FHA think it is doing?” – One buyer borrowed from her retirement account to fund the 3.5% down payment).  Didn’t we get into the financial crisis through sub- prime lending?  As a footnote, a former FHA official projects the agency is more than $54b underwater on its portfolio and is expected to need a major taxpayer bailout.

  • Why Lend Money When You Can Earn Risk Free Returns Courtesy of the Fed?

The Federal Reserve has adopted a zero interest rate policy and promises to keep it in place for an extended period of time.  Complementing its zero interest rate policy, the Fed now pays interest on excess reserves kept on deposit with them.  In a recessionary economy it is risky to lend money to private borrowers.   Why lend in the real economy, when you can borrow at zero percent, redeposit the money to earn interest on these Fed reserves, and pocket the differential?  This risk free maneuver is a disincentive for banks to lend to borrowers.  Isn’t the Obama administration trying to stimulate the real economy through lending? See Fed’s Zero Rate Policy Sparking Complaints and Banks are Not Lending?  So What

  • Why Return to Prudent Investing or Compensation Policies When You Have a Government Guarantee?

The “Too Big to Fail” institutions have a federal guarantee if they get into trouble.  If you are socializing losses through government guarantees and leaving profits in private hands, the real world result is excessive risk taking and reckless speculation.  Merely look at the rising “value at risk” (the amount of money a firm could lose in one day of trading) at firms like Goldman Sachs and you see a microcosm of capitalism run amok.  Why not leverage up and speculate in the commodity markets when the government is the ultimate underwriter of risk?  Excessive leverage was one of the triggers for the financial crisis. These activities have returned and have possibly exceeded pre- crisis levels.

Excessive risk taking has led to record bonuses on Wall Street.  Prudence would suggest reinvesting profits in the firm instead of record payouts.  Why be prudent if the government is your guarantor?

  • On the Verge of Bankruptcy?  Why Not Raise CD rates?

If you are a financial institution in trouble, why not offer CD rates far in excess of your competition?  In a world where the FDIC effectively guarantees these CDs, there are no limits on offering CD rates to attract deposits.   Just before Washington Mutual became effectively insolvent, it offered CDs way above market. Only the taxpayers have to worry about any future losses.

Conclusion

When the government intervenes in the real economy, the laws of economics and prudent business practice are suspended.  This is all done in the name of “saving the economy.” I have highlighted some of the perverse incentives. I am sure there are more and more will develop with continued government meddling.  Is it worth it?  If I am a taxpayer underwriting financial follies, I might want to express my disapproval to my elected representatives.

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