The Market Can't Fix the Financial Crisis by Itself

The failure of the financial bailout proposal that was before Congress on Monday shows a profound lack of leadership by members of Congress.  In the biggest decisions of their lives, Congress chose to put party ideology ahead of the well being of the American people.  In times like these we need elected officials who are prepared to lead a public that is nervous, frightened and angered by the events on Wall Street.  Large chunks of Congress and nearly all of the financial pundits strongly believe in the financial markets and their ability to self-correct in the event of mass disruption.  As we have seen over the last two weeks, the cost of a self-correction by the financial markets is simply too great for our society given the financial interconnectedness or our institutions.  It should be clear to all that a significant government intervention is needed in order to prevent a severe recession.         

History has shown that the free market’s pricing mechanism works well under normal circumstances and we surely need to be careful when we decide to interfere with it. Adam Smith's invisible hand certainly corrects for many of the changes in the economy and the financial markets but given the complexities of our current era, until global asset values can be determined on a consistent basis, we must realize that there is simply not enough data on all of the credit products out there to allow for efficient financial markets.

One needs to understand that while people may believe that financial markets are infallible they have a profound tendency to seize up when a lack of information and data used to determine prices of financial assets does not exist, or is not accurate.  Financial Market’s are simply not as efficient in today’s day and age as far right economists would want you to think. 

Economics, like other sciences, has seen its practitioners strive to develop universal "laws" that can be applied to how the particular science functions in conjunction with the natural world.  In the case of economics, these laws have been used to predict how the economy will function.  While universal laws may work with Physics and its many equations they do not work in a world where economic models and the “laws” developed by economists have a tendency to function only during a typical day in a financial market and not when financial markets are put under the pressures that we have seen over the last several weeks. 

To make the equations of economics work you have to make several assumptions such as that supply and demand curves are independent of each other and that both curves are independent of the market’s prices, the market perfectly prices in all available knowledge, people act rationally, all markets are perfectly competitive and prices are perfectly flexible.  None of these assumptions always stands up in the real world.  In the real world, there is feedback between demand and supply curves, the market does not perfectly weigh all available knowledge, people act on their emotions and biases, no market is perfectly competitive and prices are not perfectly flexible.  In the last decade, we have had two bubbles burst, the dot-com bubble and now the housing/lending bubble.  Bubbles should never happen under a traditional economic theory that dictates ultra efficient financial markets. 

Lets look closer at the dot-com bubble to illustrate how traditional economic theories can break down.  Obviously, dot-com stocks were not priced rationally as their pricing was based on flawed group think that was focused on greed and the belief that anything was possible.  The high demand for dot-com stocks caused prices to skyrocket and as a response to high prices many more dot-coms were started and IPOed until the supply of dot-coms became so great as to pop the bubble sending prices back downwards.  As the prices of dot-com stocks rose the demand for those stocks also rose as people wanted to get in on the profits.  The situation was similar with rising home prices as rising prices enticed many new players to speculate in the housing market.

If you examine the dot-com bubble you will notice that instead of the prices of dot-com stocks finding an equilibrium balance between supply and demand, prices instead shot up and then crashed down.  They did this because the demand for dot-com stocks was influenced by the flawed idea that the explosion of the internet would lead to incredible dot-com company profits at some point in the near future.  This flawed idea sent dot-com stock prices shooting upwards and the idea spread, which was seemingly justified by the price action.  As people saw dot-com stock prices skyrocketing they got in the game seeking the same profits that many people had made before them, this sent prices upwards further still.  Some people bet against the dot-com bull market, George Soros was one of them.  But George Soros and other dot-com shorters who called the top too early had their investments crushed and those that were long were rewarded with huge profits.  The market not only rewarded those that were long with profits but many used those profits to borrow on margin to purchase more dot-com stocks pushing the market up further.  The early shorts saw their capital shrink making it more difficult for them to sell short driving prices back down.  In short, the process was self-reinforcing not self-correcting. 

Market bubbles self-reinforce on the upside as well as the downside.  The current housing bubble was caused by aggressive lending, a bias that housing prices never drop and an accelerating demand to own houses for speculative flipping.  Now we are seeing the other side of the bubble.  As the housing bubble reinforces on the downside we are seeing home prices drop which causes increasing foreclosures and erosion of the balance sheets of banks.  This makes the banks unable to lend to credit worthy businesses and individuals, as banks are unable to lend, home prices begin to drop further because people cannot obtain the credit they need to make purchases.  Home price declines decrease both the demand to purchase houses and the supply of available credit.  As this process continues the ability of banks to lend continues to decrease and this decrease in lending will eventually affect every area of the economy.  As the economy worsens, people will lose their jobs, further increasing foreclosures and further hurting the banking system.

The last time the market was allowed to correct a financial crisis (without timely government intervention) our country found itself digging out of the Great Depression. Fortunately, the Federal Reserve learned its lesson and we now provide liquidity to banks via the Federal Funds market and the discount window.  In addition, we attempt to deal with struggling banks that are deemed systemic risks.  In addition, we offer FDIC insurance on bank deposits and we attempt to intervene when the economy is contracting and banks are failing.  Members of congress need to realize that the market interventions of the past offer a methodology by which the interventions of today can be carried out.

The real key as to why the financial markets cannot self-correct from the housing crisis is that prices are not downwardly flexible because of the role of leverage in our financial system.  A bank's assets can go down in price but its liabilities cannot.  Therefore, if its assets go down in price enough the bank can easily become insolvent and face certain failure.  It is the same for homeowners because of their ties to depreciating assets.  When people are upside down on their houses they have an incentive to default.  As banks are unable to lend, due to a contraction in their balance sheet, the result is a decrease in the money supply, which is deflationary.  Should the price level of an economy decline, a business that has borrowed money to fund its operations will still be required to make the same payments regardless of any deflation in the economy and the effect of the deflationary environment on its business.

Essentially, what is occurring in today’s financial markets is that the self-reinforcing housing and credit collapse is beginning to raise the specter of deflation, creating yet another self-reinforcing process by which the economy will march ever so slowly to an unwanted fate.  Widespread deflation will crush the economy in a self-reinforcing manner because almost every business and individual with debt will experience financial stress. The more home prices drop the more insolvent banks we will have.  The more insolvent banks that we have the less credit will be available, adding fuel to the deflationary fire and greatly impacting American business.

Either we can allow the self-reinforcing credit contraction process to continue and watch the economy collapse or we can support our government’s efforts designed to recapitalize the banking system.  It should be clear to lawmakers that this economy will not self-correct as many people think.  Should congress fail to pass any meaningful legislation the Treasury Department and Federal Reserve will have to resort to buying what mortgages they can, printing hundreds of billions of dollars and offering full protection via the FDIC to bank depositors. 

What Have You Done Jamie Dimon?

Should the economy worsen dramatically over the next several years the rescue of Washington Mutual by JPMorgan Chase will be remembered as the event that brought the American financial system to its knees.  While the terms garnered by JPMorgan may appear favorable on first review, the deal raises far more questions then it answers in regards to the health of the financial system of the United States.  There is a significant possibility that this rescue may have begun the process by which the financial risk of lesser banks is thrown upon the three majors in an attempt to save the entire financial system.

In concentrating the financial risk of our system in JPMorgan, Citigroup & Bank of America there is the acute chance that we will inadvertently kill our rescuers, leaving us no choice but to rely on a federal assumption of banks that are truly to big to fail.  Should the economy take a dramatic turn for the worse and unemployment rise dramatically, JPMorgan’s current loss assumptions will prove shortsighted.  As we have seen over the last several months when such assumptions are realized by the investment community to be inadequate terrible things happen.  JPMorgan with its massive derivative exposure can ill afford the unfortunate series of events that will undoubtedly come about should the losses associated with the Washington Mutual acquisition prove considerably larger then currently expected.  

Based on JPMorgan’s current estimates the purchase of Washington Mutual will cost the venerable bank very little, namely a $1.8B dollar payment to the FDIC, an $8B dollar capital raise and a $31B dollar write down of the firm’s newly acquired loan portfolio.  While I certainly have no qualms with the first two items, the third appears to be questionable.  Below is a table of JPMorgan’s assumed losses on Washington Mutual’s loan portfolio:

	Projected Remaining Losses as of 9/30/08 ($B)	Estimated Balance as of 9/30/08
Option ARMs	$10.346	$50.300
Mortgage	2.183	51.100
HE Loans & Lines	11.739	59.500
Subprime	6.438	15.100

The home equity (HE) and mortgage loss assumptions are almost laughable in my opinion as they place far too much faith in Washington Mutual’s underwriting capabilities.  Unless there is a profound turnaround in the real estate markets out West, I simply do not see how losses on the home equity loans will not be much higher then currently expected.  It seems reasonable to me that JPMorgan should have marked the loss assumptions for home equity loans up to such a level so that they match the percentage decline of home prices in the most depressed housing markets. 

According to JPMorgan’s own assumptions the company expects losses to expand to $42B should the recession deepen and $54B should the recession become “severe”.  These figures would represent an $11B and $23B dollar reduction of capital at the bank on top of the $31B dollar write down that JPMorgan has agreed to take initially.  It is important to note that these figures take into account 7.5% and 8.0% unemployment respectively.

Throughout the credit crisis and for that matter throughout its history JPMorgan has been viewed as having a fortress like balance sheet.  The Washington Mutual acquisition should put to an end this belief in the impenetrability of JPMorgan’s balance sheet, especially if the economy were to worsen.  At the end of September, JPMorgan will have a capital base of $107B and a Tier 1 Capital Ratio of 8.3%.  While the company’s capital base will have increased from $99B at the end of June, the Tier 1 Capital Ratio will have fallen dramatically as it stood at 9.2% in June.  Such a rapid decline in this key metric is appalling, as it would suggest that JPMorgan is now nothing but a mere mortal.  

Should the country enter a “severe” recession, as defined by JPMorgan, the company would find itself with a Tier 1 Capital Ratio that would be quickly approaching 7% (barring additional capital raises).  When compared to its peer’s capital ratios, which can be found here, we would see that JPMorgan would have the lowest capital ratio of them all should events unfold in such a manner.  The loss of its fortress like balance sheet will likely place the company under considerable strain as it will force it to restrain its derivative and investment bank operations.  The future, while still existing for JPMorgan, has gotten bleaker with the acquisition of Washington Mutual.  If we were to continue with the “fortress” metaphor, it is as if Jamie Dimon has lowered the drawbridge, raised the gates and proceeded to welcome the Barbarians into Camelot. 

For Further Review:

NY Times Article on the Deal

JPMorgan Presentation 

Disclosure: None

Why I Bought AIG

I have a confession to make, last week I bought AIG.  Even with all of its faults it was simply too cheap to pass up at 2 dollars and change.  Despite the governments bailout proposal there was and still is substantial value left in the company.  Even after accounting for an 80% dilution of the common shareholders, the company still has a book value as of the end of the most recent quarter of $5.80.  While there are significant risks in owning AIG, namely accelerating losses in the company’s credit default swap (CDS) portfolio, which I talked about back in mid May, the potential upside that exists as a result of the sale of company assets far out ways the risks associated with owning the stock at these price levels. 

The government bailout is certainly a terrible deal for AIG’s current shareholders.  The deal’s premise is built on the fact that a government rescue was necessitated by the possibility that a failure of the company would bring about an utter failure of the credit markets.  An intervention based on an attempt to provide the liquidity that the company needed was certainly warranted and as I mentioned earlier, I applaud the Bush Administration's rescue efforts.  The government’s $85B dollar loan and controlling stake in AIG will provide just what the company needs; however, I doubt the deal will go through, as it will still likely require shareholder approval. 

If AIGs large shareholders can block the deal, as it appears they are trying to do, the shares will soar as the company begins to unload its assets.  The tentative agreement between AIG and the government has without a doubt bought the company a small window during which it has the support of the financial markets to unload its assets.  If these asset sales can be carried out fast enough, the agreement can likely be terminated prior to the company having to ask its shareholders for the agreements approval.

In looking at the company’s assets, it is clear that significant value can be realized from the sale of numerous subsidiaries.  To start with, we can use Melissa Gannon’s article that was written over at thestreet.com, Ms. Gannon did a wonderful job of breaking out AIG’s three most likely U.S. domiciled subsidiaries to be sold.  They are the following:

1. Lexington Insurance (fire insurance) – $4.7B in Capital, $6.6 B in annual premiums
   
2. National Union Fire Insurance (liability) – $12.0B in Capital, $5.5B in annual premiums
   
3. American Home Assurance (workers comp & liability) – $7.0B in Capital, $ 6.7B in annual premiums
   

These companies, with their strong balance sheets and relatively sound investment portfolios will likely fetch one times book value, or about $23.7B.  While these sales will go a long way towards freeing up capital and much needed liquidity for the company, they cannot be the only ones undertaken.  AIG’s foreign subsidiaries are surprisingly sound and have been able to sustain their operating margins throughout the credit crisis.  As a result, their sales will likely be the most important for the company.  According to my rough calculations, the company could raise anywhere between $10.8B & $14.4B from the sale of both of its Foreign Life & Foreign General subsidiaries for a total of between $21.6B and $28.8B.  These sales will allow the company to refocus on the company’s core area of alleged competence, domestic insurance.      

In addition to the sale of three of its domestic insurance units and the sale of its foreign units the company will also be able to raise a substantial amount from the sale of its ILFC unit.  The company’s aircraft leasing business simply has no place in a slimmed down AIG.  If you were to assume that ILFC’s margins were only a little lower then GATX Corp. (GATX), the publicly traded railcar leasing company, I believe that we could safely value the company at somewhere near $5-$7B.  Other investments such as a controlling stake in Transatlantic (TRH) and a stake in Blackstone (BX) coupled with an investment being managed by the money management firm could be sold for nearly $3.9B.  For those keeping track the successful sales of the above-mentioned units could yield between $54.2B and $63.4B.

In addition, AIG could also attempt to monetize its massive money management unit.  The firm currently manages in excess of $750B dollars.  The majority of the money is tied to the companies investment portfolio related to its insurance policy reserves and the float that comes along with being an insurance company.  In my opinion, if the sale is structured appropriately, AIG could easily expect to generate an additional $15B-22B dollars.  While this would dramatically reduce the input that AIG has on its future, it is likely for the best and without a doubt the most critical piece of the value story at AIG.  Possible suitors include BlackRock (BLK) & overseas financial institutions and sovereign wealth funds.  The sale of AIG’s asset management unit would bring the total amount raised by the company through the above mentioned asset sales and the above assumptions into the neighborhood of 69.2B-85.9B.

While the subsidiary sales that I outlined above would be drastic and would lead to the dismembering of a storied company, they are likely the only option available to the firm and its investors in their effort to avoid the completion of the public bailout and the sacrifice of shareholder value.  The cornerstone of my plan, the sale of the company’s asset management unit, would likely improve risk management and allow what is left of AIG to focus on writing profitable insurance in its remaining domestic markets.  Upon the completion of these sales, it would be my hope that AIG could move towards competing directly with companies such as Travelers (TRV), Chubb (CB) & Allstate (ALL).  Its going to be a long trek for AIG shareholders but if we can force management to begin an immediate sale of the more valuable parts of the company we may just be able to unlock shareholder value that appeared to be lost not a week ago.  As I wrote in early May, AIG has truly fallen from a blue chip stock to unquestionable mediocrity; nevertheless, even broken companies, when reorganized appropriately, can yield great returns.    

For Further Review:

WSJ Article

Bloomberg Article

thestreet.com Article

Disclosure: Long AIG

A Bailout to End All Bailouts

Another weekend has come and gone and yet another rescue has been put into place.  While Secretary Paulson’s new “RTC” like proposal may seem like just another rescue in a long line of dramatic rescues, bailouts and deal makings this summer it represents a proactive step in bringing an end to the credit crunch and its many symptoms.  The proposed $700 billion bailout is the right plan for the right time and I hope that lawmakers move swiftly to enact it.

The fact of the matter is that no other option had a legitimate chance at brining about an orderly resolution to the profound risk of systematic financial collapse.  When financial markets cease to function they cannot be relied upon to solve the issues that they were built to resolve.  While noticeable pressure was brought onto the credit market by the failure of Lehman, the sale of Merrill and the near failure of AIG the most dramatic impact of their failure and near failure was the fear that they instilled on Wall Street, Main Street & around the world.  This fear, coupled with the impact that their respective demises had on the credit markets put extreme pressure on money markets funds, and the inability of select few to hold up as advertised caused gargantuan outflows and threatened the ability of businesses large and small to conduct their operations.  Had the run on the money market funds continued, their forced sale of illiquid and liquid credit securities in markets that was previously frozen would have led to a system wide collapse that would have moved the crisis on Wall Street to the door step of every American.    

The government bailout fund, while having noticeable risks, is the best option available at this point and the only one that can be relied upon to speed our nations economic recovery.  In attempting to radically speed up the bailout we will hopefully avoid a decade lost to financial reorganization.  While I rarely say this about anything the Bush administration does, I am truly impressed by their realization that our country needs proactive solutions instead of reactive responses.  We live in a world where we cannot be limited by dogma and ideology.  Secretary Paulson, Chairman Bernanke & the Bush administration have realized this and we should all be thankful.  In my article on moral hazard and the bailout of Lehman Brothers I expressed a deep frustration that the Bush Administration was not doing enough to save our financial system and our way of life, I would now like to just take a moment to applaud these men for their foresight and their move away from reactive responses to this financial crisis.   

For Further Review:

Text of Bailout Proposal

WSJ Article

Disclosure: None

Finding Morgan Stanley's Suitor

The dismal performance on Wednesday of our country's two largest independent investment banks has resulted in rampant speculation that these banks will be forced to merge with a traditional commercial bank in order to get access to the commercial bank’s large deposit base.  Such an action would allow Goldman Sachs (GS) and Morgan Stanley (MS) to dramatically reduce the liquidity issues that are inherently tied to short term financing, which is at the core of their business model.  When looking at possible suitors it is important to understand that the commercial bank must have not only a significant deposit base but a strong capital position as well.  The market has driven down the market caps of the vast majority of publicly traded commercial banks because of the possibility that their capital positions have been impacted by non-performing loans.  The reduced market capitalization of our country’s commercial banks make it much harder for either of these two investment banks to get a deal done.

Given Morgan Stanley’s $25B dollar market cap and Goldman Sachs $42B dollar market cap any deal would dramatically reduce the ownership stake of a commercial banks current shareholders.  Their sheer size dramatically limits the number of commercial banks capable of completing any deal and likely means that in order to survive these two investment banks will have to race against each other in an effort to tie the knot with whoever will take them.  Should one of the investment banks merge it will likely lead to the other’s demise, as it will likely be unable to withstand the relentless market speculation against it.  Below I have summarized the deposits and capital ratios of the ten largest U.S. commercial banks as well as the five largest Canadian commercial banks, they are listed from largest market capitalization to smallest.  

US Banks
Bank	Market Cap	Deposits	Tier 1 Capital Ratio
Bank of America	$124.0B	$786B	8.25%
JPMorgan Chase & Co.	$122.3B	$722B	9.20%
Wells Fargo & Co.	$110.6B	$310B	8.24%
Citigroup	$76.4B	$803B	8.74%
U.S. Bancorp	$58.1B	$135B	8.50%
The Bank of New York Mellon	$37.9B	$127B	9.33%
PNC Financial Services	$24.9B	$84B	8.20%
Wachovia Corp.	$19.5B	$447B	8.00%
BB&T Corp.	$19.4B	$88B	8.90%
SunTrust Banks	$16.8B	$81B	7.47%
Canadian Banks
Bank	Market Cap	Deposits	Tier 1 Capital Ratio
Royal Bank of Canada	$55.0B	$409B	9.50%
Toronto-Dominion Bank	$43.1B	$354B	9.50%
The Bank of Nova Scotia	$40.1B	$332B	9.80%
Bank of Montreal	$21.3B	$248B	9.90%
Canadian Imperial Bank	$19.8B	$228B	9.80%

 

Yesterday, I talked a little bit about the lack of regulation in the financial markets and it is interesting to see how well the Canadian banks have done despite having to operate under what some would call "excessive" regulation.  Continuing though with today's article you can see from the information above that there are maybe five U.S. and five Canadian commercial banks capable of taking on the balance sheet that would come with the merger between any one of the respective commercial banks and Goldman Sachs or Morgan Stanley.  I have removed any possible European suitors due to their incredibly low capital ratios and the possibility of any Asian suitors because of almost certain objection by government regulators. 

In looking at the likely domestic purchasers, we see that Bank of America, JPMorgan, Wells Fargo, Citigroup & Wachovia all have the balance sheets to get the deal done.  However, on closer examination we can throw out nearly all of them.  Bank of America’s recent deal with Merrill Lynch almost certainly removes it from the hunt, while Citigroup’s massive exposure to hard to value securities likely would force regulators to block the deal as it would only add lighter fluid to the bonfire that is already raging in Citigroup’s books. The bad loans at Wachovia that are related to the company’s most recent California acquisition will also likely remove it from the hunt for much the same reason that Citigroup will not be participating.  Wells Fargo, despite holding up fairly well during the recent credit crunch has the lowest Tier 1 capital ratio of any of the large commercial banks and I doubt that the Federal Reserve and the Treasury will want to waste Wells Fargo’s balance sheet on an investment bank when they will likely need it to help clean up the mess in California.  I will not be surprised at all to see Wells Fargo grow its presence significantly in the West as a result of the Federal Reserve’s near incessant requests for it to absorb failed California, Nevada and Arizona based banks.

This leaves JPMorgan as the only U.S. domiciled commercial bank with the ability to purchase either Morgan Stanley or Goldman Sachs.  While I fully realize that JPMorgan has already absorbed Bear Stearns this year, it would not surprise me at all to see the authorities overlook anti-trust concerns in order to ensure market stability.  If given the choice to choose between Goldman Sachs and Morgan Stanley we should not be surprised to see Jamie Dimon reunite the House of Morgan.  In doing so he will have prepared JPMorgan to battle Bank of America for financial supremacy in America over the course of the coming decades. 

Should Morgan Stanley merge with JPMorgan, Goldman Sachs would be left to the whims of the market and I doubt that their alleged ability to master any type of market environment will hold true forever.  With the volatility of the financial markets, it is not a question of whether or not they will make a mistake but when and when they do the bears will be waiting to mull the company’s stock.  Goldman Sach’s management team needs to realize that they must be attached to a depositary institution, as it is the only way to assure their survival in the current market environment.

As seen above there are five Canadian commercial banks with balance sheets and a deposit bases that are capable of absorbing Goldman Sachs.  Unfortunately, only two of the five have truly global aspirations and as a result, these are likely the only two that would even consider a Goldman Sachs deal.  They are the Bank of Nova Scotia and Toronto-Dominion Bank, both of these company’s have shown an aggressive drive to expand overseas and an acquisition of Goldman Sachs would move either of them definitively into the ranks of the global money center banks.  The Bank of Nova Scotia has a strong international business with branches in the Caribbean, Mexico, Central America, Latin America and Asia while Toronto-Dominion Bank has been aggressively expanding into the U.S., most recently with the purchase of Commerce Bancorp. The major trouble with a cross boarder deal is the additional regulatory bodies that will have to approve the merger and it is doubtful that the Canadian government will want to sacrifice its near impeccable banking institutions just to help the United States out of its own self-inflicted wounds.

As a result of capital base, depositary and regulatory limitations it is likely that JPMorgan is the only large commercial bank capable rescuing either of the two large remaining investment banks via a merger.  Therefore, it is without any real doubt in my mind that both Morgan Stanley and Goldman Sachs should be running into Jamie Dimon’s arms as his bank offers the only chance that these two banks have to preserve significant shareholder value.  Goldman Sachs reluctance will ultimately lead to its demise, as there will be no one left to save the firm should the Canadians be unwilling to sacrifice their institutions for ours.  Such a merger would not be seen as a sign of failure as both investment banks have done a fairly good job of navigating the credit crunch but rather the result of a changing world that has made it inconceivable to fund one's operations through constant involvement in the credit market.

Disclosure: None

Moral Hazard & LEH

John Authers’ piece in the Financial Times stating that the decade of moral hazard has ended provides a chance for us to look back on Lehman Brothers demise and the idea of moral hazard in a globally integrated society.  On the 16^th Authers stated that:

“In hindsight, this behaviour by banks was obviously irresponsible. The authorities' actions over the past weekend will doubtless be debated even longer than the LTCM rescue 10 years before, but that is the context for their decision. Lehman Brothers bankruptcy will not end the credit crisis. But it ends a decade of moral hazard. Nobody will again assume that the government will bail them out if they lend foolishly.”

While I would concur with Mr. Authers’ that the Lehman Brothers bankruptcy marks an end of an era, I would differ with him on the era that ended.  I strongly believe that the failure of Lehman Brothers marks the end of lightly regulated financial markets both here and around the world.  In the future, starting with the AIG bailout, the U.S. government will be an active participant in not only the financial markets but financial companies as well.  

Furthermore, the very idea of moral hazard as it applies to a market or industry is suspect.  If markets and industries are properly regulated, moral hazard should not occur.  When it does occur the individuals who are involved, namely the employees of the company in question, face substantial risks should they undertake certain actions that attempt to pass risk up the food chain.  The fact that Lehman’s management understood the actions that it did and still lost 100’s of millions of dollars for themselves and billions of dollars for their employees should not be overlooked. 

The failure of Lehman Brothers pushed the world very close to the brink, all in an attempt to teach financial markets a lesson.  I hope that the Bush administration realizes that there is a fundamental difference between eliminating common stock holders equity and terminating management teams and the placing of firms into bankruptcy to teach not only shareholders and management a lesson but the bondholders, customers and counterparties as well.  In placing the bondholders, customers and counterparties at risk the Federal government allowed an intolerable amount of risk to be placed on the financial system.      

The free market neo-liberalism that drove the world for the last several decades is dead and it is time that the Bush administration understands this and begin to implement aggressive policies that will save America’s financial system.  Unfortunately, I fear that the failure of Lehman Brothers, coupled with a failure of AIG, if allowed by the Federal government, will mark the beginning of a prolong decline in the U.S. economy and the start of deflationary era similar to Japan’s predicament in the 1990s.  We can only hope that the Federal Reserve’s bailout of AIG goes through.  Even if it does, there will surely be a crisis around the corner whose severity we can barely imagine. 

During the Great Depression Herbert Hoover was accused of doing too little, I fear that history will repeat itself if the Bush Administration does not step in to support the financial companies of America.  The problems created by this administration, and its predecessors, through a chronic lack of regulation of the financial markets are what led to the failure of Lehman Brothers and the other disgraces that have marked our headlines this year.     

At whatever the financial cost, America’s institutions must be protected by proactive government intervention to assure the continued prosperity of our country.  In a world that is increasingly integrated, we cannot rely on a good cop – bad cop form of moral hazard where we punish the financial market and the people of the world for the incompetence of a select few.  It is clear after the events of the last several weeks that sound institutions in conjunction with free markets and not free markets alone are the path to sound economic development and societal progress.    

For Further Review:

Financial Times Article

Can the US government Afford Further Bailouts?

Simply put, yes it can. In the days following the bailouts of Fannie Mae (FNM) and Freddie Mac (FRE) there have been countless pundits on television and many articles on Seeking Alpha and other investment sites proposing the misplaced thesis that we should worry about the US government's finances following the recent bailouts.  The prevailing idea is that if the market's bad debts are transferred to the government than the government will be the one having the problems. 

The responsibilities piling onto the government include the Bear Stearns liabilities, the Fannie Mae and Freddie Mac liabilities and potentially Lehman Brother’s liabilities.  While these are significant issues and will likely act as albatrosses around the neck of the next administration they were necessary actions that will support the financial framework of not only the United States but the world as well. 

Below are some of the more common questions that have appeared around the financial community over the last several days:  

-       How much can the government add to its $9.6 trillion debt before it too cannot handle its own liabilities?

-       When will foreigners refuse to let the US government borrow money? 

-       When will the dollar truly collapse?

The people asking these questions misunderstand the nature of money and the function of the dollar in the modern global economy. So, how much can the government add to it's $9.6 trillion debt before it too cannot handle its liabilities?  The answer is the government can borrow as much as it wants and that it will never be unable to service its debt. 

There is a prevailing view that people want to look at government in the same way that they look at a business.  People mistakenly look at tax receipts as revenue and government spending as an expense.  When the government has a budget deficit and is borrowing money to make up the difference people think the government is losing money. 

Certainly, if a business's expenses were greater than its revenues for the last 150 years the business would go bankrupt and people would at some point refuse to lend money to a failing business.  The key difference between a private business and the government is that the government has infinite access to money, since the government can literally print its own money.  If foreigners will not buy US government debt to make up the budget deficit the government will always have the ability to print money to make up the shortfall.  Fortunately, foreigners will not stop buying our debt because they have no other choice. 

Take China for example.  China's economy is built on selling products to the US.  If China stops selling products to the US, China would face a terrible recession, which would cause severe political unrest for the country’s political authorities.  As a result, China is going to keep selling its products to the US.  When China sells its goods to the US, China is literally trading goods for US dollars.  At the end of the day, China always ends up holding a huge and growing number of dollars. China has few options on what to do with these dollars.  The country can either hold them and earn no interest, buy US treasuries and earn interest, buy other US financial assets, other US exports or sell the dollars for another currency.  Holding dollars and earning no interest simply is not sensible.  China can also buy US financial assets and US exports, and it does that.  As for selling the dollars, what would China sell the dollars for?  Euros?  Yen?  If this were done, China would be left with the same set of choices all over again.  The real bottom line reason that gives the dollar value to foreigners is the products and services that you can buy with dollars, namely US exports.  Despite the fact that we are a net importer the US is still the highest gross exporting country and this gives us substantial leverage in world affairs that is routinely understated.  China can either spend all of its dollars now or it can save those dollars for later by purchasing US treasuries.

The idea of the government printing money for any purpose is frightening to many.  However, it is not as bad as one might first assume.  Printing more money is inflationary, which is one of the main principals that worry people.  However, for a better perspective on the issue we should look at the Fannie and Freddie bailouts.  If Fannie and Freddie were to have gone bankrupt (instead of being placed into conservatorship), their debt probably would have become worthless and the value of the mortgages that they insure would have droped substantially. If this happened it would set about a self-reinforcing trend beginning with nearly all financial institutions having severe problems supporting their own liabilities which would force them to stop lending.  This would cause economic activity to grind to a halt which  would further worsen the health of the banking system.  Bill Gross described this scenario as a “systematic debt liquidation” and I talked in greater detail about such an event here.  As a result, we are faced with the choice of either possibly causing some inflation at a future date or allowing another Great Depression to happen.  One should not have to think too long about which alternative one would prefer.  This is especially true when you consider that things can be done in the future to fight inflation, such as raising interest rates or raising taxes net of spending.  Given the fact that the current credit crunch is deflationary the inflation caused by the expansion of the government’s balance sheet is likely to be a good thing in the near term. 

Bill Gross: Brilliant as Usual

Bill Gross’s Investment Outlook for this September was a wonderful contribution to the general knowledge pool of the investment community.  The article, which can be found here, proved spot on in its belief that Treasury Secretary Paulson would be required to rescue the GSEs in an effort to avoid systematic financial failure.  In discussing the need for a significant and prolonged involvement by the Federal government in the financial markets, Bill Gross brought up a term that I had not heard. His statement that a, “rarely observed systematic debt liquidation” is currently confronting, “the U.S. and perhaps even the global financial system” was a startling turnaround for a man who not long ago was on CNBC warning the world about the specter of inflation.  Gross’s comments, which relate to his belief that the financial markets are rapidly delevering suggest that there is the potential for significant deflationary pressures going forward as asset prices collapse under their own leverage.   

Gross’s main argument is that asset prices will continue to collapse until additional capital comes into the market, this is in addition to the $400B that financial institutions have raised so far in the credit crunch. His statement that, “we will require policies that open up the balance sheet of the U.S. Treasury – not only to Freddie and Fannie but to Mom and Pop on Main Street U.S.A., via subsidized home loans issued by the FHA and other government institutions.” Implies the need for a coordinated effort on a national scale in order to prevent further mortgage losses at the nation’s traditional banking institutions that goes far beyond what has already been undertaken during the rescue of the GSEs.  Such a statement has hints of governmental actions similar to what was taken to prop up Japanese and Chinese banks during their struggle with troubled loans in previous decades.   Yet, Gross’s point that the private sector is tired of trying to call a bottom in financials only to see their investments deteriorate substantially is well founded.  If in fact, the private sector is no longer willing or able to undertake any further significant investments only two options remain.  Either we need to see massive markdowns that leave no doubt that there will be no further write downs or we need to see the government come in and buy everything up to prevent asset price erosion.  Both are very scary scenarios.  

The possibility of a “systematic debt liquidation” driven by the forced sale of falling assets that had been purchased with significant leverage is likely the most significant issue facing the market at this time.  If such a liquidation were to occur it would undoubtedly cause the, “financial tsunami” that Gross has predicted as distressed sales of financial securities would lead to a domino effect in the financial industry.  While remedies exist to ease the pain of such a failure, we can only hope that Bill Gross is far too pessimistic about the current state of the financial markets and the economy.

Below is Gross’s take on the anatomy of delevering:

What Happens During Delevering

1. Risk spreads, liquidity spreads, volatility, term premiums – they all go up.
2. Delevering slows/stops when assets have been liquidated and/or sufficient capital has been raised to produce an equilibrium.
3. The raising of sufficient capital now depends on the entrance of new balance sheets. Absent that, prices of almost all assets will go down.

For Further Review:

Bill Gross's Investment Outlook for September

My Thoughts on the GSE Bailout

Disclosure: None

Thoughts on the GSE Bailout

This weekend's news that the Federal government has placed Fannie Mae (FNM) and Freddie Mac (FRE) into conservatorship likely marks a bottom in financials and provides further support for the July lows. Below I have tried to summarize some of the key points that I believe warrant further attention for those investors trying to be informed about the situation.  

First, the common stock holders will see their share in the equity of Fannie Mae fall to 20% of the pre-conservatorship level amounting to $ 8.2B as of the end of the second quarter (total equity at the end of the second quarter was over $41B).  Given the distressed nature in the stock, the shares, even after the dilution, are still worth $7.66 if they company were to trade at a book value that would reflect the dilution caused by government’s warrants.  Such a price would not reflect the effect of additional losses going forward and as such cannot be used to properly value the company; nevertheless, it is an interesting figure. 

Secondly, the Treasury will be purchasing $20B of MBS securities a month through 2009.  Such an action will allow Fannie Mae to get a much better price for its securities then it would have been able to get in the public markets.  This will additionally guarantee the company a large boost to its fee income as it will likely be guaranteeing the securities as well originating them.

Additionally, the Treasury’s new credit facility will allow the company additional borrowing sources at what will undoubtedly be fairly generous rates.  This should allow the company to continue to function normally and allow for a safe rundown while at the same time allowing the company's net interest margins to expand from current levels, boosting net interest income.

The fourth item I found interesting was the lack of comment on the company’s mortgage guarantee business.  To me this can be interpreted that it is doing surprisingly strong and will likely be a significant contributor to the company’s turnaround going forward, should their rates begin to rise dramatically.  The problems at the company appear for the most part to be centered but not isolated in the company’s mortgage portfolio.

Another item that caught my attention was the distinct possibility that the shrinkage of the company’s mortgage portfolio could have potentially gargantuan effects on the financial markets.  Earlier this year the two GSEs were involved in over 80% of all mortgages originated in the U.S. so I would be leery of seeing these two company’s shrink their portfolios until there is a system in place that ensures that publicly traded banks will be able to ensure that there is a perpetual mortgage market in operation.  Otherwise we risk the possibility of a global market failure should no government entities such as Fannie Mae and Freddie Mac be in existence to prop up credit markets during the next crisis.  Fortunately, it appears we will have time to work on that, as the portfolio will only be forced to shrink 10% a year starting in 2010.     

Finally, there were these startling tidbits in Secretary Paulson’s remarks on Sunday:

“The federal banking agencies are assessing the exposures of banks and thrifts to Fannie Mae and Freddie Mac. The agencies believe that, while many institutions hold common or preferred shares of these two GSEs, only a limited number of smaller institutions have holdings that are significant compared to their capital.”

“The agencies encourage depository institutions to contact their primary federal regulator if they believe that losses on their holdings of Fannie Mae or Freddie Mac common or preferred shares, whether realized or unrealized, are likely to reduce their regulatory capital below "well capitalized." The banking agencies are prepared to work with the affected institutions to develop capital restoration plans consistent with the capital regulations.”

While Paulson & Co. assure us that the number of banks effected will be small, I can not be sure, as a fair number of large regional banks own preferred stock in the companies, which will be at least temporarily impaired.  In addition, smaller banks invested in these GSEs and there is as a result the distinct possibility that they could have had significant positions in the company’s common stock, in addition to positions in the GSE’s preferred stocks, as it was viewed as relatively safe until last August.  Whether or not this will cause any banks to go under is hard to say; however, it can be concluded that it is not a good thing and will likely further strain the banking system and by default the FDIC’s investment fund.   

During the remainder of 2008 and through all of 2009, it will be interesting to see how Fannie Mae holds up.  The placement of Fannie Mae into conservatorship signals the failure of the company’s former management team’s effort to manage earnings in such a manner as to try to spread the financial impact on the company over a longer period.  While I would expect the company to take significant charges in the immediate future as it adds to reserves, I do not expect the company to become utterly insolvent and to run through its capital overnight.  In fact, lower borrowing costs, the elimination of dividends, the sale of MBS securities at par to the Treasury and a surge in fee income, as I talked about here, should allow the company to do surprising well.  At some point I would not be surprised to see the company emerge from conservatorship and for common stockholders to be left with shares that are much more valuable then what the market will likely value them on Monday morning.  That being said I do not endorse buying shares of Fannie Mae at this time.  It is however important to realize that these two companies have not filed bankruptcy.      

The Bush administration’s action shows their willingness to do whatever necessary to guard against cataclysmic financial failure.  In placing these two GSEs into conservatorship, the administration has thrown its ideological beliefs out the window.  While this was surely necessary, it marks a reaffirmation of the high level of involvement by the Federal government in financial markets for years to come.  This action effectively opens the door for massive governmental involvement in the insurance, reinsurance and banking industries.  The opportunity for corruption and government mismanagement is extraordinary, fortunately the Treasury appears to be willing to use a decidedly market based approach to dismembering these beasts leaving some hope that significant errors will not be made.   

If we can manage to avoid a massive derivative/CDO blowup, we may just have witnessed a definitive bottom in financial stocks and in the financial markets as a whole.  

For Further Review:

Paulson's Remarks

Lockhart's Remarks

My Previous Thought's on the Bailout

Disclosure: None