Tuesday, March 31, 2009

Southpark Uncovers Bailout Decision Making Strategy

This is from Southpark last week but I missed it until now...short and a chuckle

Thursday, March 26, 2009

How Many Lifetimes Does It Take to Count One Quadrillion Dollars of Derivatives?

Five-hundred-ninety-five and one-quarter. Not kidding. I typically do this sort of math when trying to comprehend very large piles of money. Think about that for a second. Assuming an average life span of 80 years and that you counted (1-2-3, etc.) every waking moment from birth, it would take 595.23 lifetimes to count one quadrillion dollars, which is roughly the total notional value of financial derivatives in existence on the planet today. Unbelievable! And this notional value is just that ...notional...existing merely as marks on paper or more likely electrons on computer screens somewhere. As Dr. Evil would say, "Frickin' weird!".

Financial derivatives have existed for a long time and were originally created by highly educated mathematicians intent on providing hedges or insurance to dampen the risk associated with their clients underlying tangible investments. But since the late 1980s the industry has grown exponentially --- largely unchecked, regulated or accounted for --- and now dwarfs the value of the underlying assets they were originally meant to protect. Indeed, this value is more than 15X annual world GDP, roughly 10X the values of all tangible illiquid goods (land buildings etc.) and more than 5X the value of semi-liquid property (stocks, bonds, mortgages, etc.). I hadn't realized just how big the monster had grown until....well, yesterday when Hernando De Soto wrote in the Wall Street Journal,

everything of value we own travels on property paper. At the beginning of the decade there was about $100 trillion worth of property paper representing tangible goods such as land, buildings, and patents world-wide, and some $170 trillion representing ownership over such semiliquid assets as mortgages, stocks and bonds. Since then, however, aggressive financiers have manufactured what the Bank for International Settlements estimates to be $1 quadrillion worth of new derivatives (mortgage-backed securities, collateralized debt obligations, and credit default swaps) that have flooded the market.

I had been focusing on the $60-$70 trillion number being batted around the press the last few months, which represented the size of the Credit Default Swaps (CDS) market which rose to prominence in the back half of 2008 as financial firms were fighting for their lives and more recently as the reason why AIG keeps getting a "big gulp" refill from Uncle Sam. I thought that number was huge relative to the original size ($1 trillion) of the subprime problem (given the havoc it had wreaked)and been very concerned how we would survive unwinding the CDS mess and so was stupefied to realize the CDS market was still largely tip of the iceberg. I thought $1 quadrillion may have been a typo but then had it confirmed later in the day after listening to an interview on NPR's Fresh Air with current law professor, former derivatives salesman and author Frank Partnoy.

Until what seems like only a short while ago, I held no more than a passing interest in this strange and opaque world filled with exotic instruments that were generally so difficult to understand my brain hurt trying. I am not a stupid person but was generally made to feel like one by practitioners when trying to understand what real purpose many of these instruments served beyond as simple speculative currency. And as the complexity multiplied so did the acronyms by which they were named until at some point I lost nearly all interest. Apparently so did a lot of people until the acronyms --- MBSs, ABSs, CDLs, CDOs, CDSs --- exploded on to center stage at the heart of the sub prime crises in the summer of 2007.

So what precisely is the problem with unregulated derivatives? Their purpose being largely undefined in reality, they have grown vastly bigger than the tangible property they were meant to hedge or insure in the first place. As such, they have become the tail wagging the dog--at best--more likely a vaccine that has turned into a life threatening virus. Mr. De Soto makes the point that global commerce and trade, which has done so much to positively transform our collective standards of living can only operate in a system based on trust that property, as evidenced largely by pieces of paper---or now electrons---is reliable. And that it is that system of trust in paper and promises etc. that has been compromised by the shadow system of opaque claims that are the basis of the vast OTC derivatives market. Once again from his op-ed,

Today's global crisis -- a loss on paper of more than $50 trillion in stocks, real estate, commodities and operational earnings within 15 months -- cannot be explained only by the default on a meager 7% of subprime mortgages (worth probably no more than $1 trillion) that triggered it. The real villain is the lack of trust in the paper on which they -- and all other assets -- are printed. If we don't restore trust in paper, the next default -- on credit cards or student loans -- will trigger another collapse in paper and bring the world economy to its knees.

These derivatives are the root of the credit crunch. Why? Unlike all other property paper, derivatives are not required by law to be recorded, continually tracked and tied to the assets they represent. Nobody knows precisely how many there are, where they are, and who is finally accountable for them. Thus, there is widespread fear that potential borrowers and recipients of capital with too many nonperforming derivatives will be unable to repay their loans. As trust in property paper breaks down it sets off a chain reaction, paralyzing credit and investment, which shrinks transactions and leads to a catastrophic drop in employment and in the value of every one's property.

How did we get here? Many ways to be sure, but its important to understand some of the key players who politely opened the door, several generations after the disaster of unregulated risk from the 1920s/30s had largely faded from memory, for the geeks bearing formulas onto the unsupervised and hidden playground that global financial institutions had been only too eager to construct and exploit. And according to Mr. Partnoy, we hear at about the 10 minute mark of the interview how Wendy and Phil Gramm, from the late 1980s until about 2000, were probably most responsible for enabling the massive deregulation of derivatives that has directly led to our problems today. According to Partnoy, conservative economist Wendy Gramm, when head of the Commodity Futures Trading Commission, in 1993 signed an order exempting derivatives from regulation, making them vastly easier to market and grow and shortly thereafter left government to join Enron's board. Others bearing significant responsibility are former Treasury Secretary Robert Rubin, Fed Chairman Alan Greenspan and former Treasury Undersecretary and current Director of White House Council of Economic Advisors Lawrence Summers, who opposed CFTC Chair Brooksley Born in 1998, who sought comments on the need to regulate derivatives, specifically swaps that are traded at no central exchange (known as the dark market), and thus have no transparency except to the two counter-parties. With such strong opposition, it went no further, no actual regulatory scheme was proposed and Born resigned her post. Shortly after, the Commodity Futures Modernization Act of 2000 cemented the deregulated status of derivatives and it was Gramm's husband, Senator Phil Gramm who added the provision virtually unnoticed to an 11,000 page omnibus bill voted on and passed just before Christmas recess. The rest is history! Listen to the interview--it's 30 minutes long---but fascinating.

So where do we go from here? Mr. De Soto offers six principals that he claims have rooted global trade for centuries and are necessary conditions for returning balance to the system. Waiting to let "the markets" figure it out will never work. Governments must take coordinated action to restore the trust and sense of order necessary to allow trade to once again flourish without reservation. Mr. De Soto offers six requisites

Property is much more than a body of norms. It is also a huge information system that processes raw data until it is transformed into facts that can be tested for truth, and thereby destroys the main catalysts of recessions and panics -- ambiguity and opacity. To bring derivatives under the rule of law, governments should ensure that they conform to six longstanding procedures that guarantee the value and legitimacy of any kind of paper purporting to represent an asset:

- All documents and the assets and transactions they represent or are derived from must be recorded in publicly accessible registries. It is only by recording and continually updating such factual knowledge that we can detect the kind of overly creative financial and contractual instruments that plunged us into this recession.

- The law has to take into account the "externalities" or side effects of all financial transactions according to the legal principle of erga omnes ("toward all"), which was originally developed to protect third parties from the negative consequences of secret deals carried out by aristocracies accountable to no one but themselves.

- Every financial deal must be firmly tethered to the real performance of the asset from which it originated. By aligning debts to assets, we can create simple and understandable benchmarks for quickly detecting whether a financial transaction has been created to help production or to bet on the performance of distant "underlying assets."

- Governments should never forget that production always takes priority over finance. As Adam Smith and Karl Marx both recognized, finance supports wealth creation, but in itself creates no value.

- Governments can encourage assets to be leveraged, transformed, combined, recombined and repackaged into any number of tranches, provided the process intends to improve the value of the original asset. This has been the rule for awarding property since the beginning of time.

- Governments can no longer tolerate the use of opaque and confusing language in drafting financial instruments. Clarity and precision are indispensable for the creation of credit and capital through paper. Western politicians must not forget what their greatest thinkers have been saying for centuries: All obligations and commitments that stick are derived from words recorded on paper with great precision.

Which brings us to what the government is doing? Well under George Bush, largely turn a blind eye. To be fair to Hank Paulson, he saw the need for a vast overhaul of regulation of the financial services industry to eliminate the possibility of regulatory gaps and he had an awareness that certain institutions had become much too big to be left unattended as they had the ability to bring down the entire system through their own stupidity. But actions speak louder than words and unfortunately none were really taken. Now, its the Obama administration's turn and I'm heartened to hear Treasury Secretary Geithner, testifying before the House Financial Services Committee today citing the need for "comprehensive reform -- not modest repairs at the margin, but new rules of the road", including the creation of a new entity to oversee risks to the financial system, systemically important firms and systemically important payment and settlement systems. He said that federal authority over credit-default swaps and other over-the-counter derivatives was too fragmented (or non-existent). Under Treasury's plan, the government would regulate the markets for credit-default swaps and over-the-counter derivatives for the first time. The devil is in the details and there will be enormous push back from the very powerful derivatives and financial services lobbies. But I'm delighted to see that they are willing to pick the fight and the current and potential future crises are too enormous not to have the stomach for this. Governments around the world must safely put the genie back in the bottle and restore these products to their original intent and purpose for the safety of all involved.

And what can we do? At a minimum, here's what I've committed to do. When hearing about derivatives on the radio or TV, turn up, not down, the volume. When seeing a headline in a newspaper or magazine about derivative, read it instead of looking for something more interesting on the next page. When somebody wants to discuss the derivatives mess with me, I won't give them the bleary-eyed look of someone cornered who thinks they're about to be bored to tears and tune out-- I will fully engage. Knowledge is power and we have been denied the knowledge (and therefore the power) for too long. Yes, we have been tricked but we also allowed ourselves to stay in the dark longer than we should have, hoping somebody else was on point when they obviously weren't. Now, we must all take responsibility to look out for ourselves. Contrary to former Fed Chairman Alan Greenspan's positive characterization at the beginning of the decade as shock absorbers to offset systemic catastrophe, Warren Buffet several years ago more accurately depicted financial derivatives as weapons of mass destruction. More recently and bluntly, the Oracle of Omaha offered this sage advice, "Beware of geeks bearing formulas". There are derivatives underlying, or more accurately on top of, almost any and all loans, mortgages, bonds, stocks, insurance contracts, leases, currency holdings, agriculture, commodities, and the list goes on. Adding to Mr. Buffet's warning, if someone offers to sell you a financial instrument that relies on a series of hoops to be jumped through in order to get paid, that is labeled with an acronym, and is based on an asset in which you have no financial interest to begin with, I would advice you to quietly step back, hold fast to your wallet and ....run away. Trust no one, particularly not your broker if he's the seller. Buying a derivative through a central clearing exchange with full transparency as a hedge to an underlying asset (ie buying a put option on an underlying stock position) is logical and prudent. Buying an OTC derivative from a broker on an underlying asset in which you have no economic interest is speculative and dumb. This is something we can all do better at.

Tuesday, March 24, 2009

If $1 Trillion Is Not Enough to Address All Toxic Assets, Why Bother in the First Place?

It is generally agreed that the size of the problem is 2x-3X larger than the Treasury Department's Public Private Investment Partnership (PPIP) announced last week. The mechanics of the plan can be found here and I wrote about it in two posts below, focused mostly on the incentive scheme. So, what's going on here? Is the administration totally tone deaf to the magnitude of the problem? If not, why not use the Powell Doctrine of overwhelming force and summon enough fire power once and for all? And what about the question of whether this will work at all without nationalizing the problem banks?

To answer these questions involves a great deal of suppositions but maybe here's whats going on:

1) In light of the administration's ambitious fiscal agenda (and no intention to scale it back) , combined with tremendous bailout anger/fatigue, the political will to ask for (and secure) more funding than available from TARP does not currently exist,

2) nor does the appetite for full scale bank nationalization,

3) PPIP will force price transparency for toxic assets (currently absent) and, when combined with the "stress tests" to be finished sometime in April, will more clearly delineate good (viable), bad (viable with assistance) and ugly (insolvent) banks, so

4) the good banks will be able and willing to begin cleaning up their balance sheets, paving the way to recapitalization and the ability to begin lending again, at which point with the financial system partially under repair it will

5) be apparent that PPIP has done some good but requires more funding to finish the job and

6) at that point it will be significantly clearer which major banks will have to be nationalized and how that would affect counter-parties (not readily apparent today) so we don't repeat the enormous dislocation caused by Lehman's failure.

So while academics and textbooks might clearly tell you where you need to get to and to do it posthaste, in practice, there are speed bumps caused by the mechanics of politics and more importantly the difficulties of renovating when plans are still mostly wanting or suspect. There are clearly many risks in this incremental approach but here are some of the bigger ones.

1) The two step process of the government inducing and funding private bidders is overly complicated and no one shows up for the party---I doubt it, the incentives are enormous in general and with respect to the part of the program focused on purchasing asset backed securities (see my posts below) the bidders will be hand picked (and/or arm twisted) by Treasury.

2) You don't get the full price discovery needed as banks choose not to offer all their assets at auction---Treasury through its TARP investments and the Fed through its oversight role will clearly have to apply appropriate pressure where needed.

3) The auctions make things much worse for some banks as the bids come in materially below where they are willing to part with the assets, and whether they take those bids or not, are forced to materially mark down those assets to the point of insolvency---the significant non-recourse leverage provided bidders incents them to bid significantly higher than the current "unlevered" environment (where bidders can't get private sector loans) and, again, perhaps the plan is to rapidly separate "wheat from chaff" on the road to specific nationalization of large banks.

4) We're just putting lip stick on a pig, creating a new set of "off balance sheet" (from the banks' perspective) special investment vehicles (SIVs) that will inevitable blow up 8-10 years down the road. That's one way to describe what's happening but practically speaking, these portfolios will get priced, one way or another, to yield hefty cash flows (even with big defaults) which when compared to the low cost of money borrowed from the government, should ultimately earn handsome returns for patient (mostly taxpayers who have no choice) investors. If the prices paid for or used to mark the portfolios of a given bank, and add up in total to something less than liabilities, then they are headed to the nationalization butcher shop in those specific circumstances.

5) What the plan clearly doesn't do is prevent this mess from happening again in the future. That will fall to new regulatory schemes which I will not deal with here but the most important aspects will be a) putting all derivatives into a box where they can be dealt with (read my post below) and b) moving from a mindset of "too big to fail" to "too big to begin with" (you must read Simon Johnson's article in the Atlantic).

So, this plan is a good start at the current toxic asset (therefore toxic bank) mess but clearly just the beginning of a multi-step process, the later details of which are still waiting to be written. It will certainly help to separate the good (banks), the bad and the ugly --- paving the way for the good to get back in business, the bad to get help and the ugly to disappear altogether. And it will hopefully set a marker for what Europe must begin to do to address its even bigger banking problem, which up to this point they have been largely avoiding. And with that I await to see what of substance will come out the G-20 summit---unfortunately and in all likelihood, nothing.

Monday, March 23, 2009

The Geitner Plan---Great Work If You Can Get It, Part II

Here is an update to calculations made in my earlier post today (below), now that I have seen the details of the Treasury's Public Private Investment Program for Legacy Assets. This is a 2 part plan (not 3 as weekend leaks had indicated) to purchase up to $1 trillion of Legacy (formerly known as Toxic) Assets: 1) a Public Private Investment Program (PPIP) for Legacy Loans and 2) a PPIP for Legacy Securities each expected to get roughly equal amounts of up to $100 billion in TARP money. FDIC leverage (debt to equity) for both programs will be equal to a max of 6:1 and Treasury (TARP) money will participate with private equity capital on a 1:1 basis in both programs, with one difference: in the Legacy Securities program Treasury can add 100% leverage to the combined equity. So that means that private capital will represent 7% for the Loan program but potentially as little as half that for the Securities program. Put another way, tax payers are on the hook for 93% of the investment in the Loan program and almost 97% for the Securities program. Another big difference, the Loan program will be open to a number of "qualified" investment managers but the Securities program will pick just five investment managers. The investment firms will have management discretion subject to certain government restrictions but will be free to set fees and maturity up to a max of 10 years. While the government keeps stressing that they will be participating in the equity capital pari passu with private investors, it does not appear that Treasury will have any participation in the management fees charged equity investors (including Treasury) other than receiving warrants whose terms aren't specified. The TARP money is expected to be allocated in equal amounts to each side of the program. On the Loan side of the program the annual management fees (the 2% on an assumed "2 and 20" structure) would pencil out at $2 billion a year, or $20 billion over 10 years. It would take roughly a 15% increase in the value of the pools purchased under this program to generate a 100% gross increase in the equity investors capital. On that basis, the investment manager would earn additional incentive profits of $20 billion. On the other hand, it would take only a 15% loss to wipe out all the equity in the pool. In the event that the investment manager made no money for the equity investors (ie broke even) or lost all the equity, they would still earn the management fees of $20 billion over 10 years in our example. The numbers in the Securities program are actually smaller given the potential additional leverage from Treasury, meaning less equity on which to earn fees. The cumulative 2% management fees would total ~$7 billion but it would take only a 7 % increase/decrease in the total value of the pools to generate a double in gross value/total loss for the equity investors. Big numbers for the lucky managers

In conclusion, while the government keeps stressing that they are participating pari passu with private capital on the upside, they really aren't since the fund management firms are reaping windfall profits in the event of either success or failure. And whether or not this will ultimately work as planned and entice enough buyers and sellers to reach a clearing price to trade these Legacy (aka Toxic) Assets remains to be scene. And if that does happen, whether that will be enough to cure the Toxic (ie potentially insolvent on a mark to market basis) Bank problem is doubtful. This will certainly NOT cure all banks (some of them very big) and significant recapitalization (from private and potentially public) sources will still be required to ultimately finish the job. The market's extreme positive reaction today, I believe, was not an indication that this is a great plan that will work but rather a big sigh of relief that after so many months and flubbed attempts (starting with the Paulson Treasury) the details of a somewhat comprehensible plan were finally put forth. And as I concluded in the earlier version of this post, there appear to be other potentially more palatable variants of this program. They seem to do this all the work in a bit of a vacuum without fully understanding market implications. Oh well, stay tuned---we're living through historic moments as if we didnt know that already.

The Geitner Plan---Great Work If You Can Get It

My screen's all green so I know the markets are loving it today. The details of the Geithner plan to unload toxic assets from US banks' balance sheets aren't in ---maybe this will work, maybe it won't ---- but one things for sure, the private equity folks who are lucky enough to be invited to bid are going to make a killing! It's like the scene in Trading Places, when Ron Bellamy and Don Ameche of the mythical Duke & Duke investment firm, revealing the finer points of their business model to Eddie Murphy explain, "The good part is that no matter whether our clients make money, or lose money, Duke & Duke get the commissions."

What's my point? There are 3 flavors to the Geithner plan. If you're not up to speed read here. In one of them, the Treasury Department will provide $75-$100 billion of equity capital to join with private investors, at a ratio of 4-1, to bid on pools of toxic assets. The FDIC will then lever those investments with non-recourse loans for as much as 85% of the purchase of the pool. The simple math says if Treasury allocates $100 billion to this flavor, then private capital will come in for $25 billion at the 4-1 ratio. Now the $125 billion of equity will be levered up 6.7X by FDIC loans allowing ~$840 billion to bid at the toxic assets. Paul Krugman calls that FDIC facility a huge subsidy. But thats just for starters. Presumably the private money will be raised by investment managers forming special purpose LLCs to invest in these assets in a "private-equity" model. These types of investment funds typically carry a "2 and 20" remuneration structure, where the managing partner, collects 2% of the assets under management (in this case just the unlevered equity) and 20% of any investment gains. The toxic asset pools will be auctioned to the highest bidder. To make it simple, lets assume we form our own LLC and raise enough money to bid and succeed in winning all the auctions---so we are managing $25 billion of private equity along with the Treasury's $100 billion. And, in typical fashion, our fund will lock up investors' money for 7-10 years-- to give it time for things to work out. Now, if we bid right and the "toxic assets" we bought go up a mere 15% in value over 10 years to ~$965 billion of value (less than 2% annual appreciation) then everybody's happy. The FDIC gets their loan payed back in full, the equity investment has doubled in value (ie +$125 billion) and we (the general partners of the LLC) make a fortune on our 20% of that $125 billion in profit. Do i need to spell it out---$25 billion (yes, with a "b") for the LLC. And presumably if we're very smart or very lucky or both, we can do much, much better than that. But, the sword cuts both ways and if we're wrong and overpay and the toxic assets decline just 15% to $710 billion in value, the FDIC would still be repaid roughly in full but the Treasury's investment (meaning tax payer dollars) and our private equity investors are wiped out. And obviously if we're really wrong and the value of the toxic assets is even lower, then tax payers get hurt again as the non-recourse loans can't be paid back in full. This is the part Dr. K is talking about in his blog today when he says
the Geithner scheme would offer a one-way bet: if asset values go up, the investors profit, but if they go down, the investors can walk away from their debt. So this isn’t really about letting markets work. It’s just an indirect, disguised way to subsidize purchases of bad assets.
But here's where we start channeling Duke & Duke, for no matter whether the private equity investors or the Treasury make any money or are wiped out, no matter whether the FDIC loans are repaid in full or something approximating zero, our LLC will have earned $2.5 billion annually, or $25 billion cumulatively, over the 10 year life of the fund! Great work if you can get it!! So I'm not surprised that some investment managers who plan on bidding are already on the tape today saying its such a good plan. And the Obama administration was also out in force yesterday saying these new guys are "friends" who won't get AIG'd and have their profits ex-post clawed back through an unconstitutional retroactive tax (don't get me started on this again).

Maybe I'm just misunderstanding all of this or it won't seem as bad when the details appear in the fullness of daylight. But, my concern is that we are throwing a lot of leverage at fixing a problem of too much leverage to begin with and that the incentives here may be very misaligned for optimum success. I'm a taxpayer and don't want to see any more of my dollars put at risk on half baked ideas where somebody (besides me) has an opportunity to make huge gobs of money, while risking my family members future social security and medicare payments, that I never get to share. The way I see it now, the banks, who will not participate in the upside once they are rid of the toxic assets, want to maximize the sales price today---making it harder for bidders to make money on the backend and easier for the taxpayer (through the Treasury investment and FDIC loans) to lose. And the private equity managers, playing with other people's money get to win, even if they lose, as long as they get to manage a huge pool of money to buy those toxic assets with---so their incented to pay up and win the auction. This cures the short term problem of ridding the banks of their toxic assets and allowing them to recapitalize and go back to the business of providing loans to grease the economy to start moving forward again. All good. But the long term is less clear given the potential problems for recouping tax payer dollars. After all these months of waiting, is this really the best plan ?? Are there not alternatives to consider??

One idea offered by our friends at the Baseline Scenario has the government offering up the investment opportunity to non-institutional investors (ie little people) on a no-fee basis. Yet another idea from my friend Gary Syman (not a blogger..yet) has the banks able to split the "2 and 20" with the LLCs who buy their toxic assets, so they can make up on the backend in return for accepting a somewhat lower price at auction. My simple idea would be to have the Treasury participating pari passu in the economics of the LLCs , ie earning 80% of the fees so that we the taxpayers get our fair share of the potential windfalls. Maybe this is part of the plan but I won't know until I see the details.

Enough for now

Sunday, March 22, 2009

The Patient Will Recover But It's Gonna Leave a Mark

The last thing I want to do is dampen anybody’s spirits on a beautiful Sunday afternoon when you could be spending time with the family. But I have to admit that watching the last week or so of current events unfold has left me very despondent—and I’m an optimist by nature.

First, the good news. From a confidence instilling 60 minutes interview last Sunday, we could see that Fed Chairman Ben Bernanke is competent, understands the gravity of the situation, history and the role he must play in it. Most importantly, he will continue to try everything in his bag of tricks to prevent The Great Recession from turning into something worse. And so, with the announcement of Shock and Awe 3 just a few days later, taking the fairly radical step of monetizing the government debt to a previously unthinkable degree, the Fed’s balance sheet will expand to nearly $4.5 trillion by the end of the summer, a nearly 4X increase from the same time last year. As a student of hyperinflation, this gives me the willies but I believe it’s a risk worth taking given the alternative of a debt deflation tailspin and prolonged monetary cardiac arrest. With the degree of global excess goods’ and services’ capacity in the system after a prolonged period of easy money, it’s hard to imagine a serious threat of inflation for quite some time. But at some point, it will come and I don’t think the Fed will able to alter the trajectory with surgical precision---so either we experience another hard landing as the punch bowl is taken away too early or an even harder landing as it's taken away too late. But it’s far down the road and while I worry late at night, I’m staying in the moment, respecting both the educated wisdom and heroic actions. So, on balance and ceteris paribas (as economists like to say), I’m optimistic.

Here’s where the problems begin. Across the pond, Uncle Ben’s counterparts at the European Central Bank look in the mirror and see Nero staring back. The G20’s finance ministers met last weekend and decided to blame the United States and beggar thy neighbors (former soviet bloc nations), instead of stepping up to the plate and trying to win the game. Europe’s economy has slowed more quickly and deeply than the US and its financial system is far more leveraged and structurally difficult to fix. Yet, the patient refuses to accept the gravity of the situation and so take bold and decisive medical treatment. Simon Johnson of MIT agrees. At best, the region will act as a brake while the US (and China—more on them in a second) stomp on the gas, prolonging the adjustment and/or a potentially worse outcome if continued poor policy decisions lead to varying degrees of social unrest and nationalism. This IS a problem. Maybe they hope that China will come to the rescue --- but that’s a pipe dream. While the Chinese are taking very commendable and decisive steps to stimulate their own economy, on balance they will likely be offering less global credit (reduced exports means less need to recycle foreign currency reserves) and with their consumer base being one-tenth the size of American spenders (who bought almost one fifth of what the world had to offer before the downturn) can only provide so much of an offset to plunging world demand. So China’s helping but not going to save the world.

And here’s where it gets really depressing, for as Thomas Friedman wrote today
“We’re in a once-a-century financial crisis, and yet we’ve actually descended into politics worse than usual. There don’t seem to be any adults at the top”.
Nauseating to say the least. Our elected officials on both sides of the aisle seemed determined to snatch defeat from any jaws of victory. Nobody alive could have missed the kabuki theater of last weeks AIG Bonusgate affair, deflecting attention from the bigger picture to score minor voter points but laying land mines on the terribly bumpy road to recovery by hardening voter bailout fatigue. Not to mention, potentially trampling all over the constitution trying to punitively tax a minority and at that not actually getting the real scoundrels. This will come back to bite for as Robespierre learned too late, be careful how you incite the crowds.

Now, we await the official announcement (maybe tomorrow) of Secretary Geithner’s plan to rid US banks of their toxic assets to pave the way to recapitalization and start the heart of the credit system beating again. As has been widely leaked in the press since Friday morning, this is a complicated 3 pronged approach, leaving plenty of room for confusion and potential real or perceived failure---neither of which do we have the time to afford. You can read details about the programs here but let me just say that in one of the 3 flavors private investors may only have to put up ~3% equity in certain investments with tax payers providing the rest of the funding . If you thought Bonusgate got ugly, you can imagine how political football could be played with that scenario. And with the death threats received by AIG employees and Congress' lust to retroactively claw back legally awarded income, there is every chance that a fair number of hoped-for private investors may fail to show up for the party in the first place.

So let me say again, I’m an optimist by nature. And I remain convinced that we are not going to go where nobody in their right minds would want us to go. I believe that the US has the benefit of a national ethos rooted in finding opportunity, happiness and ultimately fairness and equality. We also have the institutional capacities to reinvent our market based system for the better and, while I know its hard to believe at the moment, will find the political will to enable that to happen. And I believe that the ascendant economies of the developing world, most notably China and India, will be our partners in this effort. But I worry about Europe, being a counterproductive deadweight, unproductively throwing stones. And I increasingly believe that this whole thing will take a very long time to work through and definitely leave a permanent mark on all our foreheads. With that I will go enjoy what’s left of family time before pushing the rock back up the hill come tomorrow morning.

Monday, March 16, 2009

”The only function of economic forecasting is to make astrology look respectable.” -John Kenneth Galbraith

Funny, but these days it's no laughing matter. I heard on NPR the other day that Economics is becoming one of the most sought after majors on college campuses…not because students want to practice the profession but because they want to understand what the heck is happening to the world around them. While it serves as the basic underpinning of our modern western way of life, we get little to no formal instruction and even then typically on only a very rudimentary basis.

When I studied Economics at university, it seemed so simplistic and disconnected from the real world. My textbooks lacked any sort of vital energy and had the amazing capacity to grow in weight and induce drowsiness whenever I held them too long in my hands. And rather than presenting from a rich and diverse landscape, they seemed to describe a monoculture, subscribing to just one framework of thinking --- capitalism---and in a Cliff Notes version at that. In the same way religious school was a total turn off growing up but “comparative religions of the world” turned me on later in college, it wasn’t until I started looking at differing economic theories in the historical contexts from which they had sprung and reading the actual writings of the gospels (Smith, Ricardo, Keynes, etc.), that the dismal science began to fascinate. When in doubt, follow the money---Om!

If you find yourself still feeling this way, take a few minutes to read Amartya Sen’s new essay, Capitalism Beyond The Crisis, which appears in the New York Review of Books. Rather than arguing for a new economic theory to supplant capitalism, she argues for a deeper understanding of the full wisdom of some of its greatest thinkers to optimize the best of what it already has to offer. For example, you may be surprised to learn that Adam Smith, who many consider to be the ultimate free-marketeer, in fact clearly believed that morality, certain state protections and other non-market based institutions are necessary to an optimized market economy. Well worth the read as you ponder why we should trust that the macroeconomic policy tools of capitalism can help guide us out of the mess they would in fact have seemed to have created in the first place.

Friday, March 13, 2009

Jack Welch Nips Kool-Aid, This is Big!

What the...? It cant be! Did Jack Welch really just say that? The same macho/honcho who led the whole "enhance shareholder value or you're toast!" mantra? Who figured that if all his operating businesses could maximize "externalities" --- in other words get others to pay for expenses that should rightfully be yours (like disposing of incredibly toxic wastes) --- they would also be maximizing corporate profits? The guy who ultimately sat in the seat where the buck stopped when all those PCB's got dumped in the Hudson River, creating the nations largest Super Fund site.

Well, I'll be -- maybe it was his hanging around Cambridge, Mass the last few years breathing all that socially responsible air. Or maybe it was being on the other side of the pond where they sort of get "it" already. Whatever, I'm tickled pink but still can't believe it. Yesterday, the CEO almighty, the one all the financial rags repeatedly declared the greatest living CEO of his time for his ability to crank out quarterly earnings increases with precision.... the poster child for the overriding pursuit of shareholder value above all else.....you know what he said?.......wait for it....I cant contain myself........ he said that focusing solely on quarterly profit increases was “the dumbest idea in the world”. “Shareholder value is a result, not a strategy,” he said in the Financial Times today. “Your main constituencies are your employees, your customers and your products.” Okay, so he missed a few others but that's a big move already...and I'll take it as a great sign of hope that if he's becoming a convert maybe there's hope for the rest of them...and therefore us. That maybe there are way more than we're aware who also get "it" but have been afraid to admit it. Maybe we're further along than we could have imagined that there can be a concept of "just and equitable" capitalism that can truly get behind the biggest issues of our lifetimes (climate change, ecological destruction, inequitable and overuse of scarce resources, poverty, hunger, access to healthcare, etc.) to make our world a sustainable one for ours and future generations. So this is big--maybe really big, but I can't say for sure yet. In the meantime, I'll keep listening..for the sound of more cracks in the armor. And on a Friday night, after this and the little bear market bounce the last few days, I'm having one of whatever Jack is drinking.

Monday, March 9, 2009

For Crying Out Loud, What’s Taking So Long? Bring Back the Uptick Rule

Major imbalances in the global economy, dangerous misconceptions and pricing of risk, inadequate capital requirements, lax oversight, poor corporate governance, greed and a host of other fundamental problems were the root causes of the stock market crash we are living through. But repealing the “uptick” rule in July 2007 was akin to taking off the snow chains before entering the highest mountain pass in the dead of winter, with a perfect storm on the horizon.

Our stock markets have never fallen so far, so fast. Psychologically damaged investors are fleeing, afraid to take any degree of prudent risk in what appears to be the complete absence of market stabilizing forces. Despite countless attempts and unimaginable sums of taxpayer money aimed at programs that were hoped would indirectly help calm the markets, why is it that one simple measure that would have direct impact--- costing nothing more than the stroke of a pen --- has yet to be implemented? As the chorus grows louder from market professionals, main street investors, corporate executives, members of congress, and other knowledgeable players --- for crying out loud, bring back the “uptick” rule.

In response to destabilizing “bear raids” on stocks that contributed to the 1929 crash and its volatile aftermath, the “uptick” rule was instituted in 1938 by the SEC as an important step to boost investor confidence. The rule stipulates the “short sale” of a stock (a bearish bet from someone who doesn’t actually own the stock) can only be executed at or above the last price paid if that was higher than the one before---hence on an “uptick”. This was designed to prevent short sellers from piling on a target company’s stock, panicking investors to abandon their positions or sometimes have them liquidated, involuntarily and inopportunely, to meet margin calls. Clearly, short selling provides a valuable role in a free market, aiding price discovery, helping contain unrealistic euphoria in individual stocks and to punish company managements and their investors for making financially unsound decisions. A patient, long-term investor ---say, investing for retirement --- can withstand short sellers’ impact on a financially sound company whose stock price has levitated beyond economic reason. But, no investor should have to suffer a bear raid that severely injures, or dooms, a financially viable company that has temporarily been caught in the crosshairs. It can have devastating effect, when this happens to important institutions that provide credit and liquidity, as the fear creates funding problems potentially leading to collapse, triggering defaults and a negative contagion of write downs and ever-weakening balance sheets, sucking liquidity out of the system just when it’s needed most. This is the nightmare many Americans experienced in their portfolios in 2008 and, if still invested, continue to fear today.

Critics of the rule argued that it impeded proper price discovery and was becoming obsolete in the era of electronic exchanges. The SEC conducted a short trial in 2005 --- a relatively hospitable period for stock market investors --- analyzed by its economic staff. Based on findings from the study of that trial, SEC commissioners concluded that the rule was no longer necessary and eliminated it in July 2007. But the findings could arguably have been misinterpreted. Reaching a very different set of conclusions, a more recent analysis by the New England Complex Systems Institute argues that the elimination of the rule had negatively effected the stocks in question---in a potentially meaningful enough way to alter investor behavior. Compounding the error, the repeal couldn’t have come at a worse moment, just as the subprime crises erupted, leading the credit and stock markets into a tailspin. Indeed, analyzing market performance during similarly terrible twelve month periods this past decade, these same researchers found a statistically significant increase in the number of jaw dropping one day individual stock price declines (>40%) in the period absent the “uptick” rule compared to while it was still in effect. A little known term outside the professional investor community for decades, retail investors are ever more frequently hearing about the absence of the “uptick” rule as one of the reasons why their once thought to be “sleep at night” stocks are suddenly down 50% or more from one brokerage statement to the next.

There have been many calls over the past year to reinstate or at least re-evaluate the rule. Respected leaders of investment services firms (that may sound oxymoronic but the ones I refer to had nothing to do with creating the witch’s brew of toxic mortgages) have argued for reinstatement. House representatives sponsored a bill to order newly appointed SEC Chair Mary Schapiro to reinstate the rule as a first priority. Fed Chairman Ben Bernanke recently said the rule “might have had some benefit” in the midst of the crash. And echoing a study done by the NY Stock Exchange, where 80% of senior corporate executives said reinstating the “uptick” rule would help instill market confidence, NYSE CEO Duncan Niederauer stated bluntly last week “when markets are psychologically damaged like they are right now I actually think it will go a long way to adding confidence.” Even former SEC Chair Chris Cox now claims to have been interested in reinstating the rule towards the end of his tenure but was apparently unable to convince fellow commissioners.

At her confirmation hearings in January, Mary Shapiro testified that re-examining the rule is “one of the things that I would be committed to doing very quickly”. But in the meantime, US equity markets have dropped another 20% or so, while a spokesperson for the SEC recently stated there was no specific proposal under consideration. Undoubtedly, there are a number of difficult and complex issues for the SEC to address with urgency, but this is one that should be moved to the front of the queue --- what’s taking so long?

To borrow an often-used phrase from President Obama --- this is not a silver bullet. But it may be a psychologically important one. And the markets are in need of anything that can have a potentially soothing effect. Its time to press the reset button on a poorly informed and ill-timed decision and President Obama, I have a suggestion for you. Fire up the chopper and head to the NYSE to announce that you have ordered the SEC commissioners to work quickly to implement a new version of the “uptick” rule---to be followed shortly by other measures to ensure enhanced oversight and regulation of all securities markets. And while you’re at it, don’t forget to ring the opening bell on what will hopefully mark the beginning of the new road to restoring investor confidence.