Wednesday, September 24, 2008

What would ya like?

Does the TARP mark the death of capitalism? To some commentators, apparently it does. To be sure, this kind of massive government intervention is the last thing any real capitalist wants to see. But is what we have now any better? Let's think about why we like capitalism as a concept, then consider whether this market even remotely resembles capitalism.

Free markets are supposed to efficiently allocate resources. If there are too many pizza places in your town, but not enough auto mechanics, the free market is supposed to drive one of the pizza places under and encourage entry by an auto mechanic. While we may feel for the proprietor of the pizza joint, we know that in the long run, we're all better off when the market is allowed to move resources away from the pizza business.

But we don't want to see the pizza guy forced to close shop because of some external dictate. We want to see a vote held to decide whether we have too many pizza shops in town. We want all the pizza places to compete for business, with the better competitors enjoying strong profits. In fact, we don't even want to see the weaker competitors driven under. Ideally, the weaker competitors will improve their operations and become stronger competitors. But if not, then indeed one or more of the pizza restaurants will undoubtedly go under.

So what kind of world are we living in now?

Let's take a hypothetical investment bank. We'll call it Merrill Brothers (MB). MB became involved in underwriting a series of commercial real estate loans during 2006 and 2007. MB retained some subordinate interests in these loans, as management believed these projects were attractive investments.

Some of these were for condo deals, which is obviously not the best place to be now. Perhaps given the benefit of hindsight, MB wouldn't have entered into the condo deals at all. But it is what it is. MB's management needs to decide what to do about the loans now.

I think in a real capitalist economy, MB would be given the chance to live or die based on the actual performance of these loans. Why? When any bank makes a loan, their credit analysis is based on the perceived odds of the loan remaining current. The capitalist system should reward the banks that make good underwriting decisions based on this criteria.

But in today's market, MB would not be given that chance at all. In terms of mark to market, all credit-oriented securities have declined in value from 2007 to today. Obviously a loan for a condo project would have declined significantly in market value. Forget, for a moment, why these loans have declined in market price and/or whether that decline is reasonable. Let's just stick with the fact that the market price is lower than the original price.

Let's assume that MB's management absolutely loves their loan portfolio, but the market believes their loans are only worth $0.60/dollar. And many will question whether $60 is a good price. But if MB plans to simply hold the loan, what does the market price matter anyway? It really shouldn't. MB should have the chance to live and die by the economic reality of their lending decisions. Not the market's perceptions of those decisions.

Now perception becomes reality as the continuous negative headlines cause trading partners and lenders to back away from MB. In the end, MB either fails or runs to some better capitalized partner. But ultimately it isn't a capitalist ending at all.

Think of it like a poker hand. There are two queens and a 10 on the board, and you have a 10 in your hand. Your opponent is betting the hell out of it. Sure seems like he's got a third queen, and maybe the best play is to fold. But should the other players at the table step in and force you to fold? In a free market, you can bet, raise, or fold, no matter what other people say.

So now we're faced with to non-capitalist paths. On one hand, the current situation. On the other hand, a government bailout.

The bailout will create some semblance of confidence in financial institutions and their balance sheets. There will be some increase in lending capacity. There will be some end in sight for declining home prices.

If there is no bailout, then what? When do things improve? Does the commercial paper market shut down? Is it possible to leverage trading books? Can anything be securitized?

So as much as we all hate the idea of a government bailout, we really need to consider what kind of capitalism we think we're defending. I'd love to hear more about long-term solutions to our problems. But in the short-term, we have to stem the relentless waves of fear. Before its too late.


Brad S said...

No, you can also check. And that is what I wish for all of them to do. Check. And if they're insolvent, we'll see what comes out of bankruptcy. And if they aren't insolvent, then there stock can sit at $0.10 for a year, and it will rebound eventually.

Any bailout that pays more than the market price for the assets is a simple giveaway. And next time the bailout won't be run by Paulson, but by some mid level bureaucrat who buys all of his friend's, crony's and political allies' assets. The path to corruption here is so obvious. If this bailout goes through, in 10 years, the government will be involved in backstopping all financial instruments. No recession/depression will be worse than that outcome for you.

The road to hell is paved with good intentions. I understand Paulson's trying to help, but this will just set in motion another governmental flywheel that will never stop.

clyde said...

The problem is not that assets devalued, it is that those assets were leveraged to a ridiculous level, often 30x at investment banks. Those banks leveraged to increase their returns, but got burned while taking the extra risk. Leverage cuts both ways (Finance 101).

As for letting the institutions fail, let them. There are plenty of investment groups that are not in trouble who will pick over the remains and buy assets at a significant discount. There will be some repurcusions due to fear in the fallout, but that is park of a market economy. Returns are not always positive. As for tightening credit markets, commercial paper, etc, what is wrong with tightening credit standards when loose standards are the heart of the problem we are in? If you want a repeat, show people that you can take extra risk to get better upside, but you won't get burned if it doesn't work out. That cost will get spread to everyone.

Along the loose credit and underwriting line, I still wonder why we haven't seen more than cursory mentions of credit rating failures. Lehman's debt was investment grade (good enough for money market funds) the morning they filed for bankruptcy. It is not like it wasn't widely known that they were highly leveraged and held significant MBS.

Michael H said...

Capitalism can't tolerate one way bets.

asphaltjesus said...

I second the check option in brad s's reply.

There was actually a committee-member with a clue. She asked Paulson how the plan as put forward ease the liquidity crisis. She didn't shut up and give Paulson a moment's discomfort. Sadly, the rest of them are grandstanding....

In the draft legislation I've read, there's no transparent mechanism for the funds in discussion to ease the credit crunch. I'd say that's what should be worked out.

Both the TED spread and commercial paper are *still* astronomical despite the potential for $700 billion availability.

I'm not the expert here, so I'd like to hear what kind of liquidity mechanisms are available.

I'm also in favor of a more loosely coupled financial system, but I have no idea how that would work. There is no doubt it is less efficient, but the point is not maximum optimization. It's less prone to failure.

Keith said...

FRE and FNM were nationalized because they might soon have had less money than the govt wanted as a cushion after they devalued their current assets and set aside capital for their expected future losses. The cushion, by the way, was 20% higher than before their accounting scandals.

Does anyone have a clue how very, very far that is from insolvent? I understand that FRE had enough real hard cash to last until mid-october without having to sell a dollar's worth of new bonds (that is including what they would have to pay out to maturing bonds)

PNL4LYFE said...

I think the flaw in your hypothetical Merrill Brothers example is that if it were operating in a truly free system, it probably would have blown up months ago. Sure, MB has the right to sit and hold their assets to maturity if they are confident of their underwriting. But their creditors have an equal right to refuse to lend more money. If it weren't for the expectation of some type of bailout, I think most financials would be trading at 30 pts upfront instead of 500bp which would make it impossible for them to refinance any maturities. In my opinion, the market still views LEH as a one-time event and expects that no more failures will be allowed except WM.

Scurvon said...

To add to the chorus...

The question is not whether we need to do something but whether the proposed plan is the right one.

There are many models for how to deal with a failing banking system (e.g., Scandinavia). The government is proposing an entirely novel way and saying crazy times demand crazy solutions. For $700 bln, I would like a more compelling argument.

Chris J said...

I would suggest your merrill bros (mb) is fine as to the asset side of the balance sheet. However, have you borrowed short to lend/invest long? What does Buffet like about insurance companies? Guaranteed float and their attendant investment portfolios. He borrows from no one, unlike your MB example, and can purchase the occasional less than liquid asset (again a function of buyers and sellers meeting or not meeting at the right moment in the right market environ). Your MB example has made this investment without that kind of right side balance sheet flexibility. Lenders get antsy and they are f_ _ _ _ ed, as we have seen.

pg said...

ai - you have ignored that MB chose to finance those assets with short term paper. had MB locked up multi-year funding in size, it would not have been an issue. a large issue of (ir)responsibility is criminally poor gap management. i would like to see the government fund some of this with pursuit of ill-gotten bonuses of executive level management. after all, pay is a very significant portion of street profits. and that is particularly so for the executive office.

Unknown said...

Merril was 'forced' to leverage 30:1 by it's competitors and the greed of its executives. It and 4 other IBs were allowed to do this by special SEC order. No doubt they asked to be on that list so that it could pay extra large bonuses.

Now that the house has fallen down they want a full bailout. They've already had months (if not effectively years) of support from the FED and they still couldn't raise enough capital to remain solvent? Their creditors must loan them money because their bets might pay off? Where is the capitalism in that?

In a truly free market I can put a gun to your head and take all your money.

All markets are regulated and they can be efficient when the rules are reasonably stable, there are enough participants to provide liquidity, and each of the parties have reasonable and roughly equal visibility into future value.

What we had was a lack of rules (on leverage and accounting) and we let the bankers (along with the Chinese) put a gun to our head. The IBs have been taking money out for years. Now we have to decide if we're going to let them off and pay them out entirely, or not. No good choices.

Unknown said...

My apologies for the rant, but I didn't even mention CDS.

How can you have an unregulated 'private' system of insurance that puts at risk the entire financial system of the US and the world and call it capitalism?

There isn't even a market!

Is not our currency and fractional reserve system a commons?
Wouldn't it be a tragedy if something happened to it?

Brad S said...

Why is there no good choice? If Merrill Brothers fails I fail to see the problems. Will there be fallout, of course. As a customer of Wachovia, is my bank likely to be caught in the mess: perhaps. Will some previously "riskless" investments lose value. I presume. So what.

Quite simply we cannot trust Washington to only do the bailout this one time. Do I think Hank Paulson will make a canny trade? Sure. But Hank Paulson's successor will not. And the supreme court, who will later rule that the Treasury must perform bailouts in some circumstance will only ensure that the bailout responsibility is forever enshrined.

A few nickels now, are not worth the growth in govt intrusion in the markets. Unfortunately, the desire for a few nickels now (with no future risk assessing) is what caused this mess; and, not ironically, the same people are using *exact same* justification to support the bailout.

Wall Street and Washington have the exact same kind of myopic idiots in charge. The foolishness would be laughable if there were a better country to emigrate to.

Ben Bittrolff said...

Yes. Its true. (News from Bloomberg)

The real question is, who is copying who?

Kazakhstan Plans Paulson Style Bailout: Borat?

Bill Long said...

Markets convey information. That is the only reason they exist. One doesn't need to be an Austrian to believe that, but it helps. If some other system were better at allocating resources, including capital, then such a system would have worked out better than it has in actuality. Does anyone think the world economy is worse off now than the Soviet Union was in the 1980's? If you do, then I have some land in Kazakhstan that I'll gladly take your bids on.

cap vandal said...

Great example, because in normal vanilla banks, it doesn't work that way.

First, your example assumes the loan is current.

If it is current and if it is in their "held" portfolio, then it ISNT marked to market. It is marked to amortized value and there is a provision for loan losses.

If the calculation of the loan loss provision is reasonable, then the auditors sign off on it.

The assets borrowed "short" are FDIC insured deposits. No problem there.

The only risk (assuming it is, in fact, a solid asset), is if short term rates increase to the extent that their cost of funds puts them out of business.

That was the original Savings and Loan problem. The second and worse came after the insured deposit limit increased to $100k and they took brokered deposits and tried to "earn" their way out of it.

Under the traditional bank system, the Fed doesn't have to bail anyone out. They just have to agree that the assets, if held to maturity, are good.

Investment banks, hybrids, etc. have structured asset backed securities with no decent market pricing mechanism and must be held in the investment portfolio. The investment portfolio generally includes stuff that will be sold prior to maturity. It is marked to market and has all the problems you mention.

If Wells Fargo took its held loan portfolio and made all the loans into asset backed structured securities, they would be insolvent.

cap vandal said...

"FRE and FNM were nationalized because they might soon have had less money than the govt wanted as a cushion after they devalued their current assets and set aside capital for their expected future losses. The cushion, by the way, was 20% higher than before their accounting scandals."

F&F were nationalized because they threatened to deleverage and run themselves as businesses.

Under pressure the last year, they raised fees, they improved underwriting, and started trying to dig out.

After nationalization, F&F don't have to deal with the dual public/private mission. It's just a government program.

They might have made it through, but only by increasing fees even more and beginning to delever.

Not thrilled with nationalization, but the government is very tough business partner. Makes Buffett seem like a softie.

cap vandal said...

If the money markets were allowed to fail last Friday, we would be looking at 1930 all over again.

Any institution that had backed up their commercial paper program with bank lines would be out of luck, since the banks wouldn't be able to fund them.

If Paulson had waited until the weekend to backstop the money market funds, then people would have seen the abyss more clearly.

The abyss is when YOU have everything ship shape. You have cash. You have no leverage. You have assets and liabilities perfectly matched. All your customers, however, need credit to continue to function. Your customers tank. Your business has no paying customers.

The real irony is that the S&L interest rates used to be fixed. Set by the Fed. They competed by giving away toasters. However, money market funds started offering higher rates. They then deregulated the interest rates paid by S&L's and their asset/liability mismatch did them in.

Now it turns out money market funds were just apretend free market "innovation". They had turned their risk into systemic risk which had to be mitigated by the government.

Horace Kent said...

As much as I'd like to jump in with y'all, that isn't the point. Is it worth burning everything to save our pride? What do you expect to come from either administration that follows? Perfect marxism or capitalism? Is it ok, or shall I say "proper" to let money market mutual funds burn into nothingness because the commercial paper market is locked? And then who knows what else because we are too proud of our ideology.

What do you think is going to be built upon this wreckage when the dust is nothing but ash? A perfect ideology based upon the good intentions of Smith or Lenin? And when that perfect world hits a snag much smaller than we face today how will those pure hearted ideologues that built our new "perfect" system legislate then?

AI has hinted so much in this post. But let me attempt my own translation..... What do you expect to be built upon this pile of shit? Utopia always changes with those who hold the money or the votes. Let me ask. State Street saw the most violent trading range I have seen in my 8 years of trading; are the ideologues prepared to burn everything, and I mean everything else to save our future? Further, who do you think is going to sow the seeds of our new foundation? Ron Paul? That seems to be the consensus of the "day traders". However, we need about 500 or so more of him; and the last time I checked, he wasn't in that much supply.

The foundation is still solid. We don't need to abandon it because the house is infested with termites.

As much as I'd like to think, I'm no expert in pesticides, or foundations for that matter. I don't know if Hank's plan is the right one or not. I suspect there are several that will work. Point is, its now clear (as it always is post-mortem) as day how it all came to bear, FASB, FNM & FRE overleveraged, the ratings agencies greased by greed, the IB's and various other banks copying that model thanks to ultra low rates, an unregulated market for securities, and a fed that believed it create dollars to make it all go away. What do you want to replace it with? And how are all of us going to do it? These are all problems that face us no matter how we rebuild. Question is..........where do you want to start from?

The burn it all crowd makes the assumption that there are no honest bankers left, or none that have learned their lesson. I disagree. I am just a pup. There is still some green on my horns (I thought otherwise for a while until latest meltdown). Speculative excesses cannot be legislated away from any aspect of human nature. Only the market can re-teach the pups and those who have sinned. And so far, I think its doing a pretty good job at it. Do all of us deserve life without parole?

Thanks for the forum A.I. One of the few market blogs looking forward in this wild time.

Anonymous said...

What I would really like is some of the bloated pigs who caused this problem to leave the financial industry and do something useful. Plenty of people did not get caught up in this drama, let them win.

PNL4LYFE said...

Cap Vandal: "F&F were nationalized because they threatened to deleverage and run themselves as businesses."

Right on! I think that the Frannie takeover was designed to keep mortgage rates artificially low to help put a floor under home prices. That will benefit their existing book along with the rest of the banks.

That being said, I think it was only a matter of time; if they had been allowed to delever, mortgage rates would rise, prices would fall further, and porfolio losses would have overwhelmed their increased earnings power.

Unsympathetic said...

Or, we could get behind the Dodd legislation demanding equity stakes and strong oversight combined with the return of Glass-Steagall.

The Republican ideology that no regulation is good regulation.. is the sole reason for this crisis. Leverage KILLS - and I for one am not shocked that AI's hypothetical didn't discuss the amount of leverage used to make those home loans.

This simply isn't "bailout nownownow or we're all going to a Gulag!" Nope, AI, that rhetorical pablum's not flying. Nothing Bush has demanded Congress pass immediately has been a remotely positive idea.. so I'd rather call his bluff. Goldman BK's, I lose no sleep.

Paulson doesn't propose legislation. He won't agree to modify the plan? That's cute - his chicken scratching is immaterial until a Congressman backs it. He has no plan until a bill has passed Congress.

Unknown said...

should the other players at the table step in and force you to fold? In a free market, you can bet, raise, or fold, no matter what other people say.

Not true.

When you put up a 3% stake (MB in your analogy), and someone in a more powerful position puts up the other 97% of the bankroll (or 33 times leverage), the gambler has given up some of their freedom. This is particularly true when things start to go south for the gambler.

Anonymous said...

If the immediate problem is that (a) the commercial paper market is freezing up and (b) everyone's running to short-term treasuries even at zero yield, then why can't we fix the problem by creating a new bank-like entity to step in and unstick things?

Let's call the new entity Hank's Bank and Trust. Here's how it'll work. We'll seed it with $700 billion, or, well, pick a number. The bank will also accept deposits in unlimited amounts, 100% insured because, well, the bank's owned by the government and can't fail. The bank will pay, say, 50 basis points on deposits - not great, but apparently better than the market rate now. In fact, maybe we don't need $700 billion if we get enough deposits. The bank will step in and start making those short-term loans that are apparently so important to keeping the economy running.

The institutions with bad paper can then sink or swim on their own; we can fiddle with the mark-to-market rules or whatever so that they don't have to act with guns to their heads.

At some future time, Hank's Bank will wind down its operations and/or sell off its assets and deposits to stronger institutions and quietly go out of business.

As Paris Hilton would say, "Financial crisis solved!"

Accrued Interest said...

Great conversation, even those that disagree. Surprisingly little name calling!

To those that take exception to my Merrill Brothers example b/c of the leverage factor, that's fair. If Merrill Brothers had their bank credit line pulled because the lender bank didn't trust them anymore, then that's capitalism too. It really makes an argument for bank-type funding for everyone. That of course has its own problems.

Another great point is the fact that tax payers are already on the hook for FDIC insurance. So in terms of cost to tax payers, pick your poison...

I'm all for creating some disincentive for banks to use the Treasury facility willy-nilly. Like the equity warrant plan. But I would like to see the purchase price be attractive enough to help banks recapitalize.

PNL4LYFE said...

My fear with the TARP is that the name was chosen because that's what we'll be living under by the end of this...

Hopefully that will get a laugh; laughes have been hard to come by these days.

Unsympathetic said...

Good god, WaMu's bonds are being zero'd out? Lehman's bonds trade at 0.12/dollar? No wonder dollar Libor is nearly 4.

Could you comment/opine on what's happening today in the guts of your world, AI?

For example, I'd like to believe that the bailout isn't merely targeted at the primary dealers of T's simply to enable them to be able to make a market for US .gov debt......

Christopher Wheeler said...

Out here in flyover country, the consensus is that we just don't get it. There's a flight to treasuries because they're safe, and the banks are holding on to their cash because they're not sure who to trust.

That seems like a two-edged sword to me. If the guys working in the industry don't trust each other, why should the folks on Main Street trust them when they say this is a threat to the entire economy. The concern out here is that the government writes the $700billion check to Paulson, the government (meaning the taxpayers) owns all the worthless securities, and then the champaigne corks start poping on Wall Street as all the traders celebrate pulling out a bonus for 2008.

One of the things that's been missing for me is anybody coming out and saying this is so important, they will not take a bonus for '08, or '09.

Up to now, I would not characterise the actions of the Fed and Treasury as "bailouts," because shareholders and employees have been taking it on the chin at BSC, Lehman, IndyMac, AIG, and now WaMu. The TARP plan looks like the taxpayers take on all of the losses. Wall Street needs to have some skin in the game.

Dave Wright said...

Muni VRDO/VRDN Market showing stress.

I have a Municipal Money Market as the sweep for a brokerage account. Like most Muni MM Funds it holds mostly VRDOs and VRDNs for the state I live in. The yield on the overall fund has been averaging about 1.7% for the last 3 or 4 months. The yield is now spiking up; 3.8% yesterday and 4.21% today.

Called and spoke with my rep, and he's telling me that in the last 2 weeks the rate resets on the underlying VRDO/VRDNs has gone from the 1.7% range up to 5.5% last week and 7% this week. He believes they could go to 10% next week.

That's obviously not sustainable for short term borrowing needs of local municipalities. Very reminiscent of the ARP blowup, except these instruments have a put option as long as the insurer retains an investment grade rating.

Not sure if I should bail on this fund or take the higher yield. I've asked them to find out if this fund is enrolling in the new Fed Money Market insurance program - I hadn't realized that the Fund Mgr. has to choose to enroll and pay a premium for the insurance.


GeorgeNYC said...

I take issue with the Merrill example. Effectively what you are saying is that the managers should be allowed to basically lie about the value of the assets. That would be fine if they were merely lying to themselves but when they are also lying to investors that is a bigger problem. Certainly an investor is free to decide that despite the market value of the assets, he/she believes the manager that they are really going to e worth more down the line. But allowing the company to basically ignore market prices is simply allowing them to lie to the world. That seems contrary to the entire rationale for accounting rules and disclosure.

Anonymous said...

Too late for what? No personal offense intended, Mr. anonymous fixed income investor, but perhaps the real answer is… too late for you to keep your Wall Street job?

My wife and I have ½ Million in liquid investments (all cash and CDs today). But, we largely own our property, including two rental homes, and we have small govt. and defense industry pensions, and she can sign up for Social Security in two years. Finally, we live in sparsely populated, ruggedly individualistic Montana, where we don’t have to cope as much with today’s increasingly Soylent Green reality – except over the TV!

Thus, I told my wife yesterday that I think I could accept having that ½ Million in cash GO TO ZERO – so long as it meant wiping out Wall Street!

By this I mean wipe out every dimwit, Ivy League MBA that caused this mess thinking he/she was smarter than those of us that play by the rules and pay our bills on time; wipe out America’s Wall Street aristocracy; wipe out the Washington Lobbyists and the Mega Corporations behind the entire ugly, cronyistic sham such people lie to cover with labels like market-based Capitalism; wipe out government by DJIA; wipe out government by Hedge Funds; wipe out government by those presently insuring that my qualify of life will never, ever, ever improve, no matter how hard I work, save or invest…

Seeing that wiped out would be worth a BILLION dollars to me – if only I had it to lose!

Unknown said...

5 Posted by guest, Oct 02, 2008 3:31PM

URGENT: At 3:20PM today Thursday October 2, 2008.

The has called for a bottom. Fireworks start tomorrow!

Deatils of the call are at:

ALD said...

Generally a well argued piece, but it falls apart with the following statement.

"The bailout will create some semblance of confidence in financial institutions and their balance sheets."

It will not, mostly because it's an idiotic plan. All we're going to end up with is the same bunch of financial institutions with wrecked plus an additional $700 billion of public debt.