Thursday, August 27, 2009

Turning Japanese

Once upon a time there was a country that was the envy of all others. Its currency was strong, its stock market was buoyant, its real estate was unstoppable, its banks were the largest in the World, its companies were imitated and their management techniques studied in business schools throughout the globe.

Then, one day, without any warning, everything began to go wrong. Markets went down, people couldn’t pay the outrageous mortgages they had used to buy expensive real estate. The economy got progressively weaker while analysts and policymakers forecasted a near term bottom and recovery while making one policy mistake after another.

That was Japan in the late ‘80s and early ‘90s. Nobody seemed to worry about 100 year mortgages and other oddities and nobody seemed to question the model because the market kept going up. Once the correction began, policy makers exacerbated the problem by trying to help every last financial institution. Banks were not forced by regulators to recognize their losses and so the final day of reckoning was indefinitely postponed until markets recover. Except markets never recovered (the Nikkei is still almost 75% below its peak of 1989).
Analysts said the problem was eminently cultural. The Japanese value the community ahead of the individual and they prefer to endure a long deflationary period rather than embarrass their bankers and ultimately their country. Sadly, by avoiding the problem, they managed to do both. Eventually somebody had to recognize the consequences of the bad decisions that are inevitably made during long, prosperous booms.

Fortunately, this could never happen in The United States. Americans understand risk-taking. Nothing ventured, nothing gained. If you fail, get up, wash your face and try again. Markets are allowed to clear. If someone has to go bankrupt, so be it. It is not the end of the World and, eventually, under these dynamic conditions, everyone who looks for it gets a second chance. We take our losses and move on because that is good for the economy. We understand the system.

Or do we?

Most analysts and market historians think that prolonged bear markets only come from policy mistakes. Japan in the ‘90s and the World in the ‘30s are classic examples. Naturally, we try to avoid policy mistakes. Except the allure of waiting for the market to bail us out is just to hard to resist. According to several stories published since yesterday (here is one), the US Treasury and the Federal Reserve have decided that the best policy for our banks is to follow a Japanese strategy. In other words, let the banks mark their loans and toxic securities at whatever price they (the banks not the regulators) deem reasonable until the market recovers or until they earn their way out of the problem by borrowing from the government at zero percent whichever comes first.

Call me old-fashioned, but I think it is at least illogical to ask any society to subsidize the industry where the average compensation is the highest while neglecting other basic needs. In any case, since I have yet to hear of a town-hall heckler complaining about bank subsidies I suppose this topic is not a high priority for the American people. The problem with the strategy, however, is that it has very little chance of success.

Unless you think real estate prices will come back in a hurry, most of the losses Ms. Bair worries about have already occurred. In fact, much money has already been lost no matter what happens next. Thus, the choices are when and/or how fast are the losses going to be recognized. Mr. Geithner, like the Japanese, hopes that the banks will write them off as they earn money from current activities either by increasing reserves or selling assets at a loss. Except nobody forces them to do so. As you may know, the dirty secret of the financial system is that one gets away with whatever the regulator and the market allow. Since both are currently looking the other way the banks have chosen not to do anything for the time being. That way, their earnings looks good and, you guessed it, they can compensate their talent.

I suppose this state of affairs could last for a very long time (ref. Japanese model), or maybe this will all blow up soon (the Nikkei was spooked several times by this issue), or (less likely) the politicians will force the regulators to act, or (least likely) the regulators will blow-up their chances of landing a job in Wall Street and act on their own. In the meantime, the banks will continue to surprise everyone by posting good earnings while they sit on their toxic assets and postpone the day of reckoning. If that day ever comes (I was tempted to write "when" but I hate predictions) all mentioned above will excuse themselves by stating that "things were worse than expected." Bonuses securely in the their bank accounts, toxic waste the responsibility of the American taxpayer, and fairness avoided by virtue of the ignorance of the average voter.

Fortunately, both Geithner and Bernanke have studied the Japanese crisis so they have all the information they need.

Thursday, August 20, 2009

AIG: The Lesson Not Learned

Almost a year ago in the aftermath of the Lehman Brothers collapse, our government decided to change tactics and bailout AIG. We were told that failure to step in would result in a global disaster as the "insurance" company was essentially bankrupt but too interconnected to be allowed fail. AIG's problems were due to their exposure to Credit Default Swaps and other derivative products that obligated the company to make up for losses in various fixed income products. Naturally, the worst losses were related to mortgage related structures.

Although the complete details of their exposure remain, in my opinion intentionally, a mystery, we do know that the government contributed several billion dollars in different facilities and guarantees (I believe the analysis done by Propublica here looks reasonably accurate). We were also told that the company would sell its assets to repay the government. Since the assets, to my knowledge, look to be worth less than the government's stake, the expectation is that the equity is worth zero. Of course, nobody knows the future, and there is a lottery ticket chance that AIG makes a lot of money from asset sales, or that their obligations are worth a lot less than the market says right now, or that their accounting is wrong and they do not really owe anything, or that this has all been a nightmare and we really never had a housing collapse and prices indeed have never gone down, but I digress.

So, using the time-honored Cartesian analysis here are the facts:

  • AIG still owes the government several billion dollars and they have not sold many assets.
  • At least some of their senior bonds are offered at $90 for 2010 maturity. In case you care to buy some, yields are 15% and higher.
  • 5Y CDS are offered at 21 points +500bps which means dealers still charge a steep price for AIG protection (as a rule the points reduce your protection making it more expensive).
Opinions are a dime a dozen but I would pay attention to CDS dealers since they actually put money on the line. Clearly these guys don't think the common equity is worth $4.5B as implied by an AIG-common price of $33.50.

So why is AIG up over 100% in less than a month?

Wouldn't you know? Because the new chairman gave a pep-talk to the troops (here). Of course there is nothing wrong with an all-American pep-talk and Benmosche, his troops, and equity holders can believe whatever they want, except for this.

In other words, we have two alternative theories:

1) Things are much better at AIG than the CDS dealers, Paulson, Bernanke, Geithner, and Liddy, among several well informed players, had anticipated and the company just needed a leader with a vision. Or,

2) Benmosche landed a prime-job in this difficult economy and sees nothing wrong with talking up his stock while offering a wildly optimistic assessment of the company.

Naturally, as was the case with Mozillo who famously announced a positive quarter for Countrywide right before selling the company to Bank of America, or Dick Fuld rebuffing a $10 offer for Lehman right before it went to zero, you never quite know what these CEO's really think. While it is clear that Mozillo knew he was lying it is possible that Fuld believed his own statements at that time.

The facts, however, seem to point to option (2) above. The fact that nobody can prove what is really in Benmosche's mind does not obscure the obvious conflict of interest or the incredible compensation package for what is in essence a government job.

I am sure that many would argue that talking up the assets will eventually benefit the taxpayer as we may get more of our money back. Notwithstanding the fact that it is unlikely that potential buyers of AIG assets will ignore the prices in the CDS market, I believe that our government is following a dangerous road if they are attempting to make money by deceiving the potential buyers. In addition, I am not sure how good people would feel if they found out that the assessment made by Bernanke et al about the seriousness of the AIG situation proved to be totally incorrect in less than a year. After all, a great deal of trust (and money) has already been invested in the judgment of these individuals.

In my opinion, the real problem we continue to have is that we, as a society, seem to want to continue to play this duplicitous game. On the one hand, we know that the crisis was really our fault because we allowed a few individuals to run amok with our financial system. On the other hand, we try to play the game one more time to see if we can avoid paying for the losses. In this instance, we have given Benmosche a big payout in the hope that he can make magic and turn around what US government had deemed a financial house of cards. Furthermore, it seems to me that Benmosche's behavior is entirely rational. It pays for him to believe. Whether it pays for us is another story.

As for the lawyers at the SEC investigating this guy for stock manipulation you can rest assured that it will not happen. The most likely scenario is that, after all is said and done, he will declare that he didn't know things at AIG were as bad as he discovered later. Or that he thought the recovery would be far stronger. By then he will probably be in agreement with Liddy, Geithner, and everyone else on the list.

caveat emptor


Disclosure: long AIG debt, short AIG common (much smaller position). By the way, I am disclosing my positions for the sake of fairness. My purpose here is NOT to give financial advice.

Tuesday, August 18, 2009

Say again, why did we bail out the banks?

Almost a year ago, in the aftermath of the Lehman debacle, Secretary Paulson asked the American Congress for $700 million to relieve "our banks" (the meaning of the term was and is highly dependent on the user) of their "toxic assets" (his words). As Congress first said no, Paulson (aided by Bernanke) pretty much told us that failure to give him the money would mean the end of life as we knew it (another highly context dependent definition).

The American Congress, after consulting their oracle (aka "The Dow Jones Industrial Average") acquiesced under proclamations of better regulations that would ensure that "this will never happen again." Even those who knew that the mess had been bipartisan (the Glass-Steagall Act was repealed during the Clinton administration) believed that some regulation would be coming. After all, that is what normally happens in politics after the horses have left the barn.

I retrospect the appointments of Tim Geithner, who was involved in all the bailouts and other interventions at the NY Fed, and Larry Summers who was the main architect of the "self-regulatory" environment that created the $60 trillion CDS market, should have been enough warning that something wasn't quite the way we had expected.

Last week, Elizabeth Warren, who was appointed by Congress to oversee the banking bailout, said on a TV program that the banks still hold most of their toxic assets. At the same time, we learned that the large banks are not lending much and that Goldman has not reduced its leverage and is trading as aggressively as ever. In addition, the same compensation schemes that had encouraged the excessive risk taking by these "regulated" institutions are back in vogue and close to their highest levels. If anything, we hear complaints from banks who cannot keep up with the competition. Furthermore, as far as I know, banks are not only still allowed to hold large off-balance sheet items but they continue to be allowed to trade CDS' and other leveraged products. Their own risk profiles are down, however, since we now KNOW that they won't be allowed to fail.

The question I would pose is why did we save these banks? It is clear that they are NOT indispensable as we were told since companies who can get credit seem to find willing substitutes either directly in the market or through smaller and healthier banks. Why should I, as an American taxpayer, have any interest in the existence of a large multinational bank prone to large risky bets that from time to time risk bringing down the whole financial system? Why does our society need to support these large institutions with their internal hedge funds and other operations that seem setup for the sole benefit of their executives?

Banks, which are regulated entities, allegedly exist to facilitate commerce by bringing together savers and borrowers for profit. Why do they need to be regulated? Because our society decided, in the 1930s that it was better to minimize systemic risk. In other words, we allow banks to exist under certain conditions because we think efficient intermediation is essential to our economy. In this model, our society as a whole benefits from having efficient banks as the cost of bringing our aggregate savings to deserving entrepreneurs is minimized. This was the argument used beginning in the Reagan administration to deregulate the banks and thrifts, "let us do business and we will bring borrowing costs down." Nothing wrong in principle as too much regulation can often get in the way of efficiency.

Unfortunately the original idea of freeing up the banks to allow them to compete at the national and global scale was stretched beyond recognition during the Clinton-Bush years. The repeal of the Glass-Steagall Act that separated investment from commercial banking, the conversion of Fannie and Freddie into aggressive for-profit institutions, and the extreme friendliness of government officials who were often regulating their future employers were all celebrated by republican and democrats alike as triumphs of deregulation. As if to add insult to injury, our system was imitated by many around the world.

This is how we ended up with our largest banks filled with toxic assets, off-balance sheet commitments, and in-house hedge funds among other "investments." I mean, who wanted to make money by intermediating savers and borrowers when you could ride the bull market with the bank's money and get paid in stock options? Unfortunately for us, they had it right because we were underwriting the risk. It wasn't the Greenspan or the Bernanke put but the USA put.

The reason this sad story is relevant today, is that this is STILL the model under which Geithner and Summers want to revive the banks. Forget about whether you believe it is possible for the banks to earn their way out of trouble "Japanese style." This is the model for when they become healthy. Lots of complex risk for large personal payout under the friendly eye of someone who will join their club in the not to distant future. If you think I exaggerate, ask yourself what has changed since the pre-Lehman days for those still employed in Wall Street? Not to mention that interest rates are zero again and the stock market is rallying (again) and they are making boat loads of money, again. How long until they decide to take another shot at sub-prime? (this time they will promise to get it right).

I personally have no problem with hedge funds and other speculative clubs, so long as they are not risking taxpayer money, whether directly (like Fannie and Freddie) or indirectly by threatening to bring down the system. On the other hand, since banks are supported by taxpayer money, I think it is fair to have their risk tightly controlled by an external regulator who should never allow them stray into areas unrelated to their core business of intermediating financial products. It is as simple as that. If they want to make money by guessing which way the December oil contract is going they can set up a hedge fund outside the bank and without implicit or explicit government guarantees.

Financial markets are perversely didactical, they will set us up to revise the lesson as often as needed, but learn it we will.