Tuesday, September 30, 2008

The Financial Crisis, Part II

Well, I should have written Part I before yesterday. Yesterday was occupied by other news, a 777-point drop in the Dow Jones Industrial Average. Today, the DJIA increased by 485 points. Volatility, anyone?

It is worth noting that the DJIA follows only 30 publicly-traded companies, and those are in the industrial sector, not the financial sector. Broader markets like the S&P 500, comprised of 500 stocks in various sectors of the economy, saw an 8% loss yesterday followed by a 5.3% gain today. Of the "$1.2 trillion" lost yesterday, we seem to have regained more than half, in a 24-hour period.

My real losses and gains for the past two days are easy to calculate: $0.00. Or in Yen, also 0. Same for Euros. In any currency you choose to measure, I lost precisely nothing because I traded precisely nothing. The DJIA is largely irrelevant to me because I don't actually own personally any of the DJIA stocks, and any losses are paper losses. I am, like many investors, a class that comprises 66% of US citizens, a buy-and-hold investor. I buy stocks in companies I like and believe they will appreciate in value. Same for my mutual funds.

Besides, I cashed out a lot in January.

The news item driving these wild gyrations is The Bailout, its failure to pass yesterday driving prices down and the promise of its passage later in the week driving prices up today.

If I knew exactly what the sentiments driving stock investors were, I would be writing this blog from my yacht. I am writing it from my office, I still have a day job, and plan to until I retire, so I don't write as one with supreme knowledge of market forces. To be honest, I'm guessing about as much as anyone. The press will tell you that the Bailout is the only thing driving markets, and that may be true, but there is also the fact that value investors love to see people dumping shares of companies for no good reason and driving the price down. One of the stocks I own, Diamond Offshore, is paying better dividends than a T-bill when you consider the price to which it fell yesterday. People bought today maybe out of expectation that their cookies were going to get hauled out of the fire, and maybe because the stocks they've been following hit buy points that met with their requirements.

The Bailout, as I understand it, is a program whereby the Treasury Department on behalf of the government will be granted an initial $250-350 billion dollars to be used to buy assets from banks and investment companies that are otherwise unsalable. Things like CDOs, and RMBS shares and the like. This sale will be conducted as a reverse auction: the companies will price their assets and the Treasury will buy assets it feels are "worth the investment". The assets will then be held by the Treasury and something done with them in the future. The banks who sell investments to the government will be required to accept restrictions on their activities, particularly in the realm of executive compensation, and will be subject to other no-doubt-onerous restrictions on future actions. There is even a "clawback" clause in the bill that will compensate the government for any truly stinky assets it overpays for.

If this initial process goes poorly, the Congress can veto the rest of the $700 billion next year to prevent us getting any further into a sinking process. While this will put $350 billion into the financial services sector within a few months, there are some other problems.

1. Nobody knows if this investment, even the whole $700 billion, will be enough. As quoted in Forbes regarding the $700 billion figure:

"It's not based on any particular data point," a Treasury spokeswoman told Forbes.com Tuesday. "We just wanted to choose a really large number."

Well, I know that reassures me.

2. Financial companies are likely to dump their worst assets on the public at prices the market would not give them. Citigroup agreed to take on Wachoiva and its $312 billion in subprime mortgages only if the FDIC agreed to cover all but $42 billion of that debt, in return for $12 billion in Citibank preferred stock. At most, Citibank is out $54 billion and the government is on the hook for $260 billion. That's about 20 cents on the dollar for $312 billion in loans, assuming everything goes south. Why would anyone else ask for anything less? The intrusion of the government will only distort prices in unpredictable ways.

3. Mark-to-market accounting rules may spread the pain farther. "Mark-to-market" is an accounting rule adopted in November of 2007. Financial companies holding an asset (like CDO shares) have to value that asset at whatever the last transaction of that asset was. If one company reverse-auctions CDO shares to the government, they've just set the valuation for everyone holding those shares, no matter what the price is. The Treasury can overpay and inflate that value, or underpay and crush everyone else holding what may be a producing asset. There is no way to tell, one would hope companies would discard their worst assets that are near-zero in value in any event, but there is no certainty there. If the resultant underpricing makes other banks have to write down the value of their capital, then purchasing these assets may actually force companies to further limit their capital available to lend -- which is 180 degrees from the intended result.

4. Which sector is next at the public trough? This year it's financial services. Next year it may be homebuilding, or the auto industry (who already got $25 billion in loan guarantees), or some other area where the risk-reward ratio got badly out of whack.

The hazard of not doing a bailout is that the credit crisis will worsen and businesses will be unable to increase their investments. If you've just won a contract for your electrical business and need to finance $20,000 in raw materials to complete the job, you're out of luck. If you sell cars and your customers need finance, good luck with that. Even banks that normally lend to each other at 50 basis points (100 basis points equals 1%) over T-bill rates are now seeing short-term loans going out at 450 basis points over T-bill rates -- and that's to other banks, who are usually considered "preferred" customers.

Banks are getting so stingy with one another that the Federal Reserve has made $225 billion available in 84-day loans. Apparently, nobody else will make these loans. There is also another $330 billion available in loans to people making currency exchanges into dollars, which is probably some of the reason the dollar is increasing in value against the euro -- the Fed is paying people to denominate their money in dollars!

If there is a freeze in credit, the problems will extend much farther than to the Dow Jones Industrial 30, it will hit Main Street square in the face. Small businesses will find financing very difficult to find, and when they find it they will find it at much higher interest rates to reflect the risk that even small distributions of capital are to large financial institutions. Further restrictions on credit will likely make the mortgage default problem worse, and will further depress housing prices. There is no real 'soft landing'.

This is about as close to a nightmare as it gets.

But it's worse than that.

This article from Fortune/CNN Money should scare the daylights out of most of the people who read it, I know it scared me. The credit-default swap problem dwarfs the economy. I mean, the economy of the world. There are nowhere near enough assets to pay off the credit-default swaps that now exist, and apparently they're down $10 trillion from their peak last year. If you read no other article I've linked to, please read this one.

This is also the first example I have seen of government action making this worse. In 2000, according to the article, Phil Gramm authored legislation that passed with the support of Bill Clinton's Treasury Secretary Lawrence Summers, as well as Alan Greenspan, to forbid the government from regulating these contracts. In retrospect, this was a mistake. $250 billion in subprime loans is a big loss, no doubt. What makes this worse is that financial companies and hedge funds got into the business of writing contracts on the success or failure of deals they were not involved in. The article specifically lists John Paulson, a hedge fund investor, who pocketed $15 billion in CDS payouts when he took contracts against the failure of subprime loans. He didn't make these loans, he just bet other companies they'd fail -- and collected 15 billion dollars.

That's 3% of the money we're looking at spending to fix this mess, for one hedge fund. With that much money at stake, and with those kinds of side bets possible -- unregulated and unreported to stockholders -- you can imagine the reasons people would have to sabotage companies and even entire financial sectors of the country and the world. I am reasonably certain that billions of dollars have been "bet" through credit-default swaps on the failure of GM, Ford and Chrysler, probably more than the companies have in combined worth. If you're a GM or Ford or Chrysler employee, how does it make you feel to believe that wealthy people stand to gain even more wealth with the demise of your industry? What is it worth to them to see you fail?

Say what you will about Randolph & Mortimer Duke from Trading Places, at least all they bet was a dollar. With this kind of money to be made, the idea that what we have is Milton Friedman's free market is becoming laughable. At least the SEC banned short-selling in financials, but since CDS contracts are not limited to financial companies (or much of anything) there is no reason that short-sellers won't pick out another lagging bison from the herd and bring it down just because they can.

With all of this, I've yet to be convinced that The Bailout a) is necessary, b) will be effective, or c) addresses the elephant in the room that is credit-default swaps. The one thing the Bailout will do is to provide time to sort out the bad investments from the truly awful investments, as the Federal Government is able to wait to see which will be which, and might actually prosper from some of the deals. I still don't know if this justifies sinking so much taxpayer money into a potential hole that we don't even know the bottom of yet.

Something needs to be done. I would much prefer that the CRA be revoked, CDS contracts become regulated and CDS obligations be required to be reported on a company's website within 24 hours, "mark-to-market" rules be replaced for a period until the subprime issue has been sorted out, and the mortgage insurance program Eric Cantor and others proposed be tried before a direct cash injection from taxpayers becomes both law and precedent. Even if it costs an election, even if it costs a recession, there has to be something better than throwing money at a problem.

Enough money has been thrown for enough reasons. Let's try having a real fair market without social engineering distortions and without back-room side bets, let the weak institutions fail and the ones that showed more judgment and less greed prosper.

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