Thursday, November 26, 2009

Turkey Day Readings

Before we get to today’s links, I want to wish everyone a Happy Thanksgiving. While this has been a tough year for many people it is important to reflect on the positive influences in our lives and things we are thankful for.

Tanks or a slow moving train wreck? In his missive this week, John Hussman compares the coming credit losses in home mortgages as Option ARMs reset and prime borrowers fall even further behind on their payments to tanks slowly rolling over a hill to attack villagers. This is very similar to the slow moving train wreck analogy. I think of the impending commercial real estate (CRE) problem as a slow moving train wreck. Everyone is talking about it. Bernanke, Buffett, Elizabeth Warren; you name it. Honestly, the need to refinance billions of CRE debt over the next few years and the associated difficulty based on plummeting property values is the worst kept secret in America today. The conundrum is that there is no way to quantify the damage it is going to cause. Banks are clearly extending and pretending as much as they can. They are putting up a good face but you know that some of the managers are not sleeping at all at night because they know how exposed they are to CRE. (Well, except for at Goldman because it is easy to sleep when God is clearly on your side.)

There are two reasons why I think the market has not reacted more dramatically to the continuing negative impact dodgy CRE loans will have on bank’s balance sheets and capital levels (as evidenced by the huge run-up in banks stocks and levered REITs trading at ridiculous valuations). First, everyone is hoping that markets will rebound before the refinancings are necessary. If you look at previous periods in which real estate lost a significant portion of its value, it has taken many years for prices to reach their prior peaks and in places like Japan it never happened. I actually wrote a piece on this that I think is very pertinent. So, while lenders and borrowers would be much better off if prices went up and cap rates went down, thus causing the properties to no longer be underwater, based on the data I looked at this scenario does not seem particularly likely. Second, the whole process of the unwinding of CMBS and the need to roll over property debt is sort of nebulous. In aggregate the numbers are gigantic but the pain will probably be spread out over a number of years unless vacancy rates continue to go up and lead to more actual foreclosures.

Now, why am I rambling on about CRE when Hussman’s piece was about residential real estate? Because, in contrast to the well known CRE issue, the fact that housing has not yet bottomed is actually a bit of a secret. There have been plenty of people who have called the bottom in housing and have cheered as the $8,000 homebuyer credit and normal seasonality have propped up housing data. But no matter how many RMBS the Fed buys and how much money the government gives homebuyers in an attempt to re-inflate the housing market, job losses, interest rate reset and underwater mortgages are going to cause even more foreclosures and further declines in prices. Throwing money at potential buyers does not fix the underlying problem that people took on too much debt and/or no longer have a stable flow of income. I’ll let Hussman take it from here:

Now, we face a coupling of those weak employment conditions with a mountain of adjustable resets, on mortgages that have to-date been subject to low teaser rates, interest-only payments, and other optional payment features (hence the “Option” in Option-ARM). These are precisely the mortgages that were written at the height of the housing bubble, and therefore undoubtedly carry the highest loan-to-value ratios.

The inevitability of profound credit losses here is unnervingly similar to the inevitability of profound losses following the dot-com bubble. In that event, it wasn't just that people were excited about dot-com stocks in a way that might or might not have worked out depending on how fast the economy grew. Rather, it was a structural issue that related to the dot-com industry itself – those bubble investments couldn't have worked out in a competitive economy, because market capitalizations were completely out of line with what could possibly be sustained in an industry that had virtually no cost to competitive entry. If you understood how profits evolve in a perfectly competitive market with low product differentiation, you understood that profits would not accrue to the majority of those companies even if the economy and the internet itself grew exponentially.

In the current situation, the assumption that the credit crisis is behind us is completely out of line with what possibly could result from the marriage of deep employment losses and an onerous reset schedule on mortgages that have extremely high loan-to-value ratios. A major second wave of mortgage losses isn't a question of whether the economy will post a positive GDP print this quarter or next. Rather, it is a structural feature of the debt market that is baked into the cake because of how the mortgages were designed and issued in the first place…

The past decade has been largely the experience of watching tanks rolling over a hilltop to attack the villagers celebrating below. Repeatedly, one could observe these huge objects rolling over the horizon, with an ominous knowledge that things would not work out well. But repeatedly, nobody cared as long as it looked like there might be a little punch left in the bowl. As a result, long-term investors in the S&P 500 have achieved negative total returns over a full decade. These negative returns, of course, were also predictable at the time, based on our standard methodology of applying a range of terminal multiples to an S&P 500 earnings profile that has – aside from the recent collapse – maintained a well-behaved growth channel for the better part of a century.

An interesting proposal on banking reform: Lately there have been a number of political and financial commentators speaking out about the need to return to a Glass-Steagall-influenced banking model in which commercial banks and investment banks are forced to get a divorce. The thinking, as espoused by Paul Volcker and others, is that investment banks should be free to gamble with their own money but should not be allowed to gamble with taxpayer money provided through the FDIC deposit backstop. If that forced people inclined to risk taking to move to hedge funds then so be it. At least hedge funds risk their own capital and aside from LTCM have failed without taking down the entire global economy. Personally, I happen to like the idea of going back to a partnership structure for investment banks in which the partners are always at risk of losing their own capital. That’s a much better situation than the US taxpayer being at risk when the banks lever up and do foolish things.

With the understanding that something should be done (although it looks less and less likely every passing day) to remove the taxpayer from the above equation, I came across this op-ed article in the Wall Street Journal by the deputy director of financial and enterprise affairs at the OECD that makes the case for what are known as NOHCs (as if we needed more acronyms in our lives):

One proposal, which we now submit for consideration, is that banking and financial service groups could be structured under a variant of non-operating holding companies (NOHCs), in all countries.

Under such a structure, the parent would be non-operating, raising capital on the stock exchange and investing it transparently and without any double-gearing in its operating subsidiaries—say a bank and a securities firm that would be separate legal entities with their own governance. The subsidiaries would pay dividends through the parent to shareholders out of profits. The nonoperating parent would have no legal basis to shift capital between affiliates in a crisis, and it would not be able to request "special dividends" in order to do so.

These structures allow separation insofar as prudential risk and the use of capital is concerned without the full divestment required under Glass-Steagall or in response to the recently-expressed concerns of Paul Volcker and Mervyn King—such extreme solutions should remain the proper focus of competition authorities. With an NOHC structure, technology platforms and back office functions would still be shared, permitting synergies and economies of scale and scope. Such a transparent structure would make it easier for regulators and market players to see potential weaknesses. Mark-to-market and fair value accounting would affect those affiliates most associated with securities businesses, while longer-term cost amortization would dominate for commercial banking. It would create a tougher, non-subsidized environment for securities firms, but a safer one for investors.

If a securities firm under this structure had access to limited "siloed" capital and could not share with other subsidiaries, and this were clear to the market, this would be priced into the cost of capital and reflected in margins for derivative transactions. The result would likely be smaller securities firms that are more careful in risk-taking than has been the case under the "double gearing" scenarios seen in mixed or universal bank groups.

Finally, if a securities affiliate were to fail under such a structure, the regulator could shut it down without affecting its commercial banking sister firm in a critical way—obviating the need for "living wills." Resolution mechanisms for smaller, legally separate entities would be more credible than those needed in the recent past for large mixed conglomerates—helping to deal with the "too big to fail" issue. To protect consumers, deposit insurance and other guarantees could apply to the bank without being extended to the legally separate securities firm…

The structure of organizations and how they compete will be critical to future stability. Going forward, the aim must be to keep the "credit culture" and the "equity culture" separate so that government implicit and explicit insurance does not extend to cross-subsidizing high-risk market activity, and so that contagion and counterparty risk can be reduced. The right balance must also be struck between sufficient size conducive to diversification and strong competition to meet consumer needs at reasonable costs.

I’m sure there are some drawbacks and there would be some unintended consequences from implementing this structure, but given the difficult political landscape and the lobbying power of the banks, if we could kill this many birds (too big to fail, too big to unwind, subsidies for being so large, systemic risk) with one stone, we would be in much better shape than we are right now.

The deficit bogeyman: When people are not talking about gold, commercial real estate, the US dollar or the evil being that is Goldman Sachs, they are talking about the US debt and budget deficit. The Republicans are crying about big government. The Democrats are blaming Bush tax cuts, the 2 wars and the recession for the increased borrowing and spending even as tax receipts have fallen off a cliff. The fear is that either bond vigilantes or our foreign creditors will force interest rates up as they stop buying Treasuries, thus causing the nascent recovery (that I happen to believe is a mirage) to be stifled and the cost of servicing the humungous debt burden prohibitive. Are these just scare tactics or are they legitimate concerns?

As many people have written lately, this was what was expected in Japan and never did happen. Now, I am concerned that Japan may finally have run out of time and luck as a result of the current global recession, but that is not the point. The argument is that the US could run huge deficits and without causing a crippling rise in interest rates. For those of you who are convinced that interest rates are going to go straight up as US creditors become less inclined to hold our debt and inflation starts to pick up, I suggest you take a look at this piece from James Kwak of The Baseline Scenario. I personally have no idea how this will all play out. I think two logical people could argue both sides very convincingly. That is why it is always important to understand events that could kill your investment thesis:

One of the curious things about the debt scare that is building in the media is that it is happening at a moment when long-term interest rates are very low. In other words, it’s based on a theory that the market is wrong in its collective assessment of the debt situation. I’ve heard this blamed on “non-economic actors” (that is, foreign governments that buy U.S. Treasuries not as a good investment, but for political reasons), or on a “carry trade” where investors are exploiting the steep yield curve (free short-term money, positive long-term interest rates), as Paul Krugman discusses here.

Menzie Chinn crunches some numbers. He takes a model that he and Jeff Frankel created several years ago to estimate the impact on interest rates of inflation, the future projected national debt, the output gap (economic output relative to potential), and foreign purchases of Treasuries. That last term is important, because the oft-heard fear is that foreign governments will suddenly stop buying our debt.

Using the future growth in the debt projected by the CBO, this model predicts that real interest rates will … go down by 7 basis points over the next year, assuming foreign purchases of debt are constant. The reason the impact of the debt is so small is that it’s already priced in; since the looming debt is no secret, it should already be showing up in the data.

The counterargument is that it hasn’t shown up in the data because of the “flight to safety” and foreign governments’ irrational purchases of Treasuries. So Chinn also looks at what would happen if foreign purchases of U.S. debt fell to zero, nada, zilch (which is an extreme scenario). In that case, interest rates go up by 1.3 percentage points. That’s not nothing, but it still keeps interest rates at reasonable levels by historical standards. In addition, the CBO is already incorporating higher interest rates into their forecasts; they expect the 10-year Treasury bond yield to go from 3.3% in 2009 to 4.1% in 2010, 4.4% in 2011, and 4.8% in 2012-13, and that’s built into their projections of future interest payments.

So I’ll say again: none of this is good. But if we’re going to make important policy decisions based on fear of the debt, we should have a rational way of thinking about the impact of that debt rather than just fear-mongering.

Why did AIG get bailed out and not the monolines? According to Thomas Adams of Paykin Krieg and Adams, LLP (who is a former managing director at Ambac and FGIC), it may have been due to—you guessed it—AIG’s relationship with Goldman Sachs. In this post on Naked Capitalism, Adams carefully goes through the similarities and differences between the situations facing the monoline insurers and AIG. One major difference? Goldman had little exposure to the monolines. Thus, his conclusion is that a major wild card in the decision to save AIG and let the monolines flail was the amount of money AIG owned Goldman for collateral on credit default swaps on those wonderful ABS CDOs (there are those acronyms again). Clearly there is no way to know for sure and the timing of the AIG blowup (right after Lehman went away and the financial markets were on fire) may have influenced the decision. However, after the recent revelations by Neil Barofsky about Tim Geithner’s refusal to force the banks to take haircuts on their CDS positions, I would not be surprised one bit if Goldman’s exposure to AIG was a swaying factor:

As we have been reading the latest coverage on the AIG bailout from the SIGTARP report and the Treasury Secretary Geithner’s Congressional testimony, a nagging question remains unresolved: why did AIG get bailed out but the monoline bond insurers did not?

The business that caused AIG to blow up was the same that caused the bond insurers to blow up – collateralized debt obligations backed by sub-prime mortgage bonds (ABS CDOs). This was actually one of the few business that AIG Financial Products had in common with the monolines. AIG didn’t participate in municipal insurance, MBS or other ABS deals, which were all important for the monolines.

Certainly, AIG was larger than any of the bond insurers, but in aggregate, the bond insurers had a tremendous amount of ABS CDO exposure, which at the peak was probably over $300 billion. Despite AIG’s claims to have withdrawn from subprime at the end of 2005, we have identified particular 2006 deals with substantial subprime content that AIG most assuredly did guarantee…

I hate to get sucked into the vampire squid line of thinking about Goldman, but the only explanation I can think of for why AIG got rescued and the monolines did not is because Goldman had significant exposure to AIG and did not have exposure to the monolines.

When it became clear that AIG could face bankruptcy, Goldman’s plan to profit by shorting ABS CDOs was threatened. While they had the collateral posted, thanks to the downgrades, this collateral could be tied up or lost if AIG went bankrupt. This was a real crisis for Goldman – they thought they had outsmarted the subprime market with their ABS CDOs and outsmarted all of the other banks by getting collateral posting from AIG when they got downgraded. But if AIG went away, this strategy would have blown up and cost Goldman billions.

In addition, I believe that Goldman and their helpers – including their many connections with the White House and the Fed – pumped up concerns about the systemic risk that the market was facing from a Lehman and AIG failure, so that they could force the government to step in and bail out AIG. This would also explain why Lehman was not bailed out. Lehman didn’t really matter to Goldman. But the fear created by Lehman’s failure served as a good excuse for why they should rescue AIG.

I’m going to keep writing about this until the insanity stops: I have to admit it is a little disconcerting. I have heard ostensibly smart people who work with the financial markets every day argue that stocks could continue to rally because of “money on the sidelines.” Again, last I checked, aside from IPOs and other offerings, for every share of stock bought there is an identifiable seller. So as each dollar comes from the sidelines into the market another dollar leaves the market. Now, of course irrational buyers could pay too much for certain stocks and of course that could drive prices up. However, the argument you hear has to do with liquidity on the sidelines waiting to jump into the markets; not about foolish buying in relation to market valuations. Either I am completely crazy and have lost any and all sense of how markets function or this “truism” is in fact complete hogwash. Please, if you want to buy stocks because you think the valuations are attractive, just say so. I would likely argue that in a lot of cases stocks are discounting returns and margins that are implausible given the economic backdrop, but at least the rationale for buying based on intrinsic value reflects some semblance on investment sanity. If the only reason you are buying is because you think there are other buyers waiting in line (the greater fool theory, maybe?) then I implore you to take a step back and examine the macroeconomic and company specific fundamentals.

Thankfully, I am not alone in my plight. Here is a recent piece from Comstock Funds on this topic (hat tip to The Pragmatic Capitalist):

When making our bearish case for stocks we’re amazed at how often our audience brings up the old “cash on the sidelines” argument as a reason to doubt that the current rally can tank. We have been in this business for a while and don’t remember a time when this fairy tale wasn’t trotted out as a reason to be super bullish. In fact we don’t recall any point where observers ever said that the market was going down because there was not enough cash on the sidelines.

A relatively recent example was the summer of 2007 when a majority of commentators insisted that the availability of huge amounts of global liquidly would never allow the market to retreat. The words were hardly out of their mouths (or word processors) before the ECB and the Fed were forced to pour hundreds of billions of dollars into their banking systems. As we indicated at the time, liquidity is never there when you need it.

The fact is, as John Hussman has so eloquently pointed out, the purchase or sale of a stock is net neutral with regard to cash entering or leaving the market. For every buyer there’s a seller, and for every seller there’s a buyer. When “A” buys stock for $100,000 he/she has $100,000 less cash on hand, but “B”, the seller, receives the $100,000. No net cash has entered or left the market.

The reason stocks go up or down is not a result of cash moving into or out of the market. Stocks go up when prospective purchasers are more anxious to buy than sellers are to sell. If there are more willing buyers than sellers at any given level the market has to go up to equalize demand and supply. In fact, it sometimes doesn’t take any transaction at all to move the market. If Intel reports surprisingly high earnings and Dell reports a disappointment the bid and asked price moves up or down before any transaction even takes place.

Furthermore, if even one anxious buyer of a relatively small number of shares drives up the price, the total capitalization of all the shares of that stock rises. And if the purchases are a result of a real upside earnings surprise in a key bellwether stock, the entire market can rise without a dime of new cash entering the market.

Despite the obvious truth of this case, strategists and the media always bring up the old myth of “cash on the sidelines” to justify their bullish views of the market, particularly when their arguments for the economy and valuation are flawed. If you hear anyone make this case just ignore them—it’s a fallacy. If the market rally continues from here, it will happen as a result of buyers being more anxious to buy than sellers are to sell, not because sideline cash is entering the market. If fundamental and technical conditions deteriorate as we expect, prospective purchasers will become less anxious to buy while sellers will be more willing to sell, and the market will decline by enough to equalize supply and demand.

(Picture courtesy of

Sunday, November 22, 2009

The Weak Dollar vs. Strong Dollar Dilemma

Does the US really want a weak or strong dollar? No matter what the setting or topic, lately just about every discussion between economists, market participants, and government officials turns to the US dollar. Tim Geithner says the US has a strong dollar policy. Unfortunately, that’s about as credible as the International Federation of Bodybuilders saying that is has a no steroids policy. One look at the impressive but clearly unnatural Ronnie Coleman and it becomes obvious that the very large pink elephant in the room is that those body builders are not clean. In a similar fashion, the Fed’s money printing and the willingness of the federal government (both democrats and republicans—let’s not forget that the Bush tax cuts and Medicare Part D were deficit funded) to run massive fiscal deficits patently contradicts the claims of Geithner. So, if the government and Fed are willing to say one thing and do another, what is the point of all the posturing? Have the leaders become resigned to some kind of stealth default on our foreign debts through inflation? Are they just jawboning with that hope that our foreign creditors don’t precipitate a disorderly unwinding of the dollar?

I honestly don’t know. There is no question that a weak dollar makes US exports more attractive. But I’m not sure how to reconcile that the deleterious impact of the falling value of the dollar on the foreign creditors we are desperately going to need to keep financing our massive spending. It was within this context that I came across a guest post on Simon Johnson’s Baseline Scenario that argued that a weak dollar may actually be just what the doctor ordered when it comes to rebalancing the world economy. I advise everyone to examine both sides of this argument because this is going to continue to be a topic that dominates the financial discourse and may eventually affect the results of numerous investment strategies:

A lower dollar is good news for US exporters and foreign importers and bad news for foreign exporters and US importers. However, if policymakers respond appropriately, there is no reason to fear overall harm either to the US economy or to foreign economies. Indeed, a lower dollar could jumpstart the long-overdue rebalancing of the global economy away from excessive US trade deficits and foreign reliance on export-led growth, putting the world on track for a more sustainable expansion.

The fear in economies that are appreciating against the United States is that a falling dollar will choke off exports and hobble economic recoveries. The correct response is to ease monetary policy and temporarily delay fiscal contraction. As I explain here, even in economies with short-term interest rates near zero, there is plenty of scope for central banks to stimulate aggregate demand, and doing so will help to limit the extent to which the dollar falls.

For the United States, the benefits of a falling dollar are obvious: stronger exports and a faster recovery. The fear is that a falling dollar would be inflationary. However, as I have shown in two recent papers, even very large currency depreciations in developed economies have no effect on inflation unless they are caused by policies that attempt to hold an economy’s unemployment rate below its equilibrium level. With US unemployment currently at 10 percent, there is no chance that inflation will rise in the near term. Whether inflation rises in the longer run will depend on whether US monetary and fiscal policy stimulus is withdrawn appropriately as the economy recovers (and tighter macroeconomic policies would tend to support the dollar). Many believe that US policymakers erred in not withdrawing stimulus soon enough in 2003-05, but policymakers now seem to be keenly aware of this mistake and have expressed their determination not to repeat it. Only time will tell, but my own view is that the Federal Reserve, at least, will not allow runaway inflation.

For economies that peg their currencies to the dollar (notably China) the costs and benefits of a falling dollar are the same as those facing the United States and so is the policy dilemma: how fast to tighten macroeconomic policy as the economy recovers? These economies differ on several dimensions, including financial market development and capital controls, strength of economic ties to the United States, and prospects for economic slack and inflation. These differences will determine the appropriate policy stance. To some extent these economies have forfeited the freedom to adjust monetary policy, but they retain the option of adjusting the levels of their dollar pegs. In some cases, a further decline in the dollar may represent an opportune moment to move to a floating exchange rate.

Two quick comments on his analysis. First, I worry about any outcome that is dependent on the Fed being able to withdraw all the potentially explosive liquidity before inflation kicks in. Even if you give the Fed the benefit of the doubt and assume that the members will be vigilant on this front, monetary policy changes are blunt instruments that impact the economy many months after implementation. As such, they are incredibly hard to time and calibrate accurately in order to get the desired effect. Second, we must keep in mind that oil is priced in dollars and dollar weakness that causes oil to increase significantly in dollar terms could put a further strain on consumer spending (as it has in the past—remember $4 a gallon gas?) and stifle any nascent recovery. Since we import far more than we export (note the current account deficit) it is hard for me to see how a weak dollar is a net benefit to the US.

Too bad Q3 GDP growth isn’t actually leading to less suffering: As we assess where the US is in terms of a legitimate recovery, it now appears that there are two very different economies and corresponding realities that both policy makers and investors need to understand. There is the government backstopped, Wall Street and multinational corporation economy that seems to be experiencing a return to prosperity. And then there is the real world economy made up of small business and individual households that is struggling to keep its head above water. Wall Street is about to have a record year. S&P 500 companies have become so lean that bottom line profitability has not shrunk commensurately with sales. When this efficiency is combined with the renewed strength abroad, many companies with significant operations outside the US have hardly missed a beat. Unfortunately, that is not true for small businesses and households. Mortgage delinquencies are at all time highs and foreclosures continue unabated. The overall unemployment rate (U3) is at 10.2%, U6 is at an astonishing 17.5% and the rates in states such as Michigan (15.1%) are downright startling. Further, as discussed in this opinion piece in the NY Times, there is evidence that the recession is having an outsized effect on people who were already not particularly prosperous:

If the elites are correct, if the Great Recession really is over, then these core supporters of the president are being left far, far behind — as are blue-collar workers of every ethnic and political persuasion. Nobody wants to talk seriously about class in America, but the elites are smiling and perusing their stock portfolios while the checklist of Americans locked in depression-like circumstances just grows and grows: construction and manufacturing workers, young men without college degrees (especially young black and Hispanic men), teenagers, and those who were already poor when the recession began.

Now we’re learning that unmarried women are among those being crushed by the epidemic of joblessness. As the Center for American Progress has noted, “The high unemployment rate of unmarried women, and particularly the 1.3 million unemployed female heads of household who are primary breadwinners for their families, is devastating to their financial circumstances and standard of living.”

This was not a normal recession, and we are not on the cusp of anything like a normal recovery. The unemployment rate for black Americans is 15.7 percent. The underemployment rate for blacks in September (the latest month for which figures are available) was a gut-wrenching 23.8 percent and for Hispanics an even worse 25.1 percent. The poverty rate for black children is almost 35 percent.

Wall Street can boast about recovery all it wants, much of America remains trapped in economic hell.

Not that Bob Herbert does this in the article but, honestly, I am sick and tired of people using the Great Depression as a benchmark for this recession. Yes, the current unemployment situation is nowhere near as bad as it apparently was in the 1930s. Great! People are not as desperate as they were in one of the worst periods in this country’s history! That’s not much to celebrate in my eyes and unfortunately the diminished relative severity certainly does not preclude a dangerous situation from emerging. My fear is that people who have nothing more to lose are willing to do things they never would have dreamed of in better times. It doesn’t matter what color or age a person is, we all need to eat. While spikes in crime and widespread social unrest may be on the periphery of proximate concerns, policy makers need to remember that a Wall Street and stock market recovery just leads people who don’t have the means to invest even further behind. So, before we all start celebrating the economy’s apparent return from the abyss, let’s keep our eyes on what is at stake: there is no Wall Street, stock market, or K Street if we disenfranchise every person on Main Street to save the elites from suffering any harm.

How can the US avoid “turning Japanese?” No two countries face the exact same headwinds or tailwinds and thus policy decisions will inevitably have varying impacts depending on the country and the exogenous circumstances of the times. Therefore, comparisons of the current US situation with that of Japan in the 80s may be about as enlightening as the aforementioned benchmarking off of the Great Depression. However, the attempts of the Japanese to extricate themselves from the aftermath of the stock and real estate market crashes of the late 1980s do provide an interesting template to scrutinize as the leaders of the US embark on a similar task. For better or for worse the US has decided to follow the dubious path blazed by the Japanese when it comes to a potentially insolvent banking system cluttered with bad loans and dodgy assets. Extend and pretend was chosen over the Swedish model in which banks were quickly forced to recognize their losses and were then recapitalized. Could it work out differently for the US? Sure. A lot of components of the economy are subject to positive feedback loops in which more confidence leads to increased spending (this link is to an article from Bob Schiller from this weekend’s NY Times on this topic), bank lending and eventually to real growth. If that dynamic played out, the banks (given the incredibly steep yield curve) might be able to earn their way through the cycle and be able to sell their toxic assets at much more favorable prices once the economy had recovered. Having said that, I think there is a compelling argument to be made that we should all be aware of the underlying factors that clearly led the Japanese to fail to reinvigorate their economy and asset markets. In that vein, the following article (hat tip to the Pragmatic Capitalist) discusses some of the elements that did not work in Japan:

The Japanese government’s easing of credit rates, instead of spurring real demand, created artificial demand. Federal loans and stimulus spending were not economically productive, and they vastly increased the nation’s debt and prolonged the economic malaise. Worse, businesses spent critical time on the sidelines, waiting for government bailouts and other centralized actions, instead of speedily consolidating their losses, clearing their balance sheets of bad investments, and reorganizing.

The United States in 2008–09, unfortunately, has started down the same path. Federal intervention and the expectation of additional government action are removing firms’ incentive to clean up their balance sheets by selling “toxic” assets. Why accept pennies on the dollar if a deep-pocketed new bidder (i.e., the state) looms large on the scene? The Japanese experience shows that when the government is an active participant in the market, many firms would rather accept state support than initiate the inevitable financial reckoning. Such a status quo does not provide a sustainable foundation for the economy. Instead, it restricts economic growth and creates a cycle of stagnation…

Capital reserve requirements. In 1988 the Basel I Accord between the Group of 10—which then included the U.S., Switzerland, Japan, Germany, France, and the U.K., among others—set new capital requirements for banks around the world. But the requirements were focused on loan amounts and did not factor in a debt’s underlying risk. In other words, a loan to a sound borrower required the same percentage of capital to be set aside as an equal amount lent to a high-risk borrower. There was already a developing atmosphere of heavy lending and insensitivity to risk, but the Basel requirements rewarded firms for making loans to shaky borrowers because they could earn higher interest rates that way without having to set aside any more capital than they would for loans to safe borrowers.

The chief problem was not that the requirements were too low. It was that the rules created a false sense of security for investors and lenders. Banks were meeting their legal requirements, although it was never clear what kind of debt they were holding capital to cover. Without a standard or competing standards for transparently measuring the value and risks of portfolios, Basel I proved ineffective at preventing systemic rot. (Emphasis added)

Government lending to poorly managed firms. The Bank of Japan tried to ease economic pain by loaning large amounts to businesses. But the attempts to recapitalize the market ignored underlying management problems in the dying firms. It was a costly mistake. Intense lobbying from special-interest groups representing various sectors of the Japanese economy perpetuated the ill-fated loans and funneled government money to zombie businesses. [Emphasis mine—how familiar does this sound]

Conflicts of interests. With all those loans, the Japanese government found itself deeply entwined in the market, skewing its policy incentives. Daniel I. Okimoto, former director of the Shorenstein Asia-Pacific Research Center at Stanford University, points out that Japan’s banking industry and economic bureaucracies were too interdependent. Studies from Okimoto’s center and the Bank of Japan concluded that data revealing the scope of the economic malaise were suppressed and that regulations were developed with governmental interests in mind. At the height of financial industry bailouts, there was little transparency or public accountability. [Cough---audit the Fed—cough]

Short-term, static political vision. You can blame the length of Japan’s asset deflation, recession, and liquidity struggles on an unwillingness to choose hard but necessary policies, such as allowing banks to fail and the market to reset itself. Politicians bent on retaining their power and showing the public they were doing something took actions without regard to their long-term effects.

There was little effort to clean up the banking system or get rid of harmful regulations. The government refused to acknowledge the breadth of Japan’s economic troubles, and the Ministry of Finance went so far as to order banks to hide their toxic loans to create the appearance of success..

Beware of those pesky activists: The reluctance to accept any change when it comes to corporate governance in America is absolutely astounding. Despite the fact that the corporate boards of literally hundreds of financial institutions sat idly as the companies took on extreme amounts of risk, there is still a lot of resistance to any proposals that would make directors more accountable. Interestingly, buried in Senator Dodd’s financial reform bill is a section regarding shareholder rights that allows shareholders who meet certain qualifications to nominate directors. Here is an excerpt from an article by David Reilly on the subject:

The SEC would require that shareholders looking to nominate directors hold a certain percentage of stock depending on the size of the company. Shareholders also would have to show they have owned stock for a period of time, say one year. Nor could shareholders take control of a board.

One caveat: while requiring the SEC to take up the issue of giving shareholders greater say over directors, the Dodd bill doesn’t set minimum requirements for what the agency ultimately adopts.

In spite of the common-sense nature of these proposals, supporters of the present dysfunctional system still argue that the changes will ruin American business.

A memorandum on the legislation prepared by lawyers at Wachtell Lipton Rosen & Katz, and posted in part on a Harvard Law School corporate-governance blog, argued that giving shareholders greater say over boards will only increase short- term pressures on companies from “shareholder activists and hedge funds.”

Is it me or is the fallback of the opposition to any legislation to blame hedge funds? There is no question that there are some activists who are interested in short term gains. However, there are many more firms that are genuinely invested in trying to improve corporate governance, company performance, and returns to all shareholders. As it stands, it is incredibly costly to run a proxy battle and very few funds have the resources, time or patience to wage a war against a company’s board. That is a shame because it has become blatantly obvious in retrospect that directors have not been living up their fiduciary duties and have become nothing more than rubber stampers of CEO initiatives. Reilly makes the very ironic point that no matter how devious the motivations of activist investors are, how could they possibly harm the companies more than the directors have by not diligently evaluating the actions of the management teams?

Here’s something else to consider. Let’s say opponents of greater shareholder democracy are right. And let’s assume that hedge funds and union-backed pension funds run amok, dictating that boards hew to short-term profit goals or ideological agendas.

Would they actually do more damage than has already been inflicted by imperial CEOs backed by obsequious and crony-filled boards? At last count, the U.S. has lent, spent or guaranteed almost $12 trillion to keep banks, Wall Street and the economy afloat, according to the latest Bloomberg estimates.

Even the hedge-fund hordes supposedly waiting to swarm corporate boards won’t stick taxpayers with that kind of bill.

Would contingent capital buffers help to stave off a crisis? Policy makers worldwide are trying to figure out how they can prevent another financial crisis (like the one we have apparently emerged from) from happening again. Some of the options on the table are leverage caps, higher capital ratios, and even shrinking the size of large financial conglomerates to mitigate counterparty and concentration risk. Another interesting idea is to force banks to issue contingent capital that converts to equity at a certain point during uncertain times. One of the problems that a number of firms faced during the depths of the liquidity crisis had to do with not being able to raise equity. If contingent capital had been in place the stressed company would have been able to convert debt to equity and would have enjoyed a larger cushion. However, according to James Kwak of The Baseline Scenario, contingent capital sounds great on paper but has a number of potential pitfalls:

Contingent convertible bonds, a.k.a. contingent capital, are the latest fad to hit the optimistic technocracy in Washington and London. A contingent convertible bond is a bond that a bank sells during ordinary times, but that converts into equity when things turn bad, with “bad” defined by some trigger conditions, such as capital falling below a predetermined level. In theory, this means that banks can have the best of both worlds. They can go out and borrow more money today, increasing leverage and profits (which is what they want). But when the crisis hits, the debt will convert into equity; that will dilute existing shareholders, but more importantly it means the debt does not have to be paid back, providing an instant boost to the bank’s capital cushion. In other words, banks can have the additional safety margin as if they had raised more equity today, but without having to raise the equity.

[Gillian] Tett [of the Financial Times] is skeptical for all sorts of reasons — defining the trigger point (remember, Bear and Lehman were well-capitalized on paper when they collapsed), finding people willing to buy these things, the impact on the market of triggering a conversion, etc.

I’m skeptical for a more basic reason. Contingent capital, like any other type of capital requirement, assumes that we can predict in advance how bad the crisis will be and therefore how much capital will be necessary to avert a bank-killing panic. That means we have to be able to predict (a) just how fat the fat tail is, based on virtually no data points, and (b) how panicked people can get and for how long. That seems to me technocratic hubris of the first order.

So why is contingent capital so popular? (It’s even mandated by section 107(b)(1)(D) of the Dodd bill.) Well, the people don’t matter don’t listen to me or to Gillian Tett. Here is Tett’s explanation:

“Even amid all those hurdles, the CoCo idea currently has many fans, not just among investment bankers touting for business, but some western regulators too. The reason stems from a big, dirty secret stalking the financial world: namely that while global policymakers have spent a year wailing about the ‘Too Big to Fail’ problem, they have hitherto done almost nothing tangible to remove that headache in a credible manner.”

The idea that any clever regulatory scheme we come up with today, which by definition will be untested, can be counted on to come through in the next crisis seems hopelessly naive to me. I think it would be more honest to admit that there are really only two choices:

1. Break up any institution that is too big to fail.

2. Leave them in place (because “big companies need big banks,” or whatever other nonsense justification you want to use) and admit that we’ve done nothing to solve the TBTF problem.

That’s the real choice.

Properly regulating these entities has proven to be just about impossible in the past. Why do we think it will be different next time? Bankers are paid a hell of a lot more than regulators and will inevitably find a way to get around just about any regulation. Is contingent capital better than nothing? Sure, if the goal is to enact reforms that get us as close to the bubble status quo as possible without completely letting the banks off the hook. But, if we want real change and to limit the powers of the banksters, we need legislation that includes options such as contingent capital but is centered on breaking the banks into more manageable and potentially less explosive pieces.

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