Sunday, March 15, 2009

The Looting of America's Coffers

I am increasingly convinced that the looting of fiscal coffers by the international transactional class is one of the great defining issues of our time. I have observed this phenomenon with increasing frustration since the Bear Stearns intervention in early 2008. This type of looting is not new, of course.

We have become a society of looters. The transactional classes feel it is their noble right to perpetuate their status by looting the productive classes. This occurs in three ways:

1. The transfer of tax revenues to entities whose only productive effort is lobbying. This is nothing more than a form of graft and is the enemy of democratic society.

2. The incursion of sovereign debt, which is a tax on the productivity of future generations, in order to offset the natural loss in wealth of the current transactional classes as a result of capitalistic attrition. This looting occurs via 'bail-outs'. Whenever you hear the term 'bail-out' remember that this is a synonym for 'looting'.

3. The continuous creation of fiat money, which dilutes the purchasing power of savers via the hidden tax of inflation. The transactional classes protect themselves from this tax via the ownership of 'assets', the prices of which increase at a rate that exceeds the rate of inflation. It is the fear of asset price deflation that the transactional class fears most of all, and this fear is the motivation for looting.

Importantly, the transactional class is distinguished from the productive class in that the transactional class receives income from capital while the productive class receives income from productivity. Note that those who profit disproportionately from the productivity of others, such as a large fraction of corporate CEOs and other executives are also members of the transactional class, and are by definition 'looters'.

The recent announcement of $165 million in bonuses set aside for payment to executives of AIG provides the perfect example of a transfer of wealth from the productive class (taxpayers) to the transactional class (looters). AIG’s fourth-quarter loss of $61.7 billion was the biggest ever recorded for any U.S. company, and taxpayers are on the hook for several hundred billion dollars in 'bail-outs' to AIG.
The Looting of America’s Coffers

Sixteen years ago, two economists published a research paper with a delightfully simple title: “Looting.”

The economists were George Akerlof, who would later win a Nobel Prize, and Paul Romer, the renowned expert on economic growth. In the paper, they argued that several financial crises in the 1980s, like the Texas real estate bust, had been the result of private investors taking advantage of the government. The investors had borrowed huge amounts of money, made big profits when times were good and then left the government holding the bag for their eventual (and predictable) losses.

In a word, the investors looted. Someone trying to make an honest profit, Professors Akerlof and Romer said, would have operated in a completely different manner. The investors displayed a “total disregard for even the most basic principles of lending,” failing to verify standard information about their borrowers or, in some cases, even to ask for that information.

The investors “acted as if future losses were somebody else’s problem,” the economists wrote. “They were right.”

On Tuesday morning in Washington, Ben Bernanke, the Federal Reserve chairman, gave a speech that read like a sad coda to the “Looting” paper. Because the government is unwilling to let big, interconnected financial firms fail — and because people at those firms knew it — they engaged in what Mr. Bernanke called “excessive risk-taking.” To prevent such problems in the future, he called for tougher regulation.

Now, it would have been nice if the Fed had shown some of this regulatory zeal before the worst financial crisis since the Great Depression. But that day has passed. So people are rightly starting to think about building a new, less vulnerable financial system.

And “Looting” provides a really useful framework. The paper’s message is that the promise of government bailouts isn’t merely one aspect of the problem. It is the core problem.

Promised bailouts mean that anyone lending money to Wall Street — ranging from small-time savers like you and me to the Chinese government — doesn’t have to worry about losing that money. The United States Treasury (which, in the end, is also you and me) will cover the losses. In fact, it has to cover the losses, to prevent a cascade of worldwide losses and panic that would make today’s crisis look tame.

But the knowledge among lenders that their money will ultimately be returned, no matter what, clearly brings a terrible downside. It keeps the lenders from asking tough questions about how their money is being used. Looters — savings and loans and Texas developers in the 1980s; the American International Group, Citigroup, Fannie Mae and the rest in this decade — can then act as if their future losses are indeed somebody else’s problem.

Do you remember the mea culpa that Alan Greenspan, Mr. Bernanke’s predecessor, delivered on Capitol Hill last fall? He said that he was “in a state of shocked disbelief” that “the self-interest” of Wall Street bankers hadn’t prevented this mess.

He shouldn’t have been. The looting theory explains why his laissez-faire theory didn’t hold up. The bankers were acting in their self-interest, after all.

The term that’s used to describe this general problem, of course, is moral hazard. When people are protected from the consequences of risky behavior, they behave in a pretty risky fashion. Bankers can make long-shot investments, knowing that they will keep the profits if they succeed, while the taxpayers will cover the losses.

This form of moral hazard — when profits are privatized and losses are socialized — certainly played a role in creating the current mess. But when I spoke with Mr. Romer on Tuesday, he was careful to make a distinction between classic moral hazard and looting. It’s an important distinction.

With moral hazard, bankers are making real wagers. If those wagers pay off, the government has no role in the transaction. With looting, the government’s involvement is crucial to the whole enterprise.

Think about the so-called liars’ loans from recent years: like those Texas real estate loans from the 1980s, they never had a chance of paying off. Sure, they would deliver big profits for a while, so long as the bubble kept inflating. But when they inevitably imploded, the losses would overwhelm the gains. As Gretchen Morgenson has reported, Merrill Lynch’s losses from the last two years wiped out its profits from the previous decade.

What happened? Banks borrowed money from lenders around the world. The bankers then kept a big chunk of that money for themselves, calling it “management fees” or “performance bonuses.” Once the investments were exposed as hopeless, the lenders — ordinary savers, foreign countries, other banks, you name it — were repaid with government bailouts.

In effect, the bankers had siphoned off this bailout money in advance, years before the government had spent it.

I understand this chain of events sounds a bit like a conspiracy. And in some cases, it surely was. Some A.I.G. employees, to take one example, had to have understood what their credit derivative division in London was doing. But more innocent optimism probably played a role, too. The human mind has a tremendous ability to rationalize, and the possibility of making millions of dollars invites some hard-core rationalization.

Either way, the bottom line is the same: given an incentive to loot, Wall Street did so. “If you think of the financial system as a whole,” Mr. Romer said, “it actually has an incentive to trigger the rare occasions in which tens or hundreds of billions of dollars come flowing out of the Treasury.”

Unfortunately, we can’t very well stop the flow of that money now. The bankers have already walked away with their profits (though many more of them deserve a subpoena to a Congressional hearing room). Allowing A.I.G. to collapse, out of spite, could cause a financial shock bigger than the one that followed the collapse of Lehman Brothers. Modern economies can’t function without credit, which means the financial system needs to be bailed out.

But the future also requires the kind of overhaul that Mr. Bernanke has begun to sketch out. Firms will have to be monitored much more seriously than they were during the Greenspan era. They can’t be allowed to shop around for the regulatory agency that least understands what they’re doing. The biggest Wall Street paydays should be held in escrow until it’s clear they weren’t based on fictional profits.

Above all, as Mr. Romer says, the federal government needs the power and the will to take over a firm as soon as its potential losses exceed its assets. Anything short of that is an invitation to loot.

Mr. Bernanke actually took a step in this direction on Tuesday. He said the government “needs improved tools to allow the orderly resolution of a systemically important nonbank financial firm.” In layman’s terms, he was asking for a clearer legal path to nationalization.

At a time like this, when trust in financial markets is so scant, it may be hard to imagine that looting will ever be a problem again. But it will be. If we don’t get rid of the incentive to loot, the only question is what form the next round of looting will take.

Mr. Akerlof and Mr. Romer finished writing their paper in the early 1990s, when the economy was still suffering a hangover from the excesses of the 1980s. But Mr. Akerlof told Mr. Romer — a skeptical Mr. Romer, as he acknowledged with a laugh on Tuesday — that the next candidate for looting already seemed to be taking shape.

It was an obscure little market called credit derivatives.

Heads Banks Win, Tails Taxpayers Lose

I know it’s not our place to have an opinion about how U.S. taxpayer dollars are spent. We may however, in the coming weeks and months, be facing similar questions about our ‘visionary’ Canadian banks as commercial property, revolving credit, and potentially residential mortgage loan provisions start eating away at tangible Canadian bank capital.

In the meantime, if we must sit on our hands we might as well become better acquainted with what is really going on in the boardrooms and offices of Washington, New York, London, Zurich, etc.: the shameless perpetration of a “hideous public subsidy of the global transactional class, a transfer of wealth from [snip…] taxpayers to the institutional investors who hold the bonds and derivative obligations tied to zombie banks, AIG and the GSEs.” – Institutional Risk Analytics

It is important to note that bank bondholders and shareholders have a responsibility to analyze the investments they make. They are entitled to profit from their purchase if their analysis is correct, and they should suffer the consequences if their analysis is wrong. These investors (and the management of these companies) did and would continue to benefit from these investments if the banks were making a profit. Now that the banks are in trouble, investors (and executives) seem to feel they should be able to avoid the negative consequences.

I adamantly oppose this perspective.

From Institutional Risk Analytics (All bold, underline, and capitalization emphases are mine.)


Stress Test Zombies: Not Too Big To Fail? Tough Tootsies Little Banks!

March 13, 2009

There are certain professions in which the collective genius of the American people dominates the field: semiconductor design, fast food product differentiation, fire-control systems for air-to-air combat, and con artistry. That these are not, at the moment, sufficient to earn a current account surplus, is a problem being worked on, not least by the service exporters in the latter occupation.

John Dizard
Financial Times
March 1, 2009

Last week, we learned from Fed Chairman Ben Bernanke and Treasury Secretary Tim Geithner that Washington lacks the guts to fix the problems eating away at the US financial system, at least so far. So large are the derivative-fueled losses and so majestic the collective incompetence of the Congress, regulators and the Sell Side dealers on Wall Street in enabling these losses, that the judgment of the single party state called Washington is to simply hide the problem under an ever-widening public TARP.

Now, in most parts of the country, a TARP is used to cover unneeded things, usually a pile of stuff nobody wants, far in the back yard. This is essentially the plan articulated by Bernanke and Geithner: Buy the bad assets, invest more capital in the zombie banks, and hope asset prices eventually recover. This is not a plan to do anything but buy time and extend losses. The scary part is that nobody else in the Obama White House seems to know enough about finance to argue the point.

As we told the subscribers to IRA's Advisory Service, the Fed and Treasury have created a rule without reason, a ridiculous standard that only ensures the unsoundness and instability of the US financial system. Apparently, banks that fail the Supervisory Capital Assessment Program stress test will not be broken up as required by law, but instead given more capital at taxpayer expense. This is the solution to the financial crisis embraced by President Barack Obama. There is no market discipline, no bad results for the bond holders who stupidly funded these giant derivatives-driven, risk-creation machines.

Below is our best guess as to the identity of the 19 or so banks that are part of the stress test process. We hear in the community that these 19 domestic financials are the de facto "Too Big To Fail" banks, which of course means that all other banks are not part of the group. We should probably add American International Group (NYSE:AIG) and the Depository Trust and Clearing Corp, which owns a Fed member bank, to the TBTF list.

Holding Company


Notice that there are no foreign-owned banks as part of the stress test group. Note too that there are several banks on the list that are rated "F" by the IRA Bank Monitor as of year-end 2008. These negative ratings are driven both by negative ROEs as well as above-average realized credit losses.

We see two issues facing Bernanke, Geithner and the Obama Administration when it comes to the cowardly "feed the zombies" approach articulated last week. First, it is not sustainable financially and must eventually be changed because of funding constraints. And two, the policy of subsidizing the bond holders of the largest banks is unworkable politically and must eventually also be changed to conform with domestic political reality. That's right, at some point the Obama Administration may need to choose between our foreign creditors and American voters.

The Bernanke/Geithner approach to not dealing with the financial crisis amounts to a hideous public subsidy of the global transactional class, a transfer of wealth from American taxpayers to the institutional investors who hold the bonds and derivative obligations tied to the zombie banks, AIG and the GSEs. All of these companies will require continuing cash subsidies if they are not resolved in bankruptcy.

Remember that the maximum probably loss ("MPL") shown in The IRA Bank Monitor for the top US banks with assets above $10 billion, also known as Economic Capital, is a cash number representing the amount of incremental capital the banks may require to absorb the losses from a 3-4 standard deviation economic slump, such as the one we have today. If you include the subsidy required for the GSEs and AIG, the US Treasury could face a collective funding requirement of $4 trillion through the cycle. Do Ben Bernanke and Tim Geithner really believe that they can sell such a program to the Congress? To put it in perspective, the $250 billion in the Obama Budget for additional TARP funds will not quite cover Citigroup (NYSE:C).

Bottom line: The policy decision articulated this week by Bernanke and Geithner represents the largest transfer of wealth in American history, yet no legislation has been passed and no meaningful debate has occurred. The biggest danger facing the markets is that Ben and Tim still do not seem to have a clue what to do about the big banks -- other than to write more checks against the public trust. The conflict over this decision to pass the cost to the taxpayer, between the Fed, Treasury and the Congress, on the one hand, and the Wall Street dealer banks is staggering, yet nothing is said in the Big Media.

The Fed and Treasury claim that situations like C and AIG cannot be addressed idiosyncratically, to paraphrase our friend David Kotok, but the reality is more complex. Fact is, the Sell Side dealers have leveraged the real economy via OTC derivatives to such a degree that bailing out toxic waste sites like AIG, several large Euroland banks and the world of structured finance could cost trillions of dollars. That is the true cost of the crisis. The only issue is whether we recognize it directly, via a public resolution, or hide the costs via public subsidies and future inflation.

If we wish to preserve some semblance of market discipline in the US, an alternative strategy must be found. Until somebody, somehow gets to President Obama and effectively refutes the self-serving argument of the Fed and Treasury that we can't resolve C or AIG, the cost of the zombie dance party can only grow. The way you end the need for public subsidy is by resolving these firms via a restructuring and forcing the bond and equity holders of the bank's public parent company to absorb the cost of marking assets to market. If we establish a hard rule regarding solvency and break up rather than recapitalize zombie firms, then we have started to apply a real solution.

Mark to Market Accounting

To answer your many questions about our view on mark-to-market accounting, the damage - or adjustment - is done. We opposed the way the return to FVA was handled because it was too much driven by accounting and not enough other issues around business reporting. We need to be cognizant of not just accounting goals and rules, but also business reporting, investor relations, legal and business issues in order to assess this question.

We like the idea of more disclosure. We just think that swings in short-term prices observed by M2M need be confirmed by time, then you begin to convince us that the observed average price over a period of time equals value and should affect assets or income.