Citi has been bailed out. Again.
I will not delve into a discussion of the exact modalities of the deal, as it has been done here. I will however elaborate on why I think that the deal is wrong, very wrong and misguided.
Here's why:
1) It is expensive.
A 27bn equity investment. And then guarantees on a further 306bn. The size of the TARP so far, for only one firm!
2) It may be insufficient to turn the market - or - don't throw good money after bad.
Citi has over $2 trillion in assets and a further several hundred billions of dollars in off-balance sheet liabilities. Earlier capital injections have not been enough, so what makes this one different? In fact, it seems rather ill advised to put a ceiling on the size of the bailout at all, especially if the real commitment is meager relative to the size of the problem.
3) It has excessive distributional consequences.
Joe Sixpack is now paying for the Armani shirts of Jack the banker. Simple as that. It's not that Joe Sixpack is aware of it, or would even want the shirts, he would however need the money. Amazingly, the US government no longer appears to find it necessary to disguise the direct subsidy nature of this program. After all, the approach adopted to buy troubled assets over equity stakes is widely discredited, and the prospect of the government buying equity stakes at ~3x the prevalent market price is an affront to both socialists and capitalists. Indeed, it seems more like theft to me.
4) We're not being duped, so it won't work.
This crisis is about confidence. All measures currently adopted have been about shoring up confidence. After all, that is why they have to be so hastily put together and not scrutinized properly, as confidence is key (still trying to get my head round this one).
However, it does not appear to be working. The reason for this is largely point (2), but there is another, altogether more worrying element.
The US cannot really afford it.
Given US twin deficits and the already enormous debt and liability overhangs the US government is fighting with, US debt will most likely never be repaid without extremely inflationary policies on the part of the FED, which will bring with it new problems, most relevantly a crisis of confidence in the US dollar.
To put it simply, shoring up confidence in financial institutions is bringing to the fore a much more problematic issue: a potential crisis of confidence in the US Dollar, which remains the global reserve currency of choice.
Again, unfortunately, Switzerland is an example of a country which has chosen a similar route. Although Switzerland was in fact in a relatively healthy financial position, the UBS deal also mainly chose the path of buying up overvalued toxic assets to recapitalize the bank. The main difference is the size of the Swiss banking system relative to the size of the economy. Indeed, the balance sheets of UBS and Credit Suisse alone equate to several times the Swiss annual GDP. The UBS deal, which may prove to be insufficient to solve the problems of the bank, has taken up almost half of the balance sheet of the Swiss National Bank. It remains to be seen what the Swiss National Bank would do should the ~70bn CHF already provided prove to be insufficient, given that they already used up most of their conventional firepower.
This shoring up of confidence in theoretically private institutions at the expense of the confidence in currencies may prove to be a poor tradeoff by national monetary authorities.
Tuesday, November 25, 2008
Friday, November 21, 2008
Bankruptcies are good!
US car companies are currently lining up for crisis cash. Whether they get it or not is largely up to the political process. Whether or not doling out cash to failed enterprises is a good thing for the economy is within the scope of this blog.
I will attempt to make it simple:
-The big three failing means massive layoffs and an immense cost to society.
-The big three not failing means keeping employees employed in structures which, despite having had ample warning and time to adapt, were unable to meet the challenges of the market. We should also not forget that bailing out these enormous cash burners would come at an immense ongoing cost to society. Note that GM is currently rumored to be burning about 2bn US$ every month.
So whatever way we choose to go, there will be an immense cost to society. Given that consumers have already voted down the product range, the question remains: Do we, as a society, want these companies? Do they produce positive externalities for society?
The answer, for me, is no. Car manufacturers exist to produce cars. If they fail, they can no longer produce cars. Equity and to a large extent debt holders get punished for investing in a bad company. End of story?
Not quite. Many proponents of bailouts or not letting companies fail argue with the employees. That companies should be maintained due to the fact that their highly specialized workforce would encounter difficulties in finding new jobs and therefore their jobs should be maintained, subsidized with public wealth.
Nothing could be more far from the truth. Indeed, society has already taken these peoples jobs away by not buying the cars. To keep people in jobs to NOT build cars would not only be a waste of money, but also a waste of talent. Auto engineers with time freed up from keeping their seats warm in Detroit could go out and start designing the kind of car / electro-mobile / apparatus that people actually want to buy and use, thus becoming efficient participants in the economy. I for one am certainly unwilling to believe that all US auto engineers were designing the products they actually wanted to.
Of course, many auto workers will not be able to find work in their industry of choice, and will have to adapt. This is also a good thing. After all, laid off auto workers could become teachers, laborers, financial institution liquidators or a multitude of other things that the economy of today requires.
In general terms, the same logic applies to financial institutions. Let's take the example of Citigroup.
Citigroup is about to fail. Maybe, probably. The stock market appears to be reacting to the announcement that they would be firing up to 75'000 employees, or a quarter of their workforce. I must admit this comes as little surprise to me, as I gather that they have been effectively bankrupt for quite some time now. After all-even CITI must be hard pressed to liquidate non-core assets to the tune of half a trillion in this market.
What strikes me is that although they have been obviously extremely distressed for quite some time now, they have been kept on a lifeline by 25bn of TARP funding via sales of preferred stock. Now that the Tarp is no longer buying up distressed assets (which could have relieved the CITI balance sheet to the tune of 79bn$, according to some analysts) the company is being forced to recognize its dire straits.
Well - good that the mess is now being cleaned up, pity about the 25bn investment which may now be largely worthless?
The US treasury can invest in financial institutions, allowing for more savvy investors to exit their positions at more attractive prices, but it appears that this time they cannot compensate for the immense value destruction which is the bursting of the credit bubble without putting themselves at risk. Furthermore, there are gaping moral hazard and socialization of losses issues. After all, the bailout money does not come from nowhere, it comes from the state. This is money which, rather than bailing out investors who made poor decisions, could go to repairing the pisspoor US infrastructure, or to education, or to medicare...
There are similar examples everywhere. As I am based in Switzerland, I will go into the example of UBS. With UBS stock going down the drain (now trading around CHF 11 down from over 80 just over a year ago) it appears that they may be challenged to shore up confidence, despite the Swiss taxpayer committing to buy up "assets" to the tune of around 60 billion CHF alongside an equity investment of about 6bn. Despite guarantees and subsidies by the Swiss taxpayer equating to almost 9000 CHF (~7500 US$) per PERSON IN SWITZERLAND the markets, and particularly UBS board members appear to have little confidence in the firm.
From my perspective as a taxpayer in Switzerland, I feel ripped off , and would prefer to have not had my currency backed with debt bought from US credit Ponzi schemes, thank you very much (and I hold UBS restricted stock in an amount which used to have quite significant value)!
But what about the systemic implications?
Admittedly, systemic issues are critical. The uncontrolled failure of Lehman Brothers wrought havoc in Financial Markets, with banks unwilling to lend to each other. This is due to the fact that other banks know what kind of assets their peers hold. Assets which were bought and priced at values which were based on assumptions of inflation which are now turning out to be false.
So the banks are bankrupt. Well not all, but a lot of them.
The solution adopted so far is to recapitalize the banks (for more detail see Wednesdays post). This would be an ok approach if we were merely experiencing a temporary glitch which can be compensated by short term liquidity provisions. This is not the case. The banks are not insolvent but bankrupt. It appears very unlikely that credit markets will recover to a point where most leveraged banks who participated in US credit musical chairs will be able to recover their investments.
Given these constraints, the questions beckons regarding financial institution recapitalizations is: Will it be enough? Where will we draw the line? From the point of view of somebody who has worked for many a financial institution, let me just note that honesty is not a virtue they are known for.
From a macroeconomic perspective, the issue is becoming is it already too late? Do countries, and especially the US, even have the cash necessary to undertake such immensely deficitary exercises just as their tax base is shrinking?
I will attempt to make it simple:
-The big three failing means massive layoffs and an immense cost to society.
-The big three not failing means keeping employees employed in structures which, despite having had ample warning and time to adapt, were unable to meet the challenges of the market. We should also not forget that bailing out these enormous cash burners would come at an immense ongoing cost to society. Note that GM is currently rumored to be burning about 2bn US$ every month.
So whatever way we choose to go, there will be an immense cost to society. Given that consumers have already voted down the product range, the question remains: Do we, as a society, want these companies? Do they produce positive externalities for society?
The answer, for me, is no. Car manufacturers exist to produce cars. If they fail, they can no longer produce cars. Equity and to a large extent debt holders get punished for investing in a bad company. End of story?
Not quite. Many proponents of bailouts or not letting companies fail argue with the employees. That companies should be maintained due to the fact that their highly specialized workforce would encounter difficulties in finding new jobs and therefore their jobs should be maintained, subsidized with public wealth.
Nothing could be more far from the truth. Indeed, society has already taken these peoples jobs away by not buying the cars. To keep people in jobs to NOT build cars would not only be a waste of money, but also a waste of talent. Auto engineers with time freed up from keeping their seats warm in Detroit could go out and start designing the kind of car / electro-mobile / apparatus that people actually want to buy and use, thus becoming efficient participants in the economy. I for one am certainly unwilling to believe that all US auto engineers were designing the products they actually wanted to.
Of course, many auto workers will not be able to find work in their industry of choice, and will have to adapt. This is also a good thing. After all, laid off auto workers could become teachers, laborers, financial institution liquidators or a multitude of other things that the economy of today requires.
In general terms, the same logic applies to financial institutions. Let's take the example of Citigroup.
Citigroup is about to fail. Maybe, probably. The stock market appears to be reacting to the announcement that they would be firing up to 75'000 employees, or a quarter of their workforce. I must admit this comes as little surprise to me, as I gather that they have been effectively bankrupt for quite some time now. After all-even CITI must be hard pressed to liquidate non-core assets to the tune of half a trillion in this market.
What strikes me is that although they have been obviously extremely distressed for quite some time now, they have been kept on a lifeline by 25bn of TARP funding via sales of preferred stock. Now that the Tarp is no longer buying up distressed assets (which could have relieved the CITI balance sheet to the tune of 79bn$, according to some analysts) the company is being forced to recognize its dire straits.
Well - good that the mess is now being cleaned up, pity about the 25bn investment which may now be largely worthless?
The US treasury can invest in financial institutions, allowing for more savvy investors to exit their positions at more attractive prices, but it appears that this time they cannot compensate for the immense value destruction which is the bursting of the credit bubble without putting themselves at risk. Furthermore, there are gaping moral hazard and socialization of losses issues. After all, the bailout money does not come from nowhere, it comes from the state. This is money which, rather than bailing out investors who made poor decisions, could go to repairing the pisspoor US infrastructure, or to education, or to medicare...
There are similar examples everywhere. As I am based in Switzerland, I will go into the example of UBS. With UBS stock going down the drain (now trading around CHF 11 down from over 80 just over a year ago) it appears that they may be challenged to shore up confidence, despite the Swiss taxpayer committing to buy up "assets" to the tune of around 60 billion CHF alongside an equity investment of about 6bn. Despite guarantees and subsidies by the Swiss taxpayer equating to almost 9000 CHF (~7500 US$) per PERSON IN SWITZERLAND the markets, and particularly UBS board members appear to have little confidence in the firm.
From my perspective as a taxpayer in Switzerland, I feel ripped off , and would prefer to have not had my currency backed with debt bought from US credit Ponzi schemes, thank you very much (and I hold UBS restricted stock in an amount which used to have quite significant value)!
But what about the systemic implications?
Admittedly, systemic issues are critical. The uncontrolled failure of Lehman Brothers wrought havoc in Financial Markets, with banks unwilling to lend to each other. This is due to the fact that other banks know what kind of assets their peers hold. Assets which were bought and priced at values which were based on assumptions of inflation which are now turning out to be false.
So the banks are bankrupt. Well not all, but a lot of them.
The solution adopted so far is to recapitalize the banks (for more detail see Wednesdays post). This would be an ok approach if we were merely experiencing a temporary glitch which can be compensated by short term liquidity provisions. This is not the case. The banks are not insolvent but bankrupt. It appears very unlikely that credit markets will recover to a point where most leveraged banks who participated in US credit musical chairs will be able to recover their investments.
Given these constraints, the questions beckons regarding financial institution recapitalizations is: Will it be enough? Where will we draw the line? From the point of view of somebody who has worked for many a financial institution, let me just note that honesty is not a virtue they are known for.
From a macroeconomic perspective, the issue is becoming is it already too late? Do countries, and especially the US, even have the cash necessary to undertake such immensely deficitary exercises just as their tax base is shrinking?
Wednesday, November 19, 2008
Some thoughts on the financial crisis
This being the first post in my new blog, I would like to outline what in my mind is the fundamental issue with efforts currently being undertaken as a response to the current financial crisis, and conclude with an outline of what a more attractive solution might entail.
Financial Crisis
The financial crisis has been going on for quite some time now, despite repeated claims to the contrary by the Paulson - Bernanke fire brigade, and several other bureaucrats in the initial stages of the crisis.
Given that the US administration is soon to to change, it is interesting to note the differing agenda of the current administration, who remain focused on "shoring up confidence" while implementing incoherent and hastily stitched together programs to stop the crisis from worsening, from that of the incoming administration, who appear to be talking up the crisis. Paul Volker's speech at Lombard Street research certainly does little to foster confidence: "What this crisis reveals is a broken financial system like no other in my lifetime". It should be noted that Paul Volcker was alive and kicking during the Great Depression. Whether this is a warning by Volcker to go out and buy canned food or whether this is merely an attempt to pre-empt partisan attacks when the Obama administration proves incapable of solving the mess left by the current incumbents is unclear to me at this time.
However, I do generally appreciate a bit of straight talking regarding this crisis as I tend to get rather worried when I see Central Bank Board members, Professors with substantial reputations, turn in to cheerleaders for the financial system, as experienced at this event. The point being of course that the crisis must be really bad if a member of the Governing Board of the SNB is unwilling to tell you that it is, in fact, really bad.
It appears clear to me as it has for some time now that the current financial crisis is indeed going to be the major historical economic crisis of our time. Deflation appears to be increasing, causing enormous wealth destruction across the globe. The extremely expensive programs to buy up toxic assets and recapitalize the degenerate financial system appear to be largely futile, as banks remain unwilling to provide capital to the real economy. Therefore, it appears inevitable that the situation will get worse before it gets better.
What to do about it?
Problem: The highly overleveraged financial system has produced paper liabilities (to itself) that are so enormous that they can no longer be borne by the financial system.
So far, two main paths have been chosen to solve this problem:
Solution 1: Liabilities will be transferred to the public (Switzerland mostly, initial TARP) so the financial institutions can continue as if the crisis never happened, in the knowledge that the state will always bail them out.
Solution 2: The public invests in financial institutions via equity participation, thus recapitalizing banks and subjecting banks to increased oversight and control by the state. Once the banking system works again, state equity participation will be sold.
To me, solution 1 is certainly the most irresponsible, short term solution imaginable, and signals excessive coziness between Central Banks and the Private Financial system. Indeed, without severe penalties to the financial institutions who seek public capital to operate, the moral hazard involved in this operation is extreme. Solution 2 is far more attractive, as it goes some way to align interests and also control between the investor (the public, i.e. you) and the entity invested in. Banks do not want to be controlled by the state so they will endeavor to become self-sufficient once again as soon as it is feasible, and then try and make sure that they remain independent from state interference.
However, the main problem with both of these approaches is that they do not address the main problem, namely, unsustainable levels of risk taking in the financial system. Both approaches have the aim of financial institution recapitalization, and do so by injecting public capital into supposedly private enterprises, with the implicit goal of reflating the credit bubble so that we can all continue as we have so far. It is widely accepted that levels of leverage prevalent in the system were excessive prior to the crisis. For this reason, attempts to maintain previous levels of credit such as directives to financial institutions in the UK and US to maintain or even expand levels of mortgage lending will not only be extremely expensive, but largely futile. Indeed, such measures will merely postpone the inevitable.
The long term solution will have to focus on maintaining the economy in a state of relative balance by eliminating the excesses which led to the current crisis. It will have to address issues such as the role of state in the markets, moral hazard, government sponsored entities or the problem of being "too large to fail" and most fundamentally, public vs. private risk raking.
I realize that this is quite an undertaking, However, if you decide to follow this blog then maybe I may find the time to attempt an outline of a real, sustainable solution to the problem, one that will hopefully minimize the exposure of the public to financial system excesses.
Financial Crisis
The financial crisis has been going on for quite some time now, despite repeated claims to the contrary by the Paulson - Bernanke fire brigade, and several other bureaucrats in the initial stages of the crisis.
Given that the US administration is soon to to change, it is interesting to note the differing agenda of the current administration, who remain focused on "shoring up confidence" while implementing incoherent and hastily stitched together programs to stop the crisis from worsening, from that of the incoming administration, who appear to be talking up the crisis. Paul Volker's speech at Lombard Street research certainly does little to foster confidence: "What this crisis reveals is a broken financial system like no other in my lifetime". It should be noted that Paul Volcker was alive and kicking during the Great Depression. Whether this is a warning by Volcker to go out and buy canned food or whether this is merely an attempt to pre-empt partisan attacks when the Obama administration proves incapable of solving the mess left by the current incumbents is unclear to me at this time.
However, I do generally appreciate a bit of straight talking regarding this crisis as I tend to get rather worried when I see Central Bank Board members, Professors with substantial reputations, turn in to cheerleaders for the financial system, as experienced at this event. The point being of course that the crisis must be really bad if a member of the Governing Board of the SNB is unwilling to tell you that it is, in fact, really bad.
It appears clear to me as it has for some time now that the current financial crisis is indeed going to be the major historical economic crisis of our time. Deflation appears to be increasing, causing enormous wealth destruction across the globe. The extremely expensive programs to buy up toxic assets and recapitalize the degenerate financial system appear to be largely futile, as banks remain unwilling to provide capital to the real economy. Therefore, it appears inevitable that the situation will get worse before it gets better.
What to do about it?
Problem: The highly overleveraged financial system has produced paper liabilities (to itself) that are so enormous that they can no longer be borne by the financial system.
So far, two main paths have been chosen to solve this problem:
Solution 1: Liabilities will be transferred to the public (Switzerland mostly, initial TARP) so the financial institutions can continue as if the crisis never happened, in the knowledge that the state will always bail them out.
Solution 2: The public invests in financial institutions via equity participation, thus recapitalizing banks and subjecting banks to increased oversight and control by the state. Once the banking system works again, state equity participation will be sold.
To me, solution 1 is certainly the most irresponsible, short term solution imaginable, and signals excessive coziness between Central Banks and the Private Financial system. Indeed, without severe penalties to the financial institutions who seek public capital to operate, the moral hazard involved in this operation is extreme. Solution 2 is far more attractive, as it goes some way to align interests and also control between the investor (the public, i.e. you) and the entity invested in. Banks do not want to be controlled by the state so they will endeavor to become self-sufficient once again as soon as it is feasible, and then try and make sure that they remain independent from state interference.
However, the main problem with both of these approaches is that they do not address the main problem, namely, unsustainable levels of risk taking in the financial system. Both approaches have the aim of financial institution recapitalization, and do so by injecting public capital into supposedly private enterprises, with the implicit goal of reflating the credit bubble so that we can all continue as we have so far. It is widely accepted that levels of leverage prevalent in the system were excessive prior to the crisis. For this reason, attempts to maintain previous levels of credit such as directives to financial institutions in the UK and US to maintain or even expand levels of mortgage lending will not only be extremely expensive, but largely futile. Indeed, such measures will merely postpone the inevitable.
The long term solution will have to focus on maintaining the economy in a state of relative balance by eliminating the excesses which led to the current crisis. It will have to address issues such as the role of state in the markets, moral hazard, government sponsored entities or the problem of being "too large to fail" and most fundamentally, public vs. private risk raking.
I realize that this is quite an undertaking, However, if you decide to follow this blog then maybe I may find the time to attempt an outline of a real, sustainable solution to the problem, one that will hopefully minimize the exposure of the public to financial system excesses.
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