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?