Day: November 20, 2008

It’s Called a Depression

It’s Called a Depression

Posted on by David Merkel

I’m going out on a limb here, and I’m going to suggest that we have already entered a depression.? The concept of a depression is even less objective than that of a recession,? but some suggest that a decline in real GDP of 10% or more is the criterion, which we have not attained yet.

I don’t think a 10% decline in GDP is the right threshold.? Depressions are different because of their widespread nature, often coming through financial systems that are in danger.

As it is now, many things are happening that are depression-like.? Here we go:

  • Record high levels of total debt to GDP
  • Many go hat in hand to the government.
  • The spreads of the bond market are at record levels since the last depression, and maybe comparable.
  • There is policy paralysis and confusion.? No one knows what to do (or leave alone), they act blindly or cower in fear.
  • Ultrasafe investments have record low yields.
  • Banks don’t trust each other.
  • GDP is shrinking, and unemployment is increasing at a rapid rate.
  • Financial businesses are failing and shrinking at high rates.
  • The government comes in to “help” the markets, and ends up replacing the markets.
  • The security of banks and other financial entities is open to question.

Will we get a 10% decline in real GDP?? I think so, but I am nowhere near certain on that.? What I am certain of is that the gears of finance are jammed.? The bond market is a shadow of its former self, and few are willing to take seemingly prudent risks.? I’m not sure the government can do much to affect this; it will work out over time, as debts are paid off and forgiven, as the last depression did.

I won’t be your host through this depression, should I live so long.? But knowing what things will be like if we are in a depression is a real advantage for those who invest or run businesses.? Be careful.

Who Has A Balance Sheet?!

Who Has A Balance Sheet?!

Posted on by David Merkel

From 2003 to 2007, we went through a period where the balance sheets of financial entities went through a systemic downgrade.? They became:

  • More leveraged
  • Less transparent via derivatives
  • More reliant of floating rate finance
  • Reliant on debt structures with shorter maturities
  • More sensitive to calls on cash via ratings-sensitive collateral agreements

That is what has set us up for the problems that we have today.? In the bond markets, those conditions have led to the failures of many large market makers, straining the remaining system.? The remaining market makers in bonds are offering little liquidity amid the panic.? It doesn’t matter what sub-segment of the bond market I point at, every part faces a lack of risk-bearing capacity as parties hoard cash.

Part of this is the fault of the Treasury and Fed, as they proffered their TARP and pulled it back.? The greater the uncertainty from large parties, the more that small parties run and hide.

Away from that, many parties with capital have decided (seemingly) as a group to seek safety all at once, leading to a general malaise in all things risky.? Part of that could be related to the original TARP, as many parties decided to wait on selling until the TARP came along.? With no TARP (as originally conceived), those inclined to sell made offers, and the markets balked.

What can I say? Compared to 2002, there are fewer entities willing to bear credit risk during the crisis, even for short amounts of time.? This allows for arbitrage situations that don’t immediately get resolved, because no one has the balance sheet necessary to do it.

Eventually we will get to a point where those with unencumbered cash will make an effort to close those arbitrage gaps, and lend to worthy businesses at exorbitant rates, but it may take some time.? Until then, the market will flounder in the volatile way that it does.

Add a New Chapter to the Bankruptcy Code

Add a New Chapter to the Bankruptcy Code

Posted on by David Merkel

I have been of two minds on bailouts.? First, I would prefer we did not do them because bailouts beget more bailouts.? Free money brings out the worst in humanity.? Where is the logical end?? How do we choose what is critical, and what is not?

Second, if we’re going to do bailouts, they should be a last resort to the companies receiving them.? Unlike the relatively sweet terms of the capital offered to the banks, bailout capital should be something that a management says, “Ugh, time to fall on our swords, guys, but at least the business and much of the rank-and-file will survive.”

So, when I look at hopeless cases like the “big” 3 automakers, I think that we need a new chapter in the bankruptcy code for businesses that are “too big to fail.” [TBTF]? The rules would be a little different here:

  • Failure of a TBTF institution usually occurs during a major economic crisis.? Other institutions would be stretched too thin, so the US Treasury (together with the Fed) would serve as the Debtor-in-Possession [DIP] lender.
  • In addition to being senior to the existing debt, the Treasury would receive some stock in the reorganized entity.
  • There would be a special court to deal with the competing claims, with a goal of speedy resolution.? Marginal claims would get thrown out early.? Claims without a lot of variability would get little attention.
  • The Court would have the power to throw out contracts, including union and management contracts.
  • The idea is to preserve the business while finding who really owns the new equity, and quickly, so that real life can resume with a balance sheet that has little debt.
  • The court would choose who puts together the first restructuring plan, aiming for the party that has the most at stake, skipping the current nominal equity, in favor of the parties that practically are the equity.
  • A Chapter 11 case could be moved into this chapter if no DIP lender is found, at the option of the Secretary of the Treasury.

A method like this tries to respect the taxpayer, making it unlikely that bailout funds would be tapped, while still allowing for situations where TBTF institutions could be reorganized in an emergency where the banks can’t lend, rather than a quick liquidation.? It’s a tough balancing act, but one that has to be done for the good of the nation as a whole.? Formalizing methods like this could have value for future crises, such that businesses end up saying that they don’t want to go down the TBTF Bankruptcy Chapter, which would be good for the nation.

That’s my reasoning.? I am open to other ideas, and improvements to the concept.

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