Ethics – Page 14 – The Aleph Blog

A New Appreciation for the Plumbing

Posted on 27 February 2009 by David Merkel

I am the son of a plumber, who was the son of a plumber.? My wife gives me a bemused look when I go off to fix a plumbing problem, usually minor, when she asks, “Can you do it?” and I say, “Son of a son of a plumber.”? Truly, my statement means nothing, though I worked with my Dad for two summers that I enjoyed a great deal.? He installed sewers all over southeastern Wisconsin, and was known for doing quality work.? He never got sued once in his 35-year career.

So, I can appreciate plumbing.? Most of us never think about it.? Open the spigot — water!? Flush the toilet — waste gone!? Simple.? Beautiful.? As my Dad, a happy man, would say, “I have brought civilization to southeastern Wisconsin.”? A good man, my Dad.

Figuratively, plumbing exists in many areas of life.? People don’t want to think about the mechanics of how something works; they just want it to work when they need it.? More people drive cars than are mechanics.? More people listen to music than can sing well.? (I love to sing.)

The sad aspect of plumbing for the financial markets today is that we are drawn to the front end of investing processes.? This man looks successful.? He has a great story; a way to make money that others do not know about.? There are documents showing his track record — impressive, though he doesn’t solicit publicly; investing with him is a family affair.? Do you want to be part of the family and gain the benefits thereof?

There are questions to be asked, particularly of nonstandard ventures:

How are the returns earned?
Who checks the results?? (Auditing — should not be a small firm.)
Who has custody of the assets?
Is the trustee a reputable third party?
Is liquidity proportionate to the asset class invested in?
Is this under US law?
Do the returns look too good to be true, either in absolute amount, or always positive with low volatility?
Is this marketed to everyone, or just a select few suckers?
Is the profit motive of the sponsor obvious and standard?
How are asset values calculated each accounting period?

Whether we are talking about Madoff, Stanford, or any of the other recent frauds, an attention to the details of how the financial plumbing works can pay off in terms of avoiding situations that are too good to be true.

When the next bull phase comes, be aware, and avoid slick talkers who have a good private game going, unless it can be verified by many competent independent third parties.? The bear phase is here now, revealing the slick talkers, and those that were taken in by them.? Be aware; you are your first and best line of defense.

Bad Job, Naughty Boy! Here, Have Some More Money…

Posted on 15 February 2009 by David Merkel

As I stated in my prior piece, Bailouts are Unfair to Those Who are not Bailed Out, the main objective of the management of a large company that is in trouble is to get your foot in the door.? Get something going now, even if it is inadequate, so that you can beg for much more money later.? Once Congress has committed to initial funding, they will be far more disposed to hand over more money, in order to protect their earlier bad decision.

Another way to think about it is to set up a pattern.? Even if it is a small amount, getting a legislature to agree with a concept on a small level is the precursor to getting it to agree for big money.? Once a pattern is set, the legislature will continue to fund, absent some big economic catastrophe, or other political hurdle.

So we have GM coming back to the trough.? Congress protected them last time, they will protect them this time as well.? There is no good reason to give them money, in my opinion.? Better to send them through bankruptcy, and let Toyota and Honda buy what few pieces of GM have value.

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For those that read me, please realize I work along two tracks — first, the government should not intervene in private transactions.? (That means no central bank also.)? That is my core belief, aside from fraud and implied fraud.? There should be freedom of contract.? But the second track is, “Well, if you are going to be rogues and intervene in the markets, well, here is a less evil way to do so.”? I offer those thoughts, because I know my first track will not be bought.? So it goes.

Full Disclosure: long HMC

Who Do You Work For?

Posted on 11 February 2009 by David Merkel

When I was an actuary running a GIC desk inside a medium-sized insurer in the 1990s, I quickly learned about creditworthiness.? My company, for the sake of accounting convenience, placed all GICs in a separate account.? Now the state of domicile did not have a law that said that guaranteed products in separate accounts have protection from the assets in the separate account, and the company if the assets in the separate account fail.

So, when no one would buy the GICs, because an A1/A+ insurer was no longer good enough, in 1997, I shut the line down.? I looked into credit enhancement — the cost was too high.? I asked the CEO for a guarantee — he refused (he did not understand much generally, except how to line his venal pockets).? I did what was best for the company, given the limitations of the management team, and closed the line of business.

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My goal as an actuarial businessman was to make profits with modest risk for my ultimate owners, who were the mutual policyholders.? Once I faced a situation where there might be easy profits — writing floating rate GICs.? So, I went to my models and tried to figure out how we could make money safely while our interest rates would shift every three months.? I came to the conclusion that there was no safe way to do so, and so I walked into the office of my boss and told him so.? He surprised me by supporting my thesis, and in his usual back-of-the-envelope way, explained to me in a few minutes why it had to be so.

A few weeks later, he informed me that an actuary from Goldman Sachs (yes), would be dropping by to tell about one of their new derivative contracts that would enable us to write floating rate GICs profitably.? The meeting day came, and I validated the expectations of my boss.? The year was 1993.? I asked the actuary from Goldman what happens if the yield curve inverts.? He answered honestly, “This strategy blows up when the yield curve inverts.”? Score a small victory for me.? I gave myself points for avoiding trendy bad ideas.? Over the next twelve months, two major insurers and one investment bank would announce billion-dollar blowups from following that strategy.

After the blowups, I went back to the buyers of floating-rate GICs, and asked them if they would accept a lower spread over LIBOR.? The response was a firm “no.”? So much for that market.

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Shortly after the visit from the Goldman Sachs actuary, interest rates began to rise.? I had benefited from falling rates for some time, and I had gotten a bit lazy, because the investment department could buy investments, and I could wait to sell my GICs.? After all, with rates going down, time was on my side.

Now, there was one odd thing about the company that I worked for.? They left the hedging decision in the hands of the line actuary and not at the investment department (no joke).? I had control of interest rate policy for my line of business.

1994 started out bad for me.? The rest of the industry went wildly competitive selling GICs, and I was way behind my quota.? What was worse, I had a lump of maturing GICs that left my line of business short of cash.? Our Treasurer gave me a curt phone call that my line of business had forced the company to draw down on its line of credit.? (The Treasurer was the only person in the firm that could have blended in easily at AIG.)

I considered my options.? I could sit on my hands, and the wrath of Senior Management would grow.? Or, I could write business with subpar profitability.? With the yield curve so steep, I wrote a bevy of barbell GICs that the buyers mispriced.? They would compare a GIC with half maturing in one year and half in five to a three year GIC.? With a steep yield curve, that was the wrong decision.

I sold a bunch of those barbells to get out of my cash hole, and then began cutting bargains, and selling like mad, as I concluded that the residential mortgage-backed market was pushing up interest rates.? I sold my quota early that year, and the investment department dawdled (at my request), waiting to put cash to work at higher rates, and improving credit quality as well.? It was the best year we ever had, amid the worst year for the bond market in 60+ years.

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I don’t recommend handing over interest rate policy to those that manage the line of business.? That is too dangerous a thing to do.? I didn’t undersatand that at the time, so I did the best that I could, which was pretty good.? Sadly, the same was not true for the actuaries at the other two lines of business — they assumed rates would stay low.

I tell these three stories to illustrate the ethical choices one faces when working in a financial business.? Will you act in the best interests of your ultimate owners, or will you serve the management, or worse, yourself?

We can lay the blame for mismanagement at the doors of the company managers of financial companies.? But lower level managers have their share of blame as well.? Did they follow the short term economic incentives given by their companies, or did they do what was right for their owners.

When working for investment firms at later dates, I would tell the junior analysts these stories, and I would ask them, “What do you think they gave me as a bonus?” (for my work that protected the company and made very good money?)? They would always guess high.? I never received more than a couple of thousand dollars, and I was happy with it.? I did my job to do what was right in my field, not to make excess money.

And so I would say to my peers in financial services… have you done what is right?? Have you served the best interests of shareholders?? Not you, your boss, your CEO…? You have a choice, as I do.? Life is too short to work for unethical firms.? Find a place where you can ply your trade ethically and competently.? I am grateful to my current firm for having such a place today.

The Humility of Realism — II

Posted on 30 January 200930 January 2009 by David Merkel

This post is supposed to be a kind of “catch up” post, where I write about a number of small things that I thought were interesting, but weren’t worth a full post.

1) The government can’t fund everybody. The recent backup in the US treasury note market is a great example of that.? As the demands for funds now in exchange for funds later has increased, Treasury interest rates have risen.

I have several biases, but one of them is that the Government can’t unilaterally create prosperity.? It can create conditions that encourage economic activity, through predictable and fair laws, but it can’t make us immediately better off through deficit spending, or tax-and-spending.? The Government does not know what is needed to a better degree than its citizens do individually.

But let the government fund or guarantee everybody.? When they do that, there is just one overleveraged credit that matters, and it will fail, taking us with them.

2) Equity Private is one clever lady.? Fair value accounting primarily exists to deal with investments that are as volatile as equities. How are publicly traded equities valued?? At market.? How about volatile assets where the value is derivable from market prices?? They should be valued at pseudo-market.? If we were back in the old days, and all of our assets were bonds, we wouldn’t need fair value accounting.? Even if we did it, the values wiould not vary much. ? But when you slice and dice the various pieces of bonds, the volatile bits jump around a lot.? To value them at their initial value is ridiculous, the value is too volatile.

3) Felix is right.? There needs to be more of a debate over bank nationalization. I’ve written my pieces there, influenced by the better regulations of the insurance industry, and how they deal with insolvencies.? Mark assets to market.? Do the triage.? Send insolvent institutions to RTC 2, and take stakes in some marginal institutions.? That is where the money will do the most good.

4) “We have to buy up assets that are selling at fire sale prices.? We will even make money for the taxpayers.” So go the arguments of those that want to create a “bad bank”.? Oh, please.? Profits are rare in bailouts.? They happen by happy accidents, a la Chrysler (80s, not now), which possibly could have made it without a bailout.

Assets are at fire sale prices because there is not enough balance sheet capacity to buy and hold them over a period where the realization of value is likely.? I’ve seen structured assets rated AAA where the collateral is okay, and the likely realization of value is in the 90s, if you can hold it for 5 years.? Where does it trade?? Around $60.? Another asset, which would likely be worth $35 if it could be held for 15 years, where does it trade?? It doesn’t trade, but you could get rid of it to a broker for zero.

Strong balance sheets can’t be created out of thin air, though.? Remember how formidable Fannie and Freddie used to be, or many of the FHLBs?? Strong balance sheets only exist through investments where the cash flows will not be needed for decades, like pension and endowment plans.

5) Some commentators complain that the current crisis destroys the concept of efficient markets, because a trust in markets led us to failure. Oh please.? First, all of our markets were by no means free from government mismanagement, and many of the distortions came from poor regulation.? Our dear government had many lending programs pre-crisis, and even more post-crisis.? They further encouraged the increase in debt through the tax code.

Why is debt finance tax deductible, and equity finance not?? What might the system have been like if interest payments could not be deducted on taxable income, but dividends could be?? Leverage would have been a lot lower, and the system would be a lot more stable.

Market efficiency means many things.? In the short run, it means that no one can do better than the current situation. In the intermediate-to-long term, markets are efficient in a different way.? They reveal problems that need to be solved.? Some might call those market failures but they aren’t.? In the present crisis, the invisible hand is saying to us: reduce debt levels; your economic system in too inflexible.? The visible hand, the government, says: “Have some more of the hair of the dog that bit you.? We need lower mortgage rates.? We need more consumer lending.? We’re going to borrow more than ever before in an effort to create prosperity.”? Caroline Baum takes a similar view, and as usual, she expresses it well.

Market efficiency does not mean things are trouble-free, but it gives us sharper incentives to solve our problems.? Some things become revealed as truly public goods that the government needs to regulate.? But that is not the majority of human actions.

6) AIG is one black hole for cash.? Selling or IPO-ing units during the bust phase, when valuations are compressed does not seem to be an optimal strategy here.? If all of the assets were sold, would there be enough for the junior debt or preferred shareholders to get paid?? (Forget the common.)? So, in the face of it, do they IPO partial stakes in enterprises, with an eventual end of IPO-ing or selling the whole thing later?? If so, there is little free cash flow being generated to pay down debt.

What this implies to me is that the huge loans that the government made to AIG will likely hang out there for a long time.? Is this the best use of the government’s credit?? I think not.? If there are still systemic risk issues, wall those off separately, and send the rest of AIG into liquidation.? The insurance units are intact; let others buy and manage them.? Speculating on a future boom in asset prices is not a reaonable government policy.? Hope is not a strategy.

7) It is simple to blame the US for the current global crisis.? Simple and wrong. The US deserves blame, true, but not even the majority of the blame, just a slightly larger than proportionate amount for its size.

But when China blames the US, it goes too far.? In the era of neo-mercantilism, China had political goals to achieve.? Industrialize the country.? Get surplus workers off of the farms and into the cities.? Keep the currency undervalued to support export-led growth.? Force savings through restrictions on imports.? As a result, suck in developed country debts and companies where strategically desirable and possible.? Do these deals in their currencies because of the need to keep the Yuan cheap.

China made its bed, let it sleep in it.? They knew that they were lending to the US in its own currency; it was a necessary part of the bargain to achieve their own goals.? Just as the mercantilists sucked in gold, and then found it to be less valuable than they imagined when they had to draw on it, so it will be when nations want to draw on the US dollar assets that they have hoarded.

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My phrase, “the humility of realism” is meant to get us thinking about the system as a whole, and about the long-term consequences of societal actions, whether by the government or private parties.? Humility says that sometimes we have to say, “No, we can’t.”? It also says that we should think carefully about major policy actions, and not let ourselves get bullied by those who rush, shouting “crisis, crisis,” while quietly angling for their favored pet projects to get swept in while no one is looking.? Realism sometimes means the government has no good solutions, so it should inform the public that they aren’t omnipotent, and humbly say the crisis must be borne with grace.

The problems generated by the short-termism of the past three decades will not get solved by more short-term thinking.? The present rush to assure prosperity will not end well, in my opinion.

Revisiting TARP FOIA Requests

Posted on 29 January 2009 by David Merkel

I’m tracking three FOIA lawsuits involving the TARP (using Bloomberg Law, and Googlebots):

Bloomberg L.P. v. Board of Governors of the Federal Reserve System
Fox News Network, LLC v. Board of Governors of the Federal Reserve System
Fox News Network, LLC v. United States Department of the Treasury

In the first case, there is a motion for summary judgment — this might come to an amicable end, itf the parties can compromise on terms of disclosure.

The second case has the Fed writing out Vaughn Indexes — explaining what they can’t tell the plaintiff.

The third case has the Treasury Department saying that they are in the process of complying with the original request, but that they are backed up now, and there are many sub-departments to co-ordinate.? Just wait your turn, and there will be many blacked-out documents for Fox News Network to review.

I write this partly because I wonder whether the Obama Administration will create an open culture with respect to disclosure of data from the Federal Reserve and the Treasury.? My guess is no, because once someone is in power, they tend to reflect the interests of those who were in power.? But, I can hope, and remember, hope is audacious!

I will continue to track these cases, and will report as biggish things happen.

Next are JP Morgan and Wells Fargo?

Posted on 15 January 2009 by David Merkel

Part of the too big to fail/succeed legacy was the four banks that were inviolate: Citi, Bank of America, JP Morgan and Wells Fargo.? The Fed can’t let any of these fail, so Bank of America (what a nice name) gets extra aid, even after the almost failures of Citi and? Wachovia.

From an idealistic strandpoint, I don’t get the aid.? If aid were not available, Bank of America would have been less aggressive, and we would be moaning about the smaller Merrill and Countrywide troubles today.

But, that’s not the case.? The aid provided has perverse incentives to banks.? The more you moan, and the bigger you are, the more you get.

This will not end well.? My experience tells me that those who are dependent tend to be so, until something big jolts them back to independence.? After all, dependence is comfortable.

What I Would Do

Posted on 15 January 2009 by David Merkel

My friend Dr. Jeff wrote in response to one of my articles:

Jeff Says:
December 21st, 20081:18 am at EditMost of the questions you ask have been answered on the public record. They are available for our evaluation.

In the case of Lehman, the Fed could not take the collateral because it did not qualify. If they had, you would have been leading the charge in objecting. Treasury had no authority.

In the case of AIG, there was concern about counter-party risk that extended worldwide. We got a demonstration of that from Lehman.

I am mystified by your criticism of the Obama administration ? yet to weigh in on this.

As a careful, loyal, respectful, and interested reader of your work, I have some questions. You have been critical of elected officials, appointed officials, independent bodies ? in fact ? every agency of government. Just how do you think we should be setting policy?

Is there some other country or system that is doing this better?

Just wondering?

Look, Jeff, I feel the same way,? I hate being merely a critic.? That is one reason that I submitted many of my policy ideas to the Obama administration.? Given the limitations of their website, though, I can’t easily point to what I submitted.

Aside from China, the competitive fringe in Asia is doing better.? Aside from that, other countries are a tie at best.

But what I would propose as a solution to our current crisis is this:

If I were offered the opportunity to fix things, I would take it, and:

Create a new RTC for the small stuff
Create a new chapter in the bankruptcy code for Too Big To Fail institutions
Create a means of resolving home foreclosure issues in a manner similar to Chapter 11, which would lead to more compromises.
Institute true tax reform that eliminates the sheltering of income, and eliminates all tax preferences.
Wind down the Fed?s current ?solutions?
Begin inflating the currency to force up the value of collateral relative to nominal debt levels

The last one I like the least, but I?m afraid it would have to be done.? Phase two would be:

Move to a currency that is gold-backed.
Replace the Fed with a currency board.
Create a new unified regulator of all depositary institutions.
Slowly raise bank capital requirements, and make them countercyclical.
Bring all agreements onto the balance sheet with full disclosure.
Enforce a strict separation between regulated and non-regulated financials.? No cross-ownership, no cross-lending, no derivative agreements between them.
Bar investment banks from being publicly traded, and if regulated, with strict leverage/risk-based capital limits.
Move back to balanced budgets, and prepare for the pensions/entitlements crisis.

That is my proposal, and it is better thought out than the politically driven drivel that occupies DC today. I am thinking longer term than most politicians do, and aiming for a society that can work in the long run.

Closing Out Ten Odd Lots

Posted on 13 January 2009 by David Merkel

1) Do you need new investment ideas?? John Dorfman’s column at Bloomberg is back.? There are some good ideas in the second column.? I always liked it in the past, and so I recommend it to you.? They don’t have a page for him yet, so perhaps this link will help if you want to see his ideas in 2009.

2) I have never read Atlas Shrugged.? I have better things to do.? But, I still believe that much of what the government is doing will cause more harm than good, because they delaying the reconciliation of bad debts.

3) We must restore confidence!? But what is confidence?? Are we talking about some loony Keynesian idea like “animal spirits?”? (We are sentient men, not animals, and have our own unique follies.)

When am I confident about my economic status?? I am confident when I think my goods and services have adequate demand, and my assets are going to throw off cash flow because the economic processes they depend on have adequate demand.? But that is a bicycle stability answer.? What if I am in debt, and most of my economic contacts are in debt, and many of our assets rely on the repayment of debt that is coming from assets with impaired prospects?

Confident men are willing to take on debt; they are so confident that they are willing to take some risk of a large loss from borrowing.? Men who are frightened try to preserve some subset of what they have.

My point is this: in the bust phase of the economic cycle, it is normal for those that have not planned prudently, keeping debts down, and leaving enough in reserve, to be scared.? Given the foolish nature of our government to encourage, rather than discourage debt, it has left us all less confident in the future.? 1984-2007 was one incredible bull phase, and it will be followed by an similarly large bust phase, as debts will have to be reconciled.

Instead, our dear government layers on more debt to try to solve the problem, risking the national credit for political gains.? Some of the debt proceeds are used to buy up other bad debts, others are used to recapitalize marginal institutions.? Nothing much happens, and the big risk appears slowly, that needed change has been postponed through government intervention, leaving a larger problem to solve later.

4) Are Defined Contribution [DC] plans fatally flawed?? No more so than Defined Benefit [DB] plans.? From the article:

The most obvious pitfall is that 401(k) plans shift all retirement-planning risks — not saving enough, making poor investment choices, outliving savings — to untrained individuals, who often don’t have the time, inclination or know-how to manage them. But even when workers make good choices, a market meltdown near the end of their working careers can still blow their savings to smithereens.

“That seems like such a fundamental flaw,” says Alicia Munnell, director of Boston College’s Center for Retirement Research. “It’s so crazy to have a system where people can lose half their assets right before they retire.”

Uh, many of the same flaws apply to DB plans, which are also under stress now.? After large market losses, DB plans will look for ways to reduce their liabilities.? There’s no magic here.? When the market goes down, everyone gets hurt, and corporations do not want to contribute more to their DB plans — they would rather terminate them, or shed them to the PBGC after bankruptcy.

5) As an example, consider the pensions of the automakers.? I was somewhat skeptical about the health of their DB plans, partly because GM had contributed a big slug of its own common stock as an asset in the past.? Where was the PBGC when the bailout discussion was active?? They could have derailed the talks by pointing out the underfunding.? Oh, wait.? They want more money to go to the automakers because it might minimize their liabilities.

6) What GSE (government sponsored enterprise) sounds like a mistake?? The Federal Home Loan Banks [FHLBs, pronounced “flubs.”]? They lurk behind the banks that own them, and provide credit to their owners.? As it is now, a large portion of the FHLBs may no longer deserve their AAA ratings because of the losses they may take from risky mortgage assets.

If the Treasury has to rescue the FHLBs, we are truly in sad shape.? They have operated behind the scenes for so long that few know about them.? Better that the owners bail out the FHLBs than the taxpayers.? As it is, the owners are already taking pain.

7) Do you need a free reading on your credit score?? Consult quizzle.com.? I tried it and found it to be free and safe.

8 ) Need some productivity enhancement tools?? Jack Ciesielski provides a year end list at his blog.

9)? I was unimpressed to say the least with this piece by Dean Baker on Social Security.? If all that he is saying is that some benefits will be paid in some form for some time, then I have no argument.? But if he is saying there is no plausible scenario where benefits will not be paid over the long term, then I disagree.? Here’s my argument:

Consider my piece The Biggest, Baddest Bubble of Them All.? The present value of the net liabilities of the US Government on a consolidated basis was $25 Trillion at fiscal year end 2002, $50 Trillion in 2007, and $53 trillion at the most recent reading.? We are facing deficits verging on $1 Trillion for the near future, and on an accrual basis, those deficits are over $1 Trillion, as we take in more than we pay out on our social insurance programs.

To close annual gap of $1 trillion, or even $450 billion (most recent cash deficit) through tax increases and spending reductions will be painful.? Much of the budget involves entitlement programs like Social Security that would be hard, but not impossible to change.? As William Proxmire said back in the early 80s in this famous exchange:

Senator William Proxmire: “…there are 37 million people, is that right, that get Social Security benefits?”

Social Security Commissioner James Cardwell: “Today between 32 and 34 million.”

Proxmire: “I am a little high; 32 to 34 million people.? Almost all of them, or many of them, are voters. In my state, I figure there are 600,000 voters that receive Social Security. Can you imagine a senator or congressman under those circumstances saying, ‘We are going to repudiate that high a proportion of the electorate?’ No.

Furthermore, we have the capacity under the Constitution, the Congress does, to coin money, as well as to regulate the value thereof. And therefore we have the power to provide that money. And we are going to do it. It may not be worth anything when the recipient gets it, but he is going to get his benefits paid.”

Cardwell: “I tend to agree.”

My point here is that benefits may get paid in dollars that aren’t worth that much. The cost of living adjustments will be limited or eliminated.

Increased means testing will eliminate benefits to those that are better off, and turn the program into an old age welfare program, which will bring back the stigma of receiving benefits, and reduce its political legitimacy, because it would no longer have the useful fiction of something that is everyone’s right.? The “contributions” to Social Security are just another tax to support

Benefits will be cut, and taxes will be raised, to be sure.? The point is that the government took the excess “contributions” and spent them on whatever the government needed at that time.? There was little care for future generations — spend it now.? Each succeeding generation gets a progressively worse deal from Social Security, paying in more relative to what will be received.? (As an aside, I know of few that are more pessimistic about the situation than the actuaries I have met at the SSA.)

It is not impossible that younger generations might finally rebel against the burdens placed on themselves over which they have no say.? Social Security could be dramatically scaled back in such a crisis, to the point where it no longer resembles the current program.? At least that would be better than a failure of the nation as a whole.? There is some level of indebtedness at which the US government would fail, whether through internal or external debt repudiation, or inflation.? I guess we have to test how much US debt the rest of the world can take down before the door finally shuts to the US Government borrowing in its own currency.

10) On that note, I want to close by mentioning my friend Cody Willard‘s new website SpokeUp.com.? Cody has been amazed at the anger he has been hearing over the current crisis, and our government’s seemingly unfair methods of handing out relief.? SpokeUp.com is an effort to enable people to connect over political issues, and possibly organize to effect political change.

Three Long Articles on Three Big Failures

Posted on 31 December 200831 December 2008 by David Merkel

If you have time, there are two long articles that are worth a read.? The first is from the Washington Post, and deals with the demise of AIG, highlighting the role of AIG Financial Products.? It was written in three parts — one, two, and three, corresponding to three phases:

Growth of a clever enterprise, AIGFP.
Expansion into default swaps.
Death of AIG as it gets downgraded and has to post collateral, leading to insolvency.

What fascinated me the most was the willingness of managers at AIGFP to think that writing default protection was “free money.”? There is no free money, but the lure of “free money” brings out the worst in mankind.? This is not just true of businessmen, but of politicians, as I will point out later.

My own take on the topic involved my dealings with some guys at AIGFP while I was at AIG.? Boy, were they arrogant!? It’s one thing to look down on competitors; it’s another thing to look down on another division of your own company that is not competing with you, though doing something similar.

As I sold GICs for Provident Mutual, when I went to conferences, AIGFP people were far more numerous than AIG people selling GICs.? The AIG GIC sellers may have been competitors of mine, but they were honest, and I cooperated with them on industry projects.? Again, the AIGFP people were arrogant — but what was I to say?? They were more successful, seemingly.

The last era, as AIG got downgraded, was while I wrote for RealMoney.? After AIG was added to the Dow, I was consistently negative on the stock.? I had several worries:

Was AIGFP properly hedged?
Were reserves for the long-tail commercial lines conservative?
Why had leverage quadrupled over the last 15 years?? ROA had fallen as ROE stayed the same.? The AIG religion of 15% after-tax ROE had been maintained, but at a cost of increasing leverage.
Was AIG such a bespoke behemoth that even Greenberg could not manage it?
My own experiences inside AIG, upon more mature reflection, made me wonder whether there might not be significant accounting chicanery.? (I was privy to a number of significant reserving errors 1989-1992).

In general, opaqueness, and high debt (even if it’s rated AAA), is usually a recipe for disaster.? AIG fit that mold well.

Now AIG recently sold one of their core P&C subsidiaries for what looks like a bargain price.? This is only an opinion, but I think AIG stock is an eventual zero.? Granted, all insurance valuations are crunched now, but even with that, if selling the relatively transparent operations such as Hartford Steam Boiler brings so little, then unless the whole sector turns, AIG has no chance.? Along the same lines, I don’t expect the “rescue” to be over soon, and I expect the US govenment to take a significant loss on this one.

The second article is from Bethany McLean of Vanity Fair.? I remember reading her writings during the accounting scandals at Fannie Mae.? She was sharp then, and sharp now.? There were a loose group of analysts that went under the moniker “Fannie Fraud Patrol.”:? I still have a t-shirt from that endeavor, from my writings at RealMoney, and my proving that the fair value balance sheets of Fannie were unlikely to be right back in 2002.

Again, there is a growing bubble, as with AIG.? The need to grow income leads Fannie and Freddie to buy in mortgages that they have guaranteed, to earn spread income.? It also leads them to buy the loans made by their competitors.? It leads them to lever up even more.? It leads them to dilute underwriting standards.? Franklin Raines’ goals lead to accounting fraud as his earning targets can’t be reached fairly.

One lack in the article is that the guarantees that Fannie had written would render Fannie insolvent at the time the Treasury took them over.? On a cash flow basis, that might not happen for a long time, but it would happen.? Defaults would be well above what was their worst case scenario, and too much for their thin capital base.

The last article is another three part series from the Washington Post that is about the failure of our financial markets.? (Here are the parts — one, two, three.)? What are the main points of the article?

Bailing out LTCM gave regulators a false sense of confidence.? They relished the micro-level success, but did not consider the macro implications of how speculation would affect the investment banks.
Because of turf and philosophy conflicts, derivatives were left unregulated.? (My view is that anything the goverment guarantees must be regulated.? Other financial institutions can be unregulated, but they can have no ties to the government, or regulated financial entities.
The banking regulators failed to fulfill their proper roles regarding loan underwriting, consumer protection and bank leverage.? The Office of Thrift Supervision was particularly egregious in not doing their duty, and also the the SEC who loosened investment bank capital requirements in 2004.
Proper risk-based capital became impossible to enforce for Investment banks, because regulators could not understand what was going on; perhaps that is one reason why they gave up.
The regulators, relying on the rating agencies, could not account for credit risk in any proper manner, because the products were too new.? Corporate bonds are one thing — ABS is another, and we don’t know the risk properties of any asset class that has not been through a failure cycle.? Regulators should problably not let regulated entities use any financial instrument that has not been through systemic failure to any high degree.
Standards fell everywhere as the party went on, and the bad debts built up.? It was a “Devil take the hindmost” situation.? But as the music played, and party went on, more chairs would be removed, leaving a scramble when the music stopped.? Cash, cash, who’s got cash?!
In the aftermath, regulation will rise.? Some will be smart, some will be irrelevant, some will be dumb.? But it will rise, simply because the American people demand action from their legislators, who will push oin the Executive and regulators.

A few final notes:

Accounting rules and regulatory rules were in my opinion flawed, because they allowed for gain on sale in securitizations, rather than off of release from risk, which means much more capital would need to be held, and profits deferred till deals near their completion.
This could never happened as badly without the misapplication of monetary policy.? Greenspan enver let the recessions do their work and clear away bad debts.
Also, the neomercantilistic nations facilitated the US taking on all this debt as they overbuilt their export industries, and bought our debt in exchange.
The investment banks relied too heavily on risk models that assumed continuous markets.? Oddly, their poorer cousin, the life insurers don’t rely on that to the same degree (Leaving aside various option-like products… and no, the regulators don’t know what is going on there in my opinion.)
The insurance parts of AIG are seemingly fine; what did the company in was their unregulated entities, and an overleveraged holding company, aided by a management that pushed for returns and accounting results that could not be safely achieved.
The GSEs were a part of the crisis, but they weren’t the core of the crisis — conservative ideologues pushing that theory aren’t right.? But the liberals (including Bush Jr) pushing the view that there was no need for reform were wrong too.? We did not need to push housing so hard on people that were ill-equipped to survive a small- much less a moderate-to-large downturn.
With the GSEs, it is difficult to please too many masters: Congress, regulators, stockholders, the executive — all of which had different agendas, and all of which enoyed the ease that a boom in real estate prices provided.? Now that the leverage is coming down, the fights are there, but with new venom — arguing over scarcity is usually less pleasant than arguing over plenty.
As in my blame game series — there is a lot of blame to go around here, and personally, it would be good if there were a little bit more humility and willingness to say “Yes, I have a bit of blame here too.”? And here is part of my blame-taking: I should have warned louder, and made it clearer to people reading me that my stock investing is required because of the business that I was building.? I played at the edge of the crisis in my investing, and anyone investing alongside me got whacked with me.? For that, I apologize.? It is what I hate most about investment writing — people losing because they listened to me.

The Shadows of the Crisis: Past and Future

Posted on 30 December 2008 by David Merkel

Should the Fed have intervened on LTCM?? My answer is no.? It set up the seeds of the present crisis, and encouraged the Fed to meddle in places where there is no significant legal basis to do so.? If they had let LTCM fail, the debts of the system would have shrunk more, and the system would not have failed, as it seems to be doing today.? It would have been a salutary check that would have brought us back to reality.? (Now, would that they had not loosened so much in 2002, 1995, and 1991, but that is another story….)

The failure of LTCM did have some positive effects on me.? It made me more skeptical about arbitrage, leverage, and illiquidity, at least to the degree that one has to be paid to take on these risks.? Also, that hedge funds as a group posed some systemic risk, even if none were as big as LTCM.

But now consider a problem in our future.? Is Social Security a Ponzi Scheme?? (I like Eddy and Jim, so this is not about either of them… I have been writing about this for 15 years.)? I don’t typically call it that, not because there aren’t some elements that resemble a Ponzi Scheme, but because it loses the writer credibility on the broader issues involved.? Rhetoric matters, and even tone of voice matters.

In analyzing Social Security and Medicare, the first thing one must do is unify them with the US Government, and consider them as a whole.? The US Government has moved two two plans off-budget and on-budget at their convenience in order to make the deficits look smaller.

When one looks at the system as a whole with current US Government borrowing, one sees the imbalance.? Many say, “The trust fund won’t run out of money until 2042,” or “Inflows will exceed outflows until 2022.”? The trouble is, we are at the peak now of inflows over outflows.? Starting four years from now, when Obama is a lame duck, that overage will shrink.? As the overage shrinks, taxes will have to be raised, or borrowing will have to rise.? And all of this is on top of what we have done in 2008, and will do in 2009, where the deficits are as aggressive as in wartime.? From an old CC post:

		David Merkel
		Every Little Help Creates a Great Big Hurt
		8/23/2007 5:09 PM EDT

So there are some that want the US Government to bail out homeowners. Need I remind them that on an accrual basis, we are running near record deficits? Never mind. In another 5-10 years, it won’t matter anymore, because foreigners will no longer fund the gaping needs of the US Government as the Baby Boomers retire.

But so as not to be merely a critic, let me suggest an idea to aid the situation. Income tax futures. We could speculate on the amount the US Government takes in, and the IRS could use it for hedging purposes. One thing that I am reasonably sure of: tax rates will be higher ten years from now, and I would expect the futures to reflect that.

Position: long tax payments

I have focused on the latter half of the 2010s as my period for when the US will face a crisis, because then it will become obvious that the US can’t make good on all of its promises.? Well, the government is testing the boundaries of crisis now.

What everyone who relies on Social Security and Medicare should know is that those programs are subject to the will of Congress.? They could eliminate them tomorrow and no one could sue for damages.? “Wait, I paid into that for 40 years!”? Sorry, you paid extra taxes for 40 years, the law had no provision guaranteeing results for any individual.

All of that said, I am reminded about what former Senator William Proxmire said about Social Security.? (I met him at my High School when I was 16 — when I shook hands with him, there was no one else there, just me and him; I felt honored, particularly as he was a rare politician at that time who would not spend aggressively to win elections.)? He said that all Social Security benefits would be paid, but the purchasing power of those benefits would be limited.? That is a common sense warning from a man who knew that you can’t get something from nothing.

That brings us back to the present.? You can’t get something from nothing.? Why should you expect the government to rescue us from this crisis?? Who will lend us the the money/resources?? What return are they expecting?? What happens if we default?

I’m not specifically worried about Social Security anymore, because we are presently testing the boundaries of what the US Government can borrow at present.? I don’t precisely know where that limit is.? In implicit terms, we are past the debt limit if one includes that Social Security deficit.? But foreign powers, OPEC and China, can fund the US for their own reasons, even when US creditworthiness is scant.

If I were advising the governments of Saudi Arabia or China, I would tell them: sunk costs are sunk.? Do what maximizes value for your people from here.? That might break the current cycle where they support the US.

What I have written here outlines what we might expect over the next decade.? I hope and pray that matters prove better than what I expect.