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Technorati Tags Economic Indicators, unemployment

Employment as measured by the “establishment survey,” was down by 190,000; and Many feel it is an improvement that we are not falling as fast.

Well, let us take a moment to look under the hood of these numbers. First, while the establishment survey was down 190k, the number of unemployed soared by 558,000, to 15.7 million, as measured by the household survey. The establishment survey is taken from large businesses while the household survey calls individual households. It is the household survey that sets the unemployment rate. The establishment survey of companies doesn’t count the self-employed and undercounts employees of small businesses. So the economic picture is probably worse than the headlines when it comes to jobs.

Let’s look at the establishment survey. The actual change in unemployment for October was 641,000, not 190,000 which is seasonally adjusted. The so-called birth-death ratio added 86,000. Who knows if that is a reasonable statistical adjustment. While we should adjust the number seasonally, in the real world the jobs were still lost.

The total (U-6) employment rate has climbed to a record high of 17.5%. This is complied by adding in those employed part time for economic reasons. Total job losses since the onset of the recession now are approximately 10.5 million.

From John Mauldin we get this report from Greg Weldon (www.weldononline.com). Greg points out one of the issues with just looking at unemployment, because if you have not looked for a job in four weeks they no longer count you as unemployed:

Moreover, when we combine the monthly change in the number of Unemployed, with the number Not in the Labor Force, we might consider the result to be a proxy for the actual ‘change’ in the underlying labor market situation … in which case, October’s figure of 817,000 represents the fourth LARGEST yet, behind last month’s (September’s) second largest figure of 1,021,000 … for a two-month combined figure of 1.838 million, in newly Unemployed, or no longer ‘in’ the Labor Force …

… the second LARGEST two-month total EVER posted, barely trailing the December-08/January-09 total 1.955 million.

Bottom line … basis this measure AND the ‘Total Unemployment Rate,’ we could conclude that not only is there NO ‘improvement’ in the labor market, but moreover, that it continues to DETERIORATE, intently.

Of course, unemployment is typically a lagging indicator, but not always. In a “balance sheet” recession where home price declines, rising defaults (yes they are still rising) credit losses, a wave of foreclosures as large or larger than the subprime tsunami and deleveraging are in motion, unemployment rising at the rate we are seeing now is likely to be a significant drag for years to come.

Looking back at 1982, which so many people told us was far worse than today could ever be, we see households dealing with similar “levels” of unemployment with more than three times the debt load and half the savings. Workers are finding it takes longer to find work than in 1982. The count of people jobless for six months or longer stands at a record 5.6 million.

There was a bright spot, though it is so early we might see it revised down or a statistical aberration. Temporary employment grew by 33,700 jobs, its third straight month of gains after steep losses earlier this year. Typically employers add temporary workers before hiring permanent ones.

The even uglier fact. Average hours worked still stands at 33, a record low. Two important things to be gleaned form that number:

1. The unemployment number is much lower than it otherwise would be because workers hours have been cut rather than jobs lost.
2. Hiring is likely to be slower than normal as early on we will see hours worked rise rather than bring in new employees.

So how are companies beating their estimates amidst all this gloom? First off, they always beat their estimates. They are not beating the estimates of a year ago, or six months ago, or even three months ago. They are beating the estimates which keep getting chopped almost until they are reported. The estimates six months out from now are unlikely to be met, but by then they will be reduced yet again.

Still, profits are better than many expected six months ago, even if they are worse than the analysts estimates from then as well. Why? John Forsyth gives us the skinny:

The genius of American business for doing more with less has been evident in the parade of earnings reports showing profits improving far more than the revenue that produces them. The secret: Productivity soared at a 9.5% annual rate in the third quarter, a stunning increase that was nearly half again as much as economists had projected. Business cut labor costs at a 5.2% annual rate, with total hours falling at a 5% pace. Fewer workers worked fewer hours.

That is a recipe for deflation and slow growth if it doesn’t reverse. Profits can only be improved by cost cutting for so long, and the carnage amongst workers is made even worse.

Charts are courtesy of Barry Ritholtz. Also posted at The View From the Bluff.

Posted via email from Risk and Return’s Posterous

Technorati Tags economy, Employment, investing

Here is part I:

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Technorati Tags credit crisis, deflation, Economic Indicators, Economics, housing, Housing Market, Inflation, investing, markets, monetary policy, Risk, subprime

Click for larger version of charts.

Technorati Tags economy, Employment, New York Times

The cure for our housing crisis is prices coming down and all the pain that comes with it. Making them “affordable” through extra low interest rates just creates a new crisis down the road.

Technorati Tags Charlie Mayer, debt crisis, Glenn Hubbard, housing crisis, Housing Market

Technorati Tags Automobile Industry, bailout, banks, Big Three, Hank Paulson, Treasury

The sad thing is that it isn’t only “liberal” economists, it is the meat of the profession and plenty of so called “conservative” politicians.

Hat Tip: McQ

Technorati Tags Barack Obama, Economics, economy, fiscal stimulus, Fred Thompson, Humor, Politics

We keep hearing about positive signs month after month, but the latest data on the housing markets shows the pace of declines has been accelerating and widening, not slowing down.

In my opinion this is good. The decline in prices of overvalued assets is a good thing, whether houses, stocks or debt. The problem has been overvalued assets, the cure is lower valuations. it is uncomfortable (to say the least) if you hold those assets and assumed their prices would stay high, but the price of them staying high was huge. Decades of low returns, unstable asset markets from even more outrageous pricing levels (making the eventual correction even worse) an inability for savers to profitably put money to work without taking on enormous risk and housing prices straining the ability of consumers to rationally house themselves (and leading to a need for more debt to maintain standards of living.

This highlights that the amount of debt which will need to be written off or through government fiat (and lots of cash) magically made good is still nowhere near finished. My long standing estimate of 1.2 trillion in writedowns now looks positively quaint, when a year ago I was considered a fear mongerer. So far our government has deployed over 7.7 trillion to try and paper over this disaster. The ultimate likely losses from all manner of debt to financial intermediaries (whether or not they are recognized or disguised by the government balance sheet) is climbing way past 2 trillion and the ceiling on that number is very hard to confidently set:

“All three aggregate indices and 13 of the 20 metro areas are reporting new record rates of decline. Looking at the returns of the U.S. National Index, prices are back to where they were in early 2004. As of September 2008, the 10-City Composite is down 23.4% from its peak, the 20-City Composite is down 21.8% and the National Composite is down 21.0%.”

I still believe the Case-Shiller index will decline at least 35% peak to trough, and adjusted for inflation will bottom out around 50% from its all time peak before all is said and done. From Barry Ritholtz:

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Technorati Tags Case-Shiller, credit crisis, Housing Market, Valuation

As one of the few who saw this crisis coming and how it might play out across the board, not just in particular areas, he deserves a listen. As one of the most successful investors of the last 30 years he would warrant a listen anyway.

Watch the whole thing.

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Technorati Tags Asset Allocation, credit crisis, Emerging Markets, equities, Housing Market, investing, Jeremy Grantham, Risk, value investing

The resentment, irritation, condescension and, at times, outright hostility to my Cassandra act makes me wish I had a video of my own. Sigh…

Oh well, it pays to remember that Cassandra was right. I was never as sure of myself as Peter, but risk management isn’t about knowing you are right, but knowing what could go wrong and whether it is likely enough to act upon.

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Technorati Tags credit crisis, financials, investing, Peter Schiff, Risk

The Fed’s massive and numerous liquidity facilities are making things worse. The problem is more than banks unwilling to lend to each other, they are also unwilling to borrow from each other. Banks can get all the funding they need (and then some) from their central bank so they do not need to seek a loan from another bank. I believe it has gotten so bad that they don’t even bother to make a decent market for inter-bank loans anymore. No reason to, they don’t need them anymore as central banks have replaced them.

I would suggest more subtle factors should also be emphasized besides how this distorts rates on loans. If banks do not need each other then they don’t communicate. Thus the hard work of investigating what counterparties real credit risk is goes undone. The market is shunting that off to governments. Furthermore, banks have no incentive to arrive at a believable accounting of their assets, they can wait and hope for a bailout rather than find a way or terms that other banks will accept.

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Technorati Tags banks, central banks, credit crisis, Federal Reserve, lending

JP Morgan is a special discussion, because I point out a rather astonishing fact, they have a notional exposure to around 90 trillion in derivative contracts, or did last March (pdf.) 58 trillion of it swaps of some sort. Probably credit default swaps (CDS) are the majority. Which means…what? I don’t know, and frankly if anybody really does they aren’t telling me. In essence I am left telling people that I have to treat that as a “black box.” Not exactly confidence raising. Personally there are better ways to make money than hoping a company with 90 trillion in derivatives exposure has a handle on it in my book, but then again, I am admitting that I have no idea what I am talking about, and cannot find anyone else who does either.

Warren Buffet often speaks of defining a circle of competency when investing and staying inside it. It doesn’t matter how big the circle is, just knowing when you are inside it. Well, 90 trillion in derivatives exposure is outside of my circle of competency to assess.

The nightmare is what if it is outside of JP Morgans circle? I suspect it is, and the massive exposure of two other banks as well (Citibank and Bank of America have approx. 38 trillion apiece.)

What makes me wonder about it today? Personally I have always felt that there was a good chance that JP Morgan was who was being saved when the Fed brokered the acquisition of Bear Stearns. Bear goes under and JP Morgan would have to come up with huge payments on CDS contracts. Also, I suspect that Bear was a counterparty for a large number of derivatives, which if Bear was insolvent might not have all been paid up. Or maybe not. Then I see this over at Barry Ritholtz’s:

“Lehman Brothers Holdings Inc.’s main lender and clearing agent, JPMorgan Chase & Co., caused the liquidity crisis that led to Lehman’s collapse, creditors said.

JPMorgan had more than $17 billion of Lehman’s cash and securities three days before the investment bank filed the biggest bankruptcy in history on Sept. 15, the creditors committee said in a filing Oct. 2 in bankruptcy court in Manhattan. Denying Lehman access to the assets on Sept. 12, the bank “froze” Lehman’s account, the creditors claimed.

JPMorgan, the biggest U.S. bank by deposits, financed Lehman’s brokerage operations with daily advances, while money market funds and other short-term lenders provided overnight loans, according to bankruptcy court documents. When JPMorgan shut Lehman off from funds, Lehman “suffered an immediate liquidity crisis that could have been averted by any number of events, none of which transpired,” according to the filing.

The creditors asked the judge in charge of the case to let them interview a witness and request relevant documents from JPMorgan and to pursue possible legal claims. U.S. Bankruptcy Judge James M. Peck is scheduled to hold a hearing Oct. 16 on that request, the creditors said.”

Hmmm, so Lehman may have been torpedoed by JP Morgan? Hardnosed but not weird, until this little tidbit in the update:

Ron Kirby notes: “I wrote about a very strange occurrence – the reporting of J.P. Morgan “transferring” 138 billion dollars to Lehman, after Lehman had already filed for Chapter 11 bankruptcy early last Monday morning…It is highly likely [or a certainty on my planet] that J.P. Morgan was INSOLVENT and was “BAILED OUT” last Monday, September 15, to the tune of 138 billion dollars. This would explain why the Fed and Treasury dictated that Lehman fail – to disguise or otherwise obfuscate the recapitalization of or illicit transfer of 138 billion to A MUCH SICKER, TEETERING ENTITY, J.P. Morgan Chase.”

The link is filled with some rather out there speculation (and I have no intention of confirming or discrediting it) but this is a very odd transaction. Immediately after sending Lehman 138 billion they received 138 billion from the Federal Reserve. What were they off loading? Meanwhile they allegedly cut off Lehman.

Back to Bear. Was allowing JPM to take over Bear and the Fed guaranteeing most of their debt a back door method of recapitalizing a banking behemoth? Are the acquisitions that JPM has been making under very favorable terms a sign of strength or weakness? Gifts from the Federal Reserve to recapitalize them? How much trouble is in that book of derivatives?

I have already pointed out the problems in Europe, problems which the failure of AIG would have exacerbated due to their massive involvement in  the CDS market. Is it possible that JPM was also heavily exposed to a failure by AIG? With 90 Trillion in nominal exposure it is hard to imagine they were not. With that much exposure who could possibly be more of a candidate for the “too big to fail” label. Could the Fed be manipulating these events to save them without causing the kind of panic that Bear and the later victims have caused?

I don’t know, which is the real tragedy. Nobody knows what the exposure of anybody is, so we are all left guessing. The Federal Reserve, our government, the financial institutions themselves are all busy obscuring rather than bringing things to light. In order to avoid panic by showing us all how deep the problems are, they are busy spreading suspicion, distrust and panic by keeping everybody, including financial institutions they have to deal with, in the dark. The hope of generous terms from the government keeps banks from admitting what their books really look like, or to try and sell in an orderly manner what they have. Who needs to expose your books to potential lenders when the Federal Reserve will take a used car as collateral and at a lower rate.

How bad off are these institutions? We have no idea. We are left with our imagination and our nightmares.

Technorati Tags AIG, Bank Of America, banks, CDS, Citibank, credit crisis, Credit Default Swaps, Federal Reserve, finance, JP Morgan

On a similar note one of Yves Smiths commenters left this comment, which is well worth pondering when thinking of the bailout plan being considered:

One of the most critical functions of the banking system is converting short-term deposits into longer-term loans for businesses. Much of the working capital market, for decades has come via money market funds (MM). Joe public or Joe CFO deposits money into a MM. That MM loans it to a bank (usually by buying paper, and usually at a medium duration) and then that bank loans it out to business for inventory, payroll or whatever. The MM has converted Joe’s demand deposit into a fixed-duration loan.

The problem we’re having is that people are fleeing commercial MM for treasury MM. Those are buying treasuries and thus converting the money to the desirable medium duration BUT that money is loaned to the Fed, and the Fed doesn’t make working capital loans. So the deposited money that had been made into working capital has been diverted into the Fed and lost to working capital.

The Fed is kind of trying to address this by loaning out money via various auction/discount windows. BUT, those loans have been overwhelmingly overnight – a particularly nasty demand deposit because it goes back so fast. For a bank to convert that to a 90-day loan it’s got to win 90 auctions in a row – a very risky deal with a crunch on. So the Fed undoes the duration conversion, and then some, converting the liquidity into a form that the banks can’t make into useful-duration loans.

Right now we have both commercial and treasury MMs. Deposits have shifted from commercial MMs to treasury MMs, and consequently we have less working capital (a commercial MM product) and better credit for the Fed (a treasury MM product). But, treasury MM rates are now very low and the gap between treasury and commercial fairly high, which creates an incentive for depositors to put money into commercial funds, producing some working capital.

When Paulson dumps out his 700 billion in treasuries it’s going to be at the short end. That will drive up rates for short-term treasuries. This will obviously draw even *more* deposits into the treasury MMs. That means even less in the commercial MMs and thus less working credit, the eventual commercial MM product. Hence Paulson’s billions remove working capital by competing for the deposits that could get used to make working capital loans. That 700 billion is going to go to fairly long-term mortgage securities. So Paulson’s billions divert credit from working capital to long-term mortgages – from where it’s most needed to where it’s most wasted.

Even if the giveaway adequately props up the banks, which I doubt, they still can’t make working capital loans, because the raw material they used (commercial MM deposits) will be desperately short.

I think it’s very telling that in two days of hearings and two weeks of discussion we have yet to see *any* detailed mechanism for how Paulson’s plan will increase the supply of, say, inventory loans. It’s not that every economist in the world is an idiot, it’s just not going to help. I think people have fallen into the fallacy that if it costs a lot it must be valuable. Paulson’s plan falls into the category of very expensive way to hurt ourselves.

Technorati Tags bailout, Federal Reserve, Financial crisis, Hank Paulson, money markets, Treasury

1. Glass-Steagall repeal was not a major cause of the financial crisis, nor was government-induced “minority lending.”

I agree on the first, the second charge has some validity, but only in terms very different than the typical charge.

2. We should use regulation to move more of the currently unregulated derivatives markets to the clearinghouse model.

Bingo! Especially Credit Default Swaps.

3. The crisis represents a massive conjunction of both market and governmental failure.

Check.

4. I would not nationalize banks as ongoing concerns, at least not short of a far more extreme emergency than the current status quo.

Check.

5. The modified Paulson plan was better than nothing — especially after the market had been scared — but far from my first choice. In any case the plan would have been revised almost immediately. The Paulson and Dodd plans were never that far apart.

I disagree. No plan was better than the plan as advertised, though Michael has pointed out that it gives Paulson the opportunity to do some useful things.

6. My first choice is to induce and if need be to force more information revelation, identify the insolvent banks, close them up, and give the battle-tested FDIC a much greater role in the whole process.

This is the critical step, and we need to move as quickly as possible and begin a process of financial triage.

7. In the meantime the Fed should not worry much about inflation.

I agree. Deleveraging is inherently deflationary.

8. The critical deregulatory mistake was allowing excess leverage. Many deregulations get blamed but in fact contributed little to the problem.

I couldn’t agree more.

9. Everyone says that letting Lehman die was a big mistake but I’m not yet convinced. Maybe a bracingly high TED spread is what we need.

I am with him here.

10. Libertarians are overrating the moral hazard argument, as many equity holders have been wiped out.

True as to past actions, but they are not overstating the moral hazard of buying the bad assets at a price that might actually add meaningful capital into these institutions.

11. If someone is pushing conclusions and not identifying the potential weak points in his or her arguments, be suspicious. Also beware of anyone pretending to offer you simple answers.

Who can argue with that? This crisis will not be solved, but worked through. We will be struggling with this for years, not months.

12. I have a long and complicated view on the relevance of Austrian Business Cycle Theory which resists easy summation, but markets could have and should have been more cautious in response to Greenspan’s easy money policies.

Exactly. Whatever poor incentives were in place, whatever regulatory elements were lacking or unfortunately in place, that is no excuse for their behavior, their excess risk taking, the leverage employed or the dishonesty about their books.

13. Insolvent hedge funds and the commercial paper market remain outstanding issues which are not easy to address.

Insolvent hedge funds should die on the vine, the commercial paper market is a tough nut to crack.

14. I agree with Arnold Kling about relaxing capital requirements though at this point I don’t expect it to help much.

Check.

15. The crisis is complex and has many causes; there won’t be a simple or quick solution.

I agree. There is no solution, just trying to keep the ship from going down. We at best will be able to muddle through.

Arnold Kling responds to Tyler and adds several key elements which you will recognize from my comments:

In hindsight, I think that the crisis was caused by
a) creation of the secondary mortgage market (50 percent)
b) low down payment mortgages (30 percent)
c) the “suits vs. geeks” divide (15 percent)
d) other (5 percent)

Read his explanation of each. I can find no real complaint with them. I am going to highlight his suits vs. geeks divide. As someone on the geek side of this i admit to being biased:

My point about suits vs. geeks is that too many people did not understand the risk characteristics of these loans. I disagree with James K. Richards, who claims that the risk modelers got it wrong. The risk modelers told Richard Syron of Freddie Mac not to plunge into subprime lending with so little capital. The risk modelers at Goldman kept that firm from making the sorts of mistakes other companies made.

The decline in house prices was not a Black Swan. It was a highly plausible scenario. The problem is that the suits did not grasp the impact that such a decline would have on mortgage securities. The clueless suits include regulators, which explains why the crisis took them by surprise. It also explains why I do not trust them to come up with the best solution.

Decent, upstanding people say that we have to trust Ben Bernanke, Henry Paulson, Barney Frank, and other leaders. The public are considered rubes for not respecting the establishment. In this case, the public happens to be right. The suits are clueless.

I agree. These are smart people, but I don’t believe they understand what they are dealing with. Unfortunately the people who do are not qualified to make policy or hold office. This is a very troubling issue.

Risks:

The economic ship faces a number of icebergs. Oil markets are taking wealth out of the country. House price declines are taking paper wealth away from ordinary families. On the horizon, there could be an adverse shift in the terms of trade. The number of hours that the average American has to work to earn enough to buy a bottle of French wine, a pair of Italian shoes, or a Chinese-manufactured product could (should?) be much higher than it is today.

In this context, the consolidation in the financial sector is a relatively minor issue. The only policy challenge is to keep banks functioning. There are many ways to do that which do not involve speculating in mortgage securities.

Dead on.

Housing:

We need housing units to be occupied, at whatever rent or price clears the market. We need owners to be legitimate, meaning people who can afford reasonable down payments and mortgage payments. Getting from here to there is not easy, but I suspect that the more government intervenes, the longer and more painful the process will be.

I share that suspicion. The government at best should encourage dissemination of workable solutions and getting rid of legal obstacles to people taking advantage of them.

I do not think that the private sector is blameless. I do not think that the public sector is blameless. I do think that lobbying and corruption are endemic in the mortgage securities business. We ought to be trying to let that cesspool gradually dry up, rather than throwing taxpayer money into it.

I find it unsettling that Congressional leaders would announce that they have a deal and then fail to pass a bill. It used to be that the definition of having a deal was having the votes to pass legislation. It didn’t used to be a form of bluffing.

I find it unsettling that the establishment is promoting fears of another Depression. It used to be that worries about another Depression were confined to obscure books written by crackpots and lunatics. Today, the fear of a Depression is being promoted by the establishment, while those of us who are trying to remain calm and measured are treated as crackpots and lunatics.

My only disagreement is with the last statement. I have already discussed ways in which we are being frightened unnecessarily. I do believe that if not a depression, a severe and lengthy recession and sluggish growth for long afterward is a real possibility, if not probable.

It seems the three of us are not that far apart.

Technorati Tags banks, Chris Dodd, Credit Default Swaps, deregulation, Glass Steagle, Hank Paulson, regulation

In my previous post I discussed the balance sheets of our most highly leveraged institutions. Let us look at them a little closer. Let us go back to Lehman Brothers as a textbook case of what has been happening and why some of what we are being told is exaggerated.

It is no accident that the dominoes in the investment banking world have fallen in precisely the order of their gross leverage. Bear Stearns, Lehman and then Merrill. The next domino is Morgan Stanley in terms of both leverage and market pressure. We see the same pattern in Europe.

So let us look at Lehman Brothers.

Just prior to their collapse Lehman reported 600 billion in assets. Think about that number and reflect on why our government buying 700 billion in assets is such a tiny number relative to the problems we are facing. This is just one institution.

So why would an institution with 600 billion in assets be in trouble?

First, what are those assets? They include mortgage backed securities, commercial real estate and a host of securities including treasury bonds and bills. Most of those assets were not going to disappear.

The problem is that Lehman had only 20 billion in shareholder equity. What does that mean? It means it had liabilities of approx. 580 billion! To put it in plain english, they owed that much to various creditors in the form of customer obligations, counterparties, preferred stock holders, subordinated debt and senior bondholders. To figure out how much equity that the common stockholders had in the company you take 600 billion, subtract 580 billion and you get 20 billion. Given what happened to their stock price, and the lack of buyers for the company investors felt that 600 billion in assets was a bit fishy, subsequent accounting seems to have borne that out.

That does not mean that the assets were not substantial. The problem is that when one has 600 billion in assets and only 20 billion in equity your leverage is 30 to 1 (600 divided by 20 equals 30.) Therefore if the assets were written down by only a bit more than 3% it would wipe out the equity and make them officially bankrupt (3.4% of 600 billion is 20.4 billion.) In fact, it seems they were bankrupt.

So, were customers or counterparties at risk? Should this have led to a systemic problem? Not really. Those 600 billion in assets are worth something, in fact they are worth quite a lot. In Lehman’s case the equity plus various bondholders added up to 143 billion. So, the markdowns would have to exceed 143 billion before customers or counterparties were at risk. That would be exceedingly unlikely. What our treasury was concerned about was not customers or counterparties, but the bondholders! The goal there, with Bear Stearns (and with far more justification, Fannie and Freddie) was to protect the bondholders from the risk of default.

That is right folks, that is who your tax dollars bailed out in Bear Stearns and each other case, bondholders. We should be sickened.

So what does an institution in Lehman’s case try and do to shore themselves up? Raise capital so that their assets are even larger than their liabilities. They can issue stock, sell preferred stock which pays interest but it is only paid if they have the cash to do so, etc. The problem with Lehman was they were so weak that investors wouldn’t pay them enough per share issued to raise the amount of capital they needed. Preferred stock is only attractive if people believe you will stay in business as well and you are likely to be able to pay the dividend. Lehman was pretty much shut out of all the traditional methods of raising capital.

Is this an institution the plan I proposed would apply to? Possibly not. The key would be to force them to mark their assets lock stock and barrel to market, possibly sell the problematic ones at fire sale prices and see if the resulting write downs left enough cushion of shareholder equity and debt holders to eat through to keep the capital injection safe in case of default. The key is that stock and bondholders before accepting such a deal would have to see that the action would improve their situation enough to risk being wiped out in the case of stockholders, and having to stand in line for payment in a default situation in bondholders case.

Stockholders would never agree to such a deal unless they felt there was no other way, so it would be the bondholders who would hold the key. If the capital would be sufficient to allow the company to survive, they would go along with it. If all it would accomplish was for a failing institution to go on losing money a while longer they would just ask for bankruptcy. The balance sheet would be the key.

From the taxpayers standpoint, the treasury would make the same calculation. If a sufficient amount of capital would leave too thin a cushion of bondholder liabilities to cover us in the case of default, we allow them to go into bankruptcy or call in the FDIC (for banks) to liquidate.

Let us go back to Hussman:

Look at the insolvent balance sheet again. The appropriate solution is not for the government to purchase bad assets with public money. The only way such a transaction would add to the institution’s capital would be for the government to overpay for those assets. Rather, the government should either a) provide new capital, taking a claim in front of the company’s bondholders and stockholders, or b) execute a receivership of the failed institution and immediately conduct a “whole bank” sale – selling the bank’s assets and liabilities as a package, but ex the debt to bondholders, which preserves the ongoing business without loss to customers and counterparties, wipes out shareholder equity, and gives bondholders partial (perhaps even nearly complete) recovery with the proceeds.

Let’s now look at Morgan Stanley:

For example, consider Morgan Stanley’s balance sheet as of 8/31/08. Total assets were $988.8 billion, with shareholder equity (including junior subordinated debt) of $42.1 billion, for a gross leverage ratio of 23.5. However, the company also has approximately $200 billion in long-term debt to its bondholders, primarily consisting of senior debt with an average maturity of about 6 years. Why on earth would Congress put the U.S. public behind these bondholders?

Why indeed?

The answer is the credit markets. When Lehman failed one systemic risk was a problem, that is the risk that without knowing who was in what kind of shape nobody wants to be the bondholder left holding the bag. Hence the run on money markets following Lehman’s collapse.

The answer isn’t to bail Lehman or others out, it is to clarify for the market who is and isn’t solvent. That however will have to wait for another post.

The key point to be made, is that the nonsense about systemic risk due to customers and counterparties not being made whole with a cascade of defaults is not true, and there is no excuse for our media, our politicians and others to try and panic us into believing otherwise. We can survive a large number of failed financial institutions, even if it is not pleasant.

I should also point out that our commercial banks are not as leveraged as the investment banks, so they are far less problematic.

Technorati Tags bailout, banks, credit crisis, debt, Hank Paulson, investment banks, John Hussman

Today I would like to endorse one proposal that aligns exactly with my thoughts on this, which is we need to recapitalize banks in a more effective, less arbitrary manner while protecting taxpayers and homeowners as well.

John Hussman (a long time favorite of mine) has written an open letter to Congress that unfortunately few Congressman or women are likely to read, and it reminds me of the Chilean experience McQ posted about here. Nor is it being debated in the press. This is sad, so hopefully whether the new bailout bill passes or not, we can see our approach restructured along these lines eventually:

1) Public funds must function to increase the capital of distressed financial companies, not simply to take bad assets off of the balance sheet at market value (which may improve the “quality” of the balance sheet, but does nothing to improve the capital cushion and therefore little to avoid future runs on the institution).

2) In return for these funds, the government should NOT take equity (which is a subordinate claim and also creates potential conflicts of interest), but instead should take a SENIOR claim that precedes not only the stockholders but also the senior bondholders in the event the company defaults anyway. Congress may need to make some modification to existing bankruptcy law or provide for expedited bondholder approval to do this, but essentially, the government’s claim should be subordinate only to customers in the event of default, and senior to both stockholders and bondholders. However, it should also be countable as capital for the purposes of satisfying bank capital requirements.

3) Ideally, the rate of interest on such funds should be relatively high (which will encourage these firms to substitute private financing as soon as possible), but actual payment should be made once the firms are again profitable so that the payment burden does not weaken them during the present recession.

4) The bill should allow for expedited bankruptcy resolution for these institutions, so that in the event of failure, the “good” bank (all assets and customer liabilities, but excluding debt to bondholders) can be cut away and liquidated to an acquirer as a “whole bank” sale. For nearly all of these institutions, the debt to bondholders is far more than sufficient to absorb any losses even in the event of bankruptcy. The current difficulty is that the bankruptcy process itself draws out the process of taking receivership, cutting away the good bank so that it can be sold to an acquirer, and delivering the proceeds as a residual to bondholders. Streamlining that process is one of the best ways to ensure that the failure of one institution does not have “systemic” effects.

5) To assist homeowners, the bill should allow for a reduction of mortgage principal during foreclosure, but the mortgage lender should also receive a Property Appreciation Right (PAR) that gives the original lender a claim on future property appreciation up to that original mortgage amount. In other words, the homeowner receives a substantially lower mortgage balance and payment burden now, but the lender stands to be made whole over time through property appreciation rather than immediate burdens on the homeowner to make payments.

I think number 5 is key. It helps people who want to stay in their home, but the PAR allows for the bank to have a more valuable asset on their books than the value of the renegotiated mortgage itself. Note: the PAR needs to stay with the property, so if it is sold the buyer still owes the mortgage company. It would be an assumption in other words. This way the pain is shared by homeowners and financial institutions, while market pricing still is allowed to work.

One of the issues which has bothered me throughout this crisis has been the bailout of senior bond holders in most of the interventions so far. The rationale has been that customers and counterparties were being protected, bond holders merely were being brought along for the ride. Lucky them.

However, that has not been true in any of these bailouts with the possible exception of AIG. If these institutions had been liquidated in an orderly manner there were more than enough assets to cover counterparties and deposits. John does a good job of educating us as to why that is true and expands upon that in his letter, so read the whole thing. More on that can be found here in, September 29, 2008 – You Can’t Rescue the Financial System If You Can’t Read a Balance Sheet:

1) as the assets of a financial company lose value, the losses reduce the asset side of the balance sheet, but also reduce shareholder equity on the liability side;

2) as the cushion of shareholder equity becomes thinner, customers begin to make withdrawals;

3) in order to satisfy customer withdrawals, the financial company is forced to liquidate assets at distressed prices, prompting a further reduction in shareholder equity;

4) go back to 1) and continue the vicious cycle until shareholder equity goes negative and the company becomes insolvent.

Let’s return to the basic balance sheet of a typical financial company before the writedowns:

Good Assets: $95
Questionable Assets: $5
TOTAL ASSETS: $100

Liabilities to Customers: $80
Debt to Bondholders: $17
Shareholder Equity: $3
TOTAL LIABILITIES AND SHAREHOLDER EQUITY: $100

Now let’s write down the questionable assets – not all the way to zero, but to $2:

Good Assets: $95
Questionable Assets: $2
TOTAL ASSETS: $97

Liabilities to Customers: $80
Debt to Bondholders: $17
Shareholder Equity: $0
TOTAL LIABILITIES AND SHAREHOLDER EQUITY: $97

This shortfall of protection on the liability side of the balance sheet is what causes a run on the institution, because once shareholder equity is gone, the only way to get at the debt to bondholders is for the company to declare bankruptcy. The concern has been that continuing bankruptcies would throw the whole financial system into disarray, especially for investment banks having lots of counterparty relationships with other institutions. But the reality is that for nearly all of these institutions, the cushion of debt to bondholders has always been more than sufficient to protect customers from losses even in the event of bankruptcy.

What the financial system has needed most has been for Congress to streamline the bankruptcy process for investment banks, so that in the event of failure, the “good bank” (assets and liabilities, ex the debt to bondholders) could be cut away quickly and liquidated to an acquirer, leaving the proceeds as a residual for the bondholders. Indeed, that’s exactly how it works for regulated banks. What investors overlooked in last week’s panic was that we actually saw the largest bank failure in history – Washington Mutual – with absolutely no losses to customers or the U.S. government, precisely because the good bank was seamlessly cut away and sold to J.P. Morgan, wiping out shareholder equity, preferred equity, and subordinated debt, with partial repayment to the bondholders. Snap – just like that.

Now, let’s go back to the previous balance sheet. The Treasury plan seeks to buy up those questionable assets and thereby protect the institution against failure. Problem is, suppose the Treasury buys those questionable assets at their going value of $2. Here’s the result:

Good Assets: $95
Cash Proceeds from Sale of Questionable Assets to Treasury: $2
TOTAL ASSETS: $97

Liabilities to Customers: $80
Debt to Bondholders: $17
Shareholder Equity: $0
TOTAL LIABILITIES AND SHAREHOLDER EQUITY: $97

Does this transaction protect the institution against failure? No! If you buy the bad assets off the balance sheet at their market value, nothing changes on the liability side! You may have improved the “quality” of the balance sheet, but you’ve provided no additional capital. At best, you’ve allowed the bank to liquidate its assets more easily to meet continuing customer withdrawals in the vicious cycle described above.

The only way that buying the questionable assets will increase capital on the liability side of the balance sheet is if the Treasury overpays for them.

Hussman also makes a good point about Warren Buffett’s investment in Goldman Sachs:

As a side note, a lot has been made of Warren Buffett’s investment in the senior preferred stock of Goldman Sachs. But it’s notable that Buffett invested in Goldman only upon the conversion of Goldman to a bank holding company, which puts it under a different regulatory structure that gives it access to the Fed window. Goldman’s balance sheet has $40 billion of shareholder equity that would have to be drilled through before getting at the preferred. Evidently, Buffett believes that Goldman’s asset mix is diversified enough, and light enough in mortgage assets, that Goldman won’t take a major haircut on its entire (largely hedged) portfolio of assets.

Buffett’s investment may reflect confidence in Goldman, particularly with a government backstop on whatever questionable assets it does own, but if anything, it suggests that the government should have gone the same route – namely, provide capital in return for a financially viable security that is senior to common shareholder equity, have it accrue a relatively high rate of interest, and allow it to be repaid early (Buffett’s preferred is callable by Goldman) as soon as the financial institution can secure cheaper financing.

Instead, the government is taking on financially non-viable securities and warrants on common equity, while failing to improve the capital position of these financial companies at all (unless it overpays). Taxpayers will not make money here.

As Congressman Scott Garrett noted to taxpayers on Sunday, “This morning we should be very much alarmed. Obviously, Washington is not listening to your wishes. Those who used to work for Goldman Sachs will support this deal. Those who have blocked reform in the past will support this deal. I will not support this deal.” I couldn’t agree more. This is not a good deal, because it will waste taxpayer money without addressing the fundamental solvency problems.

That last comment is very important. There are many problems with the current approach from a ethical, ideological (from all parts of the spectrum) and long term viewpoint. All of which might make sense anyway of the plan were in any way likely to be a good short term solution. The problem is that it isn’t.

I’ll put up a few twists on John’s proposal in the coming days, which some will find more or less appealing. However, it should be cautioned, none of this will likely avoid pain, a recession or poor asset performance for some time. This will be years in the fixing, and it will be a drag on growth for some time. Shuffling the burdens to allow for price discovery and functioning markets will avoid disaster, closing weak institutions, which needs to begin in earnest, will allow healthier institutions and new market participants room to grow. It will not change the fact that the losses exist, that they will have to be paid for, that the nominal and real wealth of the US will have shrunk, that consumers and our own economy will need to delever (reduce debt) and all the pain which that entails.

Technorati Tags banks, credit crisis, debt, economy, Goldman Sachs, Housing Market, investment banks, John Hussman, Paulson Plan, Warren Buffett

The Senate proposal would cost more than $100 billion and extend and expand many individual and business tax breaks, including tax credits for the production and use of renewable energy sources, like solar energy and wind power.

The bill would also extend the business tax credit for research and development, expand the child tax credit, protect millions of families from the alternative minimum tax and provide tax relief to victims of recent floods, tornadoes and severe storms.

In a delicious bit of soon to be civics geek trivia, the Senate worked around the Constitutional restrictions against voting on tax legislation not already considered by the House by attaching the bailout plan along with a tax extender bill to the Mental Health & Addiction Act (which passed the House several months ago).

You gotta love our government.

In addition to the Paulson plan details, various tax cuts and dealing with the AMT it includes a very helpful proposal, increasing government insurance on bank deposits from 100k to 250k.

Technorati Tags bailout, Paulson Plan, Taxes

Well Yves, Paul has a nice little summary, but I’ll suggest a more detailed look from the same people here. It is truly hair raising. I am more concerned about the fallout from overseas collapses than I am about our own ability to get through this.

Technorati Tags AIG, credit crisis, europe, European banks

Money tends to go where it is best treated, as measured by an asset class, hedge fund or by a traditional investment adviser. As a result, a lot of money will be shifting by year-end, and it is bound to have a disruptive market effect as well as likely to feed continued volatility.

If you delegate investing to an adviser, here are several questions that you may consider asking during a 2008 year-end review of your investment performance:

1. What were your adviser’s expectations for the stock market’s returns in 2008, and how did these expectations compare to the actual results?

2. How did your investment performance compare to that of the major indices? In what areas did you outperform, and in what areas did you underperform — and why?

3. What was your adviser’s economic and credit expectations, and how did these expectations compare to the actual events? Where and why were his assumptions wrong?

4. Did your adviser change his strategy as economic and financial events changed? If he didn’t, ask why?

5. Did you experience outsized individual stock or large specific industry or sector share price losses? Did your adviser institute a discipline to stop losses, or were your losses allowed to compound? Did your adviser “double down” on poor investments?

6. Ask your adviser whether he “eats his own cooking” — that is, did he invest along with you in the same investments, and are both of your interests aligned?

Briefly, I think I will answer for those of you who do invest with us, how I would answer the questions. Feel free to question us more closely in person. Note: While this discussion applies broadly to all of our clients, it is specifically addressed to the vast majority of our assets under management, accredited and qualified investors (those with a net worth of 1 million and up) in our model portfolio’s.

1. What were your adviser’s expectations for the stock market’s returns in 2008, and how did these expectations compare to the actual results?

In our case this discussion really should not be constrained to 2008. We believe we are in the midst of a long term bear market that began with the bursting of the tech bubble in 2000, especially for US financial assets. We participated in the cyclical bull that began in 2003, with significant allocations to international, emerging market, real estate and other high flying assets. Starting in 2006 we began to become more defensive as valuations became more and more unreasonable, allowing our portfolio to move forward based on those areas we felt were most attractive. That allocation allowed us to post strong results through the third quarter of 2007, but the portfolio was dominated more and more by assets not dependent on the general direction of the market. By 2007 we felt returns were likely to turn negative, the economy would struggle and a defensive portfolio was the most prudent path. We had by February of 2007 scrubbed nearly all exposure to financial stocks from our portfolio.

In general our expectations have been met. The markets, especially financial stocks have struggled. Following our strong showing through the first three quarters of 2007 we had a strong burst in the fourth quarter as the markets in the US fell. We weathered the storm in January with a small gain and when all was said and done had a solid first half of the year, with positive returns in each quarter, with solid gains in June to finish off the second quarter.

We began to have concerns short term with our exposure to commodity stocks, especially energy, and hedged that exposure somewhat. We assumed that some of the relationships in our hedged positions might have a short term reverse as well. Unfortunately all of our main performance drivers reversed from the middle of July to the middle of August. It was unusual that all would reverse at the same time, as opposed to being spread out. Unfortunately most, if not all, of our gains during 2008 were lost, though we were still positive since the downturn in the broader equity markets began in October. We feel that most of what we are doing now is still well positioned, with the most likely trouble spot being our unhedged positions, specifically commodity stocks and Asia. Depending on their relative performance we will have a flat to positive end to the year. Our expectation is we will finish the year with returns in the high single digits, which is what we expected at the beginning of the year.

What about surprises? The relative strength of small cap and real estate stocks stick out. We feel they will resume their under performance going forward. Commercial real estate is starting to roll over and we expect that to weigh on REITs. Small cap stocks are still very overvalued, and earnings likely to continue to disappoint. As credit markets and the economy become even more strained access to credit will hit them hard. If they struggle greatly relative to larger, higher quality stocks we could see our expected return numbers increase markedly.

2. How did your investment performance compare to that of the major indices? In what areas did you outperform, and in what areas did you underperform — and why?

We have outperformed broad market indices handily year to date, since the downturn began, and for trailing one, three and five year periods. Heck, we are positive for the year! Accomplishment enough, if unspectacular. Compared to the indices the various areas of our portfolio have performed from okay to fantastic. No major underperforming areas.

3. What was your adviser’s economic and credit expectations, and how did these expectations compare to the actual events? Where and why were his assumptions wrong?

We felt the US faced a high probability of a recession coupled with a worldwide slowdown. We felt the credit markets were the most vulnerable, due to a severe housing downturn, and inflation would be an concern. Interest rates were a bit uncertain since, with inflation an issue and growth vulnerable, the fed would be pushed in both directions. More importantly, due to the difficulties in the credit markets we felt interest rates would be relatively insensitive to the federal reserves efforts and interest rates would remain stubbornly high, with credit spreads likely to widen dramatically. Thus we felt diversifying credit exposure internationally would be prudent and bonds would not be as positive a counter to equity risk as they were in the last downturn.

That has all come true, but our moves to diversify in fixed income have not proven of much benefit. However, our emphasis on other strategies to reduce risk versus fixed income has added value, demonstrating that an over reliance on traditional fixed income to protect in a downturn would not be optimal. In fact, fixed income has been a drag on performance on both the upside and downside of the market over the last two years for us.

4. Did your adviser change his strategy as economic and financial events changed? If he didn’t, ask why?

Yes, though our change occurred before the downturn. We have made some small tactical changes as the year has progressed, though our fundamental approach we feel is still sound. We are preparing for some significant changes in the near future, especially if the equity markets weaken substantially from here and we position the portfolio for a more positive market environment.

5. Did you experience outsized individual stock or large specific industry or sector share price losses? Did your adviser institute a discipline to stop losses, or were your losses allowed to compound? Did your adviser “double down” on poor investments?

This question really doesn’t apply to us since we don’t trade individual securities, though we have hedged positions where one side or the other have struggled. That of course is the expectation for a hedged pair of positions targeting an absolute return. Nevertheless we wish some had been more successful, even if as a pair they outperformed the indices.

6. Ask your adviser whether he “eats his own cooking” — that is, did he invest along with you in the same investments, and are both of your interests aligned?

Not only do we, it is a core value at our firm, and that is exactly how we put it. “We eat our own cooking.”

Hat Tip: Barry Ritholtz

Thanks for visiting Risk and Return. Please feel free to contact us with any questions and/or comments. Please note our disclaimer. For information on our investment process see here.

Technorati Tags absolute returns, advisors, assessing performance, bonds, investment performance, markets, stocks

While I have been of the opinion we have a good ways to go, I think these charts are pretty telling. I don’t see anything here to make me suspect a bottom is anywhere close.

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Price Index, Single Family Existing Homes

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Real Home Prices and Rents

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OFHEO Purchase Only Price Forecasts

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Home Price Simulations

Thanks for visiting Risk and Return. Please feel free to contact us with any questions and/or comments. Please note our disclaimer.

Technorati Tags economy, Housing Market, IMF