The horizon is not so far as we can see, but as far as we can imagine

Category: Financial Crisis

Did AIG Never Intend to Pay Off Most Collateralized Debt Swaps?

There’s an interesting article going around which notes the widespread use of side-letters in the insurance industry. Side letters were used to say “even though you’ve said that you’ll take on X amount of risk on this insurance policy, we won’t hold you to that.”  The letters were generally buried off to one side, only to come to light if things did go wrong.  Insurance companies did this because if they bought say 1 million of reinsurance for $100,000, they freed up $900,000 of regulatory capital which they could continue to use for further insuring or lending and so on.

Think of this as essentially the same as fractional lending.  Insurers have to have enough assets on book to cover their liabilities—policies they may have to pay off on.  If somene else is going to pay off on that risk because you bought reinsurance from them, you don’t need that capital.  So buying reinsurance frees up capital.  As for the seller of reinsurance, they get money in exchange for no risk, if there’s a side letter.  Win, win.

The article goes on to suggest that many Credit Default Swaps (CDSs) AIG sold may have had similiar side letters, which since AIG was never seized, may have been destroyed.  I don’t know if such side letters existed, but my take is that neither side, in many cases, expected to every have to collect on CDSs, or pay on them.

But when everything went to hell, they certainly tried to.  The key fishy problem with AIG wasn’t the bonuses, it was that counterparties were getting paid 100% of the value of CDSs with government money, something they had no right to expect from what amounts to a bankrupt company.  In such a case, either as AIG or the counterparty, why would you bring up the side letters, if they exist?  The counterparties are getting money and AIG is paying out with money that isn’t theirs anyway.

As for the government, the reason all that money was given to AIG was specifically so they could pay off counterparties—it was a way of getting money to various damaged financial firms, including overseas ones, who needed the money, without it being obvious that the government was giving that money away, especially to foreign firms, which would have caused a firestorm

So, I don’t know if these side letters existed, and it’s worth finding out because if they did, that makes all the transactions fraudulent and we can insist on all the money back and prosecute.  But the bottom line is that the government, AIG and the counterparties all wanted the money to be paid out, whether there was a legal obligation or not.  So don’t expect anyone to look too hard, unless Congress really gets the bit between its teeth.

The Market is Not The Economy

Image by Admit One

Image by Admit One

Repeat after me: “The market is not the economy.  The market is not the economy.”

Of course the market is doing well.  Geithner, Bair and Bernanke promised to put around $2-$3 trillion more into the market in various forms.  Everyone now knows that the Obama administration will do whatever it takes to turn the market and financial sector around— even if that means trillions of dollars of risk for taxpayers.

Rule of Investing: when the government puts its full muscle behind something, be sure to ride it, and don’t get in the way.

What you want to watch now are:

  • Currency Rates
    Does the dollar go up or down?  The government printing and borrowing tons of money may not look so good to foreign debtors.  Or they may decide it’s the only game in town.
  • The Treasury Market
    Same thing.  Are private investors and foreign governments willing to buy?  Or will the Fed have to buy more treasuries?
  • Oil prices
    All of this money is going to show up somewhere, and a lot of people are (literally) betting on it showing up in energy prices.

What’s probably going to happen is a technical recovery that shakes apart based on unacceptable inflation before the recovery has reached a lot of people at the middle and bottom of the economy.  Unless  Geithner’s plan fails in absolute rather than relative terms, in which case there isn’t enough lube in the universe to make what will occur even tolerable, let alone pleasant.

In the meantime, remember that the market isn’t the economy, and unless you’re connected to the financial sector, odds are you aren’t going to see much of all this money.  The banks are being bailed out, not you.

The Geithner Plan’s Unpleasant Consequences

Asian fan

Image by rom

The Geithner Plan, combined with the other steps taken by the Federal Reserve and the Treasury, make fairly clear the Obama administration’s plan.  The sardonic summary would be “to continue the work of Hank Paulson”, but the more serious one would be, “we’re going to throw money at this problem untill it goes away.”  The end result will be riptide inflation, and an economy that suffers from the Japanese sickness where the good times just never, ever, seem to return.

It is unclear how much money has been spent, guaranteed and loaned at this point.  Given that back in February the number was $9.7 trillion, and that trillions have been committed since then, I think it’s safe to say that we’re over $12 trillion.  This is a lot of money.  The entire US GDP for 2008 was about $14 1/2 trillion.

The Fed has even decided to buy treasuries, which is the absolute definition of “printing money” since it amounts to one part of the government funding the other part of the government.

All of this money is going to land somewhere.  What we are going to see is another bout of riptide inflation, where some parts of the economy (such as wages and housing prices) are in deflation, while other parts are inflating.  My guess where the money is going to land?  Oil prices again.  It’s already begun.  Put all that money into the hands of speculators and they have to park it somewhere.

Likewise when America buys its own treasuries, that means that the treasury bubble is going to start deflating.  Private investors aren’t going to want to invest in a Ponzi scheme which is coming to an end.  The US dollar has also very likely peaked, and we’re going to see it deflate over the next year.

All of this was avoidable.  What should have been done was to take steps to deal with oil inflation: such as  a 55 mph speed limit, 3 day weekends at major corporations, and so on.  Such steps should have been instigated the second Obama took office, or put into the bailout bill or the stimulus bill.

The result instead is riptide inflation/deflation combined with a falling dollar and more difficulty financing this expansion in any way that isn’t nakedly printing money.

Then we come to the Geithner plan, which amounts to the federal government subsidizing hedge funds to buy toxic securities at overvalued prices using mostly money from the Federal Reserve and the FDIC in order to make sure they don’t have to ask Congress for money, since they know Congress would never give them another trillion and a half or so.

At the end of the day, the FDIC and Fed are backed by the US government, so any losses will have to be made up for by the American taxpayer.  (In the old days, this was known as “taxation without representation”.)

There will most likely be losses, because a good chunk of the loans to hedge funds are non-recourse, meaning that if the value of the security goes down, it’s Uncle Sam who’s  on the hook for most of the loss, not the hedge fund.  Likewise the funds will be heavily leveraged, allowing them to pay higher prices than otherwise. Add to that the continuing collapse of  housing prices and the economy, and you have a situation where the target is moving.  As the economy gets worse, more and more people default on their mortgages, leading to a decrease in housing prices and thus the prices of securities built on top of housing.

Which leads us to the stimulus bill.  The Stimulus bill is not large enough or constructed well enough.  So even if it works in a technical sense (gets GDP growth above zero) it’s probably not going to really turn the economy around in the ways that matter: recovering jobs and increasing wages.   Without these two things increasing, and without a clear direction for the economy other than hedge funds receiving massively leveraged loans to play paper games—which worked so well before the crisis, you just know we should try it again—housing will keep decreasing, demand will not recover properly since consumers won’t have money to spend, and the assets underlying the financial crisis will continue to decline in value.

Because the  government has loaned money to buy up the assets, and guaranteed much of the remainder of it, the government will be on the hook for the losses. (And by “the government,” I mean “your tax dollars.”)

What happened in Japan after their bubble is instructive.  Instead of taking the toxic waste off their banks hands, or forcing write downs, they allowed zombie loans and zombie banks to sit around doing not much of anything.  They also tried large Keynesian stimulus, but every time it looked like it might be working, they backed off.  The end result was, and is, 20 years where the Japanese economy never really got good again.  Short periods of modest growth were followed by recessions, over and over again.

Defenders of the Geithner Plan would say that we’ve learned from Japan’s mistakes.  What we’re doing is taking the loans off the banks’ books, so we don’t have zombie banks.  This misses the point, even assuming the government does eventually manage to move all the bad debts from the banks and into taxpayer hands, which is questionable since the losses are a moving and increasing target.

Why?—Because in macroeconomic terms it really doesn’t matter who has the debt, it doesn’t matter who is impaired.  If the government has all the debt and winds up crippled, and government spending and loans wind up crippled, the effect is virtually the same as having crippled banks hanging around.  The debt still has to be paid off.

The key difference here is between “paid off” and “wiped out”.  “Paid off” means the full value gets paid back (minus whatever inflation the US has, which may be a lot). ” Wiped out”, on the other hand, is what would occur if private banks, firms and investors were forced to take their own losses.  In that case, when the full value of the investor or firm was gone, any remaining value would simply disappear.  If a bank goes bankrupt owing $200 billion, and the bankruptcy windups leave only $100 billion of proceeds, then the remaining $100 billion goes away.  Yes, that $100 billion may wipe out some other people, but it’s done. It’s over with.  It’s finished.  You can’t get blood out of a stone, and when a firm or person is wiped out, they’re wiped out.

Instead the decision has been made, in effect, to pay back the full amount of the losses—and not to force those who made the bad bets to pay them back, but to put as much as possible of the losses onto the government and make taxpayers pay them back.

Since we’re talking about trillions of dollars of losses, in a declining economy, that means impairment of both government and private spending for years to come.

The end effect will likely be little different than what happened in Japan, with the exceptions that the US may see significant inflation, and that as net importer rather than a net exporter, the US probably can’t keep this up for 20 years.  Which means that at some point in the future it will either have to default on the debts, inflate them away or have a financial collapse.

None of this is necessary, and there are still ways thing could be done better.  The administration is set to announce their regulatory reforms next week.  If those reforms are thorough and complete, ending the existence of “too big to fail firms”, sharply increasing tax progressivity and putting firm limits on leverage, then perhaps the pain to come will be worth it, if only because steps will have been taken to make sure it doesn’t happen again.  But if real regulatory reforms aren’t put in place soon, the future will be bleak indeed.

Market Rallies On News of Trillion Dollar Giveaway

Image by TW Collins

Image by TW Collins

Is anyone really surprised the DOW is up almost 500 points, after Geithner promised to give private investors almost $1 trillion to gamble with?

The details of the giveaway are fascinating.  I sure wish that I could get financing like this to play the market:

Under one part of the plan focused on bad loans, the Treasury will provide up to 80 percent of initial capital alongside investment by private funds. The FDIC would then offer debt financing for up to six times the pooled amount.

Now, unless I’m messing up my math, that’s 24/1 leverage.  If older details hold, and the 80% is a non-recourse loan, meaning that it’s secured only by the value of securities bought, then it’s even sweeter.

PIMCO has announced it’s interested in participating, which means that the plan has succeeded in one sense—it has the buy-in of some very smart money.  That doesn’t mean that it’s necessarily good for taxpayers, or that it will be good in the long term for the economy, necessarily, but at least it isn’t being laughed out of Dodge.  On the other hand, would you refuse 24/1 to one financing?  Or even matching funds, as contained in part two of the plan?

I sure wouldn’t.  And PIMCO have been scavengers before.  They bet heavily in Fannie and Freddie bonds after it was clear Fannie and Freddie were insolvent, which was a bet that the government wouldn’t shear bondholders when it bailed out Freddie and Fannie.  Smart bet, but not a good return for taxpayers, who would have been better served by letting Freddie and Fannie’s debtholders lose money.

I am becoming increasingly convinced that my original call was the right one: that the various bailouts would lead to Japanification.  For 20 years now, since its own bubble burst, Japan has had an economy which slips in and out of recessions like clockwork and which never ever really got good again.  In Japan’s case, the lousy economy was in large part because they left a lot of debt debt on the books of private corporations.  In America’s case, the debt may be transfered to taxpayers, but the end result is likely to be the same, only compounded by attempts to create secondary bubbles so that the toxic waste regains enough value to claim a win.

Given that Geithner’s trillion dollar giveaway has been greated ecstatically by the financial sector, I expect we’ll see more money used in this fashion.  This plan appears to be good for about $2 trillion of lousy debt ($1 trillion from the matching 1/1 program, $1 trillion from the high leveraged portion).  Total current toxic waste on the banks books is probably about $4 trillion, which will still have to be dealt with.

That money will have to be paid off, eventually.  Doing so will cost the US  and the world a great deal of future growth, and individuals a great deal of future income and employment.  As things stand right now, I don’t think employment levels as measured by employment/population ratios will recover in the forseeable future—post recession “full” employment will just be lower than pre-recession “full” employment.  There are still some ways this could be made to work for everyone, and I’ll discuss those at a later date.

More Details On Geithner’s Plan

US Gold Coin

US Gold Coin

Bloomberg’s has more highlights of Obama’s plan for toxic assets that will be unveiled Monday by Treasury Secretary Geithner.  Newer details include:

  1. Geithner will ask Congress to give the Treasury and FDIC more powers: to guarantee more types of debt, limit payments to creditors,  and break executive compensation contracts.
  2. The Federal Reserves Term Asset Loan Facility program (TALF) will expand to riskier assets. Financing will be 1:1, and will apparently include private partners (in a way similar to the Treasury fund) who will make the investment decisions.  Profits and losses will be shared between the government and the private sector.

I still don’t like the FDIC funding plan, because the public component is up to 97%, but the Fed TALF plan makes a lot more sense.  Doing the funding 50% public, 50% private is much more fair, is not nearly as heavily leveraged (although leverage can be applied in other ways) and losses are shared much more equally, assuming these are not non-recourse loans (which they appear not to be, though that’s not certain.)

The additional powers Geithenr is asking for are acceptable, except for the ability to guarantee more types of debt.  The FDIC is already guaranteeing many bank assets: the idea of them guaranteeing even riskier classes only serves to set up  taxpayers to shoulder even more losses from the private sector’s.

Many of these concerns would be moot if the administration would just nationalize firms which are effectively insolvent. But, given that the administration won’t nationalize the banks, at least parts of this plan are not completely stupid.

The plan does however appear to perpetuate the trend of taking on private losses and putting taxpayers at risk for most of them.

Why Financial Crises Will Keep Happening

American dollar toilet paper roll

American dollar toilet paper roll

The financial crisis currently unfolding before our eyes in slow motion was inevitable and predictable. I say this because it was predicted by numbers of people. It was obvious; anyone with sense knew it was coming (a group which apparently includes very few people); and despite the fact that we’ve known for years it was going to happen, it happened anyway.

The same was true of the dot-com bubble. The inevitability of the dot-com collapse was obvious, at least as far back as 1996/1997. Everyone knew it who wasn’t paid not to know it, and it happened anyway and burst anyway.

Both of these foreseeable collapses raises the question of deliberate government policy—both bubbles were fostered and grown from tiny soap-suds with the aid of Alan Greenspan’s Fed and various other government and private and semi-private actors (in the case of the current collapse, including Fannie Mae and Freddie Mac).

Creating the bubble behind the current financial crisis took the cooperation and encouragement of a lot of people beyond the government, people who benefited a great deal from it. Let’s take Chuck Prince, the ex-CEO of Citigroup. Prince walked away from his near-destruction of Citigroup with about $41.5 million, including a $12 million bonus for his performance. The moral of the story is: drive the place into the ground, get paid well. Then there’s Merrill Lynch’s Stan O’Neal who walked away with $160 million.

Nice work if you can get it.

But if the rot was limited to the top, it wouldn’t be nearly as big a problem.

The Executive Coup

federal-reserve-seal

I’m going to discuss the administration’s plan to take toxic assets off the banks, then talk about what this and other moves this week (such as the FED announcing $1.15 trillion in new spending) tells us about the administrations plans for the financial sector and the economy, and how I believe they’re going to play out, as well as what the political power realities now are.

There are three parts to the plan to take toxic assets off the banks’ hands, of which we have mostly the details of the first part, in which the FDIC will form “private/public” partnerships to buy up assets.

  1. The plan has the FDIC loaning up to 85% of the cost of purchase as a non-recourse loan which is backed up only by the value of the loan.
  2. Of the remaining 15%, the treasury will lend up to 80%.
  3. The remaining 3% money must be put up by the private partners.

The government will share in any profits or losses of the underlying security, though we don’t know what percentage goes to the private investor or the public.

Think of the investment split in simple terms. If I want to invest in securities, why would I want a 3% partner with whom I have to split the return? If the government is investing 97% of the money, why are they even bothering with private partners? Why not just pony up another 3%? Oh sure, there may be some occasions on which the private partners put up more, but if the government thought they could get more, why are they offering 97% financing, with 85% being a complete write-off if the asset goes down rather than up?

There are two possible answers I can see.

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