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Godot's Page: September 2008

Godot's Page

Gatekeeper to the Theater of the Absurd

Thursday, 25 September 2008

Moral Hazard

To many, it appears that the Paulson-Bernanke (Paulnanke) duo is causing moral hazard in cosmic proportions by picking and choosing what entities to bail-out. The Economist writes:

“The Treasury’s decision on September 16th to take over American International Group (AIG), one of the world’s biggest insurers, in exchange for an $85 billion credit line from the Federal Reserve, was momentous. More so than allowing Lehman Brothers, which was even bigger than Bear Stearns, to go bust the day before; more so, even, than the takeover of Fannie Mae and Freddie Mac, the big mortgage agencies, just over a week before. With AIG, the stakes were higher for both the financial system and the authorities’ credibility.”

First off, the treatment of Fannie and Freddie as a quasi public entity has always pissed me off. In what is made out to be the champion of capitalism, the American system has ironically been taking a socialist approach with Fannie and Freddie; keep the profits private, and make the losses public. Bullshit. Nationalize or force into Chapter 11/7. The latter was the pragmatic approach in which scenes from the Great Depression kitchen soup lines were averted…Fair enough Paulnanke. For AIG, see the blurb below, as well as my previous post:

“[AIG] quietly built itself into a juggernaut in the global financial system by using derivatives to insure hundreds of billions of dollars of corporate loans, mortgages and other debt. Holders of these assets ranged from the world’s biggest banks to retired people’s money-market funds. Allowing AIG to fail could have panicked small investors, forced banks to take steep write-downs, and introduced a terrifying new phase to the financial crisis.”

Which brings us to Bear Stearns. Why was Bear supplied with a bailout package when its bigger compatriot, Lehman, was forced into bankruptcy? You’ll hear many opinions on that one, but I think this is mainly due to timing. Bear was first to go down, and back then, the Paulnanke must have thought that we’re still in blip correction mode, so a package was in order to gauge a proper market response on future sentiment. The sentiment, clearly, was not in favor of banking institutions. I’m sure if they had a second go, which they don’t, Paulnanke wouldn’t partially bailout Bear. Paulnanke would instead wait until the market fairly priced Bear’s assets at $2/share, inevitably the outcome, as far as Bear is concerned would have remained the same. I leave you with a snippet from last week’s article on the issue by the Economist:

“…back in July Mr Paulson had argued in favour of a formal mechanism to take over and wind down non-banks, such as investment banks and insurers, in an orderly way, much as already exists for retail banks. But Congress was only prepared to consider that as part of a bigger regulatory overhaul under the next president. That forced Mr Paulson, Ben Bernanke, the Fed’s chairman, and Timothy Geithner, the president of the New York Fed (the three are virtually joined at the hip) to pursue rescues ad hoc. Yet a certain logic has governed their actions.

It is possible to detect a pattern of sorts emerging in Mr Paulson’s interventions. First, establish if a firm is so large or so entangled within the financial system that its unexpected failure could be catastrophic. If the answer is “no”, as the authorities concluded it was in Lehman’s case, encourage a private sale but commit no public money. If the answer is “yes”, as with Bear, Fannie and Freddie, and AIG, then make sure that taxpayers get first claim on the assets, common and preferred shareholders pay a steep price, and management is replaced. Mr Paulson argues that the approach combines pragmatism with an intense focus on moral hazard, or letting people pay for failure. “I don’t believe in raw capitalism without regulation. There’s got to be a balance between market discipline, allowing people to take losses, and protecting the system,” he says.”

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Economics Explained

Recently, the Sandmonkey voiced his opinion regarding the bailout plan and described it nicely in his opener as “the most ridiculous hit I’ve ever seen in my life.” If he were to argue about the methodology, or the rationing of the bailout fund, then this post would be redundant. But an adamant rejection of a bailout in principle reflects a general unawareness of the various stakeholders in play.

First off, the ‘make a quick buck’ mentality is not the primary cause of the housing bubble. The ‘make a quick buck mentality’ underpins the golden foundation of capitalism via arbitrage; it is the irrationality of the consumer in an appreciating market that causes prices to rise and fall. The real causes of the bubble were the low prevailing interest rates and the generally lax lending requirements enforced by banks in the last half decade. I digress, back to the bailout:

AIG insures approximately $1 trillion of consumer assets including, but not limited to, houses, mortgages, lives, and cars. Imagine one day, hurricane Ike hits your house which you’ve bought using your hard earned money. You call up AIG to claim your home insurance cheque and you get an answer you don’t want to hear…you subsequently get a heart attack because you just realize that all the money you’ve invested in the stock market has gone down the drain, and the only asset you owned has been reduced to rubble because of a natural disaster which you’ve insured yourself against and have been paying the premiums on for the past decade and a half…that also goes down the drain. When your funeral is over (b3eed ilshar), your next of kin receives a phone call from an AIG rep saying that she will receive compensation in the form of a massive zero. Your next of kin stages a protest along with the 100,000 other people living on the coastline of your town affected by Ike, who also had insured at AIG. The mayor says “look guys, there’s no money here, its all being spent on tanks and school buildings in Afghanistan.” Your next of kin picks up a shotgun and goes on a rampage because she loses faith in the system. By arguing against a bailout, you are arguing for this, and many more less sensationalized scenarios to occur.

As far as you pointed out in argument 10), the good ‘ol American who is paying his mortgage on time and in full amount who gets charged a higher rate now that markets have gone to shit has alr3eady factored that risk when he signed the loan doc which stated a floating interest rate of LIBOR+x%. The libor part is floating, thus the argument is invalid. Also, see paragraph above.

So, in short, the bailout plan is designed to help banks and financial institutions de-lever their balance sheets – i.e. reduce debt levels – not to bolster profits in an evil capitalist conspiracy. The payouts per institution on the bailed out entities will trickle down the capital structure, from secured lenders, to bond holders, to finally, equity holders, who will surely get nothing after liquidation. More stakeholders (ie good ‘ol Americans) will be saved than if you leave this crisis untouched. Finally, bailouts in the form of nationalization (see Fannie and Freddie, and AIG) as well as aid, gives the Federal Reserve the right to inspect the companies’ books at any time it chooses to do so, thus reducing the risk of hiding away risks in piles of collateralized securities.

For my views on the moral hazard of picking and choosing what to bailout, see my next post, I have a one page policy per post in effect here.

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Tuesday, 16 September 2008

One for the History Books

Lehman Brothers will file for Chapter 11 bankruptcy protection and Merrill Lynch will be acquired by Bank of America for $44bn / $29 per share in an all stock transaction (70% premium to last Friday's close, but only a 5% premium to the stock price last Monday). In addition, AIG has asked the Fed for a $40bn loan and will look to sell assets after rejecting a buy-out offer from JC Flowers. The group is believed to be looking for a $10-20bn equity injection from a group of private equity firms.

In response to events, the Fed has announced that it will increase and broaden its liquidity facilities for primary dealers, and will temporarily allow depository institutions to fund their broker-dealer subsidiaries with customer deposits. Also, a $70bn fund to ensure market liquidity is being established by a consortium of 10 banks including Goldman Sachs. These measures are designed to ease any temporary shortages of credit by financial firms

There has been widescale, almost indiscriminate selling across sectors, although the financials and the higher leveraged names (inc pubs) have been hit hardest. The dollar has weakened and oil has moved down over 4% to c. $94/brl as investors take a more negative view on the US economy. Basic resources stocks are retracing last week's gains.

The FTSE is currently down 4.9% / 260 points at 5150 while European indices are down 3.5 - 5.0% and the US is so far off c. 3%. The market has weakened progressively through the morning.

Investors focus has been on exposure to Lehman / ML / AIG and anticipation another round of write-downs. Capital preservation is key and the weaker players are in the spotlight. HBoS is leading the FTSE lower, down 32%, given its perceived weaker balance sheet. As investors look into the secondary effects of this dramatic shift in the financial landscape, focus will move onto companies in unrelated sectors that have exposure to the groups through funding, liabilities, derivative contracts, etc

If one were to look for a silver lining, requiring, I concede, a particularly optimistic disposition, then the announcement of the weekend's events at least provides a degree of clarity. While there will undoubtedly be further write-downs and asset sales, some investors are seeing value at current depressed levels. Indeed, this morning trading desks have had a number of buyers in the UK financials sector - predominantly long funds re-establishing their weighting in financials with some short covering by hedge funds. However, volumes remain light and it will take some time for the full ramifications of events to play out. Expectations are for markets to remain highly volatile.

This is the worst economic situation the world has faced in the past century. Many are drawing comparisons to the Great Depression of the 1920’s…the comparison goes in favor of the Great Depression. Commentary to follow in other posts.

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