Still too big to fail

Former Fed chair Paul Volcker is reiterating his argument for the need to bifurcate the banking industry: commercial banks that are important to the economy, and risky speculators who are on their own.

From Volcker’s speech Wednesday in Los Angeles, the WSJ emphasized limits on the acceptable activities for the former.

Mr. Volcker, who currently is chairman of the White House's Economic Recovery Advisory Board, suggested banks should be restricted to trading on their client's behalf instead of making bets with their own money through internal units that often act like hedge funds.

"Extensive participation in the impersonal, transaction-oriented capital market does not seem to me an intrinsic part of commercial banking," he said in a speech to the Association for Corporate Growth in Los Angeles.
…
Mr. Volcker said banks should be banned from "sponsoring and capitalizing" hedge funds and private-equity firms, which are largely unregulated. He also said "particularly strict supervision, with strong capital and collateral requirements, should be directed toward limiting proprietary securities and derivatives trading."

The Bloomberg account explicitly linked Volcker’s proposed control on activities to the availability of bailouts:

In his speech, Volcker renewed his call for a limit on the activities of banks that are considered “too big to fail,” going beyond what other officials in the Obama administration have advocated.

“I do not think it reasonable that public money -- taxpayer money -- be indirectly available to support risk-prone capital market activities simply because they are housed within a commercial banking organization,” Volcker said.

Since January, Volcker has advocated that regulators should prohibit financial companies whose collapse would pose a risk to the economy -- those considered “too big to fail” -- from engaging in certain types of trading and investing activities.

Presumably there is a third group of banks — smaller commercial banks that (as with most of the bank failures of 1980s and the past 18 months) — that can fail and be acquired through normal market processes.

Libertarians and fiscally conservative Republicans would argue one of the biggest mistakes of the Bush administration was to perpetuate the idea of “too big to fail,” an idea that certainly continued into 2009. If the (eventual) financial reforms don’t fix this ongoing moral hazard problem, the bailouts next time will be even worse.

When it comes to financial regulation, the current administration seems to have a quandary. On the one hand, bankers are rich and greedy capitalists worth bashing at every opportunity. On the other hand, many of those based in NYC are very close financial and political supporters to leading Democrats such as the president's chief of staff and the senior senator from NY.

However, right now the assumption is that the administration (and Congressional majority) are uninterested in financial reform, because they want to leverage the president’s (shrinking) electoral mandate to pass a national healthcare plan and cap-and-trade.

If the problem remains unresolved before the GOP retakes one or both houses of Congress, then it will be both an opportunity and a trap for the GOP. This time, the GOP must prove that they really believe in free markets — rather than act as shills for Wall Street — by carefully limiting (and regulating) those firms “too big to fail,” while marking the less regulated segments a truly “bailout free” zone.

A billion here, a billion there

More outsourced criticism from JD Foster:

The Bush Administration pumped $4 billion into Chrysler to keep it alive long enough to go into bankruptcy well-prepared. Obama has waived the $4 billion and a $300 million fee. In exchange, taxpayers are receiving an 8 percent stake in a company likely worth zilch.

In addition, the Obama Administration loaned another $3.2 billion to keep Chrysler operating in bankruptcy. Expected repayment: zilch.

But the plan is to use Chrysler’s assets to pay off creditors and replenish the UAW’s fund for its retirees, with enough left over to make the new Chrysler a pretty bride for Fiat the Italian groom. There’s nothing wrong with Fiat acquiring a controlling position in a new Chrysler. But the taxpayers shouldn’t be asked to fund a $7.5 billion dowry. Before any monies are paid to the autoworkers’ union, Fiat, or any non-secured creditor, taxpayers should get their money back.

This is the inherent risk of the government making financial “investments,” which are always for political reasons rather than business reasons. If it looked like giving money to Chrysler was a bad investment, it’s because it was. The likely bankruptcy of Chrysler has been discussed and recommended for six months. So it’s not clear why the government gave them $7b in the first place, other than it was more politically convenient (for George Bush and Barack Obama) for Chrysler to file for bankruptcy April 30 rather than October 30.

A billion wasted here, a billion wasted there — eventually it adds up to real money.

BofA bombshell

The other shoe has dropped on BofA’s value-destroying strategy to buy Merrill Lynch after learning the extent of its toxic assets.

The lead story in today’s WSJ reports on sworn testimony by NationsBank Bank of America CEO Ken Lewis was pressured by then-Treasury Secretary Hank Paulson and Fed chairman Ben Bernanke.

Excerpts from the interview conducted by the NY attorney general:

Q: Were you instructed not to tell your shareholders what the transaction was going to be?
Lewis: I was instructed that “We do not want a public disclosure.”

Q: Who said that to you?
A: Paulson…

Q: Had it been up to you would you (have) made the disclosure?
A: It wasn’t up to me.

Q: Had it been up to you.
A: It wasn’t.

The article also said

• Paulson told NY investigators that Lewis “misinterpreted” what Treasury wanted kept secret.
• Paulson threatened to remove BofA’s CEO and board if it cancelled the merger.

Being threatened with losing your job shouldn’t be enough to convince a CEO to do something that will destroy more than $150 billion in shareholder wealth. But it does illustrate the pressure that government officials were applying, and demonstrate why we don’t want central governments to have such power over free markets.

Where the meltdown began

From the WSJ on Saturday:

'Perhaps the largest regulatory failure of all time." That's how J.P. Morgan Chase CEO Jamie Dimon describes the "inadequate regulation of Fannie Mae and Freddie Mac" in his annual shareholder letter, released this week.

Mr. Dimon devotes nearly a quarter of the 28-page letter to analyzing what caused the panic of 2008, and he hands out plenty of blame all around. But he calls it "amazing" that Fannie and Freddie were allowed to grow "larger than the Federal Reserve" thanks to Uncle Sam's implicit guarantee of their obligations.

Quoting from the letter:

Perhaps the largest regulatory failure of all time was the inadequate regulation of Fannie Mae and Freddie Mac
The extraordinary growth and high leverage of Fannie Mae and Freddie Mac were well-known. Many talked about these issues, including their use of derivatives. Surprisingly, they had their own regulator, which clearly was not up to the task. These government-sponsored entities had grown to become larger than the Federal Reserve. Both had dramatically increased their leverage over the last 20 years. And, amazingly, a situation was allowed to exist where the very fundamental premise of their credit was implicit, not explicit. This should never happen again. Their collapse caused damage to the mortgage markets and the financial system.

Dimon also makes some very interesting points about the prevalence of positive-feedback (he calls “pro-cyclical”) loops in the system: when things got bad, these policies made things worse. An example would be stringent mark-to-market rules (despite their other advantages) that encourage liquidation of assets at firesale prices — thus depressing the value of similar assets across the industry.

I certainly can’t agree with everything Dimon says. He seems quite enamored with more regulation to prevent failure rather than designing markets to be more self-governing and thus more resilient to the inevitable failure. But then as the CEO of one of America’s largest banks, he has a huge stake in preserving the current industry positions rather than seeking what’s best for the American economy as a whole.

Interestingly, Dimon is running at full tilt away from Federal money for Chase and thus Federal micromanagement, in hopes of gaining market share on its two main rivals, the TARP-enabled, bureaucratically hobbled Citibank and BofA. I suppose this is a form of market incentive — if these two banks will perform worse with government shareholders, they have a strong incentive to pay back what they owe and soon rejoin the ranks of (somewhat) free market companies.

The moral hazard of cleantech hubris

Since last summer, many firms have lined up to get their share of taxpayer subsidies. It is not always clear which firms deserve such subsidies and which ones do not, but as always, it’s predictable that the undeserving firms will do their best to appear deserving.

One of the companies seeking Federal aid is electric car maker Tesla Motors. Tesla has shipped its Roadster to an affluent niche market, but hopes to find a broader (niche) market with its $57,000 Model S sedan. Plans for the Model S have been on again and off again; right now they’re said to be on again.

Tesla is personified by chairman/CEO/founder Elon Musk, a 37-year-old serial entrepreneur who appears to be simultaneously running his 3rd and 4th startups.

My coworker Randy Stross (author of Planet Google) wrote about Tesla in his New York Times column. His Nov. 30 column questioned Tesla’s suitability for Federal bailout dollars:

The Tesla Roadster is an electric car that goes fast, looks sensational and excites envy. The seductive appearance, however, obscures some inconvenient truths: its all-electric technology remains woefully immature and don’t-even-ask expensive. If enough billionaires step forward to inject additional capital to keep the doors of its manufacturer, Tesla Motors, open, I’m happy for all parties.

If investors pass up the opportunity, however, why should taxpayers fork over the capital that Tesla needs? The company is requesting $400 million in low-interest federal loans as part of the $25 billion loan package for the auto industry passed by Congress last year.

The program is intended to encourage automakers to improve fuel efficiency, but should it be used for a purpose like this, as the 2008 Bailout of Very, Very High-Net-Worth Individuals Who Invested in Tesla Motors Act? Can you conceive any way that federal dollars could be put at greater risk — and for no equity in return, keep in mind — to benefit fewer people?

Tesla Motors, a privately held company based in San Carlos, Calif., has spent almost all of the $145 million in capital it has raised to date. It says it will soon receive another round of $40 million from its private investors to sustain operations.

In the start-up ecosystem of Silicon Valley these would be respectably large numbers, but in the automotive world, fully developing an entirely new line of technology can easily run $1 billion. That is what General Motors’ first attempt at an electric vehicle, the EV1, was estimated to have cost to develop in the 1990s.

Stross had two inaccuracies in the original article. First, he confused the $109k Roadster with the “mass market” $59k Sedan (later corrected online).

Secondly, he said Tesla wanted $400m in Federal loans: today, the current estimate is $700m. The money would from the Department of Energy’s loan guarantee program instituted by President Bush. The first $250m would be funded by 2005 legislation to reduce carbon emissions, the second $450m from the 2008 program for drive-train electrification. (The loan guarantees will charge fees to cover the program’s projected default rate, estimated at 25% by the GAO.)

While Stross’ comments were harsh, they don’t seem unusually so. Silicon Valley companies are often called on their wildly optimistic predictions. And in this climate of bailout fatigue, formerly entrepreneurial companies embracing government subsidies should expect some level of public examination and accountability.

Still, this was in November: after four months, all was forgotten, right? Wrong.

In video clips posted Friday to Yahoo Tech Ticker, Musk was interviewed by Sarah Lacy. In one of the video excerpts, Lacy shows one of Tesla’s scarce Model S prototype and asks the question “Should your taxpayer dollars go towards producing it?” She then began her interview with Musk:

Lacy: The New York Times did this piece that everyone in Silicon Valley got very up in arms about…

I don’t think “everyone” in Silicon Valley got upset. Some are too busy trying to keep their own startups alive to worry about Musk’s electric cars. A few tech entrepreneurs (like Paul Allen) were even willing to be politically incorrect and oppose the bailout.

Let’s restart the hard-hitting investigative interview:

Lacy: The New York Times did this piece that everyone in Silicon Valley got very up in arms about, saying that, you know, that the government money going to Tesla, would be this, you know, huge risk of capital that would only benefit the wealthy and venture capital backers who put money in the company, and called the Roadster basically a $109,000 concept car.

What do you say to that article?

Musk: Randy Stross is a huge douchebag! [Both laugh uproariously.] And an idiot!

Wow! I’m impressed! What a command of the English language! What an ability to inspire confidence among taxpayers that their $700m will be well spent! I’m not sure which is the greater need: journalism lessons for the new-media host or PR lessons for the centimillionaire entrepreneur.

After this ad hominem attack, Musk changes the subject:

Musk: First of all, what is he doing picking on electric car company? I mean, why would he pick on the little guy who's trying to do good, when you’ve got egregious wastes of money in the tens of billions occurring in … in … in Detroit? Why?

Hmmm... So wasting nearly a billion dollars on a little car company is OK because it’s not as bad as wasting $10 billion on a big car company? Musk said the money was intended for a “mass market car,” but (since no one owns a car in Manhattan) only in Silicon Valley would $57k be “mass market.”

Musk supposedly has an undergraduate economics degree from Wharton, so I assume this is just posturing rather than a serious answer. Here is how I would explain why that answer would get an “F” in my technology strategy class:

We can look at a wide range of cutting edge technologies in the past — biotech, dot-com, PC makers, disk drive makers and semiconductors — and see that when many companies enter the market, some companies survive while other companies fail. A priori, there was no way to tell the winners from the losers: if there were, investors would not have invested in the losers.

Today, while society may want electric cars, we don’t know which companies will survive and which will fail. If Tesla fails, U.S. taxpayers could lose $0.7 billion.

A VC expects to lose its entire investment anywhere from 10% to 33% of the time. It compensates for that risk by taking equity and getting a 10x return for the big winners. Here, the government would be supplying 80% of Tesla’s invested capital, but will only earn a fixed fee should Tesla have a smash success.

If you and the current investors don’t want to put up that money — but instead want taxpayers to bear most of the risk — perhaps you know something that the public doesn’t about the riskiness of the investment.

Economist Ken Arrow calls that a moral hazard problem due to information asymmetry. Economics tells us we should be suspicious when people who know the most want others to shoulder the risk.

When funding is tight, many tech companies will grow slowly until their positive cash flow will enable further re-investment. However, in this case, Tesla wants to expand its capitalization fivefold to fuel explosive growth, in hopes of grabbing market share before GM, Nissan, Toyota and others bring their electric vehicles (or plug-in hybrids) to market.

However, by taking Federal funding, Tesla would move into the realm of a regulated government-sponsored enterprise, along with all the other companies received bailouts and subsidies. Government money means playing by government rules, however irrational those might be. The best and brightest of Wall Street are fleeing from the TARP-sponsored wards of the state, presumably a lesson that (most) cleantech entrepreneurs will learn someday, as well.

A timely critique of bailout bull

Tonight Libertarian John Stossel is doing a 20/20 special called “Bailouts and Bull.”

Allied with comedian Drew Carey, the preview suggests that the two men present a consistently Libertarian view guaranteed to alternately infuriate the right and left . They argue against a government role

• suppressing California’s marijuana decriminalization (aka “medical marijuana”)
• spending money on a border fence (ignoring the Milton Friedman critique)
• Obama’s new Federal spending on (and control of) preschool (quoting angry parents who claim to be able to educate their kids better)
• publicly owned highways

Carey (and Stossel) argue that the government shouldn’t be the first solution for all societal problems. Carey has been making this point in a series of videos for Reason.TV.

Carey concluded:

We don’t say, “Well the government needs to run these diners because I’m sick of getting a bad cheese sandwich — If the government ran it, it would be so much better.”

You’d be afraid for your life if the government ran the diners. You would think “Oh no I’d never get another good cheeseburger again if the government ran the diners” because the government screws everything up.

Interviewed earlier this week, Stossel criticized the bailout by saying “look at what happened with something — maybe we should give nothing a chance.” He then quoted the Reason.TV video about using stimulus when “economies have performance issues.”

20/20: 10pm (9pm Central) on your local ABC station.

A 50-year-old critique of today's bailout

Quote without comment:

'Atlas Shrugged': From Fiction to Fact in 52 Years
By STEPHEN MOORE
Wall Street Journal, January 9, 2009, p. W11.

Some years ago when I worked at the libertarian Cato Institute, we used to label any new hire who had not yet read "Atlas Shrugged" a "virgin." Being conversant in Ayn Rand's classic novel about the economic carnage caused by big government run amok was practically a job requirement. If only "Atlas" were required reading for every member of Congress and political appointee in the Obama administration. I'm confident that we'd get out of the current financial mess a lot faster.

Many of us who know Rand's work have noticed that with each passing week, and with each successive bailout plan and economic-stimulus scheme out of Washington, our current politicians are committing the very acts of economic lunacy that "Atlas Shrugged" parodied in 1957, when this 1,000-page novel was first published and became an instant hit.

Rand, who had come to America from Soviet Russia with striking insights into totalitarianism and the destructiveness of socialism, was already a celebrity. The left, naturally, hated her. But as recently as 1991, a survey by the Library of Congress and the Book of the Month Club found that readers rated "Atlas" as the second-most influential book in their lives, behind only the Bible.

For the uninitiated, the moral of the story is simply this: Politicians invariably respond to crises -- that in most cases they themselves created -- by spawning new government programs, laws and regulations. These, in turn, generate more havoc and poverty, which inspires the politicians to create more programs . . . and the downward spiral repeats itself until the productive sectors of the economy collapse under the collective weight of taxes and other burdens imposed in the name of fairness, equality and do-goodism.

…

The current economic strategy is right out of "Atlas Shrugged": The more incompetent you are in business, the more handouts the politicians will bestow on you. That's the justification for the $2 trillion of subsidies doled out already to keep afloat distressed insurance companies, banks, Wall Street investment houses, and auto companies -- while standing next in line for their share of the booty are real-estate developers, the steel industry, chemical companies, airlines, ethanol producers, construction firms and even catfish farmers. With each successive bailout to "calm the markets," another trillion of national wealth is subsequently lost. Yet, as "Atlas" grimly foretold, we now treat the incompetent who wreck their companies as victims, while those resourceful business owners who manage to make a profit are portrayed as recipients of illegitimate "windfalls."

As they say, read it all.

Ding dong, the bailout's dead!

The Big Three auto industry bailout died last night in Congress. On a largely party line vote, the last test vote 52-35-12, i.e. 52 votes for a bailout with some strings, 35 votes for forcing the industry to fix its cost structure, and 12 votes too chicken to stick their necks out. Perhaps this will end the habit of bailing out companies that are either badly run, or that have structural problems that cannot be resolved without wiping the slate clean.

The Big Three keep screaming “recession” as the cause of their problems, but the rest of the auto industry will survive just fine. The current economic woes are merely exposing the depth of the companies’ self-inflicted problems, including uninspired product design, unsustainable labor costs, and smoke-and-mirrors balance sheets.

Ford appears able to hang in there for now. Apparently now GM and Chrysler are starting to take seriously the bankruptcy option, which is what most firms do when their problems become unsolvable.
Toughlove means that you say no to a dysfunctional friend or relative and stop acting as an enabler for the pathologies that got them in trouble in the first place. It would be best for the country if the Big Three (Dying Two) will face up to their problems, but it seems more likely that they will keep their focus on lobbying for a better deal — now, from the 111th Congress.

Bob Rubin: it's not my fault!

From Saturday’s WSJ:

Under fire for his role in the near-collapse of Citigroup Inc., Robert Rubin said its problems were due to the buckling financial system, not its own mistakes, and that his role was peripheral to the bank's main operations even though he was one of its highest-paid officials.
...
Its troubles have put the former Treasury secretary in the awkward position of having to justify $115 million in pay since 1999, excluding stock options, while explaining Citigroup's $20 billion in losses over the past year and a government bailout of at least $45 billion.
...
"Even though he has no 'operating' responsibilities, he still has a fiduciary responsibility as a board member," said William Smith, a New York money manager and frequent critic of Citigroup's current management and board. "He has overseen the entire meltdown, yet been compensated as an operating employee while bragging about having no operating responsibility." Mr. Rubin can't "have it both ways," Mr. Smith added.

Citibank stock is down 70% since Rubin joined the firm in 1999, and down 86% since its peak two years ago.

Citibank is the most egregious example of banks saying that everything is OK as the financial collapse built this year, and systematically underestimating the risk posed by complex derivative instruments.

I guess NY bankers have the same attitude towards personal accountability as Washington politicians. (Of course, Rubin is both, having served as US Treasury Secretary from 1995-1999). If Wall Street is supposed to have the smartest financial minds in the world, why is it that they couldn’t create

Decades from now, historians may look at Enron and Worldcom as rare examples when leaders of business collapses actually paid a price for their malfeasance. Meanwhile, “leaders” like Rubin get millions for their pockets, billions in taxpayer bailouts, and help destroy trillions in US equity market value, while continually dodging any responsibility for their actions.

Creating even more "too big to fail" firms

If the stereotypical Republican economic policy error is pandering to Wall Street, then the Democrat one is pandering to labor (usually organized labor).

Andrew Ross Sorkin of the NYT predicts that, in the name of saving jobs, the Obama administration will approve mergers that it might otherwise have rejected. He bases this on an interview with former Clinton era tormentor (now highly paid Democrat lobbyist) David Boies, who says

“Antitrust theory is theoretical. Losing jobs and plants is real.”
…
“Preserving jobs and economic stability will be perceived as more important than preserving competition,” Mr. Boies said.

There’s a huge fallacy in this reasoning: we got into this mess because certain companies became “too big to fail,” so the government decided to intervene to prevent them from failing. Some companies that are broken need to fail: if they don’t, taxpayers are providing an indefinite subsidy to enable management, labor or business model pathologies (e.g. autos).

Letting broken companies be gobbled up by their competitors should mean that new management will run these companies better. But it also means the survivor will be bigger and perhaps has to be bailed out at any cost. The progression of Hudson and Nash to AMC to Chrysler (whose next owners are pressuring GM to bail them out) illustrates the progression.

So allowing a merger to form an ever-larger struggling company is creating a bigger problem that’s deferred into the future. There will be another economic downturn five or eight or ten years down the road, when these troubled companies will again go into crisis mode. Or maybe they’ll skip the next crisis, and it will be 15 or 20 years off before the government is asked to bail out a company that’s “too big to fail.”

In politics, this sort of intentionally short-term thinking is called “kick the can down the road.” Politicians hope is that when the problem reappears they will be gone, or if they’re not gone, that no one will remember their culpability in creating the problem. Exhibit A: is Fannie Mae.

The cumulative effect of such creeping corporatism is to eliminate the financial accountability for managers, employees, directors of privately held companies. This would have to be funded by taking ever-more money from taxpayers to prop up politically favored large companies — while keeping the tax and regulatory burden high on the well-run companies that don’t need bailouts. Heck, why don’t we change our name to the United States of France?

The US test (since the days of Teddy Roosevelt) for rejecting a merger has been: will the new company have too much power to hurt customers? The EU standard (since the days of Mario Monti) has been: will the new company have too much power to hurt competitors? (Such concerns are trumped by a second test: will the merger serve national or EU industrial policy goals?)

The 21st century, free-market standard should be: will the new company be “too big to fail”?