The bailout problem in a nutshell

Professor James Hamilton writing at Econbrowser:

And, as was the case in the 2008 difficulties, one can either view this primarily as a liquidity problem, for which we simply need the central banks to step in boldly to arrest the jitters, or as a solvency problem, in which case the policy decision is how to allocate the unavoidable capital losses among bank owners, bank creditors, and the government so as to minimize collateral damage to innocent bystanders. The fundamentals facing Greece suggest there is an overwhelming solvency component to the current problems. And the policy response so far seems to be choosing to allocate 100% of losses to the European and U.S. taxpayers.

It is not the role of the ECB, IMF, or Federal Reserve to bail out banks. These measures are profoundly unpopular with voters in countries such as Germany and the United States. I think it is incumbent on the architects of these measures to communicate what is the structural defect in banking regulation that made such intervention necessary, and what reforms have been implemented to ensure that such measures won't be needed again.

I have yet to see a convincing case that the financial reform legislation in Congress accomplishes such a task. Go read the whole (short) thing.

Fools for the Citi

OVER the past 80 years, the United States government has engineered not one, not two, not three, but at least four rescues of the institution now known as Citigroup .

Reports the New York Times. The article has a brief history of the various bailouts, including this eerily familiar item about the 1929 Crash:

Before the crash, industry practice allowed National City not only to underwrite securities but also to employ a sales army to peddle them to depositors. After Congressional hearings determined that this conflict of interest was a major cause of the debacle, lawmakers passed the Glass-Steagall Act, separating activities of commercial banks (which offered plain old savings accounts and loans) from those of investment firms (which trafficked in more highflying endeavors like stock trading and underwriting).

The Glass-Steagall separations were eventually eliminated, but restoring them has become a key part of the discussion over regulatory reform. Our current crisis saw banks like Citi underwriting mortgage-backed securities (those CDO's you hear about), selling them to their customers, and also keeping pieces of some of them on their own books. They often kept the most risky pieces, hence the so-called toxic asset problem (which, if I'm not mistaken, still persists).

While the history lesson is fun, it's not all academic. The current Citi bailout amounts to $45 billion in TARP money, plus $300 billion in FDIC guarantees. Getting this taxpayer money back, or realizing we never will and deciding on how to avoid repeating this mistake, is critical before we turn Ken Burns loose on the documentary of the Great Financial Collapse.

TARP on Steroids

That's what Congressman Brad Sherman (D-CA) has called the new resolution authority proposal put forth by Secretary Geithner and the Treasury.

Resolution authority is the ability for the government to take over and somehow deal with failing financial institutions. There seems to be a fair amount of agreement that this was something lacking during the current crisis and that this authority is needed to avoid a repeat of the wave of bailouts the financial industry has been riding of late.

Treasury's proposal though, would be a step in the wrong direction. Here's Congressman Sherman's highlights:

The new Resolution Authority, set forth in Treasury’s 253-page legislative draft of October 27, 2009 provides permanent, unlimited bailout authority....

The Secretary of the Treasury has rejected a $1 Trillion limit on this bailout power...

The chief economic effect of Treasury’s proposed unlimited bailout legislation is to cause creditors to lend money on favorable terms to “systemically important institutions” (the top 10 to 25). If the institution cannot repay those creditors, the Government probably will....

This law will allow those institutions which are clearly systematically important (the top 10 to 25) to borrow at a lower cost. This will help the largest institutions get bigger, so they can pose a greater systemic risk.

I suppose it's too much to ask anyone in government not use a crisis as cover for a huge power grab, but couldn't they at least make a pretense toward improving the situation?

This proposal seems little more than an attempt to put into law the system of business friendly back room deals that have proceeded ad hoc over the last year. If this is the shape "change" then we are in for a whole lot more of the same.

OK, One More Lehman

One of the refrains that has been heard accompanying the string of government bailouts over the last ten months has been, "no more Lehmans." This refers to the Lehman Brothers financial firm which declared bankruptcy last fall after the federal goverment did not come to its rescue. An event which some see as a major contributing factor to the weak economic conditions since then. Hence the refrain.

True to their word, we really haven't seen any other Lehmans since then, but we just might.

News today has centered around the possible bankruptcy of CIT Group. That's C-I-T, not C-I-T-I, and that might be why they are allowed to fail. Dad29 had coverage of the potential CIT bankruptcy in response to my post on the federal bailout of GE Capital. CIT is a lender to many small and medium sized businesses, which would be negatively impacted by its failure.

Today, economist Simon Johnson covers CIT at his blog, The Baseline Scenario:

Traditionally, CIT provided vanilla loans to small and medium-sized business. “But under its current chief executive, Jeffrey M. Peek, a well-liked Wall Street veteran who lost out several years ago in a race to run Merrill Lynch, CIT made an ill-timed expansion into sub-prime mortgage and student lending” (NYT today).

What happens to CIT will help define exactly where we are with regard to “too big to fail.”

At the end of 2008, CIT had total assets around $80bn, which was about 1/10th the size of Goldman (and about 1/25th the size of Citigroup) and puts it just outside the top 20 publicly traded financial services company. Presumably, it just missed the cut for inclusion in the government’s recent “stress tests”.

So in this case, CIT is the quintissential marginal firm. Whether or not it receives a bailout should clearly indicate what the federal goverment thinks about which firms need to be saved given the current economic environment. Maybe.

Johnson, an MIT economist and former IMF official, is often pessimistic about the prospects for effective governmental intervention in, and reform of, the financial sector. On this story, he seems downright cynical as he ends on this note:

So then it all comes down to political donations. At least in terms of what is in the public record, Mr. Peek has not been overly generous, but he did give money to John McCain – and not to any Democrats. If this is in fact the limit of his recent contributions, I think you know the outcome.

Perhaps its the case that CIT doesn't represent the kind of risk that Lehman did. However, a seemingly haphazard approach to bailouts has its own kind of corrosive effect on the economy.

Imagination At Work - Tax Dollars At Risk

It turns out that one of the hastily constructed programs designed to deal with the crashing credit markets last fall has proved to be very beneficial to General Electric. A Pro Publica/Washington Post story details how the corporate behemoth has become the major participant in the FDIC's Temporary Liquidity Guarantee Program (TLGP).

This program allows participating companies to issue debt that is backed by the FDIC, which means it is ultimately backed by the taxpayers. Of the $340 billion guaranteed by the program so far, GE's portion is $74 billion at the end of the first quarter of 2009. The government guarantee has a real benefit to GE since with it they are able to borrow at lower rates.

While GE is well known for household appliances, light bulbs, and NBC, I doubt it comes to mind when one thinks of the major financial institutions of the nation. So how did it end up participating in a government bailout of the banking an finance sector? The answer is at first, it didn't.

From the article:

Though GE Capital owned an FDIC-insured savings and loan and an industrial loan company, they accounted for only 3 percent of GE's assets. Company officials concluded that GE couldn't meet the program's eligibility requirements.

So the company requested that the program "be broadened," GE's Wilkerson said. GE's main argument was fairness: The FDIC was trying to encourage lending, and GE Capital was one of the country's largest business lenders.

GE deployed a team of executives and outside attorneys, including Rodgin Cohen, a banking expert with the New York firm Sullivan & Cromwell....

Two days later, the FDIC announced a new category of eligible applicants – "affiliates" of an FDIC-insured institution. Bair explained that "there may be circumstances where the program should be extended" to keep credit markets flowing. That meant "certain otherwise ineligible holding companies or affiliates that issue debt" could apply, she said.

GE Capital now was eligible.

If there is still anyone that believes wealthy and well connected corporations actually prefer a free and competitive marketplace over one where they manipulate government power for their own advantage, please wake up.

No doubt this type of activity goes on at all levels of government throughout the nation. It is perfectly rational for corporate leaders to pursue a strategy to increase profits by securing advantageous government intervention in the market.

This is why those that govern, at any level, should be held to an extremely high standard of accountability. This, however, is only possible when governing is done in the most transparent way possible. Unfortunately, of late we seem to be suffering from a transparency deficit whose only rival for sheer size might be our budgetary one.

***Update: Dad29 has coverage of the second half of this story. Think our government isn't picking winners and losers in the market? Think again and click the link.

You to Citi to Cerberus to NewPage

Dad29 has this item worthy of special attention for all in NE Wisconsin (my emphasis):

This is kind of interesting:

Chrysler owes ... lenders, which include banks such as Citigroup Inc. and J.P. Morgan Chase & Co., about $6.9 billion. But President Barack Obama and his auto team had demanded that the banks cut that to $1 billion, while gaining no equity stake in a restructured Chrysler.

IOW, Obama's boyzzz want the Banks to give Cerberus about $6Bn.

Those would be the banks which are the recipients of taxpayer money, folks....so in effect, YOU are giving Cerberus about $6Bn.

The owner of Chrysler is Cerberus Capital. Cerberus is also the owner of NewPage Corp. a paper producer that owns a mill in Kimberly. The mill was shut down last year, killing about 600 jobs. The shut down was even more bitter due to the fact that New Page refused to sell the mill even though there appeared to be other interested buyers.

The Cerberus connection was one of the reasons why Rep. Steve Kagen D-Appleton voted against the auto bailout last fall. I wonder how he feels about a taxpayer funded loan to Cerberus funneled through bailed out banking giants?

I did a quick search, but couldn't find a recent update on the state of the mill. If anyone knows, please leave a comment or email me. I assume worsening credit & economic conditions since last year have made sale of the mill impossible now, but I don't know this for sure.

Leverage & the hair of the dog

The aspect of leverage in the Geithner plan that I previously found puzzling enough to call the paradox of leverage, may be just what we need. So argues Robert Samuelson Over at Real Clear Politics:

But succeed or fail, Geithner's plan illuminates a fascinating irony. "Leverage" -- borrowing -- helped create this mess. Now it's expected to get us out.

He goes on to argue that what we are seeing is a contraction in leverage resulting in prices of assets being unrealistically low, the inverse of a bubble. The Geithner plan, which Samuelson calls Uncle Sam's hedge fund, is an attempt to increase leverage. This will then entice buyers to purchase assets that they wouldn't otherwise.

Samuelson thinks that the biggest obstacle to Geithner's plan succeeding is whether or not buyers and sellers will be able to agree on prices. I am not sure this is an insurmountable problem. After all, buyers would put up only a fraction of the purchase price and then borrow much of the rest on favorable terms. But the really sweet part of the deal is that if the assets turn out to be worth less than the purchase price, they don't have to pay the loan back. US taxpayers will take care of that.

Coming to agreement on a price may not be a cakewalk, but buyers are faced with a quantifiable risk, their initial cash investment, and the potential for a huge payoff if the assets do turn out to have value.

Samuelson's discussion seems to hinge on the assumption that what we have is a liquidity* problem, not a capitalization problem. He is in the majority of opinion-holders in this respect, but that doesn't necessarily mean he is right. But then he goes on to note this:

Presumably, the government-supplied leverage would enable investors to pay higher prices.

That is to say, the government guaranteed low interest loan is in fact a subsidy for these purchases, which will drive prices up. No one doubts that this will push prices above what buyers are offering today, that is the whole point of the plan. However, this contradicts the fact that in describing the plan, Secretary Geithner has made a point of saying it uses the market to correctly price these assets, something the government can't do well in his estimation.

So excessive leverage helped create this mess by fueling an unrealistic run-up of asset prices. Now Geithner wants to try a controlled bubble to move assets off of bank balance sheets in order to get lending going. Please insert your own comparison to catching lightning in a bottle, a tiger by the tail, etc.etc. here. In any case, it sounds risky, but the alternatives may be worse.
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For a discussion of the liquidity vs. capitalization question, click here.

Some counterparties are more equal than others

President Obama gave GM and Chrysler another monetary lifeline today coupled with another ultimatum about coming up with a workable plan for the future. Who knows, maybe this time really will be the last time. The NY Times quoted his announcement (emphasis added):

“And so today, I am announcing that my administration will offer G.M. and Chrysler a limited period of time to work with creditors, unions and other stakeholders to fundamentally restructure in a way that would justify an investment of additional tax dollars...”

That is to say, GM will no longer be able to meet all of its current obligations to workers and to creditors. It is clear these parties will be expected to accept less than they are owed. This is the dreaded "haircut," that one often hears about in the press.

So, to be clear, AIG has a bailout history that looks like a version of the movie Groundhog Day, except that Bill Murray gets a new $1 billion dollar check every time he wakes up. Even after this long and winding and very expensive road, the folks sitting on the other side of the table from AIG are certainly getting different treatment than those across from GM.

Counterparties to AIG contracts, which include some of the biggest financial institutions in the world, get paid in full using taxpayer money. Folks that lent money to GM, or sold them parts on credit, no such luck. Get ready for the haircut.

AIG employees, some of whom helped bring the company down, get bonuses to which they were contractually entitled. Workers on GM assembly lines - haircut!

I'm not a GM worker, but even I can't help wondering where Larry Summers is. When it was AIG bonuses it was, we are a nation of laws and contracts must be honored, but today, nothing.

In both cases, I don't think we are talking about a little off the sides. These two groups may not even be recognizable after Uncle Sam the barber gets done with them.

What problem is the Geithner plan addressing?

It seems clear to me that the goal of the evolving financial rescue plan is to increase lending in order to facilitate economic recovery. From the details of the plan that Secretary Geithner unveiled last week it is also clear that he believes the way to do this is by getting those toxic (now legacy) assets off of the balance sheets of financial institutions.

The obvious question then, is will this work. It depends. The answer though, doesn't depend on whether or not Geithner has proposed the correct solution, but whether or not he has correctly diagnosed the problem.

Implicit in Geithner's plan (and explicit in the document describing the plan) is the fact that he believes what we face is a liquidity problem. This means that the assets that are being held by financial institutions are actually worth more than people are currently willing to pay for them. So the asset they are holding has value, but it is frozen, stuck in its current form. Being unable to turn these assets into cash cripples lending.

There could be a lot of reasons for this. Investors that would normally be willing to buy these assets may be reluctant to buy fearing more bad economic news. They may be reluctant to buy due to the complexity of these assets and the difficulty in accurately valuing them. Or they may be able to value them and are willing to buy, but they are unable to get financing to actually make the purchase.

The public/private partnerships in the Geithner plan are set up explicitly to address these problems. With the partnerships, assets get purchased, balance sheets improve, and institutions are willing and able to increase their lending.

There is another possibility, however. It is possible that the price people are currently willing to pay for these assets really is what they are worth. If this is the case, we have a problem of capitalization, not liquidity.

If banks and other institutions made loans and bought securities that are now worth a lot less than they paid for them, then they have lost money. If the losses are big enough, these institutions could be bankrupt.

The Geithner plan does not address this possibility. The question of whether or not banks had adequate capital was supposed to be answered by the 'stress tests' - remember those? No one hears to much about them now, certainly not in the context of the asset purchase programs.

Not only does the Geithner plan not address the capitalization question, but if the problem is in fact one of capital and not liquidity, the Geithner plan would be among the worst possible solutions from the taxpayer's perspective.

Treasury will use taxpayer money from the TARP and taxpayer guaranteed loans to entice private buyers to bid up the purchase price for these assets. If these assets really do turn out to be worthless, or close to worthless, taxpayers will be left holding the bag. A very big empty bag which we will have to fill with money.

It is true that in these cases the private entities will lose all of their money, but this represents a very small percentage of the purchase price. The vast majority of the funding is a government guaranteed loan that we will have to pay.

Given these two scenarios, I hope you can see just how important it is that our government has correctly identified the problem with the banks. If they have, then the Geithner plan may well work. If they have not, things are going to get much worse before they get any better.
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Click here for the RWC Blog primer on the public private partnerships in the Geithner plan.

Going to Plan G: The Geithner Plan

Treasury Secretary Geithner has now released the much awaited details of his plan to alleviate the banking crisis and return lending to normal levels in the hopes of fostering an economic recovery. As we know, the reactions of the market were generally positive. The reaction of Paul Krugman, not so much. Oh well, you can't please everybody.

I have been reading and thinking about this plan for much of the week and there is a lot to digest, so my blogging approach is going to be more shotgun blast rather than laser beam.

Geithner believes that at the heart of the credit freeze is the fact that banks have assets on their books that they can't sell, at least not at prices they are willing to accept. These assets are of two types: actual loans and securities which are backed by loans. Getting these assets off the books should increase lending, at least that's what Geithner thinks. The method that he proposes to get these assets off the books is the Public Private Investment Program (PPIP).

There are two types of PPIP, one type will buy pools of loans, the other will buy mortgage backed securities. These are the 'toxic assets' we have been hearing so much about. In an attempt to class it up a little, the word toxic has been replaced by legacy, which in this case should be means, "we're not sure what they're worth." The batch of loans or securities that gets purchased from a bank is the "investment" part of the PPIP. So how does the PPIP pay for the investment?

Both types of PPIP involve money raised by private companies. This private capital is then matched by the Treasury, dollar for dollar, using money from the TARP. These two piles of money together form the equity portion of the investment. But this makes up a very small percentage of the purchase price for the investment.

The bulk of the money for the investment comes in the form of a loan guaranteed by the government (that is, the taxpayers) to the private entity of the PPIP. When you hear coverage of the plan that is talking about a subsidy or wealth transfer or some other even harsher term, like boondoggle, this is what they are talking about. When the PPIP's purchase actual mortgage loans from banks, the government guarantee will come from the FDIC. When they purchase securities, the guarantee will come from the Fed.

So the private money, the TARP money, and the borrowed money, all added together, are what pay for the bundle of loans or securities that the PPIP buys from the bank.

The details of the plan indicate that Treasury hopes to purchase anywhere from $500 billion to $1 trillion of these legacy assets. But the money that congress explicitly authorized for the financial rescue, you know, the TARP money, was only $700 billion, and much of that has already been spent, so how do we get to $1 trillion. Here is the NY Times from March 20th:

The goal of the plan is to leverage the dwindling resources of the Treasury Department’s bailout program with money from private investors to buy up as many of those toxic assets as possible and free the banks to resume more normal lending.

This description omits the crucial detail that the leverage doesn't just mean private money, it also means those government guarantees which make up the bulk of the purchase funds. So a small slice of the money that was actually authorized for a financial rescue is being used to foist an obligation onto the taxpayer that is somewhere just south of $1 trillion. It's the paradox of leverage. While we are all trying to de-leverage our private lives, the Treasury is busy ramping up the leverage in our public ones. This begs several questions:

1. Did the original TARP legislation permit the leveraging of those funds into a much bigger obligation for taxpayers?

2. If it didn't explicitly allow the use of funds in this manner, is the Geithner plan illegal, or does it at least violate the spirit of the legislation?

3. Perhaps, since the loan guarantees will come from the Fed (or FDIC), it doesn't matter whether the original TARP legislation permitted the use of funds in this manner or not.

4. If the Fed is indeed allowed to take on huge burdens in the name of the taxpayers without an explicit authorization from congress, does that make it a thoroughly undemocratic institution?

5. Does the fact that I posed question #4 indicate that there is a Ron Paul rally in my future?

I'll leave it at that for now. This quick and dirty version of plan G was meant only as an introduction, a way to get my mind around just exactly what it is our government is doing in our name. More to come in the days ahead since there are many other angles to explore.
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Check out the Treasury's fact sheet on the plan here.
For some reactions to the plan click here, here, here, or here.

No seriously, go read the Treasury's fact sheet. It's short. If you can't be bothered, please go back to watching un-reality TV and absolutely do not ever vote again. Ever!

AIG, Goldman, Spitzer, and Me

Over the weekend I saw a google news headline that caught my attention since it was trumpeting news of a Goldman Sachs claim that they wouldn't have been negatively impacted if AIG had been allowed to fail.

Here is how the New York Times reported it on March 20th:

Hoping to reduce a swirl of speculation over its role in the bailout of the American International Group, Goldman Sachs reiterated Friday that its direct losses would have been minimal if A.I.G. had failed.

Funny, here was one of those much talked about AIG counterparties indicating that they wouldn't have collapsed along with a dissolving AIG. I thought the danger of just such an occurrence was the entire basis for the bailout from the very beginning.

In fact, I seem to recall that last fall we were forced to accept the bailout of financial firms like AIG or face the prospect of total global financial collapse due to a complex web of interrelationships. I am pretty sure that the threat also indicated an AIG collapse would cause clocks to run backwards, epidemic male-pattern baldness, previously obedient canines to refuse to roll over, and that gangs of wayward youth would overrun our streets, jaywalking and stealing candy from babies at will.

Sure enough, here is then-Secretary Paulson discussing the bailout last September:

“It would have been, in my judgment, unthinkable for AIG to declare bankruptcy,” he said, outlining “catastrophic” impacts on financial markets, money market funds and the savings of individuals and families.

So that was Saturday. I then spent two days snatching spare moments to think about how I would blog that the bailout was unnecessary and sold to the American people on false information (sound familiar?). It was going to be this great Gotcha! moment. And then today I read Eliot Spitzer in Slate:

What risk—systemic or otherwise—was being covered? If Goldman wasn't going to suffer severe losses, why are taxpayers paying them off at 100 cents on the dollar? As I wrote earlier in the week, the real AIG scandal is that the company's trading partners are getting fully paid rather than taking a haircut.

Scooped by Slate! No doubt thousands of other blogs probably covered this same topic, but I didn't read them, so I still felt like I was adding to the discussion, not just the noise. But once I read Spitzer's piece I thought well, what do I have to add.

Getting scooped is one thing, but getting scooped by the former governor of New York who resigned after it was revealed he engaged the services of call girls*, well, that's hard to top. Unless Bill Clinton starts a blog.

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*The news coverage on Spitzer often seemed to include the fact that the governor wasn't just trolling darkened alleys for your average street-walker. But let's face it, a call girl is just a high priced hooker. Econ majors that are too clever for their own good like to tell people that prostitution is good where high prices are used to signal quality. When you get right down to it, though, you can jack up the sticker price and call it a Lexus, but underneath it's really just a Toyota.

The Bush-Obama Plan

During the election, the Obama campaign made a strenuous effort to connect John McCain and President George W. Bush in the minds of voters. This was smart politics - Bush was, and remains, tremendously unpopular.

I wouldn't be surprised if a large number of voters in the last election voted for Barack Obama because they believed that McCain represented a continuation of Bush policies and Obama represented a break with those policies.

Well, if these same people examine the Obama plan to handle the so-called toxic assets on bank balance sheets, they have to be asking themselves whether they didn't accidentally confuse exactly which candidate it was that represented a continuation of Bush policies.

When it comes to adressing the banking cirisis the Obama approach is identical to the Bush approach. Here is the New York times from March 20th on the plan:

The plan to be announced next week involves three separate approaches. In one, the Federal Deposit Insurance Corporation will set up special-purpose investment partnerships and lend about 85 percent of the money that those partnerships will need to buy up troubled assets that banks want to sell.

In the second, the Treasury will hire four or five investment management firms, matching the private money that each of the firms puts up on a dollar-for-dollar basis with government money.

In the third piece, the Treasury plans to expand lending through the Term Asset-Backed Securities Loan Facility, a joint venture with the Federal Reserve.

The goal of the plan is to leverage the dwindling resources of the Treasury Department’s bailout program with money from private investors to buy up as many of those toxic assets as possible and free the banks to resume more normal lending.

But the details have been treacherously difficult, politically and financially, and some of the big decisions are the same as those that bedeviled the Treasury Department under President George W. Bush last year.

Sound familiar? This was the approach taken last fall by then-Secretary Paulson. I guess since Geithner was closely involved in the plan from his position at the New York Fed, no one should really be surprised at the nearly seamless transition. Someone might want to let Obama know that the plan was too difficult for Bush and Paulson to implement and nothing came of it other than the catatonic nature of the economy over the last six months.

I have yet to see anything from Obama and Geithner that would lead me to believe that they would be any better at making this plan work.

It is quite possible that Obama defense policies, carried out by Bush-appointed Robert Gates, differ more from the previous administration than does the Obama response to the financial crisis, which is crafted and implemented entirely by Obama appointees.

Liberal advocay group Move On has a website called the Bush-McCain challenge which was intended to demonstrate and reinforce the similarities of those two men, in order to prevent McCain from being elected.

If they haven't already, some smart Republican activist should start their own version of this game, the BushBama Banking Bailout.

Bonus Coverage

Andrew Ross Sorkin of the NY Times recently made an attempt to follow The Other McCain's Rule 4, but only on the flimsiest of pretexts, so I really don't think that it counts.

Mr. Sorkin argues that we should, in his words, swallow hard and pay the AIG bonuses that have caused so much outrage over the last two days in order to maintain the "sanctity of contracts."

Meanwhile, preeminent econoblogger Tyler Cowen over at Marginal Revolution takes time to blog about the fact that he is not blogging about the AIG bonuses.

Memo to these agents provocateurs of media old and new: Bucking conventional wisdom in such conventional ways does not make you Christopher Hitchens. It won't even get you points toward your contrarian merit badge.

Did we really need Sorkin to extoll the virtues of maintaining contracts when we already have Ed Liddy and Larry Summers doing the same.

As for Cowen, if blogging about blogging is 'meta', what is blogging about not blogging?

Try again guys. Next time just don't try so hard.

AIG: Pharaoh should let it's people go. Now.

News has come down that AIG will pay out $165 million in bonuses.

No doubt much ink and many pixels will be spilled venting outrage at these antics. For myself, I can only add, somewhat dejected, I am not entirely surprised that this type of thing is going on since the government has made it clear that AIG is not going away.

Bill Kristol on Fox News Sunday summed it up nicely:

AIG sold these credit default swaps to very sophisticated investors, mostly to other banks and other major financial institutions, many of them in Europe, they bought these thinking hey easy profit, no risk....[these were] insurance policies against stocks that they didn't own. They thought they were just making money. AIG thought they were making money and the counterparty thought they were making money. And the way the bailout has worked, as I understand it, is that the counterparties have been relieved of any risk, not only any risk, any loss...If you're a sophisticated bank who bought a credit default swap from AIG you've been made whole. No haircut even, not even 80 percent or 90 percent, 90 cents on the dollar.

I was just going to leave it at that, but reading that news story linked above I can't resist these.

"But where there are contracts, binding contracts that were entered into long before the government put any money into AIG -- we're not a country where contracts just get abrogated willy-nilly," he [White House National Economic Council director Larry Summers] added.

Well, when you run your company in to the ground and you know, bankrupt it, then it cannot pay its contracts. My question is why should taxpayers have to do so?

Then, there was this item (emphasis added):

In a letter to Geithner Saturday, Liddy [the government-appointed AIG boss] said the bonuses could not be cancelled due to the threat of lawsuits for breach of employment contracts, and that AIG risked an exodus of senior employees if it does not pay them out.

Finally some good news! The "senior employees" of AIG are threatening to leave. Why are these people even still on the premises? Is there any reason we would want to keep senior leadership that runs a company the way that AIG has been run?

AIG has got to be the best argument of an "exodus of senior employees" at least since Enron. Here's hoping that exodus or not, we don't end up wandering in an economic desert for forty years.

Economic Meltdown Works Weekends

It seems that both blog production and blog reading go down dramatically on the weekends. This feels counterintuitive to me, since I work on what could be called a traditional M-F schedule and I have more time for blogging and blog reading on the weekends. Maybe I am just out of step with most of the rest of the world. It wouldn't be the first time.

Regardless, here are two items that I read over the weekend that are worth taking a look at:

First, here is a Bloomberg article which discusses former Fed Chairman Paul Volcker's idea for a two-tier system as the future of banking:

Commercial banks would provide customers with depository services and access to credit and would be highly regulated, while securities firms would have the freedom to take on more risk and practice trading, “relatively free of regulation,” Volcker said.

I realize we are nowhere near out of the woods yet, but it is never too soon to start thinking about how to avoid a similar catastrophe in the future. It is possible that identifying a system that could prevent the problems we have now from recurring might also provide some insight into just how to get out of the current situation.

In explaining economic matters of late, it seems that writers often resort to medical metaphors. Particularly those of patients on tables with acute coronary symptoms. Of course, when you're in the middle of a heart attack you want to talk to the intern with the defibrillator, not the dietitian with the tray of low-fat food from the cafeteria. But let's face it, our economy is not a sick patient so maybe the long term fix has some bearing on the short term one. Frankly, I blame E.R. for the rampant use of medical metaphors (For all the talk of zombie banks, that E.R. is a zombie television show. How many times has that show recycled its plots and characters? Wow. That was uncalled for.)

But Volcker's idea is definitely worth considering. It may be a way to provide meaningful regulation that can make our financial system stronger (not brittle) while not destroying the entrepreneurial spirit, which accounts for so much of our economic success.

Also, any future scheme (and any plan to fix the current mess) must protect depositors and must not protect shareholders. It has to have both elements. These days our government seems unable or unwilling to distinguish between people that deposited their money in institutions with an explicit guarantee of safety and those that put their money at risk by buying stocks and, to a lesser degree, bonds.

Speaking of protecting shareholders, Yves Smith at naked capitalism had a great post discussing the nationalization question. It is in the form of a call-and-response smackdown that she gives to a piece by Alan Blinder in the NY Times.

It's a long post, but worth the read if you want to be armed to tackle the question of nationalization. She puts a fine point on it right from the beginning:

...opponents to nationalization often raise the image of enterprises being expropriated by the state, in other words, healthy (or at least viable) businesses being stolen.

We have the reverse here. Instead a transfer of wealth from the private sector to the state, we have the state (as in the taxpayer) propping up businesses and keeping management demonstrated to be incompetent, perhaps corrupt...

I would try to create a sense of urgency for checking these out, but since neither involves massive spending on long sought after Democratic agenda items, I doubt the government will tackle either any time soon.

AIG (All Income from Government)

I wish Obama had spent some time in his speech outlining exactly why it is we need to keep pouring money down the AIG rabbit hole?

I see we may be giving them another $30 billion. Oh, and converting those dividend paying preferred shares into non-dividend paying shares.

It seems AIG will join Citi in the pantheon of corporations with too much government money to fail. Ever.

Citi, USA

There have been reports this week that the government is considering an even bigger stake in Citigroup, a stake possibly as large as 40%. I can't figure out how this is in the taxpayer's interest, but I can imagine a scenario where it is in Citi's.

The larger stake would come from the conversion of the currently held preferred stock (the stuff purchased with TARP money) into common shares.

With the preferred shares, the U.S. government had shares that pay a much higher dividend than common shares. The preferred shares have the additional benefit of being ahead of common shares in any claims on the bank's assets.

Of course, converting to common shares would greatly reduce the value of the shares that are currently held. But at least one report I read indicated that Citi's management has actually asked the government to take the proposed larger stake. Why? First, of course, the dividend on the preferred shares would no longer have to be paid. But could there be another reason that this would be in Citi's interest?

A bankruptcy and liquidation (call it nationalization, receivership, the 21st Century Resolution Trust Corp., whatever) will result in the value of common shares being wiped out. Now imagine that the U.S. government owns 40% of the common shares. Under this scenario would the government ever, regardless of what any stress test shows, declare that Citi is insolvent and should be liquidated? This would require Geithner or Obama to stand at a podium and announce that the money used to buy the preferred shares is gone, wiped out.

They could try to pin the loss on Bush/Paulson, but this is one case where I doubt that line would even make it out of the briefing room. Besides, you know Karl Rove would have an Op-ed in the Wall Street Journal the next day claiming the purchase of preferred shares had the chance of being a moneymaker for the taxpayers of this nation.

The illusion of value with the preferred shares may be just that, an illusion, but I can't believe that the Obama administration would convert the preferred shares to common only to turn around and force Citi to dissolve. If they were too big to fail before, now they will be too valuable. After all, they received taxpayer money under the TARP.

Could Citi see a 40% stake in the form of common shares held by Uncle Sam as an insurance policy against ever being forced to close its doors?

The possibility of government action, both the possible conversion to common shares and the possibility of a goverment imposed liquidation have kept Citi share prices down. If the government does become a large common shareholder I would guess that private money may flow back into Citi shares on the belief that there is no way the Obama administration will force to Citi to liquidate when it holds so many shares. (Hey TARP Results Blog, you still have those Citi calls?)

So, let's see. For the taxpayers, conversion to common shares would mean no dividend and would guarantee that the TARP money would be lost in the event that Citi closes for good. For Citi the conversion means a reduced dividend payment and the tacit backing of the U.S. Government.

Of course, I could be way off on all of this. I mean, I'm no Gordon Gekko. In fact, I didn't even see Wall Sreet. But this sure sounds like more of the same from the last six months: heads they win, tails we lose.

I've heard there are 99 strains of the common cold....

.....and we have been suffering from eight of them, so blogging time has given way to nose wiping and medicine dispensing.

And no, I am not live-blogging the President's address to Congress.

But I wanted to note quickly that Yves Smith over at Naked Capitalism has a great post up on exactly what is wrong with the AIG bailout. Here is a taste:

What has been appalling about AIG is that Uncle Sam initially imposed a suitably punitive deal but then for reasons that remain a mystery, relented . Since the federal government is NOT a regulator of AIG, there was no reason to expect the authorities to step in, save Ben Bernanke and Hank Paulson's attentiveness to the needs of the financial sector generally. AIG has globe-spanning operations, and there is no good reason why the US public should be stuck with the consequences of their lousy risk management decisions. But not only did AIG get considerably more in loans in version 2.0 of its deal with the US government, but the terms on its initial loans were improved considerably.

Go read the whole thing.

And just to be clear, even though the blog is called Naked Capitalism, it is totally safe for work. Unless of course you work at AIG corporate headquarters. (But not at one of its still well regarded subsidiaries!)

Why NASCAR Will Never Replace Football

Since I wholeheartedly embrace all things related to my adopted home state of WI, I am glad that Kenseth won. But really, the future for a so-called sport with this many problems is seriously limited.

1. Their equivalent of the Super Bowl is the first event of the year. Does that make the rest of the season anti-climactic?

2. OK, so you want to have your premier event first? Fine. But finish it. I mean to declare a winner with almost one-quarter of the race remaining?

3. I realize part of the appeal is the wrecks, but when a driver that hasn't done much lately manages to wipe out a good sized percentage of the field, including the car that had been running the best, how does that add to the excitement? (Football was less exciting when Tom Brady went down, not more exciting because he got hurt.)

4. They only turn left, except for the road races, where they also zig-zag, but then they have to drive slow.

5. Oh yeah, and after tomorrow, the companies that make the cars might not be in business any longer.

See, I knew I could relate any blog post to the economic crisis. It's like a new twist on that Kevin Bacon game, Six Degrees of Government Bailout.

A co-worker of mine, who is a NASCAR enthusiast, once disparaged open-wheel racing in my presence because during the pit stops they only had to remove and replace one lug nut. Maybe if we do move to a more European style economy, we can learn to love European style racing too.

Too Much Insolvency, Not Enough Resolve

If it wasn't already, it is now becoming increasingly clear that the stimulus bill will not be the tool for ultimately reviving the troubled economy. While there is an argument to be made for expanding the safety net in a sudden and drastic downturn, it is the near total collapse of functioning credit markets that is at the heart of the matter. Only by restoring the flow of credit will we put ourselves on the road to recovery.

No doubt a large part of our total credit system comes through finance companies that provide money for all types of purchases, but the real center of the broken lending system is the large banks. The notion that these large banks are for all intents and purposes insolvent, is approaching a critical mass, but don't take my word for it: Here is Yves Smith on naked capitalism; CNBC; Historian Niall Ferguson in the LA Times; The Crunchy Con.

Even at this late stage in the crisis though, no one on Wall St. or in Washington seems ready to declare that the emperor has no money and figure out a way to move forward. To that end, I offer the following.

Memo to bank shareholders (and corporate boards): You weren't paying enough attention to the companies that you owned and those companies are now worthless. Therefore, your money is gone. That is what can happen when you invest.

Memo to lawmakers: Stop calling the heads of major banks to Capitol Hill for a ritual flogging that is little more than political theater, resulting in no discernible change in the state of affairs. It doesn't count as calling them on the carpet when they are standing on an $87,000 area rug.

Memo to Geithner: We're twisting in the wind out here while you find your inner Secretary of the Treasury. You want to give the banks a stress test? Great. Here is an instant stress test: Announce that there will be no program under which the US taxpayers will purchase assets for more than market price. Once this is clear, this game of wait and see will be over and we will know which banks can survive and which cannot.

Memo to bank CEO's: We get why you are waiting, as long as Treasury strings you along and keeps you alive, you can wait until taxpayers subsidize all of your terrible decision making. Perfectly logical. I've got news for you though, people in this country are fed up. You had better do a lot better job of making a case as to why we should rescue you, if one even exists. It is not at all hard to imagine your collapse followed by a government takeover that includes restructuring most of your bad loans on terms that have some reasonable chance of being met. Then these scrubbed loans being sold to whatever institutions are left standing after all of this (or possibly some new ones that come into being just to buy up loans that have been through a government restructuring). By the way, just because you don't like the market price of an asset you are holding, that doesn't mean the market is wrong. And if nobody wants to buy the asset you are trying to sell, then it is worth nothing.

Memo to self: Enough already with the memos.............