The Bubble Asks for a Bail Out

Last Monday the front page of the Wall Street Journal headlined a story  which outlined why the most powerful real estate developers in the U.S. have formally asked for a bailout loan from the Federal Government. A drop in asset values from to the real estate bubble, rising vacancies and dropping rents in the commercial markets have depressed cash flows so much that many of these large developers cannot meet their debt obligations.  These developers cannot look to banks for additional credit because they are already over leveraged; they are left to turn to the government for help. 

The depressed rents and a sudden depreciation in assets that the developers are describing should not be a surprise to anyone. When Bernanke and Paulson said the real estate market would be entering an adjustment period, this is exactly what they were talking about! 

To understand how dangerous it would be to extend government credit to real estate developers, it is important to first take a step back and restate the causes of the "real estate bubble" which is considered the impetus of the 2008 recession. The real estate market is like any other free market, driven by supply and demand forces. In its most simplistic and fundamental form, the real estate bubble was created by artificial demand side changes. An extremely lax credit environment created artificially¹ high demand for real estate, (more borrowers qualified for loans = more demand) which in turn led to an artificially high valuation for real estate. Credit was then extended based on this artificially high valuation of real estate assets.² The bubble "popping" was the realization that all the underlying assets were, in fact, overvalued, which meant many of the properties purchased within the bubble had mortgages based on a value higher than asset’s actual worth. The bubble was simply a difference between an artificial inflation and reality. This recession is an adjustment period for the credit markets, where all of the mortgages will somehow adjust or unwind to meet pre-bubble prices.

Offering government issued loans to developers would slow or reverse this market adjustment, which must happen for the real estate market to find a firm footing and for credit to start flowing again. If the government extends loans to real estate developers they could only do so by ignoring the deflated value of the underlining assets. (This is inherently true in the request to the Government. The market has deemed these assets unfit to extend additional credit, forcing developers to ask the Government for a loan.) To issue a new loan on these deflated assets the Government would have to repeat the mistakes of the past and secure a loan based on an inflated asset value. The Government would essentially be reinflating the bubble by allowing Real Estate Developers to continue to over leverage their depreciated assets. This will continue to fuel the artificial demand that caused this recession and prevent the market from finding a bottom from which to rebuild. 

The recovery of the credit markets is hinged on a return to a realistic (pre-bubble) valuation for real estate. Proper underwriting depends heavily on being able to comfortably assign an applicable risk premium within the interest rate, and this can only be done if the lender is comfortable with the stability of the securtized asset. If the Developers received a bail out their assets will not undergo the market adjustment, it would artificially keep real estate prices high, and prevent the market from finding a bottom.   

There is no solution that will help troubled Real Estate Developers, they are probably extremely over leveraged now that their assets have lost so much value. As the economy contracts real estate rents will need to come down to meet demand changes. It may also pose the scenario where an asset manager may need to offer space at a loss to cover at least a portion of fixed costs. The riskiest of the real estate developers, those who took on the most debt based on inflated values, will probably not survive the adjustment, but this is a necessary process. 

If left uninhibited, the market forces that are driving real estate values downward are the path to economic recovery. Inexpensive space decreases the barrier to entry for emerging businesses. New and more conservative Real Estate Developers will now have a greater opportunity to expand by capitalizing on the bad bets made by riskier developers. The worst over valued properties will be defaulted, and then resold at more realistic values at auction and lenders will be insulated by auction losses by Government backing already guaranteed through TARP. This process will eventually lead to the bottom of the market, where prices become stable. This stability will allow credit to start flowing again by solidifying confidence in the value of real estate, which will once again be used to leverage new loans.  

This new request will prove to be a real test for the Federal Government. The Developers' problems are a description of the natural market forces adjusting in the wake of a real estate bubble. Depressed rents, and depreciated assets are a necessary evil as our economy searches for a firm footing. I can only hope that congress has the sense not to hand out money to everyone that asks, and instead analyzes the impacts of their stimulus. This will be an opportunity to either show a true understanding of the causes of this recession by denying the developer loans, or show true ignorance by granting them. 

 

1.   Demand was "artificial" because borrowers received loans they should not have qualified for in a normal credit environment. This is a widely accepted cause of the real estate bubble. 

2.   To understand the crisis in more detail please see two articles I wrote in October, "Truly Understanding the Credit Crisis..." and "You Would Have Been an Idiot Not to Take a Teaser Rate..."

Money Does Grow on Trees! The Fed Goes to 0%.

In the past two weeks the Fed made a remarkable policy decision by moving the federal funds rate to zero, and the market made a remarkable move to push the U.S. treasury yield on a 4 week note below 0%. These stories are an important fear indicator. The Fed has taken the position that they are willing to flood the market with dollars. With not even a whisper of inflation the policy is to literally give money away for free. But instead of throwing money out the backs of armored cars, banks and a broad range of investors are giving it back by buying short term treasuries at a loss, saying thanks, but no thanks, the market risk just isn't worth it. 

The treasury yield story is history in the making. Both the Times and the Wall Street Journal have various economists weighing in, both suggesting that this has not happened since the Great Depression. The interesting nuance now is we supposedly have safety measures in place that would curb the kind of risk one assumed when keeping cash in a simple bank account during the Great Depression. This treasury yield signals that a bank/investor/hedge fund would rather give
their money to the federal government for safe keeping rather than holding it in cash. There is so little faith in the U.S. Banking system in the year 2008 that there are people making rational choices to have the Federal Government hold onto their money, at a loss, for the protection from a financial collapse over the next 4 weeks. If this all sounds very grim, it is because there is no
other rational explanation. Many of the articles site the fear of other riskier options like the broader stock market that have driven higher demand for these safe treasuries, but such a mounting demand that it actually pushed the yield negative is shocking.

The story on the federal funds rate seems to be a last stand, it is the Fed’s Alamo. What more can the Fed do to try to spur lending again? They have literally left the vault open and no one has shown up to take the money. There have been some early reports that this, along with moves by other major central banks to cut their benchmark rates, have helped curb some investor fears, but these are unchartered waters and no one really knows how long it will take for credit to flow again.

This all circles back to the uncertainty in the real estate market. I see the majority of lending in the U.S. as a house of cards with real estate as the base. Most loans are secured on a real estate asset. Small - medium businesses rely on the real estate market to leverage capital improvements and individuals rely on their real estate stability to access credit and build wealth. We are in a time where no one is really sure when the real estate trough will be. As a result, the base of the house of cards has collapsed. No one wants to take on additional risk lending or borrowing when the value of the securitizing is completely unknown. It creates the circumstance we see today, the Fed can offer money for free but with lenders and borrowers sitting on the sidelines there seems to be little interest to be the first one back into the pool. 

These two stories indicate that the recession still has a way to go to find its bottom. Even with the fund rate at 0% and the Fed pumping dollars into banks to sure up their balance sheets (See "Throw in the Kitchen Sink" for a description of all government infusion programs) lending continues to be sluggish and the market seems extremely risk adverse overall.

Because every story has a silver lining, these two represent a unique advantage to the President elect. The government now essentially has zero cost to capital. Even the 10 year treasury is at an all time low, settling just over 2% today. With such inexpensive borrowing this is an excellent time to make the kind of infrastructure investments Barack Obama has suggested. This approach will indirectly stabilize the housing market by putting dollars directly into the hands of consumers and our nations infrastructure will get a much needed face lift at the lowest possible cost. Maybe a massive government driven stimulus is exactly what this free market needs to get back on track.  

Homeowners Re-defaulting. I Told You So?

I read a report in Reuters today that was titled "Homeowners Redefaulting After Getting Aid" and I now have the unfortunate right to say to the FDIC, "I told you so." 

The FDIC plan to restructure mortgages seemed dangerously underdeveloped when I first analyzed it in my article "When a Government Becomes a Bank, Anyone Else Concerned with Moral Hazard (part 1 of 3)."  In this 3 part series I analyzed 2 proposals for readjusting troubled mortgages, the worst of the two being the FDIC's loan guarantee program. The basic argument I tried to convey is the loan guarantee does not address the essential problem troubled borrowers are facing: Troubled homeowners are over leveraged, at best they can afford their loan principle at a "teaser rate" which the current market cannot provide, even with a government guarantee. Without addressing this core issue the FDIC program is going to fail, miserably. This Reuters article reports that over half of all restructured mortgages have failed within the first 6 months; it is just proving my point. 

I am disappointed the FDIC program did not take into account some nice aspects of the second program I profiled in "When a Government Becomes a Bank," which extended the term of the loan. The term focused plan was part of the depression era Home Owners Loan Corporation program. It allowed principles to be extended over a longer period of time, thereby reducing the monthly debt service to a manageable level. This is still a viable solution if the market is willing to look at a much longer time horizon. If not, this may be the best government driven solution I have heard so far, and presumably would have significantly less risk to the taxpayer.

I see this recent statistic as the start of a colossal blunder by the FDIC and I am worried that it may shake congress' confidence in Henry Paulson and Ben Bernanke's (who were weary of the FDIC plan as I pointed out in "Nice to Know Henry Paulson Agrees a Loan Guarantee Will Not Work") economic recovery vision. The Reuters article is already showing signs of grandstanding by politicians, citing Rep. Barney Frank (D) who chairs the House Financial Services Committee as saying that he would agree to release the remaining $350 billion only if "they (the Bush administration) made it clear they were wrong in refusing (to use) it for foreclosure relief...Foreclosures are getting worse." The problem is not a resistance to help foreclosures, the problem is the FDIC plan is fundamentally flawed, and does not address the central over leveraged issue. Someone needs to either guide the private market to provide term extending debt packages, or seriously explore a government driven alternative in order to make any real change in foreclosure rates. 

In light of these new statistics I tried to find any FDIC projections for default rate, which were unavailable, but I did uncover a new shocking detail about the plan. From a press release from Nov. 20, 2008 which highlights a speech given by FDIC chairman Bair to the Johns Hopkins Cary Business School:  

"We'll accomplish this (the loan guarantee program) at no cost to the taxpayer or the deposit insurance fund. The TLPG is being offered under the systemic risk exception in our statute. Fees for the guarantee have been structured to cover our expected costs. However, in the unlikely event of a shortfall, the difference will be made up through a special assessment on all insured institutions, consistent with the procedure contained in our statute." 

A very relevant, yet not widely publicized detail. In this case the taxpayer is saved, new burden for default is put on the already distressed financial sector. So if I understand the reasoning:

1.    The banking sector cannot afford the losses they are taking on defaulting mortgages. Therefore: 

2.   The FDIC will "guarantee" the mortgages. But 

3.   The guarantee will be paid for by the banks that are FDIC members. Therefore:

4.   Banks are again guaranteeing themselves. 

Is this madness?! This is not a government guarantee at all, this is spreading the losses out among all banking institutions through a government created utility. I won't even begin to address the free market problems and backward incentive structure this creates, it will have to be put into its own installment. How did this plan get approved? 

 Everyone cross their fingers that Obama has someone a bit better for the FDIC, this plan is a fast sinking ship.

What if Housing Doesn't Come Back?!

I have been mulling around a simple concept over the past two weeks. Our housing market for many years has been driven primarily by easy access to credit. It allowed many home buyers to overextend, and even more suitable buyers access to extremely (relative to the 80s) inexpensive financing options. Much of this (putting aside much better Fed policies since the 80s) can be attributed to an extremely lucrative market for mortgage backed securities. It leads me to the simple question, what if the mortgage backed securities market doesn't come back...ever?  

 

Many economists, including Henry Paulson, are calling the real estate tumble a "market correction" which is an inherent acknowledgment that there was something wrong with the housing market that now needs correcting. There has been a lot of discussion about the need to make mortgage backed securities more transparent so investments carry the appropriate risk level to stem a future crisis from happening again (I have yet to hear of one viable option). But no one is really admitting that whatever new form these securities will take, it will never be the same. These new securities will have added cost due to new government oversight, and more importantly they will be sold in a market where investors now consider the security extremely risky, instead of extremely safe. 

 

Since most individuals purchase real estate with credit, cost of accessing credit is a strong contributing factor for the demand for real estate. Packaging mortgages and selling them in a bulk security greatly lowered the cost of borrowing. It opened the mortgage market up to a world (literally the entire world) of investors. A bank in Ohio no longer needed to hold the entire mortgage amount; they could sell these mortgages on the open market, possibly finding a buyer in an investment bank in India. The attraction for investors was a chance own what was considered a diversified (a wide range of underlying properties in a security), safe asset. The U.S. housing market was perceived as very strong through the 90s and could offer a lucrative return, thereby encouraging more investment. So what happens when the perception of mortgage backed securities moves from being the safest to the riskiest investments? There is the obvious response that credit immediately freezes, we have already seen that, but what happens 10 years from now?  

 

This may be the end of real estate based wealth building as we know it. For years housing prices were driven upward, I would argue primarily by easy credit. Securitizing mortgages brought borrowing costs down so low there was an influx of new demand into the market. Now, with more investors becoming extremely risk adverse to U.S. housing market investments, there will be an immediate capital drain from the market. Even as the credit markets begin to thaw it will take a significant amount of time before the fear towards the market subsides.  

 

Looking forward two years from now, after the global recession will begin to (hopefully) ease, and when consumer spending and Fed policy returns to normal; the mortgage market may look very different. With an additional fear factor, investors will be looking for a higher return to account for newly recognized (does not even need to be real, just perceived) risk in the U.S. market, this will translate into much higher interest rates for mortgages. Higher rates means a higher barrier to enter for new buyers, and demand will take a heavy hit. I would also predict this will effect all tiers of real estate in different ways. Those with good credit that remain in the market post-crisis will not be able to afford the principle they were able to pre-crisis because of higher debt service. This means even the luxury home market will take a significant hit. I also believe the overall skittish feeling toward the market will deter eager investors who purchase properties on spec for a short term reward. All of this translates into a long term national depression in demand for new housing. In the end I think this "correction" will adjust for more realistic risk, and once the adjustment is made home prices will appreciate again, but at a much slower pace then we may have become accustomed to over the past two decades. I would predict, after the adjustment is completed in about a year or two, the appreciation of most real estate will closely follow local income growth (which hasn't been too great on a nation scale the last 20 years) of the middle class or better, (those with good-to-great credit) rather than any other external factors. 

 

To end on a bright note. If you rent, this is great news! Wait out this adjustment period, build your credit now,  save up for a ridiculously high down payment to secure your loan, and hopefully the post-recession, post-crisis, interest rates won't be too far out of reach! Just don't count on your home being your nest egg unless you anticipate a sudden jump in U.S. income growth, similar to the growth we had post world war two, but have not seen since. Your home will just be your home, it will not generate income or make you a millionaire, but at least you get a tax credit on the mortgage and don't have to deal with a landlord! 

Throw in the Kitchen Sink!!

On the front page of today's Money & Investing section of the Wall Street Journal the front and center article outlined all the new plans the Federal Government is putting in place to boost consumer loans and help keep yields low. The article was titled Fear Recedes in the Debt Markets, and it is quite clear why. The Federal government has decided they can't decide what new tool implemented out of all the various options considered in the last few months, so they have decided to do them all! I would hope fears have receded because the whole financial market has been effectively backed by a boat load of government guarantees.  

Here is a list of each program proposed to be implemented thus far (that I know of), some are old favorites but the Fed has some nice new ones:

 Directly under the Treasury 

• Troubled Assets Relief Program (TARP) - this program has changed over the last couple of weeks. First introduced as a tool to purchase toxic assets off the balance sheets of financial institutions, Secretary Paulson indicated 2 weeks ago will instead be making direct equity contributions. He has also indicated that he will reserve nearly $400 billion for the use of the next administration. 

 Directly under the Federal Reserve

• Term Asset-Backed Securities Loan Facility (TALF). This facility will lend as much as $200 billion to holders of certain high grade securities backed by assets such as student loans, credit-card loans, auto loans and small-business loans. Only $20 million of this $200 Billion of which will be backed by TARP. 
• Direct purchase of $500 billion of mortgage bonds guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae. 
• Direct purchase of $100 billion of Fannie, Freddie, Ginnie and the Federal Home Loan Bank debt securities through a reverse auction starting next week.  Apparently Secretary Paulson didn't see this fitting into TARP but someone thought it was still necessary. I am assuming this will allow toxic debt to come off of balance sheets and held by the Fed. 

 Directly under the FDIC 

• FDIC insurance on Financial Notes. This is a boost to the bond markets. The FDIC backed the first issuance of financial corporate bonds Tuesday when Goldman Sachs issued $5 Billion of three year notes. The Government backing nearly halved the yield on the notes to about 3.25%. 

 Looking over the list I see everything. I have not heard of any other finance industry related rescue plan since this crisis began. It seems as though the Federal Government couldn't decide what would work so they swooped in and backed everything. We will never be able to know if this was all necessary. I would never want to be in Secretary Paulson's place now, so I will only assume he is making the best choices he can given the information. I just hope this is enough to stem market fears in the long term and induce private investors back in the market because this is it. The government is out of ideas.  

The Company Lost Billions this Year But Where is My Bonus!

Over the last two weeks the gloom and doom economic reports seemed to have no end. Citi got another boost from the government, the auto companies pleaded for help, the entire "free market" as I knew it seemed to have dissolved. I was left wondering the why and how, and then I was given a bit of clarity. A large part of the problem may be a poor incentive structure that rewards executives for very risky, short term, decisions. I want to focus on two stories about two companies, Goldman Sachs and the audacity behind the executive request to forgo bonuses, and the severance checks for the executives of the fallen Wachovia. Both circumstances, although different, point out a unique nuance to our "free market" incentive structure, one that may be responsible for short sided decisions that can contribute to a cataclysmic demise of a multi-national goliath.  

 

It seemed oddly out of place the other day when I read that many Investment Banking Executives have decided not to take bonuses this year, sending letters to the board of directors requesting their usual bonuses not be offered.  What seemed so wrong about this story is the notion of Executives making a request. Over the years Goldman Sachs has posted some of the highest profits on Wall Street, and as a reward their top executives have seen healthy bonuses for leading this highly profitable company. Last year Lloyd Blankfein, CEO of Goldman, received a salary and bonus worth $68.5 million, almost all in bonuses (his salary was approximately $600,000). This very lucrative compensation is supposedly  awarded by the board of directors, representing happy stock holders and showing their power over the company’s leadership. The fact that the executives requested bonuses be withheld tells a much different story. An effective board would insist that the CEO who lost billions of dollars in stock value and nearly bankrupt the company would not receive a bonus. This effective board would never honor a request from executives to forego a bonus because it is not their decision to make. The Goldman Executive request shows the board does not really have the power of the purse, or any real control, it is all held with the corporate executive. This is a problem because the two groups represent different time horizons. The Executive view is short term, how can they make profits as high as possible year over year to justify a huge bonus at year end. In contract the board is supposed to represent longer view, ensuring company sustainability to ensure the company they own rises in value indefinitely. When the balance shifts completely to the executive view, because there is a powerless board, it results in short sided, quick profit decisions. In this case it meant diving head first into high risk sub-prime mortgages to get a $70 million pay day. The consequences are then left to the long term stock holders when the bets go wrong and the company is brought to its knees.

In yesterday’s Wall Street Journal, buried way back on page C5, was an article by Dan Fitzpatrick telling a story of the compensation received by executives in the wake of the Wachovia collapse. As a refresher Wachovia was one of the victims of the crisis, nearly collapsing under its exposure to sub-prime debt and eventually was acquired by Wells Fargo (Fargo won a fight for the company with Citi). In its wake was a devastated stock price, moving from about $50/share pre-crisis to today's value of about $5/share, and the prediction that most employees will be laid off as part of the acquisition. Today's WSJ article reports that the top 10 executives that controlled the helm of this company through its demise will be receiving a combined $98.1 million in severance for their fine work. I think a $100 million severance is a bit too high of a reward for destroying a company. Besides the obvious discomfort that comes with the fact that an executive is rewarded for bad work is the reality that this represents a backward incentive structure. In this case the severance is only accessible if the executive is let go. Similar to the Goldman situation they are now empowered to determine their salary. Looking at the fall of their stock options at some point a Wachovia executive would be better off letting the company fail and taking the severance rather than try to keep the company alive.

The stories of both companies point to an absurd incentive structure where executives may not be looking out for the best interest of their companies. By putting compensation decisions in the hands of those receiving compensation what is best for the company no longer persists, it turns into how someone can squeeze as much value out in a short period of time. In the Goldman case the CEO made very risky short term decisions to justify the enormous bonus he received, only to see the company approach collapse the next year. Then flexing his power, deemed it not necessary to receive a bonus for their own abysmal work. In the case of Wachovia one could assume at some point executives were inclined to cut and run from a failing company, a process that they put into motion. A publicly traded corporate structure means that at the end of the day shareholders have the ownership stake in a company, and therefore should be making the final decisions on the best path of a company. We toss around the phrase "a duty to the shareholder," but in these cases the phrase has little meaning. The above examples show real issues in the modern corporate structure because it does not hold Executives accountable over the long term. These are terrible market forces all working against long term sustainability and growth. 

Because I am never one to point out a problem without offering a solution, I will offer a simple and easy fix for this incentive structure: stock options only with a restriction on sale for 15 years.

For Wachovia a severance should only be offered as a certain number of stock shares and a restriction of sale for 15 years after the Executive leaves.  This assumes a severance is really necessary because of some belief that it is needed to attract talent. I really believe the best structure in this industry is no severance at all. Any highly paid executive has such a lucrative level of compensation that a comparable severance creates indifference for good work. (Go ahead and fire me I literally will make millions.) But if the market does somehow deem it necessary I think stock options instead of cash is a much better solution.

For the Goldman issue, the same solution. All executives of any company should only receive stock option bonuses, all with restrictions of sale of at least 15 years. By shifting from cash to stock with a long term outlook it would ensure decisions made in the short term are targeted at long term growth. If decisions made today go wrong these long term assets will be valueless.

This shift is not something that should be enforced by government but rather by shareholders through boards of directors. It is in the best interest of the stockholder to design a proper incentive structure; this change will do just that by making the executive reliant once again on the success of the company and the stockholder. 

Update on AIG, The President Defends The Invisible Hand of the Bailout

Today The Economist had a great article describing the need surrounding the revised AIG bailout. I assumed things at AIG had gone from bad to worse, prompting the government to react I just could not imagine a scenario that would cause such a lucrative government action (as I pointed out in my last article). I think The Economist describes the scenario nicely, and has the appropriate tone of how ridiculous things have become to result in a bailout of this size. In short AIG did not have the ability to repay the loan, and would have defaulted if the government did not act… again.

 

I find it ironic that this article describing the largest government bailout of any private company... ever, occurred on the same day the President made a speech (in the federal building on Wall Street) defending “American Capitalism”. The speech is not moving to any degree it has all the classic familiar President Bush elements including a 10 syllable limit per sentence, but you can find the full text here. For an excerpt, my favorite line completely out of context, “I'm a market-oriented guy, but not when I'm faced with the prospect of a global meltdown.” Such a wise businessman leading our country!

 There is one portion of the speech I want to focus on because it relates to AIG:

 “Secondly, we must ensure that markets, firms, and financial products are properly regulated. For example, credit default swaps -- financial products that insure against potential losses -- should be processed through centralized clearinghouses instead of through unregulated, "over the counter" markets. By bringing greater stability to this large and important financial sector, we reduce the risk to our overall financial systems.”  (note: I did not add the “” around "over the counter", it reads that way in the transcript, and I do not know what the president is referring to)

 I am curious what the President (really the Treasury, I think we all know this is not the President’s idea) has in mind for this clearinghouse. The President insists it prudent not to over regulate but how will the government set up this clearinghouse? AIG’s business and sole purpose of existence was to assess the risk of a security and assign the proper insurance premium to account for the risk level. Is the President implying a government vehicle can somehow be more efficient than this market driven entity, because clearly AIG was doing something wrong. I leave this to a future announcement of possibly (hopefully) our next president. 

When Government Becomes An Insurer: The AIG Revised Bailout

Every major U.S. Newspaper covered the revised AIG deal (WSJ,  NYTimes,  CNN,  MarketWatch,  Bloomberg) yesterday, but none of the articles explain the need for the revision.  As the NY Attorney General continues to probe some very lose spending habits post bailout,  I find it very difficult to trust this company, so any plan that shifts even more cost and risk to the government disturbs me a bit. Ideally we would examine the new needs AIG since the original bailout plan and how this revision satisfies those needs, but since need has not been made public we are left with comparing the old plan to the new. The analysis will show this is a much sweeter deal for AIG. This deal clearly puts more cost onto the government, injects significantly more capital into AIG, and gives all the momentous risk of real estate backed securities onto the taxpayer. I am left wondering in what way this is a better policy decision. 

When the first AIG bailout was announced I thought it was the best concept that had been put forward at the time. It was an $85 billion loan, the term was 2 years at 8.5% plus three-month LIBOR interest rate. In today's market the rate would be approximately 11%. The rate was way above prime which gave the incentive for the government to be a lender of last resort, the position the government should take in a free market economy. Together all of the above articles give enough detail on the revised plan to make some interesting comparisons between the old and new AIG bailout. (I thought the WSJ article was the best, even though the real juicy details were buried in the continued portion of the article on page A15 of the paper.) The new program reduces the loan amount to $60 billion, extends the term to 5 years and reduces the interest rate to 3% plus LIBOR, a total of about 5.5% interest rate in today's market. Hardly a deterrent for a lender of last resort, the government is giving a prime rate for an "emergency loan."

Here is a simplified (rounded to the nearest billion) chart comparison of the original and revised loan scenarios:

	Total Loan Amount	Total Interest Payments (nets out principle repayment)	Scheduled Monthly Payment (assumes 12 pmts/yr)
Original Bailout	85,000,000,000	10,000,000,000	4,000,000,000
Revised Loan Structure	60,000,000,000	8,000,000,000	1,000,000,000

 

In total there is a nominal loss of $2 billion in loan interest payments over the life of the loan.1 But what I think is most important here is the scheduled payment. The original plan had an extremely high month-to-month cost, which was a strong deterrent to use the program in the future. This is an important incentive structure the revised plan is missing which may make the government the first source of money instead of the last. 

Additionally the government will purchase $40 billion in preferred shares which bumps up the total upfront bailout cost by $15 billion (total of $100 billion loan+shares now compared to $85 billion loan originally). These shares will carry a 10% annual interest payment. How this 10% is calculated is  not entirely clear to me so I cannot do comparison against the original bailout. A preferred stock option usually pays a dividend, a certain dollar amount for each outstanding share, the WSJ states these shares "carry 10% annual interest payments", it is not clear if the payments are calculated off the principle $40 billion, or the value of the shares at time of payment (which would be calculated as: number of shares*share price at time of calculation). These details could have a significant impact as AIG shares still have the potential of dropping further, which would expose the government to further loss.  

The most interesting of the new proposals are two new entities that will be created to remove the toxic assets off of AIG's balance sheets. These entities will be almost entirely funded by the government. 

The first entity will be capitalized with $30 billion from the government and $5 billion from AIG. The entity will purchase securities that AIG agreed to insure with credit default swaps2.  The entity will pay about 50 cents on the dollar for these securities. Unless I am viewing this wrong, this vehicle will pay AIG Parent 50 cents for each dollar of toxic debt it takes off the balance sheets. Essentially allowing another $12.5 billion (half of the government infusion minus AIG portion plus the return of half of the AIG portion) to be added to the parent company's bailout in exchange for its riskiest holdings. The separate entity that now holds all of this toxic debt, is essentially a government funded (and therefore controlled) company, with very little chance of surviving, let alone returning a profit to the taxpayers. This seems like an extremely risky bet with tax dollars. 

I saved the best for last. The second entity is designed to solve the liquidity problem in AIG's securities-lending business. This business lent out securities to short sellers in exchange for collateral, AIG then took this collateral and invested it for gains.  Unfortunately for AIG these gains turned into losses and now they owe a substantial amount of money to return the collateral.This business epitomizes risky behavior and the bailout plan is a wonderful example of a terrible incentive structure. To establish  this entity the government is expected to foot a $20 billion bill, while AIG contributes $1 billion. The government will inherit all of these bad debts and AIG will walk away risk free. I cannot imagine a plan that rewards a company better for risky behavior. 

These two entities will essentially remove all of AIG's high risk debt and hand it over to the taxpayer. Taxpayers may see a positive return if these assets, which are tied to the housing market, begin to recover. But these entities also open taxpayers up to what I think is the more realistic scenario of losing a substantial amount more as these assets continue to decline in value.  In theory the housing market will eventually come back, and hopefully every penny invested in AIG will be returned, however this new program seems extremely lucrative to the surviving AIG entity and gives taxpayers an extremely risky portfolio. Without knowing the whole circumstance of AIG's current situation it is hard to judge if they are taking advantage of the situation, but when all the numbers are worked out in this new deal you can't help but think they are greatly benefiting from shedding all risk at little cost. From a policy perspective this seems to be the worst incentive structure I have seen thus far. The program has changed from making the government a lender of last resort, to a prime lender that pays a risky company's debts at little or no cost... Is this still America? 

 

 

1.   These are nominal calculations because I did not think it was appropriate to compare by present value since the government is not weighing the opportunity cost of two investments but rather the nominal value of two costs it will put onto AIG to use the government bailout.

2.   A credit default swap is insurance against a bond default.  

Economic History in the Making, Iceland’s “el error de diciembre”

As an economics student one of  the most fascinating topics I ever studied was the Mexican Peso Crisis (nicknamed “el error de diciembre”, in Mexico). When studying the Mexican crisis and the ripple effect it had through the developing world (the ripple was a run on several developing Asian countries because of a fear that even well maintained small economics were exposed to similar risk) I never thought it possible in a modern developed economy[1]. Now, after watching Iceland approach the brink of disaster I have an entirely new perspective. Here is a brief background on how a currency crisis occurs and overview of what is going on in Iceland.

 

 

 

Monetary Economics 101 - A brief background.

Currencies are traded on an open market. Businesses make transactions in a specific currency, and then deposit those transactions in a bank. The bank acts as a clearinghouse by trading large quantities of their deposits on the foreign exchange market so they can provide domestic currency to customers at local branches. The foreign exchange market determines the currency’s value using a supply and demand model.

 

The demand side of the market, can be described through a simplistic example. An Icelandic businessman makes a transaction in dollars, deposits the dollars in his Icelandic account, the Icelandic bank trades dollars for Krona in the foreign exchange market, then the Icelandic businessman is able to withdraw Krona and use it to buy things. This basic process happens in bulk countless times throughout the day, more demand to change dollars into Krona will push the value of Krona (relative to dollars) up.

 

The supply side of the market is controlled by a Country’s central bank. A central bank uses open market operations to reduce or increase the amount of currency in circulation, thereby inflating or deflating the currency. An open market operation can be demonstrated through another very simplified example. The Icelandic Central Bank holds several different currencies including U.S. Dollars. Through a direct open market transaction it can “buy” Krona using its dollars, then hoard the purchased Krona, thereby reducing the supply of Krona in circulation. Central banks can also indirectly effect the money supply through the interest rate (in the U.S. the federal funds rate). By increasing this rate a central bank makes it relatively more expensive for commercial banks to make loans, less loans means slowing general economic activity, which translates into lower amounts of circulating domestic currency.

 

During a currency crisis there is a sudden drop in demand for the at-risk currency. There is a fear that a country is having some catastrophic problem, and will not be able to control the value of the currency through an open market operation. As demand for the currency drops, the value of the currency (in relation to other currencies) follows. A central bank can raise interest rates and/or buy domestic currency directly in the foreign exchange market using foreign denominated assets (from the example above a central bank can take all the US dollars it holds and buy as many Krona as possible to hoard from the market, which decreases supply). These actions will attempt to curb the fleeting value of the domestic currency measured as the inflation rate. The problem is if the fear factor that set off the crisis cannot be stemmed. As world demand for a currency spirals downward a central bank will have an increasingly difficult time keeping up on the supply side. Just as a bank run this is a self fulfilling prophecy, a country’s currency is perceived to be highly risky, so demand for the currency drops, and that makes the currency even more risky. A central bank will continue to fight the run on the currency by continuing to contract the money supply, but once this snowball starts it is often difficult to stop.

 

This crisis also has far reaching effects on the domestic economy. With the central banks raising the interest rate there is an automatic cooling effect on the economy, unemployment will start to creep up and business credit will slow. For small and developing countries there is often a huge problem with foreign debts. If a business has any debts denominated in foreign currency a rapid inflation can be devastating. For example if I owe someone $100 when 1 dollar = 1 Krona, and now 1 dollar – 10 Krona my debt just increased to $1,000. Multiply by the billions of dollars in trade and even the slightest drop in value could bankrupt a country.

 

 

What happened to Iceland

On October 7^th Iceland made drastic moves to protect its financial system by nationalizing two of its three major banks. Within days the last and largest of the three banks was also swept under the control of the Icelandic central bank, triggering a fear driven collapse of the foreign exchange market for the Icelandic Krona. It is a mark of how serious the liquidity crisis has become.[2] The fear was that Iceland was overexposed to U.S. sub-prime real estate market, and the Icelandic banks would not be able to meet their debt obligations given the collapse of the real estate market. Once controlled by the Icelandic Government, the concern passed onto the central bank. Further a lot of these debt obligations are denominated in U.S. dollars, and as noted above this can compound debt many times larger than its original principle. This tiny country with far less citizens than many U.S. cities was forced to defend its currency against a run.

 

Iceland at the start of this financial crisis had all cards stacked against them. The country’s leading export in recent years is financial services. Iceland’s major banks were heavily leveraged in foreign mortgage markets which were all denominated in foreign currency. It led to a boom in Iceland’s GDP during the golden years but left the country open to a disaster when the U.S. housing bubble popped. As soon as the instability was apparent Iceland’s central bank immediately requested support from allied nations to shore up the balance sheets of its financial institutions with foreign investment. Unfortunately with all major countries looking at a global recession Iceland suddenly found itself without any friends. The member of NATO found its only hope for survival with Russia, and the IMF.

 

The central bank followed protocol, and raised its key interest rate 6 points overnight on October 28th, putting the rate at 18%. The estimated $6 billion IMF loan will be denominated in dollars giving some added protection to shore up the currency but the country is facing some serious economic hardship ahead, adding fuel to the problem.

 

To add insult to injury Iceland probably never expected to be stabbed in the back by the Brits! An important modern twist to this story was reported in last Sunday’s New York Times. For reasons described above Iceland moved to liquidate many of their non-Krona based assets in an effort to buy up as much Krona as possible. Britain, fearful that Iceland may default on their government debt held in British banks, used a broadly defined anti-terrorism law to freeze all Icelandic assets held within the country. In one quick move Britain classified this NATO ally as a terrorist state, and tied their hands from protecting their currency. The public relations disaster did not help in curbing the fear that the country could not meat its debt obligations, further fueling the problem.

 

Iceland’s situation is a tragic piece of economic history. The country has not survived this crisis yet, there are dismal growth projections and still the possibility of hyper inflation but I am confident it will overcome eventually and sit next to Mexico, and the Asian countries as another to weather the storm. In a final note when Mexico entered their crisis in 1994 the U.S. stepped up through a series of emergency loans to try to stabilize the country. It is sad to see (obviously we were in a much better situation in ‘94) we could not have done the same for Iceland, and even sadder to see the acts of Britain in their time of need.

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[1] Britain had a devastating run on the Pound in 1931 when it abandoned the gold standard, which is why I specify modern developed economies.

[2] This is not the only currency crisis occurring right now. There is the well known currency crisis that has gone on for a long time in Zimbabwe that is absolutely out of control. In August the inflation rate in Zimbabwe hit 11.2 million percent. I would argue this is not due to the global credit crisis as much as it is a result of a mismanaged government.