Treasuries Below Zero

Treasury was able to obtain $30 Billion in interest free loans today from the U.S. bond market as 3 month t bills dipped below zero for the first time since 1940. Investors are showing their real fear of the economic situation. They have foregone any risk and are essentially paying treasury to hold their money. There is more concern over counterparty risk and deflation than anything at this point in the market. Lenders are concerned that those on the other side of the trade will not be able to repay. The sale is good for taxpayers and the government, however, as the U.S. needs more financing to bail out the big institutions of this country. The massive flight to safety in these bonds has usually indicated that a more drawn out economic downturn is in sights. A quick recovery is out of the question.

The negatives outweigh the positives in this situation. At the very least the U.S. is financed for another 3 months with most of these bonds most likely going into the hands of foreign governments such as China, not necessarily the U.S. business environment. Thirst for the safest assets in the world are probably growing at fever pitches everywhere. There is an exacerbation, a sudden quickening of the financial imbalances between governments taking place. One has to wonder how quick this is moving and where it will go in the next few months. If a snap is about to take place. Systemic risk may be approaching critical levels. If China is purchasing these bills it may be trying desperately to continue its stimulation of unprecedented growth. The money being pumped into this country may even further harm the structure of our society while the imbalances become even greater in terms of what we produce and what we consume.

http://www.theatlantic.com/doc/200801/fallows-chinese-dollars/4

http://www.guardian.co.uk/business/feedarticle/8135756

http://latimesblogs.latimes.com/money_co/2008/12/wall-street-kee.html

http://latimesblogs.latimes.com/money_co/2008/12/some-investors.html

EU Approves Lower Rates

The European Competition Commissioner, Neelie Kroes, has approved a new French aid plan as well as more flexible rates for some of the top banks of Europe. The aid will allow governments to recapitalize fundamentally sound banks at rates as low as 7% to encourage interbank lending and to encourage lending to businesses. The cost of capital is being reset to rates of 7 and 9 percent plus a premium based on a risk profile structured by the commission. The commission is simultaneously trying to create safeguards against unfair competition based on the use of government aid against banks not using government aid. Governments want to control the money being put into the hands of these banks by setting conditions for aid such as requiring banks to lend to companies and households by between 3 and 4 percent.

These actions call into question some of the techniques being used in the U.S. to save the U.S. banking system. Why were Bear Stearns and Lehman Brothers allowed to fail? The failure of large banks is constricting competition and giving too much power to too few banks. The EU's actions have built in safeguards to protect other banks and consumers against unfair competition by ensuring that banks don't use funds to "finance aggressive commercial conduct to the detriment of competitors who managed without state aide." More steps are being taken to ensure banks don't mismanage funds through built in risk premiums based on the risk profile of each bank. Banks are not treated the same on the basis of how well they have been managed. The U.S. seems to be just throwing money at any big bank or insurance giant (?) that asks regardless of poor performance. The EU's pro-competition measures are innovative in the face of undesirable competitive circumstances involving government money. The effects of these steps will give a more favorable picture of the banking environment in Europe once the crisis passes.

http://www.iht.com/articles/2008/12/08/business/08euaid.php

Tax Evasion Crack Down

The European principality, Lichtenstein has reached an agreement to sign an agreement with U.S. authorities on December 8th. This would end years of banking secrecy provided to wealthy Americans and corporations trying to hide assets within the small country. The agreement involves Swiss banks as well as Lichtenstein banks, including LGT Group, controlled by the Lichtenstein ruling family. This will leave Monaco and Andorra as the only places left for Americans to hide their money under bank secrecy laws. The Lichtenstein accord will take affect in 2010 to give the country time to enable legislation. All money will begin being reported to the U.S. starting in 2009, meaning, everyone involved in Lichtenstein banking will have a month to move into tax compliant accounts. If information implicates tax evasion, banking clients can take advantage of IRS leniency by reporting all offshore income before hand. Under the agreement, the principality will be able to report corporation's use of their banks to reduce tax bills.

Corporations attempting to illegally avoid taxes will face large reputational risks to their firms if they are implicated in these evasion schemes. Practices such as these will also affect Swiss and Lichtenstein banks. It is apparent that these banks have been trying to repair their reputations by agreeing to terms with the U.S. in disclosure of these accounts. The U.S. has been pressing the principality's European neighbors to push them into more disclosure. They have been on global blacklists as supporters of money laundering for almost a decade. This agreement moves the world in a safer direction as well as prevents these unpatriotic acts.

http://www.cnbc.com/id/28034065

http://news.bbc.co.uk/2/hi/business/842781.stm

http://www.bloomberg.com/apps/news?pid=20601100&sid=aewltPzw8E7Q&refer=germany

Spike In Oil Not Necessary

Evidence suggests the spike in oil may have been due to misleading analyst perceptions led by Goldman Sachs and the U.S. Energy Department, and speculators in the market. The 2008 spike in oil may have been prevented and was almost certainly unnecessary as it did not seem to be driven by decreases in supply or increased demand. The speculative side was proven to be a part of the equation by a "squeeze play" on September 22nd when oil shot up $25 dollars. Speculators were forced to cover their positions or actually take the shipment of oil. They had to buy back their shorts or take the shipment. This showed traders were looking for a profit and not actually interested in taking on shipments all along. Demand was actually dropping all year while the government reported back in April that we had more gasoline on hand than at any point since 1992. While this was happening, both George Bush and Energy Secretary Sam Bodman gave credence and legitimacy to the speculators arguments. Demand in the beginning of May was reported by the Energy Department to be lowering by 190,000 barrels compared to historical averages. Soon after knowing that Saudi Arabia was sitting on huge tankers of oil with no place to ship, they raised the demand destruction numbers to 400,000, then 800,000, with it now at nearly 2 Million less than historical averages.

It looks as though the government held off admitting demand was actually decreasing instead saying that supplies were tightening. The bubble would not have inflated as large as it did if they had admitted what was really happening. Also, speculators should not be allowed to move such an important market in wild directions when they are not planning on taking shipments. The consequences of these actions has sent GM into a spiral with huge declines in their sales over the prospect of never being able to drive SUVs again. Individuals and business's will feel less of a strain with lower prices as they strive to adjust their budgets, especially if they are dependant on oil. The lower oil prices provide tax cuts that may soften the blows of a deepening recession as they should have without the spike in oil.

http://www.businessweek.com/lifestyle/content/oct2008/bw20081023_350289.htm

Pension Plans In Danger

The deepening recession is taking a toll on not only the single-employer pension plans in this country but also the multi-employer pension plans. Multi-employer pension plans pool together the assets of many companies to minimize the risk to the employees of failed companies. If one corporation failed the others would be able to support the employees that are left behind. The problem now is that too many corporations are failing and the ones that remain are left covering the others. This is causing huge cuts to the profits of these companies and causing strains on the companies ability to make payroll. Thanks to the 2006 Pension Protection Act that is now taking affect, corporations must make sure their pension plan have enough money to cover present and future obligations and have only a short amount of time to cover the shortfalls. They have been cutting jobs to do so. The country might actually have to come in and bail out the failing pension programs through the Pension Benefit Guaranty Corporation which is having its own shortfalls.

To protect themselves, pensions need to invest in less risky assets. Bonds have been helping healthy pensions stay current on their obligations. Even GM's pension is one of the healthiest in the industry because only 26% of their assets are in stocks. Even though it may seem like a bottom and most money managers would hate to sell at this point, it would make the most sense to do so and preserve and work with what they have now. Consistent volatility are proving stocks to be untrustworthy and will be for many more years as long as the Government and a very small number of Superbanks control the country's financial system.

http://www.businessweek.com/magazine/content/08_50/b4112040140636_page_4.htm

Obama Drops Windfall Tax

President-elect Obama's team anonymously announced that Obama would be dropping his promised windfall tax on Big Oil. Obama had originally pledged a 20% profit windfall tax on oil that went above $80/barrel. Many environmentalists and liberal groups are criticizing this move as a policy retreat. Oil's recent decrease from $147 to $47 has some groups looking for other ways to control the effects of Oil companies on the environment and tax payers. Some say the windfall profit tax is not this issue as much as the tax giveaways that Big Oil receives.

Obama's transition team has reiterated that $80/barrel was the target price for the tax. The tax is not included in Obama's middle class rescue plan. The oil companies need to be prepared for such a tax. If such a policy were enacted it could put a dent in profits past a certain level. This could open new windows of Tax Risk facing these companies. New assessments would need to be performed to identify the new tax environment facing the firms. The Risk would then have to be managed and monitored and would then have to be communicated across all levels of the company from shareholders to suppliers. Such a tax would expose management to new corporate governance processes. The tax should be set in place now as a country wide insurance policy against rising prices. The idea would be perfect right now with prices below $50 as the companies would have more incentive to keep the prices below $80. It would be ideal for the American people as well. If Americans know that prices are hard pressed to go above $80 for Big Oil then they would be more likely to reduce their own consumption toward that level.

http://www.businessweek.com/bwdaily/dnflash/content/dec2008/db2008124_176271_page_2.htm

http://findarticles.com/p/articles/mi_m6552/is_2_56/ai_n6051627

UAW Makes Concessions

With the country facing the real possibility of a depression on the heels of a failure of U.S. auto companies, the United Auto Workers made concessions to the big 3. The biggest of those concessions was a pay for no work provision enacted in the 80s to pay laid off workers whose factories had been shut down. Concessions were also being made by the CEO's of the auto companies. Rick Wagnor of GM and Alan Mulally of Ford both plan on working for $1 per year if a government loan was approved. They have returned to congress much humbled over their disaster of a first appearance with much more detailed plans of how they will use government money. Support for the auto companies is very soft in congress but many acknowledge the catastrophic effects of a failure.

Controlling labor costs is one of the most important aspects of restructuring GM, Ford, and Chrysler. So much more is needed to be done however. The mistakes of past management of GM, Chrysler, and Ford gave too much up to the UAW and other unions while sacrificing efficiency. If it were possible to send the 3 CEO's back to the drawing board for a 3rd and 4th time, the changes really needed may be achieved. Ultimately the companies need to be structured entirely different with many revisions to the contracts between workers and management. I'm beginning to believe these companies are quite capable of becoming world leaders in green car technologies if they took further cost saving steps. If Ford is able to come out and say they no longer need a bail out after going back and rethinking a bailout, I'm sure there are measures the other companies can take to avoid bankruptcy.

http://www.businessweek.com/ap/financialnews/D94RJLM80.htm

Recession Official

The country has officially fallen into recession and has been there since December of 2007. December of 2007 was the peak of the expansion that began in November of 2001. Two of the key determinants of economic downturns, manufacturing and construction, saw the biggest declines since the end of last year while the manufacturing index saw its lowest level since 1982. Payroll levels are used extensivly as indicators of recessions and expansions. These levels have been declining every month since the end of 2007. The prices-paid gauge fell to its lowest level since 1949 from a high in June not seen since 1979. This is the steepest decline ever recorded for this index. There are severe contractions now being felt in domestic activity. Liquidity continues to decline and will continue to decline according to analysts. Credit card companies are beginning to speak of calling 2 trillion in credit lines in the next year. This means they will be suspending credit and working with debtors to pay off the line balances. This, in combination with lowering incomes, could have a disastrous affect on consumer spending and could harm business's fueled by consumer spending. On top of this, the holiday season is expected to be the worst on record.

If the decline in credit card lines is any indication of how important it is to save money then the action taken to decrease credit available for business's and individuals will certainly drive home that point. The importance of raising capital is now more important than ever with this warning from creditors. This is what is instore for 2009 alone. The fall out from this could really be brought home toward the end of next year. The country's businesses are going to see a further increase in liquidity and credit risk. Now its possible that liquidity risk can turn quickly into compounded credit risk. If business's are unable to make payments to their creditors on credit that has been called, they may not be able to raise the money needed by selling assets. There will be no buyers for any assets and they will be forced into default. Working with creditors to expand payments to 1-3 years would be the best option at this point.

http://www.cnbc.com/id/27993643

http://www.businessweek.com/investor/content/dec2008/pi2008121_134253_page_2.htm

Toyota's Credit Rating Reduced

The downturn in the global automotive industry is becoming so severe that Toyota now has to face a credit downgrade from AAA to AA by Fitch Ratings. Global slumps in demand as well as adverse exchange rates are impacting the company with increases in material costs coming down the pipeline. Toyota has noted that for every 1 Yen decrease in the Yen's value to the Dollar and Euro trims operating profit by 40 Billion Yen for the Dollar and 6 Billion for the Euro. Toyota's profits have decreased by 2/3 in the past year as they are expected to bring in 5.5 Billion in net profits. Toyota depends heavily on the U.S. market where half of their operating profit is made. They have relied heavily on taking market share from SUV's and trucks and have based their growth strategy on this gain. This may be halted for the next 2-3 years as the slump is expected to continue. This year alone has seen an operating loss of 34.6 Billion Yen in North America. Industrywide analysis shows a decrease to 11.7 Million cars sold from 14 Million forecasted and Hyundai says they believe the U.S. could fall to 10 Million cars sold.

Japanese carmakers are still in a much better position than the U.S. big three. For the past 20 years Japan's business model has included a fuel efficient culture while U.S. manufacturers have insisted on sitting on SUV's and pickup trucks to bring profits. After weak periods in demand for these auto's a spike in demand has the big 3 making profits while smaller more fuel efficient cars are foregone. This cycle may be ending now. The big 3 did not reinvest their profits to include more fuel efficient cars and this time they may not be able to pull it together after years of very little planning. Car makers need to look to Toyota's vision and change their core thinking in envisioning a world with limited resources.

http://www.bloomberg.com/apps/news?pid=20601087&sid=aybXO4OangM0&refer=home

http://www.cnn.com/2008/BUSINESS/11/24/japan.auto.industry/index.html

http://www.businessweek.com/ap/financialnews/D94MC3QO0.htm

China's Manufacturing Risks

China is becoming a risky place to do business according to a new survey. More manufacturers are pulling out of China and moving into areas in their own backyard such as Mexico and even back here in the U.S. More and more U.S. companies are indicating a demand for products made here that have moved to China in recent years. It is cheaper to order from the U.S. in the face of exchange rate fluctuations, labor costs, and shipping costs. American companies are able to compete now but the problem is that they do not have the capacity ready for orders. The biggest risks companies face in China are decreasing quality and intellectual property theft. There has been a sharp increase in these concerns since May of 08. Other risks include regulatory compliance, commodity price volatility, supply chain security breaches, and information technology problems. Piracy, sweatshop abuse, and recent worker protests are also contributing to upswings in costs and harm reputations of companies.

China seems to be forcing itself to grow when it does not seem able or ready. There are questions to the truth of the percentage rates of growth they have been experiencing in recent years as the leadership bases its legitimacy as a Communist nation on the expansion. The worker uprisings across the country signal demands for better pay and working conditions while the country downplays the extent of the unrest. China is no longer a haven for cheap labor and high quality products and intellectual property violations indicate the business community is becoming untrustworthy in partnerships. U.S. companies should consider expanding capacity at home and in Latin America to take advantage of the swings in costs. China is simply becoming too big for its low quality britches.

http://www.businessweek.com/bwdaily/dnflash/content/nov2008/db20081126_315336_page_2.htm

http://www.businessweek.com/magazine/content/08_26/b4090038429655.htm

Homebuilder Bailout

The nation's homebuilders are next in line for a government bailout. The companies are not asking for a direct injection of capital but a program for subsidies and tax credits. They are calling this program "Fix Housing First." The tax credit for new home purchases would be 10% of new homes purchased while the subsidy would work to bring interest rates down on new mortgages to 3% for the beginning half of 2009 and to 4% for the second half of the year. Realtors are also pushing for 4.5% interest rate buy down for new mortgage loans. They say that for each 1% that rates fall 500,000 to 800,000 new homes could be sold. These ideas will only temporarily fix a systemic problem. Further drops in interest rates would temporarily relieve the basis risk of small business's and homeowners while it increases in the long run when asset prices decrease from an oversupply. We don't need more easy money in the system and we certainly don't need anymore homes in the market. These plans will allow the homebuilders to build new homes and make quick money as they increase the supply of an already flooded market. It would attempt to inflate a bubble that already burst and we would then be taking our money to make the situation worse. Housing prices need to increase along with income to be sustainable, not inflate independently and artificially. Homebuilders already have a surplus of labor and there isn't a need to continue paying idle workers. Before running to the government serious thoughts on employment levels, compensation, and the over-inflated prices of the homes they offer should be re-evaluated. The country can survive without these enormous homebuilders. Any of the workers presently employed could go off and make their own companies if they wish when the time is right. Thats the best part of economic downturns and layoffs.


http://www.nuwireinvestor.com/blogs/investorcentric/2008/11/homebuilders-next-in-line-to-beg-for.html

http://tranharry.com/2008/11/do-home-builders-really-need-that-bailout/

Balking Banks

Goldman Sachs called off negotiations with Panasonic on Tuesday over electronics subsidiary Sanyo because they were not pleased with Panasonic's bid for the company. Panasonic offered $1.26 per share with a present value of $1.55 and a Goldman estimated worth of $2.58 per share. Sanyo is the world's number 1 producer of lithium-ion batteries and a major producer of solar cells, both very promising capacities for the future. If any of the past couple months have taught us anything its that the nations banks must raise capital in order to save themselves from failure. Most firms have had to do this by selling assets at unfavorable prices. It is becoming unacceptable for company's not to go through with offers like these when the future does not look good for the economy and the nation's business's. Eventually, firm's such as Goldman Sachs will be owned by the U.S. Government and essentially the tax payers. The less stake the government has in these companies, the less the country will have to pay for these mistakes. If the firm's in question can do what is necessary to save their companys, even if the terms are not favorable, then they have a responsibility to do so without waiting for government intervention.

Accountability, Citigroup, and Robert Rubin

Since the U.S. government took over Citigroup over the weekend the call of taxpayers to point fingers and place the blame where it is due is becoming louder. It goes beyond politics at this point and the real players in the destruction of the banking industry are coming out of the wood work. A recent article in the New York Times points the finger at Robert Rubin for the downfall of Citigroup and his allowing the company to go 40-1 on leverage. He is being credited as the architect of the present financial crisis when, as Secretary of the Treasury, along with Alan Greenspan, he opposed the regulation of derivatives when proposed by the head of the Commodity Futures Trading Commission. Overexposure to derivatives such as Credit Default Swaps was essentially the cause of the failure of Bear Stearns, Lehman Brothers, Merrill Lynch, AIG, and Washington Mutual. In November of 1999 Alan Greenspan and Robert Rubin recommended that Congress permanently strip the Commodity Futures Trading Commission of regulatory authority over derivatives. This was accepted. Charlie Gasparino, on-air editor at CNBC, says Rubin was the chief advocate at Citigroup to over leverage the company and that the board of directors and Bob Rubin hold the largest amount of blame for mismanaging the company. The most concerning part of all of this is that Rubin is now one of the top economic advisors to Barrak Obama. If Alan Greenspan, head of the federal reserve with the power to adjust interest rates, and Robert Rubin were joined at the hip on deregulation of the derivatives industry, and Bill Clinton, days before Rubin departed as Treasury Secretary, repealed the Glass-Steagall Act (allowing the supermerger between Travelers and Citi just in time for Rubin to join the company 4 months later), I would question the subsequent build up of leverage. When a company builds up incredible amounts of leverage in the way that Citi did, it means that management is making the company extremely large and taking a large share for themselves while taking no interest in the company shareholders. This was also the case at AIG. The only thing Alan Greenspan could say in front of congress was, "I still don't fully understand why it happened", while admitting, with 3 other regulators, that deregulation was wrong and a mistake. Poor management is not just a risk to these companies, it is a risk to the entire nation.

http://en.wikipedia.org/wiki/Robert_Rubin

Hedging Opportunity for Airlines?

In a recent interview aboard a Virgin Airlines aircraft, CEO David Cush spoke of a unique opportunity to hedge fuel prices. The airline was founded last year and currently has a fleet of 28 planes. The one year old airline recently moved their profit targets back a year to 2011 in light of the current economic crisis. Hedging fuel costs now could save the company cash and have it continue running for at least the next 4-5 years. The airline currently has enough funds to last 3 years without hedging. Cush says he plans on taking long positions 4 years out to lock in the fuel prices of today's markets.

The recent credit crisis could dampen the possibility of this idea, however. Reports out of Europe have many European airlines not seeking new hedging arrangement even with the price of oil down to $55/barrel because of the rising costs and risks. The failure of Lehman Brothers puts into question the viability of such deals. Its much harder and more expensive simply because its difficult to find a counterparty in a deal with a market so illiquid. Lufthansa, for example, is hedging down from 85% to 72% of its fuel bill in 2008 and is at 57% for 2009. The failure of Lehman saw the loss of many contracts and contributed to these decreases. The decisions will remain with the airlines. Irish airline, Ryanair, has followed a strategy of not hedging its fuel prices and suffered for it over the summer. They decided to enter the hedging market at triple digit prices and have now decided to switch back to their old strategy. It seems airlines are not finding it easy to get new deals. The deals appear to be out there, however, as some airlines are continueing their hedging strategies even with prices at $55 such as French airline Air France-KLM. Aggressivly seeking counterparty's willing to take a position would be the best opportunity for airlines dedicated to a hedging strategy.

http://www.iht.com/articles/2008/11/13/business/air.php

Public Ownership of the Banking Industry

Hugh Hendry, Chief Investment Officer at Eclectica Asset Management, says the U.S. government will own all the financials in a year. He says in terms of profitability, there is none left for these companies. The nationalization is an alternative to dramatic losses in the private sector that will affect society on a much broader level. Society has had to intervene in the failure of the banks because the risks to society are too large. Mergers between even the two largest banks, Goldman and Citi, is being ruled out as irrelevant because, ultimately, the largest partner will be the U.S. Hendry believes the punishment is being felt by the shareholders through the stock prices of the banks because they looked the other way for more than a decade in a case of excessive moral hazard. The shareholders should get nothing as the government comes in and buys these banks at very modest prices because the tax payer will be paying for these mistakes for a very long time.

Such a huge amount of wealth is being held by the executives of these companies as the country pays for their taking on of such huge risks and subsequent ignorance of the warning signs. This money should be taken back and those much better qualified to deal with the present situation need to be brought in. There are too many stakeholders in these companies (the American people seem to be the biggest) to allow those who made these mistakes to go scott free while also keeping the money they did not earn.

GM Cannot Fail

In an interview on CNBC, billionaire investor Wilbur Ross spoke of how a GM bankruptcy is not an option as opposed to government financing. He was not as concerned about the employees of GM itself and the losses associated with an isolated GM failure, he was more concerned with the auto suppliers supplying parts to the company. There are four times as many employees in the supplying sector then in the big car companies - about three quarters of a million. If GM or any of the other big car companies were to go bankrupt the suppliers would have to write off 10% of this years receivables. Few suppliers would be able to handle this and would be forced to shut down and would then cut off supplies to the other car companies. He claims the car makers problems were the southern states allowing subsidized transplants for the Japanese, Koreans, and Germans taking $35/hour jobs from the North and creating $17/hour jobs in the south. It helped the states, but hurt the nation as a whole in coordination with a poor national economic development policy. The country would not be able to stomach the failure of GM and its connected suppliers but I still see the government trying to keep an industry alive that is doomed to failure. Even if there was a restructuring to allow more fuel efficient cars or cars not dependant on fossil fuels to be built, would the suppliers not be out of business anyway? There was simply not enough planning and no account for a world demanding more and more oil. The best the company can do now is accept government assistance to use its existing manufacturing capabilities and, as quickly as possible, change its entire production line because it is unsustainable in its current form.

Investing and the VIX

The riskiest moment for investment firms and individual investors to commit capital to an investment is the best moment - or is it? In the past 25 years there have been four market bottoms: the 1987 crash, the 1990 Iraq war bottom, the 1998 LTC bottom, and the 2002-2003 dot com bottom and second Iraq war bottom. Characteristic of these four periods included four indicators; front page headlines of market pains, an Investors Intelligence survey of less than 40 percent bulls, large outflows from mutual funds, and a VIX reading above 40. A reading in the VIX of above 40 indicates pure panic in the market place. Given the VIX has moved as high as 80 on Oct 27, the highest it has ever been, you may think and still think even at 53, where it is today, that investing would be a viable option. Knowing how close we came to a second great depression, had we not had the knowledge of the first one and the methods to prevent another one, we can pretty well gauge that it was entirely possible. Seeing the VIX jump to 80 is understandable given that possibility, but this may not be the best moment to jump in for investment firms. If you look at volatility during the Great Depression and the 1907 Bankers Panic, which was as high as present fear values, the fallout was more severe.

Even though we have the tools available to prevent the collapse of the financial structure of the country (so far so good) we may be in a situation similar to the 1929 and 1907 crashes; a long term decline in the stock market. Whats different about the four bottoms previously mentioned is that there was a bounce back. There wasn't a bounce back in 1907 or 1929. During those crashes the market headed a lot lower following the sharp rise in volatility. The question then becomes, are the stops in place today able to stop a long term decline in stocks? The amount of debt and the debt mentality of this country isn't changing and won't change until our standard of living and quality of living decline to levels unbearable (modest in comparison to other countries). Saving is the most important financial policy that firms, governments, and individuals should keep (China's savings rate is 40 percent while the USA's is...zero percent, the lowest since the Great Depression). Until this sinks in we will continue putting band-aids on a rotting system. We will eventually have an enormous ball of band-aids holding together something that is no longer salvageable. When we unwind the ball of band-aids and heal the real underlying problems in the system, it will be safe to enter the market again. Lets just say it will be a while.

What Happened to AIG

2 things: Greed and no Risk Management.

In the past few days Hank Greenberg, the former CEO of AIG, has admitted that the finance part of AIG hurt the business as well as the "dissapearance of Risk Management."

The two are related to the company's over use of credit in the early part of this decade. At the time of failure, AIG's leverage was 60 to 1. There was definetly no risk management oversite to the finance area. This overleveraging was due in part to AIG's issuance of over $440 Billion in Credit Default Swaps. These financial instruments are used to create an insurance policy against bonds for a fee. Issuing $44o Billion in CDS meant quite a bit of revenue for AIG. (If there was any question of how AIG made huge profits year after year in the early part of this century, as it was to many in the industry, including regulators, we now know the answer.) And since now asset backed securities, derivatives, and bonds are all becoming worthless, AIG is responsible for all payments on their CDS. They cannot fulfill these obligations and, in turn, have become insolvent. This means that all the institutions that they sold these obligations to are losing their insurance. If this is allowed to happen it would trigger the end of our financial system as we know it because if AIG fails, many institutions would soon follow. The result was a hesitant government bailout merely to prevent the fallout of such events.

Implications of an AIG Failure

Lehman brothers was allowed to fail today without a government bailout, and without a buy out (although there was opportunity for the latter by the Korean Bank KDB as I discussed in a previous post.) It could be assumed that the failure of this bank was a risk the government was willing to take in its strategy of picking and choosing companies in order avoid a complete collapse of the U.S. banking system. AIG, however, with its balance sheet worth over a trillion dollars, does not appear on the list of companies that will be allowed to fail and shouldn't. The implications of AIG failing are much greater than Lehman Brothers. AIG faces the threat of a credit downgrade from the rating agencies if the company is not able to sell its assets and raise capital. Personal insurance under the insurer would not be affected but commercial insurance would. If AIG was to receive a downgrade commercial interests across the world would not meet its obligations of having high grade insurance and would be forced to find insurance elsewhere. This would create opportunity for companies such as Metlife, Allstate, Prudential, Chubb, and The Travelers as AIG would lose a substantial portion of this market share. This is needless being that a substantial portion of AIG's woes come from its risky backing of complex derivative securities. AIG spans 130 countries with assets so large in number it would be impossible to quantify. It's failure would be incredible.

My contention on action must be weighed against it's ultimate benefit to society. You can say that all of these delicate actions to keep the country's economy afloat is ultimately beneficial in that it is preventing another great depression. You can also say that we are merely propping up the dead in the name of preventing a collapse - this having great social risks in itself through moral hazard. AIG was given a 20 Billion loan from the state of New York to create a bridge to sell more of its assets. Another 20 Billion is still needed which will presumably come from the federal government. If AIG can overlook its pride, the best course of action would be to sell all of its assets as cheap as they can and divide up what has become too large to quantify and too risky to manage. Merrill did this very intelligently. Bank of America bought the company cheap which at least keeps the company alive. I am personally impressed with the CEO of that company, John Thaine, for his diligent, selfless actions to save that company from collapse. AIG needs to do the same, as do all other companies in danger of collapsing in order to prevent a financial calamity with far reaching social consequences.

Privately Sponsored Public Security

When reading Professor Klein's post, "Public Goods and Risk Management", I was reminded of an anecdote I had heard on a radio show about privately sponsored militarys hired after Hurricane Katrina. The story alarmed me in its descriptions of obvious conflicts of interest. The caller on the radio show spoke about a special police force he had encountered in the wake of Katrina which didn't appear to be U.S. military. It wasn't in fact, it was a private company hired by the U.S. government to protect special interests in the area. The caller described how he went up to the men asking for assistance and receieved a response indicating lack of care or concern. The caller described their snide comments about the situation and how they were saying they were being paid so much for doing nothing.

In researching more about companies offering these services, I found information on a few. I found companies offering "risk advisory services" like Kroll, Inc., CRG, and Global Options, Inc. Global Option's company profile described itself as "a multi-disciplinary, international, risk management and business intelligence company."..."the staff of professionals includes former intelligence and law enforcement officers, veterans of America's elite military units, and legal and crisis communication specialists."

Kroll has a security service and describes itself here:
"Global threats are forcing companies to take a harder look at their security programs.
Kroll’s experts in security, protection, engineering, business continuity and emergency management help clients prevent, prepare for and respond to the many threats they face at home and abroad.
From assessment to implementation, clients benefit from Kroll's seamless integration of services, resulting in a more efficient, cost-effective security program. Our experts develop proactive, tiered approaches that can respond quickly to changing threat conditions and help ensure operational continuity in the wake of a crisis."

Here is a description of some of the activities of private militarys and their involvement with the U.S. Department of Defense:
The laws surrounding hired soldiers and civilian contractors is not clear and not well defined under international agreements. This is a reason why increasingly the focus is regulation at the national level; e.g. as the licensing mechanisms used by the United States and South Africa demonstrate. Yet many of the hired soldiers are not American; they could be from the country of conflict, or flown in from Chile, El Salvador, or South Africa. Exactly what jurisdiction, aside from their employer, they are under is, according to some commentators, uncertain. [1]
This is true for American contractors as well. Civilian contractors working for Dyncorp in the Balkan wars were implicated by a fellow employee for indulging in a child prostitution and sale ring in the war torn country. [2] Those who turned in the employees were fired, and later the offending employees were fired , however not charged with anything. [3]
Some of the interrogators in the Abu Ghraib crimes were civilian contractors provided by Titan and CACI. They have yet to be charged for any crimes, however they are being sued as are the two companies. [4][5][6] All three companies have continued to receive large wartime contracts from the US government.
In 2006, the US Congress published an official report on US enterprises that had signed contracts with the State Department or the Defense Department so as to carry out anti-narcotics activities as a part of Plan Colombia. Most the private contract enterprises are under the responsibility of the Defense Department, but the largest contract (DynCorp) is in the hands of the State Department.

I believe it is dangerous for the public to have privately funded public services as the services are more likely to be bent to serve the interests of the ones writing the checks.

“The mercenaries and auxiliaries are useless and dangerous, and if anyone supports his state by the arms of mercenaries, he will never stand firm or sure, as they are disunited, ambitious, without discipline, faithless, bold amongst friends, cowardly amongst enemies, they have no fear of God, and keep no faith with men,” wrote Machiavelli in The Prince.

http://www.sourcewatch.org/index.php?title=Global_Options%2C_Inc.

http://www.kroll.com/services/security/

http://www.sourcewatch.org/index.php?title=PMC

Lehman Brothers and Merrill Lynch

With the fall of Bear Stearns in March other major investment bank names began popping up in speculation over their possible failure. Lehman Brothers, Merrill Lynch, and Morgan Stanley were said to have high counterparty exposures to the failed bank and would have followed suit had Bear not been bailed. We discussed the sale of assets by failing companys to capture some equity before an ultimate collapse. This would almost seem the case with Lehman and Merrill. Lehman and Merrill have both been putting up pieces of it's companies for sale in the past couple months which would, if today's discussion can be applied, indicate an imminant failure or atleast a slow unraveling of a doomed enterprise. Because it is against the law to start rumors and short big banks on Wall Street now-a-days, and because of these increasingly large sales of assets, especially with a bid to buy 25-50% of Lehman by Korean Bank KDB, I would be willing to bet (not on the open market) that Lehman Brothers and Merrill Lynch are failing.

http://ap.google.com/article/ALeqM5gdhcgQsMtGn3t44cuC8W6GaVJxcQD92V73UO0

http://www.cnbc.com/id/26546070

Moral Hazard in Fannie Mae and Freddie Mac

Dr. Bob mentioned controlling moral hazard in his last post. The following blog describes the highest height of moral hazard currently facing the U.S. It describes the actions of Fannie Mae and Freddie Mac as it used government subsidized guarantees to essentially create "risk free" securities. These securities created an insatiable appetite for Freddie and Fannie to purchase their own products. Restricted only by strict underwriting standards, the corporations grew their "golden goose" by easeing those credit standards. These actions, based in moral hazards are, in large part, responsible for the creation of the U.S. credit crisis. As the end of the blog implies, the moral hazard created in the 80s and 90s is seemingly only fixed by more of the same moral hazards.

There are two stocks now in the stock market which are not capable of ever reaching zero because they are backed by the U.S. government. How is this possible? What are the implications for capitalism in such a case?

"Guaranteeing oneself against risk is not insurance, its an exercise in futility."




http://billburnham.blogs.com/burnhamsbeat/2008/07/fannie-maes-gol.html

07/11/2008
Fannie Mae's Golden Goose: A Lesson In Moral Hazard
In the mid 1990’s I spent over a year as part of a team consulting to Fannie Mae. Given that they have been in the news a bit over the last few days, I thought it might be interesting to pass along a few observations that initially crystallized during my time there.


The World’s Biggest Mortgage Bank:
For those of you that don’t know Fannie Mae, it is one of the largest financial institutions in the county with over $880BN in assets. It is almost exclusively focused on buying, selling, and guaranteeing single family residential mortgages. Fannie Mae was originally a US government agency, but became a public company in the 1970s. Despite being a public company, Fannie Mae has remained a quasi-government agency subject to federal oversight and regulation. This government regulation, combined with a few perks such a direct credit line from the US Treasury as well as its overwhelming size and importance to the US housing market has resulted in what amounts to an implicit US government guarantee that Fannie Mae (and its cousin brother Freddie Mac) will never default on their debt. There is no law or regulation to that effect, just an assumption by the market that Fannie Mae is too big, too close and too important to the government for the government to ever let Fannie Mae fail. With the mortgage market in massive turmoil and Fannie Mae’s stock down 85% in the last year, that assumption is currently being heavily tested.
I don’t know exactly what the future holds for Fannie Mae, but I think I can shed some light on how it got in this position in the first place. The seeds of Fannie Mae’s current crisis were actually sown in the recovery from its last crisis. In the mid-1980s Fannie Mae almost went out of business thanks in large part to some very poor and rather unsophisticated asset and liability management practices. What basically happened is that the aggregate cost of Fannie Mae’s debt exceeded the income it was deriving from its (then relatively modest) mortgage portfolio. This never should have happened given the instruments and strategies available to Fannie Mae’s finance team, but they had become somewhat complacent and had failed to keep up with the state of the art in portfolio and treasury management.

Creating the Golden Goose:
A new team of people took over the finance side of Fannie Mae and implemented a series a relatively sophisticated and ultimately incredibly profitable Asset and Liability Management (ALM) strategies. One of the key innovations was issuing debt instruments, specifically callable debt instruments, that enabled Fannie Mae to much more closely match both the duration and pre-payment characteristics of its Assets (primary residential mortgage securities) with its debt (primarily Fannie Mae corporate debt). Normally, callable debt is quite expensive (much more expensive than residential mortgage debt), because bond holders want to be compensated for selling the call option to the issuer, but thanks to Fannie Mae’s quasi-government status it was able to issue this callable debt at yields that were only marginally above straight treasury yields. This debt combined with a more sophisticated overall ALM approach, not only reduced Fannie Mae’s borrowing costs significantly, but enabled it to very quickly adjust its portfolio in the event of rapid changes in pre-payments.
With this strategy in hand, not only could Fannie Mae buy mortgage securities for less than the cost of its debt (and thus earn a nice spread), but it could almost entirely contain pre-payment risk effectively making the purchase of mortgage securities “risk free” except for credit risk, which itself was very low thanks to Fannie Mae’s strong underwriting guidelines. Fannie Mae had discovered the equivalent of a financial golden goose.

Let’s Get This Party Started:
With its golden goose in hand, Fannie Mae almost immediately began buying a lot more mortgage securities. Who did it buy these securities from? Why none other than Fannie Mae itself. You see Fannie Mae’s original role was to buy mortgages from individual banks, package them up into securities, guarantee those securities against loss, and then sell them to other financial institutions. However once Fannie Mae realized that the “golden goose” allowed them to buy those same securities for its own portfolio and lock-in “risk free” profits, Fannie became a major buyer of its own securities. Fannie Mae was thus in the rather bizarre position of guaranteeing an ever increasing portion of its own assets against default.
By the time I showed up in the mid-1990’s, Fannie Mae had become one of the largest buyers of its own securities. Its stock was up over 40X from it’s 1980s nadir and it seemed as though the single biggest problem it had was deciding on how much money it wanted to make. This was a bigger problem than you might imagine because as a quasi-government agency, and a constant political football, Fannie Mae realized it couldn’t be seen to be abusing its market position. So rather than go crazy and buy every mortgage security in sight, Fannie Mae just settled on charting a nice predictable upward growth in earnings fueled largely by buying an ever increasing share of its own securities.
Now a normal private company could not pursue this strategy because as it issued more and more debt to fund the golden goose, the yields on the incremental debt would start to increase to the point where the strategy no longer made sense. But Fannie Mae was different. Because of the implicit government guarantee of its debt, Fannie could issue incremental debt with little or no regard to its existing debt load because everyone assumed the federal government would backstop the debt.
Fannie Mae’s only significant problem thus became that the supply of mortgage securities would prove insufficient to fund its projected earnings growth (which was well above the projected growth in mortgage debt). As a result Fannie began a series of largely successful political campaigns to increase the volume of mortgage securities available to fund their habit. Theoretically, the easiest way to increase the supply of mortgage securities was to get the federal government to increase the size limit of mortgages that Fannie could buy and guarantee, but this was a very difficult political fight for Fannie to win because commercial and investment banks dominated the so-called “jumbo” mortgage market and, already smarting from Fannie’s dominance of the so-called “conforming” market, they had drawn a line in the sand in the jumbo market and committed most their lobbying resources to keeping Fannie’s size limit as low as possible.

Moral Hazard vs. Mo’ Money:
While Fannie still fought to increase its size limits, it quickly found another, much more politically palatable, way to increase the pool of mortgages it could buy: it dropped underwriting standards under the guise of increasing “home ownership” and “affordability”. Traditionally, Fannie had required the mortgages it purchased to be so-called 80/20 mortgages wherein the borrower puts at least a 20% down payment on the mortgage. This was a requirement because residential mortgages in the US are a “no-recourse” loan in which the borrow can generally “walk away” from the loan with no recourse to the lender other than seizing the house and reporting the default to a credit agency. A 20% down payment was generally thought to be enough to dramatically limit the moral hazard of borrowers “walking away” because housing values would have to decline 20%+ for the borrower to be underwater and even then the borrower would still face the prospect of losing their own sunk capital which makes walking away even more difficult from a psychological perspective
The problem with a 20% down payment is for many people it was very hard to come up with that big a down payment and thus it limited the total size of the mortgage market which in turn limited the volume of mortgage securities that Fannie Mae could purchase for its golden goose. While the obvious solution to this problem is just to lower the down payment requirement, Fannie couldn’t do this unilaterally because the government unit that regulated it would see such cuts as needlessly raising Fannie Mae’s risk profile. Far more politically astute that that, Fannie Mae began a campaign to increase “home ownership” and “affordability”. It created a home ownership “foundation” which opened offices in almost every congressional district and promptly set about mobilizing all the local advocates for “affordable” housing to put pressure on their elected representatives to let Fannie Mae offer “affordable housing programs”. Of course, “affordable housing problems” was just a euphemism for allowing Fannie Mae to lower its underwriting standards so that more mortgages could be created and the golden goose could thus kick out more golden eggs.
This proved to be a highly effective political coalition for Fannie Mae. Not only did they build a huge network of grass roots political supporters through their “foundation”, but politicians saw political advantages in supporting the programs because it cast them in the role of trying to help families buy a new home (as opposed to lowering underwriting standards to help a giant corporation keep up its earnings growth by taking a free ride on the US government’s guarantee). Even commercial banks and investment banks signed on to the program because it at least resulted in higher origination fees and an expanded credit market, even if most of the assets ultimately went to Fannie Mae and Freddie Mac.

A Victim of Its Own Success:
Fast forward to the mid-2000’s and Fannie Mae’s financial and political strategy was largely a resounding success. Fannie was now offering a wide range of mortgages that required less than a 20% down payment including even some that required no down payment at all! These products had dramatically increased the addressable size of the mortgage market. The increased size of the mortgage market enabled Fannie to purchase a massive amount of its own mortgage securities. In fact by this point Fannie Mae had become the single largest purchaser of its own securities. These newly purchased assets in turn enabled Fannie to continue to grow earnings which in turn supported a stock price that continued to trend nicely upward (though at a much more modest rate).
However beneath the seeming calm, the seeds for Fannie’s distress were now firmly planted. Fannie’s drive to lower underwriting standards had created a pool of mortgage debt with a much higher level of embedded moral hazard risk as well as good old fashioned credit risk. Fannie’s purchases of mortgage securities were so large that it was getting increasingly difficult to feed the golden goose enough food. On top of all that, with hundreds of billions of dollars of assets and liabilities to manage, Fannie's ALM strategies had become more and more complex and some of its bread and butter strategies started to become less profitable as the sheer weight of over half a trillion dollars of debt started to compress spreads (it would seem that even an implicit government guarantee has its limits).
It is no coincidence that the current mortgage crisis started in the so-called sub-prime market as that’s the mortgage market with the lowest credit quality and underwriting standards, however as the mortgage crisis has spread it has become increasingly clear that the traditional conventional, conforming mortgage market, long the domain of Fannie Mae and Freddie Mac, shares many more similarities with the sub-prime market than it would like to admit. While credit and underwriting standards are clearly much higher in the conforming market, they are also undoubtedly much lower than they were 10 or 20 years ago. What’s more the two biggest insurers against loss in that market now happen to also be the biggest owners in that market thanks to 20 years of purchasing mortgages to fund their government subsidized golden gooses. Guaranteeing oneself against risk is not insurance, its an exercise in futility.

The Goose Is Not Dead Yet:
Despite all of this, I personally don’t expect either company to go out of business. If recent comments from a slew of politicians are any indication, they are indeed “too big to fail”.
What I find most ironic in all of the current commotion is that rather than trying to address the root causes of Fannie Mae’s precarious state: dramatically lower underwriting standards and a massively levered balance sheet taking a free ride on the government’s back, politicians are doing the exact opposite: they are dramatically increasing the size of the mortgages that Fannie and Freddie can buy and pressuring them to maintain and even further lower their already un-sustainably low underwriting standards. I don’t know where this ends, but reinforcing the bad behavior that led to the crisis in the first place can’t end well

Re: Talking About GM

     The Wall Street Journal article concerning GM and the 2009 release of the Chevy Cruze shows the company's new strategies for global competitiveness and increased profitability.  The strategies involve its continued, decades-long quest to improve its image, while improving gas mileage, and increasing their presence in the global market place.  A CNBC special titled "Saving General Motors" took a glimpse at General Motor's image around the world, especially in China, where the GM image is highly regarded.  Young business men searching for their first new car are attracted to the car's quality above anything else and hold the car at the top of their lists when deciding which brand to choose.  As noted, the Cruze will debut in Europe and Asia before the U.S. which is indicative of the level in which GM is relying on its overseas markets.  These markets are the only area in GM's business portfolio keeping their business alive in the face of slumping SUV and truck sales in the U.S.  The Cruze will offer MPG ratings attractively higher than the Civic with a price competitively set around the Honda favorite.  Being a GM car owner myself with interest in a Civic based on it's fuel efficiency, I would consider a Cruze when it becomes available in the U.S.  GM's dedication to fuel efficiency gives the car a greater chance of profitability once it is introduced to U.S. markets.