Ilargi: Here's for something unexpected: economics and biology. Or, since it sounds far better: bankers and fish. Check out Gillian Tett's upcoming book Fool's Gold, a chapter of which is at the bottom of this post.
A lesson for bankers from the birds and the bees
by Gillian Tett
This spring, Mervyn King, the doughty governor of the Bank of England, has good reason to think about the birds and bees – alongside other matters linked to zoology, epidemiology or ecology. The reason? A few months ago Mr King and other Bank officials started brainstorming with Lord Robert May, the prominent zoologist and former head of the Royal Society (and ex-chief scientific adviser to the UK government). The aim was to see whether the animal kingdom or global environment might offer lessons on how to predict and control (mis)behaviour of bankers – and thus avoid the type of financial panic that has just convulsed the system.
"There is a common ground in analysing financial systems and ecosystems, especially in the need to identify conditions that dispose a system to be knocked from seeming stability into another, less happy state," observed Lord May in a paper co-authored last year with two eminent American scientists (an analysis that cites the fishery industry as one possible source of good ideas about how to run finance). Welcome to the one of the hottest new trends in the modern banking jungle. Three decades ago, it was presumed in places such as the City of London that the Bank could best control private banks with informal guidance (or a stern twitch of the governor’s eyebrows). In the past few years, banks and regulators alike have come to rely increasingly on complex computing systems and bureaucratic rules to measure financial risk.
Now, though, faith in those mathematical models has been shattered. Financiers are scrambling to find fresh ways to monitor the systemic risks that could damage the financial system – which, in turn, has prompted the Bank to begin talking about fish, and other matters. It is a very welcome development, if not long overdue. Three years ago the New York Federal Reserve pipped the Bank to the post by organising a conference with the US National Research Council that aimed to "stimulate fresh thinking on systemic risk" by comparing financial systems with those from engineering or ecology. As part of that process, the Fed mapped out the $1,200bn (€905bn, £810bn) daily network of US interbank payments in the US, and compared it with non-financial systems, such as the electricity grid, to search for lessons. Although that path-breaking exercise was fascinating, it received little attention, in part because it was published as the financial crisis broke.
Now, however, this interdisciplinary approach looks timely. For one thing, this type of debate could offer policymakers a way to implement badly needed reforms without being entangled in endless political controversy and finger-pointing – or fights about economic ideology. Moreover, the fields of science or ecology might offer useful lessons about how to manage systemic financial risk. One moral of the recent banking crisis is that regulators spent too much time monitoring individual banks – but failed to see how they might interact. That mistake is not unique to finance. As Lord May notes: "For the past half century investments in fisheries science have focused on management on a species-by-species basis (analogous to single-bank risk analysis)." But, as Lord May goes on: "This approach is giving way to the view that such models may be fundamentally incomplete and that the wider ecosystem and environmental context ... are required for informed decision-making." The Bank, for its part, is already trying to extend the lesson about fish to banks.
This week Andrew Haldane, the Bank’s head of financial stability, published a paper comparing the Sars epidemic and the collapse of Lehman Brothers and other catastrophes. He concluded that the dynamics of the modern financial network make it both "robust and fragile ... a property exhibited by other complex adaptive networks, such as tropical rainforests". While the financial network looked diversified, individual finance houses had pursued strategies uncannily similar to each other – meaning that all were vulnerable to collapse once the system reached a "tipping point". Regulators are now striving to analyse financial networks and maintain "network resilience" in the future, Mr Haldane said. Parallels between the financial and non-financial world do not always work. When the Fed tried to compare the US bank payments with the electricity grid, it concluded that "in contrast to management of the electric power grid, there are only coarse or indirect options for control of the financial system."
Yet, even if such brainstorming has limits, there is another reason to welcome a trend towards a more interdisciplinary approach: it is a powerful reminder that banking is simply one branch of human activity, alongside many others. This is a lesson that badly needs to be relearnt. During the credit bubble, many bankers viewed finance as a quasi-sacred, semi-detached world where society’s normal rules barely applied. Now the bubble has burst, non-bankers are apt to see finance as utterly peculiar – if not demonic. Unless we find a way to demystify finance and reintegrate it into society, it will be hard to build healthier banks. Treating financial systems as if akin to fish, tropical trees or pestilent diseases, in other words, might not just be good for the bankers; it might help to build a money system that is safer for everyone else too.
Feds Seize The Silverton, The Nation's Largest Bank of Banks
This afternoon Federal banking authorities seized Silverton Bank, the Atlanta-based bank for banks. The troubled bank had already been subject to government censure, prohibited from paying dividends, paying interest on its debt or issuing new debt without prior consent from the Federal Reserve. The seizure is bad news for Silverton's shareholder base, comprised entirely of its customer banks. More than 1,500 banks across the country are Silverton customers, and 400 hundred of those are shareholders. The bank provides banks, especially community banks, with credit lines and other back-office services. It is the largest bankers' bank in the country.
Silverton had more than $4.1 billion in assets, making it the fifth largest bank to fail since the financial crisis began last year. The FDIC says the seizure could require as much as $1.3 billion from its insurance fund. There had some question about whether or not Silverton was too big to fail or too connected to fail. Some Georgia bankers had argued that its collapse could take at least 8 to 12 banks down with it. Silverton killed itself by drinking too much housing boom kool-aid. It created a huge portfolio of residential real estate construction projects. Some of these loans were syndicated out to smaller shareholder banks. But when the market for the loans collapsed in 2007, it was stuck holding a bunch of debt that quickly went toxic.
Banks In Georgia, NJ, Utah Shut By Regulators
Regulators shut down Silverton Bank in Georgia on Friday and set up a temporary government-controlled bank until a buyer can be found. Silverton, which operated as a sort of wholesale bank, fell victim to large losses on real estate construction and development loans, regulators said. The federal Office of the Comptroller of the Currency closed Silverton Bank, based in Atlanta, and appointed the Federal Deposit Insurance Corp. as receiver. Silverton Bank had about $4.1 billion in assets and $3.3 billion in deposits as of May 1. Also closed Friday was Citizens Community Bank in Ridgewood, N.J., and America West Bank in Layton, Utah.
Citizens Community Bank had roughly $45.1 million in assets and $43.7 million in deposits as of Dec. 31. Its deposits are being assumed by North Jersey Community Bank in Englewood Cliffs, and its sole office will reopen on Monday as a branch of that bank. America West Bank had total assets of about $299.4 million and total deposits of $284.1 million. Logan, Utah-based Cache Valley Bank agreed to assume all of the deposits of the failed bank at a discount of $352,000. The three branches of America West will reopen on Monday as branches of Cache Valley Bank. The three bank closings brought to 32 the number of bank failures this year in the U.S. That compares with 25 in all of last year and three in 2007. The FDIC estimated that the cost to the deposit insurance fund from Silverton Bank's failure will be $1.3 billion _ the fourth-largest such loss since the financial crisis began felling banks last year. The combined cost of the closings of Citizens Community Bank and America West Bank is an estimated $137.5 million.
Geithner's New Bank Fix Is Bogus, Too
Tim Geithner has a clever new way to recapitalize the banks that failed the stress test: Convert the taxpayer's preferred stock to common stock.
From Geithner's perspective, this technique has several advantages:
- The banks will suddenly seem healthy, because their assets-to-common equity ratios will rise.
- Geithner doesn't have to ask Congress for more baillout money yet.
- Taxpayers won't understand that they're giving up a nice dividend and a safer security just to make the banks look better.
- If Geithner is right that what's wrong with the banks is just a temporary liquidity problem, the taxpayer should do well when the stocks rise. (We don't think he's right.)
Unfortunately, the plan also has two major flaws: First, it's smoke and mirrors. Second, the taxpayers are even more exposed than they are now.
Because the banks will still have the same amount of crap assets on their balance sheets, and they'll have no more capital available to absorb these losses. The only thing that will change is that the taxpayer will now get hit first as these losses flow through the balance sheet, instead of getting hit second, as is the case now. The banks' bondholders, meanwhile, will still be protected to the tune of 100 cents on the dollar (by administration policy). Which means that if the common equity is wiped out by the losses, the government will have to dig into the taxpayer's pockets to cover any shortfall. (See Paul Kasriel's detailed explanation below).
In other words, Geithner has hatched yet another plan to avoid dealing with the bank problem once and for all.
How would he do that? As we've argued, we think the best way would have been to seize the banks and restructure them. Since Geithner has opted against the route, however, the next best way would be to convert unsecured bank debt to equity, not just the taxpayers' preferred stock (the taxpayers' preferred stock should have been senior to all the bondholders, but that's spilt milk at this point).
Doing that would give the banks a much bigger equity cushion with which to absorb losses. It would split the bank ownership up among current common shareholders, taxpayers, and current debtholders, which would help Geithner avoid having to take full control. It would also, finally, stop exposing the taxpayer to further losses.
The idea that bondholders should share the bank pain is finally gaining some momentum. Let's hope that continues in the coming weeks.
Why is Geithner's new plan just "accounting alchemy?" Paul Kasriel of Northern Trust explains:
Consider Balance Sheet One of hypothetical Gotham City Bank. Assets equal liabilities plus common equity.
But suppose the Treasury believes that Gotham should have a ratio of common equity to total assets of 10% rather than the 5% it currently has. No problem. Treasury will just convert $5 of the preferred shares it owns in Gotham to $5 of common equity. This is shown in Balance Sheet Two. Now Gotham is well capitalized, right? Wrong. The depositors and the bond holders always were in line in front of the preferred shareholders in case Gotham had to be liquidated. So, moving $5 from the preferred equity category to the common equity category does not make the depositors and bond holders any better off. Are taxpayers any worse off? Not really. If Gotham’s original $5 of common equity was not going to be enough of a cushion to protect depositors and bondholders, then taxpayers were not going to get all of their preferred-share holdings back anyway.
Now suppose that $30 of Gotham’s loans and investments become uncollectible, as shown in Balance Sheet Three. This means that all of Gotham’s common equity has been wiped out. Infact, Gotham now has an equity “deficiency” of $20. No problem, according to Treasury. It will simply convert its remaining $10 of preferred equity to common equity. That won’t cut it in this case.
As shown in Balance Sheet Four, Gotham still has a common equity deficiency of $10. In other words, if Gotham were to be liquidated, there are only $70 of assets to pay off $60 of deposits and $20 of bonds. Either the Treasury would have to come up with $10 of new funds or bondholders would have to take a 50% haircut. If the Treasury wanted to keep Gotham open and with a ratio of common equity to total assets of 10%, Treasury would have to inject $17 of new funds, all of which would be common equity. In other words, Treasury, meaning us taxpayers, would own 100% of Gotham.
In sum, Treasury’s plan to enhance the capitalization of some financial institutions by beating preferred equity shares into common equity shares is accounting alchemy.
Bank stress tests to clarify crisis
The true dimensions of the U.S. credit crisis will become much clearer next week with the release of results from unprecedented government "stress tests" of the nation's 19 largest banks and their capital needs. The results are expected to show that the 19 banks must raise possibly $150 billion or more in fresh capital, with investors expected to punish stocks of the neediest banks. "Most banks will have to raise capital in some form," said FBR Capital Markets managing director Paul Miller. "The capital raises will be much bigger than people think."
Uncertainty about what the tests might reveal had made banks stocks "uninvestable" at this point, he added. "You just don't know how the government is going to view it." Public release of the stress test results is set for Thursday, a government official said. A source told Reuters U.S. officials plan to brief the banks themselves on Tuesday. The stress tests have transfixed markets for weeks, shaping a suspenseful episode in the ongoing financial crisis that has worsened the U.S. recession and shaken economies worldwide, burdening the newly arrived Obama administration and Congress.
It stems from hundreds of billions of dollars in shaky assets on banks' books. Accumulated during a massive debt bubble, when real estate soared and exotic debt securities multiplied, these assets are now clogging credit markets. "I can't think of a time since I've been watching banks when there's been so much uncertainty about the true value of a key set of assets," said Douglas Elliott, a fellow at the Brookings Institution, a Washington think tank. He estimates the 19 banks must raise between $100 billion and $150 billion. The banks being tested include Citigroup, Bank of America, JPMorgan Chase, Wells Fargo and Goldman Sachs. Together, the 19 banks hold two-thirds of total U.S. bank assets.
When results are announced late next Thursday, analysts believe the government will say all 19 banks are solvent, but that some need to raise more capital than others to cushion themselves in case the U.S. recession deepens. The banks likely to be tagged as needing the most fresh capital are Citi and Bank of America, said Fred Dickson, chief market strategist at D.A. Davidson & Co. Below those two, the next banks needing the most capital will likely be JPMorgan and Wells Fargo, he said, adding that this would likely halt a recent recovery in bank stocks. "My guess is we will see another fairly significant sell-off of banks that are going to be involved," he said.
"The recent market rally I think has been a lot due to short-covering." Bank shares have rallied in recent weeks after some large banks posted surprise first-quarter profits. The KBW bank index .BKX is up 75 percent from a year low of $18.62 on March 6. It finished on Friday at $32.13. Regulators are expected to urge banks to quickly boost capital by converting existing preferred stock to common equity, diluting common shareholdings, and will likely also be encouraged to sell assets. The most vulnerable could face new government capital infusions, which would extend Washington's reach over the sector and potentially put some CEOs' jobs on the line.
Bank stocks have been under pressure on uncertainty about credit losses and rumours of nationalization. The banks' woes have hurt the overall market, helping to push the Dow Jones industrial average down 27 percent in the first two months of the year to a 2009 closing low in early March. It has since gained back more than 25 percent of its value. The stress test results will disclose information about the 19 bank holding companies as a group and individually. They will also disclose estimates of losses for certain types of loans, and detail resources needed to absorb those losses under an adverse economic scenario, the government source said. The government has said the tests are not about solvency, but a "what if?" exercise to help gauge the need for additional capital should the U.S. recession deepen unexpectedly.
The Federal Reserve, the regulator in the lead, said banks with inadequate capital will have six months to find private funds, but analysts doubt banks' ability to raise capital if the government pinpoints their vulnerabilities. Some questions surround the tests, which have never been conducted before on this scale, as more than 150 bank examiners and economists were dispatched to perform a consistent inspection of the largest firms. Chief among them is whether the direst economic scenario envisioned by regulators is dire enough. Anil Kashyap, a professor of banking and finance at the University of Chicago and a former Federal Reserve economist, said it could be hard for regulators to prove they were tough enough. "The stress scenario is a pretty weak scenario," he said.
In addition, FBR's Miller said, it is still unclear how banks will be made to treat setting aside reserves for bringing off-balance sheet assets back onto their balance sheets under recent accounting standard changes. The Fed said last week that the changes could bring $900 billion of assets onto the 19 banks' balance sheets. "This off-balance sheet issue is a wild card," he said.
Fed's Stress Test May Compel 14 Banks to Raise Capital
U.S. Regulators may compel as many as 14 of the nation’s 19 largest banks to raise common equity based on financial stress tests due to be completed next week, said Paul Miller, an analyst at FBR Capital Markets Corp. Miller, a former bank examiner, said his estimate assumes regulators will require banks to maintain tangible common equity, one of the most conservative measures of capital, equal to 4 percent of their risk-weighted assets over the next two years, to withstand losses in case the recession worsens. The tests, originally scheduled for release on May 4, are set to be disclosed after U.S. markets close on May 7, according to a government official who spoke on condition of anonymity. Bank of America Corp., JPMorgan Chase & Co., Citigroup Inc. and the 16 other banks received preliminary results last week and have been debating the findings with regulators.
Officials favor tangible common equity of about 4 percent of a bank’s assets and so-called Tier 1 capital worth about 6 percent, people familiar with the tests say. Tangible common equity, or TCE, is a gauge of financial strength that excludes intangibles such as trademarks that can’t be used to make payments. Tier 1 capital is a broader measure monitored by regulators. "When you start talking about 4 percent on risk-weighted assets based on the stress test two years out, most banks will be required to raise more capital," Miller said in an interview yesterday. "I believe it will be as high as 14." He declined to name them. Citigroup, which has already taken $45 billion in U.S. taxpayer funds to shore up its finances, may need to raise as much as $10 billion in new capital, the Wall Street Journal reported today, citing people familiar with the matter. Jon Diat, a spokesman for the New York-based bank, declined to comment.
Miller, 47, is a former examiner for the Federal Reserve Bank of Philadelphia and was the top-ranked stock picker among bearish analysts evaluated by Bloomberg Markets magazine last year. He’s based in Arlington, Virginia. Miller’s views aren’t shared by all of his peers. David Trone, who covers 13 of the 19 lenders at Fox-Pitt Kelton Cochran Caronia Waller in New York, said his math shows that only four of the banks he focuses on will need more capital because of the stress test. Trone’s team upgraded the U.S. banks to "marketweight" from "underweight" this week. The four are Regions Financial Corp., SunTrust Banks Inc., PNC Financial Services Group Inc. and Wells Fargo & Co., Trone said. He estimates that PNC Financial needs $1.9 billion, Regions Financial requires $1 billion and Wells Fargo has to line up $1.5 billion. SunTrust needs $400 million, he said.
He added that, while his calculations don’t show a need for Citigroup and Bank of America to increase common equity, it’s possible the government is using different assumptions and will require them to do so.
Miller and his team expect the banks will be encouraged to convert preferred stock held by private investors into common stock before converting preferred stock purchased by the government as part of the
It’s possible the government will forfeit dividends on its preferred stock to enable the banks to suspend payouts on trust preferred securities, known as TRUPS, that are held by private investors and encourage those investors to convert into common stock as well, Miller said. "You couldn’t pay the TARP dividend and cut the TRUP dividend, you’d have to cut them both, so the government could do that, the government could allow that to happen," he said. "And frankly we’ve argued that you’re bleeding capital away from these banks that need it by making the banks pay these dividends and that they should waive all these dividends."
By contrast, Trone said he doesn’t think the government should encourage the banks to exchange privately owned preferred stock and dilute common shareholders in anticipation of potential future losses.
Instead he said the government should help the banks that may need more common equity by converting the government’s preferred stock into a new class of so-called convertible preferred securities, which could be turned into common stock as required. "Converts could provide you contingent common in the amount needed," Trone said. "A lot of these companies could end up doing better than we expect. This is supposed to be the worst-case scenario." The 19 firms include Goldman Sachs Group Inc., GMAC LLC, MetLife Inc. and regional lenders, including Fifth Third Bancorp and Regions Financial.
The banks in the tests hold two-thirds of the assets and more than one-half of the loans in the U.S. banking system, according to a Fed study released April 24. The delay in releasing the stress-test information follows an internal debate among regulators about how best to reveal to markets the health of the biggest banks, which is usually reserved for bank examiners. The government will disclose both aggregate information about the capital buffer required to absorb losses if the recession worsens and firm-specific details, the government official said yesterday. The details may help investors distinguish strong from weak banks, leaving the latter to turn to the government for capital.
Citi Said to Need Up to $10 Billion
Citigroup Inc. may need to raise as much as $10 billion in new capital, according to people familiar with the matter, as the government continues negotiations with banks over the results of its so-called stress tests. The bank, like many others, is negotiating with the Federal Reserve and may need less if regulators accept the bank's arguments about its financial health, these people said. In a best-case scenario, Citigroup could wind up having a roughly $500 million cushion above what the government is requiring. The discussions stem from the tests being run by the Fed and the Treasury to assess the health of the country's 19 largest banks. Those results will be released Thursday, later than initially planned. The tests will predict each bank's potential losses in certain asset categories under dire economic scenarios. The government is expected to direct several banks, including Bank of America Corp., to bolster their capital by raising new funds or converting existing securities into common stock.
The government's strong preference is for banks in need of fresh capital to raise it either through private investors or selling assets, officials say. That won't be an option for certain weaker banks, who may have to give the government big stakes in their common equity to boost capital levels. Such a move would help fill banks' capital needs but would also raise thorny questions about how large a role the U.S. might play in their daily operations. The Obama administration is expected soon to outline what type of investor it will be in companies where it has a stake, according to people familiar with the matter. The Treasury is discussing applying different levels of governance depending on the size of the U.S. government's stake. The overall goal is to get out of the investments as quickly as is possible and minimize government intervention in banks' operations.
The outcome of the stress tests could play a major role in shaping the next phase of the U.S. government's intervention in the nation's ravaged financial system. After the results, banks will have 30 days to give the government a plan and six months to put it into effect. The banks are expected to reveal their plans next week. Concerned about investor and depositor panic, government officials have said banks needing more capital should not be viewed as being at risk of collapse. In fact, the government has said it would not allow any of the 19 banks undergoing the test to fail. Some banks still might need to seek more money from the government. Goldman Sachs Group Inc. and J.P. Morgan Chase & Co., widely regarded as two of the nation's strongest banks, aren't expected to be required to boost capital, according to people familiar with the matter. It's not clear whether officials will permit the banks to immediately repay the government's existing investments in these banks. The stress tests are a central part of the Obama administration's effort to restore confidence in the U.S. banking system. They have met resistance from top bank executives who complain the government's estimates are wrong and too theoretical.
The Fed has told bank executives it's looking at a measurement of capital called "tangible common equity," which essentially measures what shareholders would have left if a company were liquidated. Some bankers say the Fed wants them to hold TCE equivalent to at least 4% of their risk-weighted assets, under the stress-test scenarios. Banks have been scrambling over the past week to refute the Fed's preliminary conclusions. Bankers say those negotiations are part of the reason the government has pushed back its announcement of the results. "The gloves have been taken off, and there's some real battles going on right now," said Gerard Cassidy, a bank analyst with RBC Capital Markets. Government officials originally hoped to release the results May 4. The plan now is to do so after U.S. stock markets close May 7. A smooth release is a critical component of the effort, as policy makers fear investors could punish banks that appear to have performed poorly. "I would not read anything into the delay and results, except the notion that regulators and the administration want to get this right from the very beginning," White House spokesman Robert Gibbs said.
Citigroup announced Friday it was selling its Japanese brokerage business for about $7.9 billion, a deal that will boost the company's tangible common equity by about $2.5 billion. The New York-based company has argued the Fed should give Citigroup credit for the planned transaction, along with other pending sales, as it tabulates the company's capital levels. Under an earlier government effort to stabilize Citigroup, which involved a conversion of preferred stock into common, the U.S. was going to end up with 36% of Citigroup's common stock. To raise new capital, Citigroup is likely to broaden the conversion to include preferred securities held by private investors. The end result will likely leave Washington holding about the same amount as previously envisioned. Some banks are haggling with the Fed over how it calculated their projected 2009 and 2010 revenues -- a central factor in gauging banks' ability to absorb losses. Some have pushed the Fed to use their strong first-quarter performances as a baseline, even though many acknowledge their first-quarter results are likely unsustainable.
Citi Defies Stress-Test Results
Making business headlines today is the still-unofficial results of the government's bungled stress tests, which show that Citigroup (C) may need to raise up to an additional $10 billion of fresh capital. However, the embattled bank, one of the worst hit by the financial crisis, is arguing that that won't be necessary, according to the Wall Street Journal, which leads with the news. In fact, Citi is conducting its own analysis, and "best-case scenario" is expected to find that the bank has a $500 million or so capital cushion already. The Financial Times reports that as a result of Citigroup's objections, publication of the tests' findings has been delayed to May 7, three days after the original announcement date.
Stress tests were administered to 19 of the nation's largest banks to determine what they would need to survive under more extreme and strenuous conditions. The government has said that it will not allow any of the banks that underwent the test to collapse, and those that are determined to need more capital, but are unable to raise it through issuance of preferred shares or from private investors, will be eligible for additional loans. "The Obama administration is expected soon to outline what type of investor it will be in companies where it has a stake," the Journal writes. "The Treasury is discussing applying different levels of governance depending on the size of the U.S. government's stake " with the end goal being to get out of the investments as quickly as is possible. It paper adds: "The outcome of the stress tests could play a major role in shaping the next phase of the U.S. government's intervention in the nation's ravaged financial system. After the results, banks will have 30 days to give the government a plan and six months to put it into effect."
The New York Times highlights Chrysler's weak month-end sales, which fell 48 percent in April. "The decline, reported Friday, was the biggest drop among major automakers, and considerably worse than the industry average of 34 percent compared to a year ago," the paper says. But the company's bankruptcy filing Thursday, followed by a speech by President Obama that encouraged consumers to buy American-made cars, was a boon for the automaker. That day, the company had 11,400 sales, or approximately 15 percent of its total for the month. "We closed a lot of deals after the fact," said Steven Landry, Chrysler's executive vice president for North American sales.
Overall auto industry sales slumped 34 percent in April, according to Reuters, "as [it] held near the lowest levels in nearly 30 years," Analysts blame all the issues surrounding General Motors (GM) and Chrysler, which they say "spooked" consumers. U.S. auto sales came in at a 9.32 million seasonally adjusted annual rate last month, according to Autodata Corp. The number fell short of the 9.8 million rate that analysts had expected. Reuters points out that "the annualized rate of U.S. auto sales is a closely watched indicator of economic activity ... U.S. auto sales typically account for as much as one-fifth of all retail sales in the country and represent one of the first indicators of consumer demand every month."
Bloomberg scours Chrysler's bankruptcy filing, and uncovers that company's secured lenders—you know, those that refused to accept the government's debt-for-cash offering of 29 cents to the dollar—included OppenheimerFunds, Perella Weinberg Capital Management's Xerion hedge fund, Stairway Capital Advisors, TCW Group, and Schultze Asset Management. That group was said by Obama on April 30 to have tried "to hold out for the prospect of an unjustified taxpayer-funded bailout," The list of more than 100 secured lenders included in the filing also contained those that were for the government's offer. Other creditors listed include Yale University, Oaktree Capital Management and assets managed for the University of Kentucky, Halliburton (HAL), Kraft Foods Master Retirement, and the Bill and Melinda Gates Foundation.
The Washington Post says that now the government has turned its eye to General Motors as it will in coming weeks have to reach "an agreement with GM's diverse collection of bondholders, who range from large corporations to ordinary Americans, will be the key to preventing the company from an outcome similar to Chrysler." Following the president's remarks about Chrysler's dissident debt holders, members of the auto task force met with representatives of GM's bondholders, "a vastly larger group with claims to nearly four times as much money." The paper quotes David Cole, chairman of the Center for Automotive Research, who says, "The stakes are higher [for GM] because [GM] is bigger and more complex."
According to the WP, "differences between the creditors to Chrysler and GM could alter the course—or at least the tenor—of the negotiations. The Chrysler holdouts were secured lenders, meaning they have a direct claim on the company's assets and legally would receive priority in a bankruptcy proceeding. Most bondholders are unsecured and face a higher risk of getting wiped out in court." Also on Bloomberg, SEC Chairman Mary Schapiro said in an interview on Bloomberg Television airing this weekend that the SEC should be allowed to regulate which securities hedge funds can buy and how much leverage they can use. Just making them register is not enough, she said, adding that "it's certainly possible" that the SEC would consider forcing hedge funds to publicly disclose short-sale positions. "We're not at the point where we've made decisions about those things," she said, and made the point that the SEC would first consult with other government agencies. Hedge funds are a $1.33 trillion industry.
Buffett: Berkshire may lose money on some derivatives
Warren Buffett on Saturday said he believes the Berkshire Hathaway Inc derivatives contracts tied to equity stock indexes will probably make money, but those tied to the credit quality of junk bonds may end up in the red. Berkshire at year end had 251 derivatives contracts, most of which are essentially bets on the long-term direction of stocks and junk bonds. They has accumulated billions of dollars of paper losses because stock prices have fallen, but Buffett has said these contracts differ from other derivatives he has called "financial weapons of mass destruction" in part because of the billions of dollars of premiums he collects upfront.
"I personally think that the odds are extremely good that on the equity put options, we will make money," Buffett said at Berkshire's annual meeting. But he added that "we have run into far more bankruptcies in the last year than is normal," and that on contracts tied to credit defaults, Berkshire will probably "lose money." He added: "I would expect those contracts to show a loss before investment income, and perhaps after investment income." Berkshire's contracts tied to equity indexes expire between 2019 and 2028. The junk bond contracts expire between 2009 and 2013.
Buffett Says He Sees 'No Signs' of Recovery in Housing, Retail
Billionaire investor Warren Buffett, the chairman and chief executive officer of Berkshire Hathaway Inc., said he’s seen no indication of recovery from the real estate slump that helped cause the U.S. recession. "There’s no signs of any real bounce at all in anything to do with housing, retailing, all that sort of thing," said Buffett, 78, in a Bloomberg Television interview before the Omaha, Nebraska-based company’s annual shareholder meeting today. "You never know for sure, even if there’s a leveling off, which way the next move will be." Paul Volcker, one of President Barack Obama’s economic advisers, said this week that the economy was "leveling off at a low level" and doesn’t need a second fiscal stimulus package after the $787 billion plan signed by Obama in February. The U.S. economy contracted at a 6.1 percent annual rate in the first quarter, weaker than forecast, making this recession the worst since 1957-1958. The annual meeting gives Buffett and Vice Chairman Charles Munger a platform to discuss markets, the economy and Berkshire’s businesses. Shareholders were expected to attend in record numbers this year after Berkshire reported five straight quarters of profit declines, ratings companies took away the firm’s top AAA credit grade, and Buffett confessed to an ill- timed investment in oil producer ConocoPhillips.
The loss of the top credit grade in the last two months from Moody’s Investors Service and Fitch Ratings "has no economic impact" on Berkshire, Buffett said. "It just doesn’t," he said. "We don’t use borrowed money in any real significant sense. My pride may be wounded just a bit." Berkshire, with a U.S. stock portfolio of $51.9 billion, has been pressured as equity markets dropped and U.S. unemployment rose to its highest in 25 years. Berkshire shares have plunged 31 percent in the past 12 months. More than 500 U.S. financial institutions have won approval for government bailouts with the total value exceeding $390 billion, and federal programs are buying distressed assets, backing debt and insuring customer deposits to prop up the economy and encourage banks to lend. Buffett, in his most recent letter to shareholders in February, said he supported the U.S. government actions, while predicting bailouts will cause "unwelcome aftereffects" including inflation.
Known as the "Oracle of Omaha," Buffett has grown into a cult figure among investors who admire him as much for his homespun aphorisms as for his stock-picking savvy. Visitors from 43 countries were expected to fill the arena and the overflow rooms, and students from 45 universities have been invited to watch from a ballroom in the Omaha Hilton across the street. Buffett and Munger have used recent meetings to promote Berkshire as a buyer of non-U.S. businesses and distinguish their operations from what they consider the sometimes reckless behavior they see on Wall Street. Their pronouncements reach shareholders, potential customers and ratings firms. Berkshire’s profit has fallen on deteriorating results at insurance units and liabilities from derivative bets on world stock markets. Buffett will announce first-quarter results May 8, the company said this week. Berkshire said Feb. 28 that book value, a measure of assets minus liabilities, had dropped by about $8 billion from $109.3 billion on Dec. 31.
Book value per share, a measure Buffett highlights in his yearly letter to shareholders, slipped 9.6 percent in 2008, the worst performance since Buffett took control in 1965, on the declining value of the derivatives and holdings in financial companies including Wells Fargo & Co. The Standard & Poor’s 500 Index has declined about 38 percent in the past 12 months. Shareholders at today’s meeting have a chance to browse booths at the Qwest Center where Berkshire units including See’s Candies, R.C. Willey Home Furnishings and car insurer Geico Corp. hawk their wares. The meetings in recent years have started with movies where Buffett hobnobs with celebrities including actress Susan Lucci and basketball player LeBron James. Then Buffett and Munger sit for five hours and take questions from the floor. Shareholders haven’t been screened in past years, and some people took the opportunity to ask Buffett about baseball, abortion and Buffett’s personal relationship with Jesus Christ. Buffett, in his "Visitor’s Guide" for this year’s attendees, cited the paucity of inquires about Berkshire at the 2008 gathering as the reason for restructuring the question-and- answer session.
The new arrangement, in which half the questions are pre- screened by reporters, may ensure more discussion on planning for Buffett’s replacement as chief executive officer, Berkshire’s $37.1 billion in derivative bets tied to stock markets and ratings cuts. "It will probably be the most worthwhile annual meeting in recent times," said Jeff Matthews, the founder of hedge fund Ram Partners LP, in an interview before the meeting. Matthews, who wrote in his book, "Pilgrimage to Warren Buffett’s Omaha," about the lack of inquiries about Berkshire businesses is among investors who publicly compiled lists of potential topics of inquiry. Their questions cover the firm’s 20 percent stake in Moody’s parent company, an investment in Chinese rechargeable-battery maker BYD Co., and Berkshire’s reliance on Ajit Jain at its reinsurance operation. The three reporters -- Carol Loomis from Fortune magazine, Andrew Ross Sorkin of the New York Times and CNBC’s Becky Quick -- took questions via e-mail and were under instruction from Buffett to ask only about Berkshire.
Berkshire’s Munger Says 'Venal' Banks May Evade Needed Reform
Berkshire Hathaway Inc. Vice Chairman Charles Munger, whose company is the largest private shareholder in Goldman Sachs Group Inc. and Wells Fargo & Co., said banks will use their "enormous political power" to prevent changes to the industry that would benefit society. "This is an enormously influential group of people, and 90 percent of that influence is being spent to gain powers and practices that the world would be better off without," Munger, 85, said yesterday in an interview with Bloomberg Television. "It will be very hard to accomplish the kind of surgery that would be desirable for the wider civilization." Munger said policy makers should seek to impose limits on banks that are deemed "too big to fail" after financial institutions worldwide suffered more than $1 trillion in losses. The U.S. government and the Federal Reserve have spent, lent or committed $12.8 trillion, an amount that approaches the value of everything produced in the country last year, to stem the recession.
"We need to remove from the investment banking and the commercial banking industries a lot of the practices and prerogatives that they have so lovingly possessed," Munger said. "If they are too big to fail, they are too big to be allowed to be as gamey and venal as they’ve been -- and as stupid as they’ve been." Omaha, Nebraska-based Berkshire Hathaway, run by Munger’s long-time business partner Warren Buffett, nevertheless is a large investor in some of the biggest U.S. banks. Goldman Sachs Berkshire paid $5 billion in September for preferred stock and warrants in New York-based Goldman Sachs, which was the world’s most profitable and highest paying securities firm before converting to a bank holding company. Goldman is now the fifth-biggest U.S. bank by assets.
Berkshire’s second-largest holding by market value after Coca-Cola Co. is Wells Fargo, the sixth-biggest U.S. bank. Berkshire also owns stakes in Bank of America Corp., the biggest U.S. bank by assets, as well as U.S. Bancorp, M&T Bank Corp. and SunTrust Banks Inc. Munger said the financial companies spent $500 million on political contributions and lobbying efforts over the last decade. They have a "vested interest" in protecting the system as it exists because of the high levels of pay they were earning, he said. The five biggest U.S. securities firms, only two of which still exist as independent companies, paid their employees about $39 billion in bonuses in 2007. "They would like to get back as closely as possible to business as usual, and they have enormous political power," he said.
Berkshire’s Munger Favors '100% Ban' on Credit Swaps
Berkshire Hathaway Inc. Vice Chairman Charles Munger said he supports an outright ban of credit- default swaps to prevent speculators from profiting on the failure of companies. “If I were the governor of the world, I would eliminate it entirely -- 100 percent,” Munger said in a Bloomberg Television interview today. “That’s the best solution. It isn’t as though the economic world didn’t function quite well without it, and it isn’t as though what has happened has been so wonderfully desirable that we should logically want more of it.” Munger, second in command at Omaha, Nebraska-based Berkshire behind billionaire Chairman Warren Buffett, has long decried some of Wall Street’s tactics as short-sighted.
He said in a Washington Post opinion column in February that the U.S. government must expand regulation to prevent the excesses that caused the current fiscal crisis, and said credit-default swaps were partly to blame. Munger, 85, and Buffett have touted a buy-and-hold strategy of investing in undervalued firms as a more reliable way to profit from financial markets. The two have at times departed from that approach, and Berkshire began selling credit-default swaps on individual companies in 2008. The firm backed $4 billion in debt of 42 corporations as of Dec. 31, Buffett, 78, said in a February letter to shareholders.
“The national policy that allowed the derivative markets to develop as they did was a stupid policy and we think the derivative markets as they evolved have done more public damage than public benefit,” Munger said. “That said, if they exist and they are legal and some opportunity therein is presented to us that we think makes sense to the shareholders of Berkshire, we would seize that opportunity.” Berkshire is scheduled to hold its annual shareholder meeting tomorrow. Credit-default swaps “play an important role in the growth and function of our nation’s and the global economy,” Robert Pickel, chief executive officer of the International Swaps and Derivatives Association, said in a statement. ISDA, which sets rules for the market, published a survey of the world’s 500 largest companies last month that found 76 percent of financial firms and 20 percent of all companies used credit swaps. “Amidst the current financial turmoil, the CDS market has performed well, remained liquid and is providing an important price signaling function,” Pickel said.
The proliferation of credit-default swaps in the portfolios of debt investors and banks can eliminate incentives lenders have to keep companies out of bankruptcy, according to academics including Henry Hu, a law professor at the University of Texas in Austin, who testified before Congress in October on the so- called debt decoupling created by derivatives. Creditors that have hedged themselves “might well want its borrower to go into bankruptcy and have incentives to use its control rights to help grease the skids,” Hu told the House Committee on Agriculture, which oversees the Commodity Futures Trading Commission. Credit-default swaps, which are used to hedge against losses or to speculate on a company’s ability to repay its debt, pay the buyer face value if a borrower defaults in exchange for the underlying securities or the cash equivalent. “The whole mass of incentives created is quite counterproductive,” Munger said. Buyers of the swaps get a “vested interest in the destruction of some business.”
Berkshire also used credit derivatives to bet on indexes of 100 companies with high-yield, high-risk debt, and the company paid losses of $542 million on premium revenue of $3.4 billion, Buffett wrote in February. The contracts caused an accounting liability of $3 billion as of Dec. 31, Buffett said. “In last year’s letter, I told you I expected these contracts to show a profit at expiration,” Buffett said. “Now, with the recession deepening at a rapid rate, the possibility of an eventual loss has increased.” Credit swaps guaranteeing mortgage-linked debt led to the near failure of Berkshire competitor American International Group Inc. last year when the insurer was unable to post collateral as the assets plunged. AIG has received four U.S. bailouts valued at $182.5 billion.
Buffett said his firm is unlikely expand the sale of swaps tied to individual companies because would-be counterparties demand collateral if the underlying assets decline “and we will not enter into such an arrangement.” At least 32 companies as of March 12 had more credit swap protection outstanding on their bonds than actual bonds, according to a March 27 research note by Christopher Garman, chief executive officer of Garman Research LLC in Orinda, California. “Simply put, there may be less forbearance in store for stressed companies where credit-default swaps notional greatly outstrips the deliverable bond,” he wrote. “Hedges may have entirely taken out the default risk.”
Credit-default swaps dealers, including JPMorgan Chase & Co., Deutsche Bank AG and Barclays Plc, have taken steps at the behest of regulators to improve transparency in the market, where there were at least $27.5 trillion in contracts outstanding as of April 24, according to the Depository Trust & Clearing Corp., which runs a central registry that captures most trades. After subtracting trades that offset each other, banks, hedge funds and other asset managers have bought protection on a net $2.5 trillion in debt using the privately negotiated contracts. Dealers and investors last month created a committee to govern key decisions for the market, such as when the contracts can be settled and what securities are covered by the derivatives.
The committee for the first time brought into the decision-making process investors that weren’t among Wall Street dealers. House Agriculture Committee Chairman Collin Peterson in January circulated a draft bill that would have banned credit swaps trading unless investors owned the underlying bonds. The bill that passed the Minnesota Democrat’s committee the following month stopped short of an outright ban, though it would allow the CFTC to suspend trading in the market, if needed, to protect investors. The bill has not been taken up by the full House of Representatives. U.S. Treasury Secretary Timothy Geithner, who in his past post as president of the Federal Reserve Bank of New York pushed dealers to curb the potential for systemic risks from the market, told Congress in March that a ban such as Peterson had proposed “is not necessary and wouldn’t help fundamentally.”
The Great Bank Robbery of 2009
This week America witnessed Black Thursday for workers and families as the Senate defeated a bankruptcy bill that would have protected distressed homeowners and the House passed a bill that encourages and guarantees banks will continue abuses the bill pretends to remedy for a full year. Politically and financially, Americans will look back on these years, and judge what happens when a Democratic president and Democratic Congress use the government as an instrument of reform, change and problem-solving. To state my conclusion at the outset, I do not believe Treasury Secretary Timothy Geithner has carried this mantle well and what I see in current policy is little more than a gigantic transfer of wealth from taxpayers to banks, which is being abused and misused by most banks. It will be a disaster if this becomes the historic, political and financial legacy of Democrats using government to solve problems, and I believe it is essential for Democrats and progressives to join a great debate on the side of workers and families and against the abuses that are front-page news and continue every hour of every day.
It is outrageous that banks take trillions of dollars of taxpayer money for the purpose of lending to Americans while they raise credit card rates, turn fixed rates to variable rates that guarantee huge additional rate increases when the Fed resumes raising its rates, while they raise banks fees, cut customer lines, and increase foreclosures when trillions of dollars were spent for them to do exactly the opposite. On Black Thursday the Democratic House (many of whose members take enormous sums of money from banks, as do Republicans) passed a bill to allegedly protect consumers that will not take effect for at least a year. This means the House supports continuing every abusive action the bill claims to oppose for one full year, at least, in a stunning triumph for the banking lobby. It is time to break ranks with an almost universal Washington consensus about how business is done in this town, a consensus that is leading our country to financial disaster.
My “epiphany” came when I glanced at the recent campaign finance report of Sen. Chris Dodd (D-Conn.), which shows a stunning lack of support from home-state donors and a deluge of donations from companies doing business with his Senate Banking Committee. Dodd is a good man in a corrupted system. Both parties profit from this crisis through massive campaign donations. Those who manage troubled institutions profit from it through massive bonuses and compensation. While Wall Street pay is quickly moving back to bubble levels, the system of speculation for compensation (which creates perpetual bubbles) remains intact. Campaign money still flows like a mighty river in a legalized pay-for-play system that corrupts our financial and political systems alike. The source of public anger is this: The core policy is fundamentally a multi-trillion-dollar transfer of money from taxpayers to banks, which borrow money from taxpayers at low interest, punish taxpayers by charging them higher interest and pay themselves a king's ransom for doing it.
The president speaks of transparency and accountability, but: Does anybody know exactly how much money the various government agencies have spent rescuing banks that still refuse to lend? Four trillion dollars? Seven trillion? Ten trillion? What, exactly, have taxpayers received in return? These monies were provided to increase lending, but net lending is down. When banks receive trillions of dollars to increase lending, they insult the intelligence of taxpayers and the integrity of government by increasing credit card interest rates, increasing bank fees, lowering credit limits, increasing home foreclosures and lowering net lending. Where's the accountability? Meanwhile, Obama and McCain received huge amounts of money from banks, Wall Street firms, hedge funds and mortgage companies while congressional fundraisers continue ad nauseam.
While money is doled out to banks by Congress, money is doled out to Congress by banks. It is a direct attack against economic recovery, a direct attack against economic stimulus and a direct attack against economic growth for interest rates to be hiked, credit limits to be cut, bank fees to be raised and lending to be lowered. Have they no shame? Taxpayers pay for the bailout, subsidize the lobbying, underwrite the campaign donations. Then they are taxed by banks through fees and rates that work as regressive taxes. They will be taxed again to pay for the deficit. They will be taxed again when the value of their money declines from the inflation these trillions of dollars will inevitably cause. Does anybody understand exactly what the Federal Reserve money is used for, exactly who received it, exactly what taxpayers receive in return and exactly how much money has been spent? Where's the transparency?
Can anyone justify the number of senior Treasury jobs that remain unfilled, or the pay-for-play schemes surrounding state pension funds? Everyone should read the lengthy story in Monday's New York Times about the career of Mr. Geithner. Did he do his job well, or disastrously, at the New York Fed when he failed to regulate the firms while they were causing this crisis? Mr. Geithner is without doubt a great power-networker, who spent much time at the N.Y. Fed in endless networking events with the financial powerbrokers who were creating the crisis that Geithner was failing to prevent. Geithner was not reforming the system, protecting the customers or opposing the abuses that endanger our national solvency. He was cultivating the support of financial powerbrokers who were, and remain, his true constituency.
What does it tell credit card CEOs that the president's chief economic adviser falls asleep at a meeting where he should have been defending taxpayers and consumers like a lion? The Republicans have virtually nothing to offer except hoping the president fails without serious ideas of their own. The Party of No has earned its 21 percent approval rating. But, as a matter of conscience and concern for my party and my country, I must break ranks. What is happening is wrong. A whole generation will pay the price for what we do today. The cost will be enormous and incalculable. Both parties owe the next generation far better than either party offers today. No bank should ever be too big to fail. Instead of taxpayers subsidizing mergers, regulators and legislators should break up any bank so large that its failure endangers the nation as a whole.
It is inexcusable and shameful for even a Democratic House to pass a bill to allegedly combat abuses against citizens, and make that bill effective a full year later, which means all of those abuses will continue for least 12 more months. To call this a consumer protection bill is an abuse of language and a fraud against consumers and voters who do not want these abuses continuing for another year, and supported by Democrats as well as Republicans in Congress for another year. Banks given trillions of dollars to lend should lend. Those of either party who tolerate these abuses are betraying the largest financial trust ever given to public officials in the history of the nation, the world or any generation.
Chrysler's Bankruptcy Deals Blow to Affiliates
Pressure mounted on Chrysler LLC as the auto maker was forced to idle four plants and its dealers scrambled to find new sources of credit a day after the company filed for Chapter 11 bankruptcy protection. The developments sparked fresh questions about Chrysler's prospects for quickly exiting from bankruptcy protection and about the web of suppliers and dealers that are linked to the company. The plants were idled after suppliers halted shipments, while dealers were squeezed when Chrysler Financial stopped providing cut-rate loans. Fiat SpA Chief Executive Sergio Marchionne, seen as likely to take the helm of a restructured Chrysler, is counting on the bankruptcy process to move swiftly, allowing him to plunge into restructuring the troubled automaker. Over the next month, Mr. Marchionne will begin touring Chrysler plants and sifting through its other operations.
Fiat, which is partnering with Chrysler, is likely to use Chrysler's journey through Chapter 11 to slim its bloated dealership network, according to a person familiar with the matter. In bankruptcy, Fiat can press dealerships that have underperformed to renegotiate or terminate their contracts. For several months Chrysler dealers have been feeling the strain of slumping sales. On Friday, Chrysler reported sales of cars and light trucks fell 48% in April to 76,682. However, Fiat faces a bumpy road. Gaining Chrysler's extensive sales network is a key attraction for the Italian company, and Mr. Marchionne does not want Fiat's re-entry to the U.S. market after nearly three decades to be marred by a messy court battle. A Fiat spokesman could not be reached for comment Friday, a holiday in Europe. Already-strained parts suppliers, hurt by Detroit's plummeting sales, face a squeeze of their own.
In court filings, Chrysler warned that many parts makers could follow the company into Chapter 11 if its proceedings drag on. Its largest unsecured creditor is Ohio Module Manufacturing Co., a supplier that is owed $70.3 million. Chrysler in court Friday asked that it be allowed to continue to pay its employees and suppliers. "Without a clear timeline for when the [bankruptcy] situation will end and production will resume, I believe we will see massive suppliers bankruptcies that will stop Chrysler from resuming production," Chrysler's procurement officer, Scott Garberding, said in a statement filed with the bankruptcy court Thursday. Chrysler was preparing to shut down all of its vehicle assembly plants for 60 days on Monday. But on Friday two plants in the U.S. and two in Canada were forced to cease production because a few suppliers stopped shipping parts or materials.
Officials from the Obama administration's auto task force cautioned that there was no reason that suppliers should be hesitating over shipments to Chrysler or getting worried about payments. "It is the company's intentions to continue to pay suppliers in the ordinary course," said one official. "This company will operate in the ordinary course throughout the bankruptcy process." Chrysler is being given access to $1.3 billion in federal financing to keep it going during the bankruptcy process. And afterwards, the U.S. government is prepared to offer an additional $4.7 billion in loans. Across the country dealers Friday were scrambling to line up new banks to provide auto loans for buyers after the company's ailing lending partner, Chrysler Financial, stopped providing loans with subsidized interest rates such as 0% deals. Chrysler Financial is still offering auto loans to buyers purchasing vehicles from Chrysler, said the lending company's chief executive, Tom Gilman. However, he acknowledged his company isn't offering the lowest rates available. "Our rates haven't been competitive for some time because our costs are so high," he said.
David Kelleher, owner of one Dodge store and a Chrysler-Jeep franchise in the Philadelphia area, said he was working on paper work on Friday to be able to get customers auto loans from GMAC LLC to make up for the loss of loans from Chrysler Financial. "Having those partners at Chrysler Financial was very, very important to the dealer body," Mr. Kelleher said. In the past Chrysler Financial worked closely with dealers to help them sell cars, although it had become less so in recent months as it tightened up credit terms and approved fewer and fewer loans. Mr. Kelleher added he's concerned about working with GMAC because it is affiliated with Chrysler's competitor, General Motors Corp. "It's going to be a real challenge to get GMAC to act on behalf of Chrysler," he said. "It's very difficult if a finance arm is not aligned with you." GMAC is prepared to handle business from Chrysler customers and dealers, and will handle their business the same as GM customers, a GMAC spokeswoman said. Cerberus Capital Management LP, Chrysler's former parent, has sizable stakes in GMAC and Chrysler Financial.
On Thursday President Barack Obama expressed optimism when he announced Chrysler would seek bankruptcy protection after his administration's auto task force failed to reach a debt-reduction deal with about half of Chrysler's 46 secured lenders. "The necessary steps have been taken to give one of America's most storied auto makers, Chrysler, a new lease on life," Mr. Obama said. But bankruptcy adds a new element of risk to the government-led restructuring of Chrysler. Since Chrysler is halting production, shipments of parts and materials from suppliers to its 12 North American assembly plants will cease, putting jobs at suppliers as well as at Chrysler on the line. "When Chrysler doesn't run, we don't run," said a person at Ohio Module who identified himself as a human-resources manager at the company but declined to give his name. Other officials at Ohio Module, which builds chassis for Jeep Wranglers and was spun off of Chrysler in 2006, couldn't be reached.
Chrysler's Conner Ave. assembly plant, which builds the Dodge Viper, has been stopped by interruptions in its parts supply for the last three weeks, said Chris Vitale, a worker at the plant. A Chrysler spokeswoman said she didn't know the reason production was suspended at the Conner Ave. plant. A parts shortage will not only affect production at Chrysler but would ripple through the industry, which could create some disruption for other auto producers. "We're all interconnected, so we're evaluating it right now," said Edward Miller, a spokesman for American Honda Motor Co. Honda buys parts from 525 U.S. suppliers. But Mr. Miller notes those companies all buy parts from thousands of other producers as well, some of which could also be forced out of business. "We're anticipating there will be some impact," he said. The bankruptcy was on the minds of the few customers who were in Chrysler stores on Friday.
The Chrysler showroom of Boardwalk Auto Center in Redwood City, Calif., had a lone customer, Ken Hopkins, who was eying a ruby red PT Cruiser to replace his 2001 model. The retired technology consultant said Chrysler's bankruptcy was making him think twice about a purchase. "You want to have the assurance that they'll have follow-up service," he said. Still, Mr. Hopkins said he hoped to pick up a bargain because of the bankruptcy filing. Many dealers said they have already been contacted by GMAC and are lining up credit through the company, or are already able to get customers car loans from other banks. Brian Kelly, owner of Kelly Jeep Chrysler, in Lynnfield, Mass., a Boston suburb, said his dealership plans to arrange financing through local banks. "We have long-standing relationships with banks that do this," he said. "That is primarily going to be our biggest option." For this weekend, his dealership is advertising a "new cars at used car prices" promotion. "We want the world to know that this makes it a buyers' market," he said. "We are just pointing it out and giving people the opportunity to take advantage."
Chrysler’s Fall May Help Administration Reshape G.M.
Fresh from pushing Chrysler into bankruptcy, President Obama and his economic team are hoping that the hard line they took last week gives them leverage to force huge changes in General Motors, a far larger and more complex company. Officials say that, difficult as Mr. Obama’s decision was on Wednesday to take all the risks of a Chrysler bankruptcy, the politics of reshaping G.M. will be far harder. Already a shadow of the company that once dominated the American landscape, G.M. will be forced to eliminate tens of thousands of additional jobs and close factories and dealerships nationwide.
In Chrysler’s case, the tough job-cutting decisions had already been made and the government is taking only a small stake. An alliance with Fiat envisions selling the company’s cars in new markets around the world and adding cars that use Fiat’s fuel-efficient technology. But in G.M.’s case, Mr. Obama will be forcing deeper cuts and becoming the controlling shareholder. He will also be overseeing the radical downsizing of G.M.’s work force as he is trying to reverse rising unemployment. "G.M. is very different than Chrysler," Rahm Emanuel, Mr. Obama’s chief of staff, said Friday. "But I suppose the one lesson for G.M., and all the other players, is that this is a moment when a Democratic president said, ‘I am really willing to let a company dissolve, and there’s not going to be an open checkbook.’ There’s got to be real viability."
No one thinks Mr. Obama is going to allow G.M. to be broken up, its assets sold or abandoned. But if the Chrysler legal process unfolds as the White House hopes it will in coming weeks, the bankruptcy option may look increasingly attractive for G.M. as well, officials on Mr. Obama’s automotive task force said. Bankruptcy may also be the only way to force the kind of paring down that Chrysler, with a third of G.M.’s workers and half the number of plants, did not have to endure. "The threat of bankruptcy is very important in the negotiations with the bondholders and the dealers and others," said David E. Cole, chairman of the Center for Automotive Research in Ann Arbor, Mich. "Without a clear and present danger to them, they won’t make a reasonable deal."
G.M.’s latest restructuring plan — which the White House has yet to approve — calls for trimming 47,000 jobs worldwide, closing more than a dozen plants in the United States, eliminating four brands and shuttering 2,600 dealerships. Even that may not be enough. As the leaders of Mr. Obama’s task force faced down recalcitrant Chrysler creditors on Wednesday, a team of more junior officials was in Detroit assessing whether G.M. was cutting deeply enough to turn a profit. "Our marching orders were to do both Chrysler and G.M. the way we would do a strictly commercial deal," said a senior official on the task force, who would not speak on the record because the negotiations with G.M. were still in progress. "We’re not going to sit there and tell G.M. how many jobs to cut, or what models to eliminate. But we are going to look at the financials, the balance sheet, and see if the plan they come up with passes that test."
Because Chrysler was already the most marginal of what were once called the Big Three — this will be its third corporate reincarnation in a decade — Mr. Obama could afford to take a hard line. But when dealing with a company as politically sensitive and as large as G.M., the administration will have a far harder time separating the economic decisions from the political challenges. In Chrysler’s case, a handful of the company’s 46 lenders presented the biggest roadblock. Mr. Obama could portray them as obstructionists who put their demands for repayment ahead of preserving the company. But General Motors’ creditors number in the tens of thousands and include pension funds that bought the company’s unsecured bonds. G.M. bondholders have no claim on its plants or inventory, but they will probably attract more sympathy than Chrysler’s Wall Street lenders did.
The Treasury Department will pay $2 billion to Chrysler’s bondholders, but it is offering only stock in a new G.M. to its creditors — 225 shares for each $1,000 in debt held, making them minority owners who are invested in the company’s success. "That’s the bargaining chip," said Mr. Cole of the Center for Automotive Research. Ahead of the June 1 deadline, Mr. Obama holds all the leverage: The bondholders’ only alternative would be to get in a long line of creditors who will be paid relatively little, because G.M. bonds are trading at about 10 cents on the dollar. It "may not be such a bad deal in the end," Mr. Cole said.
G.M.’s case also differs from Chrysler’s in another crucial sense: there is no Fiat in the wings, no big private investor ready to bring new money and new technology. Instead, Mr. Obama will effectively use taxpayers as that investor, with the federal government getting slightly more than a 55 percent stake in the company in exchange for forgiving $10 billion in the automaker’s outstanding federal loans. The United Automobile Workers’ retiree trust would have just under 40 percent of the stock, under the G.M. plan. The huge federal stake in G.M. — even if temporary — means that for all of Mr. Obama’s protests that he is a reluctant investor, eager to fix the company and sell the controlling interest ( hoping for a hefty profit), he will be judged by whether his plan actually works.
Mr. Obama has said repeatedly that he is not an automotive engineer and has no desire to pick models, engines, factories or corporate governance structures. But while he may not be choosing automotive designs, he has already started dictating the company’s direction. The president has made it clear that G.M. must produce small, fuel-efficient, low-carbon-emitting cars — steps G.M. has taken only haltingly. Its vehicles range from the Cadillac Escalade, which gets 12 miles to the gallon in the city, to the experimental Chevy Volt, an electric car that it says will go 40 miles gas-free.
Members of Mr. Obama’s auto task force say that even after the government owns a majority of the company, it will have no role in management. That, they say, will be farmed out to professionals, the work supervised by government-appointed members of a new G.M. board. But at some point, some task force members acknowledge, the drive for profitability is likely to collide with Mr. Obama’s fuel-efficiency and low-emission goals. G.M. produced heavy gas-guzzlers because they were among the most profitable in its line and, for a long time, the most popular. It is unclear whether smaller cars can be as profitable — or, for a few years, competitive with offerings from Toyota and Honda and a raft of inexpensive cars under development in China.
Chrysler Hopes For Miracles In Bankruptcy Hearing
Attorneys for Chrysler LLC said the company will file a motion by Saturday to sell substantially all of its assets to Italian automaker Fiat Group SpA, but that won't include eight plants, including five that the automaker revealed it will shutter by the end of next year. While Chrysler faced its first hearing Friday in Manhattan bankruptcy court, court documents showed the ailing automaker plans to close plants in Michigan, Missouri, Ohio and Wisconsin that employ about 4,800 people. Chrysler said they will be offered jobs at other plants. The company also announced President and Vice Chairman Tom LaSorda is retiring effective immediately. Judge Arthur Gonzalez approved a series of motions at Friday's swift hearing, launching a chain of events designed to ensure Chrysler's bankruptcy process is the quick and "surgical" one the company and the U.S. government have promised.
But what could prove to be the case's biggest challenge still lies ahead. Chrysler must eventually deal with creditors who refused to come to a deal that would have erased much of the automaker's debt and might have avoided a bankruptcy filing in the first place. Another hearing was scheduled for Monday morning, where Chrysler attorneys will ask Gonzalez to let the company start using $4.5 billion in loans from the U.S. and Canadian governments to keep operating under bankruptcy protection. Chrysler attorney Corinne Ball, of the firm Jones Day, said the loans and the sale to Fiat represent "an important lifeline" for Chrysler's dealers, supplies and customers. "We have to move at a good speed throughout this proceeding," she told Gonzalez.
Gonzalez wasted no time, opening the meeting with just five words: "Please be seated. Debtor's counsel?" Later, Gonzalez twice cut off an attorney representing Chrysler's dealers, then said, "I think you've gotten your point across." By the end of the hearing, the judge had decided six motions in about an hour. Chrysler, the nation's third-largest car manufacturer, filed for bankruptcy protection Thursday after a group of creditors defied government pressure to wipe out the automaker's debt. The company plans to emerge in as little as 30 days as a leaner, more nimble company, with Fiat potentially becoming the majority owner. In return, the federal government agreed to give Chrysler up to $8 billion in additional financing, on top of the $4 billion the company already has received.
Ball said that lawyers on Monday would ask to set a date for the first hearing on the sale of Chrysler's assets to the "new Chrysler." In bankruptcy, assets are sold in a two-part process during which the court asks for competing bids. None are expected in Chrysler's case, since documents show the company already tried to form alliances with dozens of companies, including Nissan-Renault, Toyota, Honda, Volkswagen and even General Motors Corp. Heidi Sorvino, bankruptcy partner at Smith, Gambrell & Russell LLP, said a sale could be completed in 30 days to 60 days. "I think the sale will happen quickly," she said. "The actual proceeding is going to take a long time." Until the deal with Fiat closes, the automaker plans to idle all of its plants in the U.S. Chrysler's Canadian assembly plants also halted production Friday because of parts shortages stemming from the U.S. shutdown. In court documents, Chrysler said it won't keep its Sterling Heights, Mich., plant that makes Chrysler Sebrings and Dodge Avengers, and the Conner Avenue plant in Detroit that makes Dodge Vipers. The St. Louis North plant that makes Dodge Ram pickups would also close.
Chrysler's Twinsburg, Ohio, parts stamping plant and Kenosha, Wis., engine plant will also be shuttered. Two other plants that will be left out of the Fiat sale are the St. Louis South plant and an assembly plant in Newark, Del., that were idled last year. Another facility, Chrysler's Detroit Axle plant, is already scheduled to be replaced by a new factory near Port Huron, Mich. The "new Chrysler" would lease the eight plants, then shutter them by December 2010. "While some facilities may close, substantially all Chrysler employees will be offered employment with the new company," Chrysler spokeswoman Dianna Gutierrez said. "Employees currently located at a facility identified for disposition will be offered a position at one of the facilities sold to the new company." At Friday's hearing, Gonzalez's large courtroom quickly filled with lawyers and other observers, and two overflow rooms with video and audio feeds were opened to accommodate the crowds. The hearing was briefly halted after a woman standing in the warm and stuffy courtroom apparently fainted.
Gonzalez approved Chrysler's motion to allow the automaker to pay $48.8 million in employee and contract worker pre-bankruptcy wages, benefits and businesses expenses. The motion also references an estimated $86 million in employee vacation benefits that it may not ultimately have to pay. The judge also approved Chrysler's motions that will let it continue to honor its warranties and continue its current banking practices. It's uncertain when Gonzalez will face objections from the creditors that hold $6.9 billion of the automaker's debt. Four banks holding 70 percent of the debt agreed to a deal that would give the lenders 29 cents on the dollar. But a collection of hedge funds refused to budge, saying the deal was unfair because they deserve to recover more than other creditors like the United Auto Workers.
President Barack Obama on Thursday chastised the funds for seeking an "unjustified taxpayer-funded bailout" after Chrysler and his auto task force cleared the company's other hurdles, including the Fiat deal and a cost-cutting pact that the UAW ratified this week. Chrysler's bankruptcy filing is the latest step in a drastic reordering of the American auto industry, which has been crushed by higher fuel prices, the recession and customer tastes that are moving away from the gas-guzzling SUVs that were once big money makers. The government already has sunk about $25 billion in aid into Chrysler and rival General Motors. GM faces its own day of reckoning on June 1, a date the administration has set for it to come up with its own restructuring plan. GM has announced thousands of job cuts, plans to idle factories for weeks this summer and has even offered the federal government a majority stake in the company as it races to meet the deadline. Like at Chrysler, debt may be the stumbling block. GM has asked its unsecured bondholders to exchange $27 billion of debt for a 10 percent stake in the automaker. The creditors balked, saying that would leave them with just pennies on the dollar and that they deserve a majority stake if they give up their claims.
Chrysler judge well-versed in corporate failures
The bankruptcy judge who oversaw the massive cleanup after the Enron and WorldCom meltdowns has a new challenge that may be his toughest yet -- overhauling Chrysler LLC. Judge Arthur Gonzalez of U.S. Bankruptcy Court in Manhattan was assigned the case on Thursday after the iconic carmaker sought Chapter 11 bankruptcy protection following the breakdown of intense negotiations with lenders. Chrysler filed the case in one of the premier federal bankruptcy courts, and Gonzalez is one of its most experienced judges.
He simultaneously handled the Enron and WorldCom bankruptcies earlier this decade -- both filed after massive accounting frauds were unearthed at the companies. "We have a judge here with experience, who did Enron and WorldCom at the same time, so he's not afraid of work and he understands complex issues," said Natasha Labovitz, a partner in the restructuring group at law firm Kirkland & Ellis LLP, who has appeared before the judge. A former New York City schoolteacher, Gonzalez took the bench in 1995 after monitoring bankruptcies for the government as a U.S. Trustee for New York, Connecticut, and Vermont.
"He is experienced, wise, patient and fair," said Martin Bienenstock, a bankruptcy attorney at law firm Dewey & LeBoeuf LLP, who represented Enron in its bankruptcy. "He works indefatigably and keeps a sense of humor." Gonzalez will "not at all" be put off by a big case with national attention, Bienenstock said. "He's been there, done that." If the company and government officials have their way, Chrysler's most profitable units will emerge from bankruptcy in 30 to 60 days as a new company -- a rapid-fire sale process in which the judge will face big decisions early in the case. But other aspects of the case could drag on for years.
The first-day hearing in the case is set for Friday morning. Gonzalez received a bachelor's degree in accounting from New York's Fordham University in 1969 and a master's degree in education from Brooklyn College in 1974. He was a public school teacher for 13 years. He got his law degree at Fordham's law school in 1982 and a master of law degree in 1990 from New York University Law School. Other cases Judge Gonzalez has handled include the Chapter 11 filing by appliance maker Sunbeam Corp in 2001. He also oversaw the bankruptcies of Iridium LLC, a satellite telephone service, and the collapse of Livent Inc, a Canadian theater-production company that fell apart amid accounting irregularities.
Chrysler Lawyers, Advisers May Reap $200 Million in Bankruptcy-Court Fees
Chrysler LLC, the bankrupt automaker, may pay an estimated $200 million to lawyers and other professionals helping it try to create a more viable carmaker in partnership with Italy’s Fiat SpA. The third-largest U.S. automaker already has paid Jones Day lawyers $18.9 million in retainers since November to avoid, and then prepare for, the company’s Chapter 11 proceeding, according to court documents. Lawyers, bankers and accountants may reap more than 10 times that amount in court-approved fees by the time the case ends, said Stephen Lubben, who teaches bankruptcy- law at Seton Hall University School of Law in Newark, New Jersey, and keeps a database on fees. Chrysler, with about 54,000 employees, listed yearend 2008 assets of about $39.3 billion and liabilities totaling $55.2 billion in court documents.
It aims to sell its best assets -- which include its Jeep brand and Dodge Ram pickups -- to Fiat, using bankruptcy law to wind up its liabilities. The automaker’s lead lawyers at Jones Day, led by restructuring partner Corinne Ball, will charge Chrysler as much as $950 an hour, according to court filings. Ball’s billing rate as of April 2009 was $900 an hour, as was her colleague David Heiman’s, according to the filing. Lubben’s estimate, based on Chrysler’s reported assets and liabilities, assumes it may take two years to wrap up the Chrysler bankruptcy, he said. A bankruptcy of Chrysler’s larger rival General Motors Corp., if it happened, would throw off double the amount of fees, he estimated. Washington-based Jones Day has 2,400 lawyers in 32 offices around the world.
Rome salutes Fiat deal with Chrysler
The Italian government on Friday threw its weight behind Fiat’s alliance with Chrysler in spite of doubts over whether it would succeed during the global economic downturn. The deal, in which Fiat will ultimately acquire a 35 per cent stake in the US carmaker in return for technology and other resources but without any cash injection from the Italian group, also received a chorus of approval in the domestic media. Sergio Marchionne, Fiat’s chief executive, said the deal "represents an historic moment for both Fiat and Italian industry" that would "give Fiat an even greater capacity to succeed in markets worldwide".
Claudio Scajola, Italian industry minister, pledged full support for making the alliance work and said: "A Fiat that is stronger in the world will be stronger in Italy and will make Italy stronger in the world." Silvio Berlusconi, Italy’s prime minister, said he was "proud" of a deal that "represents the ultimate testimony to the strong commercial and economic relations" between Italy and the US. Luigi Angeletti, a trade union leader, told a May Day rally it was "testimony to what Italy can do". Extensive media coverage of the most high-profile international transaction ever undertaken by an Italian company reflected a mix of pride and disbelief that an Italian group long seen as one of the weaker global carmakers was riding to the rescue of a stricken US peer.
"Italy toasts the Fiat-Chrysler alliance" noted La Stampa, a newspaper owned by Fiat in Turin. But bankers and industry analysts in Milan said the alliance with Chrysler represented a gamble for Mr Marchionne, who has turned round Fiat since joining the group in 2004. In an interview with La Stampa on Friday, he acknowledged the size of the task he set himself: "We can’t afford to get this wrong, because the whole world is watching," he said. Analysts said investors were concerned not so much with the strategic rationale for the deal but with whether the restructuring of Chrysler that it envisages and on which it depends would ultimately succeed.
They said it was not obvious that Fiat’s plan for Chrysler – to use the Italian company’s small-car production model to recast the US firm for a leaner, greener time – would work with US consumers. "This is going to be very tough but at least Fiat is not putting cash up front," said an investment banker in Milan who spoke on condition that he not be identified. Fiat’s share price fell 6 per cent on Thursday as the deal was being finalised between Detroit and Washington. The Milan stock market was closed on Friday for the May Day holiday.
What's good for GM is good for banks
The maneuvering over Chrysler LLC provoked lenders to decry what they say is a nationalization of the beleaguered car company. General Motors Corp., they warn, will be next. Which revives the question: Will the banks follow GM? There are striking similarities between Treasury-brokered efforts to keep U.S. carmakers from liquidation and the machinations to shore up finance. "There are certain parallels," admits Jim Eckenrode, a banking analyst at TowerGroup Inc. With the proposed settlements (GM floated its own but clearly with the federal sanction), the government would own controlling stakes in GM and Chrysler and would have the right to appoint directors, senior management and influence strategy. "The Treasury's auto task force is making GM get rid of Pontiac and Saturn. I think GM wanted to keep Pontiac, but the government said no," Eckenrode says. Similarly, the task force shot down GM's plan to buy Delphi's global steering business, he notes.
"We haven't gotten to such a point of nationalization in the banking industry, but the pressure applied to Bank of America to buy Merrill Lynch has an aspect of that," he adds. Banks so far have more leverage to keep officials at arm's length, he says. For starters, banks really don't face a union with huge pension obligations that could be dumped on the government. The automakers do, and as a result, the government will do whatever it can to preserve jobs and to prevent taxpayers from being saddled with pension costs. Besides, the car companies continue to bleed, where banks are posting relatively positive first-quarter results. "They have a little more wherewithal to hold off government because they don't depend on it as a lifeline," he says.
But with the results of stress tests on the 19 largest bank holding companies due to be unveiled May 4, the government will likely be even more involved to ensure they can weather future threats. Taxpayers are already major shareholders in the largest banks through the Troubled Asset Relief Program, and at least six institutions are under pressure to raise more capital. If they don't obtain the funds privately, they may have to take more Treasury money, giving the government an even larger stake. "Because of the financial industry's systemic importance to the economy, banks are viewed as a public good and have always been susceptible to government direction," Eckenrode says. "The stress tests could be the lever that allows the government to take more direct ownership of some of these institutions. The feds are the only ones with money right now."
Many of the carmakers' creditors are fighting nationalization. Smaller creditors and hedge funds are opposed to large stakes being offered to the government and unions. But the banks, because they are beholden to the government, can't make too much fuss over the car companies. "The four banks dealing with Chrysler are all sitting on TARP money," says David Bitterman, managing director at Huron Consulting Group Inc. "That gives the government a little bit of a lever. I don't think Jamie Dimon wants to be the guy responsible for the liquidation of Chrysler." Indeed, smaller creditors accuse the big banks of caving to the government. The same day Chrysler filed for bankruptcy, the ad hoc committee of General Motors bondholders unveiled a counterproposal aimed at preventing a similar fate for GM. "We do not believe that nationalizing one of America's largest and most important companies is the right policy decision for our country," proclaims Eric Siegert, senior managing director of Houlihan, Lokey, Howard & Zukin Inc. and financial adviser to the rebel bondholders.
Siegert says his group's proposal would allocate new GM equity on a pro-rata share to the union and to GM bondholders according to the funds GM owes to each. Retirees would own 41% of the new GM, and bondholders 58%. Current shareholders, including the government, would retain a 1% share. He predicts the government would have to inject little additional capital into GM beyond the $17 billion provided since December. The notion that neither car company will need more money will likely be viewed as far-fetched both to the markets and to a bankruptcy judge. So confident were White House officials that the fight to keep the company operating would be compelling to taxpayers that President Obama's statement on Chrysler's bankruptcy didn't even include a boilerplate pledge to restrict the government's role to a minimum and restore the free market as soon as possible. Warnings against nationalization, whether applied to GM or the biggest banks, may gain political traction but likely fail to blunt a growing federal role. The government has the only card that matters -- money.
Now for the main event
In the last week of April, President Obama's automotive task force accomplished what few thought possible, convincing long-bickering stakeholders of Chrysler LLC to work out a plan to restructure the troubled automaker. Since creditors didn't approve the plan unanimously, it will be implemented in bankruptcy -- a fact the president himself announced in a high-noon White House speech that may help retire that "No drama Obama" nickname. "I can report that the necessary steps have been taken to give one of America's most storied automakers a new lease on life," Obama said, with task force leader Steven Rattner and other members of the group arrayed behind him. "Unfortunately, a group of investment firms and hedge funds decided to hold out for the prospect of an unjustified taxpayer-funded bailout. I don't stand with them."
Bankruptcy will make the restructuring longer and less predictable than the Obama team had hoped. The task force is optimistic, predicting a 30-to 60-day process. But in any case, it's only Act I in a far larger production. In Act II, we'll find out how the government's actions with Chrysler will affect the much larger and more important task of reorganizing giant, far-flung General Motors Corp. And somewhere beyond that lies the answer to an even bigger question: How the terms of the Chrysler and GM deals will influence restructuring and capital raising by industrial companies in the years to come. Chrysler, the rusty jalopy of the U.S. car industry, was able in a 72-hour span to reach agreements with unions in the U.S. and Canada, not to mention a majority of the secured lenders who just days earlier had threatened to force the company to liquidate.
Those concessions put Chrysler in position to complete an alliance with Fiat SpA and qualify for up to $6 billion in additional government assistance. The cramdown would not have been possible without Washington's clout. The government paid a steep price for its seat at the table, providing Chrysler and GM with nearly $20 billion to fund operations since December. But once assembled, the task force left little doubt about who was in charge or how the turnarounds would proceed. Mixing politics with a painful restructuring of one of the nation's largest -- and most heavily unionized -- industries appeared to some a recipe for disaster. Indeed, in the task force's early days, some creditors appeared skeptical about threats that the White House would allow either GM or Chrysler to fall into Chapter 11. Unions have fared miserably inside bankruptcy in recent years, with companies using the Bankruptcy Code to tear up contracts, cut benefits and dump pensions.
To wit, bondholders at GM initially demanded new, government-backed securities as a condition for surrendering their debt. And secured lenders at Chrysler, estimating that they could recover much of what they were owed in the event of a liquidation, initially demanded 40% of the company's equity in return for erasing less than half of the $6.8 billion in loans they held. In Chrysler's case, most lenders settled for much less. Facing an April 30 deadline for Chrysler to be cut off from the government trough, a group representing a majority of the debt last week agreed in principle to forgive all but $2 billion of what is owed in exchange for less than 10% of the company.
According to sources these lenders, most of them banks (including J.P. Morgan Chase & Co., Citigroup Inc., Goldman Sachs Group Inc. and Morgan Stanley), bowed to political pressure as well as concerns that the U.S. Treasury would use debtor-in-possession financing to trump their secured claims in court and leave them with significantly less recovery. But a smaller group of lenders, including some hedge funds, held out for more. Whether the holdouts -- which Obama called "a small group of speculators" -- will fare any better in court remains to be seen. Some sources think the company will be able to use the Chapter 11 filing to bring the laggards into line and also to break franchise agreements with underperforming dealers. With a majority of lenders, unions and the government on board, the likelihood of an extended or contentious stay in Chapter 11 or even a liquidation has been reduced.
The majority creditors accepted what at first blush appears to be a lousy deal. They traded their secured claims for a small minority stake even as the United Auto Workers union was pledged a majority of the company's equity in return for swapping out unsecured claims on cash to fund a retiree healthcare fund, along with other labor concessions. "The takeaway is that the government is serious," a restructuring source working with an industry participant says. "And when they are serious, it is foolish to argue with them." The message is unlikely to be lost on stakeholders at General Motors, which faces its own June 1 deadline to secure cuts or be cut off from funding. In fact, many suspect the government staggered the deadlines to use the smaller Chrysler to prove its resolve, willing in the worst-case scenario to see Chrysler disappear if that could help eventually save General Motors.
GM is a very different company from Chrysler. Far more global, it is trying to bring down its North American costs while at the same time sell multiple brands on two continents and find investors to fund a turnaround at its European affiliate. But like Chrysler, GM is at the government's request seeking draconian cuts from a group of creditors who have been left to choose between taking a disproportionate haircut or testing their luck in bankruptcy. In GM's case, bondholders have been offered about 10% of the post-restructuring company's shares for surrendering the $28 billion they are owed. The UAW healthcare trust, meanwhile, has been offered $10 billion in cash and 39% of the company's equity in return for its $20 billion in obligations.
A group of bondholders has criticized what they see as "a blatant disregard of fairness" in "using taxpayer money to show political favoritism of one creditor over another." But they have few good options. It is unclear whether the government's threats will work as well on the thousands of GM bondholders, including institutional and retail investors, as they did on Chrysler's banks. Some, including bond analyst Kip Penniman of KDP Investment Advisors Inc., have predicted GM is unlikely to get the support of 90% of bondholders, as the government has requested, making a Chapter 11 filing likely. But if nothing else, the Chrysler example frames the debate for bondholders, the restructuring expert says. "Bondholders are saying 'Let's talk about this,'" the source says. "Chrysler's banks found out Steve Rattner is not in the mood for talks."
That the government has applied a heavy hand in dealing with the automakers seems beyond debate. The long-term implications of these actions, however, will take years to fully understand. Supporters of the government's actions will point to the jobs saved and industrial base maintained, not to mention the avoidance of what could be immense government outlays should an automaker's pension or healthcare funds collapse. Some, though, wonder if other unionized industrial sectors will find their long-term borrowing costs rising in future years because of newfound ambiguity about creditors' rights in the event of a reorganization. Peter Kaufman, restructuring expert and president of New York investment bank Gordian Group LLC, worries that what the government has done so far sets a terrible precedent for restructurings. "They are standing our bankruptcy law on its ears by giving preference to unsecured lenders like unions over senior secured creditors," Kaufman says. "This is not a restructuring, it is a nationalization."
Workers Always Lose, Even in Rescue Operations
What’s wrong with this picture: Four groups invest in a company. One group puts in a 55% investment, a second puts in a 20-35% investment, a third puts in an 8% investment and a fourth goes in for 2%. The group putting in the 20-35% stake gets three seats on the company’s nine-member board of directors, which will be appointing the new company’s management team. The group investing 8% gets four board members, and the group investing 2% gets 1 seat. Finally, the group that will hold the majority stake in the company, 55% of the shares, gets…the one remaining seat on the board. Why would anyone buy a majority stake in the company and accept only a 1/9 representation on the board, and thus virtually no say in the selection of management or in management decisions?
The answer is that that particular shareholder is the unionized workforce of the company—in this case Chrysler Corp. One seat is all the workers were offered in the Obama Administration-brokered deal. Under the plan worked out by the White House, Chrysler management, Fiat and the company’s lenders, Fiat, the Italian automaker, will take a stake of somewhere between 20-35% of the bankrupt American automaker, getting a third of the board for its efforts. The US government, which has provided and will continue to provide billions of dollars in loans and guarantees to underwrite the rescue plan, will get an 8% ownership but an outsized four members on the board in return, and Canada, for just a 2% stake, will also get one seat on the board.
Logically, Chrysler workers, who will be covering half of the company’s $10 billion obligation for retiree health care (putting their own future health care at risk should the venture fail), and who have agreed to significant cuts in wages, benefits and work rules that had been negotiated over years of struggle, should clearly be getting five of the seats on the board and the right to name the company’s new management team, but that would smack of socialism, apparently. Imagine workers actually being in charge! Preposterous, right?
Of course, if you step back a minute and think about it, it was corporate managers, put in place by boards of directors who represent the elite of the Wall Street investment crowd, who have run most American companies, and indeed the whole US economy, into a ditch. These supposedly smart folks with their fancy MBAs and PhDs and law degrees have outsourced jobs, pillaged the environment, destroyed communities, piled on debt, failed to modernize and invest in R&D, laid off highly skilled workers in favor of lower paid, less skilled workers, poisoned and injured their own workforces, made stupid acquisitions motivated by a desire to aggrandize more power or more market share, rather than to achieve real synergies, and have pilfered corporate resources to boost their own undeserved obscene levels of compensation.
How, on reflection, could a worker-run company—and I mean a real worker-run company where the board is in the hands of the workers, and the workers chose and hire and fire the managers—do any worse than what we’ve seen over the last decade? There is an irony here. Corporate lobbyists have been battling against the Employee Free Choice Act, a labor law reform bill in Congress which would eliminate the need for workers to go through a supervised secret-ballot election in order to win representation of a union at their workplace, substituting the requirement that organizers simply obtain signed cards calling for a union from a majority of the workers at a workplace. The corporate argument against this reform is that it violates the "sanctity" of "one person, one vote".
And yet, here we have not only a much larger number of people—the 27,000 unionized workers at Chrysler—but also the holders of a much greater number of shares than everyone else combined, getting only a tiny fraction of the vote. That glaring inequity doesn’t seem to bother the corporate elite and their elected servants in Washington one bit. And it’s actually even worse than it looks on its face. Chrysler’s unionized workers don’t even have a direct vote to control their own shares, which are actually controlled by a trust fund headed by a group of "independent" trustees not chosen by the workers. ("Independent" means "not controlled by the workers.") Chances are, if Chrysler were really placed in the hands of its workers, it would be a great success. Workers, after all, need to think long term. Their key motivation is to have a company that will provide them with jobs and wages until retirement, and with a decent, secure retirement pension for the rest of their lives. That is exactly the kind of motivation that we should have in our companies, and in our corporate management suites. It is not what we have right now.
As a long-time business journalist, I can tell you that you would have to search long and hard to find a management in American business that is thinking even five years ahead. One or two years would be more common, and plenty are focused on the short end of that span. A genuinely worker-run Chrysler would not be putting golden parachutes in the contracts it offers to new top managers, nor would it be giving them annual performance bonuses. It would not be paying those managers 50-200 times what an assembly-line worker makes. It would not be making gas-guzzling SUVs and high-end sports cars. Instead of trying for quick sales of high-priced vehicles aimed at boosting earnings for the next quarter, it would be designing and making cars that Americans need, and that would propel the company’s sales and earnings for decades to come.
Actually, we’ve been here before. When Chrysler almost went belly up the last time, back in the economic crisis of 1979, it was rescued with a $1.5-billion government loan. At that time, the workers, then three times more numerous, also took pay cuts and benefit cuts, and in return were given a seat on the corporate board, held by then UAW President Douglas Fraser (who died last year at 91), but no real say in management. Fraser’s appointment—the first ever of a union executive or representative to a corporate board—was seen as a shocking development, but he was never more than a token. The company’s management, headed by Lee Iacocca, proceeded to ignore the 1973 gas crisis and its early warning about the need for energy-efficient cars, which were in any event fueling the import surge of cars from Japan and elsewhere, and went off in the direction of short-term gain, building vans and trucks, and paving the way for Chrysler’s next crisis in the 1990s, when it ended up being taken over for a song by the private equity group Cerberus, then by Germany’s Daimler, finally ending with the current near-death experience.
Odds are, had Chrysler been worker-run back in 1979, the company would be in a wholly different place today. The trouble is that what is deceptively called "worker-ownership" here in America, with the exception of some very small companies and co-operatives, is in reality just a carefully circumscribed rip-off scheme, in which workers surrender their assets and swallow pay raises, and maybe get a token representative on the board, but end up being systematically excluded from any significant role in managing "their" company, which is actually run by a board composed of the agents of banks, institutional investors and other owners.
The only difference this time around is that the governments of the US and Canada will now have majority control of Chrysler’s board. Perhaps the board members appointed by those two public investors will act more in the interests of the workers at Chrysler, and in the long-term interest of both Chrysler and of the two countries, the US and Canada. But given that President Obama has put this nation’s economic management in the hands of the very people who helped bring the US economy to its knees, and that Canada is currently being run by a conservative prime minister, the odds of this happening seem pretty slight.
Towering Vacancies: Office Market Hits the Skids
When the housing market began collapsing across the developed world, commercial real estate remained a bastion for builders. But now the global recession is dragging it down, too. Central business districts that only a year ago were crowded with construction projects are emptying out as office tenants cut staff and operations. Building values are sinking, while delinquencies on securitized loans have tripled in the past six months. The abrupt downturn in commercial real estate is punishing cities as varied as Detroit, Dallas, and Hartford, where downtown office vacancy rates top 20%. Unoccupied space is piling up quickly in San Antonio, Las Vegas, Charlotte, and San Jose. Outside the U.S., high-profile towers have been halted everywhere from Dubai to Santiago, Chile.
New York, though, may be the epicenter of the bust. The world's biggest office market, with roughly 350 million square feet of floor space, New York added 2.9 million square feet of vacant property in 2009's first quarter alone -- more than the entire Empire State Building. In that same period, calculates commercial real estate brokerage CB Richard Ellis, rents slid 14.6% to an average of $57.35 per square foot, the largest quarterly drop on record. At 8.5%, New York's office vacancy rate is still well under the U.S. average of 14.7%. But with virtually no demand for new space, that percentage is likely to hit double digits within months, putting New York's recovery well behind that of cities such as London, where some analysts and investors think the worst may be over.
Steven J. Pozycki could add to the glut in New York next year. Pozycki, founder of SJP Properties in Parsippany, N.J., is plugging away at a 40-story tower in Midtown Manhattan with 1.1 million square feet of space. The $1 billion project, a joint venture with Prudential Real Estate Investors, was started in early 2007, when property values were still soaring and vacancy rates were at all-time lows. It is scheduled to open next spring but has yet to find a single tenant. The developer had intended to anchor his building, known as 11 Times Square, with financial companies and law firms. After these would-be renters began teetering, several other developers canceled projects at earlier stages. Boston Properties called off plans for a nearby tower in March. A few weeks later, developer Larry Silverstein said he may delay construction at the World Trade Center site for decades. But Pozycki says that by last fall construction on his site had gone "past the point of no return."
The slide in the office sector mirrors trouble throughout the nonresidential real estate industry. On Apr. 16, General Growth Properties (GGP.), the nation's second-largest mall operator, with 200 shopping centers, filed for bankruptcy. MGM Mirage, which is erecting an $8.6 billion complex of stores, offices, hotels, and a casino on the Las Vegas Strip, came close to default this spring. In New Orleans, a $400 million Trump International Hotel & Tower is now on hold until the credit market rebounds. With homebuilding moribund -- the sector is at its weakest in 50 years -- it's no surprise the U.S. has been shedding more than 100,000 construction jobs a month since December. Meanwhile, new assignments for architecture firms have become all but nonexistent, forcing big names such as New York's Daniel Libeskind to trade down to designing doorknobs and light fixtures.
Office construction is skidding outside the U.S., as well. Work was halted in March on a Cesar Pelli-designed skyscraper in Santiago, Chile. Building has reportedly stopped on Norman Foster's Russia Tower in Moscow. And many Persian Gulf projects that were green-lighted when oil topped $100 a barrel have been shelved, including the kilometer-high Nakheel Tower in Dubai. "We've had several projects in Dubai that have basically been put on hold until further notice," says Daniel Kaplan, a senior partner at architecture firm FXFowle. The financial impact will spread. The commercial real estate debt market in the U.S., valued at $3.4 trillion, is three times larger than it was in the early 1990s, creating the potential for huge losses as defaults and bankruptcies rise. Already, delinquencies on commercial mortgage-backed securities have jumped from $3.48 billion in February 2008 to $11.99 billion a year later, and a report from Deutsche Bank forecasts they will swell to at least $24 billion before 2010.
"It's like subprime," says Richard Parkus, head of CMBS research at Deutsche Bank. "Knowing what's in the delinquency pipeline, we can predict a dramatic rise in defaults." The expected upsurge is due, in part, to timing. A huge share of commercial mortgages was taken out in the mid-2000s, when building prices were rising to record highs and the loan-to-value ratio was around 90%. Many must be refinanced this year. These days the maximum loan-to-value ratio has fallen to 65%, while property values are plunging. On Mar. 31, for example, the John Hancock Tower in Boston was auctioned off for $660 million -- half the amount a private equity firm shelled out for the property three years ago. Of course, real estate is a cyclical business. Many of today's troubled office markets were hurt badly in the U.S. recessions in 1990 and 2001. But within a few years, as a halt in construction constrained supply, and businesses began to require more space, vacancy rates shrank, rents climbed, and developers started breaking ground on new towers.
Some real estate brokers are looking to London for signs of a turnaround. Prices there may be stabilizing after falling nearly 30% in 2008. As a result, equity buyers are emerging to snap up deals, encouraged by the weaker British pound. Hessam Nadji, director of research at real estate brokers Marcus & Millichap, thinks the U.S. may be less than 18 months from leveling off, too. "If there's moderate economic stabilization," he says, "we could see that translate into new demand for commercial office space in mid- or late 2010." Should that happen, Pozycki's SJP might be positioned well. None of its properties has a loan coming due in the next year or two. Most of the Midtown office buildings that 11 Times Square is competing with date to the mid-20th century. And no other towers are expected to open nearby before 2014. He also has plenty of space.
World's Top Economists Agree: The Global Recession Will Continue
"As you might have realized by now, we're in a difficult situation," said billionaire investor and philanthropist George Soros to a sold-out crowd at the Metropolitan Museum of Art on Thursday evening. Though Soros earned over $1 billion last year, eighteen months into a housing crisis and after over a year of decreasing GDP it's clear that the rest of the country is in dire need of economic salvation. Soros was flanked by some of the best economic minds in the country, who gathered on stage at the Metropolitan Museum of Art to discuss solutions to the global economic crisis. The panelists unanimously agreed on two points: this is a global crisis, and we're not through with it yet.
The discussion was sponsored by The New York Review of Books and part of the PEN World Voices Festival of International Literature. Panelists included Harvard Professor of Economics Niall Ferguson, a senior research fellow at Oxford and the evening's only staunch Milton Friedman acolyte; Princeton Professor of Economics Paul Krugman, noted New York Times columnist and recipient of the 2008 Nobel Prize in Economics; Princeton Professor of Economics Robin Wells, Krugman's frequent writing partner; NYU Professor of Economics Nouriel Roubini, a former senior adviser to the White House Council of Economic Advisers and the U.S. Treasury Department under Clinton; and former New Jersey Senator Bill Bradley.
Krugman and Ferguson dominated the discussion. Ferguson made a case for conservative free market capitalism, while Krugman -- with support from the other panel members and the majority of the crowd -- advocated the Keynesian economics underlying Obama's stimulus bill. Ferguson began by describing the economic crisis in psychological terms, pointing to the initial widespread denial of readily apparent problems in 2007. "I called it the great repression," he told the crowd. "Then last September we went into shock" after admitting that something was seriously wrong. Ferguson took issue with what he believed to be mutually exclusive remedies for the crisis, massive injections of liquidity and debt spending that requires "vast quantities of newly printed bonds," both of which are currently being pursued by the Obama administration.
In a clear shot at Keynes, Krugman and the other panelists, Ferguson criticized debt spending as a outdated remedy for the economy: "This prescription says 1936 on the bottle... and I fear we'll get the 1970s for fear of the 1930s." Ferguson also took issue with the risk of inflation posed by issuing government bonds to pay for expansive fiscal policy. "If you want the Soviet model, that's fine," he told a hostile crowd. With a look of disdain, Krugman reminded Ferguson that the U.S. national debt was 100 percent of Gross Domestic Product (GDP) after World War II and the economy didn't suffer. It's a mere 60 percent of GDP today. "The only thing that would drive up interest rates is if people don't believe the U.S. can pay down its debt," said Krugman, who did not seem to believe that investors would stop trusting the U.S. Federal Reserve.
After the panel, an elderly fan suggested that Krugman should have given Ferguson an uppercut to the chin. "The danger is that [Ferguson] thinks he knows what he's talking about," Krugman told the man. While some pundits use recent gains in the stock market as evidence of a recovery, Bradley took issue with such simplistic thinking, saying, "Citicorp drops from sixty to one [dollar] and then goes back to three. I don't think that's a recovery." Wells agreed, saying, "If the economy continued to drop at the rate it did in the first quarter, pretty soon we'd end up in the stone age." She reminded the audience that a slowed decline does not mean the end of the recession is around the corner. Both Krugman and Wells waxed hopeful about "green shoots of spring," implying the possibility of new life cropping up on the bleak landscape of the global economy.
Krugman went on to describe the current dilemma in terms of a "global savings glut." While overspending from the 1970s onward created $13 trillion in household debt and helped catalyze the economic crisis, the problem today is that "people want to save, but there's nowhere to put their money," says Krugman. Due to the volatile financial sector, businesses lack access to credit and the few that can borrow refuse to invest. With an abundance of capital, Krugman argued that only government spending could create the required demand for investment in the current market. "We understand this rather well, at least some of us do... I'm referring to the 38 Republicans who voted against the stimulus package because they thought we needed another round of Bush style tax cuts," Krugman said of the Senate Republicans with a glance toward Ferguson.
Krugman told the crowd that American policy makers have not fully applied the lessons learned from Japan's lost decade, when Japan spent thirteen years under the economic dead weight of insolvent banks before crawling out of a prolonged recession in 2003. "We've actually turned Japanese despite of a determination, at least verbally, not to do so," said Krugman. "The point about the Japanese is not that they did too much, but that they failed to do enough. What Larry Summers was saying before was that you need to have a Powel doctrine; you have to attack this type of problem with overwhelming force. What we got instead was a Vietnam style escalation."
Apart from Ferguson, the panelists all stressed the importance of reestablishing strict financial regulations to prevent another financial collapse in the future. As the only politician on the stage, Bradley took it upon himself to define the importance of regulations in layman's terms. "It's not news that people are greedy," he said. "That's kind of human nature. It is that we made conscious decisions not to put limits on that natural human impulse." He listed three fatal errors, beginning with the elimination of the Glass-Steagall Act in 1998, which paved the way for investment banks, banks and insurance companies to combine.The second mistake was in 1999: the explicit decision by an administration and Congress not to regulate derivatives and credit default swaps, which in 2002 were worth $1 trillion and today are worth $33 trillion... 384 people in the London office of AIG doing the derivatives destroyed a company that had 116,000 employees in 120 countries. Why? Because there was no regulation at all.
Third, in 2004 the FCC allowed banks to go from ten-to-one leverage to thirty-to-one leverage. And guess what, once they were allowed to do it... they did it. If we're to look into the future, we might look at those three mistakes and remember that the Chairman of the Federal Reserve is supposed to remove the punch bowl from the party when things get out of control. That did not happen during the Greeenspan years--just the opposite.
Britain's company failures are 'tip of the iceberg'
Personal insolvencies could top 150,000 this year, suggesting UK economy is not through the worst
Insolvency experts warned today that a 59% annual jump in failing companies was "the tip of the iceberg" as official figures highlighted the impact of Britain's plunge into recession on the hard-pressed corporate sector. Evidence that tighter credit, falling demand and a weak property market are pushing an increasing number of individuals and companies over the brink blunted fresh evidence that the economy may be through the worst of its downturn. Data from the Insolvency Service showed that the number of failed companies stood at 6,724 in the first three months of 2009, when the economy shrank by 1.9% and claimant count unemployment rose by almost 290,000. Corporate insolvencies were up 6% on the quarter.
Personal insolvencies increased by 1.6% on the quarter to 29,774 and were 19% higher than in the first three months of 2008. Although the Chartered Institute of Purchasing & Supply reported that conditions for manufacturing were less bad than a month ago, insolvency practitioners warned of more bad news to come. Liz Bingham, head of restructuring at Ernst & Young, said: "As worrying as these figures are, this is just the tip of the distress iceberg. Many more companies and individuals are being restructured outside of formal processes and the figures do not include those companies that are effectively dead in the water, but lacking the triggers that force intervention. The number of corporate insolvencies has once again risen significantly, but we fear that the worst is not yet over for many UK businesses as the economy continues to contract and credit remains constrained."
A breakdown of the government's figures showed personal bankruptcies rose by just under 1% to a record 19,026 in the first quarter of this year, with more than 10,000 people entering into individual voluntary arrangements with creditors. The accountancy firm KPMG said personal insolvencies would continue rising as a result of company failures, increasing unemployment and the introduction of the new debt relief orders (DROs) last month. DROs allow consumers with debts of less than £15,000 and minimal assets to write off their debts without entering into a full-blown bankruptcy. Mark Sands, director of personal insolvency at KPMG, said: "We expect this new approach to increase the number of people using personal insolvency as the way to deal with their debts. In KPMG's view, DROs, together with the expected increase in unemployment, are likely to lead to record levels of personal insolvency of more than 150,000 in 2009."
The Insolvency Service said that though bankruptcy represented a means for households to relieve financial pressure, it should not be seen as an easy option for those who accumulated debts recklessly. The CIPS/Markit monthly snapshot of industry showed its second successive monthly rise, with its purchasing managers' index up from 39.5 to 42.9. Any reading below 50 indicates that factory output is contracting. Roy Aycliffe, director at CIPS, said: "Although April saw some reprieve for the UK manufacturing sector, we are still far away from a turnaround and the industry is still firmly embedded in the trenches of recession." He added that there had been a welcome pick-up in output and orders, but a third of firms laid off staff to cut costs.
Aristotle's Choice Of Money Revisited
There are countless tips on how to make money. This article is not about that. Rather, we examine the definition of money, what makes good money, and how some bad monies stay bad while others have become acceptable through new ideas and technology. In the end we will talk about how money and currency will evolve in the future.
Definition of Money
Money is anything that is generally accepted as payment for goods and services and repayment of debts. The main uses of money are as a medium of exchange, a unit of account, and a store of value.
Aristotle on good money
Aristotle (384 BC - 322 BC) was a Greek philosopher, a student of Plato and teacher of Alexander the Great. Aristotle discovered, formulated, and analyzed the problem of commensurability. He wondered how ratios for a fair exchange of heterogeneous things could be set. He searched for a principle that makes it possible to equate what is apparently unequal and non-comparable.
Aristotle says that money, as a common measure of everything, makes things commensurable and makes it possible to equalize them. He states that it is in the form of money, a substance that has a telos (purpose), that individuals have devised a unit that supplies a measure on the basis of which just exchange can take place. Aristotle thus maintains that everything can be expressed in the universal equivalent of money. He explains that money was introduced to satisfy the requirement that all items exchanged must be comparable in some way.
Within such frame work, Aristotle defined the characteristics of a good form of money:
1.) It must be durable. Money must stand the test of time and the elements. It must not fade, corrode, or change through time.
2.) It must be portable. Money hold a high amount of 'worth' relative to its weight and size.
3.) It must be divisible. Money should be relatively easy to separate and re-combine without affecting its fundamental characteristics. An extension of this idea is that the item should be 'fungible'. Dictionary.com describes fungible as:
"(esp. of goods) being of such nature or kind as to be freely exchangeable or replaceable, in whole or in part, for another of like nature or kind."
4.) It must have intrinsic value. This value of money should be independent of any other object and contained in the money itself.
Money, 1,000 years ago
Only humans satisfactorily solved commensurability with the idea and practice of money. Throughout history, we have seen the adaptation of various forms of money. Here are some examples with relative merits denoted.
One couldn't treat oil as money since it was not exactly durable and portable. Neither could one use a business (such as a restaurant) as money since it is hardly divisible and ever lasting. Gold has been the choice of money for over 5,000 years because it is valuable, durable, divisible and relatively portable.
Trading assets on paper
A thousand years ago, the ownership title of a land parcel or a business is merely a piece paper for decorative purpose and a registry for the tax collector. The oldest existing stock certificate was issued in 1606 for a Dutch company (Vereinigte Oostindische Compaignie) seeking to profit from the spice trade to India and Far East . Though very profitable in its day, when the company was dissolved in 1799, it was some 10 million Dutch guilders in debt.
American Stock exchanges were introduced in the early 18 th century and wasn't prominent until the 19 th century, where we saw globalization expanded massively with computer technology, air travel, transcontinental pipelines, and giant cargo ships. Today over 50% of US households own stocks collectively worth over $10 trillion. It's only in the last 15 years that an average person can access instant world news and buy stocks with few computer clicks thanks to the internet. Hundreds of millions of people around the world own publicly traded stocks collectively worth over $40 trillion. Over 5 trillion dollars worth of US mortgages have been securitized and owned by world citizens. Title certificates to commodities stored around the world are changing hands valued in the hundreds of $billions on various commodity exchanges.
Oil, which has always carried intrinsic value but difficult to store and exchange for other goods, all of a sudden becomes a viable medium of exchange and store of value through the advent of Oil ETF. Oil is stored in a warehouse and your digital ownership certificate is tucked safely in your brokerage account, which you can practically instantly exchange for anything else you want, whether it be Microsoft, gold, wheat, air ticket, hotel room, for less than 1% of commission. Granted, we rely on dollars to calculate the exchange ratios but the role of dollars has diminished greatly in the process as we used it only as an exchange reference (and a lousy one at best) and never kept dollars.
Like oil, various assets once thought to be non-divisible, non-portable, and non-durable are gaining popularity and being saved in lieu of traditional money such as gold and dollars. REIT ETF allows you to "store" real estate around the world and sell in any increment you like, S&P spider ETF allows you to own a piece of America's 500 largest companies with auto rebalancing. You can own Japan , Banks, Wheat, Motion Picture, anything you desire with transparency, liquidity, and low transaction cost.
Those assets are becoming more attractive as store of value with enhanced trading volume, portability, durability and divisibility.
Money must be a good store of value by definition.
Fiat paper currencies are popular at times since they are convenient and can be created at will to please the public. However fiat money fails the all important "intrinsic value" test, as its value is solely derived from legal tender laws. The compliance of such law rests on the credibility and strength of the issuing authority. As we know government and political factions can rise and fall faster than pop stars in some cases. It's no surprise that no fiat money has ever survived through time, and they can never be viable money regardless of technological breakthroughs or other human advances.
The value of a dollar
What Aristotle described as good money 2,000 years ago has not changed, sound money must be a good medium of exchange as well as a store of value. Assets such as oil or land once weren't considered to be good forms of money due to poor physical or liquidity constraints, have received renewed interest thanks to novel ideas and innovative technology. The internet and various pooled products (ETF) on world markets enabled those once immobile and/or illiquid goods to be transacted with ease, speed, transparency and low cost amongst world buyers and sellers.
The role of fiat money is vanishing. This morning, I sold Newmont Mining to book a hotel in Hong Kong without owning dollars for long. I don't own many dollars, or euros or yuans. Fiat money carries a hefty premium for being a good currency but bad store of value. There is no reason to keep any money without intrinsic value.
My view on gold from this evolution is mixed. On the plus side, gold will crowd out inferior fiat currencies at a faster pace. On the minus side, the choices of store of value have expanded vastly, reducing gold's role to being a fair medium of exchange. Consequently I don't see the combination of a $2,000/oz gold price, a crashing stock market and $30/barrel oil. If that happens, I'd be selling gold, storing oil, and paying with oil.
How can I pay with oil? One can already make payments with digital gold via www.goldmoney.com , I wouldn't be surprised if one invents a way to pay merchants with a share of Disney, or a slice of someone else's mortgaged backyard through a digital land token!
Bulgaria Faces 'Junk Status Abyss' in Bond Market
Bulgaria risks having its credit rating cut to below investment grade as it struggles to shrink the highest current-account deficit in emerging-markets, according to RBC Capital Markets.
"Bulgaria is teetering on the edge of the junk status abyss," analysts led by Nick Chamie at RBC Capital Markets in Toronto wrote in a research note today. The Balkan country faces a "painful reduction" in domestic demand to lower its deficit because adjustment cannot come through the euro-pegged currency, the note said. Bulgaria’s current-account deficit reached 25 percent of gross domestic product in 2008, the highest ratio of the 80 emerging-market countries rated by Fitch Ratings, leaving it vulnerable to increased financing costs as the global economy sinks into the most severe recession since World War II.
The country’s lowest non-investment grade rating of BBB- was reduced to negative from stable by Fitch yesterday, indicating more cuts may be imminent. It is "inevitable" that Bulgaria will seek a bailout from the International Monetary Fund to ease the country’s financial crisis, RBC said. Eastern Europe is suffering the most rating downgrades in at least a decade. Standard & Poor’s last month lowered Latvia’s credit rating to BB+, or non-investment, and cut Ukraine’s grade two levels to CCC+, six steps lower. S&P reduced its rating on Romania to BB+ from BBB- in October, cutting the grades for Hungary and Romania on the same day.
Ilargi: See yesterday's TAE for Gillian Tett’s article in Morgan Stanley and Kazachstan.
Derivatives and attempted state capture in Kazakhstan
by Willem Buiter
A fascinating contribution by Gillian Tett in today’s Financial Times on the role of CDS in the default of the largest Kazakh bank, BTA, raises a number of wider issues. Last week, BTA went into partial default when Morgan Stanley and another bank demanded repayment of loans they had made to BTA and BTA was unable to comply. Tett also discovered that, just after calling in its loan to BTA, Morgan Stanley asked the International Swaps and Derivatives Association (ISDA) to start formal proceedings to settle credit default swaps contracts written on BTA. I don’t know the aggregate value of the credit default swap contracts written on BTA that Morgan Stanley owned, whether it was smaller or larger than the value of the loans to BTA called by Morgan Stanley, or who the writer(s) of these CDS contracts was or were. But it raises concerns.
The reason it raises concerns can be made clear with the following hypothetical example. Assume some large western bank, let’s call it St. Manley Organ Bank, has made a loan of size A to BTA or has bought its debt in amount A. As a creditor to BTA, St. Manley Organ would normally want to avoid a default by BTA, because St. Manley Organ is bound not to get paid in full in the event of a default by BTA. But now assume that St. Manley Organ has also bought CDS in amount L to cover the risk of default on BTA debt. As long as A > L, St. Manley Organ has a net long position in BTA debt, and it will get hurt financially if BTA defaults, even if the writer of the CDS is creditworthy and pays up in full. The purchase of CDS therefore is the purchase of insurance: St. Manley Organ has an insurable interest. However, CDS can be bought in any amount without the purchaser having any insurable interest in the underlying security. If St. Manley Organ had bought CDS contracts for a larger amount of BTA debt than it owns, that is, if A < L, then St. Manley Organ has a net short position in BTA debt, provided the writer (seller or issuer) of the CDS is creditworthy. It is better off if BTA defaults than if it does not default. It profits from a BTA default.
If you own CDS written on BTA in an amount larger than the amount of BTA debt you own, you are not insuring yourself against the risk of a default by BTA and the resulting loss this would cause you. Instead you don’t have an insurable interest and you are placing a bet on a default by BTA. You win your bet if and only if BTA defaults. This would not matter greatly if St. Manley Organ had no way to influence the likelihood of default of BTA. But if St. Manley Organ can influence the likelihood of default of BTA there would be a nasty case of moral hazard. Gillian reports that "Right now more than $700m BTA CDS contracts are registered with the Depositary Trust & Clearing Corp in New York". The two loans BTA defaulted on were worth $550 million . This does not mean that someone made a $200 million profit: total outstanding borrowings of BTA were around $13 billion, and it is quite possible that some or all of the CDS in question were written on the $12.250 billion worth of BTA debt that has not defaulted (yet). But it does cause one to ponder.
Moral hazard causes what I call micro-endogenous risk. It is a powerful argument for requiring purchasers of derivatives like CDS to have an insurable interest. In this case it would have meant that you cannot own CDS in excess of the amount of BTA debt you own. This can be enforced by requiring that a CDS contract only pays off if the same amount of the exact security the CDS was written on, is presented and handed over to the writer of the CDS. I favour requiring CDS contracts to become instruments of insurance rather than instruments for placing bets - for gambling. This is both because of moral hazard considerations and because the tradability of the CDS contracts adds a dimension of macro-endogenous price risk to the micro-endogenous price risk caused by moral hazard. This would mean banning ‘naked CDS’, the analogue in the CDS market of banning naked short sales of equity.
Kazakh tax payers versus foreign unsecured creditors
There is a second issue. Last February, BTA, which had been a privately owned bank, was nationalised by the Kazakh state. When it became clear that BTA, like most of Kazakhstan’s banks was tottering on the edge of the precipice, the foreign unsecured creditors of the bank began to lobby the Kazakh government to guarantee the bank’s unsecured liabilities. Pledging the resources of Kazakhstan’s National Oil Fund to rescue the unsecured foreign creditors is an option that is especially popular with those who were caught with their pantaloons down. There is no insurance like ex-post insurance. When first BTA and then a second Kazakh bank, Alliance Bank, went into partial default, the sound of foreign bankers lobbying the Kazakh government became a might roar. Those doing the lobbying were presumably those long in Kazakh bank debt, that is, creditors whose credit exposure exceed their holdings of CDS contracts written on Kazakh bank debt and the writers of the CDS.
About 40 percent of the liabilities of Kazakh banks are held by foreigners, mainly by banks and investment banks. State ownership of a bank does not, of course, mean that the state guarantees any of the liabilities of that bank. Limited liability means that the exposure of the state, like that of any owner, is limited to the state’s equity in the bank. The foreign creditors of BTA were not simple widows and orphans who put their money in IceSave accounts without being able to spell the word ‘insolvency’. They are sophisticated, professional financiers, who earned very handsome spreads over US Treasury bonds by lending to Kazakh banks. This lending became grossly undisciplined and led to a massive investment, construction and real estate boom as the world economy thundered along and the prices of oil and gas (Kazakhstan’s main exports) skyrocketed.
A mole wearing sunglasses could have seen the Kazakh boom was unsustainable and would crash. There never were creditors more undeserving than the creditors of Kazakh banks. The spread between US Treasury bonds and US$-denominated Kazakh bank debt is called a (differential) credit risk spread. When you see it, it means that there is likely to be greater credit risk associated with the security earning the higher yield. The spread is the reward for bearing that risk. Sometimes that risk comes home to roost. Then you have to eat it. That’s known as the rules of a capitalist market economy. The World Bank and the IMF, in countries as far apart as Iceland and Kazakhstan, have been on the side of the angels, arguing strongly with the governments of these countries that the state should not guarantee the foreign liabilities (or indeed any liabilities other than insured deposits) of banks that are in default or threaten to go into default. Icelandic tax payers should not pay for the follies of foreign banks (including some well-known German banks) that lent serious money to the Icelandic banks long after it was obvious that the Icelandic banking system was an accident waiting to happen. The foreign banks lobbied and continue to lobby furiously, and even recruit their own governments to put additional pressure on the Icelandic authorities.
In Kazakhstan, some of the foreign banks that lent unsecured to the Kazakh banks are not only lobbying furiously - they are playing hardball, threatening to invoke assorted cross-default clauses in loan contracts that could bring down most of the Kazakh banking system. There is no financial upside for the creditors from following through on that threat, but there is, of course, considerable downside for the Kazakh government and people. Such behaviour is deeply unethical and should be illegal. I hope the home governments of the foreign banks that are financially exposed in Kazakhstan have the good sense either not to get involved at all, or to take the side of the Kazakh tax payers. The sight of bankers from the rich industrial countries capturing their home governments is bad enough. To watch them attempting to capture or bully foreign governments, often in emerging markets or developing countries, is truly objectionable. It is time to play the international lending game with an honest deck.
Politicians Are In Office But Banks Are In Power
Dick Durbin knows his way around the Senate. He’s been there a long time, long enough to know how things really work. Over the years, the man from Illinois has come to realize that it’s not the elected officials who are in charge. Last week, he said it was the bankers "who run the place" acknowledging that Senators may be in office, but not necessarily in power. Usually, the people who pull the strings stay in the background to avoid too much public exposure. They rely on lobbyists to do their bidding. They prefer to work in the shadows. They may back certain politicians, but coming from a world of credit default swaps as they do, they hedge their bets by putting money on all the horses.
They have so much influence because they have been reengineering the American economy for decades through "financialization," a process by which banks and financial institutions gradually came to dominate economic and political decision-making. Kevin Phillips, a one time Reagan advisor and commentator, says our deepest problem is "the ascendancy of finance in national policymaking (as well as in the gross domestic product, and the complicity of politicians who really don’t want to talk about it." Curiously, despite the journalists like Bill Moyers and Arianna Huffington who have been blowing the whistle on the role of the "banksters" in our political life, criticizing the Republicans and Democrats who deregulated the financial system, this issue seems to float above the heads of most of the public, much of the press, and even the activist community more drawn to punishing the torture inflicted on a few by a former Administration than the economic duress being imposed on the majority of Americans by a minority of the superrich.
Demonstrators are still drawn more to the White House than the banks that have proliferated on every corner of the country. Last week, a Zogby poll found that a majority of the public believes the press made things worse by reporting on the economic collapse. Not only is that blaming the messenger, it also overlooks the fact that much of the media was complicit in the crisis by not covering the forces that caused the collapse when it might have done some good. Exacerbating the problem is that the Obama Administration has, in Robert Scheer’s words, enlisted "the very experts who helped trigger the crisis to try to fix it." "Obama," he writes "seems depressingly reliant on the same-old, same old cast of self-serving house wreckers who act as if government exists for the sole benefit of corporations and executives."
The team of Tim Geithner and Larry Summers has been carrying Wall Street’s water as Robert Rubin did before them. No wonder that Obama’s Attorney General Eric Holder told the Street last February, "We’re not going to go on any witch hunts." That was before we learned that Wall Street forced US regulators to delay the release of stress test results for the country's 19 biggest banks until next Thursday, because some of the lenders objected to government demands that they needed to raise more capital. They are trying to rig the results. That was also before the public learned of the obscenely huge bonuses the firms benefiting from the TARP bailout were shelling out to their executives. That was before, we saw how the bankers with help from Democrats, including new convert Arlen Spector, vited managed to kill a bill to help homeowners stop foreclosures.
"The Senate on Thursday rejected an effort to stave off home foreclosures by a vote of 51 to 45. It was an overwhelming defeat, with the bill’s backers falling 15 votes short — a quarter of the Democratic caucus — of the 60 needed to cut off debate and move to a final vote. Across the United States, the measure is estimated to have been able to prevent 1.69 million foreclosures and preserve $300 billion in home equity." Commented the Center for Responsible Lending, "Instead of defending ordinary Americans, the majority of Senators went with the banks. Yes, the same banks who have benefited so richly from the TARP bailout.
There was one small victory with the House approving a bill to protect consumers from credit card abuses. Its not clear if the Senate will pass it too. "It's one step forward and one step backward," said Travis Plunkett, of the Consumer Federation of America. "Congress is moving in fits and starts to re-regulate the financial services industry and the banking lobby still has tremendous clout." "Tremendous clout" is an understatement."
In this past week, we also saw how a few hedge funds undermined the attempt to save Chrysler from bankruptcy by holding out for more money even after the unions and big banks agreed to compromise to save jobs. The President was furious but apparently powerless: "A group of investment firms and hedge funds decided to hold out for the prospect of an unjustified taxpayer-funded bailout," Obama said. "They were hoping that everybody else would make sacrifices, and they would have to make none. Some demanded twice the return that other lenders were getting." Explains the blog Naked Capitalism, "the banksters are eagerly, shamelessly, and openly harvesting their pound of flesh from financially stressed average taxpayers, and setting off a chain reaction in the auto industry which has the very real risk of creating even larger scale unemployment than the economy already faces. It’s reckless, utterly irresponsible, over-the-top greed."
Will they be allowed to get away with it? A "captured" Congress is doing their bidding. There is no doubt that class antagonism is stewing, says the editor of the blog. He expressed a fear of a reaction that will go way beyond flag-wavng tea parties. "… I am concerned this behavior is setting the stage for another sort of extra-legal measure: violence. I have been amazed at the vitriol directed at the banking classes. Suggestions for punishment have included the guillotine (frequent), hanging, pitchforks, even burning at the stake. Tar and feathering appears inadequate, and stoning hasn’t yet surfaced as an idea. And mind you, my readership is educated, older, typically well-off (even if less so than three years ago). The fuse has to be shorter where the suffering is more acute."
One is reminded of the title of that movie, "There will be blood." Rather than show contrition or compassion for its own victims, Wall Street is hoping to jack up its salaries and bonuses to pre-2007 levels. The men at the top are oblivious to the pain they helped cause. And so far, they’ve only occasionally been scolded by politicians that have mostly enabled, coddled, bankrolled, funded, rewarded, and genuflected to their power. Wall Street’s behavior may be predictable but how can we account for the silence of so many organizations that should be out there organizing the outrage that is building? Knock, Knock, Obama supporters, bloggers, trade unionists, out of work workers and fellow Americans. Will we fight back or roll over? Pitchforks anyone?
Former Countrywide CEO Angelo Mozilo to stand trial in Florida
Angelo R. Mozilo, the former chairman and CEO of disgraced lender Countrywide Financial Corp., will have to stand trial in Broward County Circuit Court on charges of deceptive trade practices. U.S. District Court Judge Dana Sabraw granted Florida Attorney General Bill McCollum’s request that the case be sent back to state court. Mozilo’s attorneys had argued the issues in the case were federal and not state. "Angelo Mozilo should absolutely face a Florida court and Florida’s citizens for his business practices, especially those which victimized Florida homeowners," McCollum said in a news release.
The original lawsuit, filed last June, alleged that the company signed up clients with mortgages they could not afford or provided loans with rates that were misleading. In October, Bank of America Corp. agreed to provide $8.4 billion to modify the troubled mortgages it acquired as part of its purchase of Countrywide last July. The deal was part of a settlement with attorneys general in seven states, including Florida, which filed lawsuits against Countrywide, accusing the mortgage lender of deceptive and misleading practices that led to borrowers obtaining potentially risky and costly loans.
'When the President does it, it's not illegal': Rice may have admitted to conspiracy
In little-noticed comments Thursday, the former White House counsel for President Richard Nixon John Dean said Thursday that former Secretary of State Condoleezza Rice may have unwittingly admitted to a criminal conspiracy when questioned about torture by a group of student videographers at Stanford.
Rice told students at Stanford that she didn’t authorize torture, she merely forwarded the authorization for it. Dean, who became a poster child for whistleblowing after aiding the prosecution of the Watergate affair, told MSNBC’s Keith Olbermann that Rice may have admitted to a criminal conspiracy.
In a video that surfaced Thursday, Rice said, “The president instructed us that nothing we would do would be outside of our obligation, legal obligations under the convention against torture… I conveyed the authorization of the administration to the agency. And so by definition, if it was authorized by the president, it did not violate our obligations under the Convention Against Torture.” (Video of Rice’s comments appears at the bottom of this article.)
Her comments raised eyebrows from online observers, who compared Rice’s answer to that of Richard Nixon’s infamous quip: “When the President does it, that means that it’s not illegal.”
Dean said he found Rice’s comments “surprising” and put her in a legal mire of possible conspiracy.
“She tried to say she didn’t authorize anything, then proceeded to say she did pass orders along to the CIA to engage in torture if it was legal by the standard of the Department of Justice,” Dean said. “This really puts her right in the middle of a common plan, as it’s known in international law, or a conspiracy, as it’s known in American law, and this indeed is a crime. If it indeed happened the way we think it did happen.”
Asked if the comparison between her comments and Nixon’s were fair, Dean said it was “fuzzy.”
“She was obviously trying to extricate herself and keep herself in a safe distance, that she was only operating under some general guidance of the president making things legal,” he said. “So it’s not clear whether this is a full-throated Nixonian-type defense or whether it’s a lot of confusion of the facts and throwing things up there to try to protect herself.”
“These kinds of statements are going to come back and be interesting to any investigator,” he added.
Olbermann asked Dean whether Obama was violating the Geneva Conventions prohibiting torture himself by refusing to prosecute those responsible.
“He is indeed is in violation if the United States does not undertake investigation of this, or ultimately prosecution, if that’s necessary,” Dean asserted. “It’s not only the Geneva Convention, the Convention Against Torture also requires this. There are no exceptions with torture. There are no real things like “torture light.” The world community I think is going to hold the United States responsible, and if we don’t proceed, somebody is going to proceed.”
This video is from MSNBC’s Countdown, broadcast Apr. 30, 2009.
Extinction has a weird appeal
This week, the Sears Tower in Chicago collapsed, London was swallowed by the Thames and Atlanta was taken over by wild beasts on a television show called Life After People. Ordinarily the History Channel, which aired it, uses old footage and photographs to bring the past to life. But last year the network decided to envision, with the help of time-lapse photography and computer graphics, what would happen to the world if, from some unspecified cause, every last human being died. Over the course of two hours, highways disappeared under meadows, collapsing cities turned into verdant hillocks and automobiles crumbled into dust. It was macabre but riveting. Life After People became the most-watched programme in the history of the History Channel. Hence this season’s 10-part follow-up, which has just begun to air. It is not the only evidence of a new fascination with human extinction. Two years ago in the US, Alan Weisman’s The World Without Us became one of the top 10 non-fiction bestsellers of the year. This spring Fox bought the rights to turn it into a major film.
Mortality is an obsession as old as our culture ("Dust thou art and unto dust shalt thou return"). So is Judgment Day. Extinction, though, is a relatively recent worry. Tennyson’s "In Memoriam" still shocks us with its vision of man winding up, like other species, "blown about the desert dust, / Or seal’d within the iron hills." What is the appeal of Life After People? It is fun to watch things break down and blow up on television, of course. But there was a vindictive serves-you-right tone to last year’s film: "San Francisco’s stately wooden Victorians are now only useful as timber," says a gravelly voiced narrator as a street is consumed by flames. The same voice describes the crumbling of Manhattan: "The tunnels echo with the sound of cracking steel and cement as the streets above are sucked into the underground." Such scenes rub mankind’s nose in the fact of its impermanence. A few stone-chiselled memorials will survive, from the pyramids to Mount Rushmore, but mould spores will devour our libraries and acid will melt our films. The History Channel view is Tennyson’s, recast in a mood not of dread but of glee.
A frequent technique is to go to places that humans have abandoned and to see what has happened to them: the island of Hashima 35 years after the Japanese coal industry abandoned it, for instance, or parts of Gary, Indiana, that have been derelict for decades. The news is mixed. If you are human, these are catastrophes. If you are an ailanthus tree, you will have a different perspective. Last year’s film took the same approach with Pripyat, the company town built to serve the Chernobyl reactor and abandoned after the nuclear disaster in 1986. Chernobyl’s environs are now something of a nature preserve. Roe deer are back and the bird-watching is magnificent. Mr Weisman, who wrote an article on post-disaster Chernobyl for Harpers magazine in 1994, is circumspect. He thinks it will take generations to see just how habitable the landscape is. But the History Channel has no time for such qualifications.
"Incredibly," says the narrator, "the effect of the absence of humans for 20 years has outweighed the initial damage caused by the nuclear nightmare." A scientist looking out over the ruins reflects: "It seems pretty sad when you look now and see what’s become of this beautiful city of Pripyat, and that people will never live here again ... " Then there is a silence. In the eight seconds that it lasts, there is never a moment’s doubt that the next word will be but. " ... But there’s another side to the story, a very encouraging side, one that says that life is much more resilient than what we thought possible." The speculative excitement of the scientists interviewed for the film is the most unnerving thing about it. One scientist standing amid the grand judiciary buildings in Manhattan’s Foley Square notes that, without people, "nature would re-establish itself, and slowly bring us back to the green heart of what it means to be on the planet Earth." The zoologist Ray Coppinger of Hampshire College just cackles with delight: "If the city is abandoned, rats will have to go back to making an honest living," he says. And later: "I could picture New York City with all the buildings covered with vines, you know, hawks sailing around ... It’d be lovely. It’d be absolutely lovely."
How many people feel this way, and why? Do they only want a dramatic illustration of the process by which, left alone, some kinds of environmental damage done by man can be reversed? Mr Weisman has insisted in interviews he is a journalist, not a misanthrope or a crusader. He is speculating about our absence only as a means of "looking at our impact by extraction". From a scientific perspective, that is sensible. But most viewers seem to want something else. They want Judgment Day. "In my opinion the Earth will be better off without humans," writes a correspondent on a YouTube message board. "Humans are the main cause for altering the way the Earth once was." Maybe this sort of view is the dark unconscious of the universalism that is preached in the age of globalisation. Love of one’s own kind has gone out of fashion – we are now supposed to offer that love to a refugee in Darfur as readily as to our neighbours. Kantian ethics have replaced allegiances. But what happens to dislike for the neighbour down the street, which is equally part of the human condition? Apparently that sentiment gets universalised too – to the point where people begin not just to wish ill to their neighbours but to dream about the end of mankind.
Genesis of the debt disaster
by Gillian Tett
In the 1990s, a young team at Wall Street investment bank JP Morgan pioneered a new way of making money – credit derivatives. Within a decade, the market for these exotic securities had exploded to more than $12,000bn – and some people later blamed them for fuelling the global financial fiasco. In the first of two extracts from her book, Fool’s Gold, the FT’s Gillian Tett reveals how the innovation genie was first let out of the bottle – and eventually devoured the system, to the horror of its creators. The first sign that there might be a structural problem with the innovative bundles of credit derivatives that bankers at JP Morgan had dreamed up emerged in the second half of 1998. In the preceding months, Blythe Masters and Bill Demchak – key members of JP Morgan’s credit derivatives team – had been pestering financial regulators. They believed that by using the new credit derivative products they had helped create, JP Morgan could better manage the risks in its portfolio of loans to companies, and thereby reduce the amount of capital it needed to put aside to cover possible defaults. The question was by how much. (Though these bundles of credit derivatives later went under other names, such as collateralised debt obligations [CDOs], at that time these pioneering structures were known as "Bistro" deals, short for Broad Index Secured Trust Offering). Masters and Demchak had done the first couple of Bistro deals on behalf of their own bank without knowing the answer to their question for sure. But when they were doing these deals for other banks, the question of reserve capital became more important – the others were mainly interested in cutting their reserve requirements.
The regulators weren’t sure. When officials at the Office of the Comptroller of the Currency and the Federal Reserve had first heard about credit derivatives and CDOs, they had warmed to the idea that banks were trying to manage their risk. But they were also uneasy because the new derivatives didn’t fit neatly under any existing regulations. And they were particularly uncertain over what to make of the unusually low level of capital available to cover losses on the derivatives.
When the team did their first Bistro deal, they pooled more than 300 of JP Morgan’s loans, worth a total of $9.7bn, and issued securities based on the income streams from these loans. The lure of the idea was clear: the team had calculated that they only needed to set aside $700m – a strikingly small sum – against the risk of defaults among the 300-plus loans. After much debate, the credit rating agencies had agreed with the team’s assessment of the risks, and the deal had gone ahead on the basis that if financial Armageddon wiped out the $700m funding cushion, JP Morgan would absorb the additional losses itself. To Masters and Demchak, the chance that losses would ever eat through $700m were minuscule.
That argument didn’t wash with European regulators, and some of their US counterparts were uneasy, too. Christine Cumming, a senior Fed official, indicated to Masters and Demchak that JP Morgan should look for a way to insure the rest of the risk – the "missing" $9bn in their original Bistro scheme – if the bank wanted to gain approval to cut its capital reserves. So Masters and her team set out to find a solution. They started by giving the bundle of "uninsured" risk a name. Masters liked to refer to it as "more than triple-A", since it was deemed even safer than triple A-rated securities. But that was too clumsy to market, so they came up with "super-senior". The next step was to explore who, if anyone, might want to buy or insure it.
The task did not look easy. As far as JP Morgan was concerned, this risk was not really risky at all, so there was no point paying anything other than a token amount to insure it. On top of that, whoever stepped up to acquire or insure the super-senior risk had to be brave enough to step into an unfamiliar world.
. . .
The seeds of AIG’s destruction
Masters eventually spotted one solution to the super-senior headache. In the past, one of JP Morgan’s longstanding blue-chip clients had been the mighty insurance company American International Group. Like JP Morgan, AIG was a pillar of the American financial establishment. It had risen to prominence by building a formidable franchise in the Asian markets during the early-20th century. That business was later extended to the US, making the company a powerful force in the American economy after the second world war. AIG was considered a weighty and utterly reliable market player, and like JP Morgan, it basked in the sun of a triple-A credit rating.
But within AIG, an upstart entrepreneurial subsidiary was booming. In the late 1980s the company hired a group of traders who had previously worked for Drexel Burnham Lambert, the infamous – and now defunct – champion of the junk-bond business under Michael Milken in the mid-1980s. These traders had developed a capital markets business, known as AIG Financial Products and based in London, where the regulatory regime was less restrictive. It was run by Joseph Cassano, a tough-talking trader from Brooklyn. Cassano was creative, bold and highly ambitious. More important, he knew that, as an insurance company, AIG was not subject to the same burdensome rules on capital reserves as banks. That meant it would not need to set aside anything but a tiny sliver of capital – at most – if it insured the super-senior risk. Nor was the insurer likely to face hard questions from its own regulators because AIG Financial Products had largely fallen through the cracks of oversight. It was regulated by the US Office for Thrift Supervision, whose officials had scant expertise in the field of cutting-edge financial products.
Masters pitched to Cassano that AIG take over JP Morgan’s super-senior risk, and Cassano happily agreed. It was a "watershed" event, or so Cassano later observed. "JP Morgan came to us, who were somebody we worked with a great deal, and asked us to participate in some of what they called Bistro trades [which] were the precursors to what [became] the CDO market," he explained. It seemed good business for AIG.
AIG would earn a relatively paltry fee for providing this service – just 0.02 cents per dollar insured per year. But if 0.02 cents is multiplied a few billion times, it adds up to an appreciable income stream, particularly if no reserves are required to cover the risk. Once again, the magic of derivatives had produced a "win–win" solution. Only many years later did it become clear that Cassano’s trade had set AIG on the path to ruin.
With the AIG deal in hand, the JP Morgan team returned to the regulators and pointed out that a way had been found to remove the rest of the credit risk from their Bistro deals. They started plotting other sales of super-senior risk to other insurance and reinsurance companies, which snapped it up, not just from JP Morgan but from other banks too.
Then, ironically, just as this business was taking off, the US regulators weighed in again. Officials at the Office of the Comptroller of the Currency and the Fed indicated to JP Morgan that after due reflection they thought that banks did not need to remove super-senior risk from their books after all. The lobbying by Masters and others had seemingly paid off. The regulators were not willing to let the banks get off scot-free. If they held the super-senior risk on their books, they would need to post reserves one-fifth the size of the usual amount (20 per cent of 8 per cent, meaning $1.60 for every $100 that lay on the books). There were also some conditions. Banks could only cut their capital reserves in this way if they could prove that the risk of default on the super-senior portion of the deals was truly negligible, and if the securities being issued via a Bistro-style structure carried a triple A credit rating from a "nationally recognised credit rating agency". Those were strict terms, but JP Morgan was meeting them.
The implications were huge. Banks had typically been forced to hold $800m reserves for every $10bn of corporate loans on their books. Now that sum could fall to just $160m. The Bistro concept had pulled off a dance around the international banking rules.
For a while, Demchak’s team stopped transferring super-senior risk from JP Morgan’s books. But then Demchak became uneasy. The super-senior risk was ballooning to a staggering figure, because when the bank arranged these credit derivatives transactions for clients, it typically put the super-senior risk in the deal on its own balance sheet. In theory, there was no reason to worry. But by 1999, the total pipeline of future deals had swelled towards $100bn. Something about that mountain of risk started to offend Demchak’s common sense. "If you have got $60bn, $100bn or however many billions of something on your balance sheet, that is a very big number," he remarked to his team. "I don’t think you should ignore a big number, no matter what it is."
. . .
The problem with correlation
Demchak was acutely aware that modelling the risks involved in credit derivatives deals had its limits. One of the trickiest problems revolved around the issue of "correlation", or the degree to which defaults in any given pool of loans might be interconnected. Trying to predict correlation is a little like working out how many apples in a bag might go rotten. If you watch what happens to hundreds of different disconnected apples over several weeks, you might guess the chance that one apple might go rotten – or not. But what if they are sitting in a bag together? If one apple goes mouldy, will that make the others rot too? If so, how many and how fast?
Similar doubts dogged the corporate world. JP Morgan statisticians knew that company debt defaults are connected. If a car company goes into default, its suppliers may go bust, too. Conversely, if a big retailer collapses, other retail groups may benefit. Correlations could go both ways, and working out how they might develop among any basket of companies is fiendishly complex. So what the statisticians did, essentially, was to study past correlations in corporate default and equity prices and program their models to assume the same pattern in the present. This assumption wasn’t deemed particularly risky, as corporate defaults were rare, at least in the pool of companies that JP Morgan was dealing with. When Moody’s had done its own modelling of the basket of companies in the first Bistro deal, for example, it had predicted that just 0.82 per cent of the companies would default each year. If those defaults were uncorrelated, or just slightly correlated, then the chance of defaults occurring on 10 per cent of the pool – the amount that might eat up the $700m of capital raised to cover losses – was tiny. That was why JP Morgan could declare super-senior risk so safe, and why Moody’s had rated so many of these securities triple-A.
The fact was, however, that the assumption about correlation was just that: guesswork. And Demchak and his colleagues knew perfectly well that if the correlation rate ever turned out to be appreciably higher than the statisticians had assumed, serious losses might result. What if a situation transpired in which, when a few companies defaulted, numerous others followed? The number of defaults required to set off such a chain reaction was a vexing unknown. Demchak had never seen it happen, and the odds seemed extremely long, but even if there was just a minute chance of such a scenario, he didn’t want to find himself sitting on $100bn of assets that could conceivably go bust. So he decided to play it safe, and told his team to look for ways to cut their super-senior liabilities again, irrespective of what the regulators were saying.
That stance cost JP Morgan a fair amount of money, because it had to pay AIG and others to insure the super-senior risk, and those fees rose steadily as the decade wore on. In the first such deals with AIG, the fee had been just 0.02 cents for every dollar of risk insured each year. By 1999, the price was nearer 0.11 cents per dollar. But Demchak was determined that the team must be prudent.
. . .
The mortgage time bomb
Around the same time, the JP Morgan team stumbled on a second, potentially bigger problem. As the innovation cycle turned and earnings declined from the early Bistro deals based on pools of corporate loans, Demchak asked his team to explore new uses for Bistro-style deals, either by modifying the structure or by putting new kinds of loans or other assets into the mix. They decided to experiment with mortgages. Terri Duhon was at the heart of the endeavour. Only 10 years earlier, Duhon had been a high-school student in Louisiana. When she told her relatives she was going to work in a bank, they had assumed she was going to be a teller. Now she was managing tens of billions of dollars. She was trained as a mathematician, and she thrived on adrenaline, riding motorbikes in her spare time. Even so, she found the thought of being in charge of all those zeros awe-inspiring. "It was just an extraordinary, intense experience," she later recalled.
A year after Duhon took on the post, she got word that Bayerische Landesbank, a large German bank, wanted to use the credit derivatives structure to remove the risk from $14bn of US mortgage loans it had extended. She debated with her team whether to accept the assignment; working with mortgage debt wasn’t a natural move for JP Morgan. But Duhon knew that some of the bank’s rivals were starting to conduct credit derivatives deals with mortgage risk, so the team decided to take it on.
As soon as Duhon talked to the quantitative analysts, she encountered a problem. When JP Morgan had offered the first Bistro deals in late 1997, it had access to extensive data about all the loans it had pooled together. So did the investors who bought the resulting credit derivatives, since the bank had deliberately named all of the 307 companies whose loans were included. In addition, many of these companies had been in business for decades, so extensive data were available on how they had performed over many business cycles. That gave JP Morgan’s statisticians, and investors, great confidence in predicting the likelihood of defaults. But the mortgage world was very different. For one thing, when banks sold bundles of mortgage loans to outside investors, they almost never revealed the names and credit histories of the individual borrowers. Worse, when Duhon went looking for data to track mortgage defaults over several business cycles, she discovered it was in short supply.
While America’s corporate world had suffered several booms and recessions in the later 20th century, the housing market had followed a steady path of growth. Some specific regions had suffered downturns: prices in Texas, for example, fell during the Savings and Loans debacle of the late 1980s. But since the second world war, there had never been a nationwide house-price slump. The last time house prices had fallen significantly en masse, in fact, was way back in the 1930s, during the Great Depression. The lack of data made Duhon nervous. When bankers assembled models to predict defaults, they wanted data on what normally happened in both booms and busts. Without that, it was impossible to know whether defaults tended to be correlated or not, in what circumstances they were isolated to particular urban centres or regions, and when they might go national. Duhon could see no way to obtain such information for mortgages. That meant she would either have to rely on data from just one region and extrapolate it across the US, or make even more assumptions than normal about how defaults were correlated. She discussed what to do with Krishna Varikooty and the other quantitative experts. Varikooty was renowned on the team for taking a sober approach to risk. He was a stickler for detail and that scrupulousness sometimes infuriated colleagues who were itching to make deals. But Demchak always defended Varikooty. His judgment on the mortgage debt was clear: he could not see a way to track the potential correlation of defaults with any confidence. Without that, he declared, no precise estimate could be made of the risks of default in a pool of mortgages. If defaults on mortgages were uncorrelated, then the Bistro structure should be safe for mortgage risk, but if they were highly correlated, it might be catastrophically dangerous. Nobody could know.
Duhon and her colleagues were reluctant simply to turn down Bayerische Landesbank’s request. The German bank was keen to go ahead, even after the uncertainty in the modelling was explained, and so Duhon came up with the best estimates she could to structure the deal. To cope with the uncertainties the team stipulated that a bigger-than-normal funding cushion be raised, which made the deal less lucrative for JP Morgan. The bank also hedged its risk. That was the only prudent thing to do, and Duhon couldn’t see herself doing many more such deals. Mortgage risk was just too uncharted. "We just could not get comfortable," Masters later said.
In subsequent months, Duhon heard through the grapevine that other banks were starting to do credit derivatives deals with mortgage debt, and she wondered how they had coped with the lack of data that so worried her and Varikooty. Had they found a better way to track the correlation issue? Did they have more experience of dealing with mortgages? She had no way of finding out. Because the credit derivatives market was unregulated, details of the deals weren’t available.
The team at JP Morgan did only one more Bistro deal with mortgage debt, a few months later, worth $10bn. Then, as other banks ramped up their mortgage-backed business, JP Morgan largely dropped out. Eight years later, the unquantified mortgage risk that had frightened off Duhon, Varikooty and the JP Morgan team had reached vast proportions. And it was spread throughout the western world’s financial system.
This is an edited extract from ‘Fool’s Gold: How Unrestrained Greed Corrupted a Dream, Shattered Global Markets and Unleashed a Catastrophe’ by Gillian Tett.