Teddy Bloggie Blog Blogging

Will these two icons of American industry will go bankrupt in the near future? They have enough cash to burn for another year or so, but I think they're done for. Building what people don't want to buy and financing people they shouldn't finance got'er done. They'll go the way of Studebaker and Packard. GM and Ford have huge finance divisions and the markets are especially unkind to financial companies right now. They must be sitting on a ton of loans that are going bad and getting worse. I imagine those same people who are having trouble with mortgage payments probably borrowed to buy cars. They are now defaulting on car payments and getting repossessed (like the guy behind me at the DMV two days ago). So it might not even be the slumping auto and truck sales that really kills GM and Ford but their no-money-down, 0% financing.

Some people argue that hundreds of thousands (maybe millions) of jobs are related to Ford and GM -- and so they're too big to fail. In many auto-related blogs people say that it's the right time to invest. I wouldn't. Just because they're too big to disappear doesn't mean they're too big to go bankrupt. A government bailout might not bail out the equity holders just as in the case of AIG, and a corporate takeover might not help equity holders either when it's sold for close to zero. I would be really worried if I'm an American retiree of GM or Ford right now because even if they don't go bankrupt, any takeover will only be interested in profitable operations in China, Brazil or Europe. A bankruptcy of GM or Ford will basically mean the recession will be longer and deeper than what we're looking at now. The seemingly virtual world of Wall St. will hit home. The repercussions of bad CDOs will have caused your GM retiree neighbor to stock up and eat canned tuna.

Low growth, low inflation, low interest rates. The Japanese economy writ large? I think that's what's going to happen for the next few years. The credit squeeze and the fall in home prices is going to shrink the nominal values of everything in the economy. There's going to be a rise in unemployment and a lack of investment, keeping the demand for money and interest rates low. I think I'm going to invest in healthcare because expenditure in healthcare is more inelastic and there's still a tremendous amount of innovation happening in the healthcare sector.

Alex sent me an email linked to Laffer's article criticizing the bailout:

There are many more examples, but none hold a candle to what's happening right now. Twenty-five years down the line, what this administration and Congress have done will be viewed in much the same light as what Herbert Hoover did in the years 1929 through 1932. Whenever people make decisions when they are panicked, the consequences are rarely pretty. We are now witnessing the end of prosperity.

It's right I think that the bailout is being rushed, but a slow bailout would be as effective as no bailout. Speed really matters but speed with some point-guard decision making skills would be even better. To me, the injection of money into bank equity seems like a mistake but buying up mortgages seems like a good idea.

Here's my reply to Alex:

Laffer's right that this is going to cost us more than we think 25 years from now. But I like to think of the bailouts (if done right) as your neighborhood fire department. We all pay taxes so that if some three-alarm fire next door erupts, they will be there to put it out. It might cost a lot in terms of paying for 5 guys and a shiny red truck, but it's better than having your house burn down because your next door neighbor was foolish and went to sleep with a lit cigarette and no one's there to stop the fire. It's kind of a similar situation in financial markets. You can stop bailing out the people who took too much risk, but then you'll probably lose your job too when the banks stops lending to the company you work for and people have no money to buy the goods or services you produce. The systemic risk is too great to do nothing and an unregulated financial market with very dispersed ownership and information creates a lot of unchecked systemic risk. Until someone figures out how to solve those fundamental problems of information asymetry and principal-agent (stock-owner/management) problems, we'll have more bailouts in the future.

Excellent story on CDS from NPR/This American Life:

"The line between investing and speculation or gambling in financial markets is always a pretty gray one," he says. "And speculation is always a motive."

So, how did we get from one of the safest activities on the planet "insurance" to one of the riskiest "gambling"? There's one key difference between an insurance policy and a credit default swap.

"The way that I first described the credit default swap is, you own the bond and you want to transfer the risk to someone else. But what if I want to buy protection but I don't own the bond?" Berman says.

But isn't buying protection on a bond you don't own like buying fire insurance on a house that's not yours?

"It is exactly like buying insurance for a house you don't own," Berman says. "So it's like you took out fire insurance on your home, and I also took out fire insurance on your home, and a thousand other people took out fire insurance on your home.

"And when that happens, what you're doing is, you're betting on the house."

So, a CDS allows people to get paid off by insuring something they don't own ?" not a house in this case, but a bond.

......

Imagine someone with a hedge fund worth $100 million who wants to make a killing in the credit default swap market. He starts calling and e-mailing all those credit default swap desks and hedge funds out there, saying, "I'm selling protection, who wants to buy?"

Someone calls back and says, "I have a billion-dollar bond from Lehman Brothers, I want to insure." He says, great, "I'll insure your bond if you agree to pay me 2 percent of its value every year." The caller says, "All right." They are in business.

Now, let's review those numbers: 2 percent of $1 billion is $20 million, which the person with the $100 million hedge fund gets every year. So, by signing one piece of paper, he has doubled his money in five years - psyching him and his investors.

That's the upside of leverage: You make profits on a billion dollars even though you only have $100 million.

The downside of leverage is that he is on the hook for up to $1 billion if the bond defaults and he doesn't have a billion.

So there are three big problems with the CDS market as told in this story.

1. OTC instruments are not regulated in terms of leverage.

2. The value of CDS are not marked-to-market. If they were and the CDSs are marked to market, as the seller gets on the hook for more and more money, they would be forced to get out of those positions day-by-day as the likelihood of default goes up.

3. Since the products are not marked to market, you can also get into the situation that as hedge-funds, investment banks, and AIGs of the world hold on to their short CDS positions "gambling for resurrection" instead of living in financial reality. Once the underlying bond actually defaults everyone has to pay up at the same time and instead of a bad financial bet by some investment professionals it becomes a financial meltdown.

So, it seems the solution is to just have CDS traded on a market with a clearinghouse. In fact, it should be a rule that any financial instruments regulated banks and insurance companies invest in or sell should be traded on a market, marked to market, and have a leverage limit.

Update: It seems that CDS have collateral that acts as margin calls. The collateral ratchets up if the firm is downgraded. As Felix Simon explains via this WSJ article:

The WSJ shines a bit more light on what went wrong at AIG today, with a story centering on the chap who designed its risk models, Gary Gorton. In a nutshell, anybody writing credit protection runs two risks: the default risk of the underlying security, on the one hand, and market risk, on the other. It seems that AIG only ever asked Gorton to worry about default risk; no one ever bothered to calculate the risk that CDS spreads would gap out, forcing AIG to take billions of dollars in mark-to-market losses and post many billions of dollars more in collateral.

Mr. Gorton's models harnessed mounds of historical data to focus on the likelihood of default, and his work may indeed prove accurate on that front. But as AIG was aware, his models didn't attempt to measure the risk of future collateral calls or write-downs, which have devastated AIG's finances...

AIG began selling credit-default swaps around 1998. Mr. Gorton's work "helped convince Cassano that these things were only gold, that if anybody paid you to take on these risks, it was free money" because AIG would never have to make payments to cover actual defaults, according to the former senior executive at the unit. However, Mr. Gorton's work didn't address the potential write-downs or collateral payments to trading partners.

Incidentally, AIG Financial Product's Joseph Cassano was kept on as a consultant after he retired in February -- at a rate of $1 million per month.

The WSJ also reports, without citing even anonymous sources, on the subject of Goldman's exposure to AIG, and the amount of AIG collateral that Goldman now holds:

Goldman Sachs Group Inc., for instance, has pried from AIG $8 billion to $9 billion, covering virtually all its exposure to AIG -- most of it before the U.S. stepped in.

Goldman protected itself in other ways, too, since it's not easy getting that collateral:

Late last October, Goldman asked for even more collateral, $3 billion. Again, AIG disagreed, and it ultimately posted $1.5 billion. Goldman hedged its exposure by making a bearish bet on AIG, buying credit-default swaps on AIG's own debt, according to one person knowledgeable about this move...

Mr. Gorton attended the Federal Reserve Bank of Kansas City's annual gathering in Jackson Hole, Wyo. He presented a 92-page paper, "The Panic of 2007," which explained how the financial markets came unglued after a series of unexpected events, such as when clients of financial firms suddenly sought to reclaim assets put up as collateral. "It is difficult to convey," he wrote, "the ferocity of the fights over collateral."

At heart, here, is an age-old debate over the value of any fixed-income instrument. Let's say you buy a bond at par which makes all its interest and principal payments in full and on time. Then you're happy, and making money. But let's say that a couple of years after issue, that bond is trading at just 10 cents on the dollar. Have you lost money?

As far as AIG was concerned, it was one of the biggest companies in the world, more than capable of weathering any mark-to-market storm -- and therefore all it cared about was default risk, not market risk. But as a result, it took on much more market risk than it was really aware of -- and that market risk ended up forcing the entire company into the arms of the US government.

The lesson, of course, is simple, but hard to learn: it's not the risks you measure which bring you down, it's the risks you don't measure. But protecting against those risks is very, very hard.

I thought the problem was that all of the marking-to-market and collateral calls came at the same time because they are tied to the rating of AIG, and I still think that's the case. If, as the article indicates, that there's very little default risk then it makes sense to bail out AIG, but I'm skeptical that their models are right when evidently the model failed to account for market risk.

The bigger problem of course is that any firms dealing in CDS are now finding it hard to get credit because counterparties can't be sure how much exposure they have to AIG and Lehman Bros. All these OTC instruments are traded in a dark and scary place where it's hard to figure out who owns what from whom. Since the company you might be dealing with may have some CDS purchased from AIG, you might be hesitant to lend money to them in case AIG defaults resulting in said company defaulting on your loan. In addition the default risk of bonds have skyrocketed so more defaults are coming. No one knows from where or how to assess the risks. When the markets can't put a number on the amount of risk there is, it sits on its hands. Why oh why wasn't this stuff traded on an exchange with a clearinghouse???

I think part of the problem with financial markets is that transactions are almost costless. That's a problem because it lowers the incentives for people to keep the assets on their books for any length of time. It also diverts capital and talented people into the financial sector when they otherwise would make great mathematicians, physicists or professors.

I think financial transactions should be taxed to reduce that tendency. If it's more costly to buy and sell and day trade, it would make people do more due diligence. Part of the problem with asset bubbles is that people expect the ponzi scheme to go on, but it's less likely if the transactions get stuck in the molasses of government taxation. The taxes can go into a fund that insures systemic risk rising from unfettered asset bubbles. The more bubble-icious the market, the more money there would be to bailout that sector of the economy.