The purpose of Outside the Box is to present views which cause us to think through our basic assumptions. This week our old friend Michael Lewitt of Hegemony Capital Management gives us a view as to why the bailout bill going down may not be as bad as I think it might. There is much we agree on, however. And part of our agreement is that a deeper recession is in our future. Let me be clear. Muddle Through is now at risk.
I have talked with my publisher, and for the next few weeks of The continuing Crisis, we are going to send more than one OTB per week, and I may also add some short commentary. These are extraordinary times, and I know a lot of you (as I can tell from phone and emails) are worried and are interested in analysis that is not biased with either a perma-bull or perma-bear stance. I will call it as I see it, as always, and forward you material from my best sources.
That being said, we will get through this, one way or another. Sanity and clarity will return, as it always does after times of crisis. I wish you the best in your situation.
John Mauldin, Editor
Outside the Box
Haste Makes Waste
By Michael Lewitt
"Examining the record of past research from the vantage of contemporary historiography, the historian of science may be tempted to exclaim that when paradigms change, the world itself changes with them. Led by a new paradigm, scientists adopt new instruments and look in new places. Even more important, during revolutions scientists see new and different things when looking with familiar instruments in places they have looked before. It is rather as if the professional community had been suddenly transported to another planet where familiar objects are seen in a different light and are joined by unfamiliar ones as well. Of course, nothing of quite that sort does occur: there is no geographical transplantation; outside the laboratory everyday affairs usually continue as before. Nevertheless, paradigm changes do cause scientists to see the world of their research-engagement differently. In so far as their only recourse to that world is through what they see and do, we may want to say that after a revolution scientists are responding to a different world."
Thomas S. Kuhn1
The problem with trying to legislate in the middle of a revolution is that you aren't sure whether you are governing the world that is being destroyed or the one that is coming into being. There can be little question that the Wall Street that existed at the beginning of this year is no longer the industry that Congress is seeking to rescue from its own excesses. The financial world has been permanently altered by the collapse of the debt bubble that inexorably built up over the past three decades. Now Congress is trying to design a rescue plan for a world whose shape is highly contingent and unstable. Such an undertaking requires more than two weeks of work. Conventional thinking tells us that the government must do something to stabilize the markets immediately, and that doing something is better than doing nothing. Once again, conventional thinking is wrong. Congress would be much better advised to take the extra few days or week it would take to structure a plan that the world is going to have to live with for a very long time. As we were completing this newsletter, the House of Representatives voted down the emergency package and the financial markets are panicking. Such panic is unwarranted. The world should take a deep breath and consider whether defeat of a deeply flawed bill should be treated as a catastrophe or a rallying cry to develop a better plan that addressed the underlying issues that need to be fixed.
The Paulson Plan
HCM has been warning for years that all of the king's horses and all of the king's men wouldn't be able to put this mess back together again. It is now time for America to take the pain and figure out how to move forward. Any plan that is adopted must include a sufficient dose of strong medicine to prevent the culture of self-delusion and moral hazard that created the current crisis from further perpetuating itself. The purpose of the Paulson Plan has to be to rebuild confidence in the financial system. The manner in which the plan was presented and debated rendered that more difficult but hopefully not impossible. For any plan that fails to bring confidence back to the market will not work.
The great economic historian Charles Kindleberger wrote in his seminal study of financial crises, Manias, Panics, and Crashes, that, "[f]or historians each event is unique. Economics, however, maintains that forces in society and nature behave in repetitive ways. History is particular; economics is general."2 This is a very important observation. While each financial crisis is unique in terms of its causes and the types of assets that it engulfs, the conditions that led to it are always driven by human irrationality and hubris. Financial busts are preceded by financial bubbles. The current bust was preceded by a debt bubble whose unique manifestations were debt securitization and credit derivatives. Underlying these novel debt structures were the human emotions of greed and fear that led to abuses by even the most sophisticated individuals and most highly respected institutions in the market. While these human attributes are the most difficult to legislate, their ability to wreak havoc is clear evidence that they must be regulated in a thoughtful way.
Recently, former New York Federal Reserve Governor Gerald Corrigan led a group of market experts that released a report entitled Containing Market Risk: The Road to Reform, The Report of CRMPG III (Corrigan III) (August 6, 2008). In that report, Mr. Corrigan and his colleagues wrote the following very wise words:
"The fact that financial excesses fundamentally grow out of human behavior is a sobering reality especially in an environment of intense competition between large integrated financial intermediaries which, on the upside of the cycle, fosters risk taking and on the downside, fosters risk aversion. It is this sobering reality that has, for centuries, given rise to universal recognition that finance and financial institutions must be subject to a higher degree of official oversight and regulation than is deemed necessary for virtually all other forms of commercial enterprise."
What is lacking from the public debate is a serious understanding of the difference between treating the symptoms of the crisis and trying to cure the disease. The disease is a total loss of confidence in the American model of debt-engorged free enterprise, and American economic and political leadership. The cure is regaining that confidence.
In his new book, economic consultant David M. Smick writes,
"the survival of the world financial system depends on an elaborate confidence game. The size of the financial markets, relative to the governments, has become so monstrously huge there is no other means of maintaining stability than to establish a psychology of confidence. The governments themselves cannot by edict restore order. They can only project to the markets a sense that they know what they're doing."3
What Henry Paulson and Ben Bernanke are desperately trying to explain to Congress is that America's leadership must immediately restore the world's confidence in American economic and political leadership. But the Paulson Plan was generated under impossible conditions. Were it to succeed, the best that could be expected at this point is a slow revival of the credit system. To hope for more is sheer folly. It is a certainty that America, and then the rest of the world behind it, is going to experience a severe recession the likes of which it hasn't seen for decades. Frankly, HCM can't see any way that such a slowdown can be avoided, although HCM has some ideas on how to begin to work out of it. Moreover, if by some miracle it were to be avoided, it would merely delay the inevitable purging of the psychological and financial excesses that have been piling up in our economic system over the past thirty years. One of the problems plaguing America is that we have become so frightened of short-term pain that we are willing to risk incalculable long-term suffering. Any plan that treats the symptom (the loss of confidence) and not the disease (the underlying problems that caused the loss of confidence) will not solve the real problem.
At one point during the bailout negotiations, Henry Paulson was seen genuflecting at the feet of House Speaker Nancy Pelosi, a fitting emblem of just how far the credibility of the Bush Administration has fallen.4 Earlier policy blunders are now haunting a lame-duck Administration. The Paulson Plan is being pushed with the same kind of urgency that pushed the U.S. to invade Iraq, and the President has no more weapons of mass destruction to sell. There are legitimate fears that anything approaching the Paulson Plan, like the Iraq War, will get quickly bogged down in the complexities and contingencies that will be encountered on the battlefield. Despite the cries of pain from the credit markets, HCM has never believed that the world would spin off its axis if a deal is not rushed to completion in the next few days. A bad deal would be worse than no deal at all.
There is one practical problem that will plague the Paulson Plan and any plan that involves the government purchasing distressed assets from financial institutions. These assets are NOT(!!!) accurately valued on the books of financial institutions.5 Accordingly, these institutions are not in a position to sell them to the government at current fair market value. Any sales at current market value would inflict huge losses on these institutions. The alternative is for the government to grossly overpay for these assets, which would constitute a disguised capital infusion into these firms that would short-change the American taxpayer. This flaw in the plan is why members of Congress from both sides of the aisle insisted on some kind of profit-sharing structure that would compensate taxpayers in the event the government pays above-market prices for assets. HCM fears that very little of the $700 billion is going to be spent in the near future because of the reluctance of banks to part with assets at anywhere near their current value, and the government's reluctance to overpay for these assets.
HCM views the Paulson Plan as a matter of form over substance. The details of how the plan will work are ultimately less important than whether the plan succeeds in rebuilding market confidence. In order to be successful, the Paulson Plan needs to be followed up by comprehensive regulatory reform that accomplishes the goals of convincing the public that the financial system will be fairer in the future than it has been in the past (i.e. that the gains will be spread more equitably and that failure will not be rewarded) and that strong steps will be taken to prevent the oversights that led to the current instability from being repeated.
An Alternative Bailout Plan
A successful plan must address the following elements:
- Confidence: It must restore market confidence by convincing both Wall Street and Main Street that the government will stand behind the mortgage obligations that are the weakest part of the financial system.
- Time: It must provide time for financial institutions to earn profits that can be used to absorb future losses on bad mortgage paper. The primary way financial institutions make money is by borrowing money at one rate and lending it out at a higher rate. The cost of money for financial institutions must be lowered immediately.
- Prevention: It must convince both the American people and the global community that the regulatory lapses that allowed this disaster to occur will not happen again, and that the system will be fairer in the future. This is closely tied to the issue of restoring confidence in the markets as well as in American economic and political leadership.
The government's plan must restore market confidence, give companies the time to heal their balance sheets, and prevent a recurrence of the most abject series of regulatory lapses in the history of Western financial markets. For the sake of contributing to the public debate, which will continue even after the initial plan is adopted by Congress, HCM suggests that the government move ahead with the following measures in an effort to restore order and stability to the global credit and financial markets:
The HCM Bailout Plan
- The government should announce that it will effectively stand behind the U.S. financial system against failure through some sort of guarantee or insurance program. The government has already done this with respect to money market assets.
- Mark-to-market accounting for financial institutions should be suspended for an indefinite period. Since nobody knows what these assets are worth, we should not drive the system into insolvency trying to place a value on assets that nobody is willing to purchase at the current time.
- The Federal Reserve should reduce the overnight interest rate by 75 basis points immediately. This will allow financial institutions to begin to earn more on their assets, which will begin the process of rebuilding their balance sheets.
- The Securities and Exchange Commission should announce the formation of a study group that will report back no later than December 31, 2008 on a comprehensive regime for regulating the credit default swap market.
As noted above, HCM is concerned that the plan to purchase mortgage assets from financial institutions will not produce the intended results because of the difficulty of reaching agreement on price without inflicting too much further damage on the sellers' balance sheets. That is why we favor a guarantee or insurance program rather than the Paulson proposal.
Will The Paulson Plan Work?
The American taxpayer is going to suffer economically whether the Paulson Plan, or some variation on it, is passed or not. HCM does not believe for a second that taxpayers will profit from this bailout as some prominent commentators are arguing. The assets that are clogging bank balance sheets are highly complex and illiquid, and the time required for them to return to any reasonable value will consume their recovery value in present value terms. Nonetheless, voices considered wiser than ours are touting the plan as a good deal for the American taxpayer.
Bill Gross of PIMCO, for example, has argued that taxpayers could profit from the $700 billion plan put forth by the Bush Administration. According to Barron's, Mr. Gross "estimates that the average price of distressed mortgage debt that will pass from troubled financial institutions to Treasury will be about 65 cents on the dollar, representing about a one third loss for the seller from face amount. Financed at 3% to 4% by the sale of Treasury debt, Treasury will be in a position to earn a positive carry, or yield spread, of at least 7% to 8% on the purchases, even after taking into account severe assumptions of default rates and foreclosure recoveries."6 Mr. Gross to his great credit has offered PIMCO's services to the government gratis in this endeavor (provided his competitors do the same). In PIMCO's hands, he argues, the government will get a fair deal for the assets it buys. "'The prices that Treasury will get will be somewhere between par, which of course might screw the taxpayer, and a fire sale price of, say, 20 cents on the dollar, which would likely bankrupt some weak institutions and defeat the purpose of the bailout.'"
We think Mr. Gross is unduly optimistic from a couple of standpoints. First, he appears to be assuming that virtually all of the assets that the government will be purchasing will be AAA-rated mortgage securities, since these are the only mortgage securities trading remotely close to 65 cents on the dollar today. Unfortunately, many of the securities that are weighing down the balance sheets of financial institutions carry lower ratings, and many AAA-rated tranches are trading at well below 65 cents on the dollar today. (We would note that the Federal Reserve had already agreed to take onto its balance sheet much lower rated collateral, including equities, in order to support these same financial institutions.) Current trading prices may be unduly depressed by speculative shorting of the ABX indices as well as crisis conditions in the marketplace, but by all accounts AAA-rated tranches of 2006 and 2007 vintage collateralized mortgage obligations are deeply distressed due to inordinately high levels of defaults in the underlying pools of mortgages. While current prices may reflect unrealistically pessimistic projections of future mortgage defaults, the fact remains today's prices are today's prices. If the government pays more for these securities, it will be giving the seller a windfall. Mr. Gross's scenario glosses over this dilemma, which lies at the heart of why the Paulson Plan is unlikely to yield rapid progress in moving troubled assets off bank balance sheets.
Second, we have yet to see the non-financial economy bear the full brunt of the collapse of the financial economy. Main Street is only starting to pay for the sins of Wall Street. The stock market remains in deep denial about the scope and depth of the economic slowdown this country is about to face. As the consequences of tighter credit seep into the mainstream of the American economy, there is every reason to expect that mortgage default rates will rise and home prices will continue to fall, further depressing the value of the mortgage securities that the government is supposed to be purchasing under the Paulson Plan. We wish we could share Mr. Gross's optimism, but we question whether deep in his heart he isn't trying to use his bully pulpit to talk up the market.
One of the tough questions that deserve to be asked in the wake of the U.S. government's bailout of the U.S. finance industry is whether American prosperity of the 1990s and 2000s was as illusory as Japanese prosperity of the 1980s? Just as Japan's prosperity was based on a rigged economic system constructed out of a cheap currency, cross-ownership of institutions and a nonmark-to-market accounting system, America's recent prosperity was also built on a cheap dollar, a non-mark-to-market accounting system, and an addiction to debt. While this comparison can be debated endlessly, and will likely be the subject of many scholarly articles and books, the real question is whether the United States will suffer anything like the "lost decade" that haunted Japan (actually, it has been almost two "lost decades"). There are significant differences between Japan and the United States (the most troubling, perhaps, being that Americans do not possess nearly the savings that the Japanese did entering their difficulties), but the question will gain more attention in the coming months.
While it is too soon to make any judgments that far into the future, America is certain to see very slow economic growth in the immediate future. The world's only superpower may see its first trillion dollar deficit within the next couple of years, although Washington will try to dress up the number to keep it under thirteen figures (an unlucky number in too many ways to count). That alone should be sufficient to knock down American hegemony a further peg or two. Such a deficit will contribute to a further debasement of the U.S. dollar against Asian currencies and the Swiss franc.
The primary reason why economic growth is going to be sluggish is that credit is going to be strictly rationed for the foreseeable future, which means that only the most creditworthy borrowers will be able to access capital at a reasonable cost. Companies that need capital will be the ones that find capital most difficult and expensive to access. This means that many companies will have to pay exorbitant rates to borrow, and many highly leveraged companies that have to borrow will be forced into bankruptcy or capital restructurings in order to do so. Many leveraged companies are already drawing down their revolving credit lines before their banks withdraw them. General Motors was the most prominent company to have done this recently, but HCM is seeing this occur throughout the corporate credit market.
One of the most discouraging parts of the debate over the Paulson Plan was the discussion about limiting executive compensation for those firms that might benefit from the plan. While trying to help rebuild confidence in American capitalism, Mssrs. Paulson and Bernanke tried to convince Congress that bank executives would prevent their institutions from participating in the bailout if it meant that their compensation would be capped. One would think, as the financial system teeters on the brink of collapse, that the Secretary of the Treasury and the Chairman of the Federal Reserve could make a more persuasive argument than one that poses the likelihood that corporate executives would knowingly violate their fiduciary duty and refuse to participate in a plan to rescue the financial system because it might limit their compensation. If troubled financial institutions are going to be run by individuals who would conduct themselves in such a manner, there isn't much hope that any plan is going to work. The mentality that led two of our best and brightest public officials to attempt to defend the kind of avaricious conduct that played a central role in the current crisis is something that must be changed if we are to avoid future market crises.7
This brings HCM to two related areas that need to be legislated immediately: financial institution leverage; and the taxation of highly compensated financial executives. There is a point when free enterprise tips over into a degree of economic and social inequality that is politically unacceptable, and the United States has reached that point. HCM is well aware that its views on this topic genuinely anger many of its readers, but this is an issue that must be addressed as an essential component of any program that will return confidence to the financial system. Free market economic policies, in particular tax policies, have led to the creation of an American oligarchy whose wealth and power is excessive. While not as pernicious as the oligarchy that rose from the ruins of the Soviet Union and now lords over Russia and spends its money garishly over the world, an American oligarchy has unduly benefitted from ill-advised tax and economic policies and must be reigned in as a sign to Main Street that the game will no longer be rigged against it.
We do not believe it is presumptuous to state that the debate over whether Wall Street firms were too leveraged is over. The decision by Goldman Sachs and Morgan Stanley has decidedly ended the leveraged investment banking model that brought down Bear Stearns, Lehman Brothers and Merrill Lynch. The profits that Wall Street generated over the past few years were not the result of some new-found genius in the executive suites, but were merely the product of adding unprecedented amounts of leverage to balance sheets. Unfortunately, compensation schemes did not take into account the fact that adding leverage is far different than adding value (i.e. compensation schemes were not properly risk-adjusted). As a result, compensation structures for these executives were largely asymmetrical, particularly with respect to the portion of their pay that was distributed in cash. Multimillion dollar cash payments for profits earned in a single year were not subject to being repaid if losses in later years wiped out those earlier profits. Too much cash exited these firms each year in the form of compensation, significantly weakening their capital bases. Fortunately, a significant amount of compensation was also paid in stock, which did not weaken these firms' balance sheets but still failed to instill sufficient caution in management when it came to assuming balance sheet risk.
In addition to the gargantuan amounts of compensation being paid out, the taxes paid on these amounts continued to drop over recent years. This is a result not only of reduced taxes on capital gains and dividends, which are only good economic policy up to a point, but on tax deferral schemes and other aggressive tax stances taken by corporate, private equity and hedge fund executives to reduce their taxes to unconscionably low levels.8 Private equity managers, for example, are able to treat their "carried interests" as capital gains and pay taxes at only a 15% rate. Yet these earnings are no less the product of their labor than a teacher's or a policeman's earnings are a result of his or hers. Last year, several private equity billionaires actually had the gall to lobby on Capitol Hill to retain the 15 percent tax rate on their "carried earnings." These individuals argued that if their taxes were raised, they would no longer be willing to take the kinds of business risks that lead to new job formation and economic growth. Attempts to require these over-indulged [fill in the blank]9 to pay the same taxes on their income as ordinary Americans were derailed in what must go down as one of the most cynical lobbying efforts in history. It would be one thing if private equity firms were funding innovation and job creation, but in the last few years they have done little more than use cheap financing to engage in speculative transactions that generate fees for themselves and what are going to turn out to be at best mediocre returns for their investors.
Hedge fund managers play their own games. The most popular tax reduction technique among this crowd is the formation of offshore trusts that enable them to defer their management and performance fees for periods as long as ten years. A ten year deferral of taxes reduces the effective tax rate paid on these managers' already huge earnings to virtually zero on a present value basis while they continue to enjoy the ability to profit from investments in America's (once) free markets. This tax deferral scheme, which comes in a number of variations, further separates the interests of those hedge fund investors who are paying taxes on their income from those of managers who are not. (Of course, investors don't mind as long as they are making money. Investors never mind as long as they are making money. That's the problem.) As one memorable television commercial put it, "it's not what you earn, it's what you keep." And hedge fund managers have figured out how to keep virtually everything for themselves. Now that the bloom has come off the rose for many hedge fund strategies, investors are going to discover just how one-sided was the deal they made with their managers. Redemption requests from hedge funds are expected to reach epic levels this year, yet many investors are going to be greeted with the unhappy news that they can't get their money back right now (or anytime soon) because it is stuck in illiquid, hard-to-value investments. Others will be told that it would be unwise for their funds to liquidate positions to meet redemptions in the middle of a financial crisis, failing to be informed of the likelihood that many of these securities will most likely be worth less in the future.
Fairly taxing the upper 1/10 of 1 percent isn't going to plug the gaping U.S. budget deficit, but it will go a long way to returning a sense of fairness to a system that has lost its moral compass.
1 Thomas S. Kuhn, The Structure of Scientific Revolutions (Chicago: University of Chicago Press, 1962), p. 111.
2 Charles Kindleberger, Manias, Panics and Crashes A History of Financial Crises (New York: Basic Books, 1989), p. 16. This book should be required reading in Congress.
3 David M. Smick, The World Is Curved (New York: Penguin Group (USA) Inc., 2008), p. 23. Not that we need more things to worry about, but Mr. Smick also makes a compelling case for why we should be concerned about China's future economic stability in the near future.
4 According to The New York Times, September 26, 2008 ("Day of Chaos Grips Washington; Fate of Bailout Plan Unresolved", p. A1)"[i]n the Roosevelt Room after the session, the Treasury secretary, Henry M. Paulsen, Jr., literally bent on one knee as he pleaded with Nancy Pelosi, the House speaker, not to withdraw her party's support for the package over what Ms. Pelosi derided as a Republican betrayal." Nothing else has worked, so why not try this?
5 Although in fairness all the blame for this can't be placed on these institutions. There is currently no market for many of these assets and placing a value on them would be an arbitrary exercise. This is why mark-to-market accounting should be suspended for an indefinite period of time.
6 Barron's, September 29, 2008, "Making A Mint," p. 30.
7 There were unconfirmed media reports late last week that certain Wall Street firms were marketing products to hedge funds that were designed to avoid the restrictions on short selling that were imposed by the Securities and Exchange Commission. Whatever one thinks of the short-selling restrictions, which were far from optimal, the prospect of financial institutions trying to circumvent them suggests that even the biggest financial crisis since the Depression has been insufficient to instill good judgment into some of those in positions of responsibility on Wall Street. Anti-fraud rules are designed, among other things, to prevent individuals from doing indirectly what they can't do directly. Gaming the short-selling restrictions would be a perfect opportunity to teach somebody a lesson that there are things more important in this life than making money.
8 It would not seem unreasonable, particularly during a period when the government is going to be starved for revenue, to impose a higher capital gains tax of 20% or 25% at significantly higher levels of gain, so that a taxpayer would pay 15% on the first $1 or $2 million of gain and the higher rate on gains over that amount. In general, however, lower capital gains rates stimulate economic growth and should be maintained. Dividend tax rates should be maintained at very low levels since these earnings are already taxed once at the corporate level.
9 HCM always likes to identify cultural images that capture the spirit of the times. There is currently an exhibition of modern sculpture called "Beyond the Limits" being held in the gardens of Chatsworth House, home to the Duke and Duchess of Devonshire, in England. One of the works on display is entitled "Planet" by Marc Quinn; it is a giant white sculpture of a baby lying/floating on its side. "Planet," which belongs more to the category of stunt or spectacle than art, seems to be a perfect emblem of these private equity chieftains groveling for tax relief from our elected officials (although the baby is not sucking its thumb). To view "Planet" on-line, see www.chatsworth.org.