The report of Anton R. Valukas, Examiner, in the bankruptcy case of Lehman Brothers is out, and it provides much food for thought, of which a small portion is consumed here. There is one intriguing paragraph at the outset that raises a question in my mind: How different is the U.S. government from Lehman?
What happened to Lehman? Lehman Brothers made bad and increasingly risky bets and it could not fund them. Management was heavily funding the company with very, very short-term debt, namely repos. They were analogous to a bank's demand deposits in that the lenders could withdraw the financing source at any time. Hence, the moment that lenders lost confidence in the value of Lehman's assets, the company could fail.
Lehman's subprime business soured, which meant the worth of its securitization business fell in value. Lehman's management mistakenly thought that the subprime market would not seriously affect other markets, such as commercial real estate, equity-like investments, and leveraged loans. It shifted from intermediating subprime loans to using its own capital to fund these activities and it increased its leverage. Its risk controls didn't restrain it. It took on too much operating risk and too much financial risk, so that it became too sensitive to any decline in asset value. It overreached. Also, it tried, as it had successfully done in the past, to increase its growth and market share while other competitors were under stress. When these markets in commercial real estate and such also soured, Lehman went downhill rapidly. The decline in value of its assets was so swift and large that it could not find another company to buy it out, which would have been a source of funding to replace the holes being produced by the withdrawal of repo financing.
In the struggle to maintain lender confidence and fund the company, the managers pushed accounting rules and window dressing to the limit and beyond. The Examiner believes that they will be answerable to fraud charges, and so may associated parties such as accountants and government regulators.
Early in the report (p. 16), we run across this statement:
"Lehman failed because it was unable to retain the confidence of its lenders and counterparties and because it did not have sufficient liquidity to meet its current obligations. Lehman was unable to maintain confidence because a series of business decisions had left it with heavy concentrations of illiquid assets with deteriorating values such as residential and commercial real estate. Confidence was further eroded when it became public that attempts to form strategic partnerships to bolster its stability had failed. And confidence plummeted on two consecutive quarters with huge reported losses, $2.8 billion in second quarter 2008 and $3.9 billion in third quarter 2008, without news of any definitive survival plan."
Now, basically, the U.S. government in important ways is a giant Lehman (actually worse managed) and increasingly so, but also with a few important differences.
As Lehman did, the U.S. is reporting gigantic losses. They are called deficits. The cash outflows vastly exceed the cash inflows, so that if we were using cash accounting to measure income, we'd be reporting immense losses for the U.S. government. Of course, many states are in the same condition.
As Lehman did, the government engages in significant window dressing, a.k.a. accounting fraud, in order to understate its liabilities, understate its cash outflows, and overstate its cash inflows.
As Lehman did, the government is increasing its holdings of illiquid assets with deteriorating values. Taking over Fannie and Freddie is one huge example. Its involvements with AIG and GM and banks are others. Its vast spending programs on uneconomic purposes do little to build asset values while constantly increasing liabilities.
Worse than Lehman and as AIG did, the government has written more and more liabilities in the form of guarantees of all sorts, without having the assets to back them up. The U.S. guarantees bank deposits, many loans, medical care, welfare, prescription drugs, old age payments, pensions, and real estate loans. It's only a matter of time before the U.S. either reneges on some of these guarantees or is faced with making good on them. If it makes good on them, the deficits will increase. This will send lender confidence lower. If the U.S. reneges on some guarantees or scales them back, the immediate effect may be to lower confidence, both of lenders and of investors, and this has a negative economic impact. But the longer term effect may be to improve confidence if people think that the government is intent on seriously reducing its liabilities.
The management of the U.S. government is worse than the typical business, being heavily influenced by politics, by lobbies, by special interests, by its access to power, and by the weak control exerted over it by voters.
Unlike Lehman, there is no potential partner or buyer to bail out or merge with the government, to replace its management, and to pull it into shape.
As with Lehman, confidence in the U.S. government is now fading, or there would not be talk about its AAA rating or warnings from trading partners about its securities or warnings from many people, even inside government, about its failing finances.
As with Lehman, there is no "news of any definitive survival plan." There is no known plan to control government spending and lower its liabilities. The opposite is the case. New spending and controls are in the works on health care and energy. Further warfare, such as against Iran, remains a distinct possibility.
As with Lehman, the funding of the U.S. government is largely via short-term means, namely, short-term securities and current cash flows from taxes. Hence, the government is exposed to a potential cash flow squeeze in several ways. If current lenders refuse to renew their loans, that's a problem. If lenders renew their loans but only at higher interest rates, that's a problem too. It will sharply worsen the deficits and possibly create a death spiral. If the economic recovery remains weak, or if further negative shocks occur, then tax revenues will decline. On the other hand, there is a benign scenario in which the economy improves and the improvement in tax revenues offsets increased interest costs. The fact remains that the government is heavily exposed to an economic factor that is the strength or weakness of the overall economy, just as Lehman was exposed to strength or weakness in real estate markets.
Unlike Lehman, the government has two financing tools at its disposal; but upon inspection, they may not work. It can raise taxes, and it can pressure the FED to buy its securities. The government's problem is as ticklish as was Lehman's. It wants to and has to retain confidence in the face of its deteriorating balance sheet and income statement. If it raises taxes, especially tax rates, that will have the net effect of hampering recovery. If the FED is required to support its debt issues, then that will undermine confidence.
Unlike Lehman, the government does not go bankrupt by entering a Chapter 11 procedure directed by a court. The "bankruptcy" event for the government, or what is tantamount to it, is not the same as a business failure. Its form depends on the political and economic situation. What Argentina went through differs from Iceland, and both differ from Russia and Germany. What generally occurs is some sort of currency failure, government inability to issue securities, defaults on obligations such as holding back income tax refunds or delaying Social Security payments, cessation or interruption of government services such as the cutbacks now being seen at the state level, banking failures, and general economic dislocations such as rationing, waiting lines, shortages, price inflation, riots, street demonstrations, emergency measures, martial law, and high unemployment. Governments make up 40-50 percent of the economy, so that if the government starts to or does fail, the impact affects the entire economy. If the government, for example, stopped making Medicare payments, many companies and persons would immediately be affected, causing ripple effects and further bankruptcies. It does not take much thought to see that government default is a very serious event whose consequences we may wish to avoid unless we want to see a political revolution that we believe will improve matters.
The government can improve its financial and operating position by attacking both the asset and liability sides of its balance sheet. On the liability side, it needs to reduce its commitments, liabilities, promises, and guarantees. For example, it can buy time by increasing the Social Security retirement age or by scaling back its security commitments worldwide or by scaling back prescription drug benefits. On the asset side, it needs to reduce its spending. The government is doing the opposite at present and promising more of the same as it tries to borrow and spend the economy into recovery. This is hampering the recovery that the government needs in order to raise its tax revenues.
The severe dislocations that fall upon an economy due to a government default arise when the government's situation becomes unmanageable and/or the government's management of a bad situation is haphazard, poor, ill-chosen, weak, vacillating, and/or badly conceived. The government itself chooses measures that make matters worse, or else fails to choose measures that will alleviate the problems. The results are now being seen in Greece, for example, where choices have to be made immediately; and they have to be the right choices in order to reduce the dislocations felt by ordinary people within the country. If they are the wrong choices, the threatened bankruptcy or threatened default plays out in a worse way.
The U.S. is not there yet, but it is surely getting there. Economists like Lawrence Kotlikoff tell us that the U.S. is already technically bankrupt. The time is getting very short to make the right moves. There is not yet a sense of urgency. People do not yet realize how bad conditions can get when default occurs and/or the government runs out of real resources to meet its commitments and then handles this in inept ways that make it worse, such as by high inflation or controls or expropriations. There is no limit to the set of possible benighted actions that a government can impose as it faces stringent circumstances. This sort of "bankruptcy" is to be feared and avoided.
There is no politically easy way out now that we have reached this stage, and that is the core of the problem. There needs to be a political consensus to do some things that are bound to harm some people now, but that prevent much greater harm to a lot more people later on; and there is no such consensus. For example, fundamental tax reform might alleviate the present situation and spur growth. But there is no visible movement toward it. Or basic entitlement reform might alleviate the situation, but that too is off the table. In fact, the movement is toward even greater entitlements in health care and more centralized control of this important economic sector.
The main differences between the Lehman case and that of the U.S. government are two. The U.S. government case is worse in size and potential effects, and it hasn't happened yet. It does not have to happen, but unless some serious and wise statesmen arise, it can and will.
