Friday, April 17, 2009

GM's Wacky Sales with Partial Recourse

Over the past few weeks, government-controlled auto maker GM has been running a somewhat bizarre commercial on cable television.

A blue-collar line worker smilingly tells the viewer that GM is such a friendly, gentle industrial company that even if the purchaser of a GM vehicle loses his/her job, the firm will forgive a generous amount (I think it is up to $500) of the buyer's monthly payment for, again I believe, six months.

The GM worker extols the company's kinder, softer new image that cares so much for their customers.

To me, the commercial showcases so much of what is wrong with GM. Desperate to sell cars, they are now getting involved with dodgy buyers, assuming recourse on the loans and entangling themselves in the financial instability of others.

This is precisely the sort of nonsense that you get when the federal government meddles in the private sector. If I'm not mistaken, the feds have also become the ultimate guarantor of GM warranties.

How about GM just trying to sell cars straight up, as is, with no special financial incentives? Shouldn't we get a sense of whether anyone actually wants the firm's cars, and at what prices?

Heaven's knows how much more liability the firm is now incurring by promising payment relief to customers who may lose their jobs in the next year or so. It's hardly a model for a near-dead firm to employ in order to stagger back to life.

Thursday, April 16, 2009

Welcome To The US Centrally Planned Economy

Early this month, I wrote this post concerning our government's involvement in GM's crisis, and its increasing role in planning the US economy with its selective bailouts and intrusive actions. I wrote, in part,

"It is simply wrong for our federal government to engage in such massive intervention as to be lending private-sector companies money, in hopes of avoiding their demise.

How can our government possible know, better than the natural forces of our markets, that the best use of, for example, some building in Flint, Michigan, is as a GM plant, rather than the new home of some entrepreneur's business?

Isn't this what the Soviet Union tried, and ultimately found to be inefficient, unworkable and a failure for most of the 20th century?

Who among us truly believes that our federal government is more skilled than consumers and investors in the selection of those business which ought to survive and prosper?

Government isn't the right institution to select our economy's winners and losers. For that, we have a process which we have trusted for most of our country's life- our freely-operating, private capital and consumer markets."

Then, just yesterday, I read the Wall Street Journal's article describing our president's recent economic address. The piece quoted from the speech,

"We must build our house upon a rock. We must lay a new foundation for growth and prosperity- a foundation that will move us from an era of borrow and spend to one where we save and invest; where we consume less at home and send more exports abroad."

I don't know about you, but I find it chilling that a president is decreeing what our economy's allocation will be between consumption and investment, domestic consumption and exports.

As I noted in my prior post, the Soviets tried this from the 1930s until their country failed, economically, in the 1980s. Centrally planning never worked, except in a limited sense during wartime, as was true in the US.

But that was only because government essentially prohibited consumption of capital goods and many foodstuffs, in order to use such items for war production.

It's also ironic that the largest spending bills and increases in our deficit occur under someone who claims to be returning America to a 'save and invest' ethic.

It's preposterous. And our prior president didn't do us any favors, either, both by failing to veto excessive Congressional spending and by engaging in multiple, unnecessary sector bailouts at taxpayer expense.

Among the 'five pillars' of the current president's envisioned new US economy mentioned in the article are: "renewable energy investments to create jobs and lessen the nation's dependence on imported oil."

Again, I am frightened that a government official thinks he can better judge the correct mix of US energy usage, pricing and employment than can the numerous firms which constitute that sector.

America has succeeded for centuries by employing prices as signals to either accelerate or decelerate investment in various sectors, technologies and activities. Why should we now depart from this practice and succumb to government-mandated targets other than prices?

Does any thinking person really believe that civil servants without experience better know how to run our energy sector and plan our energy usage than all of us, consumers and producers, by engaging in normal activities, in light of market price signals?

Wednesday, April 15, 2009

A Brainless Immelt?

GE has been running this green energy technology ad for some time.

Every time I see it, I cannot help thinking of hapless, inept GE CEO singing the lyrics,

"If I only had a brain."

Seems both ironic and fitting for the firm to use such lyrics in its commercial.

Now I'll have this image of King Jeff I as a brainless scarecrow at GE board meetings.

Anyone have a match?

Returning TARP Money: The Case of Goldman & BofA

Back in the fall of 2008, after the Bush administration urged Congress to pass the TARP legislation, then-Secretary of the Treasury Henry Paulson made clear that government investments in preferred equity of weak financial institutions was to be temporary.

Now, in the spring of 2009, we learn that Goldman Sachs and BofA, both wishing to repay the TARP money that the government requested them to take, must have permission from the feds to do so.

How did this come to pass?

Why would there need to be any permission given? If a bank can pay back its TARP funds because it has either made profits or found other investors, that's a good thing.

If, upon repaying the TARP money, a bank is essentially insolvent or has inadequate capital, then the Fed can find it so, and have the FDIC close it.

This afternoon, on Fox News, Judge Andrew Napolitano noted how curious it is that, as BofA CEO Ken Lewis wants to repay that bank's TARP funds, the SEC is suddenly investigating an allegation that Lewis and the BofA board knew of the Merrill Lynch bonus payments and failed to inform shareholders prior to their vote to approve the acquisition.

Napolitano laid out other relevant details, including the Fed's and Treasury's pressure on Lewis to make the acquisition, despite Lewis' reticence, concern over capital adequacy and due diligence.

Now it looks like there will be a full-scale fight between BofA, the SEC, Treasury and the Fed as to who knew what, when.

In the meantime, according to Napolitano, BofA's desire to get rid of the federal government as an investor is being met with the SEC investigation as a form of coercion.

Many have opined that the center of American finance has moved to Washington from New York. Given what is occurring with Goldman and BofA as they reasonably attempt to repay their TARP funds, it's troubling to see that much of what governs the US financial sector has become more political than economic or financial.

Tuesday, April 14, 2009

Sources of Goldman's Profit

The Wall Street Journal lead in this morning's Money & Investing section features yesterday's better-than-expected quarterly profits by Goldman Sachs.

According to the article,

"Driving the earnings was record performance in the fixed-income, currency and commodities division, where the trading of products tied to interest rates and strength in commodities helped generate $6.56 billion in net revenue, a 34% rise from the comparable period last year. Those results offset a downturn in investment banking and money management."

I don't presume to be a CFA, but I can read financial statements, and have fairly extensive experience in the financial and banking sectors.

The activities in which Goldman made most of its money last quarter are essentially trading, not lending in nature. That is, they are somewhat transitory, probably heavily proprietary, and do not reflect the bulk of what is supposed to be the 'new' commercial bank Goldman Sachs.

Yes, even old-line commercial banks make money from trading interest-rate products. But to rely on such businesses for most of their profit is to basically function as a hedge fund and/or brokerage, with some loan businesses bolted on. And it's riskier, in terms of consistent results, than most people realize.

On currently-available balance sheet data, Goldman's debt/market capitalization is roughly $323B/$57B, or 5.7x leverage. Using shares outstanding and equity share price, a rough figure of $51.2B in book equity would boost that leverage ratio to 6.3x.

Comparable ratios for Chase are debt/market cap of 5.4x, debt/equity of 4.7x, implying a market/book ratio of less than one.

So Goldman apparently is no longer leveraged much higher than one of the two remaining, large, comparatively healthy "real" commercial banks.

What puzzles me is how Goldman can be generating lower-risk profits without its prior leverage. I don't happen to know what its leverage ratios were a year ago, but one would think they must have been higher. Yet they clearly are neither taking consumer deposits, nor making garden-variety commercial loans.

Just how is this recent profit sustainable in the manner of a true commercial bank, without excessive leverage or risk?

Credit Spreads As Predictors of Economic Activity

Last Friday's Wall Street Journal contained an article discussing a predictive tool with which I had been previously unacquainted. The focus of the piece was a paper studying spreads between corporate debt and Treasuries. Essentially, higher corporate debt rates, and a widening spread over Treasuries, signals bad economic times. The key portion of the Journal piece was,

"To compensate for that, economists Simon Gilchrist and Vladimir Yankov at Boston University, and Egon Zakrajsek at the Federal Reserve constructed credit spreads over the 1990-2008 period from monthly price data on the corporate debt of about 900 U.S. nonfinancial companies. They divvied up the bonds based on both expected default rates (a more timely measure of quality than ratings) and time to maturity.

In a forthcoming paper in the Journal of Monetary Economics they show that spreads on low- to medium-risk corporate bonds, particularly those with 15 or more years until maturity, predicted changes in the economy phenomenally well, forecasting the ups and downs in both hiring and production a year before they occurred. Since writing the paper, they extended their analysis back to 1973 and found bonds' predictive ability still held.

It would be better for everyone if it doesn't hold in the future. With the massive widening in corporate-bond spreads last fall, the economists' model predicts industrial production will fall another 17% by the end of the year, and the economy will lose another 7.8 million jobs on top of the 5.1 million it has shed since the recession began."

A very revealing chart that accompanied the article was missing from the WSJ online version of the piece.

Never the less, the implications are sobering. This predictive tool, validated back more than 30 years, suggests that unemployment is not even half of the level at which it may peak, as production falls further this year.

Actually, this fits what my partner and I suspect, given the once-in-a-lifetime massive private credit deleveraging which has occurred in the past two years. While almost no government official mentions that deleveraging, or, when they do, suggest that federal replacement of that credit will "fix" everything, we think that the coming economic conditions forecast by this debt spread model seems accurate.

Monday, April 13, 2009

The "Empty Creditor"

Henry Hu, a professor at the University of Texas Law School, wrote a very interesting editorial in the Wall Street Journal on Friday concerning what he terms "empty creditors."

Such creditors, according to Mr. Hu's description,

"Thus the "empty creditor": someone (or institution) who may have the contractual control but, by simultaneously holding credit default swaps, little or no economic exposure if the debt goes bad. Indeed, if a creditor holds enough credit default swaps, he may simultaneously have control rights and incentives to cause the debtor firm's value to fall. And if bankruptcy occurs, the empty creditor may undermine proper reorganization, especially if his interests (or non-interests) are not fully disclosed to the bankruptcy court."

It's the sort of convoluted situation that the writers of our bankruptcy laws never imagined.

In the case of AIG and Goldman, which Mr. Hu uses to illustrate his point, the latter avoided a $7B loss, rather than, say, made an actual gain. But, as I observed to my business partner, on a relative basis, that's still a $7B gain over their original, unhedged position.

Imagine if a firm went further, and bought protective swaps beyond the value of their exposure, thus giving them a bona fide incentive for their counterparty's dissolution.

Mr. Hu's point is that there should be some acknowledgement of this problem, and some sort of safeguard to avoid allowing a counterparty to undermine legitimate bankruptcy proceedings.

Hu's own suggestions are rather lame- a "real-time informational clearinghouse for credit default swaps...." Highly unlikely. Those firms trading in this market are not interested in divulging their positions.

What would make more sense would be a modification of bankruptcy law such that any creditor found to be an "empty creditor," per Mr. Hu's description, would be removed from the pool of truly at-risk creditors, so that their lack of consent to a bankruptcy plan would not hinder its acceptance.

It seems to be a genuine problem, with the current concentration in commercial banking. Actions by a counterparty to a weak bank can trigger a rise in value of the credit default swaps of that bank, thus giving the counterparty a an interest in the bank's failure. This is probably not behavior which we, as a society, wish to reward.