Lieutenant Island Views : Commentary About Finance, Politics and Baseball

Assessing Krugman’s Take on Toxic Asset Plan

March 23, 2009

Regardless whether one agrees or disagrees with Paul Krugman’s op ed in today’s New York Times, it is hard to disagree with his agrgument that the the plan is largely a subsidization of banks and/or a low risk option for investors. What he fails to point out is that, because of his points, that it is a huge subsidy, banks ought to rush to sell as much as they can of their toxic paper. Without the low interest rate, non-recourse government loan (means that the government can’t go after the new investors for any more than the underlying assets), the assets would almost certainly sell at lower price levels. Krugman argues that this is a failure to recognize the loss. He probably is correct but such recognition won’t get capital flowing or move the process forward. This government/private investor investment is effectively another capital injection into the banks. What Krugman also fails to note is that the subsidy should help facilitate trading in the aftermarket for these assets, if for no other reasons than the fact that there will be an auction to determine value. If nothing else, and maybe only for today, the market seems to like the plan. This evidenced by a huge rally led by the financial sector. I am sure that even Prof Krugman agrees that it is hard to ‘fight the tape”.”>

Brazil Should Count on Meirelles not Washington

March 23, 2009
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Mary Anastasia O’Grady has an excellent and insightful piece on Brazil’s ongoing success in the current market turmoil. She also points to the irony of a Socialist President calling for more free trade and the possible “United States risk” in Brazil’s economic future. In particular, she notes issues with Citibank financing trade and a declining dollar as impediments to Brazil’s continued success. The one major item that she missed was that the secret key to Brazil’s success has been the vigilence and fortitude of their Central Bank President, Henrique Meirelles. In the face of cries to lower interest rates and a more “American” like monetary policy, he has persevered in the best interests of his country. He deserves much of the credit for Brazil’s success. Lula also deserves great credit for not succumbing to calls from the left and the right to ease up on Meirelles economic vigilence. They both deserve kudos for a continuing job well done!

From Whence Cometh Our Financial Mess?

March 22, 2009
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Beneficiaries of a Jesuit education learn early that logic and careful analysis are predicates to better judgments and conclusions. Jesuit pedagogues would also suggest that careful analysis and judgments are also necessary for appropriate corrective actions in addressing major problems. When it comes to our current national and global financial mess, blaming the usual suspects (George Bush, greedy CEOs, Wall Street, high executive compensation et al) or pandering to mass frustration may be cathartic but can never be confused with analysis or be a basis for corrective action.

In the coming days, we hope to address the nature of many of the issues that we believe contributed to our current economic troubles. We will endeavor to do so in a clear, simple and concise manner. Please do not be offended if we do not cover each issue in the first or second post. We believe that the issues fed on one another and are best examined seriatim rather than in one fell swoop.

What then were some of the most significant issues?

• The Growth of Leverage, Particularly in the Last Five Years
• Credit Default Insurance
• Mark to Market Rules
• CDOs (Collateralized Debt Obligations) and CLOs (Collateralized Loan Obligations)
• Failure to Guarantee Fannie and Freddie Preferred Shares
• Letting Lehman Fail
• Delayed and Insufficient Action on AIG
• Treasury “Crying Fire in a Burning Building” to Pass TARP
• TARP Mismanagement

From these issues flowed incremental and very significant problems and issues including:

• Bank Failures and Capital Inadequacy in the Financial Sector
• AIG Insolvency
• Sub-prime Surge and Failings
• Mortgage Foreclosures
• Stock Market Meltdown
• Post-TARP AIG Compensation Levels

In the coming days we will deal with each issue and seek to expand our discussion by building on each issue and reflecting on subsequent problems that flowed from them. Stay tuned!!

(Note: While the author has long admired the discipline, training and learned nature of the Jesuit Order, he is neither a Roman Catholic nor the beneficiary of a Jesuit education.)

Wall Street Compensation Legislation; A Pyrrhic Victory

March 20, 2009

Members of congress recently passed a bill which will tax all individuals working for institutions which received over $5billion of TARP (Troubled Asset Relief Program) funds at a rate of 90% of all income earned over $250,000. Rather than basking in the glory of their decisive and punitive action, perhaps members of Congress should go back to their Plutarch and Roman history to learn about Pyrrhic victories. The tale of King Pyrrhus of Epirus, whose army suffered irreplaceable casualties in defeating the Romans during the Pyrrhic War, has lessons applicable today. Plutarch reported the King to have said after his final victory that “one more such victory would utterly undo him”.

Congress had a victory which could utterly undo the recovery progress that has been made to date and certainly result in a number of unintended negative consequences. As I say this, in no way am I apologizing for the bad judgment, avarice or possible malfeasance by bonus recipients at AIG. It is disgusting on its face. That said, the solution being proffered gives America a Pyrrhic victory. The reason is that it goes way beyond AIG. To punish some 400 people, Congress chooses to take action that has innumerable negative consequences:

1) It discourages future investment by private investors in a public/private TALF (Term Asset-Backed Securitization Loan Facility) program to restart asset securitizations-logical concerns arise as to potential government intervention in compensation and the general investment decision making of such private investors

2) It raises significant issues as to the sanctity of contracts and whether the government could unilaterally force the breaching of contracts with institutions in which it has made TARP investments-If you can’t rely on a written contract, what can you rely on?

3) It will likely lead TARP recipient banks to take actions to rapidly repay their TARP investments. While this may sound good, they will likely do it by decreasing lending to generate requisite capital for TARP repayment-Is this a time we want to take action which discourages lending?

4) We have seen the adverse consequences of inadequate regulation and supervision of highly motivated and intelligent players on Wall Street. That said, the problems really were generated by a small minority of the participants on Wall Street. The majority were honest hard working people who have suffered significantly in terms of job loss and investment in their companies’ equity (the currency which very many were paid with significant liquidity restrictions). Do we really think that they will want to stay working on Wall Street or that we will continue to attract top minds to an industry where top performers make substantially less compensation than do the lawyers, accountants or mid level executives at businesses across the nation with whom they work? It would be a mistake to think that top people have no alternatives. Foreign institutions are already seizing on the opportunity to strip American firms of top performers (BofA/Merrill is now suing Deutsche Bank for just such an action). Other savvy Wall Street veterans with significant experience in prior downturns are simply retiring or turning to other more remunerative and/or less stressful pursuits.

5) The real bad guys already have made their money. The rogue traders and irresponsible CEOs making $30-50million per year over the last ten years are crying all the way to the offshore bank. To punish the AIG 400 the way that Congress desires, we also have to punish those tens of thousands who we expect to remain at their posts to clean up the mess. Who among us really believes that spanking the innocent for the misdeeds of others is an effective motivational tool??

How did it ever get to this place to begin with? The answer to that lies with Hank Paulson’s ill conceived three page TARP plan to give money to desperate institutions with no pre-conditions. While not quite the moral equivalent of giving an alcoholic another drink, it is not a completely inappropriate analogy. In the United Kingdom, Gordon Brown clearly saw the need to stipulate significant preconditions to the granting of bailout funds. Tim Geithner’s comments that he did not know about bonuses etc reminds one of Inspector Reynaud’s comment in the movie Casablanca as he closed down Rick’s Cafe for gambling (after accepting his winnings). The time for assertive action was then. For Geithner to not have thought about compensation and contracts is naive. He was and is an experienced hand at dealing with Wall Street. He is neither naive nor stupid. Moreover, he had the example of Gordon Brown to follow (repugnant as it may be for an American financial titan to follow the example of an over educated son of a Scottish preacher). The sad reality is that he either was unduly influenced by Paulson, opted to not fight with Paulson for fear of adversely influencing markets or lacked the fortitude to do what had to be done at the time. As a result, and to paraphrase Julius Caesar, another ancient Roman, “the die was cast”.

What then should be done about AIG? Initially, each bonus recipient should be both “jawboned” and told that they will be publicly identified with all of the attendant ridicule. While many may not mind, there is tangible evidence that a number do care and are stepping forward to return their bonuses. All who do not voluntarily return the bonus money should be subjected to investigation to determine if their deportment was appropriate to warrant receipt of such a bonus. If found lacking, litigation should be undertaken. Finally, the government should seek the agreement of all other TARP recipient institutions to refrain from hiring or doing business with such individuals and/or institutions which hire any of the AIG 400. This de-facto “Black List” would serve as a powerful signal as to the government’s intention to avoid doing business with people who are not “on board with the program”. It will similarly provide a material disincentive for TARP and non-TARP recipients from hiring any of the AIG 400. Because TARP recipient firms firms like JP Morgan, Citibank, Morgan Stanley et al touch so many players in finance, this is a draconian threat to the future employment prospects of anyone who does not “play ball”.

The government needs to make it clear that it will take appropriate action on the AIG bonuses and not tolerate the AIG bonus situation from occurring again. It is equally important that it must not allow a mob mentality to impair its judgment in a manner that results in a Pyrrhic victory of expediency and unintended consequences over the desired administration of serious punishment for non-compliance with the people’s wishes.

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About author

Mr Thaler is currently the Managing Partner of Lieutenant Island Partners, an organization providing corporate finance advice and general consulting to corporations and not-for-profit organizations. Mr Thaler retired as Vice Chairman of Deutsche Bank Securities in early 2008. His background includes experience as an investment banker, senior manager, business builder, college professor, not for profit board chair and trustee. In his thirty plus years as an investment banker for Deutsche Bank and Lehman Brothers, he has been involved in numerous significant debt and equity financings, mergers & acquisitions, leverage buyouts, restructurings and cross border transactions. Of particular note, Mr Thaler has been one of the most active participants and strategic advisors to the homebuilding industry. In a period of significant turmoil and losses, he was one of the few active bankers to the industry who did not have either a loss or credit write down. He is currently advising several public builders on strategic matters and is an adjunct professor of finance at Morehouse College in Atlanta, Georgia. Though he lives in New York, he is a life long Red Sox fan!