Tipping Points Revisited

This edited repeat – okay enhanced too – is dedicated to Mark who asked the question, “How did we really get here?” Maybe he heard Joe Perella, the legendary investment banker, ask a similar question to an insurance conference on November 18, “The question of the day remains where is the bottom?” It was after the markets crashed on November 20, 2008 and after the big three automakers, each CEO flying into Washington, D.C. on a separate corporate jet, begged Congress for a bailout. What did happen?

When worlds collide and markets fall, there are always “tipping points,” forks in the road when a wrong decision takes you down the wrong road. Some believe it started in 1978 with Jimmy Carter’s Community Reinvestment Act aimed in part at making housing more affordable to lower income buyers… Fannie Mae and Freddie Mac followed, implemented this philosophy and were spun off as private institutions by the government. But too much time passed to make those events the likely culprits. What exactly was the chronology of our failures? My list?

1999 – Congress partially repealed the Glass-Steagall Act (a 1933 statute that created the Federal Deposit Insurance Corporation (FDIC) and created clear restrictions on where and how banks could do business). In effect, this partial repeal enabled investment banks and stock brokers to merge or be created and operated by commercial banks (and vice versa). The problem? Now investment banks and traders had the ability to borrow money from the Federal Reserve at the discount rate – cheap borrowed money was placed into the hands of folks who loved to invest and play in the markets.

2000-2004 – The derivatives market – securities whose value is measured by the performance of “other” instruments (could be mortgages, default risks, etc.) – developed with fierce resistance from Congress and the administration to regulation. Looks a lot like Vegas to me… only the odds aren’t as good. But it is a mega-trillion dollar market today, dwarfing our national debt.

2004 – On April 28, the U.S. Securities and Exchange Commission exempted the largest financial institutions (only those worth more than $5 billion) from the 12 to 1 ceiling on the ratio of debt to equity. This allowed big bad financial players, like Bear Stearns and Lehman Brothers, to leverage themselves (borrow with little “down”), some going up to 32 or 33 to 1! This enabled these players to demand and absorb the high-yield flimsy derivatives (subprime mortgage-backed securities, credit default swaps, etc.) that can only work in markets with stellar growth and cheap money. This demand allowed (actually encouraged) local banks and thrifts to lower their lending standards to satisfy the new demand for mortgage paper, almost at any price. Teaser rate mortgages redefined “stupid,” and P.T. Barnum was proven yet again right.

2004-2006 –Home prices skyrocketed; (because of all the new buyers flooding the market after loan qualifications were lowered) as these “teaser” rate interest loans were made with deferred interest (to future years), 2006 was the banner year for real estate. Without meaningful SEC oversight, companies that rated creditworthiness (and everyone relies on those ratings) had given subprime mortgage packages very high ratings (meaning they were considered low risk), fueling the buying frenzy.

2007 – As teaser rates began to transform into very large interest payments (normal interest + risk premium + deferred interest), the rising number of mortgage defaults warned us that the subprime mortgage structures were headed for trouble. In addition, there were $52 trillion dollars of “default insurance” paper (credit default swaps) – issued by big financial institutions and hedge funds – that weren't looking so good either. Think of an insurance company that was so certain there would be no claims that it didn't even bother to sock away any of the premiums.

2008 (Summer) – The government realized that it was going to have to intervene as some of the biggest players, (those with the potential for major negative ripple effects all over the economy), were about to die. Bear Stearns was forced to merge into another big financial structure. Merrill Lynch was shoved into another company too. Insurance giant, American International Group (AIG), which covered so many of America’s risks, got a direct infusion of money from the government in exchange for significant ownership and restrictions. The markets knew we were headed down, but most CEOs (and many politicians) thought the government was on the right track; there was no crash and no panic.

2008 (September) – As Lehman Bros. neared bankruptcy, the markets expected the government to force a merger or at least infuse some working capital to ease the pressure from the toxic derivatives that plagued Lehman’s balance sheet. After all, if Lehman went down, then everyone could go down… and the government wouldn't allow that… Would they? Henry Paulson, (who has been trying to defend why he bailed out Bear, Merrill and AIG yet not Lehman ever since), allowed Lehman to go belly-up.

The markets, all of them, crashed.

2008 (October) – Congress needed an answer quickly; constituents were screaming. The President looked to Treasury Secretary Henry Paulson for a plan, and Henry had one – but it had been created before the big crash. Since this was the only plan that had been fleshed out, it was presented to Congress. Some Republicans wanted top down assistance (the likely effect of the Paulson plan – which originally gave Henry almost unlimited power); many balked at bailing anybody out. They were joined in that sentiment by “Blue Dog” Democrats who didn't want to bail out big financial institutions. The result: the $700 bailout plan that now contained some tax incentives, oversight and other compromises that got enough Democrats on board to pass. Too little, too late, but it was all we got.

Postscript – Paulson’s implementation (top level cash infusion with the hope of a “trickle down”), with a rate cut and buying of commercial paper by the Fed, has only allowed the biggest financial players to hoard cash to “de-leverage” (generally or to qualify as banks for some that made that choice), cover possible calls on credit default swaps and other liabilities or to merge competitors and consolidate the financial industry. The money has not trickled down to those who need it most. No help for homeowners. No help for job seekers, No help for small business. Payrolls are failing. Layoffs are everywhere. Paulson himself said it will take months for his package to reach the consumers and stabilize the market. Then he reversed himself and indicated that the Treasury would now not use the bailout money to buy toxic mortgages from trouble banks.

What are the next areas that worry bankers? Consumer credit card defaults. Investors in hedge funds pulling way, way out. Private equity looking for ways to restructure and deal with companies they bought along the way with vastly more debt than made the slightest sense. Is it credit default swap calls based on big corporate defaults, or maybe just the looming retail implosion over the holidays? In short, nobody thinks we’re near bottom, and the markets are just sick about it. Jobless claims are soaring, home values are plunging and there is no commercial marketplace where normal bank lending is required for basic operations. Until those three fundamentals steady and stop falling, when speculators will have been exhausted from an unpredictable market, when that most precious recovery requirement – confidence – returns, then, Mr. Perella, and only then, do we hit bottom. And remember, “bottom” is where you’ve got no place to go but up.

I’m Peter Dekom, and I approve this message.

Ice In The Fall

Consumers have largely been ignored in the Trouble Assets Relief Program as Treasury Secretary Henry Paulson has embraced the questionable “trickle down” notion of helping the big boys at the top to create liquidity in the markets as the money “flows down.” We know it didn’t flow.

Big financial institutions (with banking capacity) used cheap money from the Federal Reserve and the potential of the bailout funding to “de-leverage” – reduce the proportionate debt on their books to comply with regulations that required saner debt loads since some of these big boys became real banks (Goldman Sachs, Morgan Stanley, American Express – banks have stricter controls), to create cash reserves for possible losses and to provide money to buy “valuable failures” (their less-than-prudent competitors) and consolidate the financial industry. The result: with a few scattered local exceptions (small banks that didn’t play the stupid loan game and didn’t get bought out by loan-happy big boys), the only real banking taking place in America right now is with the mega-institutions at the top. JP Morgan Chase, CitiGroup, Wells Fargo and Bank of America.

There’s been an election since with a clear message – the emphasis will be on the consumer, the employee and the homeowner. With the writing on the wall, and a little bit more than two months until there is a change in Administrations, Henry Paulson seems to be waking up to the reality that the fixing at the top has had virtually no impact on most Americans with financial issues created by this meltdown. Since the change in focus is now inevitable, Paulson announced on November 12 that Treasury will no longer use the $700 billion bailout funding to buy troubled assets from troubled banks.

Instead, with writing on the wall morphing into screaming voices, Treasury will use $250 billion of the bailout fund to buy stock in functioning non-banking lending institutions as well as banks (specifically to bolster their balance sheets and encourage them to resume ordinary lending and in support of restoring the real estate market). Paulson also noted that the government was looking at a major expansion of the program into the markets that provide support for credit card debt, auto loans and student loans.

Wow! Two months since the first mega-fall of the markets and well after everyone knew about the subprime meltdown, the Department of the Treasury seems to have discovered that ordinary human beings are actually suffering in a way that makes it impossible to stabilize even the biggest financial institution. With crashing real estate values, plunging retail sales, rapidly escalating unemployment figures. I guess no one told him that 70% of economic activity in this country is based on consumers. Dirty little secret.

I’m Peter Dekom, and I approve this message.

The “Deciders”

The “Deciders”

Ever know one of those men or women who just happen to do one job so well that they keep getting promoted. Up and up and up. They may even have an educational pedigree that makes it all look so much more impressive. I work in the entertainment industry, and I see these fair-haired “boy or girl wonders” make a few good (lucky?) picks on film projects or TV shows, be declared “geniuses,” and move up the corporate ladder.

I also see bright folks who worked hard to get to a place of power, make all the right decisions based on that hard work, and then just assume that they “have the gift,” and believe that their decisions going-forward will all be good even if they stop working and learning in a changing universe. They keep applying what they’ve learned so well in the past and are even terrified of deviating from their experience path for fear of jinxing their decision record. They’ve learned to “talk the talk” and “walk the walk” such that everyone around them is convinced that they always have the right answer. They also tend to surround themselves with folks who confirm their perpetual “genius.” This can work for a while, but…

As empirical facts contradict their new choices, even as the marketplace and technology conflict with their perception, they are so isolated and surrounded by “yes” men and women that they actually believe that the choices were good at the time and whatever made them fail could not possibly have been foreseen or have been their fault. Blame others or “circumstances”!

They often remove people who contradict them and hang out with other equally “powerful” people to enjoy the heady lifestyle of the rich and powerful. They attend posh, invitation-only retreats, engage in lots of public speaking and public appearances, hobnob with world leaders… instead of spending time learning about the changes that will eventually provide the instrument of their demise. Sometimes, they'll even preach clear and distinct paths to future growth that are flat out wrong just to cover up an earlier mistake that is now proving costly.

I’ve seen broadcast television network chiefs tout the invincibility of their model, the necessity of broadcast network advertising to “mass market” products and services – even in a world where mass marketing has been dead for almost a decade and where network ratings average under 3 million viewers in prime time (out of about 100 million household(s) with television in the U.S.). When CBS – the highest rated network – plunged by over 70% in stock value in the current meltdown, the market caught up to the myth. Studio executives in search of a never-ending supply of “stupid money” were waking up to find that production financing for films was getting hard to come by these days.

It is so strange to watch this set of behavior patterns repeat itself at the highest levels of the federal government. I seem to recall a Harvard MBA, head of one of the most powerful investment banks on earth, groveling before the Securities and Exchange Commission to persuade them to relax the borrowing restrictions placed on financial institutions so that his investment bank could borrow more to buy theoretically valuable stuff like… er… subprime mortgage derivatives and credit default swaps. The SEC deferred to this powerful and legendary genius' sterling pedigree and said yes on April 28, 2004.

Sure his company bailed on a lot of that (apparently not-so-valuable) stuff after he left, and yeah, those borrowing levels proved toxic to two of the banks that got relief from those borrowing restrictions – Bear Stearns and Lehman Bros. His old firm is currently “de-leveraging” from the mistake of letting debt pile high on the company’s books (or as they called it, "significant market dislocation").

But in his next job, this Harvard ("genius") became a global political force; he was now a Cabinet Secretary to the President of the United States. He was hobnobbing with the hobnobbiest of the hobnobers. Unfortunately, he was still making the same decisions, surrounded by the same folks he had back at the firm. Funny thing though, for almost a year, every major decision he made turned out to be wrong. He announced new policies, selling them to Congress with his charismatic aplomb (and the credibility of his Harvard MBA and his tenure as the CEO of the leading investment banking firm in the world), and then reversed his own decisions, changed course and made contradictory pronouncements.

His governmental job description looked a lot like how he carried out his CEO responsibilities in his waning days at the bank. He advised and served major corporate institutions. He hung out with top financial ministers and “did what they did” even though his country was profoundly different. He was now faced with the responsibility of fixing the derivative mess he (lobbied so hard to) create. Only now, the economy was plunging at his every move. As the child revealed what everyone was too afraid to admit in Andersen's classic tale, the markets could now see that the emperor had no clothes. You’re not at Goldman Sachs anymore, Henry Paulson, and that Harvard MBA isn’t big enough to cover your posterior. Sadly, Henry, the markets are just like you... completely without direction!

I’m Peter Dekom, and I approve this message.

ICE IN THE FALL

Consumers have largely been ignored in the Trouble Assets Relief Program as Treasury Secretary Henry Paulson has embraced the questionable “trickle down” notion of helping the big boys at the top to create liquidity in the markets as the money “flows down.” We know it didn’t flow.

Big financial institutions (with banking capacity) used cheap money from the Federal Reserve and the potential of the bailout funding to “de-leverage” – reduce the proportionate debt on their books to comply with regulations that required saner debt loads since some of these big boys became real banks (Goldman Sachs, Morgan Stanley, American Express – banks have stricter controls), to create cash reserves for possible losses and to provide money to buy “valuable failures” (their less-than-prudent competitors) and consolidate the financial industry. The result: with a few scattered local exceptions (small banks that didn’t play the stupid loan game and didn’t get bought out by loan-happy big boys), the only real banking taking place in America right now is with the mega-institutions at the top. JP Morgan Chase, Wells Fargo and Bank of America .

There’s been an election since with a clear message – the emphasis will be on the consumer, the employee and the homeowner. With the writing on the wall, and a little bit more than two months until there is a change in Administrations, Henry Paulson seems to be waking up to the reality that the fixing at the top has had virtually no impact on most Americans with financial issues created by this meltdown. Since the change in focus is now inevitable, Paulson announced on November 12 that Treasury will no longer use the $700 billion bailout funding to buy troubled assets from troubled banks.

Instead, with writing on the wall morphing into screaming voices, Treasury will use $250 billion of the bailout fund to buy stock in functioning non-banking lending institutions as well as banks (specifically to bolster their balance sheets and encourage them to resume ordinary lending and in support of restoring the real estate market). Paulson also noted that the government was looking at a major expansion of the program into the markets that provide support for credit card debt, auto loans and student loans.

Wow! Two months since the first mega-fall of the markets and well after everyone knew about the subprime meltdown, the Department of the Treasury seems to have discovered that ordinary human beings are actually suffering in a way that makes it impossible to stabilize even the biggest financial institution. With crashing real estate values, plunging retail sales, rapidly escalating unemployment figures. I guess no one told him that 70% of economic activity in this country is based on consumers. Dirty little secret.

I’m Peter Dekom, and I approve this message.

“A Once in a Century Credit Tsunami”

“Those of us who have looked to the self-interest of lending institutions to protect shareholder's equity (myself especially) are in a state of shocked disbelief.” Words of reassurance from the former Chairman of the Federal Reserve (he left in 2006), Alan Greenspan testifying before the House of Representatives Committee on Oversight and Government Reform about the incredibly stupid Wall Street feeding frenzy regarding those horrible and virtually unregulated “default insurance” instruments – the credit default swaps – that I have been ragging about.

Thedeal.com reviewed Greenspan’s concern about risk exposure and overzealous investing back in 2005, but the former Fed Chairman still noted: “this crisis, however, has turned out to be much broader than anything I could have imagined.” The only scarier Halloween costume I can think of than an Alan Greenspan mask would have to be one with Treasury Secretary Henry Paulson’s face. Looking at the overall economic picture, Greenspan warned that he expects this financial “tsunami” to get worse before it gets better. And remember those cash-hoarding financial institutions not funding the credit markets until they see a clear bottom? Doesn't look like they'll be shaking out cash for lending to the hoi polloi (us chickens and small businesses) any time soon!

We also heard today from SEC Chairman, Christopher Cox, who in all fairness is a recent appointee and was not present when the SEC deregulated the biggest financial institutions from prudent debt ratios in 2004 (see earlier blogs). He just stated the obvious: "The lessons of the credit crisis all point to the need for strong and effective regulation, but without major holes and gaps.” Woo hoo! So what do we do in the meantime, since obviously no one in Washington is reading my blogs?

We should all rest assured that the federal “regulators” – the guys at Treasury – told the Senate Banking Committee that they are working on a new plan could include creating standards to change mortgages structures and rates, making them more affordable and giving loan guarantees to banks that meet those new standards. Keep working guys; we know where your priorities are.

The Associated Press notes that even other branches of government are complaining about too little, too late being done by the Treasury to help individuals in trouble: “Sheila Bair, chairman of the Federal Deposit Insurance Corp., told the same Senate panel that the government needs to do more to help tens of thousands of home borrowers avert foreclosure, including setting standards for modifying mortgages into more affordable loans and providing loan guarantees to banks and other mortgage services that meet them… ‘Loan guarantees could be used as an incentive for servicers to modify loans,’ Bair said. ‘By doing so, unaffordable loans could be converted into loans that are sustainable over the long term.’” Gee, why didn't I think of that? Oh, I did, with more details!

Funny how the feds instantly came up with a plan to bail out the big boys – the cash-hoarders – but they need more time to help those who are losing their jobs and their homes now.

I’m Peter Dekom, and I wonder when this madness will end.

Boy is It Hot in Here!

The markets were up Thursday for the reasons mentioned in yesterday's blog, but so are the autumn temperatures in the Arctic – a record 9 degrees Fahrenheit (5 Celsius) above normal. Melting ice reveals dark ocean waters beneath; darkness absorbs heat better than light (which reflects it away), which accelerates the warming process. And I can't even blame that on Henry Paulson, but I am checking! I wouldn't count on a sustained up-market by any sane estimates any time soon (they're already down!) – stocks should waffle up and down based on each day’s news, and should tumble hard if Henry makes any more recommendations to work through institutions… but I think I would count on Arctic temperatures holding to the “rising temperature” phenomenon for the foreseeable future.

Those aren't Republican or Democratic degrees; they're the old fashioned Celsius and Fahrenheit kind. They're the kind of degrees that should set our best and brightest scientists to thinking about managing the inevitable consequences, preparing the infrastructure for the inevitable strain, and maybe, just maybe, bring Americans together to work together to find energy alternatives, improve efficiency and solve problems from a bi-partisan platform. Or not.

I could just blame this on the Democrats who repealed the Glass-Steagall Act in 1999 and allowed banks to merge into and own financial trading companies (and vice versa) – a spur to big fat bank/financial institutions that helped fuel the economic mess or the Republican Securities and Exchange Commission that, on April 28, 2004, created a horrible exemption to a rule on how much equity five financial companies (those worth over $5 billion at the time: Goldman Sachs, Morgan Stanley, Bear Stearns, Lehman Brothers, and Merrill Lynch – look who’s gone from that list!) needed to have against their debt load – allowing them to borrow their way into buying massive piles of derivatives based high-yield (and very flawed) subprime mortgages and other secondary values (Bear and Lehman went from 12 to 1 – the old limit, and the limit on everybody else – all the way up to 32/33 to 1 before they died)… but I won't.

Instead, I'd like to suggest that we gather together and simply get to work solving problems that plague us all. Us… you and me… people… making individually responsible decisions. Using less energy. Not borrowing above our means. Not buying it all now. Saving and investing in each other, our children and our future. We can ask the government to help, but they seem not to notice you or me. Not enough of us are plumbers, it seems. I'll keep railing about what the government should do or stop doing, but I know, in the end, it’s just up to you and me to begin to make this a better place, one individual step at a time.

I'm Peter Dekom, and I approve this message.

All for One, and None for All

Business liquidity = payroll funding = jobs = income = ability to afford houses + ability to pay taxes = real estate values = viability of the mortgage market = financial health of the financial institutions (and viability of “credit default swaps”) = business liquidity…. Well, you get it. It isn't a confluence of separate messes; it’s a profoundly interrelated series of messes, compounded by the federal government’s choosing to act on that part of the problem (financial institutions) that will take the absolute longest time to stop the hemorrhaging of home values and job loss… assuming you believe in the “trickle down” theory, which I do not.

I guess that’s what you get when you take a guy out of the investment banking world – whose career is totally wrapped up in financial institutions – the former head of Goldman Sachs, and give him a problem to solve. Treasury Secretary Henry Paulson, an extremely wealthy man, actually has no clue what’s it’s like to feel your job slipping away and seeing the very real threat of losing your home. He’s an institutional guy with institutional sensibilities.

Here’s what Henry said today (carried on AOL): "We're not proud of all the mistakes that were made by many different people, different parties, failures of our regulatory system, failures of market discipline that got us here," but he said he had "no regrets" about the announced steps the government is taking now. Sorry Henry, you're still making mistakes; they're just getting bigger. The global markets, governments and business press have not been kind to your strategies.

When the market rises, as it did today, it isn't because of your efforts. Europeans announced bigger bank deposit guarantee limits, several states are now implementing protections for renters whose homes have been foreclosed, oil is cheaper and the Bank of England will introduce new emergency overnight borrowing facilities for banks starting Monday

The rest of the federal government is muddling along too. Federal Reserve Chairman, Ben Bernanke, seems to have thrown up his hands noting that this looks like it’s going to bad for more than the near term. The Attorney General’s office is doing a little tiny bit of prosecutorial investigation: investigating the management of the collapsed Washington Mutual Inc. bank to see if they broke federal laws that led to the largest banking fall in U.S. history and investigating funds and companies like SemGroup, the parent of bankrupt SemGroup Energy Partners LP, which filed for protection under U.S. bankruptcy laws in July after it lost $3.2 billion in bad bets on oil prices. We need a lot more investigating.

But we also need to be a lot more basic right now as well. Look at the first sentence in this blog. Where would you start if your job were to begin to fix this mess? At the top of institutional level as the government believes? Or might you want to get jobs funded and home foreclosures stopped right now? Hey!

I’m Peter Dekom, and I approve this message.

Making a Mess Messier

After the U.S. Treasury Secretary, Henry Paulson, began to implement his “force the banks to accept overpriced federal funding” Capital Purchase Program earlier in the week, the market crashed and the American banking community cried foul, a few more wise voices chimed in to reinforce exactly how inadequate – even stupid (my words) – that plan was. Yesterday, Japan ’s Prime Minister, Taro Aso, addressed his parliament (the Diet), and described the U.S. effort: "Since it was insufficient, the market is again falling sharply."

Our own Federal Reserve heads, past and present, also seem to be realizing that this is all too little and too late. The Associated Press (on AOL on October 15, 2008), posited the following quotes: "‘I don't think we can escape damage to the real economy,’ former Federal Reserve Chairman Paul Volcker said this week in Singapore. ‘I think we almost inevitably face a considerable recession.’"

“The Fed's current chairman, Ben Bernanke, delivered a more measured, but similarly grave assessment to economists, saying the recent financial turmoil ‘may well lengthen the period of weak economic performance and further increase the risks to growth.’" Bernanke isn't raving about Paulson’s plan?! They're part of the same team! Think Paulson is the only one selling manure into the markets? There are other hair-brained schemes out there in the ether, seriously being considered as real solutions.

Try, “let’s buy up all the bad home loans from those insurance and finance companies that have no clue what to do with them and negotiate with the subprime mortgage-paying homeowners who can't pay their mortgages any more or are in default.” Brilliant! Let’s bail out big companies out of their stupid investments and begin to place the federal government into millions of individual mortgage negotiations (and credit evaluations and real estate appraisals) and do it soon to stop falling home prices. Oh, by the way, we won't help folks who are paying their mortgages and are having trouble, only the ones who took stupid loans.

Like exactly who is going to do this at the fed? A new level of bureaucrats we haven't met yet? And how are they going to do it fast anyway without a moratorium on foreclosures to give the government enough time to create a real solution? And what about the dozens of other issues, like failing credit lines that support payrolls, inter-bank lending assurances, creating a “hold” on the derivative markets, etc, etc, etc.

For those of our leaders who are brain-damaged or need a simple formula:

1. Freeze the markets as much as you can. Place a moratorium on foreclosures and restore short term bank credit confidence to get payrolls funded.

2. Prioritize and implement the short term solutions. Focus on increasing liquidity (lending capital), keeping people in their jobs, setting new livable interest rates and creating new jobs (even if they are government-sponsored infrastructure repair efforts).

3. With the understanding that this is a recession that will be with us for a lot longer than we have experienced in recent history, create a ground-up reexamination of the financial regulatory and oversight rules, sharply curtail if not eliminate exchange-traded derivatives and over-the-counter (OTC) derivatives, make over-leveraging (borrowing beyond your means) exceptionally difficult, and set in place a system of checks and balances to prevent trends based on loopholes or instruments that can survive only under sustained periods of growth (but not downturns) from being the basis of new financial instruments.

4. Apply a little RICO (civil & criminal) action to the main perpetrators and get some fat bank accounts back to the taxpayers by force of law.

It’s truly complicated, but there is one absolute in the market today: What the federal government has done so far has not worked, and the markets do not believe that the announced plans will ever work. Time for another approach. Fast!

I’m Peter Dekom, and I approve this message.