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1999 – Congress partially repealed the Glass-Steagall Act (a 1933 statute that created the Federal Deposit Insurance Corporation (FDIC) and created clear restrictions on where and how banks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.

Comes Now the Night - Doing It Right (Part 2)

As we watch markets falling at levels reminiscent of the Great Depression, and states attorneys general implementing direct actions against corrupt banks and implementing moratoriums against foreclosures that have not appeared from the feds, it does appear that we need some federal action immediately, before the markets freeze up so badly that lay-offs become permanent job losses. Fire!

1. Impose 120 day federal moratorium on foreclosures of residential real estate.
2. Until a bigger plan can be implemented, provide instant federal guarantees to banks operating under their reasonable and standard business practices in providing “receivable” financing to small business owners (those with fewer than 1000 employees) consistent with past practices (this means lending against sales that have been made but not yet collected). This will stop unnecessary bankruptcies and layoffs, perhaps permanent job loss, that will vastly exceed the cost of the guarantee. Begin looking at growing the credit markets to bigger companies as the economy justifies.
3. Ask the Department of Labor (with input from other federal agencies like Energy, Interior and Transportation) to submit a plan to create a massive job corps to rebuild our nation’s bridges, dams, highways, levees and comparable infrastructure under the supervision of the existing building trade unions, but at entry-level wage rates. Prepare to submit that plan to Congress and the President within 60 days. Since this represents a productivity investment, the fact that it may strain the federal budget must be ignored. It will pay for itself many times over and will put a huge cadre of unemployed workers in paying jobs.
4. Ask the Department of Education to prepare a budget and an action plan to: a. retrain laid off workers into fields where growth clearly exists (traditional and alternative energy, health care, etc.), and b. to add one additional hour per day to junior and senior high schools in math and quantative science (can be applied math, such as is standard in manufacturing or construction) to upgrade our national schools to provide competitive job skills (another productivity increase).
5. Invoice and collect the $79 billion of oil revenues sitting in the Iraqi government, and give them their wish of an accelerated withdrawal starting now (muster out 2/3 of the returning troops and send the other 1/3 to Afghanistan), to stop the drain on our budget – whether you are for or against the war, we just do not have the money to pay for it (this is not a productivity investment). The civil war will continue as we depart – it would no matter when we left.
6. Phase out water-wasting and unproductive ethanol farm subsidies over three years and all other farm subsidies (which mostly benefit large corporate farmers, whose commodity values are soaring in this market) over five years. Terminate the oil depletion allowance.
7. Train local and federal investigators and prosecutors in the prosecution of the white collar crimes that gave rise to this debacle. Go after the folks who lied on their loan applications, the lending officers who told them to do it, the financial wizards who having done the numbers still insisted on creating the “derivatives” that pushed us over the edge, and the senior managers at banks and other financial institutions who either encouraged this misconduct or chose to look the other way as it fell beneath their feet. Make them pay – in cash, assets and, perhaps in serving time.

I am sure that what I have written will offend one special interest or another, but what is at stake is the America I know and love. Time is not on our side. We need action. Now!

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

America: Addicted to Debt

It’s un-American not to be in debt over your eyeballs! We, as individual consumers, borrow more than we earn! For four years in a row, an event that has not occurred since the Great Depression. That alone is an alarming fact. People believed that real estate could only rise. Everyone seemed to borrow more than was prudent, even beyond the sub-prime market. As the January 23, 2008 New York Times noted: “Everyone from first-time home buyers to Wall Street chief executives made bets they did not fully understand, and then spent money as if those bets couldn't go bad. For the past 16 years, American consumers have increased their overall spending every single quarter, which is almost twice as long as any previous streak.”

We all follow the lead of our government that borrowed 100% of the cost of the Iraq War. The United States currently owes $9.5+ trillion of “national debt” (the aggregation of unpaid deficit-borrowings), which in turn generates a massive $350-$400 billion dollars in annual interest payments, mostly to other countries that have politely funded our deficits. Put another way, the national debt currently grows by $1 million a minute or $1.4 billion a day!

We Americans have another form of debt; we call it a “trade deficit” – it runs about $60-$70 billion a month – what happens when you import much more than you export. The November 30, 2006 Business Week predicted that “[f]or the first time in recent memory, the cost of imported goods and services will exceed federal revenues. In other words, Americans will soon pay more to foreigners than they do to their national government.” That happened this year. Even with the slowdown from the recession/depression (whatever you want to call this total meltdown). With massive amounts of our national debt in foreign hands, with global competition accelerating at the expense of U.S. workers and with oil reserves predominantly in antagonistic foreign hands, the future of our economy is decreasingly within our own control. We live based upon the “kindness” of strangers.

So enter Wall Street. Not only did they encourage all the above consumer borrowing, they repacked the debt and sold “derivatives” (including aggregations of risky mortgage loans), making fees creating, buying and selling these “derivatives,” but they fell so much in love with debt, that investment bankers (who make the big bucks when companies are bought and sold – mergers and acquisitions) decided that you really didn't need a whole lot of equity to buy huge companies either – you could use stock and, gotta love ‘em, debt. Lots of it, not a whole lot different from people buying houses without much of a down-payment.

They even figured out how to make even more money by creating layers of debt – the top guys (senior debt) got paid 100% with interest before the next level (mezzanine debt) gets paid off with its higher rate of interest (being in second position is always riskier than being on top). The shareholders (the equity) sit at the bottom, hoping their management made the right decision.

The investment bankers figured out how to get still higher fees by structuring and supplying the high interest mezzanine debt. And giant hedge funds were created, some within these very investment banks, to raise all that capital needed to fuel the mortgage demand, the mezzanine debt demand and all of the other “needs.” A little equity, not a whole lot of government interference (the government even made interest rates so cheap, why not borrow?!), the debt just got higher and higher.

As long as the marketplace was going up, who cared about the debt load? You got a new house or a nice new company or a nice new investment. The housing market woke up in 2007; the financial markets awoke slightly after Bear Stearns went down, but went back to sleep only to awaken to one of the greatest market crashes in American history in the last few days. Lehman Bros. was gone. AIG, an insurance company alive only by government intervention. There was blood in the streets and no short term “fixin’s” gonna right a ship that has run so far aground.

Bottom-line: The laissez-faire lending markets do not work. The derivative markets are a disaster. Without government oversight, required limits on how much real equity you need to borrow and how you will pay it back, we will watch the markets react over time, minus a whole lot of companies and homeowners, until the next debacle. What kind of America will we be then? Competitive? Vibrant? Hopeful? Or a worse version of what the unregulated economy gave us this week?

I'm Peter Dekom and I approve this message.