Archive for the ‘Financial Crisis’ Category

Obama laughed at the suggestion that he was a socialist during the campaign. But the scale of his spending, his intrusion in the private economy, and his disregard for traditional freemarket principles is breathtaking. The latest is a “compensation czar” who will oversee the pay of the many companies the government has subsidized. Pretty soon, I think we’ll all end up on a GS schedule.

This, of course, is the biggest threat of government handouts: in addition to the government picking winners and losers in a way totally inappropriate to a free market system under the rule of law, the principle of independence of private companies and their business decisions is completely undermined. It’s the kind of “help” that smothers the recipient and creates systemwide degradation of the “animal spirits” and cold-hearted market logic on which the whole economy depends.

The latest news reads like something out of Atlas Shrugged:

Administration: Rein in pay across private sector
Obama administration: Executive pay needs curbs, better management, across private sector

In addition, Obama’s likely instincts–cutting salaries–is the wrong one, and he’d know this if he paid attention at the many law and economics lectures that were available while he was at the University of Chicago Law School. I wrote about it here. Salaries are the long-term incentive for corporate managemnet, while options and bonuses of one kind or another are the shorter term regime. The market is already engaging in this correction, though, and, unlike Obama, it has its own money in the game.

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As I’ve discussed before, the present financial crisis is not just a problem with liquidity, but one of insolvency. The money is not there. The assets have declined and will stay depressed, and the ponzi scheme that is the last ten years’ inflationary monetary policy is yielding its predictable result: mass liquidation of improvident investments, chiefly in housing.

The Democrats’ usual class warfare rhetoric has more resonance than usual in the light of Treasury Secretary Paulson’s proposed bailout. After all, the guys who got paid huge when this elevator was on the way up now want to be helped out by the general public as it goes down. It would be comforting if we could just take this money from the CEOs and well-paid executives of the institutions about to be bailed out, but that money, as much as it is compared to most Americans’ net worth, would only be a drop in the bucket. The problem is not that Wall Streeters want to make money, made money in the past, and likely will make lots of money in the future. They always want to make money. Everyone wants to make money. Investors have always made good money because they do something useful: they make other people even more money.

The problem with this bubble is that it was further enabled by the bonus-heavy compensation structure of Wall Street and the expansion of this structure to commercial banking. Salaries are typically a small part of the overall compensation structure in investment institutions; the lion’s share is a bonus, which is usually tied to the upside benefit of placing money on one or another position. Since a manager’s bonus is a fraction of a fraction of the investors’ upside, for every bonus dollar paid to money managers, the investors made many millions or billions more in profit. The problem is on the downside. If a huge position tanks, a fund manager does not typically book his own comparably-sized loss. He doesn’t have enough skin in the game. It might mean a zero bonus and termination. If his own money is on the line, bankruptcy sets a floor on his ultimate losses. (Similarly, mortgage originators get paid up front, but if the homeowner defaults down the road, none of that money is charged back against future commissions.)

Higher salaries and smaller bonuses for investment managers, however, would give bankers managing important institutions more sensibly aligned incentives where stability is just as important as big, money-making risks. This should be an especially important priority in FDIC-insured institutions, managers of AAA-rated paper and their underlying investments, and any institution which plays a substantial role in trading in government securities, such as Treasury Bills.

In other words, Wall Street compensation packages consisting of bigger salaries would be a good thing. A less bonus-heavy regime coupled with penalties for bad performance and larger salaries would create a more optimal risk incentives for institutions federally insured or that otherwise have a serious impact on the economy as a whole. The Democrats’ desire to punish CEO compensation simply on principle will lead to more backdoor compensation schemes that would reward excessive risk, such as larger equity stakes in investment projects. Smaller salaries would further promote heads-I-win-tails-I-go-to-a-competitor culture among investment managers that contributed mightily to the present crisis.

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Steve Sailer has a very funny piece on WaMu’s advertising, which bragged about the company’s contempt for stodgy old bankers. Pretty obvious generational and ethnic subtext in this ad: WaMu positioned itself as a new kind of bank for the the age of diversity and free spirits.

Interesting piece from the Von Mises Institute on the Federal Reserve’s direct involvement in Mortgage-Backed Securities (MBS). I was under the impression almost all of the Fed’s assets were in Treasury Bills, a near equivalent of cash. Since its liquidity, stability, and the like are supremely important, I’m a bit disturbed to learn this was going on through the System Open Market Account (which is also the institution that holds the Bear Stearns bailout entity, Maiden Lane, LLC.) I have no idea how much direct MBS exposure the Fed has, and I’m surprised this has not been discussed by more commenters.  Does anyone know the scoop out there? I think from this chart it’s either the “other loans” or “other assets” portion of the Federal Reserve’s asset pool. In any case, this year’s expansion of the Fed’s asset pool should be worrisome; it usually portends an equally significant expansion of their liabilities, i.e., printing of money either directly or otherwise.

Apparently the bailout is a done deal. There is no significant change in concept from original Paulson proposal other than a bit more oversight. Still no word on pricing goal, i.e., lowest possible, above market (to create upward bidding), or something in between. I will make a rare series of predictions: a rally of stocks for 1-2 months with big days this week, i.e., the last of our inflationary bubbles. A few months from now, probably after Christmas, Paulson with lame duck President Bush will solemnly announce massive and continuing losses from first wave of MBS purchases and continued deleveraging by nonparticipating or ineligible entities. The losses will stem from overpricing of the Mortgage and Asset Backed Securities (ABS) Paulson bought for the US, the stagnation of third party securities, the impact of declining credit on our consumption-oriented economy (and trade partners), and the failure of the market to push prices upwards for debt-based assets because of continuing, excessive housing inventory. In other words, this debt is toxic for a reason, and its revival depends upon an upward-moving near-term housing market, which will not materialize.

On news of the failure of the first stage of the bailout, the market tanks. Bonds fail and numerous big, credit-dependent companies seek bankruptcy. Runs on banks become more common. Credit markets manifest serious breakdowns in everything from commercial paper to auto loans. Deleveraging by institutions continues having an additional negative effect on the immediate money supply. Foreign bond rating agencies downgrade Treasury Bills, but the US rating agencies stand firm for fear of retaliation.  This creates a crisis of confidence in all US-rated paper.  There is a swift shift away from dollars as a reserve currency overseas.  A severe and also inflationary recession starts January-February 2008.

The federal government will have blown the foreign creditors’ wads on the first stage bailout. But the more important FDIC bailout for commercial banks will become strained as nervous customers yank money from their longer-term accounts, just as unemployed depositers quit paying on their various loans. Instead of a sharp chastening lesson for Wall Street sorted out reasonably quickly in bankruptcy, the government will find that this bailout has strained its own ability to meet ex ante obligations to ordinary commercial banks. The banks who shifted their mortgage debt off the books to Fannie Mae, Freddie Mac, and other investors will now find the government’s bailouts of third-party holders of ABS and MBS left less money and weaker government credit available to fund the FDIC during the second-stage of the crisis (i.e., more WaMu-type failures and fire-sales).  Since money in checking accounts and saving accounts being wiped out is totally unacceptable politically,  the government begins monetizing the debt in short order.

I hope I’m wrong.  Bonus question below.

Which recessions since the Great Depression have been inflationary?

Answer: Every single one of them.

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