If it motivates you to fully realize in concrete detail how the the insanity of the current government bailout policy is utterly backwards and destroying our economy and our way of government and life -- possibly permanently as he implies -- your voice in print or anywhere else you can speak in public could be one of those helping save the United States of America.
The author (whom I don’t know and there was no link provided) draws a parallel between
He starts with an example of a large mall developer (GGP) and shows how the government easy money policy is creating a domino effect of business failures by increasing the “spread” between those who can get free money (the government-seized banks) and those who can’t (every productive business in America) get credit to keep their businesses going. This is wiping out equity holders everywhere.
His argument goes on that the market has been so traumatized by the arbitrary seizures of the banks that it is depressing values and accelerating failures because no one believes they will get a fair shake in bankruptcy court – ie, relief on debt payments till the crisis abates – because the Treasury will preempt the courts. As he says,
Here is the critical parallel as I’ve condensed it from many pages of the article (all emphasis added by me to bring out high-points to motivate skimmers to read):
As some of my colleagues pointed out, the best possible analogy to the administration’s policy so far is that same administration’s policy in
In theory this kept the troops safe to sustain a strategy of wearing down and outlasting the enemy until order could be restored to the country. In actual practice, the strategy not only failed to restore order, it cost the lives of several thousand American soldiers killed on the raids or going back and forth.
The key problem of the strategy, which General Petraeus identified and reversed, was the implicit assumption that an orderly productive society can be established by dividing the country between small safe zones in which the government lives, safe zones created by massive and unsustainable expenditures of government resources, and large barbarized zones encompassing, among other things, the economy that must ultimately support the government inside its gated community.
...If government backed entities can finance an asset at 5 percent, and everyone else in the room is obliged to finance it at 15 percent, ...the government itself can massively confiscate assets. ...A lone trusted borrower in the midst of a financial terror can borrow and lend at an extraordinarily favorable spread, putting assets on its balance sheet at amazing bargain prices. This is exactly what the government is doing right now...
If such a condition could persist forever, only the state would own any assets... Everyone else, precisely because before the crisis they made money rather than lost it, acquired assets prudently, and did not recklessly imperil the financial system, remain out in the cold, borrowing at double digit rates... In the Green Zone money is cheap... Alas, ...the worst [people of the Green Zone, who] spent years making an easy living as grifters, frauds, and crony capitalists [are the ones who profit].
He makes a case that there are three ways out of the crisis, two of them not pretty at all (Great Depression II and massive inflation), and says the current “plan” is heading us towards a bailout that costs well over $3 Trillion dollars without providing any solution at all.
He then argues for a third alternative that could have ended the crisis in a few days had it been enacted. I’m not fully qualified to judge it, and you may read on your own, but he concludes by saying that one way to enact it would be a $10,000 tax rebate to 300M Americans, or
Even better, suspend all federal taxation, including both sides of the Social Security tax, for 2009.
Amen. That’s been part of my own prescription all along -- along with a call for a Constitutional amendment calling for a separation of State and Economics, cause nothing else will end the destruction of our way of life by the fools in Washington.
Robb
Sucked into the Green Zone
—Andrew J. Redleaf, December 3, 2008
Consider General Growth Properties (GGP) for what it can teach us about what happens to more or less sound companies in a catastrophic credit contraction. GGP’s income easily covers its interest obligations by a factor of somewhat more than 1.5. It is, or was a few weeks ago, certainly solvent in the ordinary, muddle-through sort of way that any ongoing business that can pay its bills passes for solvent. There is a lot of debt, and the company’s disclosure is not as wonderful as it could be, so the situation is not entirely clear. Still I would guess that a consensus of analysts looking at the company’s assets 90 days ago would have concluded that, even if the business were to be unwound, its assets, sold in an orderly way, would fully cover its liabilities.
And yet GGP may well be pushed into bankruptcy by senior creditors—mortgage holders in this case—suddenly eager to pounce and seize assets. And that is the curious thing. Normally they would not pounce. In all the time I have been in this business I cannot remember one other instance of a company being forced into bankruptcy while current on its obligations and with 1.5x interest coverage.
So why are the creditors poised for the kill? Are they behaving irrationally? Not at all. Their actions are consistent with value of the dollar, a.k.a. the price of credit, having perhaps tripled in two months.
Here’s the 30,000 ft view of GGP, with all numbers rounded for maximum convenience. The company bought about $30 billion in mostly desirable shopping malls in the
The debt, which is roughly ¾ mortgages and ¼ corporate paper, matures at a variety of dates from next week to 10 years out. The mortgage holders are senior. The business model presumed GGP would be able to roll the near term maturities. Thanks to the events of the last two months, it can’t.
It can’t because, thanks to the government’s collapse of credit markets, today only a federally supported commercial bank (or one of the growing list of federally supported institutions) could finance even top-shelf shopping malls at 5.2 percent. Some real estate wannabe, trying to fill GGP’s shoes, or even GGP trying to fill its own shoes, would certainly have to pay double digit rates, making the malls a losing proposition.
That’s why the mortgage holders can push the situation to crisis.
The two remaining questions are, "why do they want to, rather than swiftly renegotiating an accommodation?", and "why does the market, which is currently pricing the bondholders claims at 10 cents on the dollar, think the mortgage holders can make off with nearly all the value of the assets?"
Let’s continue to simplify the numbers. Even better, let’s make them up. Say the money to finance GGP’s assets would cost 15 percent today, which is not far off. An equity holder would need a larger return to do the deal; let’s call that 20 percent. This makes the properties for which GGP paid $30 billion, and which continue to generate $2 billion in income, now worth $10 billion, distinctly shy of the total debt to mortgage holders.
Because at current market prices there are only $10 billion of assets left to split, the mortgage holders, at least in their fondest dreams, would get everything. "Everything" would mean all those assets that were worth $30 billion 90 days ago. And it would mean not a pro-rate share of the $1.2 billion in interest for which they contracted, through whatever maturity, but the whole $2 billion of annual EBITDA. Of course after getting hold of the assets they would, regardless of formal arrangements, be in the position of equity holders. If credit markets do not heal and we get the Great Depression Redux, much of their $2 billion in income would go away. But if the government reflates the currency and the spread between Treasuries and risk capital closes, the rents would not disappear and would probably grow over time, even in real terms.
At 10 cents on the dollar, the bonds are priced as if the fondest dreams of the mortgage holders will play out almost exactly. Mortgage holders get everything, or pretty darn close, leaving bond holders with little and equity holders with nothing. And this happens solely because the dollar denominated (i.e., interest-rate-adjusted) price of "everything" this week is a small fraction of its dollar-denominated price ten weeks ago.
This is almost as bizarre as the fact that an apparently solvent company is headed for bankruptcy.
Look at it this way. The mortgage holders are tempted to push an essentially solvent company into bankruptcy and seize nearly 100 percent of its assets, taking advantage of the fact that a company that normally would have routinely extended its near term maturities can’t because of the credit crisis.
The market is assuming the mortgage holders are right and will be able to seize nearly 100 percent of the assets. But the basis for this assumption is that the current market price of the assets is dispositive.
Here is one more way to put it. Equity holders, in this scenario, would be wiped out because they live in a world in which the value of a dollar is now so high that they cannot borrow to refinance properties acquired when the dollar was much cheaper. Bondholders mostly get wiped out with them, for essentially the same reason: dollar denominated recovery values on these bonds will be astonishingly low because the dollar has repriced so drastically that only the mortgage holders claims are still visible. Meanwhile the mortgage holders who can dream of seizing the property only because the dollar has tripled in price, are also no doubt dreaming of collecting rents amounting to $2 billion in income, rents set back when the dollar was much cheaper.
It seems to me the market, and for that matter the mortgage holders, are missing one crucial point, or at least one crucial player: the bankruptcy judge. Bankruptcy law has a strong equity tradition and a strong prejudice in favor of maintaining ongoing businesses and against liquidation. Bankruptcy judges dislike opportunism; they especially dislike their courtrooms being made into tools for creditor confiscation of essentially sound companies. Rather than do that it seems to me most judges are far more likely to look at GGP, see a sound company, impose an extension of current maturities on the creditors, impose an interest rate premium on the shareholders to compensate for said extension, and then tell the whole crowd to get out of his courtroom and stop wasting his time. Even more likely, the case never gets to a judge because all the lawyers will recognize the probabilities and work out something out along similar lines. If they do, and the company continues on, and the dollar reflates, then in due course of time the bonds will once again reflect the economic value of the assets, rather than what will have turned out to be their transitional deflationary valuation.
If I can see this, why can’t Mr. Market?
I’d suggest two reasons. The first is that Mr. Market has been so traumatized by the ‘bankruptcies’ of recent financial companies, that he is having a hard time remembering how real bankruptcies work. When regulated financial companies—especially of the ‘too big to fail’ sort— go bust, or come close enough to make the government nervous, they don’t go through bankruptcy in the ordinary sense. The goals of the ordinary bankruptcy process, though sometimes obscured by adversarial procedures, are to maximize the recovery value of the assets, including preserving the business if possible, and then distribute that value equitably. This takes time, as well as some patience for resolving claims not strictly dictated by contract, and for the extended negotiations that tend to result.
The government’s priority when a financial player fails is not fairness to claimholders, but avoiding domino effects. The banking system, though dominated by private companies, collectively executes a core government function: regulating the value of the currency. Because a domino-like tumbling of banks would cause a catastrophic credit contraction and deflation, the government quite rightly sees its role as accelerating a resolution. If bondholders are roughed up and assets dissolved in the process, so be it.
Now, as we have seen rather dramatically in the last couple months, this haste does not necessarily achieve the healing for which the government hopes. But that is not the relevant point here. The relevant point is that all of sudden Mr. Market is behaving as if there were no safety for any company, or any claimant’s capital, in the bankruptcy process. It is behaving as if the arguably necessary but certainly exceptional rules that apply to distressed financial companies are to be applied to companies in general.
This makes no economic sense. The general pattern of bankruptcies always has been quite the opposite. Far from assets being disposed of in fire sales, assets that should be sold are not, and management teams that should be tossed over the side are allowed to hang on, hoping for an exogenous event to improve their results.
When bankruptcies go wrong they tend to be more like
My best guess is that Mr. Market’s new view of bankruptcy is a financial version of post-traumatic stress syndrome. Call it the Hank "Halloween" Paulson serial murder flashback syndrome.
So traumatic was it for Mr. Market to witness the recent torture killings in the financial sector that he now seems to see this fate just around the corner for any firm experiencing some financial trauma.
Above all, "Paulson flashback syndrome" seems to be a generalization from the Lehman bankruptcy in which hundreds of billions of financial assets were liquidated in a matter of days with no regard whatsoever to the interests of claimholders. As it turns out there was no possible justification for the Lehman fire sale; it formed no part of a coherent plan to save the system. To the contrary, Lehman’s death and dismemberment was the proximate cause of the credit market seizure that followed. There is thus no rational reason for the government to repeat the performance.
Yet the freakishness of the government’s behavior in the Lehman case does not seem to reassure Mr. Market. On the contrary, the Lehman bankruptcy was an inflection point in the financial markets. It’s scale, suddenness, and unexpectedness in light of the government’s very different handling of Bear Sterns only months before, has made it the dominant image and metaphor of the moment, the sum and source of all fears. It is the very outlandishness and irrationality of the event that has impressed itself upon Mr. Market.
Serial murders are frightening not only in the ordinary rational sense that any violent crime is frightening. They are also spooky; they make no sense in the natural order and are thus beloved by novelists and screen-writers. Mr. Market has stayed up late watching scary movies—and no doubt snacking shamelessly before bedtime—and now he is hiding under the covers with the flashlight on.
Broadening the point, the Executive Branch has been so active, so dominating, both in precipitating the crisis, and in all the attempted resolutions so far, that Mr. Market, quite understandably, seems to have forgotten for the moment that there are two other branches of government and that neither of them has yet spoken in any significant way. Yes Congress passed a bill, but after that body’s initial protests its chief contribution so far has been to shout ‘how high?’ whenever Mr. Paulson says jump.
I don’t claim for a minute that when Congress weighs in that its own policy will be any wonder of wisdom compared to the Executive’s. But it will be different. It will be predictably more democratic, more egalitarian, more Main Street than Wall Street, to debtors, and above all more inflationary.
I should say, more effectively inflationary. The Executive is certainly trying to reflate, even inflate, but the market is resisting and so far the government is losing.
As some of my colleagues pointed out, the best possible analogy to the administration’s policy so far is that same administration’s policy in
In theory this kept the troops safe to sustain a strategy of wearing down and outlasting the enemy until order could be restored to the country. In actual practice, the strategy not only failed to restore order, it cost the lives of several thousand American soldiers killed on the raids or going back and forth.
The key problem of the strategy, which General Petraeus identified and reversed, was the implicit assumption that an orderly productive society can be established by dividing the country between small safe zones in which the government lives, safe zones created by massive and unsustainable expenditures of government resources, and large barbarized zones encompassing, among other things, the economy that must ultimately support the government inside its gated community.
This cannot work. It is almost exactly what Secretary Paulson has been doing so far.
To see this, let’s go back to GGP.
Assume for a moment that the ambitions of the mortgage holders are realized, and all the assets of GGP end up in their hands. In essence, what will have happened is that the deflation, even if it lasts only a matter of months, will have effected a massive transfer of wealth from GGP to its mortgage holders. But will the mortgage holders be able to maintain control of the assets? Even at the bargain price at which they will have acquired those assets, this is not assured. In a credit-based economy (i.e., in any economy supported by a complex of intermediary relationships driven by the need to move capital from where it is idle to where it can be productive) assets that appear in themselves to be quite securely held, even free and clear, may not be.
When a massive and sudden deflationary credit collapse hits a modern economy, borrowing becomes extremely expensive for everyone—almost. The government, and certain government backed institutions, will still able to borrow at pre-deflation rates. With money plentiful and cheap on one side, the government’s side, but scarce and expensive on the other side of the room, assets will flow toward the government’s side of the room like water flowing downhill. Over time all ‘normal’, not government-backed, asset holders who can borrow only at high rates would lose everything they own to those who can borrow at the government rate. If government backed entities can finance an asset at 5 percent, and everyone else in the room is obliged to finance it at 15 percent, and if this condition could long endure, ultimately every asset in the economy would be owned by the government backed crowd.
Thus, just as in an inflation, by precipitating a sudden catastrophic deflation the government not only shifts wealth from one citizen to another, the government itself can massively confiscate assets.
At first this seems odd, since the government itself is massively a debtor, and deflation is generally held to be bad for debtors (as inflation is generally held to be good for them). Is it not for this very reason that governments are tempted to inflate the currency, so that their own debts can be wiped away, paid off with cheap currency of its own issuance?
All true. But our deflation—let us call it the deflation of the Red Zone—is the creature not of a long term shortage of currency, as for instance the US saw frequently in the 19th century, but a catastrophic credit collapse. A credit collapse, as the very word implies, is preeminently a crisis of trust. A lone trusted borrower in the midst of a financial terror can borrow and lend at an extraordinarily favorable spread, putting assets on its balance sheet at amazing bargain prices. This is exactly what the government is doing right now—even though it is trying to give the spread away by tossing money to its favored banks. Right now, the only
A deflation arising from a catastrophic credit collapse can thus be described simply as a condition in which the spreads between risk free, or Treasury rates, and all other rates, or risk premiums, are radically out of proportion with real economic risks. (Or at least those real economic risks apparent before the collapse. The longer credit markets remain dysfunctional, the more the real economic risks will increase to match the increase in risk premiums.)
If such a condition could persist forever, only the state would own any assets, which is why the estimated price of the bailout keeps rising. The government is borrowing, lending, and buying in an attempt to keep the system afloat, but it is not closing the spread between risk free and risk premium paper. Perversely, by driving down risk-free rates it is actually widening the spread.
Normally of course lower government rates mean lower commercial rates; spreads not rates rule the world. But in a panic of the current sort, that link is broken. Lower government rates have no gravitational effect outside the Green Zone, because in a panic everyone focuses on the undoubted truth that poor is better than dead.
Thus for all the cheap money Treasury has been pumping out, all it has achieved is to extend the definition of the US Treasury to include banks (and banks-elect), Fannie and Freddie, AIG, soon the auto companies, etc. There is an ever expanding Green Zone of institutions, which, because they were imperiled and imperiled others, have been adopted by the Treasury. All these, using government money, can finance assets at reasonable rates. Everyone else, precisely because before the crisis they made money rather than lost it, acquired assets prudently, and did not recklessly imperil the financial system, remain out in the cold, borrowing at double digit rates, or not at all, which they will do until they drop, and are sucked into the Greater Treasury.
We must reflate the currency, the government says. But it has already done so—within the Green Zone. In the Green Zone money is cheap, and freely available for anyone who is up for a shopping spree down those mean streets where assets are priced in hard-to-get deflated dollars. Alas, the people of the Green Zone, the best of whom are careful to a fault, and the worst of whom spent years making an easy living as grifters, frauds, and crony capitalists, don’t like it very much on the mean streets. No matter how low the yields on Green Zone paper, they would rather not venture out.
If a catastrophic, credit-collapse-driven deflation can be described as a non-economic, and therefore unsustainable, spread between risk free rates and risk premiums - a massive inefficiency in credit markets - how does the spread close?
There are three basic paths, two of them very ugly. The most likely outcome is some combination of the three.
The first and perhaps ugliest is that the spread becomes economic, making the market inefficiencies disappear in the most painful way. This is the Great Depression scenario. The assets against which risky paper is held degenerate until their deterioration justifies, ex post facto, the risk currently implied by the spread. In the case of GGP, this would mean that the $10 billion valuation (down from $30 billion) implied by interest rates of 15 percent would become the ‘real’ valuation (the net present value of estimated future earnings), as a result of a catastrophic drop in rental income.
Nominal risk premiums would decline to reflect the fact that the risk had been realized, that economic uncertainty had been resolved—resolved alas by actual economic failure. One could once again borrow at some reasonable spread to acquire the formerly $30 billion worth of shopping malls, because the price of the property would have been adjusted to the rental income.
To look at it another way; right now there is an inefficiency between GGP’s healthy rental income of $2 billion and the impoverished market price of its assets. In the Great Depression scenario that inefficiency is resolved on the down side.
The second way the spread can close is that lenders to the US Treasury realize that the
(If, at the end of the previous sentence you were tempted to ask, ‘but wouldn’t a sell off of Treasuries raise Treasury rates, and doesn’t raising rates cause deflation?’ you could have an excellent opportunity working for Hank Paulson in his next job, if he ever gets one. The most important point Paulson is missing is that manipulating Treasury rates does not work in the ordinary way when the world has turned upside down and expectations have become perverse. Rising Treasury rates would not be ‘cause’ of anything; they would be a sign the dollar is reflating, (that the spread between risk-free rates and risk premiums is closing) just as falling risk-free rates now are a sign of the deflation outside the Green Zone. They are a sign, more precisely, that no one wants to accept risk.)
Then there is the sensible way to close the spread, which should have been pursued from the very beginning, and to which the Federal Reserve, though not Treasury has been inclined from the beginning. Forget saving institutions directly. Forget establishing a Green Zone. Forget working through the banks (which really just means taking them over.) If a non-economic spread of massive inefficiency has been created by a panic in credit markets, and the only buyer able to accept the liquidity risk of facing down the panic is the government, then attack the panic, and the spread, directly. Sell Treasuries and buy any corporate bond in sight that appears to be priced at some arbitrarily large spread to its economic value, starting with the cheapest.
Had the government done that on September 15 the crisis would have ended on September 16, and its end would have been apparent within a week. Instead of having to spend vastly more than originally predicted, while making the problem worse as the Green Zone sucked the life out of the rest of the economy, in all probability the government would have spent less than predicted. TARP was awkward even in its original form because it was focused on buying the bad paper off the balance sheets of particular institutions, rather than in the open market. It was awkward because it was focused on healing institutions, not the market panic that was wounding those institutions. It was awkward from the beginning because the government perceived the problem to be the collapsing price of non-performing loans held by money center banks, when the real problem was the collapsing price of performing loans held by everyone else.
Awkward, but it might have worked, almost inadvertently, because at least the government was going to buy some paper from someone, which may have contracted spreads and rallied other buyers into the market. But the next step, "fixing" TARP to make it look more like what the Europeans (those economic geniuses) were doing, investing directly in the banks, made it much worse.
That was the moment the government really established the Green Zone policy. Treasury then immediately ordered the banks it now controlled to raise margin requirements on investors so bold as to still own corporate paper. Thus the government launched into the Red Zone, except unlike the splendid US Army, the US Treasury only ever seems to shoot civilians. Treasury is on a mission in which all damage is collateral damage.
What was needed, instead of TARP, was a three sentence piece of legislation: (1) For the next 90 days the US Treasury is authorized to buy asset-backed securities whose price appears to be an extreme discount from economic value. (2) For the purposes of calculating the debt of the
That didn’t happen and so far the Green Zone rules. But there are other, albeit less efficient ways to get out of this. The Executive, or this Executive, hasn’t been able to reflate dollars outside the Green Zone, which is what is needed. It naturally focuses on the official banking system, which it is accustomed to view as the mechanism through which monetary policy is executed. Congress, not routinely engaged in monetary policy, is not constrained by such habits of thought, or perhaps by the habit of thought at all. Gloriously, Congress is mostly inhabited by fundamentally unserious people, most of whom have not the slightest pretense of knowing what they are doing. This is just what we need.
There are 300 million people in the
I am not predicting Congress will do either of those. And I am not estimating GGP’s future bond price on the assumption it will do either. But there is a good side to having a bunch of crazy, liberal, vote-buying, demagogues in power. They are very likely to do some crazy, liberal, vote buying, demagogic sorts of things. And not a moment too soon.
