Defending Credit Default Swaps, Arnold Kling Edition

Posted on December 11, 2008 by Felix

One of the things I’ve been missing in recent months is a smart and detailed attack on credit default swaps: my slogan when it came to CDS is that "the less you know, the worse they look". So I’m very happy that Arnold Kling, in his testimony to Congress yesterday, devotes five closely-argued pages of prose, totalling over 2,700 words, to explaining why he considers credit default swaps to be primarily useful only for "creating systemic risk".

Of course, I think that Kling is wrong. But at least now there are clear and specific arguments to respond to, rather than vague hand-waving about how "complex financial instruments" caused "trillions of dollars in losses".

All the same, I do wish that Kling had been clearer. For instance, he starts off his CDS section with this:

A number of commentators have pointed out that the loss of market value at financial institutions

appears to substantially exceed the markdown in housing values. I believe that credit default swaps

played a major role in causing this loss multiplier effect.

A couple of numbers here would have been very useful. "Market value" is normally considered to be market capitalization; I don’t know what the fall in market cap of US financial institutions has been, but let’s call it a couple of trillion dollars. Meanwhile, housing values have fallen say 20% from a peak of about $25 trillion — an erosion of wealth of about $5 trillion. And that’s not even counting the markdowns in commercial mortgages, leveraged loans, and other bank assets. Even if he’s only including the value of homes with mortgages, I’m not sure how Kling has come to this conclusion.

Kling then continues:

In my opinion, the problem with credit default swaps is not counterparty risk. The problem is that there

is no natural seller of default swaps.

Kling has clearly never spent much time with big bond investors. If you buy a bond, you get a steady income stream, while running the risk that you might lose substantially all your money. If you sell default protection, you get exactly the same thing: the only difference is that in some (but not all) cases, you don’t have to put all your money up immediately.

Basically, any institutional investor is a natural seller of default swaps. They’re ways of deploying risk capital: if there’s no event of default, you end up with more money at the end of five years than you started with. If you’re selling a CDS, you’re an investor: you’re taking on a certain amount of risk, in exchange for an expectation that you’re going to come out ahead. What makes Kling believe that such investors don’t exist?

Kling never stops to think that there might be such a simple motivation for writing default protection. Instead, he says that all CDS sellers are taking their side of the deal for one of two reasons: either they’re betting on diversification, or else they’re engaging in "dynamic hedging".

I don’t get this at all. Kling’s arguments against diversification — the idea, basically, that correlations are low — make perfect sense, but I don’t see the connection to CDS. He writes:

One way to think about credit default swaps

is that some quantitative financial engineers believe that a diversified portfolio of B-rated bonds can

have lower risk and a higher reward than a lone AA bond.

I think Kling’s confusing credit default swaps, here, with collateralized debt obligations, or CDOs. To be sure, at the height of the credit bubble, there were some CDOs which were funded solely with CDS, rather than cash bonds — but the diversification idea underlying the CDO market has nothing to do with CDS, and applies equally to plain-vanilla cash CDOs.

What’s more, only part of the ratings transformation in CDOs came from diversification: most of it came from tranching and overcollateralization.

As for dynamic hedging, Kling has constructed a truly elaborate fiction. Whence it sprang I have no idea, but do check it out:

Another strategy for selling credit default swaps is dynamic hedging.

Suppose that the seller of a default swap on a bond issued by XYZ Corporation starts to suspect that the

probability of a default on that bond is increasing. The seller can hedge its risk by selling short either

XYZ Corporation stock or other XYZ Corporation bonds. In the event of a default, the loss that the

seller will take by having to purchase the defaulted bond at par will be offset by the gains on the short-selling.

The problem with dynamic hedging is that it only works in a relatively stable market, in which few

others are attempting similar strategies. When everyone is trying dynamic hedging at once, the result is

a wave of short-selling that overwhelms markets.

Overall, then, if dynamic hedging is used by sellers of credit default swaps, they generate systemic risk.

The individual swap sellers form contingency plans which, in the aggregate, are not compatible. When

swap sellers perceive an increase in risk, they all seek to short securities simultaneously, creating the

equivalent of a bank run.

Arnold, did it ever occur to you that if you’ve written credit protection on a credit, and you want to hedge that position, the easiest and most obvious way of doing so is to simply buy credit protection on the same credit? The CDS market is just that — a market. You make bets on whether spreads are going to widen out or tighten in, and you make money if you bet right, and you lose money if you bet wrong. Just as in the stock market, you can unwind your position at any time simply by taking an equal and opposite position. There’s really no need whatsoever for this kind of dynamic hedging.

Kling then moves on to what he calls "liquidity risk" — which is really nothing more than standard margining requirements in any derivatives market. If the market moves against you, you’ve lost money, so you need to put up that money as collateral. Kling is very exercised about the fact that when a protection seller loses money on a trade, they have to put up collateral, even if there hasn’t been an event of default. But if I buy an out-of-the-money equity put or call, and the markets move against me, I still need to put up margin or collateral, even if the option hasn’t moved all the way into the money. It’s no different.

"The seller may lose liquidity due to margin calls or lose solvency due to the change in

the value of the swaps," writes Kling: well, yes. That’s how derivatives markets work. If this is an argument against CDS, then it’s an argument against all derivatives: equity options, commodity futures, interest-rate swaps, you name it.

If you think Kling’s argument is a little bit funny so far, just wait till you see where he goes next:

The demand for safe collateral has two adverse effects. First, it increases the demand for short-term

Treasuries, artificially raising their price (lowering their interest rate), while driving down the prices

(driving up the interest rates) on other securities. Second, it squeezes the liquidity of sellers of credit

default swaps, threatening the viability of those firms, which in turn triggers even more demands for

collateral in the system and even further flights to safety.

First: No. Treasury bills are the single most liquid market in the world, and a the fact that a few of them are being used as collateral in the CDS market has zero effect on T-bill interest rates. And I don’t even understand why increasing demand for T-bills would drive up interest rates on other securities.

And if I’m a seller of credit protection these days, the amount of collateral I need to put up is fixed, as per the Isda master agreement: it has nothing to do with my own viability. If I find myself with a lot of collateral calls, well, I’ll either need to unwind my CDS trades and take a loss, or else I’ll have to find that collateral. In neither case is the "demand for collateral in the system" increased.

All I can think of is that Kling is thinking of a situation where my own dubious solvency means that CDS written on me widen out, and that people who have sold protection on my debt have to put up further collateral. Which might have happened with the monolines, but it’s hardly a systemic problem. After all, CDS, like any other derivatives market, is a zero-sum game: if some people are losing money, other people are making money. That kind of thing doesn’t trigger "even further flights to safety".

Kling then wanders off into a casino metaphor I don’t understand, before eventually circling back to the real world:

We have had Mr. Bernanke and Mr Paulson running around with huge bags

of money, frantically dumping it on the tables in casino. $30 billion to cover Bear Stearns’ bets, $100

billion to cover AIG’s bets, $300 billion to cover Citigroup’s bets, and so forth.

But two of these things are not like the other. Bear Stearns’s losses had nothing to do with credit default swaps. The government backstop on Citigroup assets is on just that — real assets — not on credit default swaps either. The only one of these three cases which is CDS-related is AIG. And yes, as I’ve argued before, AIG and other triple-A rated insurers did indeed pose a nasty systemic risk, precisely because they didn’t need to put up collateral on their CDS so long as they retained their triple-A ratings. In other words, the system of collateral calls doesn’t make things riskier; it makes them much safer. Yet Kling gets this entirely the wrong way around:

The way I see it, we should have punished

the impatient grabbers and instead rewarded firms that were willing to sit back and let the contracts

play out.

Not at all. By far the most systemically damaging attitude in the CDS market was the one held by the triple-A insurers: we don’t need to worry about the market value of our CDS because we only need to pay out if and when "the contracts play out" and there’s an actual event of default. The discipline of posting collateral to "impatient grabbers" would have prevented tens if not hundreds of billions of dollars in losses at AIG, MBIA, Ambac, and elsewhere.

So that’s Arnold Kling’s Congressional testimony. I should also briefly address his blog entry, about me. Kling says that if I’m right and it’s pretty much impossible to back out implied default probabilities from CDS prices, then there can’t be any use to them at all. That’s just silly. The purpose of the CDS market was never to give people implied default probabilities. But actually, if the Default Recovery Swap market takes off, maybe we will, finally, be able to get a better idea of implied default probabilities than we’ve ever had in the past. Which would be a nice ancillary benefit to the CDS market, but hardly the main one.

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Default Recovery Swaps

Posted on December 11, 2008 by Felix

With Bank of America flip–flopping on whether the appointment of a car czar constitutes an event of default for CDS purposes, Alea, who found the flip-flop, also finds a new default derivative product: the Default Recovery Swap. These things aren’t a way of buying up assets on the cheap, but they do imply, at least to me, that equity-market valuations might yet have a long way to fall.

The DRS is an interesting concept: let’s say that Archie buys a DRS from Bertie, based on a GM recovery value of 7 cents. Then if GM defaults, Bertie will pay Archie 7 cents, while Archie will pay Bertie whatever the recovery value on GM debt is, as decided at the end of the default auction. (Details of how that works here.) Of course, the DRS is cash-settled, so if the actual recovery is 11 cents, then Archie ends up paying Bertie 4 cents — while if the actual recovery is 2 cents, then Bertie pays Archie 5 cents.

Default Recovery Swaps have become increasingly attractive in recent months, as recovery rates have plunged. In a normal world, recovery rates are generally quite high: after the equity holders have been wiped out, there’s quite a lot of assets for bondholders to split between them. But in a chaotic world like today’s, lots of firms are going bust and selling assets into a market where no one has the money to buy them:

“One would expect much lower recovery rates as default rates soar,” Diane Vazza, head of S&P’s global fixed income research group, said in an e-mail…

S&P cited an “inverse correlation” between defaults and investor recoveries in a February 2007 report.

When default rates are less than 2 percent, more than half of defaulted debt recovers more than 70 percent of face value, according to the rating company.

When defaults are greater than 8 percent, more than half such debt recovers less than 40 percent, S&P estimated…

“Nobody thought about hedging the recovery rate” when default rates were low and recoveries stable, said Philip Gisdakis, a Munich-based credit strategist at UniCredit SpA.

“Typically, investors thought recovery rates for financial companies should be in the range of 80 to 85 percent,” Gisdakis said. “With Lehman below 10 percent and with other financials at very low recovery rates, that’s something that is completely new.”

Even non-financials are trading at very low recovery rates: DRS on Tribune, for instance, were trading at about 7 cents before the default was announced — more or less where it’s trading today. But according to the official default petition, Tribune has $7.60 billion in assets and $12.97 billion in liabilities — which, if you could convert those assets easily into cash, would amount to a recovery value of 59 cents on the dollar. Or, to put it another way, as far as Tribune’s bondholders are concerned, that nominal $7.6 billion of assets — which includes, I believe, the Chicago Cubs — can in fact easily be sold only for less than $1 billion.

What does this mean for equity-market valuations? I think it means that if you’re looking to pick up cheap assets, you’re much better putting your money to work buying bits and pieces of bankrupt companies — possibly by buying up their senior debt post-default — than you are buying stocks. While Tobin’s Q might be below 1, stock-market price-to-asset-value ratios are nowhere near as low as what we’re seeing right now in the distressed-debt market. As a result, we might have to see distressed-debt prices rise quite a bit before the smart money starts moving back into equities.

Update: RobertB makes a good point about Tribune in the comments: it has $8 billion of secured debt. Whenever a company has secured debt, the unsecured debt, even if it carries the name "senior", becomes a leveraged play and can easily go to zero — as seems to be the case here.

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Homeownership Makes You Fat and Unhappy

Posted on December 11, 2008 by Felix

Grace Wong dived deep into a survey of 809 women in Columbus, Ohio, in 2005 — before the property bubble burst — and came up with some startling results:

An interesting portrait of homeowners emerges from my analysis. I find little evidence

that homeowners are happier by any of the following definitions: life satisfaction, overall mood,

overall feeling, general moment-to-moment emotions (i.e., affect) and affect at home. Several

factors might be at work: homeowners derive more pain (but no more joy) from both their home

and their neighborhood. They are also more likely to be 12 pounds heavier, report

lower health status and poorer sleep quality. They tend to spend less time on active leisure or

with friends. The average homeowner reports less joy from love and relationships. She is also

less likely to consider herself to enjoy being with people… The results are robust after controlling

for reported financial stress.

I’ve been saying for as long as this blog has existed that homeownership is overrated and that it carries a downside as well as an upside. Today, of course, the biggest downside is the risk of foreclosure. But even absent that risk, buying a house doesn’t seem to make people any happier, and in fact homeowners find their home to be more of a source of pain than of pleasure.

For this we make mortgage interest tax deductible, we create monsters like Fannie and Freddie, we run election campaigns promising everybody their own home, we equate homeownership with the American Dream? It’s idiotic. I don’t expect Americans to all go to Germany and realize how happy people are when they don’t need to worry about all the stresses which accompany homeownership. But I do think that substantially all of the upside to homeownership in recent years has been a function of rising house prices. Now that’s come to an end, it’s hard to see why anybody would want to buy.

In fact, if Americans could be persuaded that rent payments aren’t "wasted money" and that owning often makes less financial sense than renting, I think the rate of homeownership might, happily, drop substantially. But it’s not going to happen. The ideal of homeownership is deeply embedded in the American psyche, and any datapoints which don’t fit into that ideal are automatically discarded.

(Via Florida; HT Knobel)

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Warren vs Treasury

Posted on December 11, 2008 by Felix

Many thanks to Andrew Leonard, a more adept web surfer than I, for tracking down Elizabeth Warren’s incendiary report to Congress on the disbursement to date of TARP funds. Unfortunately, it’s not only a PDF, but it’s also one which can’t be copy-and-pasted; I do hope that Warren posts the report online in HTML form very soon, to make it as accessible as possible. (She has a blog, she should use it.)

This report makes a clear-eyed and compelling case that Treasury really has no idea what it’s been doing so far; that policy decisions have been ad hoc and ill-thought-through; and that no one has spent much in the way of time or effort in terms of thinking seriously about what the ultimate purpose of the TARP is, and how best to achieve that end.

Today’s news does, however, answer one of Warren’s many question. Asks Warren:

Is the Strategy Helping to Reduce Foreclosures? What steps has Treasury taken to reduce foreclosures? Have those steps been effective? Why has Treasury not generally required financial institutions to engage in specific mortgage foreclosure mitigation plans as a condition of receiving taxpayer funds? Why has Treasury required Citigroup to enact the FDIC mortgage modification program, but not required any other bank receiving TARP funds to do so? Is there a need for additional industry reporting on delinquency data, foreclosures, and loss mitigations efforts in a standard format, with appropriate analysis? Should Treasury be considering others models and more innovative uses of its new authority under the Act to avoid unnecessary foreclosures?

The question about Citigroup is answered today by Charles Duhigg:

On the weekend before Thanksgiving, Washington’s top financial regulators were gathered on a conference call to discuss the rescue of the banking giant Citigroup when Sheila C. Bair, the chairwoman of the Federal Deposit Insurance Corporation, interrupted with a concern.

Speaking from her home, Mrs. Bair declared that the F.D.I.C. would contribute to a bailout only if Citigroup were forced to participate in a foreclosure prevention program she was championing on Capitol Hill. After a brief discussion, she got her way.

In other words, the answer to Warren’s question is, essentially, "Sheila Bair was on the right phone conference at the right time". Duhigg continues:

White House and Treasury officials argue that Mrs. Bair’s high-profile campaigning is meant to promote herself while making them look heartless. As a result, they have begun excluding Mrs. Bair from some discussions, though she remains active in conversations where the F.D.I.C.’s support is needed, like the Citigroup rescue.

I’ll pass on the question of whether Bair is guilty of self-promotion (in Washington! Imagine that!). But Bair and Warren do seem to be much more concentrated than Treasury on the big questions of how the TARP funds are going to help the economy as a whole, and individuals under severe financial strain. Treasury, by contrast, looks a bit like it’s following the Underpants Gnome strategy:

  1. Throw lots of money at the banks
  2. ???
  3. Success!

The real problem here is not that Step 2 is undefined, it’s that Step 3 is undefined as well. If you don’t know what you’re trying to achieve, it’s really hard to achieve it.

If I were Tim Geithner, I’d be setting up a regular meeting with Elizabeth Warren right now, so at least the areas of agreement and the areas of disagreement could be clearly delineated and explained. The problem with today’s Treasury, and the reason why Neel Kashkari was given the third degree yesterday, is that it’s far too autocratic: it never feels any need to explain or talk about its decisions, or the philosophy which underlies them. I do hope that Geithner’s Treasury will be different.

Update: Warren’s panel does have its own website; the version of the report there does have copy-and-paste functionality. Thanks to commenter H.Slavkin for the pointer.

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The GMAC Game of Chicken

Posted on December 11, 2008 by Felix

The NYT does a good job today of explaining what’s going on at GMAC, although it doesn’t quantify the haircut that the company is asking bondholders to accept; my commenters put it in the 10% range, which seems roughly right. If GMAC can convert 10% of its debt into equity, that should be more than enough to become well-capitalized enough to become a bank.

But the key player here is Cerberus, which owns 51% of GMAC, and whose equity stake in the lender would likely be wiped out were GMAC to declare bankruptcy; "industry experts" are quoted in the article as saying that a bankruptcy filing could come as soon as this month if neither bondholders nor shareholders recapitalize the company.

So what we have is a game of chicken. Neither bondholders nor shareholders are likely to be well served by a bankruptcy; both would be better off recapitalizing the company now, either through a debt haircut or through a cash injection. But the shareholders want the bondholders to step up (hence the tender offer), while the bondholders reckon there’s no way the majority shareholder will simply let GMAC fail:

Some bondholders see the bankruptcy threat as a bluff. Pimco, the giant money manager in California, is one bondholder that is unconvinced that Cerberus would actually push GMAC into bankruptcy, according to people close to the matter.

Cerberus has been consistently high-handed and opaque in its dealings not only with bondholders but also with Congress; it’s an understandable tactic for a relatively secretive private-equity fund, but one which has clearly backfired in recent weeks. Now, it’s crunch time. Either Cerberus really engages GMAC’s bondholders (and it’s probably too late for that at this point), or else it will be forced to choose between throwing good money after bad, on the one hand, or seeing a major portfolio company fail, on the other.

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AIG’s Speculative CDS Bets

Posted on December 10, 2008 by Felix

Did you know that AIG has a Blog Relations department? For real. They sent out a big email earlier today, which wound up in places as varied as Dealbreaker and Welt Online, taking issue with the WSJ’s story about them this morning. Unfortunately, they seem incapable of writing in English, and even if you do try to decipher what they’re saying, it seems to be little more than "this isn’t news, it was on page 117 of our 10-Q".

The notional amount attributable to the cash settlement portion of the AIG Financial Products multi-sector credit default swap portfolio has been consistently included in the total AIG Financial Products multi-sector credit default swap exposure in AIG’s SEC filings and is explained on page 117 of AIG’s Quarterly Report on Form 10-Q for the period ending September 30, 2008.

I did end up talking to a human at AIG about this, since I wondered whether the company actually had any substantive issues with the WSJ story. It turns out that there is one big issue — that the amount of money in question is not $10 billion, as the Journal would have it, but…

…and there AIG goes quiet. They’re happy to tell you that the $10 billion is a notional amount, and not a mark-to-market loss: it’s AIG’s maximum possible loss, and the insurer does not at this point "owe Wall Street’s biggest firms about $10 billion", as the Journal says. But AIG won’t tell us how much it does owe on this book, so it’s impossible to tell whether its actual mark-to-market loss is close to $10 billion or not.

AIG is not disputing the main thrust of the story, which is that AIG Financial Products was stepping far beyond its remit as part of an insurance company. Most of the credit default swaps written by AIG were real insurance: they were sold to banks who held the securities in question and wanted to hedge their exposure.

But this $10 billion book wasn’t insurance at all, it was outright speculation. And now the US government is having to put up billions of dollars in collateral against those bets — bets which have gone very sour indeed.

I’m calling this one for the Journal. There might be a few minor errors when it comes to the specifics, I don’t know. But the big picture is clear. AIG insured banks, and it was necessary to bail out AIG in order to prevent a much larger domino effect caused by those banks not being paid out by their insurer. At the same time, however, there’s no reason to bail out the bits of AIG which were simply making speculative bets on the credit markets — and indeed there’s no reason why a triple-A insurer such as AIG should ever be making such speculative bets in the first place.

How much have those speculative bets cost? AIG won’t say. This time last month, it held a quarterly conference call, and in the slides for that call, on page 15, it gave some numbers for its total CDS exposure — both insurance and speculative. AIG wrote $71.6 billion of protection on multi-sector CDOs, and its mark-to-market loss, as of September 30, was $30.2 billion. That’s all we know so far. In October, that loss surely went up substantially; the loss on the speculative CDS might be much greater, in percentage terms, than the loss on the insurance CDS. But it’s probably safe to say that at a minimum, AIG’s mark-to-market losses on its speculative bets — losses for which the government has to provide collateral — are at least $4 billion or so.

That’s a lot of taxpayer money to put to use bailing out an insurance company’s prop desk. And given AIG’s recalcitrance in coming up with hard numbers which might contradict the Journal’s reporting, I do wonder why the Blog Relations department was so keen to send us all this note. They might have been better off just keeping quiet, frankly — especially when their formal statement is so incredibly stilted.

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The Goldman Munipal Conflict Non-Story Refuses to Die

Posted on December 10, 2008 by Felix

Remember the silly ProPublica report about alleged Goldman Sachs conflicts of interest in California? ProPublica subsequently took its act on the road, and used exactly the same Goldman report to produce an almost-identical article about New Jersey, in the Newark Star-Ledger. Except that one was even weaker, because in this case the state officials weren’t playing ball:

Tom Vincz, a spokesman for the New Jersey Treasury Department, declined to comment. Douglas Love, a member of New Jersey’s State Investment Council, which sets investment policy for the state’s pension funds, said he was not troubled.

"Research is research; it’s supposed to be independent," said Love, chief investment officer for an insurance fund. "That is proof they’re independent."

In fact, the only person troubled by the allegations in the second article was exactly the same person who was troubled by the allegations in the first article: Geoffrey Heal, a professor at Columbia. It’s all quite a song and dance to make out of one person’s opinion that there might be a conflict of interest at an investment bank — especially considering that investment banks, as the intermediaries between buyers and sellers of the same securities, always and by definition have conflicts of interest.

The worst bit about the second article, however, was the headline: "Goldman Sachs Sells New Jersey Bonds, Then Warns of Default". Nothing in the article suggests that Goldman actually did warn of default; instead, it simply opined that CDS spreads on the bonds in question were likely to rise. ProPublica, here, is suggesting that Goldman thinks New Jersey might default; I don’t think Goldman ever thought that.

ProPublica is right, however, that warning of a possible default is something which could do serious harm to municipal finances. If Goldman uncritically published something like this, I can imagine that New Jersey’s officials would be very angry:

New Jersey, like many other states, is facing a budget crisis, leading some to worry that it may default on part of its bond debt.

"Of the approximate $32 billion in outstanding debt in New Jersey, approximately $28 billion was never approved by the voters," John L. Kraft, a bond attorney in New Jersey, told us.

The state has no legal obligation to repay that portion, according to Kraft, because the contracts specified that the repayments would only be made if the legislature voted to approve them every year.

"Faced with budget deficits of many billions of dollars, and also being required to adopt a balanced budget each year, in these economic times, it’s possible that the state would choose to spend its money on essential purposes such as aid to the elderly and welfare, education, rather than making a debt service payment that they’re not required by law to make," Kraft said.

Of course, that didn’t come from a Goldman report, that came from another article by ProPublica’s Sharona Coutts. Is she being deliberately inflammatory here? I don’t know, and in fact I’d let her fall off the radar, until Bloomberg’s Joe Mysak, for reasons known only to himself, decided to resuscitate the story today. It’s still a non-story, and it still teeters improbably on a single Goldman recommendation dating back to September, but Bloomberg’s imprimatur gives it more legitimacy than it had before.

The biggest irony of all is that Goldman was completely and utterly right. As you can see, when Goldman issued the report, credit spreads on municipal debt (the MCDX index) were significantly tighter than spreads on investment-grade corporate debt (the CDXIG index). But that’s no longer the case: the MCDX is now at 330bp, while the CDXIG is at 269bp.

mcdx.jpg

Goldman’s strategists, it turns out, were inspired: if you shorted municipal debt in September and hedged by going long credit more generally, you would have made a lot of money by now. Does it really make any sense to say that the few people who are actually able to call this market correctly should shut up and say nothing, just because municipal issuers sometimes use Goldman to underwrite their bonds? Of course not. But for some reason, ProPublica — and, now, Bloomberg — doesn’t seem to understand that.

Posted in banking, journalism, Media, Politics | 3 Comments

How to Deal With GM’s Bondholders?

Posted on December 10, 2008 by Felix

If the comments on my GMAC bond entry earlier this morning are any indication, it’s going to be harder than I think a lot of people anticipate to bail in GM’s bondholders as part of any government bailout. Here’s three:

fresnodan: I have a friend whose father-in-law owns GM bonds, and he simply can’t see that it is possible for GM to go bankrupt. For him, any loss on the bonds seems ridiculous.

ken_g: Bankruptcy is the only way to deal with uncooperative bondholders.

anonymous: Why should GMAC and GM bondholders take a haircut but AIG counterparties and Bear Stearns, Citi, and Morgan Stanley bondholders not have to?

I am a GM bondholder, and I will certainly not agree to any haircut. If it were not for us having lent GM money, then GM would need even more federal money to avoid bankruptcy.

I suspect this is going to be a really big problem. Back in 1981, when Chrysler’s creditors were bailed in as part of the last big auto-industry bailout, they were much fewer in number and were generally much more sophisticated investors than a large chunk of the people holding GM bonds today.

Now, there’s a large contingent of GM bondholders who don’t mark to market and therefore won’t jump at any opportunity to get, say, 50 cents on the dollar for their paper. They want what they’re owed, and the easiest legal way of preventing them from getting it is bankruptcy.

Yes, there can be a tender offer with things called "exit consents" which make it harder for holdouts to sue for the money they’re owed. But the results of the GMAC tender offer would seem to imply that getting a critical mass of bondholders to agree to those exit consents would be tough. And in any case such an offer wouldn’t extinguish the holdouts’ debt, and those holdouts would certainly be a noisy thorn in GM’s side for many years to come.

GM doesn’t have a group of bank lenders it can get round a table and negotiate with: it has a bunch of very angry bondholders who do not, under any circumstances, want to take any haircut at all. And I fail to see how any car czar is going to be able to force them into taking one, short of putting together a pre-packaged bankruptcy.

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Q Datapoint of the Day

Posted on December 10, 2008 by Felix

Remember Pimco’s graph of Q showing it around the 0.3 level? I wasn’t sure where that number came from, and now CLSA’s Russell Napier has come out with a slightly more realistic (to me) number — which is also a lot more bearish.

The Q ratio on U.S. equities has dropped to 0.7 from a peak of 2.9 in 1999, and reaching 0.3 has always signaled the end of a bear market, said Napier, 44, the author of “Anatomy of the Bear,” a study of how business cycles change course.

Napier reckons that Q will go all the way down to 0.3, which would correspond to the S&P 500 trading at around 400. Yikes. All the same, if you’re willing to stomach a possible drop to 400, the absolute value of Q is already significantly below 1, which is one indicator that stocks are cheap — even if they are getting cheaper.

On the other hand, Q will naturally decline over time even if stocks are flat, as the denominator grows — as it’s bound to do if the government starts injecting large sums into corporate America. Indeed, I believe that Q was falling through much of the 2002-07 bull market. Which would imply that it has limited usefulness as an indicator of future stock-market direction.

(HT: Eisinger)

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Finding Holes in the TARP

Posted on December 10, 2008 by Felix

Elizabeth Warren is on the warpath. As chair of the Congressional Oversight Panel, charged with making sure TARP expenditures make sense, she’s going to be scathing, according to the WSJ, when she presents her first findings to the House today.

Quite right too: Treasury never did what it said it was going to do with the first $350 billion, and it certainly gave no indication of driving hard bargains when it repurposed those funds for recapitalization efforts rather than debt purchases. What we’ve seen so far looks much more like a bailout for the banks’ benefit than a bank rescue for taxpayers’ benefit.

That alone would make it hard for Treasury to get the second $350 billion from a very unhappy House. But when you add in the difficulties that the automakers have faced in getting much less cash, the hurdles facing Paulson and Kashkari seem immense.

All the same, there’s a huge amount of momentum behind TARP, and everyone knows the downside of failing to release the second tranche of funds:

House Financial Services Committee Chairman Barney Frank (D., Mass.), said Monday that Treasury would have to commit to using a large amount of the money to help prevent foreclosures in order to satisfy him. He said it would still be a tough sell with other lawmakers.

"With most of my colleagues, they’ll need police protection to even ask for the money," he said.

Even though a growing number of lawmakers have criticized the program, it is unclear whether Congress could actually block the second $350 billion from being used.

"I would see that being very difficult," Sen. John Ensign (R., Nev.) said of the prospect of Congress blocking the funds.

My guess is that the second tranche won’t be released before January. The oversight panel was installed for a reason, and it’s clearly unhappy about progress to date. If Treasury can simply barge on regardless and effectively ignore the panel, that’s tantamount to telling Congress that it has no real control over government expenditure. And that’s something you never want to tell Congress.

Besides, the financial markets aren’t placing as much weight and hope on the second tranche as they were on the first. They thought the first tranche would help a lot; it didn’t. They’re pretty sure that the second won’t be sufficient; they’re right. So if the $350 billion doesn’t come now, it’ll simply be tacked onto a much bigger stimulus package in January — one which House Republicans will find much harder to block, thanks to November’s election results.

I, for one, am suffering from a certain amount of bailout fatigue these days, and these ad hoc measures aren’t cutting it for me. If Geithner’s Treasury put together a strategic plan for the second $350 billion with Warren’s input, that would be a much easier sell.

Posted in bailouts | Comments Off on Finding Holes in the TARP

GMAC’s Recalcitrant Bondholders

Posted on December 10, 2008 by Felix

Can someone explain what’s going on with this GMAC tender offer?

The basics of the situation are clear: back on November 20, GMAC (which is 51% owned by Cerberus and 49% owned by GM) offered to swap existing bonds for new ones, as part of its bid to become a bank holding company. If the offers were taken up by 75% of bondholders, then GMAC would have enough regulatory capital to become a bank holding company and therefore eligible for TARP funds. But so far only 22% of bondholders have tendered, and despite today’s announcement that GMAC is extending the deadline on the offer, it seems improbable that the 75% figure will be reached.

The bit I don’t understand is this: why has the tender offer failed to gain traction? At first glance, the haircuts involved seem minimal — in fact for most of the GMAC (as opposed to ResCap) bonds, you get an identical bond in return, plus a cash payment for your troubles.

Of course there must be a haircut somewhere, because simply swapping bonds for identical bonds doesn’t raise your regulatory capital base. A haircut is not necessarily a bad thing for bondholders, since the viability of GMAC would increase were it to be able to tap the TARP, and their bonds are worth very little these days anyway. But it would be great to see an indication, somewhere, of the effective haircut that GMAC is asking its bondholders to take.

Because if GMAC’s bondholders aren’t even accepting a modest haircut, what are the chances that GM’s bondholders will go along with the surely much larger haircut which seems to be embedded in the current bailout plan? If they’re all really this recalcitrant, maybe bankruptcy is the only resort after all.

Posted in bailouts, bonds and loans | Comments Off on GMAC’s Recalcitrant Bondholders

Monopoly Money

Posted on December 9, 2008 by Felix

Larry Doyle thinks he’s joking:

That’s when the bankers and the C.E.O.s all disappeared into that underground paradise they’ve been building since the eighties; that’s when women’s skin started falling off; that’s when the Treasury Department, in a last-ditch effort to solve the financial crisis, certified all Monopoly and other board-game moneys…

Hm. People have been wondering what the best way, in practice, of dropping money from a helicopter might be. To within an order of magnitude, I reckon that certifying all Monopoly money would constitute an immediate liquidity injection of about $1 trillion, or 66 million extant US sets, based on total historical worldwide sales of 200 million games.

And Hasbro wouldn’t even need to change anything! They conveniently switched to a new set of currency in September; only the old notes would be certified.

You can only imagine the frantic searching through dusty attics. And the way that all of us, pace Jay-Z, could suddenly "play Monopoly with real cash". At least until we took our moldering board games straight to the nearest bank. And discovered that the owners had all taken off to their secret underground paradise.

Posted in fiscal and monetary policy | Comments Off on Monopoly Money

Extra Credit, Tuesday Edition

Posted on December 9, 2008 by Felix

Three-Month Bill Yield Goes Negative: I guess the credit crisis ain’t over yet.

Liquidity, Default, Risk: Brad DeLong on where the money went. Waldmann comments.

Infrastructure: Roads and The Smart Grid: Where infrastructure money should, and shouldn’t, be spent.

Deep Capture? Deep Shmapture: Another naked-shorting conspiracy-theorist CEO.

Symmetrical Shopping Spree: Eye-popping sums being spent on numerical domains such as 245.com and 8808.com.

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Don’t Fund Infrastructure Projects Separately

Posted on December 9, 2008 by Felix

Barack Obama wants to spend tens and possibly hundreds of billions of dollars on new infrastructure projects. It’s lucky that the government can borrow money for free, right? After all, whenever the government takes on obligations which are funded through any other mechanism, that always ends up being much more expensive.

But according to Michael Lind, that’s exactly what Obama should do: rather than fund infrastructure projects out of general funds, it should issue infrastructure-specific debt, perhaps via the creation of a National Infrastructure Reinvestment Bank. He writes:

Today the federal government, unlike state and local governments, lacks the capability to borrow money by issuing bonds for particular capital improvement projects like Obama’s priorities of infrastructure, school buildings, broadband and energy-efficient retrofitting.

Frankly, this isn’t a capacity I feel the government really needs. After all, we can borrow as much money as we like, at rock-bottom rates, directly in the Treasury market. Why fund infrastructure investments with more expensive borrowing from an infrastructure bank? And if the infrastructure bank starts funding things like school buildings, how is it going to be repaid? Through tuition fees?

Some crucial infrastructure investments — a major upgrade of the electricity grid, for instance — simply don’t have nice future cashflows associated with them. If the National Infrastructure Reinvestment Bank needs some kind of positive return on investment, they’ll never happen. Which is why I’m not convinced that it’s a good idea. Of course it will always find projects to fund. But they’ll be the projects which are the most profitable, and those aren’t necessarily the projects which are the most needed.

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In Defense of the CDS Market

Posted on December 9, 2008 by Felix

John Dizard wants to kill off the entire CDS market. It does no good, he says, and quite a lot of harm, and we’d all be better off without it.

I disagree. Dizard says there are only "three possible defences for treating the CDS market as a going concern"; in fact, there are more than that, and he misses out the big one, which is that the CDS market has allowed investors, for the first time ever, to hedge their credit exposure. Yes, there’s a downside to that — which is that it becomes easier to simply buy credit protection than to do the hard work of fundamental credit analysis. But CDS by their nature are more liquid than bonds, and it will always be easier to buy credit protection than to sell a bond.

What’s more, CDS prices are a much better indication of credit risk than bond spreads are, for many reasons including the tax treatment of bond coupons and the fact that many bonds simply don’t trade. In other words, not only are they more liquid, they’re also more transparent. These are good things.

But Dizard doesn’t concentrate on simple things like liquidity and transparency. Instead, he talks about CDS providing "support for capital raising", which was never something it was designed or even really used for. The whole point of credit default swaps is that they’re derivatives: they’re not cash instruments to be used for raising capital.

Dizard does have a good point that as spreads have widened, banks have seen increasing amounts of money tied up in CDS collateral. That’s a concern, and it’s a good reason to work hard on compression, netting, and rehypothecation. It’s not a reason to kill the CDS market outright.

Dizard’s other big point, however, eludes me:

Price discovery is a useful economic function; that is the rationale for commodities markets. But CDS are derivative instruments, whose price is "discovered" these days as a function of equity volatility, since buying equity puts is one way to dynamically hedge the illiquid legacy books…

At high levels of default risk and equity volatility, if you hedge the one with the other you get frantic, self-defeating activity.

I’m not sure I understand this, but Dizard seems to be saying that there’s a lot of capital-structure arbitrage going on: people hedging equity positions in the CDS market, and vice-versa. That’s a strategy which has blown up quite consistently since the summer of 2007, and it tends to require quite a lot of leverage, so I’d be surprised if it was a major factor today. But even if it is, I still don’t see why it means the CDS market should be abolished.

I do understand, however, what Dizard is saying here:

If the default rates implied in investment grade CDS spreads were to occur, the only economic activity would be court-supervised reorganisation. The CDS market has been preventing efficient price discovery.

He’s wrong. I just had a long conversation with Kai Gilkes of CreditSights, who confirmed for me that it’s pretty much impossible, in this market, to back out implied default rates from CDS spreads. There are so many technical factors in the market, so many reasons beyond expected default that people are buying protection on certain credits, that it’s impossible to isolate expected default probabilities. So I don’t know what implied default rates Dizard is using, but I do know that they’re unreliable to the point of uselessness, since right now CDS spreads tell us precisely nothing about expected default rates.

So yes, if you try to use CDS spreads as a guide to default probabilities, you’re not going to get very far. But there are lots of other things that credit default swaps are useful for. So let’s not abolish the entire market quite yet.

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The Auto Bailout, in a Nutshell

Posted on December 9, 2008 by Felix

What is that fugly minivan, anyway? And why do I get carsick just looking at it?

Posted in bailouts | Comments Off on The Auto Bailout, in a Nutshell

Civil Society: Falling Apart

Posted on December 9, 2008 by Felix

Yesterday, the idiot was Marc Dreier; today, it’s Rod Blagojevich. Both of them powerful men near the very top of their professions; both of them sworn to uphold the law; both of them resorting to the kind of desperate criminality which is almost certain to be caught and prosecuted.

Is this the beginning of a pattern? First it was subprime mortgages, then credit markets, then the financial system, then the economy. Now it’s civil society in the crosshairs.

Normally, political developments have little effect on markets, and nor should they. But if I were bullish on equities generally, this news would give me pause: things are still falling apart, still getting worse.

Yes, we do seem to be in something of an up market right now. But all that means is that there’s no indication the recent spate of bad news and high-profile downgrades has really been priced in: another big stock-market crash is eminently possible. The volatility isn’t close to being over yet.

Posted in law, Politics | Comments Off on Civil Society: Falling Apart

Nationalizing Detroit

Posted on December 9, 2008 by Felix

David Sanger has an insightful and sober piece in today’s NYT which first calls a spade a spade — yes, we are in the process of nationalizing the Big Three — and then looks at the implications.

If the government were to choose a bankruptcy jurist as the car czar, things might be different: the czar would perform what Nancy Pelosi calls barbershop functions — handing out haircuts to all stakeholders — and then get out of the way. But that doesn’t seem to be the intention: it looks like the czar is going to have much broader strategic input than that, and will be charged by Congress with essentially guiding Detroit out of the wilderness and into some kind of sustainability.

This is good news for Detroit’s bondholders, no matter how much of a haircut they’re forced to take. Once Uncle Sam’s very own car czar is in charge, you can be sure that further liquidity support will be forthcoming whenever it’s needed, and that the chances of a re-default in the near future are slim.

On the other hand it’s bad news for taxpayers, who will pony up billions of dollars now, just to get the Big Three into the new year, and then billions more in January, as part of the restructuring plan, and then untold billions on top of that in the years to come, as no one in Washington wants to take any responsibility for pulling the plug.

And of course it doesn’t stop there. Just for starters, think for a minute about the car czar’s responsibility for Opel, and the negotiations which are going to start up between the US and German governments over the European marque’s fate. On the one hand, Opels are clearly the kind of thing which Congress wants GM to make more of. But they want GM to make those cars in America, not in Europe. And GM has already asked the German government for money to keep Opel going.

This is likely to start out messy, and only get messier. The balance of probabilities has to be that it will all end in tears.

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Extra Credit, Monday Edition

Posted on December 8, 2008 by Felix

The stock market’s 1930s-style behavior: "It’s awfully hard to say at the moment what shares in publicly traded corporations, especially financial corporations, might be worth. A lot of them might be worth nothing at all. So it really shouldn’t be a big surprise that markets are struggling to settle on what the correct prices might be."

DTV to save economy? How digital TV is its own stimulus package.

Bailout song for the holidays

Posted in remainders | Comments Off on Extra Credit, Monday Edition

Conspicuous Consumption Datapoint of the Day, Private Jet Edition

Posted on December 8, 2008 by Felix

Times have changed over the past ten years when it comes to attitudes to

private jets. In October 1998, Nathan Myhrvold famously wrote a lavishly-illustrated paean to his Gulfstream V in Vanity Fair, and even appeared in a Gulfstream ad in the same issue. Fast-forward ten years, however, and William Langewiesche is much less sympathetic to the conveyances of the super-rich, or to those who write glowingly about them:

The Legacy occupies a position toward the high end of private jets–among airplanes like Gulfstreams, Challengers, and Falcons–which by political, ethical, and environmental measures are abhorrent creations, but which nonetheless are masterworks of personal transportation. The Legacy weighs 50,000 pounds fully loaded, and is powered by twin Rolls-Royce turbofan engines mounted aft against the fuselage, delivering a total of 16,000 pounds of thrust at a price to the atmosphere and global oil reserves of about 300 gallons an hour…

Along for the flight was Embraer’s North American sales representative Henry Yandle and a New York Times contributor named Joe Sharkey, who writes a business-travel column for the newspaper and was doing a story for a U.S. magazine called Business Jet Traveler… Sharkey seemed a decent sort, and unlikely to delve into the airplane’s dark side–the fuel burn per passenger-mile, the expense to company shareholders, the disproportionate use of public resources like air-traffic control and landing slots. No, it was a safe bet that Business Jet Traveler would not be publishing that.

Myhrvold appeared in the October 1998 issue only as "Anonymous", but was outed soon thereafter by the Wall Street Journal. Even then, it seems, there was a certain amount of shame associated with such profligacy. Today, it’s more obvious why private jets are shameful things, and why it was idiotic for Detroit’s CEOs to take three of the the things to the initial Washington hearings on the fate of their industry.

Still, I do wonder how much their combined wristwatches were worth. Maybe the gilded few are still burning through money, just more quietly than before. The tick of a second hand is so much more understated than the roar of a jet engine, after all.

Posted in consumption | Comments Off on Conspicuous Consumption Datapoint of the Day, Private Jet Edition

Why Elizabeth Warren is an Inspired Choice to Oversee TARP

Posted on December 8, 2008 by Felix

Tom Brown has a peculiar column today taking issue with the inspired choice of Elizabeth Warren to chair the panel overseeing the TARP program. The problem, in his eyes, is that Warren is a fighter for consumers, rather than banks. Brown reckons she’s absolutely wrong when she says that banks attempt to pry every dollar possible out of consumers, fairly or otherwise:

Warren’s view of the consumer finance industry, and the “tricks” at lenders’ disposal, happens to be 100% wrong. If consumer lenders really did have the fearsome advantage over their customers Warren imagines, how is it that the entire subprime mortgage industry has gone out of business over the past 18 months? Or that most monoline card lenders have either gone belly up or have been forced to seek buyers? Here’s why: consumer lending is a tough, competitive business. Lenders don’t have proprietary, unfair tricks. They all get competed away.

Tom Brown should, frankly, get out more. For many years, lenders have made an ever-increasing proportion of their revenues from fees, penalties, and interest rates which spike up for any or no reason. The lenders have every incentive to maximize those fees, to the detriment of their customers, even when they bear no relation to the actual costs involved.

Remember, for instance, the fixed $78.10 cost of wiring money from a dollar bank account in Ireland to a dollar bank account in New York. All but $20 of that went straight to banks, whose aggregate actual costs were to all intents and purposes zero. Funny how those fees haven’t been "competed away" — or any of the other fees which mean that the overwhleming majority of Americans end up paying large sums for the privilege of lending their money interest-free to the bank.

Yes, consumer lending is tough and competitive. But that’s precisely why there are so many hidden fees. If the fees were obvious and up-front, no one would choose to bank at that institution, even if they totaled a fraction of what other banks charged. And so the banks get increasingly devious and unpopular.

In normal times, there’s very little that we the people can do about this, but these aren’t normal times: in fact, the tables have now, deliciously, been turned. It is we who are now setting the terms; it is the banks who are being forced to accept them. The taxpayers who are coming up with $700 billion to save the banks are exactly the same people who have been systematically squeezed by the banking system for years, and it’s only just that they should try to put an end to unfair and underhand practices.

Says Brown, on Warren:

She cares less about seeing that the TARP money helps end the financial crisis, I suspect, than she does about finding ways to bind the industry in a straitjacket of new “consumer-friendly” regulation. Unfortunately, those new regulations would almost certainly have the effect of slowing the supply of credit–the opposite of what the TARP plan is supposed to achieve.

There’s no reason why "consumer-friendly" should be in scare quotes there: the term means exactly what it says. Excess lending to consumers is not consumer-friendly, even when it results in lenders going out of business. Banking isn’t a zero-sum game, not when it’s played the way it has been over the past few years. If I take out a $500,000 loan to buy a house I can’t afford, and then I fail to pay it back, both I and the lender lose.

Honest lenders have nothing to fear from simple consumer protection. All that Warren is asking is that their fees be up-front and clear, rather than buried in small print — so that consumers know exactly what they’re getting themselves in for. There’s no reason this should slow the supply of credit at all, especially considering that it should have the happy consequence of lowering default rates and increasing the quality of the asset side of banks’ balance sheets. Which would also help to minimize the chances that we’ll have to have another bank bailout.

After all, the constraints on lending, right now, are on the supply side, with the banks: there’s no shortage of demand for new loans. The banks should know now, if they didn’t before, that treating loans as a loss leader, with the real profits to be made in hidden fees and other underhand tactics, is not a good long-term strategy: it weakens the quality of your loan book too much. And credit is so tight right now that banks don’t need to advertise low loan rates in order to get customers.

So let’s take this opportunity to get truth in lending, and put an end to the practices that Elizabeth Warren has been railing against. If we do it well, everybody will end up a winner.

Posted in bailouts, banking, regulation | Comments Off on Why Elizabeth Warren is an Inspired Choice to Oversee TARP

Re-defaults

Posted on December 8, 2008 by Felix

The word of the day is re-default:

Comptroller of the Currency John C. Dugan said today that new data shows that more than half of loans modified in the first quarter of 2008 fell delinquent within six months…

A key question, Mr. Dugan said, is why is the number of re-defaults so high? “Is it because the modifications did not reduce monthly payments enough to be truly affordable to the borrowers? Is it because consumers replaced lower mortgage payments with increased credit card debt? Is it because the mortgages were so badly underwritten that the borrowers simply could not afford them, even with reduced monthly payments? Or is it a combination of these and other factors?”

An even more key question is why on earth Mr Dugan is surprised by this number. As Paul Jackson points out, loan mods normally have a 50% failure rate. On top of that, there are two key points which Dugan seems to have missed:

  • The single most important factor underlying mortgage defaults is falling house prices.
  • House prices have continued to fall throughout 2008.

Given all that, we should be thankful that loan modification programs have managed to keep half of formerly-delinquent homeowners out of default.

We should also understand why, from a bank’s point of view, it’s silly to modify loans by reducing the principal amount outstanding. It makes sense to reduce interest payments — to something well below the bank’s own cost of funds, if necessary. But the bank will also want to protect itself if that doesn’t work, by keeping the total amount owed high. The problem there is that the homeowner will remain underwater — and having an underwater loan is a strong incentive for any homeowner to walk away.

As ever, there are no easy answers. But maybe it really takes a year’s worth of re-default data to persuade the OCC of that.

Posted in housing | Comments Off on Re-defaults

Thain’s Bonus

Posted on December 8, 2008 by Felix

A bunch of investment-bank CEOs are dangling from a rising hot-air balloon. Dick Fuld, as we know, held on for too long, and by the time he finally let go, there was too far to fall, and he died. Jimmy Cayne was slightly luckier: he too held on too long, but when he finally let go, Jamie Dimon was there to help break a little bit of his fall. Cayne suffered serious injuries from which he will never really recover, but a flicker of life remains. John Mack and Lloyd Blankfein are both still holding on. And John Thain? He let go just before it was too late, suffered a few broken bones, but lives to fight on.

So the question is: Who deserves a bonus? Jim Surowiecki reckons that Thain’s decision was "bonus-worthy", and implies that a $10 million bonus would not be unreasonable. But none of the others are getting a penny: not Fuld, not Cayne, not Mack, not Blankfein.

Did Thain really do a better job than Blankfein? Maybe, it’s too early to tell. But he certainly looked pretty bad back in July. His subsequent decision to sell to BofA was, in hindsight, a good one. But he doesn’t need the money, and the optics are terrible. If I were him, I’d voluntarily renounce a bonus for this year, rather than ask the board for an eight-figure sum. Alternatively, if he does get that $10 million, he should immediately give it away to loyal Merrill Lynch support staff who have lost their jobs and their futures through no fault of their own.

Posted in banking, pay | Comments Off on Thain’s Bonus

The Case for Making Bigger Cars

Posted on December 8, 2008 by Felix

I just watched the webcast of Paul Krugman’s Nobel Prize lecture (slides here). In it, he laid out his theories of economic geography, which help explain why industries tend to cluster in certain geographical locations.

He ended on a topical note: Detroit. The fact is, he said, that the world as described in his models — "one of circular logic and agglomeration" — actually peaked in the 1920s, at least in the US. Since then, the world has become increasingly classical, and while Krugman’s theories remain relevant, they’re not quite as relevant as they were.

Krugman didn’t go so far as to predict the (further) decline of Detroit, although he hardly needed to. But his theories do suggest what might be needed for Detroit to survive: specialization.

The old GM slogan of "a car for every purpose, a car for every pocketbook" can’t work any more. Back in the 1920s, or even the 1960s, making cars was itself a specialization. Cars were made in Detroit, carpets were made in Georgia, and the two would trade with each other. But now there are so many different types of car, and the global competition in the car industry is so fierce, that there’s no point in Detroit trying to do what it’s bad at.

Specialized car companies can be spectacularly successful: look at Porsche. But when Detroit tries to do that kind of thing, by, say, buying Aston Martin, it never seems to work. It’s just not what Detroit is good at.

What’s more, Detroit knows what it’s good at. For decades now it has railed against any Congressional attempts to mandate increasing fuel economy, and its single biggest success — the SUV — has been the vehicle which did an end-run round fuel-economy standards by classifying itself as a truck. If you try to force us to make more fuel-efficient cars, say the Big Three with monotonous regularity, we’ll lose money. We can’t do it. We don’t have the technology. (And please don’t notice that our European subsidiaries, such as Opel, seem to be very good at such things.)

Right now, the Big Three — Chrysler and GM especially — will say anything which will get them the money they need to avoid declaring bankruptcy. But their declarations that they’ve suddenly got religion when it comes to small, fuel-efficient cars ring hollow. What’s changed since they last protested that they were incapable of manufacturing such things? Why should we believe that Detroit will ever have any kind of comparitive advantage on that front?

Ironically the Big Three might be better off if they stuck to what they’re good at: gas guzzlers. Why is Ford the healthiest of the three? There’s one big reason: the F series pickup truck. And the brightest of GM’s dim bulbs is Cadillac, a marque which has never been known for its fuel economy.

Detroit knows that it needs to get smaller. If it’s going to downsize, it should stick to what it’s good at, rather than try to compete with Japanese and European manufacturers on turf it conceded to them decades ago.

Either that, or persuade the US authorities to adopt European safety standards, thereby allowing Detroit’s successful European models to simply be introduced directly to the US market. If Detroit is going to undergo wrenching reforms, Congress could at least help out a little on the regulatory front.

Posted in bailouts, economics | Comments Off on The Case for Making Bigger Cars

Is Goldman Covered by the Community Reinvestment Act?

Posted on December 8, 2008 by Felix

Sanford Bernstein’s

Brad Hintz knows much more about banking than I do. And he seems to have discovered a CRA loophole, at least insofar as the Community Reinvestment Act applies to Goldman Sachs:

Mr Hintz, who predicts a change in Goldman’s model, understands that the brand remains sacrosanct and so he doubts the firm will acquire a conventional bank. “If you acquire a bank, you’ve got Community Reinvestment Act requirements,” he says, referring to US banking rules that require banks to lend in all segments of their communities. “It’s hard for me to believe that Goldman executives are going to be out calling on Korean bodegas.”

It seems that, at least according to Mr Hintz, Goldman still isn’t covered by the CRA — even though it is now a commercial bank. What’s more, Goldman can avoid ever being covered by the CRA, so long as it doesn’t acquire a conventional bank. (For some reason, Goldman Sachs Bank USA, in Salt Lake City, doesn’t seem to count.)

As for the CRA requirements, there’s a universally-accepted way of getting around them without directly lending to Korean bodegas: you just put money on deposit at credit unions which do lend to Korean bodegas. My credit union, for one, would love to take a large deposit from Goldman Sachs, and would put it to good use lending to low-income borrowers in Goldman’s own local community of downtown Manhattan.

But now it seems that maybe Goldman isn’t covered by the CRA after all. And, of course, even if it is covered by the CRA, it can happily ignore that so long as its regulator, New York State, is willing to overlook the fact. It’ll be interesting to see when, whether, and how Goldman clears this issue up.

(HT: Richards)

Update: I just heard from Goldman, and they don’t know what Hintz is talking about either. Yes, now that Goldman is a bank holding company, it is already governed by the CRA, and they’re in the process of putting the legal infrastructure together and hiring a CRA officer.

Posted in banking | Comments Off on Is Goldman Covered by the Community Reinvestment Act?