Creative Destruction: Automotive Edition

The shares of General Motors, America's largest automaker, are now worth less than those of Goodyear. In a sense, GM is now worth less than the sum of its part. This is bad news, not only for those employed by GM, but for everyone who is even remotely concerned about the government throwing caution to the wind and bailing out uncompetitive, politically-sensitive industries.

You see, GM and the rest of the Big Three are vying for public funds to keep them out of bankruptcy, or at least to keep them functional during a bankruptcy. For some firms, like United Airlines, it is possible to enter into bankruptcy proceedings and resume flights a short time later. However, unlike with commercial aviation, car consumers are looking at shelling out anywhere from $20-70K for a vehicle with the expectation that the firm will be there five, ten years down the road to provide ongoing support. The worry is that, should GM, Chrysler or Ford enter into Chapter 11 bankruptcy proceedings, consumer confidence will plummet and they will never recover. Kaput.

Unlike the airline edition of this series, I have nothing personally riding on the outcome of this bailout debate. Nevertheless, the principle is the same. If a firm with as many assets as an enormous automotive company cannot receive financing, there's got to be a good reason. In fact, there are two good reasons. The first is that, due to the credit crunch, financial institutions are currently de-leveraging their liabilities and are thus unwilling to take on a large-scale financing project of this nature.

The second, more relevant, reason is that these firms have been operating under a failing business strategy for at least a decade. These companies are simply uncompetitive: they have over-priced, lower-quality vehicles (pickups excepted), silly-expensive labour union deals and are failing to adjust to environmental concerns.

Moreover, this bailout plan smacks of thinly-disguised politicking. It is a well established fact that the Big Three have considerable traction in Washington, and a Democrat-dominated legislature tends to lean towards protectionism on these issues. In any event, we'll find out on Monday how this one is going to play out. In the meantime, some questions to ponder and some readables to read.

Question first: Do the Big Three pose systemic risk for the economy in the same way that Bear Stearns or AIG do? If not, why are they being considered under TARP?

Question second: Should the government finance GM's bankruptcy, do they have any prospect of getting their money back?

Yet more questions: For a considerable chunk of the electorate (and thus a considerable chunk of politicians), defending the Big Three is equivalent to defending American industry. But what is an American car anyway? If it's a Ford minivan made in Windsor, Ontario with Japanese parts, does it count? What if it's a Honda made in Ohio? Or that Mercedes engine plant in Alabama?

Links
- FT Alphaville thinks we've moved past moral hazard into a barely-concealed sense of entitlement. Nobody "deserves" a bailout.
- GM wants a bailout? Clusterstock lays out their conditions.
- Clusterstock responds with a counter to its own argument.

Opening material sourced from Planet Money.

Subprime Mortgages & Risk Sensitivity Explained

"It is sad how little we have learned about the market’s frequent insensitivity to risk."

That's the concluding sentence of a short essay by Avinash Persaud that helps to explain why sub-prime mortgages, which account for less than 1% of the world's debt, caused this whole mess:

The pursuit of “risk sensitivity” led to a re-organisation of bank assets away from lending on the basis of the banker’s private views about the borrower - regulators considered this hard to quantify and a little suspect – towards lending on the basis of an external credit rating. The higher the rating, the lower the capital banks had to set aside against the loan. Regulators saw this as not only risk-sensitive but transparent and quantifiable. Banking by numbers was oh so modern.

Regulators always seem to be pushing towards greater transparency in all things. Transparency is, in itself, a good thing - no question. But I find the total and complete focus on transparency to place too much faith in the ability and/or willingness of market actors to understand what these indicators reveal (or don't) and to alter their behaviour accordingly. In this case, the article concludes that the push for quantifiable risk actually obscured the nature of the risk within debt instruments.

For the policy discussion at hand, this is part of a larger point on regulation. Last night we heard Senator Obama blaming "deregulation" for the current crisis, and it's reasonable to expect the regulatory hand to come down a lot more heavily in the months to come. So be it. But preventing future bubbles in non-mortgage-related markets will require better regulation, not simply more of it. This is, of course, easier said than done - but I think it's time to take a good hard look at the market's historical record in sensitivity to risk.

Hank Paulson's Flawed Bail-Out

I was asked yesterday why, given the state of the US economy and looming prospect of credit markets becoming as liquid as the Arizona desert, the US Congress was not passing Treasury Secretary Hank Paulson's troubled asset relief program (TARP). Let me provide you with a taste of the answers to that question:

The Economist:

It could safeguard irresponsible bankers’ jobs, while doing little to stop troubled mortgage debtors from being thrown out of their homes. It seeks to invest massive power in a treasury secretary with a lifelong loyalty to Wall Street. The banks with the worst assets (ie, those which have made the worst decisions) could receive the most help. Most disturbing, the taxpayer will be funding an enormous, ill-defined programme, without any stipulation as yet that the banks who orchestrated the mess will pay a penalty.

Martin Wolf:

The fundamental problem with the Paulson scheme, as proposed, is then that it is neither a necessary nor an efficient solution. It is not necessary, because the Federal Reserve is able to manage illiquidity through its many lender-of-last resort operations. It is not efficient, because it can only deal with insolvency by buying bad assets at far above their true value, thereby guaranteeing big losses for taxpayers and providing an open-ended bail-out to the most irresponsible investors.

Luigi Zingales:

If banks and financial institutions find it difficult to recapitalize (i.e., issue new equity) it is because the private sector is uncertain about the value of the assets they have in their portfolio and does not want to overpay. Would the government be better in valuing those assets? No. In a negotiation between a government official and banker with a bonus at risk, who will have more clout in determining the price? The Paulson RTC will buy toxic assets at inflated prices thereby creating a charitable institution that provides welfare to the rich—at the taxpayers’ expense. If this subsidy is large enough, it will succeed in stopping the crisis. But again, at what price? The answer: Billions of dollars in taxpayer money and, even worse, the violation of the fundamental capitalist principle that she who reaps the gains also bears the losses.

24/7 Wall St:

What has become clear is that Treasury plans to purchase bad assets from banks at prices very near their original value. The risk to taxpayers under this program would be tremendous. If housing prices continue to fall, so will the value of the paper the government has purchased. Under this set of circumstances the public could be at risk for underwriting the great majority of the Treasury's purchases and never having a chance to recoup their investment.

Let me add my own two cents. Here's how Section 8 of the original proposal reads:

Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.

Excuse me? This gives an enormous amount of discretionary power to the US Treasury and its boss. Given the sums of taxpayer's money involved, oversight is absolutely necessary. Paulson responds.

On a related note, does anyone else think Henry Paulson sounds like a professional wrestler?

Moral Hazard and the US Federal Reserve

As first reported by the WSJ, the US Federal Reserve has rescued AIG with an $85bn bridge loan, and has taken a 79.9% stake in the firm. This comes less than 24 hours after the US Treasury indicated that there would be no government bail-out of the firm. After a coordinated private-sector loan package failed to materialize, the Fed invoked its legal authority under Section 13(3) of the Federal Reserve Act, allowing it to lend to a firm in "unusual and exigent circumstances" if the borrower "is unable to secure adequate credit accommodations from other banking institutions."

AIG is a counterparty to insurance, corporate, and financial transactions around the world. It passes the "Bear Stearns test" (interconnection) for government intervention better than Bear itself. Plus, as Hank Greenberg (former Chairman/CEO of AIG and the man who literally built the firm from scratch) has argued, AIG's problem is one of liquidity, not solvency (like Lehman's). It is thus understandable, and appropriate, for the Fed to step in.

But this latest intervention has raised fresh problems for the global financial system. Moral hazard has increased substantially because the criteria for a government bail-out is undefined and poorly articulated in the current environment. No one envies Bernanke, Paulson, and Geithner, and there is no formula for this terrible mess. But government bail-outs have been entirely subjective, and future ones are now impossible to predict. Greater uncertainty is lethal to the markets in their current state, and may lead other fragile financial institutions (namely Morgan Stanley and Goldman Sachs) to assume a safety net. This is dangerous if it leads these firms to refuse asset sales or other prudent (and, most importantly, timely!) actions to raise capital and shore up confidence in their books. Both AIG and Lehman have faced the havoc that just 24 hours of inaction/delay can bring.

Many thought that the bankruptcy of Lehman was a sign that regulators were confronting moral hazard head on. But within hours, moral hazard came back with a bang. Luckily, there are only a few firms left that would qualify as truly "too interconnected to fail".
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UPDATE: Demonstrating how quickly things are changing, Reuters is reporting that Morgan Stanley is "weighing" a merger with a commercial bank. This would obviously negate much of the comment above, as it would appear banks are finally accepting the inevitable.

Prediction: by Christmas, there will be no major, independent US investment banks left. The broker-dealer model is dead.