GM got a stern dressing down when it showed up in Washington with Detroit's other suffering automakers, hat in hand, seeking a bailout. Would you rescue an outfit with these characteristics:
The company is on shaky financial footing, perhaps insolvent. It is guilty of overpaying workers (blue-collar employees got generous union contracts that provided unsustainable benefits). Its core business suffered from stunningly bad decisions (not developing enough good high-mileage or green vehicles, for example, leaving the company with unpopular products it has trouble selling).
The verdict: Let it perish! But what about the following supplicant:
The company is on shaky financial footing, perhaps insolvent. It is guilty of overpaying workers (white-collar executives got outrageous bonuses and salaries that didn't reflect the long-term viability of the operations they oversaw). Its core business suffered from stunningly bad decisions (taking on too much leverage and acquiring risky, complex securities, leaving the company with unpopular products it has trouble selling).
The verdict: Save it at any cost!
Of course this second example is Citigroup. The financial giant not only received a bailout, but the terms were astonishingly generous. First Citigroup gets a $20 billion loan. Then the federal government agrees to backstop its losses on $306 billion of potentially crappy mortgage-backed securities. That's billion with a “b.” Worst-case scenario, taxpayers would be on the hook for roughly $250 billion on the backstop provision alone. That's more than ten times how much the embattled Big Three automakers sought to borrow, only to be rebuffed.
To be clear: GM shouldn't get a rescue package, not without a tough shakedown. But what about Citigroup? I know it's large. I know letting it fail would be akin to letting die the guy in the science-fiction film whose body is teeming with highly virulent viruses that, if he expires, will explode into the air and perhaps wipe out civilization.
But can’t the Bush team knuckle down and drive a hard bargain with at least one of these financial companies, especially since they’re bargaining from a position of weakness? It’s really baffling.
Monday, November 24, 2008
Saturday, November 15, 2008
Give Me a Lever Long Enough and I'll Buy the World
When the definitive history of this financial crisis is written, the role of leverage should get a hard look. In the ailing credit markets, leverage turned what should have been chest pains into a full-blown heart attack. The “seize up" metaphor became especially apt.
Those following the storyline closely will know that leverage at Wall Street investment banks soared from levels of 12-1 to 30-1 in about four years. But what does that mean? To the average guy on Main Street, leverage is a rather abstract, foreign concept. However it's critical to grasp the destabilizing power of leverage to understand the mess we're in.
The standard definition of leverage compares money borrowed to equity. So if you take out a $3 million loan and your only equity is a $300,000 house, you’re leveraged at 10-1. But there's another way to look at this idea that illustrates the vulnerability created.
Let's say you buy a stock option (that financial engineers have dreamed up) that behaves this way: it costs $3.33 and captures the return on a $100 share of stock. That's leverage at 30-1. The upside is wonderfully lucrative. If that stock gains a bit more than 3 percent, you double your investment. Beautiful, you may be thinking. The only problem is that when it drops the same amount, you find yourself wiped out. So leverage magnifies risk.
Dizzying amounts of leverage contributed to the demise of Long Term Capital Management in 1998. When it began to implode, the firm had $4.9 billion of capital supporting a towering, Seussian edifice of $1.25 trillion of positions not reflected on its balance sheet. LTCM effectively had no cushion to fall back on when setbacks in the market began eating up its capital.
When LTCM began crumbling, the Federal Reserve had to intervene to ensure an orderly dismantling of the company. LTCM had become too big to let it simply collapse. Sound familiar? One takeaway lesson should have been that financial regulators need to closely monitor levels of leverage in the system. But somehow we lost sight of that.
Those following the storyline closely will know that leverage at Wall Street investment banks soared from levels of 12-1 to 30-1 in about four years. But what does that mean? To the average guy on Main Street, leverage is a rather abstract, foreign concept. However it's critical to grasp the destabilizing power of leverage to understand the mess we're in.
The standard definition of leverage compares money borrowed to equity. So if you take out a $3 million loan and your only equity is a $300,000 house, you’re leveraged at 10-1. But there's another way to look at this idea that illustrates the vulnerability created.
Let's say you buy a stock option (that financial engineers have dreamed up) that behaves this way: it costs $3.33 and captures the return on a $100 share of stock. That's leverage at 30-1. The upside is wonderfully lucrative. If that stock gains a bit more than 3 percent, you double your investment. Beautiful, you may be thinking. The only problem is that when it drops the same amount, you find yourself wiped out. So leverage magnifies risk.
Dizzying amounts of leverage contributed to the demise of Long Term Capital Management in 1998. When it began to implode, the firm had $4.9 billion of capital supporting a towering, Seussian edifice of $1.25 trillion of positions not reflected on its balance sheet. LTCM effectively had no cushion to fall back on when setbacks in the market began eating up its capital.
When LTCM began crumbling, the Federal Reserve had to intervene to ensure an orderly dismantling of the company. LTCM had become too big to let it simply collapse. Sound familiar? One takeaway lesson should have been that financial regulators need to closely monitor levels of leverage in the system. But somehow we lost sight of that.
Thursday, November 6, 2008
Wall Street’s Deafening Silence
Throughout the long dark days of this financial crisis, one thing that has struck me is the silence of Wall Street’s public relations machines. I keep waiting for one bank, any bank, to give us their best-spin version of what went wrong, or why they aren’t as bad as all those others – or to say something. Surely they must see how vilified they have become. Shareholder activist Nell Minow even quipped that the Street is one bonus away from having the villagers descend with torches.
But when “60 Minutes” did its exposé on the financial crisis early on, none of the major Wall Street banks would comment, apparently in any form. None of them even sent what I call the “coward’s note” – that carefully crafted defense/statement that is read on air at the end of the broadcast segment. Later, when the bank CEOs went to Washington to sign off on billion-dollar bailouts, they left the meeting with Treasury Secretary Paulson and fled to their limousines. They adroitly dodged the press corps waiting outside. None of them did so much as issue a short statement of thanks or say that the money would help them extend more loans to unfreeze the credit markets.
How to explain this total silence? Partly it may stem from a “duck and cover your ass” mentality: anyone who raises his head to defend himself at this unsettled time may just draw more incoming fire. Also the more you say, the more ammunition you supply prosecutors and lawyers busy cobbling together investigations and lawsuits related to the financial meltdown. But the biggest reason may be simply that Wall Street’s largest banks realize how badly they screwed up.
When you think you’re an innocent man, you want to shout your message to the world. When you think you’re innocent to some degree, you seek ways to disseminate your version of events. When you think you’re guilty as hell, you shut up and pray for an earthquake or something that will bump news of your misdeeds off the front page.
But when “60 Minutes” did its exposé on the financial crisis early on, none of the major Wall Street banks would comment, apparently in any form. None of them even sent what I call the “coward’s note” – that carefully crafted defense/statement that is read on air at the end of the broadcast segment. Later, when the bank CEOs went to Washington to sign off on billion-dollar bailouts, they left the meeting with Treasury Secretary Paulson and fled to their limousines. They adroitly dodged the press corps waiting outside. None of them did so much as issue a short statement of thanks or say that the money would help them extend more loans to unfreeze the credit markets.
How to explain this total silence? Partly it may stem from a “duck and cover your ass” mentality: anyone who raises his head to defend himself at this unsettled time may just draw more incoming fire. Also the more you say, the more ammunition you supply prosecutors and lawyers busy cobbling together investigations and lawsuits related to the financial meltdown. But the biggest reason may be simply that Wall Street’s largest banks realize how badly they screwed up.
When you think you’re an innocent man, you want to shout your message to the world. When you think you’re innocent to some degree, you seek ways to disseminate your version of events. When you think you’re guilty as hell, you shut up and pray for an earthquake or something that will bump news of your misdeeds off the front page.
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