Basis Point

Jim Rickards on Wall Street Risk Models

Jim Rickards, the former Long Term Capital Management general counsel who, as principal negotiator of the rescue of LTCM knows a thing or two about Wall Street risk, will testify tomorrow at 10 am before the House Science Committee's Subcommittee on Investigations about the risks of financial modeling. 

Here's a summary of the main points and an advance copy of his testimony:

Main Points

• The financial crisis would not have happened but for the fact that bankers, investors, rating agencies and regulators all relied on quantitative models which told them risk was under control.  These models go under the general name of "Value at Risk" or VaR.

• VaR is fatally flawed.  It relies on three assumptions about (i) efficient markets, (ii) random price movements and (iii) risk distributed in a normal or "bell curve" shape.  All three assumptions are wrong.  Markets are not efficient, prices do not move randomly and risk is not distributed in a bell curve.

• There is a better model.  It is built around a power curve rather than a bell curve.  The power curve accounts for frequent large scale failures.  It tells us that risk is a function of the size or scale of the system.  But as we increase scale, risk does not grow in a straight line, it grows exponentially.  This is why the system failed in such a spectacular fashion the past few years.

• If scale is the problem, it is also the solution.  By de-scaling we can reduce risk to manageable levels.  We do this in three ways: (a) reinstate something like Glass-Steagall to separate commercial from investment banking, (b) put all derivatives on exchanges where risk can be netted out and collateral maintained at safe levels and (c) reduce leverage by imposing stricter capital ratios for banks and brokers.

• There has been a lot of talk about this but little action.  The identical lessons of the 1998 collapse of LTCM were never learned or quickly forgotten.  Will that happen again?

$23.7 Trillion Out On a Limb

TARP Special Inspector General Neil Barofsky stunned everyone yesterday with an estimate that government support under the bailout could reach $23.7 trillion.  It’s an eye-popping number.  There is debate about what the $23.7 trillion number really means.  The New York Times’ Floyd Norris deconstructs it today under the headline “Big Estimate, Worth Little.”  However, we shouldn’t let this debate distract us from the fact that we are injecting a staggering amount of money into the economy. The taxpayer is out on a limb in support to the financial sector in a much bigger way than most people realize.  If the $23.7 trillion figure helps to illustrate the extent to which our government has committed us to save the financial sector, then, with apologies to the New York Times, it’s worth a great deal. 

It’s important to understand that $23.7 trillion is not a measure of what will be spent on the bailout, rather it is the total value of the amount of support available through government programs.  Direct spending, through programs such as the stimulus, makes up just one part of this calculation.  The loan programs through the Federal Reserve and FDIC intended to revive moribund credit markets are the most significant contributor. 

Treasury points out that the $23.7 trillion figure is misleading because, among other things, it includes loans that have assets behind them.  As an analogy, if the bank lends you $500,000 on a house, for the purpose of this calculation, the bank is providing $500,000 of support.  That doesn’t mean that the bank will be out $500,000 if things go wrong.  Ultimately they could sell the house for something.  Similarly, much of the government lending has significant collateral behind it.  Also, many of these programs, such as the $1 trillion TALF, are garnering little interest from investors so will likely never be fully utilized.  So, let’s concede that under no conceivable circumstances will the taxpayer be out $23.7 trillion.  But, that doesn’t mean we aren’t spending massive, unprecedented amounts of money on a scale that boggles the mind.  

The truth is no one has ever put this kind of money into an economy before and no one knows with anything approaching certainty what will happen.  Are we creating new bubbles (and preserving old ones) that will ultimately stagnate our economy?  Richard Bernstein, writing in the Financial Times today thinks so. (LINK: America is Now Still Blowing Bubbles). 

…[T]he goal of Washington’s policies has been to stymie the inevitable consolidation, keeping companies operating – and employing voters – rather than managing the consolidation to maximise the economic benefit. History says that Washington’s is an unwise and ultimately fruitless strategy. Certainly, there may be short-term gains in an economy by keeping a bubble’s unnecessary capacity alive (this may explain the recent improvement in economic statistics), but the continued misallocation of capital significantly hinders longer-term growth.

Bernstein goes on to argue that our policies are locking in overcapacity in the economy creating a situation analogous to Japan in the 1990s where we will limp along in economic stagnation for some time to come. 

Others, such as Arthur Laffer ("Get Ready for Inflation and Higher Interest Rates") and John Taylor ("The Threat Faced By Ballooning Federal Reserves", have argued that the amount of money being spent is creating dangerous inflationary pressures that will wreak havoc on the economy down the road.

Regardless of the outcomes, the question remains.  Did anyone ask us before they committed our money to back $23.7 trillion dollars in programs? 

Buffet Says the Economy Needs More "Viagra"

The Oracle of Omaha shared an interesting pharmaceutical metaphor for the economy with ABC News this morning:

"Our first stimulus bill ... was sort of like taking half a tablet of Viagra and having also a bunch of candy mixed in... as if everybody was putting in enough for their own constituents.  It doesn't really quite have the wallop that might have been anticipated there."

Warren Buffet Supports Second Stimulus for Economy - ABC News

Jim Rickards with Great Insight on the G-8 This Morning on CNBC

Of Schmucks and Toxic Assets -- An Innovative Idea to Rescue the Foundering Toxic Asset Program

Nobody likes to play the schmuck.  But, that’s exactly what the Feds are asking banks to do in order to participate in the Public Private Investment Partnership (PPIP).  

So is it any wonder the FDIC, as reported by The Wall Street Journal this morning, is considering scaling back its $500 billion part of the PPIP?  There are several small reasons, such as uncertainty about executive compensation restrictions, and one big one.   It looks like the banks aren’t inclined to sell much of the toxic assets on their books – at least not at a price that would be attractive to investors.  And why should they? Banks are better able to raise capital now and if they run low, the government is unlikely to let them fail.  The so-called toxic assets owned by banks’ could only be sold at steep losses, losses that might be avoided if the banks could just hang on to the assets until the market recovers.  So, why should banks sell?  Why not just wait it out?  

The FDIC seems surprised by this, but they shouldn’t be.  Lynn Tilton, the whip-smart CEO of private equity firm Patriarch Partners has been warning about this from the start.   She raised this issue in an article published by Dow Jones and in an interview with TheStreet.com when the PPIP was first announced.  

Lynn knows a thing or two about such things.  She is one of the few people in the world who has successfully structured a “bad bank” for dealing with toxic assets – in fact she’s constructed two, for Fleet and CIBC, and owns a rare financial patent on how to do it to boot.  

In the Fleet and CIBC deals, Lynn encountered this exact same problem.  The remedy is not rocket science.  If banks don’t want to be schmucks, then simply give them schmuck insurance.  Lynn suggests allowing selling banks to share in the profits of the assets they sell, just as she did in the Fleet and CIBC.  

Even if banks don’t need to sell these assets to avoid insolvency, we need to get more capital on bank balance sheets to spur desperately needed lending.  The dearth of lending is suffocating small and middle-market companies, destroying countless jobs in the process.  Additionally, until these assets start trading, their value can never recover.  A push from the PPIP that gets these assets moving again will speed up the process of price discovery and the recovery of value.

The FDIC has rightly scoffed at some bankers’ suggested fix, allowing banks themselves to buy assets under PPIP.  But Lynn Tilton’s solution elegantly addresses the problem without the drawbacks inherent in allowing banks to play in the PPIP directly.  She has proven this approach works and, if the FDIC and Treasury are willing to think a bit out of the box, it will work again.

How the Commercial Property Meltdown is Helping to Strangle Middle-market American Companies

Today’s Wall Street Journal offers a revealing look into the coming storm for regional banks brought on by rising defaults on commercial property.  The AP’s very smart investigative reporter Matt Apuzzo framed up the issue well in an ahead-of-the-curve story on the coming commercial property meltdown last November:

"Unlike home mortgages, businesses don't pay their loans over 30 years. Commercial mortgages are usually written for five, seven or 10 years with big payments due at the end. About $20 billion will be due next year, covering property ranging from office and condo complexes to hotels and malls."

Now those problems are coming home to roost as commercial property owners, many of whom borrowed money through no-recourse loans and put very little of their own money into the deal, have little incentive to absorb losses and avoid default.

The stress on mid-sized banks from commercial property will result in further tightening of lending, exacerbating the problems of small and mid-sized companies who continue to be starved of desperately needed credit.  As a result, the problems in the formerly go-go commercial property markets will have a ripple-effect that will force further lay-offs and liquidations at small and mid-sized companies unable to obtain the credit needed to survive.

Which raises the question, where is the bailout for small and midsized companies?  The Fed’s TALF plan provides incentives only for SBA loans, which are available to only the smallest of businesses.  It does little for the middle-market companies too big to qualify for the SBA loans backed back the TALF and too small to play in the commercial paper market.  For these companies, who depend on bank credit, there is no bailout.  The additional TARP funds will help rescue injured regional banks, but it won’t be enough to restart lending.  The tragic irony is that in all the talk of saving jobs, the government has not implemented one program that directly helps provide credit to the small and mid-sized companies that employ the majority of Americans.  Perhaps there is a good reason, but I have yet to hear it. 

UPDATE: Reports today that the Fed will expand the TALF to include legacy commercial property loans.  While a step in the right direction, if the history of meager participation in the TALF is any guide, those measures are unlikely to prove sufficient to meaningfully address the problem.

Sulgrave Partners' Client Lynn Tilton Discusses Chrysler on CNBC

Our client, Lynn Tilton, discusses the Chrysler bankruptcy on CNBC's Kudlow Report Friday.

False Spring

The economic data has been starting to look a little better lately.  The Commerce Department reported yesterday that personal consumption was up in February (if only in nominal terms) for a second month in a row.  Durable goods are also up and even the housing market showed some signs of life last month.  But, as the FT observed in an editorial, it's far from time to break out the party hats:

Judging a recession is like walking down uneven stairs in the dark. We do not know how far down we must still go, only how far we have come. The end of the recession will not be clear until we are some way past it.

...But it is important not to read too much into such statistical movements. The world has rough edges. Investors and employers overreact and under-adjust. Markets do not clear instantly. There will be jolts and judders. On their own, even in the best of times, month-on-month variations tell us little.

And they are almost certainly right.  All indications are that unemployment will continue to rise -- we'll see how those personal consumption numbers look when unemployment hits 10%.  Free Exchange gives us yet more to worry about with a chilling post on what can only be described as a spectacular drop in global trade:

Argentina's exports were down 35.8%. Canada's were off 34.6%. Chile's by 41.3%. China's were down 17.5%. Ecuador's fell by 47%. Germany's by 28.7%. France's by 30.7%. India's by 15.9%. South Korea's by 32.8%. Malaysia's by 35.3%, etc. I could go on. I wonder—have there been such widespread and large drops in exports in any other modern period? The best estimates I have seen for trade declines in the Depression were of a drop of between 50% and 66% in world trade, but my guess is that the big drops were concentrated among a smaller number of large players back then. For this year, the WTO is forecasting a 9% drop—a lot bigger than the 2% drop the World Bank was forecasting back in December.

Hold on to your hats, this thing is far from over. 

TRANSCRIPT: Jamie Dimon on CNBC

JP Morgan's Jamie Dimon talks to CNBC's Erin Burnett about today's meeting with President Obama.  Here's the transcript:

Talking Down Our Book -- AIG Rage and the Law of Unintended Consequences

Ironically, the orgy of outrage over the AIG bonuses may end up costing taxpayers far more than the $165 million that everyone is so upset about. That’s because we, the U.S. taxpayers, essentially own this company.  And the pitchfork-wielding displays of indignant hyperbole debate over the last couple of weeks are destroying our company's brand.

While AIG may yet turn out to be the secret plot to destroy the world we've long suspected it to be, it also happens to be the world’s largest insurance company. While its financial products division is an unholy train-wreck of credit default swaps and other ridiculously imprudent derivatives, the rest of AIG is a viable business that sells people insurance and makes money.

AIG’s already tarnished brand has dropped to somewhere just above that of Enron and Satan. Who will buy insurance from AIG now? If AIG isn’t selling insurance, AIG isn’t getting paid. If AIG isn’t getting paid, neither are we. And that’s a problem. Frankly, I’d like us to get a return on our investment. Our elected officials aren’t making that any easier.     - Taylor