The US has had a number of banking crises since the 1850s. The way to fix it to to swamp the system with cash.
The negative economic forces currently are much larger than most understand. Even greater than what I thought in a worst case scenario. I would equate it to a wild fire. The regulators have to overwhelm the system with cash. Pour it in. Otherwise the fire in the banking arena may continue to show up in unexpected places as cinders stay hot. A half hearted effort will not restore confidence.
Now a look at the bright side. There are positives to this painful process. Eventually markets will stabilize and the credit markets will function properly. This is all a process that will make way for the next bull market. The excesses had to be cleaned out. No doubt we will be so much better for it in the future. Credit was way too easy and asset prices (real estate and equities, others too) went too high. However, the seeds of economic prosperity are now being formed. It will take some time, probably a lot of time but this is the necessary process to bring future prosperity.
Tuesday, September 30, 2008
Friday, September 26, 2008
Is The Worst Over
'Is the worst over?' This has been a common question over the past few months as Bear Stearns blew up, as Lehman went bankrupt as Fannie and Freddie were rescued. The list goes on. It seems like every time you think that things cannot get any worse wham another hit. One way to answer that question is to compare the current state of affairs with another time history.
From John Kenneth Galbraith's The Great Crash of 1929 page 108 (soft cover edition):
"In the Autumn of 1929 the New York Stock Exchange, under roughly its present constitution, was 112 years old. During this lifetime it had seen some difficult days. On September 18, 1873, the firm of Jay Cooke and Company failed, and, as a more or less direct result, so did fifty - seven other stock exchange firms in the next few weeks. On October 23, 1907, call money rates reached 125 per cent in the panic of that year. On September 16, 1920 - the autumn months are the off season in Wall Street - a bomb exploded in front of Morgan's next doors, killing thirty people and injuring a hundred more.
A common feature of all these earlier troubles was that having happened they were over. The worst was reasonably recognizable as such. The singular feature of the great crash of 1929 was that the worst continued to worsen. What looked one day like the end proved on the next to have been only the beginning."
From John Kenneth Galbraith's The Great Crash of 1929 page 108 (soft cover edition):
"In the Autumn of 1929 the New York Stock Exchange, under roughly its present constitution, was 112 years old. During this lifetime it had seen some difficult days. On September 18, 1873, the firm of Jay Cooke and Company failed, and, as a more or less direct result, so did fifty - seven other stock exchange firms in the next few weeks. On October 23, 1907, call money rates reached 125 per cent in the panic of that year. On September 16, 1920 - the autumn months are the off season in Wall Street - a bomb exploded in front of Morgan's next doors, killing thirty people and injuring a hundred more.
A common feature of all these earlier troubles was that having happened they were over. The worst was reasonably recognizable as such. The singular feature of the great crash of 1929 was that the worst continued to worsen. What looked one day like the end proved on the next to have been only the beginning."
Wednesday, September 24, 2008
A Plan To Stabilize the Financial System
Here is an alternative to the Treasury's plan. I came up with based on the US Treasury's plan and the hearings in Congress and other interviews I have watched on TV and what I have read. It will have flaws. I used game theory which means that the players involved have to sacrifice something but also receive something in return. I put myself into the shoes of all of the key players trying to look at what is best for all. I will likely change this.
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The Problem:
The financial system is melting down. Credit markets have seized up. A flight to safety away from risk based financial assets into the ultimate safe haven 3 Month T-Bills is occurring. If this continues credit flows will stop and money will sit in banks; depositors and investors will move money to perceived safe havens real or other wise. The financial system could come to a halt. The Treasury believes the solution lies in removing bad assets from financial institutions so that these institutions can re-lend money into the system.
The players and their goals:
- Tax Payers (Home owners and other). Access to loans at reasonable interest rates; jobs; a safe place to put cash; long term growth of retirement accounts; keep ownership of home. Not take much blame for the economic fallout. Not lose money. Not pick up the bill for Wall Street's excesses.
- The Financial Institutions and other Holders of decaying financial assets. Keep companies in business. Get rid of bad assets at a good price or best available price. Access to loans at reasonable interest rates; access to credit at reasonable rates, make profits for their shareholders, stay in business. Not get stuck with loans that people don't pay off. Not be seen as the bad guy. Do the right thing.
- The Corporate Executives - Keep their firms in business. Make profits. Not be blamed for financial melt down. Do the right thing.
- Congress - Stay in office. Not be blamed for financial melt down. Not get blamed for writing a blank check to Paulson. Over sight. Protect taxpayers. Do the right thing.
- The President - Stop financial melt down. Not get blamed for melt down. Do the right thing.
- The Secretary of the Treasury - Save the system. Provide leadership to get out of crisis. Push hard to accomplish objectives. Not get blamed for allowing crisis to get out of hand. Do the right thing.
- The Fed - Stop financial meltdown. Keep the economy rolling. Stop inflation / deflation. Do the right thing.
The Solution:
Keep Credit flowing, keep the economy afloat. Keep foreclosures to a minimum, keep as many home owners as possible in their homes.
What Needs to be Sacrificed and What is Received
- Tax payers. Temporarily pay for a solution through an addition of the Federal debt. Keeps job. Depending on the circumstance may keeps home (with excess cash Congress can put in place programs to help tax payers - see below) Financial stability. Worst scenario - May lose money and have to pay more in taxes. Best scenario - May make money and pay less taxes.
- Financial Institutions - Stay in business. Lose some oversight, get rid of bad assets, face financial / equity penalty.
- Corporate execs - Keep jobs, lose some compensation and oversight.
- Congress - Giving authority to use cash to buy assets. Credit for helping to save the system.
- The President - Give Secretary power to fix problem. Credit for helping to save the system.
- The Secretary of Treasury - Gives up some oversight. Gives congress more say in how program will work. Gets credit for the idea and for saving the system.
- The Fed - Makes their job easier to keep the economy afloat.
How to get there
The Treasury and Congress:
The best minds in the business believe that if financial institutions were relieved of decaying assets that the system would begin to heal itself. The Treasury thinks this will cost $700 billion. I don't have time to come up with an alternative dollar value. I will use that. So let the Treasury buy these decaying assets. At the end of every three month period a detailed financial report will be issued from the Treasury to Congress. It will show the costs and what was spent to purchase assets. This result will be audited by an outside firm hired by Congress to cull through the data.
The Tax payer and financial institutions:
The tax payer pays for the $700 billion for the program. The pricing of the asset that the tax payer buys from the financial institution will be important. The lower the price that is paid for the asset the better it will be for the tax payer as it becomes more likely the tax payer will be able to make a profit. However, the institution selling the asset has to replenish its balance sheet so the higher the price the asset is sold for the better for the financial entity.
I will demonstrate the pricing mechanism via an example. Lets say that Fair Value for an asset is twenty cents on the dollar which is what the financial entity values the asset on the balance sheet. If the Treasury buys it for that amount, nothing is accomplished. So the Treasury needs to pay a premium to the asset price. Lets use a 25% premium. I picked that on the belief that it will help recapitalize the banking system. The asset is sold to the Treasury for twenty-five cents on the dollar (0.20 x 1.25). In return, the Treasury receives the asset and a special bond-like security. The security that the Treasury receives will be payable to the Treasury at the end of 10 years. It will be issued at 10% fixed interest rate. (The 10% interest rate comes from the Berkshire deal with Goldman Sachs.) The principal amount of the bond will be the amount that the Treasury pays over the fair market value of the asset bought from the financial entity. OK, an example may help. The Treasury buys an asset that has a $1 billion fair market value (say $0.20) but pays $1.25 billion (or $0.25). In return, the Treasury receives the asset and a bond for $250 million. The bond will mature in 10 years and will pay 10.00%. This bond will be highest up on the structure of corporate debt and will be first in line in any bankruptcy proceeding.
Oversite. Financial institutions that participate in this solution will have their executives take pay cuts and a cut in bonuses. The top 3 executives would be subject to this. A 25% cut in both the salary and bonus would suffice.
Summary:
With some luck the assets bought by the Treasury will increase in value, the bonds received by the Treasury will pay for the other costs like the oversight. Excess cash earned by the Treasury can go to the tax payer in the form of low interest loans to home owners or other types of programs. With a $700 billion plan recommended by the Treasury, $560 billion would be used to buy the frozen assets, the other $140 billion will be used to replenish the financial entities balance sheet. If the asset purchased by the Treasury goes up in value the Tax payer makes out. The Treasury will also own $140 billion in bonds that pay 10.00% in interest and throw off $14 billion annually to the tax payer. Congress can use this to help home owners with some type of plan. Over the 10 years the interest will amount to $140 billion. That money and the potential appreciation of the bought asset will likely make this a winning situation for the taxpayer.
-----------------------------------------------------------------------------
The Problem:
The financial system is melting down. Credit markets have seized up. A flight to safety away from risk based financial assets into the ultimate safe haven 3 Month T-Bills is occurring. If this continues credit flows will stop and money will sit in banks; depositors and investors will move money to perceived safe havens real or other wise. The financial system could come to a halt. The Treasury believes the solution lies in removing bad assets from financial institutions so that these institutions can re-lend money into the system.
The players and their goals:
- Tax Payers (Home owners and other). Access to loans at reasonable interest rates; jobs; a safe place to put cash; long term growth of retirement accounts; keep ownership of home. Not take much blame for the economic fallout. Not lose money. Not pick up the bill for Wall Street's excesses.
- The Financial Institutions and other Holders of decaying financial assets. Keep companies in business. Get rid of bad assets at a good price or best available price. Access to loans at reasonable interest rates; access to credit at reasonable rates, make profits for their shareholders, stay in business. Not get stuck with loans that people don't pay off. Not be seen as the bad guy. Do the right thing.
- The Corporate Executives - Keep their firms in business. Make profits. Not be blamed for financial melt down. Do the right thing.
- Congress - Stay in office. Not be blamed for financial melt down. Not get blamed for writing a blank check to Paulson. Over sight. Protect taxpayers. Do the right thing.
- The President - Stop financial melt down. Not get blamed for melt down. Do the right thing.
- The Secretary of the Treasury - Save the system. Provide leadership to get out of crisis. Push hard to accomplish objectives. Not get blamed for allowing crisis to get out of hand. Do the right thing.
- The Fed - Stop financial meltdown. Keep the economy rolling. Stop inflation / deflation. Do the right thing.
The Solution:
Keep Credit flowing, keep the economy afloat. Keep foreclosures to a minimum, keep as many home owners as possible in their homes.
What Needs to be Sacrificed and What is Received
- Tax payers. Temporarily pay for a solution through an addition of the Federal debt. Keeps job. Depending on the circumstance may keeps home (with excess cash Congress can put in place programs to help tax payers - see below) Financial stability. Worst scenario - May lose money and have to pay more in taxes. Best scenario - May make money and pay less taxes.
- Financial Institutions - Stay in business. Lose some oversight, get rid of bad assets, face financial / equity penalty.
- Corporate execs - Keep jobs, lose some compensation and oversight.
- Congress - Giving authority to use cash to buy assets. Credit for helping to save the system.
- The President - Give Secretary power to fix problem. Credit for helping to save the system.
- The Secretary of Treasury - Gives up some oversight. Gives congress more say in how program will work. Gets credit for the idea and for saving the system.
- The Fed - Makes their job easier to keep the economy afloat.
How to get there
The Treasury and Congress:
The best minds in the business believe that if financial institutions were relieved of decaying assets that the system would begin to heal itself. The Treasury thinks this will cost $700 billion. I don't have time to come up with an alternative dollar value. I will use that. So let the Treasury buy these decaying assets. At the end of every three month period a detailed financial report will be issued from the Treasury to Congress. It will show the costs and what was spent to purchase assets. This result will be audited by an outside firm hired by Congress to cull through the data.
The Tax payer and financial institutions:
The tax payer pays for the $700 billion for the program. The pricing of the asset that the tax payer buys from the financial institution will be important. The lower the price that is paid for the asset the better it will be for the tax payer as it becomes more likely the tax payer will be able to make a profit. However, the institution selling the asset has to replenish its balance sheet so the higher the price the asset is sold for the better for the financial entity.
I will demonstrate the pricing mechanism via an example. Lets say that Fair Value for an asset is twenty cents on the dollar which is what the financial entity values the asset on the balance sheet. If the Treasury buys it for that amount, nothing is accomplished. So the Treasury needs to pay a premium to the asset price. Lets use a 25% premium. I picked that on the belief that it will help recapitalize the banking system. The asset is sold to the Treasury for twenty-five cents on the dollar (0.20 x 1.25). In return, the Treasury receives the asset and a special bond-like security. The security that the Treasury receives will be payable to the Treasury at the end of 10 years. It will be issued at 10% fixed interest rate. (The 10% interest rate comes from the Berkshire deal with Goldman Sachs.) The principal amount of the bond will be the amount that the Treasury pays over the fair market value of the asset bought from the financial entity. OK, an example may help. The Treasury buys an asset that has a $1 billion fair market value (say $0.20) but pays $1.25 billion (or $0.25). In return, the Treasury receives the asset and a bond for $250 million. The bond will mature in 10 years and will pay 10.00%. This bond will be highest up on the structure of corporate debt and will be first in line in any bankruptcy proceeding.
Oversite. Financial institutions that participate in this solution will have their executives take pay cuts and a cut in bonuses. The top 3 executives would be subject to this. A 25% cut in both the salary and bonus would suffice.
Summary:
With some luck the assets bought by the Treasury will increase in value, the bonds received by the Treasury will pay for the other costs like the oversight. Excess cash earned by the Treasury can go to the tax payer in the form of low interest loans to home owners or other types of programs. With a $700 billion plan recommended by the Treasury, $560 billion would be used to buy the frozen assets, the other $140 billion will be used to replenish the financial entities balance sheet. If the asset purchased by the Treasury goes up in value the Tax payer makes out. The Treasury will also own $140 billion in bonds that pay 10.00% in interest and throw off $14 billion annually to the tax payer. Congress can use this to help home owners with some type of plan. Over the 10 years the interest will amount to $140 billion. That money and the potential appreciation of the bought asset will likely make this a winning situation for the taxpayer.
Thursday, September 18, 2008
The Upside Down Street and Risk Management
The financial world has changed rather quickly of late. Equity indices from all over the world have collapsed and capital has fled to US treasuries. As an example the 3 Month TBill Yielded 0.05% at the close of trading yesterday. The day prior the yield on the 3 Month T-Bill was at 1.50%. Money was leaving all instruments and running to the 3 Month Tbill. According to the WSJ that 0.05% yield was the lowest since the 1950s.
I hope that the readers out there are finding ways to survive. The only advice I wish to give at the moment as far as trading or investing is that Risk Management has to be the highest priority right now. Cutting losses and keeping position sizes small enough that even if a large percentage loss were to occur that it does not damage your portfolio or trading account too much.
Live to fight another day is really the motto to go by right now. Heroes are not made in markets like this. Be a hero today with a large position size might work out, but eventually a large position size will back fire and may even be catastrophic. This point cannot be stressed enough as those who survive this massive down turn will be either very lucky or very good at risk management.
I hope that the readers out there are finding ways to survive. The only advice I wish to give at the moment as far as trading or investing is that Risk Management has to be the highest priority right now. Cutting losses and keeping position sizes small enough that even if a large percentage loss were to occur that it does not damage your portfolio or trading account too much.
Live to fight another day is really the motto to go by right now. Heroes are not made in markets like this. Be a hero today with a large position size might work out, but eventually a large position size will back fire and may even be catastrophic. This point cannot be stressed enough as those who survive this massive down turn will be either very lucky or very good at risk management.
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