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Tuesday, March 10, 2009

Still MIA: A Real Recovery Plan

The financial meltdown still in progress has led most debate within government and the chattering classes to focus on the balance between any short term stimulus benefit and the weight of the long term debt added to pay for it. When the numbers involve "Ts" as in trillions, it seems logical to pay attention to that debate. It's also possible that the size and timing of the stimulus are NOT the most critical issues to resolve first. Until measures are taken to correct the broken financial, legal and regulatory processes that allowed the meltdown to occur, it's HIGHLY likely vast amounts of money will remain on the sidelines and out of the hands of banks, corporations and money managers who enjoy virtually ZERO public trust.

Here's a laundry list of changes that might improve investor confidence in the market to help dissipate the current sense of panic in and anger at the market and replace it with more constructive caution that allows money to flow back into the market for legitimate investment and growth.

Regulatory Reform for Credit Default Swaps

Anyone who has been following the financial news over the past two years know credit default swaps (CDSs) are a key part of the larger meltdown in the financial system. Some may also know that the total nominal value of all of the existing CDS transactions is in the $55 trillion dollar range. Upon hearing that figure, most people would probably assume that SURELY, after events on the ground have proven these instruments to be such a colossal disaster, sophisticated investment firms and hedge funds would have learned their lesson and would avoid entering in new CDS contracts LIKE THE PLAGUE.

They would be wrong.

As stock prices of megabanks head to the penny range, speculators who have already lost their shirt are attempting to make up past losses by betting on the next "sure thing" -- collapsing stock prices of megabanks. There's no certainty any legal change or central bank strategy can gracefully unwind $55 trillion in existing CDS contracts. However, it seems a child of five could understand that it makes NO SENSE WHATSOVER to allow additional CDS contracts to magnify the instability that's already leading to the current remake of The Grapes of Wrath.

The Securities and Exchange Commission and its equivalents in the European Union and Asia need to explicitly restrict new CDS contracts in cases where one or both of the parties are not direct owners of publicly traded stocks or bonds involved with the contract. If the various power brokers can't agree on an outright ban on new CDS instruments, surely a compromise can be reached banning them on securities related to banks and insurance companies.

Regulatory Staffing and Qualifications

The testimony provided by Harry Markopolos to the House Financial Services Committee on February 4, 2009 not only provided a cogent explanation of the Madoff ponzi scheme fraud but also served as an indictment of the entire federal regulatory framework. His testimony made it perfectly clear staffing levels at regulatory bodies were wholly inadequate to keep up with the explosion of complexity of financial arrangements and strategies adopted by banks, hedge funds and insurance firms. He also confirmed the limited staff on hand was completely unqualified to analyze and critique the information they reviewed, even when twenty nine areas of suspicion were handed to them on a silver platter. (#3)

Perhaps the most damning part of his testimony was the revelation that for eight years after he first filed concerns with the SEC about Madoff's firm, not a single staffer had the presence of mind to confirm Madoff was even making the trades claimed in his public explanation of his investment strategy. Had anyone checked, they would have realized the number of trades required to produce the profits claimed would have exceeded all available options on the Chicago Board Options Exchange where those options were traded. (#4) In simple terms, this is like claiming you earned $50 billion dollars making two cents per share in a market that only moved 50 billion shares total. Basic math.

This isn't the first failure of this magnitude due to filings that all added up but failed basic business tests involving simple math. Worldcom inflated profits for years by capitalizing the costs of trunks accepting / terminating call traffic from local telephone companies instead of expensing them. For a telephone company, the relationship between minutes of use that produce revenue and the cost of trunk circuits to carry those minutes of use can be easily calculated. The fact that one carrier in an entire industry had trunking costs one seventh of their competitors should have been a red flag to its own auditors. Even with the failure of Arthur Anderson to flag the fraud, it should have been obvious to SEC staffers reviewing the Worldcom filings.

All enforcement personnel at the SEC should be required to pass a detailed test in "forensic accounting" to retain their jobs. Compensation for enforcement positions should be adjusted to attract more competent, analytical talent and provide incentives for actually pursuing cases for legitimate fraud. Equivalent measures should be taken within the Justice Department as well.

Real Anti-Trust Enforcement in Financial Services

The megabanks we have today are not "too big to fail" -- they're too big to succeed. I made this point months ago (#1). In the panic of 2008 around Bear Sterns and Merrill Lynch, the idea that the shotgun marriages hastily arranged by the Federal Reserve and Treasury were actually compounding the larger problem by further concentrating assets into institutions that had already proven themselves unable to stay away form the dynamite didn't get much coverage. The idea is still out there, however. In so many words, Sheila Bair, head of the FDIC, said the same on the 60 Minutes program aired March 8, 2009. (#2)

I think taxpayers rightfully should ask, that if an institution has become so large that there is no alternative except for the taxpayers to provide support, should we allow so many institutions to exceed that kind of threshold?"

For a better picture of the degree of consolidation in the banking industry, check out the market share of banks in your area using this handy web form on the FDIC web site:


For virtually any geographic area selected, you'll find two or three banks each controlling between 8 to 29 percent of the market with roughly 30 other banks sharing what's left. A market share of even 29 percent share doesn't sound like much compared to other industries. However, when you consider that banking is pretty much a commodity function, that level of market share concentration produces opportunities to use leverage to boost short term profits which are -- by all facts in evidence -- irresistible.

Every bailout should be used as an opportunity to "right-size" the mega-banks back to manageable size. If taxpayer money is going to be used to provide an expanded margin of error to avoid panic in the system, that margin of error should be provided in the form of deals that allow assets to be offloaded to smaller regional banks. A new market share limit of maybe fifteen percent should be imposed going forward. Banks currently over the limit are free to continue to operate BUT:

1) absolutely no purchases of other banks will be permitted
2) any request for bailout assistance will force an auction of assets equal to the bailout to competitors to whittle down assets until the losing bank comes in below the cap

Legitimate Analysis of Automaker Bankruptcy Impacts

We are four months after the first round of dollars was thrown at GM and the other automakers yet not one day closer to any realistic plan for handling the impact of a bankruptcy of GM or Chrysler. The question everyone is asking isn't really "if" but "when." However, the real questions should be "how much" and "to whom?". Without a clear technical plan about the brands and specific product lines to survive, no practical analysis can be completed about plants likely to close or suppliers and dealers likely to be affected. Those plans cannot be made overnight but become more cataclysmic in scope as the firms continue burning through cash and poisoning customer confidence in their long term viability.

What all that really means is that any "rescue money" tossed at the automakers needs to be described for what it really is --- unemployment compensation to workers, healthcare subsidies for retired workers and stabilization money for communities with high concentrations of auto related jobs. From an economic standpoint, which alternative is preferable?

1) spend $30 billion to "rescue" GM to protect 70,000 assembly jobs and retirees
2) spend $30 billion on direct assistance to affected workers and retirees

Either way, it's $30 billion we don't actually have. However, option #1 funnels the $30 billion through a layer of incompetent, unimaginative executive management, thereby diluting the final impact and rewarding thousands of players who already pulled down more than their fare share in the glory years of $50,000 SUVs and $1.40 gasoline.

If the federal and state governments are bent on "helping" workers tossed out of work from auto makers, then pass legislation providing cash to bolster state unemployment funds, retraining programs and tuition assistance plans. Don't attempt to accomplish those same goals by passing the dollars first through the rotting management carcass of firms which are fundamentally unable to move transportation and manufacturing to the next level.

The auto industry debacle also poses a more theoretical question.

Tens of thousands of workers have been unceremoniously cashiered out of well paying jobs over the past twenty years, in some cases tempted by "guarantees" of healthcare coverage for life, only to find their employer later went bankrupt leaving them not only without a pension but without healthcare as well. A disastrous, retirement planning "oh-fer". No national effort was made to replace these workers' pensions or make up for promised but lost healthcare coverage. In the go-go, bubble driven economy, I'm not even sure any thought was even given to the topic.

If GM and Chrysler are truly headed to the bottom because of legacy pension and healthcare costs, exactly what qualifies auto workers and retirees for EXTRA pension and healthcare protections that have not been provided to former employees in other industries that hit hard times? This is a very hard nosed question and is not easy to ask knowing the situation facing these workers. Nonetheless, current auto workers and auto retirees are not the first to face this situation. Arguing for special financial treatment for these workers, by either trying to bail out a failed business model or providing direct benefits to these workers not provided to others makes no more sense than bailing out megabanks and their workers.


#1) http://watchingtheherd.blogspot.com/2008/09/too-big-to-succeed.html

#2) http://www.reuters.com/article/gc06/idUSTRE5256SB20090306

#3) http://www.msnbc.msn.com/id/29009555/

#4) http://money.cnn.com/2009/01/22/news/companies/madoff_tradingfiction/index.htm