Law is two steps behind

UPDATE: This appear to be a bigger problem with GM…read this.

A small group of hedge funds appear to be behind the failure to restructure Chrysler.  Its been argued that this was against their economic interest.  This is hard to know but lets imagine for a moment that the government is offering them the best deal on this particular assets (better than they will get on that asset in bankruptcy).  Why would they do this?  One possibility is that they have a large CDS protection positions that they think will pay out well in ch11.  What does this mean?  It means that for a small amount of money (the debt they own) they are planning to kill Chrysler and the other debt holders.  They make this very profitable by having side bets on Chrysler failing.  As far as I know (and I’m not a legal expert) this is legal: it shouldn’t be (If it not, I’d love to hear about it).  If you want to be part of the economic negotiations about debt you should have to be net long; having a large CDS positions on the debt should take away your seat at the table. 

Note to HFs: If you think this is a great opportunity to create alpha I’d urge you to take into consideration the policy and political risk (these are real).   Note I’m not making a plea to some moral standard or national interest.  I’m arguing that abusing this legal loophole may bite you hard.  If you are doing this is and Congress gets a hold of it they could do a variety of things (beside writing crushing HF regulation).  Imagine your own punitive tax law or having the treasury bid up the CDS auction (pushing losses on you – they are going to have to buy the assets anyway) or …there are lots of extreme options to crush this action (use your imagination).

UPDATE: I want to make clear I have no information that this is what has happened.  And from everything I can gather it isn’t but I also don’t know why this couldn’t happend…it seems like a legal hole that should be filled.  That being said the restrucuting plan was tough on the debt holder compared to the other debt (retiree benefits, suppliers debt etc…); I suspect what the HF are thinking is that in bankruptcy it is not that they will get a better deal but that they will all be classed in the same group as unsecured creditors and once that happens they will have to be treated the same.  If this is the case it may be a better deal for them and – simply – the restructuring plan was not sweet enough.  Hopefully the CH11 moves fast. 

UPDATE: As more information has come out about the ’holdouts’ it seems that it is simply a view that they could get a better deal under CH11 by having all the unsecured creditors treated under the law.  This may or may not be true, don’t know, but it is clear that creditors that should be treated the may be being treated differently in the bankruptcy.  I strongly view that the law should not be tweaked on the fly to try to favor one group over another; if we want to change law we must do it before not after something happens.  If the rules of the game are in flux, capital will retreat to the benches.  We’ve known this for hundreds of years.  Hamilton knew it when he argued for full payment on revolutionary war debt and hopefully we haven’t forgotten it.  Capital flight (to other countries or under the mattress) will make this recessions much worse.  The economist has a good article on this…here.

Cash is Risky

You can’t get away from risk unless you are dead, which is fairly high price to pay for eliminating risk.  A portfolio of cash just has different risk exposures than a portfolio of other assets.  Cash as a component of a portfolio makes all the sense  in the world.  It increases robustness and allows you to take advantage of situations as they arise but if you think because you hold a boat load of cash (or deposits or t-bills) that you are risk free; you are wrong.  Consider the following picture, it shows the real value (inflation adjusted) draw-down (or value relative to its previous peak) of a T-bill portfolio.

What does this mean?  We’ll for most of our lives T-bill have been fairly safe investments but in the early 1940s they were terrible and although you didn’t lose the nominal (number value) of the investment you did lose it purchasing power as inflation ate away at what you could buy. You can see this illustrated by the next chart which shows year over year inflation and T-bill rates.

Maybe you now believe me that cash is risky and I have not even illustrated the real risky case studies for fiat cash holding: Currency collapses.  Think Germany after WWI or Argentina a few years ago or Russia or (this is a long list).  Investors who held thier wealth exclusively in cash were devistated. 

Thus I repeat my intro, you can’t get away from risk, you can only manage it.  Sensible risk based diversification is the means to do this.

Where was the Bubble?

One classic presentation of a equity market bubble is to show the share of market share that was represented by that given sector (look at the tech bubble around 2000).  The following chart illustrates the reality that the financial bubble was not in financial equities.  It happened on the credit side (in particular issuance).  What makes this interesting is that although financial sector earning boon-ed after 2000 the sector market cap did not gain share.  This in and off itself it not particularly interesting but it give one more data point on the nature of the ’bubble’ that crashed the system.  (I’m am becoming increasingly convinced that the collapse was by no mean inevitable but rather bad policies (read letting Lehman fail, the ‘rescues’ of the agencies, and slow response to capital problems), but I digress..

The Knock-On by Region

Economist will often talk about volatility (often meaning something more broad like friction) in the financial markets but preface the comment that as long as the financial economy does not spill over on the real economy then the problems are ‘not real’.  There is some truth to this but it is also sort of a joke because the spill over are not discrete although they are not linear eithier.  On top of this it is tough to measure how much of the down turn is simply financial and how much is ‘true’ adjustment.  (This judgement is the call that must be made when policy officials think about bailouts – both national and domestic.  Think: is this problem simply a function of financial dislocation or is it is part of a needed economic adjustment).  One paper that kind of gets at this (I quickly skimmed it; interesting but not profound).  It tries to show (I say tried because it is based on a survey) the impact of cashing constraints.  The charts show firms that are cash constrained and firms that are not cash constrained (one could imagine that cash constrained firms are younger and emerging firms and cash rich are established businesses) and what percentage of these firms are passing up NPV (value added projects).  Cash constrained firms are passing up investment opportunities.  It is hard to know if the NPV projects are really NPV or if there are also capital problems that are correlated with the cash problems (probably) but it does suggest that good investments are being passed on because cash is hard to get.  That is what is meant by bad spillovers. 

Don’t Let Them Pay It Back.

I’ve argued before that we don’t want the banks to pay back the capital.  The capital is one of the constraints on money creation (one being the reserve requirement and another being that capital requirement of banks); to the extent that the either of these are constraining credit, aggregate money will not be created.  And to the extent velocity is falling or the constraint is forcing deleveraging deflation may result (and thus a damaging debt deflation spiral).  Thus is is encouraging to hear (or read) that the administration is considering ways to essentially prevent the banks from paying the capital back but allow them to get out of the government oversight; thus allowing them to convert shackling political capital into not exactly shackling political capital.  Or in my view converting what is viewed as a short term loan into capital and thus repair the damage the congress did to the recapitalization plan.

According to the FT…“Our general objective is going to be what is good for the system,” the senior official said. “We want the system to have enough capital.”  Wisdom does exist in government but as is far too common it doesn’t have a name (or is too afraid to have an ill informed public know that they said something).

Be Confident that we don’t know…

In an era of fairly dire economic predictions it is, in a way, comforting to reflect that these prediction are by no means set in stone.  They are guesses, it could be better (although it could be worse).  Looking at some predictions about today from a decade ago illustrate how off we can be.  Look at the following IMF report (based on CBO projections) that the U.S. would have negative marketable debt (or have excess cash of debt) starting in 2006.  Now this projection was before the Bush tax cuts which would have altered these projections but even with that in mind the change in circumstances is incredible.  What is the take-away…be skeptical and operate knowing that we live in an uncertain world. 

The Peversion of Better than Expected

The recent increase in the stock market has been taken by some in the media and many in the American public as an indication that the economy has or is near to a turning point.  The assumption underlying that statement is that the equity market is evaluating the current state of the economy.  Although this is part of what it is doing it is not that simple.  From a valuation perspective it evaluates the probabilisticfuture paths and assigns risk premiums to that aggregate path to create a discountable value stream.  This means that the stock market can go up or down without (necessarily) implying any changed perception in the path of the economy (in fact it could go down and imply a great growth path if the risk premium goes up at the same time).  And remember the current state is just one point along that path (albeit an important one). 

I tend to think that rally in the stock market was driven by two major factors.  (1) Breathing room for deleveraging asset managers (and buyer less afraid to step in front of that supply) and more related to this discussion (2) expectations about the future improved (not that those expectations are good).  An improvement in expectations (or performance better than expectations) is a relative concept, like a sports team covering the spread.  Covering the spread is all and good if your simply gambling on a team but you may be interested in winning.  My interpretation of the equity market movement is that the expectations of total collapse has come out of the market and we have repriced equities at a bad L-ish shaped recession. 

For a qualitative example take a look at the most recent beige book.  The markets responded fairly positively to this report (S&P rallied over a 1% from the release to the close), but what the report said what hardly uplifting (in an absolute sense): ‘Reports from the Federal Reserve Banks indicate that overall economic activity contracted further or remained weak. However, five of the twelve Districts noted a moderation in the pace of decline, and several saw signs that activity in some sectors was stabilizing at a low level.’  In English things are getting worse but not getting worse as fast as they were before.   We are still headed in the wrong direction but we’ve hit the break.  Not to downplay avoiding total collapse, which is an accomplish, but that’s not exactly the ‘green shoots’ one might hope for.

From Russia with Love…

Let the mailbox burn

Last week I went to a speech given by a major private equity firms COO.  He was highlighting the global economic crisis from his perspective.  (He noted that being a lawyer and not an economist he wasn’t sure why people wanted to hear him talk about it….he did a reasonable job).  But before the speech began I was discussing the new PPIP (public private investment partnership) program another attendee.  She argued that it would fail because there was bound to be fraud just like with RTC (resolution trust corporation) after the SNL crisis in the early 90s.  Given, she argued, that fraud was the underlying driver of the economic crisis, we could never get out of it by bring to life another program that would be rife with fraud.  I pointed out that although fraud facilities the crisis it was not the underlying cause (global economic imbalances) and that just because a program has a bad side affect it shouldn’t necessarily be scraped.  I noted that if the PPIP gets the financial system working so that credit is moving around (new balance sheet capacity) but some fraud occurs the net is positive.  She was insistent that this was not the case. 

To me she was letting the house burn and focusing on saving the mailbox.  Or according to Nietzsche she was engaged in the most common form of human stupidity; forgetting what one is trying to achieve. 

But she did, unknown to her, have a point.  The success of any public program, in a democratic society, that requires continuous support depends on at least the tacit support (or at least not the vehement opposition) of the program.  If fraud in PPIP undermines the federal government’s ability to respond to crisis it will have serious consequences.  To fix the analogy it would be as if the firefighters had the hose cut by an angry mob because the mailbox was burning.  Foolish but if the hose is cut the house will burn.  You could see some of this as an affect of the AIG bonus fiasco; we nearly let a few million dollars undermine the legal system which is part of foundations of a 15 trillion dollar economy.

Debt Bubble II or Not?

One chart that is commonly use to explain the challenges we are having is the amount of Debt to GDP.  At a first glance it seems to suggests two things (1) we have a debt bubble just like the great depression and (2) that the aggregate level of debt is drowning us (who could support a debt 3.5x the size of their annual income). 

Part of this intuition is right.  Higher levels of debt exposure mean that the leveraged entity is exposed to a higher level of risk (call it survival or crisis risk).  But I think a closer look is warranted.  First, the ‘debt bubble’ that started in 1929 was – from my back of the envolope calculations – driven by the denominator not increased in nominal debt levels.  Nominal GDP collapsed  – both because of falls in real GDP and massive deflation.  The total debt to GDP increased by about 30% (in a X1-Xo sense) in each year between 1929 and 1933.  The below chart show where the increase is coming from.  It wasn’t an increase in debt that sunk the country but debt failures due in large part to deflation (yes, it was the Fed’s fault….Damn it; why did Ben Strong die….please don’t die Bernanke) as well as an economic collapse. 

If we can avoid deflation, the delevering process is much much easier (and if we have some inflation its even easier…although this is like playing with fire). 

My next complaint is that including finanicaldebt in the debt burden is odd.  This large increase show how much more interconnected the financial system and the degree of counterparty risk but it does not suggest an increase in real debt burdens.  If you take out the non financial debt then it looks like:

Yes debt has increased across the sectors, particularly in households, over the past 20 years but if you compare this level to the 1929 (before the deflation driven spike) its very similar.  I have a very hard time believing people who say that what has happened was inevitable.  Think about the debt level as the speed you are driving your car.  If you drive 80 it is risky, if you drive 100 it is even riskier, and if your drive 120 even riskier but you could die driven at 80 and you could live driving at 120 under the right circumstances (and the car – which in this story is the structure of your economy).  Typically you (the driver or economy) only die if there is a sudden stop or shock….which is what happen this time around (to a degree) after Lehman. 

So what does this mean going forward.  Don’t know for sure but I think low growth is obtainable and a depression avoidable.  If deleverging is done in the context of new capital and increasing money/balance sheet capacity (not deflationary) instead of shirking balance sheets, we are not in for a depression.  If deleverging is done in the context of a paradox of thrift and deflation balance sheet contraction then we are in for a rough ride.