Tuesday, September 30, 2008

Why Paulson's Money is No Good

Money frees you from doing things you dislike. Since I dislike doing nearly everything, money is handy.
         - Groucho Marx

As Diana points out, free-market economists and businessmen are starting to articulate the proper principles, causes and needed actions in this crisis. I fear however, that the prevailing philosophy in Washington will not respond to these voices and we will see a nominally similar bail-out pass through Congress. Coupled with a probable Obama presidency and a Democratic Congress, and the tax increases and "relief" measures sure to pass, I also fear a looming full-scale Depression. If capital should flee American shores as a result, we will see a severe loss of value as the Dollar slides and is no longer the bulwark of stability in a storm. Capital has options today. It's not like the Crash of '29.

Many of my Objectivist friends are blogging and articulating the proper philosophical principles by which to evaluate the crisis including The Rule of Reason, Galileo Blogs, Applying Philosophy, and the Ayn Rand Center for Individual Rights.

In today's post I thought I'd attempt to discuss what the current crisis consists of, what a proper solution would accomplish, and why bail-out money cannot accomplish the same thing.

Most of the free-market solutions I'm seeing posted all involve the same sorts of actions: orderly liquidations, and/or recapitalizations, and some sort of write-down/containment of the distressed instruments (mortgage-backed securities and credit default swaps) to restore liquidity. But what the heck does that mean?

The primary issue here is one of confidence, and hence liquidity. A lack of liquidity is jargon for the inability of money to flow (hence the "liquid" reference) to where it needs to. Note that this does not mean that there isn't money out there ready to flow, but that it simply is frozen. Why? Well, the primary reason is that some banks are holding assets or liabilities that are changing in value at a rapid pace, and in some cases this is threatening to overwhelm a banks ability to pay its obligations. These banks can no longer loan out money. Banks to whom they owe money see that they may not get paid and as a result have stopped lending funds to conserve cash. Healthy banks that might loan them money do not wish to do so because it's unclear what their assets are worth and whether they can pay back the loans. Some banks are sick, some banks are really sick, and since the value of their potential liabilities are changing, it's difficult to decipher which banks could go under and which will survive. So money stops flowing. Uncertainty is high. Confidence is low.

Note, when a bank is close to going under, this does not mean that the healthy assets of a bank somehow vanish. What it means is that under the current capital structure, the bank has more liabilities than assets and has run out of cash, and can no longer raise cash to meet it's obligations.

The key is with the sick banks. In order to restore confidence to the system and hence liquidity, these banks have to be restructured or recapitalized. This can involve the purchase of a stake in the company, outright purchase and assumption of the obligations, and write downs of the asset value. It almost always means that some parties, most notably the owners or stockholders must take a loss. Sometimes certain of the banks obligations are defaulted upon, and even creditors may lose a portion of their assets. Usually the capital infusions result in new controlling interests and the management team is replaced. The new cash, coupled with the loss taken by the various interests, and the change in value of various assets or obligations restores the balance sheet of the company to health. At this point, the bank has the assets to be able to begin loaning again, and confidence in it's balance sheet and it's new management mean that other banks will loan to it. The banks that were owed have taken some loss and may or may not need recapitalization of their own, but eventually, they too can begin loaning again.

There is an orderly due process by which this occurs in the free market, up to and including the use of receivership/bankruptcy to liquidate assets. This process preserves the existing priorities of owners of the company, and it has been shown to work. In a phenomenal article in Monday's Wall Street Journal, "Calling J.P. Morgan" the mechanism by which Morgan recapitalized banks in the crisis of 1907 is wonderfully detailed.

In the fall of 1907, it took J.P. Morgan just eight weeks to resolve a credit crisis similar to ours. Several years of buoyant growth and too much risk-taking in poorly understood investments led to needs for capital that could not be met. Morgan, then 70, locked the nation's top bankers into the ornate library at his home for late-night confession sessions. He asked them to lay bare their balance sheets, keeping himself alert with endless Havana cigars.

[Information Age]

The bankers reviewed one another's assets and liabilities. Morgan then decided which financial institutions had to go and which would live, getting commitments from the survivors and from the U.S. Treasury for infusions of capital. This Panic of 1907 had rattled the New York Stock Exchange and the markets for gold and municipal bonds, ruined several banks and trust companies, and nearly bankrupted New York City. Share prices fell by half. But once Morgan was done knocking banking heads together, markets swiftly recovered.

Ever heard of the Panic of 1907? There's a reason. "Markets swiftly recovered." The faster that this can happen today, the faster that we will recover. Yes, government intervention in our economy for the last 10 years means that a large amount of assets are far overpriced and these assets must be revalued, and losses will occur. It will mean that bankers that were foolish enough to overvalue these assets will lose their companies. However, these distressed assets are limited to two sectors of the economy (sub-prime mortgages, and credit default swaps) and in the case of sub-prime the underlying assets (homes) still have value, as do the remainder of assets in all the other sectors. The devaluation of the overvalued assets will mean a recession, but the quicker banks are restored to health, the quicker capital begins flowing and the economy revives.

The question is, aren't capital infusions from the government to recapitalize companies just as good? Here are some key differences to think about, and they are differences that are so fundamental that I counter that even an attempt by Hank Paulson to "look" like a free market will still fail. In a free market:

1. Capital is not used to prop up unhealthy balance sheets. Assets that are truly overvalued are written down quickly. Losses are taken quickly. Propping up bad decisions by pretending that they weren't bad only compounds the problem. Govt money most assuredly will mix it's aims, seeking to rescue those who do not deserve it, either out of altruism or the "too big to fail" doctrine. Government will buy assets before private investors would (since they claim that no one is stepping in, when really no one rationally would step in, at that price) and so guarantee the taxpayers a loss.

2. The people doing the recapitalization have proved themselves adept at managing these operations. In effect, the successful are taking over the unsuccessful. With a regulator making decision, who know if he is capable or not.

3. The people doing the recapitalization have a strong incentive to value assets properly - they put their own money on the line. Transparency of target balance sheets is demanded or no deal. I considered some sort of system where Paulson was required to put every last cent of his personal fortune against his restructuring decisions in direct proportion as a motivator. That certainly incentivizes him, but because of #2 it does nothing to assure that he's capable of making the proper decisions, only that he's motivated.

4. Prior management teams are almost always disposed of. The key here is less that we get rid of the old CEO's but that their replacements are proven to be capable. I don't worry for an instant that Paulson could depose a CEO, but I strongly doubt his decisions on a replacement.

5. The rule of law and sanctity of contract are preserved. In the seizure of WaMu, Treasury seized the company and by fiat destroyed all contractual priorities set forth in the capital structure. This act alone has exacerbated the liquidity problem because now any potential lender to a distressed bank risks losing his entire investment regardless of pre-negotiated terms, to arbitrary exercise of force. Henry Paulson's money comes paired with the potential for wholesale rights violations.

The use of government to attempt this function necessitates rights violations, spends money indiscriminately, and preserves the structures which created the panic at taxpayers expense. The proposed bail-out illustrates perfectly the concept of chasing bad money with good. Voluntary action by the free market instead "cleans house". It cannot be otherwise, no matter how well-intentioned the government.

What can the government do? Primarily, get out of the way, and preserve the rule of law. It needs to definitively state that it will not meddle in the function of the market. By implying that it will do so, government actually impedes the free market from functioning as it should since distressed bank management are hoping to preserve their operations through government action, rather than lose their banks in recapitalizations. It should reduce taxes; capital gains, corporate income, and personal income. In so doing it will encourage the influx of capital and stimulate liquidity and healthy economic functioning. It should clear bureaucratic barriers to bankruptcy and receivership so that these mechanisms can function as quickly as possible. In essence, government should proceed to leave the economy, not meddle in it.

There is one answer to this crisis: laissez-faire!


Rob said...

Kendall - I thought this post was so good I sent it to my Congressperson.

Kendall J said...

Shoot Rob, thanks for that compliment. Hopefully it did some good.

Tenure said...

"Ever heard of the Panic of 1907? There's a reason. "Markets swiftly recovered." The faster that this can happen today, the faster that we will recover."

Aptly put, sir.