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!

ARC Website on the Financial Crisis

The Ayn Rand Center for Individual Rights has opened up a web site as a resource for ideas regarding the financial crisis. Your refueling stop for principled ideas!

Humor in a Crisis

Two items struck me as ironically funny today:

1. I received a pre-approval for a WaMu Visa Card.

2. I was talking to a buddy of mine who used to work in fixed asset investing at my company. He was around when bankers tried to sell credit default swaps as an instrument that they claimed should be an integral part of our investment portfolio. From that experience he learned 3 key statements to always cause you to run, not walk, away from any new financial instrument:

a. What could possibly go wrong?
b. It's different this time.
c. You just don't get it.

Monday, September 29, 2008

A Rational Plan

I saw this vid today, and I like his proposal to address the financial markets. His plan addresses the issue the same way that I've indicated, an orderly and speedy restructuring and/or liquidation of insolvent assets.

What the Treasury has been doing, in seizing companies such as WaMu is egregious. Hank Paulson is circumventing the law and property rights principles to use the force of government to do what he thinks is best. These asset sales could have happened speedily and with due process. Instead assets were seized and disposed of, and the capital structures of the companies decimated.

I have a longer post on the principles behind government's proper role coming, but this gentleman has it correct as well. His proposal is here.

Congress did not defeat this bill based on any rational principle. It was for various politically expedient reasons depending on which group a congressman belonged to. I suspect another plan that is materially no different than this one, and another vote will be eminent before week's end. You must keep up the pressure.

Another Banker Weighs In

David Littman, former vice president and chief economist for Comerica Bank and Chief Economist for my home town free-market think tank, The Mackinac Center for Public Policy, has penned an op-ed in last week's Detroit News laying blame for the financial mess where it belongs, on government intervention in the economy.

Add that to the letter to Congress penned last week by John Allison, CEO of BB&T, stating the same thing.

Certainly if the risk of financial ruin that advocates of the current bail-out want us to believe necessitates it is so certain, it's odd to me that people who are intimate with the banking industry don't think so.

Sunday, September 28, 2008

"How Your Government Can Wreck Your Economy and Get Away with It" in 6 Easy Steps

1. Set up a Mechanism to Launder Risky Home Mortgage Debt. Create an agency whose sole purpose is to "offer liquidity to the secondary mortgage market." The agency will guarantee home loans for a small "insurance" fee, or it will buy them and repackage them as "mortgage-backed securities" also guaranteed to pay, regardless of default. Set low standards for the types of loans that will quality, and make sure your fees are low so lots of people will sign up for your insurance. Sell these new low risk securities into the financial markets. Viola! You make risky debt look good, and sell it to "suckers" thereby providing liquidity to the mortgage market. Oh, it's true that some of them won't fall for it, but all we need a few, the dumber ones, and the ones who know what's going on, but who are hoping to find a sucker of their own to pass the buck to. Oh, almost forgot. Make sure you set up this agency as a "private" company. Imply that you'll save it if it gets into trouble, but don't promise it explicitly. Give it a nifty, folksy name like Freddie Mac or Fannie Mae.They'll love that.

2. Force banks to offer Risky Debt. What? Not enough people are helping you issue risky debt? Well, that's easy. Just pass a law that forces banks to lend to high-risk prospects. Tell them you won't let them do things like merge with other banks unless they can prove they are issuing risky debt the way you want them too. Make sure the law states that they specifically shouldn't look at things like applicants' income, or current assets when making decisions about them. If it doesn't work so well at first we can just revise it, so our money laundering agency gets into the act too. Oh, name again. We certainly don't want something like the "Let's Issue More Risky Debt Act", so we need something that will tug at their heartstrings. Got it! the "Community Reinvestment Act"! They'll love that.

3. Hold interest rates down so anyone can afford Risky Debt. OK it's starting to work, but still not enough risky debt to clobber the economy. We need more time! A delaying tactic. Wait! We control interest rates right? Shoot let's just keep interest rates low for a while. We know low interest rates stimulate potential new risky debt holders to go ahead and get that house they can't afford. Do that for a couple of years and we'll have risky debt all over the place!  Oh, once again, we don't want anyone to know. Let's wait until we have some sort of minor crisis and say we're doing it to help "stimulate" the economy. How about that "Dot com bubble" we just had? Oh, and we need some cover again. Let's get some free-market guy to advocate it. Some pragmatist who's advocated some pretty strong free-market principles but who'll sell them out at a hat drop, and whine about it afterward that he didn't know. What? Robert Stadler isn't available? How about that Greenspan guy? Yeah, they love him.

4. Make it a moral, noble action to take out Risky Debt. Proclaim that every citizen should indulge the noble dream of home ownership. That buying a home is good for the economy; that it's the government's duty to help you afford your new home purchase, and it's your duty to help out the economy. Use the full power of the largest public relations machine in the free world, the U.S. Government, to trumpet the notion. This is the key, of course. Now when Joe Citizen shows up at his local bank and wonders why his banker doesn't ask him about his income, he won't second guess it because he knows that what he's doing is good for the economy. When Joe Banker sells of his mortgage to Freddie, and wonders how it is that Freddie can afford to guarantee what he suspects is a risky debt, he won't think to ask, because it's the government's duty to see that everyone has a home. Oh, I just get warm and fuzzy thinking about it.

5. Wait. That's it. Just let the machinery work. After a few years, Risky Debt will be everywhere. Some people will be worried, but our PR will have worked on most. Even if they're worried, they'll think about how noble and selfless they're being and all that worry will just evaporate in a cloud of happy thoughts.

6. Blame the Free Market. The implosion will happen. What sets it off will be immaterial because the mechanism, the time bomb, will have long been in place. Everyone will be powerless to help it. We will be too, but think of the mileage we'll get by blaming the free market! We'll get to nationalize things, and give out tons of money. We'll call those Wall Streeters "greedy" bastards, call for their heads, take away their companies. Everyone will come to us for help, and we'll tell them we will, even though we can't really. We'll ask for broader powers. Say that we need to be left alone to handle things the way we see fit. And they'll give them to us, of course. Because they won't know any better.

Now I certainly don't want to imply some sort of conspiracy on the part of government here, but the cause and effect I've outlined is real. It is the cause of this financial mess we're in. And it has nothing to do with the free market. But after all the finger pointing at the greed of the businessman I've heard spewed in the last few days, this version pales in its sinister quality, and the actual actions line up better with the facts on the ground. Free-market intellectuals know this and they are saying so, Bank CEO's, the ones who weren't duped by this trickery, know this and they are saying so.

There is one action on this list however that was taken, consciously and consistently. #4 - making it a noble, moral action. You cannot go anywhere today and not hear the resounding chorus. Man is too selfish and greedy; it is his duty to help those less fortunate; we are our brothers' keepers; it is right for government to force this to happen; people rise to their highest when they pursue a "cause greater than self-interest". It doesn't matter if all the other actions above are mistakes. #4 is not, and from #4 all the others necessarily follow. #4 is known as altruism, and it has only one known antidote, rational self-interest as a moral code, and a politics based upon individual rights.

From his recent The Objective Standard article "The Resurgence of Big Government", ARI Executive Director Yaron Brook states it better than I can:

If selfishness and the profit motive are immoral, then no wonder they are blamed for any and all economic crises. Nor is it any wonder that the government—which we are assured is not self-interested—is posited as the solution to such greed-induced crises. Politicians and bureaucrats, we are told, are working not for their own benefit, but for the “common good” or “public interest.” Thus, economic disasters cannot be their fault; the blame must lie on the shoulders of greedy businessmen.

Because Americans accept the notion that self-interest is morally wrong, they have come to equate businessmen with crooks, on the grounds that both pursue self-interested goals. The argument goes, in effect, like this: Left to his own devices, free from the watchful eye of our public servants in Washington, a businessman will try to make a buck by raiding the cookie jar rather than by producing and selling cookies.

...

Americans must come to understand that appeals to the “common good” and the “public interest” are not moral claims but licenses to evil. Because the American public is just a number of separate individuals, whenever some group trumpets action in the name of the “public interest”—say, a new prescription drug benefit or Social Security scheme—it is declaring that the wishes of some individuals trump the rights and interests of other individuals. But everyone has a moral right to pursue his own happiness, free from coercive interference by others. If it is to have a legitimate meaning, the “public interest” can mean only this: The rights of each and every individual are equally protected by the government.

If Americans want to turn permanently toward a genuinely free market—and thus toward peak prosperity—they will have to reconsider their moral convictions. They will have to discover a new morality, one based on the requirements of human life and backed by detailed arguments and demonstrable facts. This is what Ayn Rand offers in her body of writings. She is the only champion of capitalism who would and could defend capitalism on moral grounds, as indicated by the radical titles of her books Capitalism: The Unknown Ideal andThe Virtue of Selfishness. Those who want to fight the trend toward statism—those who want to effect a real and lasting turn toward capitalism—would do well to study her thought.

The people who know what's going on are saying so. I'm saying so. It's time for you to do the same.

No friends of capitalism

The following letter went to my congressmen at the end of last week. Should another "bailout" plan be proposed which, while smaller in total dollar figure, differ little in principle then subsequent follow-up letters will be sent.

I urge you if you have not done so yet, to do the same!

Dear Sir:

As Congress considers a bail-out provision totaling over $700B and which could run higher, please reconsider any decision to vote for this sort of proposal in any way.

What the country needs now is not the govt granting broad reaching, unchecked powers to the Department of Treasury so that it can spend taxpayers money to buy up bad paper and greater than market prices. Such a measure will not save the economy but plunge it further into crisis. It will not punish those executives who made poor decisions while saving those who were smart. It will treat all equally.

What the country needs now is for the govt to provide an orderly mechanism to allow banks to liquidate assets as needed to solve their liquidity problems. That mechanism exists under the rule of law already. It is known as Chapter 11 restructuring. The free market, a truly free market must be allowed to work to clean up the mess, which ultimately has government intervention in both monetary policy and the mortgage industry at the heart of its cause.

Today John Allison, CEO of BB&T, one of the largest commercial banks in the country articulated the principles by which government should behave in a letter to all of Congress. I agree wholeheartedly with his assessment and urge you not to vote for any sort of bail-out plan.

I have generally voted for you and the Republican party party in the past; however, your vote for such a plan now will irrevocably change my future vote. This action will be akin to the disastrous aftermath of the 1929 crash whereby government attempts to solve the financial problems they created only made them worse and caused a protracted Depression. The Democrats were no friend of capitalism in that time, and should this measure pass with Republican approval, then I will have to conclude on principle that the Republican party is no longer a friend of capitalism either.

Respectfully yours,

Kendall Justiniano

Monday, September 22, 2008

Provenzo's Tops in My Book

Kudos to Rule of Reason's Nick Provenzo today for standing up to nationally-syndicated talk show host Laura Ingraham. His recent piece analyzing Sarah Palin's choice to give birth to a baby she knew had Down Syndrome and the broader implications that the glorification of her choice implies for abortion rights was picked up by pro-life media in a big way, culminating in his invitation to appear on Laura Ingraham's show. Misrepresented time and again, he published a follow-up piece as well.

Ingraham, a fervent religionist, is staunchly pro-life. While she deals with most of her "friendly" guests in a respectable manner, those who have views contrary to hers can be subjected to anything from berating to a downright railroad job, and Nick was no exception. His talking points for the show, and his response after the interview are here and here respectively.

Nick stuck to his guns, did not allow himself to be misrepresented, and eventually forced Ingraham to direct and blatant ad hominem. My respect goes out to Nick. Facing tough audiences like this is a tough job, and he handled himself well.

Tuesday, September 16, 2008

How NOT to Teach China a Lesson

"It is the government's duty to intervene. Now we have a very good example that it is acceptable."    -- former Chinese government advisor

What is this government official referring to? Could it be the Russian invasion of Georgia? The latest move by Venezuelan strong-man Hugo Chavez to nationalize more of his country's industry? Not at all. The official refers to Treasury Secretary Paulsen's decision last week to effectively nationalize the U.S. mortgage industry.

As fellow blogger, Gallileo articulated last week, this nationalization was simply making a long standing situation explicit. However, this very public act serves as a demonstration of how far away from the free market the US has actually strayed, and how badly we undercut our efforts to influence other nations' policies.

From a Wall Street Journal article, "U.S. Plan serves as Template For China to Bolster Its Markets"

Still, over the past 30 years, China has studied the U.S. economic model and cherry-picked elements to introduce little by little. It has adopted U.S.-style financial principles to build a market-based system for trading stock. It has invited U.S. financiers to help, with cash and advice, transform its banks into consumer-focused firms with mortgages and private lending. America-focused economic courses are popular at Chinese universities.

U.S. officials have often called on China to cease heavy-handed interventions and occasionally lectured Beijing on financial issues such as how it manages its currency. With the U.S. having to increase its own market intervention, foreign calls for liberalization are likely to be received more cynically in Beijing.

"I think the Chinese regulators will learn the wrong lesson from this," says Liu Jing, professor of accounting and finance at the Cheung Kong Graduate School of Business in Beijing. "Both systems have problems. The problem in China is too much government control, not too little. And they will end up thinking that they should control even more."

The Federal bail-outs, nationalizations and liquidity injections over this crisis are some of the largest interventions in the financial sector since the Great Depression. They are an example of statism, and statist moves. But as this example points out, the US is seen by others as trumpeting the free-market, as an example of how to run free markets, and it is the name of the free market that will be sullied instead of the true cause here, statism.

As Yaron Brook effectively points out in his recent Forbe's op-ed, "The Government Did It," the blame for this financial crisis is to be laid squarely at the doorstep of big government and statist policies. This not an example of the free market mismanagement, but of statism, using an altruist philosophy, run amok.

Again, the The Wall Street Journal article,

Overall, however, the U.S. housing crisis has raised questions about the wisdom of adopting too much American-style capitalism that aren't likely to dissipate soon. The U.S. mortgage crisis is "sobering" for Chinese, who are used to believing "that American financial markets are the best regulated and best managed," says Mr. Zhou [Zhou Dunren, deputy director of the Pudong Institute for the U.S. Economy].

What other nations get wrong when they see this example is that this is a case of American-style statism, not capitalism. True American-style capitalism takes one form, lasseiz-faire, and it would do America some good to once again start practicing it.

Tuesday, September 02, 2008

Woo Hoo! I'm In!!!

Dear Kendall,

I am pleased to inform you that you have been accepted into the Objectivist Academic Center. After carefully reviewing your application for admission, we are confident that you will thoroughly enjoy and benefit from our unique undergraduate-level educational program for the study of Objectivism.

Classes will begin in October 2008. Congratulations, and I look forward to meeting you soon.

Sincerely,

Onkar Ghate
Dean, Objectivist Academic Center
Ayn Rand Institute