AIG bonuses

Despite all that has happened there are still some good businesses at AIG.  21st Century – an auto insurance company largely based in California is one.

AIG was not fraudulent from top to bottom – and not everyone working there stuffed up the real economy though AIG FP was probably ground zero for bad lending.

I have no idea what the guy who runs 21st century is paid – and I haven’t looked.  But if 21st Century were private – and I controlled it – I would have no problem paying a good guy there 15-20 times average earnings – that is something in the 1-1.5 million range.  Those sums would make the said executive extraordinarily wealthy by the standards of the average American.  If he is good – and I was a shareholder – I would just wear it.  

I might make a fair bit of the salary bonus – and make it contingent on some performance metric – but I would have no problem justifying it.

I would have an awful time justifying paying the guy 50-100 times average.  There is just nothing that the guy could do that would justify that incremental level of salary.  

We have executives paid 30 million a year and executives paid 1.5 million a year and they generate the same level of outrage on Main Street where (compared to say $65000 in household income) both numbers are incomprehensible.  That said – 30 million per annum is enough money that you can’t spend it unless you run multiple houses with servants and fly private jets fractional share.  1.5 million per annum buys you an upper middle class life in Manhattan – or an opulent existence in Los Angeles – but multiple houses with servants are still out of the question.  Private jets are unthinkable.

The bonuses paid at Merrill Lynch were 3.6 billion - 22 times the AIG bonuses.  

They were paid by a firm that would not have survived without a bailout by the US Government through Bank of America.  Moreover they were sometimes large – the 30 million variety – not the 1.5 million variety.

We should be at least 20 times as outraged over the Merrill Lynch bonuses than the AIG bonuses.  But as a society we are not.

And don’t tell me it is because AIG is ultimately public and Merrill Lynch private.  I used to be a retail fund manager – and my end investors included a broad cross-section of society.  The low paid council worker was a part owner of companies where senior staff were paid $20 million per annum.  

I have come to the conclusion a long time ago that most people are ill equipped to handle large numbers.  They can’t see the difference between a billion and a trillion.  This leads to irrationality in bull markets and bear markets.  The irrationality is common amongst rich and poor and across genders and political views.  

There has to be investment opportunities in that.  But also in the eyes-glaze-over aspect of big numbers there are plenty of opportunity for management to loot shareholders entirely.

Gold is very expensive

When priced against real assets.  

I know the gold bugs – and there are many of them – compare the amount of gold in existence (160 thousand tonnes being the total ever mined) with the amount of nominal money (including bank deposits etc) in existence.  Gold adds up to $4.7 trillion at $950 per oz – nominal money maybe 60 trillion.

They thus assume that gold must go up.  

I am not going to approach that argument – because much of the cash really is trash (or should be trash after we have got through throwing it out of helicopters).  

What I want to note is the widespread headlines that maybe 50 trillion dollars of nominal wealth has been “wiped out” in this crisis and that something between 150 and 200 trillion remains.  The official figure for the total US household wealth about 51 trillion.  I don't have a number for the whole world – but just under 200 trillion is a reasonable guess in total – the US being just under a quarter of global activity – and having slightly more expensive equity markets than most the rest of the world.

Now does anyone really believe that the store of gold in vaults is worth over 2% of all tangible assets everywhere?  Seriously?    

Gold may be cheap against nominal assets in which case you would be better off holding gold than US Treasuries.  But I can't believe you would be better off holding gold than diversified timberlands or other real assets.  Unless of course the world degenerates into total war and all your timberlands burn down.

I know the gold bugs will hate this idea – because it harks back to the argument against gold – which is that it has no intrinsic value.  We spend a lot of money (and kill a lot of birds with cyanide) to dig gold out of the ground only so we can bury it again with expensive guards on the vault.  

And I am not bullish on nominal assets.  Long Treasuries at very low yields look like a very bad bet to me.  But maybe now is the time for lowly levered real assets.  

Even better is highly levered real assets – but where the debt is very long dated and cannot be called and has no covenants attached.  You get to be long the real assets (good) and short the nominal assets (also good) without the financial crisis risk of being called on the debt (very bad). Candidates for that (rare) category highly desired.

John

Post script - looking at the comments in the email most people are giving me assets where the asset value has not been marked down appropriately (lots of real estate for instance) or where there are problems rolling the debt (most assets).

I am being pretty picky.  I want an asset appropriately priced for NOW as if it were non-leveraged - but with huge leverage and with NO DEBT ROLLS at all.  If it requires a debt roll I am not interested.

Leverage is death if you need to roll it.  But long dated debt that you do not need to roll for 20 years - that is wonderful.  That is effectively short treasuries.  

Fannie versus Freddie credit performance

For a long time I was convinced that Fannie's credit criteria were slightly more stringent than Freddie's.  

It appears I was wrong.

Fannie and Freddie give cumulative default curves in their latest results.  The 2006 pool (which is very bad at both) has 115 points of cumulative default at Freddie and 148 points at Fannie.  The cumulative default curves are pointing to the sky at both companies.

This occurs across almost all vintages.

Is there anyone knowledgeable who can explain to me why the cumulative defaults are so different between companies.

Thanks

John 

Financial chauvinism

There is a lovely comment on the last post accusing me of financial chauvinism – suggesting it is wrong to guarantee all bank liabilities.

This gets to the nub of the issue.

The current US policy is – pretty close to officially – that there should be “no more Lehmans”.  Bernanke said it this week.  Geithner has said similar.  

It is unequivocal that a policy of “no more Lehmans” requires an effective guarantee of all the large US financial institutions.  When one of them threatens to become the next Lehman it needs to be bailed out.  The US government tips $30-300 billion in and gives us a Sunday evening press release – just for me to read in my Asian time zone before our local market opens!

Face it – the current policy is to issue the broad guarantee.  That is what we have done.  That is what “no more Lehmans” means.  It means losses are covered when they are incurred by the taxpayer.

Once we have done that there is no real argument against a non-recourse funded troubled-asset program.  That is just another form of non-recourse funded financial institution.  The argument really is “how much capital should we demand the private sector put in, and on what leverage and confiscation terms?”  It is the same argument for regulation of a bank.

But it is not universally accepted that the right policy is “no more Lehmans”.  Chris Whalen (who I respect) thinks the right model for the dismantling of large financial institutions is Lehman.  As he says the model is easy to determine – just go down to the Southern District of New York and talk to the trustee.

I think the consequences of allowing several uncontrolled large bank failures would be catastrophic – and the cost to the taxpayer of the effective guarantee will be huge (but probably less than a trillion dollars by the end of the cycle) – but lower than the cost of the great-depression event that would follow from a cycle of mega-bank collapses.

In Sweden the right policy was the guarantee – and selective nationalisation – precisely because the cost of the guarantee was not large.  The institutions were not very insolvent.  In Iceland the institutions were so large that the guarantee just was not feasible.

It is however very hard to tell what is insolvent in advance.  Svenska Handelsbank was brimming with solvency and the market wrote it off for dead.  It was a rapid 20 bagger when the crisis ended.  If it were easy to tell how insolvent then there would be no big banks that were rapid 20 bagger stocks when financial crises end.

And it would be easy to tell the right policy.

The most important policy question is whether you issue the blanket Swedish guarantee.  I think the answer is an unequivocal yes in the US – and a probable no in the UK.  Krugman is edging towards a yes as he says in this post.

If it is a yes (open for debate) then the non-recourse finance model for the troubled asset funds does not pose any further problem.

The facts on the ground are that the policy is a de-facto guarantee – as officials regularly say that there will be “no more Lehmans”.

Krugman’s current position (probable yes on the Swedish position, blanket opposition to new capital on a non-recourse basis) is untenable.

John

PS.  I have stated before - and it is reiterated in the comments

The problem with the ad-hoc guarantee is that nobody really thinks that it is a guarantee – and the generalised wholesale run on financial institutions will continue until they are sure. In other words we are effectively guaranteeing the liabilities without getting the policy benefit of that guarantee (which is the restoration of faith in the financial system).

Krugman’s illogic extended

I am flattered that Paul Krugman thought to reference this blog on his.  I have been a fan since undergraduate days at the Australian National University where I read (as a second year) some of his then recently published trade papers and thought that he was a seriously smart guy.  He later won the Nobel Prize for that work.  

I have kept a copy of Currency and Crises on my shelf for years too – and – like Paul am surprised that currency has played such a small role in this crisis.  The post on Swedbank (still the most visited post on this blog) was a direct application of Krugman’s book to the business of stock picking.  (Paul please read the post.  You will be amused.  Given what has happened in Latvia since I wrote that post it looks pretty good.)

I purchased seven copies of Pop Internationalism – Krugman’s mid 1990s popular work – and gave them to people who spouted all sorts of (Lester Thurow) crap about trade.  I even reviewed Krugman's book on Amazon – you can find that and my other reviews here.  

To put it bluntly – I am a Krugman fan almost to the point of idolatry. 

So I am getting puzzled at some illogic.  Paul has not (yet) agreed that the Swedish bullet (effective guarantee of all banking liabilities before selective nationalization) is going to be the way the US goes – but he acknowledges that a large amount of banking is effectively non-recourse finance with the losses going to the taxpayer.

He agrees with the obvious – that when banks are guaranteed they need to be regulated so they have more than zero capital.  Presumably they want to have quite a bit of capital (amount open to debate) or the incentives on the management to bet the money on red at the casino – or even loot the bank – is pretty high.  They also need to be regulated.

But he appears vehemently opposed to the (still not well detailed) Geithner plan to price toxic assets by giving a bunch of hedge funds non-recourse finance to purchase them.  He even refers to this a zombie financial idea - one that will not die.

This an illogical position.  Banks are non recourse.  Krugman acknowledges that and says that banks require adequate capital or they should be confiscated.  (No disagreement there – but I am sure we would disagree about the quantum of capital and how to measure it and what the confiscation process should be.)  

Anyway if there is new capital put in banking it will also be levered up non-recourse.  

I hope (and maybe I read Paul wrong here) that he wants new capital in banking and he would prefer it be private.  

Well isn’t that the Geithner plan?  Lets finance the tough stuff (scratch and dint mortgages, some commercial property) with new capital – as per any other bank – leveraged non-recourse to the taxpayer.  

The objection Paul makes is to it being “non recourse” – an objection which is illogical.  He has made this objection repeatedly.

 The debate should be – as this blog has made clear before – about the numbers (and possibly the confiscation rules).  It is not whether the Geithner idea is good or bad – it is whether Geithner demands enough private capital to be a reasonable outcome for taxpayers.

If the government requires enough capital then hey it is real capital and it reduces risk to the taxpayer.  If they require too much capital then the returns won’t be attractive enough.  There is not much economic difference between just establishing new banks and the Geithner idea – spelt out in some detail in the "long post" – for providing non recourse finance to several toxic asset funds.  

Just because it is non-recourse doesn’t mean it is evil.  If there is adequate capital then – hey – its new capital to the banking system – something that many (but not all) of us strongly desire now.  The issue is how much new capital for how much taxpayer risk.

John  

PS.  Paul - I know you are a busy guy - but I would love an email.  I once sent you an email (on Iceland) via Joe Nocera of the NYT.  I have no idea whether you got it - but it also looks pretty good...

Accrued interest on Voodoo maths

Accrued interest argues that banks should be given time (by government fiat) to work out of their problems - so that their underlying cash flow keeps them solvent.  My voodoo maths point entirely.  And he does it in the context of GE - where I think Voodoo Maths will do its job.

Any more people on this bandwagon and we would have a movement.

John

Note - an assessment is still required.  Nationalisation after due process.

Paul Krugman’s false logical step

To my way of thinking Paul Krugman has finally nailed the question as to bank nationalisation that matters.  This the money quote:

That said, some decision must be reached on bank liabilities. Sweden guaranteed all of them. If forced to say, I would go the Swedish route; but of course we can’t do that unless we’re prepared to put all troubled banks in receivership. And I’m ready to be persuaded that some debts should not be honored — this is a deeply technical question.

He is absolutely right that this is the critical step in the decision making process is what parts of the banking structure you are going to either guarantee or effectively guarantee.  The critical question is not nationalisation.

Sweden could guarantee all banking liabilities because – frankly – their banks were not that deeply insolvent.

We know they were not that deeply insolvent for a few reasons – the best of which is that ex-post the Swedish bailout cost very little (and the Norwegian bailouts were actually profitable for the government).

However it is fairly easy ex-post to tell how insolvent the banking system was.  It is not very easy ex-ante to tell.  If it were easy then banks that were not at all insolvent (such as Svenska Handelsbank) would not become 20 bagger stocks quite quickly after the crisis.  The stock market would not have marked them down so much.  

The US Government’s stated position – Bernanke yesterday as well – is that there will be "No More Lehmans".  What that means is that there will be no more uncontrolled liquidations of large financial firms.  

The only way that the government can say that there will be no more Lehmans is to effectively guarantee large parts of the financial system.  That is what the statement “no more Lehmans” means.  If you want to make that statement operational you either (a) need to guarantee the banking system or (b) pour money in continuously whenever a bank (Citigroup. AIG or otherwise) threatens to become the next Lehman Brothers.

The state of US policy at the moment is nothing more sophisticated than (b) above – which is whenever an institution threatens to become Lehman the US Government tips in another 30-300 billion.  We are still in the world of the ad-hoc guarantee - of the Sunday press release.

The problem with the ad-hoc guarantee is that nobody really thinks that it is a guarantee – and the generalised wholesale run on financial institutions will continue until they are sure.  In other words we are effectively guaranteeing the liabilities without getting the policy benefit of that guarantee (which is the restoration of faith in the financial system).

Krugman has nailed the right question.  The right question is whether the correct policy is “No More Lehmans”.  I am pretty sure it is.  I think the revisionist history about how bad the Lehman failure was is simply revisionist crap.  I am convinced that at least in some instances the “no more Lehmans” policy will be operationally expensive in some instances and will leave the taxpayer with an enormous hangover*.  The alternative is simply to allow big institutions to be pulled apart by the FDIC.  Chris Whalen by contrast is convinced the other way – he says the model is easy to determine – just go down to the Southern District of New York and talk to the Lehman Trustee.  

There is a reason why the right policy might not be "No More Lehmans".  Its about cost.  If the cost of making that promise operational was $12 trillion then you probably should just let the financial system burn.  Why – because it is so much money the taxpayer could not plausibly absorb it without decades of higher taxes.  If the cost is $1 trillion then hey – just suck it up - a fast rebound to the US economy as per Sweden after its crisis is worth more than a trillion dollars.  The cost depends on the size of the banking system and the size of the losses relative to GDP.  Iceland had to let its system burn because it could not plausibly bail out its banks.  The UK banks started with very little capital and with very big balance sheets relative to GDP.  They are also problematic.  The US banks by contrast started with lots more capital and smaller balance sheets relative to US GDP.  The upper-end estimate of losses (Roubini) is $3.4 trillion.  If that is the case the upper limits to cost of the "No More Lehmans" policy is less than $3.4 trillion.

My long post has some indication of how you might estimate the costs of making a “No More Lehmans” promise operational.  I have a forthcoming post which explains quite carefully what the least cost way of making that promise operational is.   (The costs are however potentially very large - and whilst I think substantially less than the Roubini number I can't dismiss the possibility the costs could be large indeed.)  

Anyway – if you have made the decision to have “No More Lehmans” then you have made the important decision – you are going the Swedish Route and guranteeing stuff - whether by Friday evening crisis or whether by design.  I think America will go the Swedish Route – I am just waiting.  The Swedish route is guarantee and selective nationalistion.  I have never been afraid of the Nationalisation word – and anyone who buys money center banks now can expect a few of them to be nationalised.  I have small positions - which would be larger positions if I knew the rules.

But the second part of Krugman’s paragraph contains a deeply troubling false logical step.  He says: “but of course we can’t do that unless we’re prepared to put all troubled banks in receivership”.

To see why this is a false logical step you need a little history.  A long time ago most the liabilities of almost all banks were deposits.  The government guaranteed the deposits by creating the FDIC – it hence stopped crisis driven bank runs.  It increased stability in a crisis.  However it also allowed financial firms to take huge risks or even be looted (as per Charles Keating).  The solution which was adopted (and let lapse of late) was that banks got the guarantee – but were heavily regulated to protect taxpayer interests.  There was no need to nationalise the banks simply because you guaranteed the bulk of their liabilities.  There was however a requirement to (a) regulate them, (b) assess their capital and (c) take “prompt” corrective action when that capital was inadequate.  Prompt corrective action included confiscation.  You did not take over banks because they had runs (the purpose of the FDIC guarantee was to stop runs), you took over banks when they inadequate capital.**

Nowadays a lot of banks have the bulk of their assets funded by things that are not deposits.  Indeed at many banks deposits constitute less than half the balance sheet.  

The old FDIC guarantee can’t stop runs because the run that happens is wholesale – it happens outside FDIC guarantee limit.  If you want to stop bank runs the way that the original FDIC stopped bank runs you need to bite the “Swedish Bullet” – that is you need to effectively guarantee everything.

However just as the creation of the FDIC did not require you to be “prepared to put all troubled banks in receivership” a Swedish guarantee also does not require you to put all troubled banks into receivership.

What the FDIC guarantee required – and what a Swedish Guarantee will require – is you be prepared to (a) regulate banks heavily on an ongoing basis, (b) test the capital of banks, (c) force them to be adequately capitalised (rasing money if they can), and (d) nationalise the banks that cannot raise adequate capital.  

When the good times return you probably need walk away from this general guarantee.  In other words you have to regulate banks in such a way that they can’t become large enough to destroy the whole economy - so that you reduce the systemic risk at the cost of stifling "financial innovation".  That means that the recidivist Citigroup – a bank that seems to blow up every cycle – will never be allowed to become as big and nasty again.  It would be a terrible policy outcome if we did not learn from this crisis and did not regulate in such a way that it was less likely to happen again.  Willem Buiter's call for "over regulation of banks" looks right to me.

Krugman’s illogic however does not help the debate.  There is a need to guarantee all banking assets – and it should be done provided it is affordable.  There is no consequent need to nationalise the whole system – though there will be a need to have a process which will result in nationalisation of some institutions – what I call “nationalisation after due process”.   

Oh, and the number of losses in the system is not fixed.  If the ability to borrow to fund risk assets is not restored then commercial property for instance will fall until its yield becomes attractive to an unlevered buyer.  My guess is that is about 15%.  As the economy will be in a slump at the same time and rents will also fall that might mean a top to bottom move in commercial property of 80%.  If the move is that big then all the banks (good, bad, otherwise) are insolvent.  However if the banks had guaranteed funding then (a) they could lend so the slump in the economy would not be so bad and (b) people could borrow to buy commercial property so its price does not need to fall until the yield is 15%.  The top to bottom fall might be 35%.  The system losses would be smaller.

If we do not guarantee all bank funding then I am afraid that Christopher Whalen will be right - the macroeconomic wave going through the economy will just smash up everything fast.  

The longer we wait before biting the Swedish bullet the larger the system losses will be - and hence the higher the cost of biting that bullet.  Either do it now or give up saying that there will be "No More Lehmans".  If you wait too long everything becomes Lehman.  

It took Krugman a long time to realise that the "Swedish Guarantee" is the important question.  And it is.  Nationalisation (which should happen for some institutions) is only the secondary question.

John Hempton

Some post scripts

*The instances in which I think the “no more Lehmans” policy will be operationally expensive are (obviously) AIG (almost certainly) Fannie and Freddie and speculatively a few others that are properly insolvent.  My biggest problem child is Barclays – which is technically a UK institution – but it is too big for the UK to bail out – and which has a lot of its operations in the US.  I suspect that the US can – as a technical thing – let Barclays be the next Lehman – saying – hey – its not one of ours!  But that is a post for another time.  

**This is one of the things that most annoys me about Sheila Bair’s confiscation of Washington Mutual.  WaMu had a run.  The old role of the FDIC was not to make banks fail when they had runs – it was to stop runs.  I would have no objection to confiscation of WaMu if it was demonstrably insolvent.  However it was not demonstrably insolvent – and Sheila Bair’s own press release said it was capital adequate when confiscated.  It was a very strange interpretation of her role indeed that she should close a bank because it had a run.  

Fools seldom differ

Warren Buffett was on CNBC last night.  Maybe he is getting old and vain and likes to be on TV.  Maybe he is falling for the (considerable) charms of Becky Quick – but he allowed himself to be interviewed for three hours starting at 5am Omaha time.

That made it good evening TV for me in Sydney Australia.

I was amused to hear my own views – parroted back to me in a more articulate and folksy manner than this blog.  

There is a saying – usually ironic – that “great minds think alike”.  I immediately think of the come-back that “fools seldom differ”. 

Whether Buffett and I are fools – well I will leave that for others to decide.  However Joe Kernan (and not the dulcet Becky) got out of Buffett what I believe to be the money quote of the whole interview:

BUFFETT: Yeah, the interesting thing is that the toxic assets [of American banks is] if they're priced at market, are probably the best assets the banks has, because those toxic assets presently are being priced based on unleveraged buyers buying a fairly speculative asset. So the returns from this market value are probably better than almost anything else, assuming they've got a market-to-market value, you know, they have the best prospects for return going forward of anything the banks own.  The problems of the banks are overwhelmingly not toxic assets, you know. They may have been one or two at the top banks, but they are not going to do in--if you take those 20 banks that are subject to the stresses, they're not going to do those banks in. Those banks have the earning power which has never been better on new business going out of this to build capital positions if they pay low dividends which they're starting to do now.

JOE: Hm.

BUFFETT: Toxic assets really are not the problem they were. Now, when I said it was contingent--I didn't remember being exactly contingent on TARP, but it was contingent on the government jumping in. 

JOE: Right.

BUFFETT: The government needed to act big time in September, I will tell you that.

JOE: So...

BUFFETT: And they did act big time.

JOE: So you are OK with the shift to providing the banks with capital as opposed to the original intention of the TARP for actually getting the toxic assets off the books?

BUFFETT: Yeah, and interestingly enough, they don't need to supply the banks, in my view, with lots of capital. They need to let almost all of--I mean, the right prescription with most of the banks is just let them pay very little in the way of dividends and build up capital for awhile, and they will build up a lot of capital. The government has needed to say--what the government needs to say is nobody's going to lose a dime by having their deposits in these banks. They're going to make lots of money with the deposits.

JOE: Hm.

BUFFETT: The spreads have never been wider. This is a great time to be in banking, you know, if you just get past the past and they are getting past the past. I mean, right now every time a loan is made to somebody to buy a house--and we're making, you know, making millions of loans--four and a half million houses will change hands this year out of a total stock of less than 80 million. So those people are making good mortgages. You want those assets on your books and you get a great spread in putting them on now. So it's a great time to be in banking, but you do have to get past this past. But the toxic assets, in my view, you know, if they've been written down to market, I'd rather buy those assets from the bank than any other assets they've got.

JOE: Hm. OK...

Lets pick this apart:  Warren Buffett has been saying that the toxic assets are the best assets of the bank (provided they are marked to market).  This is precisely what I have been saying.  Moreover he says it for precisely the same reasons that I do – which is that they are being priced based on “unleveraged buyers” buying a fairly speculative asset.  Compare this to my explanation in the “long post” – which was that they had large yields because you could not borrow to buy them.

Then Buffet says that the returns from the toxic assets are better than almost anything else.  Several people (including some high profile academic economists) disagreed with me about the spread on those assets.  That is fine – they are also disagreeing with Warren.  He is wrong fairly regularly too.

Then he says the problem of American banks are not overwhelmingly toxic assets.  This is a radical view – but it is in my view correct.  The problem with the banks is that nobody will trust them and they have not been able to raise funds.  The view that this is a liquidity crisis – and not a solvency crisis – has long been a staple of the Bronte Capital blog.  It is radical though.  Krugman, Naked Capitalism and Felix Salmon think alike – asserting – seemingly without proof – that the problem is solvency.  Buffett doesn’t even think the US banks (on average) require capital – a view that most people would find startling (though again I think is correct provided appropriate regulatory forbearance is given).  

Moreover Buffett thinks it is not solvency for the same reason as me.  To quote: “those banks [including presumably most of the big 20 banks in the US] have earning power which has never been better on new business going out of this to build capital positions even if they pay low dividends which they're starting to do now.”  I have been criticised endlessly for pointing out that on pre-tax, pre-provision earnings American banks can quickly regain solvency provided they can maintain funding.  This was the point of my Voodoo Maths post – and also the point of much of the long post.  

Moreover he goes on to repeat that the opportunities in banking are simply wonderful now – so long as you can get past the past.  This was the point in my series of posts on Bank of America’s quarterly numbers.  To anyone that looks at the American numbers it is self-evident that the margins in banking are going up sharply and that the opportunities are large right now.  However this simple observation set my inbox on fire – to the point that I felt I needed four posts (links 1, 2, 3, and 4) to defend the obvious.  

(Incidentally the margin expansion is not evident in the UK – where the banks are properly insolvent – and it is not evident in France where the banks are almost certainly highly solvent.  I can’t work out why it is not in evidence in France but if someone wants to explain it send me an email. I would be pleased.) 

There were other parts of the interview where Buffett simply agreed with me.  For instance he thinks that bank liabilities should simply be guaranteed at this point (at least for the large banks) and that guarantee should carry the personal weight of the President.  The alternative is either endless government injections costing as much as the guarantees or uncontrolled liquidation –a dozen Lehmans - as the banks run out of funding.  They did issue guarantees in Sweden – and I was hoping and praying that the US would become Swedish.  

Krugman is finally coming to the view that the important technical question is whether to issue that guarantee.  He is right.  Provided the guarantees can be issued at reasonable cost they should be issued.  Both Warren and I think the cost would be reasonable in the USA.  By contrast I am not sure the UK has the blanket guarantee option because the UK banks are very large relative to the UK economy and they started highly capital inadequate.  US banks by contrast started with a lot of capital.

Buffett did not approach the issue of how you treat banks after you have issued that guarantee.  I think you should have a process for assessing their capital and require that they have sufficient.  Those that do not have sufficient and can't raise it you should nationalise (by diluting the shareholders and preference shares out of existence).  That was the point of my “nationalisation after due process” post.  Though the nationalisation question is entirely secondary to the question of whether you treat this like a liquidity crunch (by guaranteeing liquidity) or whether you treat it like a solvency crunch (by forcing insolvent banks to liquidation).  I know which side I am on – and it is the same side as Warren.

Now it is all very nice to be demonstrably thinking the same way as Warren Buffett.  I should have an operating funds management business after I get through complexities of Australian licensing and similar hurdles.  If people widely believed that I thought like Warren I would be inundated with money – and that would be a good thing – at least for me.  

But I have to note that Warren was not entirely straight forward in the interview.  Warren did not think he could get the preference share deals he got from GE or Goldman Sachs now.  That might be true with Goldies – but it was unequivocally false with GE.  With GE you could construct a better deal on market.

This blog (painfully) admits its mistakes and tries to analyse them.  A money manager should be brutally honest with himself.  Warren however is an old man and his credibility is harder to question that mine.  But Warren was wrong with his GE preferred (if only because he could get a better deal later).  He should have admitted that (at a minimum) his timing on that one was awry.  

It would be inordinate vanity to hope that I will be better than Warren.  But I hope at least to think clearly and rationally like him.  Oh, and to hold myself to a decent standard of self-analysis and criticism when I stuff up.  

John 

Optimism Porn – used car prices

There is so much bad news out there that I thought I might start a little bit of optimism porn to counter the pessimism porn that is becoming so common.

So here is your first dose of optimism porn: the used car business is holding up surprisingly well.  This was mentioned in the Federal Reserve’s Beige Book – but also in the Manheim index of used car prices at auction.  This index spiked up last month!

The biggest single determinant of losses in a subprime auto finance book is not loss rate – it is severity – the loss after the car is auctioned.  I am not about to buy non distressed auto securitisations or anything – but if you want to play in the distressed stuff this is clearly good news. 

 

John

PS.  One comment from below deserves highlighting:

that is great news. anyone in NY want to buy a 2003 mazda protege with 55k miles really cheap? i bought it to commute to my hedge fund job and don't need it any more.

Voodoo maths and GE

Keith Sherin – the GE CFO – put out a press release that you can find here.  I just want to extract one paragraph.

Mr. Sherin said he expects the financial services business to be profitable for the first quarter and full-year 2009, and he addressed questions on the Company’s position on cash generation and loss reserves:  "Over a three-year period here, we expect GE Capital to be profitable, even after $35 billion of losses and impairments. We're looking today for GE’s total cash flow to be around $16 billion for the year. In our stress case we could be down in the $14 billion level.  In either scenario, we can fund the company. If conditions were to deteriorate beyond what is in our stress scenario, we also have the option of scaling back originations in GE Capital to conserve cash and capital."  Emphasis added.

Now when I pull apart GE I get embedded losses above 35 billion.  The more bearish get losses at 65-70 billion.  I am not convinced about such numbers but 55 is plausible.  Losses of course are unknowable - but 35 is plausible.

$35 billion in losses and impairments over three years may have sounded nonchalant.  This is substantially higher than 2008 where losses and impairments were only 7.5 billion.  

In other words Sherin is predicting a substantial downgrade in GE profitability.

No surprise there.  The market knows it.  However Keith Sherin’s prediction (reasonable – but high estimate of profitability in my view) is wildly inconsistent with Jeffrey Immelt’s shareholder letter.  Immelt’s shareholder letter says that they are “targeting returns [in GE Capital] to be about 15%”]  

$35 billion in three years is not consistent with 15% - so somewhere the message changed.  

Has the CFO just dumped the CEO in it?  No- the stock market did that first!

Now if the losses are going to be that elevated (and they will) then GE should be taking the provisions when it deems them likely.  That is when they are incurred.  If they were to do that then the tangible capital of the whole of GE goes negative.

However if they take the extra provisions over three years then pre-tax, pre-provision earnings (ie Voodoo maths) will see them through. 

Oh, if the losses are where the bears think ($60 billion range) and if the government supports GE’s liquidity (likely in my view) then voodoo maths will still see GE through – but the time period is five years and the dividend gets cut to zero.  

The stock may not be a buy - but on those sort of numbers the CDS is unnecessarily wide - and Warren Buffett will make money on his preferred.