AskDong

I recently finished reading When Genius Failed by Roger Lowenstein.   The book details the glorious rise and ignoble fall of Long Term Capital Management, a fund that boasted not one Nobel laureate but two.   I had been meaning to read the book for the last 4 years, but recently came to it indirectly.   The previous week, I had finished reading the Warren Buffet biography Snowball by Alice Schroeder.  The characters of LTCM, especially Jon Meriweather, play a prominent role during Buffet’s days at Salomon Brothers.  My curiosity was ignited to hear another tale of high finance.

Roger Lowenstein is great writer, and an even better financial writer.  He doesn’t just thrown down good prose, but understands the basic financial issues at hand.  I write here not the review the book, but dwell on one issue that epilogue raised - did the bailout of LTCM set the stage for the recent financial collapse and subsequent bailout?

Lowenstein writes prophetically, “If one looks at the Long-Term episode in isolation, one would tend to agree that the Fed was right to intervene, just as, if confronted with a suddenly mentally unstable patient, most doctors would willingly subscribe a tranquilizer.  The risks of breakdown are immediate; those of addiction are long term.”  In the case of LTCM, the Fed did not risk any public money - it merely orchestrated the meeting of the heads of the various Wall Street banks so they could privately fund a bailout.  In 2008 we had the Fed and the government take unprecedented steps to prevent a financial collapse, and this time the public did foot the bill.

I for one think it worked, but the spectre of long term addiction that already loomed since the days of LTCM rides much higher in the horizon.   Moral hazard is easy to recognize; if the government is willing to bailout financial firms that are “too large to fail”, the government is implicitly encouraging financial institutions to take on too much risk.  Moral hazard is easy to recognize and hard to avoid.   Purists will argue that we should have let AIG and brethren banks fail, and dealt with the consequences even if those consequences were another Great Depression.

I’m not a purist, but have to admit the precedent that we’ve set is a dangerous one.   Ultimately, it’s not just about  making sure that those who do misdeeds are punished.  At some point, as the stakes become greater and greater, there will be no recourse and the consequences even greater.   There are failures which cannot be bailed out.

The question is, can we pursue a course of action that is “correct” for the here and now while still setting the right precedent?  I like to believe there is.   Commonly, we make no distinction between Banks and Bankers, but there is a distinction to be made.   Institutions devoid of people should not susceptible to moral hazard.  So how can we bail out banks and not send the message to bankers to engage in ever riskier activity?

I think the “bailout” of LTCM spoke spades about how badly we deal with the guilty right now.  The managers/partners of LTCM received 250k salaries and 500k bonuses.  Yes, these amounts were trivial in comparison to the compensation these partners made in the good years, and admittedly many of the partners saw a majority own net worth vanish with that of their fund.  A few lost even more than they had as they borrowed money into invest in the fund.   Still why were they paid anything?  The twisted irony of failing in the financial world is that one is most needed when one has screwed up the most badly.  As a result financial sinners are able to hold their saviors hostage.  The worst part is that the same partners at LTCM took in more money from investors a little more than a year later in a new fund.   Should not there be repercussions?

Should we not hold some of those in the finance industry who nearly brought us brink of armageddon criminally liable?   I like to think there is some way, but here in lies the rub.   The banking crisis of the past year was widespread with no one party truly at the heart of the crisis.  The financial risks were truly institutional.   There was no one activity that was in itself too risky, but sets on interconnected activities that amplified risk.   How do you reform Wall Street?  It’s not arbitrary limits on pay going forward.   It’s a combination of good regulation that prevents systemic risk, and it’s also policies that let’s bankers know that they will not get away with risking the entire financial sector without repercussion.   Do you punish everyone who had a hand at all in the crisis which would be most of Wall Street, real estate agents, appraisers, home buyers, sellers, etc?  Individually each can claim their innocence, but collectively we are all guilty.

In general I don’t like to putting extra principal toward my mortgage.  I actually like leverage, the ability to control more money via borrowing.  Leverage is a dangerous tool in the wrong hands.   I like to believe my hands are not such hands, and because of this I’ve always looked at mortgage as a blessing rather than a curse.   In what other situation would banks lend customers hundreds of thousands dollars at remarkably low rates?  Not for a business, and certaintly not as a personal loan.  Of course in the last few years this kind of borrowing has proved rather disastrous for banks and mortgage holders alike.   Luckily, I fall into neither of the victim groups (banks and those being forceclosed upon).

Given my naturual disposition towards mortgage debt, I did the unthinkable.   I made a fairly substantial principal payment towards one of my two mortgages (the rental property).  Why?  It was simply the best place, I could park money.  The interest rate is 5.375%, and most banks are not paying even 3% of a 5 year CD.   Despite the stellar returns of the past few months in the stock market, I am not ready to put all money into the “market.” for what I think are uncertain returns (good or bad) in the near term.  

Ultimately what drove me to pay down my principal was a decision I’ve come into the last 3 months.  I’m almost 95% likely to sell my rental property in the next year.  Selling my rental property will allow me to take some capital out towards buying a larger place to live in while also allowing me to convert my current apartment into a rental.   It’s far from a done deal, but making a principal payment is almost like putting money into a 1 year CD that yields 5.375%…

The last few months really have been doozie. As a result of the rally my portfolio is trailing the market as whole, despite another up month from the the last.
Last month I predicted that we would see retrenchment. So far I’ve been wrong, and with any luck I’ll continue to be wrong.  However, I am proceeding with caution.   A market that runs of 50% so quickly is a market that can easily give up 25% as people take off profits.   I do believe, however, the economy has turned a corner.   The imminent financial meltdown no longer seems so imminent.   I doubt things will be as rosy as the stock market seems to believe, but it does seem like the worst is behind us.

The Cash for Clunkers program has been getting quite a bit of press lately.  Will it be renewed or will it not?   It will.  Not suprisingly there’s been quite some debate about the merits of the program.  Is it an effective program?  If one were to judge by the good news coming out of Detroit, one would have to think that it must be.   However the numbers coming from the automakers are not the only criteria that the program should be judged upon.

Pros

The Cash for Clunkers program serves 2.5 primary purposes:

1. Improve the overall gas efficiency of the US auto fleet
2. Stimulus for the economy
3. Assistance to beleaguered automakers (similar to point 2)

Using those metrics only, it seems the Cash for Clunkers program has been success.  The program has been so successful that it’s run out of funds.  People have turned in cars averaging 15.7 for cars that average 25.4 MPG.   People are driving more effecient cars.

Cons

On the other hand, if you believe that Government has no place in choosing what industries deserve to be helped during an economic downturn, the Cash for Clunkers program is anathema to sound economic policy.   If the government must encourage spending, then a tax cut is surely the best way to do so.  Let people choose what they will spend money on.  In addition, it’s unclear that the Cash for Clunkers is truly benefiting the economy or the environment.

Some believe many of the people trading in clunkers would’ve have brought new cars anyways.  If this is true for the great majority of car buyers then program does nothing to stimulate the economy.  It serves only as subsidy from non car buyers to car buyers, and as a result does little to actually benefit the environment.  Additionally it can be argued that by encouraging people to buy new cars when they were able to make due with an older car has net detrimental effect on the environment because the construction of new car in itself is not good for the environment.   The cars being turned into the program will have their engines disabled, making them only useful for parts.   Ruining a perfectly good engine seems like a waste.  Though not to do so would curtail the effectiveness of making the car fleet more effecient as these cars would then make their way into the market.  As a stimulus program it’s not too much different from the age old example of hiring someone to dig a hole, and hiring someone else to fill it back up.

So is it a good program?

Not surprisingly how people feel about the program has broken down predictable partisan lines.  Equally not surprisingly, I’m a fan of the program.  I supported the original stimulus package because I believe the Economy needed it.   The cash for clunkers program is actually exactly the type of intervention that we need if you believe in Keynesian economic stimulus.  The money was delivered quickly and directly replace spending that was being curtailed (assuming that you believe that it actually encourages people who would otherwise not purchase cars).  Even if people moved up purchases, the program is still effective.   The goal of the stimulus package is not to encourage more consumption, but to encourage more consumption at this moment to prevent a spiral towards a depression like scenario.   While on the surface it might seem a tax cut would serve the same purpose given the prevailing mood, it was more likely a tax cut would’ve gone into savings - good in the long run, but bad in the short run which in turn puts the long run in jeopardy. 

One issue I am worried about is that we have encouraged people who should not be buying new cars into taking on more debt to purcahse new cars.  While such behavior may be good for the here and now, the long run consequences of burdensome consumer debt is not.