Unintended Consequences of Four Government Policies

Intelligent leadership is not determined by eloquence alone - instead it is measured by one’s ability to foresee unintended consequences and act accordingly. Many have remarked on the intelligence of President Obama, and early on he has been hailed as the perfect candidate to usher in a new era of change. It is encouraging to witness his ability to bring people together and his ability to inspire confidence but at the end of the day, he must enact policies that will solve the current crisis without creating new ones. Let’s take a closer look at some unintended consequences alive and well in today’s world:

1) The salary cap on executive pay. President Obama has decided that executives at banks who hold toxic assets and are in need of taxpayer assistance don’t deserve to be paid a customary salary. That sounds like good justice at work but might there be some unintended consequences looming around the corner? The performance of U.S. banking lies at the center of the global economy and it is important that we attract the best and brightest. Who is going to want to lead the mighty Bank of America (BAC)/Merrill Lynch/Countrywide conglomerate that controls such a massive portion of our nation’s future? Like it or not, Bank of America has mega influence over our lives and I wonder who will want to run it for $500,000 when non-TARP can pay millions upon millions.

2) Buy American. The ‘buy American’ provisions proposed in the stimulus package only serve to infuriate global competition that has become such an essential part of the American lifestyle. Limiting competition unearths many unintended consequences such as mediocrity, limited trade, and artificial growth.

3) Mark to market accounting. This regulation was passed in the aftermath of the Enron scandal as a preventative measure against corporate deception. As an unintended consequence, this regulation has actually deceived the globe into thinking that a large chunk of our financial system is no longer solvent because of the short term devaluation of the mortgage backed securities that many of our banks carry on their balance sheets. Those who champion the principle of transparency aren’t intelligent enough to see the collateral damage and the true flaws in the timing of such marks. This valuation method caused Wall Street to get ahead of itself during its time of growth and it caused Wall Street to overreact and crumble during the housing correction. We need a more stable system.

4) Printing too much money. By going to such extremes in all things stimulus, interest rates, bad bank, etc... the government is printing a lot of new money that will be in the system once the economy turns. Inflationary plays could be a major investment thesis as these programs mature.

Now that the government is at the center of all economic recovery efforts, let's hope that solving one crisis doesn’t create another. The theme of unintended consequences is a big one for investors to grasp. Being able to identify such events can be very profitable. Right now it is looking like non TARP banks like Goldman Sachs (GS) and Morgan Stanley (MS) will attract all of the top talent and therefore lead going forward. It also looks like US Steel (X) and Nucor (NUE) will get a concentrated portion of the materials contracts for the roads, bridges, and tunnel projects built into the stimulus package, and it looks like short plays on bond funds like TLT might have nice returns if inflation creeps in and we continue to tick off the large international holders of such assets by only ‘buying American’.

Disclosure: Long LONG XLF.

Comments

[Eric K.:]

On mark to market ... I completely disagree. Marking to market might have encouraged false confidence in the past few years as asset prices inflated into fantasyland - but competent risk managers should have recognized that, and managed their business as well as their compensation level implied they could. Blaming the accounting rule is weak - shooting the messenger that is revealing to us now that these risk managers were in fact not competent. The transparency the accounting rule provides is important, and the marks reflects the current market value - what the assets (and the company) are worth today, like it or not. The consequence was not "unintended" - it was fully intended.

If YOU think the assets will truly be worth more in the future, then by all means put your money where your mouth is, and buy the stock! Thanks to the accounting rule, at least you understand the magnitude of the risk you're taking....

Sure, SOX is costly and bothersome in many respects - but so is insurance. Costly, and necessary.

Feb 06 10:41 AM

[socrateazz:]

The Idea of mark to market is actually good in some ways and accounting on a cost basis has many advantages. My thought is do both and average. A small downturn will not mushroom into a great problem as quickly as that which just conciders the market price but still gives some asset value if temporary inflation becomes a problem. Things are the way they are for a reason. Change usually causes other problems. Before making changes one has to really concider why things are the way they are. And what could happen as the result of that particular change. For millinea people have acted from various beliefs without concidering the consequences adequately. Some actions have improved the world. Others have appeared to improve things but instead led to disasters. I fear the current decisions may cause results no sane person wants. We will see! My idea for stimulus: Goal: more folk working, help industries survive, and help keep standard of living within acceptable range. Problem: those with money are not spending! Too many people have too little discretionary monies, and the poor have few choices to improve their lives! My stimlus will not solve any of these problems but it will help. The key is to get some monies out of the hands of those who have it and into the hands of those who need it. I believe You need healthy companys to increase jobs. To make companies healthy one needs incentives. My thought: Why don't we encourage companies to hire and keep employees with a tax incentive like take fed unemployment rate subtract 5% then multiply by hours employees work and multiply that by .10 and allow that result to be a cost deduction on any companies taxes but be counted toward that companies reported income. Many advantages are available under that situation including incentive to keep and hire workers. stronger business balance sheets and allow the strongest earning companies to hire more workers for tax advantages. I would make that permanent though. If government choises to tamper with it. You could guess what would happen to it

Feb 06 10:43 AM

[Harry Tuttle:]

Private companies can pay whatever they want if the shareholders approve.

Government entities have caps because the taxpayers, right or wrong, want caps.

Once the banks receive government money they are no longer free to make their own decisions.

Does this mean we will miss on the great superstar trader at one of OUR government supported institutions? I am will to take that risk. If I want to speculate I can always do it on my own.

Feb 06 10:56 AM

[ilovesum:]

The management issue is pretty simple;
1 they should get 30% guaranteed wage , 70 % options.
2 the options should be held for min 5 years and only redeemed
at a max amount that they recieved per year .
3 they cannot redeem options within 6 months of corporate share buy backs . This falsely inflates the share price .

Holding the options for 5 years would compel the management ensure the future of the company not just today .
Angelo Mozilla from Countrywide sold hundreds of millions of dollars of options in 2006 at the peak of the housing market . I'm sure he would have done things differently if he was still holding his shares today.

At the very least he would have taken the same loss as the rest of the shareholders instead of walking away like a bandit. He runs the company thus has inside information, who would know better when to sell at the peak ?

The management has no incentive to think about the company , the future , the shareholder or anybody else. Having them hold the options for 5 years would give them some incentive.

Feb 06 11:15 AM

[waf76:]

1. I say cap all these CEOs. They don't like it, go work overseas. Their prior year bonuses is the money that's missing from the middle class' 401ks.

2. Buy American - Very foolish, the US companies who seem to be thriving despite the downturn are our multinational companies who's overseas sales, once converted into dollars, made huge profits.

3. To blame accounting rules is ridiculous. I agree SOX may have been a bit excessive to small to mid size companies but big banks had to be compliant with FDICIA so the transition to SOX shouldnt have been very difficult. Also mark to market is a step towards adopting IFRS. We want companies valued on their books at what they're worth, not what they paid for them. Also, we dont want companies to hide their debt financing activites with off balance sheet items.

4. Thank God the dollar is the world's reserve currency. It is for this reason we will not crash and burn like the UK. Inflation is coming but when it does the Fed is in position to raise rates and control it pretty well. Rates are zero now so this is where I think they have the most flexibility.

Feb 06 11:18 AM

[andyjd:]

The banking industry will shrink in the course of continued deleveraging. So bonuses and salaries of will shrink too. To put a cap on salaries is just accelerating this desirable process.
With existig salary models incentives for bank managers were wrong set anyway. Egoism was honored instead of responsible behavior. The banking industry has to come up with responsible salary models that support responsability. Until this happens it is okay to put a cap.
I think Obama is just showing leadership which was obviously lacking to the previous administration.
Free market did simply not correct for criminal behavior (Madoff, extended mortgages allowed for those who cannot afford, securization of such without possibilty to trace back)

Feb 06 11:27 AM

[endoftheworld:]

1. Salary Cap - why should some jackass be paid millions for driving the company into the ground? Why are they the "best & the brightest"? There are probably lots of superstars who'd work for $500K to lift a company out of near death. If they can prove their mettle, they'll make millions later.

2. Buy American - what does this even mean? Nike shoes are designed & manufactured by Nike - IN CHINA - does that make them chinese?

3. Mark to market - what's wrong with this? do you never get a margin call when you're broker feels you may not be able to pay back your loan? Don't borrow so much then. A house worth $150K listed on the books for $500K should stay on the books for $500K indefinitely? It will NEVER be worth $500k unless another bubble arises. Sure over time, prices will rise over time, but indexed to inflation the rise will never be to the extent of the bubble price , the only way the asset prices will reach the absurd values they are on the books at is via another bubble or via some other supply/demand imbalance. You can't ignore a problem by calling it something else.

4. Printing too much money - yes - inflation is coming..

Feb 06 02:10 PM

[User 352422:]

Why doesn't Obama just decide whom would make the best bank boss, and force him to take the job. We are Communists, aren't we?

Feb 06 02:20 PM

[James Wilson:]

What did JEB BUSH and KARL ROVE get out of Lehams ?

Two BUSH PRESIDENTS and 2 banking failures will we ever learn ?

Feb 06 05:51 PM

[Joel87:]

I agree with the majority, I do believe that the salary cap will deter great leaders and only attract mediocre management. Now, #2) I know many disagree with me, but I doubt this will create a trade war, the buy American provision does not create tariffs and does not disencourage American citizens from buying imported goods, it is far from the protectionism many have been screaming. It is merely serving the purpose of the stimulus package; to stimulate the American economy and not the Canadian (or which ever nation that plans to flood us with steel once this bill becomes a law). Apart from the obvious connections with the automotive industry, I also believe the government are attempting to lead by example, They'll buy American steel, and we buy American Cars

Feb 06 07:34 PM

[hoover:]

I disagree that enormous salaries must be paid to attract so-called superb talent for top executives. I would suggest its a bogus economic theory floated in the media and in academic circles by the very wealthy. Why do I think this? First, gross failure and incompetence have been obviously displayed by the overpaid heads of the biggest banks and auto companies. Obviously they are not paid for performance. Also, in the bowels of most big corporations (which I served for 33 years) there are talented people that perform most of the corporation's "thinking and managing" work. The range of pay in this large group of middle people (managers, engineers, supervisors, legal staff, buyers, department heads, project chiefs, sales managers, and many others) range from maybe $60,000 to say $300,000 or so at many corporations. If you look at manufacturing labor (another essential component) it may range from $25,000 to $50,000 or so. So, why do you have to pay $20 or $40 million (basically a lottery winner) for REAL talent for a hotshot CEO? The Chinese get talented very successful big biz CEO's for $100,000. Common sense tells me that CEO's are worth only a fraction of what they make and they should be fired regularly for incompetence like evryone else.

Feb 06 09:18 PM

[Michael K:]

This is 2009, not 1930, and America has a huge trade deficit. We are not the manufacturing and export nation that we once were, and retaliatory tariffs aren't going to hurt anyone but the nations making them. Do you think that Canada, Mexico or China can afford to endanger the US Market? An intelligently implemented Buy American policy, especially for infrastructure materials, will help spur the US Economy, which ought to be the point of a stimulus, work on helping the global economy can come later.

Feb 06 11:06 PM

[max12345:]

Regarding #1: - salary caps and retaining the best and the brightest.

First of all America's (or any country's) so called "best and brightest" are not the folks working on Wall Street (or its equivalents) they are the scientists and engineers diligently working away in university, government and private sector research labs and R& D departments who come up with the inventions and technologies that create true wealth. And they all earn normal salaries and on occasion win Nobel Prizes to round out their incomes. So could we all please stop with the myth that the "best and brightest" work on Wall Street and with the other self-serving myth that they must be attracted, motivated and retained by humongous salaries and outsized bonuses. There are plenty of highly capable people all over the place who would love to work on Wall Street (assiduously) for the salary of the U.S. president.

Regarding # 2 - buy American - It won't work anyway and will only annoy our trade partners. Let every American who thinks he or she can "buy American" simply quietly do so. (if they wish to, and most have been proven not to care in the least, since they buy based on either quality or price, and hardly ever sourcing)

Regarding # 3 - mark to market accounting. It may well have been a well intentioned idea but it is misguided. The cost or price (let alone the value) of things cannot be determined exclusively and only by the price the market assigns to them at any arbitrary point in time. Somebody needs to come up with something better and more meaningful.

Regarding # 4 -printing too much money. Money that is printed and injected through so called "quantitative easing" later needs to be "mopped up". (which means paying for it) To avoid the Weimar Republic or Zimbabwe it's probably best not to print too much of the stuff in the first place. (or the absolute minimum that is absolutely necessary to get the job done)..(and does anyone know how much that is?) (or maybe we should ask some of those "best and brightest" on Wall Street who are now at Treasury and -by comparison - are now working for peanuts? (or should we add a couple of zeros to their salaries before they might be willing to tell us?)

Feb 07 09:21 AM

[max12345:]

Dear Max 12345

I couldn't agree with you more.

Max 12345

(it never hurts to lighten up a bit!)

Feb 07 09:34 AM

[Bud K:]

The argument that the top talent will navigate to non-tarp banks has limitations. The so-called "top talent" got us into this mess and I certainly don't want them picking up where they left off. Also I agree totally with "buy American. Foreign governments have been subsidizing their industries for years and have been able to undercut our prices dramatically. Time to even the playing field. I didn't vote for Obama but I am having second thoughts. Go America!

Feb 07 10:07 AM

[Econ 101:]

The "talent" that got us into this mess is in Washington. They pushed for low standards for loans for houses. They are pushing too much money into the system that will result in hyper inflation. They wont let the system correct itself so middle class people can survive. They want all of us to be poor and dependent upon the dole from washington. Barney Frank, Nancy Peolsi, Chris Dodd and Bill Clinton are the culprits along with many others going back the "the great society" where we were lead to believe we could aford both guns and butter.

Feb 07 11:16 AM

[skwestorange:]

I think mark to market should be replaced with mark to real world experience with defaults. That is carry assets at their cost and mark them down each quarter based on the previous three quarter average default percentage. This way, we have a reasonable way to value assets based on the real world experience and markdowns will be smooth and gradual not to disrupt the balance sheets based on irrational fear/guesses.

Feb 07 12:32 PM

[Roland Cycan:]

"...the short term devaluation of the mortgage backed securities
..."

If the market believed the devaluation was short term, people would be rushing to buy them. Can you show me, please, that the devaluation is short term. I believe that it is long term.


And, I agree with the sentiment expressed by Brahm about protecting investors. How would you feel if you bought a stock based on its financial statements, only to be told shortly thereafter, those assets on our books, well the fair value of them is only 50% of what we are carrying them at on the statements? You'd have been lied to and screwed and you'd be right to be mad as hell.

Feb 07 01:13 PM

[ChipSeal:]

Unintended consequence number one (Salary caps) is causing consternation at GE. Their media conglomerate will see all the talent walk away if say, David Letterman an only be paid $500,000!

Now you know why the talking heads on "news" shows are so alarmed at this!

Feb 08 10:53 AM

[M-P:]

Many of these consequences have been debated ad nauseum ... the salary cap piece is political symbolism - most have been grandfathered and the main part of total comp has not been salary ... the best and the brightest comment is amusing, if not inane. If the salaries over the last few years at GS, Countrywide, BAC, ML, etc., etc., are directly related to the "talent" that was/is there, please define talent for me - get real specific. A talent for malfeasance and literally mortgaging one's future on specious bets and vegas-style risks is not "talent" in my mind. The best and brightest and the comp correlation is weak at best - think politics, business, sports, etc. Also, the bottom line on the mark to market is the underlying asset - it was often too risky, too opaque, and too hard to value. The mark is part of the issue in illiquid, hard to value markets (mark to model markets), but the other issue is the asset itself. Risky decisions have consequences - in the mark case, it's more immediate - hopefully, the bank's, etc. decisions are within a portfolio of decisions that balance risk and prudence. The mark issue seems like a false dilemma.

Feb 08 03:30 PM