How Bailouts Are Messing with Capitalism 30 comments
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We have a new F word: failure.
One unhappy hallmark of the Great Recession is a dramatic spike in financial distress. Moody's predicts that the default rate on corporate debt--which helps foretell bankruptcies--will be three times higher this year than in 2008. Home foreclosures are already at record highs, and going higher. Defaults on credit cards and other consumer debt will crest right behind mortgages.
The Obama administration is on the case, bailing out banks and homeowners and aiding dozens of industries either directly, through a financial-rescue scheme that could top $2 trillion, or indirectly, through the $787 billion stimulus bill. Automakers, furniture companies, real estate developers, and even porn magnates have their hands out.
Those efforts ought to help soften a sharp recession. But the unprecedented aid to the private sector may also unleash new problems, the way antibiotics have generated stronger strains of bacteria. "There's something fundamental about the need for failure," says Syd Finkelstein, a professor at Dartmouth's Tuck School of Business and author of Think Again: Why Good Leaders Make Bad Decisions and How to Keep It From Happening to You. "We're tinkering with the genetic DNA of a capitalist society."
Before “failure” became an unspeakable word, entrepreneurs understood that most business ventures in America fail--producing acute lessons that have helped make America fabulously prosperous. In the 1870s, for instance, there was a five-year depression, followed by a historic era of mechanization that destroyed old industries and generated new ones at a pace nobody had ever seen. "It was a time of terrific insecurity," says James Grant, founder of Grant's Interest Rate Observer. "It was also a golden era of dynamism." Landmark companies like IBM (started in the 1880s), Johnson & Johnson (JNJ) (1885), and General Electric (GE) (1892) date from that time.
Other familiar companies have their roots in failure--either their own or somebody else's. Upstarts Nike (NKE) and Reebok gained a foothold in the 1970s because their established competitors--Converse and Keds--failed to foresee the boom in running and aerobics. Toyota (TM) has relentlessly exploited the failure of Ford (F) and General Motors (GM) to satisfy their customers. IBM went through a near-death experience in the 1990s after betting wrongly that the old mainframe would dominate the PC--a painful experience that the company's leaders now tout as a crash course in adaptation.
Failure is personally enlightening, as well. "Ask 100 people, 'What have you learned from success?' and most of them will just look at you," says Don Keough, former CEO of Coca-Cola (KO) and author of The Ten Commandments for Business Failure."But ask what you learned from failure, and you'll get lots of answers." One of Keough's most painful failures was the 1985 introduction of New Coke, which market researchers predicted would be a hit. It was an instant flop. "The whole process made me a professional skeptic," he recalls. "I learned to look beyond data and apply common sense."
Saving companies from their mistakes short-circuits that kind of learning. Chrysler, for instance, got its first government bailout in 1980. It recovered, but it is now burning through another $4 billion in government loans–and asking for $11 billion more. The unseen harm of floating weak businesses is the "opportunity cost": What might have happened if more nimble, innovative companies got a chance. "The American [auto] industry would be much stronger today if Chrysler had been allowed to go out of business in 1980," insists Jack Nerad of kbb.com, a car research site.
Banks are a special case, since the capital they provide is the lifeblood of capitalism. But billions in aid to huge, struggling lenders like Citigroup (C) and Bank of America (BAC) might be counterproductive. A recent study by New York University's Stern School of Business, Restoring Financial Stability, argues that the government has been too generous to bailed-out banks, giving them up to $70 billion more than necessary. A better approach, the study argues, would be to plump up healthier banks, while letting market forces determine the fate of sick banks.
The bank-rescue plan unveiled by Treasury Secretary Tim Geithner–the Public-Private Investment Partnership--seems to go in the opposite direction. Under the plan, the government would heavily subisidize private purchases of so-called “toxic assets” from banks. It could restart the market for these assets and help banks clear them out. But because the government will bear most of the losses if it doesn’t work, “it amounts to yet another subsidy to banks,” says Dirk van Dijk, director of research for Zacks Investment Research. And even then, he says, the government may still have to nationalize some of the most troubled banks.
There’s another mechanism for dealing with insolvent companies--bankruptcy protection. Once failing companies like GM declare Chapter 11, the NYU study contends, the government could offer loans to help them restructure. Bankruptcy judges have broad power to boot existing management, cut executive pay, and order sweeping changes. And if liquidation looks like the best option, the company probably went too far astray to be saved.
That’s clearly what happened at AIG, where disastrous bets made by a small financial trading division essentially wrecked a conglomerate built mostly of healthy insurance businesses. But AIG is considered too important to consign to an indelicate bankruptcy process. Since it insures hundreds of the world’s biggest institutions–and held nearly $3 trillion worth of derivatives contracts with trading partners worldwide, as of last fall–its collapse could have triggered a chain reaction of institutional-level bank runs. So instead of letting AIG fail, the government executed the biggest corporate bailout in American history, totaling $180 billion so far. The outrage over $165 million in bonuses for executives of that very same division may mark a turning point in Americans’ tolerance of bailouts.
AIG’s lengthy tentacles make it “too big to fail,” which is why Obama and Geithner are pushing for new laws that would allow the government to take over the biggest institutions if they become insolvent and threaten the rest of the economy. Another solution might be to downsize the biggest firms until they are small enough to let fail. Once they’re out of the way, better-run firms will be able to take their place, and free enterprise will no longer come with a government warranty.
Disclosure: no positions
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From childhood we yearn for a parental leader with God-like power and infinite resources to protect us all in economic downturns. There is an inherent drift towards "too big to fail" government and corporate entities.
After centuries of government growth, privatizations in recent decades began to address to some degree the risks of big governments and their agencies that were "too big to fail" (albeit with notable sacred cows in most countries...what's the future for Freddie Mac?).
However, corporate management is naturally tempted by a lust for profit via more scale, more employees and more power, even when the costs of large scale coordination start to exceed the value added from economies of large scale.
It would be interesting and useful to see leaders of so-called "too big to fail" corporations simply forced to reduce the risk of failure, if necessary by reducing scale (i.e. via spin offs, closures, not just acquisitions & mergers) precisely to eliminate "too big to fail".
Recessions naturally encourage the elimination of too big too fail corporations and the growth of dynamic new corporations from their remains. Now is the time.
There is nothing to fear from this process except delay, but this requires political will, firm regulation and balanced boards of qualified, resourced independent directors to motivate corporate leaders to execute the optimisation of their corporations.
Please keep banging this drum.
On Mar 29 01:23 PM Mike smoth wrote:
> This is another silly article from somebody who grew up during the
> Regan era and thinks that such dogma as the absolute truth and is
> unhappy to think of anything different. The reality is that a lot
> the bad things that are happening today in America comes from decisions
> made during the Regan era and his attacks on government. I agree
> with Regan that government can be inefficient however; the inefficiencies
> of governments exist because it works with the tax payer’s money
> and it has to be accountable for it or people vote politicians out.
> That’s no secret and we ALL realize that but that’s no reason to
> destroy of all the government and create a cruel society with everyone
> acting only on their self interest. This type of attitude just destroyed
> Wall Street.
>
> As inefficient as government can be it has added great value in our
> society by making sure that the conditions exists for ALL American
> and not just a few to the opportunity for a better life. Government
> can make investment with generational value that private industry
> in incapable of doing. That’s why government can do such things such
> as the Louisiana or Alaskan purchases or build a cross country highway
> system than when first built were roads to nowhere but they are now
> roads to somewhere. The value of these government investments were
> not realizes for generations. It is the same thing with investments
> in education, energy, etc.
>
> I am happy that you use IBM, JNJ and GE as example of companies that
> came of out times of Depression because the reasons these companies
> came out of hard times it was because they had government contracts.
> Take IBM as an example, what allow IBM to succeed initially was a
> huge government contract to provide machines for the US Census. This
> government investment gave IBM the capital to generate profits and
> sustain the company for another round of innovative ideas in the
> future.
On Mar 29 09:49 AM Miken wrote:
> With regard to the auto companies, I believe that everyone is overlooking
> the fundamental issues. I don't think there is any doubt that the
> current Wall Street fiasco has damaged the ability of the American
> based, and even foreign based companies to survive. But even before
> the Wall Street mismanagement, the American companies were in a state
> of decline. The central question should be why the American companies?
>
>
> I don't think the simplistic answer is management or unions. I believe
> the simple answer is a view of the people running the country, and
> those on both coasts that a healthy manufacturing sector is passe
> and not important. The reasons I have drawn that conclusion are
> the following:
>
> 1. There is no articulated industrial policy. What do we think a
> manufacturing base should look like? What are the policies that
> should shape our industrial policy? Have we developed the infra
> structure to support our vision? There apparently is no appetite
> in Washington, or anywhere else in the country to have a dialogue
> on this.
>
> There certainly is in countries that are emerging as the new manufacturing
> base in the world order. In countries such as China, Mexico, South
> Korea, Japan, Thailand, etc. there is a very clear priority given
> to the manufacturing sector because they recognize the economic value
> stream connected with making things.
>
> 2. More fundamentally, is a manufacturing base important? Or should
> the country try to exist on retailers, services, and shuffling other
> people's money around (Wall Street)? I don't think so. See the
> value stream discussion in item 1.
>
> 3. What is our energy policy? The beginning of the current crisis
> for the American based auto companies was the sudden spike in gasoline
> prices because we have continued to let ourselves vulnerable to foreign
> despots and royal families whims to control energy prices. At $1.50
> per gallon, customer preferences are significantly different than
> at $4.50 per gallon. Were the American companies asleep at the wheel,
> or were they better at building larger cars and trucks than the foreign
> companies? Were they callous or were they giving the customers what
> they wanted? The evidence suggests the latter. Toyota, Honda, Nissan,
> BMW etc. all where trying desperately to break into the truck market
> without much success.
>
> When our foreign dependence allowed a drastic change in energy costs,
> not only were the American companies caught off guard, but others,
> especially Toyota was closing plants delaying start ups, etc.
>
> I don't care if prices are high or low, the auto companies can exist
> in either scenario. When Washington decides to address this, it
> will help them develop better strategies. After all, most of the
> American companies have world wide operations that were doing just
> fine making small economical cars using a variety of fuels from CNG
> to ethanol.
>
> Too long for a post, sorry, but I don't buy the simplistic answers
> to the question, "what's wrong with Ameican companies?".
1) Nationalize (for a limited time as an option) the institutions that hold credit-default swap obligations that pose systemic risk (this will allow item (2) without inducing cardiac arrest in the judicial system).
2) Limit the credit-default swap claim liability on long/speculative contracts to the premiums paid in, not their full-face value. Remember ’speculators’ are not net-owners of the underlying assets (CDO’s). This is possible to figure out in spite of the tangled mess.
3) Honor in full long/hedged contracts up to the insured risk - but no more. Remember, real derivatives are a sum-zero game. We must get back to that.
In this solution speculators will be made whole but not collect the lottery-size payments that Geithner/Paulson have been awarding so far. These speculators (including major investment banks that both hedged CDOs and speculated their collapse) bought these insurance policies in good faith on the assumption that they would be allowed to speculate in this unregulated, uncollateralized market. Unfortunately, from the taxpayer’s point of view this was absolutely wrong. That would mean that the gambling derivative writer could make the taxpayer the risk-provider of last resort. Think about it (Geithner and company would prefer you didn’t), if they are allowed to unwind all these contracts over the contract period (5-years on average) then the taxpayer does wind up paying off these losing gambling bets.
Under normal bankruptcy laws, failure to pay claims would wind up in court. But in this case, the sheer size of the money at stake would, no doubt, freeze-up the court system. I’m sure Obama’s team has considered this consequence, but if the government were to take ownership of these contracts the power of a Presidential Order or Act of Congress is at hand and can mitigate a seizure of the courts.
This solution suggests that the fairest way to end this crisis would be to limited payment to the investment bankers who bet that the housing bubble would burst. Deny them their Frankenstein, credit-default swaps. Did they not take advantage of a laisse-fare regulatory environment? Was the Fed AWOL with regard to these new derivatives? Were swaps at the heart of CDOs and the reason they were given AAA-ratings - in spite of their C- components in the first place? The issue must be presented in simple to understand terms. Beware of efforts to suggest the contrary and think about whose interest is being served in doing so.
Or has huge union influence.
You'll be OK.
wasn't the point of the stress tests to determine who we would let go and where we would put their assets. I think there will not e any real stress tests as the government has said they won't let a big bank fail.
the above was a headline from Bloomberg. I'm tired of getting lied to by these guys.
AND...we blame deregulation, free markets, and capitalism!
Will someone please kick me in my next life if I don't go into government work! It seems to be the only sure, easy thing in life.
Actually, I thought that was the job of the BOD and shareholders.
If this makes them feel better, so be it.
Who is John Galt?
On Mar 29 09:49 AM Miken wrote:
> With regard to the auto companies, I believe that everyone is overlooking
> the fundamental issues. I don't think there is any doubt that the
> current Wall Street fiasco has damaged the ability of the American
> based, and even foreign based companies to survive. But even before
> the Wall Street mismanagement, the American companies were in a state
> of decline. The central question should be why the American companies?
>
>
> I don't think the simplistic answer is management or unions. I believe
> the simple answer is a view of the people running the country, and
> those on both coasts that a healthy manufacturing sector is passe
> and not important. The reasons I have drawn that conclusion are
> the following:
>
> 1. There is no articulated industrial policy. What do we think a
> manufacturing base should look like? What are the policies that
> should shape our industrial policy? Have we developed the infra
> structure to support our vision? There apparently is no appetite
> in Washington, or anywhere else in the country to have a dialogue
> on this.
>
> There certainly is in countries that are emerging as the new manufacturing
> base in the world order. In countries such as China, Mexico, South
> Korea, Japan, Thailand, etc. there is a very clear priority given
> to the manufacturing sector because they recognize the economic value
> stream connected with making things.
>
> 2. More fundamentally, is a manufacturing base important? Or should
> the country try to exist on retailers, services, and shuffling other
> people's money around (Wall Street)? I don't think so. See the
> value stream discussion in item 1.
>
> 3. What is our energy policy? The beginning of the current crisis
> for the American based auto companies was the sudden spike in gasoline
> prices because we have continued to let ourselves vulnerable to foreign
> despots and royal families whims to control energy prices. At $1.50
> per gallon, customer preferences are significantly different than
> at $4.50 per gallon. Were the American companies asleep at the wheel,
> or were they better at building larger cars and trucks than the foreign
> companies? Were they callous or were they giving the customers what
> they wanted? The evidence suggests the latter. Toyota, Honda, Nissan,
> BMW etc. all where trying desperately to break into the truck market
> without much success.
>
> When our foreign dependence allowed a drastic change in energy costs,
> not only were the American companies caught off guard, but others,
> especially Toyota was closing plants delaying start ups, etc.
>
> I don't care if prices are high or low, the auto companies can exist
> in either scenario. When Washington decides to address this, it
> will help them develop better strategies. After all, most of the
> American companies have world wide operations that were doing just
> fine making small economical cars using a variety of fuels from CNG
> to ethanol.
>
> Too long for a post, sorry, but I don't buy the simplistic answers
> to the question, "what's wrong with Ameican companies?".
_/_/_/_/_/_/_/_/_/_/_/_/
Any thoughtful person reading this should also consider the word "future". And by that I do not mean "future failure", rather looking to the future. It's of course paramount that we deal with the present, since this affects our daily lives and the hope of the future.
_/_/_/_/_/_/_/_/_/_/_/_/
One unhappy hallmark of the Great Recession is a dramatic spike in financial distress. Moody's predicts that the default rate on corporate debt--which helps foretell bankruptcies--will be three times higher this year than in 2008. Home foreclosures are already at record highs, and going higher. Defaults on credit cards and other consumer debt will crest right behind mortgages.
The Obama administration is on the case, bailing out banks and homeowners and aiding dozens of industries either directly, through a financial-rescue scheme that could top $2 trillion, or indirectly, through the $787 billion stimulus bill. Automakers, furniture companies, real estate developers, and even porn magnates have their hands out.
_/_/_/_/_/_/_/_/
I was raised to believe in working for what we have and not relying on credit to fuel my spending habits. As I grew older and left the shelter of my parents home and their watchful eyes, like everyone I was taken with the ease of garnering credit, then using either for my determent, or enhancement. For those with good business acumen, OPM (other people's money) allowed them to amass sizable fortunes, while others squandered it passing fancies and are probably today still paying off high interest credit card debt.
I suppose I'm left with a concern, and this is not reflective on what Obama may or may not accomplish, but what has credit done for America. Certainly it has allowed most to realize the American dream, but has that dream now turned into a financial nightmare. In my case (and probably by good fortune and not necessarily wisdom) I didn't borrow against my home, and thus I'm not now facing the dilemma of many Americas.
I'm certainly thankful for reverse mortgages (they allowed my mother to realize her dreams late in life), and loan mods may help money starve off bankruptcy, however are these present financial difficulties the darkness before the dawn, or the twilight before more financial darkness?
I've always believe in looking toward the future, thinking that if I fall, I need to get up again, and again, but that is self preservation and not government interventions. Should we all be able to walk through these shadows of financial gloom unscathed, I trust we will look to our roots (or our parent's roots) and gleam what is necessary to walk forward into financial prosperity without requiring government intervention.
That's my two cents, good post.
Ron
Why not use Public-Private funding instead of the above?
An FDIC sponsored and supported Economic Recovery Re-investment Plan.
This can be achieved by the government providing initial capital (let's say $1T) and the private sector providing another $4T for bailing out distressed companies not only the financials but also other companies in the other sectors of the economy.
Let's face it. There will be more distressed companies in the near future and they will keep on increasing in numbers and magnitude with mounting unpreventable bankcrupcies and spiraling unemployment until the economy can no longer sustain such loses and goes into unmanageable major dislocation that is going to threaten capitalism, the government, and even democracy itself if not arrested pro-actively at the present time.
But investors are not going to take the risk in such an extremely unpredictable economic environment in order for new re-investment capital to plow back into the economy and prevent further job losses and/or generate new jobs needed for an economic recovery.
The government has to establish an Economic Re-investment Bank.
Private companies and individuals can deposit (invest) into that bank. The gov't can use those deposits to bail out companies that are facing liquidity issues. Excess capital can be used to jump-start new promising businesses that may crop out of this economic crisis as new needs are going to surface out of this highly uncertain times.
There will be No interest payment on those deposits (investment) and a minimum holding period of 5 to 10 years is required.
Deposits are Guaranteed and Insured by the FDIC for the same period. Nobody is going to take the risk of bailing out distressed companies without government guarantee.
But, as soon as those companies become profitable, they are going to allocate proportional amount of net profit before tax back to the Bank. Likewise, any dividend those companies provide to their common shareholders must also be enjoyed by the Bank and it's depositors.
After 5 years minimum; Depositors (or rather Investors) can withdraw their funds together with the accumulated profits - if there is a profit, there will be no guarantee of any profit during and after 5 years.
Profits must not be subjected to capital gains tax nor dividend tax. Tax free and tax exempt. Quid-pro-quo.
The government makes profits on this Private-Public re-investment plan with their own $1T seed capital. Also the government will make more income through increased tax collection as the economy recovers. Better than nothing.
This is not a risk-free proposal. Privated depositors are still facing possible collapse of the Bank if the whole plan fails and the economy goes into unmanageable meltdown. Capitalism, the Government, and Democracy itself might get irrecoverably damaged as this economic crisis kept on worsening at an increasingly prolonged period of time.
We are now in the 19th month and counting starting Oct 2007. Time is not a friend with this mounting problems that are getting worse by the minute.
The time to act is now while the chances of success are still favorable rather than later when things got into Do or Die situation.
This proposal is going to end right here and now the public outcry against government using public money in order to bail out distressed companies.
Prevent civil unrest from escalating into a rebellion as the government finds itself quagmired into desperate monetary bailouts as the only means to prevent a major economy dislocation.
Use money from willing investors to bail out distressed companies instead of forcibly taking them away from reluctant tax payers.
OF COURSE those of us working for uncompetitive companies in dying industries don't want to hear it. But if our children are going to have any sort of viable future, listen we must.
Oh, Boo Hoo Hoo!
Hoover didn't bailout banks. He let them fail--hundreds and hundreds of banks failed.
As Doctor Phil would say, "How's that working out for ya?"
The whole point of bailing out banks is because it was one of the *major* mistakes to let banks fail that caused the Great Depression.
DOH!!!!!
First of all, it is "D'oh!"
"The whole point of bailing out banks is because it was one of the *major* mistakes to let banks fail that caused the Great Depression."
No. Miton Friedman was a smart guy, but you are possibly using his premise to mistakenly summarize TGD. Please consider reviewing something called "cause and effect".
Bank failures were caused by runs on banks by depositers to get their cash. But what caused the run on banks? Once TGD ran its course, what was the real reason the US recovered?
Please note that during the recovery, farmer Lucious P. Shortbloomers gave his cow an extra bucket of corn. Why do I bring this up? Because unlike the New Deal, Shortbloomer's cow feeding had no negative impact on the recovery even though it coincided with the recovery.