A Capitalist's Letter to President Obama

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Includes: DIA, FMCC, FNMA, GM, KBE, MCO, QQQ, SPGI, SPY, XLF
by: Gene Chan, CFA

Dear President Obama,

I had always been a supporter of you, precisely because you are not married to any particular ideology, and you have an ability to listen to varying opinions, weigh their merits, and ground them on reality.

I am writing to you because your heavy-handed economic policies are too interventionistic for their own good. I previously wrote about Capitalism in Jeopardy, where I feared that governments all over the world will use the recent credit crisis as an excuse to enact various protectionistic and socialistic economic policies, undoing human progress over many decades past. My worst fears are beginning to take hold.

I will not go as far as naming you a socialist, as I remain convinced that your decision-making process is not overly hindered by any ideology. Which is why I even attempt to make a free-market capitalist's case to you at all.

First off, I want to debunk a common misconception that the mortgage crisis was a failure of the markets. On the contrary, the private sector did their ordinary profit-seeking thing, but it was the government's policies that were the prime drivers of the mortgage bubble:

  1. The Federal Reserve maintained an artificially low interest rate for over a decade, enabling cheap credit that caused a cascading effect down to the regular consumers who maxed out their credit cards and took out mortgages they couldn't afford;
  2. Fannie Mae (FNM) and Freddie Mac (FRE) were created as government sponsored entities, with the mandate of increasing home ownership, again with the overall effect of encouraging low quality loans made to borrowers living beyond their means;
  3. The government sanctioned status of the rating agencies (S&P (MHP) and Moody's (NYSE:MCO)) were given too much influence, enough to convince investment funds to treat AAA-rated mortgage-backed securities as golden, when in fact they were junk.

It is not hard to imagine that without the low interest rate, the credit bubble would not materialize. Without Fannie and Freddie, the supply of loans made to credit-unworthy borrowers would be significantly limited. Without the rating agencies, investment funds would rely more on their own research when purchasing these structured products.

The cure for misguided regulations is, of course, not more regulations, but smarter regulations. Now, it is very difficult to pass smart regulations on economic matters, mainly because the free market, when left alone, is a well-oiled machine that functions efficiently the vast majority of time.

However, I am not implying that the government should never intervene in the economy. Contemporary economics identified some cases of true market failures, for example: instances of externality, monopolies, the free-rider problem of public goods etc. The trick is to identify if a particular fall-out was caused by a true market failure, or if it is the remnants of some previous misguided policies.

I agree with Keynes that "in the long run, we are all dead." There are merits to his supply-side economics - the government has a role in resuscitating an injured economic by spending stimulus money. But let's not weaken your stimulus package with any ulterior agenda. I don't have to remind you of the global backlash you received upon inserting protectionist language like "Buy American" into the stimulus bill.

Congress's fiasco over the banks' executive compensation did more harm than good. If the terms of compensation were not stipulated originally when the TARP money was handed out, we should not dictate them retroactively. However, if we do dictate, it makes the banks reluctant to take the money, which reduces the effectiveness of TARP in resuscitating the credit market. There is no free lunch - tinkering with the market in one place causes unintended side effects in another.

Recently you ridiculed the bond-holders of Chrysler for not compromising their loans in order to save the company. You said "I stand with Chrysler's employees and their families and communities, not those who held out when everybody else is making sacrifices."

You neglected that the lenders like hedge funds and investment firms have a fudiciary duty to their own investors to maximize return, and in this particular case they actually have a duty to bring matters to a bankruptcy court because that is where they can recoup most of their investments. The investors trusted the fund managers to look out for their interests. These fund managers bought into what they thought was the most senior of Chrysler's debt, but your proposal would effectively make them subordinate to the UAW union.

Imagine the consequences if this took hold. The hedge funds buying into senior debt can no longer be sure of their senior status. Going forward, this will make them less willing to lend, or they will demand a higher interest rate from the companies that need the capital. The investors will no longer trust the hedge funds in watching over their money, so they would either withdraw their capital, sue them, or both. End result is there will be less capital available to lend. And did you say you need the private investors' help in providing capital for your PPIP initiative? There is no free lunch.

The government should intervene to negate true market failures. But the bankruptcies of Chrysler and GM are not failure of the market; they are failure of Chrysler and GM themselves for producing crap that nobody wants. These companies should be allowed to fail such that they either restructure to become competitive, or, over time, have their labor and assets reallocated to other more productive enterprises.

An author of The National Review recently claimed that you declared a "War on Capital". I think that is still an unfair statement at this point. Once again I trust that you will judge these arguments on their merits alone, without ideological bias. Please carefully consider each economic policy you enact and err towards the side of non-intervention; we do not need another war.

Sincerely,

Gene Chan

Disclosure: No positions