My post of Monday August 20 closed with the following comment: “as one reads a book like ‘More Money Than God’ by Sebastian Mallaby, one observes that lots and lots of money is made off of government mistakes. The problem is that generally the people that make the money off of these mistakes are people that have the information, the access, and the scale to take advantage of the mistakes. However, these 'tools' are not available to most people. Maybe that is why the distribution of wealth in the United States has become so skewed.”
Well, Steven Davidoff of the New York Times gives us a perfect example of this type of situation as he discusses the evolving consequences of the government bailout of General Motors (NYSE:GM). Let me just say before we get started that “government mistakes” can be split into two categories. The first relates to overt government mistakes like the British government trying to maintain an un-maintainable price for the British Pound in the 1990s. The result was the classic case of George Soros laughing all the way to the bank with billions of dollars.
The other type of mistake has to do with “unintended consequences,” the result of government action that may occur because the government either does not have the incentive to totally examine the results of what it is doing or the government does not have the same goals and objectives of the private investor. An “unintended consequence” gets this story started. Davidoff sets the scene. “GMAC (General Motors Acceptance Corporation) was the financial arm of General Motors. In the years leading up to the financial crisis, it was also GM's most profitable unit, which tells you something about the auto industry at the time. The company earned more profit from lending money to customers than in selling cars.”
Why did GMAC become “GM’s most profitable unit?” Well, in the 1960s, the U.S. government was very concerned with rising unemployment. In an attempt to keep unemployment as low as possible, the government established a policy of credit inflation to keep workers employed. The justification was something economists called “the Phillips Curve.” The Phillips Curve encouraged the government to inflate the economy because there was a tradeoff between inflation and unemployment. A little more inflation could buy the government a little more employment thereby keeping the unemployment rate down.
Milton Friedman showed this argument to be a fallacy because a little more inflation got built into inflationary expectations and this worked in the opposite direction of lowering unemployment. However, politicians got stuck on the first point and, in order to get elected or get re-elected, they (both Republicans and Democrats) they continued on with a policy of credit inflation into the 21st century.
Inflation, however, changes incentives. As I have written many times before, inflation results in people and businesses taking on more risk, taking on more financial leverage, mismatching the maturities of assets and liabilities, and introducing more and more financial innovation. People make lots and lots of money off of betting with inflation!
General Motors did this through GMAC and the subsidiary became “GM’s most profitable unit.” But General Electric (NYSE:GE) also did this and more than half the profits GE earned came from its financial wing. And, this was true of other “major” U.S. corporations.
Yes, people were kept employed but General Motors did not have to focus on productivity or labor skills or “selling” cars. It could focus on keeping its labor unions happy with “good” labor contracts and as an unintended consequence, GM became uncompetitive. But GM executives benefited greatly from the profits now coming from the financial side of the business.
I won’t go deeply into the situation described by Mr. Davidoff because he does a very good job at explaining what is going on. What is important is that what is going on is a result of another “unintended consequence.” The government’s objective in resolving the bailout as the Treasury Department stated was “to exit in in a manner that balances speed of recovery with maximizing returns for taxpayers.”
As Mr. Davidoff goes on to explain, “That’s the problem with companies being bailed out. They’re no longer as entrepreneurial or risk-taking as they might be, and instead have to balance gains against a need to pay back the government.”
The situation: GMAC became Ally Financial. But GMAC was not just about financing automobiles. “The company was also one of the largest subprime housing lenders through its ResCap subsidiary.” ResCap is the fifth-largest mortgaging service and origination unit in the nation. Thank you, credit inflation!
ResCap has lost billions during the Great Recession and Ally has subsidized this loss lending ResCap $1.2 billion and also infusing $10.2 billion into the subsidiary since January 1, 2007. That is, until recently. Ally Financial put ResCap into bankruptcy. And, here we get to Mr. Buffett.
In the bankruptcy of ResCap, the company was to split up into two parts, one part consisted of the mortgage servicing and the other part was a legacy portfolio of mortgages with $5.2 billion in loan principal. Ally initially “announced its intention to serve as a stalking horse bid for the legacy portfolio, bidding from $1.4 billion to $1.6 billion.”
Ally has now dropped out. Guess who showed up? Berkshire Hathaway (NYSE:BRK.B) … which, by-the-way, is one of Ally’s biggest creditors. Berkshire has now replaced Ally as the “stalking bidder” for the loan portfolio.
Although the outcome of this bidding will come in bankruptcy court auction, Ally will not be a part of the bidding: Ally, which has lost billions of dollars in the portfolio. They leave just at a time when there is some indication that the housing market might be getting stronger so that there seems to be a growing possibility of getting something more back from the loans.
The government apparently believes that it cannot wait because the outcome of acquiring the loans is uncertain and “working out” the loans would take an extended period of time. “When the government is your lender, paying back the money is your first goal.” So someone in the private sector stands to gain a lot of money from this transaction -- and that “someone” is not the “small person.”
As I stated in the August 20 post, “generally the people that make the money off of these (government) mistakes are people that have the information, the access, and the scale to take advantage of the mistakes. However, these ‘tools’ are not available to most people.”
As Mallaby suggests in his book, these returns are “alpha” returns, returns that are not dependent upon the movement of the whole market. Governments, acting on the best of intentions, seem to create a relatively large number of these “alpha” opportunities. And they are not kept a secret and they are legal. Our job is to look at what the government is doing and determine what are the “unintended consequences” of the government’s action and then take advantage of it.
Mr. Buffet and Mr. Soros seem to be good role models for us to follow.